American Assets Trust, Inc. Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2020 American Assets Trust, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Adam Wyll, Executive Vice President and Chief Operating Officer. Please go ahead, sir.

Thank you. Good morning, everyone. Welcome to American Asset Trust's third quarter 2020 earnings call. Yesterday afternoon, our earnings release and supplemental information were furnished to the SEC on Form 8-K. Both are now available on the Investor Section of our website, americanassetstrust.com. A telephonic replay and on-demand webcast will also be available for this call over the next week. During this call, we will discuss non-GAAP financial measures which are reconciled to our GAAP financial results in our earnings release and supplemental information. We will also be making forward-looking statements based on our current expectations. These statements are subject to risks and uncertainties discussed in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements. Actual events could cause our results to differ materially from these forward-looking statements for a number of reasons, including uncertainty related to the scope, severity, and duration of the COVID-19 pandemic, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic impact of the pandemic and containment measures on us and our tenants. And with that, I'll turn the call over to Ernest Rady, our Chairman and CEO, to begin the discussion of our third quarter 2020 results.

Thank you, Adam. Good job. First and foremost, I would like to wish all of our stakeholders and their loved ones continued health and safety during these truly unprecedented times. We remain optimistic that a vaccine will be forthcoming over the next six to nine months. Trust me; I'm going to be one of the first in line. But nevertheless, we are prepared to endure a prolonged pandemic with our solid balance sheet, world-class properties, and tenants, and incredibly dedicated and competent employees. Fortunately now, the second and third quarters are behind us. I can tell you that our operations and financial results were nowhere near as catastrophic as my worst-case projections that we modeled in April 2020. As most of you know, for many years, many outsiders believed our asset diversification was perceived negatively, relative to many of our best-in-class peers. However, we now know that our ownership of a combination of irreplaceable office, multifamily, retail, and mixed-use properties, as opposed to a single asset class, provided us with much-needed stability and protection from the risk associated with the changes in economic conditions of a particular market, industry, or even economy such as those changes created by COVID-19. We have constantly defended our asset class diversity to stockholders and naysayers, but not anymore. Thanks in large part to our asset diversification. I wanted to mention that the Board of Directors has approved the quarterly dividend of $0.25 for the third quarter, which is supported by our rent collections in that third quarter. Could we have declared a larger dividend? Yes, probably. And I would have benefited more than anyone. But as fiduciaries to our stockholders, and staunch defenders of our balance sheet, we felt it's most prudent to remain conservative on our dividend until there is more valid visibility into a vaccine and economic recovery. In any case, a year or so from now, once there is a vaccine, we expect to look back and hope that this will be nothing but a bad memory. Adam, Bob, and Steve will go into more detail on our various asset segments and financial results. I will be available for any questions you may have at the conclusion of the prepared remarks. I'm now going to turn this call back over to Adam.

Thanks, Ernest. One of our primary focuses over the past quarter has been collections in our retail segment; we were pleased to have made meaningful progress on that front, where we began the pandemic initially collecting approximately 40% of retail rents in April, to collecting approximately 80% of retail rents in the third quarter, a number that we expect to improve. No doubt this was in large part due to the tireless work of our in-house collection team comprised of our property managers, lease administrators, legal staff, and direct engagement by our executives with retailers. They remain sensitive and at times accommodating to the financial challenges of certain impacted tenants. We have certainly taken a more aggressive position with better-capitalized tenants, knowing the high quality of our underlying real estate and the clear rights we have embedded in our leases. We expect those tenants to adhere to their contractual obligations, and we continue to refuse to agree to deals that are not in the best interest of our company and our shareholders. As such, we expect our third-quarter collections to improve further as we continue our efforts. In fact, we know more significant checks and wires are currently in transit from tenants on account of third-quarter collections. Our most notable collection challenges in the retail segment remain with our movie theaters, gyms, and apparel stores, as well as many of our retailers at Waikiki Beach Walk, which until mid-October had no income in tourism to sustain meaningful revenue for our tenants. It is likely going to take several more months or quarters for us to have better visibility into recovery by these more challenged tenants. That said, our focus continues to prioritize long-term strategic growth over the short term. We've entered into lease modifications that have provided certain tenants relief during the pandemic, by way of deferrals or other monetary concessions where necessary, provided we obtained something in return, whether by lease extensions, waiver of certain tenant-friendly lease rights, or an incremental percentage rent. Otherwise, we intend to pursue all means to enforce our rights under leases, including litigation if necessary, particularly for those unilaterally withholding rents when we believe they have the funds to pay. Additionally, we're pleased to report that 100% of our properties continue to remain open and accessible by our tenants in each of our markets. Anecdotally, the majority of our employees are voluntarily working in person at our properties or at our corporate offices each week while taking all prudent safety precautions despite having the flexibility to work from home. We continue to firmly believe that post-pandemic, being together in person will promote much better productivity, collaboration, and innovation. I've heard similar sentiment from the majority of our office tenants. Finally, regarding the election, we are closely following two propositions on the California ballots that take direct aim at commercial real estate. Of course, we are firmly against Prop 15, which would eliminate Prop 13 taxpayer protection. If it passes, we would not expect it to create an immediate meaningful impact on our company; rather it would place a significant pass-through financial burden on our tenants at a time when they are already struggling, not to mention the likely negative impact of those property taxes on future rent growth. Additionally, we are against Prop 21, which we believe is a flawed measure that would implement a significant amendment to existing rent control laws on the multifamily side, limiting landlords' rights and likely making the housing crisis in California even worse. We are contributing our resources to oppose those propositions. While the challenges we face today are complex, whether relating to the pandemic, racial justice, technology, or legislative matters to name a few, we do believe that we are well-positioned to navigate through and manage these challenges with, as Ernest mentioned, our best-in-class assets, our 200 talented and dedicated employees, and the strength of our balance sheet. With that, I'll turn the call over to Bob to discuss Q3 results in more detail.

Good morning, and thank you, Ernest and Adam. Last night, we reported third quarter 2020 FFO of $0.44 per share and net income attributable to common stockholders of $0.08 per share for the third quarter. Let me begin with my perspective that I am optimistic about the overall performance of this portfolio, even in light of the pandemic we are all going through. We too are feeling the bumps along the road like everyone else in our sectors. What makes me optimistic about our portfolio and its future is the following: number one, our collections of monthly recurring billings continue to improve in Q3 over Q2 with total collections of approximately 89% in Q3 versus 83% in Q2. Number two, we believe we have ample liquidity to weather the storm that we are going through. We prepared for the worst-case scenario by modeling a $50 million quarterly burn rate at the beginning of this pandemic, not knowing what we were going into. Our actual burn rate in Q2 was approximately $6 million. In Q3, we ended up with a cash surplus of approximately $9 million, and this is after the operating capital expenditures and the dividend. We started Q3 with approximately $146 million of cash on the balance sheet and ended Q3 with approximately $155 million of cash on the balance sheet, primarily as a result of increased cash NOI quarter-over-quarter due to our successful collection efforts outlined earlier by Adam. Number three, we have additional liquidity of $250 million available on our line of credit combined with an entire portfolio of unencumbered properties with the exception of our only mortgage which is on City Center Bellevue. Number four, we believe we have embedded growth in cash flow in our office portfolio with approximately $30 million of growth in office cash NOI between now and the end of 2022, as Steve will discuss later. Lastly, once we get a vaccine, we believe our high-quality West Coast portfolio will rebound. We believe our Embassy Suites, which is currently at approximately breakeven cash NOI, will rebound based on its location and tourism. On October 15, Hawaii allowed tourists to come back to the island as they can demonstrate that they have had a negative COVID test within the last 72 hours. On the first day, there were approximately 10,000 tourists that landed in Hawaii. We expect that tourism inflow to continue to increase each week and to start benefiting our Hawaiian properties over the coming quarters. Let's take a moment and look at the results of the third quarter for each property segment. Our office property segment continues to perform well as expected during these uncertain times. Office properties excluding One Beach Street in San Francisco, which is under redevelopment, were at 96% occupancy at the end of the third quarter, an increase of approximately 2% from the prior year. More importantly, same-store cash NOI increased 13% in Q3 over the prior year, primarily from increases in base rent at La Jolla Commons, Tory Reserved Campus, City Center Bellevue, and the Lloyd District portfolio. Our retail properties continued to be significantly impacted by the pandemic. Although the occupancy at our retail properties remains stable for the third quarter at 95% occupancy, this was a decrease of approximately 3% from the prior year. Our retail collections have been challenging during the pandemic as reflected in our negative same-store cash NOI. Our multifamily properties experienced a challenging quarter as same-store cash NOI decreased approximately 5.4% due primarily to the decrease in average occupancy at Hassalo in Portland offset by a favorable master lease signed with a private university in the San Diego area at the beginning of the quarter. On a segment basis, occupancy was at 87.5% at the end of the third quarter, a decrease of approximately 3% from the prior year. We expect our occupancy to return to normal stabilized levels at Hassalo as we've recently adjusted pricing and concessions. With these adjustments in the last 10 days, we've already seen leasing traffic increase from a weekly average of four to six tourists per week to 10 to 12 tourists per week. We have captured a total of 11 new leases in just the last week. Our mixed-use property consisting of the Embassy Suites Hotel and the Waikiki Beach Walk retail is located on the island of Oahu. The State of Hawaii remained in a self-quarantine throughout most of the third quarter, significantly impacting the operating results for the third quarter of 2020. The Embassy Suites average occupancy for the third quarter of 2020 was 66% compared with the average occupancy in the second quarter of 2020 of 17%. The average daily rate for the third quarter of 2020 was $209, which is approximately 40% of the prior year's ADR. Waikiki Beach Walk retails suffered considerably with virtually no tourists on the island until recently. We're working daily with our tenants at Waikiki Beach Walk to formalize a recovery plan that benefits both our tenants and the company, utilizing all resources necessary including state and city grant programs and lobbying efforts. Let's talk about bad debt expense reserves in the third quarter. As noted in our earnings release, in the third quarter, we collected approximately 89% of what was billed in Q3 to our tenants. We had COVID-19 adjustments amounting to 2% of what was billed in Q3 to our tenants. The balance of approximately 9% is the amount outstanding that was billed in Q3. This is compared to the second-quarter collections of 81%, COVID-19 adjustments of 5%, and Q2 amounts that were billed and still outstanding of 14%. Also, as noted in our earnings release in the third quarter, we incurred an additional bad debt expense on accounts receivable of approximately 21% of the outstanding uncollected amounts at the end of Q3, and we incurred an additional bad debt expense of straight-line rent receivables of approximately 11%. This is compared to a bad debt expense of accounts receivable of approximately 14% of the outstanding uncollected amounts at the end of Q2, and bad debt expense of straight-line rent receivables of approximately 7% at the end of Q2. It's easy to get confused in all these percentages. However, from a big picture perspective, at the end of the third quarter, our total allowance for doubtful accounts, which reflects the cumulative bad debt expense charges recorded totals approximately 39% of our gross accounts receivable and approximately 3% of our straight-line rent receivables. Let's talk about liquidity. As we look at our balance sheet and liquidity at the end of the third quarter, we had approximately $405 million in liquidity comprised of $155 million of cash and cash equivalents and $250 million of availability on our line of credit, and only one of our properties is encumbered by a mortgage. Our leverage, which we measure in terms of net debt to EBITDA, was 6.7x on a quarterly annualized basis. On a trailing 12-month basis, our EBITDA would be approximately 6.0x. Our focus is to maintain our net debt to EBITDA at 5.5x or below. Our interest coverage and fixed charge coverage ratio ended the quarter at 3.6x on a quarterly annualized basis and 3.9x on a trailing 12-month basis. As it relates to guidance, as previously disclosed, we withdrew our 2020 guidance on April 3 due to the uncertainty that the pandemic would have on our existing guidance, particularly in our hotel and retail sectors. Until we have a clear view of the economic impact of the pandemic or more certainty as to when a vaccine becomes available, we will refrain from issuing further guidance. I'll now turn the call over to Steve Center, our Vice President of Office Properties for a brief update on our office segment.

Thanks, Bob. As Bob said earlier, at the end of the third quarter, net of One Beach, which is under redevelopment, our office portfolio stood at over 96% leased with just under 6% expiring through the end of 2021. Given the quality of our assets and the strength of the markets in which they are located, with technology and life science as key market drivers, we continue to execute new and renewal leases at favorable rental rates, delivering continued NOI growth in our office segment. The weighted average base rent increase for our nine renewals completed during the quarter was 6.7%. Additionally, as Bob pointed out earlier, with leases already signed, we have locked in approximately $30 million of NOI growth in our office segment priced at approximately $6 million in 2020, $14 million in 2021, and $10 million in 2022. We anticipate significant additional NOI growth in 2022 and 2023 through the redevelopment of leasing of 102,000 square feet at One Beach Street in San Francisco and 33,000 square feet at 1110 Oregon Square in the Lloyd submarket of Portland. Furthermore, we have the ability to organically grow our office portfolio by up to an additional 768,000 square feet, or 22%, on sites we already own by building tower three of La Jolla Commons, and a 213,000 square foot tower that is currently in the city for permits, as well as blocks 90 and 103 Oregon Square with two configuration options: one at 392,000 square feet and the other at 555,000 square feet, for which we recently received entitlements from the Portland Design Review Commission. We continue evaluating market conditions, prospective tenant interest, and hopefully decreasing construction costs on these development opportunities. In summary, we have a stable office portfolio with little near-term rollover, significant built-in NOI growth, and additional upside through repositioning and redevelopment within our existing portfolio, plus substantial new development on sites we already own. Operator, I'll now turn the call over to you for questions.

[Operator Instructions] Our first question comes from Richard Hill with Morgan Stanley.

Good morning. You got Ron Kamdem on for Richard Hill. A couple quick ones for me. The first is just on the bad debt. I just would like to dig into that one a little bit more. I think I heard correctly that bad debt is at 39% of accounts receivable and 3% of straight-line rent receivables. So I guess the question number one is, has that been increasing from Q2 to Q3? It sounds like it has. I just want to confirm that and maybe a little bit more color on what's driving that? And are you guys thinking about it? And maybe are you being too conservative and so forth? Thank you.

Good morning, Ron. Thanks for the question. Yes, so if what we said in the script was that it is 39% of total accounts receivable, the bad debt, and that's on our allowance for doubtful accounts. So from a dollar standpoint, that's about $7 million. We had about another $2.5 million in straight-line rent receivables or bad debt reserves against straight-line rent. So the total of the two amounts is about $10 million, just slightly under that. When we look at where we were at the end of Q2, that amount was approximately $3.3 million on the bad debt reserve, which increased from $3.3 million to approximately $7.7 million. The reason for this increase is that until we get this vaccine, it's difficult on the retail tenants. Each quarter, we evaluate the likelihood that we will receive what's billed, and we'll make a decision at that time as to whether it's probable we'll receive 95-5% of the remaining cash flows.

Thanks, Bob. Ron, this is Ernest. As a matter of policy and strategy, we'd much sooner be on the conservative side than the optimistic side. Bob has made an accurate assessment. Our strategy has always been if we're going to err, err on the conservative side. Thanks for the question.

Got it. That's helpful. My other question I get that it sort of ties in to the bad debt was just on the guidance. I think historically, the team has provided guidance for the next year at this time. And, obviously, I can appreciate there's a lot of moving pieces. But just what was the thought behind not giving some broad strokes for the retail portfolio and the office portfolio? It feels like you have pretty good visibility on the office portfolio with the presentation you've put out. So, just curious why not sort of put a guidance number out there and help sort of the street, get some broad signposts?

Ron, we'd love to give the guidance that you're asking for, but there is just so much uncertainty out there from an economic point of view and a health point of view, that we thought that we have very little to gain and a lot to lose by saying something that doesn't turn out to be true. We just assumed to remain silent until we know exactly how this is all going to play out. I understand your concern, and it's our concern too. We're monitoring where we are and where we're going. We're doing the best we can. But I wouldn't want to mislead anybody, including ourselves.

And, Ron, from time to time in our investor presentations, we'll include some foresight as to what we know at that point in time. But we're not issuing guidance, as Ernest said.

On the office side, we've given some indication of where our sentiment is. This is because of the high quality of the assets and the high quality of the tenants, with some assurance that what we say will turn out to be true. But in the rest of the portfolio, it's so COVID-affected that we're just not certain.

Got it. And then my last one, if I may. I found it interesting your opening comments about Prop 15 and Prop 21. I know the governor of California came out in opposition to Prop 21. Just in your mind, obviously, the goal is for none of them to pass, but is one more likely or more of a concern than the other? So if you're thinking out loud, is Prop 15 maybe a bigger risk of passing than Prop 21? Or do you see the same odds across the board? Thanks.

I think Prop 15 is a threat to the entire state, not just to us. As Adam pointed out in his presentation, there will be short-term discomfort for us but long-term pain for the businesses involved and the residents of California. I saw a survey recently that suggested Prop 15 would pass, but now they think it's unlikely to pass. God only knows what's going to happen, but I hope for the sake of California, that Californians and us as long-term residents can ensure that it fails to pass.

Our assessment is that Prop 15 is not going to have a huge impact on us initially, but rather on the customers as a pass-through, and then in turn, potentially on rent growth in California looking forward. So we're definitely opposing Prop 15.

Our next question comes from Craig Schmidt with Bank of America.

Good morning. Thank you. In terms of the reserve for bad debt, primarily being at the foot of a couple of properties, I think I understand Waikiki and Del Monte, and I'm guessing Alamo Quarry is somewhat related to regal centers, but why was Carmel Mountain Plaza pushing that bad debt number?

I think a lot of it that you're seeing at Del Monte, Alamo Quarry, and Carmel Mountain Plaza is because that's where the three theaters are located. So we've gone through and placed a reserve on those properties, and we just had a lot of challenges in the apparel industry. Adam, maybe you want to talk to some of the negotiations specifically, but in general.

Yes. Based on our challenges with a lot of these retailers, not just the mom-and-pop, but some of the national companies, we're taking a more conservative view of our probability of collections on those companies. We're still working with them as much as possible but want to be more conservative in our presentations and hope to surprise to the upside.

That's right. All these tenants are operating as if you don't ask, you don't get, so virtually everyone is asking for some form of relief from us. We've given relief to 20% to 30% of these tenants so far, only when needed, but we're trying to be smart about it and take our time. For those that are unilaterally withholding rents and have the money, they are the ones we are pursuing, and we're not necessarily having to take reserves against those companies. It’s the folks that are more challenged financially.

I think our stakeholders can be assured that we're doing everything we can on behalf of our stockholders to collect every dollar of rent that we're entitled to. If we don't collect it, as Adam said in his presentation, we're going to try to get something for what we have to give up. It's a negotiation with a committee that evaluates every opportunity to come up with the best transaction for the company.

Okay, thank you for that. I see a somewhat lower rent collection in October versus September for retail, going from 82.6% to 77.3%. Is that just a matter of timing?

It's probably just a matter of timing, because that's only as of October 16. A lot of that comes in at the end of the month, as negotiating and some are slow-paying, but we're getting it.

Yes, even those with recurring payments that are making them are starting to pay later in the cycle. So we do expect that number to increase, that's our expectation.

Great. And then just finally, it looks like you had 71,000 square feet of renewals. Could you categorize those? If you were an anchor, what type of tenants were they?

On the renewals, that information would be in the supplement. I don't have the details on that in front of me, Craig.

The 71,000 square feet is just a mix of different tenants that have come through the system.

Our next question comes from Todd Thomas with KeyBanc.

Hi, thanks. Good morning. Just a couple of questions on the office segment. Curious for an update. I think last quarter there were no changes to the build-out and floor plans for Google at Landmark. Just curious if you can provide an update there if anything's changed, and then whether there are any other tenants in the portfolio that might be looking to either reconfigure or maybe shed some space.

Jerry has told me that Google is continuing as per their original plans. Steve, are you aware of anything that we should make Todd know?

Yes, both Google and Autodesk are reconfiguring and investing more in their space. We're fortunate in that regard. So all our bigger tenants are moving forward with plans past this pandemic.

Okay. Is there any sublease space in the office segment of the portfolio at all today?

It's market by market. So I'll say, starting in San Diego, sublease is really muted. Delver Heights is at 0.6% vacancy for sublease space. UTC is at 0.7%. Those are our two main markets. In San Francisco, there is a lot of sublease space right now, there has been a big uptick. Fortunately, Autodesk and Google occupy the entire Landmark building. One Beach is under redevelopment, and we won't deliver that until 2022. So hopefully, we're through the worst of this at that time. Portland again, sublease space is muted; the total sublease vacancy in Portland right now is 1.5%. Bellevue has significant sublease space, but it's not really an indicator there. And that just currently, on the east side market, Bellevue is part of the east side market. It's a 37 million square foot market. There’s 4.3 million square feet of office space under construction on the east side, and it's 96% pre-leased. So it's just a very strong market. We've got one floor available for sublease that Cisco has up. We just received an RFP yesterday for 52,000 feet from an engineering firm being displaced from a building being torn down to make way for a new building for Amazon. Bellevue is just extremely robust, and sublease space really isn't a big factor there. So hopefully, that answers your question.

Fortunately, being in Bellevue is about being in the right place at the right time. I don't know that we're that smart, but we're certainly that lucky. So we're glad to be there. Thanks for the question, Todd.

Great, yes, that's helpful. Do you have a sense for what employee occupancy looks like in your assets across the office portfolio?

It's low. It's probably sub 20%.

About 20% to 25%. As I look at that circumstance, the associates want to come back to work, and we want them to come back to work. This working from home is not as enjoyable as everyone says. There will be some work from home going forward, but from an operational point of view, and a mental health point of view, and a company point of view, back to the office is the way to go, in my view. It will transform to that at some point depending on what happens with COVID-19.

To add to that, I've had conversations with tenant rep brokers that represent some of the biggest companies out there. They said, behind the scenes, CEOs are saying get back to work.

That's what I say.

It's not a matter of if; it's a matter of when. Google is again, a good example as they did not modify their plan due to COVID in terms of configuration. So we will get there.

Okay, and then in terms of the Embassy Suites, Bob, I was wondering if you had any visibility there on occupancy and ADR heading into the fourth quarter, and maybe also an update on bookings as we think about 2021.

Yes, we ended at 66% occupancy on a weighted average basis for the quarter. During the third quarter, we saw it tick up to like 75%. We've been trending in the last month somewhere between 52% to 65%. As we go into the fourth quarter, we'll probably keep it in that range, somewhere between 50% to 65%. Right now, we do have bookings, and we're looking forward, though they have the ability to cancel them depending on the quarantine, if the openness of the quarantine in Hawaii remains.

Is it safe to say that the ADR is affected by the nature of our tenants, now who are mostly government employees and not tourists? Once this thing returns to normal, our ADR will return to normal?

Yes, I think that's been very helpful. We can lean on the DoD, which has been about 80% of our occupancy, and then the local Hawaiians have been the other 20%. As a result, both of those are at a much lower ADR. The ADR is probably somewhere between $205 and $225 compared to last year where we hit $360 on an average basis, obviously some rooms went much higher and some were a little bit lower. As I understand it, we are one of two hotels that are open in Waikiki. We expect more to open as tourism comes back. That having that open and being able to achieve breakeven has been a win for us during this pandemic whereas I think the other eight hotels in Waikiki have been completely closed.

Not that I can guarantee you, but I think once people can travel, they're coming back to Hawaii. They're returning to Waikiki. It's a great property. We've used this time to upgrade the property by painting, fixing the spalling, salt air damage, and upgrading the room furniture, so we're ready to go. In this economy, people will be anxious to travel once this pandemic is over. Thank you. I'm not showing any further questions. At this time, I would now like to turn the call back over to Ernest Rady for any further remarks. I want to thank you all for your patience during this difficult time. I can assure you that everybody at American Assets Trust is working hard to ensure that when things return to normal, the results we present will be more than adequate. During this time, we're doing our best, and it’s not easy for anybody, including us. But we're going to get there, and at some point, we'll look back on this. It will be a terrible memory. Thank you all for attending.

Thank you, ladies and gentlemen. This concludes today's conference call. Thank you for participating. You may now disconnect.