Brandywine Realty Trust (BDN) Earnings Call Transcript & Summary

Welcome to the 10:15 a.m. session of Citi's 2024 Global Property CEO Conference. I'm Michael Griffin with Citi Research, and we're pleased to have with us Brandywine 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 desks. For those in the room or the webcast, you can go on liveqa.com and enter code GPC24 to submit any questions if you do not want to raise your hand. Jerry, will turn it over to you to introduce Brandywine and the team, provide any opening remarks, and then we'll get into Q&A.

Great. Thank you very much, Michael [Technical Difficulty] All right. So really, the focus is leasing and strengthening the balance sheet. Right now, we have a very high-quality portfolio. We are outperforming our competitive set in our markets. 41% of our new deal activity is coming from flight to quality tenants. Our physical tour volume was up in the fourth quarter over the third quarter by about 42%. For the year, we're targeting occupancy levels in the 87% to 88% range, and that's after accounting for 8 of our properties that account for about 53% of our vacancy. So we have plans in place to accelerate occupancy or conversions on those properties. And the other thing that we're -- we've reached out into the maturity curve a number of years ago. So if you look at the portfolio between now and '26, we only have about 6.2% of annual rollover. We've been experiencing very good mark-to-markets. We've kept our capital ratios in the 10% to 13% range. And the operating climate, we think, is improving with more and more tenants entering the market. Certainly, the return to work dynamic, we think, is moving along at a good clip, particularly with our smaller-sized companies or attendance in our property. On the balance sheet, right now, we are focused on -- we have a bond maturity in October of '24. As we enter Q&A, we can address some specific tactics we're looking at with that, but we think that's well in hand. We're also very much focused on the high level of debt attribution we have on our portfolio coming from joint ventures, as well as the amount of capital we have tied up in development right now that's not producing any income. As we've talked on the earnings call, one of our objectives is to exit or streamline some of those joint ventures and then, during the next couple of quarters, that will reduce that level of debt attribution. And we continue to make good progress on our development projects that will generate upon stabilization of that $60 million of additional NOI. So with that, Michael, really, I'll turn it back to you for Q&A.

Great. Thank you so much, Jerry. We're starting off each of these roundtable sessions with the same question, what are the top reasons investors should buy your stock today?

I think there's -- the 3 top reasons I would mention is existing portfolio, quality, and the growth projections. I mentioned very low rollover, higher occupancy than our peers. We've been targeting and achieving very good cash and GAAP mark-to-markets. We've kept our capital cost well below our peer group. And then we take a look at our forward growth projections, those 8 properties I alluded to earlier, about 500 basis points of occupancy for us. So we're running our core quality portfolio in the 92% to 94% range, with the mark-to-markets in the capital control, we think there's some very good embedded growth into the existing portfolio. So that would be number one. I think number 2 is, when we take a look over the next several years, we have tremendous portfolio diversification opportunities available to us. We have -- our forward growth we can do on our development pipeline is broken down 42% residential, 27% life science, 10% retail and other hospitality uses, and 21% office. So we really do believe that even though the development climate is adverse to more starts now that given our market position at Schuylkill Yards, uptown in Philadelphia, Uptown ATX in Austin, Texas, and the growth of our university business, the most best evidence that is our program with the University of Maryland, we have tremendous stability over the next few years to diversify our revenue mix. And the final one is that we think we are incredibly well positioned to take advantage of life science growth as it returns to the marketplace. Philadelphia has moved up significantly in the last few years to be the #5 life science market in the country. There's tremendous NIH private capital flowing into the market for life science. University of Pennsylvania, Wistar, Children's Hospital, among others, are curating a number of gene and -- cell and gene therapy companies. There is a number of public policy initiatives underway in the Commonwealth of Pennsylvania to devote more money to life science growth, and we think we're well positioned for their B+labs initiative. It's about 110,000 square feet now. We just delivered another 60,000 square feet; 30,000 is fully leased upon delivery. And the remaining 30,000 that will be delivered later this year, we have a lease under negotiation for the full amount of space. So we think those 3 elements really differentiate us from our traditional office peers.

Thank you, Jerry. With the headwinds facing the office macro environment broadly, how is Brandywine differentiated, whether it's term of the -- whether it's the composition of the portfolio, the tenant makeup, or any growth opportunities that differentiate yourself from the competition?

Yes. I mean I think the underlying foundational point is the quality of the portfolio and its positioning relative to our competitive set. As I mentioned, we have about 41% of our pipeline really coming from tenants looking to move up the quality curve. And when we say move up the [ quality ] curve, it's not just the building itself, but it's also the quality of the sponsorship. To give you a good example, we see our competitive set shrinking in almost every single submarket we're in. There are 12 buildings -- looking just at Philadelphia CBD, you have 12 buildings that comprise 55% of the vacancy in the marketplace. 5 of those properties are in special servicing, several others are close to that. So our sponsorship, relative capital strength, or on-the-ground leasing efforts, I think, will continue to generate some additional activity for us. And to wit, in 2023, we had more expansions than contractions, which continued the trend line we had in 2022. And while the overall vacancy rate in Philadelphia is about 16%; in the Trophy Class Inventory we're in, it's about 9%, and Brandywine's running about 5%. So we think our portfolio and the quality of our delivery platform, Michael, will continue to add square feet to our pipeline. We still are targeting about 33% of the proposal we issued turn into leases. So that's back to the pre-pandemic levels. Our deal cycle time is back to about 90 days, which was pre-pandemic. So we actually think with the additional activity in the marketplace that we are seeing, we'll be able to generate some more leasing activity going forward.

Maybe turning to your markets next. What makes both Philly and Austin relatively more attractive office markets compared to other Gateway or Sunbelt markets?

Yes. I mean actually, Philadelphia has shown a fairly high degree of resilience over the last several years. It's never been a high beta market. It's a marketplace that still is characterized by service companies and eds and meds. There have been no real additions to inventory other than build-to-suits in the last decade. So the inventory base has been fairly stable. We do continue to see growth, particularly in Philadelphia, in the financial services and life science sectors, which we benefited from. So I talked a few moments about a point of differentiation, but we definitely see an uptick in activity on the life science front. It was slower in the second half of '22 and slower in '23, but we're definitely seeing it pick up so far in '22. So we think the relative stability of Philadelphia, the quality of our portfolio positioning in that regional marketplace, with the green shoots of growth in financial services and life science, will continue to provide some good growth for our portfolio going forward. Austin is a different dynamic, a much higher beta marketplace. It's right now suffering from the double hit of oversupply and underdemand. But you still had about 140 people a day move into Austin, Texas, last year. There's still about over 50 companies looking to make Austin's their headquarters, including about 19 life science companies. It's become the #1 leader in STEM-based jobs over the last decade. So I think that the growth dynamics in Austin, even while temporarily impacted by this disequilibrium, provide a great long-term landscape for the company. So the combination of the high beta in Austin with the relative stability of Philadelphia, we think, provides a great prescription for growth going forward.

You talked about the pickup you're seeing in terms of demand for life science. Is that mostly coming from smaller tenants or have larger tenants started looking at taking more space?

Yes, great question. I think for the most part, it's still kind of tenants in the 10,000 to 25,000 square foot range. I know in several of our developments in the Philadelphia marketplace, we are talking to a range of companies that are between 100,000 to 150,000 square feet. But they definitely tend to be more the outlier than the norm. Most of our targeted tenant prospects are between 25,000 and 50,000 square feet. In Austin, historically, that's been a market moved by larger tenant requirements. Most of those were tech-driven. For the most part, they're all on hold right now. So actually, most of our tenant activity in Austin right now is really coming in the tenant sizes below 25,000 and 30,000 square feet.

And then just in terms of leasing expectations, what are tenants looking for or asking for today that they might not have been 6 to 12 months ago? And have more tenants started coming back to the market or are many real estate decision-makers still dragging their feet?

No, I definitely think there's more tenants in the marketplace. Certainly, year-over-year, if we were in March of last year, I think there was a lot of -- there were a lot of companies that were still trying to figure out their work schedule, hybrid versus remote, 3 versus 4, 2 versus 3. And I think we've seen a tremendous increase in the level of clarity in what tenants are deciding to do. That's very helpful because that accelerates their decision-making process for new space. So certainly, I think the drivers of demand are better this year than this time last year. I think what tenants are looking for is, as I touched on, the good-quality buildings, but also looking for good quality landlords. Then if you think about it, in the production cycle, most tenants are represented by brokers, most brokers want to get paid leasing commissions. Most brokers who are representing tenants want to go to landlords that have demonstrated financial capacity to now pay broker commissions but also provide the money for the tenant improvement costs. So when I alluded to earlier, the competitive set is shrinking, we are definitely seeing that dynamic across the board. So we're able to give those companies assurances that we can stand financially behind our promises. We have a long demonstrated track record of making capital investments in every one of our projects that we can clearly show the tenant prospects. So I think the quality buys and the sponsorship of the landlord are very, very important. We really have not seen, Michael, a big increase in requirements for additional free rent, and TI commitments have held pretty much static year-over-year.

You talked about having a pretty manageable lease maturity schedule over the next couple of years. I think you said it was about 6% per annum. As those leases come due, do you think you'll have the ability to push rents? Or do tenants still have a lot of leverage when it comes to those renegotiations?

Well, it depends on the market. But I think generally, we're seeing the ability to generate higher net effective rents, particularly in our CBD Philadelphia, our University City projects as well as some of our core suburban markets like Radnor and Conshohocken, again, primarily due to some of the dynamics we've talked about. In Austin, Texas, I would say that we do not have the ability to move effective rents at this point. That market, given its higher level of vacancy, slowdown in tenant demand, we tend to be a price taker there right now versus the price driver. But we are still projecting our '24 business plan positive mark-to-markets in our core markets with the exception of Austin.

And for those, I believe it was 8 buildings that you highlighted in your earnings supplemental that make up about 50% of the vacancy, can you talk about some initiatives that you're undertaking to try to lease up those buildings and have them contribute more on the occupancy and NOI front?

Sure. And they run the gamut from some of our higher-quality buildings with temporary or transitional vacancy to build into some structural issues in terms of market demand. So for example, we have 2 of those projects -- actually, 3 of those projects were undergoing legal zoning and architectural review to see whether they are good conversion opportunities to residential, including potentially taking down a couple of the buildings where we feel as though the physical plant that's in place now does not meet the quality standards required today. So that represents several of the properties on that list that we identified in our supplemental package. We have a couple of other properties in Austin should have lost major tenants there. We've accelerated our leasing programs, embarked on a couple of capital renovations for lobby improvements, bathroom improvements, additional landscaping improvements to present those properties better and being more aggressive on the rental curve. We have one of the buildings on that project is Cira Centre, which is one of our premier properties. As you know, we're converting the lower bank of that building, first 9 floors to life science. Most of that vacancy that we show right now is -- are the spaces we're converting to life science and pre-leasing. So we think that that will take care of itself during '24. And then a couple of other properties, again, are in Austin, Texas, where we're underleased right now. So each project has a specific plan, either marketing, conversion, renovation to make sure we accelerate the lease-up of those properties. And of course, some of those properties were certainly willing to sell as well. So we're exploring a number of other options with those. Even on the residential conversions, for example, whether once we get clarity that we can get the properties rezoned, redesigned, that doesn't necessarily mean that we will do that work ourselves, we may figure that's an optimal value point for us to exit those properties.

If you were to sell those properties, and then maybe this can just be a comment on disposition cap rates overall, but where would you expect to transact that? And if cap rate isn't the right metric, what kind of valuation do you think investors could be looking at in terms of dispositions?

Yes. I think what we experienced in -- first of all, it's a challenging market to sell because of the overhang on how people are viewing the office sector but also the lack of available debt financing. So debt financing tends to be a significant gating issue. Certainly, one of the big -- one of the issues we ran in 2023 and trying to sell some properties. Our cap rates in '23 range from mid-single to high single-digit cap rates based upon really the occupancy level and the weighted average lease term in each of those buildings. So we are assuming somewhere in the 7% to 9% cap rate is probably the right target for some of the things we're trying to sell. That can vary by property and by submarket. And we have indicated, in some cases, the willingness to take back seller financing if the quality of the buyer is high and the rate of return we can get on our seller financing is good. We did build $80 million to $100 million of sales into our '24 business plan targeting the second half of '24 to get those sales done.

And then just maybe expanding a bit more on capital allocation opportunities. Can you give us any sense if we could see potential acquisition or development opportunities in the year ahead? Or does the math and the economics still not pencil for those?

Yes. I think for us right now, our major focus, as I mentioned, is on leasing and balance sheet improvement. We are not really focused on looking at any other properties to buy right now. We do -- we have, I think, a fairly well-thought-out sale program in place. The properties we have under development right now, most of the capital is already funded on those developments. So there's very little capital call going forward with the exception of monies for TI work as leasing occurs. And frankly, from Brandywine's standpoint, we don't really see any additional developments unless there's significant fully leased build-to-suits for the foreseeable future until we lease up our existing developments, get better clarity on where interest rates and resulting cap rates were going.

So you would have to really see a kind of market shift in where the macro environment and demand is currently to then want to start future spec development?

We would need to see that for sure, along with making sure that we leased up our existing development sets. As I mentioned, that can generate about $60 million of incremental NOI for us. It's a huge growth driver for us. So I think the sole focus for the company from a leasing standpoint is getting those projects leased up. The rest -- some of the other considerations are purely secondary.

Maybe we can just turn to the balance sheet now. I think you've done a good job addressing some of the upcoming maturities. We can talk about the October bond coming due as well. But for the remainder of debt, call it, over the next 2-or-so years, particularly on the JV side, I mean how should we think about refinancing expectations for this going forward? And with secured versus unsecured debt, would any one of those look kind of more appealing as those refis come up?

Yes. Certainly, Tom, why don't you pick up on that for us?

Yes. So on the unsecured bond that's coming due here in October of '24, we do expect to refinance that in the next, call it, 60, 90 days. We are looking at both secured and unsecured as an option. Part of that's going to be a function of pricing. We do think the bond market is open for us. We do believe we could get a bond deal across the finish line. But we're also again unsecured -- I mean secured, which we think has a better rate on loans. So we're kind of looking at both. We may do both as opposed to just one or the other, depending on our capital thinking for the next couple of years. And then we have no bond -- no maturities until '27 after that.

And what would kind of the rate differential be, secured versus unsecured debt, if you were to issue one versus the other?

We're seeing about 150 basis points.

That is helpful. ESG has become a very important focus of line for many investors these days. Can you highlight some important ESG initiatives that Brandywine is undertaking?

Sure. And we have a dedicated senior executive who really leads all of our ESG initiatives, working with all of our property managers, leasing agents and corporate support functions. So we've actually already received some excellent recognition for ESG. We have the highest ISS governance score of 1. We were awarded the ISS ESG Corporate Ranking Prime status last year. We have 17.2 million square feet are green certified. We're a GRESB Green Star award for the ninth year in a row, and we're awarded 5 stars for the last 2 years in our reporting. We're a committed member of the CEO Action for Diversity and Inclusion. We were awarded the Green Buildings United Groundbreaker award last year for sustainable building operations for our Cira Centre location in Philadelphia. And we're a Green Lease Leader Platinum award winner in 2022 and '23. We've also achieved some significant savings from an operating standpoint to reduce water usage, energy usage and greenhouse gas emissions by over 15% in the period from 2018 to 25%, 30% from an energy standpoint, 35% from greenhouse gas, and 23% for water. So it's a major initiative. We work very much hand in glove with a lot of our larger tenants to make sure as they work through the design and construction of their tenant improvement costs, it's all -- the sustainable construction protocols are used, and we continue to expand that. We have a very good ESG report we issue to all of our stakeholders every year, and actually connect with many of our larger tenants that dovetail our initiatives with the initiatives they use within their space.

We had a question just come in from live QA. Just turning back to the balance sheet, do you still plan to reduce joint venture debt by $100 million, which I think was something that you all had guided to last year?

Yes, we do. We have a number of operating joint ventures that we're working through with our partners and our lenders for overall restructurings. While those restructuring take longer than we would have liked, we were open to get some of those time last year. All of the discussions with the lenders are very, very constructive. I think the lenders are clearly focused on quality of the sponsorship they have. We're working with our partners and our lenders on effective debt restructurings and extensions that will provide us the ability to reduce our ownership stake in a number of those ventures. As I mentioned earlier, on our balance sheet, we have about $400 million of debt attributed to our balance sheet coming through non-recourse financings in our ventures. We're determinate to meet -- at least meet that $100 million target this year, if not exceeded. And we think we're well on the path to do that.

And maybe just expanding on that a bit, if you couldn't find viable financing or the economics wouldn't make sense, could you look to give back the keys on some of those assets that you do have mortgage on?

Certainly, that's always an option given the structure of those debt instruments being completely non-recourse. I think from our perspective, relationships are important. A lot of these venture is financed with banks we do a lot of business with. So our hope is that we'll be able to work out mutually agreeable resolutions that work for us as well as for the bank. To the extent we're not able to do that, that's certainly an option that's on the table. But I'd rather have the banks make that call versus us. I think we're focused on creating capital structure in each of those joint ventures that provide a justifiable path back to full loan recovery and potential equity recovery as the years progress.

We had another question come in from live QA. Can you give any update on the lawsuit related to the State of Texas and Austin and what the plan is for that, I guess, lease and property going forward?

Yes, we -- there's no real significant update that we're going through the legal process there. The background there is the State of Texas had a large lease with us. I forgot the exact square footage; do you remember that Tom?

It's about 150,000 square feet.

Yes, a fairly large lease that they terminated based upon their assertion that they did not have budgetary authority through the legislature. We did research, we disagree with that assertion. So we have filed suit against the state of Texas. The first real step for that is going through the legal process that will determine the right of the sovereign, whether the sovereign has the ability to unilaterally cancel leases, even though some of the conditions pursuant to that may not have been met. But I don't really have any more update on that than it's going through the normal process. We continue to pursue our -- what we think is a justified course of action.

Maybe we can just touch a bit on the development opportunities, both at Schuylkill and Uptown ATX. I think you did some leasing at 3025 JFK, recently you disclosed. But how has demand been for those properties there, and we can touch on both the office component, the resi component and life science as well?

Yes, taking them in sequence in terms of delivery. The first project we delivered was 3025 JFK, which is our first vertical development at Schuylkill Yards. It's 200,000 square feet of commercial space, [ 100 spaces ] of underground parking, some retail and 326 apartment units. The apartments are right now over 30% leased. So very much running online with pro forma. Of the 200,000 square feet in the commercial space, we have about 60,000 -- I'm sorry, 35,000 square feet leased with about 160,000 square feet left. We have a pipeline of about 700,000 square feet for that space. We have active discussions underway with a variety of tenants ranging from 10,000 to 120,000 square feet. So we're optimistic now that project has been fully delivered. Lobby is done, the amenity floor is done, parking is operational. The adjoining pocket park is done, that we'll be able to have some good success during that -- in that project in the next couple of quarters. Moving across to [ Schuylkill ] 3151 Market Street project is -- will be delivered in the third quarter of this year. That is a special purpose-built life science project of about 400,000 square feet. There, we have about 600,000 square feet of prospects. We are in active discussions with about 140,000 square feet. So the demand drivers there, we think, will continue to evolve as the building gets finished. The curtain wall just went up -- was completed a couple of weeks ago. Lobby, amenities will be done mid-summer. So we certainly think, as in most projects as that building presents itself better, will generate some additional demand. Down in Austin, Texas, we have a combination office and residential project. The office project is being delivered early this year. We signed our first lease there last year. The pipeline there is good in terms of number of tenants. Most of the tenants are fairly small between 10,000 and 35,000 square feet. So really a couple of larger users, but their time line for decision-making is pretty proactive. So we hope as that building is fully delivered, the amenity level is fully completed, we'll pick up some demand drivers there. The residential will be opened up in May of this year. And certainly, the expectation we can meet pro forma on that as well.

Are there any existing assets in the portfolio that you could look to convert to another use away from traditional office?

There are several -- actually, several of those are on, Michael, that list of the 8 problem children. So we have 3 different properties in there that we think are very viable from a marketing standpoint to convert to residential use. Now of those 3, 2 are suburban office complexes where we would take down a couple of buildings and build new residential. The third is a building in downtown Wilmington, Delaware, that is a small floor plate building that converts readily to residential, and we're going through the final pro forma and architectural drawings on that now. We continue to look at a few other properties, as well as, frankly, some of our landholdings. I mean I'll give you a good example. We had a piece of ground of 50 acres that we had originally designed and programmed for office. We converted that to zoning for industrial for 200,000-, 300,000-square-foot industrial buildings. We completed that entitlement program and, before the -- in the fourth quarter of last year, sold that to an industrial developer for a large profit. So we're actively looking at every single piece of our inventory. We have 2 pieces of land in Austin, Texas, that were programmed for office. We're going through the rezoning evaluation for both of those to convert those to residential as well.

What do you think it's going to take to get larger office space users back into the market?

Well, I think the -- in Austin, I think that we'll need to see a little bit of the tech overhang dissipate. I think the tech companies are still mix of remote, hybrid and in-person work. So I think you see -- get a little more legs on what -- how that plays out and then, also, once that happens, get a feel for how much of the space that tech companies in Austin have already leased that -- when they leased it was built for growth requirements versus current demand. So I think looking for the tech companies to kind of come back to work, and start hiring again will be a clear indicator of additional large user demand in Austin. In Philadelphia, again, from a life science front, from the office standpoint, we are seeing a couple of hundred thousand-plus square foot users in the market now. So we think that trend line will continue.

Do you have a sense of where office utilization throughout your portfolio is? I imagine some of your suburban buildings probably don't have key card swipes, but do you have any sense of how things are trending from a utilization perspective?

Yes. I think the last -- and you're right, I mean some of our buildings don't have the card key swipe in the suburb. So there, we can just anecdotally make an assessment via parking lots. I mean utilization rate in our suburban buildings is much higher than our downtown buildings even on Fridays. I mean I think people in the suburb still work Friday, so they come to work. Downtown, we're running between 65% and 70%. Anecdotal piece, though, interesting is our occupancy, effective occupancy levels now on Mondays are higher than they were last year on Tuesdays. So we're seeing more, large companies -- 2 of the larger employers in Philadelphia, Comcast and Independence Blue Cross, have bought all their employees back 3 or 4 days a week. The new mayor in the city of Philadelphia announced last week, she's bringing back all municipal workers to the office. So we're definitely seeing a clear trend line of more return to work. And I think that's a positive for both street-level activity, retail use as well as office demand.

Well, there are no other questions from investors. I've got my 3 rapid fires to end the segment. What is the best real estate decision today? Buy, sell, develop, redevelop, or pause?

I like lease, which is not one of your options. But so given the other 4 options, I'd say pause, but it's really lease.

What is your expectation for same-store growth for 2025 for the office REIT sector overall.

I think you'll see between 2% and 3%.

And lastly, will there be more, fewer, or the same number of publicly traded office REITs a year from now?

I'll say fewer.

Great. Thank you so much.

Thank you very much.