PS Business Parks' (PSB) CEO Joseph Russell on Q1 2016 Results - Earnings Call Transcript

| About: PS Business (PSB)

PS Business Parks, Inc. (NYSE:PSB)

Q1 2016 Earnings Conference Call

April 27, 2016, 01:00 PM ET

Executives

Edward Stokx - Executive Vice President and Chief Financial Officer

Joseph Russell - Chief Executive Officer

Maria Hawthorne - President

John Petersen - Executive Vice President and Chief Operating Officer

Analysts

Manny Korchman - Citi

Blaine Heck - Wells Fargo

Craig Mailman - KeyBanc Capital Markets

Eric Frankel - Green Street Advisors

Michael Mueller - JPMorgan

Operator

Good afternoon. My name is Jesse, and I'll be your conference operator today. At this time, I would like to welcome everyone to the PS Business Parks first quarter investor conference call. [Operator Instructions] Ed Stokx, you may begin your conference.

Edward Stokx

Thank you. Good morning and thank you for joining us for the first quarter 2016 PS Business Parks investor conference call. I am Ed Stokx, CFO of the company. And with me 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 on our press release, which can be found on our website at psbusinessparks.com.

Now, I will turn the call over to Joe.

Joseph Russell

Thanks, Ed, and good morning, everyone. Thank you for joining us. I will highlight a few areas we are focused on for the remainder of 2016, and then turn the call over to Maria and JP to discuss more specifics on the quarter, and then Ed will wrap up with his financial updates.

With Q1 behind us, PSB is well-positioned for 2016, as we see no let-up in customer demand in the majority of our markets. From the West Coast to Texas and Florida, we can capture ramps that have trended towards or beyond past peak levels for a broader range of space sizes within our well located flex, industrial or office business parks.

We can often reduce concessions in these markets as well, with little or no competitive new inventory. Pricing pressure is evident with rent growth of 5% to 20% and even beyond, depending on unique circumstances of a space or location. Washington Metro is still weak enough that we lack command of pricing and will likely need a discount to negotiate around market factor that still favor the customer.

PSB's balance sheet is in excellent shape. We are poised to pay off the $250 million CMBF loan on June 1, thus eliminating the only mortgage in the company. Our only leverage will be the $920 million of preferred equity that has a blended coupon of 6%, and we will generate good cash flow this year, likely above $50 million.

There is no new news on the acquisition front. Too many assets are overvalued in our opinion and we have not seen compelling reasons to pay low cap rates for stabilized assets. So we are still hunting for the under managed value-add opportunities.

Finally, I would like to acknowledge and thank, Mike McGee, who is retiring from PSB's Board of Directors. Mike has served the company for nearly a decade and has been a great advisor to me, the Board and the management team. We wish him well and appreciate his numerous contributions to PSB.

Now, I'll turn the call over to Maria.

Maria Hawthorne

Thank you, Joe. In Q1 performance on several key metrics, including NOI, rent growth, and tenant retention continued to grow. NOI increased by 6.2% on the Same Park portfolio, due to occupancy and rent growth. Same Park occupancy remains strong at 94.1%, while our non-Same Park is 95%. We feel our intense focus on occupancy is the key strategy leading the way towards a strong performance in other areas of our business.

As most of our markets see healthy customer demand, we generated cash rent growth of 4.4%. Owning quality and sizable business park concentrations in great locations allow us to attract and retain many customers, as we specialize in providing institutional ownership for small business America. 70% of our business parks are 92% occupied or higher. Retention in the first quarter was 71.3%.

We started the year with 5.6 million square feet, expiring in 2016, and this number is now 4.2 million square feet. Of special note, Washington Metro had the largest leasing volume this quarter, and they reduce their expirations for 2016 by 450,000 square feet. This leaves that team with about another million square feet in expiring leases, which is now in line with historical expiration levels.

Now, here's a quick update on Highgate. Construction is underway and you can see its progress on our web camera, if you go to our website and look under Development. I will continue to give quarterly updates regarding our schedule, and we are still set to deliver in mid-2017.

Our confidence is high and Tysons had good absorption of new apartment even during the typically slow winter month, thus continuing to prove that people are moving into this underserved residential market. As JP mentioned last quarter, we have a full building at this park that will vacate on September 30. We are running a parallel process, where we are considering the merits of retenanting the office building versus redeveloping the site as another residential project.

JP will now go into more detail on this specific market metrics, and overall we are encouraged by our results.

John Petersen

Thanks, Maria. I will take you through some specific marketing commentary from the quarter. I am encouraged that PSB's existing customer base continues to provide opportunities for additional occupancy absorption.

Taking advantage of the robust economic climate in Northern California, we executed 335,000 square feet of deals, retention was 73% and rent increased nearly 21%. Occupancy was strong at 96.6%. We are well aware of this landlord-friendly environment and our teams are keenly focused on extending lease terms when we can while improving the quality of our customer base at these elevated rents.

Southern California was able to capture the benefits of a strong market as well and signed 386,000 square feet in 148 deals, an average of 2,600 square feet with occupancy at 94.3%, once again demonstrating the strength of our targeted customer base. Rents were up 8.1% and retention was 68%.

In Texas, we completed 271,000 square feet and grew rents 14.2%. Specifically in Austin, where the economy is very strong, rents were up 22.8% and occupancy was 95.9%. Dallas booked rent growth of 7.2% on 188,000 square feet of leasing. The South Florida economy continue to hum along in Q1 and we closed 265,000 square feet with rent growth of 6.5%. Occupancy was 95.1%.

In Washington Metro, I was pleased we were able to sign 518,000 square feet with 88% retention and occupancy of 91.4%. This leasing volume included the successful renewal of 160,000 square foot customer we have been working with for some time.

This relatively healthy volume did come with a negative 7% change in rental rates. With the DC platform that allows us to source customers with an average size of 5,000 square feet, we know how to maneuver in this environment and focus on our healthy small customer base.

As we look ahead to the rest of 2016, our approach is to extract as much rent growth, occupancy and term from accelerating markets in California, Seattle, Texas and Florida, while maintaining a relative market outperformance amid challenging conditions in Washington Metro.

Now, I'll turn the call over to Ed.

Edward Stokx

Thank you, JP. FFO for the first quarter of 2016 was $1.26 per share compared to $1.13 per share for the first quarter of 2015, an increase of 11.5%. Total portfolio NOI for the first quarter increased 7.1% over the same period of 2015 with Same Park NOI up 6.2%.

Same Park revenue increased 4.8%, as a result of a 2% improvement in occupancy combined with improving rents. Same Park operating expenses increased 2.1% on higher repairs and maintenance and utility costs.

Sequentially, Same Park NOI was down 1.5% as revenues increased 1.2%, while expenses increased 7.4%. The sequential increase in our operating expenses is tied to $1.8 million of snow removal cost incurred in the first quarter of 2016.

Recurring capital expenditures were $6.3 million in the first quarter compared to $9.2 million in the same quarter of 2015. This year-over-year decrease is a reflection of managements continued focus on lowering transaction cost combined with the timing of leasing activity.

As you know, in the first quarter we increased our quarterly dividend by 25%. With the increase in distributions, our total retained cash after capital expenditures, debt service and distributions for the quarter increased 3.5% comparatively to $12 million.

As Joe noted, we will be repaying the $250 million mortgage as of June 1 of this year. We will fund the repayment with cash on hand and our line of credit. Eliminating this mortgage will reduce quarterly interest cost by $3.3 million and improve FFO per share by $0.10 per quarter.

We will now open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Manny Korchman from Citi.

Manny Korchman

Maybe if we can talk about the acquisition environment. Have you seen a big difference in the pricing between single assets and portfolios? I know that your comments were that things probably seem too frothy for you to be involved. But just give us an idea of sort of how packages are trading right now?

Joseph Russell

I mean, again, as I talked to you in my prepared comments, there really doesn't seem to be anything new and different at the moment. We were hoping that with some of the early turmoil in the first quarter, more from a international money flow standpoint or again some of the things that seem to be trending early in the quarter that we might see a little softness in the environment, whether on an individual asset basis or on a portfolio basis we'd see some pricing opportunities.

But towards the end of the quarter, it appears that a lot of that was short-up and activities right back at the table. And I really can't talk anything new and different at the moment. It continues to be, in our view, a time to be very cautious about the valuations that seem to be playing through time and again on many deals, again, whether individual assets or larger portfolios.

Manny Korchman

And if we just focus back on Metro DC or Virginia, I'm hearing sort of mix messages. And one message is that rents are weaker, but there is still demand. The other is that there is still a lot of navigating to be done and it's really the smaller customer that's okay, and other customers aren't. Can you just help me sort of pinpoint exactly what's going on in that market?

Joseph Russell

Well, I don't know if I can pinpoint exactly what's going on in the market in a couple of minutes here. Manny, I can tell you that you kind of hit the nail on the head. The small customers that we target are active, they are busy. As you know, unemployment is in the 5% range in that market. Where we struggle and where the market struggling is kind of deals over 20,000, 30,000 square feet. It's highly competitive TI Packages. They are very high in $20, $30, $40 square foot range. And so that creates an overhang on the overall market.

When you look at our targeted customer base, as I mentioned in my comments, about 5,000 square feet, we continue to do deals, we are very active in the quarter and we're seeing strength there. But with government contractors and the government being very cautious about the utilized space, et cetera, that does especially impact these larger tenants, which is really no surprise.

Operator

Your next question comes from the line of Blaine Heck with Wells Fargo.

Blaine Heck

I know you guys don't provide guidance, but if you look at consensus through the year at $5.34 that implies about $1.36 per quarter for the rest of the year. Can you guys talk about the drivers that are going to be major positives or negatives for the upcoming quarters? And maybe whether you think that estimate is reasonable?

Joseph Russell

Well, yes. To begin with, you're right, Blaine. We don't predict or give guidance in that regard. What I'd reinforce is thematically what we just walkthrough, which is we're very encouraged, the 70%-plus of the portfolio sits in markets that have very strong, if not, continuing tenant demand that's giving us lots of pricing power.

The pricing power that we've seen in Northern California and Austin specifically is very good and we don't see really any let-up there. The pricing power in Dallas, Southern California and Florida appears to be poised for better strength going into 2016. So again, we're encouraged by that. And then, again, what we're buffering Washington Metro around is, again, overall very good metrics on 70%-plus of the portfolio.

So again, we're encouraged by some good traction that not only came out of the first quarter, but we'll hopefully continue to sustain itself and give us great opportunities as we do good volume of leasing quarter-to-quarter and we're seeing good customer demand, good expansion. So it's a very good environment to go out and re-lease space in.

Blaine Heck

But I guess that's a different way and kind of aside from the market and the strength you're seeing in there. I think kind of the major drivers are going to be, you're paying off the $250 million of debt, and then a possible negative might be the tenant that you guys lose in the fourth quarter. Is there anything other major that I'm kind of missing?

Edward Stokx

No, I think Blaine you've touched on some of the key drivers. As you know, Joe said it too, we don't give guidance, but we do when there are large headline events that we're facing, we try to put them out there.

Blaine Heck

So second question. It seems like occupancy and re-leasing rates are definitely pointing in the right direction for same-store NOI in the near future. Can you just talk and remind me whether you guys are building in rent bumps into your leases? And what they are at this point on average?

John Petersen

Sure, Blaine. We're pushing the envelope here where we can in good markets. As Joe mentioned, our typical rent bump is going to be in the 3% range on an annual basis. So if we do a three or five year lease, we'll build in annual bumps of 3%. Certain markets we're pushing that, whether it's going to be South Florida, maybe certain spots in Texas, where we may push for a 4% or 5%, but that's not the standard, but we're trying for that where we can.

Operator

Your next question comes from Craig Mailman from KeyBanc Capital Markets.

Craig Mailman

Just a kind of bigger picture, your views on where you think that kind of equilibrium is between pushing rents and occupancies with a lot of markets sort of in that stabilized in mid-90s kind of range. What kind of push back are you seeing? What are you telling folks on the ground to accept is that trade off?

Maria Hawthorne

Craig, our two levers is occupancy and rent growth. As I mentioned in the comments over 70% of our business parts are above 92% occupancy and that's kind of that inflection point wherein you're 92% and above, you can really, really hit rent growth. And you'll see that especially, as we mentioned, Northern California is about 96% or over 96% occupied and that's where we're seeing rent growth north of 20%; same in Austin, strong rental growth; same in Seattle, where we have extremely high occupancy.

Craig Mailman

I guess what I was getting at is your occupancy almost too high in Silicon Valley at 97%. Should you guys be pushing rents even harder, kind of what should we expect with occupancy, or is that the case, you guys think that you're pushing it hard enough and you're still getting the occupancy or do you think that there is room to push it even more to see where kind of the breaking point is from tenant perspective?

Joseph Russell

Well, Craig, rest assured, we push it as hard as we can. And do we think there is more than 20% plus rent growth in Northern California, we're certainly going to try in. I can tell you, deal-to-deal, we make it to 40% or 50% or 60% rent increase, other deals may not be as much for a variety of circumstances.

So as Maria pointed out, is 92% the magic number in terms of occupancy? No, I don't think so. It's really on a suite-by-suite, park-by-park, what's the current customer that's renewing at or what's the surrounding situation like in a particular submarket, are there other options for this perspective tenant in that size range, who is the landlord, et cetera. So it's really on a suite-by-suite, park-by-park basis that we push rents. And there is no directive from us other than to push rents as high as we can and maintain that high occupancy. Does that help?

Craig Mailman

I was just curious. Occupancy came down a bit this quarter. Just curious if we should expect it to trend down and you guys continue to push rents, but it sounds like you're able to do both at least so far?

Joseph Russell

We're trying.

Craig Mailman

And then just the last one, with the 1 million square feet left in the DC Metro, you guys had pretty good retention rates, almost 90% in Maryland, Virginia. And it sounds like the 160,000 square foot renewal probably helped. Is that a good outside of the Tysons' known move-out, is that a good kind of retention rate to think about for the balance of the year or is that going to trend lower as the year progresses?

Joseph Russell

Well, certainly we're pleased with first quarter retention. And you're right, the large renewal help is going to fluctuates. I wouldn't expect it will be that high on a quarter-by-quarter basis. We do have move-outs that we're aware of, especially one you mentioned. So if we can be above 65%, we can push 70% retention. That range is where we're shooting for us. Certainly, if we can get to 80s, I mean, we're thrilled with that in that market specifically. But I would expect for the balance year that to fluctuate a little bit, goal being over 65%.

Operator

Your next question comes from Eric Frankel with Green Street Advisors.

Eric Frankel

Just want to touch upon the operating expenses for the quarter. The $1.8 million of snow removal costs, how much of that is reimbursed by the tenants?

Joseph Russell

Roughly about 50% of that gets recovered through cam billings. Eric, there are certain limits that we have just given the nature of the leases there and the government tenancy, where we have nonetheless ability to build back some of that, but 50% is a good estimate.

Eric Frankel

Can you remind us just what the rough breakdown of gross versus double net or triple net leases in your portfolio?

Joseph Russell

Roughly about 75% of the leases are triple net leases within the portfolio.

Eric Frankel

Final question, Maria, obviously, you're knee-deep, I'm looking at the videos on the website -- or I have looked at the videos of the development in Tysons. And it looks great. Obviously, I can't really tell what's exactly going on. But it looks you guys are building very quickly. Are there any lessons learned so far in the redevelopment process?

Maria Hawthorne

Lessons learned is picking a great team, we feel that we have a great partner with Kettler. And just keep an eye on construction cost and rental rates and deliver something different in the market.

So far in Tysons, there have been four high-rises delivered. And in very urban or even redeveloping industrial areas of Tysons and then what we're delivering is something a little bit different, because it is a mid-rise. It's going to have two front doors, including one that is overlooking two parks that we're building and delivering, which is something new and different in that market.

Eric Frankel

It sounds like an enticing development. We'll see how it comes out. Actually, one quick final question. Obviously, e-commerce has been impacting the industrial market quite heavily, especially for larger tenants. I would like to get understand how that's impacting your portfolio? Have you signed any e-commerce related businesses in any shape or form, for your smaller units?

Joseph Russell

Yes, Eric. We haven't signed any big headline deals in our portfolio. We have signed a handful of smaller companies. I mean anybody that runs a business these days kind of does e-commerce in terms of their product. And whether it's a small t-shirt company or a surfboard manufacturer, whatever, they are involved in e-commerce, so clearly, for the economy and us, specifically are benefiting from that. But we haven't done any large long-term leases with big e-commerce names.

Operator

Your next question comes from the line of Michael Mueller from JPMorgan.

Michael Mueller

Going back to the snow for a second, two questions. Number one, what's a more normalized level of 1Q snow removal cost? And for the reimbursement that you were talking about, did that hit in Q1 or is there timing lag with that?

Edward Stokx

Mike, it's hard to say what a normalized snow level is. I will tell you that at a $1.8 million this quarter was almost equal to what we had incurred in the first quarter of 2015. But 2015 was significantly more than we had incurred in the prior two years before that. So it does vary and can swing widely. From a recovery standpoint, most of that has been either build or accrued into the first quarter. There's some of it that will be paid over the balance of the year as the tenants pay their monthly impound amounts, but most of that was accrued into the first quarter.

Michael Mueller

And I guess going to the comment at the beginning about contemplating, doing another residential tower with the vacant building that's coming up in September, I mean, I guess, what are you thinking about, what's the back and forth discussion, what triggers are you looking for and when do you think you'll figure that out if you're going to go ahead with that or not?

Joseph Russell

The thing that Maria has talked to, and Maria you can add any color to this as well, as another lesson learned, I'd add to Eric's question is, we fundamentally know we've got a very unique site here. We've got 45 contiguous acres. That's all flat. It's prime for higher and better use. And because of the underserved nature of this growing residential environment, it's in a really nice sweet spot relative to us thinking through, and again, going through the give and take with all the entitlement process to consider even additional development for residential.

The thing that is always complicated around this are the trade-offs relative to proffers and density and again the ability to insert this kind of use into what arguably is a very successful business park as it stands today. So all that's in the mix, Maria is the lead on this and has a great relationship with all of the county and government officials based on everything that we just went through Highgate. So that's all taking place. And Maria, you can add more color to this. But we were encouraged by it, but it's going to take some time.

Maria Hawthorne

Yes. And Mike that's exactly what Joe was saying is that you kind of have to navigate through it. I mean, our goal is to keep the proffers under control as much as possible. And then just keep an eye on what's happening with construction cost and rental rates. I know that every apartment report that comes I am reading it and then I am also in my micro market tracking absorption very carefully. So right now we'll probably go through an entitlement process, but the question will be, do we pull the trigger on retenanting or do we redevelop and we're not at that point yet where we can say.

Michael Mueller

I mean, does it seem reasonable that by the time the tenants move out you'd probably have a pretty good idea at that point?

Joseph Russell

I think, again, hopefully yes. And that's again, I think the benefit of us knowing early what is happening with this particularly, and at the same time, certainly being fully immersed having one development already underway gives us great traction, great reconnaissance and gives us the ability to make that much informed decision, so we feel very encouraged, but as Maria just said, we've got to go in tandem here for a little while to determine timing, and again, best hire and better use for the site.

Operator

There are no further questions at this time. I'll turn the call back over to Ed.

End of Q&A

Edward Stokx

Thank you, every one for joining us this morning, this afternoon. And we will talk to you soon. Take care.

Operator

This concludes today's conference call. You may now disconnect.

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