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PS Business Parks Inc (NYSE:PSB)
Q2 2019 Earnings Call
Jul 24, 2019, 12:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, and welcome to the PS Business Parks' Second Quarter 2019 Earnings Results and Conference Call. [Operator Instructions]

It is now my pleasure to turn the floor over to Jeff Hedges, PSB's Chief Financial Officer. You may begin.

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

Thank you. Good morning, everyone, and thank you for joining us for the second quarter 2019 PS Business Parks' investor conference call. This is Jeff Hedges, Chief Financial Officer. Here with me are Maria Hawthorne, CEO; John Petersen, COO; and Trenton Groves, CAO.

Before we begin, let me remind everyone that all statements other than statements of historical facts included in this conference call are forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond PS Business Parks' control, which could cause actual results to differ materially from those set forth in or implied by such forward-looking statements. All forward-looking statements speak only as of the date of this conference call. PS Business Parks undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For additional information about risks and uncertainties that could adversely affect PS Business Parks forward-looking statements, please refer to the reports filed by the Company with the Securities and Exchange Commission, including our Annual Report on Form 10-K and subsequent reports on Form 10-Q and Form 8-K.

We will also provide certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to GAAP is included in our press release and earnings supplement, which can be found on our website at psbusinessparks.com.

I will now turn the call over to Maria.

Maria R. Hawthorne -- President and Chief Executive Officer

Thanks, Jeff. Good morning, everyone, and thank you for joining us today. We are pleased to report several exciting items this morning, starting with our quarterly financial results. Q2 was another strong quarter for us as our reported same park NOI grew 5.2%, with cash rental rate growth of 9% on 1.7 million square feet of executed leases.

Occupancy held steady at a weighted average of 94.3% for our same park portfolio and total portfolio retention was over 72%. These strong results again demonstrate the strength of our infill markets combined with our small customer strategy.

Now, I am extremely pleased to announce that we recently received master plan rezoning approval for The Mile in Tysons, Virginia. We're very happy with the success of Highgate, our existing 395-unit, multifamily property.

And with this master plan approval, we now have the ability to move forward with all future phases of redevelopments, which includes about 3 million square feet of mixed use density or said differently, nearly 3,100 additional multifamily units. Of course, redevelopment of the park will take several years to complete, but our rezoning approval affords us complete discretion on if and when to move forward with any future phase of development.

Today, we are only pursuing the next phase of development, which will be called Brentford at The Mile, a multifamily property, which will be very similar to Highgate in size and design. What we love about Brentford, and the potential next phase of development behind it is that, both can be developed without disrupting any of the in-place NOI we are currently generating from our existing office properties, which are currently over 94% leased. It is too early to say exactly when construction will begin on Brentford, but we are estimating sometime in mid-2020. Of course, we will keep you informed of our plans as they evolve.

Now, for a quick update on the potential sale of the Maryland office portfolio, which we announced on our previous earnings call. We are pleased with how the marketing process has progressed and you'll note that in our GAAP financials, we have reclassified a portion of the marketed portfolio to held-for-sale. These held-for-sale properties accounted for 5.9% of our total Company NOI in fiscal year 2018, and 5.5% of our total Company NOI in the first half of 2019. Expect another update from us on this process on our next quarterly call.

Lastly, I would like to welcome Steve Wilson and Kristy Pipes to our Board of Directors. Both Steve and Kristy bring with them extensive real estate and financial expertise, and we are extremely excited to have them advising us going forward

With that, I turn the call over to JP.

John W. Petersen -- Executive Vice President, Chief Operating Officer

Thanks Maria, As most of you already know, the industrial market is robust in each of our regions, with solid demand, low overall vacancy and historically low unemployment. The cumulative impact of all this is strong operating metrics for our portfolio in Q2. Our Washington Metro division had another good quarter, leasing 410,000 square feet, retention of almost 80% and essentially, flat rent growth. Additionally, combined same park occupancy in Washington Metro was 93.5%, with Northern Virginia, an outstanding 94.7%, a 370 basis point improvement over Q2 2018.

So what has been the key to our recent success? One, we have an experienced, talented team that has been in the market through good times and bad. Two, as we've been talking about for over a decade, our focus on small multi-tenant parks, buildings and suites, allows us to tap into a small business environment that has been growing for some time. And three, the tech sector is leading an expanding DC economy and we are capturing more than our fair share of this activity.

Now, for an update on our 1 million square foot, 19-building, multi-tenant Northern Virginia Industrial Portfolio we purchased in June 2018. We have completed our repositioning efforts, cleansed some of the undesirable users and improved occupancy from 76% to over 85% as of today. We are on track to stabilize NVIP in mid-2020 near 95%, just as we expected.

Leasing activity in Northern California was also active in Q2, with our teams signing 398,000 square feet of deals, generating cash rent growth of almost 17%. Occupancy dipped by 80 basis points from Q1, as we saw a handful of users over 20,000 square feet move out. We were able to lease a 130,000 square foot vacancy I mentioned last call to an existing customer that needed additional space. That occupancy commenced in late Q2. Rent growth on that lease was in excess of 30%, as we priced the space to the current market rate.

We have three other expirations over 150,000 square feet in Q4 that are currently in various stages of negotiations. We expect healthy rent growth on these deals and while we may experience some downtime on one or more of them, these buildings are in good sub-markets and we have solid interest.

Southern California had another strong quarter, signing 315,000 square feet of leases, buoyed by retention of 75%. Rent growth was nearly 10% and demand for small tenant industrial space is quite healthy. The Southern California economy, especially industrial sector, is performing at historically high levels, giving us the ability to keep our customers and push rents.

In Texas, our teams signed 264,000 square feet in 56 deals. Combined rent growth in Austin and Dallas was 8.6%, with Dallas at solid 10.3%. Small users led our leasing volume, with an average deal size of 4,700 square feet. Occupancy in Texas increased 290 basis points on the strength of these small users and a customer retention of almost 77%.

In South Florida, we have yet to see any material signs of the trade wars, and demand is active, especially for suites under 10,000 square feet. We signed 228,000 square feet, 4,000 square foot average deal size. Retention was low for us at 34%, as we saw three users over 15,000 square feet move out in the quarter. We have back filled one of those spaces and have activity, including existing customers on the other two. Based on strong market demand, rent growth was over 10% in Q2.

Finally, Seattle completed 26 leases for 73,000 square feet. Occupancy in Seattle is 95.1%, as we had two spaces over 20,000 square feet vacate in Q2. Subsequently, we released one, which has already taken occupancy with strong rent growth in the mid-teens. For the quarter, rent growth was over 15% as the Seattle industrial market remains one of the hottest in the country.

As we look ahead to the balance of 2019, we remain optimistic that the economic engine in our markets will drive user demand and with vacancies at or near historic lows, our teams will put together positive metrics. I look forward to the opportunity we have with our three larger expirations in Northern California to push rents, improve users and upgrade credit quality.

Other than that, with 13% or 9.6 million square feet of our portfolio expiring in 2019, our teams will continue to execute by pushing rents, lowering transaction costs and maintaining occupancy in the mid to high 90s.

Now, over to Jeff.

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

Thank you, JP. I'm pleased to report that we rounded out the first half of 2019 with a strong second quarter. Net income for the three months ended June 30th, was $1.04 per basic and diluted common share, and for the first half of 2019, was $2 per basic and diluted common share. FFO was $1.75 per share for the quarter and for the six months ended June 30th, was $3.42 per share, an increase of 7.8% from a year ago. Meanwhile, funds available for distribution, or FAD, increased 8.5% during the first half of the year. The increases in both FFO and FAD were primarily attributable to growth in same park NOI, which increased 4.8% in the first half of 2019 compared to the prior year. On a cash basis, which excludes the effect of non-cash rent, NOI increased 5.5% for the six months ended June 30th, driven by 4.8% cash rental income growth.

There are a couple of items I would like to point out related to our same park operating results. First, in connection with their classification as-held-for sale for GAAP purposes, the Maryland disposition properties have been excluded from our same park financial results for the three and six months ended June 30th, as well as in the comparative periods for 2018.

Second, I would like to point out that we did benefit from above average lease buyout income in Q2, which was approximately $780,000 during the second quarter. After normalizing for leased buyout income, our same park NOI growth for the six months ending June 30th, would have been 4.2%, or 4.9% on a cash basis.

Turning now to an update on The Mile. We are pleased to report that Highgate continues to perform well and NOI for the first half of 2019 came in at $2.9 million, which was in line with our expectations. We expect continued NOI improvement in the second half of 2019, as we churn through the remainder of first generation leases.

Finally, I'll wrap up by pointing out that we paid a dividend of $1.05 to common shareholders in the second quarter, and our Board recently declared a dividend of $1.05 to be paid to shareholders in the third quarter, payable on September 27th to shareholders of record on September 12th.

With that, we will now open the call for questions. Operator?

Questions and Answers:

Operator

[Operator Instructions] Our first question is coming from Craig Mailman with KeyBanc Capital Markets. Please go ahead.

Craig Mailman -- KeyBanc Capital Markets -- Analyst

Hi, everyone. Maria, a couple of follow ups here on the Maryland portfolio. Could you just give us a sense of where you are in the process and also just what's being excluded from the held-for-sale portfolio of the assets you want to sell?

Maria R. Hawthorne -- President and Chief Executive Officer

Morning, Craig. Yeah. That's a good question. And what we did when we marketed was, we marketed the 1.4 million square feet as the total portfolio, but we also marketed it in pieces as six separate portfolios that could be purchased. And what happened is that, when pricing came in, and if you remember, we said that, we would evaluate when and if and what to sell, we determined that there was one piece, which was 114,000 square foot building with a single user, it's a government user, with six years left on the term and we decided to keep that. And then the other piece of the portfolio we decided to keep was just a small lot with the land lease. It's a ground lease, with a bank on it and there's a lot of term left on that. So we excluded those two points and we're confident that the balance of the portfolio, 1.3 million square feet, we will sell.

Craig Mailman -- KeyBanc Capital Markets -- Analyst

And I think you guys had said last quarter or when it first came out. I guess, with the 160,000 square feet gone, it was like $16 million or $17 million of NOI. Is that still kind of the bogey here? I know you gave the percentages. I'm just coming trying to get the nominal value.

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

Yeah. Hi Greg. This is Jeff. We don't have any specific NOI number to guide you on related to just the portion that is being classified as held-for-sale. Other than the percentage of NOI that Maria mentioned in her opening remarks.

Craig Mailman -- KeyBanc Capital Markets -- Analyst

And then just timing on this. I know you guys are pretty sensitive to tax planning. What do you think timing would be on the assets that could sell? And are you guys even anywhere close to LOIs or under contract on any other stuff?

Maria R. Hawthorne -- President and Chief Executive Officer

Yeah. Okay. So we're in negotiations. We did qualify to moving these to being held for disposition. We're hopeful that it will happen this year. And then, the other thing I would like to say is that, we have also identified enough of an acquisition pipeline, Craig, that we feel confident that we will be able to do an exchange so that we won't be doing a special dividend, which we were uncertain about earlier in the year.

Craig Mailman -- KeyBanc Capital Markets -- Analyst

Okay. And on the what you're rolling it into, is that more industrial or more flex office? I am just trying to get a sense of what you think that dilution could be if these are in the 8% to 9% range, where do you guys think you can redeploy?

Maria R. Hawthorne -- President and Chief Executive Officer

Okay. So, right now we're looking to redeploy in a core plus market on the West Coast. So that's going to be at a cap rate far lower than 8% or 9%.

Craig Mailman -- KeyBanc Capital Markets -- Analyst

Fair. And then just one last one for me. I know you guys are going to be pretty deliberate on how you build out the rest of The Mile. But in terms of how we should anticipate you guys funding the Brentford here starting next year? You guys have typically used preferred in the past. Is it going to be more construction financing and unsecured, how do you guys see the balance sheet management changing if at all as you build this out?

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

Craig, it's a little too early to give any real guidance on that point, other than to say we have sufficient capacity under our credit facility. So we have that at our disposal for construction financing if we choose to use it. But there are a number of variables in play, including other potential acquisition opportunities or other things that could impact our cash management between now and when we actually start construction on the project. I would not expect to see any true secured construction financing just given that we have sufficient capacity again, either on our corporate credit facility or through other means available to us to fund that project.

Craig Mailman -- KeyBanc Capital Markets -- Analyst

Great. Thank you.

Operator

Our next question will come from Blaine Heck with Wells Fargo. Please go ahead.

Blaine Heck -- Wells Fargo -- Analyst

Thanks. So, just follow up on that. When you think about your cost of capital, clearly you guys have a better cost of equity than I think you ever have. Does that have any effect on your investment strategy or underwriting? And would you guys consider equity as an attractive source of funds if there were a large opportunity to come along?

Maria R. Hawthorne -- President and Chief Executive Officer

Yeah. Blaine, that's a really good point. We are trading at multiples that are extremely attractive and our cost of capital is certainly the lowest that we have seen in our history since we went public in 1998. It is given the strength of the markets, the way the industrial markets are going, it is changing how we are looking at potential acquisitions. And we plan to utilize the strength of our balance sheet right now as we go forward with development and future acquisitions.

Blaine Heck -- Wells Fargo -- Analyst

Okay. And then, I guess generally and separate from the 1031 you're talking about in conjunction with the Maryland industrial sales, are there any markets that you're currently targeting that you'd like to be in and that you're not in currently?

Maria R. Hawthorne -- President and Chief Executive Officer

Right now, all of the markets that we're in, are very deep. So like if you think about the Los Angeles market, which is nearly 1 billion square feet, we can go much deeper within our markets, and where we actually have successful operating platforms. But we do look at new markets, and to go into a new market, I think, as we've said before, we do like to enter a market with concentration of hopefully about 1.5 million square feet, which allows us to put our own leasing and management team in place, which is how we like to operate our facilities. So, we wouldn't exclude going into new markets, but right now, current potential acquisitions are within existing markets.

Blaine Heck -- Wells Fargo -- Analyst

Okay. That's helpful. And lastly, for Jeff, your NOI margin was stronger this quarter than it has been recently. While I think some of that is due to reclassifying the salary, the G&A instead of OpEx, were there any other operating expenses that you expected to incur this quarter that may have gotten pushed out or any other nuances?

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

Yeah. The short answer is it was a pretty normal quarter for us. Now, obviously, given the nature of our business, there's a number of things that could influence the timing of certain operating expense items, including utilities and repairs and maintenance. So there's no large items to note. There potentially could be a little, depending on weather patterns, storm-related damage, things like that. It's always possible that Q3, Q4 could have additional R&M spend, but we're not forecasting anything necessarily in that area.

One item I do want to clear up, though, on what you said regarding the reclassification of the salaries, we have restated that in the period shown. So just want to make sure, if you're looking on a comparative basis based on what we have produced last quarter and this quarter in our earnings supplement, we have normalized that for all periods shown.

Blaine Heck -- Wells Fargo -- Analyst

Got it. That's helpful. Thanks.

Operator

Our next question will come from Eric Frankel with Green Street Advisors. Please go ahead.

Eric Frankel -- Green Street Advisors -- Analyst

Thank you. Just to clarify on the Maryland assets that have been reclassified as held-for-sale, what is the occupancy of those assets? I understand that a large tenant left, but I just want to make sure I understand that better.

Maria R. Hawthorne -- President and Chief Executive Officer

You know what, Eric?

John W. Petersen -- Executive Vice President, Chief Operating Officer

Eric, we will have to get back to you on the specific occupancy, where it is right now, because as we've been marketing it, we continue to lease space and customers move in and out. So to answer your question, where it is right now, we don't know. We'd have to get back to you on that.

Eric Frankel -- Green Street Advisors -- Analyst

Okay. But did you backfill that planned vacancy?

John W. Petersen -- Executive Vice President, Chief Operating Officer

No, we did not back fill that larger vacancy that I think you're referring to.

Eric Frankel -- Green Street Advisors -- Analyst

Yes. Okay. That's helpful.

Maria R. Hawthorne -- President and Chief Executive Officer

Eric, the big one was a 156,000 square feet. The customer there did downsize and keep 15,000, but the balance of it is currently vacant, which we chose to do because the property is in an opportunity zone, and so, we marketed it, so that if someone wanted to take advantage of that, they could.

Eric Frankel -- Green Street Advisors -- Analyst

Right. And that vacancy is not part of your 8% to 9% cap valuation estimate that you speculated last quarter?

Maria R. Hawthorne -- President and Chief Executive Officer

Yes, it is.

Eric Frankel -- Green Street Advisors -- Analyst

It is. Okay. Got you. Even with that vacancy, you would still value everything, including that space, at a 9% cap, or whatever?

Maria R. Hawthorne -- President and Chief Executive Officer

Yes.

Eric Frankel -- Green Street Advisors -- Analyst

Okay. Maybe I'll clarify after the call. Just that math. Obviously, it always seems like fundamentals in the rest of your portfolio are doing quite well. Have you seen a move in values or cap rates for what you're looking at, is there a reason why you're more optimistic now that you're gonna be able to find opportunities to redeploy the sale proceeds?

Maria R. Hawthorne -- President and Chief Executive Officer

We're just looking at the market, looking at what is happening in our areas, and we're just being a little bit more aggressive given the valuation of our stock and where we would be able to deploy from long term unsecured debt. So that is giving us flexibility that we didn't necessarily have in the past.

Eric Frankel -- Green Street Advisors -- Analyst

Okay. That's all I've got. Thank you.

Maria R. Hawthorne -- President and Chief Executive Officer

Thanks, Eric.

Operator

[Operator Instructions] We'll go next to Manny Korchman with Citi. Please go ahead.

Manny Korchman -- Citi -- Analyst

Hey, everyone. Just switching to the Brentford development. When you're looking at your build cost assumptions there, how different are they going to be than Highgate was?

Maria R. Hawthorne -- President and Chief Executive Officer

Manny, that's a good question. We are finalizing the budget and the interior design is not yet complete, but when we locked in pricing in 2015, when we built Highgate, construction costs have gone up. So that's where you'll see -- we are seeing an increase in price. The good news is that, rents in Tysons have definitely increased over the last year, as we're seeing as we renew and move in new residents to Highgate. So, we're anticipating similar returns -- so far, similar returns to what we're getting at Highgate.

Manny Korchman -- Citi -- Analyst

And the fit and finish and quality will be equal to Highgate or is this going to be a competitive product or is it going to be higher or lower on the scale?

Maria R. Hawthorne -- President and Chief Executive Officer

It'll be equal. Finishes will be equal to Highgate. But we are making some different tweaks and it's based on recommendations from our development partners, who have expertise in this area. So, for instance, we look at what's being delivered to the market and they have to do with unit mix. And some will be larger, some will be smaller based on our success with Highgate, as well as what's being delivered to the market because we don't want to add too much direct competition.

Manny Korchman -- Citi -- Analyst

Great. And then I think earlier in the year we had spoken about other office asset sales beyond Maryland. Can you give us an update as to where those stand in the marketing process?

Maria R. Hawthorne -- President and Chief Executive Officer

Okay. So, right now, we are not looking nor I am ready to announce any additional office sales. What we have in Northern -- and if you think about it, we really only have one office park, 340,000 feet in San Mateo, which are the highest rents we're currently getting in our entire portfolio. And the park is about 97% leased. So that we won't sell. It's an amazing piece of land. And then, our Northern Virginia assets, as JP said, the office is extremely well leased, and we're selling the bulk of the Maryland office portfolio. So, at this point, we're happy with what we own, but it is something that we will evaluate as we proceed, but we won't be announcing anything else this year.

Manny Korchman -- Citi -- Analyst

I thought back in the [Indecipherable] earlier in the year that you guys pretty plainly put out there that you'll be selling all of the suburban office. Has something changed or did I just miss-read or miss-remember that?

Maria R. Hawthorne -- President and Chief Executive Officer

No. Manny, we put it out there that we will sell office that we don't have plans to redevelop, but we didn't put a timeline on it. And that's what I'm saying, that for this year, we're not going to announce anything further, but that's not to say that in the future there won't be other parks that we announce. But just so you know, all of the office parks that we would sell are now in Maryland and Virginia, because outside of the DC market, there's only one other office asset, and that's San Mateo, which is not on the table for sale. That would be a future redevelopment opportunity.

Manny Korchman -- Citi -- Analyst

Thanks, Maria.

Maria R. Hawthorne -- President and Chief Executive Officer

Sure. Thanks, Manny.

Operator

And there are no further questions at this time. So I'll turn it back to Jeff Hedges for any additional or closing remarks.

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

All right. Thank you, everyone. We look forward to speaking with you all soon. Have a great rest of your day.

Operator

[Operator Closing Remarks]

Duration: 30 minutes

Call participants:

Jeffrey D. Hedges -- Executive Vice President, Chief Financial Officer and Secretary

Maria R. Hawthorne -- President and Chief Executive Officer

John W. Petersen -- Executive Vice President, Chief Operating Officer

Craig Mailman -- KeyBanc Capital Markets -- Analyst

Blaine Heck -- Wells Fargo -- Analyst

Eric Frankel -- Green Street Advisors -- Analyst

Manny Korchman -- Citi -- Analyst

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