Easterly Government Properties Inc (DEA) 2018 Q2 法說會逐字稿

Greetings, and welcome to the Easterly Government Properties Second Quarter 2018 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Ms. Meghan Baivier, the Executive Vice President, CFO and COO for Easterly Government Properties. Thank you, you may begin.

Good morning. Before the call begins, please note the use of forward-looking statements by the company on this conference call. Statements made on this call may include statements, which are not historical facts and are considered forward looking. The company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Act Reform of 1995 (sic) [Private Securities Litigation Reform Act of 1995] and is making this statement for the purpose of complying with those harbor provisions.

Although the company believes that its plans, intentions, expectations, strategies and prospects as reflected or suggested by those forward-looking statements are reasonable, it can give no assurance that these plans, intentions, expectations or strategies will be attained or achieved. Furthermore, actual results may differ materially from those described in the forward-looking statements and will be affected by a variety of risks and factors that are beyond the company's control, including, without limitation, those contained in Item 1A. Risk Factors of its annual report on Form 10-K for the year ended December 31, 2017, filed with the SEC on March 1, 2018, and in its other SEC filings. The company assumes no obligations to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Additionally, on this conference call, the company may refer to certain non-GAAP financial measures, such as funds from operations and cash available for distribution. You can find the tabular reconciliation of these non-GAAP financial measures to the most comparable current GAAP numbers in the company's earnings release and separate supplemental information package on the Investor Relations page of the company's website at ir.easterlyreit.com.

I would now like to turn the conference call over to Darrell Crate, Chairman of Easterly Government Properties.

Thank you, Meghan. Good morning, everyone, and thank you for joining us for the second quarter conference call. Today, in addition to Meghan, I'm also joined by Bill Trimble, the company's CEO.

Easterly remains the only internally managed public REIT narrowly focused on the acquisition, development and servicing of mission-critical real estate leased to the United States federal government. Our mission has remained consistent since IPO: to provide strong risk-adjusted returns through a reliable and growing cash dividend, backed by the full faith and credit of the U.S. Government. To that end, our effort in the short, medium and long terms are all centered around this stated goal.

In the short term, we're pleased our team is renewing existing assets and lengthening the overall remaining lease term of the company's portfolio. Adherence to the bull's eye strategy has proven itself wise in our ability to achieve strong lease renewal spreads and extend the duration of our cash flows, which support our cash available for distribution.

In the medium term, we work to cultivate a robust pipeline of new assets with the goal of accretively scaling and diversifying our portfolio, enhancing the stability and growth of our dividend. I commend the acquisition and development team on their success to date in consistently growing the portfolio through the acquisition and development of mission-critical assets backed by the full faith and credit of the U.S. Government.

Finally, in the long term, I congratulate the management team on creating strong capital partners in both the debt and equity markets, which we hope will continue for many years to come. This partnership has allowed us to achieve a highly competitive cost of capital in both debt and equity, which in turn allows us to continue to deploy capital accretively and supports the next chapter of our growth, enabling us to grow our dividend for years to come.

Easterly has always been an external growth story, driven by acquisitions and development. For that reason, this has been an important quarter for Easterly. With announced acquisition volume, including one of the largest portfolios in our target market, we have propelled the company forward in a meaningful way. We have grown our public float by 34% through the completion of a successful follow-on offering. The increased liquidity from the offering puts the company in a position of strength and allows for enough dry powder to execute on future acquisitions and remain flexible in the market.

The balance sheet is in a position where we can deploy capital accretively, allowing for future growth that remains consistent and true to the fundamentals that were instilled at the time of the IPO. We believe meaningful growth that can be achieved in this manner is a success and one we consistently strive to build upon quarter after quarter and year after year.

To be clear, our priority as a management team is to deliver a trusted and growing dividend to our investors, which is backed by the full faith and credit of the U.S. Government. We're very pleased that all of our efforts and outcomes are delivering on this goal.

With that, I'll turn the call over to Bill to discuss the specifics of the quarter and to give an update on the projects we're engaged in to build shareholder value.

Thanks, Darrell, and good morning. Thank you for joining us for our second quarter earnings call. As Darrell mentioned, the second quarter of 2018 marked a meaningful point in the company's trajectory. We announced the pending acquisition of a $430 million 14-property portfolio of high-quality assets that closely mirror the profile of our existing portfolio. To review, this portfolio of 14 assets equates to approximately 1.5 million square feet of rentable space. 99% of the 14-property portfolio is leased, with a weighted average lease expiration year of 2022. The portfolio is still relatively young, with a weighted average age of just 16 years. Of the 14 properties, 79% of the assets were build-to-suit construction, meaning the design and functionality of the building was constructed to meet the specific needs of the underlying tenants. Further, these 14 assets significantly scale the portfolio in an accretive manner and increased Easterly's already strong relationship with the U.S. federal government. With this portfolio, Easterly will now meet the leased real estate needs of 31 different U.S. Government tenants.

This portfolio acquisition is one we've been watching and anticipating since prior to IPO. Simply put, we feel no other potential buyer understands the makeup of this portfolio better than us. For years, we have underwritten each asset and monitored the mission in each facility to mitigate against potential obsolescence. We knew this portfolio was focused in a similar manner to our existing portfolio, which allows for seamless integration and growth. We're extremely excited to welcome these 14 properties into our growing portfolio and look forward to doing so throughout the remainder of 2018.

Our ability to win this portfolio acquisition in a public bidding process highlights many of Easterly's strengths that distinguish us from other potential bidders: First, we understand this very niche market of federally leased real estate. We can underwrite each asset appropriately, thus enabling us to be very fair buyers in the process. Second, our cost of capital is cheaper than other bidders. Because of this, we were able to purchase this large, accretive deal at an attractive cap rate. Finally, we are flexible and dependable buyers. You've heard me mention in the past that there are plenty of reasons that a seller would want to delay a closing. Because of our flexibility and our

(technical difficulty)

Are all attributes that help this deal ultimately come to fruition. And these are company strengths in which we take great pride.

In conjunction with the announcement of this 14-property portfolio acquisition, we also successfully executed a public equity capital offering, raising $398.5 million of gross proceeds through an overnight equity offering. This offering further strengthened relationships with existing shareholders and allowed for the initiation of relationships with new equity partners. The deal was extremely well received in the market, and we are grateful for investors' confidence in our ability to deploy the capital and drive strong returns for our shareholders. Furthermore, this was also a wonderful opportunity for us to lower our leverage and position the company to be able to execute on acquisition and development opportunities that may present themselves in the future.

Turning to the acquisition pipeline. Easterly continues to evaluate opportunities and pursue our pipeline of actionable deals. Our position in the market continues to strengthen, but we will still see ample opportunity to grow in this highly fractured market. Although second quarter brought large-scale acquisition growth, we will not stop seeking to acquire new accretive properties.

Turning to development. I am pleased to report we're making meaningful progress at all 3 of our development sites. I had the opportunity to observe firsthand the progress being made at the FEMA - Tracy and FDA - Alameda sites just 2 weeks ago, and I was very happy to see these projects well under way. Both projects with -- FEMA - Tracy expected to deliver at the end of the third quarter of 2018 and FDA - Alameda expected to deliver in the third quarter of 2019. As a reminder, these nonspeculative development projects provide for great opportunities to see increased yields on brand-new facilities with long-term lease expirations. Under the current time line, we should expect to see all 3 developments, including FDA - Lenexa generating cash flows by mid-2020. And from a future development pipeline perspective, I think we can expect to see future opportunities from both FDA and FEMA, given the length and importance of these enduring missions.

Turning to lease renewals. Allow me to provide a comprehensive overview of all 2017 and 2018 lease renewals thus far and to speak to upcoming near-term lease expirations for the pending 14-property portfolio acquisition. The 2018 renewals have been a blend of highly specialized bull's eye properties, like DEA - Riverside, and mission-critical, but nevertheless, more plain-vanilla office space, like IRS - Fresno. You've heard me say in the past that when there's a bull's eye property, the lease renewal conversation centers around replacement costs. Conversely, When you have a more plain-vanilla office space expiring, the lease renewal conversation is more focused on what is considered market rent in that region. Just to be clear, less than 15% of our properties would be considered plain vanilla.

With that, I am pleased to announce the lease renewal of IRS - Fresno for a new 15-year term. Given this is not a gun-toting agency, and the space, while absolutely mission-critical, is more generic in nature, when we focused on renewal, we felt lease term was more important priority to give us flexibility to harvest value and provide enduring, stable cash flows for our investors. We're pleased to announce that this lease has been extended to 2033, a 15-year term. While the government's exact amount of TIs are to be determined, we believe that our rent at IRS - Fresno will be flat to down 5%. Renewal at this lease length for a reasonable market rent is a success. We are very excited to continue to provide the necessary housing for such an important mission to the United States, and we look forward to remaining a partner to the IRS for many years to come.

Five other properties with expirations last year, and these renewed at an average rental increase in the mid to high teens. These include SSA - San Diego, DEA - San Diego, DEA - Riverside, DEA - North Highlands, and CBP - Chula Vista. In addition to this very healthy renewal spreads, we were able to achieve valuable longer-term leases. Each have been renewed for 10- and 15-year terms, thus meaningfully extending our weighted average remaining lease term and allowing us to maintain 100% occupancy with 99% of our lease income derived from the full faith and credit of the U.S. Government. Now that Easterly has seen more lease rolls and started to establish a lease renewal history, you will notice our bull's eye properties are consistently renewing at meaningfully higher rental rates increase, providing for modest internal growth of distributable cash flow.

Now with respect to the short-term lease renewals for the pending 14-property portfolio acquisition, I would like to reiterate just how comfortable we are with this portfolio. When bidding, the team underwrote each of these properties appropriately with a very strong understanding of the strength of their tenancies. In the coming years, as we focus on the portfolio's renewals, we will work to continue driving value through extending lease terms and growing our portfolio of U.S. Government cash flows.

In closing, before turning the call over to Meghan, let me step back and commend the Easterly team for the success of this first half of 2018. In the past 6 months, we have either purchased or put under contract approximately $515 million of mission-critical assets leased to the U.S. federal government. We have renewed our second-largest lease for another 15-year term. We successfully launched a public equity offering that put us in wonderful shape for future growth. And finally, we have enhanced our balance sheet by amending our credit facility to provide greater borrowing capacity and more favorable interest rates. For Easterly, the efficiencies have never been better, and the opportunities have never been stronger.

With that, I will turn the call over to Meghan to discuss the company's quarterly results.

Thank you, Bill. Today, I will review our current portfolio, discuss our second quarter results, provide an update on our balance sheet and share our modified 2018 guidance. Additional details regarding our second quarter results can be found in the company's second quarter earnings release and supplemental information package.

As of June 30, we own 47 operating properties comprising approximately 3.7 million square feet of commercial real estate, with an additional 340,000 square feet under development. The weighted average remaining lease term for our portfolio was 7.7 years. The average age of our portfolio was 12.7 years, and our portfolio occupancy remains at 100%. In addition, 99% of our annualized lease income were backed by the full faith and credit of the United States Government.

Pro forma for the recently completed acquisition of VA - San Jose and for the future acquisition of the previously announced 14-property portfolio, Easterly will own 62 operating properties, comprising approximately 5.3 million square feet. Our pro forma weighted average remaining lease term for our portfolio would be 6.8 years, and the average age of our portfolio would be 13.5 years.

For the first quarter, net income per share on a fully diluted basis was $0.03. FFO per share on a fully diluted basis was $0.29. FFO as adjusted per share on a fully diluted basis was $0.25. And our cash available for distribution was $10.9 million. GAAP measures and reconciliations of these non-GAAP measures to GAAP measures have been provided in our supplemental information package.

Turning to the balance sheet. At quarter-end, the company had total indebtedness of $487.8 million, which was comprised of $100 million outstanding on our 2016 unsecured term loan facility, $175 million of senior unsecured notes and $212.8 million of secured mortgage debt. Availability on our revolving line of credit stood at $450 million, and the company's $150 million 2018 unsecured term loan facility remained undrawn. As of June 30, Easterly's net debt to total enterprise value was 19.9%, and its net debt to annualized quarterly EBITDA ratio was 3.9x.

As previously announced, last week, our Board of Directors declared a dividend related to our first quarter of operations of $0.26 per share. This dividend will be paid on September 27, 2018, to shareholders of record on September 13, 2018.

For the 12 months ending December 31, 2018, the company is modifying its guidance of FFO per share on a fully diluted basis to a range of $1.17 to $1.22. This modification is attributable to the anticipated timing of closing of our 14-property portfolio and the success in upsizing of our June equity offering. This guidance is based on the company completing the $515 million of acquisition announced to date this year. The company currently expects to close approximately $175 million of acquisition volume in September and the remaining $255 million in December of this year.

The company's guidance further assumes $50 million to $75 million of development-related investment during 2018. The company's 2018 FFO guidance is forward-looking and reflects management's view of current and future market condition.

As our business matures and we begin looking to 2019 and beyond, we are going to highlight FFO as adjusted in addition to FFO on a fully diluted basis as we believe this metric will help highlight the economic strength and cash flow generation capability of the underlying portfolio. We are choosing to take the time to do this, because with the renewal of significant leases in our portfolio in the coming years, like the 6 that Bill just discussed, there are noncash adjustments related to the amortization of lease-related assets and liabilities in our FFO per share on a fully diluted basis metric, which may confuse some investors regarding the cash-generating power of the FFO guidance which we have historically provided. Our objective is to deliver a growing cash dividend backed by the full faith and credit of the U.S. Government, and we believe the company's current portfolio and in-process development will allow us to deliver on this goal.

Moving on the company's capital markets activities. The second quarter was marked by 2 notable events: The first was the completion of an amended and upsized senior unsecured credit facility. In June, the company replaced its existing senior unsecured revolving credit facility with an amended and upsized credit facility consisting of a $450 million revolver and a $150 million 5-year delayed drop senior unsecured term loan, for a total credit facility size of $600 million. The revolver includes an accordion feature that may provide the company with additional capacity of up to $250 million for a total amended credit facility capacity of up to $850 million.

The revolver will mature 4 years from the closing date in June 2022, with 2 6-month as-of-right extension options available to extend the maturity to June 2023. The term loan will mature 5 years from the closing date in June 2023. The term loan has a 365-day delayed drop period and is prepayable without penalty for the entire term of the loan.

Borrowings under the revolver will bear interest at a rate of LIBOR plus the spread of 125 to 180 basis points, depending on the company's leverage ratio. The term loan will bear interest at a rate of LIBOR plus the spread of 120 to 175 basis points, depending on the company's leverage ratio. Given the company's current leverage ratio, the initial spread to LIBOR is set at 125 basis points and 120 basis points for the revolver and term loan, respectively.

In addition to the execution on the expanded credit facility, the company completed an equity offering of 20.7 million shares in conjunction with the announcement of a pending 14-property portfolio acquisition. As Bill mentioned, in June, the company launched an overnight equity offering and successfully raised $398.5 million of gross proceeds through the issuance of 20.7 million shares of its common stock, consisting of 13.7 million shares offered directly by the company and 7 million shares offered on a forward basis at a price to the public of $19.25 per share. The company expects to physically settle the forward sales agreement and receive proceeds, subject to certain adjustments, from the sale of its shares of common stock upon one or more such physical settlements within approximately 6 months from the date of the perspective supplement relating to the offering. We believe these 2 activities, the credit facility and the equity offering, put the company in a very strong competitive position going forward. We look towards the future with excitement as we continue to pursue opportunities, which we believe will drive earnings and distributable cash flow into 2019 and 2020.

With that, I will now turn the call back to the operator for questions.

Operator Instructions) Our first question comes from the line of Manny Korchman with Citigroup.

It's Michael Bilerman here with Manny. I don't know, Darrell, if either of you want to address this. But you go back to the beginning of 2016, you were basically running at $0.30 of FFO. This quarter, you put in $0.29 2.5 years later. And that's despite the fact that you've -- or maybe it's because of the fact that you've doubled your share base and more than doubled your asset base. And I keep on hearing you guys talk about accretion, accretion. I guess, at what point are you actually going to see growth in your underlying earnings? And then how do you start thinking about that level, especially given the fact that effectively now for 3 years, you'll have no growth?

It's a good question. Meghan, why don't you start, and I'll finish?

Yes, sure. So as we focus ultimately, Michael, on distributable cash flow, I think it's important to have watched our ability to increase the dividend and continue to pay cash back to investors. Obviously, at the moment, we are in a position post offering where the balance sheet is in great shape, and we have capital waiting to be deployed. So as we look out to the remainder of 2018, '19, and particularly into '20, as our development comes on board, we're confident that the portfolio's ability to continue to generate greater levels of distributable cash flow will transpire.

Yes. And then it’s -- I would say, of course, it’s a -- these REITs, compared to other businesses, without retained earnings, you don't get that compounding growth. But I think, certainly since IPO, we've done a very nice job stepping the dividend up. We've meaningfully grown the portfolio, which leads, again, to when I was speaking about diversification and stability. We're super proud of the portfolio that we built and its ability to deliver dividends. And we've laid the groundwork with the development that has -- continues to grow and for the opportunities of -- the new development opportunities that we see on the horizon. Those can make a meaningful contribution to cash available for distribution. And so as you look out in the model, again, we've had nice dividend increases over time. But I'd certainly see by the - certainly by the end of 2020, quarterly dividends of $0.30 or greater, which is -- which, again, if you look over time, I think, that's a nice return for shareholders. And that really doesn't include us having some nice positive surprises, like the large portfolio that we're able to acquire most recently.

Right. I mean, look, I think most investors will think about REIT on a total return perspective, right. And so if you look over the 2.5 years, your stock is relatively flat as your earnings have been flat, right. And you've grown the equity base. You've doubled your equity base. And so at some point, right, you can increase the payout ratio by increasing your dividend, but with earnings flat, there's not much growth, which is being reflected a little bit in your stock price. So how should the market think about -- and especially when you're committing such new capital, right, and you said you won in a public auction. You paid the highest price. And so it's easy to accumulated assets. It's harder to make those investments accretively. And so I'm just trying to get a sense of your mindset when your FFO has basically been flat for 3 years.

Right. And so our mindset is, again, the cash that comes out of the REIT -- again, backed full faith and credit by the U.S. government, we look today, the yield is 5.25 or higher essentially on what are government revenues. So we also know that we look in the market and we look at other REITs. And who am I to tell you how to think about REITs? But I would say, scale does matter. And scale equals diversification. So we have the highest-credit tenant of any REIT that you cover or any REIT that's out there. And that stability of cash flow should be the highest-value cash flow that's in the REIT world. Why has it not been most highly valued? Well, scale's probably a pretty big factor.

So our mindset, again, accounting anomalies aside. And Meghan can spend time with you and Manny going through why FFO and FFO as adjusted, as we do lease renewals, those numbers, FFO flattens out. FFO as adjusted grows. And we're looking at substantial -- we're not increasing our payout ratio of CAD. We're actually increasing the real CAD that's coming out of the portfolio. So when we look at CAD growth for next year and into 2020, it's substantial.

And so our mindset is to have a consistently growing dividend, full faith and credit of the U.S. Government. Obviously, a REIT is not a government bond, but I don't how many basis points are reasonable for our yield to be above the 7-year treasury, but we certainly see that over time that, that gap should shrink. And as long as we keep delivering what is kind of single-digit, low double-digit growth in dividend and hopefully stock price, that should put us in the kind of the top 10% of return drivers for REIT investors.

Right. But you're at $0.25 this quarter. And then adjusted FFO, you were at $0.27 at the beginning of 2016. So whether you measure it on FFO, adjusted FFO, FAD, there's been no growth. And I think that you can go through that protection of leases and things like that and government, at the end of the day, your net lease REIT that you're entire job is putting up capital and raising capital, ultimately, you have the underlying theme, growth. And I'm just trying to understand at what point will estimates start going up rather than going down, right. I mean, is it the back half of 2019? Is it 2020? Because at this point, right, all you're seeing is numbers go the other way.

Well, again, I'm not going to give what our guidance is next year for next year. But I mean, we all have the models. I think I -- again, giving you the indication that we're going to have dividends that are $0.30 or higher per quarter in -- within 1 to 2 years is certainly valuable. And I would say -- so yes, there you have it. I mean -- and remember, our leases are not one where the -- our leases over time should keep up with inflation, but the value of our REIT, I'd say it in a cheeky way, we buy the real estate and sell the credit. And that is -- we -- the value -- the stability of our cash flows, and full faith and credit going out 5, 10, 15 years, we think is valuable. And it was why we brought this REIT to the public in 2015, because it was a unique offering relative to the others that were out there.

Our next question comes from the line of Michael Lewis with SunTrust Robinson Humphrey.

My first question probably for Meghan. You ended 2Q with $150 million of cash. You've got to the delayed portion of the equity offering. You don't have debt maturities for years. What do you think is your runway or investment capacity after taking down the rest of the portfolio acquisition to make additional investments before you think you have to come back to the equity market?

No, I appreciate the question, Michael. It's an important point. And as I look at the capacity of the balance sheet, given where leverage is today and where we've stated for quarters now, our equilibrium comfort level is in that 6 to 7x. And I view our ability to have $253 million to $300 million of total assets capacity is the right number today beyond the portfolio.

Perfect. And I guess a follow-up to that. I mean, how do you think about -- this quarter, you took the upsized equity offering. You hit the ATM a little bit. How do you kind of balance the timing of taking equity when you could get it or when it's attractive versus come into the market with a deal when you need it and kind of managing that near term for any solution?

Yes, so as we approached the equity markets on the -- with the announcement of portfolio, the balancing factor was not only ensuring that we're financing with a short term, but making sure that we were -- ability or have the ability to take equity to -- given the strength of the offering, to provide that excess liquidity. But also ensure that we were able to maintain the dividend, that we spoke to Michael about before and look to grow it over time into the next year or 2.

Okay, got you. The $250 million to $300 million, that's a lot of capacity to take. Can I guess -- help us explain that dilution. I mean, listening to your conversation with Michael, that dividend growth is -- I mean, I'll do the math in my head. I guess, 20% dividend growth over -- you said, I guess, 2 years let's call it on the long end. You know what, I'll come back to that offline. Let me ask just 2 more quick ones. The -- Bill did a good job going through the leases coming up for expiration and the portfolio you acquired. You've got 3 coming up in '18, 2 in '19. Is there any reason to believe anybody would move out or downsize?

No. I think we're very confident in our tenants, and I think we feel very good. I think we've executed where we said we would, certainly within the bull's eye section. So we continue to work for a while. We'll say that the government is a -- always an interesting partner to negotiate with. But in the end, we have the same goals, and I think we've were able to keep them in our buildings.

And then just last one for me. The portfolio acquisition, is there anything in that pool of properties that maybe is fringe on the bull's eye or maybe something that's multitenant that you could -- that might be a near-term disposition? Or do you think that you'll hold all these for the long term?

I'd say I think, first of all, we have -- we've underwritten, as I've mentioned, this portfolio for literally years. It was one of the ones that would've gotten us just to go public. So I think we're very familiar and very happy with the buildings in that portfolio.

You are correct. There are several multitenanted buildings. However, I think they are some of the strongest buildings in the portfolio. And while we always bought BMWs, for example, but Mercedes makes a good model as well. And so if you look at Buffalo, you look at Portland, and you look at Charleston, we think that these are enduring and actually, frankly, Clarksburg as well. We think we've got really enduring missions in these properties. And -- however, I will tell you that overall -- and we've tried to do this. We've tried to be 100% federal leased. And we've tried to be as close to bull's eye as possible going forward. So if we see opportunities or we think that we need to make a shift, we will certainly do it. And I think we will do it decisively. However, right now, we're very pleased with the portfolio.

And this Darrell. I'm -- we -- as we've mentioned this last conference call, there are a series of portfolios that are out there. And I'll -- strongest compliments to Bill. Since the IPO, we have continued to distill and focus and really kind of push our bets onto the bull's eye. And there are many -- I mean, as anyone who runs these REITs knows and you, as the analyst community particularly, there are plenty of properties you could kind of pick up along the way that are at a higher cap rate or you could rationalize or part of your strategy, and we've been defined as much by the deals that we don't do as those that you have come to see.

So as we move forward and look to other portfolios, there certainly will be very high-quality buildings that are attractive but may not be in our bull's eye. And then I think as we concentrate to a greater and greater degree on bull's eye properties and the dynamics that we best understand around those properties, that's where -- that will be our focus in over the next 5 to 10 years.

(Operator Instructions) Our next question comes from the line of Michael Carroll with RBC Capital Markets.

Yes. Bill, can you talk a little bit about what you're seeing on the investment market? What type of deals are currently tracking? And I noticed that your guidance doesn't really assume many more incremental investments. Is that because you're working to complete this large portfolio transaction? Or do you think that there's other deals that you could potentially complete before year-end?

Well, a couple of things. I think that we -- it's not a mystery. We are in the eighth month of the year, so -- and I just want to make the analyst community realize that we've got to make sure we put them all in the different quarters correctly. This portfolio is taking a fair amount of our time, but that doesn't mean that we're slowing down in any way on what we're seeing out there. Even if we were to buy something absolutely terrific at the end of the year, it's obviously not going to be working for us until next year. So I think that's an important point to put out there.

But I think, from a quality standpoint, we continue to see wonderful opportunities. Individually, we're seeing small portfolios. And as Darrell mentioned, we're also seeing large portfolio opportunities.

I think that the increase in interest rates, as I said before, has actually given us more opportunities going forward as these sellers -- and I'll remind you, there are really about 500 GSA properties and 50 VA properties. We know where every single one of them are. And these owners' cost of capital are different than ours. And as interest rates increase, I think some -- many of the conversations, in some cases, we've been having for years, will come to fruition as these owners realize that Easterly is probably a better home for these properties. We're probably going to be more successful renewing them as they come up for renewal. We have a wonderful team of folks that can do that and have great relationships. So we really provide a lot of extra value there. So from our standpoint, I think everything is steady as she goes, with probably a positive bias on what we're seeing for opportunities.

Great. And then, Meghan, can you talk a little bit about the leverage targets going forward. I know the recent offerings have probably reduced you below the long-term target range. Is 6 to 7 still a goal? And are you comfortable near that 7x? Or would you prefer to stay near the low end of that expectation?

No, nothing has changed from our perspective there, Michael. 6 to 7x is still our comfortable range. Development and timing of development, as we've discussed, particularly with the portion of the development budgets that is lump sum can push us towards the higher end or towards that 7x. But we're comfortable because that's for a temporary period of time.

And the -- it's Darrell. I'd just lay on top of that. With these very successful lease renewals, I mean, when you look at these 10- and 15-year terms, I entirely get that 6 to 7x is the right range, and that's the expectation.

But as we've said again and again and again, the quality of our cash flows is higher than other folks out there. In theory, they should be more leverageable, but we govern our leverage ratio so that we stay within the pack among REITs. But that said, our leverage, even if we were to get to that 7x level, is an even more creditworthy, supported 7x than it ever has been in our history.

Okay. And then can you give more details on the recent renewal with the IRS? Is there any capital that you committed to that lease or any free rent associated with it?

With regard to Fresno, there is 1-month of free rent in that renewal. And we're working with the government to finalize their TI requirements, and we would expect capital in the $2 million to $5 million range.

Okay. And then finally for me. The PTO lease that comes due soon, I think in the supplement, it says 2019/2020. Is there 2 lease expirations with that asset?

Yes, there are -- there's 2 portions in the property. Actually, [Fred] owns the first floor, and then we have 2 different federal REIT partners. So we -- has a retail section. And Bilerman, I know you visited with us. And then there's 2 different sections within the building that are leased to PTO. That is ongoing, but we do expect that we will renew that property. And that will really come about and fruition January of 2020, I think will be the next lease for that.

Our next question comes from the line of Jon Petersen with Jefferies.

Great. So just one question. You guys talked earlier about potential for dispositions in around a lot of noncore properties. But I was curious specifically about IRS - Fresno. And you put a 15-year lease on that property. I don't know if you can remind us how old of a building that is. Or if that -- now as it has a 15-year lease on it, if that's something that is primed to be sold and reinvest that capital somewhere else?

Yes. It's a 2003 build, and it was built basically for the IRS in Fresno, which is 1 of the 10 supercenters, as you know, in the United States. And it handles compliance for 9 states, including California. It's an incredibly important mission, and it's actually getting upgraded within the IRS to handle some other fraud stuff as well.

That's the thing that is so important to point out. Not only do we get a 15-year lease with the federal government. I don't know how many people on this call will be here when I announce that it's renewed for another 15 years, 13 years from now, but I'll welcome you then. But the deal is, these buildings have incredible value with these long-term leases. And anything over 10 year should be reflected with a very high valuation right now. So of course, we're going to take the opportunity over the 3 or 4 years to decide as to whether we think that IRS's mission is going to continue to be as important, how this fiscal aide should tend to it. But that's the wonderful thing about getting these longer-term extensions. It gives us a lot of flexibility and a lot of value for our shareholders.

Yes. Okay. And I guess a follow-up on that. You guys talked about the value, or I guess, the impact on your stock price of gaining scale. I guess, at what scale do you kind of get to the point where you can move to capital recycling rather than needing to come to the market and issue more equity?

I mean, it is -- as we look to total assets of somewhere between $2 billion and $3 billion, we will certainly be at a place where we think strategically, we have the scale to provide the diversification and strong stability for this portfolio.

You already see it, though, in some of what we're saying. And super smart question around the flexibility that's inherent in these 15-year leases. You've heard that what we've learned, right, when we step back -- and what have we learned since 2010? Is that bull's eye strategy for us works, the insights that we have into those buildings, the ability to harvest value. Again, very hard to get rent growth in the types of leases that we have with the U.S. Government. However, with the bull's eyes properties, you can see we've been extremely successful.

We look to our plain-vanilla properties. So obviously, our strategy on the margin is to get a longer-term lease and -- to give us the flexibility to the degree to which we want to distill what we're doing around the bull's eye, the area, the target that we set up and have always known best. We're positioning ourselves for that option. And Meghan's done such a fantastic job financing these buildings, that the real opportunity to remain flexible and recycle capital whenever there's an opportunity to again concentrate on the bull's eye where we find the greatest value for shareholders will certainly be an opportunity for us.

Great. And then I apologize if you guys already said this. But just speaking about Megan and financing. The delayed draw -- or the -- not the delayed draw. The kind of deferred equity that you guys have, can you remind us how we should be thinking about when you pull that down throughout the rest of the year?

Yes. So it's $7 million, 6 months to settle that. I think you can expect us to settle that at the very end of this year, December time frame.

Our next question is a follow-up from the line Manny Korchman with Citigroup.

Manny? Michael?

Sorry about that. Yes, can you talk a little bit dividend coverage? You're running about $0.26 today, whatever metric you wanna use on Page 11. You look at $0.29 of FFO, $0.25 of FFO as adjusted and, let's call it, $0.22 of CAD, adding back the acquisition cost and the principal amortization, right. So your payout ratio's 90% of FFO over 100% of FFO as adjusted and 120% of your cash available for distribution, again adding back the acquisition costs and the principal amortization. How is that sustainable and not too high of a payout ratio?

Yes. No, thanks for the question because -- obviously, as we've been scaling, we've been in this period -- a bit of a period of transition. And there's been some anomalies in timing and how -- on kind of how acquisitions come through. But when you look at these renewals, this portfolio that we're purchasing in September and in December, as we look forward, we -- our intent is to dividend out, obviously reserving for capital and what else we need to do in order to renew leases and keep our buildings in top shape, but to be dividending out 95% to 100% of that cash that's available for distribution. When I talk about $0.30 a quarter in 2020, the throttle's on 95% to 100%. And that is -- and that's the way the math works.

I would encourage the analysts to all look at that CAD and work their models backwards. Maybe we could do a better job communicating NOI. I don't know. It's crazy to me with the stability of our cash flows that we can miss a number. And I would say that I really encourage folks to tweak their model and let's talk about CAD between here and 2020 and work it backwards. Because as we renew these leases and anomaly of the accounting of when we went -- when we went public, there are above and below market leases, which may be a little different.

To Michael Bilerman's fantastic point, FFO is not going to be the metric that actually indicates to investors our growth. As you know, we're kind of private equity people, and we focus on cash-on-cash returns. And that's why we're just going to keep talking cash, cash, cash, dividend, dividend, dividend. Get the money into our investors' hands. And I'd encouraged everybody to look at $0.30 of CAD or greater in the fourth quarter of 2020, and we'll help people in -- work it backwards either on these calls. Or if we have nonmaterial things to share, we would certainly share them in conversations with any investor who wishes to give us a ring.

But that $0.30, you're looking at it inclusive of acquisition cost and amortization, so this quarter, with the $0.19, I gave you a little bit of the benefits of the doubt that those are non -- while they're cash items, they're more debt-oriented and capitalized typically to an acquisition. So when you're talking 95% to 100%, are you comparing $0.19 going to $0.30? Or you're comparing $0.22 going to $0.30. And again, your payout, $0.26 today. So...

It's our reported CAD, Michael.

Over to flows, Meghan. We're already writing an 8-K about this, so we know just like, keep changing it out.

Your point is taken about sort of the nature of amortization. But when we think about that, that's a -- going to be professional of the business. So we're talking about CAD post that.

You want to grow from $0.19 a quarter to $0.30 by 2020. I mean, I think having the building blocks of getting there would be...

Let's do an Analyst Day, Analyst Day. I don't know what we need to do.

I don't know how you -- I don't know you have that amount of growth in 2019 and 2020 from what you have in place today. It just seems like an awful large amount of growth.

Right. It's not coming from FFO growth. Let's just be simply clear, because of as these leases roll.

We can certainly walk through your model. But obviously, we've got the equity in there for an acquisition that we do not have any cash flow from yet. We have not closed any of those buildings. So I think you're looking at a quarter a little too myopically.

Right. And remember, we just took down a ton of shares. And the way we source -- we can put a ton of money to work, we think, accretively for investors. Obviously, I think we've been deliberate about how we put our hand on the throttle since we've been public. And we were very mindful, again, of looking out and understanding where our dividend capacity is, and we -- through this offering, we're deliberate about the amount of capital that we're able to take, timing we can put it to work and making sure we can be on a very clear path around the dividend. So I think some of the numbers may seem strange this quarter, but we'll certainly see, as we move through the end of the year and into next year, how we get to this $0.30 or greater by the end of 2020.

You're talking about 16% growth, right, which is this quarter, was not weighed down -- was not weighed down too much by the equity, right. Your equity was late. And in the back half of the year, you're running about $0.30 based on your guidance, which dropped down to about the same $0.19, $0.20 on CAD. So growing from that level to $0.30 by the end of 2020 just seems like a pretty strong growth rate that we need some more details behind it.

Great. Yes, we've got to give you those. So let's just make sure we have an Analyst Day or a teach in or whatever else we needed to do. Or we can do a webinar or all those fancy things that we can do to communicate. Because we do have to get analyst models synced up with what's going on with the company. And I am entirely empathetic that a big portfolio and an equity raise is -- can make the numbers tough to track. And there is nothing gargantuan when I talk about $0.30 fourth quarter of 2020. I mean, it is -- it is what we've got in place, plus just doing our day jobs. So that is -- so yes, so let's figure it out. We -- Meghan remains open. Her line is open, and we're happy to work through stuff and get the information out to investors.

Our next question's another follow-up from the line of Michael Carroll with RBC Capital Markets.

Meghan or Bill, can you talk a little bit about the lease spreads you expect over the next 2 years? And then I know Loma Linda has a pretty big rent bump also. When does that come in? And how big is that rent bump again?

You'll take renewals first.

Sure. I think the renewal spreads are going to be consistent. What we've said is depending whether they're plain vanilla or whether they're bull's eye, gun-toting sorts of properties. So again, sort of high teens for those bull's eye properties, and plain vanilla's going to be very much in line with the market. So I think that's probably what we'll see there. Loma Linda's bump, Meghan?

Yes, that's in the first quarter of 2019.

And how much is that bump?

30%.

30% increase.

Mr. Crate, there are no further questions at this time. I'll turn the floor back to you for any final comments.

Great. Thanks, everyone, for joining the Easterly Government Properties Second Quarter 2018 Conference Call. We appreciate your continued support, and we strive to provide strong risk-adjusted returns to our shareholders through dividend growth. And we look forward to getting together now or on the next conference call. All the best.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.