Earnings Call: Q1 2019

Apr 25, 2019

Good morning, ladies and gentlemen, and welcome to the Brandywine Realty Trust First Quarter 2019 Earnings Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Jerry Sweeney, President and CEO. Sir, you may begin. Lance, thank you very much. Good morning, everyone, and thank you for participating in our Q1 2019 earnings call. On today's call with me are George Johnstone, Executive Vice President of Operations Dan Palazzo, Vice President and Chief Accounting Officer and Tom Wirth, Executive Vice President and Chief Financial Officer. Prior to beginning, certain information discussed during our call may constitute forward looking statements within the meaning of the federal securities law. Although we believe estimates reflected in these statements are based on reasonable assumptions, we cannot give assurances that the anticipated results will be achieved. For further information on factors that could impact our anticipated results, please reference our press release as well as our most recent annual and quarterly reports that we file with the SEC. After a brief overview of our Q1 results and an update on our 2019 business plan, Tom will then provide a synopsis of our financial results and then Tom, George, Dan and I will be available for any questions. 2019 is off to a great start. We're 92% done on our speculative revenue target and have increased that target $500,000 for the 2nd consecutive quarter to an aggregate of $32,000,000 Our leasing pipeline, excluding development and redevelopment properties, stands at 1,700,000 square feet, including over 300,000 square feet in advanced stages of negotiations. We have also increased our projected retention rate to 61% and our GAAP mark to market range to a new range of 9% to 11%. For the Q1, we posted positive rental rate mark to market of 14 point 6% on a GAAP basis and 3.7% on a cash basis. Leasing capital came in slightly below our 14% target and our average lease term exceeded our business plan goal coming in for the quarter at 7.7 years. All very solid results and we also posted a strong cash same store growth rate of 4%. We have maintained our original business plan range based on known activity occurring later in 2019. For example, 1676 International Drive in Tysons Corner, a project we currently have under extensive renovation, we are keeping in the same store pool and that property will become 30% occupied at the end of the 3rd quarter. That property alone negatively impacts our 2019 cash same store range by over 100 basis points. And other than D. C, which will have a negative 12% same store growth rate this year, cash same store across the rest of the portfolio remains very strong. For example, Austin, our same store growth rate will range between 4% 6%, fueled by 97% occupancy levels and a double digit cash mark to market. The PA Suburbs same store growth will be between 3% 5%, driven by additional absorption in Radnor for both executed leases to date and far along stage platform. Philadelphia will have same store growth rate between 1% and 3%, and that range will improve going forward when the pre lease at 2 Logan occupies and that free rent burns off. So based on the very strong progress from the operating metrics and our look ahead, we have raised the bottom end of our FFO range by $0.02 to $1.39 and narrowed the top end to $1.45 per share. Should also note that this quarter reflects the NOI contribution from Austin increasing to 19%, which is up from 7% at the end of 2018. Couple of other notes, Radnor is also making great progress. Our leasing percentage is now almost 93%. We have about 70,000 square feet remaining to reach our 2019 target. 2 leases aggregating the vast majority of that space are out for signature. So we are projecting Radnor to be 97% occupied by year end 2019. In our supplemental on Pages 1011, we did provide additional color on both the Greater Philadelphia and Austin markets. Both markets remain strong with good activity levels, building pipeline and solid leasing. Austin continues to benefit from corporate attraction and multiple end market expansions. For the Q1 of 2019, asking rents in Austin increased 17% year over year with around 1,300,000 square feet of absorption. Philadelphia is also doing incredibly well with rents up 4.4% year over year, supported by 1,100,000 square feet of tenants new to the city over the last two years. It's interesting to note that our trophy class vacancy rate of 5.3% is among the lowest of the top 25 largest MSAs in the country. Philadelphia does continue to also benefit from an emerging life science sector supported by close to $1,000,000,000 in NIH funding, which ranks Philadelphia 3rd nationally behind only Boston and New York City. We're also making good progress on addressing our forward rollover exposure. At 1676 International Drive, where we're investing $24,000,000 to completely reimagine the building, Construction is well underway and will be substantially completed by the end of Q3. Our current pipeline of deals stands at over 2x coverage of the space being vacated. Targeted rent levels represent a 15% increase over expiring rents, and we believe this project will generate a return of over 20% on our incremental invested capital and anticipate the project will stabilize at a 9% free and clear yield on the aggregate basis. We're also making very good progress in our development efforts. During the quarter, we delivered 4 Points 3, 165,000 Square Foot Building, successfully delivered on time, on budget and 100% leased, generating an 8.5% cash yield on cost. We also signed the anchor tenant lease for 35% of the space at our 405 Colorado project in Downtown Austin. And frankly, since commencing construction, the leasing pipeline has grown significantly with over 3 times coverage in our prospect list on the remaining vacant space. This project will cost an estimated $114,000,000 and will generate an 8.5% cash yield on cost. We are currently scheduling to open that property by year end 2020. At the Bullen building in our Schuylkill Yards development, exterior renovation work will kick off this quarter. The entire office component, you may recall, is leased to Spark Therapeutics, a life science company who recently agreed to be acquired by Roche Pharmaceuticals. We anticipate completing that redevelopment opportunity during the Q2 of 2020 and achieving over a 9% free and clear yield on full cost upon stabilization. Our development preleasing activities at Schuylkill Yards, Garza, Four Points, Broadmoor, Radnor and 650 Park Avenue in King of Prussia remain on track. We're completing the design development on each of those projects and certainly given pre leasing achievement could be in a position to start 1 or 2 of those projects by the end of this year. I guess just a quick update on Schuylkill Yards and Broadmoor, and we did provide a detailed status update in the supplemental package on Page 15. But bottom line, design and pricing work continues at an excellent pace. At Schuylkill Yards, we've seen a continuation in the increase in activity, and the current pipeline stands at well over 1,500,000 square feet, including several 100,000 square feet of life science uses. Equity discussions on Schuylkill Yards also remain on track. Schuylkill Yards is in a state and federal qualified opportunity zone with the final regulations being issued last week at the treasury level. We anticipate the pace of our discussions with both tax oriented and traditional real estate investors increasing. At our Broadmoor site in Austin, we're far along in the design of a 300,000 square foot office building, which also includes retail and a residential component that can do 300 plus apartment units. We're in the final stage of evaluating our business plan for starting that property. But again, based upon some pre leasing, we could be in a position to start that first building in the next several quarters. As you may have noted, we don't have any sales or acquisitions built into our 2019 plan. We are, however, exploring a number of asset sales to both harvest profit, generate some additional liquidity and accelerate our return on invested capital cash flow trajectory. As I mentioned on the last call, we would expect that any deployment to be relatively earnings neutral and accelerate our bottom line cash flow growth. So to wrap it up, 2019 business plan is in excellent shape. We're achieving or exceeding our goals. It's very much on track. We're confident of meeting or exceeding those goals that we've outlined in our supplemental package and remain very encouraged by both the depth and breadth of our leasing pipeline on the existing inventory as well as our forward leasing work on our development projects. Tom will now provide an overview of our financial results. Thank you, Jerry. Our Q1 net income totaled $3,900,000 or $0.02 per diluted share and FFO totaled $60,100,000 or 0 0.34 dollars per diluted share. Some general observations regarding the Q1 2019 results. Our 1st quarter fixed charge and interest coverage ratios were 3.63.9 respectively, a 9% 8% improvement on both metrics as compared to the Q1 of 2018. Our weighted average share count decreased by a net 3,200,000 shares primarily due to the 3,100,000 share repurchase program that took place in December 2018 and early 500,000 OP units. In accordance with the latest accounting standard, we have grouped several revenue line items into 1 rental revenue line item on our consolidated income statement. However, we have maintained detailed revenue composition on Page 25 of our supplemental. Looking at the rest of 2019 and its second quarter, we have the following general assumptions. Portfolio operating income at the property level will total approximately $84,500,000 and will be incrementally about 1,500,000 dollars higher than the Q1 of 2019. The increase is primarily due to 4.3 an improvement in the balance of the portfolio. FFO contribution from our unconsolidated joint ventures will total $3,000,000 and it's 700 $1,000 below the Q1 primarily due to interest on the new mortgages that were put in place at our Nova joint venture portfolio. G and A for the 2nd quarter will decrease from $9,800,000 to roughly $8,000,000 The incremental decrease is primarily due to accelerated deferred compensation expense recognized during the Q1. Our annual G and A should continue to approximate $30,000,000 to $31,000,000 Interest expense will remain at roughly $21,000,000 with 91% of our debt being fixed rate. Capitalized interest will approximate $500,000 and full year interest expense will approximate $84,000,000 to 85,000,000 dollars Termination fee and other income, we anticipate termination fees being minimal for the 2nd quarter and $2,000,000 for the year. Other income will be $1,000,000 for the 2nd quarter and will approximate $6,000,000 for the year. Net management fee and development fees, quarterly NOI will be $3,000,000 and we approximate $11,500,000 for the year. Land gain and tax provisions will be a net positive $1,500,000 for the 2nd quarter and approximate $3,200,000 for the year as we continue to monetize non core land holdings. From financing activity, Northern Virginia, we did close on 2 mortgages with $207,000,000 of initial proceeds and we received just over $30,000,000 in net proceeds in April. Based on our capital plan, which includes about $120,000,000 of development and redevelopment, dollars 40,000,000 of revenue maintained, dollars 25,000,000 of revenue create capital and spending approximately $18,500,000 for the acquisition of Radnor Land. Our line of credit balance will approximate $250,000,000 at year end. Due to the full quarter effect of our 4th quarter transactions, additional borrowings on our line of credit and lower sequential EBITDA, our net debt to EBITDA did increase to 6.5 times. However, based on future increases to EBITDA and several potential earnings neutral divestitures, we continue to project that net debt to EBITDA will remain in a range of 6.0 to 6.3 and the big main variable being timing and scope of our development activities and related capital spend. In addition, our debt to JV will approximate the low will be in the low 40 range. We anticipate our fixed charge ratios to be 3.6 and our interest coverage to be 3.9 by year end 2019. I now turn the call back over to Jerry. Great. Thanks, Tom. With that, we're delighted to open up the floor for questions. As we always do, we ask that in the interest of time, you limit yourself to one question and a follow-up. Lance? Your first question comes from the line of Manik Hurchman from Citigroup. Your line is open. Hey, good morning, everyone. Good morning. Jerry, just given the rental rate growth in Austin as well as the demand you're seeing for 405 Colorado, how much upside is there today? I'm sorry, Manny, the last part of your question cut out. I heard the upside in loss. How much upside do you have in the development yield there? It's healthy already, but given significant rent growth, is there more room for that yield to run-in that project? I think that's a great point. We the asking rents that we have on the prospect list we have at 405 are in excess of the baseline returns that we have built in. So we think there could be some upside to the targeted yield. Obviously, subject to being able to execute leases, but certainly we've been very pleased with the depth of the demand we've seen since we started moving dirt and dropping the caissons and think we'll be able to continue to push the rents up. And then if we go back to your comments on dispositions, could you be a little bit more specific on what types of properties or geographies you might want to sell? Yes. I think right now we're targeting evaluating sales from assets in the Pennsylvania suburbs, which is where we have still a fairly large presence. I think our major core focus still remains Radnor, King of Prussia contract and we do have some properties outside of those core submarkets that we're in discussions with some potential buyers. Thanks, Jerry. You're welcome. Your next question comes from the line of Jamie Feldman from Bank of America Merrill Lynch. Your line is open. Thanks. Just a follow-up on the last question. So what's the magnitude of the asset sales you guys are contemplating? Did I hear you say correctly that it would not be earnings dilutive? A. J. We're kind of targeting if we find acceptable pricing kind of layered in properly, we're targeting kind of in the $100,000,000 range. And the expectation to be able to match on that with some activities that we'll try and make it as earnings dilutive as possible, just as we did in 2018. Okay. And then I guess just bigger picture with the TIER Cousins merger, how do you guys think about the impact on the competitive landscape in Austin and kind of what that means with for your portfolio? Well, look, we recognize every market we're in is very competitive with high quality companies that we compete against at both the development and operating level. We think the teams at Cousins and TIER are both high quality teams. We've been competing against them both independently for a period of time. And we would expect that their combination doesn't really change our competitive landscape much at all as we look at our position in Austin, Texas. We have a very good asset base in Austin, both existing with a very strong forward development pipeline. So I think we viewed it as an event in Austin that simply consolidated our competitors, but doesn't change our approach or our perspective on our ability to continue being very successful in that market. Okay. And then lastly, I know you mentioned 1676, your backfilling progress. Can you just talk about the 2 large leases in the CBD Philly and what your thoughts are there in getting those leased up? Sure. And the first one really is Macquarie, which really isn't moved out until the end of July in 2020, and they're moving out of approximately 150,000 square feet. We already have a full coverage of that square footage based upon the prospect list we have now. And we fully expect that list to grow. We're looking at a very positive mark to market on re tenanting that space. It could clearly have an impact on same store growth rate coming out of Philadelphia in 2020. But I think even as we laid out in the supplemental package on our market overview, there's very few large blocks of space greater than 100,000 square feet in the city and very, very few that are at kind of the top of the bank which is where McCharter will be vacating. So given the length of time, our marketing team has just really kind of launched the full blown marketing campaign. It's been very well received. Again, we're looking forward to a strong mark to market there. It will have obviously some disruption for a couple of quarters on the revenue from that space. But the replacement revenue we think will be a nice uptick to our growth profile as we look forward to 2021. And on Reliance, George, do you want to put a word on that? Yes. Jamie, this is George. And Reliance, they'll expire twelvethirty one of 'twenty. I think all of the same market dynamics pertain to that space as well. But given the fact that it's a little bit further out, we've had a few tours to date, but certainly nothing yet at the proposal stage. But again, given the large blocks or lack thereof in other competitive buildings, we feel good about that space as well for lease up in 2021. And look, the other nuance there is Macquarie is vacating as I mentioned the upper bank which has the smaller floor plates. Reliance is mid bank which has the larger floor plates. So if you look at it from a marketing platform standpoint, we're very encouraged to having both the high visibility, smaller floor plates available out of the Macquarie situation and having a larger floor plate capacity coming out of the Reliance. So we think we're in very good position. You never want to lose a tenant obviously, but it's a known fact that we're dealing with. And we think given the rental rates currently being received on those spaces, what we anticipate being Jamie the continued upward pressure on trophy class rents in the city. We think we'll be able to generate some significantly positive mark to market coming out of both of those rollovers. Okay. All right. Thank you. You're welcome. Your next question comes from the line of Craig Mailman from KeyBanc Capital Markets. Your line is open. Two potential dispositions here, I've heard your responses already, but just curious on maybe a larger deal like a joint venture of a stabilized asset, just kind of curious how you guys are thinking about timing of that ahead of potential capital needs and kind of balancing the bigger check you may get from a deal like that versus adding a little bit more complexity to the story again with additional joint ventures? Craig, we didn't hear the first part of your question, but I'll answer it the best I've heard. If I missed it, please let me know. On the disposition front, I mean, some of the transaction we're looking are clearly smaller in size and kind of we're in that $100,000,000 range I outlined earlier and we'll see if we make progress on those over the next couple of quarters. We're certainly always looking at whether we should do a larger scale capital transaction on 1 or 2 of our assets. And I think when we look at that, given our market position, some of the markets we're in, we do find a number of buyers who are willing to pay premium pricing would like to keep us involved because of our operating history in those projects as well as our marketing platform and deal pipeline. So we really evaluate whether we do an outright sale or a joint venture or retain a minority stake and a fee revenue stream really based upon what the market tells us. We typically enter the marketplace on either a sale opened completely to a sale. And if the market tells us that the buying pool wants more active on-site engagement then we certainly evaluate a joint venture there. I think in terms of complexity, it's a fair observation. But I think when you take a look at what we've been able to do over the last several years as part of our multiple year discipline, one of our objectives was really to reduce the number of joint ventures we've had and reduce the amount of capital we have invested in those joint ventures. So over the last couple of years, we've done a fairly good job of kind of reducing the overall level of exposure we have to JVs where I think as we've laid out on I just checked it on Page 6 of the sup, we've had over 50% cumulative reduction in both the debt attribution and a corollary decrease in the amount of capital we have invested into some of these joint ventures. Okay. That's helpful. And I know that you guys have been cleaning up the portfolio and have some more of these kind of $100,000,000 assets or kind of pooled assets in non core markets. But as you guys look at the scale of development you may have over time at Broadmoor and Schuylkill and elsewhere? I mean, is it avoidable to do a bigger AV or transaction kind of how do you guys think about timing on that? Is it just you do it when the capital is there or do you try to thread the needle and minimize dilution and do it closer to the needs of capital? Well, hopefully achieve both goals. But I mean, I do think we were pretty clear on as we're looking at Craig a project where the buildings like at Schuylkill Yards are much larger in scope. I mean these are buildings a dollar investment $400,000,000 plus. We've always laid out that part of our investment strategy with that project is to find a joint venture partner, again, whether it's a tax oriented Clap and Opportunity Fund investor or a traditional real estate investor to mitigate our forward capital commitments as well as minimize to the extent possible the impact on our balance sheet. We do have 2 other partners with us at Schuylkill Yards, a residential company Gotham and a life science company Longfellow. They both have financing capabilities on their own. So as we're starting to lay out that large forward capital commitment just as integral to our thought process is kind of trying to get a pre lease pull together is also the discussions we're having with equity investors to make sure that we are in a position that when we announce one of those buildings moving forward, we can present back to our shareholders a bow tie package that identifies what the pre leasing is, what the targeted returns are and what the financing plan will be. The benefit we have frankly with the Schuylkill Yards is we have a fair amount of money already invested in Schuylkill Yards through both the predevelopment work, the land acquisitions, completion of some of the infrastructure. So we're actually hopeful that when we do announce a joint venture that the amount of equity that's already invested will really serve as our forward capital call to get those projects completed. As we look at some of the other projects whether it's a Radnor or a King of Prussia Road or a Garza or Four Points, they tend to be, call it $40,000,000 to $60,000,000 transactions that will bleed in from a cost and current standpoint over 4 to 6 quarters. So we think those production level investments we can actually manage very well within our targeted disposition plans and not really creating downward pressure on earnings. So we really do bifurcate how we look at our development pipeline between projects the scale of the Schuylkill Yards versus projects the size of frankly like the Four Points 3 Building that we put forth. That's 165,000 Square Feet. Garza is the same range. The remaining building at Four Points is the same range. Radnor is the same range. 650 Park Avenue is a little smaller than that. So when we take a look at the diversity of the development pipeline we have, we're really in a position where we can be very intentional about the financing strategies to make sure that we do thread that balance between maintaining a strong balance sheet with liquidity and having as little impact as possible on the earnings solution by prefunding it with asset sales. Great. Thanks for the color. You're welcome. Your next question comes from the line of John Guinee Stifel. Your line is open. Great. Thank you. Hey, Jerry or whoever, every time we turn around, we hear more about hard costs going up in these various markets. Can you talk a little bit about your take on hard costs and development costs overall both when it comes to 2nd generation space in your core portfolio and also development? Sure. Well, all those people that you're talking to John, I think are telling you the truth. I can't attest to every one of them, but there's clearly a lot of upward pressure on construction costs across the board. And I think in markets where you're seeing good velocity, you're seeing that actually translate into an acceleration of asking rents, so that net effective rent levels stay in the same range. But I think generally, we've seen as we start tracking or as we've been tracking construction costs, I mean, we've seen an average generally across the board of escalations running between 3% 5 percent really over the last 5 years or so. Labor increases have been between 3% and 4%. We've had I know based upon a report I just reviewed with surveying 13 CMs in the region, they're essentially forecasting that they see forward material pricing stabilizing. There's been significant downward pressure on Centimeters fees, partially as a way to offset some of the increased costs. Labor is still very tight. And frankly, given the various trades could be a harbinger of some troubled times ahead. I mean, you're seeing in many of the more technical trades, a lot of the workers have retired and they're trying to replace a lot of those folks. So we're definitely seeing some real pressure on labor and particularly at the MEP trades. If you take a look at some of the base building items, I'd take a look at where we're pricing, John, steel today versus where we were 5 years ago, we're kind of going through the same exercise for FMC Tower. Steels wasn't in the $3,500 so a ton back then. It's around $4,700 a ton now based upon the numbers we're seeing. So that's over 6% annual increase. We've seen curtain walls up about 5%. Even some of the substructure work has been growing at a rate of about 5%. MEP is in that same range probably closer to 6%. So there's clearly a lot of pressure on construction pricing, which really is one of the reasons why I think you're seeing rental rates for new construction kind of gap out from some existing triple net rental rates of existing product. We've clearly seen on existing inventory total capital commitments ranging from $5 a foot to now closer to $6.50 or $7 a square foot per lease year. The metric we really look at is kind of what our capital investment is as a percentage of revenues. And I think we've been really happy with our ability even with that upward pressure on construction pricing, we've been able to keep that range of capital costs in that 10% to 15% range. So this quarter, we were below our 14% target for this year. And the hope is that we'll continue to be able to create some upward pressure on rents, rent growth. And by lengthening lease terms to kind of keep that ratio pretty much in place. Great. Thank you. You're welcome. Your next question comes from the line of Bill Crow from Raymond James and Associates. Your line is open. Hey, good morning guys. Good morning. Harry, that last answer kind of led to where I was heading. And it's really looking at that capital cost to rents and just seeing if there's a differential in the economics between urban CBD and suburban? And if so, how is that changing as we go forward? Yes. I'm not sure that the relationship is much different. I mean, I think by our experience, we've seen that we're typically able to get longer term leases downtown, which tends to compensate us for the differential in called unit pricing. So we look at kind of our suburban assets and our urban assets. They tend to be pretty much in the same band. There may be anomalies at different points, but we're getting higher rent levels. We have converted most of our downtown rents to triple net so we're getting very little expense leakage doing the same thing in the suburbs. So trying to hedge that downward exposure given the increasing capital costs. And then to be honest, I mean a lot of the assets build that we've had years ago that were kind of the prototypical pedestrian quality suburban office buildings, we've really sold out of. So we sold out of those because we didn't see the same linearity between capital as a percentage of revenues and the need to put in a lot of additional base building capital. So I think as we evaluated our disposition program over the last half dozen years, a lot of that was driven by where we saw an inability on our part given the market conditions to generate positive net effect of rent growth. So one of the things we look at is we evaluate every lease is what that net effective rent growth is and how is that compared to where we were before. And any property that we think doesn't have the ability to kind of keep pace with our growth expectations that we have for the portfolio at large, we look to retool or get rid of. Yes, that's perfect. And one quick one for Tom. I heard a lot of positives about the Q1 and the outlook and understand the guidance that the low end being raised. What was it maybe I just missed this. What was it that drove the reduction to the high end just a couple of months after you Bill, we put out a pretty wide range and I think that Bill, we put out a pretty wide range and I think that a lot of that because of those the order of magnitude of those sizes is really if we do anything that could be in the capital market side whether it be acquisition or disposition. So part of that is that we do leave a little bit of flux in there. I think with our capital plan now being 92% done already, we felt good about taking both ends of the range down. Obviously, that could change and we could be up towards the upper end. But I think we felt like with 92% of the plan done, we felt we could really narrow the range $0.02 on either side as opposed to what we've normally done is narrowed it as we went through the year. Okay, very good. Thank you for the time. Thank you. Thanks, I'm showing no further questions at this time. I would like to turn the conference back to Jerry Sweeney. Great, Lance. Thank you for moderating and thank you all for participating in the call today. We look forward to updating you on our business plan progression on our next call. Have a great day. Ladies and gentlemen, this concludes today's conference call. Thank you for your participation and have a wonderful day. You may all disconnect.