Paramount Group, Inc. (PGRE) Earnings Call Transcript & Summary

Well, thank you, everyone, for joining us on our next session at our Life After COVID conference. My name is Vikram Malhotra. I'm one of the REIT analysts at Morgan Stanley. And really excited in that to host the Paramount Group, a U.S.-based office company with a focus on New York and San Francisco. And really, they focus on the office space. They have some street retail, but I'm going to turn it over to their CEO, Albert Behler, to talk about the company in a bit. But before I do that, let me just go over some quick disclosures. So please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. The webcast is not for members of the press. And if you are a member of the press, please disconnect and reach out separately. For important disclosures, please see Morgan Stanley's research disclosure website. And if you have any questions, please reach out to your Morgan Stanley sales rep. With that, I'm really excited to have the Paramount team joined here by -- with Albert Behler, Chairman, and CEO and President; Wilbur Paes, EVP and CFO; and then Peter Brindley, who's the EVP of Leasing; as well as Rob Simone, Director of Business Development. Albert, thank you so much for doing this. Maybe just for those investors that are new to the story, would -- it'd be great to just get a quick overview of the company.

Yes. Great. Thank you, Vikram, and thanks, everyone, for joining here today. I was telling Vikram, this is a good day after a couple of tough months. Yesterday, if somebody watched our stock price performance, we were up over 25%. So there came some good news with the vaccine situation. And that basically proves partly of what we have been saying, that we -- the company has been tremendously oversold. So for those of you, as Vikram was saying, that are new to the Paramount story, we are a bicoastal CBD office REIT that is focusing on Class A and trophy assets in New York and San Francisco. The company went public in late 2014. It was the largest REIT IPO ever at the time and still until today. We raised $2.6 billion. And at the time, we're nearly 4x oversubscribed, we raised -- we had offerings of $10 billion to buy our share. That's when CBD office buildings were very popular. And since then, we have strategically focused our portfolio. We own 7 assets in New York City and increased our holdings from, in the beginning, 2 buildings in San Francisco to now 6 assets in San Francisco. And in Washington, D.C., we had a handful of assets. We are now down to 1 asset that is under contract, and we expect that sale to close by the end of this year. So after that, we will be -- we have some asset management activities in Washington, D.C. After that, we will be a bicoastal REIT, present in New York and San Francisco. In addition, we have a fund management business, where we manage a family of off-balance sheet debt and special situation funds. If you take this entire portfolio together, including the public company REIT, we have assets under management of owned and managed of roughly $14 billion. The pre COVID, we had been generating some of the best NOI growth and leasing spreads among our closest peers. Post COVID, our collections have been exceptional at over 97% in the most recent quarter, including 99% among our office tenants, which is sector-leading amongst our peers. Going forward, myself as well as Peter and his team are all laser-focused on leasing up some pending vacancy in our New York portfolio. Most people know that we have an upcoming vacancy at 1301 Sixth Avenue. That's a Barclays lease. It's expired. We know this basically since going public. So it's a well-known opportunity for the leasing team, and we expect some activity there in the middle -- latest in the middle of 2021. Beyond that, we believe we have deliberately constructed a bulletproof portfolio designed to handle the current stress. We have been focusing on the path of tenants with investment credits. So we have, knock on wood, so far, very, very minimal calamities, I might call it. Of course, the retail tenants have the toughest -- if you talk about the restaurants in New York or San Francisco, those are tenants we are working with because you don't want to have those spaces to go black during these times. But the good news is many of those operators have already opened back up for business and working within the guidelines of the City of New York and San Francisco. And with that, I hand it over to further questions from Vikram.

Thanks so much. That was a great overview. Let me just get into sort of some of the questions pertaining to sort of during COVID, and now that we have a vaccine, maybe we can talk a little bit about your views or thoughts on post COVID. But I guess the most immediate question that a lot of people have is sort of the return to work time line. Maybe give us a sense of what you've heard from your tenants over the last few months. And what's your expectation now that we have a vaccine announcement in terms of when tenants return to work and how that impacts your building utilization.

Yes. When the pandemic hit, Vikram, we formed a steering committee under the leadership of Peter Brindley, and it was focused on tenants and their employees coming back to the offices. And we have been developing very thorough guidelines as to how we do this. And because we are a Class A operator of these office buildings, we got with our property managers and contacted our tenants one by one to try to resolve some of their anxiousness. And I think we developed very, very good guidelines and got some very nice thank you e-mails from tenants who had to deal with their own issues. Peter, do you want to...

Yes. I think we firmly believe that meaningful physical occupancy in our buildings will convert to leasing activity across all buildings, I should say. And so as Albert notes, priority #1 for us was securing the safety of our buildings. And I think that the most basic level, as Albert pointed out, we've been highly communicative with our tenants in terms of the various initiatives that we have undertaken. We've also trained our staff. We did something somewhat unconventional that we engaged the Ritz-Carlton service delivery team to train all of our building staff who will undoubtedly need to deal with all sorts of questions as tenants begin to return to the office. And so we've effectively equipped them to deal with some of these questions. We've also outfitted our buildings, to give you an idea, with thermal scanners that ensure that no person entering the building exceeds the threshold that we mandate for the building by way of their temperature. We have air filtration systems in the lobby, which eliminate all particulate matter and viruses. We have signs and markings and cues to make it very clear to anybody entering the building in terms of how they ought to traverse throughout the building. And so as I have now said, we have taken this very seriously. Tenants have responded by commenting on how much they appreciate all that Paramount has done. And the truth of the matter is it's not a one-sided solution. We've effectively coauthored our solution with their input. We need to understand when they intend to come back, and so it's really a collaborative effort. And what we're hearing is that they intend to come back more than likely in 2021. In New York, where north of 10%, call it, 11% occupancy at this point. San Francisco is lower than that, but that's because, if you recall, in mid-July, the mayor of San Francisco announced an indefinite pause to the original reopening plans and effectively closed all nonessential offices. That has effectively been reversed as of late October. All nonessential offices are allowed to reopen now. And so we're just now starting to see more and more people return to the office in San Francisco, and we think that will bode well for our properties in San Francisco.

That makes sense. And we certainly received a few questions on sort of San Francisco versus New York, which I'll get into a bit. But maybe just to expand a little bit about on what you mentioned, thermal scanners and filtration. What changes broadly has Paramount made to its buildings and operations to deal with this health crisis? And maybe going forward in so-called the life after COVID, what could be some of the more permanent changes to the portfolio?

Yes. So we've replaced all filters on our building supply fan systems with MERV-rated 13 filters, which are the highest quality filters that you can apply to these fan systems. And our expectation is that those will remain in place. We also have installed sensors that monitor the quality of our indoor air. There's no reason that we would do anything other than keep those in place. We've also been continuously introducing more fresh air into the building, which we think only adds to the air quality. And that's something that will be a permanent change on a go-forward basis. As for the thermal scanners that currently read the temperature of every occupant of the building, that remains to be seen in terms of whether or not we keep those in our lobby. We think we've done it in a way that it's not obtrusive. It's very natural-looking in the lobby, and it's effective the way it is. So that remains to be seen as to whether or not we keep that. But a lot of the protocols and policies that we have put in place as a result of this, I think, will likely carry forward. The one point I made about the Ritz-Carlton training in response to COVID, I think, has some ancillary benefits. We think of ourselves in many respects as hospitality-driven. And a big part of that training is ensuring that we are more hospitality-like in the way in which we treat our tenants at our Class A properties. So there is all sorts of unintended benefits as a result of engaging the likes of the Ritz-Carlton. So those are the types of initiatives that we've taken that will likely endure for a long period of time.

That's definitely interesting and makes sense. And so before we go on, I should mention, if anyone has questions as they listen into the webcast, feel free to type them in the browser. And if you'd like, you can also e-mail them to me at my first name dot last name at morganstanley.com. Before we sort of get into the meat and talk about COVID and what that may mean from a work from home and perhaps more permanent changes, maybe we could just set the stage in terms of the state of your key markets, New York and San Francisco. Can you talk a little bit about certain metrics like sublease trends, what you're hearing in terms of market rent so far during COVID and just maybe what your near-term expectations are for those fundamentals?

Sure. Starting in New York, the availability rate is currently 13.6%. It's the highest it's been -- in Midtown, I should say, 13.6% in Midtown. It's the highest it's been since June 2010. Sublease availability, which we're currently tracking, is about 23% of the availability. Historically, subleased space has represented 20% of availability. So it's only slightly elevated. Leasing velocity is down, as you would expect, and renewals make up a disproportionately large percentage of total leasing velocity, which is not unexpected. Anytime there is concern about what lies ahead, tenants generally elect to sort of renew short term. Majority of those renewals that we've seen over the last couple of quarters have been shorter term in length. So that's not surprising. Of the deals that we have been tracking, every deal that we've been tracking, generally, we found that net effective rents are generally down between 5% and 10%. It's been largely a function, I think, of increased concessions, perhaps some decrease in rent, but not nearly as much as a slight increase in free rent and TI, which is what's resulted in the reduction in net effective rents. So that's generally what we're seeing in New York. We're keeping a very close eye on who is listing space and sublease space that's coming online. But generally, what we found at this point is that it's largely intact. And once again, we're doing everything we can to get people back to the office. Obviously, yesterday's announcement was really very encouraging because as tenants come back to the office, activity will start to pick up. And we're just now starting to hear tenants talk about what it means when they do, in fact, return in response to COVID, how they think about their own real estate. Things such as densification versus de-densification, which we expect going forward, are now being discussed. It's early days in this regard. It's very fluid. But topics such as densification, hot desking, how can tenants get their employees back through amenitizing their space, creating more formal and informal meeting areas, recognizing the value of collaboration. These are conversations that are now starting to happen which weren't happening several months ago.

That makes sense. So COVID clearly forced employees to work from home, and you've highlighted sort of the utilization today in the buildings versus obviously what was much, much higher pre COVID. But there's clear debate as to what this means for office fundamentals. Curious to get your own view on how you see this shaping up.

I think it's too early to really say. I know you read a lot in the press about office space being obsolete. I think the longer the pandemic and the work from home last, the more apparent it gets to many tenants and especially top management that it is harder and harder to especially build and grow a company. I mean you can basically keep an even-steven kind of operation going, but growing it, training staff, building a culture, working cooperatively, collaboratively, you need to be in closer proximity. And I have to tell you, we find it within our team that they really love, especially also the younger ones, they want to be back in the office. We, at Paramount, are basically 100% back in the office within the guidelines of the city. That means 50% at the time, but the whole team is -- we don't have an A and a B team, but we have a blue -- in line with our logo, a blue and a white team. And so 1 week, we have the white team; 1, the blue team. That works, but it's not ideal, and we realize that. And I -- from talking to peers and not only in the real estate side but on the operational side, they're craving of being back in the office. And I think the office use in the future, to your point, will be most probably a little bit different. But it doesn't have to be necessarily that the tenants will need less space. It will be different. And we talked to a couple of large architectural firms who are requested by their tenants to come up with more futuristic kind of designs. And it's clearly -- and I mentioned this a couple of times, I think also when we met before, Vikram, we are talking about benching. And we talked about how densification has worked over the last 10, 15 years. I think that went way too far. I mentioned, as an example, I have a young daughter who works in benching, and I asked her -- she's 29. And I asked her, "What is your ideal work space?" And she said, "Dad, I would like to have a real office, an office for myself where I can think, where I can do real work and not being interrupted by coworkers who are very close in proximity." And I think that's -- but at the same time, being close by, have a space where you can mingle and be creative. And so it will be more a space that has been developing where you have the spaces where people work together as a team and then also have space to be by themselves. And that doesn't mean we have necessarily less office space. We also have talked to some tenants who are trying to do have some satellite offices, more like in the suburbs. It's very hard to find the right team that would be in the satellite office because you have to basically split up the work teams. And so I think at the end of the day, once these vaccines are found, people get more comfortable with coming back and working together, that I think business will be more back to normal than not.

That's an interesting viewpoint. Yes. I mean we've -- I agree. I don't think it's a binary decision, where it's one or the other. But it's more about the incremental changes, whether it's agile workspaces or hot desking or, as you said, potentially some focusing on suburban strategies. But assuming sort of work from home does become part and parcel of the workforce where you can have 3 different buckets or teams and some are more permanent work from office, others are more permanent work from home, what sort of buildings do you see are better positioned in this post-COVID world and buildings that may outperform?