Jul 28, 2010
Executives
David Hoster – President and CEO Keith McKey – CFO
Analysts
Jamie Feldman – Bank of America David Shamis – Citi Paul Morgan – Morgan Stanley James Miller – Sandler O’Neill Mitch Germain – JMP Securities Sri Nagarajan – FBR Capital Markets Brendan Maiorana – Wells Fargo Dan Donlan – Janney Montgomery Bill Crow – Raymond James
Operator
Good day, everyone, and welcome to EastGroup’s Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode.
Later, you will have the opportunity to ask questions during the question-and-answer session. Please note this call is being recorded and I will be standing by should you need any assistance.
It is now my pleasure to turn the conference over to Mr. David Hoster, President and CEO.
Please go ahead, sir. David Hoster Good morning, and thanks for calling in for our second quarter 2010 conference call.
We appreciate your interest in EastGroup. 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 describes certain risk factors and uncertainties that may impact the company’s future results and may cause the actual results to differ materially from those projected. Also, the content of this conference call contains time sensitive information that’s subject to the Safe Harbor statement included in the news release is accurate only as of the date of this call.
David Hoster
Thank you. Operating results for the second quarter exceeded the midpoint of our guidance range.
The increase was due primarily to achieving higher than projected property occupancies and termination fees and experiencing lower bad debt. Funds from operations were $0.71 per share as compared to $0.80 per share from the second quarter of last year, a decrease of 11.3%.
The $0.09 per share decline was in part the result of our lower property occupancies and less capitalized interest in development fees during the second quarter of this year. For the six months, FFO was $1.45 per share, this compared to $1.63 per share for the first half of last year, a decrease of 11.0%.
Same property net operating income for the second quarter declined 3.8% with straight-line rent adjustments and 4.7% without. These figures are approximately what we experienced in the first quarter.
In the second quarter on a GAAP basis, our best major markets after the elimination of termination fees were San Francisco, which was up 13%, Houston up 3.1%, and El Paso up 2.2%. The trailing same property markets were Los Angeles down 28%, New Orleans down 23% and Tampa down 11.3%.
Although, average rents are declining, the difference between quarters is still basically due to changes in property occupancies in the individual markets. EastGroup’s occupancy at June 30 was 87.2%, an increase of 100 basis points over our March 31 occupancy.
This improvement exceeded our expectations and it was primarily achieved in the month of June. Looking forward, we project occupancy to continue to increase to approximately 89% by the end of the year.
Please note that our occupancy statistics include our development properties that were moved to the portfolio at the earlier of 80% occupancy, a one year after shell completion. Our Texas markets were the best at 94.2% leased and 92.8% occupied at the end of the quarter.
Houston, our largest market with over 4.7 million square feet, was 94.7% occupied. Our most challenging major market continues to be Phoenix at 75.8% occupied, which experienced a small improvement over the first quarter results.
Looking at second quarter leasing statistics, we renewed 66% of the 1.1 million [ph] square feet that expired in the quarter and leased another 1.1 million square feet that had either terminated or expired during the quarter or was vacant at the beginning of the quarter. In total, we signed 131 leases in the second quarter, which was the highest quarterly number of leases ever, exceeding the previous high in the first quarter of this year.
Clearly, a positive sign. In addition, this was the first time since the second quarter of ’08 that our lease percentage increased.
As shown by our occupancy results, leasing activity has improved. We cannot call it good yet, but at least, it is better and we expect to achieve increased occupancy over the next two quarters.
There is leasing activity in all of our markets and prospects continue to expect cheap rent with significant concessions and feel a little sense of urgency since they have so many lease alternatives. As you can see in our supplemental information, GAAP rents in the second quarter decreased 16.1% and cash rents declined 18.9%, a greater decline than last quarter.
Our Arizona and Florida markets continued to have the largest decreases having achieved the largest increases several years ago. We expect to experience negative rent growth until occupancy is recovered till the 93% to 94% level.
This was the case coming out of the last recession. Average lease length was 4.0 years, which is about our average for the last year.
Tenant improvements were $2.41 per square foot of the life of the lease or $0.60 per square foot per year of the lease, which is well above our usual averages and was the result of a renewal lease at our LA Corporate Center Office Building, Los Angeles and the modernization of a number of older spaces. Our efforts to acquire properties have been frustrating.
There have been several opportunities that have been on business distribution criteria, but we have lost that on pricing. As a result, we have reduced our acquisition guidance and have the $20 million in the fourth quarter of this year, dropping out the $20 million that we had projected for the third quarter.
In the second quarter, we did acquire a small asset, East University III in the Central Phoenix Submarket for $1.3 million. The 100% leased, single-tenant building contains 32,000 square feet and is projected to generate a yield of approximately 9.5%.
We currently do not have any properties under contract to either purchase or sell. During the quarter, we transferred Blue Heron III for 20,000 square feet to the portfolio from the development program.
It is a 42% lease service center property in the Palm Beach County. At June 30, our development program consisted of World Houston 30, a pre-leased expansion of Arion 8 in San Antonio.
Together they represent 108,000 square feet and total projected investment of $8.5 million, of which only $2.1 million remains to be spent. We do not have any development starts planned for 2010, but are continuing to look at several potential build-to-suit opportunities.
Keith will now review a number of financial topics.
Keith McKey
Good morning. FFO per share for the quarter was $0.71 per share compared to $0.80 per share for the same quarter last year.
Lease termination fee income was $1.025 million for the quarter compared to $210,000 for the second quarter of 2009. Bad debt expense was a $126,000 for the second quarter of 2010, compared to $639,000 in the same quarter last year.
The net effect of these items increased FFO by $1.328 million or $0.05 per share. We have now re-leased 53% of the space given back to us from the terminations and are hopeful that the reduced level of bad debts will continue.
FFO per share for the six months was $1.45 per share as compared to $1.63 per share for last year. Lease termination fee income was $2.438 million for the six months in 2010, compared to $442,000 same period last year.
Bad debt expense was $742,000 for the six months of 2010, compared to $1.417 million for last year. Debt to total market capitalization was 43% at June 30, 2010.
And for the quarter, net interest in fixed charge coverage ratio was 3.2 times and debt-to-EBITDA was 6.4 times. Our floating rate bank debt amounted to 7.8% of total market capitalization at quarter-end and we have no mortgages that mature in 2010.
In June, we paid our 122nd consecutive quarterly cash distribution to common stockholders. This dividend of $0.52 per share equates to an annualized dividend of $2.08 per share and our dividend to FFO payout ratio was 73% for the quarter.
And rental income from properties amassed almost all of our revenue, so our dividend is a 100% covered by property net operating income. Then, again, we believe this revenue stream gives stability to the dividend.
FFO guidance for 2010 has been narrowed to a range of $2.81 to $2.89 per share, with the same midpoint of $2.85 per share. Earnings per share is estimated to be in the range of $0.62 to $0.69.
The major changes to the assumptions were to remove the proposed acquisition of 20 million on July 1st and reduce the amount and rate of the proposed mortgage on October 1st from 75 million at 6.25% to 55 million at 5.25%. We also project that termination fees and bad debts for the second half of 2010 will offset each other.
These changes along with other revisions reduce projected FFO per share for the second half of the year by $0.01 a share. Since we’re $0.01 a share better for the second quarter of a midpoint point, FFO per share projection did not change.
Now, David will make some final comments.
David Hoster
We were pleased with the re-leasing results for the second quarter and expect slow continued improvement in occupancy for the balance of the year. We will experience negative same property operating results over this period, but believe this statistic becomes positive in the first quarter of next year.
With our strong balance sheet, we are continuing to see contractive new investments in build-to-suit opportunities. We believe we are well positioned for future growth.
Keith and I will now take your questions.
Operator
(Operator Instructions). We’ll take our first question from the side of Jamie Feldman with Bank of America.
Your line is open. Please go ahead.
Jamie Feldman – Bank of America
Thank you. I was hoping you can give a little bit more color on activities since the end of the quarter, just kind of what kind of tenants are still active in the market?
And then, also, we’re seeing a lot of mixed economic data out there, including today’s Durable Goods Report. So I am just wondering how have tenant – how are tenants reacting to this data and are you seeing any kind of change?
David Hoster
Taking step back on leasing activity, there’s been a real swing. We would agree with most of what’s been written about really the first three or four months of the year, where there appeared to be, I guess, we could call a pent-up demand since companies did so little leasing in ’09 and in late ’08.
And then, I guess, towards maybe starting in May through June and maybe into early July, there seemed to be a real slowdown and we were spending time, finally getting lease assigned from that early activity and went to a slow period, three weeks to six weeks we’re starting to get worried about what was going to happen in the rest of the year. And then in most of our markets, we’ve seen at least a tick back up, it’s not back up to where it was during the first quarter, but the phones started to ring again, were putting out proposals again.
And that has allowed us to have the optimism to continue to project that we will increase occupancy over the balance of the year. Our activity seems to be spread over a whole of different categories.
We’re seeing a pretty good pickup in what we call commercial construction and products and maybe it’s not so much new construction, but retrofitting the buildings, everything from building supplies to air conditioning, wire and cable, we’re starting to see a little bit of a pickup in apparel and continuative activity in food related things, food services, food wholesaling. So it hasn’t changed much, it’s the same, it’s slowed and it’s picked up a tad, so that at least we have the sense that we can continue to improve the occupancy through the end of the year.
Jamie Feldman – Bank of America
Okay, thanks. And then, you had mentioned you think same-store NOI can turn positive by the first quarter.
When you think about your rollover schedule for next year, where would you put the market-to-market currently and then where do you think it would be by then in terms of the rents?
David Hoster
We’ve never done a very good job at determining market-to-market and rents were going up all of our office rather and talked about embedded rent growth. We never thought we had, but our rents kept going up.
So we spend our time trying to figuring out how to lease space, get leases executed, rather than worrying about that role. I think what’s going to happen to market rent is, is certainly going to be determined by what happens with economic activity in nationally and in our individual markets.
If activity picks up, we’ll start to see an uptick a bit in local market rents, so we’ve – I’d say we’ve not gotten into our 2011 projections yet, but one of the reasons we think the first quarter is going to be positive next year, because the first quarter of this year was so bad, and that we’re – and from an occupancy standpoint above it now and expect to end the year well above it, so that having a low baseline helps reporting same store when you look at future years.
Jamie Feldman – Bank of America
Okay, thank you.
David Hoster
Thank you.
Operator
And we’ll take our next question from the side of Michael Bilerman with Citi. Your line is open.
Please go ahead.
David Shamis – Citi
Hi, good morning, guys. This is David Shamis here with Michael.
David Hoster
Good morning.
Keith McKey
Good morning.
David Shamis – Citi
So just looking at your FFO from the second quarter, if we add back the lease termination fees, we get to a quarter about $0.68. So I just wondered if you could walk us through the ramp to the midpoint of $0.70 in the third quarter and then $0.71 in the fourth quarter.
David Hoster
We come at that at several different ways, but the most important one is that every quarter when we revise our budgets on occupancy by suite at every property and so that – the numbers that we are showing is our – recall we have three budgets for the third and fourth quarters and it’s on a suite-by-suite projection. Secondly, I think it’s important to note that the occupancy of a 100 basis points that we achieved in June 30 compared to March 31 was an end of the quarter number and not an average for the quarter in the comparison.
And basically all of that increase of a 100 basis points occurred during the month of June, some of it June the 1, some of it in the middle of the month, some of it at the end of the month. So you can’t look just at what the run rate was because the average occupancy will be, I would say, at least a 100 basis points higher in the third quarter versus the second quarter.
David Shamis – Citi
Thanks. And then the $20 million of acquisitions that you are forecasting for October 1st, are those actually targeted acquisitions or just the goal that you have set and then what’s the probability of that not happening?
David Hoster
It’s a target goal. Probability since we didn’t – we did 1.3 instead of 20 in the second quarter and beginning in the third, we’re going to have a couple of pop-up in the next 30 days or not do any of them.
But in terms of how it affects our guidance because it’s projected for just one quarter, I mean it’ll be a negative, but not a significant negative.
David Shamis – Citi
Great, thank you.
Operator
And we’ll go next to the side of Paul Morgan with Morgan Stanley. Your line is open.
Please go ahead.
Paul Morgan – Morgan Stanley
Hi, good morning. David, you mentioned that pricing kept you out of the deals that you bet on, could you just talk about kind of what – what cap rates those assets did ended up transacting out?
David Hoster
Well, the biggest one, and this has gotten a lot of publicity through the brokerage communities, 880,000 square foot complex in Northern Miami Airport. The brokers stated, I think they have 30 offers on and AMV supposedly has it under contract is a Sub 6, now that’s what the brokers have reported and only time will tell whether that’s – cap rate [inaudible] cap rate.
When we looked at it, we thought that that cash flow is just at about 95% occupancy now was probably going to dip before coming back up. We view ourselves as the cash flow buyer not an IRR buyer.
And I think looking down the road, five years, six years, it’s going to be heck of investment from an IRR standpoint, but we look at things on what we can do with that cash flow going forward from the day we close on it. There was an offering in Dallas, four properties, one of them was – we thought was very attractive, the other three we didn’t like at all, so we just bid – tried to bid aggressively on the one we liked and this often happens in that situation we don’t know yet what the cap rate was, but that a local buyer is tying up all four.
We generally aren’t going to let the tail wag the dog in order to get a one property out four that we like. Earlier, I think we reported, we bid on two building complex in Antonio and a single building Denver.
Both those we thought we had, but for various circumstances, another buyer ended up talking directly to the seller and we lost out. Both of those had vacancy and so it was hard to put cap rate going in, but it would have been probably stabilized at high 7 or low 8 once you lease the 25% to 35% vacancy.
Those were the projects that we’ve looked at recently. There are lot of others that are more bulk buildings, larger tenants, which just don’t fit our criteria.
There’s been a number sold in South Florida to build, fund advisors and pension advisors at fairly rich per square foot prices, but I can’t tell you what the cap rates are, because we didn’t bid on those, because they didn’t fit us. It’s been some – I want to say, somewhat, it’s been disappointing that we hope that as cap rates came down and the [inaudible] capital gain taxes going up next year, that that would shake more properties lease making it available in the marketplace.
But, right now, there’s a whole lot more capital seeking out industrial assets than good properties available at least in our sun belt markets. And it’s real hard to tell what’s going to happen between now and the end of the year, but so far, this has been very frustrating.
Paul Morgan – Morgan Stanley
You say that you are – think of yourself as a cash flow buyer. I mean are you less inclined to – it doesn’t mean you are less inclined to buy vacancy or does it?
David Hoster
All depends on the market and the amount of vacancy. If it’s a vacant – building has been vacant for two years and/or three years and it’s in a very soft market and we don’t see how we can do better with it for a period of time is one thing.
If we can buy something with a 20% or 30% even 40% vacancy factor and we see that we have the capital and there expertise to lease that up and achieve a yield that reflects that lease-up risk, we’ll definitely jump into. It’s the ones that get more difficult where there is a number of leases turning in the first two years of ownership, the rents are currently well above market and you’re going to have a probably significant dip in the NOI and the properties in both the vacancy and lease rate roll down before you can start to bring it back up three to four years out.
So it depends on each of the assets. When we look at a – we’re building with a lot of vacancy, sometimes we look at it from a standpoint of achieving development type yields or looking at it from a redevelopment standpoint where we can go in and do things to the complex, make it more attractive that the seller has not done for one reason or another.
Paul Morgan – Morgan Stanley
Okay. My other question is on the oil spill.
How has that impacted your markets generally, I guess, Houston, New Orleans, and the others?
David Hoster
So far, nobody can in any of the markets can put a finger on it and say, here is a deal that didn’t happen or here is some bad news has come out of it. New Orleans, so far, we’ve not gotten any feedback one way or another on the activities not going up or down as a result of the oil spill.
In Houston, the press has given out obviously a lot of coverage and most people believe it’s – it’ll be detrimental in the short run. But in the long run, it’ll probably help Houston, because, one, there’s still going to be drilling in the Gulf in some form or another.
And, any time the government increases rules, it usually means jobs, whether it’s more safety features, more inspections, more whatever else it is on the Gulf rigs and all that’s done out of Houston. I think, also, we’ve gotten a feedback from Houston that where there have been a loss of jobs so far is more on the coast of Louisiana, where you’ve got offshore workers, who are now sitting at home.
But, so far, it’s not any dramatic effects in Houston. But we can point finger at it and say, yes, we lost this deal for one reason or another related to the spill.
Paul Morgan – Morgan Stanley
Okay, thanks.
David Hoster
Thank you.
Operator
(Operator Instructions). We’ll go next to the side of James Miller with Sandler O’Neill.
Your line is open. Please go ahead.
James Miller – Sandler O’Neill
Good morning, guys. I just wanted to come back to the build-to-suites.
You mentioned that you’re still seeing a little bit of activity there, but I was curious if that slowed down given just sort of the economic uncertainty if people are still a little concerned about making those commitments and what they need to see in terms of given what rents are doing to make the commitment to potential do a little bit more expensive of a transaction?
David Hoster
We have a number of proposals out that have been out for a while. We still have a slow discussions with the companies to have asked for the proposals.
We are optimist that we in the next six months, at least now one, two or more down. Some of our people in the field have described, it’s just like the leasing of vacant space, nobody feels any urgency, you’ve got the unknown with the economy, the unknown with what’s going to happen with tax rates unknown with all sorts of different rules and regulations.
And so, you can’t really put a finger on is it the economy that’s causing the people not to actually jump into it or is it just an overall no sense of urgency, they know the deals are going to be there going forward. We’ve learned over the years that when people do a build-to-suit, it’s usually and ended paying up more rent than if they leased a vacant building, it’s for a – usually a whole group of reasons.
Generally, there’s not a vacant building right where they wanted to be or exactly the right size with all the specs they need or what they’re going to do on the inside of that building is so much more capital intensity are expensive than the rent that having shape, design of the building perfect to allow them to do what they need to do on the inside, it saves them more money than having a lower rent, but that – it is pretty discouraging, we hope to have something done by now. But nobody said that they’re killing the deals yet, it’s just they’re still talking, looking for approvals and that sort of thing.
But the ones that’s positive that I think most industrial owners are seeing is after a bunker mentality of tenants you look for just and keep his rent, we’re now seeing a more sophisticated users started to see this is an opportunity to the same or less rent end up with a better building and a better location, higher quality, and instead of when you’re at least looking for five year or seven year leases and that’s just one of the steps in the recovery.
James Miller – Sandler O’Neill
Okay, thanks. And then, my second question, the term fee guidance is up again.
Is that just from happening a little bit higher term fees in the second quarter? And can you just give us a little color on what the tenants are doing that are leaving or they downsizing and consolidating space or are they – is the business contracting or they just find out better deals somewhere else and trying to move to a different location?
David Hoster
I don’t think any of that I know have been a better deal. It’s been a contraction, a pulling out of the market, there are economic reasons, consolidation.
The bigger the corporation, sometimes the strangest things they do with leases in terms of what to pay on a termination fee and to get it off their books. And so, our bigger ones are generally where there’s not been an option, but where we’ve negotiated it.
For example, in the second quarter, almost $600,000 of that total was a just a single tenant in Haywood, California, that was a supplier of auto parts to the newly plant Toyota GM joint venture, we’ve got a very attractive lease termination with them, released the space within one month or we had one month of downtime, we got over a 9% rate increase. So the bigger ones, we take back where we’re getting a huge percentage of the obligation and where we think we have above average odds to release the space.
But, generally, we don’t use – lose a tenant over a – if somebody’s giving them a better deal, because you get real flexible in those circumstances.
James Miller – Sandler O’Neill
Okay, that makes sense. Thank you.
Operator
And we’ll take our next question from the side of Mitch Germain with JMP Securities. Your line is open.
Please go ahead.
Mitch Germain – JMP Securities
Good morning, David and Keith. How are you?
Curious about traffic trends called at the start of the second quarter versus end of the second quarter today. A couple of your competitors have talked about it’s bit of a pullback in leasing and I just wanted to see if you’ve experienced something similar?
David Hoster
Yes, as I mentioned, we saw a pullback, it really started mid-to-late May that went into really I guess over generalizing 3 to 4th of July, that started to get us worried. And we’ve seen a pickup, it hasn’t gone back to where it was in the first quarter, but there seems to be a pickup in calls.
I mean, even in Phoenix, everybody at Phoenix uses the heat as an excuse where there is not leasing in summer, but after a while there, we’re starting to see a – some new activity at our Sky Harbor Development and some other spaces that have been vacant for a long time. So it’s certainly not consistent and there’s still absolutely no sense of urgency on prospects’ parts, but we’re getting some more phone calls.
Now, only time will tell whether you’re optimist or not in projecting increased occupancy, only to the balance of the year, but right now we’re real comfortable with that projection.
Mitch Germain – JMP Securities
Great. My other questions were answered.
Thank you, all.
David Hoster
Thank you.
Operator
(Operator Instructions). We’ll go next to the side of Sri Nagarajan with FBR Capital Markets.
Your line is open, please go ahead.
Sri Nagarajan – FBR Capital Markets
Yes, thank you, good morning. I think the question that I had was on the 87.2% occupancy was 89.1% leased.
Now what is the ramp up in terms of actual occupancy that you guys will be having over the next couple of quarters? And related to that, the leasing, was it more on a new development or was it on order properties as well across the board on all markets?
David Hoster
To answer the first part first, it was pretty much across the board and actually probably less on new development or development that rolled into the portfolio with vacancy. We’re projecting that we will be 89% occupied by 12/31.
Sri Nagarajan – FBR Capital Markets
Okay. So pretty much in the next couple of quarters.
David Hoster
Yes, we’ve now continued – continued growth and like to have it more of it in the third quarter. But it’s hard to project that when somebody wants to move it on a certain date.
But we think we have the starting as a good level and have the amount of activity out there. One of the numbers, we’ve – spreads that we look at is what’s the difference between occupancy and leased.
And if lease space, I mean, that space is leased, if somebody had moved in yet, if that’s – if you’re only 10 or 20 or 30 basis points spread there, now you’re going have move outs, so occupancy is going down. If spread increases which it has for us, it didn’t guarantee anything, but it’s an encouraging sign that you should be able to increase occupancy overtime.
And as I mentioned, in my comments, second quarter was the first time in two years that the amount of space leased showed an increase over the previous quarter.
Sri Nagarajan – FBR Capital Markets
I see. Now, in terms of your commentary on acquisitions, I mean obviously disappointing is what you are characterizing it as.
But the question is, why not get a little bit more aggressive than your usual conservative sell look beyond the Sunbelt perhaps in markets and look beyond your light distribution facilities focus into bulk distribution. What’s preventing you from doing that?
David Hoster
Yes, over 15 plus years, we’ve refined our strategy of the business distribution and it’s worked. And when we look back at where our vacancy is today, which properties and if you had to do over again, you might not have bought, it’s in the bulk distribution area.
Our occupancy is lower in bulk distribution than it is in either our business service center or main thrust in business distribution. With our focus on infill markets, we generally are not going to build if there isn’t enough land to build big boxes.
Big box users are generally looking for the lowest rent possible, so you’ll find them on the trenches of development. Again, over generalization, but this is how we look at it.
There’s more competition out there and when you’re in that those big bulk buildings on the far west side of Phoenix or out far east side of Los Angeles, out east of Ontario, areas like that. And somebody puts up a big fancy new building next to you, the only way you compete is on rent and then you become a commodity.
And we think we’ve shown overtime that our business distribution always have outperformed because of the location, so we’re trying to compete on those locations.
Sri Nagarajan – FBR Capital Markets
Perhaps, a last question, I mean from me. The light distribution leasing versus again bulk distribution, again you described it was a little bit better.
Perhaps in terms of fundamentals, and again not necessarily going market-to-market, but with a broad breast stroke on the Sunbelt, what are you seeing in terms of rent roll downs in your bulk versus the light distribution?
David Hoster
They’re all rolling down, but the bulk is rolling down more. It becomes more competitive, people are going to get much more aggressive for a 300,000 square foot users than they do for a 10,000 square foot user.
And coming out of the last recession and we’re seeing now that the activity, each market has improved a different sweet spot today, but it’s generally and below 50,000 square feet. In some cases, it’s 5000 square feet to 10,000 square feet, some others it’s 20,000 square feet to 30,000 square feet.
Where if you look in the lot of markets, the number of leases executed on spaces over a 100,000 square feet or 200,000 square feet is pretty small. So it’s a smaller users that started to come out and started to grow first has been our experience and it continues to be today.
Sri Nagarajan – FBR Capital Markets
Thanks, fair enough.
David Hoster
Thank you.
Operator
And we’ll go next to the side of Brendan Maiorana with Wells Fargo. Your line is open.
Please go ahead.
Brendan Maiorana – Wells Fargo
Thanks, good morning. I just wanted to follow-up on Sri’s question regarding the difference between the occupancy rates and a lease percentage.
Is the outlook for the second half of the year the optimism regarding the increase in occupancy expectations due to a narrowing of the leased rate versus the occupied rate? Or is it driven by just a level of activity that you’re seeing today that you expect to have that spread, if you will, kind of remain the same, but the occupancy level will move up, because there is better activity?
David Hoster
Well, because the spread between leased and occupied is higher today than it has been for a while, that gives us optimism that those people who have signed leases will in fact move in and they’ll outstrip what we lose to new vacancy, plus and we will continue to be doing leasing. But it really gets back to what we project on a suite-by-suite basis or the activity that’s there today and what we expect through the balance of the year.
We don’t make broad generalizations about that certain markets should pickup 1% and 2%, it’s what’s going on – on the ground with each building when we do our budget revisions. So that’s what optimism’s based on.
If something goes real long with the economy in the next couple of weeks, next month, that’s going to tough to reach. On the other hand, you see a pickup, maybe we can outperform it.
Brendan Maiorana – Wells Fargo
Okay, that’s helpful. And then, David you mentioned that rent levels, you don’t expect to have improved rent levels until you get to 93% to 94% occupancy or leased rate, I forgot what you said.
Now, I just want to clarify, are you talking about have re-leasing spreads turn positive at that point or are you saying that you don’t expect your spot rent levels to move up until your portfolio reaches that level?
David Hoster
The – well, it’s a combination of factors. It’s one – one of the – well, our negative spreads are higher in this quarter compared to the next couple of quarters for two reasons.
One is that we’re comparing to a higher point in good days. And secondly, there is still some drop in market rents for individual size basis, so that those spreads are going to stay negative until one to two things.
One of them or probably both things happen. One is that we’ve come away from the peak of where we were signing leases in the really strong economic times.
And, secondly, it’s a very practical thing. When a prospect is out looking for space and they have a dozen alternatives, you don’t push rents, the rents don’t move in the market, because they’re usually one or two owners who will keep rents down in order to do a deal.
So what it takes is an increase in occupancy in the individual markets, submarkets. So when a prospect has less alternatives and that’s when the whole psychology of the leasing game changes with brokers and users and it goes from 10 to 12 good alternatives to half a dozen, down to two or three.
And then when they’re still being slow and one of those two or three get leased out from under them, then they start to feel a sense of urgency and then we have pricing power. So it really – will there will any big movements in rents in any one market, I mean, there’s going to be a – there’s happening in stabilization and then it’ll start to [inaudible], but you don’t get any real jumps until the number of alternatives and the desperate owners start to get reduced.
Everybody’s psychology what’s going to happen in the future changes.
Brendan Maiorana – Wells Fargo
So, if I look at where you’re re-leasing spreads have been over the past few quarters, I think the average is around negative 14% or 15% on a cash basis and you have got – I don’t know if there’s a little bit of a mix issue, but you’ve got the average rent per square foot on the explorations for next year, which appears to be moving up a little bit. So, even though, you’ve kind of talked about how occupancy really drives your same-store numbers, much more so then what re-leasing spreads are.
If you are in the environment of and I call it negative 15%-ish percent re-leasing spreads for the foreseeable future, are you going to be able to turn same-store NOI positive, at least in a meaningful way, if you’re still rolling down that 15%?
David Hoster
We think so. Again, occupancy still needs to have a much more important factor than a roll down in rents.
And I think that roll down in rents is going to mitigate say from the standpoint that we’re starting to seeing stabilization in markets and there will be some bounce off the bottom, but they’re not going to be any big movement up until occupancy goes up. And second factor when you look at leases rolling, when we get into next year, and then we’re three year or 2.5 years, 3 years from when rents started to go down initially.
And so, we’re not going to be comparing to such high numbers.
Brendan Maiorana – Wells Fargo
Sure. So is it fair, if I look at your average rent roll, it moved up next year, but then it moves down in ’12.
Do you think that that’s fairly representative of the movement of rents that are on a same space kind of basis, there’s not a major mix issue as you kind of look at 11 rolls versus 12?
David Hoster
I have to look at more detail on that, Brendan, to answer that one without guess on it. I mean, there’s – that’s not something that we worry about a lot, because the market is going to be the market and maybe we can outperform that by a little bit, but you never do buy a lot.
And as much more approach, we’ll deal with it when the time comes.
Brendan Maiorana – Wells Fargo
Okay, fair enough. And then, just in terms of the capital recycling outlook, if acquisitions are more challenging just given where pricing is today, where do you think that how far are rents below where they need to be to do to make a development deal work today if you had just let’s say, kind of market level rents and outside of kind of the risk of starting a spec development project?
David Hoster
Every market’s different. I mean, we don’t even talk about future development in a market like Phoenix right now.
But, Houston and San Antonio, because the rents never shot up as much they haven’t come down as much. We’re probably maybe 8% to 10% away there, maybe a little closer, because of World Houston location that always has a – generates a premium rent.
So that I – well, maybe did a little bit lot we can do something in Texas next year. Florida is somewhere in between near Arizona and Texas, but I would expect that in terms of new development, nothing’s going to happen in Texas first, probably Houston and San Antonio.
And on the strong times, we were – we were building buildings a 100% spec, I would guess our first couple of buildings that we would start would have some form of pre-leasing just to, so that we could prove to ourselves and into our investment community that those pro forma rents are achievable.
Brendan Maiorana – Wells Fargo
And do you – have you ratcheted it back or would you consider ratcheting back the return, the yield expectations just given that financing costs are down a little bit?
David Hoster
So that all goes into the picture. It’s – what we’ve talked about is, we’ve at least have felt that we needed at least a 150 basis points spread in yield over what an acquisition would cost for what we could sell a finished development for to take that construction and lease up risk.
So that’s a factor. Cost of capital obviously is another factor.
And then, just, our gut feel on the riskiness of individual markets would be a final factor, so it’s hard to say that it would exactly be a 9 or a 9.5 or a 8.5 pro forma yields going in at a level of preleasing would effect that.
Brendan Maiorana – Wells Fargo
Sure, okay, thank you.
David Hoster
Thanks.
Operator
And it looks like we have a few questions left. We’ll take our next question from the side of Dan Donlan with Janney Montgomery.
Your line is open, please go ahead.
Dan Donlan – Janney Montgomery
Thanks. Just one question from me.
Just curious, of the new leases you’ve signed this quarter, how much of that would tenants coming into the market versus just a little bit of musical chairs going on and maybe some people upgrading their space needs to your product?
David Hoster
Good question. I would say most of it was musical chairs of one sort or another and some of that’s where somebody’s downsizing or consolidating and they’re willing to pay for a little more quality and so they’re leaving one or more other [inaudible] that other landlords can’t meet their needs or that’s not attractive or they have the opportunity to upgrade.
There’s very little at this point of new users moving into the marketplace.
Dan Donlan – Janney Montgomery
Okay. And then, just on the NOI margins, if I backup the bad debt and the lease termination fees, it looks like you guys are at about 69.5%, granted your occupancy is low.
Would you expect it to move back to the 72% level once your occupancy gets back to about 92%, 93% as it has done historically or is there anything that may affect that one way or the other?
David Hoster
No, when almost all of our leases are triple net or double net leases in the one form or another where the customer is paying the operating expenses of the building –
Dan Donlan – Janney Montgomery
Right.
David Hoster
That occupancy directly, there’s always some aberration one way or another different times. But the more space we have in our hands, the more expenses we pay from a real estate operating standpoint, so that goes up and down at a very high percentage of our leases or triple net and almost all the others have at least a breakpoint where the customer pays everything above that stated amount, so that [inaudible].
As we go back up that expense percentage changes.
Dan Donlan – Janney Montgomery
Okay, thank you.
David Hoster
Thanks.
Operator
(Operator Instructions). We’ll take our last question from the side of Bill Crow with Raymond James.
Your line is open. Please go ahead.
Bill Crow – Raymond James
Hi, good morning, guys.
David Hoster
Good morning.
Bill Crow – Raymond James
I guess my question is, is kind of a combination of things that have been asked before, but maybe put it different way. And, David, if you can just about how your risk philosophy changes during the course of the cycle, whether you might be more aggressive at the bottom of the cycle than on top?
And as you’re losing your acquisitions, how the spread on your cost of capital differs from when you were succeeding with acquisitions in ’06, ’07?
David Hoster
Well, if you go back to that point in time, we really – we had trouble competing, so we didn’t buy much, we were putting our capital into new development, because we’re getting so much better yields there. And in ’09, and two of the deals closed in June of this year, but in ’09, the pricing is very attractive and that pricing almost changed overnight.
And interest rates were higher, but our stock price was higher too and how we’ve in different times taken a rightful approach on what cost of capital is. But, a couple of the deals that we lost this year, if the seller comeback and said to do this deal, you got a pay a little bit more, we’d have jumped on it.
We thought we had a deal I guess in both cases and we’re surprised when we didn’t have them. So we would have bought those at a lower yields and had been happy with them if we had that opportunity.
But what we look at – there’s a series of different things, but going in cash flow, where that cash flow is going to go in the first couple of years related to potential roll down of rents, lease up our vacancy, our estimation of what’s happening in that individual market, location of the product to complement one other assets we own in that market or seven markets. So it’s all of those factors going in.
We would certainly today be more aggressive on yield, look at our lower yield than we would have a year-ago and let’s say six months ago. But it would have to have a heck of lot of upside for us to be in a sub six going in yield at 95% occupancy, that just doesn’t work for us, is a cash flow buyer where we’ve got to answer you all quarterly – on a conference call.
Bill Crow – Raymond James
Okay, thank you.
David Hoster
Thank you.
Operator
And I’m showing no further questions in queue at this time. Mr.
Hoster, I’ll turn it back over to you.
David Hoster
Thank you very much. We appreciate everyone’s interest in EastGroup.
And, as always, please don’t hesitate to call Keith or me about anything that we didn’t clarify on the call or any other questions that come up about what we’re doing. Again, thank you, and talk to you next quarter.
Operator
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