Anthony Maretic - CFO, Treasurer & Corporate Secretary Jamie Farrar - CEO.

Craig Kucera - B. Riley FBR Bill Crow - Raymond James Michael Carroll - RBC Capital Markets Rob Stevenson - Janney Barry Oxford - D.A. Davidson Merrill Ross - Boenning.

Good day and welcome to the City Office REIT Incorporated Second Quarter 2018 Earnings Conference Call and Webcast. At this time, all participants are in a 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 now begin sir..

Good morning. Before we begin, I would like to direct you to our website at cityofficereit.com, where you can download our second quarter earnings press release and a 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 second 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. As we press the mid-point of 2018, I would like to take this opportunity to review our progress year-to-date and to highlight our areas of focus for the balance of the year.

At the beginning of the year, we laid out a roadmap to growth and our run rate earnings that focused on leasing high quality blocks of vacant space and continuing to expand our footprint through acquisitions in strong growth submarkets.

Additionally, we are focused on our balance sheet and judiciously locking down our debt cost on a long-term basis, while working towards well covered dividend. The takeaway message as we stand today is that we are tracking well towards these goals.

Overall, I'm pleased with our financial and operating results which are demonstrative of our strategic acquisitions, leasing activities, and portfolio operations. Tony will provide more detail on our results in his remarks.

On the leasing front, we have executed 136,000 square feet of new leases in the first half of this year and ended the quarter at 89.6% occupancy. However when including signed leases that commence in future quarters, we are currently at 91%.

I'd like to speak to a few recent leasing highlights including Park Tower in Tampa and our 5090 Property in Phoenix. Despite Park Tower's major renovation is being underway, we have signed 10 new leases year-to-date for 35,000 square feet at rental rates that exceed our in-place rents when we bought it by approximately 20%.

With these leases in place and committed occupancy has reached 90% milestone and we look forward to driving this number even higher. At 5090, we leased 13,000 square feet through four leases during the quarter and the property is now 94% occupied to high quality tenants including in-place and committed leases.

We continue to believe that our remaining larger blocks of space are positioned well to attract quality, long-term tenants. The largest blocks of space are at our DTC Crossroads and Plaza 25 Properties in Denver, our Sorrento Mesa property in San Diego, and our FRP Collection property in Orlando.

Over the next five months, we are focused on driving further occupancy gains and monetizing the value inherent in our vacancies. Next, I'd like to provide you an update on our $175 million San Diego portfolio acquisition that we completed last September.

When we acquired the 10 building portfolio, seven of the buildings were stabilized core assets which had performed well. We plan to further enhance these buildings through capital improvement projects including modern fitness facilities, upgraded lobbies, and central outdoor amenities among other improvements that will drive leasing.

Out of the 10 buildings that we acquired, we categorized three as having a value-added component such as vacancy or a major tenant that would likely depart in the near-term. A major focus during our first nine months of ownership has been to take steps to derisk these properties and unlock incremental value.

Late last year, we achieved the first phase of this objective when we negotiated an early lease termination with the full building tenant that we knew was likely to seize operations at the 10398 building. This transaction generated $1.6 million of termination income split between the fourth quarter last year and the first quarter of this year.

However what this really accomplished was capturing 77% of the base rent and estimated operating costs for the remainder of the tenant’s lease through March 2020. By completing this bio, we were able to take early possession of the building and a sense completed our reconditioning work to position it for releasing.

Recapturing this space coincides with the commencement of our planned central outdoor amenity for the Sorrento Mesa campus which will differentiate our buildings within their competitive set.

And finally, getting to 10398 building back early, positions us for additional upside by applying current building measurement standards in determining the rentable square footage. Securing a replacement tenant will allow us to increase the net rentable area by approximately 15,000 square feet and meaningfully enhance the property's cash flow.

The second value-add property was the 10390 building which had a tenant that planned to vacate when its lease expires at the end of this year. We believe that leasing prospects for this building would be strong with limited blocks of quality available space for life sciences tenant in the Sorrento Mesa sub-market.

I'm pleased to report that subsequent to the end of the second quarter, we executed a new replacement lease on attractive terms for the full building totaling 68,536 square feet.

The execution of the lease successfully stabilizes the building with a well-securitized lease to a life sciences company that desired to take the space with limited tenant modifications. The new five year lease is expected to commence on January 1, 2019, immediately following the lease expiration of the existing tenant.

The third value-add building in the portfolio, the 10455 building, continues to be 46% occupied. We're exploring a number of alternatives to unlock value and will provide further updates in future quarters as we advance our plans.

Turning to acquisitions, we have acquired $167 million of properties year-to-date inclusive of the previously announced Pima Center and two new properties Circle Point and The Quad. We're very excited about the prospects for these two new properties which we recently closed in July.

Both of these complexes minimize the quality of assets in sub-markets that we've targeted. Circle Point is a two building Class A Office campus comprised of 272,000 square feet, it's located in the 36 corridor sub-market of Northwest Denver which spans the area between Denver and Boulder along Road 36.

This area is known for its high quality of life, attractive housing options, well-educated employment base, and technology-related industries. Within this sub-market, Circle Point has an identity as one of the most visible and accessible Class A buildings.

Located within two miles of over 30 shops, restaurants, hotel, and entertainment options Circle Point also boasts its own amenities with an onsite café and direct access to a well landscape two acre part.

The recent lease up of 130,000 square feet over the last 12 months is indicative that the Mountain Views, contemporary finishes, and prominent sub-market location make the asset highly desirable from a leasing perspective.

We acquired the complex for a purchase price of $59.8 million at a 6.8% year one capitalization rate, it has a seven year average remaining lease term and is 93% occupied by desirable and stable tenant.

The Quad is a 163,000 square foot, 14 building Class A campus in Scottsdale, Arizona that we acquired for $51 million at a 7.1% year one capitalization rate. It is a unique creative campus file project and its recent $20 plus million renovation won it the 2018 NAIOP Redevelopment Project of the Year award.

The property features an onsite restaurant, conference and amenity center, outdoor recreational spaces, and a fitness center. With a full amenity package, excellent location in Scottsdale, and state-of-the-art tenant builders, the project has seen outstanding demand from creative and tech-oriented tenants.

Virtually all the project has been leased up over the last 24 months bringing occupancy today to 97% with limited capital requirements going forward.

On a blended basis, the weighted average year-one capitalization rate of Pima Center, the Quad and Circle Point is approximately 7.4% which we believe is an indicator that we will continue to have success in finding well located and desirable real estate within our targeted markets that possess attractive return profiles.

With that, we still have an attractive acquisition pipeline. We've closed approximately 75% of the mid-point of our acquisition guidance for the year leaving approximately $58 million remaining at the mid-point.

We continue to have an active pipeline of over $500 million of opportunities and our goal is deploying the balance of our capital by the end of the third quarter or shortly thereafter.

With our actual results in the first half of the year, and expectations for operations and acquisitions during the second half of the year, we are pleased to increase our 2018 core FFO guidance and reaffirm our occupancy guidance.

In summary, our goal for the second half of the year is to do more of the same, continue to source quality acquisitions, execute on value enhancing programs, and drive occupancy and same-store results through the lease up of our vacant space.

With that, I'll turn the call over to Tony to discuss our financial results and the details of our updated guidance..

Thanks, Jamie. On a GAAP basis, our net operating income in the second quarter was $18.5 million. This represents a $1.4 million decrease over the $19.9 million achieved in the first quarter.

The decrease from the prior quarter was primarily attributable to the reduction in termination fee income from our Sorrento Mesa property which Jamie just described and the sale of our Washington Group Plaza property which sold in March. These decreases were offset by the income from the Pima Center property which was acquired in April.

We reported core FFO of $9.3 million or $0.26 per share which was $1 million lower than first quarter and was similarly impacted by the sale of WGP and a reduction in termination fee income. Our second quarter AFFO was $7.1 million or $0.19 per share.

Our AFFO in 2018 continues to be affected by several planned, value enhancing capital, and leasing costs which have been incurred during the first two quarters. Of the $4.1 million in value enhancing expenditures that we previously estimated for the first three quarters of the year approximately $1 million remains to be spent.

These remaining costs are primarily related to our DTC Crossroads property, common area upgrades, and amenity additions which have been pushed out due to an extended permitting process and value engineering. We expect these remaining costs to be spent evenly in the third and fourth 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.

As far of our expectations for the remainder of 2018, we continue to track our previously issued guidance and we believe the assumptions and material considerations underlining our guidance remains intact at this time.

We raised and tightened our full-year 2018 core FFO guidance from a $1.08 to $1.13 per diluted common share to a $1.10 to $1.14 per diluted common share as our year-to-date acquisition volume and timing have slightly surpassed our budget expectation.

We maintained our fourth quarter core FFO guidance of $0.31 to $0.34 per share which continues to assume that we are able to fully deploy the remainder of our acquisition capital prior to the start of the fourth quarter. Our leasing activity and capital expenditures are provided on pages 19 and 21 of the supplemental package.

Consistent with our definition of AFFO, we have excluded some first generation leasing cost and the repositioning activities at several of our properties, the largest of which continues to relate to the Park Tower repositioning. Further details are disclosed on Page 21 under non-recurring capital expenditures.

Our same-store cash NOI decreased 3.1% for the quarter despite a 2.4% decrease in average same-store occupancy as compared to the same quarter in the prior year; same-store GAAP NOI actually increased 3.2%.

The difference in calculation using the two methods can be primarily attributed to approximately $400,000 of free rent credits at our Superior Point property in Denver. Occupancy at that property increased from 87% to 92% due to an expansion, a renewal, and a new tenant.

This occupancy increased help drive GAAP NOI higher, but had little impact on cash NOI due to the initial free rent periods associated with these leases. Rent escalators and renewals occurring at higher rents across our portfolio are also driving this GAAP NOI growth.

We continue to expect occupancy to tick higher through the balance of the year and finish the year within our previously issued guidance of 90% to 93%. However, we expect same-store cash NOI to remain negative through the fourth quarter of 2018 before turning positive in the New Year.

The addition of the Sorrento Mesa property to the same-store pool in Q4 will be a drag on same-store results in that quarter due to that Roca tenant vacate earlier this year which will result in a reduced occupancy year-over-year as well as continuing free rent periods associated with lease-up across the portfolio which will also impact same-store cash NOI results.

Moving on to our balance sheet, our total debt net of deferred financing cost at June 30th was $479.6 million. Our net debt and enterprise value was 44.4%. We believe our balance sheet strategy over the past four years to lock in long-term fixed rate debt has been prudent.

At June 30, fixed rate debt represented 88% of our total debt with a weighted average interest rate of 4.1% and a weighted average maturity of 6.2 years. We have also rate locked on property level financing on the two acquisitions which closed subsequent to quarter end.

10-year property financing for Circle Point and The Quad have been fixed at 4.49% and 4.20% respectively and we expect to close those loans later this month. We closed full transactions on our unsecured line of credit subsequent to quarter end and we will use the financing to repay borrowings under that line.

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

Operator?.

Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions]. The first question we have will come from Craig Kucera of B. Riley FBR. Please go ahead..

Hey good morning guys.

Wanted to start up talking about some of your leasing activity during this quarter, I think your new and renewal leases averaged both around $28 per square foot and Tony you mentioned that it was up across the board but do you have a sense of what that -- what those rents were relative to prior rents on a percentage basis or dollar basis whatever is easier?.

Hey, good morning, Craig. So the average for the leasing spread was approximately 3% in the quarter and it was slightly lower than otherwise because we actually had one renewal at a slightly lower rate and was partly due to the fact that they received no TI allowance versus before they had a TI allowance, so the average also 3% for this quarter..

Got it.

And it looks like a lot of the activity was concentrated in Park Tower and at -- in 1590 but I guess were the remainder of the activity was it pretty broad-based or were there any markets or specific assets where we saw a nice pick-up in leasing?.

Yes, the biggest change we had in the quarter was at Superior Point I talked about a little bit to push that occupancy from 87% to 92% but the rest was pretty evenly spread out..

Okay.

And as far as your occupancy guidance for the year, was that inclusive of the drag from Sorrento Mesa or was that occupancy guidance based on the same-store pool sort of at the start of 2018?.

So the short answer is yes. It doesn't include Sorrento Mesa, it was based on our December 31st portfolio which did include the San Diego properties and excluded WGP which was held-for-sale. So we're working off of our December 31st portfolio that was 88.5% occupied at the time and we're tracking nicely to get into our range of 90% to 93%..

Got it.

Can you give us some additional color on the tenancy at the Circle Point building, I know you had some occupancy challenges in Denver and it looks about 9% is rolling next year, can you tell us who that tenant is or the type of tenant and any additional color on the tenants in the building?.

Good morning, Craig, it's Jamie.

So generally when you look at that building the weighted average lease term remaining is about seven years and we haven't disclosed who the tenants are but the majority are very high credit, some in the technology, pharmaceutical, aerospace, so really solid tenant mix and those have very long-term leases going out to 2031 in some cases.

So the near term, we’re not as concerned about, it’s just great long-term leases in place..

Next we have Bill Crow of Raymond James..

Hi, good morning guys. I think I will pick up where Craig left off on Circle Point.

Just looking on line, it looks like there's maybe another million square feet of entitlements for office out in that as part of the same development, do you know what the plans are for construction there?.

Yes, most of the park is expected to ultimately be developed for multifamily. So there has been some multifamily construction. But that's the bulk of what our expectations are..

So no more office within that area?.

It's possible but I think the latest thinking of owners of the land is it's probably highest value is multifamily..

Okay.

Great, and then getting back to leasing economics, the lease that you talked about, I think you said you signed it after the quarter in Sorrento Mesa to backfill vacancy, could you specifically on that lease talk about how the starting rents compare to the any expiring rents on the former tenant?.

Sure, so the building we talked about are currently paying $36 triple net.

That was one it’s very specialized life science space, we took a pretty conservative approach when we bought the portfolio as far as what our underwriting expectations were and so signing a lease with a low TI and no downtime starting Jan 1 is a home run, the rents start at $37.80, so that's about a 15% pick-up over the expiring rents.

And have 3% bumps there is about three months of free rents spread across the first six months of the lease..

Okay, that’s good.

Congratulations on that and then finally from me, just kind of reiterate your thoughts on the balance sheet, we tend to think in terms of net debt to EBITDA and just after you finish your current year acquisition target where does that leave you as far as dry powder goes going forward?.

Hey Bill, it’s Tony here. So on a net debt-to-EBITDA June 30th, we are just as exactly 7.0 once we deploy and get to the midpoint of the guidance that we provided that number will push into the mid-7s or 7.5 and on net debt to enterprise value we're at above 44% today and will approach 50%..

So 7.5 seems like it would be pretty well maxed out, is that a fair way to think about it?.

Yes, when you say maxed out you mean that’s where we have set as the target for once we’re fully deployed.

Once we do capital raises and if and when we do capital raises in the past, what we said is we intend to put leverage on at 40% to 45% just as an over time, we kind of walk that number down, walk down both the net debt enterprise value and net debt to EBITDA, we like to ideally see it at 7 and below, it takes a little bit time to get there once we move forward..

Sure, okay. That’s it from me, congratulations on the new acquisitions..

Thanks Bill..

Next we have Michael Carroll of RBC Capital Markets..

Hi, I was just wondering if you guys could provide any updates on the plan with Plaza 25, I know you guys have said that you are considering selling this property and I was wondering is that still in the works?.

Good morning, Mike. So we actually have been ready to go to a larger renovation program for some time, we did have a few purchase inquiries earlier in the year and we decided to run a bit of process and kind of compare the two alternatives of putting the capital and repositioning it or potentially selling.

So we’re still engaged in that exploratory process, we think it will be probably wrapped up one way or the other during this quarter. So we will look to provide more guidance on our next call..

Okay great.

Secondly I was wondering if you guys could provide some more color on the Circle Point deal, the cap rates seem to come in below your target range, so I was wondering if there is anything unique about the asset?.

Yes, the location in Boulder has just been a phenomenal market, so when you look at that particular area, it's pretty much right dead center between Downtown and Boulder, so it's very easy for companies to draw the tech talent that's up in Boulder as well as people from the Downtown, so we've just seen a huge trend of companies moving to that particular area.

Rents are about 10% below market, the suites have all been built out to extremely high standards with great credit tenants and we’ve got solid weighted average lease term remaining of about seven years.

So all in all you look at the attributes of the asset, the retail base all around is a great housing option, we just think it's really well positioned long-term, so we like that, it is a little lower than our general target.

However if you look at blended acquisitions to-date, we’re at about 7.4%, so we're trending right in the middle of where we said..

Next Rob Stevenson of Janney..

Good morning guys.

Tony, given your comments surrounding leasing and CapEx et cetera, is it still the supposition with two guys with the $0.31 to $0.34 fourth quarter guidance are going to get to the -- at or above the $0.235 dividend coverage in the fourth quarter of this year?.

Hey Rob, good question. Just to answer, our guidance is predicated really on two main assumptions. One being that we fully deploy our remaining capital to the mid-point of our guidance range by the start of the fourth quarter and that will get us to that $0.31 to $0.34 you mentioned.

And two just given the relative size of our portfolio that we don't have any unusually large TI or CapEx expenses in the fourth quarter.

But if you just do the math on $0.31, $0.34 and you take our average TI capital that we have historically which is about 10% to 11%, the result is dividend coverage, I mentioned earlier in my prepared remarks that we do have a $1 million of value enhancing capital that are yet to be spent this year that could elevate our historical CapEx number and potentially could slide into Q4.

But saying all that nonetheless once the acquisitions are completed and those spikes in capital pass back to normalized dividend coverage..

And what is the sort of remaining dry powder that you guys have to invest into acquisitions?.

So roughly to hit the mid-point Rob it's about $60 million..

Incremental investment?.

Of acquisitions dollars, correct..

Correct..

Okay.

And then what are you guys thinking about beyond that, I mean given where the stock price is are you guys contemplating dispositions to turn into other assets you guys sit in the hold or if you still looking at 12 something dollar stock price, how are you guys thinking about that these days in terms of where you go from here after this next $60 million is deployed?.

Yes, it’s a good question.

So focus for us right now primarily is on closing the deals and capital that we have putting that money to work, driving occupancy, we are exploring a couple of potential sales earlier stage we mentioned Plaza 25 is one, the one particular building with low occupancy in San Diego is another one we’re exploring, we've had some enquiries around our land, so there is a number of alternatives there that we’re weighing.

And we will see how acquisition pipeline and operations come together over the next little while and make a call at that point..

Okay.

And then just last one from me, what drove the sort of shorter term on the renewals during that quarter, it was only like 2.6 years, was that one lease in particular, was that a several sort of one-year lease extensions or something like that, what brought that down from your sort of normal levels?.

Yes, so in Florida we have a couple of properties that have short-term one-year renewals that is driving down the average.

We have one tenant who's been a tenant in our Central Fairwinds building as long as we own the property that does one-year renewals that drags down the results and then we have a couple of government tenants in our Florida Research Park Collection building, they're also on basically automatic one-year renewals..

And next we have Barry Oxford of D.A. Davidson..

Great, thanks guys.

To build on Rob’s question Jamie or Tony, would you guys look from a capital structure if the stock price isn't where you wanted to be to use preferred from that type of standpoint as far as you know continuing to build your equity?.

Hey maybe I will start with answering the question Barry..

Sure..

I think the short answer is yes potentially, we have -- we believe a little bit of room in our capital stock add additional preferreds, we do have an ATM program in place that we've yet to really utilize. But potentially that ATM could be used for both the common and the preferred.

On the preferred side generally the volume is relatively low on trading.

So the ability to issue to the ATM may not be that significant but certainly ultimately whenever we're thinking about raising money, we have to kind of look at where our pipeline is and will these transactions be accretive to AFFO so all of those options are under consideration..

And just to kind of go little further, so I mean the options we get around internally as we’re looking at where various prices are on stock, I mean for us the common is preferred.

We've looked at some JVs in the past, selling assets which I just mentioned, we do have one transaction we're talking about that could be an OP unit, so there's a number of different alternatives that we can consider..

Jamie, are you looking seriously at joint ventures or nothing in discussions at this point?.

It’s been more with a few different groups that have assets that we've had a few preliminary discussions, nothing advanced on the JV side today..

[Operator Instructions]. Our next question will come from Merrill Ross of Boenning. Please go ahead..

Hi, good morning.

Looking at Circle Point and Quad, it’s very difficult to see that there is any value-added component but I just wanted to be sure it wasn’t leasing something and that these were bought more for the long-term potential that you referenced rather than these value-add components?.

There really isn't a major value-add component to either, I think what we see is great sub-markets that are continuing to perform well, there's a mark-to-market on the rents, so at Circle Point there are about 10% below market the Quad is a similar number, we think market rental rates for both of those are going to continue to grow healthy numbers.

So when we have renewals, we're looking for above average step up in long-term growth..

At this time, it appears that we have no further questions. I will go ahead and turn the conference back over to Mr.

Jamie Farrar for the closing remarks, sir?.

I want to thank everybody for joining today and wish you all an enjoyable rest of your summer. Good bye..

Thank you, sir. And also to the rest of management team for your time, again the conference call is now concluded. At this time, you may disconnect your lines. Thank you, take care and have a great day everyone..