Office Properties Income Trust (OPI) 2009 Q3 法說會逐字稿

Good day, and welcome to the Government Properties Income Trust Third Quarter 2009 Financial Results Conference Call. Today's conference is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Mr. Tim Bonang. Please go ahead.

Thank you, Marvin. Joining me on today's call are Adam Portnoy, President and Managing Trustee, and David Blackman, Chief Financial Officer. The agenda for today's call includes a presentation by management followed by a question and answer session. Before we begin today's call we'd like to read our Safe Harbor statement.

Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Federal Securities Laws. These forward-looking statements are based on GOV's present beliefs and expectations as of today, November 4th 2009. The Company undertakes no obligations to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call, other than through filings with the Securities and Exchange Commission or SEC regarding this reporting period.

In addition, this call may contain non-GAAP numbers including funds from operations or FFO. A reconciliation of FFO to net income, as well as components to calculate AFFO, CAD, or FAD are available in our Q3 supplemental operating and financial data package filed in the Investor Relations section of the Company's website at www.govreit.com.

Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-Q, which will be filed with the SEC and in our Supplemental Operating and Financial Data package found on our website. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And with that, I would like to turn the call over to Adam Portnoy.

Thank you, Tim, and thank you, everyone, for joining us today to discuss our third quarter results, which represents our first full quarter operating as a standalone public company. For the third quarter of 2009 we are reporting FFO or $0.48 per share based on a weighted average share count of about 21.5 million shares. We had no shares outstanding during the third quarter of 2008.

Our portfolio continues to be nearly 100% occupied, and we do not have any material lease maturities until the fourth quarter of 2011. About 96% of our rental income is paid by the US government and four state governments.

Even though we operate in a challenging economic environment with the expectation of further weakness in the commercial real estate sector, our company is not burdened with any tenant defaults, the need to re-lease space in markets where rents are rolling down, or the need to raise capital to strengthen our balance sheet. We are substantially under-leveraged with a ratio of debt-to-gross real estate of only 12.5% and we do not have any debt maturities until 2012.

We have the ability with about $188 million of available capital to focus on making accretive property investments and to proactively improve our tenant relationships and focus on energy savings initiatives throughout the portfolio. Let me now take a few minutes to highlight our results.

Same-store NOI for the portfolio increased by 10.4% during the third quarter. This growth was primarily driven by rent rollups associated with lease renewal activity which occurred in the second half of 2008. It is important to note that we consider this increase to be above average.

During the third quarter we entered into one new lease with the General Services Administration for the Department of Treasury to occupy about 10,000 square feet in a property we own in Kansas City, Missouri. No tenant improvements were required for this lease, which has a 2015 lease maturity date. As I said, our portfolio properties is nearly 100% occupied, we have no lease maturities for the remainder of 2009, and we are in the process of finalizing our one lease renewal in 2010.

After the end of the quarter, in October, we declared our first common share distribution equal to $0.50 per share. This distribution is comprised of a regular third quarter dividend of $0.40, plus an additional $0.10 which relates to the 22 days we were a public company in the second quarter. This distribution will be paid to our common shareholders of record as of the close of trading on October 23rd, and will be distributed on or about November 25th.

Turning to our acquisition activity; we acquired one property during the third quarter for $18.2 million plus closing costs. The property is a 322,000 square foot logistics and distribution center fully leased to the US Postal Service through February 2013. This facility is one of only 14 critical use regional processing centers used by the Postal Service across the entire United States and processes all non-letter packages to travel into and out of New England.

Although the Postal Service is obviously struggling, its non-letter package business is competitive with private parcel delivery businesses, and is one of the only profit centers for the US Postal Service. The lease terms are triple-net and our acquisition cap rate was 11.1%. We had this property under contract and discussed it during our second quarter earnings call, and the acquisition closed on August 31st.

During the third quarter, we had one property under contract to acquire for $36.5 million. The property was leased to the US government for about ten years. Unfortunately, we uncovered an issue during diligence that we cannot resolve with the seller and terminated the contract on October 29th. We continue to evaluate several acquisition opportunities.

As of today, our total pipeline of opportunities which we are actively pursuing approaches 1 million square feet of space, and these opportunities are being considered at acquisition cap rates which range from the mid-eights to the high nines. Many of our current opportunities are for relatively new properties with ten to 20 years of remaining lease term and most are with the federal government. We're also beginning to see several state governments explore sell and leaseback transactions as a means to fund shortfalls and budgets.

Our preference is to pursue opportunities for all cash purchases where we have a competitive advantage, however, we will consider acquisition where we may assume debt on favorable terms. We currently have approximately $62 million outstanding on our $250 million secured revolving credit facility, which provides us with about $188 million to support our acquisition pipeline and other working capital needs.

Overall, we are a little frustrated with the slow pace of acquisition activity during the last few months, but feel that activity has started to recently pick up substantially. We are well positioned to take advantage of what we believe to be a once-in-a-generation acquisition market for government lease properties at attractive prices.

I'll now turn the call over to David Blackman our Chief Financial Officer, to provide more detail regarding our third quarter financial results.

Thank you, Adam. First, let's review the results of third quarter operations. Rental income increased by 6.6% and total expenses increased by 7.2% resulting in a 5.7% increase in operating income for the third quarter of 2009. The year-over-year quarterly increase in rental income primarily resulted from an increase in rents from our property acquisition, lease renewal activity in the second half of 2008, and increases in contractual expense reimbursements from our tenants.

We experienced modest increases in operating expenses, as a result of utility rate increases and property tax increases. Our G&A expense includes accruing the full cost of our annual audit expense over six months instead of a full year, and expensing trustee and employee share awards that were granted in the third quarter, also without the benefit of accruing these expenses over 12 months.

It will be 2010 before we can smooth these and other G&A expenses by accruing them over a 12 month period instead of expensing them as they occur. As a result, it will take some time before our year-over-year comparison of G&A normalizes. Our large increase in depreciation and amortization expense and the inclusion of acquisition costs were the result of our property acquisition and capitalized building improvements at some of our properties.

Our consolidated net operating income margins were 66% for the third quarter of 2009, compared to 63% for the third quarter of 2008. This increase reflects our growth in rental income at a higher rate than operating expenses as previously described. EBITDA increased in the third quarter of 2009 by 6% over 2008, primarily reflecting a 10.4% increase in same-store net operating income and our property acquisition offset by an increase in G&A expense.

Interest expense increased by substantial percentage reflecting the amortized costs associated with establishing our $250 million secured revolving credit facility in April, and the fact that the average amount outstanding under our secured credit facility are substantially greater than the $134,000 of debt that was outstanding during the third quarter of 2008.

Net income for the third quarter of 2009 was $6.2 million, compared to $7.2 million for the third quarter of 2008. This decrease reflects the net result of a $1.4 million increase in interest expense and a $400,000 net increase in rental income over operating expenses.

FFO was $0.48 per share for the third quarter of 2009 and $2.49 for the first nine months of 2009 based upon a weighted average common share count of 21.45 million shares for the third quarter and 12.9 million shares for the first nine months. As Adam mentioned, we declared our first dividend in October equal to $0.50 per common share, which ascribes $0.40 per share to the third quarter and $0.10 per share to the 22 days we were public in the second quarter. The dividend will be paid to common shareholders of record as of the close of trading on October 23rd and paid on or about November 25th.

During the quarter we spend $225,000 on tenant improvements and leasing costs and $154,000 for building improvements across 11 of our properties for energy initiatives and upkeep items like paint and parking lot repairs.

Switching to the balance sheet; on September 30th we held $2.3 million of unrestricted cash. Deferred financing costs of $5.8 million are fees and expenses associated with establishing our $250 million secured revolving credit facility that amortizes on a straight-line basis through the second quarter of 2012 due from affiliates in the amount of $5.1 million, our rents collected by HRP at month-end that have since been paid to us.

HRP is still collecting rents at some of our properties contributed by them earlier this year, while we complete the change of ownership procedures with the General Services Administration. The US government will not redirect rents to us until these procedures are completed. Rents receivable include approximately $2.2 million of accumulated straight line rent as of quarter end. Other assets of $4.8 million includes a $3.5 million escrow held for a potential property acquisition that we terminated on October 29th due to an inability to successfully resolve a diligence item.

As of the end of the third quarter, we had $65.4 million outstanding on our secured revolving credit facility. As of today, we have $61.9 million outstanding on our secured revolving credit facility and $188.1 million of borrowing capacity. The facility matures in April 2012 and we have the right to extend the facility for an additional year to April 2013. The current interest rate on our facility is based upon a spread above a 2% LIBOR floor and results in a all-in rate of 5% based upon our current corporate leverage. We believe we are compliant with all terms and conditions of our secured revolving credit facility, and are operating well within these established covenants.

Overall, we are pleased with our quarterly results and the strength of our balance sheet. We have no debt maturities until April 2012 and no material lease maturities until the fourth quarter of 2011. We have a robust acquisition pipeline, and believe we are well positioned to take advantage of a tremendous acquisition environment for government lease properties.

That includes our prepared remarks. Operator, we are now ready to take questions.

Thank you.

(Operator Instructions)

Our first question will be from Dave Rodgers from RBC Capital Markets. Please go ahead.

Hey, guys, good afternoon. Just wanted to quickly address the acquisition topic that you mentioned, Adam. When you look at the acquisitions this quarter versus last quarter, then in the pipeline, are you pretty much looking at the same assets just working their way through? Are there new assets that can you talk about if, in fact, some of the assets went away from you? Were prices just too aggressive? And just give some more color on those topics.

Sure, I'd say probably three-quarters of the stuff we're looking at now is different than what we were looking at last quarter. There's a couple things that have spilled over, but most of the stuff is new. The stuff that -- what happened to those properties. We lost some of those to better bidding from competitors and some of those properties also eventually just in trade because the seller decided they didn't want to sell.

And when I say the seller, sometimes -- sometimes we've learned that what's happening is the seller is being pushed around by maybe a lender, and the seller goes out and gets a bid from us or maybe somebody else and then go back to the lender and say, look, look at these bids I can get; will you now extend by loan? And so, there's a little bit of that going on as well I think in the marketplace, not just with government leased buildings, but I think with any type of asset class out there.

So that's a little bit of what's happened and like I said, we had one property under agreement, unfortunately we found something in diligence that we couldn't resolve with the seller and so it fell out of agreement. But I think we've also been -- we're getting a little bit, I want to say smarter about how we're approaching the acquisitions. I think we're getting a little bit better at smelling out the guys that are just fishing around for a bid to go back to a lender, as I spoke about.

And I think we are getting a little better at making sure that we're focusing on the buildings I think we're likely going to be able to buy. And so I know, last quarter I think we said we had an acquisition pipeline of over 2 million square feet we're evaluating. This quarter I'm saying its 1 million square feet. I think it's a bit -- I say -- the 1 million square feet that we're evaluating now, I think we'll have a higher hit ratio or potentially higher hit ratio than let's say the 2 million square feet we may have been evaluating last quarter.

So even though we don't have a lot I can talk about concrete right now. As I said in the prepared remark, activity has picked up substantially just in the last few weeks in terms of our going back and forth with some of these sellers. And so, we're hopeful we'll have some exciting news to talk about in the fourth quarter or when we talk about fourth quarter results.

With regard to the state level portfolio that I think you mentioned in your prepared comments. How far are those along in the diligence process or in the offering process?

Yes, they're not moving very fast. The two big -- there's a couple big portfolios out there; there's a portfolio in Arizona and there's a portfolio in California. There's teasers out there, but we haven't been given -- bid dates haven't been established yet, let me put it that way.

Okay, fair enough. Last question, David. Just on the G&A going forward, I understand the accrual issues, so can you give us the target for the fourth quarter?

Yes. Think about that, David. I don't anticipate that we're going to have any one-time expenses for G&A in the fourth quarter. So, I would expect that we would see something in the $800,000 to $900,000 range for G&A.

Great. Thank you, both.

Yes.

(Operator Instructions)

Our next question will be from Jamie Feldman from Bank of America. Please go ahead.

Thank you and, good afternoon. Can you talk a little bit about your progress leasing up your largest expirations in 2011 -- that Fresno and then what's going in DC for 2012, or is it a little too early to talk about that?

Sure, Jamie, this is David. Not a lot new to report on Fresno. We do know that the agency and the GSA are working with Congress to formulate a response on renewal at that property. What we believe is happening is a consideration as to whether they exercise the five-year renewal option that's built into the lease, or whether or not they actually extend the lease for something longer than five years. But everything we hear from the agency and from Jones Lange LaSalle that works with us on a lot of our government lease properties has been very positive, and we continue to be very confident with that property.

It is probably a little early for Mass Avenue. We have had some conversations with the Department of Justice. As you may know, they are building a 500,000 square feet not too - a 500,000 square feet building not too far from our existing location, and so we've just simply inquired to see what their intent is with the space in this building and they've said that they really need much more than the 500,000 square feet.

They're very happy in our building, and they expect to stay beyond the lease maturity date at Mass Avenue. We haven't had significant conversations with Custom Enforcements around their renewal but again, it's a little early to get too deep with them at this point.

Okay, and then is there any discussion of rent, or where you think they will be (inaudible) either one of those?

I think it's early to have rent discussions at this point. We have an active leasing business in the DC market, and we are seeing rental rates in that market still probably $6 to $7 a square foot above our in-place rents for the property, but I think it is a tad early to have specific rent conversations with the tenants at this point.

Okay, and then back to the pipeline question, Adam, on the last quarter call, you mentioned -- I know you just mentioned this, but you said there were 2 million square feet, not you're mentioning there's 1 million square feet you guys are working on. Can you give a little bit more color on what kind of assets are in the 1 million versus the 2 million? And then as we think about 2010, what you guys think you can get done in terms of acquisitions?

Yes, in terms of -- I mean, the composition of what we're looking at hasn't changed very much; there are still predominantly buildings that relatively new, either recently constructed or constructed within the last ten years. And they are buildings that are going to be long-term lease with us say on average ten years to the GSA; some longer than that. That's predominantly what we're looking at, so it hasn't changed much from what we were looking at before.

State -- the wild cards with the states and that's a little new this quarter. There are those two big portfolios that they haven't put bid dates out there yet and --

And that's not included in our 1 million square feet of acquisition --

Yes, that's not included, but that's sort of the wild card that could change things if bid dates come along and we maybe are successful in bidding on some of those state leased assets. So, that's maybe the only development that's happened between now and the end of the second quarter; when we talked about the second quarter results is the state opportunities have become a little bit more real than they were then.

Another thing that's a little bit different right now, Jamie, is we are very far along with substantially all of the acquisition opportunities that we have in the pipeline this quarter, whereas when we had our call for the second quarter we were still kind of early underwriting stage for a number of those properties. We've got a number of bids that are outstanding on properties, some of which we are in a best and final round.

So we feel -- we can speak with much greater confidence today about the quality of our acquisition pipeline than we probably could the last quarter.

So, what's the dollar amount of bids outstanding right now?

Bids that we've made -- a couple hundred million probably. But don't think that we're going to win all of them.

Okay. And then should we expect some sort of deal break fee in the third quarter based on --?

No there -- we were going to have some acquisition costs that we will have to expense through, but there's no breakup fee. Our $3.5 million deposit was fully refundable.

Okay, so in terms of an impact on the run rate for the fourth quarter?

Yes, I think our diligent costs are going to be less than $150,000 associated with that property.

Okay. All right, thank you.

Our next question comes from Brendan Maiorana from Wells Fargo. Please go ahead.

Thanks, good afternoon. David, just to follow-up on that, why are the acquisition costs stripped out of FFO?

We believe that the acquisition costs are a one-time expense associated with acquiring that specific property, so it's not a recurring expense that should be included in FFO.

So going forward, is that going to be the policy with respect to acquisition costs; they'll be capitalized into the cost of the building?

We're not capitalizing in the cost of the building because GAAP won't allow us to do that, but we do think that it's appropriate to specifically exclude that from FFO, so we will itemize it in our FFO calculations so that people understand that.

Brendan, there was a change in the accounting rules that took effect at the beginning of this year that no longer allows you to capitalize acquisition costs. So historically you'd buy buildings, you'd capitalize the acquisition costs; now, you must expense them. That's a change in the accounting literature.

And so we thought it was appropriate for just exclude it, even though the accounting literature now says you have to expense it, we thought it was appropriate to exclude it from the FFO calculations for just the reasons David said, which is that there really are lumpy one-time items that you could have them in one quarter and you won't have them for other quarters. And so, we thought it was important to take them out. And basically, it keeps it consistent with basically how FFO was calculated prior to this accounting change.

Yes, understood. I think there are some of your peers that are including those numbers within their FFO calculations, but I understand that you guys are stripping it out.

Yes, and we break it out on the income statement. I mean, we make it very clear.

Yes. No, understood. With respect to the acquisitions and the USPS deal, obviously being a fairly small deal, but talking more about some more significant deals that may come down the pike; how should we think about your financing strategy or those acquisitions given that you've got a lot of capacity on your line, but I'm assuming on a long-term basis you don't want to finance those long-term assets with long-term leases with relatively shorter-term money on the line?

Yes, I think -- well, you're right. We'll use the line to initially close on the acquisitions, that would be our plan. And then we would look at the capital markets and think what's the best way to do the long-term financing for that. And I think one of the options that we would consider would be -- increase our equity base. I think one of the things we're very focused on, something we talked about when we went public was I think it's important for us to grow the business and not maintain a very small equity base.

So we would -- if the price was in a good place and we all felt good about it, we would consider an equity offering and then eventually -- we don't, as we said when we took the Company public, we don't want to have a lot of leverage on this vehicle on the street.

Yes.

And so, in order for us to grow, you'd have to think about equity and then, I think, as we get bigger we'll think about laying on some additional debt. But for now, we're still basically operating under the mandate or the commitment we made at the IPO, which said we really wouldn't keep -- we would keep leverage at below one-third in the short term, and on longer term lower than 50% of total assets. So, I think that's how we're thinking about it.

Look, eventually we'd like to unencumber our assets and be an unsecured borrower. I think that's what longer term we'd like to get to someday. And so that's how we're thinking about it. But again, all this depends on when we need to access the capital markets and what the capital markets look like and what our stock price looks like and what the cost of debt looks like. So I'm not -- we're not ruling out anything or saying we have to do anything, but if we had a bias that's -- I'm sort of explaining to you what we're -- how we think about capital finance.

That's helpful, thank you. In terms of the acquisitions, some of the sell leaseback transactions at the state level -- we've talked about California, Arizona. How do you think about the discount or the cap rate differential that you would require for some of the states that are under a little bit more financial pressure relative to maybe a cap rate for a comparable asset that's leased to the federal government?

It would be more, and I think that's probably obvious to you. The question is, how much more? And it's really so hard to pin down, because it would depend on the length of the lease and which agency, and was there appropriation clauses or anything like that in the leases. And for example, Arizona the portfolio, they will have appropriation clauses in there.

And so, they'll have the ability -- in the buildings that they're selling, they'll lease them back, but they have the ability based on budget -- whether or not they get budget on funds from the state government, they could cancel the lease. Portfolio that California's talking about wouldn't be subject to basically any appropriation.

So, obviously you'd apply a different valuation to each one of those situations, and depends on what agency was in there. In the case of Arizona, they're talking about leasing back the state house; selling the state house itself where the state legislature meets. So even though that building would have an annual appropriation clause they could technically leave, you'd probably get yourself somewhat comfortable that they're not going to leave the state legislature building --

Right.

-- and so you might apply a different cap rate then some other agency. So look, generally speaking, you're right we'd apply -- it's a higher cap rate than the federal government, but there are so many factors go into it. I'm trying to give you a flavor for some of those factors --

Sure.

-- that would affect the cap rate.

No, I appreciate the color. And has there been any update with the FBI in San Diego? I think they were looking for their own campus and I think that your building there is in the soft term phase, if you will. So, has there been any increased discussions or updates from the FBI?

They are -- they clearly are looking for a location where they can basically go from the 100,000 square feet that we provide for them to 250,000 square feet. They are having a very difficult time finding a site and finding a developer that can build something for them, and get a decent return on a rental rate at what Congress has approved for the rent. So I think that this is going to be an ongoing process for them, and I would be surprised if they are in a position where they can move into a new building within the next three years.

Okay.

Our building that they currently occupy is really a very good property, well located and, frankly, it's probably more visible than they would like because it's a corner location. And it is multi-purpose, so you don't have detention lockups and other things that would make it difficult for another federal or state tenant to come in and use, or even a general corporate user.

Right. Okay. And then just lastly, the CDC down in Atlanta is looking for I think three separate build-to-suit opportunities. You guys have pad sites down there, development's not something that you do a whole lot of, but is that something that you're entertaining?

Yes, we're aware that the CDC does have an RFP out there and we have -- we're evaluating that, yes absolutely. We're also not sure -- just to be completely clear for you and others that -- the CDC has been very quiet on this; we can't get it out of them. But, we don't know where they're taking the tenants from; meaning we lease a bunch of space to the CDC. There are a couple other big landlords publicly traded in Atlanta that lease space to CDC. We think somebody -- we've been anecdotally told that it's all expansion space that they're basically going to be using this new space that the RFP has been put out there for --

Yes.

But, you don't really know until the very end, so we've been very closely monitoring it and we are looking at the RFP, and it's something we're considering. But I also want to say that it -- anecdotally they're telling us they're not going to move out of either our campus or anybody's campus, but you don't really know until the process is finished.

Yes, I know. I heard the same anecdotes. But okay, thanks.

Yes.

Our next question is from [Chris Cayton] with Morgan Stanley. Please go ahead.

Hi, good afternoon. I'm wondering can you update us on how the GSA is looking at its space uses today and how it's evolving in the current climate. So I guess, how full are their spaces with you, say in DC and how full are the assets you're touring as you look at acquisitions?

We're virtually 100% occupied. We've got -- we're 99.6% occupied, we've got a small space, around 20,000 square feet in our Germantown Maryland property and we're in negotiations with the existing tenant to extend at that property for five years and take the existing space in that property.

Substantially, all of the buildings that we are looking at in our acquisition pipeline that are leased to federal government tenants are 100% occupied. And generally, you will find that if your typical corporate environment allocates about 200 square feet per employee for workspace, your typical government employee probably gets something less than 200 square feet. So, they're pretty full.

That's helpful. So I guess the comment on shadow space is that there isn't a lot within these leases because of how densely -- go ahead.

We have no shadow space in our buildings, and we have not seen shadow space in anything that's been put on the market.

That's helpful. Thank you.

At this time there are no other questions in the cue. Mr. Portnoy, I'll turn the call back over to you.

Thank you for all joining us on our Q3 conference call. David Blackman is looking forward to meeting with many of you at NAREIT -- at the NAREIT Annual Convention] in Phoenix next week. Please follow up with Katie Johnston if you have not had an opportunity to schedule a meeting with her -- with us. Thank you.

This concludes today's conference. Thank you for your participation.