Good morning and welcome to the City Office REIT, Inc. Second Quarter 2021 Earnings Conference Call. 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, Tony Maretic, the company's Chief Financial Officer, Treasurer and Corporate Secretary. Thank you, Mr. Maretic. You may begin..

Good morning. Before we begin, I would like to direct you to our website at cioreit.com, where you can view our second 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 fact may constitute forward-looking statements within the meaning of the federal securities laws.

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 will be made in the course of this call. I'll review our financial results after Jamie Farrar, our Chief Executive Officer discusses some of the quarter's operational highlights. I'll now turn the call over to Jamie..

Good morning. Thanks for joining today. Our quarterly results continue to be strong and consistent. In the second quarter, we achieved healthy dividend coverage, positive same-store cash NOI growth and strong leasing activity.

Major highlights for the second quarter include, completing a large backfill of leased, but unoccupied space at our Park Tower property in Tampa, and advancing opportunities to unlock value with our life science assets in San Diego. I will cover both of these items in more detail momentarily.

Before going into our results, I'll briefly touch upon what we are seeing across the office industry. After Labor Day, we continue to expect a significant increase in tenant utilization of office space that should accelerate as we approach the end of 2021.

To-date, we have seen many smaller tenants embrace a return to the office, larger tenants had generally been slower to return but are expressing intentions to ramp up their utilization in the fall. In terms of our operating results during the quarter, we completed a healthy 249,000 square feet of new and renewal leasing.

We also continued with our strong rent collection at nearly 100% and have now collected virtually all of the deferred rent granted during the pandemic. While occupancy dipped slightly at quarter end, our second quarter same-store cash NOI growth was a solid 2.7%. Of note, we achieved the 4% increase in cash renewal rents versus the expiring rent.

As I mentioned, one of the most significant transactions in the quarter involved backfilling dark space at our Park Tower property. BB&T Bank is a major tenant, but they consolidated into SunTrust location last year after the merger. This left us with 51,000 square feet of dark space leased through February of 2025.

Despite paying rent, having unused space like this is a drag on property value as it creates a known future vacancy. During the second quarter, we secured a new tenant that will occupy the full 51,000 square feet plus an additional 15,000 square feet.

At the same time, we negotiated a lease termination with BB&T with a termination fee of approximately $5.4 million. BB&T will continue to pay their rent obligations through November 30th, 2021.

The termination fee represents approximately 85% of the future base rent, an estimated reimbursement obligation that BB&T would have otherwise paid through 2025. The new tenant is a fast growing FinTech company, and they executed an 8-year lease that starts in May of 2022.

When factoring in signage rent, the new tenants will be paying approximately 5% higher rent per square foot than the parting tenant. As part of the deal, we intend to complete significant upgrades to their space, which will be accretive for future leasing.

The other significant transaction that occurred during the quarter was the acquisition of two properties adjacent to our Sorrento Mesa portfolio, which we announced on our last call. These properties are an important key to unlock greater development potential and value in those life science assets.

Rent in San Diego's life science market continues to be at a record high, with vacancy below 5%. Tenant demand for life science properties is strong and growing, fueled by record levels of venture capital funding.

CBRE estimated that there was approximately 2.8 million square feet of laboratory tenant demand with only 900,000 square feet of availability. San Diego's limited vacancy in development sites have left tenants with few options for expanding their operations. Given these market dynamics, we completed the purchase at an ideal time.

Since our last call, we've made substantial progress, exploring options for our full Sorrento Mesa portfolio. We executed the process that evaluated developing our land holdings in partnership with an experienced operator, selling the entire Sorrento Mesa portfolio or some combination thereof.

This process confirmed that the value of these assets has grown to impressive levels. Whichever option we select, will have a transformative impact to our company. Today, all alternatives remain on the table, and we're giving significant consideration to a possible sale of the entire Sorrento Mesa portfolio.

Given where we are in our process, we are unable to provide further details at this time. Should a transaction come to fruition, we anticipate providing further information at that point.

To conclude, as we move forward into the second half of the year, our focus remains on advancing our Sorrento Mesa process, achieving leasing success through both renewals and the leasing of vacancy and building our acquisition pipeline at a time when tenants are returning to the office environment.

We believe that we are well positioned on all of these fronts. With that, I'll turn the call over to Tony to provide further detail on our financial results..

Thanks, Jamie. I'll address the second quarter's results and then provide an update to our guidance for the balance of 2021. Our net operating income in the second quarter was $25.8 million, which was $400,000 higher than the $25.4 million we reported last quarter.

The increase was a result of higher termination fees offset by the reduction in income from the Cherry Creek sale midway to this prior quarter. In total, we recorded $1.5 million in termination fees in the second quarter.

Of that amount, $700,000 was related to the Toyota lease at our SanTan property discussed last quarter, we will be amortizing the fee through August 2022. $500,000 was related to the leasing transactions that Jamie described at our Park Tower property. That tenant BB&T signed an agreement that became effective at the end of June.

The agreement releases them from their obligation to pay rent after November 30th of this year. In connection with the agreement, we received a termination fee of $5.4 million. We will amortize the fee until the end of the tenants' new lease term.

We reported core FFO of $15.3 million or $0.35 per share, which was $800,000 higher than in the first quarter for the same reasons that NOI was higher. In addition, interest expense was also lower as a result of using proceeds from the Cherry Creek sale to reduce our overall leverage. Our second quarter AFFO was $9.9 million or $0.22 per share.

The largest impact to AFFO was a leasing commission on the lease transaction at our Park Tower property, which equated to $0.03 per share. The $3.6 million of tenant improvements related to that lease are expected to begin to impact AFFO in Q4, with the bulk expected in the first half of 2020.

Our second quarter same-store cash NOI growth was a positive 2.7% as compared to the second quarter last year. The leases we signed in 2020, particularly those that at our Denver Tech property and our life science portfolio are the biggest driver of these results.

Our total debt at June 30th was $613 million, which was a $40 million increase over last quarter. That increase was due to funds drawn on our credit facility for the Sorrento Mesa acquisition during the quarter. Our net debt, including restricted cash to EBITDA was a healthy 6.2 times.

At quarter end, our total debt had a weighted average maturity of 4.2 years, and 84% of our debt was effectively fixed. Our weighted average interest rate is now 3.6% and we have no property debt maturities until 2023. We also want to make one note on our disclosures this quarter.

We have decreased disclosure related to our rental collection rate and exposure to select industries impacted by COVID-19. We essentially have not had any collection issues to-date and do not currently expect material changes in our collection rate. Last, we have provided updated full year 2021 guidance in our press release.

The primary driver of the guidance changes is the Park Tower termination fee income that I mentioned earlier, which positively impacts our forecasted net operating income and core FFO. The expected departure of BB&T in 2021 has lowered our year end occupancy guidance as a replacement tenant is not expected to take occupancy until May of 2022.

We refer you to the material assumptions and considerations set forth in our earnings release. That concludes our prepared remarks, and we'll open up the line for questions.

Operator?.

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Rob Stevenson of Janney. Please go ahead..

Good morning, guys.

Jamie so if you decided that you did, that the best alternative was to sell Sorrento Mesa and its entirety, what would you do with the proceeds? I mean, the two legacy properties are something like $20 million of annual revenue? Do you sort of look to fund acquisition - some combination of acquisitions and common stock buyback? How would you, you know given you know what's like your alternatives are today? I mean, what does that look like for you if you do get that capital inflow?.

You know, thanks for the question, Rob. So we'll go into more detail if we complete a transaction. But you know, fair to say that we'd love to continue to build further depth in our markets that we're in continue to expand into new markets.

And as we look to kind of the fall and into 2022, we think it's going to be a great time to have dry powder as tenants are returning to the office..

And how does pricing look today given, you know, assets that you'd want to own without taking, you know, some substantial re-tenanting risk today?.

So if you look at more traditional assets, I mean, right now, we're in kind of the slow summer period. And we think internally that as we get to the fall, things are going to pick up.

But what we're still seeing is, you know, very high quality assets with great credit, new construction, you know, great locations still trading at prices that would be accretive to us long-term..

Okay.

And in addition to Park Tower, are there any other dark spaces of note in the portfolio where you're getting rent, but the tenant isn't occupying a substantial park or even all of the space?.

Yeah, BB&T was - hey, Rob, it's Tony here. BB&T was by far the largest of those items. Obviously, you know, just given where we are, you know, utilization rates in our portfolio are still right around call it, low 30% utilization but no other significant blocks where we know of a tenant has fully vacated..

Okay. And then last one for me.

How you know, as you sit here today, how does the leasing picture look for the second half of the year? And how should we be thinking about you know, tenant improvements, leasing commissions and the like and the need to fund some of that stuff in the back half of the year?.

So in terms of market in general, again, we think leasing will pick up and as we get to later in the year and into early next year, just as far as you know, tour activity that we've been seeing and you know, tenant interest in the return back to the office.

I'd say generally concessions, you know, I don't think are going to be terribly dissimilar to where they have been in the past and probably a bit more elevated free rent, if anything. Construction costs, you know, a little bit higher probably as costs all over the board have gone up a bit. But generally in line with what we've been seeing recently..

Okay. Thanks, guys. Appreciate the time..

Thanks, Rob..

The next question comes from Michael Carroll of RBC Capital Markets. Please go ahead..

Yeah. Thanks. Jamie, related to the Sorrento Mesa portfolio, I kind of want to walk through the options that you highlighted.

I mean, were the two options that you kind of highlight in your prepared remarks was one, sell the entire portfolio or two form a joint venture to pursue a development on the available land side? Are those the two that you're thinking about right now?.

That's exactly right, Mike. So we had the two processes. When we started the primary thrust really was to pick a joint venture partner, who would lead the development for our holdings. And we have a great option there.

And before we decided to consummate a transaction, given how strong the life science market is, we felt, we really needed to look at our options in detail. And so we had a broker target the most active and sophisticated buyers, and we had tremendous interest in very compelling valuations.

And so the focus and thrust of the direction we're going is shifted in that direction at this point..

And I know last quarter that the talk with that available land site was to potentially do a JV to do the development and/or just sell that land.

It seems like you're not planning on just on the land anymore, I'm assuming and correct me if I'm wrong here, is that, the potential acquirer would prefer to have the entire portfolio within Sorrento Mesa including that land, and that's why you're pursuing that potential disposition?.

You know, we could pretty much pursue any option that we wanted, Mike. But the special thing about the portfolio we put together is, it has great existing cash flow, and it has 1 million square feet plus of potential development, that could be out of the ground pretty quickly.

And so when you put the whole portfolio together, that becomes a very attractive package. And so as we went through our process, that was the direction we decided to head..

Okay. And then what we heard is one of the stats is that, the - what developable life science land is trading in these top cluster markets is about $200 a developable square foot.

I mean, is that kind of in line with what you're thinking on the 1 million square feet that you have within Sorrento Mesa?.

Yeah, given where we are in our process, Mike, we won't provide any further comments on value right now..

Okay, great. And then just last one for me on the Sorrento Mesa portfolio. I know you have an available block there.

Is that something that you're pursuing to lease right now? Or does a potential acquirer of this, but prefer to have that available for them to lease it up? Or do what they want? I mean, are you still actively pursuing tenant discussions to lease that space today?.

We are actively pursuing and some of the potential buyers really like having that vacancy as if you're going to launch a development, having, you know, swing space that's immediately available is helpful with potentially securing a tenant. So, you know, our focus right now is to try and find a great long-term tenant there.

And that could change obviously, if we decided to exit the property..

Okay, great.

And then, Tony, related to the lease expiration scheduled, is Ally and Toyota are those leases still reflected in, what the 2022 and 2023 expirations? Or have those been specifically Ally since they renewed? Is that kind of out to their new expiration date?.

Yeah, I mean, the way we treat that schedule is, and if a lease is signed prior to our reporting date, so in this case, June 30th, then we do update the roll schedule to reflect their new ending lease. So they -.

And then when did Ally officially renew?.

Ally, we officially renewed I want to say, it wasn't Q1, it was Q4 of last year..

Okay, great. Thank you..

Thank you..

Thanks, Mike..

The next question comes from Craig Kucera with B. Riley FBR. Please go ahead..

Hey, good morning, guys. I noticed that you pulled your acquisition and disposition guidance from your overall guidance here. I think in the first quarter, guided acquisitions was $43 million to $100 million.

A couple of questions here, I guess first of all, does the high end of the range in your revised guidance include that additional acquisition?.

So the low, Rob basically reflects the $43 million we've already put the work and the high end reflects an additional $57 million completed late in the fourth quarter. So there really isn't much of an impact to our overall results..

Okay, got it.

And I guess, looking to your leasing volume, you know, is accelerated again this quarter, particularly in a new leasing front? Would you say a lot of that activity is from tenants that you'd be on discussions previously with? Or are these effectively new folks that are walking in and wanting space and more recent discussions?.

You know, everything has been slower, Rob, given COVID and whatnot. So, you know, discussions we've been having generally had been ongoing for a longer period of time, the cycle's just a little bit longer at this point..

Okay, that's it for me. Thank you..

[Operator Instructions] And the next question will come from Bill Crow of Raymond James. Please go ahead..

Hey, guys. Jamie, you seem pretty confident that we'd see a push in the return to office I guess September on.

I'm just wondering whether tenants are starting to talk about pushing that back because of the Delta outbreak?.

Yeah, some are. So we basically have been going through every couple of weeks and doing counts of you know, who's in desks and what tenants are thinking and their latest plans. And, and for sure, that's been happening, Bill, where some are pushing it back later in the year and some are still planning kind of post Labor Day to be coming back.

So I think in our own internal view, we think as I said, it's going to accelerate post Labor Day. And I think it'll continue to accelerate through the balance of this year..

When you talk to the tenants, how much uncertainty exists over commitment to space versus, say, a year ago, have they become more definite in their plans? Or is there still this massive amount of uncertainty and how hybrid work might play out?.

Yeah, I don't think there's a definitive answer right now, Bill on how we feel a year ago, you know, the buzzwords were about, you know, hybrid is the way to go or remote work in the future. And I think that's really toned down, particularly in our markets.

And so I think, you know, kind of the latest feeling we have from our tenants is, there'll be a return. The question is, is it going to be five days a week? Is it three days a week? How do they ramp back into it? And so we're feeling way better than where we were a year ago.

But there's still some uncertainty on kind of timing and how that's going to roll out..

Okay. And then finally for me on Park Tower. I don't know how long BB&T had been in the space, but a 5% increase seems on the modest side. But and it's 5% positive. So it's good.

How are the actualized economics of Park Tower playing out relative to your underwriting originally?.

So Park Tower of BB&T had been in the space for a substantial period of time, and we renewed them, I'm thinking it was pre-COVID, maybe 2019. So we had a healthy kind of mark-to-market terms at that point. And so, we were very happy with rent and kind of where we are.

And so having, you know, $30 full service gross on the new leases our starting point with, you know, sub just under 3% kind of annual step ups and you know, healthy signage rent we're very happy. It's worked out really well when you look at our overall cost base and returns, you know, I think we're in a really good spot with that asset..

So you're running in line with expectations when you bought it.

Is that fair?.

Yeah, in line or ahead, I'd say across the board. The renovation really accelerated kind of where we thought we would be on rents. So we were pleased with how that came together. And obviously COVID has kind of slowed things down in the market. But as far as this transaction and others that we've been doing there, we're very pleased with the economics..

Perfect. That's it for me. Thank you..

Thanks, Bill..

As there are no additional questions, I will turn the conference back over to Mr. Jamie Farrar to conclude..

Thanks, again for joining today. And please don't hesitate to reach out anytime if you have any questions. Good bye..

The conference is now concluded. Thank you for attending today's presentation and you may now disconnect..