Washington Real Estate Investment Trust

F:WRI

Earnings Call Transcript 2019-Q2

[Operator]

Welcome to the Washington Real Estate Investment Trust's Second Quarter 2019 Earnings Conference Call. As a reminder, today's call is being recorded. Before turning over the call to the company's President and Chief Executive Officer, Paul McDermott, Tejal Engman, Vice President of Investor Relations, will provide some introductory information. Ms. Engman, please go ahead.

[Tejal Engman, executive]

Thank you, and good morning, everyone. Please note that our conference call today will contain financial measures such as FFO, core FFO, NOI, core FAD and adjusted EBITDA that are non-GAAP measures as defined in Reg G. Please refer to our most recent financial supplement and to our earnings press release, both available on the Investor page of our website and to our periodic reports furnished or filed with the SEC for definitions and further information regarding our use of these non-GAAP financial measures and a reconciliation of them to our GAAP results.

Please also note that some statements during this call are forward-looking statements within the Private Securities Litigation Reform Act. Forward-looking statements in the earnings press release, along with our remarks, are made as of today and we undertake no duty to update them as actual events unfold. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results to differ materially. We refer to certain of these risks in our SEC filings. Please refer to Pages 8 through 25 of our Form 10-K for our complete risk factor disclosure.

Participating in today's call with me will be Paul McDermott, President and Chief Executive Officer; Steve Riffee, Executive Vice President and Chief Financial Officer; Amy Hopkins, who will take over as Vice President, Investor Relations, following this call; and Drew Hammond, Vice President, Chief Accounting Officer and Treasurer. Now I'd like to turn the call over to Paul.

[Paul T. McDermott, executive]

Thank you, Tejal, and good morning, everyone. Thanks for joining us on our second quarter 2019 earnings conference call. We are pleased to have delivered core FFO of $0.47 per diluted share this quarter. Our second quarter performance has exceeded consensus and our own expectations and has enabled us to raise the midpoint of our 2019 guidance range by $0.01 per diluted share. Steve will explain our quarterly outperformance and the changes to our guidance in his remarks.

I would like to focus on the 3 key drivers of our near- and long-term business performance. The first is the execution of our 2019 strategic capital allocation plan, which significantly grows our multifamily exposure while reducing our exposure to the riskier commercial assets in our portfolio.

The second is the continued strengthening of our multifamily portfolio and WashREIT's ability to capitalize on growing regional demand for value-oriented multifamily product.

And third is creating greater visibility on our NOI and FAD growth trajectories through office leasing, multifamily rent growth and the delivery of the Trove multifamily development, all of which will continue to grow WashREIT's net asset value.

Beginning with our 2019 strategic capital allocation plan, we successfully executed the largest components of our plan in the second quarter. We closed on the acquisition of the Assembly multifamily portfolio, comprising 2,113 units for $461 million and completed the transaction in 2 tranches as planned. We closed on the Northern Virginia tranche, comprising 1,685 units on April 30 and the Maryland tranche comprising 428 units on June 27. We also closed on the acquisition of Cascade at Landmark Apartments in Alexandria, Virginia, for approximately $70 million on July 23.

On the dispositions front, we closed on the sale of Quantico for gross proceeds of $33 million on June 26 and on the sale of the 5 retail shopping centers for gross proceeds of $485 million on July 23.

To date, we have acquired $531 million of multifamily assets and sold $518 million of commercial assets, thereby completing the largest volume of asset recycling in WashREIT's recent history.

Regarding the sale of our power centers, we remain under contract to sell Frederick Crossing and Frederick County Square in Frederick, Maryland in the third quarter. Centre at Hagerstown in Hagerstown, Maryland, is under LOI with a separate buyer and is expected to close in the third quarter as well. Finally, we continue to expect to complete the sale of another $125 million to $175 million of commercial assets close to year-end. We expect our 2019 strategic capital allocation plan to be transformative for WashREIT and are excited about scaling our multifamily portfolio to build a sustainable and stable long-term NOI growth trajectory.

We've grown our multifamily unit count by approximately 56%, making multifamily our largest asset class in terms of number of properties owned. We expect multifamily to contribute 46% of our overall NOI on a second quarter pro forma basis and to be our biggest NOI contributor when we add the Trove's expected stabilized NOI contribution to that pro forma. Multifamily is also expected to remain our strongest and most stable business segment. We are raising our same-store multifamily guidance for the second time this year and now expect our same-store multifamily portfolio to grow NOI by 4.25% to 4.75% on a year-over-year basis in 2019 after delivering 3.3% same-store NOI growth in 2018 and 3.6% in 2017.

Multifamily demand for both Class B and A product remains very strong and for the first time in nearly 2 years, total absorption across the metro area has surpassed 10,000 units, with all 3 geographic areas absorbing over 3,000 units according to Delta Associates. Multifamily occupancy remains steady in the mid-90s allowing us to continue to push rents and optimize NOI growth through our daily pricing and asset management focus. Our multifamily leasing and recurring capital expenditures to NOI ratio is significantly lower than both office and retail at approximately 7% on a 5-year historical average basis and tracking 5% year-to-date.

We are strengthening our NOI growth prospects by allocating more capital to multifamily and our reducing risk to future NOI growth and cash flows by selling our power centers. Following this sale, we expect to significantly reduce our NOI at risk, which we define as the NOI derived from in-place leases with a 50% or lower probability of renewal in 2019 and 2020.

Finally, the completed and planned retail sales reduced our embedded capital gains in the retail portfolio by approximately $350 million and allow for more flexible and manageable capital allocation in the future.

Moving onto multifamily. We have grown our portfolio by acquiring value-add Class B assets in submarkets with solid rent growth potential, both in suburban and urban-infill locations. Class B multifamily in the D.C. Metro region is generally defined as product built between 1970 and the mid-1990s, that caters to renter households earning between $50,000 to $80,000 per year. This demographic comprises the largest pool of market-rate renters in the D.C. Metro region, who, at 30% monthly outlay, can afford average monthly rents between $1,250 and $2,000. Today, 90% of our multifamily units are Class B with average rents that range between $1,500 in the Assembly portfolio to the upper $1,600s for our same-store Class B assets. The average rent to household income ratio for our Class B multifamily portfolio is 26%, which creates runway for future rent growth. Urban-infill Class B assets have unit sizes that are nearly 10% larger on average than Class A assets with some being covered land plays as they are located on large plots of land with excess surface parking that can be entitled for additional density, which creates more value for the assets. In urban-infill areas, Class B units provide renters with a high-quality option that is typically $300 to $600 cheaper to rent on a monthly basis than Class A.

This spread is not only wide enough to preserve strong demand for Class B multifamily through periods of elevated Class A multifamily supply, but it also allows for value-add Class B renovations. Over the past 5 years, Class B net effective rent CAGR has outperformed that of Class A by approximately 70 basis points in the D.C. Metro region, despite elevated and even record-setting levels of new Class A supply during that period.

This is because the rents for new Class A supply are well beyond the reach of the Class B renter. In the 1970s and 80s, the share of all apartments that were affordable to median income renters and were no more than 5 years old ranged from between 10% to 20%. In the 1990s and 2000s, that share fell to 3.1%. In the current decade, it is flipped further to only 1.8%, according to Yardi and National Multi Housing Council data. The bottom line is that it is no longer financially viable to build apartments for the middle-market. Therefore, increases in Class A supply aren't impacting Class B multifamily fundamentals.

In the D.C. Metro suburbs, Class B suburban renters are 22% below Class B urban-infill rents on average. Unit sizes are 15% larger and schools generally rank better than they do in urban centers. Furthermore, D.C. Metro suburbs are expected to capture 73% of regional household growth over the next 5 years, according to Esri Data. Suburban Class B multifamily also offers an attractive alternative to homeownership. The Assembly portfolio offers average monthly rents that are approximately $900 less than the estimated average monthly mortgage payment for a home in those suburban markets.

Moreover, in the Assembly portfolio suburbs, the average down payment requirement is approximately $80,000, which is well in excess of average millennial savings of $9,000. This lack of housing affordability is expected to remain an issue in the D.C. Metro area where the cost of homeownership is rising even faster than the cost of renting. On a 3-year cumulative basis, the cost to own has risen 17% while the cost of rent has increased 13.5%, according to Yardi data.

Moving on to our latest multifamily acquisition, Cascade at Landmark Apartments, it is a 277-unit, high-rise, Class B apartment community located in the Landmark area of Alexandria. We acquired Cascade at an approximate 30% discount to replacement costs and sourced the deal through our strategic relationships with key multifamily players in the D.C. Metro region.

Cascade is a 10-minute drive from Amazon HQ2 and is also in close proximity to other major employers enclosing the Department of Defense's Mark Center, Inova Alexandria Hospital and the Pentagon. As a result of the strong employment drivers, Alexandria's population has grown 15.3% over the past 8 years compared to 6.2% nationally, according to Estal data, and is projected to continue to outpace national growth over the next 5 years. We believe there is scope to renovate approximately 60% of the units at this asset and to generate a double-digit average return on cost.

One of the most frequently asked questions on a recent non-deal roadshow was regarding our potential to further grow our multifamily portfolio. We expect to grow our multifamily portfolio's contribution to NOI in 3 ways.

The first is by organic growth. Year-to-date, we have grown average rents by 2.5% and renewals trade-outs by 4.1%, with growth in both metrics at all of our same-store multifamily assets. New lease trade-outs have grown at all but 2 same-store assets on a year-to-date basis, and average unit occupancy has also grown on a year-over-year basis. As a result, we have achieved revenue-led NOI growth despite deliveries of 11,000 new units in the D.C. Metro region over the past 12 months, according to Delta Associates. Our rent growth is partly due to the fact that WashREIT's multifamily portfolio is relatively insulated from the competition posed by new multifamily supply, the majority of which has been concentrated in Washington, D.C. and is Class A with rents that are at the very top of the market. Approximately 80% of our overall units are located in Northern Virginia and 90% are Class B. Moreover, we have unit renovation-led value creation opportunities embedded in 50% of our total portfolio or approximately 3,300 units. When harvested, we expect these to generate a minimum return on cost in the low double digits with renovations at Riverside, The Wellington, 3801 Connecticut and Kenmore, generating a mid-teen average return.

The second path to multifamily growth is through acquisitions. While we do not expect to complete any additional acquisitions this year, we do have a healthy pipeline of multifamily deals that we continue to underwrite. Under this management team, WashREIT has already acquired 4,322 new multifamily units in our region and has established an execution track record as well as the key strategic relationships that offer access to future value-add opportunities.

Finally, our third path to growing the multifamily portfolio is through development. While the Trove is the only development project that is currently under construction on-site at The Wellington, we have additional Class B assets that are covered land plays. We own and control the land of these assets and have approved entitlements to add on-site density. Riverside Apartments, for example, is located on 28 acres of land and is now entitled to add another 767 new units on-site.

While we continue to evaluate the current economics of ground-up development, we would note that the financing environment for multifamily development in the D.C. Metro region remains favorable and provides us the opportunity to unlock embedded development value at a desirable return and fee structure for a relatively small capital investment.

Turning out to the factors that will create greater visibility into our future NOI and FAD growth, we expect Watergate 600 to be the biggest positive office NOI growth contributor in 2020 on a year-over-year basis. We expect rents to commence on the top 2 floors of that asset by the first quarter of 2020. Other large 2019 lease expirations at 1227 25th Street, 1220 19th Street and Arlington Tower are expected to rent commence during the second half of 2020 and to be weighted toward the back end of the year. For these 3 assets, we currently have a leasing pipeline of prospects totaling approximately 386,000 square feet, which is approximately 2.5x of 155,000 square feet of current and upcoming availability at these 3 properties.

As some of the available space at these 3 assets will be part of Space Plus, our flexible office space offering, let me provide a brief update on the Space Plus program overall. We continue to see growth in demand for high-quality, flexible office space in our region, particularly among technology companies. We finished the first half of 2019 with approximately 54,000 square feet of delivered Space Plus spaces, which are located in 21 spaces across 7 buildings. The delivered square footage is currently approximately 75% leased. In the first half of 2019, the Space Plus program experienced an average of 97 days or 3.2 months of downtime until new lease commencement. We have another 107,000 square feet across 25 spaces in the Space Plus program with approximately 75% expected to be delivered by year-end.

Turning to our 2020 office lease expirations. The World Bank lease, which expires on December 31, 2020, makes up 210,000 square feet or nearly 50% of the 430,000 square feet of office leases expiring next year. The World Bank has accepted our term sheet and we are now under LOI and in negotiations. The Trove multifamily development is another key NOI growth driver in 2020 and beyond. Phase I of the Trove comprises 203 units and starts to deliver at the end of this year. We expect this Trove to contribute approximately $800,000 of NOI in full year 2020 and over $6 million in 2021.

Finally, we expect continued strength in our same-store and non-same-store multifamily portfolios through continued base rent growth that would be further augmented by value-add unit renovations across the multifamily portfolio. As we strengthen WashREIT's portfolio and long-term NOI growth, our region is also strengthening its long-term growth profile. Amazon is expected to create approximately 2,400 new jobs on average per year for the next 15 years with a multiplier effect from indirect and induced job growth that could potentially be in the tens of thousands, according to NKS data. Approximately 60% of our overall multifamily units are within a 35-minute public transit commute to HQ2, which is likely to positively impact our overall Northern Virginia multifamily and office portfolios.

Our portfolio is well positioned to capitalize on the other tech and professional business service companies that are attracted to the D.C. Metro region due to Amazon's presence. Furthermore, we expect D.C. Metro real estate fundamentals to benefit from the domestic in-migration that is likely to result from the billions of dollars that the Commonwealth of Virginia, Virginia Tech and George Mason University are collectively investing to build and grow the tech talent in that region. With that, I would like to turn the call over to Steve to discuss our financial and operational performance in the second quarter and our updated 2019 guidance.

[Stephen Riffee, executive]

Thanks, Paul, and good morning, everyone. Net income attributable to controlling interest was $1 million or $0.01 per diluted share. Second quarter core FFO exceeded our expectations and consensus by $0.02 per diluted share. Approximately $0.01 of this quarter's outperformance is timing-related and will likely be offset in the third and fourth quarters. The second set of outperformance is largely due to the higher settlements of prior year reimbursements. We have therefore, raised the midpoint of our 2019 core FFO guidance range by $0.01 per fully diluted share. We expect to deliver broadly equal core FFO per diluted share in the third and fourth quarters of 2019 in order to achieve the $1.71 midpoint of our updated 2019 core FFO guidance range.

On a year-over-year basis, core FFO per share was $0.01 lower, primarily due to the sale of 2445 M Street in June 2018 and increased interest expense, partially offset by the acquisition of the Assembly portfolio. The increase in interest expense was due to the short-term bridge loan we used to temporarily finance the multifamily acquisitions in the second quarter of 2019. We have already paid down $350 million of this loan, $100 million on our line and approximately $10 million of a mortgage associated with a retail asset we just sold, following the completion of the sale of the 5 shopping centers on July 23. And we plan to pay off the balance of the term loan when the 1031 exchange transactions are completed.

On a sequential basis, core FFO was $0.03 higher, primarily due to the acquisition of the Assembly portfolio in the second quarter as well as higher settlements of prior year reimbursements. Same-store NOI declined 0.6% year-over-year on a GAAP basis and was flat on a cash basis, largely due to a 6.4% decline in the same-store office NOI. As expected and widely messaged, the expiration of the lease for the top floors of Watergate 600 was the single largest driver for the year-over-year decline in second quarter office NOI. We continue to assume a negative 5.25% in the quarter to a negative 4.5% decline in office same-store NOI for the full year 2019.

We expect the year-over-year same-store office NOI decline in the third quarter to be comparable to the second quarter, with the year-over-year decline in the fourth quarter being steeper and at the NDR for the year due to the expected move out of a 41,000 square feet tenant and Kerr Consulting Group on September 1, 2019.

Same-store multifamily NOI grew 6.4% year-over-year as we grew rents at all 13 of our same-store multifamily assets, while also growing average occupancy by 60 basis points on a year-over-year basis. Moreover, the multifamily portfolio achieved strong renewal trade-outs of 4.2% and solid new lease trade-outs of 3.5% in the second quarter.

As referenced earlier, multifamily utility expenses in the second quarter were lower than we expected, and the quarter also benefited from lower tax assessments that were previously forecasted to benefit the third quarter. We are raising our multifamily same-store NOI growth assumptions for the second time this year and now assume 4.25% to 4.75% year-over-year same-store NOI growth in 2019. We expect year-over-year same-store multifamily NOI growth rate in the third quarter to be lower than the first, second and fourth quarters of the year because of a tougher prior year comparison, driven by $300,000 of favorable tax appeal settlement recognized in the third quarter of 2018.

Finally, our residual retail centers, which we report as Other, grew same-store NOI by 9% and cash NOI by 8% year-over-year. High rental value lease commencements at Spring Valley Village as well as higher recoveries of previously reserved bad debt contributed to the year-over-year NOI growth and were only partially offset by a 20-basis point decline in average occupancy. The 30-basis point decline in sequential ending occupancy was due to a few small leases, the majority of which have already been backfilled. As there are fewer retail centers remaining, small changes in occupancy have a magnified impact on a year-over-year basis and sequential basis statistically. That said, we have good leasing momentum at Spring Valley Village and also look forward to stabilizing Concord, Randolph and 800 South Washington Street.

Moving on to office leasing. We signed approximately 32,000 square feet of new office leases and 52,000 square feet of office renewals in the second quarter. We proactively signed a renewal with the largest tenant at Monument II in Herndon, Virginia, a 47,000 square-foot, blue-chip defense contractor. We achieved a rental rate that was in line with market and additional term of 11 years with expiration now scheduled for 2032.

While GAAP renewal rents were up 130 basis points, cash rent spreads were negative, as the prior lease had significantly escalated and led to the nearly 20% cash roll down in the second quarter. It also resulted in the renewal TIs per foot per year of term of approximately $7 as the space needed a refresh after 10 years of occupancy.

As we have messaged since November last year, we're dealing with a larger-than-usual volume of lease expirations in 2019. While we expect some large vacates in the second half of the year, the weighted average mark-to-market for the remaining 179,000 square feet of 2019 office lease expirations is slightly positive. In 2020, we currently expect a high probability of renewing approximately 320,000 square feet of the approximately 430,000 square feet of expiring office leases.

Moving on to retail leasing for all of our retail centers, including those sold in July. We signed approximately 69,000 square feet of new retail leases and 115,000 square feet of retail renewals in the second quarter. We achieved positive 14.5% GAAP and 10.4% cash rent spreads on new leases and positive 15.2% GAAP and 6.8% cash rent spreads on renewals.

Now turning to guidance. We have raised the midpoint of our 2019 core FFO guidance by $0.01 per fully diluted share to a range of $1.69 to $1.73 from our previous range of $1.68 to $1.72 per share. The increase is primarily due to the aforementioned higher second quarter results. As I've already detailed, our same-store NOI growth assumptions by asset class, I will now focus on the remaining guidance assumptions.

We continue to expect to sell an additional $125 million to $175 million of commercial assets that are yet to be finally identified. Our 2019 core FFO guidance does not assume we will complete any additional acquisitions this year. We expect development expenses to range from $47.5 million to $52.5 million. We now expect the annual impact of the adoption of the new lease accounting standard, ASC 842, to range from $1.25 million to $1.75 million in 2019. We continue to expect G&A to range from $20.25 million to $21.25 million. We expect interest expense to range from approximately $55 million to $55.5 million from our prior range of $54.25 million to $54.75 million due to the updated assumed timing and execution of acquisitions and dispositions.

Capitalized interest is expected to range from $2.75 million to $3.25 million. As a reminder, the increase in interest expense relative to the guidance we provided in February this year is due to a higher debt balance during the year related to the short-term bridge loan, which we used to temporarily finance the multifamily acquisitions. Next year, we would expect interest expense to decrease year-over-year due to the bridge loan being paid off in 2019 and lower debt and line of credit balances throughout the year as a result of the asset sales we expect to complete in 2019.

We expect non-same-store NOI and income from discontinued operations to range from $56.5 million to $57.75 million from a prior range of $54.75 million to $56.25 million due to the slight improvement and the expected contribution of the Assembly portfolio, the timing of acquisitions and dispositions and our second quarter outperformance. The non-same-store range includes $34 million to $34.75 million from the office and multifamily properties the company intends to hold. To recap the impact of the transactions, the increase in the NOI assumed from non-same-store and discontinued operations due to the updated assumed timing and execution of the acquisitions and dispositions has largely been offset by the assumed increase in interest expense.

As always, our focus remains on maintaining our balance sheet strength. Although, our net debt to adjusted EBITDA was temporarily high at 8.6x in the second quarter, we are already significantly lower on that metric. We expect to end the third quarter towards the higher end of our target range of 6x to 6.5x and in the year, in the high 5s assuming the completion of $125 million to $175 million of commercial asset sales by year-end.

We expect our 2019 core FAD payout ratio to be in the low 80% range and expect to be able to contribute to cover and maintain our dividend even after including the impact of our capital allocation, which is expected to enhance the stability of our cash flows and our long-term FAD growth. And with that, I'll now turn the call back over to Paul.

[Paul T. McDermott, executive]

Thank you, Steve. We have achieved several milestones in the first half of the year, beginning with signing a 51,000 square-foot long-term lease at Watergate 600 in the first quarter and acquiring almost 2,400 multifamily units and selling Quantico and a large portion of our retail portfolio thereafter. As we work to execute the remainder of our 2019 strategic capital allocation plan, we expect that the planned sales of our power centers in the third quarter, increased office leasing momentum and the assumed commercial asset sales by year-end will generate additional positive catalysts that further de-risk the portfolio and create visibility on our quarterly NOI inflection point, as well as our longer-term NOI and FAD growth.

While recycling assets at the scale at which we have described inevitably results in an earnings reset, we are pleased to have significantly grown multifamily, our strongest and most stable asset class, which also commands among the highest public market earning multiples from less than 1/3 to nearly 1/2 of our overall NOI. We have simultaneously shrunk retail and office from over 70% to just over half of NOI on a second quarter pro forma basis.

Not only are we de-risking our portfolio, improving the stability and strength of our cash flows and FAD and solving for some of the large embedded tax gains of our commercial portfolio, but we are also cementing our position as one of the largest value-add, multifamily REITs in the D.C. Metro region.

And finally, as many of you know, today is Tejal's last day with WashREIT. On behalf of our Board, management team and everyone associated with this company over the last 5 years, we want to thank her for her tremendous efforts in investor relations. She has done a remarkable job in creating a role basically from scratch to where it is today. Tejal, we wish you all the best in your future endeavors. I would also like to welcome our new Vice President of Investor Relations, Amy Hopkins.

Amy joins us from Investor Relations at Booz Allen, following several years of working in Senior Research Analyst roles at institutions, including Duff & Phelps, Compass Point and FBR Capital Markets. Amy will be your investor relations contact going forward. With that, let me now open the call to answer your questions.

[Operator]

[Operator Instructions] Our first question comes from the line of Blaine Heck from Wells Fargo.

[Blaine Heck, analyst]

Just big picture, Paul, when you think about the ideal portfolio for Washington REIT, what's it look like? Is it close to 60-40 multifamily to office? Or do you think you guys are going to continue to kind of migrate even more towards the multifamily side? And if that's the case, how do you think about managing the dilution and possible dividend implications?

[Paul T. McDermott, executive]

Thanks, Blaine. Well I don't have a precise number in mind. I think what we've said pretty consistently for the last couple of years is we wanted to try to overweight in multifamily. I think we are considerably seeing more multifamily value creation opportunities than we are in the office space. And so we're going to continue down that path.

I think right now, we've gone through when you look at most of the executions that we've done, we've managed to sell our assets and take care of the other thing that we need to keep in mind is the embedded tax gains. But we also have organic growth that's built into our portfolio. So we believe that we're heading on the right path, Blaine, and we're going to continue to try to surface more value-add multifamily opportunities as the office market continues to recover in D.C.

[Blaine Heck, analyst]

That's helpful. On the dispositions later this year, first off, I just wanted to confirm the cap rate range you've put out in the press release a month ago still stands at 6.5% to 7% range. And then do you guys have any more visibility on the mix between office and retail that you guys are targeting in that bucket?

[Stephen Riffee, executive]

We're not updating that now, so we're good, but that is a placeholder. We haven't finally identified the assets that we'll sell. So we're good with that as a placeholder for cap rate. What we have said is it's a range of $125 million to $175 million. We've certainly had some price discovery on some additional retail assets as a result of our process, but the majority of it, we've been saying, would at least be 90% probably office. So we'll update that more as those assets are officially identified.

[Blaine Heck, analyst]

All right. That's helpful. Lastly, congrats on getting the World Bank deal under LOI. I'm sure you can't give specifics, but I was hoping you could give some color around the economics or at least whether the spread is expected to be positive, negative or neutral and maybe some color on the concession package.

[Paul T. McDermott, executive]

Blaine, as we've been pretty consistent in the past, and I think you asked the question last call about the retail economics, we can't really get into those while we're in negotiations. We're in negotiations with the [ Borough ] bank right now. I think we're moving in a positive direction. And we will be prepared to comment on the deal once it's executed.

[Operator]

Our next question comes from line of Bill Crow from Raymond James.

[William Crow, analyst]

Just a couple of follow-ups actually from Blaine's question. As you think about that ideal portfolio, what are the odds that you're in more markets 2 or 3 years from now in Mid-Atlantic? Whether that's Baltimore, Philly or some of the regional markets there?

[Paul T. McDermott, executive]

Bill, I think, right now, we've got enough to keep us busy here between our acquisition pipeline and development pipeline. But I think we will always consider new opportunities, create value for our shareholders. So we'll keep an open mind to that.

[William Crow, analyst]

All right. The other part of Blaine's question on the dividend I'm not sure actually got answered, and I think it was an issue last quarter. I just want to make sure that you talk about the ability to grow cash flow internally, and I think that starts the second half of next year. Are you confident that dividend can be maintained at this level?

[Stephen Riffee, executive]

Yes. And I don't think it was an issue, someone asked about it last quarter. We're still targeting for the balance of this year to be in the low 80s from a FAD payout ratio. And even while we're going through sort of the gradual reset as the leases commence, we cover all the time in 2020.

When you look beyond that and you think about the relative recurring leasing capital in the last downflow -- down time in a more weighted multifamily portfolio versus commercial portfolio, we see this as a very long-term strong FAD growth opportunity. And that's how we've allocated our capital. So we'll have a capital allocation decision to make in 2021 and beyond because our FAD should be stronger than it's traditionally been.

[William Crow, analyst]

Yes. That's helpful. I just want to make sure it was clear. My other question really is just, given the changes to the portfolio, Paul, have you effected changes internally at the corporate level to strengthen the multifamily side? I know Tom departed a quarter or so ago. Or do you still have some work to do to kind of realign the focus internally?

[Paul T. McDermott, executive]

Well, I think a lot of that depends, Bill. On the acquisition side, I think clearly, we have the appropriate sized team in place, and we'll continue to stay that course. I think on the development side, we have an opportunity to augment the staff. That's going to depend on how aggressive the development pipeline can be, and that's just going to come down to the math.

I think we have an excellent multifamily team in place right now. They're doing an outstanding job on the Trove, and we are getting through design development and the appropriate processes on Riverside. But I think if we were to take on obviously more opportunities on the development front, we would have to supplement the staff accordingly.

[Operator]

Our next question comes from the line of Dave Rodgers from Baird.

[Dave Rodgers, analyst]

Paul and Steve, maybe just a follow-up on that development comment. You talked about doing new development on some of the residential sites that you've acquired. Maybe talk about the ability to kind of build to that Class B price point. That seems to be a difficult thing to do and how you'd manage that.

And I guess the second component is when you look at the other multifamily REITs that are big developers, I think they're levered at 4x plus or minus. You guys are still over 6. So how do you get down into that range in order to kind of be comfortable and comparable to your new peer set?

[Paul T. McDermott, executive]

Well, let's start with the development. I mean we're -- if you look at what we have, Dave, we've got probably 3 or 4 covered land plays that we're exploring. We're very price sensitive. We're not trying to build to the high A or kind of the lower side B. And I think we talked probably a couple of calls ago about what our basis would be going forward. I think for us on the development front, we're really -- like if you look at our current portfolio, we're targeting incomes from 50,000 to 80,000. I think we would still like to maintain that affordability gap post stick A. And so I don't really feel like you can build B today for the middle market. You have to build a value-conscious A product, and I think that's what we're doing. I think we can afford to do that because we have a lower land basis, both like at The Wellington and at Riverside. And we're doing stick instead of high-rise concrete.

So that's really -- when we talk about these new opportunities for development, that's the type of product we're talking about, and then it's down to whether it's below-grade structured or above-grade structured.

[Stephen Riffee, executive]

And David, was part 2 -- I'm sorry if I didn't quite pick it all up. Was part 2 just looking at our leverage level and our ability to fund development? Is that what you were getting at or...

[Dave Rodgers, analyst]

Yes. Maybe it was 2 separate questions rolled into 1. But yes, that was one. And then the second is just when you look at that kind of multifamily peer set being much more lower levered than where you guys sit today, do you feel like you need to get down to that leverage level in order to kind of get the multiple of being a residential redeveloper, developer, et cetera?

[Stephen Riffee, executive]

Well, I think most of the multifamilies you're looking at are large caps that have been out there for quite some time at all. I think we're still in transition, but I think we're already going to enter next year with some optionality by selling more, we'll be below our normal target levels.

I think we're comfortable with what we think potential sources of capital are. And as we're still transforming the company, staying in our targeted 6 to 6.5 ratio for now, I do think that when you think about just the risk of the cash flows of the company, we went from something like 28% to 45% multifamily as a percentage of our NOI. And our retail, which had been 22% is looking like about 6% going forward until we make further decisions.

That's a significant change in the risk profile of the company, the risk cash flows. And I think we're hoping that we'll get -- that will get recognized by the market.

[Dave Rodgers, analyst]

And then for the second, Paul, I guess as you look at Space+ versus the residential redevelopment, which gives you the better return today? And I know you're doing it for different reasons. But I'm curious on the difference in the returns there and how it -- did Space+ impact leasing metrics for it?

[Paul T. McDermott, executive]

Well, I do think they're 2 separate distinct products. I think Space+ right now, we're continuing to get that 8% to 10% market premium, I think, in the office space. We like that. I think our average duration is about 48 months on a lease that we do, and I think that in terms of comparing that to multifamily development, I mean, since I've been here, Dave, I've probably seen a 150-basis point to 200-basis point compression on development right now. And I think that people in D.C. right now are probably developing realistically from like a 5.1 to 5.25. And I don't think that's obviously not something that we're going to pursue at this time. We need to see a little bit more stability in the math in terms of construction, labor and material costs.

But Space+ right now also is really, what's it, 5% to 8% of our office portfolio. I think our big -- our observation on Space+ is some of our leases that we have in there can turn into long -- can graduate into long-term viable leases for the general office portfolio. And so we're trying to kind of incubate some of the Space+ tenants to become more permanent tenants in the office portfolio. And I think so far, we've -- Space+ has probably been up and running for 12 to 18 months. We were happy with the program, but I think we have the organic growth that's in there, but I don't think it's something that's going to take over on a relative basis a large component of our office portfolio, if you were to compare that to kind of some of the development projects we're contemplating either at Riverside or some of the other opportunities we have. I just think they're different value propositions with different return on costs.

[Operator]

Our next question comes from the line of John Guinee from Stifel.

[John Guinee, analyst]

Steve, it looks to me, quick math, is you're guiding towards about $0.80 FFO for the second half of the year, which feels a little bit like maybe $0.42 to $0.38 in the third quarter and fourth quarter. Does it bottom out at $0.38? And what's a good start for early 2020?

[Stephen Riffee, executive]

John, we've -- I think we even said in the prepared remarks, we expect it to basically be even between the third and fourth. We don't normally give quarterly guidance, but we're basically implying, if you use your math of $0.80 left for the year, $0.40 and $0.40.

In terms of not giving '20 guidance but just thinking about the lease-up pattern, we've been very transparent since the 8-K last November, of the lease -- major lease expirations in the year. We've progressed 72% that have either leased or are at LOI.

And when we think about the lease commencements, the big lease commencement will be early 2020, which will be the EIG lease at Watergate, the top floors of Watergate 600. And so the first quarter is probably the low point, and then that lease alone should then begin to show some progress as you go forward on a quarterly basis. And then the progress on the other leases that are signing, one with Space, we don't even get back yet till September 1 of this year, the Ankura space. Those kick in our models throughout 2020.

So we think the bottom will be -- and we're not giving guidance for '20, but just the pattern should be, the bottom should be around the first quarter. You should see progress as those spaces lease up.

And then our Trove development is -- we've said it's probably expected to break even around midyear next year and contribute for the year about $800,000, but it's significantly higher the following year in 2021. So the Trove starts to kick in as well in terms of the pattern of growth. And that's about as far as we can do in terms of the outyears till we're ready to give full guidance.

[John Guinee, analyst]

Great. And then, Paul, any kind of big picture in D.C.? The lease economics continue to be just brutal. Is there any submarkets or any assets that are bucking the trend and you feel a little bit better about in kind of the turnkey TI world we seem to be in?

[Paul T. McDermott, executive]

I think, John, if I was -- I mean if I was going to evaluate kind of the overall market, I think the D.C. B is marginally improving. And when I say that, I think we're seeing pickups on the concession packages and parking free rent and TIs.

D.C. A, the commodity A, no, I'm not seeing improvement there. I believe it is the turnkey package, as you highlighted. D.C. Trophy, while we're not playing in that space, we see that their deals are getting better. And then if I turn over to Northern Virginia, we're definitely seeing pickups along the Silverline and Rosslyn, both kind of the B plus A space, we're seeing slight pickups. And then obviously I think you know, the Borough you've seen kind of some of the moves there. I think -- I was just told the remaining space at the Borough has now gone up to $62.50 a foot. So I think that we're definitely seeing improvement in that market. But again, any improvement we see is pre any new supply coming on, especially in Tysons.

[Operator]

Our next question comes from the line of Daniel Ismail from Green Street Advisors.

[Daniel Ismail, analyst]

Maybe just sticking to D.C. office. With transfer taxes and property taxes on the rise, Paul, I'm curious does this alter any interest in long-term ownership in that region, both for office or multifamily? And then do you currently have an estimate of the potential impact of those tax increases?

[Paul T. McDermott, executive]

Right now, I mean it doesn't alter our desire to continue to overweight, Danny, in multifamily. I think the taxes, what the D.C. government has just layered on is kind of another pain point for D.C. office. And I think what we try to demonstrate to the market is we're continuing to look at opportunities to monetize components of our commercial portfolio. I do believe it will have a dampening effect, and I have talked to the -- probably the top 3 investment sales brokers here. I think that the D.C. investment sales market has its own challenges right now, but this was just kind of another layer of difficulty to put on to it.

I mean we look at our portfolio right now in D.C., and when you're talking about whether or not we'd hold or monetize it, the core capital is really what's dried up in Washington. We still see a lot of value-add in our D.C. B. We think that there is leasing upside, and we think that there's an ability to get paid for it. This -- the D.C. tax increase will obviously play into that, but it's not going to completely eradicate it. But I like the value-add space, Danny. That's what is still continuing to move.

Our observation will probably be that the biggest disconnect we're seeing kind of in pricing right now is on vacant space, how owners are pricing it and how potential buyers are pricing it or should I say significantly discounting it. And so we haven't really seen the amount of trades that we would expect to have seen in the first 2 quarters of this year. And even if you look at the last 2 deals that were done in D.C., they're both done by co-working companies trying to establish a bigger beachhead here in Washington.

[Daniel Ismail, analyst]

That's helpful. And just -- maybe just last one on development. Curious to hear your updated thoughts on keeping the entirety of developments on balance sheet versus potentially JV. Anything there?

[Paul T. McDermott, executive]

So we've been approached by a number of different institutions about joint venturing some of our multifamily opportunities. We are definitely looking at those and processing them. I think for us, cost of capital is paramount. I think we need to see some stabilization in the -- if you look at the last 2 to 3 years, construction costs have probably increased between 5% and 6%. So for us, the math has to work for WashREIT before we start going soliciting other partners. But I definitely think in terms of capital uses, we would certainly consider JVs if both the cost of capital and the structure makes sense for WashREIT and its shareholders.

[Operator]

Our next question comes from the line of Chris Lucas from Capital One Securities.

[Christopher Lucas, analyst]

Paul, just on the Landmark transaction, maybe you could walk us through the investment thesis there as you've been pretty clear in the past about some of the boxes you need to check for allocating capital to multifamily. I guess just curious as to how Landmark stacks up.

[Paul T. McDermott, executive]

Sure, Chris. Well, I mean as you know, we look for urban infill as well as suburban properties that we feel have an affordability gap. I think when we look in this respective, if we look at our comparable set here, we see rents ranging from a low of, let's call it, mid-1,500 to a high of over 2,100. We're probably in the 1,700 to 1,750 range. We see renovation potential here. We saw an affordability gap in excess of $350, which is, as you know from talking to us, one of our litmus tests. And we wanted to see if the market can bear additional -- or the project inside the market can bear additional renovations.

We think we can grow rents through very light renovations, at least $100 a door, and we think that the capital spend that we would be looking at would not be of the magnitude of like a Wellington or a Riverside. So the thesis is continue to get in there, work on the management of the property, work on some of the optics and do some light renovations for probably over 60% of the property and capitalize on the rent growth there.

We think that if you look at the market itself, if you look at Alexandria, I think over the last 8 years, it's grown over 15% compared to a national average of just over 6%. We like where that market is going. It's a 10-minute drive from HQ2. We also have other centers there. We're going to be running a shuttle on this asset combined with the Assembly at Alexandria. So -- and then there's also metro bus out front from the Yoakum Pkwy and Cascade at Landmark that runs between there and the Pentagon. So we think that we're going to be able to capture both value-conscious military and civilian personnel. And we think it's, again, kind of another value-add, affordable thesis that we're going to be able to incorporate at this asset.

[Christopher Lucas, analyst]

Okay, great. And then just on the 8-asset retail portfolio sale, you had previously guided sort of a 6.2 cap rate on that NOI for the aggregate. Is that still a good number overall, given the slight change in this sort of dynamics with the power center sales?

[Stephen Riffee, executive]

Yes. Chris, obviously, we will update everything in a more final way once we close, and we're still working on the rest of the sales, but a lot is closed. So we're still expecting to be in the low 6s, and we'll refine it as we get a little further along.

[Christopher Lucas, analyst]

Okay. And then last one, Steve, for you, just there were a couple of little changes on the guidance assumptions. But I guess the one that caught my attention was just on the projected development expenditures. Is there anything specific there? Or is this just kind of a cumulative delay in some spendings?

[Stephen Riffee, executive]

There's a slight delay just due to some utility delays that we had at the Trove. But honestly, we -- just while we're going through and trying to get the math to work on Riverside, we actually spent a little less -- we're spending a little less from now to the end of the year on Riverside than we had originally projected.

[Operator]

We have reached the end of the question-and-answer session, and I'd like to turn the floor back over to management for any closing comments.

[Paul T. McDermott, executive]

Thank you. Again, I would like to thank everyone for your time today, and we hope that you enjoy the remainder of your summer. We look forward to seeing many of you on our upcoming nondeal roadshows in the very near future. Good afternoon, everyone.