Liberty Property Trust's (LPT) CEO Bill Hankowsky on Q2 2016 Results - Earnings Call Transcript

| About: Liberty Property (LPT)

Liberty Property Trust (NYSE:LPT)

Q2 2016 Earnings Conference Call

July 26, 2016 13:00 ET

Executives

Jeanne Leonard - Investor Relations

Bill Hankowsky - Chief Executive Officer

Chris Papa - Chief Financial Officer

George Alburger - Executive Vice President

Mary Beth Morrissey - Chief Accounting Officer

Analysts

Jordan Sadler - KeyBanc

Craig Mailman - KeyBanc

Tom Lesnick - Capital One Securities

Michael Bilerman - Citi

Alex Goldfarb - Sandler O’Neill

Ki Bin Kim - SunTrust Robinson Humphrey

Eric Frankel - Green Street Advisers

Erin Aslakson - Stifel

Brad Burke - Goldman Sachs

Operator

Good afternoon. My name is Michelle and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2016 Results. [Operator Instructions] I would now like to turn the call over to Jeanne Leonard. Please go ahead.

Jeanne Leonard

Thank you, Michelle and thank you everyone for tuning in today to Liberty’s second quarter 2016 earnings conference call. You are going to hear prepared remarks from Chief Executive Officer, Bill Hankowsky and Chief Financial Officer, Chris Papa. Also in the room and available for questions are Executive Vice President, George Alburger and Chief Accounting Officer, Mary Beth Morrissey. Chief Investment Officer, Mike Hagan, had a previously scheduled family commitment and cannot join us today.

This morning, Liberty issued a press release detailing our second quarter results as well as our supplemental financial package and you can access these in the Investors section of Liberty’s website at www.libertyproperty.com. In these documents, you will also find a reconciliation of non-GAAP financial measures to GAAP measures. I will also remind you that some of the statements made during this call will include forward-looking statements within the meaning of the federal securities law. Although Liberty believes that the expectations reflected in such forward-looking statements are based on reasonable assumptions, we can give no assurance that these expectations will be achieved. As forward-looking statements, these statements involve risks, uncertainties and other factors that could cause actual results to differ materially from the expected results, risks that were detailed in the issued press release and from time-to-time in the company’s filings with the Securities and Exchange Commission. The company assumes no obligation to update or supplement forward-looking statements that become untrue because of subsequent events. Bill, would you like to begin?

Bill Hankowsky

Yes, and thank you, Jeanne and good afternoon everyone. This morning, we announced second quarter results. And yesterday, we announced the much anticipated signing of a contract to sell roughly $1 billion of non-core real estate. Given our prior guidance and communications on our sales strategy and this separate in particular, in other words, our goal was to sell $1.2 billion in non-core real estate this year this should be no surprise this year.

This sale consists of suburban non-core office and high-finish flex real estate. It represents our entire suburban office portfolio in South Florida and Tampa, much of our Minnesota portfolio, the Cotton Center in Arizona and a large portfolio in Southeastern Pennsylvania. These properties are, on average, 20 years old and they are 89% leased as of June 30. Two-thirds of the entire square footage is office space and 40% of that amount is single-storey office. The office portion of the sales averages between $140 and $150 per square foot. The remaining one-third is high-finish flex with a small amount of industrial. And this portion of the sale averages between $80 and $90 per square foot. The cap rate, based on in-place NOI, is in the high 8s. The buyer is Workspace Property Trust, which has purchased real estate from us in the past. This sale will substantially complete our transformation from a suburban office-dominated company to a national industrial player, with a very focused office development platform in select markets. Additional information we can share with you about the sale is addressed in the press release. And in a minute, Chris will discuss the financial impact of the sale.

Let me now turn to the quarter. Our results for the second quarter reflected growth of our new platform is capable of providing with these results outpacing our expectations that we have provided to you in December. This quarter, we leased 5.4 million square feet of space. We are only in July and we have already taken care of 80% of our projected 2016 leasing activity. We recorded double-digit growth in rents, 10.9% on our industrial portfolio again. Both industrial and office rents are ahead of our plan year-to-date. Occupancy rose to 94.3%, up 50 basis points quarter-over-quarter, aided by a robust 70% renewal rate. We brought four developments into service. They were 52% occupied at the end of the quarter and a 5.9% yield on net occupancy. They are currently 67% leased as the distribution building at Caliber Ridge is now fully leased.

Our national industrial platform continues to provide development opportunities. We started construction of 1.6 million square feet of distribution space in the quarter in five different markets. We have signed, subsequent to quarter end, a lease for 1.2 million square feet of a distribution center we have under construction in the Lehigh Valley. And just this morning, we signed a lease with a 650,000 square foot building in the Lehigh Valley that we started this quarter. So, now on a signed basis, our development pipeline is 71% leased and now our Lehigh Valley industrial portfolio is 100% leased on a signed basis.

There is no doubt we are in a terrific operating environment in industrial. Nationally, the vacancy rate declined for the 25th consecutive quarter now at 8.8%, a 20 basis point decline from the first quarter. Development remains disciplined with 125 million square feet under construction in our markets, representing about 1.5% of the stock and it’s 41% pre-leased. We continue to see solid demand with no supply imbalances. We are watchful for any negative changes, but at this point, we cannot see any.

Not reflected in the supplemental package is our proposed Camden Waterfront project in New Jersey. As you know, we envision a 1.5 million square foot mixed use development in Camden and we have indicated significant interest from corporate customers with whom we develop facilities for a fee. We are still in our due diligence phase prior to committing to purchase the site, but already, American Water has decided to locate their corporate headquarters in what would be the first development on the site.

I have a few closing comments, but now I would like to turn it over to the newest member of the Liberty team, Chris Papa.

Chris Papa

Thanks, Bill. With respect to quarterly operating results, FFO for the second quarter was $0.68 per share compared to $0.67 per share in the same quarter of the prior year. FFO in the second quarter also included a gain on debt forgiveness of $0.02 per share. Overall, FFO continues to track modestly ahead of our plan for the year on better than expected operating performance of our stabilized portfolio and more specifically, the industrial portfolio. On a same-store basis year-to-date, industrial NOI is up 5.5% on a straight line basis and 6.2% on a cash basis compared to the same period in the prior year. This compares favorably to our original expectations of 1% to 3% increase in industrial NOI for the full year driven by a combination of rents, which are up 11.4% year-to-date and average occupancy for the same-store portfolio, which has increased from 94.9% in 2015 to 97.4% in 2016.

With respect to the portfolio sale, we expect to use net proceeds to reduce aggregate indebtedness outstanding on the company’s revolving line of credit as well as up to $700 million of senior unsecured debt. This should position us not only to reduce leverage and strengthen the balance sheet, but to opportunistically tap the investment grade market earlier than we otherwise might have, setting ourselves up to take advantage of this historically low rate environment. This should also leave us with meaningful dry powder, better positioning ourselves to exploit future opportunities as we move through the cycle. With respect to the early extinguishment of debt, we expect to record a debt extinguishment charge of up to $30 million or approximately $0.20 per share in the fourth quarter of 2016.

Turning now to the dividend, Liberty has historically viewed its dividend as an important component of the REIT’s total return proposition with shareholders. As Liberty moved through its repositioning strategy, however, its dividend has become more persistently uncovered by operating cash flow albeit by manageable amounts. Nevertheless, given the uncertainty surrounding the timing of the completion of the repositioning, the company felt that maintaining the dividend until it was complete was the best strategy. All that said, in light of the smaller portfolio and the increased clarity provided by the substantial completion of the repositioning, we believe that now is the appropriate time to address our dividend policy.

In that regard, we are thinking about our policy in terms of establishing a dividend that is both well covered and supported by recurring and sustainable cash flows and which strikes the balance between the retention of capital to support the business and the importance of dividends to the REIT total return model. We think this should result in a payout ratio relative to recurring AFFO that is generally in line with our peers and that is generally in the mid-70s to mid-80s percent range. As such, based on the impact of non-core assets sales on our business plan, our Board is considering adjusting our annual dividend to the $1.60 to $1.70 per share range starting with the first quarter’s dividend payable in April 2017. We anticipate that our dividend for the remainder of 2016 will remain unchanged. Obviously, the Board evaluates the company’s dividend on a quarterly basis and any final decision regarding the dividend will take into consideration the company’s then current outlook for FFO and AFFO as well as its requirements to distribute taxable income for REIT tax purposes. In subsequent years, we believe this action would allow future dividend increases to be covered and supported by growth in cash flows from the underlying business.

And so finally, as to earnings guidance, we have revised our 2016 FFO guidance to $2.30 to $2.40 per share compared to our original guidance of $2.35 to $2.55 per share. However, our revised forecast includes a $0.20 charge relating to the anticipated early retirement of debt and so excluding this charge the midpoint of our core FFO guidance has essentially increased by $0.10 from $2.45 per share to $2.55 per share. I would break down the increase in core FFO guidance into three components: One, a roughly $0.10 per share contribution from capital activities. Essentially, the impact of pushing back the timing of dispositions predominantly to the third quarter anticipated interest savings from the net retirement of debt and the gain on debt forgiveness reported earlier, offset by the impact on an upward revision in the volume of dispositions to $1.3 billion. Second, a roughly $0.05 per share contribution from better than anticipated performance of our stabilized operating portfolio. And lastly, a roughly $0.05 per share offset relating to a variety of other items including, but not limited to the timing and volume of development, severance and other items.

With that, I will turn it back over to Bill.

Bill Hankowsky

Thanks Chris. So halfway through 2016, we are very excited about where we are and what the future looks like. We began the year with the intent to dispose of our non-core real estate. When the portfolio sale closes, we will have sold approximately $1.2 billion in non-core assets. We anticipate sales of additional $100 million to $150 million in the third and fourth quarters. This disposition activity will mark the culmination of our multi-year repositioning process, a process that saw us dispose of over $3 billion in non-core assets since 2011. The new Liberty platform will have a substantially reoriented growth profile. We will derive 80% of our revenue from industrial assets on a national scale with 20% of our revenue from a focused office platform in select markets.

It will give us the opportunity to exploit our value creating development and leasing capabilities, to drive growth through our national industrial platform in selected metro office markets. Our Board is committed to providing shareholders with a well covered and sustainable dividend that retains capital acquired to internally fund value creation activities, new development related land acquisition entitlement and that rewards shareholders to appropriately time dividend increases funded by underlying cash flow growth, a balance which is essential. And finally, as Chris laid out, Liberty is committed to maintaining a conservative balance sheet that mitigates the risk of increased growth through new development and that is well positioned to take advantage of future opportunities in more challenging periods in the real estate cycle. So we look forward to a very active and a very strong second half of the year.

And with that Michelle, we would open it up to questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Craig Mailman from KeyBanc. Your line is open.

Jordan Sadler

Good morning everybody. It’s Jordan Sadler here with Craig, so thank you for fleshing out the detail on the dividend there for us. I had a question for you Bill maybe Chris, you want to address this as well since given your tenure at post, your post had a below average dividend payout, which ultimately I think culminated in one of the best balance sheets across the apartment space and I am curious how you thought about your historical context, how you thought about this cut, which seems helpful, but I guess it’s certainly not aligned I would imagine with taxable net income or maximizing retain capital and so just any initial thought on sort of setting this level would be helpful?

Chris Papa

Well, I mean overall, we looked at the dividend payout in our yield and determined that it was a substantially higher than our industrial peers, which are average payout ratio in the upper 70s of AFFO and their dividend yield is running around 3%. Both of our metrics in that regard were higher plus we are looking at a payout ratio that was probably right – right at 100% or maybe slightly above. So that said, I think just overall from a financial management standpoint, we thought we would be better positioned given the culmination of the repositioning to bring that back in line with what was more typical in both our – amongst our peer group and amongst REITs, in general. From a capital markets’ perspective, as you pointed out, such a dividend adjustments will not only position us to more comfortably cover and grow the dividend going forward consistent with cash flow, we also anticipate that it will position us to retain operating cash flow in the business that could allow us to fund as much as 10% to 15% of the annual capital requirements necessary to fund new development acquisition, which are running around $0.5 billion per year. When you combine that with the continued recycling of capital from annual asset sales, I think this will leave us with a manageable amount of future investments to be funded with new debt while still maintaining a strong balance sheet.

Jordan Sadler

Okay. And so it sounds like, just to clarify, are you leaving yourselves some room here for additional gains next year on a run-rate basis, is that the right way to think about it?

Chris Papa

You mean from a tax standpoint?

Jordan Sadler

Yes.

Chris Papa

I think, this year, I mean our goal is to try to manage the gains and we are still targeting not having a special dividend in 2016. Obviously, going forward and resetting the dividend to the range we talked about, we think we will be able to manage in that range not so much leaving dry powder for a significant amount of dispositions such as we had this year, but at a level that we should be able to manage normal operations on an annual basis from a REIT tax standpoint.

Bill Hankowsky

And Jordan, we sort of coming at it two ways, I think Chris laid out very thoughtfully the kind of – from a financial perspective. From a business perspective, we are running starts maybe around $500 million and we are not giving ‘17 guidance, I am not telling what we are going to do next year, but I will just say the world stays relatively the way it is, which is a pretty nice environment for industrial activity. When you think about how you are going to pay for that, we think about harvesting value, it could be from a great office deal we do, it could be from a great industrial deal we do, taken those proceeds, some of which will be profit. Take the retained capital, maybe mix it as Chris said little bit of debt. And so you are thinking about how you are going to fuel that growth, at the same time how you are going to keep and provide an opportunity to grow the dividend when it’s appropriate. So we sort of look at it coming both ways, kind of what’s a good dividend policy. We will also look at sort of what this company is going to look like over the next several years and what capital that we need and how do the pieces all mesh together.

Craig Mailman

Hey, guys. It’s Craig. I just have a follow-up on the use of capital here, just kind of two pieces, it sounded like you guys are refi-ing the $700 million on secureds, but Chris also mentioned the low interest rate environment, it gives you a chance to go back and hit that market again, so I am just curious are you rolling the debt or are you using cash to pay down. And that kind of leads into the next question about capacity, there are some bigger industrial portfolios in the market. Is that something you guys are looking at given the proceeds you have here are they just going to be the slow reinvestment through development?

Bill Hankowsky

Why don’t you take the first half, Chris, I will take the second.

Chris Papa

Sure. The way we are thinking about the balance sheet management here, I mean, we are sitting here at the end of the quarter, call it $400 million on the line of credit that has grown since quarter end. We will expect to complete the sale late in third quarter of 2016. We will take that, those proceeds, pay down the line temporarily and then our goal would be to also take out up to $700 million of unsecured debt. So, implicit in that is some liability management, because obviously that will put us in a position where we would start with the line balance, pay it down to with the proceeds and then be back in the line balance after we took out that $700 million. So, we are also trying to manage the balance sheet somewhat to be opportunistic in the capital markets today.

Bill Hankowsky

And Craig, to the second piece of it, yes, there is some industrial real estate for sale. And yes, some of it’s big. And yes, we would love to get deeper in markets and we would love to get bigger. And yes, it’s probably going to be really expensive. So, I would conjecture that there is – we had, I think $0 million to $50 million in acquisitions this year. I don’t see the cap rate environment savoring buying a whole bunch of that stuff. I think development would still be the preferred place where we would invest capital looking at the returns we are getting. But look, we are always on the lookout. And as you know, it’s probably more probable that Liberty would try to find some kind of value-add industrial situation, building with an expiring lease that the marketplace doesn’t find as interesting or a repositioning situation. But my sense at the moment is the stuff that’s out there that’s in the market is going to trade at the same kind of interesting cap rates as the stuff traded out last year.

Craig Mailman

Got it. Thanks, guys.

Operator

Your next question comes from Tom Lesnick from Capital One Securities. Your line is open.

Tom Lesnick

Hi, thanks for taking my questions. I guess first, I just wanted to clarify earlier remark, I think you mentioned a cap rate in the 8s on the portfolio. So, I was just wondering if you could clarify whether that was cash or debt and is that on in-place NOI or pro forma stabilized NOI?

Bill Hankowsky

Yes. So, it’s fundamentally about the same. It’s mature portfolio. So, it kind of ends up being about the same thing and it’s the in-place NOI as of June 30, right, Chris?

Chris Papa

That’s correct.

Tom Lesnick

And you just said it’s broadly or is this high 8s?

Bill Hankowsky

No, I said high 8s. I said high 8s.

Tom Lesnick

Perfect. And then were there any stragglers not included in the portfolio to sell that you are still trying to sell? And along those lines, how should we be thinking about the pricing environment for those assets relative to the portfolio which you sold?

Bill Hankowsky

Sure. So, I think just to tie it altogether, so we mentioned a couple of minutes ago that we think we are probably going to try to do another $100 million, $150 million in sales. It’s real estate that we know what it is and we know where it is and so it is identified, I am not sure I would quite use the word stragglers, but so it might be some assets that were in other submarket or a particular building here or there. I mean, one I know of is one we got a terrific long-term lease on and it makes sense to sell it by itself. It probably fits very well with a certain kind of investment profile. So, we think those will close over the remainder of the third and fourth quarter of the year. And what was the other half of the question?

Tom Lesnick

Just in terms of how we should expect pricing relative to the portfolio?

Bill Hankowsky

Sorry, yes, yes, thanks. I think you could see – remember, let me take you back. We sold in the suburbs of Philadelphia a project that here we called Devon Park, it was three buildings. We had a long-term lease with a nice credit tenant and then we got well leased a multi-tenant building. So, there were three buildings in a small little park. And they went for, I think, 240 a square foot and the cap rate was kind of mid 6s. It is conceivable that they are assets in this portfolio that we might want to sell that would have a profile that would look like that. And it’s also conceivable that there might be some assets that are single-storey office and will fall in that range, I said it earlier, it could be $140 to $120. There could be some flex that’s in the 80s. So, I think you could – that $100 to $150 is going to have a mix of probably some low cap healthy numbers and a few more assets that are non-core that we are just sitting here and there we want to get rid of this year.

Tom Lesnick

That’s very helpful. And just following up on the last discussion about leverage and uses of capital right now, how do you – given the run in the share price recently, how are you guys evaluating share repurchases in the context of the overall capital decision among acquisitions and development as well?

Bill Hankowsky

Chris?

Chris Papa

I mean, I would think as far as share repurchase going forward, I mean, I think our view would be unchanged from where we were before we would be very opportunistic. And I think at the current level, we just don’t see as much opportunity from – relative to our underlying NAV to do share repurchases at this juncture.

Bill Hankowsky

Yes. Chris, I mean, as you recall, we – the shares we did buyback had an average price of $30.25, something like that. So, that’s pretty dramatically different from where we are today. So, as Chris said, it’s not – that capital activity is not very much on our radar screen right now.

Tom Lesnick

Sure. And just one last one from me real quick, any update on UK and what’s going on with the home sale business over there?

Bill Hankowsky

Sure. So, I think the good news is that the home sale business is a little bit Brexit – is immune to the Brexit effect. And the reason is because of national policy in the UK vis-à-vis entitlement for development. I mean, its part of the reason we find it particularly interesting to be there and be in that business. So, it is very difficult to get land entitled for candidly any kind of development and that includes residential housing. And as a result, to some extent, there is a government created shortage. And there, in fact, is national policy that encourages communities to be receptive to allow for more housing development in order to, in fact, deal with that shortage. So, homebuilders continue to find it interesting to buy sites and build homes and sell them. And of course, this is done internal to the UK. So, homebuyers are buying in pounds and mortgaging in pounds and they find low interest rate environments attractive to allow them to acquire a home. So, at the moment, we see no negative impact or effect on the home business and therefore we think we are going to continue to see the kind of nice, steady land sale activity we have been seeing over the last several years in the UK.

Tom Lesnick

Alright. Thanks, guys. Congrats on the sale. I will hop back in the queue.

Bill Hankowsky

Thanks.

Operator

The next question comes from Manny Korchman from Citi. Your line is open.

Michael Bilerman

Hey, it’s actually Michael Bilerman. So Bill or Chris, as we think about sort of run-rate FFO as we come into the fourth quarter once all the sales are completed and once you have pro forma-ed for the financing, where does that sort of get you on an quarterly run-rate perspective?

Bill Hankowsky

You are edging your way to ‘17 guidance there, Michael, but yes – no, I understand. Chris, what do you think?

Chris Papa

Yes. And again, I think if you are looking at run-rate, I mean, we are expecting to close the sale in late third quarter. So, I don’t think you are not going to see as drastic a change in 3Q. 4Q, obviously, will have the sale assets out. And then if we are turning around and redeploying that capital into the line initially and then call it 30 days later there, plus or minus into debt redemption, you could have somewhat of a pickup in interest savings, but it won’t be for the full quarter. So, I would be thinking about it along those lines.

Bill Hankowsky

Yes. And so you are going to have the – the debt repayment charge – the prepayment charge assuming the fourth quarter and you really won’t have the full impact of the interest savings in the fourth quarter. So, it’s not really a fully kind of first quarter ‘17 is your kind of cleansed run-rate quarter, I think Michael is probably the right way to think about it.

Michael Bilerman

Right. And that’s what I just….

Bill Hankowsky

We kind of know what static is up.

Michael Bilerman

Right. I mean, there is other stuff going on, but I think it would be helpful just given the magnitude of the sales and the financing that you can provide a little bit of a roadmap to either give us very specific interest rate savings in terms of the dollars and the timing so that we can calculate it, or provide us sort of December 31, 2016, here is our quarterly run rate and from there, we can model the development completions, we can model the same-store performance, we can model their earn-in from this year, but I feel a little bit lost in terms of where that actual run rate is into next year?

Chris Papa

Yes. And Michael, I think if you think about along the lines of the assets on the portfolio sale being out by 9.30, we will first invest those proceeds into whatever line balance is then been outstanding. The rate there is running about 1.5%. Now, if you look in 30 days out, we are going to be looking more towards near-term maturities. I would probably peg the interest rate on that on a blended basis in the low-6s, call it 6.25. And that will be, call it, 30 days out or so from the closing of the sale. We would also have the $0.20 charge, like Bill said, of the early extinguishment of debt in the fourth quarter. So I think if you are looking at the yield on the assets in the high-8s, you can effectively do the math and get back to where our run rate ought to be in the fourth quarter, assuming kind of at that staged approach to the use of proceeds.

Bill Hankowsky

And Chris, one thing I would add is and if we did some liability management and did a new issue, the issue today would be…

Chris Papa

Yes. You are probably looking at something that’s in the mid-3. So if we turned around and reinvested some of that, you are correct, that would also be in the mid-3 range.

Michael Bilerman

How should we think about the FFO to AFFO drop on a go-forward basis, because obviously a lot of these assets have higher CapEx in the rest of your portfolio, historically you have been running call it a $0.60 drop between FFO and AFFO, how should we think about that trend into the fourth quarter once these assets are out, how does that narrow on a quarterly basis?

Bill Hankowsky

You are more right, it’s going to narrow, Michael. I mean this is a much more capital intensive portfolio, that the $1.3 billion of assets going out. I don’t know this.

Chris Papa

It could be about a third.

Bill Hankowsky

Chris, about a third?

Chris Papa

Yes. I think it would drop by – probably about a third on a run rate.

Michael Bilerman

So instead of $0.15 a quarter down $0.10 and arguably, the sales that you are selling, $1.3 billion in just call it the high-8s and paying down debt and mix of line and other debt, let’s call it in the mid-4s once it all blends together, you could talk about may be a $0.10 quarterly drop in FFO and you pick up maybe $0.05 on an AFFO basis, does that sound reasonable?

Chris Papa

We got this prepared stuff for the Board to come to a decision to say $1.60 to $1.70 on the dividend, I am just trying to back…

Bill Hankowsky

We are just trying to get stuff that candidly. We weren’t particularly interested in giving out today, which is our projections for ‘17.

Michael Bilerman

I wouldn’t be doing my job.

Bill Hankowsky

I hear you, Michael. We are all doing our job. We prepared a lot for the Board. They looked at multi-year analysis. I can tell you, we gave them even more than ‘17. But we are candidly not particularly interested in putting all that out there today. I think you have got, you have the right logic in your analysis, but I am – I think we are not going to go much further than that today.

Michael Bilerman

Just two other quick questions, just on the ordinary dividend in terms of what you need to distribute, the last 5 years, you have the ordinary portion of the dividend in terms of ordinary income has been about $1.40 and you have had the return of capital and capital gains, that’s brought you up to $1.90 in terms of characterization, so I guess I was surprised that the $1.60 to $1.70 was so much higher than what you currently have to distribute based on what has been treated as ordinary income in the last 5 years. And I recognize there are ins and outs to that, but it’s been pretty consistent around that $1.40 level-ish. So I guess and ordinary income arguably is going down with all these sales, so can you bridge some of that in terms of the $1.60 to $1.70 relative to what has been characterized as ordinary income in the last 5 years?

Chris Papa

Yes. And again, we are going to be looking at our taxable income on a go-forward basis. Once all the dust settles from the sale that’s something we’re looking at, both for ‘16 and going forward from ‘17, obviously we will – as we get further into the year and have more complete discussions with the Board about ‘17, where we are in ’17 guidance and budgets and that type of thing, we will get more specific on the amount of the dividend relative to that taxable income. But first and foremost, I think we are looking at overall in terms of recurring AFFO. So we are thinking about the dividend policy, namely as AFFO last year are non-recurring or periodically recurring fees and other land sale gains such as that. Although we view those items as positively contributing to earnings and cash flow, we consider them to be more transactional in nature so thus we are choosing to exclude those in terms of setting the dividend policy. So we are looking at it, first and foremost, that way. And then secondarily, we are also looking at our REIT distribution requirements and obviously we are considering both as the Board meets to set the dividend for 2017.

Michael Bilerman

Okay. And just last one on leverage, you are running today call it mid-30s debt to gross asset value, 6.5x debt to EBITDA, if you were to take the $1 billion, up to $1.3 billion of proceeds and simply pay down debt, I realize you have some construction spending on the development, but if you just do that, that’s taking you down 700 basis points to 800 basis points on leverage and 0.6x to 0.7x on debt to EBITDA, where do you want your goalposts to be from a leverage perspective, where should we think about where you want to operate because arguably, those are pretty light levels, but maybe that’s where you want to be going forward, I just want to make sure that we understand the re-leveraging of the balance sheet, if that were to occur, where you are going to take it to?

Chris Papa

Well, we have let it creep up a little bit. And on a book basis, you are probably looking at leverage today that’s just under 42%, I think you are correct in that when the dust settles from all of the repositioning and the capital activities we described, we should get down in kind of the mid-30s, call it 35%, 36%. Your debt to EBITDA as it go from low-6 down to low-5s and you can certainly see that creep back up as we use debt to fund new development. But also in that combination of capital recycling and the retention of capital from the dividend policy that I went through before, I think you will go up more manageably from kind of call it mid-30s back up towards 40% or let’s call it and trying to keep that debt to EBITDA right below 6x times over time.

Bill Hankowsky

Yes.

Chris Papa

And if you look back in prior years, like 2014 and going even back to ‘13, if you are looking at a debt to EBITDA back there, that was kind of 5.9x to 5.7x. So I don’t think it will be inconsistent with that approach.

Michael Bilerman

Okay. Thank you.

Bill Hankowsky

Thank you.

Operator

Your next question comes from Alex Goldfarb. Your line is open.

Alex Goldfarb

Good afternoon. Just continuing on, I didn’t hear any mention of special dividend, so just sort of curious, the gains on the portfolio sale, are the gains minimal or it’s all taken care through just normal, whether it’s the overpayment, etcetera, that it’s all taken through the normal dividend, if you can just walk through that, especially because this would be the second dividend cut in the past 10 years, so just thinking that perhaps shareholders may want to get some sort of special dividend out of this restructuring before the dividend gets resized?

Chris Papa

Yes. Alex, I mean we will have meaningful gains from the sales. Our goal is and we are still working towards this, is not to have a special dividend in 2016. Obviously, we have a lot of ground to still cover between now and year end, but that is still our goal.

Alex Goldfarb

Okay. And then Chris can you just walk through the economics of taking out the average 6.25% coupons, $700 million on the debt. It just seems – I am assuming that it’s pretty much the same math whether you pay it versus pay it over time to maturity versus repay it now and especially given that interest rates don’t seem to be going anywhere, anytime soon, so it doesn’t seem like there is as much of a rush these days as there was several years ago where people were much more active on the prepay. So, can you just walk through the – your thinking on the paying the $30 million prepay now?

Chris Papa

Yes, I mean, Alex, if you look at it and obviously, anything you would be doing on the – is either using proceeds, number one. So, you would either be comparing that to sitting one payment down the line, which is, call it, 1.5%, but the other is sitting on cash and really earning nothing on that cash until such time as you redeploy it back into development. So, you have that component of it. But alternatively, pushing this up to a level where you can also employ some liability management where you are paying off some high coupon debt and actually reissuing new debt at lower interest rates taking advantage of the low interest rate environment today, you are probably looking at something that’s probably call it in the mid 30s to upper 40 basis point range as far as the economic cost over 10 years if you were to assume rolling this into a new debt issuance. So, it’s really again, it’s all based on what your view of interest rates are, where you think this is going to go. But if you sat on the capital, put it into cash, redeployed it more slowly, obviously, there is a cost to that as well as a cost of being a little bit more opportunistic. And I think we are just choosing today given that order of magnitude of the cost is to take advantage of some degree of balance sheet management here and take advantage of the rate environment, not knowing – really none of us know how long this will continue.

Alex Goldfarb

Okay. And then Bill, I understand that it’s not the December outlook call, but still if you are going to save about $0.30 a year on the interest expense, I am not thinking that you want everyone to bring up their estimate next year by that $0.30. So, is there some sort of debt issuance that we should be thinking about just so that, that way, the ‘17 estimates are somewhere – don’t get too carried away by the savings?

Bill Hankowsky

Yes, again, let me just – so the rough construct here – and Chris will jump in if I kind of get this wrong is the rough construct is you are bringing the proceeds, you pay down the line immediately. Then you would issue redemption notice to bondholders for up to around $700 million. You have to wait a period of time for that process to play itself out. It plays out. Now, you have redeemed, you have actually – you have actually put – the net of that will be actually put new amounts on the line, not inconsiderable and you say, hey, let’s, at that point or you could decide somewhere at the timing, maybe opportunistic, but let’s go do an issuance. We had to do $250 million, $300 million, $350 million issuances partially they fit in the index, partially because they are efficient to do. So something like that, you put that back on. But as Chris said, you have traded out 6ish average kind of cost of capital for mid-3s to average kind of cost of capital. I think that’s the way to kind of think about it. Does that kind of get you to where you want to be, Alex?

Alex Goldfarb

Okay. So, just in sort of absolute numbers, so there is no ambiguity. On a sort of estimate basis, $0.30 savings, we should think about half of that? In our effect, impacting our ‘17 number, just that way, there is just no disconnect when you guys come out versus where we are all going to adjust numbers to?

Chris Papa

Yes. And again, I think if you think about it in terms of any new issuance we will be doing along the lines of what we have done in the past kind of call it, 300ish, that’s about how I would think about it.

Alex Goldfarb

Okay, okay.

Bill Hankowsky

So, [indiscernible] whatever that, yes.

Alex Goldfarb

Bill, that’s excellent. That’s helpful. Okay, thank you.

Bill Hankowsky

Yes, thanks. Yes.

Operator

Your next question comes from Ki Bin Kim. Your line is open.

Ki Bin Kim

Thank you. Not to believe at a dividend point, but in 2017, after you get a full run-rate of the dilution from the asset sales, based on the midpoint of your payout range or the new dividend range, you are probably getting back up to like a 90%, 95% payout ratio. And I know that fixes itself as you grow the company into the following year after that, but this is just preliminary, but it seems like you don’t get to that 75% AFFO payout ratio till late 2018, maybe 2019. So one then, I mean, that is an observation and I went to see about ballpark? But second, within your kind of longer term plan, are you assuming a step up in acquisitions or something else that would effectively take you back into that kind of 75% payout ratio range?

Chris Papa

Yes. Chris, I don’t think that math is right, Ki. Because the notion is to be – in the mid-70s, call it just 75 to 85 just to put – as a payout ratio on AFFO. And part of what we are looking at and Chris talked about this is the concept of sort of recurring AFFO and total AFFO. So, we have earlier in the call here people have raised things like the land sales we do in the UK. We have mentioned our developer fee income that we get, whether it’s Comcast or Camden and there maybe other opportunities down the road. So, there is other pieces of our overall earnings that makeup everything that we do. And so what we are trying to do is say, let’s look at that piece. It comes more out of what I will the call core, basically rent, in the operating portfolio. And let’s set a ratio consistent with that. So, I don’t – I didn’t – we don’t get to a 90%.

Ki Bin Kim

Well temporarily, I thought you got there, temporarily, but I guess was when you put out guidance. And second, how will you describe the quality of your remaining office portfolio? I was wondering if you could help us out framing that in terms of rent or age or tenant quality just compared to what you sold?

Bill Hankowsky

Yes, sure. Why don’t I do it this way? By the end of the year, go with that other $100 million to $150 million in sales, just assume that happens, right. And so we would be down to about 6.8 million square feet of office space. I am excluding what’s being built in the pipeline, okay. Let’s just talk of what’s in the portfolio today. And what would that consist of, just so you have an ability to sort of add it back up. You have about 2.8 million square feet that I would call Metro, our interest in the Comcast Center, our 515,000 square foot at the Navy Yard, our University of Pennsylvania long-term 20-year-old lease building in Philadelphia, our four assets in the District of Columbia. So, that’s one bucket. We still have about 1.9 million, not quite 2 million square feet in Southeastern Pennsylvania suburbs, about 930,000 square feet of that is leased in a variety of leases to Vanguard and then the other million square feet is in the King of Prussia submarket, one of the stronger submarkets and it ranges in age some of its stuff, we have repositioned some of it – some of it’s older. There is also about 525,000 square feet in Phoenix, that’s all A stuff that mostly the Tempe project that we have built. There is another 470,000 square feet in the UK also all, what I would call A product. And then there is about 700,000 that I would put in a bucket that I would call redevelopment opportunities. So, I think many of you are aware, we have got about 280,000 square feet in Southeastern Pennsylvania that we have effectively mothballed, where we have gotten approval to do more dense project and we are working on that. We also have a 345,000 square foot building in Minnesota that’s on a 10-year long-term lease, but it’s part of a 40-acre site, where a new light rail transit stop is going in. So, we view that as a redevelopment opportunity. And there is one other place where there is about 100,000 square feet that also has a real potential to be a “knockdown” built, put something in place. So, fundamentally, this is a very heavily Metro, very heavily Class A remaining portfolio. I don’t have in my head the average age, but we will round here somewhere. Is that helpful?

Ki Bin Kim

Yes, very helpful. Maybe just one last question, how about the rent per square foot, do you have that handy?

Bill Hankowsky

I don’t. On that remaining office? Yes, I don’t. We will – maybe offline we can find it for you.

Ki Bin Kim

Okay, thank you.

Bill Hankowsky

Thank you.

Operator

Your next question comes from Eric Frankel from Green Street Advisors. Your line is open.

Eric Frankel

Thank you. I think you guys have beaten the balance sheet and office portfolio issues, so I will avoid that for my questions.

Bill Hankowsky

Thanks, Eric.

Eric Frankel

We could talk about that further offline. Can you just talk about the fee potential for some of the candid development, I am not sure you guys have outlined that?

Bill Hankowsky

The fee potential?

Eric Frankel

Yes.

Bill Hankowsky

Yes. So, the way we have I think generally characterized that is here is some sort of shorthand math. Let’s say, it’s 1.4 million, 1.5 million square feet of office development, let’s say, it gets built for $500 a square foot, let’s say you charge a developer fee that’s kind of market is that 5%, 6%. There are some expenses that you incur. But I think that will give you an order of magnitude sense of it. It would – and I am way off my expertise in terms of the accounting for this, but basically you would recognize it as it happens as the buildings get built, because you are doing this on a fee basis. So, it will depend when the starts happen and when they are done and so you kind of even it out over the construction period, what you are “earning.” So, it’s generally would be, I think, viewed as revenue, assuming all this all comes together, that would be very much of that – very little about ‘16, it’s much about ‘17, ‘18, ‘19.

Eric Frankel

Okay, that’s helpful. Then I guess we have some time to think about that. Moving to the industrial portfolio, so you talked about the types of companies that let those two buildings in Lehigh Valley that are now under construction?

Chris Papa

Okay. So, here is the headlines they are not e-commerce. There you go, alright. How about that? There were still old fashioned industrial customers. I am not going to tell you who they are, because they would prefer not to be known. But one is – one produces a product and needs a place to store it. So, they have a production facility up in the valley and they need some space to do that. The other is actually one, a contract from a very large company, like a Fortune 100 company, where they are going to provide support for that company in their business. So, they are going to have parts that they will distribute on behalf of that company to the various operations that support that company. So, it’s very classic distribution kind of users.

Eric Frankel

One thing I noticed with those two projects under construction, the development – the cost actually seems somewhat high for a – I don’t want to call it a greenfield location, but there isn’t enough tearing down buildings and there isn’t a lot of readout work that goes into construction before you actually start. And so I think it came up to $78 a foot for the smaller building, about $70 for the larger building. Can you talk about construction cost, in general, maybe construction cost from Lehigh Valley more specifically?

Bill Hankowsky

Yes. So, I think there is a couple of attributes there. Number one is this is a very big, I think it’s 425 acres site that we are developing that required a fair amount of site work. So, I mean we have had to move a lot of soil to level the site. We have had to put in a road, bring in all the utilities. So – and that’s all, to your point, in your question about construction, because that’s sort of in today’s dollars. In other words, this is not a part that we have had for a long time, where we built all that out, 5, 6, 7 years ago. This is stuff we have just built out over the last – fundamentally, over the last 12 to 18 months. And then you are also right and then we are also building these buildings literally right now, one obviously commenced in the quarter. So, costs are up a bit. I mean, I wouldn’t say that it’s – I mean, I think more recent stuff we might have done in that high 60s and this is 70s – in the mid, it’s a little bit higher. So, they have creeped up. So, I would attribute partially to site development costs, which then obviously could become part of your land cost and then an uptick in general construction.

Eric Frankel

Can I assume that rents have come along with it?

Bill Hankowsky

You can totally assume rents have come along with it. You are clearly at the high rents ever in the Lehigh Valley. You are in the – they are all starting with 5s, some low 5s, some mid 5s.

Eric Frankel

Fascinating. Okay, I kind of lied, I actually have one question related to the debt. Chris, can you just confirm, I think you talked about $700 million in debt redemptions. Are those just ‘16 through ‘18 unsecured debt maturities or could that be further along in term what you want to redeem?

Chris Papa

Again, I was going to be a little careful here, we are not giving notice as yet to redeem, but I would think about it in terms of nearer term maturities.

Eric Frankel

Okay, that’s it from me. Thank you.

Bill Hankowsky

Thanks.

Operator

Your next question comes from Erin Aslakson from Stifel. Your line is open.

Erin Aslakson

Thanks for taking the questions. So, I noticed OpEx in the second quarter looked a little bit low relative to revenues, was there anything going on there?

Bill Hankowsky

Not that I can think of, no. I think it’s right just the – just so in general variability. There is nothing special quarter-over-quarter.

Erin Aslakson

Okay. So, nothing came in unannounced. I also noticed the straight line adjustment dipped this quarter. Was that somehow related or something completely different?

Bill Hankowsky

There again, nothing – nothing special.

Erin Aslakson

Alright. And then I noticed the footnote #2 on Page 11 of the supplement, 345,000 square foot lease, was that the Minnesota asset?

Bill Hankowsky

Yes, yes. This is the building…

Erin Aslakson

What’s going on there?

Bill Hankowsky

Yes, sure. Yes, so this is a building – the 345,000 square foot building on a 40 acre site, going back way back. It actually was Best Buy’s headquarters at one time. We acquired it probably about 8 or 9 years ago, if my recollection is right. And we saw it at the time as actually a redevelopment opportunity, because there was all this acreage and we actually looked at whether we would build up new office buildings there or other kind of uses. Subsequently, very quickly thereafter, SuperValu came along and said we are out of space where we are. Could we take that building? In fact, could we take the whole building? So, we entered into a 7-year lease with SuperValu. They paid all the TIs and they were there. Then by the time that lease expired, unfortunately their business had gotten a little more rugged. And as you might recall, they actually got acquired in a private – made new private equity deal. And they moved back to a real estate that they owned. So, the building came back to us. In the interim, over that sort of 7-year period, the metropolitan area in Minneapolis had advanced pretty considerably with the concept to put in place a new light rail line that would go out towards this site, in fact, where they would literally put a station stop on our property. So, we said it will be interesting if we could find somebody who would lease this building. And in fact hopefully, from their business, it makes sense for them. But from our perspective in effect, pay the carry for that building to be there as we await that development. And then there is a process underway right now where the various communities are looking at their zoning to – I will use the term up-zone in other words densify the zoning and look around the transit stops. So in fact, we have held this property on the – I think on the south side of where the track will be. And we have also did not sell the flex assets, which we own on the north side. So we actually own roughly another 20 acres on the north side. So we would own the neighborhood around this transit stop. Whether Liberty goes ahead and executes a redevelopment play, whether some other developer whether somebody with – for example, had a residential interest, those are things that will transpire over time. But we did this transaction, it kind of didn’t – and when we gave guidance in December, I think we were specific to say that this one transaction, which we signed in ‘15, we signed it in ‘15, but by the time they did the TIs, it is commencing this quarter, we just didn’t put it in because it was sort of an aberrant transaction and it kind of moved the numbers in a way that won’t give you a very clear sense of real performance of the portfolio.

Erin Aslakson

Okay, that makes sense. So who is the new tenant there?

Bill Hankowsky

Bluestem.

Erin Aslakson

Okay. I am not familiar with them, what do they do?

Bill Hankowsky

They are a – what the heck, how about this, I am forgetting for a split second. I will come back.

Erin Aslakson

Okay, no problem. We can check it out. Thank you very much guys.

Bill Hankowsky

Thank you.

Operator

[Operator Instructions] Your next question comes from Brad Burke from Goldman Sachs. Your line is open.

Brad Burke

Good afternoon guys. I was going to stick to the theme of trying to figure out the run rate, I am just thinking about the guidance that you have given or the range that you have given, thinking about the updated dividend at the low end of the $1.60 and at the high end of the potential payout range, 85%, that would apply 1.88, almost 1.90 of AFFO. And depending on how you measure it, that’s generally in line with where you are at right now, is that the right way to think about it that even though you are going to be selling a lot of these higher cap rate assets and de-levering that, you are not going to have any degradation in AFFO. And if that’s not right, at least in the near-term, how you are thinking about the timing of eventually being able to get to that run rate AFFO that will support the dividend range and the payout range that you talked about?

Chris Papa

Yes. So I mean if you think about it in terms of selling, let’s say, incrementally $1 billion worth of real estate, redeploying that and we said high-8s cap rate on that, you are redeploying it about $700 million worth of debt, let’s call in a 6.25 rate on that. And then the rest of it will be coming out of the line at least temporarily. So you think about that, as far as potential net impact on FFO offsetting that, you have – if you do any new debt issuance, you will have that impact. And then you also have the savings on the TI and lease commissions that will also go away. So you are taking that portion of the portfolio out and the capital activities. And offsetting that going forward, you are going to have also the continued growth in the development pipeline, which will be coming on stream as we continue to build that out. So that will be offsetting some of that dilution going into 2017. Obviously, we are not giving guidance today, but in setting the ranges, I mean we are trying to give you some indication of how we are thinking about it, both from a percentage standpoint and from a dollar standpoint. And obviously, we will look at this again as we get through the year and start talking about earnings guidance probably in December.

Brad Burke

Okay. And then the other one for me, I don’t know if you said this already, but could you give any color on the cap rates on the dispositions between office, industrial and flex?

Chris Papa

Yes. We gave a – always it was we gave you a profile of portfolio being sold. So it’s roughly two-thirds office, one-third flex. We gave a sense that office is about 40% of two-thirds is single-storey office. We gave you a sense of pricing on a per pound basis which is to say that the office is probably going to trade about $140 to $150 per square foot and that the flex is probably $80 to $90 per square foot. If you roll all that up, you are in a kind of high 9s cap rate.

Bill Hankowsky

High 8s.

Chris Papa

High 8s, I am sorry, high 8s. Thanks.

Brad Burke

Okay, got it. But no color on cap rates on the office component versus the industrial component?

Chris Papa

We didn’t give you more than that.

Brad Burke

Got it. Alright, thank you.

Bill Hankowsky

Thank you.

Operator

I have no further questions in queue at this time. I turn the call back over to the presenters for closing remarks.

Bill Hankowsky

Appreciate everybody being on. Appreciate all the attention and will talk to you in another 90 days. Thanks everybody. Have a great summer.

Operator

Thanks, everyone. This concludes today’s conference call. You may now disconnect.

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