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City Office REIT Inc (CIO) Q2 2019 Earnings Call Transcript

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City Office REIT Inc (NYSE: CIO)
Q2 2019 Earnings Call
Aug 1, 2019, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the City Office REIT Second Quarter 2019 Earnings Conference call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Tony Maretic, Chief Financial Officer. Please go ahead.

Tony Maretic -- Chief Financial Officer

Good morning. Before we begin, I'd like to direct you to our website at cityofficereit.com. We can download our second quarter earnings press release and supplemental information package. Earnings release and 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 discuss the company's beliefs or expectations or that are not based on historical facts may constitute forward-looking statements within the meaning of the federal securities laws. Although the company believes that these expectations reflected in such forward-looking statements are based upon reasonable assumptions, we can give no assurance that these expectations will be achieved.

Please see the forward-looking statements disclaimer in our second quarter earnings press release and the company's filings with the SEC 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 Jamie Farrar, our Chief Executive Officer, discusses some of the quarter's operational highlights. I'll now turn the call over to Jamie.

Jamie Farrar -- Chief Executive Officer

Good morning. With half of 2019 complete and good visibility into the balance of the year, we are pleased to report that our focus on improving property cash flows and selectively recycling capital has yielded strong results. We have outperformed our earnings expectations and increased our guidance on several key performance metrics. With my remarks, I'd like to break down our results year-to-date and provide some insight into what we were expecting for the second half of the year.

First, I'd like to highlight the increase in our portfolio occupancy. We've increased occupancy for six straight quarters from 87.7% in the fourth quarter of 2017 to 93.4% today. Our high-growth 18-hour cities continue to experience strong absorption of office space. Both employers and employees are attracted to the quality of life and business dynamics in our markets. By selecting well located properties and thoughtfully enhancing them, we positioned ourselves to continue to benefit from these attributes.

Specific to our portfolio, we continue to focus on several larger blocks of available space concentrated mainly at our DTC Crossroads, Sorrento Mesa and Camelback Square properties. DTC Crossroads and Sorrento Mesa have each been recently renovated and amenitized. We continue to engage in active dialogue with prospective tenants at these properties and are confident in leasing them.

At our value-add Camelback Square property in Old Town Scottsdale, we executed a 17,000 square foot lease with a technology company during the second quarter, which equates to almost 10% of the property. The timing of this transaction was well ahead of our underwriting expectations, and we will look to continue momentum as we implement our significant renovation plans.

Our focus on new leasing activity and the 2.5% average annual escalators built into our leases has contributed to same-store cash NOI growth of 3.8% for the first six months of 2019 as compared to the same period last year. Further, we expect this trend will continue to accelerate through the balance of the year.

Next, I'd like to update you on our capital recycling activities. Last quarter, we discussed the pending sale of one of the six buildings in our Sorrento Mesa portfolio. We successfully completed the sale in May for $16.5 million, generating a gain on an asset that had significant vacancy and did not fit our long-term strategic profile.

Also during the quarter, we acquired Cascade Station, a $32 .5 million property in Portland, Oregon. We've been looking to grow our footprint in Portland and we're able to find an attractive property in a tight market. Cascade Station is situated in the Airport Way submarket, transit oriented and well amenitized location, that's a five-minute drive away from the Portland International Airport and 20 minutes from the Central Business District.

It is 100% leased to a strong tenant roster, including an investment grade company is the largest tenant. The in-place expected year one cap rate is 8.1%. With a weighted average lease term of over five years, this property provides stable and growing cash flow for us. Also, the buildings are located on a favorable ground lease that has 80 years of remaining term fully extended. ]The first 66 years are fully prepaid, which we believe makes the property more comparable to a fee simple asset. The smaller acquisition size and debt assumption requirement resulted in fewer competitors and an attractive valuation for this quality of an asset.

Moving to the quarter's results. We benefited from an assignment fee for transferring a purchase and sale agreement to a third-party. City Office took advantage of an off-market opportunity to enter into a purchase agreement for a value-add office building and then promptly assigned the contract to a local buyer, realizing a $1.5 million net profit after cash and accrued expenses. While we like the long-term attributes of this particular property, the risk-less income at preserving our capital for another investment opportunity led us to the successful outcome. All of this activity has resulted in covering the dividend with AFFO this quarter. We are also raising full year guidance for core FFO same-store cash NOI growth and year and occupancy. Tony will provide more details on this momentarily.

As we look forward, we continue to see strong leasing conditions across our cities where we own real estate. We're very pleased with how our portfolio has evolved over the last five years and our ability to buy properties with great long-term fundamentals. We continue to be excited by the opportunities that we see to further increase value. This includes selectively pruning our portfolio and redeploying capital into strategic assets that will accelerate per share cash flow growth. Management's top focus today is to drive incremental leasing, increase property cash flow and unlock value creatively.

We believe this will lead to net asset value growth and ultimately to share price appreciation. This is in addition to the healthy dividend that we continue to pay.

With that, I'll turn the call over to Tony to provide further details on our financial results.

Tony Maretic -- Chief Financial Officer

Thanks, Jamie. On a GAAP basis, our net operating income in the second quarter was $26.6 million. This represents a $3.3 million increase over the $23.3 million achieved in the first quarter. $2.6 million of this increase was due to the assignment fee income that I will discuss, and the balance of approximately $700,000 was attributable to rental income and reimbursements driven by the year-to-date acquisitions of Canyon Park and Cascade Station.

As Jamie mentioned, our results this quarter benefited from a $1.5 million assignment fee net of expenses, translating to just shy of $0.04 per share. For accounting purposes, the outlays and expenses which included brokers fees and related transaction expenses paid to be classified in G&A has one-time costs. Those costs were approximately $1.1 million, the gross assignment fee income received was $2.6 million, which was recorded within revenues.

On Page 11 of our supplemental package, we have provided extra details on the components of income that comprise our revenue line item so that other income can be clearly identified. Overall, we reported core FIFO of $13.7 million or $0.34 per share, which was $1.9 million higher than the first quarter. The assignment fee income contributed $1.5 million of this increase, with the remaining increase attributed to year to date acquisitions and same store portfolio growth.

Our second quarter AFFO was $10.3 million or $0.26 per share. Our second quarter AFFO was affected by the tenant improvements and leasing commissions associated with our leasing activity in the quarter, particularly at our peak collection, which saw increases in occupancy during the quarter. Do the relative size of our portfolio and the impact of significant leasing in any one quarter, our AFFO numbers will continue to move around some from quarter to quarter.

Our leasing activity and capital expenditures are provided on pages 17 and 19 of a supplemental package. Consistent with our definition of AFFO, we have excluded some first generation leasing costs, the largest of which relate to our recently acquired Canyon Park property. Further details are disclosed on Page 19 under non-recurring capital expenditures.

Our second quarter same store cash NOI grew 5.9% year-over-year or 3.8% for the first six months of the year as compared to the same period in the prior year. Orlando, Portland and Denver were our best performing markets in the quarter each with double-digit same store cash NOI growth, which was primarily driven by a combination of occupancy gains in those markets, free rent burn off and mark-to-market or step up in rents.

With portfolio occupancy trending ahead of target and embedded contractual rents step ups, we expect same-store results will continue to accelerate throughout 2019. Moving onto our balance sheet, our total debt net of deferred financing costs at June 30th was $710 million. Our net debt to enterprise value ratio was reported at 53.3%. That figure is based on our stock price at June 30th, using the consensus analyst estimate of NAV at quarter end our, net debt to enterprise value ratio was 50%. At quarter end, fixed rate debt represented 79% of our total debt with a weighted average interest rate of 4.2% and a weighted average maturity of 5.4 years.

When we acquired Cascade Station in Portland during the quarter, we assumed the existing debt on the property that $22.5 million loan has just under five years remaining term with fixed interest rate of 4.55%.

Finally, in our second quarter earnings release, we provided updates to our previously issued 2019 guidance. I mentioned on last quarter's call that if we saw the strong first quarter trends continue, we believed we would end the year near the top end of our range for core FFO, same-store cash NOI growth and the year end occupancy.

And effectively, that's what our updated guidance now reflects. Full year guidance also reflects the impact of the assignment fee income and related G&A costs as well as a reduced interest expense associated with lower than anticipated interest rates. Our guidance assumes no capital raising assumption and includes only modest incremental net acquisitions to achieve our previously issued net acquisition guidance of $78 million to $90 million versus the $61 million achieved year-to-date.

Based on these assumptions, we are anticipating core FFO between $1.23 and $1.26 per share for the full year ending December 31st, 2019 and same-store cash NOI growth between 4% and 5%. A full set of revised guidance estimates and underlining assumptions is provided in our second quarter press release.

That concludes our prepared remarks, and we'll open up the line for questions. Operator?

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Rob Stevenson of Janney. Please go ahead.

Rob Stevenson -- Janney. -- Analyst

Good morning, guys. Tony, is any of this -- the press release talked about the subsequent to the quarter you guys redid your agreement with the ability that any -- is any of this peak income likely to come in going forward or is this a one time thing? How are you guys sort of thinking about that?

Jamie Farrar -- Chief Executive Officer

Hey, Rob; it's Jamie. So the assignment fee income was a one-time thing in the quarter. And going forward, this arrangement really is a continuation of the one we've had in place over the last four years with the Second City fund just expanding to a new entity clarity real estate. So, we expect in 2020 and beyond that this could be another meaningful fee stream over the last four years, the old arrangement paid about $930,000 a year, which has been pretty material to the bottom line with no capital investment.

So, it's too early to say what that quantum will be. We'll have a better sense as we get toward the end of the year.

Rob Stevenson -- Janney. -- Analyst

And at this point, are you guys -- I mean, was this a one-off thing in terms of finding acquisition that wound up getting assigned to them or is this something that, given your capital needs, etc, and availability that if you find interesting acquisition opportunities that the REIT isn't going to be able to do because they're too large or whatnot that this could wind up being more recurring fees on that type of deals?

Jamie Farrar -- Chief Executive Officer

Yeah, it's possible. I mean, this particular example was an opportunity for us to step into a purchase contract for a value-add building with great long-term asset, but it had a major mark-to-market on leasing that was going to take an extended period of time to capture. So we were happy to own the asset long-term, but a local owner paid us effectively to assign them the purchase contract, which we did earned about $1.5 million net profit after expenses and accruals. So, for us, it was riskless income and we preserved our capital for a property that really is more in line of what we typically buy and is accretive to our results.

Rob Stevenson -- Janney. -- Analyst

Okay. How are you guys -- from a leasing standpoint, how are you guys thinking about known move-outs of consequence through 2020 and sort of need to backfill space?

Jamie Farrar -- Chief Executive Officer

Yeah, sure. So, maybe just talk about 2019 first, we have less than 6% of our portfolio expiring. There's really no major tenants. We have no tenants or 30,000 square foot that are expiring that have not been renewed this year. But we do have a number of known vacates, kind of smaller to medium-size tenants across the portfolio that aggregate to about 100,000 square feet in the second half of the year, the bulk of which will occur in the fourth quarter.

So we expect occupancy to dip slightly at year end and as those spaces are anticipated to be leased kind of either late '19 or early 2020. If you look further out to 2020, we do have seven tenants that are greater than 3,000 square feet whose leases are set to expire. We are putting very high renewal probabilities on four of them. We expect them to renew. And we've talked about there's three others that we're actively working on.

The first is BB&T. They occupied 51,000 square feet and they have a February 2020 renewal. We've talked about them in the past that had a merger with SunTrust. We've actually been very proactive on discussions on the extension there. And those discussions continue and we have a proposal out to them really to try to incentivize them to transact and extend that would give some flexibility on future givebacks. So, we hope to have more update next quarter, and those discussions are ongoing.

Beyond that, we also have a 41,000 square foot insurance company at our Pima property with an August 2020 renewal. We expect them to do a short-term extension that would take them into 2021 or maybe shortly thereafter. And then, lastly, we have a 30,000 square foot tenant at our Circle Point property that we do expect to vacate at the end of September 2020. So those are the big ones.

Rob Stevenson -- Janney. -- Analyst

Okay. And how material -- is there any big chunky tenant improvements, capex that's going to be needed at the back half of this year or the early part of next year to either lease up existing vacant space or to backfill some of the 100,000 square feet of moveouts?

Jamie Farrar -- Chief Executive Officer

Yeah, I think the two biggest ones that are potentially out there really relate to vacant space. We really only have a couple of big blocks left. We have a single building in our Sorrento Mesa portfolio and we also have kind of the top two floors of space at our DTC Crossroad. I can't say that the activity at DTC Crossroad has been very active and we're in active discussions with actually a couple of different groups. And if that were to come together, potentially that could hit our back half of the year in terms of a TI.

Rob Stevenson -- Janney. -- Analyst

Okay. Then last one for me. Are you guys marketing any assets for sale currently?

Jamie Farrar -- Chief Executive Officer

So we do have a small asset that we're marketing. We're contemplating maybe one or two others, but early stage. So nothing really to report there.

Rob Stevenson -- Janney. -- Analyst

Okay. Thanks, guys. Appreciate it.

Jamie Farrar -- Chief Executive Officer

Thanks, Rob.

Operator

[Operator Instructions] Today's next question comes from Craig Kucera of B. Riley FBR. Please go ahead.

Craig Kucera -- B. Riley FBR -- Analyst

Hey, good morning, guys. I wanted to circle back to DTC and Sorrento Mesa, are the other renovations there effectively complete or do you still need to spend some additional money to wrap those up?

Jamie Farrar -- Chief Executive Officer

Yeah. So both renovations are complete. As far as DTC, we've upgraded the lobby. We've built up fitness facility, common amenity room, so that's all done. Really where the capital that's going to be required there is going to be for TIs for leasing. Sorrento Mesa, we've completed the bulk of the work there. We put in a common amenity. So it's looking great. Same thing, TI. Now that's a life sciences targeted property. And so that's one where the TI could be larger, chunkier, but also higher significant rents as well. So those are the two that will hit as we leave those spaces.

Craig Kucera -- B. Riley FBR -- Analyst

Got it. And as far as your quarterly results, I think your same-store operating expenses were up pretty considerably. Can you give us some color on what the major drivers were there?

Tony Maretic -- Chief Financial Officer

So, I mean, it really is a mixture. The same-store pool we've added in a couple of new properties, one of which is Park Tower, which is a large property, and it's really just the average that's being skewed as a result of the new additions.

Craig Kucera -- B. Riley FBR -- Analyst

Got it. Got it. And one more for me. Just as far as the same-store NOI guidance change, can you talk, Tony, maybe about your expectations on new leasing spreads in the back half of the year as well as operating expense?

Tony Maretic -- Chief Financial Officer

Yeah. So, in terms of leasing spreads, I mean, that's been a very positive number. For the current quarter, our leasing spread was actually 12% at 7% year-to-date, which is helping to fuel that same-store sales growth. So, we are expecting an another healthy number in Q3 and into Q4, which will help those numbers.

Craig Kucera -- B. Riley FBR -- Analyst

Okay. Thanks, guys.

Tony Maretic -- Chief Financial Officer

Thanks, Craig.

Operator

Ladies and gentlemen, this concludes our question-answer-session. I'd like to turn the conference back over to the management team for any final remarks.

Tony Maretic -- Chief Financial Officer

Sure. Thanks for joining today. Have a great summer. And we look forward to the update on the next call.

Operator

[Operator Closing Remarks]

Duration: 21 minutes

Call participants:

Tony Maretic -- Chief Financial Officer

Jamie Farrar -- Chief Executive Officer

Rob Stevenson -- Janney. -- Analyst

Craig Kucera -- B. Riley FBR -- Analyst

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