Highwoods Properties, Inc. Q2 FY2024 Earnings Call

Good morning. Thank you for joining Highwoods Properties' Q2 2024 Earnings Call. My name is Cole and I will be your moderator today. All lines will be muted during the presentation, and there will be a chance for questions and answers at the end. Now, I would like to turn it over to Hannah True. Please go ahead.

Thank you, operator, and good morning everyone. Joining me on the call this morning are Ted Klinck, our Chief Executive Officer; Brian Leary, our Chief Operating Officer; and Brendan Maiorana, our Chief Financial Officer. For your convenience, today's prepared remarks have been posted on the web. If you have not received yesterday's earnings release or supplemental, they are both available on the Investors section of our website at highwoods.com. On today's call, our review will include non-GAAP measures such as FFO, NOI, and EBITDAre. The release and supplemental include a reconciliation of these non-GAAP measures to the most directly comparable GAAP financial measures. Forward-looking statements made during today's call are subject to risks and uncertainties. These risks and uncertainties are discussed at length in our press releases as well as our SEC filings. As you know, actual events and results can differ materially from these forward-looking statements and the company does not undertake a duty to update any forward-looking statements. With that, I'll turn the call over to Ted.

Thanks, Hannah, and good morning everyone. We delivered excellent operating and financial performance in the second quarter. First, we reported FFO of $0.98 per share, representing 4% year-over-year growth, and we raised our full year FFO outlook. Since the beginning of the year, we have increased the midpoint of our FFO outlook by $0.03 even with selling $80 million of non-core properties and absorbing the impact of higher-than-expected interest rates, neither of which were included in our original outlook. Further, our disciplined and ongoing efforts to further improve our high-quality BBD portfolio continue to pay off in the form of resilient cash flows. Second, we signed 909,000 square feet of second-generation leases, including over 350,000 square feet of new leases. This is the third consecutive quarter of strong new leasing volume. This is a testament to our SunBelt markets, our BBD locations, our high-quality asset base, and our talented team. Our leasing pipeline continues to be robust, which makes us optimistic we will sustain strong leasing volumes for the remainder of the year. Third, we signed seven first-generation leases, encompassing 61,000 square feet across our development pipeline. Upon stabilization, we expect these projects will provide approximately $40 million of incremental NOI and be a significant growth driver for our cash flows. Finally, our balance sheet is in excellent shape with a debt-to-EBITDA of 5.8 times at quarter end. Being a long-term landlord with a strong balance sheet is a clear differentiator in today's market, as we are able to fund leasing CapEx and reinvest in our best-in-class properties. Our occupancy, which was steady at 88.5%, doesn’t yet fully reflect the strong leasing over the past few quarters. We have a meaningful amount of space that has been leased but where occupancy has not yet commenced, primarily in Atlanta, Nashville, Richmond, and Tampa, and will start to contribute NOI later this year and in 2025. I want to provide an update on the former Tivity building in Nashville. As we mentioned at the beginning of this year, we modified a lease with a backfill customer for 110,000 square feet that currently leases 50,000 square feet in another Highwoods building. Since then, this customer has further reevaluated their long-term space needs. We are currently in discussions with our customer about what makes the most sense going forward, for both Highwoods and for them. It's possible we may agree to cancel their lease in exchange for recouping our investment. Regardless of what happens, we have healthy prospect interest for this space, and in fact, have already signed 66,000 square feet of new leases in this building. We do not expect any potential lease cancellation to have a meaningful impact on our near or long-term financial outlook. Turning to development, our $506 million pipeline is now 45% leased. Activity is solid at GlenLake III, our $94 million, 218,000 square foot development in Raleigh. We are now 34% leased and have healthy interest from additional prospects. At our $200 million, 422,000 square foot Granite Park 6 development in Dallas, we are developing with our 50/50 joint venture partner, Granite Properties. We signed a full-floor user for 27,000 square feet to bring the leased rate to 26%. We still have seven quarters to go before pro forma stabilization at both GlenLake III and Granite Park 6 and remain confident in the long-term outlook for both developments. Staying in Dallas, activity is steady at our 642,000 square foot, $460 million, 23Springs project in Uptown that we are also developing in a 50/50 joint venture with Granite. The property is currently 56% leased and we have an LOI for another full-floor user with healthy interest from additional prospects. As a reminder, this project is scheduled for completion in the first quarter of 2025 and stabilization in the first quarter of 2028. Midtown East in Tampa, our 143,000 square foot, $83 million project we are developing in a 50/50 joint venture with Bromley in the Westshore BBD, continues to generate strong interest. Midtown East is the only office project currently under construction in the entire market. We are 16% pre-leased two years before scheduled stabilization and have a pipeline of additional prospects. As mentioned earlier this year, we do not expect to announce any new development projects during the remainder of the year. New starts are very difficult for any developer to pencil, given the current environment, which is benefitting our existing portfolio as large requirements are seeing dwindling options of quality space available across our footprint. As we previously disclosed, we sold a little over $60 million of non-core assets early in the quarter to bring our year-to-date total to $80 million. We are prepping additional properties to bring to market and have included up to an additional $150 million of non-core dispositions in our outlook. While we don't have any acquisitions included in our outlook, we are having conversations with owners and lenders of wish-list properties in our markets. While we're comfortable being patient, we do believe compelling investment opportunities will arise. To be clear, our criteria for capital deployment is highly selective. Target acquisition opportunities must be well-located in a solid BBD, have good bones, and be well-positioned to generate attractive risk-adjusted returns over the long-term. In conclusion, we're confident about the long-term outlook for Highwoods. First, demand for our Sunbelt BBD portfolio continues to be strong, which positions us to drive meaningful growth in occupancy and NOI following our long-telegraphed trough in early 2025. Second, our $500 million development pipeline will come online over the next few years and significantly bolster our cash flow and earnings. Third, we've been successful monetizing non-core assets and believe we can continue to create additional dry powder, which will also further improve our portfolio and cash flow. Fourth, our balance sheet is in excellent shape and will enable us to capitalize on acquisition opportunities. Fifth, even with higher interest rates, our underlying cash flows remain strong. This supports our attractive dividend and allows us to continue reinvesting in our portfolio. And finally, I want to thank my 350 Highwoods teammates who deliver for our customers and shareholders every day. It is their effort that has positioned us for success for many years to come. Brian?

Thank you, Ted, and good morning all. The leasing momentum we had at the start of the year continues. Our leasing teams are busy and in the second quarter signed 106 deals for 909,000 square feet, including 352,000 square feet of new deals. We are resolute in prioritizing occupancy and we'll continue to lean on our strengths as a long-term owner while strengthening our long-term cash flows. This is evidenced by our portfolio's occupancy outperformance in comparison to our BBDs, by almost 800 basis points. We're seeing solid demand at various price points across our portfolio. As demonstrated by the leasing volume in our development pipeline, the top of the market is doing well, but we continue to see the most demand for our well-located second-generation assets. This is because a large segment of customers and prospects prioritize a premier office experience with a well-capitalized landlord at rents that are more affordable than new construction. To this end, over 70% of our leasing activity for the quarter was in suburban BBDs. Our belief continues to be that the talent within a building is the real trophy and the commute-worthy experience we're delivering is providing the lifestyle our customers prioritize to recruit, retain, and return their talent to the office. Before we walk through the markets, it's worth noting that Virginia, North Carolina, Texas, Georgia, and Florida, five of our core six states, came in one through five in CNBC's recent annual rankings of the best states for business. Our sixth state, Tennessee, was close by in eighth. While Elon Musk may dominate the headlines with his announced headquarter relocations to Texas, there are hundreds of others finding these aforementioned states as welcoming environments for their most valuable resource, talent. This is further highlighted by JLL, who noted Dallas' ascension to the third-largest office-using job market in the nation, recently surpassing Chicago, while Dallas' population is projected to pass the Windy City five years from now. Moving to our markets where Nashville, Raleigh, Atlanta, and Richmond made up almost 80% of this quarter's total leasing volume. In Richmond, our team signed 112,000 square feet in the quarter, including 57,000 square feet of new deals, including a new corporate headquarters location for a Fortune 500 company. We're seeing increasing interest from prospects in our Innsbrook BBD where our market-leading assets and sponsorship are clear differentiators. Nashville signed the most volume in the quarter with 271,000 square feet, including 157,000 square feet of new leases, the largest share of new leasing across our portfolio for the quarter. Our Nashville new leasing volume was bolstered by a large new-to-market customer. Cushman & Wakefield highlighted that the natural market posted positive net absorption for the fifth consecutive quarter. 68% of all leasing activity in the market was either expansions or new leases and new to market requirements increased with 18 tenants looking for more than 850,000 square feet in the aggregate. Further, the most active Nashville submarkets in the quarter were Brentwood and Cool Springs, where our combined leasing volumes were up over 100% year-over-year. As a reminder, these two submarkets encompass 60% of our 5.1 million square foot Nashville portfolio. In Raleigh, our leasing team signed 176,000 square feet of second-gen leases in the quarter, plus 20,000 square feet of first-gen space at our GlenLake 3 mixed-use development. JLL reported aggregate space requirements in the market increased 70% year-over-year and the number of prospects greater than 10,000 square feet increased by 23%. In conclusion, our leasing pipeline is healthy, and our high-quality portfolio is proving its resilience. The flight to quality includes a flight to quality buildings, a flight to quality experiences, and a flight to well-capitalized owners who are willing and able to invest in their portfolios. While facing the same headwinds as all office owners, we're benefiting from the long-term attractiveness of our Sunbelt BBDs and the elevation of a new commute-worthy bar of workplace experience, providing us across a variety of price points gives us a unique value proposition. Brendan?

Thanks, Brian. In the second quarter, we delivered net income of $62.9 million or $0.59 per share and FFO of $105.9 million or $0.98 per share. During the quarter, the State of Tennessee modified the methodology for calculating franchise taxes, which lowers our annual franchise tax obligations and was applied retrospectively. As a result, we received $5.8 million of tax refunds related to prior years. This non-recurring refund is included in other income in our 2Q results and was partially offset by a $1 million non-recurring charge recorded as a reduction to rental and other revenues that also relate to prior years. The net impact is a $4.8 million benefit from these non-recurring items, $2.5 million of which were anticipated in our prior outlook. In other words, these non-recurring items resulted in a net $0.02 of upside compared to our outlook from April. Our balance sheet remains in excellent shape. At June 30th, we had $27 million of available cash and nothing drawn on our $750 million revolving credit facility. Subsequent to quarter end, our unconsolidated McKinney & Olive JV paid off at maturity a $134 million secured loan with an effective interest rate of 5.3%. This property is now unencumbered. Also subsequent to quarter-end, our unconsolidated Granite Park 6 JV paid down the $71 million balance on the construction loan with an interest rate of SOFR plus 394 basis points. In connection with these paydowns, we and Granite each contributed $103 million to the respective joint ventures. These loan repayments will increase our near-term cash flow from operations and also likely be a future source of capital as we plan to obtain long-term financing for both properties at some point in the future when conditions in the secured market are more favorable. As Ted and Brian mentioned, we had a strong leasing quarter, especially new leasing volume. Our lease rate, which includes current occupied spaces plus leases signed but not yet commenced on vacant spaces, is 280 basis points higher than our actual occupancy of 88.5%. And this current lease rate assumes we end up canceling the 110,000 square foot signed but not yet commenced leased at the former Tivity building in Nashville that Ted mentioned. Typically, our lease rate ranges between 100 to 200 basis points above our actual occupancy rate. This current spread illustrates the strong demand we're capturing across our portfolio, which makes us optimistic for a future occupancy recovery. As we stated last quarter, if we continue to post strong leasing volumes, we believe our trough occupancy level early next year will be higher than our original expectations and our recovery will be faster. Our strong second quarter leasing volume certainly supports this trend. As Ted mentioned, we've updated our 2024 FFO outlook to $3.54 to $3.62 per share, which implies a $0.045 increase at the midpoint compared to our prior outlook. As I mentioned, $0.02 of this increase is attributable to the additional unexpected upside from the non-recurring items we recorded in 2Q, with the remaining $0.025 of upside, mostly attributable to better NOI. There are still several variables in our outlook, including projected property tax savings, which aren't assured yet. Same-property cash NOI, which does not include the $5.8 million of prior tax refunds that were booked in other income, does include the $1 million non-recurring charge that relates to prior years. Even with this previously unexpected charge, we still maintained our outlook for growth in same-property cash NOI of positive 0.5% to 2%. Our updated outlook, combined with the strong first half of the year results, implies lower quarterly FFO for the second half of the year. A few items to note. First, we don't expect any significant non-recurring items in the second half of the year. Second, the third quarter is typically our lowest from an operating margin perspective as utility costs tend to be highest over the summer months. Given the heat wave we've encountered so far this summer, we certainly expect lower margins in 3Q compared to the full year. Third, because GlenLake III and Granite Park 6 developments were completed in the third quarter last year, GAAP requires us to cease interest and expense capitalization on those projects in the third quarter of this year. While this will be a temporary headwind to earnings, rising revenues from those projects will fall to the bottom line as occupancy grows. Finally, we have some long telegraphed known move-outs late in the third quarter and early in the fourth quarter, and therefore, we expect average occupancy will be lower in the second half. As mentioned earlier, we expect occupancy to trough in early 2025 and recover thereafter. To wrap up, we're very encouraged about the future for Highwoods. The leasing activity across our Sunbelt BBD portfolio has been solid, which should drive future NOI growth. Plus, we have strong embedded growth potential within our development pipeline as those projects deliver and stabilize. Our balance sheet is in excellent shape, which will allow us to capitalize on future acquisition opportunities, and our cash flows continue to be resilient.

Our first question is from Camille Bonnel with Bank of America. Your line is now open.

Hi, good morning. This is Andrew Berger on for Camille. Just wanted to ask about expenses. It seems rental expenses were a bit lower this quarter. Just curious if there was anything specific driving this?

Hey Andrew, it's Brendan. Yes, there is always some seasonality, but the main unusual factor in the first quarter that didn't happen in the second quarter was related to a tax refund or payment due for 2023 on a triple-net building. We accounted for this as an increase in revenue in the first quarter, but it had a corresponding expense that balanced out to have no effect on NOI. This caused operating expenses to be unusually higher in the first quarter, but that effect did not recur. Additionally, there are typically some savings moving from Q1 to Q2 in operating expenses, and we expect this trend to continue into Q3 and Q4. However, that unusual $3 million item was the most significant change that didn't carry over from Q1 to Q2.

Got it. Thank you. And maybe switching gears to dispositions. Just curious if the buyer pool has expanded at all and any particular markets where you're sensing more interest?

Hey Andrew, it's Ted. Yes, we've closed about $80 million so far this year, with $60 million happening in the past quarter, early in the second quarter. We're hearing what you mentioned. We don't have anything currently in the market to provide data points. However, conversations with brokers indicate that there is a significant amount of capital available, and it seems people believe we are nearing the bottom of the capital markets. Consequently, there are more bidders looking at assets and making offers.

Got it. Thank you very much. Congrats on the quarter.

Thank you.

Our next question is from Georgi Dinkov with Mizuho. Your line is now open.

Hi, thank you for taking my question. Can you talk about mark-to-market and where do you see that trending over the next few quarters?

Sure. Look, this is Ted. I think mark-to-market is pretty flat. And I wouldn't expect that to change over the next couple of quarters. As you know, we're still facing a challenging leasing environment, with a lot of headwinds. So, I would think it's going to be bouncing around roughly where we are from a mark-to-market perspective.

Great. Thank you so much.

Thank you.

Our next question is from Young Ku with Wells Fargo. Your line is now open.

Yes, good morning out there. Just wanted to go back to your comment on the Tivity backfill lease. I'm not sure if that's going to be impacting the commencement timeline, but any details would be helpful.

Yes, I don't anticipate significant changes. As you know, they were planning to make adjustments regarding rent, and Brendan can elaborate shortly. We have promising prospects in that area. We're focused on developing Cool Springs V and have several potential tenants to fill that space. The situation with Landmark is positive; the activity in that submarket is strong. When they approached us about facing challenges in their business and reevaluating their office requirements, we felt it was not reasonable to commit them to a lease that wouldn't serve their long-term needs. Given the interest in the space, we are currently negotiating a solution that benefits both parties.

Yes, Young, it's Brendan. To provide some context regarding our expectations for this year, we anticipated no revenue from the backfill user in that area for 2024, and we have also removed that from our occupancy figures. Despite this, we remain optimistic about the overall outlook. We still expect occupancy at the end of 2024 to align with our previous estimates, excluding the backfill, and we do not foresee a significant near-term impact on earnings. Ultimately, we believe this will lead to a more positive long-term outlook for the building. We do not expect much impact this year or next, and we see this as advantageous for our current customers, future clients, and beneficial for us in the long run.

Got it. Thanks, Brendan. I want to discuss guidance a bit. It seems the core expectation is up $0.025, but your assumptions haven't changed much. Can you talk about the details?

Yes, that's a good question. We did not alter our assumptions on same-property. We did incorporate the $1 million charge from prior years into the same-property figures. Without that charge, we likely would have increased the same-property outlook. We haven't changed the straight-line numbers, but we've been working with several users, offering some short-term free rent in return for lease extensions, which has slightly impacted the cash NOI negatively. However, we have balanced that with improved activity in other areas of the same-store portfolio. All these factors at the fundamental level allowed us to maintain our same-property outlook despite facing some challenges within those figures. Overall, we believe everything else is trending positively, even with the increase in FFO.

Got it. Thanks, Brendan.

We have a question from Michael Griffin with Citigroup. Your line is now open.

Great. Thanks. First question was just on kind of the leasing environment and expectations there. It seems like particularly new leasing has been pretty solid this first half of the year. Can you give us a sense, are these expansions? I mean, are tenants more willing to sign and commit to leases? And has the environment kind of improved at all as we look toward the back half of the year?

Hey Michael, it's Ted. I'll start, and if Brian wants to join in, he can. As you saw, we've had our third consecutive strong leasing quarter, and I can tell you that our leasing team is focused on securing every possible deal. Interestingly, the typical summer slowdown didn’t occur this year in most of our markets, with only a few exceptions. Overall, our leasing team is busy. Our pipelines have been slow for a while, and I believe I mentioned last quarter that we are starting to see larger deals, which I define as full floor or two-floor transactions, ranging from 25,000 to 50,000 square feet. We're also closing some of those. Additionally, I think we are benefiting from some distress in the market; buildings lacking capital for investment are allowing us to gain market share. There seems to be a divergence in the market. But overall, our activity is strong, our pipeline is full, and I'm optimistic that the latter half of the year will continue to be robust.

Michael, I might chime in. This is Brian. The three years of kicking the can and kind of coming to consensus around return to work, we're seeing that come to roost. We even forwarded an internal e-mail to a 185,000-person company whose CEO is like, look, we're better together. We're back this fall; I look forward to seeing you. That's the short version. So, I think those bigger companies that have kind of delayed making those decisions can now have conviction around making decisions. I think we still are generally expanding more than contracting. The bigger ones are more rightsizing in general. We're seeing that across, whether it's in our portfolio or outside the portfolio in the markets, but it does feel busy for sure.

And Brian, to that, have large space requirements picked up across your markets, or is it still kind of that small to medium-sized tenant that you're seeing mostly?

Great question. I have some notes regarding the market, and I find it quite interesting. Inbound inquiries have been relatively quiet due to rising interest rates as everyone waited to see what would happen. However, those inquiries have returned. Economic developers and Chambers of Commerce are re-engaging, and it's noteworthy that they are involved in multiple markets, which often overlap. We can expect to see the same inquiries appearing in different cities. Activity has definitely increased, with some of the inquiries being quite substantial. For instance, Oracle has announced its headquarters relocating from Texas to Nashville and has also expanded its presence there. The pipeline for new inquiries is becoming more evident. In terms of size, the Nashville inquiry involves around 500,000 square feet, which is likely the largest we've encountered recently. To Ted's point, these businesses tend to require two or three floors, and they are now more prominent on our radar, which is encouraging to see.

Great, that's helpful. And then just one more I'd be curious to get your thoughts, Ted, you mentioned in your prepared remarks that there are select acquisition opportunities that you're looking to see. I mean when you're underwriting these prospects, are these high-quality buildings that might have poor capital structures where you could contribute equity or maybe assume the mortgage? And then can you give us any sense of kind of what hurdle rates or IRRs you're underwriting to on potential acquisitions?

Sure. On the acquisitions, you need seller financing to secure higher quality and larger deals. We're considering a mix of factors, focusing on high-quality assets in our submarkets that are solid and offer attractive risk-adjusted yields. The yield varies based on the asset's profile; for instance, a core building will require a lower yield than a large value-add asset. These assets might currently be 80% leased but could drop to 70% or less. While we're exploring various options, the yields are definitely in the double digits. However, the number of distressed deals is increasing, and there are many options available, though it's challenging to finalize them since lenders are slow to act, and some owners are trying to safeguard any remaining equity. We're finding the current environment tough, but we plan to stay patient, as opportunities will continue to arise.

Great. That’s it for me. Thanks for the time.

Thanks, Michael.

Our next question is from Rob Stevenson with Janney. Your line is now open.

Good morning guys. Brendan, what's the magnitude of the projected property tax savings in the back half of the year? Trying to get a feel if this is up to $0.01 or more than that? And is that a one-time thing or is that expected to recur in 2025 and beyond given your comments about no significant non-recurring items in the second half year?

Yes, Rob, it's about $0.01, could be maybe $0.01 of upside with, I would call it, a roughly about $0.01 of downside if none of that was realized. And the vast majority of that would be recurring, so related to this year and would recur thereafter.

Okay. And then how material is the additional interest expense on GlenLake and Granite Park that you can't capitalize? Trying to get a sense of the headwind there.

I'm going to explain this for you and everyone else on the line, and if you have follow-up questions later, I'm open to discussing them. I want to provide some context as I know it can be a bit tricky to model. To date, we've spent approximately $150 million on the two projects. Currently, they are about 20% occupied, which means 80% of the capital is being counted as interest expense. That 80% of the $150 million amounts to $120 million. If you apply a 5% capitalization rate, that translates to roughly $6 million annually, or about $1.5 million per quarter. We plan to stop capitalizing interest by the middle of the third quarter and will not capitalize any interest in the fourth quarter. Additionally, there are operating expenses that are capitalized for the unoccupied portions of those buildings, which have an impact of about $0.5 million when you compare the second quarter to what we expect in the fourth quarter without those capitalized expenses. This results in about a $2 million impact on a quarterly basis. As it stands now, we are not generating much NOI from these assets, especially since we will have no interest capitalization around the middle of the third quarter. As these buildings lease up, the resulting revenue will significantly benefit our bottom line. There is a considerable upside potential for the second half of 2024 as these assets become fully leased.

Okay, that's extremely helpful. Thank you for that detail. And then the last one for me. Ted, how are you looking at these dispositions? Has the pricing for assets improved as we get closer to the rate cuts? Are these going to be pretty similar pricing to the year-to-date sales? How would you characterize that?

Yes, Rob. Again, we don't have anything in the market right now. But what we're hearing is, again, there's more capital looking to come back. The debt markets, while they're still challenging, CMBS is coming back. I think there's a hope that an interest rate cut might be coming in September and I think that's going to help. So, all these things, hopefully, are going to be coming together by Labor Day or the back half of the year going to enable more things to start trading. Obviously, smaller deals are what we've been selling. They're easier to get done than larger deals. So, certainly, I would expect pricing is going to get better, is my view, just given the amount of capital that's out there if interest rates come down. All those things should be good for asset pricing. Now, in terms of what we're going to sell, obviously, we sold some quasi-medical buildings in the first half of the year. So, I would expect the yields on the dispositions going forward are going to be a little bit higher than what we have achieved earlier this year. But still, again, we're hopeful the price is going to improve for our next wave of assets.

What are you going to use the proceeds for? I mean, is that just to fund the remaining on the development commitment or is that earmarked for something else because you guys don't have any near-term debt maturities?

Yes, Rob. Yes, obviously, we've got a little bit of development spend to do. There are capital that's kind of, in general, I would say, available. I think we've found good uses of capital. So, if you just think about what we announced subsequent to quarter to quarter-end, right, we paid off a mortgage that we had coming due at a JV property with our partner. We paid down a relatively high interest rate construction loan. So, there will be uses of that capital. And then, of course, that's replenishing the dry powder to then hopefully be able to reinvest into investment opportunities.

Okay. Thanks guys. Appreciate the time this morning.

Thanks, Rob.

Our next question is from Peter Abramowitz with Jefferies. Your line is now open.

Thank you. Yes. Just wanted to take a step back. Brendan, you've made these comments around occupancy, I think, this quarter and last quarter, that your expectations around the recovery once you've cleared those known move-outs are probably higher than they were this time a year ago or when you started this year. Just wondering if you could kind of dig into that a little bit? Wondering kind of what do you see as the long-term potential for your stabilized occupancy in the portfolio? You're hovering around 88% today and for the last couple of quarters. I think at peak before the pandemic was somewhere in that 93% range. Just wondering if you could comment around kind of long-term potential, where do you think you can really stabilize occupancy?

Hey Peter, thanks for the question. So, I'm going to start and maybe give you some color as to why we're so encouraged in terms of the activity that we've seen and the potential, and then maybe I'll let Ted and Brian opine on where they see the stabilized levels. But if you go back to the beginning of the year, the portfolio was around 89% occupied and the lease rate was around 91%. So, we were around 200 basis points higher on lease rate. During that time, occupancy has come down a little bit, so we're down about 50 basis points. Yet at the same time, our lease rate has gone up to 91.3%. And if you think about in the beginning of the year, we also had within that lease rate the 110,000 square foot backfill user at Cool Springs V. That is now stripped out of the 91.3%. So, I think that gives you context in terms of just the good activity that we're seeing and how much net absorption we're driving on the operating portfolio. So, that really makes us optimistic in terms of kind of that if we can sustain this level of leasing, that that's going to drive the recovery in occupancy kind of when we get to what we expect to be trough levels early in 2025.

And then the only thing I would add on stabilized occupancy, look, I think you're right on pre-COVID we're in that 92% to 93% range. I don't see any reason why we can't get back to those levels. If you think about what we've done over the last several years, we've significantly improved our market selection, our portfolio quality, and I think the trends coming out of COVID, the flight to quality and the flight to capital. Never has it in my career been more important to be a landlord, a well-capitalized landlord. So, I think we're going to continue to gain market share at the expense of others. So, look, it's going to take some time without a doubt, right? I mean we've got to work through the next year or so. But I think we can get back to a stabilized in that 92% range probably in the next several years.

That's helpful, Ted. Thank you. And thank you, Brendan. And then just one other one. Could you just comment on any update and color on the role kind of distressed activities playing in the transaction market as you look at deals?

Yes, regarding the distressed transactions, is that your question, Peter? Correct. There are definitely distressed transactions, and they are taking a long time. It's frustrating for everyone, but I remind our team that after the global financial crisis, it took about four years for the best quality distressed assets to emerge, and that's what we're looking for now. Currently, there is quite a bit of distress in lower-quality assets, and those are beginning to trade with some price adjustments. However, those are not the assets we are targeting. We have a well-defined wish list of assets, most of which are not distressed. Many sellers do want to sell eventually, but it's going to take time. While there is a lot of distress in the market, it doesn't apply to the assets we are interested in, or if it does, they are difficult to acquire.

That’s all for me. Thank you.

Thank you.

Our next question is from Dylan Burzinski with Green Street. Your line is now open.

Hi guys, thanks for taking the questions. Just sort of curious, I know you guys have been focused on prioritizing occupancy as you sort of work your way through some of the known move-outs. But I guess, just curious sort of what that means for net effective rents as we sort of think about the trajectory there. I mean it seems like base rents are still holding steady. But I guess from a concession point of view, have things started to stabilize there? Or are you continuing to see further pressure on that front?

Hey Dylan, it's Ted. I'll begin, and if Brian has anything to add, he can jump in. We're seeing some stability in our key properties, including the Brentwood in Nashville and South Park in Charlotte, which are performing well for us. However, overall, there is still pressure on net effective rents. We're generally keeping face rents stable, and in some areas, we're actually increasing them. However, the pressure on tenant improvement costs hasn't lessened much. Offering free rent remains quite common, typically around a month per year of lease term, which continues to pose challenges. On the positive side, we're securing longer lease terms when we invest more in tenant improvements, which is a trade-off we're willing to make for quality tenants. Still, there's no indication that this trend will change, except in certain submarkets. Markets are increasingly differentiating between submarkets, so a detailed analysis is essential. This trend also applies to vacancy rates; much of the vacancy is focused in a limited number of buildings. Therefore, we don't expect this situation to improve in the near future, and we're still dealing with the same challenges we've been facing.

I appreciate that. Regarding your comments on acquisitions, it seems like there isn’t anything imminent. I’m curious about how you perceive the acquisition environment in relation to your balance sheet, and whether you’d consider leveraging a bit if acquisition opportunities come up.

Yes, I'll start, and if Brendan wants to jump in. Look, I think we're laser-focused on continuing to build our dry powder and get a few more dispositions out the door. Things don't happen in a linear fashion all the time, Peter. So, we've proven over the years we've been able to flex our balance sheet if and when we need to. But as you stated, really, there's nothing imminent from our standpoint. We're not afraid to do it if we need to. But right now, we're focused on the disposition side. And then finding the right acquisition at the right price. Again, the nice thing is our underwriting team, they're getting a lot of practice right now. We're getting a fair amount of reps in, but nothing imminent at this point.

Yes, Dylan, I would add that we have many options regarding capital availability. As Ted mentioned, over time, the trend is likely for leverage to decrease rather than increase in the long term. However, as Ted pointed out, that won't happen in a straightforward manner.

Appreciate the comments. Thanks guys.

Thank you.

We have a question from Michael Lewis with Truist. Your line is now open.

Thank you. I wanted to approach the last question from a different perspective. We have previously discussed funding sources for acquisitions. Your stock has increased nearly 30% so far this year, but I recall it is still significantly below the consensus NAV. Would you consider issuing stock below NAV to finance an investment if it would be accretive and make sense, potentially helping to lower your leverage as well?

Michael, it's Brendan. We consider all sources of capital. Over the past several years, we've been successful in our investment program by monetizing non-core assets and reinvesting that capital into development and acquisitions. This approach has positively impacted our cash flow, kept our balance sheet stable, and improved the overall quality of our portfolio. That model has served us well. In previous cycles, equity played a role in that strategy, and it's still an option. However, we've effectively invested a significant amount of capital in the last five to six years in a balance sheet neutral manner, primarily utilizing proceeds from non-core asset sales. This remains our priority, but we will explore other capital sources if it makes sense.

Okay, great. My second question is about the two joint venture loan paydowns. I'm interested in the options you considered. Is there any insight into the refinancing market regarding available capacity or proceeds, or is the pricing too high? Alternatively, if you wait a couple of months, might the Federal Reserve cut rates multiple times, allowing for a more favorable refinancing later? In one of your previous answers, you mentioned that there might not be a better use of capital right now than paying down those loans. How did you evaluate your choices and decide to pay down those loans instead of refinancing now?

Yes. Good questions. Each situation is a bit different. At M&O, we previously mentioned that we have a customer who needed to expand, but we couldn't accommodate them, so they are relocating to 23Springs. The lender there was less willing to offer a higher loan-to-value ratio or the valuation was lower due to the upcoming vacancy. We are confident about finding new tenants with strong prospects that we have already secured, which will help us approach lenders for more financing on that property. We wanted to stabilize the rental income before going back to the mortgage market to secure what we consider attractive terms on a new loan. This is why we haven't proceeded with a refinance at this time; it feels more temporary. In regard to Granite Park 6, that was more about taking advantage of the situation. Given the current rates for SOFR and the spread on the construction loan, the interest is higher. To clarify, we didn't pay down the entire loan; we just reduced the balance but the loan remains active. We still have the option to draw on that construction loan for future funding if we decide to. However, considering the capital we have and what our partner has, it makes financial sense to manage the high interest on that one right now. Once we stabilize that building, we plan to approach the mortgage market, which should provide a favorable source of financing for us and our partner.

I believe this highlights the strength of our joint venture partner, Granite Properties. We were in perfect agreement on the strategy for both assets, and they were able to contribute significantly alongside us to facilitate these paydowns.

Good option. Thank you.

We have a question from Omotayo Okusanya with Deutsche Bank. Your line is now open.

Yes, good morning everyone. Brendan, I was hoping you could go back to 2024 guidance. I guess still trying to understand some of the overage that you talked about earlier on, again, taking out the tax refund situation, this kind of $0.02 increase on better NOI. But again, none of your same-store numbers really changed. I know there's a kind of additional $1 million charge now that's in the numbers. But could you kind of walk us through exactly what that NOI increase at the end of the day is, especially if it's kind of coming from non-same-store NOI?

Yes, Tayo. I would like to clarify that the increase in NOI is from our same-store properties. We anticipate cash same-property NOI growth. While there is some overall cash benefit, it has largely been negated by a $1 million charge that wasn't included in our previous outlook and affects our same-store performance. The additional $0.025 increase is mainly attributable to non-cash elements. As I mentioned earlier in response to another question, we’ve initiated some lease extensions with certain tenants that include some proactive free rent for 2024, which we did not forecast before. However, these are beneficial deals for us, extending those leases well into the future. This presents a slight cash impact in 2024 for advantages we will see in subsequent years. So, it all contributes to NOI, but part of it is GAAP NOI and not cash NOI, which is our focus.

Got you. Okay, that’s helpful. Thank you.

We have no additional questions at this time. So, I'll pass the call back to the management team for any closing remarks.

Well, thanks everyone for joining the call today and thanks for your interest in Highwoods. If you have any follow-up questions, please feel free to reach out, and I look forward to seeing you soon. Thank you.