Boston Properties, Inc. (NYSE:BXP) Q3 2023 Earnings Call Transcript
Boston Properties, Inc. (NYSE:BXP) Q3 2023 Earnings Call Transcript November 2, 2023
Operator: Good morning, and welcome to Q3 2023 BXP Earnings Conference Call. [Operator Instructions]. Please be advised that today's conference call is being recorded. I'd now like to hand the conference over to your first speaker today to Helen Han, Vice President of Investor Relations. Please go ahead.
Helen Han: Good morning, and welcome to BXP third quarter 2023 earnings conference call. The press release and supplemental package were distributed last night and furnished on Form 8-K. In the supplemental package, BXP has reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Reg G. If you did not receive a copy, these documents are available in the Investors section of our website at investors.bxp.com. A webcast of this call will be available for 12 months. At this time, we would like to inform you that certain statements made during this conference call, which are not historical, may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act.
Although BXP believes that expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that its expectations will be attained. Factors and risks that could cause actual results to differ materially from those expressed or implied by forward-looking statements were detailed in yesterday's press release and from time to time in BXP's filings with the SEC. BXP does not undertake a duty to update any forward-looking statements. I'd like to welcome Owen Thomas, Chairman and Chief Executive Officer; Doug Linde, President; and Mike LaBelle, Chief Financial Officer. During the Q&A portion of our call, Ray Ritchey, Senior Executive Vice President; and our regional management teams will be available to address any questions.
[Operator Instructions]. I would now like to turn the call over to Owen Thomas for his formal remarks.
Owen Thomas: Thank you, Helen, and good morning, everyone. Today, I'll cover BXP's operating outperformance in the third quarter, key economic and market trends impacting our company. And BXPs capital allocation activities for the quarter. BXP continued to perform in the third quarter despite escalating negative market sentiment for the commercial real estate sector. Our FFO per share was once again above both market consensus and the midpoint of our own forecast. We completed over a million square feet of leasing in the third quarter with a weighted average lease term of over eight years, and increased portfolio occupancy despite a weaker operating environment for most of our clients. We completed multiple company and asset specific financings both elevating our liquidity position and demonstrating BXPs sustained access to the capital markets.
Moving to the economy, notwithstanding the Federal Reserve having increased the discount rate, five and a quarter percentage points and the 10-year U.S. Treasury having risen nearly 3% All since the since March of 2022. The U.S. economy's headline statistics remain remarkably strong, with GDP growth at 4.9% in the third quarter 336,000 jobs created in September, and the unemployment rate steady at 3.8%. This rosy economic picture is misleading as it does not accurately reflect the market tone and operating environment for many of our clients. Assuming forecasts for negative earnings growth in the third quarter are accurate. S&P 500 annual earnings growth has been negative for the last four quarters. Much of the recent strength in GDP has been consumption related.
And Job creation has been in the leisure and hospitality healthcare, education and government sectors, not in the office seizing sectors such as information and financial services. Our clients are corporations that actively managed their headcount and operating expenses in times of weak or negative earnings growth. And as a result, they're more cautious and making new space commitments. Though remote work is obviously not helping space demand. We believe economic conditions are the primary driver of our slower leasing activity in 2023 and leasing will rebound when earnings growth returns. We continue to be encouraged with the return to office two trajectory we are experiencing in our buildings as well as the rhetoric and actions of many of our clients with respect to their in person work policies.
We believe the broadly reported turnstile data from Castle systems indicating buildings are generally 50% occupied versus pre pandemic levels over the course of a whole week is a measure of aggregate human activity important to cities. But it's not an accurate measure of premier workplace space utilization. We collect turnstile data for approximately half of our 54 million square foot portfolio. And as of mid-October for Tuesday through Thursday, our New York City buildings experienced 95% of the turnstile activity achieved before the pandemic. Those figures for Boston and San Francisco were 74% and 45%, respectively. And the space utilization data in all our markets continues to improve. Workers in premier workplaces are returning to their offices in greater numbers.
And it's difficult for users to reduce space if all employees are expected in the office on specific days of the week. Lastly, and importantly, all office buildings are not the same. We share in our IR materials every quarter CBRE's report on the performance of the premier workplace segment of the overall office market. In the five CBDs where BXP operates premier workplaces represent approximately 18% of the total space and 10% of the total buildings. At the end of the third quarter direct vacancy for premier workplaces was 12.4% versus 17% for the balance of the market. Also for the third quarter net absorption for the premiere segment was a positive half a million square feet versus a negative 600,000 square feet for the balance of the market.
For the last 11 quarters. Net absorption for the premiere segment was a positive 8.1 million square feet versus a negative 30.8 million square feet for the balance of the market. And asking rents are 44% higher for the premier workplace segment including two buildings undergoing renovation 94% of the BXP CBD space is in buildings rated by CBRE as premier workplaces which has been important in driving the increasing office attendance statistics in our buildings and is a critical differentiator for BXP in the leasing marketplace. Now moving to private real estate capital markets U.S. transaction volume for office assets in the third quarter was muted, dropping 48% from the second quarter to $4.4 billion, the lowest quarterly level of office transact office transaction activity since the first quarter of 2010.
Investors in the sector face material uncertainties in both office demand due to factors previously mentioned, as well as the cost and availability of debt financing. The 10-year U.S. Treasury has been and is rising and approaching 5% and consensus market sentiment currently believes rates will be higher for longer given pernicious inflation. Most U.S. lenders are trying to reduce their exposure to commercial real estate loans and have limited available lending capacity for repayments. No sales and BXPs core markets were completed in the third quarter of significant assets that would be considered premier workplaces. In Boston, there were three completed office transactions all under $100 million of reasonably well leased assets and sold for $290 to $690 a square foot and 6.7% to 7.5% cap rates.
In Santa Monica the pin factory a fully leased 220,000 square foot redeveloped creative office complex sold for $178 million, representing pricing as of over $800 a foot and an 8.4% cap rate. The existing leases in the asset have turned but are significantly above market and seller financing was provided. In New York City a user is under agreement to purchase the 400,000 square foot vacant Neiman Marcus store at 20 Hudson Yards for $550 million or $1,375 per square foot. In the financial district of San Francisco there are for sales either completed or pending for buildings that are or nearly vacant. Each sale is for under $65 million, and pricing ranges from $120 to $320 a square foot. These deals reflect many of the characteristics prevalent in today's non premier office sales market, entrepreneurial in many cases family office buyers attracted by the low per square foot values relative to historical levels.
Small transaction sizes requiring less capital and likely not involving debt financing and renovation plans designed to take advantage of future leasing market recovery. Moving to BXPs capital market activity for the third quarter we completed a restructuring of our investment in Metropolitan Square, a recently renovated 657,000 square foot office building located in Washington, DC. BXP owned a 20% interest in and provided leasing and management services for the asset, which was encumbered by senior loan of $305 million and a mezzanine loan of $115 million. The existing mezzanine lender now owns 100% interest in the property, with BXP continuing to provide management and leasing services. Further, a new undrawn $100 million mezzanine loan has been structured to fund future leasing, operating and other expenses of the property on an as needed basis.
BXP has a 20% interest in the new mezzanine loan, which is subordinate only to the $305 million senior loan and will receive interest at 12% annual return. BXP will continue to earn leasing and property management fees as well as an attractive return with potential incentive fees for providing additional capital to stabilize the asset. We also experienced a $36 million gain as a result of the transaction. In the coming quarters, given the negative sentiment toward the office industry, which spills over into the much better performing premier workplace segment. We believe BXP will be presented with unique opportunities to expand its portfolio on an attractive basis. Our balance sheet remains strong, and we have maintained access to capital primarily through the unsecured debt markets, available to few public and private competitors.
Our portfolio is outperforming peers due to its attractiveness in the market when competing for clients the hallmark of a premier workplace portfolio. In anticipation of the current market distress in our sector, we have been positioning BXP to play offense for the past year by raising $4.1 billion in gross funding and currently holding $2.7 billion in liquidity. In search of opportunities, we're maintaining continuous dialogue with lenders that are foreclosing on or restructuring assets as well as owner seeking to reduce their office exposure. Our focus will remain in our core markets on premier workplace assets, life science and residential development. During the last major downturn caused by the global financial crisis, BXP was able to acquire the General Motors Building, 200 Clarendon Street, 100 Federal Street and 510 Madison all at attractive prices at the time.
On dispositions, we continue to pursue additional capital raising through joint ventures with select pre-leased developments and to consider incremental asset sales. Our development portfolio continues to create FFO growth for BXP. This quarter we placed fully into service 104,000 square foot renovated and fully leased building at 140 Kendrick Street in Needham, Massachusetts. This redevelopment completed for a client with stringent sustainability objectives was delivered with net zero carbon performance and generating an 18% first year yield on incremental capital invested. We also delivered into service 751 gateway as part of our gateway Life Science Park, which is a 231,000 square foot lab building that is fully leased. BXP owns the 49% interest in the asset which was delivered at a 6.7% first year return on cost.
BXP continues to execute a significant development pipeline with 11 office lab retail and residential projects underway. These projects aggregate approximately 2.8 million square feet and 2.4 billion of BXP investment with 1.4 billion remaining to be funded and are projected to generate attractive yields in the aggregate upon delivery. So, in summary, despite strong negative market sentiment, BXP had another productive quarter with financial performance and leasing above expectations and a stable dividend. BXP is well positioned to weather the current economic slowdown given our leadership position in the premier workplace market segment. Our strong and liquid balance sheet with access to multiple capital sources, our significant development pipeline providing growth.
And our potential to gain market share in both assets and clients due to the current market dislocation. Over to Doug,
Douglas Linde: Thanks, Owen. Good morning, everybody. Client demand across our portfolio has remained pretty stable over the last quarter but final leasing decisions are taking longer not pretty consistent with what Owen’s talking about relative to challenges with regards to the profitability of corporations. Our buildings continue to see the most activity from financial services, professional services, law firms, administrative services and asset management. Traditional technology demand continues to be absent from our markets and more times than not renewing technology clients are reducing their leased premises. This is most prevalent in our West Coast properties. Pretty much the same picture that I painted last quarter.
Growth from the AI organizations in the city of San Francisco is real. More than 700,000 square feet of leasing has occurred in the past few weeks. And there have been billions of dollars of recent investment into this growing ecosystem. For now, that leasing is focused on large well-built opportunities that are available at significant discounted terms relative to the rents being achieved in premier buildings. Reducing availability is a positive for the broader San Francisco market, but it's not going to impact leasing and Embarcadero center in 2024. The concentration of strongest user demand, often with growth for our assets, is still broadly speaking alternative asset managers, private equity venture, hedge funds specialized fund managers, these companies are growing their teams and capital under management.
This pool of clients typically wants to occupy premier workplaces to illustrate the point. During the third quarter, we completed a 15,000 square foot expansion for a hedge fund in Manhattan. And a 52,000 square foot multi floor lease with a private equity firm growing in our portfolio in Manhattan. A 70,000 square foot asset manager is growing in our portfolio in Manhattan, and an expansion for a 21,000 square foot private equity firm in DC. Our strongest activity remains in our Midtown Manhattan portfolio, 200 Clarendon and the Prudential Center in Boston, the urban core of Reston Town Center in Northern Virginia, and our Embarcadero center assets in San Francisco. We don't have direct availability at Salesforce tower, but we hear through the market that Salesforce has interest in their 150,000 square foot sublet opportunity.
Law firms are also an active portion of our portfolio and important clients for BXP. We are in active lease negotiations or LOI discussions with seven distinct law firms in Manhattan, DC and San Francisco. Owen highlighted that just over one million square foot have signed leases during the third quarter. Last October, we provided the leasing expectations embedded in our ‘23 guidance between 500 to a million square feet per quarter, aka 750,000 square feet on average, or 3 million for 2023. Through the first half of the year, we were at 1.56 million. So to date, we're at 2.7 million square feet. We currently have an additional 1.2 million square feet of transactions and active lease documentation. I would say we have a high confidence that we will be beating our leasing target embedded in our 2023 guidance of 3 million square feet.
This quarter the executed leases included 52 transactions 32 renewals 20 new tenants, there were five contractions and five expansions among our existing clients with a net reduction in that pool of about 33,000 square feet. There were no particular patterns relative to industry or size, given who is expanding and contracting, bringing the volume down by market we did about 439,000 in Boston, 240,000 square feet in New York, 100,000 square feet in DC and 278,000 square feet in the West Coast market. The mark-to-market of the leases that commenced this quarter was down 3% as reported in their supplemental, the mark-to-market of leases executed this quarter was positive 4%. The starting cash rents on leases we signed this quarter on second generation space were up 60% in Boston, about 1% in New York and then down 13 in DC, nine in San Francisco, 14% in LA and 6% in Seattle.
We ended the third quarter with an in-service occupancy of 88.8% compared to 88.3% last quarter. As Owen said during the third quarter 140 Kendrick Street and six 751 Gateway were added to the portfolio and Met Square was taken out. If you remove Met Square from the second quarter that comparative period occupancy went from 88.7 to 88.8. So again, modest, relevant increase. I would also note that we terminated WeWork and 44,000 square feet in the third quarter. We expect to have additional portfolio vacancy stemming from WeWork defaults as we move through the fourth quarter and into 2024. Just to remind everyone, we work leases 493,000 square feet as of 10, 01,’23, the BXP share of 2023 annualized revenue is $33 million. We don't expect we work to exit all the assets, nor do we expect them to remain in place in their current footprint.
This will be a drag on 24 occupancy and same store contribution. The development portfolio now sits at 2.8 million square feet and it's 52% leased. We've recently signed a 70,000 square foot office lease with an asset manager at 360 Park Avenue South, bringing it to 18% leased and another floor except 651 Gateway that is now 21% leased to 100% leased assets totaling 335,000 square feet were removed and put into service, which accounts for the change in our total lease and the supplemental. At the end of the quarter, we had signed leases that have yet to commence on our in-service vacancy totaling approximately 750,000 square feet was about 425,000 square feet anticipated to commence in the fourth quarter of ‘23. For the remainder of ’23 we have about 925,000 square feet of expirations.
Much of this is uncovered. So we expect a drop of a few basis points of occupancy at year end. In ‘24, we have a very manageable 5.7% of our total portfolio expiration or 2.7 million square feet. We believe our occupancy will be stable and ‘24 defined as up or down 1% quarter-to-quarter, where we end the -- as relative to where we're going to end the year in 2023. We will provide a leasing of volume outlook for ‘24 along with guidance next quarter. From a broad market perspective, the office supply picture didn't really improve much in the third quarter, with almost every market continuing to experience net negative absorption, Manhattan being the one place where there was some positive. The city specific office brokerage report are starting to characterize the markets in ways that acknowledged the bifurcation between the haves and the have nots and the distinctive trends for premier assets.
But they are not publishing their data broadly. The availability in the premier building that Owen described is depicting a more constructive picture and BXP relevant view of office supply. What's clear is that new speculative construction, which presumably would be premiere is non-existent in the marketplace today. Any new construction starts are going to require economic rents, rent and concessions that are vastly different from the current transactions. The major inputs to a new building or construction hard costs, capital costs and leasing velocity. Construction costs started dramatic increases over the past five years with annual increases in the high single digits. We've seen the rate of increase is slowing down but we have not seen any reduction of costs.
Construction financing could be found, it's SOFR plus 200 and SOFR was 25 basis points to 50 basis points. Today construction financing for office space is simply not available from traditional lenders. SOFR it's a five and a quarter. And non-traditional lenders might and I used to word might lend at double digit current interest rates with additional points upfront and lower loan to cost caps. Speculative leasing assumptions also assume a longer lease up. You put all this into a development pro forma. And you need rents that are materially higher than what is supported by current market rents in every one of our cities. This quarter, we completed a 313,000 square foot 10-year renewal in the Back Bay of Boston four years prior to expiration, and a rent level that both parties found attractive.
Our client is using all their space, believes it's a critical component of their overall business strategy. And when they looked out into the market did not believe that any new construction was likely to be built on a speculative basis. This meant they would need to pay replacement cost rents and sign a lease now, using all the inputs I just outlined to be a new construction in the Back Bay in four years. And there are no 300,000 square foot blocks of high-rise space available in premier buildings and Back Bay today. New life science activity in the portfolio continues to be like during the quarter we completed our third lease at 651 Gateway for another floor. The property will open in ‘24 and two days each lease requires our partnership to complete turnkey spaces in Waltham, where we have our other life science new development availability, we are seeing some tour activity but there is no urgency for these requirements.
There are a few large requirements that are touring but as I have discussed previously, the bulk of immediate demand is from small private companies that are looking for fully built space. BXPs legal teams continue to lease space and outperform the market because our portfolio is fundamentally comprised of premier workplaces. The majority of the demand new and existing clients in the market want to be in these types of properties. And we're investing capital and are building infrastructures, amenities and client’s spaces, which allow our teams to meet client needs. We are all seeing the stress that many buildings are feeling due to their current capital structure and the reality of the supply and demand fundamentals reflected in the leasing market activity.
The transition or recapitalization or re-equitization of these buildings is going to take an extended period of time. Many of these assets are not in a position to commit capital to existing or new tenants, which greatly impacts the leasing brokers interested in considering them for their clients, and offers us with the opportunity to further increase our market share. I'll stop here and turn things over to Mike.
Michael LaBelle: Great, thank you. Good morning, everybody. I'm going to start my comments with some discussion on the debt markets and our activity. Then I will go over the third quarter performance and the changes to our 2023 earnings guidance. We have another busy financing quarter this quarter, we extended or refinanced mortgage facilities totaling $570 million. The two largest of these related to our hub on causeway premier workplace and retail mixed use project that's in Boston. First, we exercise the first of two one-year extension options we have on the $337 million mortgage loan on the office tower. And second, we completed a three-year refinancing of the $155 million mortgage loan secured by the low rise, creative office and retail component.
We also expanded our corporate line of credit by $315 million to $1.8 billion. We honestly were surprised by the market's reaction we issued a press release on this earlier this quarter. As it increases our liquidity at a pretty modest cost. We had three new banks approach us, seeking to expand their relationship with us and up-tier the quality of their own client base. With so much uncertainty and illiquidity in the bank markets, our view is expanding our roster of banking relationships as a smart move. Last week, we closed on a new five-year, $600 million mortgage loans from a syndicate of banks on a portfolio of three premier workplaces in Cambridge. The credit spread at SOFR plus 225 basis points, is attractive in today's market. And we expect to use the proceeds to repay our upcoming $700 million bond maturity in February next year.
Given the significant recent move in interest rates, we are happy with the timing of our last couple of bond deals, both of which have been below market coupons today. We have no more financing needs in 2023, and we've taken care of a large piece of our 2024 maturities, which is the $700 million bond I just mentioned. Our other 2024 maturities include our $1.2 billion term loan and $400 million at our share of floating rate mortgages. The term loan is also floating rate, though we have swapped SOFR to be fixed at 4.64% through May of 2024. We expect to exercise one year extension options that are available on both the term loan and the majority of the maturing mortgages. As you think about our interest expense, moving into 2024, you need to account for higher borrowing costs.
We are refinancing $1.2 billion of bonds that expired in August of 2023 and February of 2024, that had a weighted average interest rate of 3.5%, with new financing at an average rate of 7%. Additionally, we've been running with an average cash balance of approximately $1 billion in 2023. In 2024, we expect to fund our development pipeline with available cash, and run with an average balance closer to $400 million. At our current earnings rate, this projects to a decrease of approximately $30 million of interest income in 2024. Now I want to turn to our third quarter earnings results. For the quarter, we reported funds from operations of $1.86 per share that was $0.02 per share above the midpoint of our guidance range. The outperformance all came from better-than-projected portfolio of net operating income.
Revenues were higher than our assumptions from a mix of better rental revenues, client service income, parking and hotel performance. Our operating expenses were in line with our assumptions. While not impacting our FFO, we did record non-cash impairment charges totaling $273 million this quarter, related to four of our unconsolidated joint ventures. The GAAP rules for unconsolidated joint ventures dictate that if we believe a loss in asset value below our basis is not temporary, the asset is market to fair value. The definition of temporary is somewhat subjective, but as the length of the current market dislocation extends, it's harder to justify a temporary loss in value. The charges relate to Platform 16, which we discussed last quarter, as well as 360 Park Avenue South, 200 Fifth Avenue and Safeco Plaza.
Given the cyclical nature of the real estate business, the value of assets like these will recover in the future when interest rates normalize and corporate economic conditions improve. And we expect to hold these assets through their recovery. Our past experience reflects this recovery after the GFC, we took a similar impairment charge and ultimately, we sold the assets a few years later at a significant gain, not only to the impaired value but to the original book values of the buildings as well. Now I want to turn to our guidance for the rest of 2023. We have narrowed our 2023 guidance range to $7.25 to $7.27 per share, with the midpoint relatively unchanged from last quarter at $7.26 per share. There are two key changes to our guidance from last quarter.
First, we're projecting $0.03 per share of higher termination income in the fourth quarter from lease terminations with WeWork at Madison Center, and Dock 72, as they have stopped paying rent in both locations. We have security deposits to cover a portion of the lost rent, which we will recognize as termination income. The revenue loss is approximately $6.5 million per year until those spaces are re-leased to other clients. They comprise approximately 200,000 square feet that equates to about 40 basis points of our occupancy. Second, we anticipate our net interest expense will be higher by approximately $0.03 per share due to lower projected capitalized interest and closing the new $600 million mortgage financing earlier than we had previously expected.
We expect to invest the funds and cash equivalents until we repay our bond expiration at the beginning of February, and the negative arbitrage on the funds is about $3 million in 2023. The remainder of our assumptions for the portfolio performance has not changed. As Doug described, we continue to execute leases in line with our expectations, and net of the lease terminations, our outlook for occupancy remains stable. As we look ahead into 2024, we have several developments that delivered during 2023 or will deliver in 2024, that will add incremental FFO next year. These include 2100 Pennsylvania Avenue, 651 and 751 Gateway, 140 Kendrick Street, 180 CityPoint and View Boston. However, as I described earlier, we expect our overall earnings trajectory will be negatively impacted by the persistent high interest rate environment that will result in higher net interest expense in 2024.
We will provide detailed earnings guidance for 2024 on next quarter's call in January. That completes our formal remarks. Operator, can you please open the lines up for questions?
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