Good morning and welcome to the City Office REIT Inc. Second Quarter 2022 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce you to 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’d 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 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 reflect 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 and thanks for joining us today. We believe the companies that are going to be most successful in the office sector are those focused on growth markets with high-quality assets that align with today’s tenant desires. From a big picture perspective, we are very well positioned in this regard.

Our predominantly Sunbelt locations are the right markets and they are poised for long-term growth in rental rates and demand. Cities like Phoenix, Raleigh, Tampa, Dallas and Orlando provide a lower cost of doing business, higher quality of life and a growing talent pool.

For these reasons, among others, they have been the beneficiaries of labor force migration and corporate relocations. We believe these trends will continue. Further, there continues to be a flight to quality with companies seeking differentiated, amenitized and well-located office spaces for their employees.

Our portfolio is principally invested in high-quality, amenitized assets that are consistent with what tenants are looking for. While we have a solid core portfolio that aligns with this opportunity, we are advancing and executing plans that we have discussed on prior calls to elevate several of our properties.

We also continue to build out spec suites across the country to drive leasing appeal and accelerate occupancy timelines. Our spec suite program is proven and effective in yielding results. Year-to-date in 2022, we have leased 17 of our spec suites totaling 64,000 square feet.

We have also leased 3 spaces totaling 38,000 square feet, where we had completed substantial space conditioning. To provide some larger context on this program, despite the pandemic’s impact on leasing, since 2019, we have built out over 200,000 square feet of spec suite inventory.

We have leased approximately 84% of it to-date with a typical lease-up period of approximately 6 months. Our remaining inventory at spec suites is 33,000 square feet across our portfolio.

We intend to commence construction on over 100,000 additional square feet of spec suites during the remainder of 2022 and plus another 150,000 square feet of conditioned space. We believe these planned investments will position us with attractive ready-to-lease inventory that will drive results.

In terms of overall leasing, it was generally healthy in the second quarter. We executed a total of 254,000 square feet of leases, consisting of 126,000 square feet of new leases and 128,000 square feet of renewals. We are also pleased to report that we signed 23,000 square feet of new leases at Block 83 in Raleigh during the quarter.

That brings the property’s occupancy to 85% when including signed leases that have not yet commenced. Our remaining inventory at Block 83 is approximately 45,000 square feet of office space and 28,000 square feet of retail space.

We remain confident in our ability to lease these spaces on attractive terms given the property’s tremendous amenities, new and modern construction and great location. It fits perfectly with what tenants are looking for.

Today, we are in lease negotiations for approximately 17,000 square feet of the space with a number of additional prospects beyond that. Overall, tenant retention rates in the quarter were approximately 60% with a strong increase in renewal cash rental rates.

These results are generally in line with our overall leasing results during the trailing 12 months. However, looking forward over the next 12 months, we do expect to have several larger tenants vacator downsize, which will lower pension rates and requires to backfill some space.

We have previously discussed Toyota vacating at the end of August at our Santan property in Phoenix. Subsequent to quarter end, we came to a conclusion on a major tenant at our 190 office property in Dallas.

Effectively, our largest tenant there, a healthcare company will reduce its footprint from 173,000 square feet to 43,000 square feet when their lease rolls in June of next year. Their renewal space has been extended by 3 years through June of 2026.

We were aware this tenant had implemented a work-from-home strategy and potentially didn’t require all of its space. To mitigate that scenario, we commenced a property upgrade earlier in the year, which was completed during the quarter.

The renovation positioned us to retain as much of the existing tenant as receivable and set us up to backfill the balance of the space. The project included enhancing the lobby and adding a modern conference center, an upscale tenant lounge, a high-end fitness facility and connected outdoor space.

The renovations look spectacular and completely transformed the property for an investment of just over $2 million or a modest $7 per square foot. We have included before and after renovation photos in our most recent investor presentation posted on our website. We have already experienced the benefits of these upgrades.

After quarter end, we have come to terms with two tenants that we expect will backfill approximately 49,000 square feet at the property and we have over 10 months of lead times to find replacement tenants for the balance. Other notable activity during the quarter included the completion of the sale of Lake Vista Point in Dallas for $44 million.

The sale generated us a $22 million gain-on-sale and was completed at a 6.1% cash cap rate. On the capital markets front, during the quarter and subsequent to quarter end, we have been executing a share repurchase program.

While we remain sensitive to reducing the number of common shares outstanding, the disconnect between our stock price and our view of its value is a great opportunity. To help investors understand our rationale on the buyback, we included a new slide in our investor presentation.

The average repurchase price to-date, including purchases after quarter end is $13.11 per share. This effectively means that we are buying our own portfolio at approximately a blended 8% cap rate. That is tremendous value and we would not be able to acquire comparable high-quality office properties in the private markets anywhere near that valuation.

We have also provided segmented information on that slide, which maybe helpful. When you consider the value inherent in our three most recent acquisitions in Raleigh, Phoenix and Dallas, purchased for $614 million, the implied metrics associated with our other 22 properties is even more compelling.

Today, newly constructed and highly amenitized office buildings with long in-place lease terms, remain desirable for investors. Our three recent acquisitions fit this segment perfectly and are highly discounted by our implied valuation.

To help illustrate this further, JLL released a report last month that provided current construction and replacement costs across Metro Denver and its five major submarkets. The estimated costs range from a low of $490 per square foot to a high of $835 per square foot with an average of $650 per foot.

We believe this range is indicative of replacement costs across each of our markets as well. Contrasting this to our stock buyback, we purchased our own portfolio at a blended $221 per foot, including our three most recent acquisitions, which should be more equivalent to premium new construction today.

Bottom line, we know our portfolio and our tenants better than anyone. And we believe repurchasing stock at these deeply discounted levels will be strongly accretive to earnings per share and net asset value over time.

As we navigate the noise in the office sector and the markets broadly, we will continue to focus on creative ways to unlock value and grow cash flow. This approach has served us well and has led us to achieve the second highest total shareholder return in the office sector since our IPO in 2014, and second only to Alexandria real estate.

I look forward to updating you further next quarter and will hand the call over to Tony Maretic, to discuss our financial results..

Thanks, Jamie. Our net operating income in the second quarter was $28.7 million, which was $300,000 higher than the amount reported in the first quarter.

This is primarily a result of the increased income generated by the properties in first-generation lease-up that were acquired in the fourth quarter of 2021 as tenants take occupancy at those newly developed properties. For instance, Block 23 Phoenix, which started the year at 62% occupancy was 94% occupied at the end of the quarter.

While operating expenses have seen increases as a result of inflation in various categories, the impact on net operating income was muted as recoveries mostly offset their impact. We reported core AFFO of $17.6 million or $0.40 per share, which is equal to the amount we reported in the first quarter.

The increase in net operating income was offset by slightly higher interest costs on our credit facility. Our second quarter AFFO was $8 million or $0.18 per share.

The largest single item to impact AFFO was $1 million of tenant improvement expenses related to the new 73,000 square foot tenant at our Tower Property, which took occupancy during the quarter.

As Jamie mentioned, we also continue to invest in building out ready-to-lease spec suites and implementing vacancy conditioning, which is a key part of our 2022 business plan. The total investment in spec suits in the second quarter was $700,000.

Last, we also completed the property upgrade project at our 190 Office Center property in Dallas, which Jamie just discussed. That investment during the quarter was $400,000, completing the $2.1 million upgrade. Moving on to some of our operational metrics.

Our second quarter same-store cash NOI change was in line with our expectations at negative 7.1% or $1.5 million lower as compared to the second quarter of 2021. Second quarter same-store cash NOI was impacted by lower occupancy year-over-year and free rent periods associated with new leases.

– contributing $500,000 to that decrease, BB&T vacated their space at Park Tower during the third quarter of 2021 to accommodate the new 73,000 square foot tenant. The new tenants lease commenced on May 1, 2022, but will not begin paying cash rent until February 2023.

That new tenant’s 8-year lease increase the value of the property, but the downtime in free rent period is a significant contributor to a negative Q2 same-store results. Further decreases were attributable to scheduled 3-month periods at a superior point and for peak collection properties as a result of recent lease renewals.

We expect same-store cash NOI results in the remaining quarters of the year will improve as these free rent periods burn off. Our total debt at June 30 was $654 million. Our net debt, including restricted cash to EBITDA, was a healthy 5.8x. We have no debt maturities in 2022 and two small maturities in the fall of 2023. Our debt is primarily fixed rate.

Restricted cash was outdated at quarter end as we held the net proceeds from the Lake Vista point sale in a 1031 eligible restricted cash account. Subsequent to quarter end, the net proceeds of $25.6 million restricted cash were released and applied against our line of credit. Last, we have provided updated guidance on our earnings press release.

There are several tuxes and minuses, the net effect of which is a slight decrease in the midpoint of core FFO per share guidance for the year. First, we are anticipating higher interest rates on our floating rate credit facility for the balance of the year.

Second, while we had healthy quarter leasing, we are reducing the expected 2022 income drive from new leasing assumptions that were included in our prior guidance.

We still expect to make leasing progress through the balance of the year, especially at Block A3 in Raleigh and our spec suites but we now forecast that income will more likely commence in 2023 than in the fourth quarter of this year.

These same leasing-related factors that impacted our core flow per share range are the same factors that led us to adjust occupancy guidance. Offsetting part of the downward impact from guidance is the positive accretion generated by the share buyback program.

During the quarter and subsequent to quarter end, we completed $30 million of share repurchases of the $50 million that our Board is currently authorized. That concludes the prepared remarks, and we will open up the line for questions.

Operator?.

Thank you. [Operator Instructions] Our first question comes from Michael Carroll from RBC. Please go ahead, Michael..

Thanks. Jamie, the larger move-outs that you mentioned you expect over the next 12 months.

Now is that mostly the previously announced tenants that we’ve been talking about for the past few quarters now including this healthcare company in Dallas, too?.

Good morning. Mike, this is Tony here. I can take that question. So on just I can just break it down for you. So over the next four quarters, we have roughly 850,000 square feet rolling. Of that total, we do have five tenants that are greater than 30,000 square feet that are known vacates.

We have discussed three of these on previous calls to take you through those. So one is Toyota. They are vacating 133,000 square feet at the end of this month. Title company at our Pima property is downsizing by 61,000 square feet in October of this year. And we have a tenant at 5090 vacating 49,000 square feet at December 31, 2022.

So, all of those have previously been discussed. Adding to those is the one the healthcare company that Jamie just spoke about at 190 they’ll be downsized by 130,000 square feet. And then we have one other tenant later than 30,000 square feet, and that’s also a 190 center. There will be vacating 44,000 square feet at March 31, 2023.

One other thing I just want to highlight is offsetting these known move-outs, we do have signed 292,000 square feet of new leases that will be taking occupancy over the next year, which includes that 49,000 square foot tenant at 190 centers completed after quarter end, which will help offset these known vacates..

Okay. Great. And then Tony, I know what does the term fee in 2Q? What did that relate to? And I believe that the new guidance range includes the bigger term fee than the prior gives range.

Can you kind of talk about that a little bit?.

Yes, thanks for that question, Mike, and I appreciate the opportunity to sort of explain that. So the single largest item in our termination fee income continues to relate to that Toyota lease.

And so just to review that, we announced in 2021 last year that Toyota paid us a total of $3.8 million and that we would amortize that until they depart at the end of August of this year. At the time we announced, we had amortized $2 million in 2021 and the further $1.8 million was scheduled to be amortized in 2022 until the scheduled departure.

At the time we published our guidance in February, we announced an additional $1 million of termination fee.

So really, the total number that we were anticipating was $2.8 million at the beginning of the year, and therefore, the change in guidance for this quarter and an additional $600,000 and that relates to that tenant of that 190 office property, which I mentioned, 44,000 square feet, who have exercised their termination option in March, and they are expected to vacate in March of 2023.

So I hope that kind of clears that up..

No. That’s very helpful. And then related to the share repurchase program, I mean, how should we think about, I guess, future activity under that is it going to really depend on your ability to sell assets within your portfolio to kind of continue to fund repurchases.

Is that how we should think about it?.

So, we have $20 million remaining that’s authorized. And our own view is we are trading at a major discount to what real estate is worth. And so we are going to continue to reassess that and we will be using cash in the line. I mean basically, to-date, the bulk of it has been funded from the Lake Vista sale.

But when we look at our own portfolio, and using the average price of $13.11, we are basically buying an incredible portfolio at around an 8 cap and $221 a foot. And you just can’t buy anywhere near comparable real estate at that metric. And so we are going to continue to reassess as we go into the fall.

And we will see versus alternatives and where our price is, and we will report back on where we land..

And Jamie, there is other asset sales that you were kind of contemplating within the portfolio.

Are you still looking at some of those right now?.

Yes. I mean we are constantly looking at our own portfolio, what we can do to create value and how best to position assets. There is nothing imminent today. I don’t think today would be a great time to be trying to monetize some assets.

I think – what we have really tried to do is lay out in our investor presentation, there is a new slide, Slide 8 that really talks about how do we create value. And this applies to our core portfolio, and it’s also going to apply to some assets that we may want to dispose over the next few years.

And it’s really how do we best position those properties capital that we can put into it to drive leasing and ultimately create value for our investors. And so across our portfolio, what we are seeing today is the best assets, the premier properties are getting the most leasing interest and you are getting excellent rental rates.

And so that side of the market is great. That covers a large portion of our properties. We do have a number of assets that are a little bit older, but in great condition and fabulous locations. And our experience is you can put capital into it, have a feeling that when a tenant or a prospective tenant walks through the door, it ticks all the boxes.

It has a fabulous lobby. It’s got an incredible fitness facility, outdoor space, all the things that tenants want and you can offer those products in great locations at a big discount to what the AA buildings are. And we think that strategy makes all the sense in the world. And so that’s a big focus for us. We are going to do that.

We have talked about certain properties that will benefit from that. And over the next few years, some of those assets may be candidates to dispose of, but we think we will create incremental value by doing that..

Great. Thank you..

Thanks for the questions..

Our next question comes from Rob Stevenson from Janney. Please go ahead Rob. Your line is now open..

Good morning guys. Tony, you talked about the spend on the spec suites in the second quarter.

What’s the spend on that business in terms of per square foot costs? What are you guys, on average, it probably differs by market, but what are you guys on average spending per square foot to build out a spec suite today?.

I will answer that. So, basically, really, to your point, it depends on the condition of the space you are getting back. But on average it’s anywhere from $40 a foot to $60 a foot. Some might be a little bit higher, depending on the condition and some are lower depending on the condition.

What we are finding though is when you build out suites and you are opening up the ceilings, you are creating really cool, modern space, lots of glass, polished concrete. The cost is a little higher. But when the lease comes due, and if you have to backfill it, it’s very economical to backfill.

The floors are already polished concrete, the ceiling is already open. And so it’s changing some color. So, we found particularly in the first role or two of those spends, even though they are a bit higher upfront, it’s far more economical long-term..

Okay. And then what are you spending – you talked about the other type of improvements that you are doing the sort of improved space or I forget what your terminology was where it wasn’t the spec suites, but it was the other.

What are you guys spending per square foot to do that type of building?.

So right now, the one example that we highlighted on the call was our 190 Center. And if you have a chance, Slide 9 in our presentation kind of shows before and after. And when you go into the space, the lobby looked good before, it looks like a brand-new building today when you go into it.

And then right off the lobby, you have got spectacular built-out tenant suites and incredible fitness facility. I wish the pictures that we put in here did justice to it. And we just – we haven’t done the professional photography yet, incredible conference room tied into food service. And this particular building has been a slow submarket.

And so doing this, we have immediately seen the tour activity pick up, and we have already done two sizable lease deals. And so that was a modest $2.1 million, $7 a foot. I would say, in some cases, it’s going to be around that range a little more.

In a few other cases, we think it could be above that, but we are going to get a much bigger payoff in the rent differential. And so I think that’s probably on average a good number with something a little higher and some being a little lower. Where we are at for the bulk of these, we are really focusing in on nailing the plans.

And we spent a lot of time with our design team. We are fabulous. We think we have pretty much are getting there and now we are going to go out and bid and value engineer. So, I can’t quote exactly where we are yet, but it should be in that range..

The only other thing I would add to that, Rob, is on the call, I think you may have referenced when we talk about vacancy conditioning or space conditioning, where we leased up some space. And that’s typically kind of the equivalent of like what we have heard for those rate boxing, and that’s a much lower cost. That’s $10 to $12 to $15 a square foot..

Okay. That’s helpful. And then last one for me.

The 254,000 square feet of leases that you guys signed, when did the bulk of that start producing revenue for commencing?.

So, it’s really staggered over the next number of quarters pretty equally. I would have to go and look, but it’s equally staggered over the next four quarters..

Okay. And is there any big quarters coming up from previous quarter signage where it’s abnormal, or is it fairly smooth when we go back and look at the first quarter signings, etcetera.

Is there anything big coming up in terms of third quarter or fourth quarter, first quarter of next year in terms of lease commencements?.

Sure. To focus on one property and specifically, if you look at our new acquisition in Raleigh, we expect that the occupancy in that property will move into the 80s by Q4. So, you will see a movement in that property specifically. That’s a significant amount of the increases..

Okay. Perfect. Thanks guys. Appreciate it..

You’re welcome..

Our next question comes from Craig Kucera from B. Riley Securities. Please go ahead Craig..

Yes. Hi. Good morning guys. You mentioned some changes in your leasing assumptions during the back half of this year.

And I would be curious, are there any particular markets that are maybe running a little slower than you had expected, or is it a little bit more broad-based?.

I would say it’s more broad-based. I mean the return to office when we went back to our original assumptions was starting to pick up. And I would say we have seen definitely an improvement in our own utilization is kind of in the mid-40s in the summer, which actually means it should be a fair bit higher than that, right.

You are at kind of peak vacation time, and we are still in the mid-40s. So, we think it’s going to continue to pick up through the balance of the year and talking to our tenants. We are seeing good thoughts on returning back in the fall. So, we are feeling good about that.

But as far as getting leases inked, it’s been a little slower than we initially thought. We thought Q4 would pick up a little bit more, and we are pushing some of those based on our latest discussions into early next year. But I would say it’s broadly spread..

Got it.

And just kind of circling back to your comments on kind of pushing things a little bit into 2023, is that – are tenants now requiring more free rent, or is it just a period that kind of they are ready to start and take occupancy from their perspective?.

Yes. I don’t think really metrics have changed that much. I mean construction costs were elevating. So, TIs were going up, that’s leveled off a little bit, I would say, recently. So, we are feeling better there. Free rent is still a little elevated from where it’s been historically. That really hasn’t changed.

So, it’s really a function of getting lease discussions across the finish line and then looking at the build-out time to get people in, it’s going to push into next year and probably a number of cases..

Okay. Thanks for the color..

Our pleasure. Thanks..

Today’s Q&A session ends there and I am going to hand it back to Jamie for any final remarks..

Thanks for joining today. And we look forward to updating you on our progress next quarter. Goodbye..

This concludes today’s call. Thank you for joining. You may now disconnect your lines..