Brandywine Realty Trust (BDN) Earnings Call Transcript & Summary

Good afternoon, everyone. Welcome to the 4:15 p.m. session here at Day 2 of Citi's 2022 Global Property CEO Conference. I'm Manny Korchman, joined by Parker Decraene from Citi Research. We're pleased to have with us Brandywine Realty Trust and CEO, Jerry Sweeney. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those of us joining us in person, you can use the mics in the room to ask us any questions. Otherwise, everyone is invited to use live QA or the question box on the Citi Velocity webstream to ask any questions -- written questions, and I will ask them here. With that, Jerry, I'll turn it over to you to introduce any of the management teams -- management team members that are here with you, and then we'll go to Q&A.

Great, Manny. Thank you very much, and great to see everybody in person. I'm joined today by Tom Wirth, our Executive Vice President and Chief Financial Officer, and certainly look forward to any questions you may have.

That was quick. You usually do an intro.

I can do an intro?

I'll go to questions, it's fine. I still can't remember how we do it.

I'm so unused to dealing with people in person, it's like a dance.

What are the top 3 reasons an investor should buy Brandywine stock today instead of any other listed property company?

Yes. I think there are 3 really compelling reasons. I think, first, is the existing portfolio growth and quality characteristics, and I can certainly amplify those as we get into more Q&A. Secondly is the unique mixed-use development pipeline that we have. The development pipeline we have, particularly anchored by Uptown ATX and Schuylkill Yards, gives us the ability to double the size of the organization over the development cycle. And then third piece, I think, is that the composition of that development pipeline is very mixed use. So it's comprised not just of office but over 1/3 life science and about 1/3 residential well. So it gives Brandywine has a tremendous ability to diversify its revenue stream through the development cycle. We can't hear you, Manny.

I had to mess it up at some point. Jerry, think about the mixed-use nature of the pipeline you mentioned, Typically, REITs that have been mixed use have not gotten credit for it. If anything, it's hurt them or people prefer a pure play and especially pure play that is easy to underwrite. How do you guys use those sort of maybe countering points of having a larger opportunity set in doing the multifamily and the office and maybe some retail versus sticking to your knitting and being just office?

Good question. And I think within the food group so we can build out, certainly, office is about 40%. Another 1/3 -- another 30% is life science. So we view those as 2 very closely related food groups, the balance being residential, amenity, retail and hospitality. And I think one of the distinctions, Manny, is that those additional product lines are to be developed within our mixed-use master development communities. So signs that we're branching out and doing spot residential development. And I think as we have done in the past, when we have done residential developments that have turned out to be very successful. We have done those on a partnership base with either a residential development company or brought third-party equity in there and then really retain the optionality of either holding those assets or selling those upon stabilization to create a real value harvesting point for our shareholder base.

And I guess the -- building them first and selling them later, why do that versus just selling opportunity to somebody else upfront?

Well, certainly, that's option is on the table as well. I think at Uptown ATX, we did commence with Block A, which is a combination of office and residential. It's part of an integrated design and development program with a shared garage. So in that case, it certainly made more sense for us to do that as one targeted development. The next phase we have at Uptown ATX, we've already identified the partner for that first phase -- for the first phase of Block F, which will start later this year. And then we have an awful lot of additional residential development we can do at Uptown, which certainly all options will be on the table for the best way for us to both finance and develop those.

And when you go to this contract of potentially doubling the company over what time frame, if this development were to play out exactly as you intended to, how long does it all take?

Well, we think the development cycle for Schuylkill Yards and Broadmoor is ideally between 5 and 7 years but certainly could be between 5 and 10 years. But now that we've actually have all the approvals in place, we've actually commenced construction of the first phases. I think the objective is to continue the build out program.

Right. And maybe we'll just jump right into the capital funding for that. Remind us what you've done so far and how you intend to do the rest of it.

Yes. I mean, certainly, the -- we've been fairly successful in attracting third-party equity into these projects from an investor standpoint. So the typical capital stack we have pulled together is about 35% equity, which has been typically split 50% Brandywine, 50% by our outside partner. We have structured those outside partnerships on a preferred basis. So there's a set coupon and a very minimal percentage upside participation by those partners. And that seems to be a very good formula for us as we bridge through those -- through the existing capital markets for office REITs. The other thing that we've been able to do is in those structures get a fairly high amount of imputed land value that counts towards our equity component which has reduced our cash component that's required from Brandywine to proceed with those developments. So for example, at Schuylkill Yards, the first phase, we're already fully funded our equity. Same thing, Broadmoor Block A as well as block F when we kick off through the imputed land value and the amount of money we invest in the design development process. So very effective use of our capital thus far.

Maybe we'll stick on -- stick to Uptown ATX. Just remind everyone what's going on there and what stage you're at, when the first buildings will deliver there.

I'm sorry.

In Austin, just where that project is right now.

Yes. The first phase we commenced late last year. That first phase consists of about 350,000 square feet of office and apartment units. The first component of that will -- to be delivered with the office will be delivered in the third quarter of '23 and the residential phase in starting third quarter of '23 through first half of '24. The next step that will take is the development of the first phase of Block F, which will commence construction sometime later this year and have about a 20-month build-out. So we expect to really be delivering stabilizing these assets in 2024.

There was recently a sale of a land site. I guess, catty-corner from you or on the corner of you and across The Domain. Is that something you guys looked at?

Yes, the site that Kilroy announced other day, look, there's an amazing velocity of land sales in Austin both in all the different submarkets. So that site is about a mile from our site, is in close proximity to the -- what will be the McKalla train station next to the soccer stadium. So it looked like a good site. But certainly, there's been a -- given all the demand drivers in Austin, there's been an ever-increasing amount of land that has traded. We think the price points that we're seeing on land trades today including the trade you mentioned are great validations of the land bases we have at Uptown ATX.

Was that just comparing the valuation there to what you are contributing at? How off or how different was that valuation?

Yes. I haven't seen all the final numbers on what that trade was. But I think it was between $80 and $90 in FAR foot, if my information is right. We're about $30 less than that on a fully approved and improved basis.

Okay. Given that, is there any consideration of just selling some of this land rather than doing it yourself at all?

Not necessarily at this point. I mean, I think we have the land sales program in other parts of the company where we expect to realize between $40 million and $50 million of land proceeds this year. where we have select out parcels we just don't think are core to our growth platform going forward.

Okay. And then maybe I'll just switch right to Schuylkill. How is construction progress there been?

Construction products is great. The project we have underway right now is a 326 million unit residential project that's on top of 200,000 square feet of life science and office space with a below-grade deck. That project will be delivered in the third quarter of '23. Construction is on schedule, on budget. And the leasing pipeline for that project right now, it's about 600,000 square feet. So we have a number of good prospects that we're talking to. As we talked before, we weren't really expecting to get any real definitive leasing activity on that until the fourth quarter of this year, first quarter of next year, and we think we're on track for that target.

And that will be office leasing or life sciences?

Well, it's a 200,000 square foot block of commercial space. It can go either fully life science or fully office. So the pipeline right now is a mix of office and life science companies.

You opened the incubator space there, I don't know, maybe it was a few weeks ago, maybe it was a few months ago. Any interesting anecdotes that you can share out of that?

I'm sorry, Manny, repeat, please.

Incubator at Schuylkill Yards, life science incubator. Anything interesting coming out of that, that you can share?

The interesting thing on that is demand outstripped our available benches, and we opened January 2nd of this past year at 95% leased. We have -- we're initially targeting, frankly, smaller start-up companies. Right now, we have about 14 companies in that incubator now. We're actually building out some additional graduate space and a couple of floors above the incubator. And I think it's working out exactly as we hope we're getting about a 9% return on all in a fully loaded invested capital there. And one of our real reasons for doing that was to create a forward pipeline of companies that would be receivers into Schuylkill Yards. And based upon the early visibility we have out of those incubator tenants, we think we have visibility for a couple of hundred thousand square feet within the next 12 to 24 months. So it really did prove the thesis that there's a number of graduate-level startup life science companies within the Schuylkill Yards ecosystem that we think will continue to grow. Another great announcement that was made several months ago, was that Roche Pharmaceuticals, which bought Spark Therapeutics, which was a publicly traded cell and gene therapy company incubated by Children's Hospital of Philadelphia. Roche acquired them a number of years ago for about $5 billion. Roche just announced that they're investing between $500 million and $600 million on a site adjacent to Schuylkill Yards to create a research and manufacturing facility that will serve as their hub for the eastern part of the United States. So we thought that was a tremendous marketing tool for Schuylkill Yards. And it really does, if you think about it, create a fourth anchor institution in that section of university city between Children's Hospital, University of Pennsylvania Health Care System, Drexel University and now Roche. So that employment base and that capital investment, again, in a fixed plan owned facility, we think, portends great things for the growth accelerators that we're starting to see at Schuylkill Yards.

Great. the comment you made on the incubator companies then growing into, I think you said 100 say, 100 to 180. Maybe I misheard that.

I'd say early visibility for about 200,000 square feet of space.

How many companies are you talking about in that 200? Is that 5 companies at $40,000 a piece? Is that 8 companies at $25,000 a piece? Is it one company at $200,000? Just kind of thinking about do you then have to build new white boxes that are a little bit bigger to kind of get those companies in versus looking at full floor and then multi-floor deals.

Yes. No. I mean most of the companies are targeting kind of growing out of the incubator into kind of 40,000 to 50,000 square feet.

And so where would you accommodate them? I thought you're trying to get sort of bulkier tenants into what you're building there.

Well, there we have the availability in Schuylkill Yards West. And then certainly, as we've talked, one of the next projects we're looking at starting at Schuylkill Yards is a 427,000 square foot dedicated life science building that's fully designed, fully priced. And based upon the level of activity you see both in the capital markets and from a tenancy standpoint, our game plan is to start that in the next several quarters. and that would deliver within 22 months.

And if things continued as they are today, do you think there's comfort on both the demand and the capital market side to do that?

We do. Yes.

And when you say capital markets, that's finding a separate JV partner that's keeping it all on balance sheet? What do you mean by the capital markets under that?

Yes. I mean, certainly, we've been able to identify a number of really high-quality potential investors in a number of our Schuylkill Yards and Uptown ATX projects. So we've had a number of discussions with some of those partners on the next phase of Schuylkill Yards. So we feel pretty comfortable that we'll be able to identify the right third-party equity structure to facilitate the start of that building. Certainly, the debt marks that we've seen on a variety of our development projects is still very deep and very robust, and we've been able to successfully line up construction financings for those as well.

All right. Go back to the questions we're asking everyone. What is the biggest growth opportunity that you believe the market is not giving you credit for?

Yes. I think the biggest growth opportunity is what we've just been talking about, which is the ability to generate significant value through our development pipeline. It is a significant scale. So the total development pipeline in building out Schuylkill Yards and Uptown ATX is north of $5 billion. It can more than double the revenue stream of the existing asset base. We're targeting returns in the 7% range and, on a levered basis, very, very attractive internal rates of return. So we know there's a lot of work we need to do to effectively line up the appropriate financing to get those done. But I think when you take a look at the value creation potential of those master developments, it's pretty significant.

And so what part of that do you think the Street is missing? Is it the magnitude of what it could contribute to you? Is it how much capital it might take or how those partnership structures look? Is it something else? Because we've been talking about what's Schuylkill and Broadmoor or Uptown ATX now for what feels like -- feels like a long number of years. So feeling that the market knows about them, so what part are you not getting credit for?

Well, I think it's the validation of the proof of concept. I mean, a lot of the time, Manny, that we were talking about those projects was going through a fairly arduous approval process to get the actual perfection of the master development plan to proceed. Now that we have actually started the vertical development of both of those projects, I think there's a much higher level of visibility on when those economics will present themselves. And I think given what we've been able to do on both the Uptown start as well as the Schuylkill Yard start, I think we have demonstrated the capacity to effectively finance those projects in a way that's incredibly accretive to our shareholder base. So I think as those projects move through their development and construction cycles, our hope is that we get more recognition for the value that those as well as the subsequent phase of those projects will deliver to our shareholder base.

Okay. During your last earnings call, you talked about a significant amount of income coming from vacancy leasing. What's been the progress in getting that leasing done? And what does your leasing pipeline look like today across the portfolio?

Yes. The leasing pipeline today for our operating portfolio is actually back above pre-pandemic levels. And I think one of the things that we've seen that's really interesting is -- and I'm sure you've heard this from some other office companies, is there really is a strong quality bias. I honestly don't know if it's going to -- if that's going to be a durable trend. But there is no question right now that a lot of tenants who are in the marketplace are looking to move up the quality curve in terms of their physical locations. So we're actually really happy with the level of pipeline that's been building. It's been very, very strong in the Pennsylvania suburbs, extremely strong in University City, Philadelphia, both from office and life science tenants. Very strong and getting stronger in CBD Philadelphia. And of course, Austin has been very strong for us as well. The one market we really haven't seen significant demand drivers is our remaining small footprint down in Washington, D.C. That's still been slow to recover. So when we look at some of the existing vacancy that can add significant near-term value, one of those is our 405 Colorado project in downtown Austin. We've executed a few leases since our earnings call. We have a pipeline of projects that we think we'll get that project to in the 80%-plus range within the next couple of months. We've had some good success backfilling some vacancies in Cira Center in University City of Philadelphia and also attracted a couple of out of city tenants to our Three Logan project in Philadelphia. We've essentially backfilled all of the SHI space in Barton Skyway and picked that up. So our remaining vacancy right now is really in 2 major blocks, both of which are in Met D.C. We have a building in Tysons Corner called 1676, which has about 180,000 square feet to lease. That has been, frankly, a slow process. We have a large pipeline in terms of number of tenants, but most of the pipeline is fairly small in size. So when you have 180,000 square feet to lease, it's great to get deals done, but you want to get a 50,000 or 60,000 square foot deal done versus a 6,000 one. And then we have a vacant building on the toll road that was vacated by defense contractor a bit ago. And we're in lease negotiations with a couple of tenants now who would take about 80% of that building. So if we continue to make incremental progress at 1676 and get these larger leases across the finish line at 2340 Dulles, I think that will generate some good earnings growth for us into 2023. The other thing that's interesting is our -- if you look at our numbers for '22 in our business plan, our spec revenue target is a lot higher than it's been the last several years. We've made really good progress on that spec revenue target. I have more work to do, but we think executing those leases by the end of calendar year '22 will put us in a very strong position to generate very solid core revenue growth in '23 and '24 because the other thing that we've been able to do during the pandemic is solve a lot of our forward rollover exposure. So when you take a look at our core portfolio, our rollover in '23 and '24 is below 8% each year. And in '23, for example, our largest rollover -- or exploration I'd say rollover -- our largest exploration is only 54,000 square feet. So a lot of those big rolls are well behind us. They've either been backfilled or otherwise handled. So the -- one of the other points that gives us a lot of confidence on the development platform is the stability of the existing operating platform that we've created over the last 2.5 years.

Got a question here in the live QA queue and it's related to just overall occupancy in the future. And specifically, is there a difference between cities? So you're operating, obviously, the majority of your assets are in Philly and growing in Austin. Are you going to see any significant differences between those 2 geographies when it comes to long-term office occupancy utilization?

No, good question. And look, I think -- when we look over the last couple of years, we think our portfolio has come through in extremely good shape. I mean right now, our overall occupancy range is kind of in the 91% to 93% is our target for '22 business plan. So right now, we're about 91.3%. But if you start breaking that down by submarket, we're about just shying 96% leased and -- I'm sorry, 96% occupied in Philadelphia CBD, 93% in University City, 92.5% in the Pennsylvania suburbs and then about 91% in Austin. So we really haven't seen that much of a disparity between the markets, the key submarkets we are in. The notable outlier really is our D.C. portfolio which again is we're down to 5 wholly owned assets there, and the occupancy levels there are in the high 60s. So that's really been skewing down our overall company averages. But when we take a look at CBD Philadelphia, University City, the other submarkets with a very manageable rollover exposure we think we have for the next several years, actually, through '26, our rollover is below 10% in each of those years. We really do think, as the office markets continue to recover, more people return to the office, we think we're in a really good position to move those occupancy levels back closer to our historical average has been in the 94% to 95% range.

On the topic of returning to office or hybrid work or somewhere in between, what have recent tenant discussions been like? What do they expect of their workforces?

Yes. I mean most -- our overall occupancy level or utilization rate is a little bit north of 40% across the portfolio. I mean that's significantly skewed, though. Most of our tenants who are less than 50,000 square feet are back anywhere between 50% and 100%. We have a number of very large companies in our portfolio who have been very slow to bring their people back to work. So for example, one of our major tenants in Austin, Texas, is IBM. They've only started to bring their people back March 1, right?

March 1, right.

Blue Cross in Philadelphia has only started to bring their employees back. So I think what we're going to see now that a lot of the public policy restrictions and mandates have been lifted. I think we will see a rapid acceleration of people coming back to work. A couple of green shoots I thought had been interesting. One was the quality buys that we talked about a few moments ago. The other thing is one of the things we were very concerned about was if people move to a hybrid work schedule, they would start to move to a hoteling concept as well. And what we're actually seeing across the board, and we did 111 leases last year, we have another several hundred thousand leases in space planning now, we're actually seeing no tenants up for hoteling. So even if they're moving to a 3- or 4-day hybrid work schedule, every employee is still keeping their offices or their workstations. And actually what was kind of interesting is of all the space planning and construction we did last year, the ratio of workstations to offices didn't change. We actually there'd be more of a bias to larger workstations or offices. It still stayed right around 65% workstations, 35% office, and that wasn't all the deals you did. And last year, we did 25 expansions of existing tenants, which we were very concerned about potentially having a complete space reconfiguration underway and that really didn't happen. So we're actually -- we're thinking the second half of this year should be a much better one for the office sector with a lot of these larger employers actually making decisions to kind of return to the office. A major focus on amenity programs, high-end physical plant conditions. I mean I really do think that employers have started to rethink this whole concept about the physical spaces that they occupy being used to kind of help them define the culture of their company, using that culture to define the brand and then really using that brand to improve productivity, profitability, employee retention. So what I'm hearing from a lot of the CEOs of our tenants that I talk to, they're very focused on getting their people back into the office. I think there's still a little bit of distance whether that's going to be 3 days a week, 4 days a week, 2.5 days a week. But I have to tell you, even before the pandemic, most companies were fairly flexible on what the in-office requirements were for their employees anyway. So if you had a soccer game, you could work from home or your children had a soccer and get a doctor's appointment. So I think flexibility has been in the workforce for a number of years. We've kind of redefined that to be hybrid, but I actually think the flexibility components have been there for a lot of the large companies for a long period of time. And certainly, the smaller companies have typically been ahead of that curve anyway.

Do you worry at all about the amenity or amenity operator offerings struggling with more of that hybrid concept? So it's not about necessarily the desks being occupied upstairs but it's the muffin cart in the lobby. It's the vendors that are selling things that -- do they struggle in this concept of a hybrid sort of schedule.

Yes. I think they certainly could. I think, look, there is a very strong bias, Manny, towards full amenity programs in these buildings. So as some of you have looked at some of our developments of our existing buildings, we've renovated a lot of lobbies, put in a lot of additional amenities during the pandemic. And frankly, we tend to look at the workplaces beyond just the walls of the office building. So even during the pandemic, we spent a lot of time working with our retail tenants, which are only a couple of percentage of our rents, but they're a very key part of our marketing tool. So to give you an example, to keep some of our retailers open during the pandemic, we actually bought about 55,000 meals from those restaurants, had them distributed both to homeless shelters and some of our employees -- some of the employees in our buildings to actually help them bridge through some very difficult periods of time. I think the restaurants and the retailers that are kind of dinner-based are doing well. What we worry about right now are those that are kind of breakfast- and-lunch based. And look, we've always taken the approach with our retailers. They're really partners in our overall envelope. So we'll work with them to kind of help them bridge through. But certainly, to the extent that everybody winds up doing 2 or 3 days a week in the office that's going to be a big impact on street-level retail, no question.

Maybe I've got one for Tom since he's been quiet there next to you. Tom, how much should we think about inflation as either increasing the need for things like TI funding or CapEx but also just operating costs being a headwind for growth here?

Sure. I think when we look at inflation, especially on the operating properties starts there is that we have triple net leases in Austin as well as in the Philadelphia CBD. So for the most part, we're pretty much inflation-protected with those triple net leases in those 2 markets. We do have base years in the suburbs. So PA suburbs will be a gross lease with inflation in the step-ups that we get. So -- and then overall, our leases are still getting 2% to 2.5% to 3% rent bumps along the way. So we're going to have those rent bumps built into the leases. And so the only other market is -- that's also gross is Met D.C. So it's really just our Philadelphia PA suburbs where we have gross leases.

How much of your income is net leases versus gross just on an NOI or ABR basis?

I'd say 20 -- probably about over -- about 60% triple net.

Okay. We need to get to this, what is your #1 ESG priority in 2022?

I think -- I mean, we have a number of priorities that we put in our reports, but I think the #1 focus near term is to continue the expansion of our renewable energy program. So right now, we have a solar carport program underway that we hope to deliver this year that will provide about 6.5 megawatts of power that will provide about 85% of the energy to an 8-building complex. So I think that's a key focus. I know you only asked for one, but another key focus is continued expansion of our community engagement programs. I think, at Brandywine, we have a neighborhood engagement initiative that we have both in Philadelphia and in Austin, Texas. And that runs the full gamut from working with community development organizations, providing apprenticeship training programs for both skilled and unskilled trades as well as providing financing capital for nascent early-stage minority women-owned businesses. So I think those 2 things, Manny, are kind of top of our list for 2022.

Great. We'll wrap it up with our rapid fire questions. What will same-store NOI growth be for the office sector overall in 2023?

I think between 2% and 4%.

What will the 10-year treasury yield be a year from today?

I defer it to Tom.

2.5%.

And will the office sector have more or fewer public companies a year from now?

We think we'll have fewer.

Great. Thank you all very much.

Great. Thank you, everybody.

Thank you.