Highwoods Properties, Inc. (HIW) is a fully integrated, self-administered real estate investment trust (REIT) that owns or has management interests in office, industrial, retail, and service center properties, including development projects and apartment units. It also provides customer-related and fee-based real estate management services for its properties and for third-party clients. Highwoods Properties owns and operates properties through its wholly owned subsidiary Highwoods Realty Limited Partnerships. The company's core markets are located in the Southeastern and the Midwestern US. As of September 30th, 2007, the company owned or had interests in 378 in-service office, industrial holdings, and retail properties, with an aggregate of 33.6 million square feet (sf) of gross leaseable space. In addition, Highwood also owned 662 acres of developable land. Office, Industrial, and Retail segments comprised 83.0%, 7.5% and 9.5% of the company's annualized revenue respectively (including joint venture properties). The company's top five operating markets (including joint venture properties) are Atlanta (13.7% of annualized revenue), Raleigh (13.4%), Kansas City (13.2%), Tampa (12.1%), and Nashville (11.7%). The federal government is Highwoods' largest tenant, accounting for 6.84% of the total annualized revenue.
Operationally, Highwood's had a slightly better than expected quarter. Same store occupancy increased to 90.4%, up 70 bps from last quarter and 70 bps from 3Q 2006. While occupancy has trended upward over the past year, some of HIW's core markets still have vacancy problems. Many of the company's markets still have what we consider low overall occupancies Columbia, SC (82.5% 3Q same store occupancy), Greenville (87.7%), Kansas City (89.3%), Raleigh (88.1%), and the Piedmont Triad (86.7%). Together, these markets make up approximately 46% of the company's total portfolio. With vacancy rates in excess of 10% in a large part of the portfolio, rent growth in the latter part of 2007 and 2008 will be difficult. Suburban market vacancy rates in three of the company's four largest markets Atlanta, Kansas City, and Tampa were 17.5%, 17.1%, and 12.6% respectively in the 3rd quarter (from CBRE 3Q 2007 national vacancy index). Vacancies in Atlanta and KC are well above national averages and there was a large market occupancy decrease in Tampa. We do not think the company can continually outpace market averages in term of occupancy. REITs in stronger, high barrier urban markets have better long term growth prospects, as it is much harder to add new supply.
The main problem is that HIW has a large asset base located in low barrier to entry southern markets, i.e. Atlanta, Raleigh, Nashville, in addition to Kansas City, which historically have not been a strong long term office market. These are markets where there is ample office and industrial supply available. Long term, developers can quickly add new supply if markets occupancies increase. While starts are still low in these markets by historical standards, we are starting to see an increase of new development in response to what many perceive as strengthening market conditions. Rent growth in this type of environment is difficult, and there could be significant rate roll downs on new leases if job growth subsides in these regions. 2008 should be a much worse year for job growth as the economy continues to slump due to residential housing problems, increasing energy prices, and inflation. The recent employment report, which came out on Friday, was not good as the US economy only added 18,000 jobs in December, the lowest monthly increase in four years. It appears that the US economy could be headed toward recession, which is not a good time to be in office stocks.
FFO for the 3rd quarter stood at $0.59 per diluted share, up from $0.53 per diluted share reported in the year earlier quarter. Same store revenue and NOI increased 5.5% and 3.2% respectively vs. 3Q 2006. YTD, same store revenue and NOI increased 4.6% and 2.3% respectively compared to the same period in 2006. By market, same store NOI increased in Atlanta (3.0% increase 3Q 2007 vs. 3Q 2006), Columbia (88.2%), Greenville (13.2%), Kansas City (5.3%), Raleigh (9.0%), and Tampa (6.0%). SS NOI decreased in Memphis (3.2%), Nashville (2.7%), Orlando (13.7%), and the Piedmont Triad (3.5%). During the quarter, total net absorption was 1.7 million square feet, bringing the year to date figure to 5.3 million square feet. The company leased 1.6 million square feet of first and second-generation space during the quarter, 91% of which was office space. Office rents increased 3% (GAAP) and declined 5.6% (cash) on new/renewal leases in the quarter. Four of the company's largest office markets, Nashville, Tampa, Raleigh, and Kansas City showed improvement with GAAP rents (office) increasing 22.5%, 18.8%, 3.7%, and 4.2% respectively on new leases. The main drag on overall office rents was Atlanta, where the company signed a large under market lease for a large block of Nortel space. Overall rents decreased 15.9% in Atlanta on new leases in the quarter. In the company's industrial portfolio, rents on new leases increased 3.3% (GAAP) and declined 6.7% (cash) on new and renewal leases signed in the quarter. The retail portfolio reported rental increases of 12.8% (GAAP) and 3.5% (cash).Overall, the weighted average rental rate in the company's portfolio of HIW's office, retail, and industrial properties was $16.56 per sq. foot in the 3rd quarter, up 6.2% from $15.60 per sq. foot in 3Q 2006.
By the end of the quarter, the development pipeline stood at $500 million and was 75% pre-leased. Highwood's has completed 860,000 square feet of new development (79% pre-leased) so far this year, and expects to complete over one million square feet of new development (83% pre-leased) by the end of the year. Development yields are estimated in the 9-10% range, which is good and gives the company a 200+ basis point premium to acquisitions.
The company is still in the process of repositioning its portfolio and selling older underperforming assets. HIW continues to sell in what we view as still a strong sellers market. Through the first three quarters of 2007, HIW sold $108 million of non-core properties (wholly owned) at an average cap rate of 6.5%. In the quarter, the company sold five wholly owned properties for gross proceeds of approximately $37 million at an average cap rate of 6.6%. In the 4th quarter, HIW completed its exit from Columbia, SC through the sale of 253,000 sq. feet for $23.6 million. The average occupancy of properties that were sold in the 3rd quarter was 75.4%. As in the past, the company is selling under leased assets, which is helping make the overall occupancy picture look better. The company is using the proceeds from sales to pay down high rate debt and fund its development pipeline. We like the strategy of selling in a low cap rate environment to concentrate on higher yielding developments, which is the best use of capital vs. outright acquisitions. HIW has not made any wholly owned acquisitions in 2007, as the historically low cap rate environment makes it difficult to find acquisitions that suit the company's criteria. Total JV dispositions in 2007 were $30.3 million the company disposed of five office properties and one multi family building in Raleigh in the 1st quarter. HIW did make one small JV acquisition in the 2nd quarter, a 167,000 sq. foot office property in Orlando. For 2007, the company reiterated its early guidance for FFO estimates and expects FO per diluted share to be in the range of $2.68 to $2.73, assuming approximately 61.6 million shares outstanding, excluding preferred stock redemption and repurchase charges aggregating $0.04 per share.
AFFO (funds from operations less capital expenditures) was $1.31 per share in 2006. With an annual dividend of $1.70 per share, HIW is still not covering its dividend with free cash flow. Although dividend coverage is getting better as operations are gradually improving, we do not estimate the company will fully cover its dividend until 2008. Our 2007 AFFO estimate of $1.65 per share still comes below the current payout. The company can cover any dividend shortfalls with asset or land sales, but this decreases the company's NAV which is not a good long term solution. We prefer companies that have good dividend coverage, as this is the precursor to increases.
3Q quarter tenant improvements (office) were $5.79 per square feet versus $8.73 in the year ago quarter, while leasing commissions were $2.44 per rentable square feet versus $2.34 recorded in 3Q 2006. The company saved significant dollars on the large block of space that it signed in Atlanta (223,000 sq. feet), although we expect TIs to move up in the coming quarters. For the most part, HIW's office portfolio is located in areas where office landlords must give away large amounts of tenant improvement to lease space. This will continue occurring until overall market vacancies increase to at least above 90%.