American Assets Trust, Inc. (AAT) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2018 American Assets Trust Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Mr. Adam Wyll, Senior Vice President and General Counsel. Please go ahead, sir.

Good morning. I'd like to thank everyone for joining us today for American Assets Trust 2018 second quarter earnings conference call. Joining me on the call are Ernest Rady and Bob Barton. These and other members of our management team are available to take your questions at the conclusion of our prepared remarks. Our 2018 second quarter supplemental disclosure package provides a significant amount of valuable information with respect to the company's operating and financial performance. The document is currently available on our Web site. Certain matters discussed on this call may be deemed to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include any annualized or projected information as well as statements referring to expected or anticipated events or results. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, our future operations and our actual performance may differ materially from the information contained in our forward-looking statements, and we can give no assurance that these expectations will be attained. Risks inherent in these assumptions include, but are not limited to, future economic conditions, including interest rates, real estate conditions and the risks and cost of constructions. Earnings release and supplemental reporting package that we issued yesterday and our annual report filed on Form 10-K and our other financial disclosure documents provide a more in-depth discussion of risk factors that may affect our financial conditions and results of operations. Additionally, this call will contain non-GAAP financial information, including funds from operations, or FFO; earnings before interest, taxes, depreciation and amortization, or EBITDA; and net operating income, or NOI. American Assets is providing this information as a supplement to information prepared in accordance with generally accepted accounting principles. Explanations of such non-GAAP items and reconciliations to net income are contained in the company's supplemental operating and financial data for the second quarter of 2018 furnished to the Securities and Exchange Commission, and this information is available on our Web site at www.americanassetstrust.com. I'll now turn the call over to our Chairman, President and CEO, Ernest Rady, to begin our discussion of second quarter results. Ernest?

Thanks, Adam, and good job as always and good morning everyone. Thank you for joining American Assets Trust second quarter 2018 earnings call. We're halfway through 2018, and we are making very good progress. We've had solid results from the second quarter as to our earnings, noting that certain of the outperformance is in large part due to the onetime termination fees, which we do not anticipate to recur in subsequent quarters. Bob will share some of the re-leasing success that we've had on the terminated space. We have published our NAV, net asset value, estimate again this year at $50.10 a share and is available on the Investor Relations portion of our website. Bob will also talk about -- more about this later. As you've heard me say before, we focus on both NAV and FFO growth. Leasing has been good. In July, we signed the lease with Safeway at Waikele Center in Oahu. We're pleased to partner with Safeway as we reposition Waikele Center. Our retail portfolio was approximately 97% leased as of the end of Q2. Our office portfolio is approximately 94% leased as of the end of Q2. San Francisco and Bellevue and Washington are -- and Bellevue, Washington are our strongest office markets, followed by Portland and San Diego. We are very well positioned in these markets. The renovation of the former Kmart building at Waikele Center in Hawaii is underway. Demolition of the former Kmart building begins this August, and we are in active discussions with multiple national tenants to fill the new multi-tenant building that will replace the former Kmart building. With respect to the renovation of one of the buildings at Oregon Square in the Lloyd District, we're currently in the permitting process, and we have signed a contract with a general contractor to commence the work in the third quarter of the year. The building is approximately 30,000 square feet and will include an open-floor plate with creative office space with more natural light. We expect this project to be finished before the first half of 2019. We also continue to focus on maintaining a low leverage investment-grade balance sheet. In addition, we believe that our high-quality diversified portfolio in high-barrier coastal west coast markets will outperform, and I think our results today confirm that. On behalf of all of us at American Assets Trust, we thank you for your confidence in allowing us to manage your company, and we look forward to continued support. I'll now turn it over to Bob Barton, Executive Vice President and CFO. Bob?

Good morning, and thank you, Ernest. Last night, we reported second quarter 2018 FFO of $0.58 per share and net income attributable to common stockholders of $0.07 per share for the second quarter. Let's start right into the outperformance for this quarter. Included in our second quarter earnings were approximately $3.7 million of termination fees or approximately $0.057 of FFO per share. The majority of these termination fees came from 2 former tenants, one at the Lloyd District, which remain current on their rent through Q2, and we were able to reach a fair termination agreement in the second quarter. That space has already been re-leased by an investment-grade tenant at a higher market rate. The new lease has a 7-year term and is expected to commence towards the end of Q1 '19. The second tenant was one of our initial tenants at Torrey Point in San Diego, and a fair termination agreement was also reached with this tenant in the second quarter. While the termination fees are a pleasant outcome for our earnings in the second quarter, if we exclude the $0.057 of termination fees, our core FFO would have still been approximately a healthy $0.52 per share in the second quarter. Moving on, the company's Board of Directors has declared a dividend on its common stock of $0.27 per share for the quarterly period ending September 30, 2018. The dividend will be paid on September 27, 2018, to stockholders of record on September 13, 2018. Our retail portfolio ended the quarter at 96.7% leased, combined with the highest annualized base rents amongst our peers. On a year-over-year basis, our retail occupancy was down approximately 10 basis points from the second quarter of 2017, leaving approximately 106,000 square feet vacant in our 3 million-plus square foot retail portfolio. A significant portion of the retail vacancy is primarily attributed to the space that has been leased to the Sports Authority at Waikele Center in Hawaii, which consisted of approximately 50,000 square feet. As Ernest mentioned, we're pleased to finally report that Safeway, as a national grocer, has signed a 20-year lease, with multiple options to extend, for the space formerly leased to Sports Authority. There is significant land work -- landlord work needed to be completed before the Safeway lease commences. We believe the landlord work will be completed and the Safeway store open -- will open in the third or fourth quarter of 2019. During the trailing 4 quarters, 70 retail leases were signed, representing approximately 200,000 square feet or approximately 6% of our total retail portfolio. Of these leases signed, 59 leases consisting of approximately 179,000 square feet were for spaces previously leased. On a comparable basis, the annual cash basis rent increased 6.3% over the prior leases. Our office portfolio ended the quarter at approximately 93.8%, an increase of approximately 510 basis points on a year-over-year basis, primarily due to the reclassification of Oregon Square into construction progress as of January 1, 2018, combined with an increase in occupancy at One Beach Street in San Francisco and our Torrey Reserve Campus in San Diego, leaving a vacancy of approximately 6.2% or 159,000 square feet of our 2.6 million square foot office portfolio. During the trailing 4 quarters, 76 new office leases were signed, representing approximately 553,000 square feet or 22% of our total office portfolio. Of these leases signed during the year, 49 leases consisting of approximately 409,000 square feet were for spaces previously leased. On a comparable basis, the annual cash basis rent increased 12.4% over the prior leases. Let's talk about same-store NOI for a moment. Same-store retail cash NOI increased in the second quarter to 5.2%. The increase primarily relates to increased rents at our Loma Santa Fe Plaza in Alamo Quarry Market shopping centers combined with the incremental NOI from the acquisition of the Forever 21 building in Q3 '17 at our Del Monte Center on the Monterey Peninsula. We own the land and acquired the building at Del Monte Center that we didn't own in Q3 '17. The incremental NOI from the Forever 21 building is approximately 135 basis points. Absent the Forever 21 building, the same-store NOI is still a healthy 3.9%. Same-store office NOI increased 13% in the second quarter, primarily due to termination fees as previously mentioned. Additionally, we saw healthy increases in the base rents at Torrey Reserve Campus in San Diego, the Landmark at One Market Street in San Francisco, and the Lloyd District Portfolio in Portland, Oregon. These increases were offset by [indiscernible] at City Center Bellevue on several existing tenants and the build-out period of newly leased space in Q1 '18. CCB is approximately 97% leased today, and we expect to see increases in base rents beginning in Q3 and Q4 of this year. Same-store multifamily cash NOI consisting of Hassalo on Eighth in Portland and our San Diego multifamily properties with the exception of Pacific Ridge was relatively flat for the second quarter, down approximately 1%. Revenues increased approximately $348,000, primarily due to higher occupancy rates. The increase in revenues was offset by an increase in rental expenses and real estate taxes. Pacific Ridge, which was acquired on April 28, 2017, will be included in next quarter's same-store calculation. Waikiki Beach Walk, our mixed-use property consisting of the Embassy Suites Hotel and Waikiki Beach Walk Retail combined same-store cash NOI was relatively flat for the second quarter, down approximately 1.5%. Broken down further, this represents the Embassy Suites Hotel down approximately 4% and Waikiki Beach Walk Retail up approximately 1.2%. The decrease in cash NOI at the Embassy Suites Hotel represents a higher occupancy combined with a lower ADR year-over-year, resulting from a softer Japanese wholesale market. At our Waikiki Beach Walk Retail property, tenant sales remain high at $1,130 per square foot for the rolling 12 months, as our tenants continue to benefit from the excellent location and good economy. Turning to our second quarter results, FFO increased approximately $0.07 to $0.58 per FFO share compared to the first quarter. The second quarter results include the following activity: first, and as previously discussed, termination fees increased FFO by approximately $0.057 per FFO share; and second, we repaid the 6.09% mortgage on Loma Palisades Apartments with a principle balance of approximately $73 million on March 30, 2018, resulting in a reduction of interest expense and increasing FFO per share approximately $0.016 in the second quarter. Now as we look at our balance sheet and liquidity at the end of the second quarter, we had approximately $379 million in liquidity, comprised of $51 million of cash and cash equivalents and $328 million of availability on our line of credit. Our leverage, which we measure in terms of net debt to EBITDA, was 6.1x. This quarter's net debt-to-EBITDA ratio benefited from the onetime termination fees received in the second quarter. Our interest coverage and fixed charge coverage ratio ended the quarter at 4.0x. Lastly, we are revising our guidance for our full year 2018 FFO per share to a range of $2.05 to $2.10 per share, with a midpoint of $2.08 per share from our original guidance of $2.01 to $2.09 per share, with a midpoint of $2.05. The increase in our midpoint of $0.03 per share is primarily attributable to the receipt of termination fees in the second quarter net of the third and fourth quarter revenue loss from such terminating tenants that were in our original guidance. As of the date of this earnings call, we estimate that third quarter FFO share will be approximately $0.49 and fourth quarter FFO share will be approximately $0.50 per share, which will result in the midpoint of $2.08 per share in our new guidance. As always, our guidance excludes any impact from future acquisitions, dispositions, equity issuances or repurchases, future debt re-financings or repayments other than what we have already discussed. One last comment regarding the NAV that we published earlier in July, which we encourage you to read together with the disclaimers as to our methodology; our NAV that we have published each year is an estimate at a point in time. It takes approximately eight weeks to complete our due diligence and discuss with local real estate brokers in each of our markets as to cap rates, unlevered IRRs, dollar per square foot, or per unit values, and recent comps. We combine that with independent brokers' opinion of values and our own knowledge of the marketplace in what we are seeing as well. We use the unlevered IRR to crosscheck third-party estimates. For our Waikele property, we have used a discounted cash flow, or DCF, model that factors in a discounted present value of cash flows during the redevelopment period in order to be as accurate as possible. Our goal is to provide an estimated NAV that we believe any individual asset could be sold for, if not more, in a private market. Last year, we published a NAV of $50.75 per share. This year we published a NAV of $50.10 per share. Our view is that AAT has a solid $50 per share value based on our NAV estimates. Unfortunately, the stock market currently has a different view as we have been trading at a discount to NAV. On the other hand, we continue to believe that it is a good long-term value for shareholders. We believe it is our job to close that gap between NAV and the current market price on the Wall Street. We are working hard on your behalf to close that gap. In our recent Analyst Presentation on our website, Page 8 reflects seven catalysts that we believe will create earnings growth over the next eight quarters. We believe these catalysts, combined with our high-quality coastal west coast assets and focus on NAV and FFO growth, will help to close that gap. We will continue our best to be as transparent as possible and share with you our analysis -- interpretations of our quarterly numbers. We're well prepared with an even -- a stronger balance sheet than in prior years to capitalize and execute on the opportunities that we believe will present themselves over the coming quarters. Operator, I'll now turn the call over to you for questions.

Thank you. [Operator Instructions] Our first question is from the line of Craig Schmidt of Bank of America. Your line is open.

Good morning, Craig.

Good morning, Craig.

Good morning. Are you finding increasing construction cost and labor shortages having an impact on the development returns and time lines?

I'd say, yes. Jerry, you want to answer that?

Yes.

Sure. I mean construction costs are rising. There are labor shortages. It takes longer to get things done and it costs more, and I don't think we're -- we have -- we're particularly suffering in that, I think the whole country is.

I understand. And maybe the planning and timing for the vacant Kmart space, when you think you might have it in shape that you could start to actively leasing it?

We're just starting -- we just signed the Safeway lease. We're just in the process of beginning demolition. We have to do that to provide the new tenants access to the space that we're creating. And the timing of that is…

Yes, for our internal guidance, we're planning on the fourth quarter of 2020. Is that…

That's correct. That's going to stabilize.

Yes, for stabilizing.

I think we're having good interest in leasing and construction is underway.

Absolutely.

Okay, thank you.

Thank you, Craig.

Thanks, Craig.

Thank you. Our next question is from Rich Hill of Morgan Stanley. Your line is open.

Hey, guys, good morning. I am sorry if I missed this in the prepared remarks, but I just want to be sure, you're not providing updated guidance on same-store NOI, or did I miss that? I came on a little bit late.

Hi, Rich, good morning.

Yes, Rich, we're not providing guidance on the same-store NOI, but we can take, I mean, our original guidance for -- on a total same-store NOI that we issued in Q3 last year was 1.9%, which was broken down, retail is 2.9%, office was flat, multifamily was about 4% and mixed use was about 2.9%. Based on what we see today, we think our best estimate for -- that we will end '18 in is we think that retail will be about the same, about 3%; office, we think will be about 3.8% versus flat, and the primary reason on that is that our initial guidance included Oregon Square and we pulled Oregon Square out. We're also going to have some pickup in the third and fourth quarter from City Center Bellevue. Multifamily, I think is going to remain the same, around 3.8% to 4%, and mixed use will be probably about where we said before. So I think that all in all, we'll, probably on a total same-store NOI basis, end up about 3%, 3.5%.

Got it. Versus the guide of -- the original guide of around 1.9%, which I think probably makes -- because if I'm doing my numbers correctly, you put up 5.9% in 1H, which would mean, if I'm thinking about this correctly, if you're going to end up at 3.5%, some deceleration in 2H. Am I crunching those numbers right?

Yes. You're crunching those numbers right.

The issue is that they're just time required for all those leases we signed to come on and that won't be till next year, and the second-half, they won't be coming on so pretty…

Got it. And Ernest, you're leading me to my next question. Our favorite property, One Market, any updates there that you can share?

I think it's fair to say that we have a building that is called Landmark and is a landmark. It's a trophy property. And that's fair to say that we have a lot of interest in leasing. I don't think -- we don't have anything we can announce just yet, but we're looking forward to the outcome. Steve, you want to add anything to that?

I think it's the best building in San Francisco. The interest level is reflecting that, and I think the [technical difficulty] reflect that, so…

Yes, that's about all we can say until there's something concrete, but that's a great question.

Okay. Well, continue to eagerly await that. Thank you.

Thank you.

Thank you. Our next question is from Michael Carroll of RBC Capital Markets. Your line is open.

Hi, Mike.

Yes.

Good morning, Mike.

Good morning. I just had a quick follow-up on the Landmark question. I guess Bob, Ernest, have you guys had discussions with Salesforce yet regarding what it would take to terminate that lease? And what's the biggest hurdle right now, I guess, given the activity in San Francisco is very strong? Is the hurdle now Salesforce?

I don't know that we can comment. I think those discussions have been on a confidential basis. And until we have something concrete, I'd be reluctant to say anything. Adam, Steve, do you want to add anything to that? Just lots of discussions, lots of activity, and I'd hate to say anything that becomes a promise and then we [technical difficulty] but we're very optimistic that the outcome will be favorable for our AAT standard…

On the landmark building, we can't get granular on it at the current time, as you realize in place is significantly below market. And then the other point is that not only is it a terrific location and great building in the current interest of millennial creative office space, it is also, I believe, the last contiguous 100,000 what -- over 100,000 square feet of contiguous space that's available in San Francisco. Is that fair, Steve?

Well, it's clearly one of the few. And it's -- the total space is to 254,000. And so yes, there are just a handful of those spaces left.

Lots going on.

And what's you desires? Is your desire to break up that space to lease it to multiple tenants? Or do you want to find one large tenant to take that whole block down?

You know, Rich, we'd to find the biggest tenant who will pay us the most rent, or the largest number of tenants who will pay us the most rent who have good quality. I think that the conclusion you should arrive at should be governed by greed, which we are long on. We'll do the best we can.

Okay, great. And then my final question is, can you talk and describe the leasing activity you're seeing at Torrey Point and Torrey Plaza? Do you still expect that you can get some leases signed by the end of the year?

Steve would answer that, but I think we will.

Yes. And we have one lease with a very high credit tenant that's being finalized right now for another 13,500 feet. And we have another 10,000 foot tour happening today. So the interest level, especially post Tsunami, has been very strong, and we're seeing people willing to pay the premium for that setting. And so we're encouraged by that. Like I said, we got one ready to go and numerous others suitors that we're hoarding. So we're feeling good about it.

I think you wanted to characterize you'd say slow but steady, and slow but steady wins the race, and I think we're going to be fine. It's just taken a little longer than we wished. And of course, the office rental market in San Diego is not San Francisco or Bellevue, but it's certainly nothing to sneeze at.

Okay, great. If you sign those leases by the end of the year, how soon can those commence? I mean what's the build-out time for those spaces?

The current lease, the rent commences on the lease we have in place, September 1. The contemplated commencement date of the lease out for signature is June 1 of '19.

Great, thank you.

Thank you.

Thank you. Our next question is from Haendel St. Juste of Mizuho. Your line is open.

Hey, good morning.

Good morning, Haendel.

Ernest, last quarter, you mentioned you were open, at least opened conversation, perhaps, of a potential asset sale that helped de-lever. Curious what your mindset here is today? Is there an update? Have you engaged -- a broke had any discussions, or perhaps as you're thinking about change given the bit of the revaluing of your stock over the last six years?

Handel, what governs us is an acquisition, which would be more beneficial to our stockholders than something we own. We haven't really found anything yet, and we really only have 1 property, which I would not characterize as a long-term keeper. The things that we have are so difficult to find and replace. So we keep looking, but we don't have anything that's impending at the moment.

Okay. And so assuming that you don't sell any assets here, Bob, where do we expect the debt EBITDA by end of next year? Is 5.5 still a viable target absent a disposition?

Yes, it is. I mean, you have to take a look at what's going on. If we complete those seven catalysts that we have referred to over the next eight quarters, we think that, that will increase EBITDA by approximately 10%, which should take a -- we should have a significant impact on the net debt to EBITDA.

Of course, I always think about the EBITDA being a quality factor too, and we have the highest quality assets and that makes them less cyclical. So I know from a public perspective that they'd like to have us at the level that is consistent with the rest of the industry but from a practical point of view, our high-quality assets in my mind at least allow us to have a slightly higher ratio and still be very, very sound and secure.

But even -- yes, I absolutely agree with being sound and secure in Ernest comments, but Ernest, the board and management are all in agreement that we want to get that -- net debt to EBITDA down. And we don't like it in the mid-6s. We want it down to 5.5 or less.

And of course, the discussion is that the quality of the assets will eventually bring us to that without doing anything. That would be short-term beneficial but long term and negative by selling something.

Got it. Okay, I like that. Okay, couple of quick follow-ups or clarifications. Bob, first, I guess on the lease termination, you mentioned you already lined up a replacement office tenant, importantly with a higher rate, but I didn't catch the update on the replacement tenant in Torrey. Is there already someone lined up, and if so, how are the rate compared to the prior?

Are you talking about the replacement tenant in Torrey or Torrey Point?

Torrey Point.

Yes. Torrey Point, Steve, why don't you talk about that? About where we are with the…

This is tied to the lease termination fees. So the tenants you referred to as being responsible for the lease term fees just was curious on where you were with replacing the tenant in San Diego?

At Torrey Point?

Yes. Yes.

So Tsunami was like roughly 30,000 feet. This replacement tenant, if you will, is 13,525 with other prospects in the same time frame that would fully replace Tsunami, and the weighted average rents are going to be roughly the same as what we have.

I think I characterized San Diego earlier as slow but steady, and we think that will win the race. But we -- in San Diego, we didn't have an absolute replacement. On the other hand, we got a termination fee, which eases the pain as we strive to re-lease that building out.

Haendel, so the tenant that left and paid the termination fee -- so let me back up a minute. Currently, we have a lease signed with 1 tenant for about 13,000 square feet.

16,000 feet.

16,000 square feet, which is about 17% of the building, and then, Steve is in discussions -- we're down the road with 1 tenant that we hope will finalize that lease and bring him in. That will bring us up to about 32%. And then, I think what's even more important though is that with those 2 tenants, it really validates the location and the beauty of that particular building.

Okay. And then lastly, you mentioned Safeway will be moving in to a space in Waikele in the back half of next year. Is that when the rent will commence as well or is that more early 2020?

I think it will commence in Q4 of this year.

Yes. We expect -- on Safeway, we expect probably in the fourth quarter of '19, be late in the late third, beginning of the fourth when the FFO starts. The cash will be shortly after that.

About 90 days after.

Yes. About 90 days after that.

Okay. So it sounds like early 2020? Okay, thank you.

Yes. Thank you.

Thanks, Haendel.

Thank you. Our next question is from Mitch Germain of JMP Securities. Your line is open.

Good morning, Mitch.

Thank you. How are you?

Good. How are you this morning?

Fantastic. Oregon Square, just -- I believe there are still tenants in there, and you're still receiving income. But maybe where does that stand? And then your thoughts about going and doing the work ahead of securing some sort of lease.

Okay. There's four square city blocks. One of them, we have the entitlement to build 600-plus units. Rents have been flat in Portland and construction costs have escalated. So we've got that on hold. The building that we're going to rehab has no tenants in it. And we've had some interest in it, but we don't have any signed lease with -- for it now. But I think that once it's -- and we've just started to market it. And I think once it's ready, it's going to be an attractive opportunity for somebody -- or some people to occupy.

Got you. And then…

And then -- and one more square block is we're getting shoveled ready in case we do find an anchored tenant for an office building. So we're actively working that entire four blocks.

Mitch, the tenants in those buildings -- on those 4 blocks, we've purposely de-leased or did not renew the leases in those buildings. And we started that about 2 years ago, and it's been empty for about a year now.

Got you. Does the type of product -- that creative office product, is there a lot of similar space in Portland or are you really trying to create something that is lacking?

I think in the Lloyd District, there is substantial interest in office of that type. And of course, there's no shortage of office space anywhere perhaps other than the other 2 we've mentioned. But we think that in that location, that product would be attractive to tenants. Steve, do you want to add anything?

Nothing.

Okay.

Last one for me. Bob, with that same-store guidance of 3% give or take for the year, was that including the term fee or is that excluding the term fee?

That would be including the term fee.

Got you. Thank you.

Thank you, Mitch.

Thank you.

Thank you. And that does conclude our Q&A session for today. I'd like to turn the call back over to Mr. Ernest Rady for any further remarks.

Thank you, guys for your interest. We continue to work to enhance the value of our properties and our stock. And we hope at some point, we get the recognition that we deserve. In the meantime, we continue to do the best we can for you. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone have a great day.