Boston Properties Inc (BXP) — Q2 2015 Earnings Call Transcript

Good morning and welcome to Boston Properties second quarter earnings conference call. The press release and supplemental package were distributed last night as well as furnished on Form 8-K. In the supplemental package, the company has reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with the Reg G requirements. If you did not receive a copy, these documents are available in the investor relations section of our website at www.BostonProperties.com. An audio webcast of this call will be available for 12 months in the investor relations section of our website. At this time, we would like to inform you that certain statements made during this conference call which are not historical may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although Boston Properties believes the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that its expectations will be attained. Factors and risks that could cause actual results to differ materially from those expressed or implied by forward-looking statements were detailed in Wednesday's press release and from time to time in the company's filings with the SEC. The company does not undertake a duty to update any forward-looking statements. Having said that, I would like to welcome Owen Thomas, Chief Executive Officer, Doug Linde, President, and Mike LaBelle, Chief Financial Officer. During the question-and-answer portion of our call, Ray Ritchey, our Executive Vice President of Acquisitions and Development and our regional management teams will be available to address any questions. I would now like to turn the call over to Owen Thomas for his formal remarks.

Thank you, Arista. Good morning, everyone. As we have done in prior quarters, I will provide an update on how we're viewing the economy and its impacts on our business, our resultant capital allocation approach and progress, and some high-level remarks on the quarter. Doug will then provide an overview of our operations followed by Mike, who will wrap up with a more detailed financial summary of the quarter. In particular this morning, we intend to highlight specific investment decisions we have made and the resultant tenant activity, which will have an impact on our 2016 and 2017 results. So starting with the environment, economic performance in the U.S. continues to unfold the way we have described in previous quarters. Economic growth is steady but modest as first-quarter U.S. GDP declined 0.2% but is forecast to be a positive 2.4% for all of 2015. Unemployment has dropped to 5.3% at the end of June, but the underemployment rate remains stubbornly high at a little over 11%. Economic growth has translated into office net absorption for the second quarter in the U.S. of approximately 15 million square feet and 1.1% of stock for the last year. Technology and life sciences-driven markets continue to lead the pack in terms of positive absorption. Office construction continues to increase as well with 2.1% of current stock under construction versus a long-term average of 1.9%. The capital market landscape has remained fairly benign as well. The 10-year U.S. Treasury rate has risen approximately 30 basis points since our last call but remains at a historically low level of 2.3%. We and market consensus continue to expect the Fed to increase rates later this year, which has stoked cap rate expansion fears and driven capital flows out of REITs, $4.8 billion from U.S. mutual funds and ETFs so far this year with a resultant negative impact on share price performance for Boston Properties and the entire sector. REIT valuation declines are not consistent with the current private market for real estate assets where investor enthusiasm remains robust. We continue to see positive rent growth, a significant yield gap, and the potential for an appreciating dollar attracting both domestic and non-U.S. investors to high-quality office assets in our core markets. Aggressive asset pricing, including for our own sales, continues to exist in our core markets. So in summary on the environment, we continue to believe capital values are more advanced in the cycle than underlying fundamentals and see more upside driven by operating fundamentals and further cap rate compression. So logically we're more actively investing in our capital and new developments rather than existing acquisitions. Further, we're taking advantage of private market pricing by funding development activity through targeted asset sales. Now moving to the specifics on our capital strategy execution for the quarter, we continue to be active, as measured in the pursuit of acquisitions. We're focused on sites and redevelopments in our core markets, and though pricing is a challenge, we're having some success as demonstrated by the new investments which I will describe in a moment. We're also looking at acquisitions of high-quality existing buildings in partnership with private capital providers given the opportunity to enhance our returns through compensation earned for providing real estate skills to targeted assets. On dispositions, we announced this week that a contract has been executed for the sale of 505 9th St. in the Washington DC CBD. This 325,000 square foot Class A building was broadly marketed globally and is under contract with a domestic investor for $318 million, which represents pricing of $977 per square foot and a 4.4% forward NOI cap rate. The buyer is assuming $117 million of above-market debt, which when factored into the valuation, brings the price to in excess of $1000 per square foot and an even lower effective yield. Boston Properties owns 50% of the building and generated a 16% unleveraged and a 30% leveraged return on the development for shareholders. We're also continuing to reduce our Montgomery County, Maryland activities with a second land parcel sale expected in the third quarter at Washingtonian North for $13 million. With these sales plus the already completed sale of The Avenue in Washington DC, we will have completed or contracted for total dispositions of $377 million measured as our share and remain on track for targeted total dispositions of $750 million for 2015. As mentioned, we continue to emphasize development for our new investment activities given the opportunity we see to recycle capital from the sale of our older buildings into new projects with higher returns. We were able to launch three new development projects in the second quarter. The most significant new development we recently announced is Dock 72, a 670,000 square foot, 16-story building located in the Brooklyn Navy Yard in a 50% partnership with Rudin Management. The building is 33% preleased to WeWork for 20 years, will cost $410 million to develop, and is scheduled for delivery in the first half of 2018. The land is leased from the Brooklyn Navy Yard for 96 years with modest levels of ground rent, and given the land is owned by the City of New York, all tenants are exempt from real estate taxes and sales tax on leasehold improvements. Further, tenants located in Brooklyn are exempt from commercial occupancy tax and can qualify for business relocation benefits. With these incentives, we can lease the balance of the building at around $60 a square foot and achieve an unleveraged initial NOI yield in excess of our target of 7% for office developments. Boston Properties will manage and be paid development fees for the construction of the building, and we will jointly lease and manage the property post completion with Rudin Management. Through this investment, we will be expanding our business to an exciting new district in New York City of great interest to technology and creative tenants and expanding our relationship with WeWork, one of the fastest-growing office tenants in the United States. Further, we think the Dock 72 investment could lead to additional development opportunities for Boston Properties at the Brooklyn Navy Yard and in Brooklyn more broadly. This past quarter, we also announced the development of 1265 Main Street in Waltham, Massachusetts in a 50% partnership with the current owner of this former Polaroid site. 1265 Main is a three-story, 115,000 square foot building that will undergo a complete redevelopment at a cost of $52 million including site acquisition. The development is 100% preleased to Clark Shoes and is forecast to generate in excess of a 7% unleveraged NOI yield on cost when delivered in the fourth quarter of 2016. Though the size of the 1265 Main Street development is modest for us, the investment secures our opportunity to develop up to an additional 1 million square feet of commercial space on a site immediately to the south and adjacent to our CityPoint portfolio. Boston Properties will now effectively control 90% of the East Route 128 frontage between exits 26 and 27 with opportunities to create transit connections between the new development and our existing Waltham assets. Lastly, we're redeveloping Reservoir Place North, a 35-year-old, 73,000 square foot building we own adjacent to Reservoir Place in Waltham, which was vacated earlier this year. We expect to generate in excess of a 7% unlevered NOI return on the $25 million of incremental costs required to convert the building to a Class A facility. Reservoir Place North is an example of existing portfolio investment opportunities that exist for us in strengthening markets such as Waltham. With these three new projects, our active development pipeline now consists of 14 projects representing 4.2 million square feet with our share of total projected costs of $2.4 billion. We forecast these projects, currently 59% preleased, will generate over a 7% cash NOI yield upon completion over the next four plus years and we have all the capital required to complete these developments with $1.3 billion in unrestricted cash currently on our balance sheet. We have now commenced $486 million on a gross basis of new projects for 2015 and continue to target $1 billion in new starts for the year. As described in the past, we have a large number of projects in our pre-development pipeline that could still be launched in 2015, including the first and podium phase of North Station consisting of 360,000 square feet of retail and loft space located adjacent to the TD Garden in Boston, a 160,000 square foot residential development located in our Kendall Center project in Cambridge, a 600,000 square foot residential and retail development located in our Reston Town Center project, three different potential office build-to-suit opportunities in the Washington DC region representing in the aggregate over 1.3 million square feet, as well as significant improvement projects at 601 Lexington Avenue in New York and 100 Federal Street in Boston, both of which will enhance and add high-value retail amenities to the building. The next wave of development will include a significant allocation to multifamily projects where we anticipate the initial yields to be closer to 6% than the 7% initial cash NOI yield we have been able to achieve on our office projects. Moving to results for the second quarter, we continue to perform well, and as I described earlier, we have made strong progress towards executing our goals. As you know, our diluted FFO for the first quarter was $1.36 per share, which is above our forecast and consensus. We're also increasing our full-year guidance, and Mike will take you through those details. We had an active quarter in leasing, having completed 88 deals representing 1 million square feet, with balance across all of our four major markets. And the occupancy of our in-service properties increased to 91.1% from 90.3%. So let me turn over the discussion to Doug for a review of our operations.

Thanks, Owen. Good morning everybody. My commentary on the general market conditions in our four core markets is going to sound really pretty consistent with what we have described in the last few quarters. Boston, both the suburbs, the city and Cambridge, New York City, and San Francisco are all really healthy markets and they are all characterized by strong demand coming from new economy companies, although there seems to be more and more flexible type users as well, accompanied by stable supply characteristics and it is all resulting in improving real estate economics which I think are flowing through our numbers as you saw in our second-generation statistics this quarter. And then DC CBD continues to work through its densification issues in the relatively modest amount of new demand generators there and then Northern Virginia really continues to be a story of both strong and weak markets. The good news is we predominantly are in the strongest markets. As I discuss the operating portfolio this quarter, I think I'm going to spend some time providing some specific expectations on sort of some of the larger moving parts in the portfolio, the major vacancy upcoming rollover and discuss some of a pretty meaningful property-specific investment and leasing decisions that we're making right now all with the goal of foreshadowing our 2016 same-store portfolio. I hope this is going to provide a pretty good backdrop to the earnings guidance that Mike is going to provide for 2016 in October. Our overall leasing activity in the second quarter dropped off a little bit from the first quarter, but was really pretty much in line with the average that we have been hitting for each second quarter for the last 10 years, which is about 1 million square feet. Again, the second-generation leasing stats were dominated by Boston and San Francisco. I think they are probably a little bit higher than you might have expected in Boston, up 30% on a net basis and that is really stemming from the impact that we're starting to see as the lease at 200 Clarendon Street, which was formerly referred to as the Hancock Tower, but we're not allowed to call it that any longer since the Hancock's lease expired at the beginning of the second quarter. As well as there was a lease commencement at 101 Huntington Ave. with Blue Cross Blue Shield, which was over 300,000 square feet, which had a big pop as well. In San Francisco, as you saw, we're up 41% while the contributions from Embarcadero Center specifically were up over 60%. Statistically, New York City was pretty limited, there was only 36,000 square feet in total and about half of that was from Princeton. Then in DC, we had pretty strong roll-up in Reston and then really flat results in the CBD and our other markets. I'm going to begin my specific market comments this morning on Midtown Manhattan. So it really continues to be a very healthy market with solid leasing activity, but as we have said in the past with 10% availability and lots of uncommitted new construction, rental rate increases have been pretty modest and really moderated. We're seeing heavy traffic across our entire portfolio but if you look at our occupancy statistics, we have very limited current availability so most of our negotiations are revolving around future availability. The one exception to this is obviously at 250 W. 55th Street where this quarter we completed eight more leases ranging from 4,000 square feet prebuilt suites to a floor and half square foot lease. We're 89% leased; we have two prebuilt suites and three full floors in the top quarter of the building to go. Our asking rents are from the low $90s to well over $100 a square foot for those full floors remaining at the top of the building. At 599 Lexington, in order to speed up the rebuilding process from the tenants that we renewed last year, we have three non-revenue producing swing floors that are all currently occupied but will be unavailable for revenue until the end of 2016. We have leases under negotiation on two of those floors and activity on the third. At 399 Park, there are two major lease expirations in 2017, 190,000 square foot block in the midrise. If you recall, this is adjacent to a 150,000 square foot block that we got back in 2016 and we released to four separate tenants in six months the entire block. There we have expiring rents of about $100 a square foot and we expect to get rents well over that. And then we have the Citi space at 399, which is really in three blocks. We have a 280,000 square foot block at the base, 97,000 square feet in the midrise, and about 110,000 square feet below grade. The above-grade space has a current rent of about $90 a square foot and we expect to be pretty close to that and discussions are already underway with more than 300,000 square feet of that 2017 rollover. At 601 Lexington Avenue, we announced a few quarters ago that Citi would be terminating its lease on about 170,000 square feet in April of 2016. Three of those floors were in the Tower and two of those floors were in the low-rise building, which is floors three through six. We have now leased the entire Tower block, 90,000 square feet, though rent is not going to commence on 60,000 square feet until 2017 and we're in the planning stages of a major repositioning of the retail and the low rise of 601, which I think we introduced at our investor meeting a year ago, and we're working on a plan to vacate the entire 140,000 square foot office building including the 70,000 square feet that is under long-term lease to Citi. This would result in additional 2016 and 2017 vacancy as we renovate this portion of the complex. With virtually no vacancy at 601, what our New York team is doing right now is trying to find ways where we can actually control currently leased space so we can move tenants around and move forward with these plans. This is very high contribution space and it is going to result in a diminution of our 2016 occupancy and revenue. But consistent with our core strategy and philosophy, we're making decisions with a long-term view of maximizing the value of individual assets in the portfolio and this is the opportune time to take advantage of what we can do at 601. Last quarter, we commented on the possible early termination of FAO. This will occur on August 1 as part of an agreement we reached with an existing tenant to use the FAO space on a temporary basis as they reconfigure their existing operations. As we look forward to 2016, the net contribution from this space will be suboptimal. We made the decision to accelerate the lease expiration and forfeit a portion of FAO's rent for 2016 in order to accommodate this tenant's requirement and set up the GM retail for even stronger future performance. The FAO space is over 60,000 square feet, 14,000 square feet on the ground floor, 34,000 square feet on the second floor with 20-foot ceiling heights, and 11,000 square feet of Concourse space. This city block has among the highest pedestrian traffic counts on Fifth Avenue, and historically, the FAO footfall has nearly matched that of the Apple Store. The FAO space will go through a major renovation and downtime as part of any releasing, which will likely occur in 2017 and we will greatly increase the contribution thereafter. Switching to DC, so this quarter I think the headline news from all the broker reports was that DC had positive absorption after a number of quarters of negative activity, and while this is certainly a positive change, the District continues to be very competitive since there hasn't been much in the way of significant demand increases. In fact, the real interesting overhang today revolves actually around the massive amount of GSA related expirations. Nearly half of all leased GSA space in the Metro area rolls between 2015 and 2017 and the GSA has mandated densification. How is this really going to work? It is really one thing to require on paper an agency to reduce its space per employee by 10% or 20% or in some cases 40%, which is what they mandated, but with specialized uses in many installations and the capital requirements necessary to build space or move tenants, we will really see what actually happens. The one wholly-owned building in our portfolio with a near-term major law firm expiration is at 1330 Connecticut Avenue and we're actively engaged in lease extension negotiations there. Our development at 601 Mass is on schedule. It is actually going to open up early, likely in September, and the office space is 83% leased. The income contribution will ramp up significantly in 2016. In the rest of our portfolio, as Ray is prone to say, we're in hand-to-hand on the availability at our JV assets at Market Square North and at 901 New York Avenue and at Met Square where we may be losing some occupancy in 2016 but we will gain it back. Reston Town Center continues to be the best-performing market in our region as well as in Northern Virginia. It has a vacancy rate under 3% while the overall Reston marketplace is over 14%. Roslyn is at over 30% and Tyson is at 18%. During the first quarter, we negotiated the recapture of 55,000 square feet of our Overlook property in order to provide expansion to a growing tenant. This quarter, we gained control of an additional 55,000 square feet and that same tenant grabbed it again on a long-term basis. The combination of walkable retail, high-quality new multifamily, community programming, and improving access to Metro continue to draw tenants to the Town Center. Small tenant demand is strong; we did eight more renewals and expansions this quarter, and many of our smaller tenants are now expanding. Switching to the Boston market, lack of available supply continues to be the story in Cambridge. Every week there seems to be another article describing a Cambridge company with growth requirements that is unable to find space in Kendall Square. The question is how is this trend going to impact other markets? Well, these companies are migrating to the Back Bay, to downtown, to the seaport, and in some cases to the suburbs. But in any case, Kendall Square continues to dramatically outperform the rest of the urban Boston market with rents above $70 a square foot. Our Cambridge portfolio, as we have said before, is essentially 100% leased and we don't have any short-term availability, but there are a large number of expansion requirements in the market. We're working with the city on an upzoning of our Kendall Square project to add 600,000 square feet of office density and about 400,000 square feet of multifamily. This filing is likely to occur sometime this summer. The GSA recently issued its plan outlining the timing for the disposal of the Volpe transportation site, and it now suggests an award in early 2017, which means no additional supply from this site for four to five years. One note of importance as you think about our portfolio in Cambridge on a going-forward basis is to remember that we previously announced that MIT has exercised the fixed-price option that we negotiated in 2002 to purchase 7 Cambridge Center. It is going to occur on February 1 and it is going to result in the reduction of about $13.3 million in 2016 comparable to 2015. In the Back Bay, our repositioning and our rebranding at 120 St. James, where we have 170,000 square feet of availability was completed last week and we had our first formal presentation, and I think the reaction was fabulous. Our asking rents on this space are significantly lower than in Cambridge, they are 40% higher than our original underwriting in 2011 and the mark to market that we expect to get on this space is 60% higher than the expiring rent. The 150,000 square foot block at the top of the Hancock Tower is still under lease until the middle of the summer. While it is certainly available to show, it is really not in very good shape and it probably won't be until the end of the year. Realistically, we're not likely to see rent commencement on these two big blocks until the very end of 2016 or early 2017. I think we will do some leasing in 2016; we may even do some leasing in 2015, but from a rent commencement perspective, not likely until 2016 or 2017. The incremental contribution from the available space of this building is going to be over $25 million. Similar to New York City, the occupancy has a much higher contribution than our average current weighted rent of about $55 a square foot across the portfolio. At 888 Boylston Street, we signed another full floor lease. We're now 258,000 square feet leased for 71% of this office building, which isn't going to deliver until the fourth quarter of 2016. We're having extensive conversations with retailers for the 65,000 square feet of space at 888 and are negotiating our first major lease there, and we have completed leasing on the entire flagship expansion, that 33,000 square feet two-story that we added on top of legal and Sephora, and Eataly begins their work soon, and we expect them to open in the third quarter of 2016. Big exciting things are about to happen at the Prudential Center. At 100 Federal Street, we're in active discussions with two tenants to restack and relocate within the building in order to accommodate a major lease with a new tenant coming in. These transactions involve more than 1 million square feet of leasing on a long-term basis in the building and take up all of the currently vacant space. The sequencing of these moves and the delivery of the space will result in revenue recognition on the available space to be delayed until 2016 or early 2017. In fact, in order to complete the deal, we actually had to take a floor back from a tenant this month which will add to the short-term availability at 100 Fed. At the risk of repeating myself, we're making decisions with a long-term view, maximizing the value of the individual assets in the portfolio, and we're sacrificing short-term FFO. The Seaport has seen its first speculative construction. So now Boston has a 400,000 square foot spec building being developed this quarter, and there is purportedly another 370,000 square feet coming after that. Moving out to the suburbs, the Waltham Metro West market continues to get stronger, driven by expansion by shoe companies, life science, and tech companies. While there are tenants that are relocating to urban locations, there continues to be significant organic growth in the Route 128 Lexington-Waltham market. This quarter, we did 15 leases in our suburban portfolio. We're now in lease negotiations for all of the remaining space at our development at 10 CityPoint and we expect to achieve rents in excess of $50 a square foot for this new project, which will deliver in mid-2016. This is a 25% increase over the last 18 months. While there is no speculative construction currently underway, as Owen mentioned, given the health of the market, we made the decision to take one of our vintage buildings, Reservoir Place North, which was built in 1981, out of service and we're completing a complete gut rehab, new skin, new core locations and it will allow for tenant occupancy at the end of 2016. Again, instead of doing a short-term deal at a lower rent, we decided to push the building, increase the rents to where we believe we will be in the mid-40s, which will be significant upgrade over the then expiring rent, which occurred this May in the low 30s. During the majority of our conversations at the June NAREIT meetings, there was a focus on demand in San Francisco and whether we were seeing signs of concern. Our answer was and continues to be no, we're not. The leasing activity continues to be healthy. During the first half of 2015, Uber, FitBit, DocuSign, Lending Club, Stripe, all took blocks in excess of 100,000 square feet, and last night there was a report in the paper that Apple, the computer company from the Valley, completed their first lease South of Market in the city. Where there has been sublet space, it has been in small pockets and it has leased for strong rents. In fact, we're getting sublet profit on two sublets at 680 Folsom. Down in the Valley, Apple, Palo Alto Networks, LinkedIn, Aruba, Nutanix, Broadcom, have all been looking for and committed to large new expansions. At Embarcadero Center, we completed another 112,000 square feet of office leasing during the quarter. The largest deal was 75,000 square feet, the mark to market was over 50% on a gross basis and over 70% on a net basis. None of these transactions are in the same-store statistics for the quarter. We're actively engaged with additional full-floor tenants with 16 and 17 expirations in total. We have about 1 million square feet of lease expirations with an average rent of $53 a square foot at Embarcadero Center in 2016 and 2017. There are significant opportunities for rental increases in all these transactions and we continue to complete more transactions with an $80 starting rent. Down in Mountain View, the lack of available supply has led to large jumps in market rents. A year ago, we were making proposals of about $40 triple net on our single-story R&D. Today, proposals are going out over $48 a square foot for this product. And in North San Jose at Zanker Road – knock on wood – we have a number of active building prospects including a user that is interested in all of the existing assets as well as the potential to expand the project by up to 500,000 square feet. The one hole in the portfolio, if you will, is at Gateway where we expect Genentech to vacate between 185,000 square feet and 285,000 square feet in early 2016. The good news here is that the CalTrain system is in the process of dramatically upgrading their South San Francisco station, which is the first stop out of the city and a short walk to the property. So we're encouraged about the location more so today than we have been in the past. At 535 Mission, we have completed additional leasing, bringing our lease space to over 249,000 square feet and we have another lease out that gets us to 258,000 or 84% leased. That is nine months after we opened the building. Our asking rents are in the low 80s. And Salesforce Tower, our marketing team continues to actively market the building as we get closer to those lease expiration-driven opportunities that we have been discussing previously. There is a continuous flow of users that have expressed an interest in the building and over the last quarter, we have had an additional 12 showings similar to the quarter before, with users in excess of 50,000 square feet and we now have active proposals outstanding with two users for between three and four floors that are in negotiation. With that, I will stop and I will turn it over to Mike.

Great, thanks, Doug. Before I get into our earnings and our projections, I just want to spend a minute on our balance sheet. We continue to have strong liquidity. We have $1.3 billion of cash. Owen covered that our development pipeline has grown; it has grown to $2.4 billion with about $1.3 billion remaining to fund, so we continue to have all of the capital raised to fund our current pipeline. Additionally, over the last couple of years, we have utilized a portion of the cash raised from our asset sales to pay down debt. We're currently operating at a net debt to EBITDA that is now in the mid-5s. This is significantly below our more typical run rate in the 6.5 to 7 range and provides us with enhanced flexibility to fund additional investments with debt. The combination of debt repayment and the delivery of higher-yielding developments funded partially with asset sales has resulted in lower balance sheet leverage, and that is despite paying out nearly $1.2 billion in special dividends in the past two years. We've also been focused on our future debt maturities and we have engaged in an interest-rate hedging program to lock in the current interest rate environment. So far we have hedged $550 million of forward starting 10-year swaps targeting the refinancing of our $750 million mortgage on 599 Lexington Avenue, which is prepayable at par in September of 2016, and our $1.6 billion mortgage on the GM building that can be prepaid at par in June of 2017. We have an additional $1.2 billion of mortgages expiring that we currently forecast refinancing in late 2016 and early 2017. We continue to monitor opportunities to accelerate this financing, which could occur earlier in 2016 or even in late 2015 and could result in a one-time charge for a prepayment premium. The bond market has endured some rate and spread volatility in the past 30 to 60 days from global events, but debt issuances continue to go well, be well received, in both the public and the private markets. And we believe our borrowing costs today for 10 years is attractive and below 4%. So turning to our earnings for the quarter, we reported funds from operations of $1.36 per share. That was $0.03 per share or $4 million above the midpoint of our guidance range. The majority of the earnings beat came from lower than expected operating expenses in the portfolio, primarily due to utilities and repair and maintenance expense. We do expect approximately $2 million of the repair and maintenance items to occur in the second half of the year. So in reality, the second quarter's benefit to our full-year guidance from expense savings is only a penny. We reported termination income of $5.4 million, which after accounting for non-controlling interest was about $1 million above our budget. The largest piece of this was $3.8 million related to the acceleration of fair value rental income for FAO Schwartz. Since this lease was below market when we acquired the building, we have been amortizing into our income non-cash fair value rental income that we accelerated upon termination of the lease. As Doug mentioned, we will have a temporary tenant in place at FAO for a little over a year before we can capture the upside of leasing this space at market. After adjusting for pushing a portion of our second quarter expense savings into the rest of 2015, the benefit from the second quarter results is less than $0.02 per share to our full-year projections. As Owen mentioned, we have our 505 9th Street property under contract for sale. We anticipate a closing in September and the future lost income is approximately a penny per share to 2015. Our portfolio occupancy improved 80 basis points this quarter to 91.1%, with the occupancy of Blue Cross Blue Shield in 300,000 square feet at 101 Huntington Avenue in Boston, increases at Bay Colony and Waltham at Embarcadero Center in San Francisco, and the continued lease-up at 250 W. 55th Street in New York City. We expect our occupancy to be relatively stable for the remainder of the year. As we have described throughout the year, our same property portfolio performance in 2015 has been impacted by the increasing vacancy in Boston at the Hancock Tower. As Doug also mentioned, we have made a number of operating decisions that will limit our revenue and occupancy in 2016 but that we believe will enhance our long-term performance. This quarter, we terminated our lease with FAO. It had a modest impact on our GAAP results for 2015, but it will lower our cash income for the rest of the year. And we terminated a lease at 100 Federal Street, which also had an impact. On the positive side, we continue to be active at Embarcadero Center signing early lease renewals and locking in rental rate increases. This quarter, we signed 77,000 square feet of renewals for tenants that expire in 2016 where we will start straight-lining the rental increases this year. As a result of these facts, we now project 2015 same property NOI to be negative 0.5% to positive 0.5% from 2014. That is no change from last quarter. However, cash same property NOI is projected to be negative 0.5% to positive 0.25% from 2014, which is a reduction from last quarter. The projected NOI from our development properties is consistent with our guidance last quarter. The properties that are not on the same property portfolio include The Avant, 250 W. 55th Street, 680 Folsom St., 535 Mission St., 99 3rd Avenue, and 601 Mass Avenue and are projected to add an incremental $54 million to $60 million to our 2015 NOI. Our non-cash straight line and fair value lease revenue is projected to be $84 million to $92 million for the full year 2015. That includes only our share of our consolidated and unconsolidated joint ventures. There is approximately $50 million of free rent in these numbers that will burn off during 2015 and 2016, much of which is in our recently completed developments. Our 2015 hotel NOI is projected to be in line with last quarter's guidance of $12 million to $14 million. Our development and management services income is tracking as expected. It is projected to be $18 million to $22 million in 2015. We project our net interest expense to be $422 million to $431 million for the year. Our development spend is meeting our current projections resulting in capitalized interest for 2015 of $31 million to $38 million. Our forecast for non-controlling interest in property partnerships is unchanged from last quarter and for the full year we project a deduction to FFO of $135 million to $145 million. So our guidance for 2015 funds from operations is now $5.37 to $5.45 per share, that is an increase of $0.01 per share at the midpoint compared to our guidance last quarter. If you exclude the impact of the expected sale at 505 9th Street, we would have been raising our guidance by $0.02 per share from better projected portfolio operations and higher termination income. In the third quarter 2015, we project funds from operations of $1.34 to $1.36 per share. Owen mentioned the potential for additional asset sales in 2015, and other than the pending sale at 505 9th Street, we have not included any additional asset sales in our updated guidance. Although we will not provide formal guidance for 2016 until next quarter, I do want to touch on a couple of items that Doug mentioned which will impact our 2016 results. These include the downtime associated with Citibank vacating 140,000 square feet at 601 Lexington Avenue, the rent differential and downtime from FAO vacating the GM building for a temporary user during part of 2016, the lease transition at 100 Federal Street, the loss of 200,000 square feet of occupancy in our Washington DC joint venture properties, and the leases expiring at our Gateway project in South San Francisco. Our share of the projected aggregate reduced income from these transactions in 2016 is projected to be approximately $35 million, which clips our same-store NOI by about 2% from 2015. Doug also mentioned the contractual sale of our 7 Cambridge Center lab building to its user in early 2016, which will result in the loss of an additional $13.3 million of NOI. These items will impact our 2016 FFO, though the effect on our AFFO will be far less significant due to the conversion of free rent to cash rents in the portfolio. We do have positive catalysts to offset these losses, including growth from the completion of the lease-up of 250 W. 55th Street and 535 Mission, as well as the delivery of an additional $850 million of new development between now and the end of 2016. We won't see the full impact of these deliveries in 2016 as several won't deliver until late in the year and they will be in lease-up. This pipeline of near-term deliveries has a projected weighted average cash return of between 7.75% and 8% and is projected to stabilize by the end of 2017, generating approximately $70 million of GAAP NOI at stabilization. In addition, we expect our organic growth to pick up late in 2016 and into 2017 with the lease-up of our vacant space at the Hancock Tower and 100 Federal Street in Boston, the releasing of the FAO space, and the roll-up on expiring leases at Embarcadero Center. As I mentioned, we're not prepared to provide our 2016 guidance until next quarter, but as you begin thinking about your FFO and AFFO models, we thought this would be helpful. That completes our formal remarks today. I would appreciate it if the operator would open up the lines for the Q&A.

I just wanted to quickly just talk about leasing CapEx for a second. It looked like it just a little higher in the quarter. I was just wondering if that was an issue of timing or what is really driving that?

Most of the leasing CapEx is really driven by the makeup of the portfolio, so to the extent that we have more urban longer-term leases, generally it goes up. But we have typically averaged somewhere in the neighborhood of $30 plus or minus per square foot on a consistent basis on an average basis for the portfolio, and there is nothing that occurred this quarter that was significant.

I think if you look at the lease terms they were a little longer, so our weighted average cost per lease term was like $5.39 I think, which is in line with what our range typically is. And I think the renewals were a little bit lower than typical. Again, it is just a makeup of whatever is happening that quarter. So since we had more new leases versus renewal leases, the costs were a little bit higher.

And then just switching gears to the build-to-suit opportunities in DC, it looks like one of the projects, I think it is a 550,000 square foot project that was in final-round bidding, something was expected to be announced here in the next month or two. Just wondering if there is any progress there at 1006 Sixth Street or if you can comment on that at all?

So those are two different projects. The one that you were describing, I believe, was the requirement for the GSA to do the TSA. So Ray, you can comment on that and then the second one is whether we have a tenant for 1001, which is the building in the CBD.

So the TSA unfortunately has been caught up in the morass of GSA and while we expected it to take place in the second quarter, we're still awaiting the final award. It is a very competitive process, but we have put forth a great offer and a terrific building in Springfield, and we're cautiously optimistic that when they finally make an award, that we will be under heavy consideration by the GSA. As it relates to 1001 Sixth, we're also in a very competitive process there with a major corporation in DC. We're still in discussions with that group. We know that it has been narrowed down to two or three finalists. We believe we're one of those two or three. We have designed a great building, offered them a very competitive economic package, and again we're cautiously optimistic about hearing something positive there as well.

Both of these projects are effectively 100% leased, so there is no speculative risk associated with any available space.

And then is there any update on the potential corporate relocation to the Wiehle Avenue site?

Well, we're in discussions with another corporation that we're under confidentiality with that is considering a site near the Wiehle Metro. Again that should be forthcoming by the next call if not sooner. It would involve us building a building there on their behalf and would involve both a land sale and a fee structure. But again we're not able to announce neither the terms nor the tenant at this point in time.

And then now that The Avant is going through really its first season of lease roles, just wondering operationally what the renewal rate is and how you guys are faring on renewal spreads?

The turnover rate is around 30%, and we are achieving a premium over the competition of between 10% and 14%, which includes the performance in Tyson, so it has been remarkable.

Those are both correct.

Maybe if we just look at sort of the repositionings, redevelopments that you guys spoke about. How much capital do you need to commit to those projects to get them sort of to where you want them to be in 2017 and onwards?

So the capital has already been committed and it has been spent at the Hancock Tower other than obviously the rollover leasing that we will do. The project at 601 really has not been fully vetted yet, but it is probably somewhere in and around $100 million. We will also be doing a repositioning at 399 at some point in 2016 and 2017. It will be a repositioning light. John would probably describe it as an image change as opposed to a repositioning. And then the project Mike described at Tracer Lane – or sorry, at Reservoir North is about $25 million, as Owen put out there. And the work that is going to go on at the General Motors building at the retail I think in large part will be based upon the existing tenants, and most of that capital will come from the users as opposed to from us.

And if we stick to the projects that you outlined, a dipping or dragging 2016, how much of a recovery of sort of lost revenues or lost NOI do you expect in 2017 from that same pool?

If you are asking if there is a markdown or not, I think there is a dramatic markup in every case. So we will get more than 100% of what we're losing in those rents. I think the only piece of space in the portfolio that is rolling over in 2016 and 2017 where we're a little bit tight on the mark to market is the low rise at 399 where right now on a cash basis, we're getting about $90 a square foot from Citi. It is actually lower than that on a GAAP basis because of a straight-line rent, and it is the last five years of the lease but John, you can comment on this. I think that we hope to get high 80s to low 90s on that space and higher on an average basis.

I think that will work out. We already have a couple of very good leads on that space, and we're working very well in conjunction with Citi. They may be able to exit part of that early, and we're in discussions with a specific tenant now for a portion of that. We do have a challenge; Doug mentioned the below-grade space. It is 100,000 feet there and we will be working on that.

Maybe my last one for Owen, when you think about your acquisition pipeline or opportunities, how do you think about what you would do on balance sheet versus with a partner?

I think acquisitions today of existing leased buildings – pricing is aggressive. That is why over the last couple of years we have been pretty active sellers of property. The building in Washington that we just announced at a little bit over $1000 a square foot is the best example. So the way we're thinking today about acquisitions of again new existing leased buildings is in partnership with capital sources, some from the U.S., some from outside the U.S. where we would make a significant co-investment but we would enhance our return through compensation that we earn from applying our real estate skills, whether it be managing the building, leasing the building, providing capital improvements, or whatever is required.

Can you talk a little bit more about the leasing demand for some of the space you are planning to backfill in 2016, 2017? Specifically the bigger blocks in New York and Boston?

I will let Bryan talk about Boston and then John can talk about New York.

One of the things that Doug mentioned earlier was the condition of our supply side in Boston. And one note that we're watching is our competitive set. Those buildings that we really compete against on a day-to-day basis in each market is below 6%. And in Cambridge as an example, it is actually sub 2%. So we have got really, really limited supply in terms of who we're competing with on a day-to-day basis versus the whole greater market. But we have actually seen a 3% drop in the CBD market as well in terms of vacancy. So the absorption has been really quite good. We have got good job growth in all sectors. I think the surprising zone to us has been the financial industry that Doug mentioned. We didn't anticipate seeing stability and job growth, especially with the smaller firms on the BC side. So we're seeing it in, I think, every category. It is not just the tech sector anymore or the biotech sector that we had earlier call it in the recovery of the market. The other side that has been quite surprising is the demand side in the Waltham market. Doug mentioned that we have done two deals with shoe companies. There are companies out there that are growing rapidly, and it is all based on the original shoe industry and the brands that are growing out there, and it is really being perceived as a wonderful place to grow a company right now.

Just to give you some specifics, Jamie, so the big quote-unquote holes in our portfolio from an occupancy perspective right now are 100 Fed and at the Hancock Tower, and I think I described that we have got literally more demand than we can actually find space for. So we're actually taking space back from tenants and restacking 100 Fed to deal with the 180,000 square feet of availability there. We're in active discussions with tenants on the low-rise portion of the Hancock Tower, and again based upon what I said about Cambridge as well as the attractive nature of that space, we feel really good about the prospects for that and the pricing that we're asking. I will be brutally honest with you; we have known about the vacancy at the top of the building for the last couple of years and we have yet to lease any of those floors, but it is a terrible showing. On the other hand, we're asking for pretty big rents. I mean, the rents that we're achieving at the top of the Hancock Tower are starting in the low 80s and higher. And so the pond that we're fishing in has relatively few fish, and so we're being patient about that. But we're very confident that they will come by and that we will be able to lease that space, and that is why I'm saying that I believe we will do some leasing in 2015; we will do some leasing in 2016, but we may not have revenue produced on that space until sometime in late 2016 or early 2017. And those are really the blocks there. John, do you want to comment on New York City?

Yes, there is not a lot of space, so I'll make my comments very brief. 250 is going very well, and we have a lot of traffic at the top and we have some term sheets out now. So I think that that has been very well received in the market. We will get some space back from Wiehle. We already have interest in that space; we already have a very nice proposal on a big block part of one floor. We talked about 399 before. Certainly, the Towers space, the base, the X Morgan Lewis or existing Morgan Lewis space is not a concern at all in this market. We already have a deal on a big block of that. Doug mentioned that we're doing some significant work at 399. We're tuning that up now with our marketing package. I think the building needs a little bit of loving care and money and we're going to do that, and we have done that in a very careful calculated way. So our marketing on that building will really start with images and renderings, etc., in September. But as I said before with regard to the low rise, we have already been in discussions with Citi potentially on getting back perhaps one of the floors or more a little earlier and to target that with some large tenants we're talking about.

If I could just mention one other thing, we will be adding something that is going to be pretty spectacular at 399 where the Citi auditorium is now on the top of the 13th floor. We're going to put a pavilion there, and it will be a green space; it will have a green roof; it will be outdoor space; it will be pretty spectacular. And we will connect that with the 14th floor when the lease expires there in 2017. I think that will be a very big enhancement for someone that wants a conference center on that space, a reception on that space. And because of the elevated situation in the building, this may be too micro, but Citi had a couple of private elevators. We would be able to connect those directly to the low-rise floors, so that is, we're very excited about that.

Some additional color on Boston, this is Bryan Koop. I cannot remember a period of time when we have had as much call it discussion and activity with our existing customers about growth. It is everything from small growth 5,000 to 10,000 square feet to even large chunks of space, 50,000 to 100,000 square feet. But our existing customer base is where I think we're going to see a good bit of our absorption.

Okay. I guess just on New York in terms of the big block demand, I mean you guys sound pretty comfortable you will be able to lock in tenants for both 601 and 399 when that time comes?

601, the only block that we will have at 601 will be in the low-rise building; that is 145,000 feet. And we're working on a repositioning of that. If it works out the way we want it to, I think that will be a very unique offering in the market in terms of the location, in terms of the outside amenities and what we want to do there. But more on that later. The block at 399, I already spoke about; we already have some interest on.

Just to reiterate what I said in my comments, Jamie, so we don't have places to put Citibank right now physically and we want to relocate them out of that low-rise block so that we can reposition and redevelop it. And so our guys are creatively looking to figure out ways to take some space back that is currently rent-producing and move Citi into that space so we can actually do this work, which is again as I said, we're looking to create vacancy so we can put the capital in to reposition the building to ultimately dramatically enhance the concourse area, the atrium, and this low-rise space which has a dip in 2016 and 2017, but it is going to be fantastic for the asset as well as for that corner where we have 399, 599, and 601 in a couple of years.

And just wondering if you have seen any evidence at all of upward pressure on cap rates in your core markets just given some of the recent changes in treasury yields and borrowing costs? And I guess related to that, Mike, you mentioned the sub 4% execution you would get on 10-year bonds. Today, just wondering if that would be closer to 3% or 4% at this point?

On the question with respect to the weight capital or interest by investors, we have not seen any diminution in that at all. And I would also point out that a lot of the investors that we see in the marketplace are not using significant leverage so I don't think interest rates have as big an impact at least for Class A office properties in our core market.

I think somebody mentioned some Blackstone selling. You are likely going to hear about or see a print on the assets that Blackstone is currently selling in Boston, and I don't think we're surprised at where those assets are going to trade. And they are going to, I think, look at again you are going to look at our portfolio and you were going to go wow. We purchased a building in 2011 at the Hancock Tower, now called 200 Clarendon Street, for $435 a square foot and it is the superior asset in the city, and you are going to see, I expect, a print that is more than double that if not significantly more than that over the next month or so with those other assets. And it is a demonstration that there is a continued desirability for these core iconic assets in our markets. And interestingly in some of these markets, they are starting to become somewhat of a scarcity issue as well because there are relatively few assets that will likely be sold over the next number of years. And the new buyers that have come in are, I think, what one would characterize as not transitional buyers, but long-term buyers who expect to own these assets not necessarily forever but certainly for an extended period of time with a very long-term horizon in terms of how they are going to invest in the assets.

The current unsecured debt market shows credit spreads in the 150s for 10 years. This indicates a borrowing rate of approximately 380 to 390. In the secured debt market, high quality assets with low leverage of 50% to 60% are seeing rates around 160 to 170 basis points, potentially tighter. As leverage increases, rates may exceed 200 basis points. Overall, borrowing costs are approximately 4%. Regarding your question about same-store performance, when comparing quarterly results, properties like The Avant may be included in quarterly comparisons but not in annual comparisons. Thus, there is some variance in the same-store profiles to consider.

And just last one on the upcoming GSA expirations you guys talked about in DC, do you think they will be making long-term decisions on those spaces or do you think it could be more of sort of a kicking the can down the road and short-term holdovers over the next couple of years?

On the bulk of it, it is likely going to be kicking the can for the reasons Doug described. There are going to be certain procurements similar to the one we're chasing down in Springfield where because it is a consolidation and they may be able to align the need for new space along with the fact that the existing facility doesn't meet the necessary security requirements, that they are actually going to go and make the jump because they have been able to argue to Congress that they need the money for the consolidation. But I think the bulk of it will likely be kicking the can for, as I said, the reasons Doug described.

Well, just to summarize, we were slightly above consensus for the quarter. We increased our guidance slightly for 2015, and hopefully we provided you helpful details on investments that we're electing to make to enhance our portfolio that have some impact on 2016 results. With that, thank you for all of your attention.