Jul 29, 2010
Executives
Gerry Sweeney – President and CEO Howard Sipzner – EVP and CFO George Johnstone – SVP, Operations and Asset Management Gabriel Mainardi – VP, Chief Accounting Officer and Treasurer
Analysts
Anthony Paolone – JP Morgan Jordan Sadler – KeyBanc Capital Josh Atti – Citigroup Dave Rogers – RBC Capital Markets Rene Bayarna – Wells Fargo Mitch Germain – JMP Securities Aaron Lafkin (ph) – Stifel Nicolaus Dan Donlan – Janney Montgomery Scott John Stewart – Green Street Advisors Gabriel Mainardi
Operator
Good morning. My name is Latangie and I will be your conference operator today.
At this time, I would like to welcome everyone to the Brandywine Realty Trust second quarter earnings conference call. All lines have been placed on mute to prevent any background noise.
After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions).
Thank you. I would now like to turn the conference over to Gerry Sweeney, President and CEO of Brandywine Realty Trust.
Gerry Sweeney
Latangie, thank you very much. Good morning, everyone, and thank you all for joining us for our second quarter 2010 earnings call.
Participating on today’s call with me are Gabe Mainardi, our Vice President and Chief Accounting Office; George Johnstone, our Senior Vice President of Operations; Tom Wirth, our Executive Vice President, Portfolio Management and Investments; and Howard Sipzner, our Executive Vice President and Chief Financial Officer. Prior to beginning, I’d like to just remind everyone that certain information discussed during our call may constitute forward-looking statements within the meaning of the Federal Securities Law.
Although we believe the estimates reflected in these statements are based on reasonable assumptions, we cannot give assurance that the anticipated results will be achieved. For further information on factors that could impact our anticipated results, please reference our press release as well as our most recent annual and quarterly reports filed with the SEC.
Before addressing our performance for the quarter just a quick observation on the economy. Clearly, the economic environment is less bullish than it was during our first quarter call.
Macro data remains mixed and the economy seems to be operating without a sense of conviction on the timing or pace of the recovery. And, while that data can certainly not be ignored, we have not yet seen either directly or indirectly any real hesitation or a lack of forward planning on the part of our tenant base.
In fact, so much to the contrary, a number of our tenants are already looking forward to 2011 and 2012 on their space requirements. An increasing number of tenants are evaluating build-to-suit opportunities.
And, while I believe most of those will stay on the “drawing board”, they do reflect I think a more positive bias by some major users. This impact as we talked on previous calls, however, remains somewhat mitigated by continued downsizing by some users that still need to align their office needs to their current business plans.
The offsetting of those two factors will results in a market environment that will continue to favor tenants. But all in all, however, we remain optimistic with a small out on the recovery we’re seeing in our primary markets.
Even when looking at our markets most impacted by weaker demand like in New Jersey, leasing activity during the quarter remained encouraging. Now in terms of looking at the second quarter, we continued solid execution of our 2010 business plan including strong leasing performance.
As you look at the quarter in the remainder of the year, several overall comments. Headline leasing news for us was 1.1 million square feet of leasing activity during the quarter, a strong and steady new deal pipeline of 2.4 million square feet, 548,000 square feet of executed forward new leasing transactions, and over 0.5 million square feet of leases in negotiations.
From our standpoint, all very strong metrics. Overall leasing velocity continued to be in line with our expectations and we do expect fundamentals to continue firming.
Some markets are recovering faster than others. These conditions are factored into our business plant and reflect our view on the market bottoming with rental rate stability in some markets and continued downward trends in several others.
Near-term pressure on operating trends, however, will persist. Our market-to-market on rents remain negative.
Same-store NOI declined both in line with our expectations. But our NOI margins remain stable and we have executed approximately 91% of our annual 2010 spec revenue target.
Our tenant retention rate for the second quarter was 66%, excluding early terminations and 56.5% with early terminations included. Capital costs for the quarter were 15.4% of gross revenues for new leasing activity and 9.1% of gross revenues for renewals.
Again, all in line with our expectations and a reflect of what we see as continued stability in the costs involved in leasing transactions. Traffic through our portfolio was down slightly from Q1, but up 11% year-over-year.
Our strongest performing markets in terms of activity and rental rates remains Philadelphia CBD, Radnor Plymouth Meeting in Newtown Square submarkets in Suburban Philadelphia, the Toll Road Carter in DC, and Austin in Richmond. As outlined on our last call, our 2010 operating and business plan assumptions are, first, our major objective for the year is to simply lease office space.
As evidenced by our strong pipeline, we have an active engaged leasing program underway for every one of our properties and are aggressively pursuing all deals. We understand the leasing realities in this type of market and have tailored marketing plans for each under leased asset to ensure that we accelerate absorption to the extent that we can.
Our original business plan contemplated a 46% tenant retention rate based on results thus far. We believe our actual retention rate will approach 55%.
Core portfolio occupancy, which is our same store plus our recently completed five developments was 86.4%. That level is down 80 basis points from last quarter’s 87.2% or down by about 211,000 square feet.
Contributing to this decline was a 150,000 square feet of early terminations, including 70,000 square feet of bankruptcy and lease defaults, and then we also had a 77,000 square-foot tenant who moved out when they purchased a vacant building. For the fourth consecutive quarter though, tenant expansions exceed a contractions.
And as I mentioned on the last call, we expect our occupancy levels to drop to the 85% range later in the year, primarily due to several known tenant departures outpacing new lease commencements. In September, we will commence occupancy and NOI on our IRS Philadelphia campus that we’ve also referred to as the Post Office project.
This event will trigger funding of the $256.5 million Ford Financing. That loan, as you recall, fully amortizes over the 20-year GSA lease, and has a stated interest rate of 5.93% with an effective rate of 6.8%.
The development yield on this project’s net cost increased slightly to 8.9% based upon among other things our anticipated $13.5 million of cost savings. After factoring in our management fee income, our return on our net cost, which is the $342 million total costs less our tax credit funding will be 9.2%, so up slight from our original projections a number of years ago.
Upon completion, the GSA will become our largest single tenant comprising 7.2% of our annual base rents and our percentage of NOI contribution from Philadelphia CBD will rise from 13.4% to just shy of 19%. Taking a look at the investment environment, we continue to see high-quality office properties located in CBD or town centers coming to the market primarily in the Metro DC area.
These assets are receiving strong interest and in some cases trading at pricing levels achieved during the high point of the investment cycle a number of years ago. Demand for these core assets is driven by ample equity availability and a very favorable lending environment for high-quality well-located well-leased assets in desirable submarkets.
We do expect that trend to continue. And, while as I mentioned, the majority of assets sales have occurred in Metro DC, some high-quality assets are now coming to market in both Richmond and Austin.
Philadelphia, on the other hand, continues to have a lack of available product of the market, but we anticipate that more investment offerings will be coming to the market as the year progresses. In assessing our investment plan, the balance we’re trying to strike is to execute on value-added transactions at price points that ensures significant upside for our company.
Clearly, in our primary target of market at Metro DC, we are in a period of hyper-investment activity and cap rate compression with properties trading at significant pricing premiums and in some cases well over replacement cost with minimal growth prospects given our perspective on near-term rental rates. Given this aggressive pricing climate, our view on near-term rents and our cost of capital, our focus is really spent on transactions that require capital stack reconfigurations, high-quality under-leased assets we can acquire well below replacement cost or other value added or partnership type of situations.
We are currently working on several opportunities while vacancy is very good, risk adjusted pricing, at an all investment base well below replacement costs where we can reposition the asset for significant growth as market conditions continue to firm. As noted previously, the execution of any of these opportunities will be part of our balance sheet strengthening program.
We’ve already taken significant dilution through equity raise last year, so the plan remains to manage further dilution through funding any acquisition activity through stock issuance. And, while we have no acquisition opportunities built into our 2010 plan, we are becoming increasingly optimistic that we’ll be able to execute on a transaction or two sometime this year.
That being said, most of our investment focused energies right now is on evaluating some of our own properties for entering into the market for sale or joint venture by the end of the year. Our overall goal remains to remove noncore slower growth properties via either outright sale or joint venture over the next several years.
With the investment market recovery, we believe that we’ll begin to see an increased level of investment activity in the Philadelphia metro area as 2010 progresses. We fully expect that with pricing becoming increasingly dear in New York City and Washington DC, capital will begin as it historically has to migrate towards high-quality office assets in key markets like Philadelphia.
Our object is to make sure that we are in a position to take advantage of those opportunities. Our 2010 business plan contemplates an additional $69 million of sales.
We currently have about $20 million of property in due diligence and contract negotiations at an average cap rate just below 8%. As I stated before, we are fully committed to moving up the investment grade ratings curve one notch.
We anticipate achieving that through a combination of NOI growth, occupancy improvement, disposing of slower growth assets, and funding any acquisitions on an equity basis. The combination of these tactics will achieve our overall deleveraging objective.
Earlier this year, and along on those lines, we initiated our continuous equity offering program. That plan is designed to move our debt to GAV towards our 40% target range position us for the ratings upgrade and create financial capacity for new investments.
Year-to-date, we’ve raised $40.9 million, by issuing 3.3 million shares. During the second quarter, we issued 2 million shares, realizing $24.8 million of net proceeds and we have about 11.7 million shares remaining under this program.
During the second quarter, we repurchased $19.3 million of our 2010, 2011 notes and 2012 unsecured notes, generating a slight loss in the early extinguishment of debt. With the debt markets continuing to firm that buyback volume will continue to diminish and our business plan does not contemplate any further purchases, but we will continue to track those markets carefully and we remain opportunistic.
Howard will walk through a more detailed capital plan, but suffice it to say, we’re in excellent shape. Our business plan does not contemplate any new financing activity other than utilizing the pending cash sources like the $206 million net recover in the IRS mortgage funding, the CIM $40 million loan repayment which is eminent, the historic tax credit funding and our remaining credit facility capacity to pay off our $197 million of 2010 bonds in December and our $42 million secured mortgage on Plymouth Meeting Executive Campus.
Subsequent to yearend, we executed an eight-month extension option on our $183 million term loan, which pushes that maturity out to 2011 and we have an additional option available at our discretion. We’re still projecting a 2010 yearend line of credit balance of less than a $120 million.
And then, finally, as noted in our press release, we revised the bottom end of our 2010 FFO guidance upward to a range of $1.30 to $1.34 versus the prior range of $1.27 to $1.34. Based on a midpoint of our new 2010 guidance, our FFO payout ratio is 45.5% and our CAD payout ratio for the quarter was 65.2%.
We continued to expect to generate free cash flow this year of between $30 million and $40 million and the upward revision to our guidance has been driven by better retention rates than we originally expected, being slightly ahead of plan on spec leasing, good expense control, which has resulted in stable NOI margins, and a lower interest rate environment that we originally forecast back in October of 2009. With that overview, Howard will now review our second quarter results.
Howard Sipzner
Thank you, Gerry. As noted, we are performing very much on track with our overall business plan and the financial results I will discuss will reinforce that.
Our FFO or funds from operation available to common shares and units in the second quarter totaled $46.6 million, that translated to FFO per dilutive share of $0.34 which beat the analyst consensus of $0.33 by $0.01. It’s a very high-quality FFO figure as we reflect on it.
And then, second quarter termination revenue, other income, management fees, interest income, JV income and net debt activity totaled $6.8 million on a gross margin or $5.3 million on a net basis at the lower end of our annual guidance range for these components. A few observations on our 2010 second quarter performance.
Cash rental revenue of a $110.4 million was down $600,000 sequentially and about $3.5 million versus a year-ago after adjusting for the effects of de-consolidating three joint ventures effective January 1st, 2010. Straight-line rent was up $300,000 versus a year-ago, but down $400,000 sequentially versus Q1 and generally in range with expectations.
Recovery income of $17.7 million and our recovery ratio of 33.8% were in line with recent quarters, although down from Q1 2010, when we had a significant impact to costs, recoveries and the recovery ratio from snow removal charges, none of those right now of course. In the second quarter, we had net bad debt expense of $400,000 versus $1.3 million in Q1 2010, in line with expectations and reflecting various write-offs recoveries and adjustments to reserves.
The net effect in the second quarter was about a $50,000 decrease in our overall reserve balance. Interest expense of $31.2 million decreased sequentially by $300,000 and by $3.7 million year-over-year due to lower debt balances from our liability management and debt reduction program.
Interest expense in Q2 includes $420,000 of noncash APB 14.1 costs related to our remaining exchangeable notes. G&A at $6.6 million was somewhat elevated above our expected 5.75% or $6 million run rate due to a variety of minor items and then we incurred $445,000 of losses on $19.3 million of aggregate debt repurchases.
Lastly, deferred financing cost declined to $860,000 reflecting prior period accelerations of deferred amounts as a result of debt repurchase activities. This figure will rise at the end of the third quarter and in Q4 and beyond as we begin to account for the new post office and garage loans.
On a same-store basis, cash rents were down $2.6 million, reflecting lower occupancies and lower rent levels. Noncash rent items increased $270,000 as we provided graining levels of free rent and new leases.
Reimbursements increased by $913,000 reflecting better lease structures including more triple net leases. Termination fees and other items increased by $428,000 as we saw increased levels of early move-outs and associated termination payments.
Property operating expenses and real estate taxes were essentially flat versus a year-ago. And our recovery ratio for the same-store portfolio improved to 32.9% from 31.2% despite lower occupancies.
As a result for the quarter, same-store NOI declined 1.9% on the GAAP basis and 2.3% on the cash basis, both excluding termination fees and other income items and largely as a result of lower occupancy in the same-store portfolio. For the second quarter, our cash available for distribution after all adjustments totaled $0.23 per share and provided a 65.2% coverage ratio on the second quarter dividend.
Our overall ratios and margins were very solid with EBITDA coverage at 2.5 interest, 2.3 debt service, and 2.2 fixed charges. And, again, despite our occupancy levels, we’re seeing very high margins of almost 61% on NOI, about 34% on recovery and 62.4% on EBITDA, which makes us very comfortable looking ahead as occupancies improve.
2010 guidance, as Gerry mentioned, we’re raising the bottom end of our range due to performance and tightening in our business plan. This is our third consecutive quarterly increase from what was originally $1.23 to $1.34 and it’s now $1.30 to $1.34.
This accommodates quarterly FFO to be in the range of $0.31 to $0.33 in the third and fourth quarters of 2010. Our key assumptions include the following; a decline of 4% to 5% of GAAP same-store NOI for the full year, excluding termination and other revenue and a decline of 5% to 6% for cash same-store NOI on the same parameters.
We’re continuing to see rents trending down. Although, as Gerry noted, the results have been mixed.
GAAP market-to-market should be down between 3% and 5% and cash market-to-market should be down between 7% and 9%. Each of these assumptions is unchanged from last quarter, except the GAAP market-to-market which is 100 basis points tighter or better.
In terms of leasing, we expect to do 2010 aggregate leasing of about 3 million square feet in our speculative revenue program to produce $28.9 million of revenue of which we are 91% down on the revenue side. Our speculative revenue production is up about $1.5 million from our prior 2010 estimates, reflecting better renewal activity as well as the overall pipeline.
We see $25 million to $30 million of gross all other income items were $20 million to $25 million net after management expenses. Our GNA should run in the five and three quarters to $6 million level.
Our total interest expense for the year should come in between a $130 and $135 million. The next two quarters will begin to rise especially in the fourth quarter as we draw down the post office and garage financing and we eliminate capitalized interest on that project as well.
We are currently not anticipating any additional issuance under our continuous equity program and as a result of all of these activities we’ll also see cash available for distribution in the 85% to 95% range reflecting about $20 million of additional capital expenditures for leasing activities this year.As Jerry noted our plan should produce between $30 and $40 million of free cash flow. Our capital plan is actually very simple and very straightforward for the balance of 2010.
We see total capital needs the balance of the year from July 1 of about $387 million that translates to about $98 million of investment activity, $53 million to complete the post office and garage. An additional $20 million or about $10 million a quarter or revenue maintaining CapEx and $25 million for remaining redevelopment outlays, lease up of recently completed projects and other revenue-creating capital expenditures.
On the debt side we see $245 million of debt repayments. As Jerry noted that includes $197 million for the 2010 note and the aggregate of $48 million for repayment of the Plymouth Meeting mortgage as well as principal amortization.
And we have extended our bank term loan to June 29, 2011 taking that out of the 2010 plan. We’ll pay approximately $44 million of aggregate dividends and as previously all in cash.
So raise this $387 million we’re projecting the following. About $80 million are for cash flow from operations for the rest of 2010 will realize the remaining $3 million of the store tax credit financing proceeds.
As noted in our press release, we received $27.4 million as the next to last installment in June 2010 towards an ultimate total of a little bit over $64 million. We expect the $256.5 million post office and garage loan to have funded by the end of the third quarter.
We have the $40 million CIM note repayment schedule for August 2nd and we may in fact get it a few days early so that is counted as an incoming fund and we are looking at additional sales of $69 million over the balance of the year. As a result of these activities, we could pay off as much as $60 million dollars of our credit facility and bring its balance down to as low as $100 million and certainly within $120 million level Jerry outlined.
Credit activity or account receivable was very much as expected in the second quarter. Our total reserves at June 30th were $15.6 million which reflected $4.4 million on $24 million of operating and other receivables and $11.2 million on $99.3 million of straight line rent receivables.Now the $24 million of other receivables is a bit elevated because it includes $7 million of receivables attributed to our advanced payments on the post office project, which presumably did not need reserves from the government.
Total reserves are comparable at the last figures quarters at outline and generally reflect good credit conditions. On the balance sheet we came in at 45% debt to gross real estate cost continuing our track record of bringing that figure down towards the 40% goal.
As I look back that’s our best debt to GAV ratio in almost five years. We continue to have a very low secure debt creating a very high quality unencumbered pool and are among the lowest in the read space in terms of reliance or use of flowing rate debt and lastly, our $600 million credit line as you saw was a $160 million drawn on June 30th providing ample liquidity for our future needs.
On the credit side, we are a 100% compliant on all of our credit facility and in venture covenants. Now I turn it back to Jerry for additional comments.
Gerry Sweeney
Operator
Anthony Paolone – JP Morgan
Gerry Sweeney
Sure. I will make some overview comments and we will see if we can pick up with somebody the submarket information.
I mean first of all we’re adding into you know the summer months which you typically tend to be slower decision periods for tenants but I think across most of our markets, we continue to see pretty good traffic and frankly even more importantly that 2.4 million square foot pipeline has remained pretty constant in the last couple of quarters with some good forward leasing activity. I mean what we’re frankly hearing from our tenants range across (inaudible).
There are some large users out there no question, Tony. They touched on we think they are still undergoing a process of rationalizing their space requirements.
You know why these companies clearly grew an awful lot over the last decade. They just like everyone else they’re resetting their business plans and as part of that reassessing their overall office requirements.
But we’re also seeing on a more positive front with a lot of the midsize companies in some of our larger users, a complete re-shifting back to looking at you know what they need to do to continue to grow their business.
George Johnstone
Anthony Paolone – JP Morgan
Gerry Sweeney
Well look, we really do view that certainly as we talk to a number of investors, the relative level of leverage we have versus some of our peers remains a bit of an equity blocker for us. So we are very much driven to bring our debt to (inaudible) down to our core peer group level all consistent with that plan of getting that investment grade upgrade.
So, as we look at it in terms of the bigger picture we certainly recognize that you know the ways to do that are increasing our occupancy and why we think we are on track to do. Disposing of some slower growth non-core assets which again is a plan that we have been executing and anticipating us going forward and then the real next step is how we either issue equity as simply de-lever or identify acquisition and opportunities that we thing would present a good capital growth story for the company as markets continue to recover.
So, as we’ve looked at the investment landscape and Tom, certainly, I’d like you to jump in and make some observations. We have seen that, given our cost of capital, our prospective on where near-term rent growth is and that possibly, maybe, more cost you on some revolutionary value calculation.
We find ourselves being priced-out of some of the markets that we have targeted earlier this year, primarily Metro DC to make acquisitions because the point of entry pricing is well below our cost cap but more importantly, Tony (ph) , when we look at how that property will perform, given our expectation of growth rates, on a unlevered IRR basis, we don’t view of those returns coming up to where we’ll take our cost of capital a day. So on those transactions, we intended to take a pass but are very much focused on those acquisition opportunities where we think that we can add some value and create some good growth rates on the acquisition going forward.
Now Tony (ph) maybe you’re saying I could shift and Carl (ph) what were you saying in some of the other markets?
George Johnstone
Hi, Tony. When we look at the other markets, we have been looking at transaction in Washington, primarily, because that’s where most of the activity has been.
We both have seen some activity in Richmond and Philadelphia, and we have been actively bidding on a number of select transactions that we’re seeing over a million square feet that we’ve looked at. But those properties, when we take a look at how they’re being bought, the final numbers are they’re close to $400 a foot, cap rates below seven.
And we’ve looked at some assets inside the district, some older assets that went for over $600 a foot, cap rate of 5.6 and we can see there was a lot of growth. We’ve looked at some assets inside the Beltway, the assets $300 a foot.
And the rents (ph) at 90% of their highs in the past couple of years and at Richmond we’ve looked at some downtown assets and again cap rates and replacement costs are challenging in rents above market based on where those markets are. We’re not seeing unlevered returns even on our – - we think are some of conservative cap rates that were in the market to buy those.
Operator
Your next question comes from the line of Jordan Sadler with KeyBanc Capital.
Jordan Sadler – KeyBanc Capital
I just would like to follow up a little bit on the investment activities side of things. I understand a bit more clearly what you’re looking to buy, I think, but maybe you can just sort of outline what you’d sell if that this will be the office (ph) if those would be fully stabilize and would those be in some of the weaker markets that you’re currently in or would it be a function of a manner of properties available for sale versus demand.
I mean how are you framing this?
George Johnstone
Jordan, I think when we looked at the properties that we’re targeting right now, a lot of the things we’re looking at are off-margin and I think that there are still developing at the end of CBDs. We’re not looking right now, although we do assess them and underwrite them.
Most of the stuff we’re looking at is going to be CBD and then our core markets. We don’t want, as we’ve said, anymore problems, trials, anymore hardly seeing that has to be done.
We’re still present’s position. So the things we are looking at are CBD but they are value added.
They will have vacancy. There will be a component there of what we feel that will help our growth.
So those assets are going to be, maybe, lower-yielding and have a vacancy but we expect that they’re in our core markets more CBD oriented. We’ll be able to lease them up over time and show some very good returns
Gerry Sweeney
Jordan, I think, you’re also alluding to what we were looking to sell. We get through a pretty rigorous review every quarter based on our forecast of (indiscernible) relative returns or fabrication property in a company.
Again our buyers right now is through that ranking process look to dispose the proper centers that are non-core markets for us. In core markets are ones in a relatively underperforming the rest of our portfolio.
By extension, number of those assets that we’re looking to move or explore to move are in – - some of the non-core Philadelphia Metro Philadelphia suburban market places, that there are also markets that frankly have not seen a lot in investment activity as of yet, where a really return of margins to show investors. So most of those transactions that we’re feeding into the market right now tend to be one of deals ranging in size from $2 million to $10 million that will be targeted towards private equity investors, smaller private development companies who have access to some capital both in the equity front.
I think we’re probably still, at least, a couple of quarters away from being able to look at any larger scale transactions in some of the suburban Philadelphia, Central, Southern New Jersey market places.
Jordan Sadler – KeyBanc Capital
What about something that might be a little bit more core but stabilize, like a tier (ph) where they maybe better institutional demands that might drive or attract the pricing and what sort of decision metrics does it relate to or something like that.
George Johnstone
Well look, it’s a very good point and I think as we’ve talked on some previous calls, I mean when we look at a tier (ph) center, that certainly and possibly a target to try to get a joint venture done a couple of years ago. We the collapse of the debt markets and is caused by impact on equity pricing, we were not able to get that executed.
Certainly as we’re tracking trophy-quality CBD asset pricing in the district inside the Beltway markets, even New York City that’s under and sing (ph) what that deep (ph) looks like. We’re certainly keeping our ears to the street on what type of demand might be coming from that bid list on high-quality buildings outside of those two core markets.
So the evaluation process is pretty simple and that we know if it’s generate from the cash flow stamp foot. We know what (indiscernible).
We remain incredibly optimistic on the future of University City in Philadelphia, but we also anticipate that at the appropriate time, we’ll be to persuade a joint venture partner of those same characteristics. And yet, what we think will be exceptionally good price on assets.
Jordan Sadler – KeyBanc Capital
Just lastly, clarification, I think Gerry said that a prospective return on those office would be 9.2% cost less the tax credit, is that the right number? Is that an unleveraged cash going into you?
Gerry Sweeney
Yes that’s basically be analyzed from the property plus the management fee and the numerator. The denominator being the $342 of cost less the historic tax credit and new market cash credit and new market cash credit funding that we’ve received
Operator
Your next question comes from the line of Michael Billerman with Citigroup.
Josh Atti – Citigroup
Thanks, it’s Josh Atti here with Michael. You mentioned in the past that you could lose up to 1,000 basis points of occupancy in New Jersey in the second half of the year, can you talk a little bit about the pipeline to fill some of that space and what’s the recent activities then?
George Johnstone
As we put in our Press Release, we saw a 345, 000 square feet worth of deals in New Jersey during the second quarter. The pipeline of new deals today stands at 408,000 square feet with another 304,000 square feet of Renault pipeline.
Again, with the average tenant size over there, it’s kind of in the 7,000 to 10,000 square foot range. There are some large users in the market that were talking with the backfill.
Some of the vacant space we’re going to take back in that laurel (ph) later this summer. So, again, as I’ve mentioned traffic was down for the quarter but we think volume from deals executed in a pipeline perspective is actually picking up some.
Josh Atti – Citigroup
Does the guidance assume that that space is vacant?
George Johnstone
It assumes that some of it in place and as we’ve talked previously we’re expecting that year-end occupancy levels in New Jersey are in 73% range.
Josh Atti – Citigroup
Okay. I’m sorry, I know you mentioned this earlier, but what was the effective gap rate on the IRS stats that’s sure to come on your balance sheet?
George Johnstone
6.8%.
Operator
Your next question comes from the line of Dave Rogers with RBC Capital Market.
Dave Rogers – RBC Capital Market
With respect to your discussions early in the year with capital partners, I think, you would kind of started the year with the assumption that maybe you’d be able to find some partners to go out that range to invest (ph) your money and give some acquisition. And now, it seems like maybe the return expectations at least between you and other buyers are certainly different in terms of the growth rate.
With that same I guess scenario true with the discussions that you had and that’s what kind of leading you to be maybe more of a seller here in the back half of the year or is it the shift in capital between the markets. If you could give a little more color on some of those early discussions?
Gerry Sweeney
You know Dave, great question for clarification. We didn’t really touch on in our prepared comments.
We are still actively engaged with a number of private capital co-investment potential partners. You know clearly when we look at our direct cost to capital versus a lever grade of return we might get on co-investment opportunity very, very different.
I mean we would still like to have a high percentage of our land or why over time coming in from the Metro DC area. We’re just recognizing that given how (inaudible) have become compressive the last couple of quarters versus what we were thinking in the fourth quarter of last year.
It’s just not a very attractive landscape for us to pursue an acquisition on a wholly own basis and finance that on an equity basis given where we’re trading. But I don’t think that diminishes our appetite to try and get some transactions done but recognizing to effectively execute those at a pricing return level to us that makes sense, that needs to be done on a joint venture format.
But certainly Tom, George are sending to the rest of our investment team, Howard and myself are engaged in a number of discussion with traditional real estate investors, pension funds, pension fund advisers, some European capital funds as well some sovereign wealth funds looking at the, particularly the Metro DC in particular the district on a some potential transaction that would have a different levered capital stack than we would anticipate having on, on an on balance sheet transaction.
Dave Rogers – RBC Capital Markets
In those discussions, not yet progressing outside of a DC Metro within your footprint?
Gerry Sweeney
I think that the appetite clearly is much more in a Metro DC area. I think we’re beginning to see some early indications that capital is refocusing back on a key market like Metropolitan Philadelphia given some of the pricing that’s happening in those core markets.
But as I say, I do think that that’s probably a couple of quarters away but certainly as we evaluate what assets we have that we currently own that we would like to explore a joint venture with, we’re having some of those discussions now in terms of identifying the right pool of assets that some of these investors might in fact find attractive as an entry point into the greater Philadelphia area.
Dave Rogers – RBC Capital Markets
What is the right spread today for as comparable acquisition whether value and value at a core-to-core between those types of markets between whether you go from DC to New jersey or DC to Philadelphia and how does that spread come in, in your underwriting here in the last six to nine months?
Gerry Sweeney
Yeah, look I mean historically the spread between kind of a New York and a Metro DC compared to Philadelphia has been between a 100 to 200 basis points. Obviously depending on the sub market, the product quality size, et cetera in as much they really have not been Dave a lot of transactions in the greater Philadelphia area this year.
It’s hard to really benchmark what that spread is I mean we’ve seen cap rates as Tom alluded to on some of the transactions we’ve reviewed in the Metro DC area, in the mid five’s to the low sixes. I mean that would imply that we can start getting back to sublate cap rates on suburban Philadelphia assets but we’re not seeing any evidence of that as of yet.
But our hope is that as the year progresses to be some more offerings that come out in this market place and we’ll get a better benchmark to quantify what that current spread is.
Dave Rogers – RBC Capital Markets
Good thank you and I guess as a follow up on a different topic the speculate revenue target, you guys are pretty close to your full expectation I imagine you’re getting a little late in the year to maybe hit the rest of that expectation but two things, one is I guess is the retention ratio higher can offsetting maybe what might be just a modest shortfall in the speculate revenue and then second if George maybe you can provide some color on versus your speculate expectation, how did you perform on absorption versus what they rent?
George Johnstone
Sure I mean we are seeing and continue to see a little bit of a shift from you know assumed vacates and subsequent new leases to some of the existing tenants staying and we you know are still projecting at 55% retention rate. On the speculated revenue we did raise the target based on some leasing that we have already achieved in a pipeline of deals that we still feel good about.
So we you know increased the target to $28.8 million and we’re 91% achieved on that. So, we’ve got about $2.5 million of speculated revenue to go on the half a million square feet of deals but again I think we feel good about where those deals are projected to occur and the pipeline that supports those.
Dave Rogers – RBC Capital Markets
Thank you.
Operator
Your next question comes from the line of Rene Bayarna (ph) 05:51 with Wells Fargo.
Rene Bayarna – Wells Fargo
Thanks, good morning. Just to follow up on Dave’s last question there.
If I look at your year-end occupancy target in the prior call were 85% to 86%, you’ve got 86.4% occupancy. Today it seems like probably the renewal rate for the back half of the year is probably around 50%.
You’ve got 425,000 square feet. That’s leasing that’s already done that’s going to come online on the back half of the year and then you’ve got the post office asset that’s going to come online.
All of that would seem like it would get you to 86% or maybe a little bit higher without getting any additional speculated revenue. Is there something that we’re missing or are your occupancy targets by year end moved up a little bit from where they were?
George Johnstone
No Rene, we’re still on that 85% range. I mean we do have in addition to some of our contractual 2010 leases that will expire and vacate.
We do have a few tenants that we have programmed that have a subsequent 2010 expiration that may be giving us back some space early. Some through a blend and extend program where we are going to retain the tenant but they are going to downsize and give us a longer term.
So we’ve got some additional early terminations kind of baked in to the plan.
Rene Bayarna – Wells Fargo
Okay so, maybe for George or for Gerry, the commentary earlier that contractions are probably still outstripping expansions a little bit. At what point do you think that your occupancy level on kind of a same property basis just stop going down.
Should that start to happen in the beginning of 2011 or do you think it’s more likely to be later in the year?
Gerry Sweeney
Yeah, we’re hoping that our occupancy levels will throw-off by the end of this year and start to move back at a positive direction in 2011. I mean in looking at kind of from where we are today through December, some of the big occupancy clients we have we known about and as George touched on, really a big piece of that by one large tenant who is leaving two of our better buildings in Southern New Jersey to buy their own building.
And then I think when you try and reconcile the land or why the earnings impact the occupancy number yet be very mindful of the timing of whatever those vacations may be. Certainly a tenant that would leave us in December may have a very minor revenue impact but we picked that up as an occupancy decline in our year end numbers.
But look I think when we spend an awful lot of time with the managing directors and the leasing teams, go to a very detailed, poorly re-forecasting process, George stays on very close touch on leasing transactions with our camp. I think you know while the overall commentary is positive you know underlying that are some areas that we know that we have areas to improve such as you know New Jersey.
You have been running that operation at 73% leased is clearly a stark low for us. We think that’s been a combination of tenant cut-backs, generally weak demand, and then a number of our key tenants either consolidating back into own facilities or buying their own facilities.
We think that weighs behind us and more importantly when our leasing came in that marketplace, works with George and we assess the quality of the prospect pipeline, we certainly do expect to be able to turn that market as well as a number of the other markets in a positive direction as the year progresses.
Rene Bayarna – Wells Fargo
Okay and then just quickly to follow up. For some of the early terminations, should we expect to see some lease term fees pick up and back us?
Gerry Sweeney
Yeah. I mean you know obviously yeah there would be a termination fee associated with any space that we’re going to take back before the scheduled expiration.
Operator
Your next question comes from the line of Mitch Germain with JMP Securities.
Mitch Germain – JMP Securities
Good morning, guys. Most of my questions have been answered.
I guess the only thing I am really looking for is leasing strategies in the Jersey region, are they similar to your portfolio or possibly a bit lower?
Gerry Sweeney
Lower. You know, for the second quarter our GAAP spreads on new leases were down 6%.
Renewals were the same first quarter spreads in Jersey were down almost 12% on new deals and down 130 basis points on renewals.
Mitch Germain – JMP Securities
Thank you.
Operator
Your next question comes from the line of Aaron (inaudible) 102 with Stifel Nicolaus
Aaron Lafkin (ph) – Stifel Nicolaus
Hello. Good morning.
Thank you for taking this call. A quick question on the—when is the actual rent supposed to begin on both GAAP and non-GAAP basis for the IRS assets.
Gerry Sweeney
I am sorry. You are cutting out.
We cannot quite make out the question.
Aaron Lafkin (ph) – Stifel Nicolaus
I just picked up the headset here. When is the rent supposed to actually begin on the IRS asset both on the in terms of GAAP and cash.
Gerry Sweeney
We are assuming around September 1st and GAAP and cash are the same on this project as it is a flat lease.
Aaron Lafkin (ph) – Stifel Nicolaus
Okay, very good. And then where do you, guys, actually the $13.5 million against the budget on that asset that what actually came in, I guess, better than your expectations.
Gerry Sweeney
Well, it is a variety of factors, certainly an element of hard cost savings there. When you undertake a project of any significant size like this particularly when it involves renovation.
You build in a fair amount of contingencies to cover unplanned items. There is some soft cost savings that we incurred that came in below budget so pretty much across the board.
No one large element that was a major driver of that versus the G&P that we executed when we undertook the project of construction.
Aaron Lafkin (ph) – Stifel Nicolaus
Okay. Great.
Thank you very much. Congratulations.
Gerry Sweeney
You are welcome.
Operator
Your next question comes from the line of Dan Donlan with Janney Montgomery Scott
Dan Donlan – Janney Montgomery Scott
Hi. Good morning.
Gerry Sweeney
Good morning.
Dan Donlan – Janney Montgomery Scott
Just a question on the NOI margins, Gerry. You guys mentioned that you are using more trip(ph) 244 on that.
At least going forward, could you maybe talk about what you are looking at for the margins maybe in 2011 until 2012 if you can actually see some occupancy increases from here?
Howard Sipzner
Yeah. Dan, it is Howard.
I will jump in first and George will probably elaborate. I think it is noteworthy to look over several quarters, even several years, we are tracking consistently at around 60% NOI margin and around 32, 33% recovery ratio and that is with occupancy down right now, 5, 600 basis points or more.
So if and when that occupancy turns, I do not think we are going to see much of an increase in operating expenses. We are spending real estate taxes are really subject to market values but if those leases are on a gross basis, obviously we will pick up the expenses.
If they have a base year, we will get whatever escalation there is above that since a portion of our leases and particularly in markets like New Jersey, parts of Pennsylvania and Austin are triple net. There will be a recovery of expenses that in effect we have incurring so it will all be bottom line effect.
So I think those margins could go nicely higher. It ultimately depends on the lease structure but there are certainly several hundred basis points on each to get to levels that the company has never been at.
Now the reason we have been able to do that is because our expense control over the last couple of years has been very, very focused as you can well imagine. George, I think, jump in?
George Johnstone
Yeah. Thank you, Howard.
Metro DC and Richmond really are non-triple net lease structure regions at this point. All the new leases in New Jersey, Delaware, Pennsylvania are converting to triple net or have converted to the triple net and we tried to convert every renewal as well so I would expect that margin to continue to go up and the one thing that can kind of skew it sometimes quarter over quarter is that bad debt runs through the operating expense line which is a pass-through item a tenant.
So the debt sometimes can have an impact on how that margin looks or become rate percentage loss quarter over quarter.
Dan Donlan – Janney Montgomery Scott
Okay. And just a follow-up on the dividend, given your low payout, just kind of curious as to how you look at that going forward because you are talking about more investment activities.
Are you 518 using more of your capital now for investment or is there an opportunities opportunity down the line to start to bump up your payoff?
George Johnstone
Well, the policy of the board is still to match our dividend with taxable income. You know, taxable income to a great degree is a function of how much revenue we generate which is a function of our occupancy levels and rents it is only to the extent that more successful in moving our occupancy levels up, generating higher taxable income, our expectations where we look at the dividend, certainly we are in a very good position here with a very, very well covered CAD payout ratio with our existing dividend.
It is good to be sitting in a position where we are going to be generating even if these low-occupancy levels 30 to $4 million of free cash flow. Given where our stock is trading right now and our relative dividend return, we certainly do not feel under any pressure to increase the dividend to try to make it more attractive for investors.
I think our major objective is to execute business plan that creates the revenue that generates the higher multiples that reward the shareholders from that standpoint but we like having a very well covered dividend. We had that for a number of years and as the market turned a few years ago, we wound up getting upside down on the CAD payout ratio.
We do not think that is a very wise way to run a business particularly in this uncertain environment so I would not anticipate any change the board would make to our dividend this year. When we certainly look at our 2011 business plan and rolled it out to the marketplace in our third quarter call and the board reviews that business plan in detail and looks at our taxable income, which make a decision at this point in time and risk assess our projections and expectations versus where we think the markets are.
Operator
(Operator instructions) Your next question comes from the line of John Stewart with Green Street Advisors
John Stewart – Green Street Advisors
Thank you. Howard, you said the IRS building is a flat lease.
Do we take that to mean that there are no ramp-up over the 20 years?
Howard Sipzner
That is correct.
John Stewart – Green Street Advisors
George, can you may be shed some light for us on the big occupancy declines and Plymouth Meeting and DRAJB (ph) 750?
George Johnstone
Sure. In Plymouth Meeting which is really a combination of both the Plymouth Meeting and the Bluebell submarkets, we had really three transactions kind of drive the decline there.
AIG had a contractual right in their lease to give us back a floor which was 36,000 square feet and they had exercised that which generated the termination fee and that occupancy declined. That happened in the second quarter that was in 401 Plymouth Road and Plymouth Meeting.
We have got several prospects looking at that space and some additional space in the building that we are currently negotiating and then the others were in Bluebell where one was a renewal with an associated contraction and then the other was a tenant that moved back to corporate-owned facilities so we had a 56,000 square foot decline in the Bluebell submarket, a 20,000 square foot net decline with some additional leasing to offset the AIG give back in Plymouth Meeting and we got pre-leasing in both those markets of about 40,000 square feet we went from 88.6 down to 81.4. We have got pre-leasing in place to get us back to 85.
With the pipeline that should get us back to close to a 90% occupancy level there.
John Stewart – Green Street Advisors
And the DRAJB (ph) 924?
George Johnstone
DRA. I will have to follow up with you after the call on DRA.
John Stewart – Green Street Advisors No problem. Howard, could you please just explain the holdback on the line of creditors as it relates to the tax credits and also maybe help us understand what happened with the swap on the term loan that I know you renewed it but it looks like the rate went from alive or plus 80 to 5.6% with hard to imagine I guess how that swap would have looked during the last 90 days?
Howard Sipzner
Okay. Good questions.
We can clarify both. On the holdback the agreement in place with our financial partner on the post office project is that for every dollar they advance we set aside or carve out a dollar and a half or 150% of availability on the credit facility.
It is really an insurance policy, so to speak, on their part that the project gets finished on time so as we reached a little over 60 million dollars at the end of the second quarter with the latest funding, that holdback or unavailability in the credit facility by contractual agreement with them reached $92 million. Once the project is accepted by the IRS and our permanent financing is in place, that holdback goes away so expect that to happen before the end of the third quarter.
John Stewart – Green Street Advisors
Got it and the term loan?
Howard Sipzner
Yeah. With respect to term loan, there is actually no change to the swaps that are in place but from a presentation purpose to make sure all of our weighted average effective rates should track correctly, we stopped just categorizing that as alive or plus 80 which it is but instead put the full swap in place so that is the 5.4% you see in the book that reflects swaps that were done back in primarily late 2007 when that loan was originated to turn it into more a fixed rate obligation.
Those swaps for the most part burned off by October of this year and then for the rest of that term, unless we do otherwise, that will be a pure floating rate obligation.
John Stewart – Green Street Advisors
Got it. That is helpful.
Thank you and then lastly, looked like there were buildings taken out of service that are under demolition, can you give us some color there?
Gabriel Mainardi
Yeah. This is Gabe.
Those are a couple of projects that we took them out of service and are classifying them as land inventory now. No current development plans.
There are a couple of ideas in place but the project is undergoing interior demolition and the structures will come down so we just made an assessment that day have no remaining useful life and they are now part of land inventory.
John Stewart – Green Street Advisors
Okay. Thank you.
Operator
At this time there are no further questions. Gentlemen, do you have any closing remarks?
Gerry Sweeney
Nothing, Tangie, just to thank everyone for taking the time to listen our call and we look forward to updating you on our business plan during the next quarterly call. Thank you very much.
Operator
Thank you. This concludes today’s conference call.
You may now disconnect.
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