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City Office REIT, inc (NYSE:CIO)
Q2 2021 Earnings Call
Aug 5, 2021, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the City Office REIT, Inc. Second Quarter 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. [Operator Instructions] It is now my pleasure to introduce to you Tony Maretic, the company's Chief Financial Officer, Treasurer and Corporate Secretary. Thank you. Mr. Maretic, you may begin.

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

Good morning. Before we begin, I would like to direct you to our website at cioreit.com, where you can view 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 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.

James Farrar -- Chief Executive Officer & Director

Good morning. Thanks for joining today. Our quarterly results continue to be strong and consistent. In the second quarter, we achieved healthy dividend coverage positive same store cash NOI growth and strong leasing activity. Major highlights for the second quarter include completing a large backfill of leased but unoccupied space at our Park Tower property in Tampa and advancing opportunities to unlock value with our life science assets in San Diego. I will cover both of these items in more detail momentarily.

Before going into our results, I'll briefly touch upon what we are seeing across the office industry. After Labor Day, we continue to expect a significant increase in tenant utilization of office space that should accelerate as we approach the end of 2021. To date, we have seen many smaller tenants embrace a return to the office. Larger tenants have generally been slower to return, but are expressing intentions to ramp up their utilization in the fall. In terms of our operating results during the quarter, we completed a healthy 249,000 square feet of new and renewal leasing. We also continued with our strong rent collection at nearly 100% and have now collected virtually all of the deferred rent granted during the pandemic. While occupancy dipped slightly at quarter end, our second quarter same-store cash NOI growth was a solid 2.7%.

Of note, we achieved a 4% increase in cash renewal rents versus the expiring rents. As I mentioned, one of the most significant transactions in the quarter involved backfilling dark space at our Park Tower property. BB&T Bank is a major tenant but they consolidated in the SunTrust location last year after the merger. This left us with 51,000 square feet of dark space leased through February of 2025. Despite paying rent, having space like this is a drag on property value as it creates a known future vacancy. During the second quarter, we secured a new tenant that will occupy the full 51,000 square feet, plus an additional 15,000 square feet. At the same time, we negotiated a lease termination with BB&T, with a termination fee of approximately $5.4 million. BB&T will continue to pay their rent obligations through November 30, 2021.

The termination fee represents approximately 85% of the future base rent and estimated reimbursement obligation that BB&T would have otherwise paid through 2025. The new tenant is a fast-growing fintech company, and they executed an eight-year lease that starts in May of 2022. When factoring in signage rent, the new tenant will be paying approximately 5% higher rent per square foot than the departing tenant. As part of the deal, we intend to complete significant upgrades to their space which will be accretive for future leasing. The other significant transaction that occurred during the quarter was the acquisition of two properties adjacent to our Sorrento Mesa portfolio, which we announced on our last call.

These properties are an important key to unlock greater development potential and value in those life science assets. Rent in San Diego's life science market continues to be at a record high with vacancy below 5%. Tenant demand for life science properties is strong and growing, fueled by record levels of venture capital funding. CBRE estimated that there is approximately 2.8 million square feet of laboratory tenant demand, with only 900,000 square feet of availability. San Diego's limited vacancy in development sites have left tenants with few options for expanding their operations. Given these market dynamics, we completed the purchase at an ideal time.

Since our last call, we've made substantial progress exploring options for our full Sorrento Mesa portfolio. We executed a process that evaluated developing our land holdings in partnership with an experienced operator, selling the entire Sorrento Mesa portfolio or some combination thereof. This process confirmed that the value of these assets has grown to impressive levels. Whichever option we select will have a transformative impact to our company. Today, all alternatives remain on the table and we are giving significant consideration to a possible sale of the entire Sorrento Mesa portfolio. Given where we are in our process, we are unable to provide further details at this time.

Should a transaction come to fruition, we anticipate providing further information at that point. To conclude, as we move forward into the second half of the year, our focus remains on advancing our Sorrento Mesa process, achieving leasing success through both renewals and the leasing of vacancy, and building our acquisition pipeline at a time when tenants are returning to the office environment. We believe that we are well positioned on all of these fronts.

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

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

Thanks, Jamie. I'll address the second quarter's results and then provide an update to our guidance for the balance of 2021. Our net operating income in the second quarter was $25.8 million, which was $400,000 higher than the $25.4 million we reported last quarter. The increase was a result of higher termination fees offset by the reduction in income from the Cherry Creek sale midway to the prior quarter. In total, we recorded $1.5 million in termination fees in the second quarter. Of that amount, $700,000 was related to the Toyota lease at our SanTan property.

As discussed last quarter, we will be amortizing the fee through August 2022. $500,000 was related to the leasing transactions that Jamie described at our Park Tower property. That tenant, BB&T, signed an agreement that became effective at the end of June. The agreement releases them from their obligation to pay rent after November 30 of this year. In connection with the agreement, we received a termination fee of $5.4 million. We will amortize the fee until the end of the tenant's new lease term. We reported core FFO of $15.3 million or $0.35 per share, which was $800,000 higher than in the first quarter for the same reasons that NOI was higher. In addition, interest expense was also lower as a result of using proceeds from the Cherry Creek sale to reduce our overall leverage.

Our second quarter AFFO was $9.9 million or $0.22 per share. The largest impact to AFFO was a leasing commission on the lease transaction at our Park Tower property, which equated to $0.03 per share. The $3.6 million of tenant improvements related to that lease are expected to begin to impact AFFO in Q4, with the bulk expected in the first half of 2022. Our second quarter same-store cash NOI growth was a positive 2.7% as compared to the second quarter last year. The leases we signed in 2020, particularly those at our Denver Tech property and our life science portfolio, were the biggest driver of these results. Our total debt at June 30 was $613 million, which was a $40 million increase over last quarter.

That increase was due to funds drawn on our credit facility for the Sorrento Mesa acquisition during the quarter. Our net debt including restricted cash to EBITDA was a healthy 6.2 times. At quarter end, our total debt had a weighted average maturity of 4.2 years, and 84% of our debt was effectively fixed. Our weighted average interest rate is now 3.6% and we have no property debt maturities until 2023. We also want to make one note on our disclosures this quarter. We have decreased disclosure related to our rental collection rate and exposure to select industries impacted by COVID-19.

We essentially have not had any collection issues to date and do not currently expect material changes in our collection rate. Last, we have provided updated full year 2021 guidance in our press release. The primary driver of the guidance changes is the Park Tower termination fee income that I mentioned earlier, which positively impacts our forecasted net operating income and core FFO. The expected departure of BB&T in 2021 has lowered our year-end occupancy guidance, as the replacement tenant is not expected to take occupancy until May of 2022. We refer you to the material assumptions and considerations set forth in our earnings release.

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

Questions and Answers:

Operator

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Rob Stevenson of Janney. Please go ahead.

Rob Stevenson -- Janney -- Analyst

Hi, good morning, guys. Jamie, so if you'd decided that you did -- that the best alternative was to sell Sorrento Mesa in its entirety, what would you do with the proceeds? I mean the two legacy properties are something like $20 million of annual revenue.

Do you sort of look to fund acquisitions -- some combination of acquisitions and common stock buyback? How would you -- given what your alternatives are today, I mean, what does that look like for you if you do get that capital inflow?

James Farrar -- Chief Executive Officer & Director

Thanks for the question, Rob. So we'll go into more detail if we complete the transaction. But fair to say that we'd love to continue to build further depth in our markets that we're in, continue to expand into new markets. And as we look to kind of the fall and into 2022, we think it's going to be a great time to have dry powder as tenants are returning to the office.

Rob Stevenson -- Janney -- Analyst

And how does pricing look today given assets that you'd want to own without taking some substantial retenanting risk today?

James Farrar -- Chief Executive Officer & Director

So if you look at more traditional assets, I mean, right now, we're in kind of the slow summer period. And we think internally that as we get to the fall, things are going to pick up. But what we're still seeing is very high-quality assets with great credit, new construction, great locations still trading at prices that would be accretive to us long term.

Rob Stevenson -- Janney -- Analyst

Okay. And in addition to Park Tower, are there any other dark spaces of note in the portfolio where you're getting rent but the tenant isn't occupying a substantial part or even all of the space?

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

Yes. BB&T was -- Rob, it's Tony here. BB&T was by far the largest of those items. Obviously, just given where we are, utilization rates in our portfolio are still right around, call it, low 30% utilization. But no other significant blocks where we know of a tenant has fully vacated.

Rob Stevenson -- Janney -- Analyst

Okay. And then last one from me. How -- as you sit here today, how does the leasing picture look for the second half of the year? And how should we be thinking about tenant improvements, leasing commissions and the like and the need to fund some of that stuff in the back half of the year?

James Farrar -- Chief Executive Officer & Director

So in terms of market in general, again, we think leasing will pick up kind of as we get to later in the year and into early next year, just as far as tour activity that we've been seeing and tenant interest and as they return back to the office.

I'd say generally, concessions I don't think are going to be terribly dissimilar to where they have been in the past and probably a bit more elevated free rent, if anything. Construction costs, a little bit higher probably as costs all over the board have gone up a bit, but generally in line with what we've been seeing recently.

Rob Stevenson -- Janney -- Analyst

Okay. Thanks, guys. Appreciate the time.

James Farrar -- Chief Executive Officer & Director

Thanks, Rob.

Operator

The next question comes from Michael Carroll of RBC Capital Markets. Please go ahead.

Michael Carroll -- RBC Capital Markets -- Analyst

Yes, thanks. Jamie, related to the Sorrento Mesa portfolio, I kind of want to walk through the options that you highlighted. I mean were the two options that you kind of highlighted in your prepared remarks was; one, sell the entire portfolio; or two, form a joint venture to pursue a development on the available land site? Are those the two that you're thinking about right now?

James Farrar -- Chief Executive Officer & Director

That's exactly right, Mike. So we had the two processes. When we started, the primary thrust really was to pick a joint venture partner who'll lead the development for our holdings, and we have a great option there. And before we decided to consummate a transaction, given how strong the life science market is, we felt we really needed to look at our options in detail.

And so we had a broker target the most active and sophisticated buyers, and we had tremendous interest and very compelling valuations. And so the focus and thrust of the direction we are going has shifted in that direction at this point.

Michael Carroll -- RBC Capital Markets -- Analyst

And I know last quarter, the talk with that available land site was to potentially do a JV to do the development and/or just sell that land. It seems like you're not planning on just selling the land anymore. I'm assuming, and correct me if I'm wrong here, is that the potential acquirer would prefer to have the entire portfolio within Sorrento Mesa, including that land, and that's why you're pursuing that potential disposition?

James Farrar -- Chief Executive Officer & Director

We could pretty much pursue any option that we wanted, Mike. But the special thing about the portfolio we put together is it has great existing cash flow and it has one million square feet plus of potential development that could be out of the ground pretty quickly. And so when you put the whole portfolio together, that becomes a very attractive package. And so as we went through our process, that was the direction we decided to head.

Michael Carroll -- RBC Capital Markets -- Analyst

Okay. And then what we heard in one of the stats is that the -- what developable life science land is trading in these top cluster markets is about $200 a developable square foot. I mean is that kind of in line with what you're thinking on the one million square feet that you have within Sorrento Mesa?

James Farrar -- Chief Executive Officer & Director

Yes. Given where we are in our process, Mike, we won't provide any further comments on value right now.

Michael Carroll -- RBC Capital Markets -- Analyst

Okay. Great. And then just last one from me on the Sorrento Mesa portfolio. I know you have an available block there. Is that something that you're pursuing to lease right now? Or does a potential acquirer of this would prefer to have that available for them to lease it up or do what they want? I mean are you still proactively pursuing tenant discussions to lease that space today?

James Farrar -- Chief Executive Officer & Director

We are actively pursuing and some of the potential buyers really like having that vacancy. If you're going to launch a development, having swing space that's immediately available is helpful in potentially securing a tenant. So our focus right now is to try and find a great, long-term tenant there. And that could change, obviously, if we decided to exit the property.

Michael Carroll -- RBC Capital Markets -- Analyst

Okay. Great. And then, Tony, related to the lease expiration schedules, is Ally and Toyota, are those leases still reflected in the, what, the 2022 and 2023 expirations? Or have those been -- specifically Ally since they renewed, is that kind of now their new expiration date?

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

Yes. I mean the way we treat that schedule is if a lease is signed prior to our reporting date, so in this case June 30, then we do update the role schedule to reflect their new ending lease.

Michael Carroll -- RBC Capital Markets -- Analyst

And then when did Ally officially renew?

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

Ally officially renewed, I want to say, it was -- if it wasn't Q1, it was Q4 of last year.

Michael Carroll -- RBC Capital Markets -- Analyst

Okay. Great. Thank you.

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

Thanks, Mike.

Operator

The next question comes from Craig Kucera of B. Riley FBR. Please go ahead.

Craig Kucera -- B. Riley FBR -- Analyst

Hi, good morning, guys. I noted that you pulled your acquisition and disposition guidance from your overall guidance here. I think in the first quarter guide, acquisitions was $43 million to $100 million. A couple of questions here. I guess, first of all, does the high end of the range in your revised guidance include that additional acquisition?

James Farrar -- Chief Executive Officer & Director

So the low, Rob, basically reflects the $43 million we've already put to work and the high end reflects an additional $57 million completed late in the fourth quarter. So there really isn't much of an impact to our overall results.

Craig Kucera -- B. Riley FBR -- Analyst

Okay. Got it. And I guess looking to your leasing volume, it accelerated again this quarter, particularly on the new leasing front. Would you say a lot of that activity is from tenants that you had been in discussions previously with? Or are these effectively new folks that are walking in and wanting space in more recent discussions?

James Farrar -- Chief Executive Officer & Director

Everything has been slower, Rob, given COVID and whatnot. So discussions we've been having generally have been ongoing for a longer period of time. The cycle is just a little bit longer at this point.

Craig Kucera -- B. Riley FBR -- Analyst

Okay. That's it for me. Thank you.

James Farrar -- Chief Executive Officer & Director

Thank you.

Operator

[Operator Instructions] And the next question will come from Bill Crow of Raymond James. Please go ahead.

Bill Crow -- Raymond James -- Analyst

Hey, guys. Jamie, you seem pretty confident that we'd see a push in the return to office, I guess, September on. Just wondering whether tenants are starting to talk about pushing that back because of the Delta outbreak.

James Farrar -- Chief Executive Officer & Director

Yes, some are. So we basically have been going through every couple of weeks and doing counts of who's in desks and what tenants are thinking in their latest plans. And for sure, that's been happening, Bill, where some are pushing it back later in the year and some are still planning kind of post Labor Day to be coming back.

So I think in -- our own internal view, we think, as I said, it's going to accelerate post Labor Day, and I think it will continue to accelerate through the balance of this year.

Bill Crow -- Raymond James -- Analyst

When you talk to the tenants, how much uncertainty exists over commitment to space versus, say, a year ago? Have they become more definite in their plans? Or is there still this massive amount of uncertainty and how hybrid work might play out?

James Farrar -- Chief Executive Officer & Director

Yes, I don't think there's a definitive answer right now, Bill, on how we feel. A year ago, the buzzwords were about hybrid is the way to go or remote work in the future, and I think that's really toned down particularly in our markets. And so I think kind of the latest feeling we have from our tenants is there'll be a return.

The question is, is it going to be five days a week, is it three days a week, how do they ramp back into it? And so we're feeling way better than where we were a year ago, but there's still some uncertainty on kind of timing and how that's going to roll out.

Bill Crow -- Raymond James -- Analyst

Okay. And then finally from me, on Park Tower, I don't know how long BB&T had been in this space, but a 5% increase seems on the modest side. But hey, it's 5% positive. So it's good. How do you actualize the economics of Park Tower playing out relative to your underwriting originally?

James Farrar -- Chief Executive Officer & Director

So Park Tower -- BB&T had been in the space for a substantial period of time. And we renewed them, I'm thinking, it was pre-COVID, maybe 2019. So we had a healthy kind of mark-to-market terms at that point. And so we were very happy with rent and kind of where we are.

And so having $30 full-service gross on the new leases as starting point, with sub -- just under 3% kind of annual step-ups and healthy signage rent, we're very happy. It's worked out really well. When you look at our overall cost base and returns, I think we're in a really good spot with that asset.

Bill Crow -- Raymond James -- Analyst

So you're running in line with expectations when you bought it, is that fair?

James Farrar -- Chief Executive Officer & Director

Yes, in line or ahead, I'd say, across the board. The renovation really accelerated kind of where we thought we would be on rents. So we were pleased with how that came together. And obviously, COVID has kind of slowed things down in the market. But as far as this transaction and others that we've been doing there, we're very pleased with the economics.

Bill Crow -- Raymond James -- Analyst

Perfect. That's it for me. Thank you.

James Farrar -- Chief Executive Officer & Director

Thanks, Bill.

Operator

As there are no additional questions, I will turn the conference back over to Mr. Jamie Farrar to conclude.

James Farrar -- Chief Executive Officer & Director

Thanks again for joining today, and please don't hesitate to reach out any time if you have any questions. Goodbye.

Operator

[Operator Closing Remarks]

Duration: 25 minutes

Call participants:

Anthony Maretic -- Chief Financial Officer, Secretary & Treasurer

James Farrar -- Chief Executive Officer & Director

Rob Stevenson -- Janney -- Analyst

Michael Carroll -- RBC Capital Markets -- Analyst

Craig Kucera -- B. Riley FBR -- Analyst

Bill Crow -- Raymond James -- Analyst

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