Highwoods Properties, Inc. (HIW) Earnings Call Transcript & Summary

Good morning. Thank you for joining today's Highwoods Properties Q3 2024 Earnings Call. My name is Cole, and I'll be the moderator for today's call. [Operator Instructions] I'd now like to pass the call over to Hannah True, Manager of Finance and Corporate Strategy. 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're 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 reported excellent operating and financial performance once again in the third quarter. For the first 3 quarters of 2024, we delivered financial results that are ahead of our initial expectations, while building the foundation to drive sustainable growth over the long term. First, our bottom line financial results this year continue to be better than we originally anticipated back in February. During the quarter, we delivered FFO of $0.90 per share and generated strong cash flows. At the midpoint, our FFO outlook is up $0.06 per share since the beginning of the year, including $0.03 increase this quarter. And this is even with interest rates higher than forecast and $84 million of noncore dispositions that were not included in our original outlook. Second, our new leasing volumes have been very strong throughout this entire year and most prominently in the third quarter, which should drive organic -- strong organic growth after our long-telegraphed occupancy trough in early 2025. With 1.3 million square feet of new second-gen leases signed through the first 3 quarters of 2024, our lease rate is over 300 basis points higher than our in-service occupied rate of 88%, roughly 2x our normal spread, indicating that we have a sizable pipeline of leases that have been signed but where occupancy hasn't yet commenced. Third, we continue to make progress on our development pipeline, which is now 49% leased, and we have a healthy pipeline of strong prospects to drive our leased rate higher. Our development pipeline will be a significant driver of cash flow growth going forward as these assets deliver and stabilize. Fourth, we continue to sell noncore assets and use the proceeds to recycle into higher-quality buildings and reduce leverage. We closed on one small noncore land sale this quarter and are marketing additional properties. We're optimistic we'll close on more asset sales over the next several months. Finally, we're laying the foundation for future wish list acquisitions by meeting with owners and lenders of high-quality assets throughout our footprint. We have long believed it would take time for the bid-ask spread between buyers and sellers to narrow. With the first interest rate cut now behind us, we can see a pathway for the office investment sales market to open back up. Overall, we continue to outperform our financial expectations. We're making significant progress improving our portfolio quality and long-term growth rate, while fortifying our already strong balance sheet. And we have a healthy number of signed but not yet commenced leases in our development pipeline and our in-service portfolio that will further strengthen our cash flows. Turning to operations. The combination of our BBD locations, commute-worthy portfolio, strong balance sheet and our hands-on approach to both customer service and property management is driving meaningful market share gains. New second-gen leasing during the quarter was strong at 530,000 square feet, and that doesn't include 39,000 square feet of net expansions, which are included in renewals. In fact, growing users outpaced contractions by a ratio of 5:1. Net effective rents, which, in our view, are more meaningful than rent spreads were the highest in our company's history and 25% higher than the previous 5-quarter average. Plus, our weighted average lease term was 10.4 years, also the highest in our history. Stated vacancy rates remained elevated, but these market-wide stats mask the improving competitive dynamics for top-of-market assets in our BBD footprint. There's still some office under construction, most of which will deliver by the middle of next year. The new starts are essentially nonexistent. With high-quality blocks of space getting absorbed, there are less options for large users seeking Class A space with well-capitalized landlords. We expect these dynamics will continue over the next few years, which should allow us to drive occupancy and rents. In addition, return-to-office mandates have steadily increased over the past several quarters as employers are emphasizing the value of in-person collaboration and culture building that isn't easily replicated with remote work. According to a recent KPMG survey of U.S. CEOs, 79% expect a full return to the office over the next 3 years. The combination of dwindling large blocks of high-quality space, limited to no development starts and increasing return-to-office requirements bodes well for the future of office demand. Turning to development. During the quarter, we signed 61,000 square feet of first-gen leases, including a small retail build-to-suit, bringing our 1.6 million square foot, $514 million pipeline to 49% leased. We have strong prospects for an additional 140,000 square feet that we expect to sign over the next several months. We don't expect to announce any other new development projects this year. New starts are very difficult for any developer to pencil, given the current environment. That being said, we've seen increasing inquiries for potential build-to-suits. I wouldn't characterize any of these as being close to a decision, but the renewed interest is anecdotal evidence that large users are coming back to the market and are focused on the in-person experience for their teams. As I mentioned earlier, we sold a small noncore land parcel during the third quarter, bringing our noncore asset sales to $84 million for the year. We've included up to an additional $150 million of noncore dispositions in our outlook. We may not hit the high end of the range before year-end, but we expect to do so by early 2025. In conclusion, we believe the outlook for Highwoods is bright. As evidenced by this year's leasing, demand for our Sunbelt BBD portfolio continues to be strong. This will drive meaningful growth in occupancy and NOI following our trough in early 2025. Our $500 million development pipeline is seeing healthy interest and will drive a meaningful increase in our earnings and cash flow as it delivers and stabilizes over the next few years. Our balance sheet is in excellent shape and will enable us to capitalize on investment opportunities. And finally, our underlying cash flows remain strong, which supports our attractive dividend and allows us to continue reinvesting in our portfolio. Brian?

Thanks, Ted, and good morning, all. Echoing Ted's overview on leasing, we couldn't be happier with the results our hard-working team posted in the third quarter. The quantity and quality of deals across our existing in-service portfolio and development pipeline is emblematic of the flight to quality occurring across our markets. As we've mentioned previously, this flight to quality isn't just about the physical space, but rather is representative of a positive bias toward quality buildings, quality landlords with access to capital and the quality of a commute-worthy experience, which is core to our DNA as both an owner and an operator. We're focused on building leasing momentum through year-end. With this, we signed 906,000 square feet for the quarter. New second-generation leasing of 530,000 square feet represents the highest quarterly performance in over a decade and is a testament to our customers' willingness to make a move in order to secure a new workplace that helps them recruit, retain and return their best and brightest to the office. Additionally, and subsequent to quarter end, we renewed 2 of our largest remaining expirations in 2025 and 2026 for approximately 300,000 square feet in Nashville and Raleigh in the aggregate. Portfolio leasing stats achieved high watermarks across a variety of metrics, including meaningful net effective rent and dollar-weighted average lease term. Our 10.4% cash and 22.4% GAAP rent spreads also reinforce our belief that customers see their relative investment in real estate as a real investment relative to their most valuable asset, their people. Our 18.6% payback is in line with our previous 10-quarter average, highlighting our portfolio's resilience in the face of continued and competitive concessions in the market. Our development pipeline continues to fill up, adding 61,000 square feet in the third quarter, which includes a new build-to-suit brewery and restaurant at our GlenLake mixed-use development in Raleigh. This regional draw will be a tremendous complement to the other food and beverage options we are curating to support the close to 1 million square feet of office customers we have at GlenLake. Highwoods believes that customers aren't monolithic in their approach to the workplace. This relates to location and to one's measure of commute-worthiness, which is greatly impacted by one's commute. This belief is representative of our best business district approach, where BBDs are both urban and suburban in nature. This strategy is proving out in our year-to-date leasing performance with approximately 20% of leasing activity in the CBDs, 50% in infill locations and 30% in the suburbs. Turning to our markets. In Atlanta, JLL reported sublease availability reached the lowest level in 7 quarters. Overall, office inventory shrank, and there were no new construction starts for the quarter. There, our team signed 271,000 square feet, including 235,000 square feet of new deals. Included in this number is the 104,000 square foot substantial backfill of a customer who vacated Two Alliance in August. In Raleigh, CBRE reports that sublease space is down almost 30% from its peak, and Cushman & Wakefield highlighted the market's Class A properties are garnering the greatest leasing activity with 79% of the quarter's leasing volume. We signed 217,000 square feet in Raleigh during the quarter and renewed 84,000 square feet after quarter end, representing a modest downsize for the company's second largest 2026 lease expiration. Moving to the market with the nation's lowest unemployment rate in Nashville and where Highwoods owns more than 5 million square feet, Cushman & Wakefield reported positive net absorption in the quarter and noted close to 3 million square feet of active prospects over 10,000 square feet are looking for space in the market. Our seasoned team in Nashville signed 54,000 square feet in the third quarter and after quarter end, renewed the company's second largest remaining 2025 lease expiration at 210,000 square feet. In downtown Nashville, our plans have been finalized for the repositioning of Symphony Place, where we have 300,000 square feet of known move-outs in 2025. This asset represents the next great opportunity for our unique Highwoodtizing approach to work placemaking, which has been proven successful elsewhere in Nashville, both in the Brentwood and Cool Springs BBDs. While it will take time, the opportunity to reposition one of Nashville's most iconic towers is right in our wheelhouse and will provide meaningful upside and value creation upon stabilization. Wrapping up our markets in Tampa, I'd like to highlight the tremendous work of our Tampa team in light of the 1-2 impact of Hurricanes Helene and Milton. While many teammates are still personally dealing with the aftereffects of the storms, our portfolio fared well and was ready and waiting for our customers when the sun came back out. Our portfolio's resilience is a testament to our team's resilience. And we are greatly appreciative of their collaborative and solutions-oriented approach to serving our customers. JLL notes in their recent market report that Tampa is strong and stable. And the 2.3 million square feet of leasing activity completed year-to-date in the Tampa market represents the greatest leasing volume among all markets in Florida. Additionally, Cushman & Wakefield highlighted that Tampa is one of the 4 hottest job markets in the U.S. For the quarter, our Tampa team signed 97,000 square feet, including 26,000 square feet of first-generation leasing in our Midtown East development, the only office building under construction in the market and which is now 35% preleased. This exceptional asset joins our successful Midtown West development in the heart of Midtown's mixed-use district, which includes a Whole Foods Market, shops, restaurants, hotels and apartments. Midtown East delivers in the first quarter of 2025 and is projected to stabilize in the second quarter of 2026. In closing, the third quarter was a strong one for Highwoods. The hard work, foresight and investment we've applied to our portfolio is delivering results. Our leasing volume and metrics are representative of a flight to quality of portfolio and people who deliver an exceptional experience. We will continue to invest in our Highwoodtizing approach through reenergizing our core portfolio and delivering the most exceptional customer experience in our Sunbelt BBDs. Brendan?

Thanks, Brian. In the third quarter, we delivered net income of $14.6 million or $0.14 per share and FFO of $97.1 million or $0.90 per share. The quarter was relatively clean from an FFO perspective. Depreciation and amortization expense, which doesn't impact FFO but does flow through net income was modestly higher during the quarter. This was due to the write-off of tenant improvements and deferred leasing costs associated with the cancellation of a future 110,000 square foot lease at the former Tivity building in Nashville. You may recall, we mentioned this was a possibility on last quarter's conference call. The former customer has agreed to repay us our upfront investment over the next 5 years. Our balance sheet remains in excellent shape. At September 30, we had nearly $800 million of total available liquidity, including cash on hand, available capacity on our $750 million revolving credit facility and undrawn capacity from our joint venture construction loans. As we mentioned last quarter, early in Q3, our unconsolidated McKinney & Olive and Granite Park Six joint ventures repaid over $200 million of secured loans. We and Granite, our joint venture partner, each contributed over $100 million to these joint ventures. These properties will likely be a future source of capital as we plan to obtain long-term financing at some point in the future when conditions in the secured markets are more favorable. As Ted and Brian mentioned, we had a strong leasing quarter, especially new leasing volume, which has driven our leased rate 310 basis points higher than our actual occupancy of 88%. This includes currently occupied space plus leases signed but not yet commenced on vacant space. Net effective rents and average lease terms on signed leases this quarter were all-time highs. And we locked in over $340 million of total lease revenue from second-gen lease signings, also a record for the company. With such strong new leasing volume, rents and term obviously comes more leasing capital. This is a natural part of the real estate cycle when capable landlords with high-quality portfolios are able to drive occupancy higher. We expect this trend to continue in the near term as we fill the pockets of vacancy in the portfolio and push for longer weighted average lease terms. We believe we are well positioned to handle any short-term uptick in leasing CapEx, given our healthy current cash flows and future embedded growth drivers. For 2024, our updated FFO outlook is $3.59 to $3.63 per share, which implies a $0.03 increase at the midpoint compared to our prior outlook. The increase is essentially all from higher NOI driven by a combination of reduced expenses and higher revenues, partially offset by modestly higher G&A. The midpoint of our average occupancy range is unchanged at 88%, which implies lower occupancy in Q4. This has been expected, given our long-telegraphed known move-outs. At the beginning of this year, we projected year-end occupancy to be somewhere between 86% to 87%. We now believe the upper half of that range is most likely. As we mentioned last quarter, the strong leasing we've achieved this year makes us confident that our trough occupancy early next year will be higher than we previously expected, and our recovery will be faster. A few items to note about our fourth quarter expectations. First, we expect to incur a higher level of OpEx in Q4 compared to the prior 2024 quarters. This is largely attributable to the timing of certain expense items that were pushed late into the year rather than being spent ratably over the 4 quarters. Second, as I mentioned, average occupancy is projected to be lower in Q4. Third, the GlenLake III and Granite Park Six developments, which were completed in the third quarter last year, will have no interest or OpEx capitalization during the fourth quarter. While these items create short-term headwinds to our financial results, as occupancy recovers in our in-service portfolio and our development properties stabilize, we expect meaningful growth in our earnings and cash flow. To wrap up, we're very encouraged about the future for Highwoods. With our strong balance sheet and high-quality portfolio in BBD locations across the Sunbelt, we are gaining market share and expect rent economics to strengthen over time. This backdrop, combined with the meaningful embedded upside potential we have in our in-service portfolio and development pipeline, provides us a strong runway for future growth. Finally, our balance sheet is in excellent shape, which positions us to capitalize on future investment opportunities. Operator, we are now ready for questions.

[Operator Instructions] Our first question is from Blaine Heck with Wells Fargo.

Can you talk a little bit more about the rental rate strength you saw in the quarter? Were there any specific leases that drove that strength? It looks like Atlanta was a standout. And then maybe you can comment on whether there are specific industries or tenant sizes that you're finding are more active in the market and willing to pay premium rents for that right space.

It's Ted. Yes, look, obviously, we did have a great quarter on the leasing front. We had a couple of larger deals that did contribute, and you nailed it in Atlanta. We had 2, in particular, one that drove the cash rent growth. One was financial services and one was -- I'm sorry, is professional services, a law firm, and then one was a GSA deal that were driving those economics. But even without those, we had a very strong quarter on the economics if you back those out. So we're sort of seeing it. It just -- it's a mix, right? It sort of depends on the submarkets and the markets we're in. But all in all, we're seeing some strength in our leasing this past quarter. And then with respect to smaller or larger, really it just depends. I mean I think it depends on the TIs that customers want. If we can get longer terms, we're willing to provide TIs, and they're willing to pay for it. I think we're seeing some customers that are willing to pay for it, and that works out well. What's pretty interesting is we always talk about the flight to quality and flight to amenities and flight to capital. It's a common theme we've talked about the last few quarters. And that's still -- that continues, but it's not always the brightest, shiniest, newest buildings, and you've heard me say that several times. We've been on both sides of what I'm getting ready to talk about, where we've been down to 1 of 2 for a customer, and they chose the new construction even though it's $20 higher than what our offering is. And we've also been down to 1 of 2 where we've won because we've been the more value play. So it's just -- it all depends on who the customer is, what industry they're in, who the CEO is, in many cases, on the ability to -- in terms of type of space they want.

Great. Super helpful. So it looks like you guys are a little ahead of schedule on leasing up 23Springs. You've got an estimated stabilization date on that project in the first quarter of 2028, but you're already 60% leased with completion expected in the quarter. I guess how do you guys feel about potentially recognizing some revenue and NOI at that project maybe even as early as next year? And does that contribute to any of your positivity on 2025?

Yes. No, 23Springs is going very well. I think we moved it. Last quarter, it was 56%, and we moved it to 60% this quarter, and we continue to see very strong activity. We have more strong prospects. I think you'll see, hopefully, some movement next quarter if we can get a couple of things going. And I think in general, our pipeline, we have about 140,000 square feet of strong prospects for our development pipeline. So yes, with respect to 23Springs, we're probably ahead of schedule. But as a reminder, it's a big building. We still have quite a ways to go. The building will be finished towards the end of the first quarter next year. And I think our first customer moves in, in June. And then, Brendan, do you want to take the rest of that?

Yes, Blaine, it's Brendan. So just -- it's a good question. And as Ted mentioned, we would expect some contribution in terms of earnings from 23Springs in 2025. That will be weighted towards the back half of the year and probably even weighted more towards fourth quarter than it will be even third quarter because we do have some customers that move in kind of middle part of the year, but then even more that would move in later in '25. So I think we feel good that, that will be a contributor, along with, I think, the other development projects should all be kind of additive as we build throughout the quarters in '25.

Great. That's very helpful. And then just one last question, if I can. How are you guys thinking about the Pittsburgh portfolio in the near to mid-term? Do you think those dispositions are kind of off the table still through now? Or are you seeing any signs of the transaction market returning there? Are there any Pittsburgh properties in the potential $150 million that you've identified for potential dispositions? And I guess just strategically, maybe talk about how you think about the balance between waiting for an acceptable price to exit versus selling sooner or wherever the market pricing is, but maybe saving some capital needed for lease-up and any renovation or refreshing projects there?

Sure. Blaine, look, I think our -- in fact, we've got a team up in Pittsburgh today, working on some leasing deals. So look, obviously, we want to get out of Pittsburgh at the right time. But as you know, the last 2.5 years since the interest rates started rising up and the capital markets sort of locked up, it's hard to get any office deal done, all right? You got to get financing, and it's really hard to get a big office deal done. So I don't think a whole lot's changed over the last couple of years as we look at Pittsburgh from an investment sales standpoint. I think we're going to sell at the right time. But we are -- I think we've now hit as -- the start of the interest rate cuts. If we can get a few more cuts done, whether it be a couple this year and into next year, I think that's going to do a lot to open up the overall investment sales market. And then certainly, that would include Pittsburgh. But in the meantime, what's been pretty encouraging is the leasing activity we're seeing in Pittsburgh. So we like the activity we're seeing there, both PPG, starting to see more activity at EQT as well. So I'm encouraged overall by both the fundamentals and then eventually our ability to get out. But it's just going to take time, and we're going to be patient.

Our next question is from Ronald Kamdem with Morgan Stanley.

Just 2 quick ones from me. Just starting on the leasing front, which has sort of been pretty strong. I think you talked about ending the year sort of at the better half of the 87%, 87%-plus sort of range and so forth. I guess my question is just, number one, is it just more leasing activity overall in the market? Or is it really sort of this flight to quality where it's just a share gain? And then number two, just any more commentary in terms of the bottoming of occupancy next year? What -- could you share sort of what levels are you guys sort of thinking at, all else equal?

Ron, it's Brendan. Good morning. So yes, so just first on kind of that outlook for year-end. So I think what we've said for the past quarter or so is I think we're -- originally part of the year, we said 86% to 87%, I think, we feel in terms of year-end occupancy. We feel comfortable in the upper half of that range now. So kind of somewhere between 86.5% and 87% is where we think we'll kind of end the year. So that's kind of where we expect those levels to be. I think the reason why we feel better overall or why that number is higher is just the leasing activity that we've had this year has been better. And I do think that, that is largely market share-driven. If you look at our occupancy relative to the markets that we operate in, that spread has continued to widen. And we think that, that's likely going to be the case as we go forward for all the things that Ted mentioned earlier, which is kind of flight-to-quality buildings, flight-to-quality landlord and landlords that have access to capital. So we would expect that would continue there. When you get past year-end, there's still some known vacates that we have in the early part of 2025 that we've talked about. We think we have mitigated a lot of that risk through the leasing that we've done thus far on future leasing that will commence generally later in '25. So the trough is still going to be lower in the first half of the year than it is for year-end '24. But we think we're going to build that back as we progress throughout 2025 because once you get through the first part of the year, there really aren't a lot of large known vacates in the portfolio. And as we disclosed last night in the press release, our second largest remaining 2025 expiration, we renewed. So we feel good about that. So we think we will end next year, from an occupancy standpoint, probably somewhere comparable to where we'll end 2024.

Great. That's really interesting, so sort of flattish next year. Just switching gears a little bit to the capital market. I know we had a couple of conversations about getting back on offense and start -- especially at this part of the cycle. Maybe could you just provide some updated thoughts what you're seeing out there in terms of whether it's distressed or not distressed opportunities and any sort of cap rate commentary to get back on offense?

Sure, Ron. Look, we continue to look at everything that's in the market. There's just not a lot of wish list quality assets that are out there. A couple maybe traded in the last quarter or so, but there's not a lot. So I think the distress continues to build. I think there's a lot of -- as well as the bid-ask spread is still there. So the sellers that -- even if they're not distressed, a lot of sellers don't want to sell in this environment. So I think the -- my optimism is if we can get a couple more cuts the next 2 quarters by the Fed by the end of the year, next couple of months and then maybe into the first quarter of next year, the capital markets are going to open back up. And there's going to be a fair amount of assets that do come to market early next year. But as of right now, there's just not a lot out there. We continue to hang around the hoop and work our wish list assets, but just not a lot out there right now.

Our next question is from Rob Stevenson with Janney.

Ted, how much beyond the sort of $150 million of dispositions are you guys thinking about teeing up over the next, call it, 6 months? I mean is this it for a while until you start to see some of these acquisition opportunities? Or are you going to continue to be active regardless of acquisition opportunities, selling down some of the assets over the next 6 to 9 months?

Yes, Rob. Look, I think we're -- if you look at our history, we're continuous asset recyclers. So we're always sort of pulling from the bottom and selling assets and repositioning into higher-quality stuff. So I think you're going to see us continue to do that. And just a reminder, that $150 million, I think Blaine asked the question, it does not include Pittsburgh. So the $150 million is other assets we have out in the market that we're actively marketing. And most of them -- what you're going to see us sell is a lot like what we've sold the last several years, I think largely multi-tenant, some of our larger assets that are more capital-intensive. So I think you're going to continue to see us do that and hopefully rotate into higher-quality assets once the capital markets open back up.

Okay. That's helpful. And then beyond the actual income-producing assets, are you guys also out there looking for office development sites for the next cycle? And how is pricing there? Has it gone down materially, stayed relatively flat? Or has that just been reentitled for apartments or something else at this point? How would you characterize your desire to -- for land as well as pricing?

Yes. Look, if you look at our land bank, I think we've done a great job over the last several years selling off older land that maybe had a higher and better use that was not office. We sold several parcels to multifamily developers over the last several years as well as we bought what we think is better BBD or mixed-use type development land. So when I look at our land bank today, it's probably in the best shape it's been in a long time. And so we're really not actively looking for any land right now. In fact, we just sold a small parcel this past quarter and then we have a couple other parcels that likely sell next year. So it's hard to characterize it, given we're not out there making offers on land to buy. But I do think there's plenty of buyers out there for the right parcels.

Yes, Rob, and I'm just going to add -- this is -- yes, Rob. Sorry, it's Brendan. I'm just going to add to that a little bit. In the sub, we've got kind of $300 million plus of land held for development between core and noncore. I think you should expect that number to go down over time. So that's probably a little bit higher than what we would expect to carry. So if anything, I think we'll get net proceeds from land sales that will be helpful in terms of capital coming in the door rather than looking to acquire additional land for development.

Okay. Is there any of that contemplated in the fourth quarter guidance?

No.

Land sale gain?

Nothing in fourth quarter.

Okay. All right. And then just lastly...

Nothing in the fourth quarter and nothing in that $150 million.

Okay. And then you guys fortunately only report one FFO number. Is there any impact to fourth quarter earnings from the hurricanes at this point for you guys?