Equity Commonwealth

NYSE:EQC

Earnings Call Transcript 2019-Q1

[Operator]

Greetings, and welcome to the Equity Commonwealth First Quarter 2019 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host Sarah Byrnes, Vice President, Investor Relations. Thank you. You may begin.

[Sarah Byrnes, VP, IR]

Thank you, Christine. Good morning and thank you for joining us to discuss Equity Commonwealth's results for the quarter ended March 31, 2019. Our speakers today are David Helfand, President and CEO; David Weinberg, COO; and Adam Markman, CFO.

Please be advised that certain matters discussed during this conference call may constitute forward-looking statements within the meaning of federal securities laws. We refer you to the section titled Forward-Looking Statements in the yesterday's press release, as well as to the section titled Risk Factors in our most recent Annual Report on Form 10-K for a discussion of factors that could cause actual results to materially differ from any forward-looking statement. The company assumes no obligation to update or supplement any forward-looking statements made today. We also post important information on our website at www.eqcre.com, including information that may be material.

Today's remarks also include certain non-GAAP financial measures. Please refer to yesterday's press release and supplemental containing our first quarter 2019 results for a reconciliation of these non-GAAP performance measures to our GAAP financial results.

With that, I will turn the call over to David Helfand.

[David Helfand, President and CEO]

Thanks Sarah. Good morning and thank you for joining us.

I'll begin with brief comments on market conditions, review our first quarter results, and provide an update on the company's current activities. U.S. economy continues to grow adding 196,000 new jobs in March. The unemployment rate of 3.8% is near historic lows, and down slightly from 3.9% at the end of 2018.

GDP increased 3.2% in the first quarter up from 2.2% in the fourth quarter of 2018. With respect to the equity capital markets, year-to-date S&P is up 18%, the NASDAQ up 23%, and the Morgan Stanley REIT Index is up 15%.

On the debit side, yield of the 10-year treasury is currently 2.54% down over 60 basis points from its peak in November, 40 basis points lower than a year ago. On the short end of the curve, 1-month LIBOR is 2.5% up almost 60 basis points from a year ago.

Turning to office fundamentals. In the first quarter roughly 15 million square feet of new supply was added to existing inventory across the U.S. with positive net absorption pushing the vacancy rate down 50 basis points year-over-year to 12.5%. National vacancy is the lowest it's been since 2007 and lower by 430 basis points versus peak vacancy for 2010.

I would add one footnote to that vacancy number. We see a lack of breadth in demand for our office space. In 2018 alone, co-working operators accounted for more than 50% of net absorption. The vast amount of space leased to co-working operators in the past few years is not at the same nature of tenor as traditional tenants. Shared office operators are meeting marginal demand and their customers are paying a premium for flexibility. When the cycle turns slightly they will return that supply to the market.

We're addressing this risk by limiting our exposure to riskier credits while also competing for high-quality tenants by operating upgraded building amenities, spec suites, and ensure lease term options. Looking forward, the supply pipeline remains elevated with over 100 million of square feet under construction nationally, deliveries expected to ramp up in the second half of this year.

With respect to the real estate capital markets, office transactions volume totaled $27 million in the first quarter a modest decline from 2018 due to fewer large transactions and increased investor caution. Cap rates were generally stable to up modestly across the country. The real estate debt capital markets remained robust with significant supply from a range of lenders at historically low all-in rates.

Turning to EQC, we had a solid first quarter. The same-property cash NOI was up 9.7%. We also completed the sale of our last asset in Downtown Philadelphia 1735 Market Street for a gross sales price of $451.6 million. Pricing was in the 6% cap rate range.

Subsequent to quarter end we closed on the sale of Bellevue Corporate Plaza, a 97% leased 255,000 square-foot office building, as well as additional development plans for a gross sale price of $195 million.

In addition we continue to work on the sale of Research Park in Austin, a 1.1 million square-foot flex property on 188 acres of land. As mentioned previously, we are evaluating the sale of Tower 333 in Bellevue Washington and the Green Harris Buildings in Washington D.C.

Since we took responsibility of the company, we sold 160 assets for $6.7 billion and 66 transactions. In doing so we've created optionality due to conversion of undervalued portfolio of assets with cash. Today we're a fundamentally different company with high-quality assets, strong balance sheet and a track record of consistent execution.

As a result of our disposition activity, we recently reduced our staffing level to reflect the smaller portfolio. Today we have 32 people down from a peak of 72 in 2015. We're grateful to our team past and present for their contributions to EQC's success.

Our strategy will continue to be informed by market conditions, and we'll be patient and disciplined in our evaluation of a broad range of investment opportunities including non-office asset classes. $3.3 billion of cash was uniquely positioned to combine our capacity and talent to create long-term value for shareholders.

With that, I'll turn the call over to Dave.

[David Weinberg, COO]

Thank you, David, and good morning.

I will begin by reviewing our first quarter leasing activity and giving an update on our properties. Then I'll cover this year's remaining lease roll. Our same-property portfolio at the end of the quarter comprised nine properties totaling 3.8 million square feet. The portfolio was 94.4% leased down 110 basis points from fourth quarter 2018 and up 210 basis points year-over-year.

Commenced occupancy was 93.7% down 20 basis points from fourth quarter and up 250 basis points year-over-year. In the quarter we signed 108,000 square feet of leases, almost all of which were renewals. Rental rates increased 17.9% on a GAAP basis and 8% on a cash basis. Most of our leasing this quarter was at 109 Brookline Avenue in Boston.

We renewed Dana Farber from 77,000 square feet. This asset is 95% leased. 109 Brookline is a great property in a very strong submarket.

In Denver at 17th Street Plaza we renewed two tenants and signed one new lease for a total of 15,000 square feet. This property is 88% leased. While this market remains competitive with a total vacancy rate of 15.6%, we continue to see steady interest from smaller tenants.

Bridgepoint Square in Northwest Austin is 87% leased with good activity. Capitol Tower in Downtown Austin is 92% leased. Austin continues to do well with a vacancy rate of 9.3%.

I would like to finish by commenting on the remaining 253,000 square feet rolling this year excluding Bellevue Corporate Plaza. Half of this roll is Georgetown University's 129,000 square-foot lease at the Harris Building in Washington D.C. which expires September 30.

We are discussing a short-term extension with Georgetown while also working to backfill its space should it vacate. Of the remaining 124,000 square feet rolling, we expect to get back 85,000 square feet. This includes BT Americas vacating 59,000 square feet at the end of July at 109 Brookline.

With that, I will turn the call over to Adam.

[Adam Markman, CFO]

Thanks David. Good morning.

I'll review our financial results for the quarter and add an update on required distributions following our recent asset sales. Funds from operations were $0.19 per share compared to $0.05 per share in the first quarter of 2018. The FFO growth was generated despite a decrease of $0.08 per share from $1.5 billion in asset sales since the beginning of the first quarter of 2018.

Offsetting the effect of the dispositions was $0.10 per share of higher interest and other income, another $0.05 per share of lower interest expense, and finally an improvement of $0.04 per share after the loss on early extinguishment of debt that hit the first quarter of 2018 did not reoccur this year.

Normalized FFO was also $0.19 per share compared to $0.14 a year ago. The growth in normalized FFO was achieved due to $0.06 per share of increased interest income, $0.05 per share of interest expense savings from debt repayments and despite a decrease of approximately $0.07 per share resulting from dispositions.

Net operating income in the nine asset same-property portfolio was up 7% in the first quarter compared to a year ago. The increase was largely due to higher commenced occupancy with the largest contributions coming from Denver, Austin, and Washington DC.

Same-property cash NOI was $21.4 million 9.7% higher than in the first quarter of last year driven by higher rental income again primarily from Denver, Austin and DC where several tenants are now through their free rent periods and have begun to pay rent and expense reimbursements.

Cash NOI for the quarter does not include $700,000 of revenue from leases in free rent. Additionally, there are 30,000 square feet of leases signed but not commenced on spaces that are currently vacant and therefore not in cash or GAAP NOI. These leases will eventually generate $1.4 million in annual rents.

As we've discussed in the past, tenant move-outs will temper growth. Given the small size of our current portfolio, we will experience greater volatility going forward. Additionally, dispositions will continue to have a meaningful impact on how much future growth flows through in the form of NOI over time or as monetized through asset sales.

General and administrative expense for the quarter totaled $12.1 million of which $2.3 million was severance resulting from our recent reduction in force. We expect an additional $1.2 million of severance-related expense in the second quarter after which G&A will be roughly $9 million per quarter.

Moving to dispositions, we have sold $647 million of properties year-to-date inclusive of Bellevue Corporate Plaza which sold last week. These sales have generated a taxable gain that's roughly $270 million in excess of the net operating loss that was carried forward from the beginning of the year.

As a result we will be required to make a common distribution this year. The timing and amount of the distribution will depend on our results from operations and the outcome of future asset sales including Research Park which will generate additional taxable gain if sold.

Briefly turning to the balance sheet, we've repaid over $3 billion of liabilities and preferred. And our debt now totals just $275 million as compared to $3.3 billion or $27 per share in cash following last week's sale of Bellevue Corporate Plaza. We continue to look for opportunities where our team liquidity and financial strength will provide a competitive advantage.

Thank you. And with that we'll open it up for Q&A.

[Operator]

[Operator Instructions] Our first question comes from the line of Manny Korchman with Citigroup. Please proceed with your question.

[Manny Korchman, Citigroup]

Thanks for your comments earlier on co-working and your thoughts in the past with all the space there. Just wondering how are buyers underwriting those same plans. Do they care when there's co-working operators in the space?

[David Helfand, President and CEO]

Manny, it's David. I'll tell you if you ask me that question six months ago I would say they're probably not distinguishing between co-working and other tenants. Although it feels more recently that it's no longer true. I can't quantify it, but there's enough talk in the market where I think buyers and lenders are starting to look at that more closely.

[Manny Korchman, Citigroup]

And then Adam it looks like you sold your marketable securities or re-classed them with the balance sheet. Can you just tell us what's going on there?

[Adam Markman, CFO]

Yes, really not much to see, we had purchased two years ago two year treasury. They reached their maturity and they are therefore now cash.

[Operator]

Our next question comes from the line of Jamie Feldman with Bank of America Merrill Lynch. Please proceed with your question.

[Jamie Feldman, Bank of America Merrill Lynch]

I guess just sticking with the co-working topic. I'm just curious to get your thoughts of when you think about a downturn, how does this really play out? And how does the space come back and where do you think the opportunities are for landlords if there are any?

[David Helfand, President and CEO]

Just a couple of comments. There's been so much things spilled on co-working. I'm not sure how much I can add. But our experience has been this is the third iteration of the co-working. The first two did not end well certainly for landlords. They are such a factor in the market and there's really a couple of issues you need to consider.

One is there is no barrier to entry to get into the business and they are essentially disintermediating credit between the landlord and their tenant. So I think you'll see more landlords get involved in business and starting to see that.

What happens in a downturn my guess is that people get that to space they can't get back and that would be probably the operational because the space that's been taken up in the last three or four years. They've been maybe 50% of the market along with tech. We see a real lack of breadth in demand. As those co-working spaces empty out we'll close even quicker because they can especially in cases where there's no credit on a lease.

[Jamie Feldman, Bank of America Merrill Lynch]

And then in terms of underwriting. I guess as you're probably not looking at many assets that have co-working. But in your own underwriting like how do you think about the cap rate spread between a fair cap rate spread between a co-worker building and a non-co-working building?

[David Helfand, President and CEO]

Yes. I don't think we quantify it like that. I think when we're looking at individual assets, we're really looking at that building that market how that space is built out and keeping in mind kind of the downside scenario should that space come back how would we deal with it.

[Jamie Feldman, Bank of America Merrill Lynch]

And then David you had commented, you're looking at office but you're also looking outside of office. Can you just give us a little your thoughts on just how far outside the sector you would look and what we might be able to expect?

[David Helfand, President and CEO]

Yes. I think it's consistent with what we've said previously that we want to cast a wide net to evaluate opportunities where we had some sort of edge and thought we could create value. I think rather than going to specifics maybe a common theme that we talk about here as we evaluate opportunities focused on demand is a growth in demand is a durable long-term demand. And if so, we evaluate the business trying to understand the fundamentals of the business let's see where we might be able to create value.

[Jamie Feldman, Bank of America Merrill Lynch]

Where would you - how would you describe your confidence in finding something today versus say six months ago?

[David Helfand, President and CEO]

Confidence, I'm optimistic. I'm confident. I'm hopeful. This has been an exercise in rationalizing the portfolio of building a team and building capacity. We're through the bulk of that. Now we'd like to find an opportunity. And so I think we're further into we assume it's still a cyclical business. We're six months closer to whatever the turn is going to be and that makes me a bit more optimistic.

[Operator]

[Operator Instructions] Our next question comes from the line of John Guinee with Stifel. Please proceed with your question.

[John Guinee, Stifel]

Adam thanks for the color on the special dividend. Can you take it one step further and the endgame is either quarterly asset liquidation some sort of M&A event or maybe a portfolio acquisition. Can you talk about the preferred share minimum, maximum obligations in either of those scenarios? And then regarding the rest of the asset liquidation, do we have any potential corporate tax issues or shareholder tax issues in any of these scenarios?

[David Helfand, President and CEO]

Let me start with the Series Ds. And really we'll refer you to the page turner that are the article supplementary from 2006 when they were filed for all the details. But I'll summarize but I just want you to know there's lots of nuance and it's important to understand that nuance.

But the holder of this preferred has the right at any time to convert at 0.52 times their $25 per share value. So converting that into per share price they're not in the money until they are at $48 or so per common share.

If they trade at $48, we then have the right to force a conversion a on those shares. Outside of that as we continue to operate they will just hang out on our balance sheet. You've talked about what happens if you don't continue to hang out, right? A liquidation or a merger or something.

And under each of those scenarios different things occur but if we liquidate the shares are redeemable at par. That's still $25 par value or $123 million in aggregate. If we merge they survive in the merged entity but there is a conversion rate because of what we call fundamental change in those article supplementary where their shareholders can convert at basically a slight premium to their $25 price. That's really the high level summary and again more detail in the filings. In terms of…

[John Guinee, Stifel]

How about just corporate tax obligation or obligations to the shareholder in the event you continue down the liquidation path?

[David Helfand, President and CEO]

There's nothing of note from that perspective. I think you if you look at what we've done in terms of creating a very small and liquid portfolio and taking the liability side of the balance sheet into a as simple as a publicly-traded company's balance sheet can be our lack of development, our lack of joint ventures, the ability to move from here that option is something that I think we can execute very efficiently.

[John Guinee, Stifel]

So is that another way you could liquidate the entire portfolio and special dividend out all the proceeds on a non-taxable basis?

[David Helfand, President and CEO]

There are taxes to shareholders. And as there would be again depending on your basis, depending on how that endgame actually played itself out.

[John Guinee, Stifel]

But there are no taxes at the corporate level?

[David Helfand, President and CEO]

No. We continue to have our REIT status and pass through any gain to the shareholders.

[Operator]

Our next question comes from the line of Mitch Germain with JMP Securities. Please proceed with your question.

[Mitch Germain, JMP Securities]

Maybe just some comments on the Bellevue Corporate Plaza sale process, please.

[David Helfand, President and CEO]

Sure, Mitch. I'll tell you it's a special asset with some very unique opportunities both in terms of its location and the development opportunities. Attracted a wide level of interest from both office developers and multi-family developers of the competitive process and we received bids from several highly qualified groups.

[Mitch Germain, JMP Securities]

Is that same buyer potentially a potential buyer of Tower 333 as well?

[David Helfand, President and CEO]

Well I think several of the bidders would also be interested in Tower 333. And if and when we choose to sell it we'll know more at that time.

[Mitch Germain, JMP Securities]

And last one for me. I know you guys mentioned Tower 333 and one of the D.C. properties as potential next kind of level of sale targets. What are the differentiated between those two properties and the remaining of the portfolio? Is it really just rent roll or leasing issues that is slowing potential sale of some of the other asset?

[David Helfand, President and CEO]

No. I look at it, the reason we've identified and we're evaluating those two as most likely candidates are one, Tower 333 we've created all this value. We've got a 16-year lease with Amazon and now would be a great time to monetize what we've done. And then the other asset the Green and Harris Buildings in Georgetown, similarly we signed a long-term lease with British school in one of the buildings.

We're working with Georgetown and the other. And that too will be kind of I guess, the work done will be completed and it will be a nice time to monetize that one. It also doesn't fit long-term given the unique nature of that lease with British school. So those two I would say are the outliers. And what's left are just really good properties, all multitenant assets in very good markets, Boston D.C., Austin and Denver.

[Operator]

Mr. Helfand, we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.

[David Helfand, President and CEO]

Thank you for joining us. We appreciate your time.

[Operator]

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.