Washington Real Estate Investment (NYSE:WRE)
Q1 2016 Earnings Conference Call
April 28, 2016 11:00 AM ET
Tejal Engman - Director of Investor Relations
Paul McDermott - President and Chief Executive Officer
Stephen Riffee - Executive Vice President and Chief Financial Officer
Thomas Bakke - Executive Vice President and Chief Operating Officer
Anthony Paolone - JPMorgan
John Guinee - Stifel Nicolaus
Jed Reagan - Green Street Advisors
Blaine Heck - Wells Fargo Securities, LLC
Richard Schiller - Robert W. Baird & Co.
David Rodgers - Robert W. Baird & Co.
Christopher Lucas - Capital One Securities, Inc.
Greetings and welcome to the Washington Real Estate Investment Trust [Fourth Quarter 2015] [sic] [First Quarter 2016] Earnings Conference Call. As a reminder, today’s call is being recorded. Before turning the call over to the company’s President and Chief Executive Officer, Paul McDermott, Tejal Engman, the Director of Investor Relations will provide some introductory information. Ms. Engman, please go ahead.
Thank you, and good morning, everyone. Please note our conference call today will contain financial measures such as core FFO and NOI that are non-GAAP measures as defined in Reg G. Please refer to the definitions set out in our most recent financial supplement available at www.washreit.com.
Please also note that some statements during the quarter are forward-looking statements within the Private Securities Litigation Reform Act. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results to differ materially. We provide these risks in our SEC filings. Please refer to Pages 9 to 24 of our Form 10-K for our complete risk factor disclosure.
Participating in today’s call with me will be Paul McDermott, President and Chief Executive Officer; Steve Riffee, Executive Vice President and Chief Financial Officer; Tom Bakke, Executive Vice President and Chief Operating Officer; Drew Hammond, Vice President, Chief Accounting Officer and Controller; and Kelly Shiflett, Vice President, Finance and Treasurer.
Now, I’d like to turn the call over to Paul.
Thank you, Tejal, and good morning, everyone. Thanks for joining us our first quarter 2016 earnings conference call. We have delivered a strong first quarter operationally and made significant progress on our full-year asset recycling plans. Our core FFO of $0.42 grew 10.5%, and our same-store portfolio NOI grew 2.5% on a year-over-year basis. Considering seasonality typically impacts our first quarter results, this is a solid performance that reflects the increased strength of our operating platform.
I would like to start by discussing the progress we have made on our 2016 asset replacement plan and the context of our stated strategic objectives. As we have consistently messaged, our primary strategic objectives are to generate compelling value add returns for our shareholders, strengthen the balance sheet, elevate the quality of our portfolio, and achieved greater parity between our three asset classes. I’m pleased to report that our asset recycling execution is consistent with these stated objectives, and that Washington REIT is on track to achieve additional strategic and value-enhancing milestones.
Starting with dispositions of the suburban Maryland assets we plan to sell in 2016, we are under contracts to sell a portfolio comprising of all six of our suburban Maryland office assets for $240 million and have one suburban multifamily asset to be placed on the market later this year. We received multiple offers for the suburban Maryland office portfolio from a diverse pool of buyers, including local operators, private equity funds, and foreign capital sources. We balanced certainty of execution with net proceeds and entered into contracts with a highly credible institutional buyer.
Our primary objective remains to minimize execution risk in an uncertain credit market environment and to accomplish a critical milestone in the transformation and de-risking of Washington REIT’s office portfolio. Upon the completion of these sales, we will have purposely transformed our office portfolio from being overweight suburban to predominantly urban with almost all of our assets located within walking distance of metro and amenities. If you exclude the suburban Maryland office assets we’re selling from our NOI – office NOI this quarter, downtown DC drove approximately 60% of office NOI, while urban centers in Northern Virginia drove the majority of the remaining 40%.
To complete the suburban Maryland asset sales planned for the year, we intend to place one legacy multifamily asset on the market later in the year. This asset has recent inflection points from where our ability to create additional value is limited. In addition, we have a suburban office asset currently in the market and are evaluating investor interest. Finally, we are under contract to sell a parcel of land at Dulles Station.
Moving on to acquisitions, we have consistently stated, both our value-add acquisition strategy and our desire to grow our multifamily portfolio through acquisitions like the Wellington. We are, therefore, pleased to be under contract to acquire a similarly structured and even more compelling value-add opportunity in Riverside Apartments, a 1,222 unit apartment complex in Alexandria, Virginia for approximately $245 million.
Located half a mile from metro near the intersection of Route 1 and the Capitol Beltway, Riverside Apartments is a 95% occupied residential complex in the heart of the dynamic Huntington Metro market. This market is experiencing significant investment-led economic growth and improvement. It anchors the north end of the Fort Belvoir Carlyle employment corridor and has outperformed the Washington metro region’s Class B rent growth over the past six quarters.
In addition to the PTO, two major employers, the National Science Foundation and MGM National Harbor Resort are expected to create approximately 6,000 new jobs and increased the employment base within three miles of the property by approximately 10% over the next 18 months. Similar to the Wellington, the acquisition of Riverside Apartments provides us with a high-quality asset at a deep discount to replacement costs. It also provides the opportunity to grow rental income through improved operations, a unit renovation program of approximately 850 units, and the ability to develop approximately 550 additional units.
In recognition of the superior value of this development potential, we are in essence reallocating capital from the sale of a parcel of land at Dulles Station to the purchase of the land associated with Riverside for future development. The acquisition of Riverside Apartments meets all of our strategic investment criteria and is also a prudent allocation of our capital. Consistent with our strategic plan to elevate the quality of our portfolio, we are purposely allocating capital out of low barrier suburban assets and into urban infill metro-centric assets in locations with strong demographics and walkable amenities.
Moreover, we are allocating capital to value-add Class B multifamily assets that meet these criteria. We believe this allocation provides the best risk-adjusted returns for our portfolio by generating greater levels of NOI growth and stable cash flows by decreasing risk. Demand for multifamily in our region continues to outpace record-setting levels of supply, due to a variety of reasons, including job growth, population growth, and demographic shifts involved in the denesting of 25 to 34-year-old living at home, a decoupling of those living in with roommates, and a trend among empty nesters and retirees to return to urban infill multifamily units. A decreasing rate of homeownership is also a key driver.
Applying the data on starter home prices in Washington, DC and Millennials’ average savings rates reveal that Millennial renters in Washington, DC will need to save for more than a decade before they can afford a 20% down payment on a home. It is these demographic and economic shifts that have enabled multifamily in our region to weather the storm of the historic levels of new deliveries over the past couple of years.
Although Class A deliveries are expected to peak at 14,000 units this year, we believe well located value-add Class B multifamily will continue to perform. This product type addresses the needs of a growing and underserved cohort of value-conscious renters priced out of the Class A supply deliveries in our region, but still seeking quality apartments in good locations.
The acquisition of Riverside will have a sizable impact on our portfolio composition. It will expand Washington REIT multifamily portfolio by nearly 40% on a unit count basis. Upon the completion of the sale of the suburban Maryland office portfolio and the purchase of Riverside Apartments, office on first quarter pro forma basis is expected to contribute approximately 46% of our total NOI, down from 55% in the fourth quarter of 2015, while multifamily is expected to contribute approximately 30%, up from the 21% in the same period last year.
Furthermore, as we allocate capital away from suburban office that requires higher level of leasing capital into a multifamily asset with an opportunity to increase revenue through prudent capital investment, we expect to continue to strengthen our core funds available for distribution or FAD going forward.
Moving on from capital allocation, I would like to now discuss Riverside’s tremendous value creation potential. Our research has identified an affordability gap of approximately $600 to $900 between the monthly effective rents at Riverside and the newest Class A product in that submarket. This is significantly greater than the $300 to $400 average differential between Class A and Class B rents in our region, and it’s highly conducive to implementing a successful unit renovation program.
We deliver further support in the knowledge that the 366 units that have already undergone renovations at Riverside have achieved premiums that are consistent with our returns as a Wellington. Based upon our own experience and research, we would expect the unit renovations to generate a year one yield on costs that is in the high teens.
Additionally, in the long run, Riverside offers an intrinsic NOI growth driver through the potential on-site development of additional units in a desirable submarket with growing employment drivers. By adding units and offering multiple price points, Washington REIT will be able to capture additional demand through a diversified product offering. Although the development is a latter phase of growth and one that we would only enter into at the appropriate time, it provides us with the opportunity to plant the seeds for future organic NOI growth.
To summarize, Washington REIT continues to demonstrate solid execution on all fronts. We remain committed to strengthening the balance sheet by paying down approximately $100 million of debt this year and addressing all of our secure debt that is expiring and pre-payable in 2016.
With the execution of the planned asset recycling, our portfolio will take a significant leap towards the strategic vision we have for Washington REIT. Our office and multifamily portfolios will predominantly be on metro in strong locations across downtown DC and in the urban infill centers in Northern Virginia. Our retail portfolio is already located in strong neighborhood centers across the Washington metro region, and is embedded with several excellent redevelopment opportunities. We will have concluded our programmatic asset sales and will be left with a portfolio and a balance sheet that will better position us for future growth.
Now I would like to touch on our portfolio activity and some of the broader trends we are seeing in the Washington metro region. After a strong fourth quarter, the office market experienced a typical fourth quarter low in activity. While activity in the suburbs remained healthy around metro, it continued to be anemic in areas without strong transit links. That said, we continue to see strong activity among small to midsize tenants in the district and expect to see a pick up in activity across parts of our Virginia office portfolio in the second quarter.
Our office portfolio continues to outperform most submarkets from an occupancy standpoint, as our focus remains on tenant retention and the ability to strategically push rents higher when appropriate to do so. As we approach stabilization in the office portfolio, we are now filling vacancy in spaces that are more typical to lease and are working hard to do so in a competitive market. An exciting future office NOI driver in our portfolio is the opportunity to reposition The Army Navy Club Building.
Located in the heart of the Central Business District in DC, this building presented us with a unique opportunity to upgrade a historic boutique property to compete as a trophy asset in an improving market. The goal is to generate double-digit incremental returns upon lease up. We have completed our redevelopment plans and are in the process of modernizing the elevators, obtaining permits for a new amenity center and lobby renovation, and preparing a 50,000 square feet of space for tours. Upon completion, we expect the repositioning to increase rents by $8 to $10 per foot from the current market levels.
Retail is the most consistent performer of any property type in the metro region with demand continuing to outpace supply and a vacancy rate that is 120 basis points below the national rate. Our retail portfolio is 94% leased and has minimal vacancy, which allows us to be prudent with our leasing decisions. Activity continues to remain robust for well-located, high-quality centers, and our best located centers see strong traffic in multiple groups looking at our vacancies. The incremental future NOI driver in retail is the additional development potential at Spring Valley Retail Center, where we are looking to construct a two-storey building of mixed-use space of one of DC’s most affluent neighborhoods.
In multifamily, the Class B markets’ exceptionally low vacancy continues to outperform that of newer apartment projects. Although the expected dramatic increase in Class A deliveries is likely to maintain pressure on occupancy and rents across A and B products this year. Encouragingly, construction starts at decelerated 8% year-over-year and the outlook for 2017 is improving with Delta Associates Research projecting demand to exceed the number of units delivered in 2017.
The future incremental NOI drivers for our multifamily portfolio are the unit renovation programs at our value-add Class B projects, such as the Wellington and 3801 Connecticut Avenue, as well as a redevelopment project at the Ashby, where we plan to convert existing commercial space into multifamily units. Finally, job growth in the Washington metro region remains impressive with 86,600 jobs added in the last 12 months to March 2016. This 2.8% growth rate in jobs is double the growth our region experienced one year ago.
Professional and business service jobs remain a key driver and have grown 3.4% in 12 months to March versus 1.6% one year ago. In terms of job growth momentum, the District of Columbia now ranks among the top five markets in the nation. Job growth momentum in DC has surpassed several other gateway markets, and is a key leading indicator that bodes well for a continued recovery in the Washington metro region’s real estate fundamentals. We look forward to entering a new phase of growth.
Now, I would like to turn the call over to Steve to discuss our financial and operating performance in the first quarter.
Thank you, Paul. Good morning, everyone. First quarter core FFO per share increased 10.5% to $0.42, compared to $0.38 per share in the first quarter of 2015. Same-store NOI increased 2.5% over the prior year, driven by NOI growth in office and multifamily. Same-store rents increased 270 basis points year-over-year and same-store physical occupancy was 91.7% at the end of the quarter.
Core funds available for distribution, or FAD was $0.41 per share and we continue to project a full-year core FAD payout ratio of 85%. Our outperformance in the first quarter was primarily due to operating expense savings across our same-store portfolio, despite the blizzard we faced in the first quarter.
Starting with office, same-store NOI grew 4% and rents 3.6% year-over-year, due to a favorable comparison to first quarter 2015, when NOI was impacted by a decrease in straight line revenues, as a result of resetting a few leases, including the Booz Allen lease in Tysons. Same-store office cash NOI grew 20 basis points and rents grew 1.4% year-over-year due to annual rent increases across several properties. Same-store physical occupancy grew 20 basis points over the previous quarter to 90.6% and was marginally higher year-over-year.
Overall office occupancy has improved 110 basis points year-over-year and stands at 87.8%. The overall office portfolio is 92.6% leased. We leased approximately 226,000 square feet of office space in the first quarter, with new leases achieving an average rental increase – rental rate increase of approximately 31% on a GAAP basis, and 16% on a cash basis.
Renewals were a 11% higher on a GAAP basis and 4.7% lower on a cash basis, which is in line with previous quarterly trends and double-digit growth in GAAP rents and modestly negative cash spreads. We achieved a longer weighted average term this quarter relative to every quarter in 2015 with 7.7 years on new leases and 7.1 years on renewals.
Our tenant retention rate in office was 79% this quarter and we renewed one of our largest tenants, Epstein Becker & Green, for 12 years for approximately the same square footage at competitive market terms. Our office lease expiration this year and in 2017 are a very manageable 5.3% and 12.4% of annualized rent and drop to our – to below 10% in 2018.
Regionally, our same-store Washington, DC office portfolio continues to outperform its market with physical vacancy of 7.8% versus the market at a 11.8%. Our office portfolio is also outperforming in suburban Maryland and Northern Virginia, where our same-store physical vacancy rates are 10% and 11% below the vacancies in those markets.
Moving onto retail, our same-store portfolio experienced strong cash rental growth of 3.4%. Retail same-store cash and GAAP NOI declined, primarily due to the negative impact of vacancy from the tenant move-outs that occurred in the second quarter of 2015. As a reminder, these vacancies have been re-leased at higher rents and that will commence later in the year.
Our retail portfolio was 94% leased as of March 31, and has stabilized. We leased approximately 39,000 square feet of retail space, with new leases achieving an average rental rate increase of approximately 36% on a GAAP basis and 20% on a cash basis. Renewals were approximately 69% higher on a GAAP basis and 32% higher on a cash basis.
Strong rental growth rates evidence that, as we approach stabilized occupancy in retail, we improve our ability to drive rent growth, especially for smaller in line retailers at our most desirable centers. Our tenant retention rate in retail was 95% this quarter. We also achieved a strong weighted average term in retail with new leases at 9.8 years and renewals, which had been in the range of three to five years over the last four quarters improving to 11.6 years.
Multifamily same-store cash NOI was up 2.2% year-over-year, driven by better operating expense management and the fact that our portfolio has burned off historical rent concessions and abatements. Rents were essentially flat on a year-over-year basis, which is typical for the first quarter.
Multifamily same-store occupancy on a unit basis improved 110 basis points year-over-year and 90 basis points over the fourth quarter of 2015. The same-store portfolio ended the first quarter, 95.3% occupied with overall occupancy at 95.2%. Our capital plan for 2016 continues to focus on strengthening the balance sheet.
As Paul said, we expect to sell all of our suburban Maryland office assets, as well as a suburban multifamily asset and a parcel of land, and additionally, as a suburban office asset presently in the market. We continue to plan to deleverage by not paying down approximately $100 million of debt. We also plan to address the remaining approximately $81 million of our fixed rate secured debt that is maturing in 2016, as well as approximately $100 million of fixed rate secured debt that is maturing in 2017 of pre-payable without penalty in October 2016.
We plan to term out more debt in the second-half of the year and improve our annualized net debt to adjusted EBITDA ratio by year-end 2016. Finally, we reaffirm our full-year core FFO guidance range of $1.70 to $1.77 per share, and are increasing our same-store NOI guidance through a range of flat to 1%.
And with that, I will now turn the call back over to Paul.
Thank you, Steve. We continue to transform Washington REIT from a suburban to an urban REIT, owning and operating well-located high-quality, amenity-rich assets in our nation’s capital. We expect to grow EBITDA as the major leases signed last year commenced later this year and we will further strengthen our balance sheet by net paying down debt this year. The Washington metro region continues to show signs of recovery, led by private sector job growth, which is the best it has been in a decade.
Today, we have both a strong private sector, as well as a stable federal government that is now growing jobs and increasing procurement in the aftermath of the budget resolution in late 2015. Our ability to execute on both the asset recycling and the operational fronts has enabled us to maintain our strategic direction and improve the performance of our portfolio through challenging market conditions. Washington REIT is a stronger company today and is among the best positioned to benefit from a continued recovery in the Washington Metropolitan region.
Thank you. At this time we will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Anthony Paolone with JPMorgan. Please proceed with your question.
Thanks and good morning. Can you share with us the cap rates at least initial ones, for the apartments that you are purchasing, also the cap rate on the sale of this office portfolio?
Tony, it’s Paul. So on – in terms of the apartments that we are purchasing, we – it depends obviously how you allocate the land, but we are looking at cap rates similar to the Wellington. And then in terms of the product that we are selling, the suburban Maryland office, we are really not at liberty to get into kind of cap rate discussions, while it’s still under contract, so happy to talk about it as we start closing those two tranches.
Okay, and on Riverside, what does the more near-term capital commitment look like in terms of the things you mentioned – redeveloping some units, and then I guess further out going ground up?
Well, let’s – I mean let’s step back and just – I just want to reinforce why we bought it in the first place. We had been tracking Riverside for over a year and when we first looked at it, it had some debt encumbrances on it that probably would have made it inopportune in terms of our balance sheet requirements, so our hats off to the seller actually for recalibrating that.
But when we looked at Riverside, we saw an opportunity to buy a concrete high-rise B Class multifamily asset at good discounts and replacement costs. I think the assets that we get into, we try to aggressively move rents immediately and we think that there maybe an opportunity here.
Renovation dollars Tony, I think historically, we are in that $10 to $12 a door. The Wellington, I think we can look at $8 to $10 a door, and this might be a little more similar to the Wellington and hoping it to get a high teens return on cost on that. And then we have additional SAR that we are looking at here that’s probably about 550 additional doors that we would look to – if the market warrants that we would look to move on some time in 2018.
Okay, but do you have perhaps like for, I don’t know maybe this year and into next year, the magnitude of I guess, for redevelopment capital you might put to work? So it sounds like you’ve got still stuff going on at Wellington, you have Riverside. And you mentioned a couple of other corporate projects as well. Just trying to get a sense of dollar magnitude?
Tony, this is Steve. So the timeframe for the Wellington and we laid out the units that still needed to be renovated there is really over a three year timeframe. At the Riverside, we actually believe that once we get started, it’s going to be closer to two years to turn the units and renovate them. So I think Paul went over the cost per door, and then the way we modeled it is, how many units in the timeframe times the cost per door and that kind of gives us are – the way we would model the capital spend for renovations.
Okay. Just on a separate topic, then on the sales of suburban Maryland, can you give a sense just what the tradeoff in the environment was between execution and price, given kind of like you guys were in the market during the quarter where there is some volatility in the capital markets?
Well, I mean obviously Tony, we would have liked to – I’m greedy, I’ll admit it. I mean we would obviously like to get higher proceeds. But I think given, like we said, given all the volatility, we definitely – we messaged to the market that we were coming out with the 1.18 million square feet in the fourth quarter.
I think January, two things happened in January. Number one, we had a pretty volatile market, especially if any of the local operators that were probably looking at a CMBS execution. That probably was a little bit disruptive, weather hurt us a touch on our doors. But I think we recovered nicely. I think we ended up – our shortlist ended up with a nice mix of local operators with private equity, as well as the institutional buyer that we selected. I think it was disruptive overall in terms of the bumps that we hit in the first quarter, but I think we recovered nicely.
Okay. Thank you, guys.
Our next question comes from the line of John Guinee with Stifel. Please proceed with your question.
Well, thank you, John Guinee here. I think it was Steve Riffee, who was going through your rental spreads and CapEx, and I finally found it on Page 20 of the sup. It looks like you are spending about $75 a foot for office renewals and getting an 11 GAAP, but a five cash rent roll down. What are you including in your $75?
Hey, John, it’s Tom Bakke. So I think the – this quarter we had some, what I would call expensive renewals, and those were Epstein Becker and a couple others in DC, where and as deal costs are high. We look at – so it’s the full TI, full commission package even on renewal, because sort of the defensive nature of some of these deals that we were faced with. We did get a lot of term on these deals, in many cases 12 years.
But I wanted to touch on Epstein, because I think it’s an important deal as you look at what’s been happening with law firms in almost 70% to 75% of all law firms in these – in a district have relocated when their leases come up, because they’re inevitably shrinking and inevitably changing their office layout and their functionality.
And so to retain Epstein Becker in the face of this kind of climate, I think was a big win for us, because we probably saved a year, year and a half of downtime, and at $50 rents, that’s probably $75 of savings there. So when you add up a full TI package, a full abatement package, and a full commission on renewals that’s over 12 years that sort of steals your numbers there.
So I guess, Paul is it safe to conclude that these kind of numbers in your office releasing world in DC is why you’re focusing on apartments?
I think – I mean, John if we step back to – I’ve been here for over two years now. If we step back, I think one thing we said right out of the blocks as we – if we’re going to remain geographically constrained. Then we wanted to achieve more clarity amongst the asset classes.
I think when I got here, I think multifamily as a percentage of our NOI was roughly about 800 – excuse me roughly about 18%. Yes, I’m happy to report that we have moved multifamily almost post closing on Riverside. We’ll move the multifamily over 1,000 basis points in terms of our NOI. We’re also trying to derisk the portfolio and take out some of the volatility and I think our suburban office execution is going to accommodate that.
I think we’ve also haven’t been shy about saying that we think we have an opportunity to create more value. And we’ve proved it in some of our renovations and multifamily and get a better return on cost on the capital that we are reallocating. And I think it’s just – it’s a good thoughtful way to derisk the portfolio and offer our investors kind of a higher quality, more stabilized cash flow.
Thank you, great.
Thank you, John.
Our next question comes from the line of Jed Reagan with Green Street Advisors. Please proceed with your question.
Hey, good morning guys.
Just on the suburban Maryland transaction, it sounds like there were obviously the markets kind of had been full during that time. At the end of the day, where you able to get your initial price expectations or did things just end up coming in a little bit below that, just given some of the changes in the market?
Well, I think – Jed, I think when we talked about this, it might have been two calls ago, and it might even has been as recent as the last call and also at NAREIT. We said that we were selling suburban Maryland. So we’re actually not done yet selling suburban Maryland.
We still have another asset that we’ll be bringing to the market in the back half of this year. And I think our blended cap rate will be inline – maybe a touch higher, but will be inline with what our expectations were. I think as we talked about a couple minutes ago, I do think that in terms of not as much focusing on proceeds, but we tried to cast the widest net to get the most buyers possible that offered us the greatest certainty of execution in addition to proceeds.
I want to tell you, we did not take the highest bid on this asset. We went with certainty of execution. We are extremely comfortable with this buyer, vetted them between our third-party broker, and our own experience with this buyer. We think this – talked this buyer worse offered us the greatest certainty of execution and was worth any minimum proceeds trade-off.
Okay, thanks for that color. And just based on the assets that you currently have in the market or playing in the market later this year, is it fair to say you expect to sell another $100 million or so properties this year to be a net seller for the year of a similar size than what you outlined on the last call?
Yes, what we try to outline on the last call – this is Steve, Jed – it was specifically that we would be net sellers for the year that we planned to pay down debt and we also plan to reinvest some of the proceeds in a 10/31 exchange. We did not say what the total proceeds at all were going to be. We actually said that we wouldn’t, because we were in the market, and so we’re still on schedule. So, and we’ve messaged that the debt pay down were estimated to be $100 million.
Gotcha, okay. And are there additional acquisition opportunities you are exploring for this year still?
Not at this time. Jed, as I think we try to message pretty consistently, we’re always looking for value creation opportunities amongst the three asset classes. But I can’t say that there’s anything out there on market right now, outside of the Riverside that has really caught our eye.
Okay, thanks. And then just last one for me, it looks like leasing costs was down a little bit last quarter, but it’s still pretty high. Are you seeing any changes in the concession environment for office or is it still more or less a dogfight out there?
Jed, it’s Tom. I think the brief answer is that suburbs are still competitive, downtown is an expensive office market. But you generally get pretty good net effectives. I think the phenomenon, we’re really seeing in downtown office is that in past cycles you would start to see when you hit the 9%, 8%, which we’re seeing in the CBD. You would start to see free rent squeezed down and TI squeezed a little bit. What’s happening is instead of that occurring, you’re seeing the rents move up, and so we have seen pace rents grow and net effectives grow, but in a different way than in the past.
Okay, great. Thank you.
Our next question comes from the line of Blaine Heck with Wells Fargo. Please proceed with your question.
Thanks. I guess maybe a second shot for first question you guys got. Can you give us any sense of the spread between the cap rates on what’s being sold and what’s being bought? Is there any other way we should be thinking about it, I guess for modeling purposes?
Blaine, the way we talked about it before is that roughly, when you look at where we end up and you have to take into account, the blended cap rate for what’s left to be sold that we were shooting for about two percentage points of dilution on the trade. I think that’s still roughly right, assuming we execute the rest of the transactions the way we anticipate.
Great, that’s really helpful. And maybe I missed this, but what’s the expected timing on closing the acquisition?
So that also I reported, we would negotiate on the last call. So we believe the acquisition should close in the second quarter. We believe this dispositions will be done in two tranches as we’ve agreed, late – sometime in the second quarter and late in the third quarter for the other tranches.
And one of the tranches was separated under a separate contract and it’s part of the 10/31 exchange that we had to plan.
Great and I guess for Paul. You touched on this a little, but what made you confident that multifamily is the right space to invest in now? Obviously there’s some supply issues in the greater DC area, but is this a sector play where you think you can get the best risk adjusted returns in multifamily or was it just more of a matter of finding the right asset for the right price?
I think it’s a combination of both, Blaine. Like I said earlier, the company was underweighted in multifamily. We’ve loved the demographics in this region long term. We continue to see demand outpacing supply. We don’t see that changing in the near term.
I think unfortunately, the construction lending community and some ambitious developers might not have taken their foot off the accelerator quick enough looking back at the last 18 to 24 months. But we still see demand outpacing supply in 2017. And we think we’re going to be back to normalized rent growth in that 3% to 4% range in 2018.
We don’t see those demographics changing. We definitely see in terms of the multifamily that we like. The only challenge I would see with multifamily is our eye has been and will continue to be on affordability. We think some of the price points in that uber Class A are unachievable and not sustainable, and we’ve looked, we tried to target.
If you look at the Wellington acquisition and you look at the Riverside acquisition and research pace, and we tried to follow employment notes and we tried to target affordability gaps. And I think we’ve executed on that, both on the Wellington, hopefully on the Riverside and we also like the opportunity to sprinkle the infield a little bit and provide some organic growth through the development, not JVs. These will be Washington REIT developed assets, and I think that’s what you should expect out of us going forward.
That’s great color. Thanks.
Our next question comes from the line of Richard Schiller with Robert W. Baird. Please proceed with your question.
Hey, guys. This is Dick with Dave here. I just want to piggyback off of Blaine’s question as well. Have you guys set targets for your weighting of NOI between multifamily and office, maybe looking at the end of 2016 and possibly even beyond that?
I think Dick, what we tried to do and I think we’ve been pretty consistent about messaging and over the last 15 to 18 months, once our Board approved our strategic plan, as long as this organization is geographically constrained in this region, we won it more parity among the asset classes and we wanted to continue to derisk the portfolio.
We think adding more multifamily right now especially the type that has value creation opportunities like the Wellington, like Riverside, with additional development components helps us achieve that. But we also have and I think we’ve also been consistent in the past about our retail portfolio.
We have an opportunity to probably kill two birds with one stone with some of the redevelopment opportunities that are embedded in our retail portfolio. And so not only would we get more parity, but we think we’re going to do improve the quality of the portfolio by derisking some of the suburban office into downtown metro centric walkable amenities, metro type offices as well as the same type of an amenitized transit oriented multifamily and retail.
Sure, that’s great color, thanks.
Hey, Paul it’s Dave Rodgers here too. I want to jump in with a question or two. I guess on your comment about risk and kind of moderating the risk in the portfolio being constrained to the region.
Two thoughts around that, one is going from six office buildings and to kind of one apartment building and it may not be apples-for-apples, but it seems like larger single assets in the portfolio maybe the way that you end up going. Curious about that from a risk standpoint, also curious about that from a G&A savings standpoint as you think longer term.
Well, let’s start with getting rid of six and going to one. As you know office is expensive to recalibrate and re-tenant and we don’t have – I would say and if you look at the vacancy rates, right now in downtown versus suburban, I think that in some submarkets you can make the case Dave, that backfilling suburban office could be protracted.
I can tell you that on our multifamily right now, somebody moves out on Friday, I think the following Friday, we’ve got five people looking at the unit. So I think we’re taking out some of the volatility. In terms of the size of the asset, we are trying to scale up the multifamily portfolio.
We think we can gain efficiencies in scale and these bigger assets that have renovation potential and additional development potential. We actually think that that provides more growth and we’re reallocating capital at higher growth vehicles than higher risk vehicles. So I would actually say we’re derisking more than you’re actually alluding to.
Okay, that’s helpful. Thanks, Paul. And maybe last question for Steve, and I don’t know if you addressed this earlier, I just jumped on late. But regarding what the stock price is today and kind of having a mix of equity in the funding sources going forward. Is that becoming more of a consideration for you and the team?
Well Dave, I also saw your piece that was out today. And as you pointed out, we built our capital plans so far this year and accomplished multiple things, the strategic recycling, which includes buying and selling of assets. And I think you’re right that we’ve managed our plans by recycling so we don’t need equity.
But we will always be looking for value-add creation opportunities in terms of what to – where to put capital and we will always analyze whether or not we should access capital prudently to create shareholder value. So it’s something that we will always analyze, but so far we have created a plan where – if we do that, it’s because we think we can do something strategically right now. We’ve been creating a recycling plant where we don’t have to have it.
Okay, great. Thanks, guys.
[Operator Instructions] Our next question comes from the line of Chris Lucas with Capital One. Please proceed with your question.
Yes, good morning everyone. I guess just a couple of questions on Riverside, Paul, as it relates to the development opportunity that’s there. Is that ground ready to go, but for market conditions or do you have some things that you need to do that related to the zoning or density that needs to get?
We have some zoning issues, Dave that, I mean excuse me – Chris that we need to get through. And we’ve already met with the planners. We’re pretty comfortable that they’re addressing them. But we’re going to follow the appropriate protocols and that will take a good 12 to 18 months to get through. And I know we just started design development, but we will continue to push forward with that same as we’ve been doing on the Wellington.
And then as it relates to just sort of the CapEx, the differences between what you are doing at Wellington and what you are planning on doing at Riverside. Is the CapEx difference a function of maybe putting better quality finishes in Riverside or is it a function of more to do at Riverside relative to Wellington?
I think there might be a bit more to do at Riverside. One of the – a third of the project was already converted a while back, and that gave us comfort when we looked at the pricing spreads that they achieved there. I think we have a better unit mix here also Chris, so that really accounts for most of the differential.
And then last question, as it relates to specifically with the Cozen [ph] space, have you had a chance to start marketing that, and what’s the timing on, when you’ll be able to sort of get that space in market?
Chris, it’s Tom. So Cozen expires in May and until they’re out, we can’t get access to the space. So we’ve been focused on our redevelopment plan, which includes new entrance, new lobby, new amenity center, new roof, or expanded roof deck. And we believe that as soon as Cozen is out, we’ll get one of those floors demoed for a show floor, marketing center, and then we can go full blast on the redevelopment.
Okay, and then last question for me. Steve, you had mentioned that you are looking to improve the net debt-to-EBITDA ratio and some of that I know how to do with commencement of leases. I guess is there any leasing that needs to be done in order to kind of get to your year-end ratio?
No, there is a lot of leasing that needs to commence. We’ve been saying the next goal that we’re shooting for is the mid-6s and that side is accomplished by both paying off some of the debt and also buying the leases that come in. So we’ve got some large leases that commence ratably over the rest of the year. Sometimes that is the trailing 12 number. So we’ll start to have everything in place in the fourth quarter, and it gets stronger as you get more months of EBITDA in the ratio.
Okay, great. Thank you.
There are no further questions at this time. I would like to turn the floor back over to Mr. McDermott for any closing remarks.
Thank you. Again, I would like to thank everyone for your time today. We look forward to updating you on the execution of our strategic milestones over the coming weeks and to seeing many of you again at the upcoming NAREIT conference in June. Thank you everyone.
This concludes today’s teleconference. Thank you for your participation and you may disconnect your lines at this time.
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