Oct 23, 2008
Executives
David H. Hoster II - President, Chief Executive Officer, Director Keith McKey - Chief Financial Officer, Executive Vice President, Secretary, Treasurer
Analysts
Philip Marin - Cantor Fitzgerald Christopher Lucas - Robert W. Baird & Co., Inc Mitchell Germain - Banc of America Securities Paul Adornato - BMO Capital Markets Wilkes Graham - Friedman, Billings, Ramsey & Co.
Chris Haley - Wachovia Chris Pike - Merrill Lynch Irwin Guzman - Citigroup Mark Bifferd - Oppenheimer Justin Mauer - Lord Abbett
Operator
Welcome to today's program listed EastGroup third quarter 2008 earnings call. At this time all participants are in a listen-only mode.
Later you will all have the opportunity to ask questions during our Q&A session. (Operator Instructions) Please note that this call is being recorded and I would like to turn this call over to the President and CEO, David Hoster.
Please go ahead, sir.
David Hoster
Good morning and thanks for calling in for our third quarter 2008 conference call. We appreciate your interest in EastGroup.
As usual, Keith McKey our CFO will also be participating in the call. Since we will be making forward-looking statements today, we ask that you listen to the following disclaimer covering these statements.
Unidentified Company Representative
The discussion today involves forward-looking statements. Please refer to the Safe Harbor language included in the company's news release announcing results for this quarter that describe certain risk factors and uncertainties that make impact to the company's future results and may cause the actual result to differ materially from those projected.
Also, the content of this conference call contains time-sensitive information that is subject to the Safe Harbor statements included in the news release is accurate only as of the date of this call.
David Hoster
Thank you. Operating results for the third quarter met the upper end of our guidance range.
Funds from operation were $0.82 per share as compared to $0.80 per share for the third quarter of last year, an increase of 2.5%. The increase over the midpoint of our guidance were due to better property operations and the sale of a building that had been purchased in our taxable REIT subsidiary.
In comparing quarter-to-quarter, please note that third quarter of this year included the expensing of $0.03 per share of original issuance cost due to redemption of our Series D perpetual preferred shares in July. Also, the third quarter of last year, an enlarged combination leaves $0.04 per share included in FFO.
For the first nine months of 2008, FFO was $2.45 per share compared to $2.26 per share for the same period last year, an increase of 8.4%. Because of the large termination fee in the third quarter of 2007, same property net operating results were negative for the third quarter of this year excluding termination fee income.
Same property operating results increased by 0.3% with straightlining of rents and by 1.4% before straightlining of rent adjustments. This was the 21st consecutive quarter of positive results for this measure.
For the third quarter on the GAAP basis, our best major markets after the elimination of termination fees were El Paso which was up 14.1%, San Francisco up 12.8%, Charlotte up 12%, Houston up 7.4%. This trailing same property markets were Tampa, down 12.2%, Dallas down 8.5%, and Jacksonville down 6.8%.
Occupancy in September 30 was 94.4%, a 60-basis point decrease from the end of the second quarter, but the same level at the end of first quarter. Our California markets were 97.5% occupied and taxes was 95.3%.
Houston, our largest market with 4.1 million square feet was 98.4% occupied. As we have discussed in our last several conference calls, leasing activity has flowed significantly and with peak in the first half of 2007 reflecting the general economic slowdown.
The good news is that there are still prospects looking for space although there are a fewer of them and it takes a lot longer to complete lease negotiations. Prospects understand that they have numerous lease alternative and as a result do not feel any urgency to act.
In addition, they and their brokers expect to receive lease incentives. Our leasing statistics illustrate that our markets are still alive.
Overall, of the 1.4 million square feet of leases that expired in the quarter, we renewed 75% and released another 8% for a total of 83%. This total is above our historical average and we believe reflects the desire of tenant not to make major new lease commitments in uncertain economic environment.
In addition, we leased another 266,000 square feet that was vacant at the beginning of the quarter, a good indication that there continues to be users out there in the market looking for space. As you can see in our supplemental information, we continue to achieve good rent growth in the third quarter with a 15.8% increase for GAAP with the straightlining of rents and 9.1% increase without straightlining.
Four large leases in the Los Angeles and San Francisco areas generated these above-average results. Average lease length increased to 4.8 years, again primarily due to the California leases.
Average tenant improvements were $1.68 per square foot for the life of the lease, or $0.35 per square foot per year of lease. These figures are below last quarter's figures and slightly above our historical averages.
At September 30, our development program consisted of 21 properties with 1.9 million square feet and a total projected investment of $129 million. Fourteen of the properties were in lease out and seven under construction.
Geographically, these developments are diversified in four states in 10 different cities, and overall, are currently 28% leased, a slight decrease from our second quarter level. Development leasing continues to be good and relatively steady in Houston and San Antonio but also continues to be slow and behind budget in Phoenix and our Florida markets.
During the third quarter, we transferred four properties with a total of 372,000 square feet to the portfolio located in Fort Myers, San Antonio and Houston. These developments have a combined occupancy of 83%.
Also during the quarter, we started construction of Beltway 7 with 95,000 square feet in Houston and acquired the 12th Street distribution center with a 150,000 square feet in Jacksonville, which we are in the process of redeveloping. The acquisition of 12th Street was part of our Orlando build to suit transaction with United Stationers.
For the full year we have reduced our expectation for development starts to approximately $50 to $60 million. This lower projection reflects current leasing activity in our development markets.
In July, we acquired 12.2 acres of land in San Antonio for future development. The price was $1.9 million.
We plan to build approximately 176,000 square feet and three buildings that is to be called Thousand Oaks Business Park. The property located in North Central, San Antonio is one block from a 480,000 square feet Whitmore Business Center.
As previously reported, we also currently have 130 acres under contract to acquire in Orlando. This site will allow for approximately 1.2 million square feet of industrial development.
Including the planned Orlando acquisition, Orlando inventory contained 360 acres with a potential to develop approximately 4.5 million square feet of new industrial product. As you have heard us state many times, our development program has been, we believe we'll continue to be a creator of significant shareholder value.
We are not a merchant builder. We are not developing to generate immediate gains with the sale of newly created assets.
Our goal as a developer is to have quality, state-of-the-art investments to our portfolio and thereby increase total returns to our shareholders in both the short and long term. In August, we purchased a 128,000 square foot vacant warehouse in Tampa through our taxable REIT subsidiary.
This acquisition like 12th Street in Jacksonville was part of our Orlando Builder suit transaction with United Stationers and had been under contract since March of 2007. Unlike 12th Street, we did not think it would be a good long-term investment and sold the building, generating the net after-tax gain of $294,000 which was included in the third quarter FFO and net income.
In August, we sold the 20,000 square feet Delp Distribution Center Three in Memphis for $635,000 and recorded a gain of $83,000. This transaction reduced our Memphis ownership to a single lane 2,000 square foot warehouse.
In September, we sold 41 acres of residential land in San Antonio for $849,000 with no gain or loss. This property was acquired as part of our Alamo Ridge industrial land acquisition in September 2007.
Last quarter, we reported in our Metro Business Park in Phoenix was under contract to sell. The transaction did not close due to the buyer's inability to perform.
Keith will now review a number of financial topics.
Keith McKey
Good morning. David reported FFO per share for the quarter increased 2.5% compared to the same quarter last year.
Lease termination fee income was $186,000 for the quarter compared to 966,000 for the third quarter of 2007. Bad debt expense was 452,000 for the third quarter of '08 compared to 107,000 in the same quarter last year.
The net effect of these items decreased FFO per share about $0.05 for the third quarter as compared to last year's third quarter. Other one-time items in the quarter were the expense in the original issuance cost on the redemption of the preferred stock $0.03 per share and gain on sale of non-operating real estate of $0.01 per share.
FFO per share for the nine months increased 8.4% compared to the same period last year. This termination fee income was 730,000 for the nine months in '08 compared to 1.16 million in the same period last year.
Bad debt expense was a 1.823 million for the nine months of '08 compared to 469,000 for last year. In that effect, these items decreased FFO by $0.05 per share.
We're in a strong financial position. Our bank line's total of $225 million and with the expected closing of a $59-million mortgage in December, we expect bank debt to approximate 110 million leaving a capacity of 115 million at yearend.
The bank lines do not mature until 2012. The other debt we have are mortgages.
And we have no maturities for the remainder of 2008, only 31.4 million in 2009, and none in 2010. We feel confident that we can withstand the slowdown of the economy and the credit crunch for a good period of time.
For the quarter of the interest coverage ratio was 3.8 times and fixed charge coverage ratio was 3.7 times, a small improvement from past quarters. Interest and fixed charge ratios will be the same in the future due to the redemption of our only preferred shares in July.
In September, Fitch Ratings affirmed our rating of BBB, noting EastGroup has a higher quality portfolio of industrial assets, strength of management team, consistent solid property operating performance and strong debt coverage ratios. Fitch view is favorably EastGroup's manageable development portfolio and its relative short construction timeframe and stabilization periods which provide bids with some comfort that EastGroup could either scale back or control the timing of development starts especially during periods of considerable economic uncertainty.
In September, we paid our 115th consecutive quarterly distribution for common stockholders. Its quarterly dividend of $0.52 per share equates to an annualized dividend of $2.08 per share.
Our dividend and FFO payout ratio was 63% for the quarter. Rental income from properties amounts to almost all of our revenues so our dividend is 100% covered by property net operating income.
And again, we believe this revenue gets stability to the dividend. FFO guidance for 2008 was narrowed to a range of $3.28 to $3.30 per share with the midpoint of $3.29 per share unchanged from prior guidance.
Earnings per share is estimated to be in the range of $1.24 to $1.26. Now, David will make some final comments.
David Hoster
With the current turmoil in the financial markets and the expected continuing deterioration of the economy, the next 12 to 18 months will not be as much fun in the real estate business. It has been over the last couple of years.
But with our strong balance sheet, debt coverages and borrowing capacity, we believe we are well-positioned to deal with whatever problems or opportunities that present themselves to EastGroup. Our strategy is simple and straightforward and it works.
Keith and I will now take your questions. Thank you.
Operator?
Operator
Yes, sir. Would you like to accept questions?
Keith McKey
Please.
Operator
Okay. (Operator Instructions) Looks like our first question will come from Michael Bilerman from Citi.
Please go ahead, sir.
Irwin Guzman - Citigroup
David and Keith, good morning. It's Irwin Guzman here with Michael.
David Hoster
Good morning.
Irwin Guzman - Citigroup
I'm sorry if you mentioned this and I just missed it, but you talked about development start guidance, I'm just wondering, you know, if you look at your pipeline right now, your developing has sort of 9% yield, given what you’re seeing the capital markets. How do you think about where that yield should be to justify new development based on where you think Cap Rates are going and what sort of the cost of that is on this also.
David Hoster
I wish I had an exact answer for you on that. I don't think anybody really knows what's going to happen with Cap Ratesand debt cost over the next 12 to 24 months.
We're now looking at starting possibly just two more developments, probably do one per share of World, Houston spec building. And the other, which could get postponed the next year, is Alamo Ridge in San Antonio.
Two markets where we're still having success in development leasing. And with both of those, we're still comfortable with our projected yields in the 9% range on cash basis, a little higher on a GAAP basis.
What happens with starts in '09, we haven't come to a conclusion on those yet so we need a little more information on what's happening with the capital markets and actually and probably more important with what's happening with our leasing markets.
Irwin Guzman - Citigroup
Thanks and, Keith, can you just clarify why the gain on the asset sale would be recorded in FFO as opposed to being backed up.
Keith McKey
When we did the United Stationer's deal, there were three parts to it. One is build-to-suit for United Stationers and then they had two buildings that they want to sell us.
One we wanted to keep and put in our portfolio and the other one we did not plan on keeping so we put it in the tax REIT subsidiary, never depreciated it and always planning on selling it.
Irwin Guzman - Citigroup
Okay, thank you.
David Hoster
Thank you.
Operator
Our next question will come from Mark Bifferd (ph 00:18:20) from Oppenheimer. Please go ahead.
Mark Bifferd - Oppenheimer
Good morning. First question, David, is towards these 130 acres you're looking at or that you have under contract in Orlando and has there been any delays in terms of the closing in that because of the financial markets and if this continues do you think that you would have to or could walk away from that deal?
And if that's the case, are there any termination fees that you just might be exposed to on that?
David Hoster
We have money at risk on the transaction. We are extremely comfortable with the price we're paying when we closed it.
We think this is an unusual buy, tremendous location with almost a mile frontage along the Beachline Expressway, in between are Sunport development and our Southridge development right basically next door and before the mall. We think that we were able to negotiate at an attractive price and attractive structure on it because of what was happening in the capital markets.
And in the past, we've found that some of our best land purchases have been when we're looking at difficult economic times. There's less competition for the land, and buyers enjoy dealing with somebody that doesn't have financing contingencies.
Our Southridge development on that land was acquired during the last recession. So that process has worked well for us in the past.
Mark Bifferd - Oppenheimer
Okay. And then lastly, just looking at lease termination fees, what are your expectations for the fourth quarter and then how is leasing going when you look at the rating of fourth quarter expirations and then into '09, what do you see in terms of tenants wanting to re-sign early?
David Hoster
A number of the leases that we executed in third quarter were '09 renewals actually. We're finding just a mixed bag.
We don't expect to have any termination fees in the fourth quarter but that can always happen. Our expectation is somewhat of a continuing deterioration of the economy so we expect, not a steady but several steps down in occupancy over the next 6 to 12 months, but we haven't tied down all our projections for '09 yet.
We traditionally have released guidance in the middle of January with the upcoming years. So, at that point we will be able to give you a lot more detail on what we see happening in '09.
We still have plenty of time to sign leases this year and that can really affect us '09 renewal projections.
Mark Bifferd - Oppenheimer
Okay, thanks.
Operator
The next question will come from Mitch Germain from Banc of America. Your line is open.
Mitch Germain - Banc of America
Hey, David. You had mentioned potentially another development at World, Houston in the fourth quarter?
David Hoster
Yes. Well, World Houston 30, obviously our thirtieth building in World, Houston, it would a specialty of development of front park/rear load.
We have almost no vacancy in that type product at World, Houston now. We've got I guess 14% vacancy remaining in our World Houston 24 which is a similar building.
Everything else in that style, is in that prototype, is leased so we think that it makes sense to put up a spec property given the environment and how we are doing at World, Houston.
Mitch Germain - Banc of America
So just a take from that, it's different than the World Houston 26.
David Hoster
Yeah, 26 which we finished just a little bit ago is across Stark building and geared to smaller cross-dock users and with just 25, which was next door to it, another 66,000 square foot cross-dock. We just recently brought it 100% occupancy recently at the end of the quarter.
So we're now too early to be worried that cross-dock product and we do have a prospect for some of the space now.
Mitch Germain - Banc of America
Okay. And I apologize if you mentioned this already.
I got on the call a little late, the $59 million mortgage debt scheduled for the fourth quarter, what's the loan-to-value on that?
Keith McKey
It was in the 60% to 65% range.
Mitch Germain - Banc of America
Okay. And just quickly browsing through your markets, David, I guess considerable pressure in Florida, I mean how much of that is related to the housing market and how much of that could be related to any other factors?
If I can get some commentary.
David Hoster
I think Fort Myers and Tampa are probably of our Florida cities are more affected by the housing market than any of the others. Orlando is projected by Florida economists to come back first of the Florida markets and we already, I think, have seen a little bit of improvement there, nothing to get really excited about yet but that's happening.
Tampa has had tremendous job wash and looking at the statistics that are our recently job growth or job loss. And so of our Florida markets, that's probably our most disappointing one at this point in time.
Mitch Germain - Banc of America
Great, thanks guys.
David Hoster
Thank you.
Operator
The next question will come from Paul Adornato from BMO Capital Markets. Please go ahead.
Paul Adornato - BMO Capital Markets
Hi, good morning.
David Hoster
Good morning.
Paul Adornato - BMO Capital Markets
Could you characterize the bad debt in the quarter, number of tenants, size of tenant industry exposure?
David Hoster
Keith is calling some of that out. As usual with us, there's no trend in either type of business or the size of the business.
It's across the board. I guess we're still seeing a little bit of problem from companies that weren't full time housing related lease on a periphery basis where, or are exposed to construction.
Keith McKey
The (inaudible 00:25:31) was 50,000.
Paul Adornato - BMO Capital Markets
I'm sorry. What was that?
David Hoster
Well, the company in Tampa, they made security gates primarily for shopping centers and shopping malls.
Paul Adornato - BMO Capital Markets
Okay.
David Hoster
They filed bankruptcy so the debt is residential but it's real estate related.
Paul Adornato - BMO Capital Markets
Uh-hmm.
Keith McKey
David, some of these other larger ones they didn't come in at all.
Paul Adornato - BMO Capital Markets
Okay.
Keith McKey
It's nothing real big. We have a lot of—
David Hoster
We're starting to see some problems with companies that sell furniture. One of them related there.
I guess you could say that's related to housing. But, again, no specific trend where you can say, okay, we need to watch any type business more closely than any other and our actual bad debt in third quarter was down from the second quarter but trending above last year.
Paul Adornato - BMO Capital Markets
Right. Okay.
And could you also talk about traffic particularly in September and into October?
David Hoster
We have not seen any significant decline in traffic over the last couple of months. I'm asked all of the time how is the credit crunch affecting your customers.
And so far, I think not enough time has passed for there be any direct consequences. I'm sure we'll hear more about it going forward.
But the complaints that we hear from our tenants is very simple either that their business is off, the ones with problems either need to downsize or want to break in rent or would like to get out of their lease. This is the normal things that happen in an economic downtime.
I would guess next quarter, if there's any real problems related to inability to raise credit, we'll hear about it and be able to report it to you at that point. The good news, and I said this a number of times, is that, really, I guess in every market at Fort Myers, we still have people out looking for space, which is very different than what happened in that fourth quarter of ’01 and first quarter of ’02 where we hit our low in occupancy and the phone did not ring.
It was just dead. Fortunately we have not gotten to that point yet, and hopefully will not.
Paul Adornato – BMO Capital Markets Corp.
Okay. Great, thank you.
David Hoster
Thank you.
Operator
Our next question will come from Wilkes Graham from FBR. Please go ahead.
Wilkes Graham
Hey, David, you may have just answered my question from the previous question, but I guess I am just trying to get a sense for given what is going on over the past few weeks, and you have not seen traffic change, but just have your expectations changed for, you know, lease rollovers next year and just your ability to resign tenants or to resign leases that roll next year?
Friedman, Billings, Ramsey & Co.
Hey, David, you may have just answered my question from the previous question, but I guess I am just trying to get a sense for given what is going on over the past few weeks, and you have not seen traffic change, but just have your expectations changed for, you know, lease rollovers next year and just your ability to resign tenants or to resign leases that roll next year?
David Hoster
This is a personal response, not anything on any kind of real data on leasing, but the bad news seems to be getting more frequent and worse. And maybe it is just the media, but there does not seem to be much light at the end of the tunnel right now in terms of what is reported.
And we get barraged every night well, for us, every day on what is happening to REIT stock prices, what is happening to the overall market, unemployment going up, credit crunch, all those sorts of things. And I think a lot of that has not filtered down to people running day to day businesses.
And it is too early to tell how much they are going to be affected by that and how severe it is going to be on them. And it is going to take some time to feel that.
So everything I hear and read, people are no longer talking about this being a short-lived recession, but it is going to be longer, and I do not know if that is a good sign. As soon as there is total despair things usually start to get better.
But there does not seem to be anything in the economy today providing the catalyst for things to improve between now and the end of next year. So we are still doing our projections for ’09 and they will probably be colored by just what we hear every day in the media.
Wilkes Graham - Friedman, Billings, Ramsey & Co.
Okay, thank you.
David Hoster
Thank you.
Operator
Our next question will come from Chris Haley from Wachovia. Please go ahead.
Chris Haley - Wachovia
My apologies if this question has been answered regarding the preferred redemption. I can not recall, I have not had the chance to check what the coupon was on that, but could you give us the pro and con of buying that in versus alternative uses of capital?
David Hoster
Okay, when we made the decision to do that, the world was very different, obviously. It was a 7.95% coupon, and we knew at the time we couldn’t have reissued it at that rate; we did not have any plans to.
And we looked at our capital situation, having just done an equity offering at an attractive price, and looking at the debt that we were locking down for 10 years, and it was a nice spread. In hindsight, I wish we had not done it, but not for capital reasons.
But if we had not done it we could have probably bought it in as a discount today given what has happened to preferred prices.
Chris Haley - Wachovia
Well, you would have to redeem it at par, correct?
David Hoster
No, we could have bought it in the open market if we had announced that we were going to do that.
Chris Haley - Wachovia
Okay. But when did you actually buy it in?
When did you actually redeem it?
Keith McKey
July 2nd, I think.
David Hoster
Yeah, it was the first week of July.
Chris Haley - Wachovia
It was the first week of July after the equity transaction, so you decided to remove a fixed expense?
David Hoster
Well, as I just mentioned, what we did was in March we had done a, I think it was a $79 million seven-year loan at 5.5%.
Chris Haley - Wachovia
Right.
David Hoster
So I was looking at a fixed expense for 10 years at 5.5 versus a fixed expense for longer than 10 years, but I thought that was a long enough time horizon to be evaluating it, and we were making the spread on 250 basis points on that $31 million. And we did not think the $33 million was a big enough number that it was going to make a big difference to our capital structure in the long run anyway.
Chris Haley - Wachovia
So when I think about that transaction then, for those—so you would have a full quarter benefit of the pay down at near 8% versus using under 6% capital. That was a benefit to the third quarter; is that fair?
Keith McKey
You factor in the common stock issuance also.
David Hoster
Yeah.
Chris Haley - Wachovia
So the net of those items, Keith, would be what? Plus or minus?
Keith McKey
It would be a plus.
Chris Haley - Wachovia
It would be additive to the FFO per share.
Keith McKey
For the second quarter as a break-even? Yeah, if you take out the redemption costs of $0.03 we had to put, I think it was close to a break-even or maybe a little positive.
Chris Haley - Wachovia
Okay, and the reason your fourth quarter is up at $0.85, or up in the mid-80s is because obviously you are not – your run rate is $0.85 without the OID?
Keith McKey
I do not know if we have got a run rate anymore, Chris.
Chris Haley - Wachovia
Well, I would hope you have a run rate.
Keith McKey
Well, that is what we are projecting for the fourth quarter. I do not know what the run rate is going to be.
Chris Haley - Wachovia
Oh, that is what I meant. Why are we up in the fourth quarter versus the third quarter?
Keith McKey
Yeah, because of the $0.03 is gone.
Chris Haley - Wachovia
Okay.
Keith McKey
And the property operations are holding up well, debt structure is good.
David Hoster
And one thing, if you go back to our original projections in January of this year, we had projected selling our Metro Business Park, and by not selling it that was a positive of a little less than a penny a share, because it is a hundred percent leased, a good asset and we hoped to sell it because it was a service center and not a dock high building. So that sale falling through benefited us at least in the short run.
Keith McKey
And thankfully liable rates have come down a little bit too, that will help.
Chris Haley - Wachovia
But they have gone back up. If I look at the end of the year—
Keith McKey
Not in the last couple of days, but that is okay.
Chris Haley - Wachovia
Right. In the last couple years you guys have benefited from some short-term occupancy pickup in the latter weeks of each year, calendar year, and I wanted to get a perspective on whether or not you think the early inquiries for that type of occupancy pop might occur again.
David Hoster
Probably not.
Chris Haley - Wachovia
All right, thank you.
David Hoster
We have not ruled it out, but retailers do not seem to be buying extra inventory when they have—with a need to park it someplace until they sell it at Christmas, so.
Chris Haley - Wachovia
Right.
David Hoster
And also we have traditionally provided space for the Post Office in several different markets and that need has not been out there yet.
Chris Haley - Wachovia
Alright, well, thank you, and thank you for keeping things clean.
David Hoster
Thank you.
Operator
Alright, our next question will come from Derek Bauer from Merrill Lynch. Please go ahead, sir.
Chris Pike - Merill Lynch
Hey guys, it is actually Chris here. David, I’m just wondering what your thoughts on construction costs, especially in some of your Sun Belt markets, with perhaps some loosening up in labor costs.
I mean, where do you see things trending on the construction side?
David Hoster
Well, our most recent activity has been in Houston, and although labor costs and availability of labor has improved some, at least when we did a number of the World Houston properties that we are starting now, steel costs were still up, and concrete took a huge leap up. That seems to be counterintuitive, but concrete is now over $100 a yard in Houston, and that has been unheard of.
That has been our cheapest market. Now, as time goes forward, I would hope those price increases do not hold, and I would certainly hope that we get in the middle or late next year and construction costs will reflect the lack of construction in a weak economy.
But we have not seen anything dramatic yet.
Chris Pike - Merill Lynch
Okay, and then I guess one of our prior conversations we were talking about some of the regional banks and the strength or lack thereof in some regional lenders, and given your customer base, smaller nature, maybe their ultimate financing sources come from these more regional, regionally-based lending banks, what are your thoughts nowadays on the strength of that lending base? How do you think that may or however you start to see it manifest itself in the financing of some of your customers, and is that in any way, shape or form leading to some of the slower lease up, at least with respect to your market niche, in terms of who you look to?
David Hoster
On an anecdotal basis we have not heard, as far as I know, the first word about the credit crunch affecting any of our customers’ tenants. Now, whether that holds true, I have no idea, but right now that has not been a negative effect.
And I think the credit crunch has not gone on long enough for a lot of that to filter down. But the negative feedback we get is that just business stinks.
Not that they can not finance it or anything else like that. And when there is an unknown in the economy, then prospects are not interested in making generally long-term commitments, and that is why I think through the good news/bad news.
The good news is that our renewal rate in our current portfolio is the highest it has ever been, reflecting that our customers do not want to make any changes because they do not know what changes to make. The bad news is that means those same customers or other prospects are not interested or have a whole lot less interest in signing long-term leases in new buildings where they themselves have to make a capital commitment.
And so that has hurt our development leasing in Phoenix and in our Florida cities. So far that has not seemed to affected too much our development leasing in San Antonio and Houston.
I mean, it has slowed, but it is still well above any of our averages. So the longwinded answer is what is happening to the banks so far, we have not heard anything is affecting our customers.
Chris Pike - Merill Lynch
Okay, thanks a lot, gentlemen.
David Hoster
Okay.
Operator
Our next question will come from Chris Lucas from Robert W. Baird.
Please go ahead.
Chris Lucas - Robert W. Baird & Co. Inc.
Okay, good morning guys.
David Hoster
Good morning.
Chris Lucas - Robert W. Baird & Co. Inc
Just a couple of follow-up questions. David, on that last comment about the development pipeline, what are you guys doing now to manage the pipeline versus six months ago, particularly in the softer markets like Phoenix and the Florida Coast?
In particular, are you looking at stretching the development process out or doing more phasing of the development?
David Hoster
Well we have always. Well, except for one exception we have always done phasing of development and that has worked very well for us.
What is different is, let’s say two years ago, if a brand new building was 30-35% leased, we would start the next building. Then about a year ago we said that current building had to be 50% leased to start the new building, and now we do not have any set rule, but I would say it would need to be 75% leased or higher, and that is still having a certain comfort in the market.
Our average building size is, what, 70,000 or 80,000 square feet, and so the average investment is $5 million. So we do not view ourselves as being really hung out in any one market, and I think our development in all these different cities shows why we are diversified, why we are in four primary growth states and how being in cities where things, good things are still happening can offset being in some cities that are slower.
But we have not put together any schedules for what we think we are going to do next year, because that is really going to depend on leasing, and not just occupancy but the rents we are getting and the constructions costs in the markets where we hope to build subsequent phases.
Chris Lucas - Robert W. Baird & Co. Inc
Okay, and then you guys have been through a number of cycles; as you think about where we are, are you looking at managing your overhead any more aggressively than you currently do?
David Hoster
Obviously thinking about that. We certainly expect there to be less development and as a result less construction in our various development markets, and as a result we actually do have a reduction in head count in our little construction operation.
But our people are – well, the way we are set up is that when somebody is a senior vice president, vice president, asset manager, in a market, they are involved with everything in that market, from acquisitions to sales to development to leasing to management. And so the fact that we are slowing down development some does not mean there are a bunch of people sitting around doing very little.
I mean, our overall head count at EastGroup has always been pretty darn efficient. I mean, we are only at 63 employees for what, $1.8 billion in assets or something, so we like to think that we run a pretty tight ship without the layers of bureaucracy that some bigger companies might have.
Chris Lucas - Robert W. Baird & Co. Inc
Agreed. And then one last question here is that historically you have looked at this type of environment at other opportunities, particularly in the, you know, M&A arena.
Can you remind us as to what characteristics you would be looking for when analyzing potential candidates?
David Hoster
Well, what we are trying to do is to look at a wide range of opportunities and try to take advantage of the best ones as they are presented to us. And that entails anything from buying completed assets to assets under development to stock in other companies, and I certainly think that there are going to be more opportunities six to twelve months from now than there are today.
I think there is a big difference today than in ’01-02. Back then everybody believed the recession was going to be short, and so nobody, especially people in the industrial sector, got scared.
And there certainly was no credit crunch, so nobody had those pressures. I think that the change in the mentality of people just in the last 60 days has changed and made that very different this time around, where nobody thinks it is going to be a short downturn, whether it is a recession or whatever you want to call it.
And so they are looking out to maybe 2010 to recovery, so if you have got leasing problems today and debt coming due, you are going to be scared and be willing to provide an opportunity for somebody with capital. So we hope to come across some of those and be very selective and maybe that will allow us to buy in some markets where we haven’t been able to afford previously.
But more than likely the real opportunities are going to be with properties that have leasing risk. And so that if we find some my guess is they will not help the bottom line initially, but looking out a year or two we hope that they would really contribute to future growth.
Chris Lucas - Robert W. Baird & Co. Inc
Thank you very much.
David Hoster
Thanks.
Operator
Next we’ll go with Philip Marin from Cantor Fitzgerald. The line is now open.
Philip Marin - Cantor Fitzgerald
Good morning David, good morning Keith.
Keith McKey
Good morning.
Philip Marin - Cantor Fitzgerald
I have a couple of questions here all over the map, but in terms of your fourth quarter tenant retention, are you seeing that track pretty similar to the third quarter, which was quite good?
David Hoster
We expect as you can see in our guidance assumptions to lose some occupancy in the fourth quarter.
Philip Marin - Cantor Fitzgerald
Mm-hmm.
David Hoster
Now we’re not seeing any big move away from what we’ve been doing.
Philip Marin - Cantor Fitzgerald
Okay, you know, you mentioned David that you still have tenants that there are still tenants looking for space out there. Can you characterize what type of tenants those are and who is looking for space out there right now?
David Hoster
Every market’s different. I mean in talking to our people in Phoenix, they say the big difference there is that the prospects are people moving around Phoenix, where a year or two ago it was new companies coming to Phoenix.
And, because of the negative job situation there that’s changed dramatically. In some other markets, the companies are still coming to town, but no there’s no one area that we see that you could concentrate on to lease space.
Philip Marin - Cantor Fitzgerald
But, you are still seeing activity. Is that really just part and parcel of your strategy of focusing on smaller tenants and buildings, you know, at least relative to many of your peers?
Do you have better positions here, you just have more potential tenants out there?
David Hoster
Well, yes that’s absolutely the case. I think the other factor is that in the downturn you’re overbuilding tends to be in the bigger boxes on the fringe of development whether it’s out far east from Los Angeles or far west from Phoenix.
It’s in the fringe. I think that’s not just industrial, but you see it in residential and some retail.
And, that’s not where we build and that’s not the type product that we construct or buy so that I think that insulates us at least for awhile.
Philip Marin - Cantor Fitzgerald
But, would you characterize the competitive supply in your existing markets as still pretty tight?
David Hoster
No, I think the vacancy is rising basically in every one of our submarkets. I mean even at World Houston where we continue to do very well, there’s more vacancy around the Intercontinental Airport.
It’s just that we have the Premier Park in the premier location and as a result we’ve been able to out perform there. But, no vacancy is going up basically all over.
Philip Marin - Cantor Fitzgerald
Okay, so it’s that you’re benefiting from your location?
David Hoster
Yeah, in fill locations are going last longer than the big boxes on the fringe. I think that’s normal.
Philip Marin - Cantor Fitzgerald
Are you, and it might be too early to tell, but are you or would you expect to see these tenants, I mean location and it depends on the tenant, but location is very important to some tenants. It’s probably less important for others, but will that location advantage that you seem to have, in your opinion, would it continue to give you some pricing power, is location the most important thing for the majority of your tenants?
David Hoster
I think location is the most important thing for almost all industrial tenants.
Philip Marin - Cantor Fitzgerald
Yes.
David Hoster
And, especially with the fuel cost, cost to distribution having gone up. As vacancy goes up pricing power goes down.
I mean we have had from our statistics tremendous pricing power over the last few years. And I think that’s proved from verification that our in fill locations and growth submarkets where there’s population growth, job growth, it certainly paid off for us.
We wouldn’t have had the tremendous same property operating result growth if it hadn’t been for those growth markets that allowed us to raise rents and keep occupancy up at the same time. But, as overall vacancy increases you just steadily lose pricing power and you can’t follow the markets down.
That’s why we spend so much time with our asset leasing people determining what prospect alternatives are. And, you can’t be arbitrary about the rent you want in a down market or nobody talks to you.
So, you have to follow, or in most cases, actually lead a trend if you want to keep your occupancy up in your individual submarket.
Philip Marin - Cantor Fitzgerald
Now, Keith in terms of the mortgage debt expiring through 2010, you know, I know earlier in the call you mentioned that some near term mortgage debt, the approximate on the value there is about 65% I think you said.
Keith McKey
Yes.
Philip Marin - Cantor Fitzgerald
What cap rate does that assume?
Keith McKey
Sevem
Philip Marin - Cantor Fitzgerald
About a 7, okay. Okay, thank you very much.
David Hoster
Thank you.
Operator
Now, we’ll take a question from Nap Overton from Morgan Keegan. You may go ahead.
Nap Overton - Morgan Keegan
Thank you, a couple of things. Good morning David, Keith.
Your development starts have been declining recently in your estimates of development starts. It’s safe to assume that they would be flat or down next year versus `08.
David Hoster
I think that’s a safe assumption today.
Nap Overton - Morgan Keegan
Okay. And, the two properties, I beg your pardon.
David Hoster
I think it’s a safe assumption. I hope maybe it will get better, but I’m not holding out a lot of hope.
We’re not planning on that.
Nap Overton - Morgan Keegan
Okay. And, the two specific properties you were talking about thinking about starting, the World Houston 30 and Alamo Ridge in San Antonio, those two that you were thinking about starting in the fourth quarter here in 2008.
David Hoster
Yes, we plan to start World Houston 30 in the fourth quarter and we haven’t determined yet whether Alamo Ridge would be fourth quarter this year or early next year.
Nap Overton - Morgan Keegan
Okay, alright. And, then I had a question on the development transfers in the third quarter.
The 83% occupancy level is that an unusually low level for those four properties to have come in at or are you having an increasingly difficult time leasing out the development properties is the basic question?
David Hoster
No, you’re right. That’s lower than we’ve traditionally done.
I guess we’ve usually been about 98%, significantly above any of our peer group averages, but yeah actually in that report our World Houston 24 we signed a lease late yesterday so that one’s up to 86%. So, it brings the total up a bit.
And, the one in San Antonio, we bring properties in either when they reach 80% occupancy or 12 months, whichever happens earlier. That one reached 80% occupancy before we hit the 12 months so we still haven’t gone through the full 12 month period on it, but yeah.
No, it just reflects softer markets.
Nap Overton - Morgan Keegan
Okay. And, then just one other question.
Has your outlook for Houston over the next 18 months or so changed at all with $70 a barrel oil instead of $140 a barrel oil?
David Hoster
When you talk to people in Houston they all say that they made their plans based on $60 a barrel oil. I don’t know how true that is.
We talked to one of our large users who has leased a whole World Houston building and they said that 80% of their backlog was based on $60 oil. So, I mean it has to hurt a little bit, but they all claim they’ll still be making a lot of money over 60 or above.
But, you know, only time is going to tell.
Nap Overton - Morgan Keegan
Yeah, thank you.
David Hoster
Thank you.
Operator
(Operator instructions) We’ll take one from Justin Mauer from Lord, Abbett. Please go ahead.
Justin Mauer - Lord Abbett
Morning guys.
David Hoster
Good morning.
Justin Mauer - Lord Abbett
Just a philosophical question, given what we’re seeing you know more broadly in terms of merchant development cuts because of balance sheet pressures, hence placing pressure on cap rates for everybody given the cost of capital as well. You know, on the one hand you could paint that positively and say that that should be a better thing for supply growth, maybe being a little bit more calibrated to the realities of the market.
You know, and of course on the flip side, which is what everybody’s doing currently is getting increasingly concerned about balance sheets and cap rate pressure and so on. You know, where do you guys, obviously given your conservative backgrounds on that spectrum of extremes would rather see things shake out?
David Hoster
I think in the short-term cap rate movement doesn’t mean much to us, other than the fact that we hope that means we’ll have less new development competition. And, I think we’re starting to feel that in the market that the local developers who were building and flipping to an institution have stopped building.
We’re still seeing some developers building with financial partners that you scratch your head over why they’re doing it, but I think they’re doing it because they have the money. For us though, whether cap rates have moved to 7 or 7.5 or 8 if we can build to something higher than that in a market where we’re comfortable it’s still going to be a real good asset for us.
We were just looking at some numbers the other day and we looked at the overall occupancy of everything that we’ve built as a developer and it’s over 96%. So, here’s our portfolio and a good number 94.4% occupied, but the developments that we’ve built over the last eight or ten years are 96.2 or a little bit higher, which says that what we’ve built has had a very positive effect on our portfolio because of the quality location, building to fit the needs of an individual submarket.
So, we see that we’re still building at cap rates that are above what we could buy these properties for and they meet other needs for us other than just a spread on a cap rate.
Justin Mauer - Lord Abbett
Yep, okay. Thank you very much.
David Hoster
Thank you.
Operator
It appears we have no further questions.
David Hoster
Thank you all and as always Keith and I are available for any questions that come up going forward or that you didn’t get to ask on this call. We look forward to hearing from you.
Thanks.
Operator
(Operator instructions)