Earnings Call Transcript - ARE Q2 2014

Rhonda Chiger, Investor Relations

Thank you and good afternoon. This conference call contains forward-looking statements within the meaning of the federal securities laws. Actual results may differ materially from those projected in the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the Company's Form 10-K, Annual Report and other periodic reports filed with the Securities and Exchange Commission. And now, I would like to turn the call over to Mr. Joel Marcus. Please go ahead.

Joel Marcus, Chairman, CEO and Founder

Thanks, Rhonda, and welcome everybody to this second quarter call. With me today are Peter Moglia, Steve Richardson, and Dean Shigenaga. As all of you have seen from the press release, we are pleased to have reported our second quarter FFO at 1.19 a share, an increase in the midpoint of our narrow 2014 guidance range $4.74 to $4.80. In the second quarter, we have witnessed very positive conversions of key cyclic and structural factors which have resulted in an exceptionally strong environment for our unique collaborative science and technology campuses in our great urban innovation clusters. We actually see exceptional opportunities, very strong tenant demand, increasing rents and occupancy, and Alexandria is able to drive earnings and NAV growth therefore. We will at Investor Day in December set expectations for growth in 2015, as well as how our value-added growth pipeline should evolve over the next two to three years. We will also detail our funding approach to our capital allocation in 2015 as the company continues to have the full range of capital sources available to it. If you take a glimpse at 2015, it can be seen on page 50 of the supplement. Other macro comments let me share with you. We see continuing strong improvement in the life science industry's ecosystem participants in urban core clusters. Peter will talk about this in a minute. The presence of tertiary locations outside of the key core urban clusters is really declining, even if you have a second-tier academic or university nearby. Pfizer's sale of three facilities and their move to the heart of Cambridge is again a prime example of this. We have witnessed strong biotech and pharma capital markets performance over the last many months, and solid profitability with lots of cash. As you know, record high FDA approvals of new drugs are currently with us, plus the FDA review time is down from about 23.8 months as the high in 2008 to about 9.4 months in 2013. When combined with the new breakthrough therapies designation and the new way of precision-targeted medicines to treat serious life-threatening illnesses and diseases, it's pretty clear that we’ve got substantial improvement over existing therapies, better targeting of medicines with fewer side effects. Out of the six breakthrough therapies approved by the FDA, four are Alexandria tenants: Roche, Gilead, Novartis, and GlaxoSmithKline. In the first half of 2014, in fact, 143 digital health companies raised $2.3 billion which is a 168% growth over 2013, so another good factor. If you look at the July 25 Wall Street Journal, they did a feature article on Google Acts, an important tenant of ours in the San Francisco Bay region. Google's so-called New Moonshot project focused on the human body was elucidated in that article. Simply stated, it’s focused on not being restricted to specific diseases, using new diagnostic tools to collect a broad range of samples, using Google's massive computing power to define biomarkers and patterns, and then using these biomarkers to detect diseases much earlier than we ever have. We are on the new frontier of some pretty dramatic breakthroughs. We have moved operations and internal growth, and both Steve and Dean will talk about this. We are certainly beating our occupancy and rental rate increase estimates and are in a strong environment given our urban locations. Leasing by region has been driving internal growth with 752,000 square feet leased this quarter; Greater Boston contributed 58%, San Francisco 13%, and San Diego 12%. On external growth, you’ve seen the disclosure on the acquisition of 500 Townsend Street in the SoMa district of San Francisco in April, adjacent to our Mission Bay cluster. Over time, we think this will integrate well and help drive our continued growth in the city of San Francisco where we’ve successfully developed over 1 million square feet. I also direct your attention to page 27 of the supplement, our near-term value-add pipeline. It is the strongest it’s ever been in key multiple and innovation clusters, and we’re very pleased about that. I'll leave the balance sheet comments this quarter to Dean and maybe finish up on the dividend. The company will continue its policy to share increasingly strong cash flows with shareholders as we maintain a low payout ratio, 61% this quarter. So I’m going to turn it over to Peter for some comments.

Peter Moglia, Chief Investment Officer

Thanks, Joel. Good afternoon. This quarter I would like to highlight one notable life science trade that provides some clarity on cap rates in Torrey Pines, San Diego, one of Alexandria's largest submarkets. Trades of office property in San Francisco and Manhattan illustrate continuing cap rate compression in the core urban markets that Alexandria invests in and operates in. I want to highlight the sale of a life science portfolio by Pfizer in West Cambridge, not so much for its financial metrics, but because it offers further support that the transition of large pharma and biotech companies from siloed research campuses to centers of innovation anchored by academic institutions continues. First, I would like to discuss the sale of 11099 North Torrey Pines Road by Angelo Gordon to HCP. The asset is 93% occupied, 92,479 square foot multi-tenant laboratory office building on the northern edge of the Torrey Pines submarket. There are about a dozen tenants in the facility, a mix of large companies or institutional credit with some early-stage private biotech. The sale price was $43,750,000 which would indicate a low 5% cap rate on in-place income, but after allocating value to excess land, it was reported to be at 5.67%. This is a solid building, but we believe our portfolio in the submarket is of higher quality and therefore this comparable should support low 5% cap rates for our higher-end Torrey Pines properties such as our Nautilus and Spectrum projects. There were no other life science trades to report this quarter, but last week an article in the registry noted that 405 Howard Street in San Francisco is being acquired by Norges Bank Investment Management and TIAA-CREF for $350 million, which is estimated to be $750 per square foot at a cap rate of between 3% to 4%. This asset is located within 1.5 miles of our 500 Townsend project in the northern edge of our Mission Bay Holdings. We believe Mission Bay is on course to be one of the most desirable locations in SoMa and Financial District as it moves towards full build-out, aided most recently by the announcement of the development of the new Golden State Warrior Stadium and supporting infrastructure. Because of this we believe that cap rates for our Mission Bay assets closely resemble those of assets trading in SoMa in the Financial District. Adding to Mission Bay’s terrific location and proximity to SoMa and the Financial District is that our Mission Bay assets are relatively new with an average age of 5.8 years and are leased to high-quality tenants such as Pfizer, Celgene, UCSF, the VA, and Baird under long-term leases. We’d also like to note that both 5 Times Square and 920 Broadway traded in Manhattan at $1,361 and $1,091 per square foot respectively, showing that investor appetite for New York City assets is not necessarily being governed by price per pound limitations. No cap rate was reported for 920 Broadway, but the 5 Times Square cap rate was reported at 4.35%, and we’d like to note that it was a leasehold transfer. Lastly, Pfizer recently sold the vacant asset at 87 and 200 Cambridge Park Drive in West Cambridge totaling 280,000 square feet to King properties for $192 per square foot. What is really interesting is that they signed a lease with MIT at 610 Main Street South in Kendall Square for 287,000 square feet and are rumored to be looking at taking another 140,000 square feet at the MIT 610 Main Street North project. A June 15 article in the Boston Globe references that Pfizer will consolidate employees from West Cambridge at 620 Memorial Drive and some employees relocated from Groton, Connecticut to 610 Main. Although only 4.5 miles away from their new location, Pfizer decided to sell fully improved owned research assets in West Cambridge and materially increase their occupancy costs by leasing space in the heart of Kendall Square. This validates our cluster model, and we expect more in the future as a result of new product pipelines and lower overall cost of drug development. So with that, I'll pass it over to Steve.

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Good afternoon, everyone. At the outset, I'd like to first commend our best-in-class regional teams for truly exceptional operational performance year-to-date as we are hitting on all cylinders. The level of expertise and commitment to excellence in all facets of the business is truly unique and unparalleled in the industry. Today I will touch on two key aspects of our operations in my remarks: one, the ongoing and sustainable solid performance of our core; and two, as we forecasted earlier this year, the increasing actual and imminent deliveries from our significant $1.1 billion current value creation development pipeline. First, the core is performing very well as we reported cash and GAAP increases of 6.3% and 13.6% year-to-date and 3% and 9.9% respectively this past quarter for renewals and re-leasing of space. We are seeing now more broadly as a trend, the clear and compelling sense of urgency towards Alexandria’s Class A facilities and operational teams and its irreplaceable cluster locations as tenants with 2015 and even in some cases with 2016 rollovers engaging our regional leadership teams to renew leases and lock down space. This is a positive and powerful market dynamic that we really haven’t seen in a decade or more. The stability provided by our Class A facilities and AAA urban science and tech campuses populated by investment-grade tenants with a high bar 96.9% occupancy rate for North American properties is impressive. This is the second consecutive quarter we have been greater than 96.5% occupied. Probably no better metric for the return to stability seen when we outlined it at our December 2013 investor meeting. The rollovers remaining to resolve in ‘14 are very manageable: 150,958 square feet or just 1% of our operating base. We will take a closer look at each of Alexandria's urban science and technology innovation clusters and the very positive fundamentals for each. In Cambridge, we are seeing demand remaining very robust and increasing with more than 4.3 million square feet of demand from both life science and tech users. Our mark-to-market and rollovers for the balance of the year are targeted at 14% on a GAAP basis, and the region has hit a high order mark of 98.5% occupancy. The clear scarcity of both large blocks and smaller blocks of space is maintaining rents at the new level of high 50s, low 60s triple net for existing product. Binney Street build-to-suit prospects are anticipating rents in the low 70s triple net. Direct office vacancy rates in East Cambridge remain very healthy at a low of 6.8%, and lab vacancy rates remain unchanged at 10.7%. Although it’s important to note that the bulk of this lab availability is really B quality leftover space from Vertex and Pfizer. As such, the desirable direct spaces are experiencing competition for multiple users creating a clear landlord's market. Moving over to the San Francisco Bay, it's also continuing its strong demand cycle as we're maintaining our strong occupancy level at 98.4% in the operating and development asset base. We're tracking 750,000 square feet of life science demand and a pretty impressive 7.9 million square feet of tech office demand. Recently, Google leased out approximately 250,000 square feet and purchased an adjacent 90,000 square foot building in the Selmont area, further contributing to lease rates for new product, now in the mid 50s triple net. The mark-to-market for 2014 rollovers is anticipated to be nearly 14%, with lease rates increasing again to the low 50s triple net in Mission Bay and mid 30s in South San Francisco. This could pop if Amgen's rumored plans to reoccupy space that they’ve had on the market for sublease transpires, and mid to upper 40s in the Stanford Cluster. The market overall continues to tighten, and vacancy rates dropped by 50 basis points in the lab market from Mission Bay to Palo Alto to 6.3%. The sense of urgency is clearly evident, with December 2015 and December 2016 tenants completing early renewals. Moving down to San Diego, the core is performing very well with 97.2% occupancy, up 300 basis points from Q2, '13. The market overall is similarly enjoying continued strong demand with 1.3 million square feet of life science requirements, significantly up from the 800,000 square feet earlier this year. A number of transactions along with Torrey Pines Villas have been completed in the range of $40 triple net for high-quality product. This has become even more scarce as direct vacancies are just 10%, and our current negotiations are now reaching into the mid to upper 40s triple net. ETC's direct vacancy rate has dropped 30 basis points to 6.1%, and although the remaining rollover is small, it's important to note that mark-to-market will be significant as legacy leases expire. Finally, Seattle will provide mark-to-market gains in the mid-teen range for the balance of 2014. Vacancy rates are also tight in the South Lake Union district at 4.9%, and demand continues in Seattle with fresh requirements for nearly 500,000 square feet in the science and tech sector. Our current value-creation development pipeline remains on track with an additional 110,000 square feet delivered into service during this past quarter. We're on track to deliver and place into service significant fully leased facilities during the second half of 2014 and Q1 ‘15. These projects represent the highest quality Class A assets in core urban science and technology innovation clusters, including Cambridge, Manhattan, San Diego, and San Francisco, and are another testament to the acumen of our fully integrated regional teams. With that, I’ll hand it off to Dean.

Dean Shigenaga, EVP, CFO and Treasurer

Thanks, Steve. Dean Shigenaga here. Good afternoon, everyone. I have four important topics to cover. First, I want to provide an update on our balance sheet, including our recently highly successful issuance of unsecured notes; second, I’ll provide a key update on land sales for the second half of this year; third, briefly touch on interest expense for the second quarter; and fourth, provide a summary of key drivers of growth and our guidance for 2014 FFO per share and confidence in our ability to deliver solid growth and cash flows, net asset value, and FFO per share in 2014 and beyond from our Class A buildings and land parcels in AAA locations in urban innovation clusters. Starting with our bond offering in mid-July, we completed our third highly successful unsecured bond offering and increased the strength and flexibility of our balance sheet and capital structure. Our $700 million dual tranche offering focused on three primary goals: first, transitioning variable-rate bank debt to longer-term fixed-rate unsecured bonds; second, prudent laddering of debt maturities, considering our outstanding bonds with maturity dates in 2022 and 2023; and third, greatly increasing flexibility as we focus on several high-value build-to-suit development projects. Our bond offering consisted of $400 million of 2.75% 5.5-year unsecured notes due in 2020; $300 million of 4.5%, 15-year unsecured notes due in 2029; blending to a weighted average rate of 3.5% and a maturity of 9.6 years. To put this pricing into context, a 10-year deal would probably have priced within an interest rate around 4%. This highly successful transaction also extended our average maturity of outstanding debt to 6.3 years, up from 5.1 years; increased our liquidity to $1.8 billion; and reduced our unhedged variable rate debt to 7% of total debt. Briefly on a few other balance sheet matters, the high-value projects that we have leased, completed, and delivered over the past several years, along with delivery scheduled over the next few quarters, underscore the strong demand for our Class A assets in urban innovation clusters. Our target net debt-to-EBITDA for the fourth quarter of '14 annualized is on track with our plan at 6.8 times and is relatively consistent with leverage at the beginning of the year of 6.6 times. Additionally, our target net debt-to-EBITDA of 6.5 times is expected to occur by the fourth quarter of ‘15. Non-income producing assets will decline to 15% by year-end and to 12% by March 31, 2015, primarily through the completion and delivery of pre-leased Class A development and redevelopment projects. These forecasts include a very conservative assumption for construction spending related to new projects and include the land sales targeted for 2014. We also anticipate significant EBITDA growth for 2015 compared to 2014, along with solid cash flows from operating activities after dividends, which in aggregate will provide funding for growth of approximately $500 million to $600 million in 2015. Briefly on our second topic of land sales for the second half of the year: we remain comfortable with our range of guidance for land sales of $145 million to $245 million for the full year ‘14, and approximately $115 million to $215 million to complete for the remainder of the year. Moving on to our third topic, I briefly want to touch on interest expense for the second quarter. Interest expense declined approximately $1.7 million, driven by a $2.4 million reduction in gross interest expense offset by an approximate $700,000 reduction in the capitalization of interest. Gross interest expense declined primarily due to the repayment in January of ‘14 of a $209 million secured loan with an interest rate of 5.6%. Additionally, we had $200 million of notional swap contracts that ended on March 31, 2014, which fixed LIBOR under the contracts at about 5%. Capitalization of interest was lower this quarter, primarily as a result of the weighted average interest rate required for capitalization at 3.41%, down from 3.88% as of the first quarter. This temporary dip in the interest rate was caused by the higher proportion of variable rate debt outstanding under our line of credit, which obviously has a lower interest rate. This temporary decline in the rate was reversed in July upon completion of our bond offering when we repaid almost all of our outstanding borrowings under the line of credit. We expect the weighted average interest rate for capitalization of interest to return to its prior run rate in the range from 3.8% to 4% for the second half of ‘14. Lastly, on guidance, our core operations continue to benefit from one of the REIT industry's highest quality tenant bases, with about 52% of our total ABR from investment-grade rated tenants. Additionally, high-quality science and technology entities continue to drive strong demand for our Class A assets in urban innovation clusters, including build-to-suit opportunities on our land parcels. This high-quality demand drove continued improvement in our outlook for ‘14. Our guidance for FFO per share this year was increased by $0.02 at the midpoint to a range from $4.74 to $4.80. We increased the range of our occupancy for year-end up to 97.2%, after hitting the upper end of prior occupancy guidance well ahead of schedule. We also increased the range of guidance for same property NOI growth to a range from 3% to 5%, up 1% on both ends of the range. Additionally, we increased the ranges in rental rate increases on renewal and re-leasing space to a range from 11% to 14% and a range for 4% to 6% on a cash basis, again both up 1% each on both ends of the range. Most importantly, strong demand for our high-quality buildings in urban innovation clusters will allow us to monetize several land parcels through development in the near term. As we look back to Investor Day in December of ‘13, our outlook at that point for 2014 was very solid. Now that we're seven months through the year, it's very clear that demand for space in our buildings has meaningfully improved. Again, this demand and the strength in the performance of our core operations drove the aggregate $0.07 today in our midpoint guidance for 2014 FFO per share. The key drivers of this $0.07 growth were $0.04 from core operations, $0.01 from value creation deliveries earlier than anticipated, $0.01 from acquisitions, and $0.01 from other items including our recent bond offering. In closing, we're very pleased to be in a solid position with our balance sheet, with continuing solid core operations, and with demand from high-quality science and technology entities to drive stable growth in FFO per share and net asset value in 2014 and beyond. With that, I will turn it back to Joel.

Joel Marcus, Chairman, CEO and Founder

Operator, we are open for Q&A.

Emmanuel Korchman, Analyst, Citi

Hey thanks guys. Dean, if we just look at your income statement, there was no other income in the quarter. Typically you’ve had some amount in there attributable at least to marketable security sales. Could you just tell us what's going on there?

Dean Shigenaga, EVP, CFO and Treasurer

Yes, I’d say we had a one-time decline in other income. Typically you see other income in the $3 million to $4 million range, and that's our outlook for the remainder of the year. In the quarter, we did have a lower amount of investment income. In fact, there was a small loss in aggregate during the quarter, so that was the driver there.

Emmanuel Korchman, Analyst, Citi

And then given the strength you spoke about in terms of assets, given that you're already selling at good cap rates, have you thought about selling more core assets into that type of market rather than just non-income producing ones?

Dean Shigenaga, EVP, CFO and Treasurer

We did go through recycling of assets that we wanted to lighten up in the uncertain sub-markets in late '12 and part of '13, and I think that was completed at the moment. We're reviewing things constantly, and you may see us do some of that, but at the moment we don’t have anything particularly to target.

Emmanuel Korchman, Analyst, Citi

And then in terms of the non-core sales, do you still plan to have them this year?

Dean Shigenaga, EVP, CFO and Treasurer

We’re certainly on target to do that, yes.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

Great, thank you and good afternoon. So I guess sticking with the acquisition or the disposition market, can you talk a little more about the types of buyers you guys are seeing for your asset class?

Peter Moglia, Chief Investment Officer

Hey Jamie, it’s Peter Moglia. We’ve seen a lot of domestic and foreign capital, private equity. We’ve had a lot of pension funds interested in both buying our product and in joint venturing with us. So I would say that pretty much every class of investor has looked at or purchased life science product now. Maybe that wasn’t the case seven years ago, but it is now.

Joel Marcus, Chairman, CEO and Founder

Yes, and I think that’s a good thing because it’s become more mainstream, and certainly cap rates have reflected that.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

And then in terms of operating, I mean a little bit of a differentiated asset class today operated in-house, or there is just specialized third parties, or do you guys maybe retain more today?

Dean Shigenaga, EVP, CFO and Treasurer

I think most of the things that have traded to those types of buyers have been long-term leases that they’ll likely probably be distilled maybe within 3 years or 4 years of those leases bringing up. We haven’t gotten to that point where someone needed to operate something yet.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

Okay, alright. And then shifting to the development pipeline, can you talk a little bit more about your leasing prospects at 3013 Science Park Road and then New York?

Dean Shigenaga, EVP, CFO and Treasurer

Yes, I’ll speak to New York; you want to talk about 3013.

Joel Marcus, Chairman, CEO and Founder

3013, we’ve got an existing building that we’re saving the steel frame where we’ve got that 25% leased to a top-tier life science company in that market. For the other project, we actually have a letter of intent for the entire 65,000 or so square feet for a long-term lease there. So all we have left would be about three floors in that development.

Unidentified Company Representative, Representative

And then in New York, we have four floors left, and we have reasonable activity on some of those floors. We don't have anything that’s moved to the stage of LOI, but we're very active, and we think that over the coming couple of months we'll have some news ahead of our internal projections. So I’d say stay tuned for that. Yes, and Jamie, let me just add from a modeling perspective, our guidance only assumes we deliver about 60% of the project by the end of this year for the West Tower.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

Okay. So I guess just thinking about leasing interest in New York, is there anything that’s changed or is just a bit lower than expected? I guess that's to a certain extent could you state your environmental guidance but just how tenants are reacting to the market into those assets?

Joel Marcus, Chairman, CEO and Founder

Yes, I believe we are exceeding our internal expectations, and this is evident in the model that Dean mentioned. However, when considering New York, it is important to recognize that we are developing a cluster there, which is different from places like Cambridge or San Francisco. I feel confident that we have several tenants, including major pharmaceutical companies and an intriguing non-profit organization, interested in substantial spaces. Overall, the market is strong, and I would say that rental rates are surpassing our expectations, so we are quite optimistic about it.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

Okay. And then finally, can you talk about your largest expirations in the back half of the year and then in 2015?

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Jamie, it's Steve. The expirations in ‘14 are really marginal; as I was saying, it’s 150,000 feet total, just 1% of the asset base. I think the largest block is potentially in Maryland and it’s probably about a third of that; otherwise it’s pretty well distributed in either Cambridge or San Francisco, really.

Joel Marcus, Chairman, CEO and Founder

And then for 2015, it’s really split among a number of regions. It’s about 1.1 million square feet which generally takes us about two quarters to lease or sometimes even just one quarter. The largest expiration is a suburban property out in Route 128, and we are well on our way to working on a re-tenanting plan. We've got one or two tenants already signed. So we feel pretty good about that. There are some phases that could be significantly up in tech square and kind of varied by region.

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Yes, I think that's right. I mean as you look at these rolls that were in the core markets, tech square, the San Francisco piece, and UTC in town center, so the larger blocks in ‘15 are all in good core locations.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

Okay. And do you have a sense of the mark to market on your expirations?

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Yes certainly in ‘14, as we touched on as we closed the year out, those are all on a GAAP basis in the mid-teens, so I think that will continue to support the guidance we had at the beginning of the year.

Dean Shigenaga, EVP, CFO and Treasurer

Yes. And I would expect directionally on the rental rate steps of our leasing activity for ‘15, I think generally speaking, we're going to be in the general ranges of both GAAP and cash steps. So I think the performance we have this year or at least our expectations for ‘14 should continue into ‘15.

Jamie Feldman, Analyst, Bank of America Merrill Lynch

You’re saying the leasing spread should be about the same you had in '14?

Dean Shigenaga, EVP, CFO and Treasurer

Yes.

Joel Marcus, Chairman, CEO and Founder

Yes, the rental rate increases.

Gabriel Hilmoe, Analyst, ISI Group

Thanks. Just maybe following up on the last question a little bit, but just on the expansion on the leasing spread guidance. Steve, you talked a little bit about the current mark to market in the portfolio. But can you talk a little bit about where things may be tracking ahead of where you thought they would be maybe three or six months ago by market I guess?

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Yes Gabe, it's probably certainly Cambridge, San Francisco, and San Diego. I think overall we just see that demand has not only continued, but it's strengthened in those areas. People are locking down space, so that's enabling us to drive rents in those kinds of key core markets more so. So, it's probably those three markets that are driving it primarily.

Gabriel Hilmoe, Analyst, ISI Group

Okay. And then I realize this is still a strong number, but it looks like the occupancy dipped a little bit in San Fran. Anything in terms of the progress and back selling some of those smaller move-ups in the quarter?

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Yes, we did have one legacy tenant at one of our mid-Peninsula properties that ultimately rolled out. We're actually working with the group right now, so it was a temporary dip from 99.9% occupancy there.

Joel Marcus, Chairman, CEO and Founder

Well, both the West Tower is still the priority with four floors left and some under active discussions, but no paper trading yet. We are in discussions with the city on the North parcel also.

Gabriel Hilmoe, Analyst, ISI Group

Any idea of any type of timing around that North parcel?

Joel Marcus, Chairman, CEO and Founder

Too early to say at the moment.

David Rodgers, Analyst, Robert W. Baird

Yes, hey Joel. You’re 97% leased in the operating portfolio, 77% leased or negotiated in the development portfolio. What should we expect to see coming out of the ground in terms of new development? I mean obviously you want to get more product out there. So may be give us a sense on starts maybe over the next 6 to 12 months and then also where those starts might be located, where do you feel the best about kind of getting new projects coming out of the ground?

Joel Marcus, Chairman, CEO and Founder

Yes. I think in my prepared remarks I mentioned, if you go to page 27 of the supplement, this is kind of the best way to visualize it. If you go to the second half, the bottom half of that spreadsheet, we find a LOI with alumina working on finalizing the lease that will kick off here pretty quickly and that will be delivered next year. We're in active discussions with two significant tenants in 6 Davis Drive. My guess is that will probably kick off here in the second half of the year. Townsend, Steve can give you a quick update on that.

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Yes, we’re making real good progress. The team on the ground is advancing the entitlements there and perfecting the entitlements. We’re engaging tenants in the market in a series of serious conversations, so we’re encouraged there as well.

Joel Marcus, Chairman, CEO and Founder

On Campus Point, we have a letter of intent with an existing tenant to take most of the new buildings, and we expect that will move forward here over the next few months. Lake Union, we’ve got two parcels in play with multiple users. Don’t know how that’s going to go, but we think we have a shot, so I’ll reserve judgment on kind of the starts there. And then on 50, 60, and 100 Binney, we’ve got a lot of activity on those parcels.

David Rodgers, Analyst, Robert W. Baird

Would you feel comfortable going just back on any of those, or is pre-leasing the focus?

Joel Marcus, Chairman, CEO and Founder

It’s possible. I think the strength of the Cambridge market might move us to go forward. We’re already doing site work right now, so I’d say stay tuned there.

David Rodgers, Analyst, Robert W. Baird

Okay. And I guess with 50, 60, and 100 Binney, can you talk about maybe the cost and return terms to you as you think about maybe what you might be giving up? And I guess the only reason I ask that is your cost of capital has come way down with the bond offering and where the stock is. And I think returns continue to improve given where rents are going in those markets. So you said you’re still on track with that, and certainly understand the capital component of it, but maybe can you talk about the cost and return terms to ARE?

Joel Marcus, Chairman, CEO and Founder

Yes, I don’t believe we’re ready to discuss anything specific at this moment, but generally speaking, we feel that we have exceptional prospects. I don’t recall using that term before in any of my conference calls. With that in mind, we want to ensure our balance sheet remains in excellent condition. Dean’s report on the balance sheet is reassuring. This allows us to pursue exceptional prospects and provides us with another significant source of capital to undertake initiatives that exceed our usual plans, giving us a considerable advantage. Just stay tuned. I wouldn’t say we’re giving up anything; rather, we’re gaining something very valuable. We are able to advance several projects much more quickly than we could independently. Our focus remains on maintaining both the growth of net asset value and, importantly, our earnings growth, not just for this year but well into next year as well.

David Rodgers, Analyst, Robert W. Baird

Great. Thank you.

Michael Knott, Analyst, Green Street Advisors

Hi guys, good afternoon. A question for you, and this has been asked a little bit, but I just want to take a slightly different tack. Your ‘15 leasing spread sounds like it will be similar to ‘14, but just curious, given the strength of the tenant demand you're seeing, if you think that you might see at some point the cycle re-leasing spreads exceed what look to be the peak from the last cycle, about 8% on a cash basis?

Dean Shigenaga, EVP, CFO and Treasurer

Michael, Dean Shigenaga here. Yes, I gave you some baseline assumptions to think about for ‘15, but no doubt the strength of our core markets and demand in the marketplace for quality space that exist in our asset base or space like the quality of our asset base, I think is going to provide opportunities, both in capturing new requirements but also as we work through early renewals; I think we have an opportunity on both sides. But I want to give you some baseline assumptions as we think well ahead of Investor Day six months from now or five months from now.

Michael Knott, Analyst, Green Street Advisors

Okay, that’s helpful. And do you guys think about where your overall portfolio is on a mark-to-market basis today? It sounded like the ‘15 expiries are in pretty good markets and are sort of inline with spreads you're seeing this year, but just curious if the overall portfolio is maybe a little better than that or sort of similar to that, sort of up 5% on a cash basis?

Dean Shigenaga, EVP, CFO and Treasurer

Yes, I think on a cash basis, we are probably in that 2% to 3% and an 8% on a GAAP basis on a mark-to-market overall operating portfolio. Keep in mind, you’ve got long-term leases. You have annual cumulatively compounding increases with some pretty great tenants. So I think it’s important to really look at the GAAP metric as well.

Joel Marcus, Chairman, CEO and Founder

And we are trying to be conservative so that it makes sense.

Michael Knott, Analyst, Green Street Advisors

Got you. And then Joel or Dean, just curious how much development you are comfortable carrying at any one time as a percent of total assets? Just curious how you think about that? And obviously the list of projects you have going is pretty appealing, but just curious how you think about it from an aggregate standpoint?

Joel Marcus, Chairman, CEO and Founder

Yes, I can ask Dean to comment from an aggregate. I think the most important thing is that we try to cover the vast majority of our capital spend with both free cash flow and the generation of EBITDA from projects. To the extent that we can do that, Dean laid out, I think, a pretty nice slide on that.

Dean Shigenaga, EVP, CFO and Treasurer

Page 44 has a really nice depiction of…

Joel Marcus, Chairman, CEO and Founder

So I think that’s how we think about that. At the same time, we are bringing down non-income producing assets as a percentage of total gross assets, funding our construction spend. Really our spend on growth is really, and this is just our own credit capital plan, nothing is definitive yet until we give for sure guidance in December, but this is I think a handy way to think about it.

Dean Shigenaga, EVP, CFO and Treasurer

Well, I think 6.5 times has been a bogie for ours for some time. So it is near term by the end of ‘15. I think we'll always look for opportunities as we grow our EBITDA to possibly improve that. But for now, that's our bogie. Most of our EBITDA growth is providing the opportunity to manage the growth of our business without moving leverage in the wrong direction.

Sheila McGrath, Analyst, Evercore

Yes, good afternoon. Joel, I noticed that Longwood had a little bit of pickup in leasing in the quarter. I just wondered if the level of tenant interest is continuing there? And how the velocity of leasing do you expect?

Joel Marcus, Chairman, CEO and Founder

Yes, as I said. Thanks Sheila for the question. As I said last time and we’ve made comments on, and maybe other places, of all the markets and all the segments, this is the one that I think is most disappointing, in a sense, when we – they had the current vacancy rate in Longwood at about 1%. But I think there has been this weird overhang of NIH not increasing the budget; it was kind of little bit under the Budget Act from Congress and then it got restored, and its current run rate is about 30 plus billion dollars, although I note that I think Tom Parkins from Iowa just introduced a bill in Congress to raise it over, I think, a five-year period to 46 billion. I don't know where that's going to go, but that would be good. But I think the institution has gotten a little bit frightened. They’re also a little bit nervous about where Obama Care is headed, because nobody really has been through that process. So I think their operating spend has been more conservatively managed while their capital spend certainly is going forward. We’ve had a lot of interest in buying floors for condominiums. We’ve kind of put that off for the moment. We may return to that at some point if we decide to. But we do have current demand for two floors which we hope to resolve over the coming quarter or so. We've got active discussions with a bunch of people but nothing to show up on the scoreboard yet. There is some pharma interest in Longwood, although the main pharma interest does tend to be, as Peter pointed out, in Kendall Square. So we’ll see what happens, but as they say, that’s the one area with such a low vacancy rate. Our view back a couple of years ago when we proceeded on this process, we thought this would be much more efficiently leased than it is, but we’re still comfortable. We don't deliver until the end of the year, and I think we’ll be well over 50% at that point, which will meet our internal projections. We hope our rates stay what they are pro forma-wise, which today have been the case. So we’ll see where that goes, reminding that we have a 27.5% interest in that joint venture.

Sheila McGrath, Analyst, Evercore

Then just on 50, 60, and 100 Binney, it sounds like you’re seeing a lot of interest, and given where you have the NOI coming online in 2016. Is the interest that you’re seeing more life science, or is it a mix of tech as well?

Joel Marcus, Chairman, CEO and Founder

It tends to be very heavy life science at the moment.

Steve Richardson, COO and Regional Market Director (San Francisco Bay Area)

Sure Sheila. The vacancy overall is probably right around 10% in the market, although if you segment that and take smaller blocks of space, you’re probably at just 3% to 4%, so that’s why we’ve been able to be very successful with our projects there. In the smaller blocks over the past several quarters, these couple of blocks you’ve got probably roughly around 250,000 square feet, and it looks like they may take back one, if not both, of those blocks of space. That’s been something they’ve talked about much more intently. I think as they look at Thousand Oaks recruiting versus South San Francisco. We’re hopeful that conversation is becoming more serious than we are occupying that space. That would drop the overall vacancy rate, probably down total that would cut it in half, really be at 3%, 4%, or 5%.

Dean Shigenaga, EVP, CFO and Treasurer

Yes, I’d make one footnote comment to that. Amgen, who I used to deal with pretty regularly, and we have pretty close relationships with, approached us recently, and we did a bit of a strategic planning session with them on innovation, and it was pretty interesting because I think Amgen, similar to one or two of the big pharma companies, probably hasn't been historically as innovative as Genentech was. Genentech ended up spinning out 75 to 100 companies over its lifespan, before it finally got acquired by Roche; Amgen is just starting to do that, but historically hasn't. So I think what Steve says makes sense in terms of their thinking about becoming a much more innovative company. They’ve been highly successful, but it hasn’t generated a lot of spin-off companies and out licensing of technology, which I think they are now under new leadership really beginning to examine pretty carefully.

Joel Marcus, Chairman, CEO and Founder

Okay. Well, thank you very much for busy time on one of the earnings days. Thank you for the questions and attention, and we look forward to talking to you on the third-quarter call. Thanks.

Operator, Operator

This does conclude today's conference. Thank you for your participation.