Excerpt of Boston Properties Q2 Earnings Call; Touches on San Francisco, Silicon Valley, and Investment Climate

Doug Linde, President of Boston Properties (NYSE:BXP), discussed on their second quarter earnings call the state of the various markets they are players in, amongst which are San Francisco and San Jose. He went into additional detail about the investment climate, as well as financing. Things to take away are that San Francisco demand for space is slow, valley market is being impacted by supply (interestingly he made mention of the Oracle/Sobrato tower), and that financing north of $100M is extremely difficult and that yield requirements to make deals pencil have shot way up.

Anyhow, here’s a transcript of his comments on the above:

Activity in San Francisco in the CBD continues to be pretty slow. There are really no large users in the marketplace for new requirements. Absorption in the second quarter was slightly negative but with a direct vacancy rate of under 9% and overall vacancy under 10%, the market still remains very tight.

There has been really no change in asking rents, so it’s our belief that the market for top space has settled out in the high 80s to low 90s. There continues to be modest organic growth from smaller firms, but there are no large requirements in the market other than those that are created by contractual lease expirations.

If you look at our occupancy statistics this quarter, you will see a reduction in occupancy in San Francisco. And that’s really from contractual lease expirations on tenants that we moved that happened to be in space in the third quarter, excuse me, in the first quarter, as well as in the first quarter, in both EC3 and EC4, and in the second quarter, they have moved out of EC3, and so you saw a decline in occupancy in EC3 this quarter.

The new development at 555 Mission, which is about 550,000 square feet, is rumored to have completed one additional lease on the top floor of the tower, sort of giving you a sense of what the top end of the market is, with average rents in the mid 80s bringing its leasing to about 30%.

The Valley continues to show job growth in the computer electronics and manufacturing sectors, where most new space requirements are really in the 15,000 to 70,000 square-foot range, i.e., smaller users.

Large user activity has moderated from the pace of the last six months, though Google has committed to build another 1.2 million square foot campus in Mountain View at Moffett Field.

New speculative development has come online, and it has led to an increased vacancy this quarter. In particular, a building that Oracle owned from BEA Systems is now in the market in San Jose, and that adds about 350,000 square feet of availability this quarter.

Just about everyone is being cautious about making decisions, and rental rate growth has slowed, and in some cases it has probably dipped 5% to 10%. But there is still incremental new demand.

Now let me shift my focus and make some comments about the financing markets before I turn things over to Mike, since they really are the key to understanding the acquisition market and individual asset pricing and where and when transactions can be accomplished.

In general, the credit markets continue to be very volatile, and access to secured mortgages greater than about $100 million continues to be very restricted. Since this is the source of debt for the vast majority of buyers, it really is the critical component in any sales process.

There are two primary markets for secured debt; the commercial bank market and then the traditional life insurance company market. The foreign banks are actually open to maturities over five years, but outside of five years you really do eliminate the domestic institutions.

And while loan-to-value matters, the primary driver to loan size and availability is now debt service coverage; and that includes amortization under either a 25 or a 30-year schedule as well as quality of sponsorship and quality of asset.

Lenders are being very discriminating regarding the assets they are underwriting. Sponsorship and relationships really matter today. Any asset with major rollover or vacancy is going to require significant equity and recourse from a well capitalized sponsor, assuming it still covers debt service.

Rates for 60% loan-to-values are probably today between 240 and 280 basis points over on a fixed-rate basis for high-quality assets. So that’s somewhere in the 6.4% to 6.8% range.

If you take a 6.5% rate, for example, and you throw in a 25-year constant on that, a 25-year amortization schedule on that, you come up with a constant of about 8.2%. Now, if you need coverage, and today coverage is probably at a minimum 1.25, and probably is more normally 1.4 times initially, and you add a 1.25 coverage onto that 8.2 constant, then the necessary yield to cover debt jumps to over 10%.

So, while you might still be interested on people maybe pricing the assets at 5% cap rates, it’s going to require an awful lot of equity in today’s market to make those transactions work.

Assets with assumable medium to long term debt are clearly enjoying the most significant interest. And, while there are potential mezzanine lenders out there to sell a portion of the capital stack, that capital is being priced from probably a minimum of 450 basis points to well over 1200 over, depending upon coverage and value.

Many of the assets that were sold over the last few years came from opportunity funds that bought wholesale and were selling retail. These funds, whether they like it or not, and whether they have the management experience or not, are now owner-operators with a long-term perspective.

With the property markets slowing and increases in future cash flows slowing, and limits on availability of debt down, we don’t expect to see any meaningful pickup in asset sales from these owners in the near term.

If high-quality properties are going to be sold, this is where you’re going to see transactions, and I emphasize the word must be sold. As an investment grade issuer, Boston Properties has the financial flexibility to raise capital in the unsecured debt market, the bank market, the convertible market as well as the traditional secured markets.

These markets are available in size, and with access to capital, we can move quickly to complete transactions. So we have availability, we’re anxious to put money to work, but we don’t see a lot of potential transactions out there in the short-term.

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