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Edited Transcript of CIO earnings conference call or presentation 1-Aug-19 3:00pm GMT

Q2 2019 City Office REIT Inc Earnings Call

Vancouver Aug 7, 2019 (Thomson StreetEvents) -- Edited Transcript of City Office REIT Inc earnings conference call or presentation Thursday, August 1, 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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* Craig Gerald Kucera

B. Riley FBR, Inc., Research Division - 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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Good morning, and welcome to the City Office REIT Second Quarter 2019 Earnings Conference Call. (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.

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

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Good morning. Before we begin, I would like to direct you to our website at cityofficereit.com where you can download our second 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 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 will 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. 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 insights into what we are 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 6 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 softly enhancing them, we've 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 Oldtown 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 6 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 6 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 were able to find an attractive property in a tight market. Cascade Station is situated in the Airport Way submarket, a transit-oriented and well-amenitized location that's a 5-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 as the largest tenant. The in-place expected year 1 cap rate is 8.1%. With a weighted average lease term of over 5 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 and preserving our capital for another investment opportunity led us to this successful outcome. All of this activity is resulted in covering the dividend with AFFO this quarter. We're also raising full year guidance for core FFO, same-store cash NOI growth and year-end 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 5 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.

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 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 would 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 in expenses, which included brokers fees and related transaction expenses, had to be classified in G&A as onetime 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 FFO of $13.7 million or $0.34 per share, which was $1.9 million higher than in the first quarter. The assignment fee income contributed $1.5 million of this increase with the remaining increase attributable 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 FRP Collection, which saw increases in occupancy during the quarter. Due to the relative size of our portfolio and the impact of significant leasing in any 1 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, the largest of which relate to our recently acquired Canyon Park property. Further details are disclosed on Page 19 under nonrecurring capital expenditures.

Our second quarter same-store cash NOI grew 5.9% year-over-year or 3.8% for the first 6 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 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 June 30 was $710 million. Our net debt-to-enterprise value ratio was reported at 53.3%, but that figure is based on our stock price at June 30. 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 5 years of remaining term with a 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 year-end occupancy. And effectively that's what our updated guidance now reflects. The 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 a $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 31, 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?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Today's first question comes from Rob Stevenson of Janney.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [2]

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Tony, the press release talked about the subsequent to the quarter you guys redid your agreement with the affiliate. Is any of this fee income likely to come in going forward or is this a onetime thing? How are you guys sort of thinking about that?

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

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Rob, it's Jamie. So the assignment fee income was a onetime thing in the quarter. Going forward this arrangement really is a continuation of the one we've had in place over the last 4 years with the Second City funds 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 4 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 towards the end of the year.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [4]

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

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

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Yes, 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 a 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're 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.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [6]

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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?

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

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Yes, sure. So maybe to start with 2019 first. We have less than 6% of our portfolio expiring. There is really no major tenants. We have no tenants or 30,000 square foot that are expiring, that have not already been renewed this year. But we do have a number of known vacates of 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 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 7 tenants that are greater than 30,000 square feet, whose leases are set to expire. We are putting very high renewal probabilities on 4 of them. We expect them to renew. And we talked about there's 3 others that we're actively working on. The first is BB&T. They occupy 51,000 square feet. They have a February 2020 renewal. We've talked about them in the past. They've had a merger with SunTrust. We've actually been very proactive on discussions on extension there. And those discussions continue. 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. 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. And so those are the big ones.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [8]

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Okay. And how material -- is there any big chunky tenant improvements, CapEx that's going to be needed 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 move-outs?

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

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Yes. I think the 2 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 2 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.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [10]

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

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [11]

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

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Operator [12]

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(Operator Instructions) Today's next question comes from Craig Kucera of B. Riley FBR.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [13]

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I wanted to circle back to DTC and Sorrento Mesa. Are the renovations there effectively complete or do you still need to spend some additional money to wrap those up?

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

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Yes. So both renovations are complete. As far as DTC, we've upgraded the lobby. We've built out 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've put in a common amenity. So it's looking great, same thing TI. Now that's a life sciences targeted property. So that's one where the TI could be larger, chunkier, but also higher significant rents as well. So those are the 2 that will hit as we lease those spaces.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [15]

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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?

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Anthony Maretic, City Office REIT, Inc. - CFO, Treasurer & Secretary [16]

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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.

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Craig Gerald Kucera, B. Riley FBR, Inc., Research Division - Analyst [17]

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Got it. Got it. And one more from me. Just as far as a 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?

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

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Yes, sure. 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%. It's 7% year-to-date, which is helping to fuel that same-store sales growth. So we are expecting another healthy number in Q3 and into Q4, which will help those numbers.

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Operator [19]

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

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James Thomas Farrar, City Office REIT, Inc. - CEO & Director [20]

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

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Operator [21]

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Thank you. Today's conference has now concluded. And we thank you all for attending today's presentation. You may now disconnect your lines.