Whitestone REIT (WSR) Q2 2013 Earnings Report, Transcript and Summary

Good day and welcome to the Whitestone REIT Second Quarter 2013 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Suzy Taylor, Director of Investor Relations. You may begin.

Thank you, Melanie. Good morning and thank all of you for joining our conference call this morning. Joining me on today's call will be Jim Mastandrea, our Chairman and Chief Executive Officer; and Dave Holeman, our Chief Financial Officer. Please note that some statements made during this call are not historical and may be deemed forward-looking statements. Actual results may vary -- may differ materially from those indicated by the forward-looking statements due to a variety of risks and uncertainties. Please refer to the company's filings with the Securities and Exchange Commission, including the company's Form 10-K and Form 10-Q for a detailed discussion of these risks. Acknowledging the fact that this call may be webcast for a period of time, it's important to note that today's call includes time-sensitive information that may be accurate only as of today's date, August 6, 2013. Whitestone's second quarter earnings release and supplemental data package have been filed with the SEC, and the Form 10-Q will be filed shortly. All will be available on our website, whitestonereit.com, in the Investor Relations section. Also included in the supplemental data package are the reconciliations from GAAP financial measures. And with that, let me pass this over to Jim Mastandrea. Jim?

Thank you, Suzy, and thank you all for joining us on our call today. Today, we're going to review our second quarter results and update you on the recent progress of our initiatives. Dave's portion on our call will focus on our financial results, and the overall strong position, trends and Whitestone's financial position. As we have stated previously, we are focused on increasing long-term FFO value per share. We do this by extracting the intrinsic value from the assets we own, leasing, redevelopment and helping our tenants grow their business by acquiring accretive assets in high-growth target markets, by lowering our overall cost of capital through debt refinancing, by initiating our first development project on land we own and by strengthening our management team as we increase the economies of scale and continue our growth. Now I would like to review the progress we've made and highlight some of our accomplishments. FFO-Core increased to $0.26 per share in the second quarter, up 8.3% from the first quarter, and up over 13% or $1.8 million from the same period last year. The book value of our real estate portfolio increased to $482 million, up 58% or $177 million since June 30, 2012. We now own 55 Community Centered Properties located in Houston, Dallas, San Antonio, Phoenix and Chicago, totaling approximately 4.6 million square feet, and we have 1,200 tenants, 70% of which are small businesses whose services target their surrounding local communities. We focus our attention on transforming properties to lease to tenants that meet the community, ethnic and demographic profile and needs. And we continue to add programs and processes that will provide increasing returns in the coming quarters and years by lowering overall cost of operations and increasing profit margins. These initiatives sharpen our competitive edge at each…

Thank you, Jim. I will start by reviewing our balance sheet, our financial position, then turn to a review of our key operating results and conclude with a few comments regarding our outlook. During the quarter, as Jim stated, we continued to strengthen our balance sheet by adding high-quality acquisitions, resulting in growth of our booked real estate assets by 18% or $72 million from year end, and by 58% or $177 million from 1 year ago. The acquisitions for the quarter were funded through the assumption of a 3% fixed-rate loan with 3 years of remaining term and from our corporate level, unsecured revolving credit facility, which had an effective rate of 2.2% as of quarter end. During the quarter, we continue to improve our overall weighted average cost of capital through the addition of low-cost debt. The addition of $49 million in debt in the second quarter brings our debt leverage, as a percentage of total market capitalization, to a modest 48%, up slightly from 45% as of the end of the first quarter. Our weighted average interest cost was 3.8% as of quarter end, down 600 basis points from 4.4% at the end of the first quarter. Our total market capitalization is now in excess of $500 million, up $225 million from a year ago. We have continued to move toward a more unsecured balance sheet with our pool of unencumbered properties, that is properties without secured mortgages, increasing to 27, with an undepreciated cost bases of $256 million. Let me touch briefly on our 2013 debt refinancing efforts. In the second quarter, we refinanced the mortgage loan on our Pinnacle of Scottsdale property with a $20 million CMBS loan. The new 10-year loan is non-recourse and has a fixed interest rate of 4.3%. Proceeds from this…

Thank you, Dave. As we look to the future, Whitestone's prospects are very exciting. Our core strength is our people, and we seek and retain only those who've demonstrated a passion and the desire to continue to hone their skills for the real estate business within the Whitestone culture. We train, educate and provide the necessary tools for our associates to be successful. Specifically, our in-house training and development program of people allows us to meet our growing needs and effectively service our tenants. Our strong results and progress this quarter are a result of our working together towards a common goal of increasing shareholder value. We remain committed to advancing our strategy and unique business model, and capturing the embedded cash flow or intrinsic value in our portfolio. In closing, I would like to thank you for your continued confidence and support, and the privilege that I have to lead Whitestone. With that, I would like to conclude the review of our results and open it up for questions. Operator, I'll turn it back to you.

[Operator Instructions] We'll take our first question from Paul Adornato with BMO Capital Markets.

You guys mentioned a couple of times, starting some ground-up developments, developments of out parcels. I was wondering if you could describe what's in the near-term pipeline, and also what types of risks you're willing to accept in your ground-up developments.

Great. Good question. The first parcel we're looking to start is called Pinnacle 2. It's adjacent to our Pinnacle center, where we have a Safeway and a Starbucks. Starbucks wants to expand and they want to have a drive-thru, so we're going to start the development of the property next to them. We have -- we're going through the architectural plans. We've had the approval with the City of Scottsdale to build an additional 55,000 square feet. We'll probably keep that under 55,000. And it'll be led by the lease we have with Starbucks. The way we'll be doing this, Paul, is taking our plans to -- out to market this and try to pre-lease as much of it as we can. We don't expect to have too much risk other than some interest carry on the debt while we're financing the development. That's one piece. A second piece we're looking at, which is in the early stages, is a property called I-10, which is an industrial property flex space. It has very low overall rents on it. And when I say overall, I'm saying in the $2 to $4 a square foot. It's a great piece of land along the energy corridor on I-10 here, and what we have is apartments sprouting up all around it. We're going through a process of looking at some combination of apartments in retail, which gives us a full range of the Community Center services to meet the community and we think that's one that we could be looking at. The third one is our headquarters office here in Houston, which we think there is some -- the market is here to be in for some more retail space and possibly some residential next to our office building here. So we've got those 3 that we're queuing up early. My guess is that no ground will be broken this year, with the exception of Pinnacle of Scottsdale. We'd like to start that this year, but we're just in the early stages right now.

Okay. Yes. Well, I was wondering if you could quantify how much you'll be expecting to spend on these projects, and also what types of returns we should expect.

Well, it's too early to tell on what we expect to return, what we expect to spend. But when we do -- when you do ground-up development, particularly what I've done it in the past, I've always targeted in the double-digit range, meaning somewhere from around 10% to about 22%, 23%. And depending on how well we control it and how well we execute and the timing of moving tenants in to get our cash flow going, you can usually expect that in development work. We're right at that point in the cycle right now where you don't have as much of a supply in the value added or the foreclosed or the off market transactions. There's still plenty of it, but the prices are increasing a little bit. So we're getting close to the point where development makes a lot of sense. And we've always positioned our strategy to pick up a parcel here and there to feed into that part of the cycle.

Okay. Great. And you've already started to answer my next question, and that is, on the acquisition front, could you maybe tell us what type of cap rate compression you've seen and where you see cap rates today on the type of stuff that you're looking at?

Yes. We look to buy on a cash-on-cash return because it isn't necessarily cap rate because the property we buy aren't necessarily fully occupied. On a stabilized basis, we're seeing cap rates from the 5% up through the 7%, depending on what type of property is. If you get in and kick around a little bit, you can usually do a little better than that and then that's how it's negotiated. We have not seen cap rates based on pro forma income as yet. That's usually the next phase. So in other words, you'll see the cash, the cash in place cap rate coming down, and then the next phase of the growth cycle with sellers is usually they start capping the income that's not the sort of the phantom income on pro forma. We haven't seen that yet.

Okay. And just one more, I was wondering if you could describe what type of leasing momentum you've had after quarter end. Should we expect some good leasing news throughout the rest of the year?

We -- that's another good question, Paul. I can always count on you for good questions, Paul. So momentum is about as it was the second quarter and picking up slightly. What we're trying to do is to flush out some of the tenants that we think will not be long-term tenants for us and there's not too many of those. We have a truly invigorated leasing team, and we've added to it. So we now have, in Houston here, 5 leasing agents that are internal to the company, and we have 4 in Phoenix. And then -- and we think that, that activity is starting to pick up. We're going through the training process on about half of them right out. And so, we expect to see more leasing activity towards the end of the year than you've seen in the first half of the year. During the summer, it stays about the same as it is in the second quarter.

We'll take our next question from Jonathan Pong with Robert W. Baird. Jonathan Pong - Robert W. Baird & Co. Incorporated, Research Division: Just wanted to dig in a little bit on the Mercado at Scottsdale. AJ's Fine Foods has, I believe, a 2014 expiration. Any update there on what you guys see on that potential renewal? Or do you think about potentially replacing them with someone else?

Yes. So that story is doing very well, Jonathan. One of the things that I'd like to point out is it has a very low rental rate. So in our underwriting of that asset, we've looked at other options in potentially being able to raise that rental rate or having another tenant. But the AJ's store is doing very well and we think their business is doing well. So we expect, over time, to be able to increase the rental rate in that space in the center.

Jonathan, I'd like to add to that. We have met with the owners of AJ and they like the locations. It's one of their early locations, so they're interested in remodeling the space. And we've talked to them about our investing in remodeling this space to change the rents in the low single digits now. We think that should be in the high single digits or low double digits, so it depends on what we invest in the property to redo it. Jonathan Pong - Robert W. Baird & Co. Incorporated, Research Division: Great. And then I guess when you think about your acquisition pipeline, are the deals that are -- that you're looking at right now, are they more stabilized fully leased deals, like Mercado at Scottsdale, or are you looking at the deeper churn opportunities like Dana Park?

We're looking at one deal that's very much like Dana Park right now, and it's under contract. We're really excited about it. And it's an opportunity to really demonstrate our strength in taking the property. It has some existing cash flow and having opportunity to expand it and even redevelop a portion of it. That's one of the deals. Another deal we had really goes to Paul's question, there was a $2 million spread. We didn't want to get into a bidding war, but when we put an offer in, they decided to take it to market and we took a pass on it. That was more cash flow and the upside in that property was to, in 5 or 6 years, to start tearing down some buildings and built some high-rise. It was right in a very dense, urban center of town. Another deal we're looking at has -- it's a bank foreclosure. It's well under $200 a square foot, and we're looking to go under contract on that property in about 2 weeks. But we're trying to position it so we can pick up some property around it. So we're still finding the deals. What we've learned and what we found is that because of our track record and our way of acquiring and closing deals, we're finding some terrific stuff that's coming to us now. We never re-trade a property. We've only -- there's only 2 deals we had in our contract that we walked away from, and that was once we went through the due diligence period, the facts weren't representing what we understood the facts to be. So we've had a high credibility in Phoenix, even though we've tried to stay off the radar and we're getting some very good sellers who are coming to us looking to do business with us. Jonathan Pong - Robert W. Baird & Co. Incorporated, Research Division: Great. And maybe just on that note, when you think about the interest rate environment, are you seeing a lot of competition sort of fall off now that rates have picked up a little bit? And does that put you guys in a better position, negotiating-wise for these deals?

I think we are seeing a fair amount of competition. If you remember, our -- primarily, the centers we're looking at, we tend to compete more against the private investors than the larger REITs because we like to look at little smaller center. Some are anchored and some are not, but we're very comfortable with the small service tenants. So we are seeing a little bit of increase in competition in the markets, but we continue to, though our relationships we've built, to be able to see deals early and get a nice off market look at many of the deals we're looking at.

Yes. Jonathan, just on -- along the debt side, what we're seeing is deals that were restructured 3 to 5 years ago with CMBS loans, that the process had become very slow in turning -- in respect to getting the CMBS approvals. There's usually 2 to 3 levels of approvals you have to go through, and that's the only obstacle that we have found, so far. The CMBS process is very slow. Sellers who have restructured their debt, restructured with CMBS loans, they're told to be assumable, and yet, it's just a very, very long process. So that's the only obstacle we've come across.

[Operator Instructions] We'll go next to Carol Kemple with Hilliard Lyons.

Earlier in the call, I think you all said there was $2 million of noncash expense you all expect to have related to vested shares over the next 14 months. Should we expect that to be kind of evenly spread through the next 5 quarters?

Yes. So that relates to the -- some restricted shares granted back in 2009. That's just the divesting of those shares as we hit the financial targets. We're starting to hit some of those targets. So you should see that fairly evenly over those 14 months.

And once that's over, then we won't have that expense anymore?

No, you'll still see -- so we have restricted shares that have been granted from our performance-based programs, where by employees -- all of our employees participate and have the ability to share in value-add as we grow the company and add value to the company. So you'll continue to see some vesting of those shares. I think we reported in our financials the amount of shares that are unvested and the targets. So hopefully, we'll be continuing to grow and add value, and as a result, hitting some of those targets over the next several quarters.

Okay. And I know on previous calls, you all mentioned that you were looking at properties in some new markets besides the ones you're already in. Is there anything that's in your pipeline right now outside of the Texas or Phoenix market?

Nothing outside of Texas right now. We're looking to see...

Texas or Phoenix, right.

Or Phoenix right now, yes. Nothing on Texas or Phoenix right now. But we're looking at the Phoenix market closely, and every time we think we're ready to pull out and look in another market, we get more deals offered to us. So the pipeline is still strong in terms of Phoenix. We've had some deals come to us in Dallas and some deals in San Antonio. We think those are excellent markets. But what we find is that we've taken the efforts to build our infrastructure in Phoenix as well as we have in Houston. So we have far fewer people in Phoenix than we have in Houston. But the infrastructure really supports it because that's necessary for our business model. So we still -- we have the capacity to add another -- anywhere from 4 to 10 properties in Phoenix without adding any people there other than 1 or 2 leasing people and 1 or 2 property managers, so we're going to see what capacity we can bring that to. And if what we do -- what we have to watch is we don't want to choke our people. We don't want to give them too much to handle in one area. And then so when we think it's getting to the point where we're optimizing that or we're at least we might just book it when [indiscernible]. But we do have properties lined up in other markets, we're just able to switch them on the back burner right now.

So there are properties in other markets besides Houston and or Phoenix, but they're just kind of really far away on the back burner?

Yes. They're on the back burner, and they're in Dallas and in San Antonio. And there's a significant number of them and it's just a matter of when we want to get aggressive with them.

It appears there are no further questions at this time. I'd like to turn the conference back to Mr. Mastandrea for any additional or closing remarks.

Well, I'd like to thank you all for not only your interest in this call, but your interest in Whitestone. We're -- we've been very excited about the opportunity to grow the company. We think the business model is getting perfected more and more everyday, and the emphasis on service-based tenants is, really, has a payoff in terms of profitability for our shareholders. While we have about 70% of our tenants that are service-based, I do want to remind you that we have a number of anchors, we just don't highlight them. For example, we have several Safeways, we have Albertson's, we have Walgreens, we have AJ's and multiples in these locations. So we do have, in the 30% of our properties in the non-service related, we have some anchors as well. So with that, I really give -- I'd like to invite you either to come and visit us in Houston at any time, or in Phoenix or Dallas or one of our other markets. And feel free to call myself or Dave at any time, as well as Suzy. And with that, I'll end the conference call. Thank you, all.

This does conclude today's conference. We thank you for your participation.