City Office REIT, Inc. (NYSE:CIO) Q1 2020 Earnings Conference Call May 7, 2020 11:00 AM ET
Tony Maretic – Chief Financial Officer
Jamie Farrar – Chief Executive Officer
Conference Call Participants
Barry Oxford – D.A. Davidson
Michael Carroll – RBC Capital Markets
Craig Kucera – B. Riley FBR
Good morning, and welcome to the City Office REIT First Quarter 2020 Earnings Conference Call. [Operator Instructions]
I would now like to turn the conference over to Tony Maretic. Please go ahead.
Good morning. Before we begin, I would like to direct you to our website at cityofficereit.com where you can view our first quarter earnings press release and supplemental information package. The earnings release and supplemental package both include a reconciliation of non-GAAP measures that will be discussed today to their most directly comparable GAAP financial measures.
Certain statements made today that discuss the company's beliefs or expectations or that are not based on historical fact may constitute forward-looking statements within the meaning of the Federal Securities laws. While the company believes that these expectations reflected in such forward-looking statements are based upon reasonable assumptions, we can give no assurance that these expectations will be achieved.
Please see the forward-looking statements disclaimer in our first quarter earnings press release and the company's filings with the SEC for factors that could cause material differences between forward-looking statements and actual results.
The company undertakes no obligation to update any forward-looking statements that may be made in the course of this call.
I'll review our financial results after Jamie Farrar, our Chief Executive Officer, discusses some of the quarter's operational highlights. I'll now turn the call over to Jamie.
Good morning. Thank you for joining us today, and let me start by saying that I hope you and your families are safe and healthy. I'd also like to give an enormous thanks to our team. They've done a great job dealing with a lot of challenges and ensured our businesses remained fully operational. Since our last earnings call at the end of February, changes in the global economic environment have impacted our operations and outlook.
Fortunately, City Office was well positioned heading into this downturn with ample liquidity and cash, lower leverage levels, and a stabilized portfolio of diversified tenants. With our call today, I'd like to discuss the specific impacts we have observed at our company and the strategic decisions we have made to address current and future uncertainty.
First, I will touch on our current operating position and levels of exposure to various elements of risk. All of our buildings are open and continue to operate. We have adopted new policies and procedures to incorporate best practices for the safety of our tenants, our vendors, and our employees.
We stopped all acquisition activity in early March and had no exposure to lost deposits or other closing risks. Overall, we have low exposure to a number of the industries that have been severely impacted by COVID-19, including co-working, retail, restaurant and cafes, travel and accommodation, live event related and energy.
Approximately 3.2% of our portfolio by square footage is occupied by tenants in these industries. In particular, we have very limited exposure to co-working space with approximately 1.1% of our portfolio leased to co-working operators and no exposure to WeWork. We provided additional information regarding our exposure to these industries on Page 15 of our supplemental package.
Our rent collections in March were normal and collections of April contractual base rent totaled approximately 98% across our portfolio to date. During the first quarter, we implemented various processes to evaluate nonpayment and rent relief requests and have been working to find tailored resolutions in each case where warranted.
Our team has done a great job working with various tenants to achieve these collection results, delving a little deeper into April results. All of our largest 40 tenants paid their rent. These tenants account for approximately 59% of occupied square footage as of quarter end. Outside of our top 40, we have approximately 300 tenants with an average size of approximately 7,000 square feet.
It is still too early to assess overall collections for May as rent payments generally arrive during the first week of the month and in some cases are deposited into local accounts, which requires more time to consolidate. That said, we anticipate that with the economy stalled, May will have elevated deferral requests as well. While each case is different, if we do grant short-term rent relief, we generally expect to achieve additional lease term or amortize the unpaid rent starting later in 2020.
Moving to our financial condition. As I mentioned earlier, we are in a very strong position. In March, we elected to draw $100 million from our available credit facility, and we've maintained an elevated level of precautionary cash. While there is a negative interest carry while holding this cash, given the economic uncertainty, we believe it was a prudent step.
We will continue to maintain elevated cash in the short term as we monitor the situation. As of March 31, we had approximately $147 million in unrestricted cash, $18 million of restricted cash at our properties, and a further $150 million undrawn and authorized under our unsecured credit facility. We have no near-term capital requirements or debt refinancings that cannot be addressed with our current liquidity.
Providing a counter to these positives and strong financial position is the significant uncertainty around the timing and extent of the economic impacts caused by COVID-19. While we achieved strong collections in April, as the downturn lengthens, we anticipate further challenges given that we have over 300 tenants. We expect to be granting some rent deferrals.
Depending on the length and depth of the economic shutdown, there will also likely be some business failures as well. We have provided our thoughts and assumptions on these issues in our updated guidance, which Tony will discuss shortly.
In terms of leasing activity, transactions have generally slowed across our portfolio. While renewal discussions have remained active, new leasing has slowed as prospective tenants focus on their own challenges and uncertain requirements. Our leasing teams have adapted by using virtual tours and other strategies, but we anticipate the time frame for leasing vacancy will be pushed out.
As a result of the economic uncertainty and the likely impact on the real estate sector, we took a number of steps early on to ensure we were defensively positioned. First, we refocused our capital allocation strategy. We paused our acquisition program and given the discounted valuation of our own stock, we reallocated capital to our common share repurchase program. We believe in the inherent value of our portfolio. And while there is dislocation in today's real estate valuations, our current price does not reflect fair value.
As a result, we have repurchased over $60 million of common stock. We believe these purchases will be impactful to our results over the long term. In terms of the remaining $40 million that is authorized, we'll continue to reevaluate market conditions and our stock buyback program. If we elect in the future to not continue with the buyback, any uninvested amounts will be reallocated to further reduce leverage.
Second, achieving lower leverage level metrics has been a frequent topic with our shareholders in the past. We previously laid out a plan that would achieve a gradual reduction by placing lower levels of leverage on acquisitions from each successive capital raise. With the proceeds from the last equity capital raise not yet deployed, we felt that now is the time to accelerate this plan. Of the approximately $202 million in gross proceeds we raised in the second half of 2019, we decided to use up to $100 million for the stock buyback program and the remaining cash to reduce overall leverage.
Third, we reduced our common stock quarterly dividend from $0.023 per share to $0.15 per share. This was a tough decision for us as we know the quarterly dividend is an important component of income for many of our shareholders. The adjusted common stock dividend allows us to operate with lower leverage, and has been established to the level we believe will be defensive under these economic conditions. The impact of these pivots and strategy are reflected in our updated guidance that Tony will discuss more specifically.
To round off my comments, I want to reinforce our underlying rationale for the strategic decisions we have made and how you can expect us to navigate the current environment. We were well positioned heading into the current economic pullback. We've always focused on having well-located properties in strong cities and high-credit tenants. While there will be more employers that allow their employees to work remotely in the future, we are confident that over time, our cities and properties will recover, and we are well positioned.
We believe that the trend towards moving to our less dense, lower cost, high-quality of life markets in the Southern and Western U.S. will continue to play out. These factors underpin our confidence in the long-term success of the company. However, we believe that significant impacts on the economy and our portfolio will continue to manifest in the near term. As such, we intend to continue to operate cautiously to protect the long-term interest of our shareholders. We will maintain higher levels of liquidity, utilize lower leverage levels, and we'll continually review our capital allocation decisions. Rather than a wait-and-see approach, we've taken measures to weather the current environment and optimally position ourselves for the long term.
With that, I will turn the call over to Tony to provide further details on our financial results.
Thanks, Jamie. I'll first address the first quarter's results and then turn to our current outlook and expectations. As you will see, our first quarter results were not significantly impacted by COVID-19, but we are being cautious on our projections for the balance of the year as reflected in our guidance. On a GAAP basis, our net operating income in the first quarter was $25.4 million. This represents a $900,000 increase relative to the amount reported in the fourth quarter of 2019. The increase was primarily attributable to the increase in occupancy.
Our bad debt provision for the quarter was only $100,000, which was related to those tenants who had business interruptions due to COVID-19. We reported core FFO of $14.3 million or $0.26 per share, which was also $900,000 higher than in the fourth quarter of 2019. Our first quarter AFFO was $7.9 million or $0.14 per share. While we do expect dividend coverage on an AFFO basis in the future, AFFO in this quarter was lower due to elevated costs of tenant improvements and leasing commissions incurred during the quarter tied to strong prior leasing activity.
The largest leasing costs relate to the previously announced 70,000 square foot new credit tenant at our Denver Tech property who executed a 10-year lease. During the first quarter, we incurred $1.2 million of the $5.0 million tenant improvement allowance for this tenant, and we expect the bulk of the remaining tenant improvement allowance of $3.8 million will be spent in Q2 with the rest spilling into Q3. As a result, we expect our AFFO results will be way down until this work is completed.
We also had some continuing capital expenditures, the largest of which related to a project at Sorrento Mesa in the quarter. Due to the relative size of our portfolio and the impact of significant leasing in any one quarter, our AFFO numbers will continue to move around some from quarter-to-quarter. We achieved the renewal leasing spreads of 6.1% on a cash basis for the quarter. This strong number indicates rolling up existing leases to market has been a driver of same-store NOI growth. Our first quarter same-store cash NOI grew 4.1% versus the first quarter last year. Denver was one of our best-performing markets in the first quarter as the impact of the recent leasing activity is beginning to result in increased cash rents.
Moving on to our balance sheet. As Janie mentioned, our cash and restricted cash at March 31 totaled $165 million. This substantial cash balance will ensure we have ample liquidity to complete our stock buyback program and withstand any unforeseen negative economic impacts caused by COVID-19. Our total debt, net of deferred financing costs at March 31, was $706 million. Our net debt, including restricted cash to EBITDA, was reported at 5.9 times. At quarter end, our total debt had a weighted average maturity of 4.9 years and 86% of our debt was effectively fixed. We have no debt maturities in 2020 and only one maturity in 2021.
During the quarter, we commenced our share repurchase program. At March 31, we had purchased 1.5 million shares. Since then, we have continued to buy stock and, in the aggregate, have repurchased approximately 7.3 million shares. These repurchases were completed at an average gross price of $8.26 per share for a total cost of approximately $61 million.
Lastly, we have provided updated full year 2020 guidance in our press release. Given the number of uncertainties in this economic environment, this was a challenging exercise as it is impossible to know the full impact on the economy at this point. Therefore, we made our best estimates for the potential impact. Our guidance involves a range of outcomes. We refer you to the material assumptions and considerations set forth in our earnings press release, which covers these in more detail than I will highlight here.
The main drivers of our revised guidance range are as follows: first, we have removed the impact of any acquisitions from guidance and assumed capital is allocated to our share repurchase program. Second, we have created general provision for uncollectible rents of between 1% and 3% of rental revenue in each of Q2, Q3 and Q4. While we envision the majority of potential concessions will relate to amortizing unpaid rent in subsequent periods, we felt it was prudent to create a general provision. Third, new leasing activity has slowed, and with the economic uncertainty, the timing is difficult to predict. We deferred new leasing assumptions until 2021 in our forecast. Based on these revised operating assumptions, our core FFO, year-end occupancy and same-store NOI results have been lowered. Our revised guidance estimates core FFO per share between $1.07 and $1.12 for the full year ending December 31, 2020. Our revised same-store cash NOI expectation for the year is negative 4.5% to negative 1.5% using these assumptions.
That concludes our prepared remarks, and we will open up the line for questions. Operator?
Thank you. [Operator Instructions] Our first question comes from Barry Oxford with D.A. Davidson. Please go ahead.
Great. Thanks guys. Jamie, when you’re looking at cap rates out in the marketplace, I’m guessing that you haven’t seen a huge change or a huge increase in cap rates to justify going into the acquisition market, whereas your implied cap rate for your stock has definitely changed and increased. Is that your thought process?
Thanks for the question, Barry. It’s really hard to say what cap rates are in the marketplace right now when COVID hit. Pretty much everything is frozen and deals that were being marketed were going to be revalued. And many sellers have basically put it on pause smartly. And I think there’s a big question mark when you’re calculating cap rate, what net operating income is going to be because there’s going to be some fallout, what market rents are going to be.
And so there’s a lot of uncertainty around that. And that was part of the reason why we hit the pause button. It’s really hard to predict. So I don’t think you could actively say where cap rates are in the market today because nothing is really changing or trading. I think what you can focus on is we looked at our own assets, which we know better than anyone. We know our own prospects of what we think we can do with them. And using stabilized forward looking numbers without COVID, right, you factor that in, but just normalized numbers, we think we’re buying in the mid- to high 8% cap on our own portfolio. And so that’s a no-brainer at $195 a foot, and that’s where we’re allocating our capital.
Great. Great. Thanks. And then Tony, a question for you, maybe more on the accounting side. You mentioned the bad debt and AFFO. As we move into next year and you’re recollecting those rents, will that kind of get unwind and we’ll see AFFO increase so that, I don’t know, a year or 18 months from now, the AFFO has all been made up.
Yes. It’s a good question, Barry. And we’re in early stages of those discussions on deferrals, and it really depend on what the final legal language is. But speaking generally on – you didn’t ask about FFO. But on an FFO basis, everything gets straight-lined through GAAP rents. So you really don’t see a change, which is…
Right. That’s why it wasn’t focused. That’s why it wasn’t – yes.
Yes. On an AFFO basis, with the backing out of straight-line rent, I think you will see an impact of that and that you’ll see a lower AFFO and that you don’t receive cash in the period. And to your point, you’ll see a bit of a catch-up in 2021 or later in the year, depending on the particular deal that we cut with these terms.
Okay. Great. Thanks. I just wanted to make sure I was thinking about that correctly.
Yes. Thanks, guys.
Thanks for the questions.
Our next question comes from Michael Carroll with RBC Capital Markets. Please go ahead.
Yes. Tony, can you provide some color on your rent deferral expectations? I don’t know if I missed this during your prepared remarks, but how many tenants have actually requested the deferral to date? And are you in active discussions with most of those tenants today? I guess, how should we think about that?
Sure. Mike, it’s Jamie. I’ll answer that one. So it’s a little bit of a tough question to answer because we’re in constant dialogue with our tenants about operations and what we should be doing. And so we have tracked kind of a wide range of discussions. And it’s anything from asking if they can temporarily give back parking, seeing what we can do about reducing operating costs, seeing about deferral requests, asking if we have some rent relief programs, and a number of larger well-capitalized companies put up their hand and asked if there was any programs we had. I think if you look at all of those combined, it’s less than 20% of our square footage. So not a huge percentage overall. And the April collections or uncollectibility right now is sub-2%. And so I think you’re going to see that probably increase a bit in May and June, but it’s too early to say.
So of those 20% that have asked for deferrals, I guess, what percentage of those are the well-capitalized companies that – I mean, obviously, you probably don’t need to offer deferral versus the ones that you’re in active discussions with today.
Yes. It’s a large percentage by square footage. The ones that really need it typically are the smaller tenants, also translates to smaller square footage for us. The larger ones with larger square footage asked, and we’ve tracked that. But it’s a much smaller number than that, that need it.
Okay. And then the buyback program, how should we think about that? I guess there’s $40 million left, I guess, with the stocks trading up above where you bought back over the past few months. I mean, are you still going to be actively pursuing that at these levels? Or what’s the best way to think about that?
So for us, we’re going to reevaluate here depending on where the price is. There’s no hard and fast number of what we are going to put out at a minimum. The maximum we said would be $100 million. We’ve completed $60 million. And so we’re really going to reassess here over the coming weeks and months and look at our options. And whatever we don’t ultimately buy in the share buyback, we’ll apply against reducing our leverage.
Okay, great. Thanks.
[Operator Instructions] Our next question comes from Craig Kucera with B. Riley FBR. Please go ahead.
Yes, good morning, guys. I’d like to talk about the remaining lease expirations for 2020. I think it totals about 5% of the portfolio. Do you get a sense as you’re talking to those tenants, are they completely on pause? Or are they – have they indicated any interest in renewing or maybe renewing it with less space? I guess, any color on kind of where their heads are at would be useful.
Sure. Craig, it’s Tony here. It may be helpful if I just talk about the larger leases that we have and kind of give you a status update. We’ve talked about these tenants in the past, and maybe I’ll just give you the latest. So we have five leases that are greater than 30,000 square feet set to expire in 2020. One is already a known renewal. They’re a tenant at our Florida Research Park. We have a second tenant at Florida Research Park that we also put a high probability of renewal on. Those discussions are going on.
As you can imagine, they are a little more sporadic. Just gets with a lot of people working from home. We have an update on a tenant that we’ve talked about in the past. We have a 46,000 square foot tenant at our Pima property. We have discussed this on prior calls. They have an August 31 expiration. We did sign them to a short-term extension in Q1. That’s included in our leasing statistics. That just extends them for another three months. So their expiration now is November 30. If you recall, they are building their own campus and will vacate on that new time frame of November 30.
And then beyond that, we also have a tenant that is paying below-market rents. And then beyond that, we also have a tenant that is paying below-market rents in our Sorrento Mesa property, very valuable life science space. No real update on those discussions. If you recall, we talked about those in the past and we put a high probability of renewal still with them. And then lastly, we have a 30,000 square foot tenant at Circle Point, September 30 expiration. Really – no real update on dialogue to report, but they do – they are a large user in that submarket, and there’s a strong possibility that they will move as they have other space in the submarket that they may consolidate into.
Great. Thanks for the – that color. Just circling back to higher handling rent deferrals. It sounds like you’re tacking on sort of missed rent as you’re working through and then amortizing that. I guess, are you – is there a general sense? Are you trying to collect those rents inside of a year? Or is it really just sort of on a case-by-case basis, maybe kind of all over the place?
Yes, Craig, it is kind of all over the case. Our own objective is giving more short term, whether that’s two to three months’ deferral for the tenants that we deem needing it. And we’ve got a pretty in-depth process where the tenants are filling out various surveys, providing us information on their own business plan, what they’re doing, what programs they’re looking at to try to get cash in to help sustain themselves. And for us, we obviously want to maintain our tenancy and health. And so it’s been shorter-term deferrals and then starting amortization, and it’s a wide range of periods depending on the tenant’s condition, but we’d like to see some of that commence in 2020, and some may spill into 2021.
Okay. Got it. And just circling back to capital allocation. If this winds up being more of a V-shape recovery, not that we’re necessarily expecting that, would you utilize that excess cash to get back into acquisitions? Or are you – it sounds like you really are just a lot more committed to running a more deleveraged portfolio. Is that a fair assumption?
Yes. Our belief is it’s the right approach is having lower leverage. Internally, we don’t have the view that it’s going to be a quick bounce back. We think it’s going to be a tough few months here. And then a slower recovery, and we’re focused on really being well positioned long term.
That makes sense. All right. That’s it for me. Thank you.
This concludes our question-and-answer session. I would like to turn the conference back over to Jamie Farrar for any closing remarks.
Thanks for joining today. We hope that everyone stays safe and well. Goodbye.
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.