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Lexington Realty Trust (NYSE:LXP) is a real estate investment trust (REIT) that owns a diversified real estate portfolio of equity and debt investments in single-tenant commercial properties across the United States. Our strategy focuses on net-lease assets with long-term leases in well-located and growing markets or markets which are critical to the tenants business. We intend to grow our portfolio primarily through acquisitions, sale-leaseback transactions, and build-to-suit arrangements. We currently pay an annualized dividend of $0.70 per share, paid quarterly.
Heather Gentry (Institutional)
Sheila: Good morning, everybody. My name is Sheila McGrath from Evercore ISI, and I'm pleased to be here with Will Eglin, CEO of Lexington Property Trust. Lexington is a unique triple net lease [suite 00:00:12] that has a long-established history as a leading investor in single-tenant commercial real estate properties across the US. The portfolio is mostly office and industrial assets net leased to major corporations. LXP's market cap is 2.3 billion, and the dividend yield is over 7%. Will, I thought it would be helpful if you just give the audience a bit on LXP's history and growth strategy, and then we'll get into more questions.
Will: Sure. Thanks, Sheila, and thanks, all of you, for coming to the presentation this morning. Lexington went public in 1993, but our franchise has been investing in single-tenant real estate since 1973 so our business has changed and we've managed it throughout many cycles, and in our period as a public company we've underwritten many different asset types, but at this point in the cycle we're principally focused on financing and acquiring build to suit projects where we are providing capital to merchant builders who are building facilities on behalf of corporations who typically commit to lease them for 15 or 20 years when they're finished, so that's how in the market today we can buy newly constructed buildings and where we can get 15- and 20-year leases, and we think there's lots of advantages to being able to get those long-term leases into our portfolio. Typically, they have 2% escalations in them so we have pretty good built-in growth.
As Sheila mentioned, most of the properties that we own are office or industrial, but we will acquire and finance build to suit projects that are outside of those asset classes if we think there's the potential for compelling total return. Last year we financed about $500 million of projects. This year we will do a little bit more than $250 million on projects that we have underway, and we have a pipeline of $100 million or so of deliveries for next year, so very active in the build to suit area.
We provide either a takeout commitment to purchase a building when construction is finished, or we have a product that's a combination of construction loan and take out, so that's our niche. It doesn't mean that we don't sometimes acquire properties outright that are subject to an existing lease, and we are also quite active in the sale-leaseback market, but it is a competitive market for acquisitions where cap rates have been fairly compressed. Right now, build to suit, we think, is our best strategy.
One of the things we've been focused on this year is executing a disposition program to take advantage of what we think are favorable opportunities to sell properties, and we said we would sell six or seven hundred million dollars of real estate this year at an average cap rate of between five and three quarters and six and a half, and the program is going well and we think we're likely to probably execute at the better end of that range as we approach the midyear point. What the disposition program will do for us is it will pay for all of our current commitments that we have on the investment side and help us shrink our leverage in the company.
We were leveraged last year at about 6.7 times net debt to EBITDA, and there's a good chance that we'll drive our leverage down below six times by year end this year, which typically lower leverage is good for the share price, and there's a good chance that we'll be building up cash as we go through the second half of the year, so being more liquid at this point in the cycle, I think, can be very positive as we look at our next round of investment opportunities.
Our shares were cheap six months ago or so. We had an active share repurchase plan, and that was, we felt like, a good opportunity to arbitrage a discount in our net asset value, but our shares have performed pretty well recently and we've been less active on share buyback. Overall as we look at how we finance the business, this year we think we can sell assets into the auction market at very compelling cap rates, and one of the things we like about build to suit is that by making a 12- or 18-month forward commitment we can get assets at a cap rate yield premium for that forward risk, so if you look at what kind of trade we're trying to make right now it's selling into the auction market and making a higher premium in the forward market on build to suit.
In many cases, we don't look to hold our long-term lease buildings until the end of the lease term, so if we have a 20-year lease, if it's an office building, we may look to sell it while there's 10 years of lease term left because in the single-tenant investment class, it is a binary outcome at the end and you either have a building that's full or empty, so in many cases we'll look to take our profit before we get to the end of the lease term and take advantage of opportunities to use attractive leverage during that holding period to generate high current yields and attractive overall internal rates of return.
On the bedside, we are an investment grade rated company and we use a mix of mortgage financing and unsecured debt to try to optimize our returns. The mortgage market can be a great way of attracting value from assets, especially if you have a long-term lease with a very high credit on it, so business has been good. If there's a single challenge, it's been define new investment opportunities that provide a good, attractive yield for us where we don't think that we're paying too much for the real estate, so that, to me, has been a challenge, but we've been, I think, pretty good at finding niche opportunities in the market and, for us, since our business is leasing big blocks of space to corporations if we can find 8 or 10 good investment risks to take in any one year it ends up being pretty healthy new volume for us.
Sheila: Will, in the net lease sector, investors often look to that sector as being a little bit more susceptible to future interest-rate increases. I was wondering if you could discuss how you think higher interest rates, if they ever come, will affect the market and also Lexington?
Will: Well, it does seem like the history, if you look at how the stocks trade, when there's the expectation that interest rates are going up, the stocks tend to trade off. What I would say that we're doing is we are trying to structure our lease rollover schedule so that it's fairly well-balanced over a 20-year window since we do long-term leases, so right now we try to have about a quarter of our revenue rolling in every five-year window, so we don't have too much of a bond-like characteristic but we have pretty good balance and we sort of stay neutral to the economy.
We have been very busy as we've refinanced our balance sheet in the last four or five years to really try to push our maturities out and lock in long-term fixed-rate financing, so we have over a seven-year weighted average term to maturity in our debt right now and a fixed interest rate of about four, so we'll be pretty well insulated against rising interest rates harming our operations, if they do, and I can tell you that as a perpetual investor in the company what we would like more than anything is an environment of robust economic growth where we have more jobs and more demand for our real estate, so that would be what I would say.
Some people say in the asset class G you only have 2% rent escalations. What if the economy is booming and other landlords are raising rents 3 or 4%? That's true, but what we would point out about this asset class is if you have a 15- and 20-year lease, you're not making another capital investment in the asset to sustain occupancy or raise rents, so if you buy a single-tenant building at a 7% cap rate and rents go up 2% a year, if you compare that to a multitenant asset which you might buy a 6% cap, sure, maybe rents will grow faster, but during that 15- or 20-year period the owner of that asset will probably have refit his building twice, so maybe rents grow faster but their investment basis is also getting bigger at the same time, so that would be, I guess, my answer to the rising rate question.
Sheila: Okay, great. Another question. The forward build to suit market seems to be your focus these days. I wonder if you could describe how you source these opportunities. Is it just brokers? Are there relationships with specific builders? How do you source new investment opportunities?
Will: One of the things that we like about the build to suit business is it's where we get to see investment opportunities direct from builders. Often merchant builders are trying to respond to requests for proposals from corporations for new buildings and they're trying to respond quickly, so they're looking for a financial partner that can execute with certainty, so most of the time they're not widely shopped opportunities. I'm not saying that there aren't three or four other people that we compete against, but usually they're not brokered opportunities where the investment is being shown to 30 or 40 other potential investors, so it is the part of the market where we think we can get direct business opportunities versus competing in the auction market, so we have relationships with developers all over the country, many of whom we've transacted with before, or tried to, so we see a good flow of new opportunity in the space.
Sheila: Do you bump into many of the other public companies in the forward market?
Will: A couple, for sure, and a couple of private investors, but it's a pretty thin pool of competitors that we're up against.
Sheila: Okay. Then, I think Lexington is unique in that you've been publicly traded for more than 20 years. I was wondering if you could describe lessons learned from the financial crisis and how Lexington's strategy is different now than it was pre-financial crisis.
Will: Arguably, since the financial crisis we probably reengineered every aspect of the business. From a financing standpoint, we principally relied on mortgage debt and bank debt, so as we rebuilt the balance sheet it was important to become an investment grade rated company so we have maximum financial flexibility and to shift down to a low-to-moderate leverage balance sheet and stay committed to that.
On the investment side, when we were a smaller company we purchased a lot of office buildings with 10-year leases when we were getting big in that window from 2001 to 2005, and our experience with 10-year office leases is that you don't collect enough rent during that 10-year term to get compensated enough for the risk of having the building being full or empty at the end of the lease term, so coming out of the financial crisis we've stayed committed to investing almost exclusively in 15- or 20-year leases, and what we like about those long leases is, in a 15-year lease you almost always collect more rent than your purchase price, so your principal is protected.
Then the question is, how do you manufacture return without relying too much on residual value at the end of the lease term, so that involves using the appropriate amount of leverage with respect to every investment, but also being sure that you have an opportunity to maximize your value and choose where you exit, and in a 15- or 20-year lease you have a wide window. You can sell after a five-year hold, you can sell after a 10-year hold, and still get good value for your asset, so I think the strategy has shifted from being a buy-and-hold investor to one that's much more opportunistic about selling when the price is right.
Sheila: On the disposition program you mentioned six to seven hundred million of assets for sale. In many of the meetings that I've had thus far, the REIT managements that are selling assets in the secondary market have noted that the buyer pool is thinner, but I think you mentioned you expect to execute on the better end of your cap rate guidance. I was just wondering if you could discuss maybe it's what you're selling that there's decent interest in your outperforming expectations. Just give us some insight there.
Will: More than half of what we're selling this year are our four ground parcels in Manhattan which were subject to long-term ground leases, so those properties already had financing in place that could be assumed by the buyer, so we still expect to get very good prices on those. When we laid out our plan this year, I think we were pretty conservative with respect to the values that we expected to get, so there was room for pricing to the road on some sales and still have us execute toward the better end of the spectrum.
Let's see. Probably by June 30 we will have sold over $160 million of real estate at a 640 cap, and we think we'll have the three ground parcels in Manhattan under contract. They should sell for a seven four and three quarter cap, so as we progress through third quarter that average cap rate that we've been able to execute at should compress compared to where we were at June 30. The buyer pool is a little thinner than it was, and on some suburban office buildings with shorter-term leases cap rates have moved up a little bit, but that's also a function of more people trying to sell assets, too, so there's a little bit greater choice for investors compared to six months ago.
Sheila: Then the six to seven hundred million, that's a lot coming back into the company this year. Can you describe how you're going to allocate that liquidity/
Will: Yeah. We'll also do probably a couple of hundred million dollars of long-term fixed-rate financing as well just to take advantage of where we are with respect to interest rates, so we will find the $265 million of new projects that we were committed to fund this year. We'll pay off $100 million or so of mortgage debt that's maturing. We'll get entirely out of our bank lines, and we could end up with as much as a couple of hundred million dollars of surplus cash as we get to the end of the year, so we'll be looking at lots of new investment opportunities over the balance of the year, but we should end up in a very good position with respect to our liquidity, and I guess I said earlier there was a very good window to repurchase stock. There's no reason to think it will ever come again, but if our shares get cheap again we'll be prepared to buy them in in size.
Sheila: Then if we look at your dividend yield, it is competitive at 7%. You did not increase it last year. Your balance sheet by year-end should be six times, pretty conservative, so how should investors think about dividend growth for Lexington and the policy going forward?
Will: Everything we've done with the company in the last couple of years since we last increased the dividend has been designed to get us to the point where we would begin increasing the dividend on an annual basis and at a growth rate that we think is sustainable over time, so as we look at our cash flows next year we expect them to be stronger than they are this year and they're certainly …
We've got good dividend coverage now and there's room for dividend growth and still have good coverage next year, so it is important to us after having kept the dividend flat for the last couple of years that we do return to a trajectory of dividend growth, but having kept it flat for two years as opposed to increasing it a couple of cents every year does mean that we're retaining an extra $10 million or so cash flow every year. It doesn't sound like much, but if you reinvest your cash flow over and over again year after year, ultimately over time we'll have more earnings and more dividend growth going forward.
Sheila: Over the past couple years the capital expenditure profile was a bit elevated with higher rollover years. I just wanted to give investors some perspective on the capital expenditure outlook and also how AFFL growth, the trajectory, might look over the next couple of years.
Will: Sure. Yeah, the other big change, if you look at the company when it came out of the financial crisis, is we had a weighted average lease term in the portfolio of five and a half years, and now it's roughly 12 years, so when you have a short lease term in your portfolio and very active lease rollover, of course capital expenditures are going to be high, so in 2013 and 2014 we spent roughly $50 million a year on expenditures relating to sustaining occupancy.
As our rollover schedule has become more balanced and the weighted average lease term has been extended, the drain on our cash flow from capital expenditures has gone down considerably and has been roughly cut in half, and that's our expectation, that we've been able to shift the portfolio such that cap ex … Twenty-five million dollars a year is probably a good assumption, it will fluctuate up and down, but with the rollover balance that's sort of what our expectation will be.
The other thing that's very different about the company is how much revenue we have from leases with escalations in them. Right now about 80% of our revenue is from leases that have built-in escalators, so it doesn't mean that we won't have some vacancy going forward, and in some cases maybe renewal rents will be lower than the rents at expiration, but with that much revenue subject to escalations we do have, I think, good prospects for built-in cash flow growth, and we'll also … The debts that we do have maturing in the next two years, it's not that much, but it's all at 5.5 or 6% interest rates, so we'll save some money for refinancing and have the accretion from selling assets at 5.5 or 6% cap this year and putting the money back out to work at 7 or 8% cap rates in build to suit transactions.
Sheila: I'm going to ask one other question, and then hopefully we'll have some audience participation. Just on the portfolio mix, I think you have about 45% of your portfolio in longer-term leases. How should investors expect that portion of the portfolio to look longer-term, and then if you could just comment on the mix of industrial and office in the shorter-term portfolio.
Will: Sure. One of our goals has been to get our revenue mix 50/50 between leases of 10 years or longer and shorter-term leases, so we're getting pretty close. I can see how within the next year or two we'll be able to get enough long-term lease revenue in the portfolio so that we have balance at that point, and the mix should continue to shift in favor of more revenue from industrial property versus office, and one of the reasons why that will happen is many times with an office building once that long-term lease gets to the point where there's 10 years of the lease term left we'll sell it, whereas with the industrial properties on long-term lease we're much more comfortable with them migrating into the shorter-lease portfolio because with a warehouse or distribution facility, when it comes off lease, chances are you're not going to have to invest a significant amount of capital in the building either to keep the existing tenant or find anyone.
That shorter-than-10-year-lease portfolio, that's where the leasing risk and reward is in the company, so we think if there's more industrial revenue in that part of our portfolio it'll make for more secure and reliable cash flow and lower capital expenditures as well, so I'd love it if it was one day 50/50 between office and industrial, but it looks to me like in the next year or two maybe it gets to 60/40, and we don't want to be too committed to reaching some smaller target on office because there is, in the build to suit area, if you can buy newly constructed office buildings with 15- or 20-year lease commitments and good credit it can be a great total return vehicle.
Office has somewhat of a stigma, but with a long-term lease so much of the return comes from the rent that we don't want to turn our back on those opportunities just for the sake of meeting some preconceived target that would be subject to changes, market opportunities change.
Sheila: Any questions from the audience? I have some more in case there are none.
Male: Last time I looked, which was six months ago, your exposure in Dallas, Fort Worth, and especially Houston, Sugar Land, was, I think, 14% [or something 00:23:09] of NOI, which isn't huge, but if there's problems there [inaudible 00:23:16] are we maybe going to have to read something in a press release about disappointments in those two markets?
Will: I sure hope not. Dallas has been very good for us and continues to be really good for us. In Houston we previously announced we had one lease termination on a lease that was going to expire next year, but other than that we have over a 13-year weighted average lease term in our Houston properties, and we don't have exposure to small credit, so I don't think there's meaningful credit risk in that portfolio, so I honestly don't really see anything ... Houston's suffering, but we've got pretty good credit exposure and good long-term leases without a whole lot of near-term expiration risk, so I would think our Houston exposure would hold up better than someone who might own a multitenant building where a quarter of the occupancy are small tenants without any credit behind them. Ryan.
Ryan: [inaudible 00:24:35].
Will: It largely depends on how far forward you're committing. If it's a warehouse that's being delivered in nine months, maybe the spread right now, maybe it's 40 or 50 basis points. If it's an office building being delivered in two years I would expect it to be certainly wider than 100 in premium, so that's kind of it. It's about how far forward it is, and more of a premium for office versus industrial. Yes?
Male: [inaudible 00:25:13].
Will: We have warehouses that we lease to different users in many different parts of the economy. I will say that we made a decision over 10 years ago not to buy retail properties anymore because we couldn't have visibility with respect to how retail as an asset class with perform in relation to developments in e-commerce, and arguably, we should have just kept buying retail properties because all the public net lease companies that buy retail have generally done better than us, but we may be about to be [inaudible 00:26:15] right to stay away from retail, so I would say that that's been our considered view for a while that we just were not sure how e-commerce would impact retail stores.
Sheila: I have another question. I think it's interesting to look at Lexington from the beginning where you didn't have a big asset management team, and not that your team is large, but I think the experience gained from repositioning when a lease expiration comes about and having to change the use to multitenant, just talk a little bit about that change for Lexington.
Will: Gosh, I started working in this net lease sector in 1987, and the way people underwrote these buildings, no one had ever had the experience of what happens at the end of a 25-year lease, and our portfolio back then had no leases rolling for probably, I don't know, 10 years or so, so since then I think we've probably turned over more leases than anybody in the industry and done more conversion to multitenant redevelopment, et cetera, so we think that that's a little bit of an underappreciated skill set that we have compared to others who haven't done so much real estate-intensive work on the leasing and redevelopment side.
It does impact our underwriting and it tends to make us more conservative than others, which I think is a positive, but at times when prices are high it also makes it more difficult for us to compete on the investment side, so we do a ton of leasing and an enormous amount of converting empty buildings to multitenant buildings and then selling them, honestly, and when we do that work where we spend the money and lease the building up to full occupancy we always end up getting to sell the asset at a lower cap rate than where we can buy a single-tenant building, so that's an important part of our capital recycling program, where we're turning yesterday's challenged assets into today's source of liquidity for redeployment. Yes?
Male: I think [making the rounds 00:28:45] these days in industrial is facilities that are used for the last mile [delivering 00:28:53] billions of cardboard boxes that are now seeing legitimate geometric growth. Are there opportunities there, or does that story already price that stuff out here [inaudible 00:29:08]?
Will: The latter. There are larger, more well-capitalized players with lower cost of capital that are going to be able to participate in that market. Yeah.
Male: [inaudible 00:29:24].
Will: Haven't had this discussion about their share ownership in a long time. They have a very low basis in their stock [inaudible 00:29:56], so they've made lots of money investing in the company, so if they ever do sell it they'll have a tax gain that they'll have to manage. If you think about it, we're a cash equivalent for Vornado with almost a 7% yield, and Vornado has tons of cash on their balance sheet and doesn't seem to have any need for liquidity to do anything, so who knows what'll happen in the future, but it seems like it's been working for them as a yield plan.
Sheila: All right. Thank you for joining us today.
Will: Thank you.