Q2 2023 American Assets Trust Inc Earnings Call

Participants

Adam Wyll; President. COO & Secretary; American Assets Trust, Inc.

Ernest Sylvan Rady; Chairman & CEO; American Assets Trust, Inc.

Robert F. Barton; Executive VP, Treasurer & CFO; American Assets Trust, Inc.

Steve Center; SVP of Office Properties; American Assets Trust, Inc.

Ravi Vijay Vaidya; VP; Mizuho Securities USA LLC, Research Division

Todd Michael Thomas; MD & Senior Equity Research Analyst; KeyBanc Capital Markets Inc., Research Division

Presentation

Operator

Good day. As a reminder, today's conference call is being recorded. Please note that statements made on this conference call include forward-looking statements based on current expectations, which statements are subject to risks and uncertainties discussed in the company's filings with the SEC.
You are cautioned not to place undue reliance on these forward-looking statements as actual events could cause the company's results to differ materially from these forward-looking statements.
It is now my pleasure to introduce your host for today, Mr. Adam Wyll, President and COO of American Assets Trust. Thank you. Mr. Wyll, you may begin.

Adam Wyll

Thank you, Desiree. Good morning, everyone. Welcome to American Assets Trust Second Quarter 2023 Earnings Call. Yesterday afternoon, our earnings release and supplemental information were furnished to the SEC on Form 8-K. Both are now available on the Investors section of our website, americanassetstrust.com. And with that quick intro, I'll turn the call over to Ernest Rady, our Chairman and CEO, to begin the discussion of our second quarter 2023 results. Ernest?

Ernest Sylvan Rady

Thanks, Adam, and good morning, everyone. With each strategic and operational business decision that American Assets Trust makes, we take the path that we believe will maximize shareholder value over the longer term. That includes remaining disciplined with respect to our strong balance sheet and continuing to invest in and improve our irreplaceable properties to remain among the best in our markets for each of our asset classes.
In Q2 2023, we were once again encouraged by our operating fundamentals, which continue to defy the odds, despite the ongoing negative market sentiment for commercial real estate, the office sector, in particular. Nevertheless, we remain optimistic that our earnings trajectory as we have increased our full year guidance based on our better-than-expected performance so far in 2023. No doubt in our minds, this is a statement -- a testament to the exceptional quality of both our properties as well of -- and frankly, mainly our people, who are the stewards of your and our organization that work to optimize our long-term growth and shareholder
wealth creation.
I'm incredibly proud of what we've accomplished operationally in the face of market headwinds and all the pessimistic headlines. And no matter what, we will remain vigilant and focused on any economic scenario that may be presented to us going forward and continue to execute our business plan to the best of our abilities. Adam, Bob and Steve will go into more details on our various asset segments, financial results and guidance. But first, I do want to mention that the Board of Directors has approved and maintained a quarterly dividend of $0.33 per share for the third quarter, which we believe is supported by our financial results and is an expression of our Board's confidence in the embedded growth of our portfolio this year. The dividend will be paid on September 21 to shareholders of record September 7.
On behalf of all of us at American Trust and especially myself, I want to thank you for your confidence and continued support in allowing us to continue to manage your company.
I'm now going to turn the call back over to Adam. Adam, please?

Adam Wyll

Thanks, Ernest. As you have all likely heard, there exists an ongoing flight to quality in commercial real estate. Quite honestly, we welcome that with our arms wide open, as we know that our irreplaceable properties are sought after by tenants because they are among the highest caliber assets in the most desired locations with top-notch amenities, sustainability elements, access to public transportation and best-in-class property management teams.
Additionally, most of our properties are close to world-renowned universities and innovation centers, which provide an excellent source of prospective tenants and employee talent for those tenants. We have always believed that these factors will contribute to our relative outperformance over the long term, even in the face of the current macroeconomic challenges impacting our organization and others.
Equally on the office utilization front, over the past few months, we have seen many large corporations like Amazon, BlackRock, Disney and JPMorgan to name a few, requiring their employees to spend much more time at the office. From what we can see based on tenant card swipes, access control records and property manager estimates, this translates to an uptick in office utilization at our properties of between 5% to 10% since early this year.
In San Diego, office utilization has increased to 65% on average and Bellevue office utilization has increased from 35% to approximately 40% to 50%. In San Francisco, we own one of the, if not the best office properties downtown with the Landmark at One Market, where utilization is closer to 70%, driven by this asset being the primary hub for one of our tenants Bay Area employees. And finally, Portland has remained relatively flat on office utilization at between 50% and 60%.
On the retail front, we are thrilled to announce that we recently signed a lease with HomeGoods for 25,000 feet at our Alamo Quarry market, bringing that property to 99% leased. The HomeGood lease backfills the remainder of our former Bed Bath & Beyond space, with base rents that are approximately 30% higher than what Bed Bath & Beyond had been paying.
In Q2, retail leasing spreads, though still positive on both a cash and GAAP basis did drop off from the past few quarters. due to the timing of rent escalations with certain of our larger renewals that we inked in Q2. We also have several retail renewal deals that have already been signed or are in lease documentation in Q3 that we look forward to discussing next quarter. With respect to our multifamily communities, we continue to see positive rent growth as we posted better-than-expected results in Q2. In San Diego, we saw leases on vacant units rent at an average rate of approximately 7% over the prior rents, while rates on renewed units increased an average of 13% over prior rents with no concessions for a blended average of approximately a 10% increase.
Additionally, in San Diego, net effective rents for our new multifamily leases are now approximately 33% above pre-COVID levels and approximately 15% higher year-over-year compared to the second quarter of 2019 and 2022, respectively. We are also pleased to announce that in Q2, we signed a new master lease with the University of San Diego for 109 units at our Pacific Ridge Apartments. And the master lease will be for 3 consecutive school years starting in August 2023, which is 9.5 to 10 month lease terms per school year with 5% annual rent bumps and staggered move-out dates.
We expect this master lease to bring in approximately $17 million in cash rents over the 3-year term. Along those lines, you may have noticed that our occupancy at Pacific Ridge dropped just below 70% as of the end of Q2. This was the result of the expected move out by University of San Diego students at the end of May, and we expect occupancy to rebound back to 90%-plus levels by the end of August this year as our lease percentage at Pacific Ridge ended Q2 at over 90%. Meanwhile, in Q2 in Portland at our Hassalo on Eighth, we saw a blended increase of approximately 4% between new move-ins and renewals with concessions being offered on longer-term leases. Though net effective rents for new multifamily leases are approximately 12% higher year-over-year compared to the second quarter of 2022. The multifamily market in Portland has remained somewhat sluggish relative to our San Diego numbers.
Finally, we published our 2022 sustainability report in Q2, which covers our 2022 operations and highlights our initiatives and commitments across a range of topics, including environmental sustainability, social responsibility, corporate governance and human capital. Hope you enjoy the report.
With that, I'll turn the call over to Bob to discuss financial results and updated guidance in more detail.

Robert F. Barton

Thanks, Adam, and good morning, everyone. Last night, we reported second quarter 2023 FFO per share of $0.59 and second quarter 2023 net income attributable to common stockholders per share of $0.20. All in all, the second quarter was a busy but quiet quarter, but overall better than expected.
Second quarter '23 FFO decreased by approximately $0.07 to $0.59 per FFO share compared to the first quarter of '23, primarily from the following 2 items: first, $0.08 of the decrease in FFO is related to the previously disclosed nonrecurring litigation settlement in January 2023 related to certain building systems at our Hassalo on Eighth in Portland. Offsetting that decrease, our office portfolio performed approximately $0.01 per FFO share better than the first quarter of 2023. Combined, these 2 items reconciled our results for Q2 '23 back to Q1 '23, of approximately $0.66 per FFO share.
Let's talk about same-store cash NOI. In Q2 2023, we ended at 7.7% growth year-over-year for the second quarter. Our same-store office portfolio grew at 8.7% in Q2 as a result of the remaining lease abatements burning off for one of our large tenants at our Landmark at One Market in San Francisco. And new leases starting at our Torrey Reserve Campus in Bellevue properties. Our same-store retail portfolio grew at 7.6% in Q2, primarily as a result of new leases starting at our retail properties. Our same-store multifamily portfolio grew at 5.8% in Q2, primarily due to higher rents at our San Diego multifamily properties. And our mixed-use portfolio grew at 4.8% in Q2 as a result of higher revenue at our Embassy Suites Waikiki Beach Walk.
Turning to liquidity. At the end of the second quarter, we had liquidity of approximately $485 million, comprised of approximately $85 million in cash and cash equivalents and $400 million of full availability on our revolving line of credit. Additionally, as of the end of the second quarter, our leverage, which we measure in terms of net debt to EBITDA was 6.6x. Our objective is to achieve and maintain a net debt to EBITDA of 5.5x or below. Our interest coverage and fixed charge coverage ratio ended the quarter at 3.5x. We are well capitalized with no near-term maturities.
Let's talk about 2023 guidance. We are increasing our 2023 FFO per share guidance range to $2.28 to $2.36 per FFO share with a midpoint of $2.32 per FFO share, an approximate 2% increase from our previously stated guidance issued in our Q1 2023 earnings call that had a range of $2.23 to $2.33 with a midpoint of $2.28.
Let's walk through the following items that make up this increase in our '23 FFO guidance. First, our office properties contributed approximately $0.02 per FFO share of outperformance in Q2 '23. That was not previously included in our '23 guidance, primarily as a result of new office leases signed and our collecting rents on certain office tenants that we have reserved. Second, our multifamily properties contributed approximately $0.01 of FFO share of outperformance in Q2 '23 that was not previously included in '23 guidance. Third, our retail properties contributed approximately $0.005 of FFO per share that was not previously included in our '23 guidance, primarily as a result of collecting rents on certain retail tenants that we have reserved. And fourth, our Waikiki Beach Walk Embassy Suites contributed $0.005 of FFO per share of outperformance in Q2 that was not previously included in our '23 guidance.
At this point in time, with visibility into hotel bookings currently being just 30 to 60 days out, we intend to maintain our prior forecast prepared by our local partners at Outrigger for the remainder of '23. These adjustments when added together will be approximately $0.04 per FFO share and represent the increase in the '23 midpoint over our previous '23 guidance at this point. While we believe the 2023 updated guidance is our best estimate as of this earnings call, we do believe that it is also possible that we could perform to the high end of this increased guidance range.
As always, our guidance, our NOI bridge and these prepared remarks exclude any impact from future acquisitions, dispositions, equity issuances or repurchases, future debt refinancings or repayments other than what we have already discussed. We will continue our best to be as transparent as possible and share with you our analysis and interpretations of our quarterly numbers. I also want to briefly note that any non-GAAP financial measures that we've discussed are reconciled to our GAAP financial results in our earnings release and supplemental information.
I'll now turn the call over to Steve Center, our Senior Vice President of Office Properties, for a brief update on our office segment. Steve?

Steve Center

Thanks, Bob. At the end of the second quarter, our office portfolio was 87.4% leased, with our same-store portfolio at 90.3% leased. In the second quarter, we executed 13 leases totaling approximately 120,000 square feet, including 3 comparable new leases for approximately 6,400 square feet with rent increases of 23% on a cash basis and 19.6% on a straight-line basis. 9 comparable renewal leases totaling approximately 113,000 square feet as follows: we renewed 7 smaller tenants totaling approximately 20,000 square feet with rent increases of 7.6% on a cash basis and 9.3% on a straight-line basis. We renewed Autodesk at our Landmark at One Market in San Francisco and approximately 93,000 square feet with a rent decrease of approximately 5% on a cash basis, but an increase of approximately 4% on a straight-line basis versus comparison rents that were set in Q1 of 2018.
We believe that this renewal was the largest office deal completed in San Francisco in Q2, and we were thrilled with the result certainly a win-win for us in Autodesk as we understand that our building will remain their headquarters for the foreseeable future, and they are a terrific customer of ours. We are encouraged by significant new leasing proposal and tour activity across our portfolio with many tenants that are willing to make longer-term commitments.
Note that this increased tour activity includes our La Jolla Commons III, which is nearing completion, but no news to share our leasing front at this point. We continue to believe the strategic investments in our portfolio will position us to continue to capture more than our fair share of net absorption at premium rents despite current market headwinds. Those strategic investments include exceptional new amenities such as fitness centers, bike hubs, conference centers, outdoor spaces and/or lounges at most of our office properties. While we are not immune to potential additional attrition due to current conditions, we believe that the flight to quality will continue to drive solid performance from our office portfolio.
I'll now turn the call back over to the operator for Q&A.

Question and Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Haendel Juste with Mizuho.

Ravi Vijay Vaidya

This is Ravi Vaidya on the line for Haendel. Just want to follow up on the HomeGoods lease. Can you discuss the CapEx and capital investments in retrofitting the space and that contributed to the 30% spread.

Ernest Sylvan Rady

[Bob] do you want to handle that?

Robert F. Barton

Sure. So the CapEx is just a matter of getting the space ready for the tenant, bringing in air, we're doing a little bit of the storefront and such. I don't have the exact numbers in front of me, but that's pretty standard of what you're going to have to do to a midsized box like that. And again, we're looking at delivering space early next year, and we're looking at a summer opening of '24 for them on that one.

Ernest Sylvan Rady

Our San Antonio properties is a great pride to us. So we're glad to have them.

Ravi Vijay Vaidya

Okay. Another -- just 1 or 2 more here. Regarding the Hawaii asset, can you discuss the tourist mix and if you're seeing further rebounding of the Japanese tourists area? And are you seeing any potential softness from the American consumer?

Ernest Sylvan Rady

Bob, do you want to handle that, please?

Robert F. Barton

Sure. Ravi, yes, we've -- the -- so far, we have not seen the Japanese coming back as strong as our expectation for the '23 summer. So a part of it is, is that, one is that you have a foreign exchange rate of JPY 140 to the U.S. dollar. But it's not a matter of if, it's just a matter of when. I know the airlines, [J.P.P.Y], HNA all the major airlines are lined up ready to take on additional tourism from Japan. And we know that Hawaii is the #1 destination for our Japanese guests from our feedback.
So, so far, we're not -- we haven't seen it in June. But what's interesting is that the ADR remains strong. I mean it's increased over last year. Not only has our ADR, but our RevPAR and our occupancy increase not only over our competitive set. So anyway, hopefully, that answers your question.

Ravi Vijay Vaidya

That's very helpful. And just 1 more here. Just a couple of quarters now. We've seen that the term for the office leases signed is about 5 years. Is this something we can expect to see going forward?

Robert F. Barton

Ravi, you're cutting out.

Ernest Sylvan Rady

Yes. I'm getting cut out. He wants to know about the office leasing and Steve, you ought to handle that and what's going to happen over the next 5 years. And if you know the answer, I'd like to have it too.

Ravi Vijay Vaidya

Sorry, my question is regarding the term. The term of office leases signed was about 5 years for a couple of quarters now. Is that something we could expect to see going forward?

Steve Center

Good question. It's actually going longer. The deals I've got pending right now either signed or in lease documentation are at 9.1 years. So -- and I mentioned, we're seeing tenants went to go longer, both new and renewal tenants. So that trend is going up.

Ernest Sylvan Rady

I think, I said earlier in my remarks that things aren't nearly as bad as the opinion of the public seems to be. And thanks to our management team, which is great and our properties, which are great.

Operator

Our next question comes from the line of Todd Thomas with KeyBanc Capital Markets.

Todd Michael Thomas

All right. Bob, I appreciate the detail around the guidance, but I was just hoping you could provide a little bit more detail, helps bridge the step down that you're anticipating in the third quarter and fourth quarter from the second quarter, right? If we assume the first half results, you're at $1.25, $0.59 in each of the third and fourth quarter would get you to [$2.43]. That's well above the high end of the revised range. Can you just talk about some of the primary [effect] with the decrease in quarterly FFO in the back half of the year?

Ernest Sylvan Rady

That's a great question.

Robert F. Barton

Yes. Thanks for the question, Todd. Yes, I mean, I think one way to look at it, especially on the bridge, is that if you recall, we started our guidance this year with $0.06 of -- $0.06 per FFO share of reserves. And that was because we identified risk that we thought was more likely than not to occur. And of that $0.06, we attributed $0.03 per FFO share of -- to the office and $0.03 to the retail. And then Q1 came along, and we updated that. And so it got down to $0.03 per office and $0.02 for retail.
And now for Q2, in our guidance, we have now ratcheted that down to $0.02 of office and $0.02 of retail. So we still have some reserves that we think that there is a likelihood that we may need to use those reserves. But if we don't use those reserves, that's another, what, $2.6 million, I think, of cash that could come back on. We just don't know at this point in time. The times that we're going through are uncertain and they're volatile. So the last thing we want to do is sandbag but we think that we're doing the right thing. And if you agree or disagree, you can adjust in your models accordingly. I hope that answers your question.

Ernest Sylvan Rady

That was a good question. (inaudible)

Todd Michael Thomas

Yes, that's helpful? So that -- yes, that's helpful. So that's about $0.04, right? And then to get to the midpoint, is there additional seasonality perhaps? I don't know if the Embassy Suites (inaudible)

Robert F. Barton

Yes. You're right, Todd, is that right now, what we mentioned is that we're going to keep the original forecast that Outrigger did who manages our property in Waikiki. And they know the economics out there better than we do in terms of who's coming to town. We have a team from Outrigger that actually flies over to Japan several times a year and they have the relationships over there. So they -- there's a lot of marketing going on. But even with all that is that pre-COVID, we were seeing up to 80% of the rooms reserve bookings occurred 90 days out. And now I mean, 60 days is the best we've seen, generally, it's probably 30, 35 days. So we don't have the foresight. And -- so I'm very hesitant to put anything down that would reflect that. But having said that, we know historically that the embassy will bring in probably another $0.02 to $0.03 if we see pre-COVID numbers again during this current year.

Todd Michael Thomas

Okay. Yes, that's helpful. And then just shifting over to the office portfolio, maybe for Steve or Adam as well. I guess, Adam, you talked about the flight to quality that you're seeing across the portfolio, I think, Steve, you did too. And I just wanted to ask about the leasing environment. In general, whether you're starting to see that translate into occupancy stabilization, whether demand is beginning to pick up as you look ahead to 2024, maybe you could comment about the expirations throughout the balance of this year and in '24, whether there's any additional known move-outs as well?

Ernest Sylvan Rady

I think Steve should cover that, please?

Steve Center

Yes. Good question, Todd. I think '23 is going to be the highest attrition we will see, I think 2024 will be muted. There will still be some. But -- and then on the leasing side, we're seeing -- the first 2 quarters were dominated by renewals, as you see. We've got new leasing activity now. We've got net absorption pending which is good. And I think that's going to continue, given the tour activity and proposal activity. So -- and then again, as I noted earlier, we're seeing longer terms as well. So you'll see that kind of as we sign new deals.

Adam Wyll

And Q3 is off to a good start, already.

Steve Center

Yes.

Ernest Sylvan Rady

Just as a compliment, so we're blessed with good properties and Steve does a great job. Steve and Adam do a great job.

Todd Michael Thomas

Do you expect -- Steve, do you expect to see occupancy trough or stabilize in '23 and then begin to rebound in '24? Or do you think that some of the additional attrition that you'll see in '24 will continue to weigh on occupancy?

Steve Center

Just what I'm looking at now, I've got '23 and '24 in front of me. I think there may be a modest attrition the remainder of '23, given what I know and move-outs. I can't predict the new leasing beyond what I've got in front of me for this quarter, but it's positive. So I think what you'll see is '24 will be a rebound. I think we'll stabilize. The good news is -- and much of attrition is not losing to competition, it's tenants rightsizing. And yet we're keeping those tenants and when those tenants sign up for their smaller space, they're paying the premium rents. So it's just kind of anomaly where you see slippage in occupancy, but it's not a softness in the rent market itself. It's more -- this is part of this thing playing through where companies have changed their operating model. They're rightsizing and then moving forward. I am seeing some positive. I've seen some growth. We have an existing tenant that's going to vacate 14,000 feet and moving to 25,000 feet. And that should sign in the next few weeks. So things are getting better. Things are getting better. As I said, there's new leasing activity. There's net absorption that I'm looking at right now. And then '24, I think the attrition is going to be much more modern, and hopefully, net absorption outpaces the attrition.

Todd Michael Thomas

Okay. And just last question for Ernest. If you could comment, I mean, you've been fairly opportunistic over the years (inaudible) sitting on about $85 million of cash today. There's a lot of volatility in the capital markets and in commercial real estate in general. Are you seeing any opportunities begin to surface anything in the investment pipeline today? And if so, how should we think about the company deploying incremental capital going forward?

Ernest Sylvan Rady

Yes. Todd, that's a good question. We're governed by greed, and we also want to put a smile on all our -- find a way to put a smile on our shareholders' face. At the same time, Bob Barton is very dedicated to 5.5x EBITDA. So we've got to weigh that, losing our liquidity during times that are turbulent with taking advantage of an opportunity that presents itself. All I can say is that we're looking at the opportunity and that if something comes along, which is compelling, we'd certainly have to deal with Bob. So we're working on it.

Operator

There are no further questions at this time. Mr. Rady, I turn the call back over to you.

Ernest Sylvan Rady

Thank you. You guys at American Assets Trust, great job. Thank you very much. To our shareholders and their interest, we're greatly appreciative. And as I said earlier, our job is to help find a way to make you smile, and that's what we keep working on. So thank you all for your interest, and we'll see you next quarter. Thank you.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.