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Edited Transcript of CIO earnings conference call or presentation 3-May-19 3:00pm GMT

Q1 2019 City Office REIT Inc Earnings Call

Vancouver May 8, 2019 (Thomson StreetEvents) -- Edited Transcript of City Office REIT Inc earnings conference call or presentation Friday, May 3, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Anthony Maretic

City Office REIT, Inc. - CFO, Treasurer & Secretary

* James Thomas Farrar

City Office REIT, Inc. - CEO & Director

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Conference Call Participants

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* Barry Paul Oxford

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Craig Gerald Kucera

B. Riley FBR, Inc., Research Division - Analyst

* Jason R. Idoine

RBC Capital Markets, LLC, Research Division - Associate

* Mitchell Bradley Germain

JMP Securities LLC, Research Division - MD and Senior Research Analyst

* Robert Chapman Stevenson

Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst

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Presentation

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Operator [1]

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Hello, and welcome to the City Office REIT First Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

And now I would like to turn the conference over to Anthony Maretic. Mr. Maretic, please go ahead.

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [2]

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Good morning. Before we begin, I'd like to direct you to our website at cityofficereit.com where you can download our first quarter earnings press release and supplemental information package. The 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 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 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 first 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 will 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.

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [3]

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Good morning. We're pleased to report that through the first quarter of 2019, the growth characteristics in our target 18-hour cities continued to lead the nation. This strong environment has helped us drive higher occupancy and same-store NOI growth across our portfolio. This also allowed us to progress capital recycling initiatives at some of our properties.

Overall, our portfolio continues to be well positioned to take advantage of the vibrant demographic and employment trends favoring our cities. Sun Belt and tech-oriented markets are expected to see the strongest percentage gains in employment during 2019, which bodes well for continued office space demand and absorption.

In the first quarter of 2019, all of our cities experienced positive net absorption and higher market rents. This translated into same-store NOI growth, which Tony will discuss further in a few minutes. Our management team continues to be focused on leveraging the well-located nature of our properties and proactively positioning them to drive leasing.

To that end, we continue to upgrade and amenitize our properties, including significant common area enhancements in progress at 5 of our properties. This includes Mission City and Sorrento Mesa in San Diego, AmberGlen in Portland and Pima Center and Camelback Square in Phoenix. These efforts have yielded success as reflected in our increased portfolio occupancy of 92.6% at quarter end, the highest level achieved since the fourth quarter 2015.

The significant leases that commenced in the first quarter included a 68,000-square-foot lease at our Sorrento Mesa property in San Diego, a 17,000-square-foot lease at our FRP Collection property in Orlando, a 15,000-square-foot expansion at our Circle Point property in Denver, and 3 leases at our Park Tower property in Tampa.

Furthermore, during the quarter, we advanced our acquisition and capital recycling initiatives. We've been selectively pruning our portfolio to concentrate on properties with the best long-term risk-adjusted returns.

In addition to the previously announced Denver sale, we entered into an agreement to sell 1 of the 10 buildings that comprise the San Diego portfolio that we acquired in September 2017. The sale of this 89,000-square-foot building in the Sorrento Mesa sub-market was part of our acquisition business plan when we bought the portfolio. The sale price is $16.5 million and the buyer has waived its due diligence conditions. We anticipate the sale will close later this month.

We've also been successful in identifying attractive opportunities in our pipeline to deploy sale proceeds and the balance of our acquisition capital. We closed the previously announced $63 million purchase of Canyon Park in Seattle in the first quarter, giving us high-quality exposure to Seattle's driving, technology and innovation industries.

Further, we continue to make progress on the loan assumption for the previously announced $32.5 million pending Portland acquisition. Provided the loan assumption is approved and other conditions to closing are met, we expect this transaction will close late in the second quarter and we'll discuss it further on our next call.

With the pending acquisition and sale activity, our net acquisitions for the year so far will be approximately $61 million. Our 2019 net acquisition guidance is $78 million to $90 million, which leaves capacity for another small- to mid-sized purchase. Beyond this, we continue to explore other accretive capital recycling opportunities to fund our pipeline.

Tony will go into further detail shortly, but we're optimistic about our prospects for the balance of 2019. We believe that the occupancy gains we've achieved to date will lead to higher same-store NOI growth for the balance of the year.

Finally, relating to corporate initiatives, we're excited to welcome Sabah Mirza to our Board, who we announced joined as an Independent Director in March. Ms. Mirza has over 20 years of legal, corporate governance and securities experience, most of which has been spent as in-house counsel across diverse industries. Her unique perspective and expertise will be a great addition to our Board.

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

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [4]

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Thanks, Jamie. On a GAAP basis, our net operating income in the first quarter was $23.3 million. This represents a $2.4 million increase over the $20.9 million achieved in the fourth quarter of 2018. The increase from the prior quarter was primarily attributable to the acquisitions of Greenwood Blvd and Camelback Square late in the fourth quarter and the acquisition of Canyon Park in the first quarter.

We reported core FFO of $11.8 million or $0.29 per share, which was $1.4 million higher than the fourth quarter and was similarly impacted by acquisitions which straddled year-end.

In accordance with the updated lease accounting standards, effective January 1 of this year, we've included in expenses the straight-line effect of lessee operating leases, which are now being recognized on the balance sheet. The impact to core FFO was less than $10,000 in Q1 and was added back when calculating AFFO under the renamed caption net recurring straight-line rent and expense adjustment.

In accordance with the new lease accounting standards, we've also updated our presentation of revenues on the income statement and consolidated our historical reporting of revenue line items into a single line. Further disclosure on this leasing standard will be included in our 10-Q.

Our first quarter AFFO was $8.3 million or $0.21 per share. Our first quarter AFFO was affected by the tenant improvements and leasing commissions associated with the leasing activity in the quarter, particularly at City Center and Logan Tower, which saw increases in occupancy during the quarter. Due to 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 the supplemental package. Consistent with our definition of AFFO, we have excluded some first-generation leasing costs and the repositioning activities at several of our properties, the largest of which relate to Park Tower repositioning, which was completed in the quarter, and our recently acquired Canyon Park property. Further details are disclosed on Page 19 under nonrecurring capital expenditures.

Our same-store cash NOI grew 1.8% year-over-year. Denver, Tampa and Orlando were our best-performing markets, each with 9% same-store cash NOI growth. With portfolio occupancy trending ahead of target and embedded contractual rent step-ups, we expect same-store results will continue to accelerate throughout 2019.

Moving on to our balance sheet. Our total debt net of deferred financing costs at March 31 was $695 million. Our net debt to enterprise value ratio was reported as 53.8%, but that figure is based on our stock price at March 31. Using the consensus analyst estimate of NAV at quarter end, our net debt to enterprise value ratio was 49%. With the pending acquisition and disposition after quarter end that Jamie discussed, we expect our leverage will be approximately 50% using the same measure.

At quarter end, fixed-rate debt represented 78% of our total debt with a weighted average interest rate of 4.2% and a weighted average maturity of 5.7 years. We closed the Canyon Park loan during the quarter for approximately $41 million with a fixed interest rate of 4.3% for an 8-year term.

Finally, in our first quarter earnings release, we reiterated our previously issued 2019 guidance. If the strong first quarter trends continue, we believe we will end the year near the top end of our range for core FFO, same-store cash NOI growth and year-end occupancy.

That concludes our prepared remarks. And we will open up the line for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And the first question comes from Craig Kucera with B. Riley FBR.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [2]

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I noted that you didn't take an impairment charge on Sorrento Mesa. Do you plan on booking a gain there or is that going to be pretty flat?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [3]

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Craig, it's Tony here. We will be recording a gain there. Think of -- it's a small number, approximately about $1 million.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [4]

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Okay. Great. And as far as the sort of remaining capacity you have for acquisitions, have you soft circled any markets or particular assets that you might go down the path of buying in the future?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [5]

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Craig, it's Jamie. So we have the Portland acquisition we're closing and then we've got room for another kind of small- to mid-sized acquisition, which could potentially be a little larger depending if we would cycle out some other assets as well. So we want to continue to concentrate and build up in the markets we're in, but we don't have anything at the forefront right now to talk about.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [6]

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Got it. Okay. And one last one from me. As far as your nonrecurring CapEx and TI, do you have a budget that you can give us or a sense of what the total amount would be for 2019?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [7]

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Craig, so -- I mean, if you look at the largest number, this quarter is really the last amounts relating to the Park Tower repositioning. So that was an elevated number. After the call, I can make -- in terms of -- you'll see that trend decrease. I don't have the exact number for the balance of the year in front of me here.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [8]

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Okay. But somewhere south of $5 million, let's say?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [9]

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That is correct.

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Operator [10]

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And the next question comes from Michael Carroll with RBC Capital Markets.

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Jason R. Idoine, RBC Capital Markets, LLC, Research Division - Associate [11]

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This is Jason on for Mike. I was wondering if you could provide a little more color on the 10455 sale in Sorrento Mesa? Just curious, what the buyer -- what type of buyers are showing interest in that asset?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [12]

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Sure. So it was a value-add deal. So occupancy was under 50% since we bought it . And when we looked at the property and the amount of capital that went in, it wasn't ideal from a REIT structure, and so transaction hasn't closed yet. They're hard and nonrefundable, but it's really suited for a value-add profile.

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Jason R. Idoine, RBC Capital Markets, LLC, Research Division - Associate [13]

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And could you provide any details on the cap rate?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [14]

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Given that it is less than 50% occupancy, the cap rate is low. So it's in the 5 range.

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Jason R. Idoine, RBC Capital Markets, LLC, Research Division - Associate [15]

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And then the leasing trends look good. There is so few large blocks available, it looks like. So we're wondering where you guys see the next biggest block coming down. Or what the next big lease-up opportunity is?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [16]

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So really there's 3 big blocks across our portfolio. So we have 1 full building in Sorrento Mesa, which if you'll recall was a building that we got back early. We renegotiated, we let the tenant off, we got prepaid roughly 80% of future rent. And so we've made a major investment there, cleaning that particular building up. We've done a significant amenity in Sorrento Mesa, which really enhances that property. So there's a number of prospects working on that. DTC Crossroads is the next. Same story. We've put in full fitness facility, building amenities, upgraded the lobby. So we have a number of prospects there. That market has been a little slower. We do have some good prospects, particularly post renovation, that's been really well-received, when we brought the leasing teams through over the last couple of weeks.

And then finally, the last big block is Camelback Square in Scottsdale, and that one's about just over 80% leased. That's one of our new acquisitions from December. We didn't assume that we would have any major leasing in the first year, although we do have some prospects that might accelerate that a little quicker than our own internal plans.

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Jason R. Idoine, RBC Capital Markets, LLC, Research Division - Associate [17]

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Okay, great. And then there is -- lastly, there is a small term fee in the quarter. I was wondering if that relates to anything in specific.

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [18]

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So there was a couple of tenants that comprises that, the largest was at Central Fairwinds. We had a tenant that effectively paid through almost the full amount of its remaining rent to get out of a lease early. So it's a combination of a couple tenants, the largest was Central Fairwinds.

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Operator [19]

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And the next question comes from Rob Stevenson with Janney.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [20]

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Any known or likely tenant move-outs of size as of now of incremental nature?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [21]

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Rob, it's Tony here. So if you look at the balance of 2019, we have about 5% that's rolling. We do have a couple of known vacates, but none are -- they are all smaller than 15,000 square feet. So there is -- we just got to continue to kind of block and tackle as we like to say to kind of field that. So we do expect that occupancy could take a small dip kind of in Q3, Q4 depending on the speed to which we release some of those known vacates, but it's not significant.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [22]

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But anything in 2020 as of yet?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [23]

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So 2020, I think we've talked about before on the call. BB&T have signage of our Park Tower building. They're there in February 2020. We're in discussions with them. And as -- it has been announced they are in the mergers with SunTrust, so it's a little bit up in the air. Beyond them, we have an insurance company at Pima that rolls in August of 2020 that's a significant size. Those are the only 2 large ones in 2020.

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [24]

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Yes, a little more color there. So that one is about 46,000 feet and the expectation there is likely there is going to be probably a short-term extension, but we think we will get that space back. The bulk of the others, there is 7 leases over 30,000 feet, one we're fairly confident is likely to vacate. The other ones we think we've got a good shot at extending.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [25]

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Okay. And then where is occupancy on that portfolio or on the Portland asset that you guys are buying?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [26]

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We believe it's just under 100% or about 100%, yes.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [27]

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Okay. So if I take out the Sorrento Mesa asset that you guys are selling, your occupancy in the portfolio is 93.4%. So that goes up a little bit because of the Portland acquisition and then comes back down a little bit because of some smaller vacates in the third and fourth quarter, is the way to think about that?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [28]

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Yes, that's correct. Exactly.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [29]

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All right. And then have you guys come up with any definitive plans for the land parcel at Circle Point in Denver yet?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [30]

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So we've been working very actively on that. We don't have anything to disclose on this call. But it is a focus for us that basically separates the multifamily component, which is about half of the land. And then we would retain the office component, which is the other half. We're hoping we'll be in a better position to talk about that on the next call.

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Operator [31]

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And the next question comes from Mitch Germain with JMP Securities.

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Mitchell Bradley Germain, JMP Securities LLC, Research Division - MD and Senior Research Analyst [32]

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Did you identify the rent spreads on leasing in the quarter?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [33]

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Mitch, it's Tony here. Again, small -- relatively a small sample size, but it averaged about 4%.

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Mitchell Bradley Germain, JMP Securities LLC, Research Division - MD and Senior Research Analyst [34]

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Got you. Great. And broader portfolio, kind of the differential between where current rents are versus market, is it still in the 5% to 10% area in your mind?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [35]

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That's right, Mitch.

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Mitchell Bradley Germain, JMP Securities LLC, Research Division - MD and Senior Research Analyst [36]

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Okay. I appreciate the color on same property results specific to the markets that had some really robust trends. I'm curious what was the offset to those markets, where there's some challenges that kind of brought the rate down?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [37]

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Yes. Sure. So -- really, it was San Diego. And San Diego was just added to our same-store pool in Q4 of last year. It's the first one we have up to 12 months where a period was crossed. Within that property, last year, we announced shortly after we acquired the building, we had an early termination of one of our tenants, who moved out. That tenant moved out in February of last year. And if you recall, this tenant, Roka, actually ended up paying 97% of its base rent for its remaining 2-plus years, that we can use to retenant the space, so effectively on a comparison of quarter-over-quarter, that rolls off this year, which led to my commentary on accelerating same-store results because that headwind alone is going to be burning up.

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Operator [38]

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(Operator Instructions) And the next question comes from Barry Oxford with D.A. Davidson.

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Barry Paul Oxford, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [39]

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Tony, just building on that same-store, where might same-store come out for year-end 2019?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [40]

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So our guidance at the beginning of the year was 2% to 4%. And in my prepared remarks, I indicated that the trends that we are seeing in Q1 continue. We're expecting it to kind of go towards the top end of that range.

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Barry Paul Oxford, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [41]

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Okay. Okay. Okay. Jamie, could you talk about some of the cap rates that are -- that you have in the current acquisitions? And then when you are looking at the pipeline, maybe give us an idea of the type of cap rates you're looking at?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [42]

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Sure. So generally, I'd say, over the last 12 months, cap rates really haven't changed much. I mean it has been a very competitive environment on the buy side. So we have to be very selective. We found we're working on a lot more transactions versus the ones that actually closed, just because there is a lot of demand out there. So cap rates really haven't changed a lot kind of -- if you look at the average of what we did last year, it was sub-7. Typically, we've been targeting 7%, 7.5% range. And so we still have a number of those in our pipeline. They may ultimately trade at a lower cap rate, higher valuation. So for us, it's really focusing and being disciplined, work through that pipeline and bring as much forward as we can, so we can focus on what we see as the best opportunities.

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Barry Paul Oxford, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [43]

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All right. And then when you look at your acquisitions and your need for capital, how would you view -- are you more inclined to kind of do dispositions and reposition the portfolio versus doing an equity offering? How are you viewing that at this juncture?

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [44]

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Yes. Barry, when you look at where our share price is, we're obviously not happy. We think we have done a very good job building out our portfolio, so raising equity today is not what our primary plan is. So it's deploying the balance of the capital that we have. We do think we've got a number of potential recycling opportunities, where we can take assets at great valuations we have and redeploy them into other investments that we think have a higher long-term return profile and better risk-adjusted return. So we are exploring a number of those right now.

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Operator [45]

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And as there are no more questions, I would like to return the floor to James Farrar for any closing comments.

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [46]

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Thank you all for joining today. We appreciate your support, and we look forward to discussing our future results with you.

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Operator [47]

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