Welcome to Armada Hoffler's Third Quarter 2018 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded today, Tuesday, October 30, 2018. I will now turn the conference over to Michael O'Hara, Chief Financial Officer at Armada Hoffler. Please go ahead..

Good morning, and thank you for joining Armada Hoffler's Third Quarter 2018 Earnings Conference Call and Webcast. On the call this morning, in addition to myself, is Louis Haddad, CEO. The press release announcing our third quarter earnings, along with the quarterly supplemental package, were distributed this morning.

Replay of this call will be available shortly after the conclusion of the call through November 30, 2018. The numbers to access the replay are provided in the earnings press release.

For those who listen to the rebroadcast of this presentation, remind you that the remarks made herein are as of today, October 30, 2018, will not be updated subsequent to this initial earnings call.

During this call, we'll make forward-looking statements, including statements related to the future performance of our portfolio, our development pipeline, impact of acquisitions and dispositions, our construction business, our portfolio performance and financing activities as well as comments on guidance and outlook.

Listeners are cautioned that these statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond our control.

The risks and uncertainties can cause actual results to differ materially from our current expectations, and we advise listeners to review the forward-looking statements disclosure in our press release morning and the risk factors disclosed in documents we have filed with or furnished to the SEC.

We will also discuss certain non-GAAP financial measures, including, but not limited to, FFO and normalized FFO. Definitions of these non-GAAP measures as well as reconciliations to the most comparable GAAP measures are included in the quarterly supplemental package, which is available on our website, ArmadaHoffler.com.

I'll now turn over the call to our Chief Executive Officer, Louis Haddad.

Lou?.

Thanks, Mike. Good morning, everyone, and thank you for joining us today. As you will hear from our discussion this morning, we have a lot going on here at Armada Hoffler. As I mentioned, during our last conference call, our company is built to thrive in a variety of macroeconomic environments, and the current backdrop is no exception.

The growing economy has yielded increased opportunities in development, public-private partnerships, build-to-suit engagements, third-party construction, mezzanine lending and tenant expansions. We believe these factors more than offset the impact of gradually rising interest rates.

Before we talk about our results, guidance and pipeline, I'd like to spend a few minutes on our business model. Many who follow our company have correctly pointed out that we do not fit neatly into the standard REIT box.

Certainly, with third-party construction profits, build-to-suit asset sales and mezzanine interest income, our platform has a unique complexity that can't be measured wholly by traditional REIT metrics.

These additional income streams are expected to continue their upward trajectory due to the ever-increasing volume of these types of opportunities coming our way. That said, please do not overlook the positive trends in our operating property portfolio.

While we are very proud of the growth in our NAV, normalized FFO, and of course, the annually increasing dividend over the past 4 years, it's important to note that our rental property NOI has nearly doubled over the past 5 years.

We expect yet another double-digit increase in property NOI next year as our development delivery stabilized and the mature portfolio continues to excel. Although we will provide 2019 guidance early next year, preliminary forecast indicates that it is shaping up to be a very strong year in all of our income-producing areas.

This morning, we reported $0.24 of normalized FFO per share for the third quarter. Same-store NOI was positive across all product types on both a cash and GAAP basis. Occupancy was higher portfolio-wide and now stands at 96%. Re-leasing spreads in the retail sector were quite a bit higher as well.

As you know, our retail portfolio is dominated by strong grocery anchors, home improvement stores, restaurants, entertainment and discounters. We expect continued high occupancy, positive spreads and strong sales performance in our centers over the coming quarters.

Overall, across all property types, our stable portfolio continues to perform at a very high level. As we announced earlier this month, we've reached an agreement to sell our at-cost purchase option to the developer of the multifamily project, The Residences at Annapolis Junction.

As many of you saw in our previous press release, we are allowing the developer to refinance the project and extend the mezzanine loan. This will allow the project to achieve stabilization prior to the ultimate sale, enabling him to recognize the full value of the project. We expect the option payment to be received in the fourth quarter.

However, the $5 million of profit will be recognized over the next 4 quarters. This effectively moves approximately $4.5 million of FFO into 2019 and also gives us the opportunity to earn additional fees and interest. Overall, this change in profit recognition has caused our 2018 full year guidance to be updated to $1 to $1.03.

Mike will give you the details on our updated guidance. As we have said on many occasions, we expect the multifamily segment of our overall portfolio NOI to grow significantly over the next couple of years.

The sale of our purchase option on this project should be viewed as one-off opportunity that we chose to take advantage of as opposed to any shift in overall strategy.

With over $60 million raised year-to-date under the ATM program, the $5 million of profit on the option sale and the anticipated partial repayment of our mezzanine loan, we remain confident in the overall strength of our balance sheet.

We continue to believe that the company is well positioned to execute on the opportunities in our development pipeline. Starting with Town Center for the development updates. The Premier, previously referred to as Phase VI, is leasing very quickly in both the retail and multifamily segments.

Despite only being open since August, retail is leased or under letter of intent at 75% and multifamily at 50%. Also, the second floor performing arts theater celebrated their grand opening bringing additional activity to this newest space of Town Center.

Point Street Apartments at Howard Point continues its upward trajectory with no sign of slowing down and now stands at 82% leased. We are projecting stabilization in the first quarter of 2019, which is also the timeframe that we anticipate bringing the project on balance sheet through execution of our purchase option.

The option portion of City Center in downtown Durham is complete and leased at nearly 90%, and the retail is leased or under letter of intent is 66%. We are in conversations with multiple tenants for the last few available spaces.

The Greenside Apartments in downtown Charlotte, formerly known as Harding Place, have begun delivery and stands at 31% leased. This product is ramping in line with our expectations.

Our 325,000-square foot Wills Wharf office development at Baltimore's Inner Harbor has started vertical construction and stands at nearly 60% preleased with several strong prospects interested in the additional space. All other previously announced pipeline projects are on track for their scheduled 2019 delivery.

This morning, we announced our fourth project in the greater Charleston MSA, Nexton Square. This $45 million open-air lifestyles center is expected to contain up to 148,000 square feet of the area's best restaurants, retailers and service providers. Nexton Square sits at the entrance of a large master plan development of more than 10,000 homes.

It is strategically located between the Boeing facility and the new Volvo assembly plant. The project is nearly 65% preleased or under a letter of intent with the first tenants opening in the second quarter of 2019. We will provide mezzanine financing as well as development and construction management.

In addition, we will receive a below-market option to purchase the project upon completion, which we ultimately intend to exercise. Furthermore, the asset would be available as a candidate in a tax-free exchange in order to potentially cycle out of an older center. Last quarter, we announced the Interlock, a partnership with Georgia Tech and S.J.

Collins to develop 300,000 square feet of office and retail space in West Midtown Atlanta. In addition, we are in negotiations with Terwilliger Pappas to be the investor and general contractor for the multifamily portion of this project, Solace Interlock.

We expect this upscale product to contain approximately 350 apartment units with an anticipated completion in the fourth quarter of 2020. In addition to our construction company's participation in the project, we will provide approximately $20 million of mezzanine financing.

We expect the finalized negotiations with Terwilliger Pappas over the next few weeks and expect groundbreaking on the entire Interlock complex in the current quarter. We are currently working on a few other opportunities to round up the current pipeline. These are exciting, large, CBD infill opportunities in Charleston, Charlotte and Nashville.

This opportunity set is primarily weighted towards Class A office followed by multifamily with a small amount of ancillary retail. We hope to have further announcements regarding these projects in the not-too-distant future.

Despite this increase in development activity, be assured that we continue to be extremely selective with regard to the projects we pursue. The vast majority of the opportunities that present themselves do not meet our criteria and are quickly removed from consideration.

Beyond the aforementioned opportunities, I would not expect any further significant development engagements until we open a number of our 2019 deliveries. Our construction company continues to perform at a very high level. We expect to finish construction and close on the sale of the build-to-suit distribution center in the current quarter.

Our backlog of third-party contracts stands at $25 million and we expect to execute another $80 million to $100 million of contracts this quarter, which we will leave this division in a very comfortable position looking forward to next year.

Remember, Armada Hoffler is first and foremost an opportunistic real estate company that employs multiple strategies to enhance profitability and create value. These have been our central tenets for nearly 40 years, and investors can count on this to remain our primary focus.

As the company's largest equity holder, management will continue to operate a business model that includes a variety of deal structures as well as the disposition of development projects, at-cost options and stable assets.

We are extremely optimistic about the company's prospects for the rest of 2018 and 2019 as well as our ability to deliver in our promises over multiyear of timeframe.

As we begin to look forward towards 2020 and the number of projects we intend to deliver and stabilize at that time, we feel strongly that our investors will recognize continued great value well into the future.

As we gauge the ultimate size and construction schedules of the pipeline projects, we will be evaluating further dispositions and use of the ATM as a part of a continuing strategy to maintain a strong balance sheet and grow NAV over the long term. At this time, I'll turn the call over to Mike to discuss our third quarter results..

total NOI in the $78.7 million to $79.2 million range; third-party construction company gross profit in the $5.9 million to $6.4 million range, which includes the expected profit from the sale of the distribution center; general administrative expenses in the $10.8 million to $11 million range; interest income from our mezzanine financing program in the $10.1 million to $10.5 million range, this includes $500,000 from the amortization of the Annapolis Junction purchase option gain, at quarter end, the aggregate loan balance of these mezzanine loans was $99 million; interest expense in the $19 million to $19.2 million range; and 64.8 million weighted average shares outstanding.

Now I'll turn the call back to Lou..

Thanks, Mike. As some of you already know, Mike and I will not be attending the NAREIT conference in San Francisco next week. We are at a critical junction on several pipeline and unannounced developments, which require our presence for final negotiations, loan closings and lease executions.

The timing required for these agreements makes travel to the West Coast for the better part of the week not in the best interest of the company. We are happy to take your questions on this or any other topic this morning. Operator, we would like to begin the question-and-answer session..

[Operator Instructions]. Our first question is coming from John Guinee of Stifel..

Great.

Two questions, one is what do you anticipate your mezz loan balance to run in 2019? And second, can you talk a little bit more in depth about the CapEx associated with your retail leasing for 3Q '18?.

Sure. Thanks, John. With this past quarter's re-leasing, that represented about 37,000 square feet and it was not a significant amount of CapEx involved there. It was primarily small shops. I don't think -- we're not anticipating a whole lot in terms of rollover in the retail for the rest of the year.

We do have some more significant rollovers next year that are going to require some pretty substantial tenant improvement investments, that's primarily at Columbus center, the 2 shopping centers here adjacent to Town Center, as well as some re-leasing in Town Center. But so far, it's been pretty light..

On the mezzanine program, we're expecting it to top out, I'm going to say, in the $140 million range, but it's all going to depend on timing. Next year, like in the first quarter, we’re expecting a Decatur Whole Foods center loan to be paid off. I believe that opens next month.

And also, it'll be around the timing of the ultimate payoff of the Annapolis Junction loan..

Great. Okay. A just little follow-up here. What it looks like is you're getting pretty healthy gap and cash spreads on your new leases. I'm assuming these are net rents, but correct me, without spending much at all for TIs and leasing commission. But you've got to come in to the tune about $6 per square foot per year for new leases.

Any idea as to what the expiring rents might be on the new leases you're signing versus the renewals?.

John, are you speaking....

Retail..

Good. Retail, okay..

Said another way is renewing your tenant seems like pretty good economics. But when you deal with a new lease, it seems like pretty challenging economics. You don’t provide the old cash rep so you are not providing the mark-to-market so we're looking for a little more detail on when you have to replace the tenant..

Yes, John, on that, the first is on a renewal -- one thing on then depends on how the renewal comes about and we don't have the leasing commission on a lot of our renewals. And the other thing is, as we've talked about, we have tenants who are doing well who don't need a lot of TIs especially in the -- they're happy with the space.

You don't have to redo anything. With new tenants, a lot of time it's the TI to get them up and going, which they've already paid for in the renewals..

And any idea on the prior cash contractual rent on the new leases, i.e., is it a rent roll-up or rent roll-down on your new leases, not your renewal?.

On the new rate?.

Yes, it's typically higher, John. We haven't seen much compression. And I think the only exception to that would be in some of the nooks and crannies in Town Center where we're after specific tenants basically to add to the mix.

That would be about the only time that we would see rents contract and that happens fairly regularly here in Town Center as we try to keep the mix as fresh as possible and add new offerings..

Then the last question, Lou. You provided 2019 guidance off a very strong year.

Can you elaborate?.

Well, as I said, we will be providing guidance on the next conference call. But John, you followed us for a while as has several people on the phone. We've been saying for 1.5 years that pointing to 2019 as the show-me year for this current pipeline that we are in the process of delivering.

And that's -- we plan on doing just that and all systems are go. You heard the updates on the deliveries and on the lease-up schedules, so I think the math is going to be pretty compelling. And we're really looking forward to that call.

There are still a few pieces to put in place, few leases to sign, and as I suggested, Mike and I really have a tough couple of weeks coming up with finalizing a couple of projects and loans. But we're looking forward to a very strong 2019 and I think an even stronger or 2020..

Our next question is coming from Dave Rogers of Baird..

Lou, wanted to start off with the Nashville, I think Charleston and Charlotte projects, I think that's what you had mentioned in terms of Class A CBD office opportunities, correct me if I was wrong there.

But 2 things around that, one would be would you anticipate those being similar type mezz investments? And what would be the peak -- not that you said 140 is a peak, but what would be your kind of max that you'd be comfortable within mezz? And then maybe a second broader question to that, just in terms of that pipeline, you said maybe nothing to be added to the pipeline after that.

Is that just that things may be starting to quiet down? Or that just takes you guys to capacity where you just don't feel comfortable adding anything else?.

Yes, I'll start with that second question first, and it's the latter. An easy way to get in trouble in this business is to get way out over your skis. There are -- the opportunities are accelerating. We're not seeing any slowdown in that.

However, we've practiced discipline here for nearly 40 years and we really don't want to get further out than where either our balance sheet or our personnel will take us. We've got really strong development partners in the locations that we are discussing to round out the pipeline.

But that's really the limit of our comfort level until we deliver some of the projects that we're talking about. We have 3 or 4 deliveries in 2019 that we really want to see done successfully and execute it well before we start shopping again. Of course, you never say never.

Something really compelling could come along, but the 3 projects that you mentioned, they would be a mix of projects that would be done on balance sheet as well as on the mezz side. We're comfortable where the mezz program is now. As Mike suggested, there's a lot that's going to get paid off or paid down here in the not-too-distant future.

And remember, these are large, lengthy projects and so you have an awful lot of a runway before these things ramp into any kind of significant hours..

Okay, that's helpful. One of the other comments that you had made was about recycling out of an older center to help fund this.

Can you start to give us an idea of maybe how much assets you're willing to sell into that bottom portion of the portfolio, get a little bit bigger if the development pipeline gets a little bit bigger and how are you thinking about asset sales relative to kind of what you've been doing?.

Sure. Actually, there is not much down there at the bottom. You heard us talk about in years past how we may cycle out of the 3 food lines that we have. We also have a Bi-Lo center. Those projects are doing really well, those assets. Food line is actually gaining market share in our area and so not sure that's going to happen.

However, as you know, we do like to regularly go through that portfolio and recycle. That's why this Nexton opportunity that came up was perfect for us. We love lifestyle centers, we love Charleston and there certainly will be something in our portfolio that we will be desirable -- less desirable of.

But I don't think, you're looking at a change in strategy, Dave. It's going to be one-off at best in terms of dispositions..

Our next question is coming from Rob Stevenson of Janney Montgomery Scott..

Lou, why do mezz on Interlock if you don't want to buy it or don't have a purchase option? I mean, what's the incentive for you guys to do mezz without path to ownership?.

Essentially, it's a moneymaking opportunity. It's a -- we have an opportunity to take substantial interest above our cost of capital and still control things with our construction company. So we're looking that as basically an income stream that's very healthy.

It's not too dissimilar to the 2 Whole Foods that we're involved in right now where those are going to trade far below our cost of capital. We expect Interlock would do the same thing. And so we'd be more desirous of taking current profits as opposed to bringing something on balance sheet that is below our cost to capital..

Another thing on that, Rob, is on the first part that we talked about last time on the mixed use of office and retail, we do get participation in cash flow and a capital transaction on that over and above our mezz, so we will have some participation on that. As we've talked about before on these mezz projects, we love these projects.

And reason involved, if these people defaulted, we'd love to own them for what we've been informed..

Okay. And then, if I'm doing the math right, on the supplemental, look like during the quarter are about 56% of your ABR came from retail.

And then if I take a look at the development pipeline, I mean, you've got the 2 Charleston multifamily projects that'll come online next year and assuming that you guys will buy in the Point Street Apartments purchase option, but there's still a lot of retail sort of coming behind that as well and any of this office looks like it's a 2020 or 2021 or beyond sort of delivery, how comfortable are you in seeing retail ratching up to north of 60% of ABR for some period of time here before other asset types come in to dilute it back down?.

Yes. So Rob, on the retail, on the development side, there's not a lot of retail. We've got the Market at Mill Creek, which is a $23 million project, not a large one then just the retail piece here at Town Center. But outside of that, on the office side, we've got the Brooks Crossing office coming online, which is 100% -- obviously 100% office.

And then we also have Greenside Harding Place in Charlotte on the multifamily coming in next year..

Yes, we think that percentage is topped out, Rob. But to answer your question whether it grows by couple of percentages or starts to go down significantly like we believe it will, as I said earlier, we're very comfortable with that retail portfolio.

It continues to perform, sales are strong, our grocers are strong, at 97% occupancy and re-leasing spreads as high as they are, we're very comfortable with what we own. And we intend on adding to it. We don't -- I don't think it's going to add materially because we're not involved in large-scale retail projects.

But it is going to -- we are going to add to that portfolio..

Okay. And then last one for me.

I mean, when you sit here in terms of the projects that you have underway and the stuff that you're looking to tee off over the next month or so, how should we be thinking about the general contracting company going forward? I mean, does that get bolstered by the continued expansion of mezz, something similar to what you're doing at Interlock? Does it retreat? Does it sort of maintain the sort of current size going forward? How best should we be thinking about the size and scope of the contracting business going forward?.

Sure, good question. So our company works best at between $200 million and $300 million worth of work in any given year. I think we're going to hit that target. It's going to be in that range in 2019.

What we don't know yet is the mix of third-party versus in-house and that mainly is going to revolve around a couple of big engagements that are coming up on both sides and there is still being a chance that they don't come to pass. However, I think you can expect the construction company to be in a range that it was last year.

This year was little bit less in volume and it's kind of artificially lower based on the distribution center and the fact that, that's all being recognized as a gain on sale as opposed to the fee income. But we're going to be in the same range that Mike has guided you to, we believe, for next year..

And our next question is coming from Jim Lykins of D.A. Davidson..

Just couple of things from me.

First of all, for Nexton Square, can you provide the rate on the mezz loan? And also when will that begin to impact FFO? Is that in 2018 guidance?.

Okay. Nexton, okay. Yes, that's going to -- we currently have a bridge loan, it's at 10%. We're anticipating going into the full loan here and closing on that here in the next two weeks and that's going to start at 15%. And then when they hit certain performance thresholds, it will drop to 10%..

Okay.

And also for the acquisition in Columbia, can we get the cap rate for that one?.

It's in the high 6s, Jim..

Yes, 6.75%..

Our next question is coming from Craig Kucera of B. Riley FBR..

I'd like to follow up on Nexton Square. You have an option to purchase below market.

Can you kind of walk us through how that agreement is constructed? Is that based on appraisal at the time of completion or just some additional color, how we should think about sort of the spread at what you're buying it versus what you think it's going to be worth or anticipated worth?.

Yes, we've negotiated a purchase option based on a cap rate times at NOI that'll be in place at the time. And the spread between what we believe to be market and what that options add is around 50 basis points.

But mind you, in the interim, we'll be collecting significant development and construction management fees as well as $2 million to $3 million worth of interest income. So inclusive of all that profit that will come our way, we still will be purchasing the project below market..

Got it. And going to Lexington Square, we appreciate that about 10% of the purchase price was paid in OP units.

But can you tell us what the pricing was or the number of units issued in that transaction?.

14-something weren't they, Mike?.

Yes, yes. They were in the mid-14s..

Got it..

There's a bit in place for quite a while..

Right. And going to the construction business, I know earlier in the year, you had stated that backlog was going to pick up, I think, a little earlier than have sort of come together and sounds like you're quite busy here in the fourth quarter.

But is that just really a function of just kind of other things taking precedence? Or did you have any potential deals that fell pipeline out of that pipeline? Or just some additional color on maybe why that slipped a quarter or so or even 2 quarters from what we saw it earlier in the year?.

Thanks for the question. Nothing has fallen out. Where our expectation is that we're going to be -- it's going to be a very robust backlog going into the first of the year. But what we're seeing the results of and I would imagine you guys have heard this on a number of conference calls, it's very difficult to find labor.

It's very difficult to confirm pricing. Schedules have elongated and so the businesses, we're proceeding very cautiously before we execute contracts.

The great thing about being in the development business, either working for other developers or working for ourselves, is that you have the time to set your cost pro formas before having to commit to tenants, and that's kind of where we are.

So our construction company has been working the same projects that we had anticipated being under contract by now. They've working them for several months. But finalized hopefully in the next month or two, but it's really a function of what's going on in the marketplace..

Got it. Wanted to circle back to one of your retail tenants that has 4 leases, Bed Bath, kind of had a tough quarter they announced earlier this month.

Can you give us some color on how you feel the stores are performing? And any update on discussions you've had with them?.

Yes, that's interesting. We have a few people kind of in that same category, Bed Bath being one of them. Their business is still very healthy, and in particular, our centers are doing great. We understand that a center that we have here, next to Town Center is one of their best-performing stores in the state.

We're watching that very closely from a couple of standpoints, one is Bed Bath is not a very strong rent payer. Those are fairly below-market deals, so it wouldn't be the worst thing in the world if we got some space back. But perhaps, more importantly, we're looking for them to update their concept.

They've got a tremendous amount of goodwill, great name and if they can just get going in a direction, we think they can probably turn around. They may need to shrink their stores. But we are -- we're very much engaged in watching that process. We got the same -- a similar situation with Barnes & Noble who's in a couple of our centers.

Again, they're working. They're little bit further along working a new concept that seems exciting and seems like it's going to be well received. And we're going to work with them here at Town Center and help them pull it off. But that environment changes -- is changing quickly, as everybody knows.

We are, like I said, we're very happy with our retail portfolio. That doesn't mean that we're not vigilant and worried about various things that are happening in the marketplace. It's particularly in soft goods, there's a lot of winners and losers out there and you've got to be careful.

But when you operate lifestyle centers, you're going to have tenants that come in and out of favor. But that's why we get paid, is to stay on top of these sorts of things..

Got it. One more for me. There seem to be rising concerns about global growth just due to higher interest rates and even maybe another round of tariffs. Doesn't sound like you guys are seeing anything on the ground.

But after going through a number of cycles, I guess what are the triggers, Lou, that you look at to sort of say, hey, we need to maybe start pulling back on development. I know you sort of outlined you have 3 new potential -- or 3 new markets with new projects.

But kind of what are you looking for to say maybe, hey, let's pull back and slow things down and just finish what we have..

Sure. I tell you, for us, the precursor is always the slowdown with our tenants. We've got a lot of architects, engineers, money managers, insurance companies and the like. And as you might imagine, all those people are on the front end of expansion in the economy and so it gives us a good gauge of what's going on out there.

That has been -- it's been a great bellwether for us. The second piece of that is, remember, we're not a large -- on a relative basis, we're not a large company. And so we really can have a rifle approach to where we want to play and where we don't.

When you do the types of public-private ventures or ventures with well-heeled tenants that we do, you're really not looking at a macroeconomic situation, you're looking at specific markets, and more specifically, even a specific submarket where you can do a really good deal in really just about any kind of environment.

So the macroeconomics are important for our overall tenant expansions and our construction company and the like.

But in terms of development opportunity, short of something like the Great Recession, the opportunities in the good markets are there, and like I said before, we feel really strongly about Charlotte and Charleston and Nashville, Atlanta and the like..

Okay. Thank you, ladies and gentlemen. We appreciate your interest in our company. We look forward to updating you on our activities and results in the coming quarters, and we look forward to 2019 guidance. Take care..

Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may disconnect your lines at this time, and have a wonderful day..