DDR Management Discusses Q2 2012 Results - Earnings Call Transcript

 |  About: DDR Corp. (DDR)
by: SA Transcripts


Good day, ladies and gentlemen, and welcome to the Second Quarter 2012 DDR Earnings Conference Call. My name is Chanel, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Samir Khanal, Senior Director of Investor Relations. Please proceed.

Samir Khanal

Good morning, and thank you for joining us. On today's call, you will hear from President and CEO Dan Hurwitz; Senior Executive Vice President of Leasing and Development, Paul Freddo; and Chief Financial Officer, David Oakes. Please be aware that certain of our statements today may be forward-looking. Although we believe such statements are based upon reasonable assumptions, you should understand that those statements are subject to risks and uncertainties, and actual results may differ materially from the forward-looking statements. Additional information about such factors and uncertainties that could cause actual results to differ may be found in the press release issued yesterday and filed with the SEC on Form 8-K and in our Form 10-K for the year ended December 31, 2011 and filed with the SEC.

In addition, we will be discussing non-GAAP financial measures on today's call, including FFO. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP measures can be found in our earnings press release issued yesterday. This release and our quarterly financial supplement are available on our website at www.ddr.com.

[Operator Instructions] At this time, it's my pleasure to introduce our CEO, Dan Hurwitz.

Daniel B. Hurwitz

Thank you, Samir, and good morning, everyone. As we navigate through the slow summer months of the retail environment, with the overhang of our presidential election adding uncertainty in the market, we, at DDR, find ourselves in a position of strength with tremendous opportunity. June retail sales results were below expectations for most retailers, but not for all, and most importantly, not for many of our key tenants. Off-price retailers and discount stores grabbed profitable market share, with sales results beating expectations and earnings guidance revised upwardly. Moreover, store opening plans for our retail partners were generally maintained or raised, and the secular negative trend in the traditional grocery business, most recently highlighted by the SUPERVALU situation, will continue to benefit our prime portfolio in the long-term.

From a capital markets perspective, we've made further progress with our balance sheet by opportunistically accessing the unsecured market and, most recently, the preferred market at very attractive rates, resulting in a lower cost of capital and an improved maturity profile.

With regard to our capital recycling and portfolio management activities, we continue to prune the portfolio of nonprime assets and weak retailers and source acquisitions of prime power centers, while simultaneously simplifying our story.

The quality of our portfolio and the credit quality of our cash flows have never been better, and the outlook for continued improvement is encouraging.

Overall, we are very pleased with the consistency of our operating results and the performance of our platform, the sales results and the market share gains of our key retailers, the continued success of our capital recycling program and the continued improvement in our balance sheet to the execution of our capital markets strategy.

While our progress has been steady and consistent, we are constantly reminded of our surroundings and, specifically, the concerns of the market most recently regarding an economic slowdown. The questions we've been hearing indicate a market searching for clarity regarding the growth outlook for our retailers, the propensity for consumers to continue spending and how this translates to the real estate portion of the equation. Given the various moving pieces, it is important to note that retailers make domestic real estate decisions based on sales and profit forecasts and their cost and access to capital, which remains very strong, as opposed to any particular election cycle or events in Europe. We continue to work with our retailers to meet their growth aspirations in a supply-constrained environment, and there has been no indication of a slowdown.

In terms of the consumer, we don't have to guess where they are shopping and spending their money on everyday products. Ready-to-wear is being purchased at off-price retailers that offer branded and private label goods at a discount price, as the vast majority of consumers seek bargains and promotional pricing presented in a simple manner. One only needs to look at the recent results of J. C. Penney and the recently-announced pricing policy adjustment to confirm this fact. Groceries are being purchased at large discount stores, warehouse clubs and specialty grocers. Consumers in this economic environment more than ever demand value and convenience as they look to maximize their dollar. This plays to our strength.

While there is certainly reason for us to be mindful and cautious of the macro environment in which we currently operate, there is no good reason to be negative now or in the foreseeable future, particularly based on the sales and profitability of our retail partners and the visibility of our property level cash flows. Please remember, leases are executed well in advance of projected openings in our guidance, which includes continued same-store NOI growth in Q3 and Q4, accounts for those contractual obligations.

Before turning the call over to Paul, I would like to address the effectuation of a strategic objective at our company as it relates to our development pipeline and the disclosure you likely reviewed in our supplemental after our earnings release last night. During the second quarter, we made a $20 million investment in a fully entitled and 100% leased development site in Charlotte, North Carolina. The project, known as Belgate, is nearly a 900,000 square foot power center that features an IKEA, Walmart Supercenter and a 170,000 square feet of junior anchor space. This is the only IKEA between Atlanta and Washington D.C., which makes us a truly unique regional site. The project is expected to fully open in spring 2013.

Belgate represents an innovative approach to meeting the growth aspirations of our retail partners without assuming the risk associated with traditional development. As you've heard us mention since the formulation of our strategic plan, our development strategy has been to monetize our existing land, which is well underway, and find new projects that enable us to leverage our platform and present upsized returns without assuming standard or historical development risks. While we have reviewed many projects over the past few years, we were consistently unenthused with the offerings. Belgate, however, represents one of the few opportunities to make an investment in a development project that has certainty of execution and that will realize development-like returns without taking traditional development risk. We anticipate that our cash-on-cost unlevered yield for this project will comfortably exceed 10%. The criteria for these investments have been fully entitled with verifiable tenant demand, no major due diligence items outstanding and appropriate risk-adjusted unlevered cash-on-cost yield make projects like Bellgate very difficult to find. Bellgate, however, meets the qualifications, and we are very pleased with this opportunity to build another prime asset and add this to our portfolio.

I will now turn the call over to Paul.

Paul W. Freddo

Thank you, Dan. As evidenced by another quarter of high leasing production, we continue to see strong demand for space in our portfolio. A combination of continuing growth from market share winning retailers and limited new supply is resulting in competition for space and positive trends in terms of occupancy gains and leasing spreads.

During the second quarter, we executed 200 new deals for 900,000 square feet at a spread of 10.7%. We also executed 226 renewals for 1.8 million square feet at a spread of 6.1%, our highest renewal spread in 15 quarters. Combined spreads were up 6.8% overall, but more significantly, up 8.3% on a pro rata basis.

Before diving deeper into what we're seeing in terms of retailer demand and growth strategies, I want to point out the impact of the 46 assets acquired in the Blackstone joint venture on our leased rate for the second quarter and year end expectations. Excluding the 46 assets that were acquired on June 20, we improved our leased rate to 94.1% as of the end of the second quarter, a 40 basis point increase sequentially and a 110 basis point increase over second quarter 2011. Including the 46 acquired assets, the leased rate at the end of the second quarter was 93.7%. Accordingly, while we are still very comfortable with our previously guided leased rate for 2012 of over 94.5% absent the newly acquired Blackstone JV. When included, our annual expectation becomes approximately 94.1% due to the lower overall leased rate of that specific portfolio.

While the Blackstone JV portfolio puts short-term pressure on the overall leased rate, the good news is the portfolio consists primarily of high-quality power centers that were previously undercapitalized. As a result of the recapitalization of the venture, we expect to realize the organic growth opportunity in this portfolio, which will positively impact our numbers at the property level NOI and leasing fee line items going forward. But regardless of the moving pieces, leasing is strong, occupancy continues to increase, spreads are growing, and our portfolio remains in very high demand.

Regardless of the speculation that near-term economic uncertainty may lead to a deceleration of store growth, and so far, that's all it is -- speculation. The fact remains that quality retailers have strong financial positions and maintain aggressive open-to-buys. Best-in-class retailers with strong brand recognition and competitive merchandising strategies will continue to grow market share through a variety of strategies, including entering new markets, developing new concepts and prototypes and acquiring other retailers.

Growing market share by entering new markets and expanding geographic presence is a traditional method of new store expansion. We've already announced the successful launch of Anna's Linens and Shoe Carnival into Puerto Rico where they joined other domestic retailers such as PetSmart, T.J. Maxx and Burlington Coat Factory that have expanded on to the island in the past few years. More recently, we entered into 2 new deals with Dick's Sporting Goods as part of their first wave of stores in Salt Lake City. We have facilitated Ross's entry into new markets with 2 of their initial stores in Chicago and 1 of their initial stores in St. Louis, with other opportunities in the pipeline. Other examples of retailers looking to enter new markets include Publix expanding into Tennessee; Kirkland's, to New Jersey; Trader Joe's, to Colorado; and Walmart expanding their neighborhood market concept across the country. While not market-specific, Whole Foods has indicated they will absolutely need to enter new markets across the country to hit their growth projections, and we are working very closely with them to help facilitate their strategy.

A timely example of a growing retailer entering new markets in an aggressive way is Five Below. As the largest landlord to Five Below, we have helped them enter several new markets and, most recently, completed 5 deals for their initial stores in Atlanta. Notably, 2 of these stores were created through small shops consolidation, and the other 3 locations were the result of filling residuals base from downsized Old Navy, Jo-Ann and Office Depot boxes at substantial rent gains. The residual space resulting from these downsizings is 100% leased, and we increased the rent per square foot by an average of 65%. The initial results of the Five Below IPO highlight the confidence investors have in their business model, and it should not be overlooked that every one of their 60-plus stores planned for 2013 will be in power centers.

Tilly's is another example of a retailer with a recent [Audio Gap] taking their concept nationwide, with 45 new stores planned for 2013. This action sports retailer has adapted its merchandise mix to one with nationally strong surf, skate and motocross brands, and they view power centers as their primary focus for new stores. We recently facilitated their entry into the Columbus, Ohio market, and we have several more deals across the country in the pipeline.

Another dynamic we are seeing is traditional mall retailers, particularly fashion retailers, looking to grow in the power center format. One example is Gap with their factory stores. Our first factory store location recently opened in Boston in a downsized Old Navy. And we're actively working with Gap on several other Gap and Banana Republic factory store locations. Kirkland's is a retailer that made a strategic shift away from malls a few years ago, and as a result, we're up to 11 locations with them. Lane Bryant, Torrid, Carter's, Crazy 8 and Aeropostale are also example of traditional mall retailers expanding their store base in power centers and with whom we have completed recent deals. Frequency of shopping trips and dramatically reduced occupancy costs, which leads to superior operating margin, are the 2 factors most often cited as the drivers behind the retailers' decision to focus on power centers.

In addition to entering new markets and in response to clear consumer preference, many retailers are growing by developing new concepts or accelerating expansion of their loft [ph] priced brands. An example of this is Bloomingdale's Outlet, which we've recently worked with to facilitate their entry into the Chicago market. Another concept which is growing aggressively is Nordstrom Rack, whom we now have opened in 5 of our centers and recently finalized the sixth deal as we facilitate their entry into Columbus. Other new concepts include Field & Stream and True Runner by Dick's Sporting Goods, Sports Editions [ph] by Hibbett Sports, Steel [ph] by Save Stores [ph] and Forever 21's 20,000 square foot concept. These new concepts are being introduced by established, well-funded existing retailers with proven and successful track record that have spent significant capital to test these concepts, know their customer and merchandise accordingly.

In a limited new supply and low cost of capital environment, another growth avenue for retailers is through the acquisition of other retailers. The recent acquisition of Cost Plus World Market by Bed Bath & Beyond and Ascena's acquisition of Charming Shoppes are 2 great examples of strong credit quality retailers capitalizing on this opportunity. Given that their previous unimpressive financial standing precluded them from being candidates for growth, we had both Cost Plus and Charming Shoppes on our tenant watch list. They represented a combined 70 basis points of our pro rata annual base rent. But now with strong credit and proven merchants overseeing these operations, we have removed them from our watch list as they have healthier overall balance sheets, improved operational strategies and new and exciting expansion plans. To that point, we're in the process of finalizing 2 deals with Cost Plus as Bed Bath & Beyond is clearly looking to take advantage of this concept's growth potential. Both of these deals were previously on our hold list.

In summary, successful retailers are not discouraged by macroeconomic news. In fact, many view volatility as an opportunity to propel growth and expand market share. When you combine that desire for growth, the financial strength of our key tenants, the preference for power centers by the retailers' dominating market share gains, the improving credit quality of cash flow in the vastly improved quality of our portfolio as endorsed by our leasing activity and overall tenant performance. We are very excited about these trends. Then, adding the lack of new supply into the equation makes me very confident that we will continue to generate solid operational improvement for the foreseeable future.

And I'll now turn the call over to David.

David John Oakes

Thanks, Paul. Operating FFO was $71.6 million or $0.25 per share for the second quarter, slightly ahead of our plan. Including nonoperating items, FFO for the quarter was $6.5 million higher at $78.1 million or $0.27 per share. Nonoperating items were primarily net gains resulting from our aggressive capital recycling program, offset somewhat by losses related to repurchase of $34 million of our 9.625% notes due in 2016. Operating FFO per share was 9% above 2011, clearly indicating that our operating performance is now flowing to the bottom line.

We were able to achieve attractive pricing on new debt, which allowed us to accomplish a significant amount of refinancing that will positively impact our earnings and fixed charge coverage ratio in the coming quarters. Perhaps most importantly, the weighted average maturity of these new financings is 6.3 years, and as a result, our consolidated debt duration at June 30 was approximately 5 years, the longest in the company's history and a significant improvement from 2.9 years at the end of 2009.

Subsequent to quarter end, we issued $200 million of 6.5% redeemable Class J preferred shares to fund the redemption of the 7.5% Class I preferred shares. The new shares are callable in 5 years, and the annual fixed charge savings are $1.7 million.

Midway through the year we have substantially addressed all of our 2012 debt maturities. Our $300 million bond offering in June funded the repayment of the $223 million of unsecured notes due in October and reduced borrowings on the line of credit. In addition, we addressed the majority of our 2012 unconsolidated debt maturities primarily through the 5-year refinancing for the 2 large debt facilities in our TIAA-CREF joint venture amounting to approximately $700 million. Remaining 2012 consolidated debt maturities consists of $13 million of mortgage debt, and our share of remaining unconsolidated maturities is $107 million. We expect to refinance these loans at attractive terms, and we also have about 80% capacity on our $815 million revolving credit facilities today. Further, DDR has no remaining unsecured consolidated debt maturities for nearly 3 years and has made considerable progress on refinancing 2013's secured maturities and adding prime assets to the unencumbered pool, which we expect to finalize in the coming months.

Today, we are absolutely prepared to withstand volatile capital markets. In addition, having less debt and longer-term -- and a longer-term more balanced debt profile, our exposure to variable rate debt has declined considerably. Variable rate debt as a percentage of total debt stood at 9% at the end of June compared to 29% at the end of 2009.

While we have made considerable progress in lowering the company's risk profile over the past 2.5 years, we acknowledge that there's more work to do. DDR remains absolutely committed to continuing to lower leverage and aggressively pursuing additional investment grade ratings. The operating environment remains favorable to retail REITs of scale with high-quality operating platforms, and combined with redevelopment initiatives coming online, further monetization of our land bank and our above-average retention of free cash flow, we project that our debt-to-EBITDA will continue to decline.

We continue to strengthen the quality of our portfolio with our sector-leading capital recycling program. During the first half of the year, proceeds from nonprime asset sales were $126 million, and an additional $26 million of fully owned assets are currently under contract for sale. Nonprime properties sold during the first half of 2012 have average trade area household incomes of $63,000, 21% below DDR's prime portfolio, and an average trade area population of 173,000 people, 46% below DDR's prime portfolio.

Net proceeds from asset sales combined with common equity issued through our ATM program were used to fund the acquisitions of 3 very high-quality large-format prime power centers: Brookside Marketplace in Chicago, Tanasbourne Town Center in Portland and the Arrowhead Crossing in Phoenix. These properties have average lease rates of 95%, average trade area household incomes of $81,000 and average trade area populations of over 500,000 people. Further, we believe that there are opportunities to leverage our operating platform to create incremental value at these assets, each of which has been added to our large and growing unencumbered pool.

Subsequent to quarter end, we acquired our partner's 50% ownership interest in Ahwatukee Foothills Towne Center, a 675,000 square foot prime power center located in Phoenix, Arizona. DDR has managed this property for 15 years. The shopping center is over 94% leased, has average trade area household income of over $80,000 on average and average trade area population of over 500,000 people and is anchored by Sprouts, AMC, Ross, PETCO and Jo-Ann.

We are also in the process of completing the acquisition of Tucson Spectrum, a large-format prime shopping center in Tucson, Arizona, anchored by Target, Home Depot, Food City, Ross, Marshalls, J. C. Penney, Sports Authority and Bed Bath & Beyond. The combined purchase price of these acquisitions is $200 million, and we expect to capitalize these transactions consistent with recent acquisitions as we deploy asset sales and equity raised earlier this year and further improve the size and quality of our unencumbered asset pool.

In reviewing the second quarter performance and looking forward, it is important to recognize that our sale of nonprime assets and redeployment of capital in the prime centers is making our operations much more efficient, and we believe these improvements are sustainable. While the initial impact of portfolio improvements is expected to be higher rental growth, it is also worth noting that nonrecoverable operating expenses decreased, bad debt continues to decrease and recurring capital expenditures should decrease. All of which improve our profitability and ability to grow net asset value.

With 2 quarters now in the books, we are reiterating our 2012 operating FFO per share guidance of $1 to $1.04, which we raised in May. However, the components have changed as balance sheet improvement has accelerated, which comes at a short-term cost despite the long-term benefit, and the Brazilian currency has depreciated well beyond our original budget. Importantly, on the other hand, internal growth has been stronger than expected, and we now expect 2012 same-store NOI growth to be at least 3%, up from the initial guidance of 2% to 3%. The drop in the Brazilian real has hurt our FFO per share by about $0.005 in the first half of this year, and we expect the impact to be about $0.01 for the full year. Accelerated refinancings will also take another $0.005 from 2012 FFO per share. Despite all of these changes, we are pleased to reiterate FFO guidance and believe that our recent actions position us even more strongly for FFO and NAV growth in the future. 2012 will mark the first year of FFO per share growth in the past 5 years, and we believe that we are well prepared to generate multiple years of FFO and more importantly, EBITDA and NAV growth to come.

At this point, I'll stop and turn the call back over to Dan for closing remarks.

Daniel B. Hurwitz

Thank you, David. Before turning the call over to questions, I'd like to thank those of you that have recently participated in our perception study. It has been 2 years since we last surveyed the market for feedback on strategy and communications with investors and analysts, and we greatly appreciate the candid feedback you provided us once again. We listened to your comments from the past, and many of those suggestions influenced our strategic plan, which we are now executing. We will certainly listen again, and I'm confident your ideas will continue to help make us a better company going forward. Your opinions are valued and your judgment of our company is not taken lightly.

At this point, we'd be happy to turn the call over to questions, operator.

Question-and-Answer Session


[Operator Instructions] Our first question comes from the line of Paul Morgan.

Paul Morgan - Morgan Stanley, Research Division

Just on the land bank and your kind of efforts to monetize that. I mean, could you just talk about any movements there and whether some of the improvements we've had in the housing market could bring some of these efforts either on your behalf or on third-party interest kind of back to life, and what kind of pipeline we see for making progress there?

Paul W. Freddo

Paul, this is Paul. We've been making progress. Year-over-year and quarter-over-quarter, we've clearly seen some progress in our land bank, and if you look in the supp [ph] even with the Belgate acquisition, we're going to be net sellers of land for 2012. And we are looking at everything, with deals we're making whether it's with department stores for pads or parts of a parcel or for residential, we look at all of that. But we are seeing some progress, and we'll continue to see some progress. And that is what's reflected in the number you see in the supplement. We're going to be net sellers of land even with an acquisition in 2012.

David John Oakes

Yes. Although, the frustrating part last year was we were talking a lot about our goal of making progress on land sales, but you were seeing very little of it show up in the transactional results, and you were seeing even less of it show up in the income statement, and I think this year, you're certainly seeing more of that flow through. There's a conscious effort internally to focus on these nonproducing asset sales. And you've seen more of that come through, which importantly, not only generates the proceeds that can be used to reduce debt or reinvest in operating assets, but also as you might have noticed in the operating expenses this quarter, we also -- since we're not capitalizing expenses on most of that land, you also see the improvement in operating expenses, they come through when we sell this land. So it has been a major focus. You're starting to see more of it show-up and will see even more of that in coming quarters. To your specific point on is the housing market having a significant impact there, we're not necessarily seeing the single-family housing market have any direct impact there. But multifamily, as you know well, has continued to be extremely hot for new development, and there are some parcels of land where we would look at a higher and better use being non-retail.


Our next question comes from the line of Alex Goldfarb, Sandler O'Neill.

Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division

David, just going to the balance sheet for a second. You guys bought back your high coupon debt this quarter, paying a premium. I think in previous conversations, you've said that tendering and then reissuing that some of your other peers have done, you weren't as interested in. But given your activity year-to-date of paying a premium to buy back the 9.625s, would you consider just tendering for the whole thing, reissuing a new lower coupon, especially given the demand for corporate debt these days?

David John Oakes

Yes, we certainly consider everything in terms of balance sheet improvement and improving net fixed charge coverage ratio. I think what it comes down to for us is, does the economics of it make sense. Obviously, the premium that we're paying for the 2016 notes or any of our other paper is really just prepaying that future interest. And while you can show a charge 1 quarter and a better run rate going forward, the reality is oftentimes in these tender reissue scenarios, we haven't believed that there is a true economic benefit. For our open market repurchases happening dramatically inside of a make whole sort of price, we were generating a current yield on those purchases in the high-7s, but more importantly, a yield to maturity in the mid- to high-3s for the most part when we could issue longer duration debt that a yield to maturity as we did earlier this year through the term loan in the low- to mid-3s. So I think for us, it was a focus on, economically is there a benefit to tender or to repurchase and reissue, and we came away even though you could do it in smaller volumes. But the open market repurchase and reissue had an economic benefit to us where the tender could have created a better run rate, but only at the expense of all the prepaid interest we'd have to put up and the significantly greater premium that we'd have to pay for a tender, and so economically we didn't think that makes sense for us.


Our next question comes from the line of Todd Thomas, KeyBanc Capital Markets.

Todd M. Thomas - KeyBanc Capital Markets Inc., Research Division

Just a question, in the prepared remarks, you mentioned that the distress in the supermarket business and you mentioned SUPERVALU will benefit the prime portfolio in the long run. Can you just elaborate a little bit on that?

Daniel B. Hurwitz

Well, there's clearly a secular shift on where people are buying food. And the traditional grocer, which has often -- it was the opinion of many, was often invincible to competition because everyone had to eat has proven to be very vulnerable to new trends, new retailers, better merchandising and better formats. So while it is true that everyone does have to eat and everyone has to purchase food, they don't have to do it at a traditional grocer. And if you look at where the sales are going -- and it's right across the board. It's the formats that I mentioned, but it's also formats like dollar stores. Because they sell a lot of boxed goods and a lot of dried goods that are competing directly with traditional grocers as well. So we feel that the traditional grocer as it sits today is less dominant than it's been; specialty grocers, Cost Plus -- I mean, I'm sorry Costco and Sam's and warehouse clubs and supercenters and Target, et cetera are all grabbing market share. As you know, Walmart today is the largest grocer in the United States, and it wasn't not too long ago. So there's clearly a shift away from traditional grocers and going to alternative uses, and those are the alternative uses that populate our shopping centers. And for that reason, we feel that it will benefit us in the long run.


Our next question comes from the line of Cedrik Lachance, Green Street Advisors.

Cedrik Lachance - Green Street Advisors, Inc., Research Division

When I look at the noncomparable leases on Page 32 and as part of your new leases budget, you do about twice as many noncomparable as comparable leases, but unfortunately, of course, we don't have anything when it comes to a re-leasing spread. Can you give us a sense of what those leases are in terms of the type of tenant you're able to attract for the boxes and the kind of quality of the properties that are included in here?

Paul W. Freddo

Yes, Cedrik, as we've talked about before, we do this count in the most conservative manner possible, which is that 1-year look, if you've been vacant for more than a year, it's not going to be in the calculation. But there are going to be other reasons that deals are not in the comp pool, whether it's a different type of deal, a consolidation of space, for example, would not be an accurate way to measure a spread. The -- you've got a significant portion of the vacancy in that category of space vacant more than a year. Then it involves varying qualities. If we look, in fact, one of the things we get because this is a question which comes up quite often. Look at if we included all of the deals in this calculation, again, it was obvious that we had a very strong new deals spread for this quarter. It would have been up over 32%, which obviously is not a true judge of market conditions and something we're not going to do. But there's space in there that's never been leased, it's first generation space, the space that we acquired in some centers which had never been occupied since we'd owned it. So it's a tremendous mix of space, but for obvious reasons, we're not going to include it. Another thing that I think is important we should look at that spread cap, as you know we're using the last rent versus the first rent. There's no straight-lining on our spreads. And again, that's a very, very conservative manner and way to look at the leasing spreads overall. Final thing I'd add is we keep coming back to -- if you want to understand where trends are and what's happening with the market, look at the renewal spread. And as I said in my prepared remarks, we have the largest renewal spread in 15 quarters. That is a very, very big deal, and that's what we're seeing happening and that's also with the last rent, first rent no straight-lining of that activity.


Our next question comes from the line of Tom Truxillo, Bank of America Merrill Lynch.

Thomas C. Truxillo - BofA Merrill Lynch, Research Division

You guys have obviously made some good progress in reducing debt on your balance sheet and also lowering the cost of the capital. Can you provide any comments on what you think that your run rate fixed charge coverage is right now, given all the changes? And kind of where you see that going over the next 2 quarters with the EBITDA growth that you have baked into your guidance?

David John Oakes

Yes, it's a great question, Tom, because especially the way the proceeds from forward equity offering hits in very late June. We had the fixed charge impact of debt, but you didn't have the excess equity proceeds beyond the Blackstone investment show up. So I do think there's additional improvement built in. Obviously, the refinancing of the preferred equity leads to additional improvement, and so I think from a fixed charge perspective, a ratio that bottomed 2 years ago or 1.5 years ago in the high-1.6s to 1.7 area is up just north, a little north of 1.8x today, and I think we see a very visible path this year to get to 1.9, and in 2013 to get north of 2x, which we think is an important metric. It doesn't represent the end game. It doesn't mean that once we get to 2x that the progress stops, but I do think we see a very credible path from the 1.8 reported this quarter pro forma, that's for a few transactions get to 1.9, and then get to 2x next year. And so I think you'll continue to see progress on that metric.

Thomas C. Truxillo - BofA Merrill Lynch, Research Division

Sure. And you guys -- part of the plan was to use some free cash flow to pay down debt. You've since increased the dividend a couple of times. Any comments on use of free cash flow that you generate now if you can increase the dividend again to kind of soak up some of that? Or if you see further opportunities to delever -- I know you don't have unsecured maturities coming due, but you do have some security you can always buy back like you have been.

David John Oakes

Yes, we -- despite the increased dividend, we still got by far I think the lowest payout ratio in the sector, and therefore, the highest free cash flow, it's being retained in the sector. And one way or another, every one of those dollars is going to improving our debt-to-EBITDA ratios. So a few years ago, you were seeing more of that go purely to debt paydown. Today, you're seeing some of that going to redevelopment spending or the acquisition of operating assets. So today, you're seeing probably more of it going to the creation of new recurring, growing and sustainable EBITDA rather than simply debt reduction. As exactly as you point out, there is less debt to be reduced. And so, you're seeing that free cash flow be redirected more often now to EBITDA increases, and I think you're going to see that show up in a more significant way in our results over the coming quarters.


Our next question comes from Craig Schmidt, Bank of America.

Craig R. Schmidt - BofA Merrill Lynch, Research Division

I hope you haven't been already touched on, but what do you think the volume of dispositions could be in the second half relative to what you were able to accomplish in the first half?

David John Oakes

This year, somewhat the same as last year. We took advantage of a market in the first half of the year that was stronger than expected. Last year, that paid off as it positioned us to not have to push on dispositions during an uncertain second half of the year. Second half of the year for 2012, also looking a little less certain, although we certainly haven't had any impact directly on transaction pricing. But I do think you saw us accelerate a few more dispositions to the first half of the year. It doesn't at all mean if we see the market hold up like this, that you'll see us slow that math process down. We'll continue to push. The improvement in portfolio quality is a massive continued focus for us. I think today, you're seeing a few more opportunities for us to redeploy that into the acquisition of new prime centers. And so, we're not scared to beat guidance on dispositions. And so, you could see another $100 million or so of dispositions hit in the second half of the year. They get redeployed in some of the high-quality acquisitions we've already identified or talked about. And we've already been sitting down to have meetings about 2013, how can we continue to sell nonprime assets and improve the portfolio quality. We're not stopping at that 90% prime metric. We want to continue to upgrade the portfolio quality and best position ourselves to own a portfolio. We can grow NAV [ph] the most overtime.

Daniel B. Hurwitz

One of the things that's also important about the dispositions, Craig, which inspires us to move forward with the program aggressively is we really saw this year at RECon the impact of the portfolio improvement, which is simply spending less time with retailers talking about bad assets and bad space and more time with retailers talking about prime assets and prime space. And that has brought a lot of creativity as you could see from the deal flow and the leasing spreads. It's improved our metrics. Our bad debt is down, as Dave mentioned in his script. Our operating margins are wider. It's just a -- it's a better business model today, and a lot of that has to do with the fact that we have been a significant capital recycler. In addition, there are those tenants out there, while we're not overly public about naming them specifically, there are those tenants out there that we are actively looking to reduce our exposure to. And we feel very comfortable that we're doing that for a good reason. As a result, as interest in certain asset with certain tenants surfaces, even though the asset may not be at the very top of our sale list, we certainly are considering it due to our desire to limit exposure to what we feel are tough credit tenants and our overall desire to improve the credit quality of our cash flows.


Our next question comes from Quentin Velleley, Citi.

Quentin Velleley - Citigroup Inc, Research Division

Just in the second half projections on the $403 million of ground-up development on hold, the negative $69 million, can you talk us through that? And then secondly, the growth impairments and not your share, I think there was about a total of $25 million of impairments on the land, can you also just talk us through what that was?

Daniel B. Hurwitz

The -- Quentin, starting with the -- what's reflected in that $66 million reduction back half, those are deals by the way not included obviously, the back half deals. But negotiations, whether they are for outright sales of an entire parcel or with anchor stores for pads on sites. But I'm not in a position to give you the exact specifics, but that's obviously stuff we have in our budget because these deals are well underway.

David John Oakes

Yes. As we've talked about before the gestation period on these land sale was always longer, and so you've heard us talk about the progress there for a while. I think to see it show up in our budget for the second half of the year means we've got a much higher level of confidence with these longer processes. And longer due diligence periods are getting to a point where we should be able to execute on those and then show you that progress over the second half of the year even if those transactions take longer than a normal asset sale. We're getting closer to the period where we should be able to show you that. It's also as you referenced the tie-in to some of the impairments on the land, there have been some situations either due to lack of entitlement progress or lack of progress with the municipality or just the fact that we are revisiting some of our assumptions on what would be possible on some of these land sites and revisiting our thought process and where that capital can be better deployed. We have taken some impairments as we've lowered the probability that we do develop several of these sites and increasing instantly the probability that we sell them. And so your accounting -- your impairment tax changes at that time to put a greater emphasis on liquidation price rather than on discounted value of future cash flows. And so, that has triggered a few impairments there. Some of which, the largest I think for this quarter was a site that we got in the Inland transaction and a few others, were sites that we'd -- that we have acquired through other transactions. And so, I think you see a bit of that, but it's only a precursor to the progress that we're making in monetizing that, just an indication that, that immediate or near-term liquidation price is less than what GAAP requires you to do in terms of valuing the asset on the - on discounted future cash flows and an assumption that you're going to develop the site.


Our next question comes from Jeffrey Donnelly, Wells Fargo.

Jeffrey J. Donnelly - Wells Fargo Securities, LLC, Research Division

A few of my questions have been answered, but I was curious for your take on direction of cap rates on A versus B assets, because I think there's something of a split view among your peers in terms of which segment just may be seeing greater relative improvement in the last quarter or so. What's your sense there? And I guess as a follow-up, from this point forward, do you think the fundamentals for NOI growth and valuation growth favor A versus B?

David John Oakes

We're seeing improvement across the board and in pricing. I think you still haven't seen a massive increase in transactional volume, but you have seen more and more transparency that would indicate that the pricing has moved higher cap rates, have moved to lower. Across the board, you get some incredible prints on coastal Class A centers and high-quality supply constrained markets going well below 6% cap rates at this point, when those used to be low 6s deals. But on the other side, you're also seeing B assets that have been in the high-7s, now in the low-7s or even at 7. The toughest of the Class B assets has seen less progress, but like you've seen improvement across the board in an environment where I think NOI growth is more credible. Debt is cheap, although not as available at sort of peak pricing periods in the past with a less reliable CMBS market today. But with cheap dept out there, as long as you're going to be sub-60% leverage, I think that supports pricing across all property types. When we look at where we see the greatest opportunity, the strongest unlevered IRRs on a go-forward basis, I do think it is going to be for the most part in the non-coastal Class A assets. So we believe that the premium being paid for some of the sub-6 transactions, it's hard to justify in rent growth over the coming years versus the opportunity for us, particularly in some of the partner transactions where we think we've gotten somewhat better than market pricing. For us to start out at a 7% cap rate and have extremely credible 2% to 3% if not higher growth and higher in some cases where there is a value-add component, but we think the visibility of a very attractive IRR is the greatest there when looking at those Class A assets, but not necessarily the trophy-caliber top 4 or 5 market, and that's where you've seen us put capital out, and I think it's safe to assume that if those top 20 to 40 markets where you'll continue to see us more likely to see opportunities because those opportunities are driven by the highest IRRs that we think are achievable.

Daniel B. Hurwitz

I think it's also very important, Jeff, that when you look at NOI growth and cash flows you look at them on a risk-adjusted basis, there are clearly opportunities in B and C assets where you can get significant NOI growth and value-add returns. But at the same time the stability of that cash flow is somewhat weak. The depth in the market, it could be a little shaky, and if you're a long-term holder that's a very different proposition than if you're a short-terms flipper. And because we are a long-term holder, we do feel that the NOI growth on a risk-adjusted basis and the operating fundamentals and A assets will exceed that of Bs and Cs on a risk-adjusted basis.


Our your next question comes from the line of Rich Moore, RBC Capital Markets.

Richard C. Moore - RBC Capital Markets, LLC, Research Division

Paul, you mentioned that some of the deals you have with a couple of retailers were on hold for various reasons. And I was wondering, is there any of that going on in the electronics, with hhgregg or RadioShack, and how do you guys feel about those 2 retailers in particular at this point?

Paul W. Freddo

Very differently by the way, between RadioShack and hhgregg, Rich, but yes, clearly, this is something we study, and you and I have talked about this. We are constantly watching all of our tenants and performance and categories. And obviously, when I was alluding to Cost Plus World Market as an example. We were not in a position whether they wanted a site or a new site or an existing asset. We were not going to make a deal given their current situation. Big change, obviously, with the Bed Bath & Beyond acquisition. We are in no hurry to make additional deals with an hhgregg right now. We talk to them all the time. We've made a number of deals over the last few years. We don't view them as any kind of immediate risk, but it is a category we will watch obviously as we do with Best Buy. RadioShack is a much different story, and RadioShack I'm glad you brought it up. And if something -- we've been watching these guys for a few years. I mean, we've continued to reduce in a very small way our exposure to RadioShack, and if something should happen more dramatic with RadioShack in the near future, we will not be unprepared on any of the locations. One of the interesting things is somewhere in the 40% range of our exposure on a pro rata basis is in Puerto Rico. And these locations absolutely cream their average sales per square foot of their domestic portfolio. So should there be stores to close, I'm quite confident those will be the last to close, and should they all close at some point in time, we are ready to release those debt as significant increases. So you look at a company like RadioShack, they have got to figure out themselves because there is no way we would do a new deal with them today. And in fact, we would go the other way, and we are prepared to replace where necessary.


You have a follow-up from the line of Alex Goldfarb, Sandler O'Neill.

Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division

Dan, just going to sales tax, the online sales tax discussion on your peer's call ahead of you guys, just curious your take if there is implemented a -- that online retailers are going to have to pay sales tax. Just your thoughts for the smaller fledgling retailers, sort of the next Charlotte Hobbs [ph] or next L.L.Bean-type retailers, do you think this could curtail their growth if they are now burdened with having to collect sales tax from all the various jurisdictions? Or you think it's pretty manageable for small up-and-coming retailers?

Daniel B. Hurwitz

I think it's very manageable for small up-and-coming retailers, and part of the analysis that has been done over time, Alex, is to survey a number of those folks through the various entities that are lobbying for a Main Street Fairness Act to see what the actual impact would be. And it's not something that most retailers, regardless of size, can't handle. It's something that has been consistently reviewed, and I really don't think that the impact would be that great. We have made great progress with Main Street Fairness, and we do expect something to happen in that regard, hopefully in the lame-duck session if not shortly thereafter. And I think all retailers today, regardless of whether they are Internet-based or bricks and mortar-based or omni-channel based, which we hope most retailers are at this point in time, are prepared for that. This is not going to be a surprise. This has been a long protracted discussion and a long protracted battle, and anyone who, quite frankly, isn't prepared to deal with the eventuality of a fairness tax, which is what this is, a fairness -- a leveling of the playing field, if you will. If you're not prepared for that you're really not paying attention to your business and you probably have bigger problems. So my feeling is that I don't think that this will catch anyone by surprise. I think people are well-prepared, and I don't think it will have really a negative impact on retailers at any level.


Our next question comes from Steve Sakwa, ISI Group.

Steve Sakwa - ISI Group Inc., Research Division

Dan, I was wondering if you could maybe talk a little bit about Amazon. Obviously, kind of relating to the last question, they are not willing to start collecting sales tax, but they're clearly building a lot more DCs across the country, at least that sort of seems to be their plan, and maybe eventually, moving kind of broad-based to kind of same-day delivery. And I'm just wondering how you sort of think about the proposition that they're offering the customer. Obviously, people have to start paying tax, but they've now got convenience [ph] and how do you think that changes the landscape over the next decade?

Daniel B. Hurwitz

Well, it's a great question, Steve, and I've great respect for Amazon. I'm not quite sure why they're valued, where they're valued, and I'm not quite sure why they're not obligated to make money like every other retailer is. And I think if they're held by this -- to the same standard as most every other retailer out there, obviously, people would be looking at them very differently. They would probably be on some sort of watch list, quite frankly, if you're looking at a less than 1% operating margin on sales of their size. I fully understand the need to invest in the future, and I fully understand the need for their CapEx, which is obviously, as you referenced, growing at a pretty dramatic rate. I get it. And I understand that they're building for the future, but at a company that does over $60 billion in sales, my question is, when is the future? If the future is -- was the future at -- is it at $100 billion, was it at $20 billion? Was -- is it $60 billion? So I think at some point in time, Amazon -- the model has to show that it can make money, and it hasn't done that yet. If you listened to their call last week, they kind of downplayed the same-day delivery notion a little bit. It got played out much more in the press than it did on their call, and I think -- I thought that was pretty surprising because that was something that everyone views as minimizing what's the competitive advantage for bricks and mortar, which is that you can pick things up and having some gratification, Amazon really can't provide you with that instant gratification. So I -- Amazon, it's an interesting case study. I think it gets a lot more attention than, quite frankly, it probably deserves. I think at some point in time, they'll be held but to the same standards as the rest of the retail. And when they're held to the same standards as the rest of retail, I think there's a real question whether the model works from a profitability standpoint. And while they continue to invest enormous sums of money in their business, and I think to grow market share, and I think that's a smart thing for them to do, I think that investment on the capital side is masking the fact that operating margin is beyond thin. And that's something that ultimately they're going to have to answer to, and I'm not so sure the model can answer to it as its currently constructed.



And there are no further questions. I'd now like to turn the call back over to management.

Daniel B. Hurwitz

Thank you all very much for joining us, and we look forward to speaking with you next quarter.


Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have a great day.

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