Franklin Street Properties Corp. (FSP) Q4 2007 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the fourth quarter 2007 Franklin Street Properties earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Scott Carter, General Counsel. Please proceed sir.

Good morning everyone and thank you for participating in this call. With me this morning are George Carter our Chief Executive Officer and John Demeritt, our Chief Financial Officer. Before I turn the call over to John, I must read the following statement. Please note that various remarks that we may make about future expectations, plans, and prospects for the company may constitute forward-looking statements for purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements. As a result, the various important factors including those discussed in Item 1A, Risk Factors of our annual report on Form 10-K, for the year ended December 31, 2006 which is on file with the SEC. In addition these forward-looking statements represent the company’s expectations only as of today, February 20th, 2008. While the company may elect to update these forward-looking statements, it specifically disclaims any obligation to do so. Any forward-looking statements should not be relied upon as representing the company’s estimate or views as of any date subsequent to today. At times during this call we may refer to Funds from Operations or FFO. A reconciliation of FFO to GAAP net income as contained in yesterday’s press release which is available on the Investor Relations section of our website at www.franklinstreetproperties.com. Now I will turn the call over to John Demeritt. John?

Thank you, Scott. Thank you all. Welcome to our earnings call. We’re happy to talk with you about our fourth quarter and year-end results and what I plan to do is to show an overview of the results and then afterwards George Carter, our CEO, will further discuss FSP in 2007. I’m going to be brief and be referring to the earnings release that went out last night. As we said before, we view our performance over the longer term rather than on a quarter-to-quarter measure because two key drivers of our business are transactional in nature. And those components are Investment Banking and Gains on Sale of real estate which we call GOS and both of those can be quite choppy. That said, for the fourth quarter of ’07, we had net income of $9.4 million and EPS of $0.13 per share and for 2007, the full year, we had net income of $61.1 million or $0.86 a share. We measure performance of properties we own and Investment Banking through our FFO measurement which for the fourth quarter was $18.6 million or $0.26 per share and for the full year we had $75 million or a $1.06 per share in FFO. Our Gains on Sale or GOS results included a small $250,000 gain in fourth quarter of ’07 which was for a property we sold in Austin, Texas and it really amounted to less than a penny and that compares to a $27 million gain in the fourth quarter of ’06 which was about $0.38 per share. On a full year basis, we achieved $23.8 million in GOS or $0.34 per share compared to a $61.4 million gain in ’06 for the full year and $0.91 per share. We combined FFO and GOS and we consider this number to be our total profits. For the fourth quarter, we achieved total profits of $18.8 million or $0.27 per share and for the full year we had FFO and GOS of $98.8 million or $1.40 on total profits per share. This total profit of $1.40 exceeds the dividend that we paid per share over this period of $1.24 and reflects about an 89% payout ratio. Each of these metrics were lower in 2007 compared to the respective 2006 periods. The reason for the decreases are primarily three… the main reasons I’ll list them out. In 2006, we had recorded about $7.5 million in termination fee income while in 2007 we had about $250,000 in termination fees. Termination fees cause a blip when it’s received by a company as we lease the space which can have some period of vacancy and performance is comparatively lower while we’re trying to lease that space and leasing economics can affect that. This decrease was partially offset by the benefit of cash flows from properties that were merged or acquired in the last year and the impact of some vacancies and a good chunk of that was leased up in the fourth quarter. These factors affected the comparison of net income, EPS, and FFO for 2007 compared to 2006 and it reflects what’s happening in the real estate and the debt markets particularly in the last half of ’07. The second reason was our real estate segment. With our real estate segment was GOS which was for 2007, $23.8 million or about $37.6 million lower than what we had last year. This also affected net income, EPS and our FFO plus GOS measure for ’07 compared to ’06. The third reason is related to Investment Banking. We earn a piece from this business based on the value of shares we sell in private placements. For the quarter, we sold shares of about $28.3 million compared to $70 million in the fourth quarter of ’06. For 2007, we were also behind last year’s pace but on a full year not as significantly. We sold shares at a value of $147.5 million for the full year compared to $170 million for the prior year. George will be talking more about this as we broaden our external factors in the market affected our sales in the second half. These two decreases combined are the primary differences comparing 2007 results to 2006 with some non-cash expenses affecting net income a bit more. That covers our financial performance and the press release goes into further detail about our results. We expect to have our 10-K filed at the end of this week or early next week as well. And I also wanted to point out that our press release has some supplemental schedules including some new information about single-asset REITs. We invest in 3 of these and manage all 12 of them and there’s some data in there about them. There’s also some data about our current owned real estate portfolio, if you’re interested. That concludes the financial highlights and at this point our CEO, George Carter, will tell you more about the quarter and where we are. Thanks for listening.

Thanks, John. Good morning everyone and thank you for taking the time to listen to our 2007 year-end earnings call. As always, I encourage you to read my written comments in our earnings release because hopefully they put some form and context to our numbers, tables, and charts that make up the bulk of the release. As John said for the full year 2007, FSP’s total profits as represented by Funds from Operations (FFO) plus Gain on Property Sales or GOS, totaled approximately $98.8 million or $1.40 per share. Dividend distributions paid for the full year 2007 totaled approximately $87.7 million or $1.24 per share. 2007 was a year that really had two distinctive halves to it relative to FSP’s businesses. The first half of the year both of our transactional businesses, Investment Banking and property sales, were very productive. Investment Banking activity during the first half of 2007 totaled $109 million, one of our strongest first halves ever. Within the second half, equity sales from this division fell to only $38 million. Property sales during the first half of 2007 produced gains totaling approximately $21.5 million while dramatically reduced property sales during the second half of the year only produced gains of about $2.3 million. Clearly the credit crunch and unsettled investment markets negatively affected these two businesses and were the largest factors in FSP’s drop in total profits from $2.13 per share in 2006 to $1.40 per share in 2007. Our ongoing recurring rental income component of our business remained solid during the year and in a relatively significant lease roll and property-repositioning year, we were able to increase our real estate portfolio’s occupancy from about 89% of the start of the year to over 93% at the end of the year. As we end 2007, FPS has no property secured permanent mortgage debt on its portfolio and is in an excellent position to take advantage of any potential real estate acquisition opportunities that may arise from the current dislocations in the credit, mortgage, and commercial real estate markets. We view the current capital market environment as a potential period of opportunity to acquire quality core office properties at excellent values. In many cases, investment competition for such properties has thinned out significantly because of the credit crunch. In a change from past practice, FSP will now consider using its balance sheet strength to help finance property secured borrowings to fund new acquisitions and thus begin to create a moderately leveraged larger real estate portfolio. The commercial real estate cycle and interest rate loan cycle has changed. FSP is likely to sell fewer properties in this type of environment and thus experience less Gain on Sale or GOS. Our portfolio of properties is now large enough and of the quality to conservatively leverage a favorable permanent mortgage debt. The objective of raising capital in this way will be to acquire Class A office buildings that provide positive rent-to-debt constant spreads. The goal is to increase the size of FSP’s property portfolio and to increase rental FFO while keeping relative risk and reward in balance. We are excited about the opportunities that may present themselves to us in 2008 and the financial position we find ourselves in to take advantage of it. With that I would be happy to open the call for questions.

Your first question comes from the line of Eric Anderson. Please proceed.

Good morning George and other members of the management team. I was wondering if you could just quickly define for us a moderate level of debt referred to in terms of percentage.

I think, this is George, Eric, if you look at most of the office rates in our category or our comparable group, you’re finding mortgage leverage of anywhere between 35% and 45% and I think that is a range that we would look at, ultimately. What you have to add to that equation, however, in most office rates is you have to add at least not a draw on the properties but a draw on cash flow, preferred stocks and their call on the cash flow ahead of everything else. We do not have any preferred stocks at this point in time. Our total ownership is evidenced only by common. It is not a current plan, and underline the word current plan, to issue any types of preferred so if we’re talking about mortgage leverage, permanent mortgage leverage, ultimately of maybe between 35% and 45% at this moment in time, that would be our horizon without any preferred stocks or other calls on cash flow in the equation.

And that would be on a specific property that’s acquired as you go along?

Well…

One at a time?

Yes, one at a time, for sure. And the bigger question is what can we acquire and what kind of values can we acquire it at and what kind of terms and rates can we finance that. If you look at the markets today, you would believe as I think we do, that there’s more opportunity today on the pricing side of acquisition than there’s been for the last few years. On the financing side, interest rates are coming down but long-term permanent financing, while still available, is definitely requiring more traditional loan-to-value ratios, loan-to-cash flow ratios, principal amortization, et cetera. So in that arena, what exactly can be done at any moment in time on any specific property will reflect the market. We do have, though, in addition to properties to acquire, we have an unleveraged portfolio of properties that exist that have tremendous loan potential against them as well. And so our potential cash availability through simply leveraging the existing portfolio, as well as the newly acquired property, can be fairly substantial, could be fairly substantial, and could easily bring us without much consternation into this 35% to 45% relative leverage level.

Have you seen any transactions from across your horizon that are up to a point now where you’re almost ready to start buying?

We’ve been looking at a lot of things and it is us being out on the field, on the ground that has said to us this is the time to do this. Maybe it’s appropriate just to take a quick step back and gives a little more context to this. FSP is, if you look at our predecessor firm, really started this business about 15 years ago, in about 1992, ’93 when a lot of the equity we’ve got going. We did not start, however, with a portfolio of properties. We, for the first two-thirds of those 15 years, were buying one property on a line of credit and then financing it out with equity. These individual properties were owned in individual entities and therefore we did not have a portfolio that was large enough and combined and diversified enough to really risk reward adjusting, warrant leverage. In the last third of our existence here we did do a series of mergers and ultimately listed our company on the American Stock Exchange and became public, and at that time we did have enough properties put together to form what is now FSP to have a diversified portfolio. However, at that point in time, our view of the real estate markets were that they were fairly heated. Competition for all properties was tremendous, prices were soaring, cap rates were dropping, financing was available anywhere you looked, underwriting standards and financing standards were relatively lax. And our feeling was, rather than keep all of our properties and lever off and try to compete, to buy properties in that environment a smarter, longer term view would be to sell into that environment and that’s exactly what we did. And we specifically sold a lot of our properties that we felt were smaller, inefficient for us to run, were early properties in many cases that had single tenants or again had a higher level of risk to them, that were getting pretty fantastic cap rates and prices, and we sold into that. We made a lot of profits doing that over the last few years and we invested the bulk of those profits as well as all of the principal into new properties that were, in most cases, much bigger, multi-tenant infill, more core-type locations. In other words we really took the last few years of a fairly heated market to improve our portfolio and we really think we have improved the portfolio. Now the consequence of that over the last few years has been a profit stream from transactional GOS which the broader markets certainly did not consider as attractive as leverage rent FFO from a diversified portfolio. But again our view of the market was, it was a good time to upgrade the portfolio and we took that opportunity and kept to our discipline, and kept our balance sheet pristine and ready to go if this cycle turned which we always thought it would, we never quite believed in the new paradigm theory. And so here we go, the cycle has turned, and we don’t know how long it will be or how deep it will be but there clearly is opportunity now to buy real estate at a better price we believe with less competition and financing is available at attractive rates if you do it conservatively and have a good balance sheet. So here we are in that environment and for all of our shareholders who have always liked the no-debt model, the no-debt model was always relative to risk and reward in our view of the capital markets. Certainly moderate leverage in a diversified, quality portfolio can increase, potentially FFO. And I think, when you look at us going forward assuming that we can make acquisitions and finance those acquisitions the way we believe this part of the cycle will allow us to, again you’re likely to see our profit stream shift from the transactional GOS portion to more of an increasing FFO portion although the FFO won’t have a leveraged rent component to it. The Investment Banking business will always be transactional regardless of the real estate markets but we have properties we’re looking at now but we have nothing under formal agreement at this point and as soon as we do, of course we will of any consequence, we will either announce it in press release or in a quarterly release.

Similarly, the way you don’t feel pressure to sell property just to make a quarterly number. I would assume that you also don’t feel pressure just to rush out and buy things now that prices are a little bit cheaper if you don’t really feel it’s the ideal complement to your portfolio. Is that correct?

It is correct. And I don’t know if you read the Journal, they’re talking about the GM building, the highest priced for any single building in the country ever. I mean the real quality, Class A properties and Class A locations, we are not seeing so much the prices fall dramatically or cap rates rise dramatically. We’re just seeing less competition for them and the ability to buy them more intelligently. Now in the B properties or the suburban non-land constrained markets, we are seeing prices drop there a bit and again a lot of the properties we sold over the last few years were in markets and were properties of that type which I, again really got recycled into more infill and more core-type locations. So we’re in no hurry to buy but we are actively, and I mean very actively, on the acquisition trail with the power that sits on the balance sheet.

Good, thanks very much.

You’re welcome.

And your next question comes from the line of Michael Burke with Mutual Fund Management. Please proceed.

Yes, hi Mr. Carter. I’m Michael Burke. How’re you doing, sir?

Good, Michael.

I was just curious. It appears that you may be going from an income rate to a growth and income rate. If that be the case, how do you think that will affect your dividend, looking out of the next couple of years? I noticed in the last quarter of ’07, FFO was $0.26, dividend was $0.31. So I’m a little bit concerned about the dividend and what’s going to happen in the future.

I hear ya. I certainly can’t give you a prediction of what the dividend will do and I have to say and absolutely the case that every quarter our Board of Directors decides on what the dividend will be, whether it will be kept the same, raised, or lowered. I can tell you though our philosophy of the dividend which I think is important to understand. We made, over the last few years, some fairly sizeable profits each year by selling some properties into this hot real estate market. Rather than pay out as a special dividend, higher dividend, those profits, we through 1031 exchange mechanisms, we invested the bulk of those profits into new profits with the specific thought and idea that there may be times in the future where gain on sale would be less, consequently profits less, consequently we might not cover the dividend from current operations for some period of time and that is baked into the longer term play. If you were a private, non-public company what you might have done is paid out the gains as a larger dividend when you got them and when you don’t have them you might lower the dividend. As a public company, the philosophy here has been to maintain the dividend and only reduce it if and when by holding the dividend you thought it would financially impair the future of the company and to only raise the dividend when we believe that we can hold that raise over the long haul. Those are philosophies which we look at all the time in which the company is built around and that while it doesn’t probably directly answer your question Michael it is something that has been planned for. And so in the context of the markets and the future economy and what we’re going to face which the question no one knows over the coming months and years, we feel like we’ve got a very, very stable situation of the company and a very balanced situation but of course no one sitting here today can tell you what’s happening next month or next quarter or next year, we take it as it comes.

Right but it appears that you all have done a wonderful job on managing the dividend over the years, as you’re just saying. One last question, the stock, any stock buyback will be planned in the future or is that hard to call?

We have a stock buyback plan. We did buy some stock in ’07. How much we buy, going forward, will depend on a variety of things. One of the concepts that I think is important to understand in, particularly as it relates to FSP, but I guess almost any real estate company that’s looking for growth, is that anytime you buy stock you are effectively taking cash, buy stock. And while you can maybe at that moment, if you buy our stock at our price now with the dividend where it is, improve FFO, you’re sort of reducing assets in a way. Now you’re increasing FFO per share but long term what you really want to do is you want to add properties to the portfolio. And properties that increase NOI, cash flow, and create better future borrowing power and better loan-to-value is really the way REITs grow. Buying back a lot of shares, while being attractive at certain prices conceptually, and I’m just talking conceptually, sort of contracts the potential long-term growth of the company until when and if you could actually go back to markets or public markets and issue new equity to acquire new properties. But in that case you’re really sort of betting on a market that would allow you to do that in that future at a better price than the stock you’re buying back today. That’s just a concept but it’s one that I think shortly relates to FSP now as we go into a property-growth mode but probably relates to most companies, in REITs in particular.

Okay, great. Thank you, Mr. Carter. I think you guys do a wonderful job. Thank you very much.

You’re welcome.

And your next question comes from the line of Bill Ford. Please proceed. Bill Ford – Analyst : Hey guys, how are ya?

Hey Bill.

Hey Bill. Bill Ford – Analyst : Hey, just a couple of things to run through. One was looking at the gain on sale on the property in Austin generally seems as a percentage of the book value you got, see a little bit bigger gains on sale, at least have recently. Was the Austin property just a small property or was the ultimate sort of gain that you were able to realize on it smaller? And if so, what do you think was going on there?

It’s George, Bill. It was a fairly small property we bought a while ago but fundamentally it’s a property that just hasn’t done up to expectation. Bill Ford – Analyst : Okay.

It was one of those properties that when we bought it that time, again when we formed the company, our capital resources were what we could raise and so we bought a number of smaller properties. Bill Ford – Analyst : Okay.

A lot of those properties have been the properties we’ve sold but we are an investment firm. We’re a real estate investment firm and I don’t view us a lot differently than people that invest in stocks or mutual funds or anything else. When you have properties that are underperforming or not coming up to expectation and you don’t believe for some reason that you can get them there, the best thing to do is to sell them. Bill Ford – Analyst : Absolutely.

That was one of those. Bill Ford – Analyst : Absolutely. Also can you guys give an update on the properties you were repositioning on the lease up of those and where you’re at on that?

Are you probably referring to the property… we have two properties in this Greater Seattle area which is still struggling to lease up the exact percentage, I don’t have the form with me right now, I know we have some active leases going there and we’ve completely, physically repositioned the property. Bill Ford – Analyst : Okay.

And the Seattle market is pretty strong. This particular property is down in the Federal Way SubMarket which is south of the airport, sort of north of Tacoma and this property required a lot of physical repositioning which has been completed. The property looks terrific. The market there is pretty darn good. We’ve got good activity. We signed several leases there. We’ve got occupancy rising, I don’t know the exact percentage right now. The other property is in Silicon Valley, it’s actually on Montague Expressway for those of you who know Silicon Valley. This was an older property that was net leased to one large tenant. The tenant was actually Novellus and when we bought the property we knew Novellus would be leaving at the end of the lease. They were occupying a larger place at that time but we bought it at a good price per square foot and always thought about repositioning. There are two buildings there, one very large almost industrial-type of building and one smaller building that had been built up. We completely redid that property and the larger building’s 100% leased, the smaller building’s about 50% leased. So in that property, we’re about 75% to 80% leased and occupied now. Bill Ford – Analyst : Okay. You guys are pretty happy with the rates you’re able to realize in that market?

Absolutely, Silicon Valley is one that’s been real good to us. We’ve been there for a long time with the number of properties that we’ve owned and done very well. This property’s location and its land area is pretty fantastic for that market. A lot of what’s happening in that market now is they’re starting to build more vertical. Bill Ford – Analyst : Okay.

And one of our views of this property, much longer term, is the ability to go vertical at the site. It’s a really great site for that and I think there’s somewhere, long-term down the road, is another repositioning of this property that could add a lot more value. Bill Ford – Analyst : Okay. Switching gears a little bit as you guys talk about the debt that you’re willing to take on now in order to finance an expansion. I mean is this something where you would also look at the cycle turns back again and terms get too easy and competition heats up, would you look to reduce this again and try and sort of do this time after time to pull back as it heats up and use the leverage as you see opportunities in the cycle or…

The general answer is yes. We believe in cycles and we believe in taking advantage of cycles. Again, the way we started without any properties and no tax consequences and no up REIT format or anything, we’re pretty flexible. We anticipate, however, that as the portfolio continues to improve and we have more core assets with longer term credit leases, multi-tenant, infill type of locations that some type of longer term permanent debt on the portfolio that leverages the FFO, will most likely always be there in some form. It may shrink or rise depending upon the markets but to go back necessarily to all cash as we continue to improve the portfolio may, in fact, not be the case. Bill Ford – Analyst : Okay. And I guess the only other question I have would be just looking in the fourth quarter at the level of repurchases you guys have talked about it on the third quarter call, as the caps came off, the timing of the announcement, you might be doing some more. Was the level of repurchases driven more by constraints on cash or your discretion like you’re talking about wanting to keep the cash there for future opportunities. What was holding you back in the fourth quarter there?

I think from a concept point of view, it’s just what we talked about, that we watched…come mid-summer you started to see this change in the markets, we sort of thought this was coming, we thought it’d gotten a little too frenzied. We certainly wanted to watch and see where things were going. As things continued to unfold, we became more and more convinced that this was a fairly significant and potentially longer term cyclical change that we’ve been looking for. To say that we may have bought back more stock if we had not seen this change and not planned to grow the portfolio through leverage is probably a fair statement. But having seen and sort of got confirmation of what was going on in the market and making the decision at the board level to now take advantage of our better portfolio and leverage them to hopefully a better acquisition market that did temper stock repurchase. Bill Ford – Analyst : Okay, thanks a lot guys.

Okay Bill.

And your next question comes from the line of William Griffin with WMG Company. Please proceed.

George, this is Bill Griffin.

Hi Bill.

You mentioned what you hoped to do with those partnerships that you haven’t yet unfolded in if you’re going to leverage and buy some more properties, why don’t you buy those properties from us?

Well, we may is the answer. All properties whether they’re properties that we have syndicated or outside properties certainly are fair game for us to take a look at.

Aren’t they good properties?

The properties that are syndicated in single-asset REITs, we have as you know in the past merged a lot of them in and with and into the company with the company’s stock price where it is right and a variety of other factors, that doesn’t seem to be the best course of business. Most of those properties that we syndicated in outside REIT structures, one of the important concepts to understand in the REIT structure is, one, the ability to escape double taxation to the REIT structure but the other is the safe harbor of not selling properties in the open market too soon. And that is to say there’s a general safe harbor that protects your REIT structure and your tax flow through of approximately four years. And so many of our single-asset REITs are now approaching this four-year safe harbor where we can sell properties in the open market, if that’s appropriate, if we believe that property is positioned to do so and fall into the safe harbor. To understand what happens if you sell a property out of a REIT before four years, you can be deemed by the service, the IRS, to be “a dealer in property” and the penalty if you are deemed to be a dealer is literally a 100% tax on the gain. So when you merge stock-for-stock you don’t have that problem. When you sell the property in the open market, you really have to look at this four-year horizon. So we’re coming up now on a lot of our single-asset REITs on this four-year horizon and property-by-property, single asset REIT-by-single asset REIT, we certainly may look at what the market offers in terms of opportunity and certainly plan to take advantage of it for those shareholders if the market is right at that time.

And George another question. You can buy your stock back at only 10% yield today and if there’s any future for this business, I cannot imagine what real estate property you can buy that would appreciate more than your stock should.

I hear you, Bill. I commented on that earlier.

No, but I didn’t find the answer satisfactory.

Well, again, we could take all of our borrowing power. If you look at our balance sheet on the earnings call, I think there’s $46 million of cash on the balance sheet. We could take all of that cash and all of our borrowing power and go buy the stock and get the 10% yield and we’d have no more cash and no more borrowing power. So we really couldn’t grow the portfolio at that point in time. So, again, you’d have a higher FFO per share and you’d say but you really couldn’t grow the portfolio longer term. Where that would work is if by getting a higher FFO per share just by not paying the dividends to the stock you retired, your stock went up in value and then you could issue new stock at a higher value, you might really clean house doing that. But if your stock didn’t go up in value because the market said, “Well you don’t have enough cash. You don’t have enough borrowing power to grow.” And long-term growth regardless of what your current FFO per share is, is really what I’m going to give you a multiple on then you’re slitting your own throat to take a lot of money and buy back a lot of stock. I don’t know if that was a satisfactory answer but that’s the way we’re looking at it now, that’s for sure.

It sounds to me as though you don’t expect the stock to be selling at a higher level?

Well we don’t control where the stock trades or…

Whatever you do you have to put…

In the marketplace on any given day and to make a bet on the future of the company relative to where the stock may trade in the marketplace is…

If the stock is not going to sell higher why do you want to grow it?

We want to grow it to get the stock to sell higher, that’s our objective.

A year ago, you thought it was the best time ever to buy things. It turned out to be the best time to sell things.

Well we sold a lot of properties over the last few years.

Hey, since I ended this business at the Baton Rouge apartment house deal, there are a lot of changes in your attitude towards how you’re going to manage it. And so far those changes haven’t produce any of the gains that we were supposed get from having escalation in the leases, higher dividends. Very discouraging.

You don’t have to comment on that.

But if you have a question, I’d be happy to answer it.

I’m through. Thank you.

You’re welcome.

This concludes our question-and-answer session. I would now like to turn the call over to Mr. George Carter, CEO, for closing remarks.

Thank you everyone for tuning in on the call. 2008 will be a very interesting year, I think very exciting for the company. And I wish all of you the best and look forward to talking to you next quarter.