Kevin Reed - Director, IR James Mastandrea - Chairman & CEO David Holeman - CFO.

Mitchell Germain - JMP Securities Ki Bin Kim - SunTrust Robinson Humphrey John Massocca - Ladenburg Thalmann & Co. Craig Kucera - B. Riley FBR, Inc..

Ladies and gentlemen, good day, and welcome to the Whitestone REIT Second Quarter 2018 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Kevin Reed, Director of Investor Relations. Please go ahead, sir..

Thank you, Evan. Good morning. Thanks for joining Whitestone REIT's Second Quarter 2018 Earnings Conference Call. Joining me on today's call is Jim Mastandrea, our Chairman and Chief Executive Officer; and Dave Holeman, our Chief Financial Officer.

Please note that some statements made during this call are not historical and maybe deemed forward-looking statements. Actual results may differ materially from those forward-looking statements due to a number of risks, uncertainties and other factors.

Please refer to the company's earnings press release and filings with the SEC, including Whitestone's most recent Form 10-Q for a detailed discussion of these factors.

Acknowledging the fact that this call may be webcast for a period of time, it is also important to note that this call includes time-sensitive information that may be accurate only as of today's date, August 2, 2018. The company undertakes no obligation to update this information.

Whitestone's second quarter earnings press release and supplemental operating and financial data package have been filed with the SEC and are available on our website, www.whitestonereit.com in the Investor Relations section.

During this presentation, we may reference certain non-GAAP financial measures, which we believe allow investors to better understand the financial position and performance of the company. Included in the earnings press release and supplemental data package are the reconciliation of non-GAAP measures to GAAP financial measures.

With that, let me pass the call to Jim Mastandrea..

the laser focus of our leasing teams, driven by extensive research of customer needs and wants, the success of our entrepreneurial businesses in our markets who are benefiting from tax cuts and economic expansion.

The neighborhood community centers we have represent the future of the landscape of the real estate industry and serve the day-to-day need of consumers. And value-add improvements to the acquisitions that we've made that are paying off.

We have transformed our portfolio over the past 8 years region by region, property by property to drive a high frequency of visits from consumers in the surrounding neighborhood that consider our properties in extension of their living rooms, dining rooms, outdoor entertainment venues, share with their families and friends.

The result increased property revenues and net operating income in our high-growth markets. For the first 6 months of 2018, our leasing activity has increased 40% in square footage terms from the same period in 2017 and represents $50 million in total lease value, up $13 million or 34% from this period in 2017.

Our well-located properties in high-household-income neighborhood during the second quarter continued to produce increased occupancies, which now stands at 91.5% in our wholly owned operating portfolio, up 170 basis points year-over-year and represents our highest occupancy [indiscernible] for the second straight quarter, a record as the best in our 8-year history as a public company.

Our strategy is to reasonably produce the results we have anticipated [indiscernible]. Our goal remains to become real estate owner of value-add properties to entrepreneurial tenants that provide local-based e-commerce resistance, necessities and services within the fastest-growing cities of the country in business-friendly states.

The operating component of our strategy is benefiting from the disruption on retail real estate caused by e-commerce.

Despite this disruption, our income stream remains relatively insulated due to numerous factors, including our well-crafted tenant base, control of our real estate through disciplined leased underwriting and triple net rents, percentage clauses and annual [indiscernible] increasing 2% to 3%.

These factors in our 8-year track record confirms our operating strategy is working. The value-add component of our strategy is benefiting from the development of land we acquired with many of our initial acquisitions and is now producing expandable leasing -- leasable square footage.

We understand the demographics and psychographics of our targeted properties and how to achieve maximum rents, high-household-income neighborhoods, the consumer spending relatively inelastic.

By developing our paths from adjacent land and redevelopment, reconfiguring space, we enlarge our property footprint, add more tenants, and in turn, increase rents in the overall value of these properties. Whitestone's portfolio [indiscernible] space entrepreneurial tenants drive surrounding neighborhood traffic.

In turn, this traffic drives increases in revenues through our grocery stores, improving cash flow and insulating our overall portfolio from expensive re-tenanting costs when spaces go vacant. In my annual letter to shareholders, I stated our long [indiscernible] 5 years are to improve our overhead of revenue and leverage ratios.

We [indiscernible] started 2018 and have made solid progress, with an improved 260 basis points reduction in general and administrative expense to revenue ratio from the second quarter of 2017.

I also stated that our unique value proposition is centered around entrepreneurial culture and is [indiscernible] focuses on neighborhood, necessities and local services. [Indiscernible] are driven by space culture and our management team for a lengthy period of time.

Digital disruption is here to stay, and we intend to remain ahead of the ever-evolving landscape focused on owning prime assets. These include specialty retail, grocery, restaurants, medical, education and [indiscernible] services. As we do, we will continue to produce results and increase property value.

With 1,650 [indiscernible] that are diversified, our cash flow is stable and will support a dividend payout ratio that will improve over time. We continue to build upon our progress as we seek to create additional long-term value for shareholders over the long term. And with that, I'll turn the call over to Dave.

Dave, please?.

Thanks, Jim. Please note that most of the financial measures and ratios I will discuss exclude the impact of $1.9 million in professional fees and related expenses incurred in the quarter related to our 2018 annual meeting. As Jim said, we continue to start on the year-end of the second quarter of 2018.

Our second quarter was highlighted by 1% same-store net operating growth in Whitestone's portfolio and 3.4% including our nonwholly owned properties. We also had strong leasing activity and spreads and made significant progress towards our 2023 goals by reducing our general and administrative expenses as a percentage of revenue to 14.4%.

Now let me give a few more details on the quarterly results. Revenue for the quarter grew $2.9 million or 9.5% from a year ago, driven by same-store growth of 2% and new acquisitions. Property net operating income was up $2.4 million or 11.8%, driven by same-store growth of 3.4% and new acquisitions.

Property operating margin expanded 140 basis points to 68.8% from 67.4% a year ago, primarily as a result of higher reimbursements. During the quarter, we signed 96 new and renewal leases, representing 259,000 square feet and $20.3 million in total lease value, representing future revenues.

The average lease size was 2,700 square feet and the average lease term was 4.7 years. Spreads were 12.2% on new leases, 7.3% on renewal leases for the quarter for a blended [12.3%] increase on a GAAP basis. Interest expense increased $1.2 million from the prior year due to higher borrowings and a rise of 40 basis points in our overall interest rates.

General and administrative expenses improved as a percentage of revenue to 14.4% from 17% a year ago. Funds from operations, excluding professional fees and related expenses incurred in connection with our 2018 annual meeting were $0.26 per share, up from $0.22 per share in 2017.

Funds from operations core increased $650,000 or 6%, and on a per share basis, funds from operations core was $0.29 versus $0.31 in 2017. Now let me spend a few minutes on our balance sheet.

We have total real estate assets on a gross book basis of almost $1.2 billion, with an annual in place net operating income of approximately $92 million, representing an unlevered cash-on-cash return on investment of approximately 8%.

Our capital structure remains simple and transparent with one class of shares and operating partnership units and a combination of property and corporate-level debt. Further, our underlying debt structure comprises a mix of secured and unsecured debt and well-laddered maturities.

Our capital structure provides us with the financial flexibility to support growth opportunity. At the end of the quarter, approximately 2/3 of debt was fixed, with a weighted average interest of 3.9% and a weighted average ending term of 4.8 years.

We had $60 million of availability under our credit facility at the end of the quarter, additional availability of $200 million from an expansion feature. Our debt-to-EBITDA ratio remained largely unchanged from the first quarter at 8.5x.

We continue to maintain a largely unsecured debt structure, with 49 unencumbered properties out of our wholly owned 58 properties. As to our guidance, we are reaffirming the funds from operations core range of $1.19 to $1.24 per share for the full year. The details are included on Page 31 of our supplemental.

And with that, we will be happy to take your questions..

[Operator Instructions]. We will take our first question from Mitch Germain with JMP Securities..

So just -- I'm curious about, obviously, you've got a whole bunch of development of land parcels within the portfolio. And particularly to that were acquired with the two properties last year.

Any thoughts when you're going to schedule commencing and what the time line is there?.

Yes, 2019. We're looking to begin -- and it's a long process. But when we start scheduling, it doesn't mean we're going to bring them online totally. But we've been working on the plans. We've got the entitlements in place now, and so we expect to break ground on some of the locations in 2019..

And do you plan on doing some preleasing before breaking ground? Or....

Absolutely, Mitch, this is Dave. Obviously we intend to prelease to ensure that there is demand [indiscernible], and then obviously do that development in phases whereby we have significant leasing..

Got you. So I missed some of your comments. I apologize. But the current occupancy level, 91.5%, I feel like record levels for you guys or at least certainly we have [indiscernible] levels for several years.

Do you think in a [indiscernible] portfolio rolling, there's obviously always a lot of leasing that's done because of the nature of the short-term lease [indiscernible].

Do you think that these levels are sustainable?.

Broke up a little bit there, Mitch, but I think you asked these -- I think these levels are sustainable.

Is that what you said?.

Yes, for occupancy. I've got some phone issues here, sorry about that..

That's all right. Sure. As we've said, we've had great leasing activity in the first half of the year, strong leasing spreads and strong leasing activity. We feel very good about the headroom in our properties from an occupancy perspective. And as such, we've increased the occupancy, I think, 1.7% or 170 basis points year-over-year.

So we continue to feel very confident about our ability to increase occupancies and drive additional cash flow and NOI. We also had [indiscernible] obviously -- we also had the ability [indiscernible] for rental increases that we roll those leases [indiscernible] from our spreads..

Got you. Last one for me.

The credit facility, I know you've got about a year, but is there any plan to accelerate that?.

Sure. We are just like -- I think you're right, we've got four-year facility. We absolutely expect to renew and extend that, and we'll report that as we conclude that. But absolutely, we've a credit facility that's a great tool for us so we continue to utilize..

Can't hear you Mitch..

I'm done. Thank you..

I think we probably didn't hear you.

Probably you said somewhat like a great quarter, keep it up guys?.

Exactly what I said..

[Operator Instructions]. We'll take our next question from Ki Bin Kim with SunTrust..

So you guys reported 170 basis points improvement in occupancy lease [indiscernible] percent. But when I look at your same-store revenues, they declined marginally, and NOI grew 3%.

And this kind of similar dynamic gave this first quarter were sort of even better occupancy in spreads, where rental revenue was up [indiscernible] and same-store NOI grew 4%. So I know there could be some reasons for [indiscernible] of the same spread. But just curious why there's GAAP between same-store rents that is imported..

Okay. Thanks, Ki Bin. This is Dave. A couple of items. So one of the things that we've been doing globally is converting some of our legacy leases that we're on gross rate, the triple net leases. But you see -- from that, you see some movement on the income statement between rental revenues and other revenues.

So that's a portion if you're just looking at the rental revenues. I think if you look at total revenues on a same-store basis, we were up 2%. That's one factor. Another factor is just of occupancy, for instance, this quarter I know there were both larger leases that drives the end of the [indiscernible] occupancy but revenues.

And then probably the third factor is looking at some of the continued improvement with properties. So what we report is the occupancy on our wholly-owned portfolio. I think that reflects one disposition during that time period from second quarter of '17 to '18, and that disposition was positive to our overall occupancy as well..

Okay.

And how should we think about the same-store revenue catered throughout the back half?.

Yes. I think we've given guidance for NOI for the second half of the year and the full year. [Indiscernible] our same-store revenue growth is 2% for the first half, same-store operating growth or wholly-owned portfolio is about 5%. So we continue to reaffirm the guidance we've given on those areas..

And your line keeps going in and out. Is this me or you? But just to let you know. And the comparable of retail of these spreads represents 55% of all your retail leasing. And I know this is going to happen with different vintage of the leasing, but can you talk -- and that percentage drop from 70%, 80% in the past couple of quarters.

So can you talk about why it was not in the pool, kind of reasons why, perhaps some color on the lease spreads of leases that were renewable?.

This is Dave again. I think we -- it's obviously we define the criteria for determining if leases are comparable. I think what we defined in our sub-data is we look for leases where there was a tenant within the last 12 months, and then the square footage renewed was within 25% of the expired square footage.

Obviously, with -- if with the smaller tenants there's a bit more of, it's not the standard, just re-leasing a little bit more of sometimes changing the square footage, sometimes doing those things. So we've been very consistent in our definition. If you look at our pool, there's obviously a high percentage of renewables.

But it is a large percent of our new leases don't meet that criteria we've defined as comparable, which is within the last 12 months, and then the square footage within 25%..

And is that because more of the timing 12-month window? Or is it more of the fact that you're kind of reassembling square footage?.

I think it's a factor of all of those. I wouldn't -- I'd hesitate to comment on which one. But I think timing is a piece. And then some of these -- with the smaller tenants, you have the ability to move the size of the space around a little bit more. And we do some of that, obviously, with our new re-leases..

And question on the leasing end, which I think is [indiscernible. It looks like in the first half of the year, you signed about 65 leases outside of the retail portfolio, which I think it was just Pillarstone representing 8000 square feet.

That actually represents about 15% of the total 1.5 million square feet at Pillar, which I know it may be smaller tenants, smaller leases.

But any commentary on just the volume and why that number looks high?.

Yes. I mean, I guess, if you think about our lease term being 3 to 5 years, Pillarstone does have a little bit shorter leases. I think in the Pillarstone portfolio, there's some other properties that ultimately make a different use. So just a little bit lease term. That volume doesn't -- is what we would expect..

[Operator Instructions]. We will take a follow-up question from Ki Bin Kim with SunTrust..

Well, I'm back..

That was quick. That's good..

So on the renewal, you guys spend a little bit of CapEx. I know it's not a big dollar for those deals days, but -- and this is not perfectly apples-to-apples. But if I take the CapEx part of it out of the rental rate, on a cash basis, like I said I know it's not apples-to-apples, but it really show a rental growth rate on an economic basis.

Are you finding that to do renewals that is basically a little bit more CapEx than what you've seen in the past?.

I don't think so. I mean, I'm looking at the leasing spreads where we report our TI and incentives. As you know, some of those TI and incentives have a -- especially TI, have a longer life cycle than the lease [indiscernible], whereby you put improvements into the space that go beyond just the current lease.

But if you look at our capital spend over the last four quarters, it's been relatively predictable, and obviously much more efficient than the larger spaces. I think looking at just the total leases about $5 a square foot for new and, renewals obviously being the smaller of that..

The real last question here. On your levered, 8.5x levered, your goal stated was about 6 to 7.

Can you just give us a walk-through on how you get there from here? What elements drive the 6 to 7x?.

Sure. We've committed to a long-term goal of 6 to 7x. I think the key there is it is a long-term goal. And so there's -- from quarter-to-quarter, we will continue to make progress. But over a little longer time, you'll see us do that.

I think the biggest factors are the headroom in our occupancy, the same-store growth, and then potentially some capital recycling with a lot of leveraging component..

Yes. And Steven, let me add to that. There's a couple of things we can look at that you'll see our occupancy increase, which will drive revenues. You'll see some of the assets that will reduce debt, and you'll see this increase as our percentage leases gear to kick in, and also as we bring the development online.

Most of the development parcels are generating anywhere from 9% to about 14% IRR on our developments. And so you're going to see some of that continue to happen. And that's what we've been doing for the past 8 years. It just takes a long time when you buy value-add properties one-by-one to bring those into production..

So what is the -- I know it's probably hard to say, but on retail portfolio at 91% occupancy, is this, in your mind, the number you can get to on a sustainable basis?.

I think this is a great high-quality portfolio of assets that are extremely well located. And so without giving a number, I think there's significant room of lease-up in this portfolio. We've shown that year-over-year.

And I feel like there's many of the properties we bought over time, where properties that had a value-add component of lease-up, and we're continuing to execute against that..

And if you recall, Ki Bin, we've talked to you before about this, that when we get a property that is 95 or plus percent, and the projected IRR start increasing at a decreasing rate, we will have probably have at least all of our goals in terms of stabilized rents in terms of marketplace and place that market up for sale.

Since we're a young company, you'll see some of those sales we have in the marketplace now happening. So you're going to see the mid-90s in occupancy, but we're always growing our portfolio as we expand it. And once we've taken the -- call it, the maximum value out of the assets that we can, we're going to sell them. That's part of the plan..

We will take our next question from John Massocca with Ladenburg Thalmann..

So touching on that last part of the last answer you gave.

Have you made any progress on the dispositions of non-core assets? Has there been any kind of change in the timing or the scope of potential sales you're contemplating?.

That's a good question, John. I think what we remain committed to doing. We're obviously in the process, and we'd prefer just to report on those as we to execute it. But we continue to remain committed to recycling capital..

And who is the potential buyer of these? I mean, I'm imagining it's primarily kind of smaller retail assets. I mean, is this mostly kind of regional investors, private investors? Are there other REITs out there that might be interested in these properties from a development perspective? Just any color on the potential buyers for these assets..

Yes. I think we're seeing a broad group of potential buyers. I don't think there's a particular category where, in the properties we're marketing, we're doing that widely. And we're seeing a broad level of interest..

Yes, we're actually having a lot of walk-throughs, a lot of showings. And I think there is a lot of interest. There's a lot of capital in the private markets, and we're seeing California buyers come to Arizona looking at some of our assets.

We're seeing entrepreneurs who've made a lot of money in the restaurant business, for example, who would like to own some of our properties. I mean, restaurants are absolutely on fire right now, particularly in our market. So we're seeing that kind of traffic. So it's a mix, as Dave said..

Okay. And then switching gears.

Is there any practical impact from the decision that the OCA made with regards to the historical consolidation of Pillarstone?.

No. I think we gave probably more detail than you want explanation in our press release. So that's kind of the activity back and forth that has resulted really in a slightly revised accounting treatment that has no material difference from our previous accounting..

Is that going to require you to restate past financials at all? Or is just kind of immaterial that's not really something....

If it's immaterial, we would not require that..

[Operator Instructions]. We will take a follow-up question from Ki Bin Kim with SunTrust..

One more.

What was the G&A, the spend due to the comp proxy fight and nonrecurring items?.

So I'm sorry, the question was, what was the G&A related to the proxy contest? That's the question?.

Yes, the outsized G&A portion?.

Sure. That was the cost of professional firms obviously involved in the proxy contest effort as well as the direct expenses related of mailings and those sorts of things..

The dollar amount?.

Oh, I'm sorry. It was $2.5 million for the 6 months, $1.9 million of which was in this quarter..

And is that going to -- is that pretty much the end of that?.

Yes..

Our next question is from Craig Kucera with B. Riley FBR..

I jumped on the call a little late, so you may have answered this already. But I'm trying to reconcile your same-store revenue to kind of what I've seen in the portfolio over the last year. It looks like your same-store rental revenue was down about $86,000.

But then your occupancy's up 1%, and your -- both your effective rents and your actual rents are both up nicely.

Is there something I'm missing in that pool? Or have you sort of identified what's going on there?.

Sure. Thanks, Craig. A couple of things. I think we mentioned one of the things we've done is convert some of our legacy gross leases to net leases. So you see a bit of movement in the lines there between rental revenues and other revenues. If you look at the same-store revenue growth for the second quarter, it was 2% for including both of those lines.

Secondly, when you look at occupancy, there's the timing, obviously, of tenants taking possession of the space. In the second quarter of '18, there were a few larger tenants that took possession at the end of the quarter. So we expected to see those results forward.

And then when we report our occupancy increase in our wholly-owned portfolio, that also does include the continued improvement of the portfolio. I think there was one property we sold during this time period that had a lower occupancy level. So that contributed as well to the occupancy.

But I think the leasing spreads, the occupancy to me are, obviously, leading indicators, and it takes a bit of time for those to come through the results..

Yes. And I'll just add a stat for you that of our portfolio, which is these 1,650 tenants, about 85% of those are on triple net leases. Some of them we converted. Like for example, Merrill Lynch we converted to a triple net. We converted Wells Fargo from a gross to a triple net. We've converted Shell gas station to a triple net.

So we've done a lot of this in our portfolio. What that does is we're able to charge on those 85% of leases of the operating cost. And we have about 205 fronts, and a significant number of those have percentage leases added to them.

So that when we get above the base rent, plus the triple nets, plus the increases, and they're doing well, we get a percentage rent. We also have a percentage rent clause on Whole Foods, which is one of our newest tenant. And we do things like ads and [indiscernible] like that, that will generate traffic, and also generate revenues.

We're seeing some very positive results to Amazon of Whole Foods, in particular the one we have that's located, in real estate terms, at the corner of Main and Main. So I think you have some promising numbers to look forward to in the future..

Got it. And Jim, you were kind of cutting out. I don't know if it was on my end or your end, but could you just sort of summarize what the financial impact is for kind of switching from some of these net leases to gross leases again? I apologize..

No worries. I'll do that, Craig. I think the financial impact is twofold. One is a different placement on the line. If you look at rental revenue and other revenues, obviously, some of the triple net showing up in other revenues, the expense reimbursement.

And then additionally, financially, provides a greater reimbursement of expenses going forward than a gross lease does, obviously, protects us from increases in TAM, taxes and other costs..

Yes. And the key protection is against inflation. We've got an economy that is truly growing. And Texas is probably growing at a multiple. So when you have these types of leases, you've got a great hedge against inflation. So where we get some relatively small amount of our debt is -- that's really offset pretty much by the annual increases.

We noticed it in the large -- the strip centers. The big boxes, they usually have [8%] a year, and it's not payable until every 5 years. So you have some things like that, that really don't -- it doesn't make a comparable to some of the other retail real estate companies in our industry..

[Operator Instructions]. And there are no additional phone questions at this time. So I would like to turn the conference back to Jim Mastandrea for any additional or closing remarks..

Yes. Thank you, operator. Well, in addition to some of the sitting numbers that we've been achieving, we've also set a record time for this call. So I thank you all for joining us in our 2018 second quarter conference call.

Our solid start to the first half of 2018 provides us with confidence in our ability to create long-term value for the shareholders. We make ourselves available to any questions you might have. And also, if you'd like to visit us or look at some of our properties, that's very easy to do. Just give us a call, and let us know. Thank you..

This concludes today's call, and we thank you for your participation. You may now disconnect..