PS Business Parks, Inc. (NYSE:PSB)
Q4 2015 Earnings Conference Call
February 17, 2016 01:00 PM ET
Ed Stokx - CFO
Joe Russell - CEO
Maria Hawthorne - President
John Petersen - COO
Craig Mailman - KeyBanc
Manny Korchman - Citi
Eric Frankel - Green Street Advisors
Blaine Heck - Wells Fargo
Michael Mueller - JPMorgan
Good morning. My name is Cania and I will be your conference operator today. At this time, I would like to welcome everyone to the PS Business Parks’ Fourth Quarter Investor Conference Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] Thank you.
Ed Stokx, you may begin your conference.
Thank you. Good morning and thank you for joining us for this fourth quarter 2015 PS Business Parks investor call. I am Ed Stokx, CFO of the company. And with me today are Joe Russell, Chief Executive Officer; Maria Hawthorne, President; and John Petersen, Chief Operating Officer.
Before we begin, let me remind everyone that all statements other than statements of historical fact included in this conference call are forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond PS Business Parks’ control, which could cause actual results to differ materially from those set forth in or implied by such forward-looking statements. All forward-looking statements speak only as of the date of this conference call.
PS Business Parks undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. For additional information about risks and uncertainties that could adversely affect PS Business Parks’ forward-looking statements, please refer to the reports filed by the company with the Securities and Exchange Commission, including our Annual Report on Form 10-K and subsequent reports on Form 10-Q and Form 8-K.
We will also provide certain non-GAAP financial measures. Reconciliation to GAAP of these non-GAAP financial measures is included in our press release, which can be found on our website at psbusinessparks.com.
I will now turn the call over to Joe.
Thank you, Ed and thank you all for joining us this morning. My comments will be relatively brief. For Q4, performance on several metrics improved on both a sequential and comparative basis. Of note, hitting same park occupancy of 94.4% and non-same park occupancies of 92.5% was a good step forward in our goal of tapping the growing tenant demand in nearly every one of the markets we operate in. A number of our full company metrics are now meeting or exceeding levels not seen in several years.
We are encouraged as cash rents are being reset into stronger market conditions, as we release spaces of our typical three-year cycle. Ed will go into reported change to NOI, FFO and free cash, while Maria and JP will comment on company initiatives and operational progress.
In regard to acquisitions, we closed out 2015 without buying any assets. For some time, we have discussed the headwinds we see in the investment arena due to aggressive buying of all three of our product types. It is too soon to judge a shift in the acquisition market for 2016, but we are in excellent shape to consider investment opportunities. In the meantime, we have spoken to the alternative benefits of using cash to redeem higher yielding preferred as we did with the $75 million redemption in Q4. We also plan to use the cash on our balance sheet to pay off the $250 million CMBS mortgage in June, the only debt instrument on our balance sheet.
Combined, these are meaningful changes to the balance sheet and Ed will remind you of the boost this gives us in free cash flow and FFO. With the successes we achieved in 2015, we are well-positioned in 2016 to leverage our strong position. The balance sheet has exceptional capacity and free cash will improve from the value we derive from higher rent levels and lower transaction costs. For these reasons, our board of directors approved a 25% dividend increase to $0.75 per quarter.
Now, I will turn the call over to Maria.
Thank you, Joe. I will spend some time talking about our strategies, market by market that led to a good year in 2015. The ability to focus on market concentrations and multitenant parks with small-business users is a successful formula. In 2015, we did record leasing, executing over 2300 deals for nearly 9.5 million square feet. I pointed out several of our strategies last quarter, and I’m pleased to report that those described for Northern California, Austin and Seattle now hold true for all our markets, with the exception of DC. As a reminder, here is our game plan for 2016.
First, we continue to focus aggressively on raising rental rates and executing longer-term leases. One of the benefits of an average three-year lease term is that we can bring these leases to market rents upon expiration. We are heartened that in the fourth quarter, the 2.1 million square feet we signed had an average lease term of 43 months. We have 5.8 million square feet expiring in 2016 and 72% of this is in strong markets. Northern California, Austin and Seattle had 15.1% rental growth in 2015 and show no signs of slowing. 25% of 2016 expirations are in these three markets, which is additional opportunity.
In 2015, Southern California and Florida grew occupancy to the mid-90s, and no longer have to balance occupancy gains with growing rental rates. Both markets are now pushing rents hard as seen in Q4, which showed combined rate growth of 6.8%. Dallas is still working to break through to the occupancy and rent growth we have enjoyed in Austin over the past few years. Finally, in DC, the story continues to be about growing occupancy, while retaining the customers we have.
PSB's focus on smaller users allows us to enjoy higher occupancy in our chosen suburban submarkets compared to those even in downtown DC. Small users represent over 55% of our DC portfolio. In 2016, we have a slightly higher expiration schedule with 25% of the portfolio rolling over. On September 30, we are getting back a 123,000 square foot building in our Tysons Westpark portfolio, as a current customer has consolidated into other space. This represents 8% of the total expirations in DC this year. The building is a great candidate for multi-tenanting. Our strategy has led to occupancy at Westpark of 96.7%, consisting of 107 tenants with an average size of 6800 square feet. In addition, this site may include redevelopment opportunities and concurrently, we will also assess those options over the next few quarters.
Now, here is a quick update on Highgate. As previously announced, construction is underway. Despite Snow Villa [ph] in January, we are still on schedule to deliver in mid-2017. We remain confident about this development for a variety of reasons. We've talked about its location in McLean, Virginia, one of the most exclusive ZIP codes in the United States and the success of the newly opened metro. Now, after two years, Tysons is beginning to reduce good residential statistics with strong absorption and healthy rental rates and a very underserved residential market. JP will go into more detail on the specific market metrics and our outlook, but overall I'm encouraged by our results.
Now, I’ll turn the call to JP.
Thank you, Maria. Our teams took advantage of the strong business environment and increased same park occupancy by 50 basis points from Q3 to 94.4%. This represents our highest quarterly same park occupancy since Q3, 2006. Occupancy improved in nearly all markets with the biggest moves in Texas, Southern California and Washington Metro. In Texas, our positive momentum continues, as we completed 72 deals for nearly 338,000 square feet and same park occupancy was 91.9%, up 120 basis points from Q3. Rent growth was over 9.6% in Austin and 6.2% in Dallas. We are focused on continuing this momentum and improving occupancy at our Los Colinas flex assets and we have five larger vacant spaces. In Southern California, our team drove leasing volume were also growing rents by 6.2%. We signed 161 deals of 412,000 square feet at an average deal size of 2,500 square feet. This volume helped us push occupancy up 60 basis points from Q3 to a solid 94.8%.
Even with tougher conditions in Washington DC, we made progress on a few fronts. The team improved occupancy by 230 basis points in 2015 to 92%. In order to do this, we had to compete on price and rents declined 8.2%. Leasing volume was robust and the Washington Metro team executed 98 leases for 497,000 square feet, an average deal size of 5,000 square feet with retention of 69%. In Florida, we completed 52 deals totaling 290,000 square feet with occupancy at 95.7%. Rent growth was 8%.
Finally, Northern California again had a solid quarter completing 104 deals turning approximately 500,000 square feet. Retention is 69% and our team posted outstanding rent growth of 19.6% and occupancy was 96%.
As we move into 2016, our teams are clearly focused on pushing rents, lowering concessions and taking occupancy to levels not seen in many years.
Now I will turn the call over to Ed.
Thank you, JP. FFO for the fourth quarter of 2015 was $1.31 per share compared to $1.15 per share as adjusted for the fourth quarter of 2014, an increase of 13.9%. Total portfolio NOI for the fourth quarter increased 7.9% over the same period of 2014 with Same Park NOI up 4.8%. Same Park revenue increased 4% in the quarter as a result of a 90 basis point improvement in occupancy combined with a 3% increase in average in-place rents over the same period of 2014.
Same Park operating expenses increased 2.2% on higher repairs and maintenance costs. For the full year 2015, FFO per share was $4.83 on an adjusted basis compared to $4.73 in 2014, a 2.1% increase. This year-over-year increase is reflective of the sale of $267 million of assets in 2015 and 2014.
Same Park NOI increased 4.2% in 2015 as revenues grew 3.2% and expenses increased a modest 1.1%. Recurring capital expenditures excluding sold assets were $39.4 million in 2015 compared to $44.3 million in 2014, which represents an 11% year-over-year decrease. The decrease was largely driven by the company's ability to lower transaction costs including tenant improvements and leasing commissions.
Total retained cash after capital expenditures, debt service and distributions for the year ended December 31, 2015 was $49.3 million compared to $45 million in 2014, an increase of 9.5%. While the company increased the quarterly dividend in the second quarter of 2015 by 20%, our dividend payout ratio remained very healthy in 2015 at 58.8%.
As we conclude, I would like to remind you that we intend to repay the $250 million mortgage outstanding as of June 1 of this year. This repayment will be funded with cash on hand and our line of credit and we'll reduce quarterly interest costs by $3.3 million, improving FFO per share by $0.10 per quarter.
We will now open the call for questions.
[Operator Instructions] Your first question comes from Craig Mailman with KeyBanc. Your line is open.
Hey, guys. Joe, in your opening commentary you had mentioned that it's too soon to judge the investment market. Are you seeing any changes that could open up some more opportunities for you maybe from kind of widening spreads or upcoming CMBS changes later in the year?
Yeah, it is too soon to tell, Craig, and there is a few more or there are few more deals that seem to be coming into the first quarter with some of the turmoil that seem to be going on towards the end of 2015 with potentially some of the international clients that have been coming into United States with either sovereigns et cetera that may or may not be as active this year. Again, I'm not sure. But we are scouring the markets as we've been doing over our history and then more importantly with the headwinds we are seeing right now, but like I said it is still too soon to tell, but we're ready to strike when the right opportunities present themselves.
And from a funding strategy, obviously, you guys have plenty of capacity on the line. Would you use that for the near-term or would you expect to maybe take advantage of the opportunity to maybe raise capital with your preferreds, and maybe just what the window looks like for preferreds at this point?
Yeah, I mean the good news there is all options are open and again depending on any particular situation and the capital requirements necessary, we got all those alternatives. Ed can talk about the preferred markets itself, but again we're encouraged by the fact that going right back to our balance sheet, we will have very good options when and if the need is there. So, Ed, you can go ahead and talk about preferred markets.
Sure. Craig, as you probably know, the preferred market new issuance standpoint has been relatively quiet. Public stores did a very large issuance last month that was very, very well received in the market at a very attractive rate. So that indicates to us that if we wanted to attack that that market it’s certainly available to us. Our outstandings are trading right at about par which is at 6%. So as an indicator of pricing, I would say that that is probably the best indicator that we have right is somewhere in that 6% range. So it is certainly a market that is available to us if we wanted to go to it.
Okay. And then just lastly, the upcoming vacancy of September, maybe just a little bit on how much NOI that is throwing off and also how much you guys could potentially spend to either multitenant and how likely is it that you do some sort of redevelopment there?
So I will start and then Maria and Ed can add a little bit more color. So I will talk to the redevelopment opportunities, then you guys can talk about maybe the more specific strategy. So this site is within Westpark, again that’s where we are developing Highgate and over time with our six years of ownership, we’ve assessed and looked at the variety of options that could come to play with higher and better use. So with the opportunity of a single building coming back to us, we are yet again going to assess that. And the site could potentially lead to either something aligned to what we're doing at Highgate or even broader uses. But those are all the things that we - we have some time to consider until the building comes back to us. So we will be doing that. And then, Ed, on the quarterly impact -
Craig, we did about $900,000 a last quarter in revenue from that lease. So it's about, call it, $0.03 per share in FFO. So again that would hit us at the end of the third quarter.
And then just to talk about opportunities with retenanting it, as a reminder when we bought Westpark in 2010, it was 63% leased. It had 36 customers. Now we are nearly 97% with 107 customers. And so we feel confident especially given that we are in a better market than when we purchased all the infrastructures in place that we would be able to just go with our slice and dice in return of it. We are analyzing right now exactly what the costs would be, and you figure it would probably be about $30 a square feet for capital investment.
Great. Thank you guys.
Your next question comes from the line of Manny Korchman with Citi. Your line is open.
Hey, guys. If we can just maybe follow up on the point you just made. So that business park is, obviously, more highly - especially in the small tenants suits, more highly occupied than the rest of sort of the Northern Virginia market. If you were to add more small tenant suites there, do think that the take-up would be more similar to the success you've had there or would it trend closer to the 90% that you've had market-wide? And so how do you think about that, when you think whether you would redevelop that asset or break it up into smaller suites?
You know what, that’s a good question, but Tysons is a very strong market for us. It has the infrastructure where it’s an invigorated market with all the residents that are moving in and if we have to take space back anywhere in our portfolio, this is where we would want it to be. And we can certainly absorb more small tenants. Just as a reminder, there is 200,000 employees that work in Tysons, and taken on its own, Tysons is the 12th largest employer market in the United States.
Great. And then any plans or any desire to take advantage of the transaction markets, sort of frothy acquisition pricing, if you will, to sell some more assets?
You know, as Ed noted, the amount of disposition activity we had over the last two years of over $260 million, so we feel like strategically we made the right moves, both with certain assets and then more specifically exiting Portland, Phoenix and Sacramento. And the vitality, the health, the interplay that we are seeing with balance of our portfolio right now gives us good options to have the commanding presence we want market-to-market or even submarket. That’s certainly part of the interplay and the way that we are able to even drive the occupancy levels that you’re seeing.
So with all that said, I’d tell you that’s a far lower priority on our side of the equation today, because the - again, the interplay, the optimization and the advantage strategically of owning the 100 parks or so that we have in the portfolio today is strong. And for the most part, it’s commanding in many, many of our submarkets. So I wouldn’t expect us to do any material selling of assets in the near-term and we - when and if we would get to that point we would certainly signal it, but at this point I don’t see that strategically going that direction.
Right. Thanks for that color.
Your next question comes from the line of Eric Frankel with Green Street Advisors. Your line is open.
Good morning, Eric.
That’s a new one. I was hoping you could comment a rudimentary question on just operating margin. So obviously I think you've hit a 70% margin, which is pretty high for you, and obviously, that's partially due to the change in composition of your portfolio. But is that achievable over the next several years or are you worried about operating expenses increasing, whether it's due to real estate tax assessments or other line items?
Eric, I think if you look back over the last couple of several years on our margins, you have seen a gradual steady increase and we have - it’s really driven by on both fronts in terms of pushing growing revenues with occupancy and rent growth and we’ve done a very good job over the last couple of years controlling our cost. We have faced some headwinds on property taxes and we’ve been able to absorb that. There is some seasonality, if you will, to our margins is our first and third quarters tend to be a little bit lower just given the utility cost in both the winter and the summer months. But I would expect our margins should continue to stay strong and improve as we see more ability to push rents with higher occupancy.
Great. I appreciate the color. The other question for you is just regarding the investment environment. Obviously, fundamentals, overall in suburban DC aren't all that great and we've seen some other REITs that are either selling properties at what seems to be somewhat low prices or even giving properties back to their lenders. And so I'm just wondering if you're seeing any sort of distress where you could take an office building and re-tenant it in your typical fashion?
Yes, Eric, that’s certainly one of the markets that we continue to source and look for potential opportunities. So again, you’ve seen us over periods of time, not recently, but periods of time where we find the right opportunities and we are highly committed to that market and again, if the proper set of circumstances come along, we would certainly focus hard and make a determination if it was right time to make an investment. So in no way is the market, not unlike any of our other markets where we said we don’t want to expand, grow or at the right time make those investment opportunities or investment decisions. But we will continue to track what’s going on there. There is probably a little bit more market just as know, or little bit more product in the market just as you know, so we are continuing to assess that as well.
Okay. Final question. Maria, I'm sure you're not going to be able to - you’re not going to want to delve into this too much. But maybe you could talk about the economics of the Highgate deal and what you're expecting? And obviously, the building is not going to be completed - or the development is not going to be completed for the next year or two. But maybe, get a sense of how you think about the lease-up and when you can expect stabilization?
Well, you know what, we don’t give guidance and it’s still little bit early to tell. We are very encouraged with the absorption and what’s going with rental rates with the four high-rises that have delivered in 2014 and 2015. What I could say is that, we are slightly different product, fortunately for us, will be at a lower price point offering different amenities with our parks and walkability. So we are comfortable, we feel good about it, but right now, I would like to get another year under Tysons belt of absorption and seeing what’s going into the market before I could really comment on that.
Okay, thank you.
Your next question comes from the line Brendan Maiorana with Wells Fargo. Your line is open.
Hey, this is Blaine Heck here for Brendan. So you guys have obviously achieved occupancy higher than it's been in several years and you are going to give a little bit back, obviously, with the move out in Tysons. But what do you think is different about the portfolio, or maybe how you are running it? And what do you think is an achievable kind of stabilized occupancy number this time around?
It’s a good question, it’s good to look back and then as much as you can look back to history, the future can always be different. But we’re very encouraged about a number of things that are different with the company and the company’s platform as we’re going into what we feel are sustainable levels of market demand. The thing that fundamentally is very different and has been different for quite some time in the cycle. There is no new competitive construction, literally going on anywhere that we’re facing. So that’s a level of fuel that goes into fewer choices for our type of tenants that’s going out looking for our average size space. So that’s encouraging. I talked previously a little bit about the benefit of owning these concentrated business parks, so with the - over $1 billion of acquisitions that we have done in the last four, five years, we have really magnified the size of our parks, whether the size we originally buy or we have been doing bolt-on acquisitions.
That advantage is quite unique, particularly in our type of space because more often than not, we’re competing with one-off owners that may have utmost one or two buildings and we have got a park that have 10 to 50 buildings as we do in many of our parks or most of our parks. It’s quite different. On the operational side, we continue to find ways of optimizing the strength of our teams, our leasing processes, our property management techniques, all those kinds of things. So there is just - there are a number of things that go into it. JP went through an initiative. We just launched a revised website a lot of the marketing that we can do to our tenant base is different than our competitors because of the scale that we have and the way that we can make the market at larger aware of where we vacancies or spaces available.
So I mean there is a lot of things along those lines, Blain I think are differing this time and even if you go through again those hundred parks that I talked to one by one, we’ve got several now that our beyond what we would even say historically used to be our prior peak, okay. And Maria for instance just talked Westpark right in the heart of DC being almost at 97%, okay, in a market we all hear and know can be tough but again we have the scale, the opportunity and the variety of strategic advantages to push many of our parks literally into those kind of occupancy ranges and in some cases even higher. So that’s you know I think a number of things that we continue to be focused on and I know we’re pretty encouraged about what’s ahead of us going into 2016.
Sure. That's great color. Then, can you just give a little bit more color on the trends up in Northern California and Seattle? You guys had really strong rent spreads in each of those markets and strong occupancy this year. But, there are now some concerns, obviously, in those markets, mostly related to tax. But can you talk about how you’re thinking about that part of your portfolio going into 2016 and whether the success seen this year can continue?
Blain, this is JP here. We’re starting the year at 96% lease on 7 million square feet. So we’re starting the year on a good spot. We are well aware of the issues with tech and what's happening in the Bay Area. We are monitoring it closely. We don't have a tech heavy portfolio in terms of our customer base. We have our typical small business America service based users, we are finding to be honest the displacement of some of these larger tech companies. They're tearing down buildings, building new ones that gives us an opportunity to tap into small business to fill our buildings up. So we’re not immune from what's going on in the Bay Area in terms of the tech situation. Right now we've been able to capitalize on the stronger economy as I mentioned grow rents up there significantly and we are positioned with our portfolio heading into ‘16 to capitalize on that even further. At the same time we are watching what's going on up there very closely.
[Operator Instructions] Your next question comes from Michael Mueller with JPMorgan, your line is open.
A couple of things. First, Maria, you were talking about 2016 game plan pushing rates. I think, increasing lease term. Just wondering, what's your definition of longer lease term? Maybe, more along those lines, for the leases that you renewed or assigned new leases, I mean how is the average lease term on that batch compared to what you replaced that expired?
Okay, that's a good question Mike. So, our average lease term is generally three years. So, for some of our larger customers that can be five year and longer term but for our very small customers that are even under 3,500 square feet they like to renew in 12 months to 18 months increments. So for the very small users we’re pushing them to at least two years and then kind of as the companies go up, we want to push five-years and beyond. Overall, if we can get a three-year average to a four average that's kind of what I'm talking about with pushing terms.
Got it. Okay. And then going back to Westpark, for a second, to the extent you go the route of breaking up the space into smaller units, can you remind us, in the past, generally, how long does that process take? So if you get the space back at the end of September, and how long does it take to retrofit before you can start releasing to new tenants?
Yeah, the way that we went through last time, Mike, on a building-by-building basis it could take anywhere from 3 to 12 months to fully refit an entire building. The great news with this building as our others that we have there is they are small floor plates and they actually even take a step further they are in wings. And by virtue of that you can actually stage and deliver spaces without tremendous disruption to either the full building or even in many cases even on floor by floor basis. So again we're encouraged by the fact that sustained game plan that we had when we bought the park originally and it could take anywhere from a few months to a few quarters to get both fully through the staging of the space and then traditional lease up.
The thing that it lends itself well to again our average tenant size in DC today is 5,000 or 6,000 square feet and you look at this building and it very easily divides down to that size of tenant space or even smaller. So we've done this many times before. It is a highly effective strategy. And I think on top of that even in a duration that we’ve been at Tysons these last six years, there's no question the market is much healthier now than it’s never been since we've been there. So we're hoping that we can actually accelerate some of the timing that we’ve had before.
Got it. And maybe going back to the first question, again, on lease term, what do you see is the benefit of having your lease term go from three years to four years, out of curiosity?
Just right now there is as we've even heard on the call there is concern in certain markets that we're at peak or maybe even like in Northern California. So if we think we are at peak, we've loved to lock in these rates with our annual increases each year and that's what it comes down to mind.
Got it. A view on the market. Okay, thank you.
We have a follow-up question from Eric Frankel with Green Street Advisors. Your line is open.
Thank you. I was hoping you could discuss the redemptions in the future for preferred equity. I think your series S is redeemable next year at a 6.5% coupon. Are you at thoughts potentially to take advantage of any opportunities in the preferred markets to redeem that as well?
Yeah, Eric, the only redemptions opportunity in relative near term is in January of 2017, we have a $230 million issuance that has a coupon of 6.45%. So I would tell you as we've done in the past if there's a decent spread between kind of where in places and where new issuance are, we would typically redeem those and effectively refinance them new preferred. Yeah, I would tell you that if new issuance today is at 6%, that's kind of in a range that would be attractive to refinance it effectively with new preferred. So time will tell and we'll watch that market, but we do see that as a potential opportunity in early ‘17.
Okay, final question. I just noticed that the US government, I think one of your largest tenants, their contractual rent payable is now about $1 million higher than last quarter on an annual basis. So I was hoping I could just get some color regarding a lease transaction or whether it was some kind of contractual rent increase that caused that bump?
I think that ties to just some of the activity that we had through 2015 with certain renewals and I wouldn’t tell you the government in our case has been expanding its footprint but we've been pleased for the most part that they have renewed on several buildings and with that we've done pretty well with rent levels et cetera.
Okay. That's it. Thank you very much.
Yeah, we did two 10-year renewals last year on two significant leases.
Got it. Okay, thank you very much.
You bet. Thanks, Eric.
There are no further questions at this time. I will turn the call back over to Ed Stokx for closing remarks.
Thank you, Tania. Thank you everyone for joining us and we will talk to you next quarter. Thank you. Have a great day.
This concludes today’s conference call. You may now disconnect.
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