Boston Properties Inc (BXP) — Q4 2018 Earnings Call Transcript

Thank you. Good morning everybody and welcome to Boston Properties fourth quarter 2018 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 Reg G requirements. If you did not receive a copy, these documents are available in the Investor Relations section of our website at 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 that its 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 yesterday'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. I’d 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, Senior Executive Vice President and our regional management teams will be available to address any questions. And now I'd like to turn the call over to Owen Thomas for his formal remarks.

Thank you, Sara, and good morning everyone. We just completed another strong quarter, capping off one of the most productive and successful years in Boston Properties' history. Specifically, in 2018, we completed 7.2 million square feet of leasing, our second highest level of annual leasing ever. We delivered and placed in service 2.3 million square feet of new developments, the commercial component of which is 100% leased. We commenced 2 million square feet of new developments, which are 80% preleased in the aggregate with strong customers such as Verizon, Fannie Mae, and Leidos as anchor tenants. We completed an important new acquisition joint venture including Santa Monica Business Park, doubling our Los Angeles presence, and a site at 3 Hudson Boulevard in New York that can accommodate 2 million square feet of new development. We completed approximately 720 million of non-core asset sales. We increased in-service portfolio occupancy, 70 basis points over the year to 91.4%. And lastly, we increased our regular quarterly dividend by 19%. In fact, Boston Properties has increased its regular quarterly dividend by more than 46% over the past three years. And more recently in the fourth quarter of 2018, we generated FFO per share in line with prior guidance, and up 7% year-over-year. We leased 1.8 million square feet including 300,000 square-feet leased with Millennium Management at 399 Park, bringing this focus asset to 93% leased. We raised $1 billion as a green bond in the unsecured debt market on favorable terms, and we increased the midpoint of our FFO per share guidance for 2019 by $0.11, raising our projected 2019 growth to over 10% at the midpoint. Our performance in 2018 highlights the key characteristics that make Boston Properties unique and its ability to generate growth and shareholder returns in the office sector. Our high-quality Class A assets allow us to attract premium rents from long-term creditworthy tenants. Our scale and diverse yet concentrated market selection allow us to benefit from growth within the strongest markets in the U.S., while minimizing the risk of single market sector or customer weakness. Our development expertise and portfolio of sites give us the opportunity to win important mandates with customers and ensure our growth is driven by a strong pipeline of preleased development, driving higher return. And our modest leverage and growing portfolio NOI provide capacity for new investment without issuing public equity, also driving FFO growth. I'm very proud of our team at Boston Properties and what we were able to accomplish in 2018 through our experience, relationships, teamwork, and commitment to success. Now let's turn to the market environment, which has become increasingly dynamic with trends impacting our business. Economic growth in the U.S. and worldwide hit an inflection point in the fourth quarter. Global and U.S. GDP growth is slowing, and elevated trade tensions, as well as government dysfunction due to the recent U.S. shutdown and Brexit, will have a further negative impact. So-called globalization is taking hold and possibly accelerating. As a result, central banks, including the Fed in December and January, shifted to a much more dovish tone on interest rates and quantitative tightening. As a result, 10-year U.S. treasuries are now around 2.7%, which is about 50 basis points below their high in early November. So what does all this mean for Boston Properties? First, we're not overly concerned about the near-term recession and expect slowing U.S. economic growth to plateau and stabilize above 2% at least for now. Second, our long-stated view that interest rate risks are overblown has proven true, and given the recent Fed rhetoric, we certainly expect rates to stay low for the foreseeable future, a significant positive for real estate value. Lastly, we see no current signs of abatements in the mostly robust leasing markets we have enjoyed. Therefore, we recognize leasing activity lags economic growth and financial market movements; hence risks of slowing leasing activity are higher. We remain constructive on further investing activity given economic growth and low interest rates. That said, we have adjusted our risk thresholds and will be increasingly discerning in our new acquisitions or launching new development. We continue to believe investment in new developments is more accretive to shareholders than repurchasing our shares, and we will continue to use private equity capital to help fund new investments in order to avoid either issuing public equity at our current share price or materially increasing our leverage. In the private real estate market, significant office building transaction volumes increased to 24% in the fourth quarter and 4% for all of '18. Though investors are increasingly selective, there were multiple significant office transactions completed again at sub 5% cap rates in the fourth quarter of last year. Examples include here in Boston in the Financial District where 53 State Street sold for $685 a foot and a 4.6 cap rate to a domestic operator with U.S. and non-U.S. capital. This was a 1.2 million square-foot building that was or is 94% leased. In Beverly Hills, UTA Plaza and Ice House sold for $954 a foot and a 4.6% cap rate. This is a 240,000 square-foot property and fully leased, sold to a domestic opportunity fund. In New York, 425 Lexington Avenue located near Grand Central sold for $940 a foot and a 4.5% cap rate to a domestic real estate firm. This is a 750,000 square-foot building and is 95% leased. In Mountain View, California, Shoreline Technology Center sold for $1 billion or $1,250 a square foot and a 3.5% cap rate to a user that occupied 92% of the building. This is a 12-building, 52-acre site is 800,000 square feet and is fully leased. In San Francisco, the 110,000 square-foot, 100% leased 345 Brannan Building sold for $1,326 a foot at high 4s cap rates to a domestic REIT. Finally, in Washington DC, 1111 Pennsylvania Avenue sold for $1,032 a foot and 5% cap rate to a domestic investment manager. This building is about 340,000 square feet and is fully leased. Now moving to our capital activities, development continues to be our primary strategy for creating value, and we remain active in pursuing both new preleased projects and sites for future projects. Since our last earnings call, we progressed further in our development pipeline activities. With the recent deliveries into service of the Salesforce Tower and Spring Street, our current development and redevelopment pipeline stands at 11 office and residential projects comprising 5.3 million square feet and $2.7 billion of investment for our share. Most of the projects are well underway, and we have $1.6 billion remaining to fund. The commercial component of this portfolio is 78% preleased, and the aggregate projected cash yields are estimated to be approximately 7% upon stabilization. Also in 2019, we expect to commence the development of 2100 Pennsylvania Avenue in Washington DC and 325 Main Street in Cambridge. These projects aggregate 870,000 square feet, $760 million in new investments, and are 75% preleased. We also completed three new acquisitions. In San Jose, we ground lease with the right to purchase next year Platform 16, a site with the potential for 1.1 million square feet of new office development. The purchase right is for approximately $125 per square foot for the site, which is located within walking distance of Diridon Station, San Jose’s primary transportation hub with active Caltrain, BART, and future high-speed rail, adjacent to Google's planned 8 million square-foot transit village. Large-scale transit-oriented sites in Silicon Valley are in high demand and rare. We are also in discussions with capital partners to make a significant investment in this site and the eventual vertical development. More recently in January, we exercised an expiring purchase option for all the remaining development land at Carnegie Center, which can support up to 1.7 million square feet of future development for $42.9 million. So growth in the Princeton market is modest; we have uses for a portion of the property and believe our Carnegie Center asset is more valuable with the existing buildings and development opportunity unified. Also this month, we committed to purchase Heinz's 5% interest net of our advances in Salesforce Tower and settled their carried interest arrangement. Lastly, on capital activities, we had an extremely successful year for dispositions, selling $720 million of non-core assets and exceeding our $300 million goal for the year. In the fourth quarter, we completed the sale of 1333 in Hampshire Avenue in Washington DC for $142 million. We felt this asset would be vacated by Akin Gump in 2019, and releasing of the building doesn't fit our current operating strategy. We presold the TSA Development project in Springfield Virginia for $98 million, which is a reimbursement of cost today, including our land. If you include the future funding assumed by the buyer, the total sale price is $324 million including development fees to Boston Properties and the forward cap rate is approximately 6%. Given this is a GSA-leased asset with flat rents in a suburban location, we would have sold the asset at completion and elected to do it early to free up capital for our growing development investment. We completed the transfer of our 50% interest in Annapolis Junction One, a 118,000 square foot property located in suburban Maryland to our JV partner in the property. It is our intention to exit the remaining assets we hold in Annapolis Junction over time. We fully exited our investment in Tower Oaks Preserve Business Park in Rockville Maryland by completing in December the sale of a 41-acre parcel of land for $46 million and in January the sale of 26 Tower Oaks, a 179,000 square foot building for $22.7 million, or $127 a square foot. In summary, 2018 was a very successful year for Boston Properties. Given our robust development pipeline and lease-up activity for in-service assets, like our hometown favorite New England Patriots, we’re well positioned to put more wins on the board in 2019 and beyond. Let me turn the call over to Doug.

Thanks, Owen. Good morning everybody. Going back, we had great leasing success in 2018, including the four leases from major new developments that Owen described, and our development delivery income continues to accelerate, and it is certainly true there is a barometer of real-time economic activity, looking at our revenue from the office leasing business, which is really a lagging indicator given the lead times inherent in our transaction cycle. It is also true that the decisions made by our customers a year ago, two years ago, or even five years ago are just starting to reflect in our top-line revenue, and they are contractual, growing for years to come. So let’s have a case in point at Salesforce Tower. We signed our first lease in April of 2014, and the building won't achieve its all-occupied rent revenue run rate until October of this year. Starting at that point, the contractual cash rent increases on average 2% per year. The first lease expiration in the building, which is only about 70,000 square feet, is 2027, and based on the last few deals in inferior buildings in the market in '18, the rent on that particular lease is somewhere between 35% and 40% below the markets today. As Owen stated, despite the macroeconomic volatility, leasing activity feels a lot like 2018. Our primary customers, large real estate users—either public or private, start-ups or established companies—continue to make decisions to upgrade and consolidate space. While we continue to see the bulk of office demands growth from the technology and life science businesses, and flexible space operators, there is also robust demand for new space, not necessarily growth space from traditional industries, as evidenced by the incredible activity in Manhattan in 2018. So let's talk about the markets, our expectations, and what's going on in our portfolio. I'll begin with New York City. In October 2017, at our investor conference, I stated that our biggest opportunities for higher contribution and occupancy improvements in 2019 and 2020 would emanate from 1590 E 53rd Street and 399 Park Avenue, and I put John Powers, Andrew Levin, and Heather Kahn on the spot. We announced the 30-year lease for all the space at 159 earlier this year with cash rent and hopefully revenue recognition at the end of '19. Then during the fourth quarter and the first week of '19, we've signed leases totaling 554,000 square feet at 399 Park Avenue. These transactions include the leasing in the entirety of the low-rise vacancy, a block of space at floors 7, 8, 9, and 10 totaling 252,000 square feet, and as part of the same transactions, we agreed to recapture 57,000 square feet on the sixth floor, which is expiring in 2020, and lease for the same tenants. On floors 33 through 35, we need to recapture 73,000 square feet, which is expiring in 2021, and we released that entire space to new tenants that are going to stay through 2035 or longer. Finally, we recaptured 97,000 square feet expiring in 2026 on the fourth floor and we released 75,000 square feet along with our renewal of the 97,000 square feet on the fifth floor through 2037. So we've leased floors 2, 3, 4, 5, 6, 7, 8, 9, and 10, the entire lower rise of the building. We've surpassed our revenue expectations for 2019 and 2020 from the vacant space, and we still have 97,000 square feet, which is available and ready to lease immediately. The expiring gross rent on the 554,000 square feet that I just described was $82 a square foot and the first-year rent is about $90 a square foot. There have been a number of recent market causing reports on New York City, and it was quite clear that 2018 was a banner year from an activity perspective. The points I would make are as follows: On the margins, there has been a lot of new construction delivered or is soon to deliver, and the overall availability rate has actually helped steady and has gone down slightly in Midtown. The addition of new construction underway at 425 Park, One Vanderbilt, 50 Hudson, and 6600 Boulevard, and the repositioning of buildings like 550 Madison all have acting rents above $100 a square foot, and $100-plus acting rents are prevalent all over Midtown South. So the inventory of high-end space has increased significantly. There were over 4 million square feet of leasing over $100 a square foot last year—including renewals in Manhattan—in a total market activity of about 38 million square feet. Eighty-five percent of the deals above $100 a square foot were under 50,000 square feet and averaged around 15,000 square feet. The leasing activity drops dramatically above $120 a square foot. Overall, we continue to see concessions—the free rent build-out time in TIs—remain very constant, with a slight uptick in rents in those buildings or submarkets that have gotten tighter. Moving to Washington DC, it continues to demonstrate the most challenging market conditions amongst our regions. As you read in our press release and heard from Owen, we have reduced our portfolio exposure in both the CBD and suburban DC market through asset sales. Our new activities are focused on the long-term leases we have signed that will commence with the delivery of our new development between 2020 and 2023. In the CBD, there are many new partially leased deliveries and relatively little new demand outside the flexible office providers that absorbed over 800,000 square feet in 2018. Based on our experience, and that's where we have one of these providers, their customers are small entities and operators that are truly aggregating demand that we could never accommodate. This has been a real benefit. With base rent on leases that are stable, it's all about concessions and rent commencement days. We have and will continue to use our operating skills and relationships to gain occupancy at market terms, and we will do as many 4,000, 20,000, and 50,000 square-foot deals as necessary to fill our availability in the CBD. The Washington DC region makes up about 17.8% of our total company NOI, down from 21% in 2015 with the CBD at just over 7% of our total NOI, so relatively speaking, a small portion of the Company's assets. The Northern Virginia portfolio comprises over 53% although regional contributions are growing and have much better leasing activity due to the more diverse demand days which contain a significant number of government contractors, technology companies, and other corporate users. We have a number of renewal discussions underway including our 492,000 square feet at the New Dominion, which is leased to the GSA, as well as 275,000 square feet to tenants in Reston Town Center. In 2019 and 2020, we will have exposure on our Reston portfolio, as Leidos relocates from their 170,000 square-foot accommodation into new 270,000 square-foot premises at 1750. And tenants who need growth, whom we were not able to accommodate in 2017 and 2018, are starting to lease henceforth. We are in active discussions with two existing tenants looking to expand their own 50,000 square-foot installations to new tenants looking for a minimum of 75,000 square feet. We will roll out a number of place-making enhancements during 2019 to our Town Center assets as we get ready for the addition of Metro in our Reston Town Center redevelopment, which will open in 2022. Moving West, in LA, we brought Colorado Center to 100% leased and with our limited availability at the Santa Monica Business Park, we are focused on early renewals at both properties. With the expected relocation of HBO in December of '20, we have the ability to accommodate the growth of other tenants at Colorado Center. And at the Santa Monica Business Park, we are working on getting ahead of our 2020 expirations. The West LA market had an active 2018 beginning of 2019 as a number of large technology companies expanded their footprint in the area. This included Google, Facebook, Apple, and Amazon, the same names you hear by the Silicon Valley, as well as a number of flexible office operators including WeWork and Spaces. Rental rates continue to rise and there are limited big box availabilities in the West LA market. The story in San Francisco CBD is one of lack of availability. The vacancy rates are at their lowest levels since the last cycle began after the Great Financial Crisis. There are virtually no direct or somewhat space in the market over 100,000 square feet other than 50 deals. The only new construction for the first admission development won’t deliver until 2023 at the earliest. We understand there is a leasing negotiation for all over the 255,000 square feet at 633 Wholesome; it's the only large addition major renovation undergoing the city right now. A technology company just leased 150,000 square feet at One Maritime adjacent to Embarcadero Center, and the majority of Salesforce's sublet when they moved into our building at Salesforce Tower has been leased. This Central SoMa plan is under a sequel litigation and will likely delay the ability to commence construction, even if the Planning Commission grants the particular site entitlements and allots a plot and allocation. There continues to be significant demand in the market. Since 2011, more than 50% of the annual leasing has come from technology companies, and the total occupied base of the market has moved from 22% tech in 2013 (about 15 million square feet) to more than 37% in 2018 (30 million square feet), so it's nearly doubled over what we could have possibly imagined. In our portfolio, Salesforce Tower, 535 Mission, 680 and 690 Folsom, 50 Hawthorne are all 100% leased. At Embarcadero Center, we ended the quarter at 91.4% and completed 258,000 square feet of leasing within existing rent in place of $61 a square foot growth and new starting rent of $85 a square foot, up 40%. The lease commencement runs from February 19 through July of 2020, when new tenants take those actions on the 125,000 square feet of EC3 when the existing tenant then vacates. If you include all the space that is either leased but not yet occupied, our office occupancy would jump to 95%. We currently have another 250,000 square feet under negotiation that could be completed during the first quarter of 2019. If you want floor space at Embarcadero Center, you’ll probably have to wait until the next delivery of available space in November 30, 2019 when our next full floor not under negotiation expires, which will take some time. Last but not least, all three of our Boston markets—the CBD, Cambridge and Waltham Lexington—continue to benefit from ongoing growth in technology and the life sciences sectors along with the very manageable new construction. The new buildings that have been started have been sized to the market with very little aggregate speculative space. Our 100 Causeway Way project, which is expected to open in ‘21, is a great example. We announced the start of a 640,000 square foot tower with a 437,000 square foot commit. An existing tenant at the Podium building at 100 Causeway Way picked up 66,000 square feet for expansion, and we’re negotiating a lease for the final 125,000 square feet. In Waltham, we started a 211,000 square foot building at City Point with a 110,000 square foot lease, and we have since leased another 121,000 square feet with 75,000 square feet remaining. In the last few months, there were additional growth announcements and in all of our Boston markets. In Cambridge, a life sciences company committed to a new 900,000 square-foot series of building, and we signed our 365,000 square foot lease for 325 Main, which we hope to start construction during the second quarter of this year. In Waltham, the only significant speculative office development during this cycle has activity that will bring its occupancy to 75%. And in Boston's Financial District, last week State Street Bank committed to be lead tenants in the 500,000 square feet of space at One Congress. The remaining 0.5 million square feet in that project and the backfill of their existing location at One Lincoln should be satisfied by other demands. The challenges we have in our Boston portfolio is not just similar to Embarcadero San Francisco—the lack of space. So, we are focused on future explorations. In late ‘17, our tenant at 33 Hayden Ave in Lexington, an 81,000 square-foot tenant with a 2019 December expiration, made the decision to relocate into Boston. During the first week in January, we terminated their lease and signed a lease for all of the space with a life sciences company that will take occupancy at the end of this year with a 94% increase in the rent. At 111 Huntington Avenue, we leased two floors, one expiring in December 2020 and the other expiring in December of 2021, with an increase of 37% to a growing tenant in that building. To give you a sense of the changes in market rents; at 200 Clarendon Street, we leased a 30,000 square-foot full floor for a short term of about 1.5 years in the middle of 2017, that space became vacant in August of 2018. Late last year, we've negotiated a similar term lease at a 12% increase in rent. Rents in Boston, Cambridge, and Lexington had strong increases in 2018 along with a decline in concessions, and we expect the same in ‘19. As I stated at the outset, the conditions across our entire portfolio feel very much the way they did in 2018. I’ll stop there and let the call go to Mike.

Great, thank you, Doug. Good morning. As I always said, we end at—we had another strong quarter in the fourth quarter. Once again, our portfolio revenues increased sequentially just over 4% over the last quarter and 7% year-over-year. We also grew our share of same property NOI by 3.4% on a GAAP basis and 7.9% on a cash basis over the same quarter last year. Net rents on our second-generation leases that commenced this quarter were up over 11% over the expiring lease—all of these are positive trends. Our occupancy climbed to 92.1%, which is a 100 basis points higher than last quarter if you exclude the delivery of Salesforce Tower. We brought Salesforce Tower into the in-service portfolio this quarter at 70% occupancy, which dampened our overall occupancy to 91.4%. Salesforce Tower is 100% leased, and we expect all of the office tenants to be in occupancy by the end of the third quarter of 2019. We issued a $1 billion green bond with a 4.5% coupon in the quarter and used a portion of the proceeds to redeem $700 million of high coupon 5.78% bond that were due to expire in late 2019. We booked a loss on debt extinguishment of $16.5 million or $0.10 per share, which was primarily the yield maintenance penalty for paying off the bonds early. This charge was included in our adjusted guidance issued in December. We are now taking care of all of our material debt maturities through late 2020. We reported fourth quarter funds from operations of $1.59 per share and full-year funds from operations of $6.30 per share, which was in line with our guidance. Portfolio revenues and management service fee income were both slightly ahead of our plans but they were offset by higher than projected G&A expense of approximately $0.01 per share. As Owen and Doug described, we had a fantastic year of leasing, and the fourth quarter was no exception. We signed over 1.8 million square feet in the quarter, including 750,000 square feet in midtown Manhattan. The vast majority of these leases had no impact on the fourth quarter earnings results, but they will have a positive impact on 2019 and beyond. In addition to the significant leasing activity in New York City, we also have strong activity in San Francisco and Boston, both for new leases on vacant space, as well as the large number of early renewals for leases expiring between 2019 and 2021 where we expect to get increases in rents. Based on the continued leasing velocity, we are increasing our assumption for year-over-year growth in our share of 2019 GAAP same property NOI by 75 basis points at the midpoint to 4.5% to 6% over 2018. We are keeping our cash same property growth assumption at 4.5% to 6.5% as many of the deals we are tracking are early renewals or new leases that will not commence cash rent until late in 2019 or 2020. As a result, we have also increased our assumptions for 2019 straight-line rents by $10 million to $85 million to $110 million. In our non-same property portfolio, we are moderating our assumption for incremental NOI growth in 2019 slightly by $5 million at the midpoint of our range due to minor changes in occupancy timing in our development portfolio. This is comprised of pushing back occupancy by a month or two for some of our office users, as well as the retail space at the hub on Causeway based upon adjusted build-out schedule. Generally, our clients are in control of their build-out and pay rent on a fixed date. However, we cannot recognize revenue until they complete their work, which is not in our control. We are often able to pick up the difference by continuing to capitalize interest, which you will see in our interest expense assumptions. We've increased our assumptions for development and management services income to $40 million to $45 million for the full year, an increase of $3 million at the midpoint from last quarter's guidance. The most significant change this quarter came from our sale of the TSA headquarters development. We've entered into a development agreement with the buyer, and we earned fees for our development services over the next two years. Lastly, we are reducing our interest expense assumption by approximately $8 million in 2019. We now expect net interest expense to total between $410 million and $425 million for the full year. The reduced expense assumption comes from a combination of the new bond deal and bond redemption transactions in December and a reduction in our projected line of credit usage, primarily due to the sale of our TSA development. Our capitalized interest projections have remained steady, with the last capitalized interest for the TSA development offset by higher capitalized interest for our other developments. Overall, we are increasing our guidance for 2019 funds from operations by $0.11 per share at the midpoint to a new range of $6.88 to $7 per share. The increase is comprised of $0.7 per share from higher same property portfolio NOI, $0.5 per share of lower interest expense, and $0.2 per share of higher fee income offset by a reduction of $0.3 per share of NOI from our developments. Our guidance does not include any additional acquisitions or dispositions, other than what we included in our press release. We are continuing to see positive trends in our markets, resulting in leasing successes that are driving up our organic growth. Additionally, our development pipeline is well-leased and provides assured external growth over the next several years. This combination of both internal and external growth points to very strong FFO growth at our midpoint for 2019 of over 10% from 2018. Operator, that completes our formal remarks. If you can turn it over to Q&A, that would be great.

Just focusing on New York for a second; if you think about Brookfield's announcements that goes back at 2 Hudson Yards. Just wondering if that curtails anything about your 3 Hudson developments; whether it'd be your desire to go spec or wait for tenants to come in or if there is any shift in timing for that development?

So, I'll make a brief comment and join in John Powers, I'm assuming you're on and you can add on. So at the moment, with the two developments at the Hudson Yards, there is—in one building, there’s just over 1.5 million square feet and in the other building just over 1.2 million square feet of available space. If the announcement that you saw yesterday, it's actually true that Brookfield tends to start on spec, that's another 2 million square feet. So that's 4 million square feet right there. Then obviously, you have other buildings in Midtown Manhattan which are under construction. I think we would certainly be looking to have a significant amount of preleasing before we start.

Well, Doug's giving you the facts there. On our situation, we've been working hard since we closed the deal with Joe to redesign the building, and we've done that. We're in a 100% BDs now. Construction is ongoing on the foundations, and we're talking to some tenants in the market, but clearly, we need a significant interest from tenants to move forward with the project. We're very excited with the redesign, by the way, and it's been very well received by the tenants that we showed it to.

The other question I was just looking at sort of new markets and new submarkets you're looking at. Is there anything else out there that you're actively tracking that you could share with us right now?

Manny, it's Owen, good morning. Nothing outside the perimeter that we've described.

I wanted to ask on some of the components of your guidance change this quarter from last quarter, which includes the higher occupancy assumption. What was that primarily due to? And also if you could talk about the termination fee where this was coming from and how likely it is you are going to release the space?

So, the guidance change is obviously we increased our guidance last quarter, and we also announced, I guess earlier this month that we signed a bunch of leases that Doug spoke of in New York City which total over 550,000 square feet. We were working on some of those leases last quarter, but they clearly weren't complete. So, we were certainly handicapping the likelihood of those things. I would say the execution of those leases—some of which are starting revenue, although not cash revenue in the first and second quarters—brought up the bottom line of our guidance because we got those things. I would say, the continued velocity of activity that we're seeing in our markets is driving up the high end of the overall guidance range. Those are really the two pieces that are driving occupancy; the increase in occupancy and the increase in the guidance range. Obviously, a little bit also came from interest expense as I mentioned. On the terminations, Doug really spoke about the recaptures both in Boston, suburban Boston; he mentioned one and in New York. So we're recapturing space that is expiring in a year from now or even five years from now, and we are getting termination payments that are driving our termination income guidance in 2019, which is higher than 2018, but we're doing that because we have leases that are signed. There may be some interruption in cash rent while that tenant builds out their space, but ultimately what we're doing is signing leases now at very strong rental rates that are much higher than the expiring rental rate because we think we want to take advantage of the market condition we're in.

And then if I can ask on the sale of the TSA developments and the impairment that you took as part of that sale. Is your view that the market value of this asset will not exceed the cost? And if that's the case, what's really changed since you out of growth of development?

So, I would say a lot of financial accounting minutiae is involved in how we recorded the sale of the TSA development. I would just point out two things. One is that we are guaranteeing completion, and we are also entitled to any savings under the contingency line item in the budget, as well as we are getting significant development fees when you include those things along with clinical with our land cost. This was a profitable development for us from a valuation creation perspective. And that accounting just let us have to report it in the way it was reported.

Owen, just going back to your commentary about being a little bit more cautious on how you guys are looking at developments other than kind of higher preleasing targets potentially on some of these. Are you guys changing at all your yield requirements or any other underwriting kind of items?

Yes, I wouldn't say that we changed our yield requirements. I had pointed to you in fact, the reference rate for the 10-year U.S. treasury drops 50 basis points in the last few months. So by keeping our yields flat, in essence, we increased profit. The answer to your question has a couple of things: One, as you suggest, what kinds of preleasing are we going to require for new developments, and I know everyone wants us to give a precise number on that question, and that's not really feasible or possible, given that all circumstances are different depending on the scale of the building and the economics, the velocity in the market, and all that type of thing. But yes, I do think we will today seek to have even more preleasing before we launch new developments, and also I think it's being disciplined in looking at new acquisitions of both buildings and sites. For example, recently we were chasing a site that we were interested in here in the Boston region and we topped out at a particular value, and based on the knowledge we have today, we are not going to win that. So that would be an example of the increased discipline that I described.

Yes, Craig, I think, big picture, our underwriting criteria have just gotten a little bit more stringent. If you thought you might lease up space quickly, now that may be elongated, and where you think you are going to be able to provide improvement allowances or get rental rate increases, you might temper those expectations. So it just all adds into the formula and makes it a little bit more difficult to go after something that we otherwise might have been more aggressive on a year ago.

And then on Platform 16, just some clarifying points. On the purchase option of $125 a foot, is that on the buildable 1.1 million? Or is that kind of land that they are…

Yes, that’s on the buildable.

So you guys are looking for all like 137 million potentially on that. And then are you guys—the way the co-development is going with a partner, are they kind of doing the non-office and you guys are doing all the spend on the office? Or could you just give us a little more color on how that works?

So this is pure office development, and the group that put it together is staying involved in the development component, and we are the principal capital partner, and we will ultimately own 100% of the asset. That being said, as Owen described, we are in serious discussions with a capital partner to participate in our interest on a long-term basis.

Have you guys had discussions with tenants? Or your discussions about higher preleasing with this project given the adjacency to Google and everything going on in San Jose kind of require less in your view to go forward? Or how are you guys thinking about it?

Let me just answer the question in the following way and then I'll let Bob talk about leasing conversations. So, the property is an assemblage site, and we are literally as we speak doing surveying work. We expect to demolish all the existing structures and do all the relocation of utilities. What we refer to as the enabling work that’s all going to go on over the next six plus or minus months. The structure is a series of buildings and they all sit on top of a subterranean parking structure. We will then decide when we want to start that subterranean parking structure and how we would phase. This is a feasible project. No different than when we started our conversations about Salesforce Tower back in 2013. We are moving forward. We are excited about the project and we are hopeful that leasing markets will provide us with tenants well in anticipation of commencing instructions, but you never know. So, Bob, do you want to just comment on the leasing activity?

Yes, we have discussions with tenants, and we plan to talk to other tenants. I think the important thing to point out about the site is it's the only transit-oriented site between San Francisco and San Jose that will have both Caltrain and BART access. BART has actually just started construction this past week where you can provide up to 1 million square feet at a location.

Hey, Doug, it's Jordan Sadler. One other quick one for you, if I could. Your cadence on New York City in the prepared remarks seemed pretty positive particularly given the asking rents on new development. Do you expect New York to see an improvement in net effective rents in '19?

We certainly think that net effective rents are not going down and that there will be modest increases in rental rates and the concession packages will have half blackout.

As you guys mentioned, these are some turbulent times with respect to what’s going in DC, given that the government is your second largest tenant. I was just hoping you guys could touch on any specific areas within your portfolio. Do you think could see some disruption because of the shutdown, and also if you could touch on any possible effect on Fannie Mae as you guys move ahead with their 850,000 square foot build-to-suit in Reston?

Well, I’ll start and Peter can jump in. First of all, as it relates to GSA, one of the great things about leases there is that they are long and strong and are not related to annual appropriations. We have seen actually no change in the current GSA structure as relates to our existing leases. We have a major lease expiring here in a few months, and we feel very confident about the renewal there. As it relates to Fannie Mae, it remains one of the most profitable entities in the United States government. So, we are very much positive about the outcome of the development. They’re keeping all that space. They have the option to take more. They’ll be in our conference room today just to talk about the status of the construction, and we’ll force them ahead; doing very good about the NMA.

Yes, I’d also jump in. The deal that was referenced earlier in the call at New Dominion is actually for the government agencies that have already exercised their independent leasing authority, and it happens to also be a mission-critical location for the government. The buildings are at the highest level of security that would be almost impossible to replicate in any kind of reasonable timeframe. So in that regard, we feel very good about the near-term exposure.

And we have also mitigated our exposure with the sale of 580 and the presale of GSA. So our exposure to the government is much less than it was even three or four months ago.

So, Blaine, this is going to be a really unsatisfying answer, but we’re in discussions with the City Assessor right now and it's just not appropriate to discuss how the valuation was done and what it was, how all of those sort of elements were figured out; we just can’t talk about.

Lastly, noticeably, the estimated total investment on 159 East 53rd increased quite a bit from $106 million last quarter to $150 million this quarter. Can you just touch on what changed there and is that going to have any effect on the pro forma yield that you guys are looking at?

So the reason that the costs were driven up were almost entirely due to the lease that we have with NYU, which is a 30-year lease versus what we originally underwrote, which would have been a shorter-term lease—effectively kind of 15 years would have been what we would have underwrote. So the leasing commission associated with that and the tenant improvement associated with that are the majority of that increase, and that lease officially came out of escrow within the last quarter. We determine to put that into our budget this quarter because there was uncertainty. The only other thing that really changed on this, we’re making some enhancements to the retail aspect of the job and improving the design and what the retail environment and atmosphere is going to be that takes the most significant advantage of the opportunity that we have to upgrade the placemaking there. So that's a design that is driving a little bit more cost into that part of the job, as well. But we still expect the project to meet the return criteria that we typically sell for this type of development.

But just to be perfectly honest about this, this is a placemaking exercise as we said. There is a great incremental investment on the works that we did at $159 to the 185,000 square feet that we released to the tenants that are taking for 30 years. The incremental return on the capital for the food hall and the other place-making experiences is de minimis and it’s really going to be reflected in the ability to rent space at 601 Lexington Avenue, 399 Park Avenue, and 599 Lexington Avenue, so it's not really—the yield was not with that result.

I'm hoping to get related thoughts on co-working and what you think that tenant base is going to mean for the office sector going forward? I mean we've seen WeWork has had a little bit of trouble raising its flash around the capital and we've seen kind of proliferation of different types of approaches to that business. So as we—just kind of an update on what your latest thoughts are and what you think it's going to mean for you guys?

It's Owen. Look, we continue to believe co-working, I'll call it shared workspace, business to be an important sector of the office business; it's been an important net absorber of space. I think in the markets where we operate, the total square footage of leases by these operators today is somewhere between 2.5% and 5% depending on the city and it has been growing. WeWork is clearly the leader by scale, but there are other operators, and in fact, as discussed on our prior call, we've been doing some of it ourselves on a small scale basis in a couple of our buildings. I think the business has created important new options for customers for individual and retail customers. It's a way to get into a community and high-quality space and in many cases, high-quality buildings, and from landlords, it's aggregated demand that would be otherwise very difficult to lease too. So I think that's been very positive. For larger companies, it's given them flexibility. We don't see large companies taking all of their space requirements and putting it into shared workspace, but we certainly see some of them procuring single-digit percentages of their space on a flexible basis to try to manage the space procurement process which can be difficult when human resource requirements are much more volatile than their ability to procure space. There has been a lot of press lately about WeWork's ability to raise additional equity capital; that may have some impact on the business—we don't know yet—but in general, I would say this sector is an important part of the office business. We think it's been very positive, and many of the shared workspace companies, like WeWork, are important customers of Boston Properties.

And Jaime, just to add a couple more thoughts. If we think about our portfolio and how the flexible office operators have impacted our portfolio and the margin, we think it's been a positive trend for the kinds of spaces that we have leased to them. At the same time, and I don’t think its coincidence, we have done more large, long-term leasing with corporate customers in the last 2.5 to 3 years than we have ever done in our history. Our average lease rent has actually gone up slightly as opposed to down slightly. It has not impacted our business at all in terms of our portfolio other than in those instances where we have done a transaction with one of these operators; we think it's incrementally helped us in some way, shape, or form. In Washington DC, it's aggregating demand, and Embarcadero center has changed the image of a particular space. We used this to showcase to demonstrate to non-traditional tenants how they could use Embarcadero center's infrastructure to change the image of their space. At 200 Clarendon St., we were struggling with convincing people that this was not a tired state financial services building, and we did a transaction and then got a whole host of customers who actually use the flexible office provider space on a short-term basis while we were building out their space in the building. It was a great shock absorber. So there are lots of different reasons why this company works. It is here to stay; there are clearly places where all kinds of companies think about how this might be helpful to their portfolios. But as Owen said, it is not going to displace the business that we are in, and we are very comfortable that we can work cooperatively with these types of users in a symbiotic way.

Do you have any thoughts on how much larger the sector can become? I know you have mentioned that kind of less than 5% to most markets.

I think it's market dependent, right? I used an example of San Francisco; in San Francisco there's just over, call it 3 million square feet of space. There is no availability; there are no blocks of space. If they wanted to double in size they would have to take every single block of space that is coming available in the next year, two years, three years in order to get there, and that’s just not going to happen. Similarly, in Boston, it’s a very competitive market, so it's just going to be really, really hard for them to grow in a meaningful way relative to the percentage of the market. I think it's going to be different market by market.

Yes, I think part of it is also identification of product bifurcations. So for example, traditional co-working is different than enterprise leasing in the smaller spaces without the community aspects to it. It's almost a totally different product, and what's taken place out there is everybody has been lumping everything together, creating some illusions that you probably are not necessary in terms of size and scope. A lot of it has to do with defining what the product is. So as an example, with our flexible product we don't have the community managers, we aren't looking to provide additional services. It's just highly flexible space that’s a shorter-term lease, and that's quite different than other products. So a lot of it has to do with their business lumping everything together.

We have seen a lot of large leases from tech and media companies in the last couple of years. What gives you comfort that the space that they will use and we're not seeing excessive expansion here?

So Jaime, in comparison to 1999 to 2001 in the dotcom era, the companies that are taking down the space are what we refer to in our small circle as tech titans. These companies have multifaceted businesses, multifaceted growth aspirations, and they are hiring people at enormous rates. They are filling their space as quickly as they can get it. Interestingly, what is going on is that they are looking to find those locations that are closest to where the talent is and where they can attract the talent. Just as again, sort of to talk about Downtown San Jose, the reason that site is interesting to us today is that the idea that companies are going to put their employees living in the city of San Francisco onto coach boxes and have them travel down to 280 or the 101 for up to three hours a day of commute is becoming really tiring. Having the ability to have a transit-oriented location where they can get on the Caltrain Bullet stop in San Francisco and be down in Downtown San Jose in about an hour is a very attractive proposition. Google has also made a commitment to build housing and retail and some other things. It is going to become a very interesting Downtown. Our view is that the market has really changed down there. Our site, which was once planned as an 800 plus thousand square foot either office or residential site at the Plaza at Almaden, we are now permitting for a minimum of 1.3 million square feet and could be larger than that. The parking ratios have changed. The use of tri-furcation has changed, and we just think these are the types of locations where companies are going to go. You’ve obviously seen Amazon and Google and Facebook make tremendous pieces of base acquisitions across their marketplaces, not just in Silicon Valley, but in Los Angeles, Austin, Boston, and Washington DC. We’re comfortable that these companies are long-term growth organizations that are going to be very aggressive about hiring talent to feed their businesses.

How was the entitlement process for new CBD development currently shaping out by market? And I was wondering if you had experienced any deltas worth sharing?

So, do you have half hour 45 minutes? That’s how long it will take to answer that question. Why don't I let Bob Pester talk about what’s going on in San Francisco, obviously, with our site at Fort Harrison and at the CBD site, and then I'll let Bryan talk about what’s going on at Back Bay in Boston—because those are sort of the two entitlement opportunities that are in front of us right now.

In San Francisco, the Central SoMa plan was approved and immediately there were four lawsuits filed, which all are CEQA land suits, which pretty much will put everything on hold unless they are settled or someone could elect to go ahead and be subject to whatever happens in the lawsuits. San Francisco continues to be probably one of the most difficult markets in the United States to get entitlements in, and other than the 6 Central SoMa sites that are called super sites, the Giants Mission Rock, in Pier 70, there is not a lot on the horizon as far as future development in San Francisco of any significance.

So in Boston, our project in the Back Bay is probably most significant on the commercial side. We do have some residential components to it, and we see that to be at least a couple more years of permitting. But that's not having to do with anything other than that’s the process, and it’s a complicated site over a transportation hub. The Back Bay has a limited amount of foreseeable product line coming on in the commercial side, and that goes for Cambridge as well. We are seeing, as it was noted earlier, a real discipline amongst the developers who have states that are permitted, and all seem to be conditioned on preleasing as well.

And just the last one for me. It was interesting to see the land acquisition at Carnegie Center in Princeton. I was wondering if you could just share some further thoughts on the suburban addition? And I'm assuming this would be a preleased type of development, perhaps life sciences; any more info there would be interesting.

When Boston Properties bought Carnegie Center 20 years ago, we bought the buildings and we got the option to purchase the site. Over the years, we have purchased a handful of the sites and done build-to-suits for customers. That option expired last year. So we were faced with the decision on whether to let the option expire or to exercise and purchase all the land part. We obviously elected the latter. We do have all this land; we acknowledge Princeton is not our fastest growing market. That all being said, we do have some uses for the land. For example, right now we have a customer parking need that we're going to satisfy with one of the lots that we've repurchased. We anticipate our ability to sell some of these individual parcels which we will do, but perhaps most importantly, our perspective is that our investment in Carnegie Center is more valuable with the buildings and the development opportunity unified rather than as they are being separated, and that was a key driver of the decision.

So two questions: first, just sort of continuing on the Princeton theme. Mike, you spoke about totally exciting Annapolis Junction. Princeton, it sounds like you may exit as well or you may keep. But as you outline your guidance for this year, is there a certain amount of dispositions that's in there? Meaning if you fully exited Annapolis Junction or anything else, does that impact your guys' ability to deliver on your growth this year? Or is there some potential that dispositions could disrupt what you guys have laid out?

Alex, I am going to answer the former and I'll let Mike jump in on the latter. We have no current plans to exit our Princeton investment. We do think purchasing this land for the reasons I just outlined in the last question, we think our investment in the whole project is more valuable by owning the land. But we have no near-term plans at exit it. That all being said, we intend in 2019 to continue with our non-core asset disposition plan. Again, we haven't finalized our exact list this year, but I would anticipate that it will revert back to levels of '16 and '17, which would account for $250 million, maybe $300 million in sales in 2019.

And Alex, as reflected in guidance as I mentioned in my call notes, we haven't included anything additional other than what's in our release for asset sales within our guidance. A lot of the non-core stuff you're talking about is suburban stuff that is not that big. Yes, some of it does have NOI that would come out, so we're going to get cash and we would deploy that cash, which would help and reduce our line of credit usage. So there is some potential, but without knowing exactly which assets there are, I think it was inappropriate to put up any amounts in the guidance. We would rather just say there’s nothing in the guidance and give us time to think things we are thinking about. But I don't think it would have a meaningful impact.

And then the second question is sort of continuing the co-working theme. Dock 72 initially takes occupancy in the second quarter of this year, still only 33% leased. It's one sort of outlier in your New York portfolio. Presumably, you want to lease it up before assessing what your options are with it. But as you stand today, what are your thoughts on keeping that versus selling it, as I say, it stands out versus the rest of your portfolio in New York?

So Alex, we have no plans to sell Dock 72. Our current focus, as you suggest, is certainly leasing the asset and that’s what we are focused on now.

A quick question on New York and then Reston; in New York, Mike or I think Doug, I appreciate your commentary as far as leases over $100 a square foot. You mentioned though, obviously, the slower demand when it goes over $120 a square foot. What are you seeing as far as interest in and options for your vacant space at 767 Fifth?

So, John, do you want to take that?

Yes, we think the market last year was really hot with 32.4 million leased space. We haven’t had a year like that in New York since 2000. So, this is really a lot of momentum. And notwithstanding the equity market jitters at the end of December, having talked now with a number of brokers and looking at the market, things still do appear to be rolling along. So we are optimistic about what's happening at GM, but we do have competition coming on place during the year. 425 Park is going to be a great building and 550 Madison—the top floors are going to be good. But we think the product is still outstanding—the best in the market—and we are starting to work on those blocks that are coming up in '19 and '20 now.

And then, John, maybe one more on the GM building, any more clarity as far as the timing of the ins and outs for the retail portion?

Yes, we are working very hard with Apple on the Apple Store, and we don't have a date, but certainly that date will be sometime in the first half of this year. We are working also with Under Armour, because Apple is the temp store now, and wants to stay there. We are working things with Under Armour. So that will work for them, although the Under Armour deal will be delayed as a result of Apple's staying in the temp store.

Just to be clear, we do have some interest in that retail space, and we think just something will occur there in the first half of this year.

And then just a quick one on Reston. Doug, I think you mentioned a place-making project down in the town center and making some improvements there. What were you referencing to? And do you have a sense of what that cost impact could be?

Sure, this has been going on for probably in terms of design and rebranding of the lower year. In the next quarter or so, we’re going to start the actual physical improvements. We have done a few minor ones to a lot of the public areas around through the Town Center. There’s been a plan for larger public open venues, the pavilion area around the fountain, etc. I would say over the course of probably the next 24 months, we're looking at investment that's probably plus or minus in the $3 million range. We’re also in the Fountain Square buildings, which the original office building is already underway with redoing those lobbies, which were ready for the refresh that is 25 plus years old.

Just a bigger picture question on the utilization of space by your tenants. One of your peers in some recent articles have suggested that the justification trends of the last few years may have overshot the mark. I'm curious what are you seeing in your end portfolio with respect to new or renewal leases? And how you guys are planning for new developments in terms of space per employee?

So, I'll start with Bryan, and then if any of the other guys want to chime in, they should do that.

One of the things that ties with the question about how clients are using their space earlier is that the sophistication with these clients is very high. A great example is Verizon, is incredible versus let’s say the year 2000 when you had growth from tech companies that were gobbling down space and really didn’t have an idea of their utilization, their growth rates, etc. What we’re finding across the board is the sophistication of the users is very knowledgeable of how they use that space and they’re far more accurate in terms of their needs. Because of that, we can shift that and it's been a great discipline that has been added to the market. You also add that with the shock absorbers that Doug mentioned in terms of how they are using some of these shorter-term spaces, I think it's really healthy.

Bob, you might want to describe how everyone has been building out Salesforce Tower; right? Because it’s the newest sort of CBD building that we have and how their program has worked.

The build-out varies by the tenant and the type of the tenant. I can say in the case of Salesforce, it's all been seating for the most part, and they're about a 160 square feet per employee. I know that they have relaxed their requirement as far as trying to get tighter than that. Initially, I think they were targeting a 120 when Ford Fish was there renting the real estate department.

Thanks for taking follow-up, guys. Just Doug or John, could you just run through your rent growth expectations throughout the different submarkets of New York?

John, you want to start?

Rent growth in submarkets of New York: So first, when we say we don't have a lot of space to lease. So if you are talking about our buildings, there are only a few pieces of space that we have to look at. I think we will do well at GM and will have some rent growth there; clearly the block we have left at 399 there will be wrinkles there and that's probably staying over $100 a foot. 159 is all leased, and I guess when we look at the base of 510, I would say we will definitely have rent growth there over the deal we've had in place.

Okay, I think that completes all of our questions. Thank you, everyone, for your interest in Boston Properties.