Equity Commonwealth (NYSE:EQC)
Q2 2016 Earnings Conference Call
July 29, 2016 10:00 AM ET
Sarah Byrnes - Investor Relations
David Helfand - President & Chief Executive Officer
Adam Markman - Chief Financial Officer
David Weinberg - Chief Operating Officer
Jamie Feldman - Band of America/Merrill Lynch
Jed Reagan - Green Street Advisors
John Guinee - Stifel Nicolaus
Manny Korchman - Citi
Greetings and welcome to the Equity Commonwealth Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Sarah Byrnes, Vice President of Investor Relations for Equity Commonwealth. Thank you, Ms. Byrnes, you may begin.
Thank you, Doug. Good morning and thank you for joining us to discuss Equity Commonwealth's results for the quarter ended June 30, 2016. Our speakers today are David Helfand, our President and CEO; Adam Markman, CFO; and David Weinberg, our COO.
Please be advised that certain matters discussed during this conference call may constitute forward-looking statements within the meaning of Federal Securities Laws. We refer you to the documents that we filed from time-to-time with the SEC, which refer to risk factors that could adversely affect the company's operating results and financial condition. The company assumes no obligation to update or supplement any statements made today that become untrue because of subsequent events or otherwise.
Today's remarks also include certain non-GAAP financial measures. Please refer to yesterday's press release announcing our second quarter 2016 results for a reconciliation of these non-GAAP performance measures to our GAAP financial results, which is available on our website. With that, I will turn the call over to David Helfand.
Thanks, Sarah. Good morning. Thank you for joining us. I will share a few observations on macro market conditions and update you on our progress for achieving the Company strategic objectives. The U.S. economy continues to grow modestly with second quarter GDP reported this morning up just over 1%. The outlook for growth is clouded by uncertainty related to the upcoming election and the repercussions of the UK's decision to leave the European Union. By historic standards, growth in the U.S. is weak. We are now seven years into an economic expansion that has produced annual GDP growth of just 2% versus a historical recovery rate of 4% plus.
Labor market conditions have slowly improved with headline unemployment falling from a peak of 10% to just below 5%, and wages have begun to grow modestly. Office fundamentals continue to improve though at a modest pace compared to prior cycles. Since 2009, demand growth has averaged less than 1% annually, roughly half the long term average. Recently, supply growth has risen to roughly 1% of existing stock, still limited compared to prior cycles though a factor in a number of markets across the country. The capital markets have been accommodated and the investment sale market remains active. Office transaction volume is down 15% or so in the first half of the year though it remains generally healthy. The CMBS market is an area of potential concern with origination volume down 50% for the first six months of the year.
Investor appetite and the regulatory outlook for CMBS lending remains uncertain. The capacity of the CMBS market for the balance of the year and the degree to which balance sheet lenders fill any void it might create could have important implications for liquidity going forward. Despite these uncertainties, historically low borrowing costs and the demand for yield are powerful trends that result in substantial investor demand. As a result, we continue to view it an attractive time to sell real estate assets. We put in $704 million of dispositions year to date, representing 22 properties comprising 4 million square feet. Since taking responsibility for the Company, asset sales have totaled $3.6 billion. During the second quarter, we closed on the sale of 13 properties in seven separate transactions, including a self storage facility in Hawaii, and a Philadelphia office building, 1525 Locust, which we discussed on our last call.
We sold two small properties in downtown Austin totaling 116,000 square feet for $32.6 million with pricing in the low 5% cap rate range. We sold a 180,000 square foot property in suburban Austin as well, Lakewood on the Park, for $37.1 million with pricing in the mid 4% of cap rate range. In addition, we sold land leased as vineyards in Gonzales, California for $48.5 million with pricing in the low 6% cap rate range, and 9110 East Nichols Avenue, a two story, 144,000 square foot suburban office property in Centennial, Colorado for $17.2 million with pricing in the mid 8% cap rate range. And finally, a six property movie theater portfolio encompassing 552,000 square feet for $109 million with pricing in the high 7% cap rate range.
In addition since quarter end, we completed the sale of six properties, two of which were held for sale as of June 30th, for a gross sales price totaling $290.2 million. This includes 111 River Street in Hoboken of 566,000 square foot ground leased office building on the Jersey waterfront for $235 million with pricing in the mid 6% cap rate range. A three-property portfolio of industrial assets totaling 804,000 square feet in South Carolina for $30 million with pricing in the mid 8% cap rate range. We sold Sky Park Center, a two-building 63,000 square foot office property in San Diego for $13.7 million with pricing in the mid 8% cap rate range. And finally, we closed on the sale of Raintree Industrial Park, a 12-building property in Ohio encompassing 563,000 square feet for $11.5 million with pricing in the low 10% cap rate range. We currently have 12 properties totaling over 6 million square feet in various stages of sale process. Our disposition program has benefited from a tailwind in the market and strong execution by the EQC team. As a result, we currently expect to exceed the $3 billion we established in early 2015 likely by the end of the year. Two years ago, we assembled a team and began the process of taking ownership of EQC. We set out to identify opportunities to create value through aggressive leasing and asset sales. In a relatively short time, out team has made significant progress reshaping the Company and establishing a track record of successful execution and value creation. We're proud of our accomplishments to date and excited about our future opportunities.
With that, I will turn the call over to Adam.
Thanks, David. Good morning. I will review our financial results for the quarter which were meaningfully impacted by our disposition program and by our recent leasing activity. Diluted FFO was $0.36 per share compared to $0.59 a year ago. Normalized FFO was $0.42 per share compared to $0.52 last year. Normalized FFO decreased primarily due to assets sold over the year and to a drop in same property cash NOI. This was somewhat offset by an increase in revenue from lease termination fees and by interest expense savings. Same property NOI was up 19.2% from a year ago due to lease termination income. The termination income was generated from a large tenant who gave back space as part of the recent 228,000 square-foot Salesforce lease in Indianapolis. Without this termination income, same property NOI would have been down 3.7%. This decrease was driven by previously discussed tenant moveouts and downsizings partially offset by leases which commenced in the past year and lower operating expenses related to real estate taxes and utilities. Same property cash NOI decreased 5.7% when compared to the second quarter of last year. As discussed earlier, a majority of the decline comes from previously disclosed moveouts partially offset by lower operating expenses. Cash NOI does not include revenues from approximately 800,000 square feet of leases and free rent periods during the second quarter.
Furthermore, neither cash nor GAAP NOI currently reflect an additional 862,000 square feet of new leases which have not yet commenced. Some of this newly leased square footage will take occupancy later in 2016 with a more significant portion commencing in 2017. Through July, we have sold $704 million of properties. These dispositions generated a substantial taxable gain which offsets a large portion of our NOL. Whether a 2016 common distribution will be required remains dependent on the amount of any gains or losses generated from future disposition activity.
Also related to future dispositions, you will notice that we have taken a loss on asset impairment this quarter. The impairment is an outcome of additional progress we have made on property sales which shorten the amount of time we anticipate owning these assets.
Hold period is an important input to GAAP impairment calculations. A shorter hold period resulted in impairments to two office buildings in Indianapolis and to one in Milwaukee. We remain focused on financial flexibility. We intend to operate within the general parameters of a BBB unsecured debt rating. To that end during the quarter, we've regained our $275 million 7.25% coupon series E preferred shares. For the remainder of 2016, we have $460 million of debt that is repayable at par. The weighted average coupon of these liabilities is 6%.
Our cash balance at quarter end was approximately $1.8 billion and is currently $2 billion or approximately $16 per share. We continue to evaluate various uses of cash including new investment opportunities, debt repayments, share buybacks, and special distributions. Our balance sheet remains very strong, and we have significant liquidity between our cash balance and undrawn revolver. We are well positioned for future opportunities.
Thank you, and I will now turn the call over to our Chief Operating Officer, David Weinberg.
Thank you, Adam, and good morning, everyone. I will begin by reviewing our second quarter leasing activity, then I will give a brief update on our top six markets and provide an overview of our lease roll in 2016 and 2017. Our same property portfolio was 90.3% leased at the end of the second quarter, down 30 basis points in the first quarter of 2016. This decline was largely due to the previously discussed 184,000 square feet we got back from FMC at 1735 Market in Philadelphia.
During the second quarter, we signed 802,000 square feet of leases including 495,000 square feet of new leases and 307,000 square feet of renewals. On a same property portfolio basis, this is the most new leasing we have done during any of the prior four quarters. As announced on our last call, our largest deal was a new lease with Salesforce for 228,000 square feet at 111 Monument Circle. This is the tallest building in Indianapolis and was renamed Salesforce Tower. Renewal volume during the quarter was slower than the prior four quarters, as we have addressed many large expirations over the past year. During the quarter, rental rates increased 6.9% on a GAAP basis and declined 3.7% on a cash basis.
With respect to our top six markets, it is more of the same. In general, they are healthy and we are seeing good leasing activity. The vacancy rates in Bellevue, Austin, Chicago, and Philadelphia range from 10% to 12%. Each of these markets has seen year to date positive net absorption and rent growth. The vacancy rate in Denver is around 14%, which is about 150 basis points higher than a year ago. The combination of new supply and a slowdown in the energy sector is impacting this market. The vacancy rate in Indianapolis is around 17%, which is about 250 basis points lower than a year ago. Our largest vacancy is at 1735 Market in Philadelphia where we continue to make progress and have signed 72,000 square feet of new leases year to date.
Finally, I would like to comment on our lease roll in 2016 and 2017. For the balance of this year, we only have 372,000 square feet expiring of which we expect to get about two thirds back. This includes a 104,000 square foot tenant at an industrial building that will vacate in October. Looking ahead to 2017, we have 1.3 million square feet rolling or 7% above leased square footage. As previously discussed, our own large tenant expiring in 2017 is Truven Health Analytics, a 175,000 square foot tenant in Ann Arbor that will be vacating when their lease expires next February. No other tenants rolling in 2017 are greater than 75,000 square feet. In the context of a 20 million square foot portfolio, this is a manageable amount of lease roll. With that, we will open it up to Q&A.
Thank you. [Operator Instructions] Our first question comes from the line of Jamie Feldman from Bank of America. Please proceed with your question.
Thanks, and good morning. I guess starting going back to your comment on the dividends, can you tell us where you are versus the operating losses? What kind of gains you will need to see here to actually have to pay a dividend?
Hello, Jamie. It's Adam. Really just echoing what I said in my prepared remarks that sales that we have completed to date this year have generated significant taxable gain. And that has used up a large chunk of the NOLs that we came into the quarter with. So what happens next is going to be very highly dependent on the specific assets and gain and loss embedded in those assets that we dispose of.
Okay. And then thinking about the sales you have teed up and what is left after there or what's going to be remaining after those sales get done, can you talk about have you gone any further in terms of shaping a strategy or thinking about markets you really want to be in long term given where the cycle is right now?
Hello, Jamie. It's David Weinberg. I think as David alluded to in his prepared remarks, we are still coming up to the end of what we set out as our original disposition plan. And we have taken obviously some more assets to the market. David referenced 12 properties, over 6 million square feet in various stages of the sales process. Beyond that, we still haven't formulated what you are looking for which is a definitive plan because as of where we are today we need you react to the market. I think we have been consistent with respect to that over various calls and meetings, and I think as these dispositions play out over the next 3, 6, 12 months, and we see how the market price is then and whether there are better opportunities on the buy side as we go forward, then we will be in a better position to answer that question.
And then I guess a question for David. Going back to your original -- to your early comments about the CMBS market and how you think it potentially could impact the lending market, are you seeing any incremental signs of that risk over the last quarter or so?
Well, I think things have firmed up a little bit over the last quarter, but I'm referring more generally to the fact that there is a lot of change going on with the retention rules and other regulatory issues. Obviously volumes are down and the question is will the balance sheet lenders be there at the end of the year. They are often there early in the year as they cherry pick assets they want for their book. But CMBS is a big part of the debt market for our buyers, and so we keep an eye on it as it affects the investment sale market track disposition program. And then if things were to get particularly dislocated, it could create opportunity for us on the buy side.
But over the last quarter you haven't seen a change?
Our next question comes from the line of Jed Reagan from Green Street Advisors. Please proceed with your question.
What are you guys seeing in the pricing environment as you shop some of these non-core assets? Any changes that you can discern, prices backing up at all anywhere?
I think it's -- David said in his prepared remarks, overall we still believe it's an attractive time to sell. We are still seeing a very good mix of buyers. And I would say, and it's probably what you've heard from others, as you move away from core assets, core markets, there's been some softening that can be evidenced by fewer bids. It may take longer to close and in some cases prices could be lower. But our experience has been we are still seeing enough bidders to create a competitive auction and overall pricing has been in line with our expectations.
I guess on the leasing side of things, any signs of softening there, lower velocity, prolonged decision making, concessions on the rise anything along those lines?
I think it's in line with my comments I had on our markets. Bellevue, Austin, Chicago, Philadelphia, we are still seeing good activity. Denver is a market we are focused on now. I think especially the asset we own, which is one of the best buildings in the market, has been impacted by the new supply coming online. And we're seeing that to be a competitive threat whereas maybe a year, year and a half ago that wasn't the case, and that has impacted the volume. In terms of demand, at least in our markets, we haven't seen any slowdown.
And on the concession environment, it looked like your leasing costs ticked up a little bit last quarter even on the new leases on an apples-to-apples basis. Any trend there or was that just some one-off deals?
Yes. I'm not sure what you're comparing to. I think over the last five quarters as a percent of our starting gross around our leasing costs have been anywhere from 19% to 24%, so this quarter was in line. The one anomaly that maybe you're looking at was the prior quarter where Expedia's lease distorted everything. But I wouldn't say we've seen any differences in terms of the leases we are looking at in our pipeline today.
And then just last one, on the cash same store numbers. Is it fair to think about 2Q as a trough for that metric and do you start to get a rebound in same store NOI and occupancy in the back half of the year as leases commence and then suddenly David's brought off?
Clearly, it's Adam. Jed, I wanted you guys to know what's coming in terms of the burn off of free rent in addition to the new leases that aren't hitting any of the numbers, cap or cash. When that stuff starts to feather in, you're going to see improvements but it takes time. That's why we will start to see it this year at the back half, and we will see a greater impact in 2017.
When do you think that cash same store number could turn positive? Could that be at 4Q 2016 event potentially?
Yes. We will start to see a positive impact by the end of this year. And the challenge of course in a statement like that for a company like ours is, that assumes the portfolio that were sitting here today with and our future portfolio is likely to be very different. So, the leasing creates value whether we see that value in the form of increased NOI the back half of this year or 2017 or we see that value in increased disposition proceeds will therefore impact what happens with the numbers that you actually see at the end of the year and in 2017.
Our next question comes from the line of John Guinee from Stifel. Please proceed with the question.
Great, great, very nice job, guys. All sorts of assets being sold that we didn't even know existed, movie theaters, vineyards, etcetera. Doing some quick math, you've $1.2, I think you have 12 assets, 6 million square feet on the market at $150 a foot, that is $900 million. At $200 per foot, it is $1.2 billion. My rough math, Adam is that you could surpass 2 billion of cash on the balance sheet by, I'm sorry, surpass 3 billion of cash on the balance sheet by year end 2016 and the net debt positive to the tune of 1.4 billion. Do those numbers makes sense?
Look, your numbers roughly makes sense. Not commenting on the per square foot value of the dispositions, but I see where you got those numbers. The thing to remember is that we do have some debt that we are able to repay at par before the end of the year. So, that will have an impact on cash balances.
Looking at page 14, I see what could be repaid at par. I see what can be repaid at par in part the first half of 2017. What can be repaid in 2016?
So 6.25% senior unsecured notes due in 2017, as well as the first three, I'm sorry, first two mortgages under the secured debt section, and that together is what will get you there.
Great. Okay. So, David what are you going to do with all of this money?
I assume you want Weinberg to answer that.
I know Weinberg is going to spend about $50 on floating TIs and leasing commissions.
Value creation, my friend.
I'm with you, John. I don't know what that's about.
You've got to do what you've got to do. All right. Anyhow, you don't need to answer that. Have a good week. Have good summer.
Our next question comes from the line of Manny Korchman from Citi. Please proceed with your question.
Good morning, everyone. David, how much of your organization's brain power is now being devoted to looking for acquisition opportunities versus dealing with a smaller potential pool of dispositions to get done?
Good morning, Manny. I would say that as we've gotten smaller, the footprint is smaller. We've got more timing to evaluate an opportunity. We've got an investment team that covers the markets that they are assigned to. Both on the disposition side that involve the disposition process, they are involved in evaluating what's going on in the market, other acquisitions, and acquisition opportunities. We've also got a small team, who are looking at corporate level transactions and we are actively reviewing a variety of things. Got to as kiss a lot of frogs, but we are looking at a variety of opportunities. Hopefully, we can find something where we can have an edge and create value with the cash on the balance sheet.
Thanks for that. Is it still appropriate to call your disposition plan noncore or are we just at the point where it's a disposition plan and that could be a wider sort of mix of quality even maybe what we've seen you sell?
I think in general your question is right on. We have sold the bulk of the things that we identified as assets we did not want to own for the long term. We have some left and those are reflected in some of the pipeline we have as well as some third ones. Still in the portfolio where we have specific things we need to do before the asset is positioned for sale. But more generally, the portfolio is a much higher quality, better assets today. And dispositions going forward will be if and only if we get prices that are in excess of what we think the asset is worth.
There are no further questions in queue. I would like to hand the call back over to David Helfand for closing comments.
Thank you, everyone, for joining us today. As always, we appreciate the interest, and we look forward to talking to you. Enjoy the rest of your summer. Thanks.
Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.
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