CapLease, Inc. Q2 2008 Earnings Call Transcript

Sep.19.08 | About: Caplease, Inc. (LSE)

CapLease, Inc. (NYSE:LSE)

Q2 2008 Earnings Call

August 6, 2008 11:00 am ET

Executives

Paul H. McDowell - Chairman, Chief Executive Officer

Shawn P. Seale - Chief Financial Officer, Senior Vice President, Treasurer

Analysts

Jordan Sadler - KeyBanc Capital Markets

Michael Bilerman - Citigroup

Analyst for Michael Bilerman - Citigroup

David Fick - Stifel Nicolaus & Company, Inc.

Rich Murphy - Cross River Partners

Operator

Welcome to the CapLease second quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Brad Cohen.

Brad Cohen

Today I would like to remind everyone that part of our discussion this morning will include guidance and other forward-looking statements and these statements are not guarantees of future performance and therefore undue reliance should not be placed on them. We refer all of you to CapLease’s second quarter 2008 earnings release and filings with the Securities and Exchange Commission for a more detailed discussion of important factors that could cause actual results to differ materially from those contained in the company’s forward-looking statements. The company disclaims any obligation to update its forward-looking statements.

Also during the call today the company will be discussing funds from operations or FFO and cash available for distribution or CAD which are non-GAAP financial measures. Please see the company’s press release for a reconciliation of FFO and CAD to net income to most directly comparable GAAP measures.

It is now my pleasure to turn the call over to CapLease’s Chairman and Chief Executive Officer, Paul McDowell.

Paul H. McDowell

Good morning everyone. With me on the call today as always is my partner, Shawn Seale, who is our Chief Financial Officer.

This morning CapLease announced its results for the second quarter 2008 and they included FFO results of $0.28 per share exceeding our prior guidance of $0.26 to $0.27 per share. Our high quality $2.1 billion portfolio continues to perform as expected and deliver stable and predictable cash flows in times of weak as well as strong economic conditions. Our per share FFO results represent 27% growth from the corresponding period a year ago.

The decision we made in the second quarter to refinance our short-term debt into a flexible three-year term facility proved to be a wise one as another round of bad economic news, setbacks and modest recovery that have been taking place in the credit markets. As we had previously announced, we closed on a new $250 million three-year term facility to replace our warehouse line that was due to roll this month.

In addition to eliminating our near-term refinance risk we retained the flexibility to prepay the facility at any time without penalty and removed nearly all of our mark-to-market risk due to changes in market credit spreads. Given the very high credit quality and transparency of our assets, we continue to believe very strongly that we will be able to refinance these assets with longer term fixed rate debt once market conditions improve.

As has been the case since last summer the primary story remains the volatile market conditions. When we last spoke in May we were seeing some signs of stability returning to the market driven largely by aggressive action by the Federal Reserve in providing liquidity during the first quarter. However, a flurry of bad news later in the second quarter, including another round of mortgage related write-downs by financial companies, sent financial and credit markets into another tailspin. These conditions continue to impact CapLease primarily by constraining our growth since debt and equity capital are generally unavailable or not available at reasonable terms.

So what does that mean for CapLease? The answer has three components.

First, there is really no impact on our investment grade portfolio given its high credit quality with mostly match-funded debt and that portfolio fully supports our operations, dividends, cash available for distribution and FFO expectations for 2008.

Second, we expect asset growth will continue to be very limited until market conditions stabilize, and given the uncertainty that has persisted I’m not sure trying to predict when the recovery will occur makes sense at this time.

Third, while we don’t know when this will end, we do know that current conditions won’t last forever. And based on our more than 13 years in this business we think over the intermediate to longer term that the market will turn favorable for us which will allow us to further profitably grow the company. Over time we believe credit conditions will improve and when they do capital will be attracted to business platforms like ours that have long-term demonstrated franchise value, ability to acquire assets, strong relationships and product expertise.

As most of you are likely aware, overall commercial real estate transaction volume is down very significantly due to the credit crisis. There has been significant movement in cap rates for below investment grade net lease properties and in some other areas of the commercial real estate markets. While we have seen some modest uptick in cap rates for high-quality long-term investment grade net lease assets, they have continued to remain quite steady to date. Credit quality and lease duration matter more than ever, and that supports the pricing on the types of high-quality assets we invest in. That’s the good news for us as that credit quality is reflected in the cash flow stability within our portfolio and the relatively stable cap rates support our net asset value.

During the quarter we continued to look at joint venture and other opportunities with a focus on strengthening our platform and providing us with the capital we need to re-establish portfolio growth when market conditions stabilize. We believe it is prudent to proceed very cautiously in this market and that has the impact of significantly lengthening the time it takes to get some of these plans accomplished. While we have nothing definitive to announce today, we remain optimistic on completing one or more of these opportunities.

Before I turn the call over to Shawn, I would like to provide a brief update on our property in Johnston, Rhode Island leased to the large insurance company FM Global. As a reminder, this property investment represents about 2.6% of our current portfolio on a cost basis. As we discussed on our first quarter call, we brought a series of legal actions in Rhode Island challenging the Town of Johnston’s expedited review and approval of FM Global’s extensive development plans to construct a new headquarters building adjacent to the building we currently own and lease to them.

Our legal efforts have begun to bear fruit as the Rhode Island Superior Court recently ruled in our favor. First, the judge agreed with us that the expedited review by the Town of Johnston was insufficient and has required that the Planning Board start over again and give us the opportunity to present our substantive concerns regarding traffic and storm water runoff connected to FM Global’s proposed development. We presented those concerns at a public hearing held last evening in Johnston. The Planning Board is currently deliberating on the issues we raised last night and is expected to render a decision on the matter within 30 days.

Second, the judge has reminded FM Global that while they may continue to construct the building, they do so at their own risk since one of the remedies he has open to him if we are successful is to require them to tear down what they have built and start the entire review, approval and building process from the beginning.

Whatever the Planning Board may decide, we intend to continue to press our concerns vigorously within the confines of the established law and procedure of Rhode Island. We believe there remain a range of possible outcomes in this matter including a negotiated solution with FM Global. In the meantime FM Global has continued construction on their new building, and as expected elected not to give us notice to renew the lease on the building we own.

We are pressing forward with our plans to re-tenant the building at the conclusion of FM Global’s lease next summer and/or a possible sale of the building in the interim. In that regard we have retained CB Richard Ellis the leading commercial real estate firm in Providence to assist us in these efforts.

I will now turn the call over to Shawn.

Shawn P. Seale

Today we reported FFO for the 2008 second quarter of $12.5 million or $0.28 per s hare which was up 27% as compared to the $0.22 per share we reported in the comparable period in 2007. The net loss to common shareholders for the second quarter 2008 was $1 million or $0.02 per share compared to a net loss of $4 million or $0.10 per share in the comparable period in 2007. Our second quarter 2007 results included about $2.3 million or $0.06 per share of a net charge for unusual items.

Total revenues for the 2008 quarter were $46.1 million up 6% from $43.6 million in the second quarter of 2007. At quarter end our overall portfolio was over $2.1 billion in investment assets about 78% of which are owned properties. Our diverse owned property portfolio includes 62 properties across 26 states leased to 33 different tenants and exceeds 10 million square feet.

Weighted average underlying Standard & Poor’s tenant credit rating on our entire portfolio is A- and on our owned property is A. Our two largest tenants are the US Government and Nestle Holdings, Inc. These tenants are rated AAA and AA respectively and comprise about 10.3% and 9.4% respectively of our portfolio. Our top 10 tenant exposures aggregate about 50% of the total portfolio and are all rated investment grade with an average credit rating of A+.

As Paul discussed we closed on a new $250 million revolving term facility during the quarter. This new borrowing facility consolidates into one agreement CapLease’s warehouse facility and revolver. The financing for existing assets on the line is currently priced at 250 basis points over one month LIBOR which is a good level in today’s environment and the facility is not subject to mark-to-market due to changes in market credit spreads for all the collateral other than the CMBS securities.

We repaid $23 million of debt to Wachovia Bank during the second quarter putting the current outstanding balance under the facility at approximately $208.1 million at June 30. Overall in the first six months of 2008 we reduced outstanding indebtedness by $33 million.

The initial term of the facility is for two years and may be extended at our option for an additional year provided we meet certain conditions. We may prepay the facility at any time without penalty or premium. As is typical under these types of facilities, the bank may request additional collateral in the event that there is a credit impairment to a specific asset as opposed to a general change in the markets with the exception of CMBS which may be marked due to changes in the broader markets. However, CapLease’s borrowings against CMBS securities on the new facility are a very modest $14.8 million and are at a conservative average advance rate of about 33% of the par balances. All of the CMBS on the facility are very seasoned, net lease back or single tenant backed, are performing well and are not generic CMBS.

At June 30 we had $1.7 billion in owned real property investments before depreciation and amortization, $291 million in loan investments and $169 million in various net lease securities including CMBS. As of today we have approximately $20 million of cash and cash equivalents, $2.6 million of cash in the CDO pending reinvestment, and roughly $42 million available under the term facility for new investments.

Turning to our dividend, our payout ratio is about 72% based on the $0.20 dividend we paid for the quarter. Through June 30 our payout ratio is 71% on a core FFO basis before hedge charges.

Given the continued turmoil in the commercial real estate finance sector, let me provide a few words on our debt investment portfolio. Our loan and structured finance portfolios are all performing well and we expect that performance to continue. The vast majority of the loans in our portfolio are seasoned, fully amortizing first mortgages underwritten by CapLease on properties net leased to investment grade tenants.

Loans and loans past due interest make up about 86% of our debt portfolio and 19% of the overall portfolio. And they have an average underlying tenant investment grade credit rating of BBB from Standard & Poor’s.

Structured CMBS make up about 14% of our debt portfolio and only 3% of the overall portfolio. For the most part our CMBS portfolio consists of highly seasoned junior classes of bonds collateralized by first mortgages we underwrote on net leased properties in the mid-to-late 1990s. The loans in those pools have been amortizing in some cases for more than 10 years. We carry the lower rated bonds themselves at deep discounts to their face and they have corresponding yields in many cases greater than 18% that we have enjoyed for years.

The bottom line is that our debt investments are not the type of assets held by finance companies and mortgage REITs, many of whom have been struggling of late. Our debt investments are primarily well-seasoned first mortgage loans on net leased properties that were underwritten by us, have attractive financing in place and are performing well.

Finally, our G&A expense continues to compare very favorably with some of the most respected REITs in the market place and we still have significant room to scale our operating platform.

Now let me discuss our guidance for the third quarter. We expect FFO to be in the range of $0.26 to $0.27 per share and for earnings per share to be in the range of -$0.04 to -$0.03 per share. Our guidance figures reflect a full quarter of modestly higher interest expense on our new Wachovia credit facility and maintaining the current portfolio level through 2008. Our guidance figures also reflect a variety of other assumptions discussed in today’s press release.

As a reminder, we compute FFO based on the Navy definition. The differences between FFO and earnings per share are add-backs for depreciation and amortization on our real estate properties and minority interest on our operating partnership units. FFO includes a deduction for stock-based compensation expense which was $0.04 per share in 2007 and is estimated to be roughly $0.05 per share in 2008.

The straight-line rent adjustment for the second quarter was -$10.2 million as our straight-line rent accrual exceeded cash rents received. Total straight-line rent adjustment is expected to be about -$1.3 million for the third quarter of 2008 and -$6.1 million in total for all of 2008.

I’ll turn the call back over to Paul now for some final comments before we open it up for questions.

Paul H. McDowell

Just a final thought or two. The second quarter was another solid one for us as our results were ahead of our expectations despite the unprecedented market turmoil. Our $2.1 billion investment grade portfolio continues to perform flawlessly and that is evident in the very strong operational results we announced today.

We have moved aggressively to protect the balance sheet which is reflected in the term loan we closed during the quarter and the loan pay-downs we made in the first half of the year. Being able to obtain such attractive financing in this market is a strong testament to our asset quality, underwriting expertise and strong banking relationships. We now have no material debt maturity beyond scheduled amortization over the next several years which should remove concerns of near-term refinancing risks.

Finally, when conditions improve we expect there will be a prolonged period where there will be very favorable investment opportunities in our sector and we are working hard now on a number of initiatives to take advantage of those opportunities when they arise.

I will now open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jordan Sadler - KeyBanc Capital Markets.

Jordan Sadler - KeyBanc Capital Markets

If you could give us a little bit of color insight into the capital raising opportunities that you alluded to that may or may not come to fruition? It sounds like a joint venture but maybe structure and timing in terms of what you’re thinking right now?

Paul H. McDowell

I’m not sure how much color we can really give on this call Jordan, but in general we are looking at a variety of ways to raise capital. Joint ventures would be probably at the very, very top of the list. We’re also considering a number of other potential opportunities. Timing is a little tough. When market conditions are stable you can say entering into a joint venture relationship will take six weeks or six months and you can come up with a definitive answer. In these market conditions that’s a little tougher. We have got a variety of parties that are talking to us about joint ventures and we continue to work with them. But like everything that’s going on in these market conditions both those parties and CapLease are very, very cautious as we move forward. So I don’t want to give a timing estimate today and then have that prove not to be accurate a month or two months from now.

Jordan Sadler - KeyBanc Capital Markets

That seems like the [inaudible] and the push but the type of JV that you’re exploring right now, would it be an investment vehicle or something where you guys would raise capital initially or both?

Paul H. McDowell

I think we would probably be interested in sort of a traditional joint venture where we partner with an institutional partner to joint venture perhaps some of our existing assets and then of course on additional assets to continue to grow the overall portfolio in the future. We may do so in both our equity component of our business; that is where we buy net leased properties; or we may do so on the debt side of our business w here we provide first mortgage loans.

Jordan Sadler - KeyBanc Capital Markets

And what about on the fee simple sales side, have you explored asset sales?

Paul H. McDowell

We have to some degree. We’re currently sort of quietly marketing an asset on the West Coast for sale right now. That’s something we will continue to look at. We have to make sure though before we sell an asset that we have a good place to put those proceeds. The assets we have on our balance sheet today are extremely high credit quality and they also have very, very high-quality debt associated with them. And those types of liabilities are not readily available in the market today. So we want to make sure if we sell a property today that we can redeploy those proceeds on an accretive basis for shareholders.

Jordan Sadler - KeyBanc Capital Markets

When you say quietly marketing [inaudible]?

Paul H. McDowell

We’ve hired a broker but we’re not taking out TV ads, how’s that sound?

Jordan Sadler - KeyBanc Capital Markets

Regarding the securities portfolio, maybe Shawn, any additional impairments taken? Obviously nothing coming through the P&L but just any impairments taken during the quarter?

Shawn P. Seale

If we had taken impairments, they would be on the P&L. To date the securities like our loan investments are all performing on schedule. No downgrades and we don’t have any reason to expect impairment on those securities. I’ll tell you that we continue to monitor particularly as we go into the what is widely acknowledged to be a weaker economic environment continue to monitor our securities particularly the lower rated or of course loss kind of investments which are quite modest for us. But we will keep a close eye on those as we start to enter into this weaker economy.

Operator

Our next question comes from Michael Bilerman - Citigroup.

Analyst for Michael Bilerman - Citigroup

On the securities portfolio, I did notice that there is slight exposure to some tenants that have gone bankrupt, such as Linens ‘n Things and other retailers. If you could just walk through how come that isn’t flowing through the impairment side for your securities investments?

Shawn P. Seale

In the case of Linens ‘n Things, we have one loan in one of our securitizations that was backed by Linens ‘n Things that is guaranteed by CVS Corporation. So notwithstanding the Linens ‘n Things bankruptcy, the lease is guaranteed by a very strong credit. And the lease so far has not been rejected so Linens ‘n Things continues to occupy that store. But our real credit exposure is not to Linens but to CVS.

Analyst for Michael Bilerman - Citigroup

I also noticed there are some other potential exposures maybe through Mervyns. Are those just things that you haven’t really seen how the bankruptcy plays out and so you have yet to have impairments?

Shawn P. Seale

We don’t have any exposure to Mervyns that I’m aware of.

Analyst for Michael Bilerman - Citigroup

On the G&A side, can you talk about the impact of this court case potentially increasing G&A?

Shawn P. Seale

If you look at our G&A year-to-date, we’re at about $3.25 million for the second quarter, our budget was $2.7 million, and substantially all of that increase is due to legal fees that we’re spending on the FM Global effort. If you look for the six months, our actual is about $6.25 million, our budget’s about $5.5 million, so again all of that call it $0.7 million is attributable to the fighting we’ve done to date. I don’t expect that we’ll have a lot more in the way of legal fees at least through the third quarter. We’re kind of nearing the end of the tough part of this phase of that fight, but it is expensive to litigate actions in the court system.

Analyst for Michael Bilerman - Citigroup

On the FM Global space, could you talk about potential conversations you’re having with new tenants and what kind of CapEx could be related to refitting that space for that new tenancy?

Paul H. McDowell

I think the most important thing is the tenant does not vacate the property at the earliest until next July. So we don’t have any substantive conversations going with new tenants yet as we’re not exactly sure when FM Global is going to move out. But the earliest they can move out is next July. We have retained CBRE. We’ve had a variety of discussions with them, which I won’t talk about on this call, about potential tenants that might fill this space. The property is well suited as a back office center or as a corporate headquarters building and CBRE is out looking very aggressively in the market place for the types of tenants that can fill this building.

As far as CapEx, we haven’t started to calculate that exactly yet given that we’re not sure whether we will have a single user in the property or whether it will become a multi-user property, and when I say multi-user as I think we disclosed before on these calls it’s the type of property that would support two to four users versus 40 or 50 individual users.

It’s also important to remember that we do receive from a cash basis as opposed to an accounting basis a full-year of rent from FM Global in 2009. So this is really sort of a 2010 issue.

Michael Bilerman - Citigroup

Where are your expectations on rent levels for that space?

Paul H. McDowell

We think market rent is in the $14 per square foot area and to the extent that we were able to obtain that type of rent, we’d have a cap rate on that property of roughly 9%. That’s $14 per square foot triple net.

Analyst for Michael Bilerman - Citigroup

The asset that’s currently on the market, can you talk about the tenancy of that and also what kind of cap rate you’re looking to get?

Paul H. McDowell

We haven’t published the cap rate we’re looking to get. We’re obviously looking to get as low as we can. The property itself is the Lowe’s home improvement center located in California. You see retail cap rates in California continue to be in the high sixes to low sevens.

Michael Bilerman - Citigroup

Is there a thought when you’re talking in response to Jordan’s question about not having to use the proceeds, how about just repaying debt and just deleveraging the balance sheet in terms of doing asset sales?

Paul H. McDowell

That would certainly be a potential use of the proceeds.

Michael Bilerman - Citigroup

Is that the direction you want to go today or you’d rather sell something and reinvest capital?

Paul H. McDowell

I think if you ask me today, which apparently you are, what I would do with those proceeds and that money arrived today, we would reduce debt.

Michael Bilerman - Citigroup

Are you looking at other scenarios to raise capital to reduce debt or it’s really not an active?

Paul H. McDowell

I think there are a number of possibilities related to debt reduction. Obviously you look at where you can do things most accretively for shareholders or fortify your balance sheet. So to the extent that we find an opportunity to buy back debt at some discount to face, we would actively consider doing that.

Operator

Our next question comes from David Fick - Stifel Nicolaus & Company, Inc.

David Fick - Stifel Nicolaus & Company, Inc.

You’ve hit FM Global pretty well. Can you just refresh my memory on what the in-place rent per foot is there?

Paul H. McDowell

The in-place rent per foot is about $27 a foot. It’s $9.6 million.

David Fick - Stifel Nicolaus & Company, Inc.

And that was known to be rolling down the market?

Paul H. McDowell

Well no, actually we thought it quite likely that the tenant would renew in which case that would have then rolled down to about $4 million or around $12 a foot.

David Fick - Stifel Nicolaus & Company, Inc.

So to the extent that you could lease it, you could have some minor upside less the TIs?

Paul H. McDowell

Yes. You might do a little bit better on the re-leasing. Of course you’re going to have some downtime and you’re going to have some TI. But for us when we looked at it we thought, if they renew, we’re going to get below market rent. If they don’t renew, we’re going to be able to renew it where we hope that market is somewhat above that. Obviously leavened by the cost expense and hassle of getting in a new tenant.

David Fick - Stifel Nicolaus & Company, Inc.

And we know that you’re planning for a fair amount of time here in the process but what is CBRE telling you right now about the block demand in that market?

Paul H. McDowell

I think the asset manager who is managing the property for us, a guy named Gary [Landery], was actually traveling back from the hearing last night. He would be best positioned to answer that for you David and we can try to do so perhaps offline. But in general there are a number of large users. There are not a large amount. There are not very many large blocks of space in this region available. So to the extent there is a large user, this is a good property for them. The Brooks Drugstore as you may remember, that was in an empty headquarters building. That recently sold to a public university so I guess there are a variety of potential users. And that sold at about $126 a square foot empty.

David Fick - Stifel Nicolaus & Company, Inc.

If we were to step back a little bit and think about the overall business plan, obviously you’re constrained by access to capital, you’re constrained by opportunity in the market and a thought that perhaps you’ll have better opportunities going forward so why invest now? But you’ve been on hiatus all of this year in terms of net investment and you’ve got people and mouths to feed and so forth. I’m just wondering, would it make sense to reconsider the kind of discipline that you’ve had in terms of credit and maybe look at other products, go to sub-investment grade, take advantage of some of the distressed debt that’s out there in the market place and continue to grow the company that way.

Paul H. McDowell

Those are all very good questions David. I think that sort of from a top line perspective or from a broad perspective, our G&A as a percentage of revenue and assets compares extremely favorable with our peers. That said, we don’t like to just sit around and not continue to grow the company so we’re trying to look at a number of opportunities, a number of ways to commence doing so that are in keeping with our generally conservative investment strategy. Below investment grade is a very, very good question. When the markets were really, really going strong you really weren’t paid to invest in below investment grade net leased assets. Now that the market has weakened considerably, cap rates have spread out and those investment alternatives look quite attractive as do some investment alternatives in distressed debt particularly to the extent that it is backed by net leased assets where the asset itself isn’t’ distressed but the holder of that asset be it a bank or a financial institution is distressed.

So the answer is yes, we’re looking at all of those things. We are actively daily trying to work our way through this process and find ways to continue to grow the company, and we continue to be optimistic that we will do so. The greatest strength that CapLease has in addition to our investment grade portfolio is the team of professionals that we’ve built here over 13 years.

Operator

Our next question comes from Rich Murphy - Cross River Partners.

Rich Murphy - Cross River Partners

Just one more question on the FM property. What happens in the case where you are successful and what does FM do come July when they move out? Where do they go?

Paul H. McDowell

FM Global’s continuing to build their property. The expectation is that that property will be completed. We’re not sure exactly when it will be completed. FM Global does have the right under its existing lease to continue to occupy the property we own on a holdover basis if necessary. To the extent that as we work our way through these various legal issues, there will come a point I suspect when we have a negotiation with FM Global about end-of-lease-term issues, so on and so forth. And then we’ll have a better handle and be able to talk to you more about that.

Rich Murphy - Cross River Partners

Is there anything right now in the contract on a holdover basis or is that just in negotiations?

Paul H. McDowell

No. The lease itself describes how holdover is accomplished and basically as is typical in these types of leases, the tenancy reverts to a month-to-month and the rent increases very meaningfully from the in-place rent.

Rich Murphy - Cross River Partners

So they’re incented obviously not to face that.

Paul H. McDowell

Yes, they are.

Rich Murphy - Cross River Partners

How long can you just sit idly by and with your dividend where it is, your dividend being protected. It’s been a year like we said, just kind of a hiatus. What if we go another year? Can you kind of just stay at this level and not turn out the dividend until things improve or do you feel 2009 you have to or the second half of this year do something?

Paul H. McDowell

As I said in my prepared remarks, the current portfolio covers our expectations for cash available for distribution and FFO for 2008. And as we’ve said previously we expect the cash available for distribution which supports the dividend of course to be somewhat over $1.00 for 2008. I think that’s an $0.80 dividend. In 2009 and 2010 as you go by you have to start to model in expectations about asset growth, refinance coupled with your scheduled amortization. At this point in time without having consulted with the Board I’m not going to give you a point of view about where the dividend will be in 2009 or where it will be in 2010 or beyond that other than to say the portfolio we have today provides very strong and very stable cash flows that support the dividend.

Operator

It appears we have no further questions.

Paul H. McDowell

Thank you very much. We are glad to have provided our investors with a quiet quarter in this turbulent market place and we look forward to speaking with you again in three months time. Thank you and good morning.

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