Piedmont Office Realty Trust - Q2 2023

Transcript

Operator (participant)

Good day, everyone, and welcome to the Piedmont Office Realty Trust, Inc. 2nd Quarter 2023 earnings call. At this time, all participants have been placed on a listen-only mode, and we will open the floor for your questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Eddie Guilbert. Sir, the floor is yours.

Eddie Guilbert (EVP of Finance and Treasurer)

Thank you, operator, and good afternoon, everyone. We appreciate you joining us today for Piedmont's 2nd Quarter 2023 earnings conference call. On Tuesday morning, we filed our 10-Q, and an hour ago, we filed an 8-K that includes our earnings release and our unaudited supplemental information for the 2nd Quarter that's available for your review on our website at piedmontreit.com under the Investor Relations section. During this call, you'll hear from senior officers of Piedmont. Their prepared remarks, followed by answers to your questions, will contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements address matters which are subject to risks and uncertainties, and therefore actual results may differ from those we anticipate and discuss today.

The risks and uncertainties of these forward-looking statements are discussed in our press release as well as our SEC filings. We encourage everyone to review the more detailed discussion related to risks associated with forward-looking statements in our SEC filings. Examples of forward-looking statements include those related to Piedmont's future revenues and operating income, dividends and financial guidance, future leasing and investment activity, and the impacts of this activity on the company's financial and operational results. You should not place any undue reliance on any of these forward-looking statements. These statements are based upon the information and estimates we have reviewed as of the date the statements are made. Also on today's call, representatives of the company may refer to certain non-GAAP financial measures, such as FFO, core FFO, AFFO, and same-store NOI.

The definitions and reconciliations of these non-GAAP measures are contained in the earnings release and in the supplemental financial information, which were filed earlier this afternoon. At this time, our President and Chief Executive Officer, Brent Smith, will provide an update on our recent refinancing activity and 2nd Quarter operating results. Brent?

Brent Smith (President and CEO)

Thanks, Eddie, and good afternoon, everyone. As we appreciate all of you for accommodating us for the short notice of this moved up earnings call. Given the refinancing activity that we announced Tuesday, we felt it was important to go ahead and get our full quarterly information into the market so that all of our investors had the benefit of the most recent financial and operational information available. First, I'd like to walk you through our rationale for our recent refinancing activities that we've undertaken and give a brief overview of the quarterly results. Following me, as usual, you'll hear from George Wells, our Chief Operating Officer, Chris Kollme, our EVP of Investments, and Bobby Bowers, our Chief Financial Officer. We also have the usual full component of our management team available to answer any questions that you may have. With that, I'll jump right in on the refinancing activity.

As we announced Tuesday afternoon, we have closed a $400 million in aggregate principal amount of 9.25% five-year unsecured notes. Concurrent with the issuance of the new bonds, we also made a tender offer at par for any and all of our outstanding $400 million unsecured senior notes that are scheduled to mature during the 1st Quarter of 2024. Although we have no way of knowing exactly how many of our current holders will tender their bonds, and given the current interest rate environment, we are projecting that a majority of the 2024 holders will participate in the tender, which will close next week. While the coupon rate on the new debt is certainly a high watermark for Piedmont, it is unfortunately reflective of where the market currently is for commercial office properties.

Over the last several months, we've gone through an extensive process of exploring and analyzing our various capital-raising alternatives, including a number of potential asset sales, the possibility of placing a mortgage on one or more of our properties, either with a balance sheet lender or utilizing the CMBS market. Issuing in the unsecured market, either through a bank term loan, private placement, or public bond offering, and corporate-level structured financings, including convertible debt and preferred equity, among others. At the end of the day, asset sales have been extremely difficult to complete given the lack of asset level financing, and we concluded that whatever modest discount there might be had on a CMBS execution did not justify encumbering more than a half dozen of the assets in our portfolio at low loan-to-value ratios.

Finally, the unsecured bond market offered the greatest financing capacity compared to other unsecured alternatives, and maintaining a large unencumbered asset pool is an important consideration for the rating agencies. In addition, a key component of our leasing and capital recycling strategy has been to maintain a flexible balance sheet with ample liquidity, primarily as an unsecured borrower. This has helped the company in many ways, including expediting capital and repositioning programs, allowing greater flexibility to move tenancy throughout the portfolio, and avoiding debt prepayment penalties with property dispositions, among others. More recently, the lack of mortgage debt in our portfolio has been instrumental in driving leasing volumes.

After considering the continued messaging from the Fed regarding additional interest rate hikes during the latter half of the year and the overall lack of financing opportunities currently available to the office sector generally, we ultimately concluded that accessing the public bond market while the opportunity was available and addressing our largest near-term maturity now, was the most prudent course of action for Piedmont. The expectations that rates will come back down over the next several years influenced our decision to go with a shorter 5-year tenure for the new notes. Turning to our operating results, the 2nd Quarter of 2023 demonstrated Piedmont's continued success despite the challenges facing the broader office sector. Our leasing formula is working, and we continue to be optimistic about the value proposition for our customers and the opportunity to continue our leasing momentum, particularly in today's capital constrained market.

The flight to quality buildings and owner operators is favoring Piedmont. Quarter after quarter, we continue to demonstrate that well-designed, amenitized work environments operated by well-capitalized, service-minded landlords, is garnering outsized demand from small and medium-sized businesses, as well as larger non-tech corporate tenants. The flight to quality occurring in the market is playing to Piedmont's strategy, providing premier workspaces at meaningfully lower rental rates versus new construction. In brief, we sustained the leasing momentum from the 1st Quarter, with Piedmont's prospective tenant pipeline remaining robust and meaningful tenant lease volumes achieved. In total, we executed almost 585,000 sq ft of leasing and generated an over 14% roll-up in cash rents. Furthermore, we continue to make significant progress towards the renewal of our largest tenant, U.S. Bancorp, for the extension of its lease on a substantial majority of its downtown Minneapolis headquarters location.

Given we remain in negotiation and documentation stage on the lease, we're limited with the details we can share, but it's a long-term lease under similar terms and metrics we've discussed on prior earnings calls. U.S. Bancorp's renewal decisions for its IT and data center operations at Meridian Crossings will follow the conclusion of the downtown agreement, so there are no incremental information regarding that location to share today. At this time, I will hand the call over to George, who'll go over to more details around our operational success during the quarter.

George Wells (EVP and COO)

Thanks, Brent, and good afternoon, everyone. Persistent demand for Piedmont's high quality assets led to another quarter of solid operational results. Office users recognize that Piedmont's attractive workplace proposition can be a key driver for encouraging or supporting mandates for more in-house attendance. CBRE Spring 2023 U.S. Occupier Sentiment Survey cites on-site food and beverage cafe, after ease of commuting and parking, as having the most impact for attracting employees back into the office. At Piedmont, we provide a wide range of local to national food and beverage options across our portfolio, from custom delivery orders, traditional cafes, full service restaurants with bar service, to white tablecloth, high-end establishments. In a moment, I'll highlight three F&B transactions that were completed this quarter and are enhancing our competitive position in the marketplace.

Overall, this quarter, we had another strong leasing performance with 49 lease transactions completed for approximately 585,000 sq ft of total overall volume. Of this amount, 237,000 sq ft, or 41% of the total, were related to new tenant lease activity, well over our pre-COVID quarterly average of about 175,000 sq ft. Our leasing pipeline activity is very strong. Continuing with operational metrics, our lease economics were very favorable, with 14.3% and 19.6% roll up or increase in rents for the quarter on a cash and accrual basis, respectively. Our weighted average lease term achieved on new lease activity for the quarter was just under 10 years.

Our lease percentage at the end of the quarter was 86.2%, slightly up when compared to the previous quarter end. Approximately 90% of new tenant activity occurred in our Sunbelt portfolio, where almost 70% of our vacancies reside. Retention rates remain consistent at approximately 70%, no doubt a reflection on both our customer-centric service approach and high quality, commute-worthy portfolio. Lastly, leasing capital commitments on our year-to-date leasing were $6.29 per sq ft per year of lease term and in line with fourth quarter of last year's averages. Now, I'd like to highlight a few key accomplishments and announcements which occurred in some of our operating markets this quarter.

Atlanta, our largest market, at almost 5 million sq ft and generating 28% of our company's ALR, captured the most activity this quarter, with 16 deals accounting for 300,000 sq ft, of which 60% were new leases. The Galleria, an investment company, relocated its headquarters from a nearby Class B facility, making this our 8th full floor larger new deal since 2020, 6 of which are headquarter location. Our Midtown LEED Gold 999 Peachtree also experienced good activity with 3 new deals, one being a high-end F&B operator that's well known in Atlanta, Lazy Betty. This operator has received multiple local culinary awards for its carefully crafted tasting menus and unique dining experience. We anticipate them opening in the fourth quarter.

In Northern Virginia, we're excited to welcome Panera Bread as our second F&B operator at our LEED Silver 4250 North Fairfax Drive Tower. We're also pleased that P.F. Chang's renewed its high performing restaurant at our LEED Silver Arlington Gateway for another 5 years with no concessions. Along with our 3100 Clarendon Tower, all 3 of our NoVa assets are 4-star rated by CoStar and have been designated a walker's paradise due to a plethora of nearby food and beverage options and their locations near Metro train stations. CoStar is the industry leader in commercial real estate information, analytics, and news, and has designated 96% of our ALR of our 70 million sq ft portfolio as either 4 or 5 stars, its highest quality rating. Our NoVa portfolio is well positioned to capture CR leasing activity going forward.

Let's drop into Minneapolis next, home to our largest near-term expiring customer, U.S. Bank. Extension negotiations with the bank at our downtown lead goal, U.S. Bank Center, are accelerating, and we're optimistic on retaining them for substantially all of its 490,000 sq ft of space there, though admittedly, we still have more work to do. As an aside, this world-class tower continues to separate itself from its competitors, with a soon-to-open elite restaurant that will be offering fresh, refined seafood in a luxurious environment. This tower also recently won BOMA's International Outstanding Building of the Year award. We will be addressing U.S. Bank's suburban lease location at our Meridian Crossing complex after we complete the larger downtown lease negotiation. We don't have any additional color on this suburban lease at this time, and we would reiterate a more conservative extension at this point, say, 50%.

That said, suburban Minneapolis has been and continues to be quite active for us. Year to date, we've completed nearly 70,000 sq ft of transactional activity here, with a good deal of flow in our pipeline. Coming back to our overall portfolio, we remain positive about our future near-term leasing trends and operational performance. Tour activity continues at the same healthy pace that we've seen for several quarters. Proposal activity is more than the trailing 12 months, coming in around $2.5 million sq ft. With only 3% of the rent roll expiring over the next two quarters, we expect positive net space absorption for the rest of the year, resulting in an anticipated year-end lease percentage to end between 87%-88% that was provided in our initial guidance. I'll now turn it over to Chris Kollme to review our 2nd Quarter investment activity.

Chris?

Chris Kollme (EVP of Investments)

Thank you, George. As you might expect, given the ongoing challenges in the market, I have very little new information to report since the last call. We announced last quarter that our two assets in Houston had gone under contract and were through diligence, but terms did contain a financing contingency. The potential buyer is working diligently to secure its capital structure, but it has not yet been finalized. We expect to have more clarity on their progress in the coming weeks. We will certainly keep you all informed if and when we have additional information to share. As for the balance of our activity, we're in preliminary discussions on select non-core assets, but it is far too early to speculate, given the market backdrop. We will continue to work creatively with interested parties on potential dispositions. Any and all sale proceeds will be earmarked towards the reduction of debt.

With that, I'll turn the call over to Bobby to review our financial results and to update you on 2023 guidance.

Bobby Bowers (CFO)

Thank you, Chris. While we'll be discussing some of this period's financial highlights today, I encourage you to please review the entire earnings release, the 10-Q, and the accompanying financial information, which were filed over the last few days for more complete details. core FFO per diluted share for the 2nd Quarter of 2023 was $0.45, versus $0.50 per diluted share for the 2nd Quarter of 2022, reflecting approximately $0.08 per share dilution from increased interest expense comparatively. This increase was partially offset by operational growth during the 2nd Quarter of this year, resulting from successful leasing efforts, rising rental rates, and asset recycling over the past year. AFFO, generated during the 2nd Quarter of 2023, was $44 million and $81 million on a year-to-date basis.

Our property operating costs and general and administrative expenses were in line with budget, with no unusual variances. As George and Brent noted, leasing has been strong throughout the year, with over 1.1 million sq ft of executed leases completed during the 1st 6 months of the year. Year to date, cash rent roll-ups for these newly completed leases are up 10% over expiring rates, and accrual rents are up over 14%. same-store NOI, however, is relatively flat thus far for the year compared to the previous year. This is a timing issue, with 60% more leases yet to commence or in abatement at the end of this quarter. That's a total of 1.3 million sq ft versus less than 800,000 sq ft that we began the previous year with.

With several leases set to commence or begin paying rent, we still project cash NOI growth to be positive, between 1% and 3% for the year. Turning to the balance sheet, during the 2nd Quarter, we repaid $350 million in maturing unsecured notes, utilizing our cash and investments on hand and our available $600 million revolver. Having addressed our $400 million bond maturity subsequent to quarter end, we have no other debt with final maturity until 2025. As Brent noted, a key component of our leasing formula is that our balance sheet and liquidity remain strong, a differentiating factor as prospective tenants scrutinize the capital structure of a potential future office building and landlord. This differentiation among office products is driving increased market share for the highest quality place making assets and well-capitalized landlords.

We've already discussed our new five-year bond issuance. We've stated that any disposition proceeds will be used to strengthen our balance sheet by paying down our line or our bank term debt. At this time, I'd like to update our guidance for 2023. With the $400 million new debt issuance completed today and in place, the approximate 5% increase in interest rate will result in interest expense increasing approximately $20 million annually. This increased interest expense will negatively impact 2023 earnings, $0.08 per diluted share over the remainder of the year. Therefore, our guidance is lowered and narrowed to $1.74-$1.80 per diluted share for 2023.

This guidance includes approximately $570 million-$580 million of total revenues, $100 million-$104 million of total interest expense for the year, and G&A expenses of $28 million-$29 million. This guidance does not include any gains or losses from the potential sale of real estate assets that Chris mentioned. We will update our guidance should a capital transaction occur. As I conclude, I will note that our board of directors will be meeting next week for a regularly scheduled quarterly board meeting. Management will be presenting this updated forecast information for their consideration as part of the board's review of Piedmont's dividend. The company's dividend for the last several years has been based upon our forecasted taxable income, that includes our property operating income, interest expense, and gains and losses from the sale of real estate assets.

With gains anticipated from the possible dispositions that Chris discussed, we are not in a position at this time to speculate on what action the board may take immediately regarding our dividend policy. However, as has been our long-term policy, we'd expect the dividend to be adjusted to taxable income forecasts. With that, I'll turn the call back over to Brent for closing comments.

Brent Smith (President and CEO)

Thank you, George, Chris, and Bobby. In summary, for the remainder of the year, we anticipate modest space absorption and operational growth. We will continue to be a net seller of assets as we deleverage the balance sheet and enhance our liquidity resources. As we previously outlined, increased interest expense will continue to weigh on earnings and FFO in the near term. Finally, I want to thank the outstanding employees at Piedmont, who provide excellent service to our customers each and every day. Their dedication, resilience, and hard work continues to drive our leasing success despite the challenging market. With that, I will now ask the Operator to provide our listeners with instructions on how they can submit their questions. We will attempt to answer all your questions now, or we will make appropriate later public disclosure if necessary. Operator?

Operator (participant)

Certainly. Everyone at this time, we'll be conducting a question-and-answer session. If you have any questions or comments, please press star one on your phone at this time. We do ask that while posing your question, please pick up your handset if you're listening on speakerphone to provide optimum sound quality. Once again, if you have any questions or comments, please press star one on your phone. Please hold while we poll for questions. Your first question is coming from Nick Thillman from Baird. Your line is live.

Nicholas Thillman (Senior Research Analyst.)

Good afternoon or good evening, guys. Just a little bit on the decision to do the debt offering here instead of waiting maybe a little bit. Is this more of a matter of the debt markets were open, so we're just gonna get it, rip the Band-Aid off here? Like, maybe walk through. It sounds like there's still potential for some dispositions. Just kind of wondering around the timing of this transaction.

Brent Smith (President and CEO)

Sure, Nick, a great question. This is Brent, again, thanks this evening and being flexible, having moved this up a week of the earnings call. A very, you know, reasonable question. You know, we continue to canvas a number of different alternatives, as we outlined in the earnings call, including asset dispositions. As we noted, it's been very difficult in this environment. Even though we've found a reasonable price from a equity standpoint, the debt has just been difficult to achieve.

We've continued to evaluate secure debt within our own portfolio, having hired a broker to help us canvas both the insurance kind of bank lending market, if you will, as well as the CMBS market. Of course, we looked at various forms of unsecured, talking to our own bank lending groups, which we did utilize in early part of this year for a sizable term loan, and a number of different, you know, structured alternatives as well, looking at creative situations around convertible preferred or other super structures, if you will, from a capital perspective. When it boiled down to it, there were a couple of things that kind of weighed on our mind. First and foremost, there is a large wall of commercial debt coming due the remainder of this year and next year.

Thinking about that overall implication and available funds, there's a lot of, basically, need and not a lot of supply. Wanting to try to address those 2024 maturities earlier rather than later was our mindset. As we continue to kind of evaluate, it's been a very challenging market, certainly, at the unsecured side, but more broadly, just a lot of concerns around recession and the rates. We had a window here where the general economic malaise had kind of lifted a little bit. I think people were somewhat hopeful of a soft landing, if you will, and some continued data points around reduced inflation overall, created a positive economic window.

We felt producing our positive economic results early and getting ahead of some of that negative headwind, or sorry, negative headlines, that may be forthcoming over the next month or week even, it was just a mindset of trying to go ahead and take some risk off the table, if you will. We had a lot of inbound inquiries through, call it last three months. We've been talking to fixed income investors regularly since our last earnings call. I think a lot of them have done the homework that unfortunately we haven't seen necessarily in the equity markets, to really discern the portfolio, and they kind of heeded our comments of following leasing and denoting success within the portfolio in that manner.

We've continued to demonstrate to the fixed income market, the stability of the portfolio, the leasing success, the continued rental rate roll-ups, the mindful use of capital, and I think they recognized that. We decided it was a good opportunity to go into the market. It was well-received, several times oversubscribed in the offering, but of course, the rate was somewhat driven by just the general difficulties in our sector. I would say, you know, it's not a representative of what we think the creditworthiness of the portfolio is. That is where, unfortunately, the market resided. We were pleased to be able to have the demand to accomplish a $400 million offering in tender and take out those 2024 that'll mature now in less than nine months.

In short, we saw a window to de-risk maturities, and we took it.

Nicholas Thillman (Senior Research Analyst.)

Very helpful. Then maybe just going back to what you were saying about non-encumbering the portfolio. What was, like, the rate differential between the secured and unsecured options?

Brent Smith (President and CEO)

I think even within a secured standpoint, and I noted this on the call, LTVs were very low. We were encumbering a number of assets, frankly, more than we would have anticipated to. The pricing was, you know, better than the unsecured market. I wouldn't say materially better. Particularly, if you think about some of the assets that we might have put debt on were our most, I guess, long-term, in terms of its walls, and probably candidates for harvesting in terms of value, because they've been maximized and mature under our ownership, which would have created prepayment penalties in addition to the interest expense incurred.

Really, we felt like the delta between secured and unsecured was within 100 basis points, and we frankly feel like keeping the portfolio unsecured, as we've talked about, is a key component of our leasing strategy today and overall, our capital recycling strategy once we're able to continue with that engine of growth and things normalize in the market. Given that lack of material discrepancy in pricing and the benefits of remaining unsecured, we decided to take the window within the market here the past few days.

Nicholas Thillman (Senior Research Analyst.)

Great. Maybe last one. It sounds like discussions for U.S. Bancorp are moving along here. You guys have traditionally, or like in the past, have said somewhere between 50%-100% on the downtown renewal. Sounds like we're trending more to the upper end of that range. Is that kind of reading into your comments?

Brent Smith (President and CEO)

That's fair to say, yes.

Nicholas Thillman (Senior Research Analyst.)

Yeah. Okay. Thanks, guys.

Brent Smith (President and CEO)

Thank you.

Operator (participant)

Thank you. Once again, everyone, if you have any questions or comments, please press star, then one on your phone. Your next question is coming from Dylan Burzinski from Green Street. Your line is live.

Dylan Burzinski (Office Sector Head and Analyst)

Good evening, guys. Thanks for taking the question here. I guess just touching on dispositions and transaction markets, could you comment on sort of the environment today versus maybe 3-6 months ago? Are things improving with regards to liquidity coming back to the private capital markets, or are things still tough?

Brent Smith (President and CEO)

I would say maybe improvement on a very, very small margin, but I still think we're gonna be in a time period here where there's gonna be a lot of headline risk, a lot of defaults and keys being thrown back. Hopefully, there's someone there to catch them. Frankly, right now, the lenders aren't really interested in taking the assets either. I think you're gonna have a time period here, we'll call it 12-18 months, where we're gonna continue to deal with some of these issues. Without any debt, there is no equity, so transaction volumes continue to be elusive. As a result, a sense of pricing and price discovery in the market... Frankly, clarity around underwriting and what an exit cap rate should be is very difficult, and that continues to weigh on overall transaction volumes.

As we've talked about, those buyers that we've been approached by in the market are generally non-institutional. They're local private equity, local family office, who understand the nuances of the market and see opportunities to either not have a competitive bidding pool and/or get a great price. I think we continue to be very patient in that marketplace, recognizing that we do have some good assets that should garner fair value once things open back up. Houston is under contract. We are being patient with a buyer to find financing, but we'll continue to look at other alternatives as dispositions as well, and still guide and co- accomplish somewhere between $100 million-$200 million of dispositions in the next 6-12 months.

Dylan Burzinski (Office Sector Head and Analyst)

Just sort of along those lines, any desire or willingness to offer seller financing in certain instances?

Brent Smith (President and CEO)

Very relevant point, Dylan. I think that's really what's gotten most of the transaction volumes that we're aware of, most of them, not all of them, over the goal line. We have considered in the past, certainly done it in the past. At this point, right now, with the Houston buyer, we've not capitulated, and we've had some discussions, but I don't think that we're meeting immediately the leverage thresholds they would like to. Overall, I think that's something we will continue to consider in some situations, but in the instance of Houston, I think our preference would be to exit the market, if possible.

Dylan Burzinski (Office Sector Head and Analyst)

Just one last one, if I can. Assuming, you know, U.S. Bancorp gets settled out here at the high end of sort of the range you guys guided to, is that a potential future disposition candidate? Or, I guess, just broadly speaking, how are you guys thinking about your Minneapolis presence over the longer-term time horizon?

Brent Smith (President and CEO)

Dylan, a very relevant question. I think, you know, we're certainly very close with U.S. Bancorp, and in discussions, so I don't want to get too much in detail or ahead of ourselves. I think we view the downtown asset as a critical component of U.S. Bancorp's operations. We would have, you know, a meaningful reposition of their space if we were to do a long-term lease, like we're talking about here. That's gonna take several years to complete. I think we're very committed overall to our position in Minneapolis, recognizing there may be an opportunity or some buildings to reduce exposure. You know, near term, I think we're focused on accomplishing those leases, and then we'll worry about opportunities overall in the marketplace.

Dylan Burzinski (Office Sector Head and Analyst)

Great. Appreciate the comments, Brent. Have a good one.

Brent Smith (President and CEO)

Thanks for joining this evening, Dylan.

Operator (participant)

Thank you. That concludes our Q&A session. I will now hand the conference back to Brent Smith for closing remarks. Please go ahead.

Brent Smith (President and CEO)

Again, I want to appreciate everyone who's taken the time to get on the call this evening. We certainly have been pleased with the operational performance of the portfolio and look forward to continuing to share that in the quarters to come. I'd like to remind investors as well, we'll be attending the Bank of America REIT Conference on September 12th-13th in New York City. If you'd like to schedule a meeting with management, please reach out to Eddie Guilbert or Bobby Bowers. Again, thank you everyone for joining. Have a good evening.

Operator (participant)

Thank you, everyone. This concludes today's event. You may disconnect at this time and have a wonderful day. Thank you for your participation.