Q2 2020 City Office REIT Inc Earnings Call

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Good morning, and welcome to the City office REIT Inc. second quarter 2020 earnings Conference call. At this time all participants are in a listen only about a brief question and answer session will follow the formal presentation.

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It is now my pleasure to introduce you to Tony Maretic, The company's Chief Financial Officer Treasure and corporate Secretary. Thank you Miss Maretic you may begin.

Good morning, before we begin I'd like a direct you to our website at city office suite Dot Com, we can view, our second quarter earnings press release and supplemental information package.

The earnings release supplemental package. Both include a reconciliation of non-GAAP measures that will be discussed today to their most directly comparable GAAP financial measures.

Certain statements made today that discuss the company's beliefs or expectations or that are not based on historical fact may constitute forward looking statements within the meaning of the federal securities laws. Although the company believes that these expectations reflect in such forward looking statements are based upon reasonable assumptions, we can give no assurance that either.

Sick patients will be achieved.

Please see the forward looking statements disclaimer in our second quarter earnings press release, and the company's filings with the FCC for factors that could cause material differences between forward looking statements and actual results. The company undertakes no obligation to update any forward looking statements that may be made in the course of this call I'll review our financial results.

After Genie for our our Chief Executive Officer discuss some of the quarters operational highlights I'll now turn the call over to Genie.

Good morning, Thank you for joining us today.

On our last call, we discussed a number of strategic initiatives that we've taken to whether these uncertain economic times and ultimately positioned ourselves going for.

I will begin by providing an update on this flat.

First we stopped all new property acquisitions and continue to expect that we will not purchase any new properties in twentytwenty.

Transaction activity remains limited in their markets and we have not seen compelling opportunistic or distress situations.

Second as part of our defensive plan, we elevated our cash holdings and lowered our targeted leverage levels to operate more conservatively.

During the quarter, we reduced our cash on hand, but we expect to continue to maintain elevated liquidity for the foreseeable future.

Third we adjusted our dividend to a level that would allow us to generate excess cash over the long term.

During the quarter, we incurred $3.9 million of costs for a previously disclosed 70000 square foot tenure lease at our Denver Tech property.

Normalizing for this new lease costs, our adjusted dividend was well covered on an AFFO basis at our lower leverage levels.

Last we announced our intention to repurchase up to 100 million of our own common stock.

In July we completed the repurchase program for the full $100 million at an average price of $8, an 80 cents per share.

I'm, particularly pleased with the results of this execution, which effectively allowed us to buy part of our own properties back at a large discount to the inherent value.

Overtime, this will be highly accretive to our performance well still leaving us a healthy level of liquidity.

Our focus during the second quarter continues to be on operations collections and leasing.

All of our buildings continued to be open operational and available for tenets.

We've witnessed a recent increase in utilization of our buildings as the country continues to reopen but utilization remains relatively low, especially as cope with 19 cases have again increased in some of our markets.

Collections have been a bright spot for the company as I highlighted on our last call. We have a relatively low exposure to the industry's most directly impacted by cold with 19.

We collected over 99% of base rental revenue during the second quarter and have collected over 98% of July base rental revenue.

We have granted rent abatement to only five tenants, primarily cafe operators, which represent a total of just 12000 square feet.

We've also reached agreement on rent deferrals on a total of 48000 square feet all of which is expected to be repaid by the end of 2021.

In total abatement and deferrals represent approximately 0.6% of base rental revenue in the second quarter.

Moving on the leasing activity.

Discussions with tenants and leasing brokers highlight the overall uncertainty regarding future space needs.

Tenants had been dealing with work from home challenges safely reopening their offices and determining their future space requirements. We continue to believe that over the medium term tenants in our markets will return to the office, but also balance elements of remote working and contemplation of additional regional offices closer to.

Suburban employee housing stock.

It is early stages, but the densification trends and workstation hoteling seems to be shifting to dedicated employees space in social distances.

This would help offset overall space reductions.

We continue to believe that our cities will be net beneficiaries over the long term as companies look to relocate their workforces to high quality of living and low state tax markets.

In terms of new leasing.

With the exception of life Sciences, which I'll discuss further in a moment new leasing activity has been slow.

However, renewal leasing discussions remain active, particularly given the quality submarkets, where we owned property.

During the quarter, we executed 60000 square feet of new leases and 266000 square feet of renewal leases.

Of the 60000 square feet of new leasing 44000 square feet was expansion space for existing tenants.

The largest expansion was the state of Colorado, taking an additional 37000 square feet of expansion space at our Cherry Creek property in Denver.

Once that lease commences, the steep will occupy 100% of the three building campus.

Before I discuss or outlook I'd like to give an update on a major lease that was executed after quarter. It.

This transaction has unlocked a lot of value in our portfolio as I mentioned earlier the life science sector continues to be very active and we had a lot of interest in leasing a 51000 square foot space at our Sorrento Mesa portfolio in San Diego that Rolls in November of this year.

Ultimately, we renewed our existing tenant.

Their lease was set to expire on November thirtyth at an annual triple net rate of $15.19 per square foot.

The renewal lease more than tripled the rate to $54 per square foot net for a 12 year term.

This will generate us approximately $2 million of incremental rental revenue per year.

In addition, the tenant will take a 26000 square foot space in the same building after the existing tenants lease expires in August of 2021.

When that expansion lease commences it will generate a further $800000 in annual rental revenue.

Finally, this tenant also occupies another building at our campus comprised of 59000 square feet.

We extended the expiration of that lease from 2026 to 2032 and enhance the overall security package underpinning the lease.

We will provide further updates on this and other aspects of our life science properties in the future, but we've been successful and finding ways to enhance the value of that portfolio.

Finally, I'll turn to our outlook for the coming quarters.

We continue to believe that providing our own internal guidance consideration is helpful for investors. Despite the challenges in forecasting today.

Even though we've achieved strong leasing and financial results in the quarter. Many of the uncertainties and risks that led us to initiate strategic shifts to our business still remain.

With the rising cases of coal with 19, and many us states, including elevated cases in some of our markets. We believe a cautious outlook is still warranted.

Further the impact on businesses and in particular small businesses that relied on government funding for short term relief will continue to manifest through this year and into 2021.

Taking into account our results and observations to date, we've adjusted our guidance assumptions and expectations for the balance of 2020.

The net effect of strong collections and leasing activity to date is an upward revision to our 2020 forecasted net operating income.

Same store cash NOI growth and core FFO per share expectations.

I'll now turn it over to Tony to provide further detail on our financial results. Thanks, Jamie.

Ill address the second quarter's results and then turn to our updated outlook for the remainder of the year.

On a GAAP basis, our net operating income in the second quarter was 25.5 million, which was slightly higher than a 25.4 million we reported in the first quarter.

We benefited from the amortization of a lease termination fee payment at our Cherry Creek property has Jamie mentioned, the Steve Colorado is expanding to occupy an additional 37000 square feet of space.

The expansion space was terminated by the existing tenant resulting in a total termination fee of a 0.9 million.

We recorded 0.4 million of this income in the second quarter and the remaining 0.5 million will be amortized into the third quarter as a tenant departure date has been set for September thirtyth.

That space will remain vacant in the fourth quarter at a loss of approximately 200000 in rental revenue until a state of Colorado commences occupancy on January Onest 2021.

Therefore, the total positive impact of the transaction is a net 700000 to our 2020 results.

The termination fee income in Q2 was offset by rent abatements in air provisions that totaled approximately 200000.

We reported core AFFO of 14.1 million or 29 cents per share, which was $200000 lower than in the first quarter.

Primarily due to higher interest costs offsetting the higher net operating income.

The higher interest costs were due to the draw on our credit facility. We made in March to ensure we had sufficient liquidity to complete our stock buyback program and whether uncertainty.

Our second quarter, AFFO was 6.6 million or 14 cents per share AFFO in this quarter was lower due to the elevated costs of tenant improvements and leasing commissions incurred during the quarter tied to strong prior leasing activity.

The largest leasing costs relate to the previously announced 70000 square foot 10 year, new lease with the engineering firm eight com at our Denver Tech property.

As Jamie mentioned during the second quarter, we incurred the remaining 3.9 million of the 5 million tenant improvement allowance for this tenant.

Those costs alone impacted AFFO per share by eight cents.

No further costs are expected for this tenant improvement allowance and therefore, we expect to return to dividend coverage beginning in the third quarter as capital expenditure costs returned to normalized levels.

We also had some continuing capital expenditures the largest of which related to work at our circle point property in Denver we.

We expanded the scope of the work originally planned that acquisition to include cosmetic exterior improvements, which impacted AFFO in the quarter.

Due to the relative size, our portfolio and the impact of significant leasing in any one quarter. Our phone numbers will continue to move around some from quarter to quarter.

Our second quarter same store cash NOI grew 2.3% versus the second quarter last year.

San Diego was one of our best performing markets in the second quarter as the impact of the free rent periods for new leasing in the prior year burned off.

Moving onto our balance sheet.

Our cash unrestricted cash at June Thirtyth totaled 83 million.

This substantial cash balance will ensure we have ample liquidity to withstand any unforeseen negative economic impacts caused by Copel 19.

Our total debt at June Thirtyth was 705 million.

Our net debt, including restricted cash to EBITDA was 6.7 times.

At quarter end, our total debt had a weighted average maturity of 4.6 years and 86% of our debt was effectively fixed.

We have no debt maturities in 2020, and only one maturity in 2021.

During the quarter, we purchased 8.8 million shares of our common stock subsequent to quarter end, we completed the 100 million stock buyback program.

Including amounts purchase after quarter end the year to date repurchases were completed at an average gross price of $8.80 per share.

Our total fully diluted share count after the completion of the stock buyback program is approximately 43.8 million versus the weighted average 48 million in the second quarter.

The share buyback program has led to a significant accretion in our per share results in the second quarter and we expect will have a similar impact in Q3 and going forward.

On a related note on August 5th our board approved an incremental 50 million share repurchase program.

The approval for this 50 million provides us with the flexibility to evaluate and implement the full spectrum of future capital allocation options. However, we are sensitive to reducing our market capitalization and maintaining conservative leverage levels as such we do not currently expect to activate the program.

Near term.

Last we have provided updated full year 2020 guidance in our press release has the impact of Coven 19 on our business in 2020 comes more into focus we have been pleased with our high rate of collections and therefore have raised our guidance for the balance of the year. The press release covers these in more details and I will highlight here.

The main driver arrived guidance range is our estimate of bad debt provisions as our second quarter provision for bad debt and total rent abatements was less than half a percent.

We have lowered our general provision for the balance of the year for uncomfortable rents to between 0.5% and 2% of revenue.

Our previous guidance was based on a 1% to 3% provision.

The positive impact of the lease termination fees, which I described earlier also contributed to the increase.

Based on these revised operating assumptions, our net operating income same store cash NOI change and core AFFO expectations have all been increased our revised guidance estimates core FFO per share between a $1.15 and a $1.18 for the full year ending December 30, Onest 2020.

That concludes our prepared remarks, and we will open up the line for questions operator.

Thank you we will now begin the question and answer session.

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The first question say will come from Michael Carroll with RBC capital markets. Please go ahead.

Yes, Thanks, Jamie can you talk a bit a little bit about the lake Vista points property. The the short term renewal that was completed and then that's a pretty big tenants and how to think that they have that lease expiration. So what's the thought process behind the short term renewals that going to.

Does that just to tie them over to until they can make their final decision or they planning on doing something bigger there.

That's a good question, Mike so discussions with that tenant has been ongoing they did have a right to extend their lease by three months and we continue to have discussions with them and they triggered that they really to take a bit of pressure off on their end.

As most tenants are trying to figure out their own space needs and usage, just given them a bit more time.

Okay and is there any property in that area they could support their needs and.

I mean, I think sense before they needed more space mature at this current environment changes that for them a little bit but is there a brighter prospects that they're going to renew there.

Yes, I mean previously one of the options. They were looking at was a build to suit theres a number of potential areas, but no Dallas is a large markets. So there are existing vacancies that they could fit to.

But we think we've got a great property in a good valuation proposition on the table for them. So discussions are ongoing.

Okay, Great I know you have another big exploration at Carlin point coming up to.

I guess, what's the discussions going on there and is there a prospect to then mom renewing the lease sometime soon.

Yes, it's similar story, all around where tenants right now we're trying to figure out long term, what do they need where do they want to be utilization was fairly low across the board and industry were probably around the an average, but we're probably in the 20% range of current utilization and so when you look at renewal discussions.

New leasing things have slowed down I think we're in a good position for that particular tenant at that space, It's a great property.

But they have some time to make a decision discussions have been ongoing there as well.

Okay, Great and I guess finally can you talk about the.

The Sorrento Mesa renewal that you completed or another is a pretty big one step ups does that you've been talking about for a little while.

Is there any T I a component related to that incremental investments that you need to making the by property.

Yes, so that was a big win for us over a year kind of in the works on that one and we kind of landed on the trifecta.

So there's three elements to it theres, a 51000 square foot renewal, which happens in 2020.

Grades step up to $54 net on an annual basis, so thats going to add about 2 million to the bottom line.

The tie on that was a very reasonable $20 a foot for a 12 year term.

The second piece was they're going to take down an additional 26000 seat in August 2021 exact same terms.

There's been a free rent on that one four months of free rent, but that will add about another 800000 incremental income and then the final piece was really extending another property that they have with US 59000 feet. We moved it from 20 to 26.

The 2032.

The rates will step up in 2026. The market then so if they're similar market rates that are in existence today will be a healthy step up and cash flow at that time at an overall, we really modified their security package to put us in a really comfortable position so as a great. Okay for us.

Okay, Great and then finally, Tony can you talk a little bit about your leverage targets I mean, where do you want on your balance sheet to be at today in especially given the.

Purchase program that you just kind of highlight if it you put into place I'm, assuming that's given were leverages today that you don't really want to execute on that yet.

Yes, that's exactly right, we really permits in place the additional 59 stock buyback program more does this make sure we have a tool for the future as I had my remarks, we don't have any intention to use a near term.

To address the higher leverage quick question, you know effectively we don't expect it to be materially different than where we were ended at June Thirtyth, we did.

Acquire another $12 million of stock post quarter end.

So if you just if we if we take a step back.

On a net debt to value basis. This is approximately 200 basis points lower than where we would have landed under our original guidance. The beginning year had we not buyback stock instead.

Pleading that $360 million of properties that we originally plan so that the pivot and strategy really allows us to operate though at the lower level that you see at June Thirtyth.

Okay, great. Thank you.

As a reminder, she would like to ask your question. Please press Star then one.

The next question will come from Craig you, Sarah with B. Riley FBR. Please go ahead.

Hi, Good morning, guys now that you've created so much value at Sorrento Mesa do those assets now potentially become disposition candidates are you more likely to hold onto them.

Yes, it's something we're considering Craig.

We bought them just over two years ago, we've had a lot of success as far as leasing enhancing cash flow and and there's still some work to be done there.

But they certainly are much more marketable at a substantially higher value than what we bought them out and we're going to consider options over the next little while and continue to really drive leasing there to try and unlock additional value.

Okay great.

And just to circle back to Cherry Creek.

On the expansion there that now being basically a single tenant in those buildings did you get a lease extension when they agreed to take that expansion states.

No we basically rolled.

The one space, they took which was going to expire, but a year ish out in the future. We push that 2026 to be coterminous with the with the rest of the space.

Okay.

And one more for me I know you're not actively looking at transactions for 2020, but I am curious to see if you're seeing any thoughts on the transaction market net so kind of what kind of changes you're seeing in pricing in a post coveted environment.

So kind of looking at it.

No not shelves as you said, we're not really thinking we're going to execute on 2020, we do think there's going to be good opportunities I personally think it's going to be 2021, and beyond and the reason being theres theres lots of opportunities out there there was a lot of things being marketed pre Goldman.

Stops and Didnt happen.

And Im sure there is a very willing seller on the other side, whether they're going to be at evaluation expectation that make sense in today's environment is another matter and so what we've seen so far really not massive adjustments and value from our own standpoint, there is.

Got a two elements, we need to get comfortable with the first element is what is the long term cash flow going to be from a property.

In today's environment, when you look at where market rents are there's uncertainty when you look at what's going to happen on renewals, there's uncertainty what's going to happen on certain tenants surviving and some of these properties long term again uncertainty and so for us to get comfortable we really want to have good visibility around but.

Cash flow at the property the other element, which can maybe maybe get a little bit more aggressive as if you're seeing valuations that are so compelling your underwriting conservatively and you're still comfortable and and neither of those elements are there today and so stepping back as far as what we're doing you look at our share buyback.

You will get us, putting a 100 million into our own company, we effectively bought.

At an 8.6 cap rate on our own portfolio. When you when you look at kind of the midpoint of our NOI and backing out land $200 a flood.

We know our assets inside and out we know some some strong things that are happening that we've identified here on cash flow and so we see that as a no brainer low risk.

And we preserve great liquidity, we see the market today is just not being valued to a level words worth the risk.

Okay, just one more for me.

Tony would you guys reauthorizing $50 million buyback, but but not really likely to to utilize it in the near term are you still gonna likely run or the balance sheet with call. It 55 ish million dollars of cash today. After the third quarter buybacks or are you likely to pay down the line because it does seem to.

You have a bit more of a positive outlook certainly given your guidance rates and the reduction in bad debt expectations.

Yeah, It's a very good question Craig.

Well back in March when we did the draw on the line of credit it was as much to test that the availability was there to us weve grown our level of confidence that that's certainly the case and the money is there if we need it and so.

Yes, it doesnt make sense for us to look at our cash and pay down some of the line during the quarter, given where our confidence level is but obviously, we'll continue to monitor the situation.

Okay, great. Thanks, guys.

Thanks, Greg.

Oh.

As there are no additional questions I would now like to turn the call back over to Mr. Ferrari.

Thanks for joining today, we hope that everyone has agreed rest of your summer Goodbye.

The conference has now concluded. Thank you for attending today's presentation you may now disconnect.

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