Manulife US Real Estate Investment Trust (BTOU) Earnings Call Transcript & Summary

Hi, very good morning to everyone joining us today. Welcome to Manulife's First Half 2022 Results. So today, we have our half year results, we have a fiscal analyst briefing and those who are joining us online and virtually, thanks for joining us. For today's session, we have with us our CEO, Mr. Tripp Gantt, who is based in Singapore; our CIO, Patrick Browne, who is with us from New York, he's flying back today, back to New York. We have Robert, who is our CFO. We have also the IR team [ Meixian Wilen ], who has just joined us. He is really fresh since yesterday; and Choong Chia Yee, who is doing our slide vendorship. So indeed, I forget, so I'm Carol. I will be moderating the Q&A later. For now, we will hand it over to Tripp, who will give us a short presentation of the slides. So the QR code, I believe, for some of you who are here, you saw the QR code earlier, you can scan or there's fiscal copies on the table. Okay, so without further ado, let me just hand it over to Tripp.

Great. Well, good morning, everybody. It's really nice to see the folks here in person after 2.5 years of being separated and being masked and virtual. It's nice to have you here in the room with us. And for those of you that are joining online, thank you for joining. I'll jump into the slides. Just starting with the first half highlights. We'll cover all this in more detail later in the slides. But really, the headline is a DPU of $0.0261, it's down 3.3% year-over-year on a property -- net property income of $57.6 million, which is up 2.8% year-over-year. Our portfolio occupancy remained strong at 90%. We signed 192,000 square feet of leases in the first half. And the physical occupancy of our buildings is still stubbornly low at about 28%, and we're going to cover that in more detail as well. So in terms of our financials, you'll notice that our top lines of revenue and income all increased as a result of our acquisitions that we made in December of 2021. Our Tanasbourne, Park Place and Diablo assets contributed $7.3 million to our NPI. We also had lower rental abatements. Our -- some of our retail tenants, our physical occupancy in our buildings is still relatively low, as some of them are still struggling a bit. But in the first half of last year, we had about $2 million of rental abatements in the first half of this year, it was about $200,000. And we also saw higher car park income. We saw about a $2.7 million increase in parking income from the first half compared to 2021. Now, these were offset somewhat by lower income and occupancy on a same-store basis. Our existing properties did see higher vacancies. We also had an accounting treatment for expected credit loss in 2021 to put our 2021 numbers higher. And so the 2022 did not have that same credit loss reversal. So comparatively, between 2021 and 2022, those numbers are different. And then finally, in terms of calculating the DPU, our denominator did increase from the private placement that we did in 2021. And the results is that our DPU at $0.0361, as I mentioned, is down 3.3% year-over-year. Then the next slide just dives a little bit more into the details so that you can see it graphically. Portfolio-wide, our NPI was up 2.8%, but it was attributed to the acquisitions that we made last year, and you can see the same-store declines on our existing properties across the bottom of the chart there. We continue to have a healthy balance sheet. We're going to be paying out 100% of our distributable income in the first half. And then in terms of capital management and debt, our finance team was able to refinance all the debt that was maturing in 2022. We were able to convert $225 million of that from property level debt into trust level debt as well. It brings the percentage of our portfolio that's currently unencumbered at up to 90.1%. It also extends our weighted average debt maturity to 3.3 years. One of the things that we're really proud of is that our percentage of green and sustainability-linked loans is up to 67% of our debt portfolio now. We're still enjoying a relatively low weighted average interest rate. It is up slightly, but it's still below 3% at 2.97%. And the percentage of our debt portfolio that's fixed is 85.7%. In terms of portfolio performance, as I mentioned, we leased 192,000 square feet in the first half with a slightly positive rental reversion of 1.0%. One of the things that we were pleased to see is that a good piece of our leases signed in the first half were new leases. As you know, renewals are important, keeping tenants in the building is important to maintain occupancy. But the way that you gain occupancy or make up for lost occupancy is through new leases. So we were happy to see the new leases taking up a bigger part of that breakdown. Over on the left-hand side of the chart, you'll see that we have a reasonably good diversification of our lease expiries, which has really provided us with a lot of stability through these kind of more challenging times. It's a result of our long WALE, our WALE is still at 5.0 years. We're happy for that stability at the moment. We continue to have a very well diversified tenant base. The traditional professional services still do make up the largest proportion of our tenants, financial, insurance and legal firms. And we're going to continue to try to target higher-growth sectors, the health care, life sciences, tech to continue diversifying this tenant base even more. The top 10 tenants, this is a slide that a lot of you have seen pretty consistently over the years. Our top 10 tenants tend to be headquarters offices, government agencies, listed companies, kind of high credit stable tenants. But a couple of updates. Two of the top 10 tenants are in our Figueroa building. As we reported in the first half, TCW did inform us that they're not going to be renewing their lease. They'll be vacating the property in December of 2023. The partners of the firm wanted a new space, and they didn't want to live through the renovation. So they chose to move to a different building where they can just move into the offices and have a turnkey space. Quinn Emanuel is our second largest tenant at Figueroa. And we were able to sign them up to a renewal that takes their lease out in February of 2029. Now they did give back 71,000 square feet of space downsizing. We were pleased to get that renewal, but the downsizing leaves us with another chunk of property that we're going to have to lease out. So the 71,000 feet is going to come back to us at the end of August, this month. And our plan is really to modernize that space and get it move-in ready. And what we're seeing in downtown LA is that large tenants tend -- it's almost like a game of musical chairs, the large tenants tend to move from building to building. And we're already beginning to see interest from other large tenants who are doing something similar to what TCW is doing. They're looking to move out of their building to have a new space, and we actually have that space to offer. So oftentimes, it's a case of just trading tenants. And we're seeing activity already from touring in groups that are interested in that. We also have some unique things to offer large tenants at Figueroa, things like signage rights, entire floor spaces. So we have the things that these large tenants are looking for downtown. The other piece of this that's positive for us is, TCW expiring rents were 9% below market. So we're targeting for positive rental reversion when we do find a tenant for that space. And the renewal that we signed with Quinn was a positive reversion of 2.5%. So when we take a look at where the markets are now and looking ahead into what are the cities for office. Now, this is a chart that you've seen before. It shows the phases of kind of the boom and bust bases of office. In a typical year, U.S. cities and U.S. submarkets are on different points on this plot. Some are doing really well, some are at the bottoming phase, depending on local supply and demand dynamics. What COVID did was, it bumped everybody down into the right. And what we're seeing though is that some markets are coming out of this stage more quickly than others. Our properties and our submarkets in Phoenix and Sacramento seem to be recovering more quickly, more quickly than a market like Downtown L.A. or Washington, D.C. is recovering. A market like Portland was a little bit slow to come into this bottoming phase. It seems to be moving through it more quickly. So you can't tell from the velocity -- you can't tell the velocity from this chart, but the idea was to show you that in the U.S., most of these markets are still on this bottom page. The next page is a series of charts that we have from JLL, it's an independent market report, you can actually access through our presentation here. But JLL puts together a submarket report, the submarkets that we're in. And what this is showing us is a lot of really mixed signals. The first chart at the top left, you'll see talks about leasing volume and lease terms in terms of the length of the leases that are being signed. And one of the things that you'll notice very clearly is that after COVID, both leasing volume and lease term were dropping. Lease term picked up at the end of 2021 quite strongly, but you'll notice that the lease terms were a little bit slower to continue to improve. What we have seen in 2022 is a drop-off in leasing volumes. The second quarter of 2022 was the lowest leasing volumes in our submarkets that we've seen since COVID hit. If you move to the next chart on the right, that shows the relationship between the net effective rents and the base rents. You can see that at the end of 2021, beginning 2022, those 2 lines were beginning to come together. The leasing volume was picking up. It was less of a tenant's market and it looks like things might be headed our way. But you can see the divergence of that chart in 2022 is pretty dramatic again. And what we're seeing are -- and the bottom left chart really shows why. We're seeing the TI allowances and free rents in our submarkets has increased dramatically in the first half of 2022, which just, again, shows that the tenants have a lot of bargaining power in our submarkets. And the other thing that we try to monitor pretty closely just to gauge the health of the market and the spacings of our tenants and subleasing activity. Midway through COVID, subleasing activity was relatively high, but it fell off pretty quickly in 2021 and it was even negative into 2022. We've seen that pick up quite a bit in the second quarter of 2022 in our submarkets. And so this is something that we're going to be watching really carefully to see where that trends as well. So with all the uncertainty and cloudy vision that we have in some of our submarkets, there are a few things to us that are becoming very, very clear. And some of them are large secular trends in office. One of the things that we truly believe is that hybrid work is here to say, this is going to be the new normal in the U.S. And what this means for property owners is that on any given day in your office building, you're simply going to have fewer people in the office than you had during the times before COVID. I think that the graphic in the bottom right kind of illustrates this and illustrates what we're expecting and what a lot of property owners in the U.S. are expecting. That top line shows how it was in the past. People came to the office, 80% of your people were on a really granular basis. You had a few people working from home and a few people doing hybrid. COVID obviously changed everything. That's what it looks like in the middle where we are now. But we think where it's going to settle out is similar to that bottom line. Where you're going to see roughly 40% of the people coming back to the office on a regular basis, another 40% doing a more hybrid arrangements and probably about 20% to 30% working from home. And so what this leads to are questions. If you're a tenant or if you're an employer and you're looking at that bottom line and you're thinking, this is where my workforce is going to be, you're asking yourself, do we need all this space? These are the questions that tenants are asking right now. What we've seen in our buildings is that the tenants, especially the large ones and the olders that have been in these buildings for a long time, they're saying no. They're saying that we are going to be downsizing. We're going to need less space. And so the impacts of this hybrid culture are something that we're going to have to monitor really closely, but that leads us to the next page. Is something that is another trend that is very, very clear is that the offices that have the amenities and the locations to attract the tenants are winning the lion's share of this demand now. There are definitely -- we feel are going to be winners and losers in this space in terms of Class A and trophy office. And so the concept of hotelization is something that we're seeing in this Class A and trophy office space. I think the graphic on the right kind of shows partly how this works. In the old days, you had an office, you had your cubes, you came to work, you sat at your desk, and that was how it worked. The top buildings that are capturing a lot of the demand right now in the Class A and trophy space are the ones that are offering these more vertical spaces, more experiential offering, hotel-like fuel, and it's a theme that we're seeing throughout the U.S. The other piece of this that's important is not just the design of these spaces, but also the flexibility that you can offer tenants in terms of their needs to expand or contract. A lot of tenants are still figuring out their space needs and providing this more flexible space is going to be important for us. And in fact, JLL in a study they did recently expect about 30% of future office space in this Class A and trophy type office to be this kind of flex space. So what does it mean for us? Well, luckily for us, we have assets that have attributes that can meet these needs. We have larger buildings that can accommodate a multi -- multiple uses like these kind of amenities. We also have Class A and trophy office assets in good locations. And so one of the things we're going to be looking at is, how we can provide these flexible spaces that the tenants are demanding. And one of the first ways we want to do that is to begin exploring partnerships with the best-in-class operators. One of the concepts out there is one called, Flex by JLL, and we're currently working with JLL to look at space in one of our properties. I think the second thing that we're going to do is really take a look at which assets in our portfolio we feel would be prime for this kind of hotelization. Again, we do have some trophy and Class A offices that are in these work, move, play locations that seem to be very well suited for this. And the idea is that we're going to take a really close look and analyze which of these assets, we can see an uplift in rental rates, and uplift in values and really have a competitive advantage and begin driving rents and being more aggressive in how we can have pricing power in these kind of assets. And one example is our Michaelson asset in Irvine. It's already recognized as a trophy building in this Orange County area. It's the tallest building. So our rooftop would be an amazing amenity, unblock views of Orange County and the airport, a fantastic space for both an F&B concept or an amenity. We also have a really good design on our lower floors with a fantastic glass lines, exposure to outdoor space, exactly the kind of things you want to look at in a really trophy asset that's going to be hotelizing to attract tenants. So this is just one example, but we're going to be going through this in the third quarter and really taking a look at which of our assets we can do this on. In terms of ESG, as you know, we've aligned with our sponsor's commitment to net zero by 2050. We've been making progress on reduction of our greenhouse gas and energy intensity. 70% of our portfolio is green certified, something that we're really, really proud of. I think the U.S. average is about 14% of buildings. So we have 70% of our portfolio right now, which is green. In terms of our image as thought leaders, we had our MUST Go Green Conference in October of last year. And since then, I feel like every time I turn around, Carol speaking at another ESG conference. Anyway, she's been at more than 10 conferences. We've spoken to thousands of people, and it's really kind of entrenched our position and our image as a thought later on this. Another important point that we want to try to be. We're trying to be the first REIT who can really target the younger generation to make people realize and invest in REITs, it's not just for old people like me, it can be something that's young and cool. And so our team came up with this cute little guy Prof. Green Dot. We're going to be really beginning this engagement for this digital generation and using digital tools to reach out to people that might not otherwise be exposed to REIT investing. And in terms of governance, we're constantly increasing our disclosures, promoting transparency and the ratings that we're getting from different groups really show our efforts in this to disclose and share information and be transparent about what we're doing and encourage others to do the same. Now looking forward, I think the message here is that we're still in a tough time. The U.S. economy is struggling with inflation and recession fears. Employment is still strong, but it is plateauing a bit. And it's possible that we're seeing human cutbacks and tech and you've seen the headlines. What that means in the submarkets that we're in, we have seen a slowdown in leasing demand and leasing activity. And tenants are still unsure about their spaces and what they need and they're really desiring flexibility. The other thing that we're seeing in the real-estate markets is the debt costs have gone up significantly just in the last 60 days. This has really led to a lot of buyers pulling back out of office transactions. Fewer buyers on the field, owners are holding their values. We're seeing differences in perspectives on value and transaction activity has just really slowed in the second half or in the second quarter, and we expect that to continue on through the third quarter and in the second half. So the way that we got these cyclical economic challenges that we're facing and these secular changes to office. And in terms of the cyclical economic downturn, we're taking a more defensive strategy. We're really going to focus on keeping our balance sheet healthy. We're going to take advantage of our -- advantages of our long WALE for stability and the quality of our assets to continue to attract these kind of stable tenants. In terms of the secular shifts we've been talking about in office, like I said, we're really going to be focusing on trying to find ways to provide these flexible spaces in our buildings by partnering with operators and taking the initiative to really hotelize the assets that we can to get pricing power. And lastly, just from a strategic standpoint, we're going to continue to look at high-growth markets and pivoting into other property types that may be able to give us more growth prospects as well. And we're always considering looking at partners both at the financial level and at the property level, who might be able to bring us capacities and best-in-class partnerships. So those are all my prepared remarks. I'm happy to jump into the next phase.

Thank you, Tripp. So now we come to the Q&A session. [Operator Instructions] Any one, Rachel, okay.

Yes. I'm not sure if I've missed anything from your remarks. So, I'm just wondering whether you could give us some color on the exchange occupancy drop on your property leasing?

Yes, unfortunately, we're streaming out a bit, we experienced a drop in occupancy exchange, which was the biggest catalyst for why our occupancy went from 91.7% to 90.0% in June 30th. And it was the result of 3 -- well, fairly large tenants of the property that had vacated. And so we're actively or we have been actively working to build those spaces, some of them were companies go at the last few months so we been proactive in trying to backfill those spaces. And we do have a number of prospects that we're in active discussions with that where I can't promise anything, but I think we feel pretty good about our momentum. We got a good head start and trying to backfill that space and increase the occupancy back up. So -- but it was 3 large tenants that left a little over 100,000 square feet of occupancy last day.

Just following up on that, the past tenants that we expected are there, invariably will be a downsizing and moving to another building outside of Jersey location market?

Yes, it's a combination. There was some consolidation of offices where they -- some moved to just cheaper, lower cost provider type operations. One of the tenants actually that did leave was not the most stellar rent payer. They're a problem tenant for us for a while. And so they have moved out, and we actually think that's a fantastic opportunity, I believe, [indiscernible] weren't the best rent payer. So it's going to deserve to leave them with their space, and we think that's an opportunity to get a better quality tend there. And then the other 2 tenants were just consolidating and closing their Jersey City office tenants -- the Jersey City office presence, they didn't move to a building next to, we didn't lose them to a competitor in the market, it was a decision to sort of close that office and consolidate 2 other offices elsewhere.

And did you guys seen that market is one of the highest sport markets loan?

No, well, it's -- the TI is really a function of your rents and that we are going to be achieving. So, higher -- your rents are typically higher you're able to provide your tenant buildings. So we have gross rents in that building. We're asking rents in the low to mid-40s. And so the TIs are commensurate for that. We haven't seen a massive spike in IT in tenant exchange. And one of the good things about this property is that we've done a pretty extensive elevated modification and a lobby refurbishment and we've been pushing up some of the vacant floors. And so the space is in fairly good condition, and I don't expect incredibly punishing and we had effective rents at this property to release it. But as Tripp alluded, there are -- the market is not at Pre-COVID levels in terms of landlord having full negotiating power. That's not unique to Jersey City or any of our markets, I take that U.S. as a whole. So net effective rents are continuing to be lower and that means just TIs and concessions are continuing to be higher than they were pre-COVID, I don't think we've seen in the first half of 2022, a big spike upwards in concessions. It's just fairly stabilized, I think that would be relative to what we saw over the course of the second half of 2021.

And maybe just my second question, and you spoke about very effective [indiscernible] office building. How should we think about your CapEx that you are aiming to put in? And when you talk about partnership, is it like a normal lease office building leased for them to manage how does that look?

Yes. So we'll be analyzing this on a case-by-case basis. I don't think that we're going to be spending all the money at one time on all these buildings. We're going to be looking on a case-by-case basis and staging the investments that we make in these properties, depending on where we can see the opportunities where there's places to build and make these improvements without disrupting businesses and disrupting tenants, first we're going to do that. And so you kind of take the low-hanging fruit first in terms of the asset improvements that you make. So we'll be analyzing that on a case-by-case basis as we go forward. So I can't give you a broad grow stroke of how we're going to spend that money right now on day 1. In terms of the Flex operators, there are several different models out there. Flex by JLL is just one of them. And the business models that they have, some of them require more upfront expenditures of building out the space and then you share the revenue on the back end, right. And what -- so Group like JLL does 2 things. They both demand -- they're a demand aggregator where they bring tenants into the building that you might not otherwise have access to. And they also help you operate and program that space in a way that's really appealing to tenants. And so some of it follows that kind of model. The old rework model that we're all familiar with, where they come in and they lease space and they sub lease it, that's it, they don't do that anymore. Other groups tend to focus more as almost like your space provider consultants when they'll help you design your spec suites on the way the tenants want, right, and you build the spec suites out and they're almost like a consultant in some ways. So there's a spectrum of offerings that these Flex operators have. And again, on a case-by-case basis, building-by-building basis, we're going to see which ones fit the spaces that we have the best. And it's going to be a mixture of both the design and the physical attributes of the buildings, the amount of vacancy that we have in the building and how much space we need to make Flex. And third, kind of staggering the expenditures. Some of the models give you more money upfront. Some models give you more of an upside on the back end. And so places where we're going to be balancing those things out, trying to stagger the amount of money that we put out with the amount of money that we get in it, if that makes sense.

I just wanted to give you more color. I think that when you talk about the flex operators and the [indiscernible], there is 2 different things. So it's not like we're going to look to hotelize our product -- so let's just be clear. So JLL Flex is one of the operators that we are talking to. There's a lot of them in U.S., and that's the way like we are going into flex space and what Tripp does explained. So that's one strategy, I would say. The other one is to shortlist properties that we have. There's maybe Class A trophy that could give us a premium in the rents when we do that. So it will be a change of the whole lobby like [indiscernible] ideas. And I think the discussion we have on CapEx and all we're looking at it, we're not talking about like $50 million to $80 million. We're talking about like maybe low single digit to like $10 million, $15 million depending on what we wanted to do. So that's -- to your question on how much CapEx we saw? Like in total, as we look at, as we plan a portfolio then we will look at what one does and which are the ones, you can let me do that --.

No, I think Carol touched on a lot, what I was going to follow up on. And on the CapEx side, like it's a great question. As Tripp said, we're sort of actively studying it right now. We're going to each building case by case, and it will be sort of a gradual process that we go on. But what -- I think important to highlight is that, not only is the U.S. market having -- they are clouds, right? There are definitely things to be worried about in terms of just tent downsizing, less demand, less people in the office this that and the other. But on the flip side is, is that as Tripp also, I think mentioned, there are going to be winners and losers. And when you have a tenant that had 100,000 square feet and they decide, I only need 50,000. What happens is, A, they want to make sure that they are in the best possible building and location that they can get to get back -- get their employees back in. And because they're cutting their footprint in half and they want to have these good buildings, they're almost becoming rent agnostic. And so if you deliver the right product in the right location with the right amenities, and they also want to have these flex options in their building is becoming a requirement where a big tenant will say, "I want to be here, it's got the right amenities, but like if we want to do a project for a year or have a contractor that we work with come in, we want to make sure that there's flex space, we can kind of grow into and contract as sort of a supplement to our traditional lease. If you have all of that, you're seeing, very large rent premiums for the buildings that are able to execute that. So that's sort of the trend that we're seeing. And we do think that there's strong returns on invested capital if you can execute. So that's something to sort of consider and we'll continue to monitor as we go.

Derek from DBS, Rachel's colleague. I was curious about this whole downsizing trend in your portfolio. Are you still seeing that? And maybe based as a crystal ball, when you expect that to phase out potentially?

First of all, it is very clear to us that many tenants, especially the ones who have large footprints in medium buildings for a long time are downsizing. We are seeing that. We also have an example of a tenant who is upsize at our Plaza asset. ACE Insurance, Chubb Insurance actually is consolidating several of their satellite offices into our building, and they're actually coming back for significantly more space, I forget what is the...

Well, we signed an 8,800 square foot expansion for the end of last year, and we're actively talking to them is...

And so what we're seeing -- again, we're seeing different tenants are doing different things, but the net that we see is a decrease in the demand for space. And what this means is that there are going to be more tenants that need smaller spaces going forward. It's -- in terms of the crystal ball, what I see in the crystal ball is that people are going to want flexible options. And I think CBRE did an interesting study. They were surveying tenants, large corporate tenants. And today, 17% of those tenants have flexible space as part of their office solution for their corporation. And something like 51% now said within 3 years, we're going to begin incorporating flexible space as a component of our workspace solutions. And so what we're seeing is, it's not just -- in the early days, it was tenants who didn't know what space they needed. They just need some space temporarily and to give the flexible options. But what we're seeing going forward very clearly is that companies are going to have a mix of this traditional office space and flexible space as part of their solution. And if you can offer those things in the same building, you have an advantage. And it's something that smaller buildings are going to have a harder time offering. If you're a smaller building owner, you can't give the tenants of the space to expand and contract as they need. Our larger buildings and actually our vacancies ironically give us the ability to do that. And so we're really going to try to play on that advantage.

Smaller buildings also going to scale up, offer the amenities that the tenants want. So...

Okay. So my second question is on this whole strategy of going -- having this flex office solutions in our portfolio. I'm just wondering whether there is going to be the demand for this product to exceed, say, for example, the downsizing that we're seeing. So is it a net positiveness in this occupancy that we should expect as you roll out maybe in the next couple of quarters?

That's a great -- it's a great question. My crystal ball doesn't go quite that far out. What I do think is that the combination of amenities and flex space, our expectation is that it's going to take up a lot of the space that would otherwise be diminished demand from the traditional office space. I think we have to see how that plays out.

I had to get, I'd just say -- I'd say it's a net negative for the market as a whole, but the net positive for the winners, you're going to see, as I said, outsized rent growth. And when you're successful, you're going to have lower cap rates and lower discount rates and higher occupancy than the broader market. I think sort of be a binary...

Just winners and losers market out there in the Class A and trophy space.

Just one more...

[indiscernible]

In report, we've actually -- to that point, outside of Flex by JLL, there was couple providers that came to us to one of our buildings for Phipps in Atlanta. Unfortunately, for various reasons, [indiscernible]. They came to us as a flex provider, that they had a tenant that they were going to plug into a day 1 for a 1 year sort of they were looking for a project space in Atlanta and needed them to move in and they were going to -- so these reverse inquiries and they control the tenant relationships. And so it makes a lot of sense in a lot of different ways as a complement to the building.

Got it. So just back to your comment, Patrick, about this carats potentially go compress. I always have this presumption I may be wrong is that, let's say, for example, look at building, let's say, Anchor by TCW, good credit versus the 30% is a flex operator. I don't deliver where they do question cautious about having a big part of the [indiscernible].

I would say it's -- there's no -- it's evolving and I think changing. I think the market is starting to come to a realization that for -- it -- not every building is going to be able to do this. So we do think that it's becoming more widely accepted. And -- but as Tripp alluded, he mentioned like the model that's out -- and I actually think it's a good thing is that I would say, I don't want to throw a shade we work, but just some flex operators saying, I'm going to come sign a 15-year lease. And they pay you $10 a foot or whatever, I'm making up a number, and then they go out and lease and they steal all the upside, because they're obviously going to rent out a big spread. And so the new model as you come in, you partner. You probably put up some upfront capital for your operator to let them build out the space and then they operate it. And you -- it's a profit-sharing agreement such that they'll still get that spread that we work was getting. But as an owner, you'll share in that outsized market rent that you're able to achieve through that. And so that will flow through your bottom line. And I guess, to your point, the question that people will still have on their mind is, well, you can't just model that as a 10-year lease, it's a little bit harder to model an evaluation. But I think the market is beginning to accept that this is -- will be a winning value proposition if you're able to execute it and it should be accretive to our value and it's evolving.

And part of it, too, is that the spaces that you're actually building out for these flex operators are beautiful space down here. So you end up with a better physical product, which again a valuer is going to come and look at and say, okay, if the JLL or the Flex operator is not in the space, you still have this really beautiful space that you can lease out as [indiscernible].

[indiscernible]

Kiang from CLSA. Can you talk about the GIs. I mean this seems to be stabilizing, but, yes, it has shot up, [indiscernible]. So if your outlook for the next couple of quarters seem to be quite -- if you can [indiscernible], doesn't mean that TIs will remain elevated or if there's another breakup?

Yes, I would it's hard to predict for sure. But I do think that they've sort of reached a tentative ceiling. Like at some point, landlord, the economics won't make sense for landlords to continue to pay higher and higher rents, TIs unless they start to see rent increases like you can't just -- every landlord can't be going out there and doing these credibly dilutive or negative NER deals or wherever just to secure occupancy. So I do think that it's stabilized. I think the biggest question around TIs is actually inflation, and it's just a simple function of can you pay the labor to get there? And there are material? And what are those -- so that's sort of the question mark. I think we've seen it stabilize, but it's something to monitor, but I don't -- my personal view is that like next quarter or the quarter after, TIs are going to be up 30% on a per square foot basis. I don't see that happening. But I don't also see them dropping to 2019 levels tomorrow either. I think we're sort of in this status quo and elevated environment, and we'll see when that chips away.

And my second question is on the lease expiry. I mean you've seen 2 large tenants with you for almost 20 years now downsize. Any visibility on that mix stay 18 months and do you expect any kind of tenants come to [indiscernible] you can expect?

[indiscernible] Well, so I would say that it's an unfortunate occurrence that this happened that one building, 2 large tenants. But I think it's a little bit of an anomaly. Obviously, the market conditions is such that tens are downsizing. So it's not -- that's not an anomaly in and it itself. And either is the fact that PCW, they were in 189,000 square feet. They've been in that space since 1991, and I can tell you that it looked like they hadn't touched their space since 1991, when I walked in, it was like a time war. And like it didn't look like this. And so I think as Tripp mentioned, like a lot of tenants, they don't have the capacity to live through a renovation and have to move from fourth floor and so that reshuffle especially when you're large like that. And they also had a unique circumstance where like they had this bygone practice of -- and I'll get to your question, but I think this color is important to give you is that, they had a full-service cafeteria with all these staff members and like you don't see that in the U.S. anymore. And so they thought to themselves 2 things. One is we don't need all the space. So they can downsize to say, I don't know exactly what their number is. It hasn't been announced, but speculation is it's about 120,000 square feet. So get rid 70,000 square feet, they can get rid of this, if they stay in place, they felt that getting rid of their cafeteria with their -- would upset their employees. Whereas if they go to a new building, it's easier to explain and they don't have to live through a renovation. So [indiscernible] I think is a little bit of an outlier in terms of tenants leaving the building. And it just so happens that there's 2 tenants going on at once. But this building has been fully occupied for 25 years. And it's because it's in a great location, it's got good floor plates, new all live work play and all these dynamics, we think that this is going to be a value prop to another tenant in the market that they can do what TCW did to us by moving in and getting new space in a better building. And so we think that we'll still something launch at some point in time. But now I get to the -- we don't -- I don't see other tenants in the -- in our portfolio over the next 12 to 18 months that are going to be full out pulling the rate underneath us, one of our top 10 tenants. It doesn't mean that it can't happen, no, of course, but it's something that keeps us up at night, we're in front of it. But I don't see any smoke signals right now that we're going to have a bunch of situations like this at every one of our [indiscernible]. So we'll monitor it. We'll work on it. Does it mean that we won't see more downsizing. No. There might be some shedding of space here or there, but I don't expect 2 very large tenants that all of our buildings to start moving out over the next 24 months.

Because I was just thinking like 20 years, [indiscernible] management crises [indiscernible] during those periods they possibly didn't downsize at all, right?

Well, they didn't have lease expirations. And the COVID, I think, is different than GFC, yes, for sure.

[indiscernible] I mean during the [indiscernible] But I think what, I mean, we are seeing -- I mean, having been on the ground, I mean, the 2 of them does really change, right? The landscape of office has changed. People are not coming back. We have to accept it. And now what do you need to get people to come back. I think that's the mix thing that we must do and run, rather than just wait and see what happens. So think it's no question there that will be downsizing. But when tenants downsize what can we do, right? Because we can attract newer tenants who are willing to pay. So I think kind of sharing with me, like those of you who have been to Microson in Irvine, we are combining about $48, I mean it's quite a -- it's not all up by about 10 years old or so. Our closest competitor is combining $60. So if we utilize it or just figure and provide it, I mean it's very nice but the upside is we could command higher rents. But we never want, I think frequently look at it and say like, okay, that's something that we need to [indiscernible]. But I think what COVID has done is we need to look at how the world has changed and then proactively move there and get upside. So you go to read articles. I mean and you were [indiscernible] just because it's like state-of-art tenant offers that you are seeing. Why? Is because [indiscernible] stick to the rent like to want to start to come back.

Yes. And -- but you also have to look at the flip side, we mentioned this tenant exchange with ACE American Insurance crept into our top 10 tenant list because they've been growing is that there are tenants that they might be downsizing on the whole. But for these big sprawling organizations, U.S. Treasury or ACE American Insurance where they have multiple locations, if you have the right product in the right location, you might capture the net benefit in your building of their downsize and consolidation. So we feel strongly that has an interesting value proposition for us. We've got trophy buildings and trophy locations. And if we spend the money suitably, we think we'll not only get rent consolidation but occupancy gains.

So, in short, without the vacancy, we won't have this kind of opportunity to refresh our buildings, whether it's the mix of flex out utilizations. But so yes, there might be musical chair [indiscernible] new tenants can come in after got that space.

[indiscernible]. You mentioned that we can downsize the [indiscernible] and new companies will be into [indiscernible].

So again, I think that if you look at the entire office market as a whole, I think demand is actually shrinking, right? But if you look at where that demand is going, it is gravitating all to the really high-quality time spaces. So there's a line somewhere to where your asset could become obsolete and empty, right? And what you want to do is stay at the end down here where everybody wants to be. And so that's really what we're saying. We have assets that can be -- can be winners in this market. It will mean that in the U.S., there will be offices that fail, there will be offices that are torn down and that are empty. And at the other end of the spectrum, you're going to have offices that everybody wants to be in that are going to have pricing power and outsized rents. And so we are bound and determined to be at this end of the spectrum on it.

[indiscernible] Since the physical occupancy is still valuable at 20%. So are we still expecting more rental speed in the second half for the [indiscernible]?

Not much, actually, as to down by a large issue of the F&Bs, -- they're only about less than 2% of our gross rental income. This very many people like purpose shares only $200,000. This was some compared to this time last year $2 million. So yes, down 90%.

Okay. So for all these F&B tenants, are they going to stay or are you paying to -- or are they need to move up?

It's going to be a mix. I think for now, they are in place. But I think as we go about evaluating strategies for our assets, we're going to take a hard look, do we think -- because F&B is going to play a very important role in this whole concept. It's not just like you need a nice fitness center. You want to have the most up-to-date and modern and sort of hit sort of F&B offerings for your tenants. And so we will be taking a hard look whether there's opportunity to sort of refresh some of our operators on the F&B side as we go about our strategy. So for now, as Robert alluded like, we've seen minimal abatement so this is relative to what was going on year-over-year, they're all open. And the unfortunate truth of the U.S. right how is that the entire country is open and operating as if everything is normal set for people being in their office space. They're going out to eat the everything as if it were 2019, but coming to the office. So the F&Bs we are probably going to look at.

So are we expecting physical output to increase in the coming quarters or will be likely to stay around this and level for the year?

I feel like we've been constantly saying, no, we expect it to improve next quarter. And then after the Labor Day holiday in the U.S., people are going to come back. Some are vacations over. We've been saying this now for 2 years. And I think that the slide that we that showed the new hybrid work model. I think that's where it's going to settle out. I don't think that we're ever going to go back to 100% occupancy and when we're pre-COVID and that's my personal belief. And so I think that we're just going to have to deal with the fact that there are going to be fewer people in our office buildings at any given time than there were. I think that's just the new normal.

And your occupancy [indiscernible] we know the U.S. and it's about 40% plus, okay. Then also in terms of like rental margin this year, are you still expecting more single [indiscernible]?

Yes. We ended the first half at 1.0%, which is, I think, where we -- we might do better next quarter or next half, but I think on the whole what it's going to be low to mid-single-digit positives moving forward.

Yes. So just to mention, the second quarter reversion, if you can share with us what the number was? And then my second question is on divestments. How far are we towards that [indiscernible]?

Yes. 2Q was basically flat. It was minus 0.1%. So if you recall, first quarter is 3.9%.

And then in terms of divestments, we've taken a look at which assets in our portfolio would be at the right point of their life cycle to maybe harvest some value. Unfortunately, the sales transaction market in the U.S. has completely seized up. We've seen transactions that were in play in June. And if the money wasn't hard, buyers have pulled back from those transactions. We've seen that in several places in the U.S. Those that were lucky enough to have their assets in contract in June and had the hard money are -- some of our peers have been able to close assets that were in contract. But literally over the last 6 weeks, we've seen the seas part in terms of transactions in the U.S. and sales transactions are really difficult right now. So I think in the third and fourth quarter, we're going to continue to monitor this. We are going to continue to do like a wholesale analysis on our assets and identify which assets might be appropriate for recycling. But it's a difficult market to sell assets in right now. And I think there's a lot of clouds around valuations at the moment. And so I think we're going to see a lot of this play out in the second half. And so we're watching this really, really closely.

Valuation of client region to change materially by the U.S. life a component and integrated it. And also when I look at the bantering bans are both year-on-year. But last year, we've been posting on wells. So now should we expect the cash rate also starting to rise. So should we expect the margin this year?

Yes. I want to be careful about forward-looking statements and those kind of things. What I can tell you is that, my background is actually in real estate appraisal. That's where I started my career. If you look at the assumptions that go into appraisals, in my 25 years in this industry in real estate, I'm not sure I've seen as many question marks as I do right now. If you're a buyer and you're looking at buying a property, your assumptions on demand, your assumptions on occupancy, your assumptions on loan growth, all these things, our question marks at the moment. Your debt is a question, how much debt you can get, how much of an LTV, what your proceeds are going to be, what kind of rates you can get. Those are question marks right now. And so what we've seen is buyers pull back a lot and get out of the markets. But you also don't see a lot of distress right now at the moment on the part of sellers. So sellers are holding on to their values. So sellers are looking in the rearview mirror at their last values and holding on to assets buyers are looking forward and it's really cloudy. And so their idea of valuation is down here. And so what you have is a mismatch right now of a valuation, what we call a bid-ask spread, right? And that bid-ask spread, where is the middle? Where is the equilibrium going to come from in these valuations. I don't know. We'll just have to see. But I do know that there are a lot of clouds out there right now in terms of valuations. And you're right, cap rates are rising as well. Interest rates are going up. Cap rates are rising. Cap rates are also a reflection of a buyer's perception of risk. So all these things are making the valuation horizon something that we have to watch and carefully. It's tough to predict right now.

I would just add that I think the transaction market is probably being more opportunistic than a valuer. The valuers are going to take, probably, I would say, a more conservative approach to valuations than like a buyer right now that is hoping to find some distress. So if you have to look at both through different -- the transaction market and how value we look at it when you're going through years of appraisal. But [indiscernible] research provider used for a lot of our data has indicated that they believe that values in the U.S. cap rates are up, I think, year-to-date about 30 basis points and values are down about 2% in private market office balance at the moment. Whether that's an indication of where our values will end up year-end, it's hard to say, but that sort of has the type things at the moment. And the last thing I just want to flex up, I think for valuing our portfolio, it's a bit premature that we're not going to just have that value or assume that we're going to have 30% flex space and will have that in their model, at the end of the year and spit out a number. I think that's probably -- we're not at that point. If we commence a relationship with Flex by JLL in one of our buildings and yes, that will be modeled into their valuation, of course. But in terms of them just assuming that we're going to have that all of our portfolio, I think it's been premature.

In terms of the bid-ask spread, how property [indiscernible] wide bid-ask spreads, which is the widest?

Well, it's hard to know because the transactions aren't occurring. So we haven't cemented it. I don't know that we have anything more than anecdotal evidence of some buyers coming in and offering 15% to 20% below fair market value for certain assets, but they're not transacting. Sellers are saying, "No, thank you. So where does that value end up being? And I think that until we either have distress on the part of sellers or until buyers begin capitulating a bit and offering the prices that the sellers are asking. We're not going to find that middle point. The flip side of this is it's also a good time if you have the resources to potentially buy assets, if valuations do drop, it could be a good time to pick assets up. And so that's something that if you're in a place where you've been able to keep your balance sheet healthy, then you can actually present an opportunity as well.

[indiscernible] U.S. office, it looks like you're well positioned [indiscernible] this work from home hybrid [indiscernible]?

That's a great question. I mean, look, I think that I'm probably on the record of saying, "Hey, listen, one of the good things about a recession might be that it gives some floors more power. I kind of want to go back and take that back at times because I don't personally feel like that, of course anybody back to the office, right. So, that's the kind of person I am. I do think that B class commodity office spaces or office buildings are in a vulnerable position. I do. I think that if you look on the spectrum of office from trophy Class A to business parks, there's an area right there in that B class spectrum that is really vulnerable. The good thing about business parks and places like that is oftentimes there are functions going on there that you can't do remotely, whether it's some sort of physical research or some sort of physical activity, you can't do that remotely. It's the B-class offices that are these kind of like what we call cube forms, back office spaces that I think are really, really vulnerable. And I think that when we talked about that overall diminishing demand for office in the U.S., those are the spaces I think that you're going to see that are going to empty out first, how to have the most difficulty in pricing. And I do think they're very, very vulnerable.

So with your class B buildings [indiscernible]?

Yes. I mean I think that as we take a look at our portfolio, we're really taking a look at which of the assets we feel could be vulnerable and figure out, first of all, what we can do defensively on them. I think that most of our assets right now are in pretty good shape. We are still seeing leasing demand. It is changing in some of our suburban assets. But the economies that we're in are still pretty strong. And a lot of the services that we -- and the tenants that we have in these buildings are providing services that are more stable. It's -- right now, we're in a good place on a lot of our more Class B assets. But I would say that as we're looking through which candidates would be good for disposal and divestment that, that plays into our decision and they're just going to move them up the list. Asset, we want a portfolio that's future proof, right?

Just to follow-up. B class, there is 2 buildings in our portfolio that if you look to our slide deck that we classified as class B, and I think both of them would fall under the description that say, have things going on that tenants are using it, not just for sort of low-cost provider back-office operations at Tanasbourne and Diablo. And at Diablo, we've got tenants literally doing this laboratory research going on in there and whatnot. Like...

Heavy machinery and...

Correct. And in Tanasbourne. Nike, there is one of our tenants in that property that we have photoshoots going on in there for LeBron James and Serena Williams comes in with hope. I don't think LeBron is going to be working home on that one. So I think those 2 are probably a little bit more protected from some insurance...

Tokyo Electronic, doing research and development, and their building this full pack. So I do think our Class B spaces are pretty well protected right now.

Just like to be mindful of time, coming in soon. Yes, I mean you do have last one question that you want to ask?

[indiscernible]?

Sorry, the refi in July, what's the impact?

[indiscernible]?

Well, just the latest series of loans are on the sofa base. So the margin is a bit higher, the bear margin, because they have to include the credit spread adjustments, but the relative to benchmark rate it's a good, let's say, assuming we hedge at the current level of 5.7%. The blended rate is about just over 4% or that refi. What it does blended to the average interest cost positive increase from 2.97% to about 3.1% approximately. But bear in mind that the rates are very volatile. It goes up and down. The long rates are lower than the short rates. So that's kind of indications that maybe in the market is assessing the interest rates, just can't keep going, at some point we'll take more, maybe come back...

Yes. Maybe if I can just wrap up. I mean last question, I think we look on the inflation slide, with the high inflation, again the pressure that came in is, are we able to get higher rental escalation? Are we seeing that in our leases that we signed any color on that?

Well, our average in-place escalation is 2.2%. And I think that this is a big question mark in the market and a lot of landlords are certainly pushing for it. But I want to caveat that it's only really a factor, a true factor for us on the gross lease side, because on net leases, which we had 4 buildings that have been leased, tenants are responsible for their operating expenses. So at least we don't bear any risk there. And the gross leases, most of our expenses are passed in to our tenants anyway. But we're all monitoring whether the escalation cause will start to ramp up to match inflation in the market. June CPI print in the U.S. was, I think, 9.1%. I can say with certainty, we're not signing any leases right now that have an aspiration of 9.1% in them. But there are some properties where we're seeing negotiations where that debt annual escalation cause is 3.5% to 2%, 4%, some it's not at that level. But I do think that's inching up, but it's ultimately going to be a function of supply and demand and your negotiating leverage over the tenants. So it's something that's planning out actively, but as I said, inflation is currently higher than the escalation costs we're seeing in the leasing.

Okay. Thank you. Thank you so much. So thank you, everyone, for coming today basically. I know there's quite a bit of questions on the online -- just advanced apology, we can't answer your questions online, but please feel free to drop the IR team your questions, and we can get back to you. So we've come to the end of the session. So just wishing everyone a nice day and do that as we get any further questions afterwards. Thank you.

Thanks, everybody.

For those who are physically here, right? So there's a little green box. It's not on purpose on here, because [indiscernible] really there's some snack inside for you, so enjoy your snack.

Yes, you guys have a busy day today.

Like yesterday [indiscernible].