City Office REIT - Q2 2024

Executive Summary

• Q2 2024 in line with company plan but softer sequentially: revenues fell to $42.3M and GAAP diluted EPS was ($0.14); Core FFO/share declined to $0.28 as Q1 benefited from a $0.9M termination fee that did not repeat.
• Leasing momentum accelerated: 269k sf executed (162k sf new), the company’s highest new leasing quarter since the pandemic; in-place occupancy 83.0% and 87.3% including 241k sf of signed-not-commenced leases, setting up a 2H occupancy tailwind.
• Balance sheet de-risking: addressed remaining 2024 property-level maturities, transferred Cascade Station to lender (reduced debt by ~$20.6M), extended two Orlando loans, and plans to repay a $50M term loan in September; net debt/EBITDA at 7.0x with $92M undrawn revolver and $43M cash + restricted cash.
• Guidance reiterated: full-year 2024 Core FFO/share range maintained at $1.14–$1.18 after Q1 cut for WeWork rightsizing; management expects occupancy to rise in each of the last two quarters as signed leases commence.
• Catalysts: conversion of signed-not-commenced leasing to cash flow, potential CMBS financing on unencumbered assets (e.g., Block 83), and progress on St. Petersburg mixed-use opportunity; risk skew includes an expected 72k sf AmberGlen move-out in early 2025 and Phoenix/Portland market dispersion.

What Went Well and What Went Wrong

What Went Well

• Record new leasing since the pandemic: “we signed 162,000 square feet of new leases during the second quarter…highest quarter of new leasing in our company’s history” (CEO).
• Occupancy tailwinds: 241k sf of signed-not-commenced leases boosted “occupied plus SNC” to 87.3%, with management expecting occupancy to increase in each of Q3 and Q4.
• Maturities addressed and liquidity preserved: transferred Cascade Station (reduced debt by ~$20.6M), extended two Orlando loans, and plans to pay down a $50M term loan; $92M revolver availability and $43M cash/restricted cash.

What Went Wrong

• Sequential earnings pressure: Core FFO/share fell to $0.28 from $0.33, chiefly due to lower occupancy and absence of a $0.9M Q1 termination fee at Block 23 that did not recur in Q2.
• WeWork rightsizing impacts: taking back a floor at Dallas Terraces and one at Raleigh’s Bloc 83 in 2H24; guidance had been reduced in Q1 by ~$1.8M Core FFO for expected WeWork downsizing (about $0.04/share, including ~$0.02 non-cash).
• Same-store pressure persisted: Same Store Cash NOI decreased 2.0% YoY for Q2 (reflecting lower portfolio occupancy YoY).

Transcript

Operator (participant)

Good morning and welcome to the City Office REIT, Inc. Q2 2024 earnings conference call. At this time, all participants are in the listen-only mode. A brief question-and-answer section will follow the formal presentation. To ask a question, you may press star then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. As a reminder, this conference call is being recorded. If you require operator assistance, please press star then zero. It is now my pleasure to introduce you to Tony Maretic, the company's Chief Financial Officer, Treasurer, and Corporate Secretary. Thank you, Mr. Maretic. You may begin.

Tony Maretic (CFO)

Good morning. Before we begin, I would like to direct you to our website at cioreit.com, where you can view our Q2 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 that 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 Q2 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 will 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.

Jamie Farrar (CEO)

Good morning. Throughout 2024, office leasing fundamentals have continued to strengthen across our markets. During the Q1 of this year, we had healthy leasing activity that was comprised of 110,000 sq ft of new leases and total leasing activity of 191,000 sq ft. I'm pleased to report that these volumes have continued to improve in the Q2. We reported today that new leasing activity increased to 162,000 sq ft and total leasing activity increased to 269,000 sq ft. In fact, this was the highest quarter of new leasing in our company's history. There are several positive industry trends that have contributed to these results. New office construction has declined to all-time lows. A record number of office conversions and demolition of obsolete buildings has also occurred.

At the same time, a significant portion of the premium space in our markets has now been leased, and sublease space has decreased for four quarters in a row. As a result of these trends, competition from the supply of new or high-quality lease space is decreasing. On the demand side, we are also seeing a shift. There are more large tenants in the market looking to fill bigger space requirements. JLL estimates that nationwide, tenant requirements have increased by 28% year-over-year. At the same time, renewal prospects are improving, with JLL reporting that 60% of tenants over 10,000 sq ft nationwide renewed in place in the Q2. This is up 15% from the prior year. The improvements on the supply and demand side have translated to an overall more conducive leasing environment.

We expect the pace of these improvements to be gradual but favorable for our long-term strategic execution. Today, one of the biggest challenges in the office market continues to be a lack of liquidity in real estate transactions, which we believe has been driven primarily by the office real estate debt market. Over the past few years, there have been very few options for new loan originations in the office sector. This has heavily suppressed office sale transactions. While debt markets are still muted, there has been a slight thawing. The CMBS market has started to open up, which will help facilitate some liquidity and capital flexibility. On the whole, the office market still faces challenges. Despite this, the pathway to longer-term success is becoming clearer for quality properties in growth markets operated by well-capitalized owners. We believe that our portfolio is positioned to benefit from these trends.

Now shifting to specifics of our leasing and operational results. The largest new lease this quarter was at FRP Collection in Orlando, where we signed a 30,000 sq ft 5-year lease with a strong credit energy tenant. At Block 23 in Phoenix, we signed a 24,000 sq ft lease with a coworking operator. This lease backfilled over half of the 46,000 sq ft that we were previously occupied at that property. The new lease is structured where we share the economics of the tenant's operation in the space. We were able to execute this transaction within 5 months of WeWork vacating. This leaves 22,000 sq ft of prime space from the WeWork give-back, which we plan to further subdivide into smaller suites. As we indicated with the expectation on our last call, we did finalize terms with WeWork at the 2 remaining spaces they lease in our portfolio.

In that regard, in July, we took back a 25,000 sq ft floor at The Terraces in Dallas, and in November, we expect to take back a 28,000 sq ft floor at Block 83 in Raleigh. We already have prospects looking to lease these spaces, which are some of the best suites in our entire portfolio. WeWork, who has emerged from bankruptcy, will ultimately lease 78,000 sq ft of well-utilized space from us when their rightsizing is completed. Aside from leasing, we are also focused on executing strategic property upgrades in some of our strongest submarkets. We're making significant enhancements in Scottsdale at Pima Center, in Phoenix's Camelback Corridor at 5090, in St. Petersburg at City Center, and in Uptown Dallas at 2525 McKinnon. These renovations are designed to provide a competitive leasing advantage and will greatly enhance the profile of all four properties.

Of the $9 million we expect to invest into these four projects, we have spent approximately $4 million as of quarter end. At the conclusion of this renovation program, the vast majority of City Office's portfolio value will reside in well-located, newer vintage, or recently renovated and amenitized properties that are very well-positioned for leasing success. While the renovation of our City Center property in downtown St. Petersburg, Florida, is underway, we have separately been exploring a value-enhancing initiative at that property. St. Petersburg has become an increasingly desirable office and residential market. It is a special waterfront community with a great quality of life and amenity offerings. The population has grown over 11% in the last five years, and office occupancy rates are some of the highest in the country. This has created strong demand for both residential and commercial development.

For some time, we've been advancing the potential of redeveloping City Center's standalone parking garage into a mixed-use development with premium high-rise residential condominiums. Today, we are in advanced discussions with a highly regarded developer to progress this opportunity. The form of the venture would likely entail us contributing the parking garage land and participating in future development profits. While any possible redevelopment of City Center remains subject to a number of conditions, some of which are beyond our control, we hope to provide an update later in the year. As we did with our transformational San Diego Life Science portfolio acquisition and disposition, we continue to focus on creative ways to generate meaningful shareholder value and will provide further updates on future calls as these plans are enacted. Aside from the updates I have mentioned, our results this quarter continue to track our expectations.

Accordingly, we reiterated all aspects of our prior guidance this quarter. For the balance of the year, we will remain focused on leasing, completing our property upgrades, and other value-enhancing opportunities. With that, I'll hand the call over to Tony to discuss our financial results in more detail.

Tony Maretic (CFO)

Thanks, Jamie. Our net operating income in the Q2 was $24.9 million, which is $1.8 million lower than the amount we reported in the Q1. NOI was lower in Q2 than in Q1 as a result of lower occupancy and a $900,000 termination fee recognized in the Q1 at Block 23 as a result of the WeWork departure. We reported core FFO of $11.5 million, or $0.28 per share, for the Q2. Core FFO was $2 million lower than the amount we reported in the Q1, driven primarily by the net operating income decrease. Our Q2 AFFO was $5.3 million, or $0.13 per share, which resulted in continued dividend coverage this quarter.

The largest impact to AFFO was a $1 million tenant improvement deduction related to a new lease at Mission City in San Diego, which we expect will take occupancy in Q3 2024. We also spent $500,000 on spec suites and vacancy conditioning. The four significant property renovations underway, which Jamie described, resulted in a $1 million deduction to AFFO this quarter. Moving on to some of our operational metrics. Our Q2 same-store cash NOI change was 2.0%, or $500,000 lower as compared to the Q2 of 2023, primarily driven by lower portfolio occupancy year-over-year. Our portfolio occupancy ended the quarter at 83.0%. Including 241,000 sq ft of signed leases that have not yet commenced, our occupancy was 87.3% as of quarter end. Our total debt as of June 30 was $649 million. Our net debt, including restricted cash to EBITDA, was 7.0 times.

As of June 30, we had approximately $92 million undrawn and authorized on our credit facility. We also had cash and restricted cash of $43 million as of quarter end. We expect to use a portion of that liquidity to repay our $50 million term loan that matures in September of this year. We also have two properties of significant value, Block 83 in Raleigh and City Center in Tampa, that are unencumbered, and we are exploring potential financing alternatives at Block 83. The remainder of our property-level debt maturities for 2024 were addressed in the Q2. First, as indicated on previous calls, during the quarter, we completed the transfer of our Cascade Station property in Portland to the lender, which reduced our overall debt by approximately $21 million. Second, at Central Fairwinds in Orlando, we extended the $16 million loan by five years to June 2029.

Including the effect of a swap agreement, the effective fixed rate is 7.68% for the new 5-year term. Third, at FRP Ingenuity Drive in Orlando, we extended the loan by 2 years to December 2026 with a 1-year extension option. The loan modification for $14 million included a principal repayment of $1.6 million and maintains the existing 4.44% interest rate. We view the debt transactions this quarter as an upgrade to our balance sheet as we have addressed all near-term maturities. Our next property-level debt maturity is not until October 2025. And lastly, for me, on our guidance, we are reiterating the guidance that we updated last quarter. With the significant amount of signed leases that are expected to commence later in the year, our expectation is that our occupancy levels will increase in each of the last two quarters of the year.

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

Operator (participant)

Thank you. As a reminder, if you would like to ask a question, please press star then 1 on your telephone keypad now. If you would like to withdraw your question, please press star then 2. When preparing to ask your question, please ensure your device is unmuted locally. We'll pause here briefly as the questioner registers. The last question is from Rob Stevenson with Janney. Your line is open.

Rob Stevenson (Managing Director)

Good morning, guys. Tony, any additional known move-outs of consequence today? I mean, the 430 basis point gap between your occupancy and signed leases not yet occupied is pretty material. So trying to figure out how much of the move-ins are canceled out by move-outs or whether or not you're going to be able to start pulling down some of that gap in the back half of the year as you talked about occupancy increasing.

Tony Maretic (CFO)

Yeah. Good morning, Rob. Yeah, you're exactly right. The short answer to your question is no. There's really no new amounts. There is really only one of significant size that is a known vacate over the next four quarters, and that's one we've talked about before. There is a 72,000 sq ft tenant at Amber Glen that's scheduled to depart at the end of January, and that's the only known move-out greater than 30,000 sq ft over the next coming quarter. So you're absolutely right. We're in our midpoint of our guidance range is 84.5% occupancy, and we're on track to hit that or maybe a tick higher.

Rob Stevenson (Managing Director)

Okay. I mean, when you're looking at the pipeline of leasing today, how is it looking in the back half of the year versus what you've seen over the last couple of quarters? Is it still as strong as what you did in the first half of the year? Is it sort of moderating as people wait and see what's going to wind up happening? How would you sort of characterize the leasing pipeline versus the last four or five quarters?

Jamie Farrar (CEO)

Hey, Rob. It's Jamie here. So there's a natural slowdown over the summer. So where that ultimately lands in the summer, it's probably a little slower. But I would say as far as requirements we're seeing, discussions we're having, it's really, really strong. And so my own prediction is kind of looking forward a year, a market that's been a little softer for us is Phoenix, and that one's really turned the corner. In fact, of the 240,000 feet of leases we signed that haven't commenced, about 70,000 of it is in Phoenix, and I think we're going to continue to see some really good traction there.

Rob Stevenson (Managing Director)

Okay. And then last one for me. Tony, I think you talked about taking the term loan and paying that off as it comes due in September. Is that part of what you're thinking on interest rates in terms of waiting and seeing what's going to wind up happening before you put longer-term debt back in place? Is that sort of more permanent, do you think, in terms of got enough property-level debt and whatever you wind up doing at Block 83 in addition to that? How are you guys thinking about addressing some of the addressing debt in the current sort of not very stable environment where rates could go down, could stay the same, and we've had a bunch of head fakes here?

Tony Maretic (CFO)

Yeah. I mean, it's a very good question, and it's anyone's guess where things will land. Obviously, there's a lot of indications that rates could be coming down as early as September. But in terms of how we're looking at it, if you look at our overall facility with KeyBank, paying down the term loan and shrinking that facility a little bit as we go forward, given our exposure to that, is probably a good idea. We have unencumbered assets. I mentioned that we are exploring placing debt. The CMBS market in particular seems to be improving. If you look at the recent originations, the percentage of the pool that's being allocated to office has just been increasing and kind of returning to more normalized levels.

We're sort of exploring the various options and feel like we don't necessarily have to do something right away and see how things play out.

Rob Stevenson (Managing Director)

Okay. I mean, I guess as a follow-up to that, if you were to do something, put mortgage debt on Block 83 at some point here, what type of rate are you looking at in the marketplace for an asset like that today if you were doing something in the next, call it, three or four months?

Tony Maretic (CFO)

Yeah. The current spreads on the reference rate is in that 275-300 basis point range for CMBS-type deals, which is the most active in the market today.

Rob Stevenson (Managing Director)

Okay. Thanks, guys. Appreciate the time this morning.

Tony Maretic (CFO)

Thanks, Rob.

Operator (participant)

Thank you. The next question is from Upal Rana with KeyBanc Capital Markets. Your line is open.

Upal Rana (Senior Equity Research Analyst)

Great. Thank you for taking my question. Jamie, you mentioned the turnaround in the Phoenix market. Anything in particular that's driving that turnaround?

Tony Maretic (CFO)

It's pretty broad. When you look at our portfolio of sub-markets, we cover a lot of different sub-markets. We're seeing a pickup in activity all around. I'd say the one that still is slow and has a lot of space in the sublease market is the tech side, but pretty much all other industries have started to pick up. We're having constructive discussions about longer-term leases and bigger blocks of space. So we're feeling really good about Phoenix, what we're seeing.

Upal Rana (Senior Equity Research Analyst)

Okay. Great. That was helpful. Then I wanted to see how your spec suites were trending, and you mentioned that $3 million number last quarter and expectations for the year-end, and just curious on interest and activity there for those.

Tony Maretic (CFO)

Sure. So spec suites are really moving. So we started, I think last quarter, we had 82,000 sq ft in inventory. We're at 48,000 right now that's vacant. A big piece of that is two larger suites that are fabulously built up. We've got to find the right tenant. That's about 30,000 of the 48. And then we've got a whole bunch of smaller suites in that. So they're continuing to lease. We're going to build about another 32,000 right now, mostly smaller, spread across our portfolio, and that's where we're seeing a great amount of our activity.

Upal Rana (Senior Equity Research Analyst)

Okay. Great. Thanks. And then just quickly on Central Fairlands loan extension, what was your thought process there on swapping that out on the floating rate and fixing it given where interest rates may be heading?

Tony Maretic (CFO)

Yeah. That's a very good question. It was a requirement from the lender that we do so at closing.

Upal Rana (Senior Equity Research Analyst)

Okay. Got it. All right. Thank you for your time.

Tony Maretic (CFO)

Yeah. Thanks, Rob.

Operator (participant)

Thank you.