Good day and welcome to the City Office REIT, Inc. third quarter 2019 earnings call and webcast. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference call is being recorded. [Operator Instructions].

It is now my pleasure to introduce to you Mr. Anthony Maretic, the company's Chief Financial Officer, Treasurer and Corporate Secretary. Thank you. Mr. Maretic, you may begin, sir..

Good morning. Before we begin, I would like to direct you to our website at cityofficereit.com where you can download our third quarter 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 facts 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 third quarter 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..

Good morning. Since our last earnings call in August, we have been actively taking steps to position City Office for long term success. During the quarter, we capitalized on strong equity and debt capital market conditions to significantly improve our balance sheet.

We have also continued to source attractive acquisition opportunities which will drive long term performance. In addition, leasing momentum and healthy same-store results have continued across our portfolio. With my comments today, I would like to speak to each of these major components of our results this quarter.

Starting with our recent capital raising activity. The combination of strong equity market conditions and outperformance of our common stock year-to-date allowed us to access equity capital at our highest pricing to-date.

Between shares issued through our ATM program during the third quarter and a follow-on offering in early October, we raised just over $200 million at an average gross issuance price of $13.56 per share.

This with an important step as it allowed us to secure capital for portfolio growth and diversification, but it also will reduce our fully deployed leverage level. Separately, we took advantage of the drop in interest rates over the summer to renegotiate loan terms on approximately $88 million of property level debt.

Tony will provide more details shortly, but these steps will generate meaningful savings over time. Moving to our recent acquisitions and pipeline. We closed a $49 million acquisition in Denver during the quarter called 7601 Tech.

This six-story building is located in the Denver Tech Center, a submarket of Southeast Denver adjacent to our existing property 7595 Tech which we previously called DTC Crossroads. We have combined the two properties into a 380,000 square feet amenitized campus that features a full suite of attractive and recently built out amenities.

This enhances the profile of both buildings and provides us leasing flexibility as tenants grow or contract within the two buildings. In addition, we will be further amenitizing the properties and have consolidated the leasing execution with one of the best leasing teams in Denver.

7601 Tech was 95% leased at the time of acquisition with a weighted average lease term remaining of 7.5 years, when including committed leases. The building has had strong recent leasing success and the tenancy is anchored by Jackson National Life Insurance Company and a well-capitalized public company.

Our third quarter occupancy for 7601 Tech shows as 80% as one of the tenants signed a lease to expand into new space and they are expected to physically occupy the space early in the fourth quarter of 2019 or early 2020. We acquired the property at a 7.1% cap rate and expect it will produce solid long term results.

Behind 7601 Tech, we continue to evaluate a broad pipeline in excess of $750 million. Given the typical timeline of a closing process, we don't expect to have any further acquisitions in 2019. We are focused on executing on the pipeline and are targeting between $320 million and $360 million of new acquisitions.

On a related note, we had two smaller dispositions in process in Denver, one of which is a land parcel adjacent to our Circle Point property and the other is our Logan Tower property. The buyer's deposit on the Circle Point land parcel is nonrefundable. We will provide further details on our next earnings call.

Turning to our operating performance during the quarter. We continued the trend of robust same-store cash NOI growth with 5.8% growth for the quarter, year-over-year. This brings our year-to-date same-store cash NOI growth to an impressive 4.5%.

Our occupancy decreased from 93.4% to 91.2% during the quarter, which is a little bit misleading as far as our actual performance. I mentioned earlier that our new acquisition 7601 Tech is 95% leased but one significant tenant does not technically occupy the space yet.

This brought down the reported occupancy of this property to 80% and lowered the combined portfolio occupancy by about 0.5% at quarter end, despite 7601 Tech being leased long term. Further, we had approximately 119,000 square feet of vacates during the quarter.

These were known vacates that we mentioned on previous earnings calls or were necessary as part of our Camelback Square repositioning at higher market rents. These moveouts in Q3 will be offset by the 114,000 square feet of new leases that are signed and committed, but not yet in occupancy.

The vast majority of these committed leases are expected to commence in Q4, although the timing of the construction of tenant suites could straddle year-end. Notably, during the quarter, we signed a 30,000 square feet lease at our 7595 Tech property, which is a significant step in leasing the attractive blocks of vacancy at that property.

We therefore expect portfolio occupancy to tick back up in Q4 and we have provided updated guidance of over 92% at year-end. In conclusion, the net effect of the transactions that I discussed and the impactful balance sheet enhancements that Tony will detail have positioned City Office to take advantage of opportunities in our thriving markets.

The management's focus continues to be on intelligently investing our capital, enhancing our balance sheet and driving NOI growth. We believe these steps will increase net asset value for our investors and increase our share price over the long term. And with that, I will turn the call over to Tony to provide further details on our financial results..

Thanks Jamie. On a GAAP basis, our net operating income in the third quarter was $24.6 million. This represents a $2 million decrease relative to $26.6 million reported in the second quarter. The decrease is primarily attributable to a $2.6 million one-time assignment fee income reported in the previous quarter.

Without the one-time fee in the previous quarter, NOI would have increased by approximately $600,000 which was driven by the acquisitions 7601 Tech late in the third quarter and NOI growth from our same-store portfolio. The gross assignment fee income received of $2.6 million was recorded within rental and other revenues in the second quarter.

For accounting purposes, the outlays and expenses were classified in G&A as one-time costs. Those costs were approximately $1.1 million resulting in a net $1.5 million benefit in the previous quarter. Overall, we reported core FFO of $12.4 million or $0.29 per share which was $1.3 million lower than the second quarter.

As I mentioned, the second quarter included a $1.5 million benefit from a net assignment fee income with an offsetting increase attributable to the year-to-date acquisitions. G&A was also slightly higher in the quarter, partly due to higher costs related to our first year being subject to auditor attestation under Sarbanes-Oxley.

Our third quarter AFFO was $9.3 million or $0.22 per share. Excluding the impact of the higher share count from our capital raising activity, our AFFO would have been right on top of our $0.235 dividend. Our third quarter AFFO was affected by the tenant improvements and leasing commissions associated with our leasing activity in the quarter.

Due to the relative size of our portfolio and the impact of significant leasing in any one quarter, our AFFO numbers will continue to move around some from quarter-to-quarter. Our leasing activity and capital expenditures are provided on pages 17 and 19 of the supplemental package.

Consistent with our definition of AFFO, we have excluded some first-generation leasing costs, the largest of which relate to our recently acquired Canyon Park property. Further details are disclosed on page 19 under non-reoccurring capital expenditures.

Our third quarter same-store cash NOI grew 5.8% year-over-year or 4.5% for the first nine months of the year as compared to the same period in the prior year.

Orlando, Portland and San Diego were our best performing markets in the third quarter each with double-digit same-store cash NOI growth, which was primarily driven by a combination of occupancy gains in those markets, free rent burn off and mark-to-market or step-up in rents.

With the slight decrease in occupancy we experienced at the end of Q3, we expect same-store growth to remain positive but moderate in the fourth quarter. Moving onto our balance sheet. Our total debt net of deferred financing costs at September 30 was $652 million.

Our net debt to enterprise value ratio was reported at 43.5% but that figure does not include the additional 6.9 million shares issued in early October. Including the proceeds from the offering, net of underwriting discounts, our net debt to enterprise value is closer to 37% today.

During the quarter, we also take advantage of a drop in interest rates to renegotiate loan agreements on four of our properties. The annual savings from those renegotiations will result in initial annualized interest expense savings of approximately $800,000 and this was achieved without incurring any prepayment penalties.

We also expanded our unsecured credit facility to $300 million by entering into a $50 million five-year term loan. Simultaneously, we entered into a $50 million five-year swap arrangement. The term loan is priced off of LIBOR. So the swap fixes a 30 day LIBOR component of the borrowing rate at 1.27% for the five-year term of the term loan.

At quarter end, the LIBOR swap effectively fixed our term loan interest rate at 2.67%. Given the positive differential in the rate, the unrealized gain from this hedge is reflected in our 10-Q in comprehensive income.

As a result of those balance sheet transactions, we lowered our overall weighted average interest rate on our total debt portfolio to 3.99% at quarter end versus 4.22% at the end of the prior quarter. At quarter end and including a swap agreement I discussed, 93.4% of our debt was effectively fixed and had a weighted average maturity of 5.6 years.

Finally, in our third quarter earnings release, we provided updates to our previously issued 2019 guidance. The updated full year guidance primarily reflects the higher share count from our share issuances and interest savings through to the end of the year.

Based on these assumptions, we are anticipating core FFO between a $1.17 and $1.19 per share for the full year ending December 31, 2019. Excluding the impact of share issuances, the updated range would have been between $1.24 and $1.26, which is a higher end of our previous guidance.

Further, we continue to expect same-store cash NOI growth between 4% and 5%. A full set of revised guidance estimates and underlining assumptions is provided in our third quarter press release. That concludes our prepared remarks and we will open up the line for questions.

Operator?.

[Operator Instructions]. Our first question today will come from Michael Carroll of RBC Capital Markets. Please go ahead..

Hi guys. Good morning. This is Jason, on for Mike. I am wondering about the 7601 Tech acquisition.

I am just curious what other type of capital was chasing that asset and also if that was a marketed deal?.

Thanks for the question. Yes, it was a marketed deal. It was fairly competitive. I think we had a good advantage, given that we own next-door and clearly knew the market well and it was a pretty large private REIT that sold it. But it was a very competitive process..

Got you.

And then, are you expecting any leasing synergies now that you guys have kind of built out a little cluster there?.

As part of what we are doing, it really was helpful to put together and amenitize campus. So we are taking a few steps there. One, the building we acquired had a great food offering. We have recently built out in our other building fitness, shared amenities, conference. So combining them all provides a much better package.

And so as part of that, we have re-awarded the leasing on that to the team that was leasing 7601 who have done a fabulous job. So we do think there is going to be some synergies and advantages there, particularly as some of the tenants in that building are rapidly growing, it might be a good candidate to grow into our building..

Okay. Great.

And then moving away from DTC, could you provide an update on leasing at FRP and Sorrento Mesa? And then any trends that you are seeing in those markets?.

Sure. So this is Tony here. So FRP Collection, we effectively have backfilled the space that was vacated by Metters some time ago and the tenants are moving in. So occupancy at quarter end at FRP Collection was effectively 89% and we have another tenant moving in, in Q4..

In terms of Sorrento Mesa, we still do have one building, life sciences that is vacant. A few prospects are looking at. We have completed the majority of our cosmetic work. We have built kind of a centralized amenity campus. So we are in good shape there. The market extremely strong there as well as far as rents.

So the value of the vacancy is very significant to us..

Got it. Thank you guys..

Thank you..

The next question today will come from Rob Stevenson of Janney. Please go ahead..

Good morning guys. Jamie, how are you thinking about market concentrations these days when you are evaluating $750 million of deals? Phoenix and Denver are now over 20% of rent. If you get Camelback in Denver Tech and Tampa isn't far behind.

Is that about where you sort of want to keep things in those markets? And maybe you will trade in and out of assets? Are you comfortable going to 25%, even 30% exposure in the market these days?.

It's a good question, Rob. So if you look at few of our markets we have got a lower weighting towards, Seattle and Portland. But generally, we are very comfortable with what we have. We are just slightly over 20% in both Denver and Phoenix. Would we be comfortable going a little higher based on getting some great quality assets? Yes.

But that's right around where we want to be long term on the upper end. So our focus is continuing to find great acquisitions in some of our other markets. We continue to look at a couple of similar markets we have discussed in the past as well and build out a broader portfolio..

Okay.

And any incremental known or likely moveouts that have to light this quarter?.

Hi Rob. It's Tony here. So in Q4, we do expect approximately another 50,000 of known vacates that will take place during the quarter. Now some of that has actually already been backfilled. But there are 50,000 square feet of known vacates in Q4..

Okay.

But looking at 2020, is there anybody who has, like, given you notification in the last 90 days or 100 days or so that is of note?.

Yes. No real change in the last 90 day that actually say that, on previous calls we have talked about we have seven tenants that are greater than 30,000 that are rolling next year. And on previous calls, we talked about having high confidence in renewals on at least four them.

We will probably bump that number to five based on recent positive discussions. And then we do have a couple of known or expected vacates in 2020. They are both the back half of the year and both of them may do short term extensions. So looking pretty good for 2020..

Okay.

And then lastly, Tony, any known difference between NAREIT and core FFO in fourth quarter at this point?.

So known and NAREIT, so you are talking about -- I mean our only adjustment for FFO is that we use core FFO definition which are backed out of the stock based compensation which is a non-cash item. That's really the only adjustment we have.

Did I understand your question, Robert?.

Yes. I just wanted to make sure that there wasn't anything, either from some of the debt refinancings or anything else, so it's like a one-time thing that we need to be cognizant about that would be in core FFO, that would be added back for core FFO that wouldn't be for NAREIT..

Fair question and it's actually a good point worth mentioning because I did talk about the refinancing. We did manage to do all those refinancings without actually incurring any prepayment penalties. So no prepayment penalties are expected..

Okay. Thanks guys. I appreciate it..

Thanks Rob..

Our next question today will come from Bill Crow of Raymond James. Please go ahead..

Thanks and good morning. Hi guys.

Any updated thoughts towards coworking exposure and maybe your thoughts going forward on that sector?.

It's something we have been looking a lot, Bill. So we have no exposure to WeWork. We do have a few Regus offices that are very well occupied. There is nothing really significant across our portfolio. And then we have a couple smaller regional, again when you look at the occupancy levels they have, they are high and the space buildout is great.

So we have no concerns within our portfolio..

All right. And then just a home-court advantage here. I just saw that your Tampa partner in the downtown building just acquired an office asset in Carillon which you also own.

And I am just wondering whether they reached out to you for a potential partnership in that building?.

That was on the table early on. Given the vacancy in that particular building, it was not something that we wanted to partner in within CIO. So that was not something we explored..

Okay. Great. Thank you..

Thanks Bill..

Our next question today will come from Craig Kucera of B. Riley FBR. Please go ahead..

Hi. Good morning guys. Given that you still have a handful of loans that are priced kind of in the mid 4%.

Are there any other opportunities to maybe work on those as well to bring them down to what you achieved in the third quarter?.

That's a good question, Craig. Just to give you a little bit more color. So when interest rates kind of start to fall and there was that opportunity, we looked at our entire portfolio.

We focused on and we had a couple of loans that had no prepayment penalty and a couple of them were actually with the same bank that had some prepayment penalties but we managed to negotiate reductions and a waiver of those prepayment penalties.

The other loans within our portfolio that do have a little bit of higher rates have substantial prepayment penalties. We have made some inquiries but were unsuccessful in sort of moving the dial in that. So that's a long way of saying, I think we have taken advantage of the opportunity as best we can.

And the remaining ones, the prepayment penalty is probably too prohibitive for it to make sense..

Got it. And just going back to your commentary on sort of your acquisition pipeline and what you are looking to do with the equity that was raised.

Is it fair to say, are you guys going to shoot to do something on the order of $320 million to $360 million next year? Or is that sort of over time that's where you see putting that money to work?.

Yes. Based on where we are, it's beginning of November, timing of transactions. We don't see anything meaningfully impact in Q4. So our own internal plan is to start taking advantage in closings early 2020 with full deployment on the back half of 2020..

Got it. And just as we think about leverage in general going forward, I guess, just sort of the back of the envelope math is about 40% leverage on this around the capital.

Is that sort of how we should think about the company moving forward as far as sort of a target leverage on new acquisitions and sort of gradually bringing on leverage?.

Hi Craig. I think you are about right. I have talked about that in the past. I have used the term low-40s. So as we are penciling it out, our own math was kind of between 40% and 45% on this acquisition capital. It will depend a little bit on the chunkiness of the acquisition. I can't time it or size it perfectly.

And a little bit may be determined by the cap rates so that we are ensuring we are getting sufficient NOI. So low-40s, certainly, I would agree that's the right number to use..

Got it. And I think you mentioned this in your commentary, but it sounds like there was a lease that got picked up at 7595.

What was that number and kind of where were the rents?.

So 30,000 feet, so it's a full floor. Now there is a tenant that's about half of the floor that's there that's going to roll, that Tony mentioned in the fourth quarter. So we have backfilled that and taken up the rest of the space on that floor. The rate we negotiated was $2,650, starting rental rate..

Okay. And I know that market for quite a while has been a little slow and I think you even alluded to the Denver Tech Center being a little slow.

Are you start seeing better activity there now and was that sort of what led you to maybe double down in that submarket?.

Yes. It was something we looked at a lot, Craig. So we think by having the campus, it really positions our buildings well. So high quality food amenities, fitness, conference, large outdoor integrated space. If you look at who was winning a lot of the major leasing activity over the last little while, it was this particular building that we bought.

And so they basically fully backfilled it and they did that by having really built out space that was move-in ready.

So that's something we are probably going to explore going into next year as advancing the quality of the vacancy that we have, building some spec suites, bringing that same leasing team that had a lot of success, moving them over onto our property. And so we think there's a lot of synergies there. But for sure, that submarket has strengthened a lot..

Okay. Thanks..

Appreciate the questions..

[Operator Instructions]. Our next question today will come from Mitch Germain of JMP Securities. Please go ahead..

Yes. Hi guys. Portland 6%, Seattle 3%.

When you talk about a deal pipeline of $750 million, is there a concerted effort to possibly grow further in some of those markets where you have less scale?.

Absolutely. The challenge we have at some of those markets is the valuations are just at a point where you are hitting a lower percentage. It's harder to buy well and make the math work.

If you look at our pipeline, really it is a mixture of some smaller transactions, a couple larger and then a couple of portfolio that are substantial size that would give us significant scale in some markets that we don't have exposure to or minimal exposure.

So I think there is a way for us to hopefully accelerate the growth in a few of those particular markets that we are feeling really good about..

And then, Jamie, just on that point, when you talk about your pipeline and your underwriting, have you made any real shifts in the way that you are underwriting to maybe account for kind of later cycle or anything that or is it really market-by-market that you are kind of looking at these assets?.

We have made a lot of shifts over the last year or two, I would say, as far as how we underwrite assets. So generally we have been seeing a lot of growth in rents. And over long term goals, we are not expecting that that's going to be there every year. It has been, but we are pricing accordingly that there are going to be setbacks.

You are later in the cycle, there is going to be some pullback in rents and we are making sure we are pricing assets accordingly so that if that happens we are still hitting our business plan.

And if it doesn't happen for a long time, we are going to exceed our business plan, but we want to make sure we are comfortable in any market for the types of underwriting that we are doing..

Great. Last one for me. Tony, just to understand the leverage.

I know you have talked about, I guess, it was debt to EV and what that is post equity raise? Is it just assuming kind of back of the envelope, post equity raise that your net debt to EBITDA that gets shaved by about a full turn? Is that the way to think about it?.

I think somewhere between half a turn, full turn. So even before we are kind of high-7s. I am now kind of guiding to low-7s in terms of the adjustment post deployment. But again, a lot of that will depend on the acquisitions and what the initial cap rates going into those acquisitions are. But it should move down significantly..

Great. Thank you..

Thanks Mitch..

Ladies and gentlemen, this will conclude our question-and-answer session. At this time, I would like to turn the conference back over to Mr. Jaime Farrar for any closing remarks..

Thanks for joining us today. We look forward to updating you further on our next call. Good bye..

The conference has now concluded. We thank you for attending today's presentation and you may now disconnect your lines..