Piedmont Office Realty Trust Inc

NYSE:PDM

Earnings Call Transcript 2023-Q2

[Operator]

Good day, everyone and welcome to the Piedmont Office Realty Trust Inc’s Second Quarter 2023 Earnings Call. At this time, all participants have been placed on a listen-only mode and we will open the floor for your questions and comments after the presentation.

It is now my pleasure to turn the floor over to your host, Eddie Guilbert. Sir, the floor is yours.

[Eddie Guilbert, Investor Relations]

Thank you, operator, and good afternoon, everyone. We appreciate you joining us today for Piedmont's second quarter 2023 earnings conference call. On Tuesday morning we filed our 10-Q and an hour ago we filed an 8-K that includes our earnings release and our unaudited supplemental information for the second quarter that's available for review on our website at piedmontreit.com under the Investor Relations section.

During this call, you'll hear from senior officers at Piedmont. Their prepared remarks followed by answers to your questions will contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements address matters, which are subject to risks and uncertainties and therefore actual results may differ from those we anticipate and discuss today. The risks and uncertainties of these forward-looking statements are discussed in our press release as well as our SEC filings.

We encourage everyone to review the more detailed discussion related to risks associated with forward-looking statements in our SEC filings. Examples of forward-looking statements include those related to Piedmont's future revenues and operating income, dividends and financial guidance, future leasing and investment activity and the impact of this activity on the company's financial and operational results. You should not place any undue reliance on any of these forward-looking statements and these statements are based upon the information and estimates we've reviewed as of the date the statements are made.

Also on today's call representatives of the company may refer to certain non-GAAP financial measures such as FFO, core FFO, AFFO and same-store NOI. The definitions and reconciliations of these non-GAAP measures are contained in the earnings release and in the supplemental financial information, which were filed earlier this afternoon.

At this time, our President and Chief Executive Officer, Brent Smith, will provide an update on our recent refinancing activity and second quarter operating results. Brent?

[Brent Smith, President and Chief Executive Officer]

Thanks, Eddie, and good afternoon, everyone. As we appreciate all of you for accommodating us for the short notice of this moved up earnings call, given the refinancing activity that we announced Tuesday, we felt it was important to go ahead and get our full quarterly information into the market so that all of our investors have the benefit of the most recent financial and operational information available. First, I'd like to walk you through a rationale for our recent refinancing activities that we've undertaken, and give a brief overview of the quarterly results. Following me as usual, you'll hear from George Wells, our Chief Operating Officer; Chris Kollme, our EVP of Investments; and Bobby Bowers, our Chief Financial Officer. We also have the usual full component of our management team available to answer any questions that you may have.

With that, I'll jump right in on the refinancing activity. As we announced Tuesday afternoon, we have closed a $400 million in aggregate principal amount of 9.25% five year unsecured notes. Concurrent with the issuance of the new bonds, we also made a tender offer at par for any and all of our outstanding $400 million unsecured senior notes that are scheduled to mature during the first quarter of 2024. Although we have no way of knowing exactly how many of our current holders will tender their bonds, and given the current interest rate environment, we are projecting that a majority of the 24 holders will participate in the tender, which will close next week. While the coupon rate on the new debt is certainly a high watermark for Piedmont, it is unfortunately reflective of where the market currently is for commercial office properties.

Over the last several months, we've gone through an extensive process of exploring and analyzing our various capital raising alternatives, including a number of potential asset sales, the possibility of placing a mortgage on one or more of our properties, either with a balance sheet lender or utilizing the CMBS market; issuing in the unsecured market, either through a bank term loan, private placement or public bond offering; and corporate level structured financings, including convertible debt and preferred equity among others.

At the end of the day, asset sales have been extremely difficult to complete, given the lack of asset-level financing. And we concluded that whatever modest discount there might be had on a CMBS execution did not justify encumbering more than a half dozen of the assets in our portfolio at low loan to value ratios. Finally, the unsecured bond market offered the greatest financing capacity compared to other unsecured alternatives, and maintaining a large unencumbered asset pool is important consideration for the rating agencies.

In addition, a key component of our leasing and capital recycling strategy has been to maintain a flexible balance sheet with ample liquidity, primarily as an unsecured borrower. This has helped the company in many ways, including expediting capital and repositioning programs, allowing greater flexibility to move tendency throughout the portfolio, and avoiding debt prepayment penalties with property dispositions, among others.

More recently, the lack of mortgage debt in our portfolio has been instrumental in driving leasing volumes. Therefore, after considering the continued messaging from the Fed regarding additional interest rate hikes during the latter half of the year and the overall lack of financing opportunities currently available to the office sector generally, we ultimately concluded that accessing the public bond market while the opportunity was available and addressing our largest near-term maturity now was the most prudent course of action for Piedmont. The expectation that rates will come back down over the next several years influenced our decision to go with a shorter, five-year tenure for the new notes.

Turning to our operating results, the second quarter of 2023 demonstrated Piedmont’s continued success, despite the challenges facing the broader office sector. Our leasing formula is working and we continue to be optimistic about the value proposition for our customers and the opportunity to continue our leasing momentum, particularly in today's capital constrained market. The flight to quality buildings and owner operators is favoring Piedmont. Quarter after quarter, we continue to demonstrate that well-designed monetized work environments operated by well-capitalized service minded landlords is garnering outsized demand from small and medium-sized businesses, as well as larger non-tech corporate tenants.

The flight to quality occurring in the market is playing to Piedmont strategy, providing premier workspaces at meaningfully lower rental rates versus new construction. In brief, we sustained the leasing momentum from the first quarter with Piedmont’s prospective tenant pipeline remaining robust and meaningful tenant lease volumes achieved. In total, we executed almost 585,000 square feet of leasing, and generated an over 14% roll up in cash rents. Furthermore, we continue to make significant progress towards a renewal of our largest tenant, U.S. Bank, for the extension of its lease on a substantial majority of its downtown Minneapolis headquarters location.

Given we remain in negotiation and documentation stage on the lease, we're limited with the details we can share but it's a long-term lease under similar terms and metrics we've discussed on prior earnings calls. U.S. Bank’s renewal decisions for its IT and datacenter operations at Meridian Crossings will follow the conclusion of the downtown agreement so there are no incremental information regarding that location to share today.

At this time, I will hand the call over George who will go into more details around our operational success during the quarter.

[George Wells]

Thanks, Brent, and good afternoon everyone. Persistent demand for Piedmont’s high-quality assets lead to another quarter of solid operational results. Office users recognize that Piedmont’s attractive workplace proposition can be a key driver for encouraging or supporting mandates for more in-house attendance. CBRE’s Spring 2023 U.S. Occupier Sentiment Survey sites on-site food and beverage cafe after ease of commuting and parking is having the most impact for attracting employees back into the office.

At Piedmont we provide a wide range of local to national food and beverage options across our portfolio from custom delivery orders, traditional cafes, full-service restaurants with bar service to white tablecloth high-end establishments. In a moment, I'll highlight three F&B transactions that were completed this quarter and are enhancing our competitive position in the marketplace.

Overall, this quarter, we had another strong leasing performance with 49 lease transactions completed for approximately 585,000 square feet of total overall volume. Of this amount, 237,000 square feet or 41% of the total were related to new tenant lease activity, well over our pre-COVID quarterly average of about 175,000 square feet, and our leasing pipeline activity is very strong.

Continuing with operational metrics, our lease economics were very favorable with 14.3% and 19.6% roll up or increase in rents for the quarter on a cash and accrual basis respectively. And our weighted average lease term achieved on new lease activity for the quarter was just under 10 years. Our lease percentage at the end of the quarter was 86.2%, slightly up when compared to the previous quarter end. Approximately 90% of new tenant activity occurred in our Sunbelt portfolio where almost 70% of our vacancies reside. Retention rates remain consistent at approximately 70%, no doubt a reflection on both our customer centric service approach and high-quality commute worthy portfolio. Lastly, leasing capital commitments on our year-to-date leasing were $6.29 per square foot per year of lease term, and in line with fourth quarter of last year's averages.

Now, I'd like to highlight a few key accomplishments and announcements which occurred in some of our operating markets this quarter. Atlanta, our largest market at almost 5 million square feet and generating 28% of our company's ALR captured the most activity this quarter with 16 deals accounting for 300,000 square feet, of which 60% were new leases. Also the Galleria, an investment company relocated its headquarters from a nearby Class B facility, making this our eighth full for larger new deals since 2020, six of which are headquarter location.

Our Midtown LEED Gold 999 Peachtree also experienced good activity with three new deals, one being a high-end F&B operator that's well known in Atlanta, lazy Betty. This operator has received multiple local culinary awards for its carefully crafted tasty menus and unique dining experience. We anticipate them opening in the fourth quarter.

In Northern Virginia, we're excited to welcome Panera Bread as our second F&B operator at our LEED Silver 4250 North Fairfax Tower. We're also pleased that PF Chang’s renewed its high performing restaurants at our LEED Silver Arlington Gateway for another five years with no concessions. Along with our 3100 Clarendon Tower, all three of our Nova assets are 4-star rated by CoStar and have been designated a walker's paradise due to a plethora of nearby food and beverage options and the locations near metro train stations. CoStar is the industry leader in commercial real estate information, analytics and news and has designated 96% of our ALR over 70 million square foot portfolio as either four or five stars its highest quality rating. Our Nova portfolio is well positioned to capture leasing activity going forward.

Let's drop into Minneapolis next on to our largest near-term expiring customer U.S. Bank. Extension negotiations with the bank at our downtown LEED Gold U.S. Bank Center are accelerating and we're optimistic on retaining them for substantially all of its 490,000 square feet of space there, though admittedly, we still have more work to do. As an aside, this world-class tower continues to separate itself from its competitors with a soon to open elite restaurant that will be offering fresh refined seafood in a luxurious environment. This tower also recently won BOMA's International Outstanding Building of the Year Award. We will be addressing U.S. Bank suburban lease location at our Meridian Crossing Complex after we complete the larger downtown lease negotiation. We don't have any additional color on the suburban lease at this time and we would reiterate a more conservative extension at this point, say 50%. That said suburban Minneapolis has been and continues to be quite active for us. Year-to-date, we've completed nearly 70,000 square feet of transactional activity here with a good deal flow in our pipeline.

Coming back to overall portfolio, we remain positive about our future near-term leasing trends and operational performance. Tour activity continues at the same healthy pace that we've seen for several quarters. Proposal activities more than the trailing 12 months coming in around 2.5 million square feet. With only 3% of the rent roll expiring over the next two quarters we expect positive net space absorption for the rest of the year resulting in an anticipated year end lease percentage to end between 87% and 88% that was provided in our initial guidance.

I'll now turn it over to Chris Kollme to review our second quarter investment activity. Chris?

[Chris Kollme, Executive Vice President of Investments]

Thank you, George. As you might expect, given the ongoing challenges in the market, I have very little new information to report since the last call. We announced last quarter that our two assets in Houston had gone under contract and we're through diligence, but terms did contain a financing contingency. The potential buyer is working diligently to secure its capital structure, but has not yet been finalized. We expect to have more clarity on their progress in the coming weeks. We will certainly keep you all informed if and when we have additional information to share.

As for the balance of our activity, we're in preliminary discussions on select non-core assets but it's far too early to speculate, given the market backdrop. We will continue to work creatively with interested parties on potential dispositions. Any and all sale proceeds will be earmarked towards the reduction of debt.

With that, I'll turn the call over to Bobby to review our financial results and to update you on 2023 guidance.

[Bobby Bowers]

Thank you, Chris. While we'll be discussing some of this periods financial highlights today, I encourage you to please review the entire earnings release, the 10-Q, and the accompanying financial information, which we filed over the last few days for more complete details. Core FFO per diluted share for the second quarter of 2023 was $0.45 versus $0.50 per diluted share for the second quarter of 2022, reflecting approximately $0.08 per share of dilution from increased interest expense comparatively, but this increase was partially offset by operational growth during the second quarter of this year, resulting from successful leasing efforts, rising rental rates and asset recycling over the past year. AFFO generated during the second quarter of 2023 was $44 million and $81 million on a year-to-date basis. Our property operating costs and general and administrative expenses were in line with budget with no unusual variances.

As George and Brent noticed, leasing has been strong throughout the year, with over 1.1 million square feet of executed leases completed during the first six months of the year. Year-to-date, cash rent roll ups for these newly completed leases are up 10% over expiring rates and accrual rents are up over 14%. Same-store NOI, however, is relatively flat thus far for the year compared to the previous year but this is a timing issue with 60% more leases yet to commence or in abatement at the end of this quarter. That's a total of 1.3 million square feet versus less than 800,000 square feet that we began the previous year with. With several leases set to commence or begin paying rent, we still project cash NOI growth to be positive between 1% and 3% for the year.

Turning to the balance sheet. During the second quarter, we repaid $350 million in maturing unsecured notes, utilizing our cash and investments on hand and our available $600 million revolver. Now having addressed our $400 million bond maturity, subsequent to quarter end, we have no other debt, with final maturity until 2025. As Brent noted, a key component of our leasing formula isn't our balance sheet and liquidity remains strong, a differentiating factor, as prospective tenants scrutinize the capital structure of a potential future office building and landlord. This differentiation among office products is driving increased market share for the highest quality placemaking assets and well capitalized landlords. We've already discussed our new five-year bond issuance and we've stated that any disposition proceeds will be used to strengthen our balance sheet by paying down our line or our bank term debt.

At this time I'd like to update our guidance for 2023. With a $400 million new debt issuance completed today and in place, the approximate 5% increase in interest rate will result in interest expense increasing approximately $20 million annually. This increased interest expense will negatively impact 2023 earnings $0.08 per diluted share over the remainder of the year. Therefore, our guidance is lowered and narrowed to $1.74 to $1.80 per diluted share for 2023. This guidance includes approximately $570 million to $580 million of total revenues, $100 million to $104 million of total interest expense for the year, and G&A expenses of $28 million to $29 million. This guidance does not include any gains or losses from the potential sale of real estate assets that Chris mentioned. We will update our guidance, should a capital transaction occur.

As I conclude, I will note that our Board of Directors will be meeting next week for our regularly scheduled quarterly board meeting. Management will be presenting this updated forecast information for their consideration as part of the Board's review of Piedmont’s dividends. The company's dividend for the last several years has been based upon our forecasted taxable income that includes our property operating income, interest expense, and gains and losses from the sale of real estate assets. With gains anticipated from the possible dispositions that Chris discussed, we're not in a position at this time to speculate on what action the Board may take immediately regarding our dividend policy. However, as has been our long-term policy, we'd expect the dividend to be adjusted to taxable income forecasts.

With that, I'll turn the call back over to Brent for closing comments.

[Brent Smith, President and Chief Executive Officer]

Thank you, George, Chris, and Bobby. In summary, for the remainder of the year, we anticipate modest space absorption and operational growth. We will continue to be a net seller of assets as we deleverage the balance sheet and enhance our liquidity resources but, as we've previously outlined, increased interest expense will continue to weigh on earnings and FFO in the near term. Finally, I want to thank the outstanding employees at Piedmont who provide excellent service to our customers each and every day. Their dedication, resilience, and hard work continues to drive our leasing success despite the challenging market.

With that, I will now ask the operator to provide our listeners with instructions on how they can submit their questions. We will attempt to answer all your questions now or we will make appropriate later public disclosure if necessary. Operator?

[Operator]

Certainly. Everyone at this time, we will be conducting a question-and-answer session. [Operator Instructions] Your first question is coming from Nick Thillman from Baird, your line is live.

[Nicholas Thillman, Robert W. Baird & Co. Inc.]

Hey, good afternoon or good evening, guys. Maybe just a little bit on the decision to do the debt offering here instead of waiting maybe a little bit. Is this more of a matter of the debt markets were open so we're just going to get it rip the band aid off here or like maybe walk through it sounds like there's still potential for some dispositions. So, just kind of wondering around the timing of this transaction?

[Brent Smith, President and Chief Executive Officer]

Sure, Nick. Great questions. This is Brent and, again, thanks for joining us this evening and being flexible having moved this up a week of our earnings call. And a very reasonable question; we continue to canvass a number of different alternatives, as we outlined in the earnings call, including asset dispositions but, as we noted, it's been very difficult in this environment, even though we've found a reasonable price.

From an equity standpoint, that debt has just been very difficult to achieve. We've continued to evaluate secure debt within our own portfolio having hired a broker to help us canvass both the insurance kind of bank lending market if you will, as well as the CMBS market. And of course, we looked at various forms of unsecured talking to our own bank lending groups, which we did utilize in early part of this year for a sizable term loan and a number of different structured alternatives as well getting – looking at creative situations around convertible preferred or other super structures, if you will, from a capital perspective. But when it boils down to it, there are a couple of things that kind of weighed in our mind. First and foremost, there is a large wall of commercial debt coming due the remainder of this year and next year and thinking about that overall implication and available funds, there's a lot of basically need and not a lot of supply. So wanting to try to address the 2024 maturities earlier rather than later was our mindset.

We continue to kind of evaluate, it's been a very challenging market, certainly at the unsecured side, but more broadly, just a lot of concerns around recession and the rates. And we had a window here where the general economic malaise had kind of lifted a little bit, I think people were somewhat hopeful of a soft landing, if you will and some continued data points around reduced inflation overall, created a positive economic window, we felt producing our positive economic results early and getting ahead of some of that negative headlines that may be forthcoming over the next month or week even. It was just a mindset of trying to go ahead and take some risk off the table, if you will.

We had a lot of inbound inquiries through the, call it, last three months. We've been talking to fixed income investors regularly since our last earnings call. And I think a lot of them have done the homework that unfortunately, we haven't seen necessarily in the equity markets to really discern the portfolio. And they kind of heated our comments of following leasing, and denoting success within the portfolio in that manner.

So we've continued to demonstrate to the fixed income market, the stability, the portfolio, the leasing success, the continued rental rate roll up the mindful use of capital and I think they recognize that we decided it was a good opportunity to go into the market, it was well received, several times oversubscribed in the offering. But of course, the rate was somewhat driven by just the general difficulties in our sector. So I would say, it is not representable but we think the credit worthiness of the portfolio is, that is where fortunately the market resided. And we were pleased to be able to have the demand to accomplish a $400 million offering in tender and take out those 2024 that will mature now but the nine months. So in short, we saw a window to de-risk maturities and we took it.

[Nicholas Thillman, Robert W. Baird & Co. Inc.]

Very helpful. And then maybe just going back to what you were saying about non-encumbering the portfolio, what was like the rate differential between the secured and unsecured options?

[Brent Smith, President and Chief Executive Officer]

Yes, I think even within a secured standpoint, and I noted this on the call, LTVs were very low, so we were encumbering a number of assets, frankly, more than we would have anticipated to. And the pricing was better than the unsecured market but I wouldn't say materially better, particularly if you think about some of the assets that we might have put debt on where our most, I guess, long-term in terms of its wealth and probably candidates for harvesting in terms of value, because they've been maximized and mature under ownership, which would have created prepayment penalties in addition to the interest expense incurred.

So, really, we felt like the delta between secured and unsecured was within 100 basis points and we frankly feel like keeping the portfolio unsecured, as we've talked about, is a key component of our leasing strategy today and overall our capital recycling strategy once we're able to continue with that engine of growth when things normalized in the market. So given that lack of material discrepancy in pricing and the benefits of remaining unsecured, we decided to take the window within the market here in the past few days.

[Nicholas Thillman, Robert W. Baird & Co. Inc.]

Right and then maybe last one. It sounds like discussions for U.S. Bank are moving along here. You guys have traditionally or like in the past have said somewhere between 50% to 100% on the downtown renewal. It sounds like we're trending more to the upper end of that range. Is that that kind of reading into your comments?

[Brent Smith, President and Chief Executive Officer]

That's fair to say yes.

[Nicholas Thillman, Robert W. Baird & Co. Inc.]

Okay. Thanks, guys.

[Brent Smith, President and Chief Executive Officer]

Thank you.

[Operator]

Thank you. [Operator Instructions] Your next question is coming from Dylan Burzinski from Green Street. Your line is live.

[Dylan Burzinski, Green Street Advisors]

Good evening, guys. Thanks for taking the question here. I guess just touching on dispositions and transaction markets, could you comment on sort of the environment today versus maybe three to six months ago? I think it is improving with regards to liquidity coming back to the private capital markets or are things still tough?

[Brent Smith, President and Chief Executive Officer]

I would say maybe improvement on a very, very small margin but I still think we're going to be in a time period here where there's going to be a lot of headline risk, a lot of defaults and keys being thrown back. Hopefully there's someone there to catch them but, frankly, right now the lenders aren't really interested in taking the assets either, so I think we're going to have a time period here or call it 12 months to 18 months where we're going to continue to deal with some of these issues. And without any debt, there is no equity, so transaction volumes continue to be elusive and, as a result, a sense of pricing and price discovery in the market and, frankly, clarity around underwriting and what an exit cap rate should be is very difficult and that continues to weigh on overall transaction volumes.

As we've talked about, those buyers that we've been approached by the market are generally non-institutional, they are local private equity, local family office who understand the nuances of the market, and see opportunities to either not have a competitive bidding pool and/or get a great price. So I think we continue to be very patient in that marketplace, recognizing that we do have some good assets that should garner fair value, once things open back up. Houston is under contract, we are being patient with the buyer to find financing, but we'll continue to look at other alternatives as dispositions as well, and still guide to accomplish somewhere between $100 million to $200 million of disposition in the next six months to 12 months.

[Dylan Burzinski, Green Street Advisors]

Just sort of along those lines, any desire or willingness to offer seller financing, in certain instances?

[Brent Smith, President and Chief Executive Officer]

Very relevant point, Dylan, and I think that's really what's gotten most of the transaction volumes that we're aware of, most of them, not all of them, over the goal line. So we have considered in the past, certainly done in the past. At this point, right now, with the Houston buyer, we've not capitulated. We've had some discussions, but I don't think that we're meeting immediately the leverage specials they would like to. But, overall, I think that's something we will continue to consider in some situations but in the instance of Houston, I think our preference would be to exit the market if possible.

[Dylan Burzinski, Green Street Advisors]

And then just one last one, if I can, assuming U.S. Bank gets sell out here at the high end of sort of the range you guys guided to, is that a potential future disposition candidate or I guess just broadly speaking, how are you guys thinking about your Minneapolis presence over the longer term time horizon?

[Brent Smith, President and Chief Executive Officer]

Yes, Dylan, very relevant question. I think we're certainly very close to U.S. Bank and in discussion, so I don't want to get too much detail or ahead of ourselves. But I think we view the long – the downtown asset is a critical component of U.S. Bank’s operations, we would have a meaningful reposition of their space, if we were to do a long-term lease like we're talking about here, but that's going to take several years to complete. And I think we're very committed overall to our position in Minneapolis, recognizing there may be an opportunity or some buildings to reduce exposure. But near term, I think we're focused on accomplishing those leases and then we'll worry about opportunities overall in the marketplace.

[Dylan Burzinski, Green Street Advisors]

Right, appreciate the comments, Brent. Have a good evening.

[Brent Smith, President and Chief Executive Officer]

Thanks for joining us this evening, Dylan.

[Operator]

Thank you. That concludes your Q&A session. I will now hand the conference back to Brent Smith for closing remarks. Please go ahead.

[Brent Smith, President and Chief Executive Officer]

Well, again, I want to appreciate everyone who's taking the time to get on the call this evening. We certainly have been pleased with the operational performance of the portfolio and look forward to continuing to share that in the quarters to come. I'd like to remind investors as well we'll be attending the Bank of America REIT Conference on September 12th and 13th in New York City. If you'd like to schedule a meeting with management, please reach out to Eddie Guilbert or Bobby Bowers. And again, thank you everyone for joining. Have a good evening.

[Operator]

Thank you everyone. This concludes today's event. You may disconnect at this time and have a wonderful day. Thank you for your participation.