Office Properties Income Trust (OPI) 2009 Q4 法說會逐字稿

Good day, and welcome to the Government Properties Income Trust fourth 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, Robert. 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. I would also note that the recording and retransmission of today's conference call is strictly prohibited without prior written consent of the Company.

Before I begin today's call, I would 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, February 22, 2010. The Company undertakes no obligations or publicly release the results of any revisions 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, TAD, or FAD, are available in our Q4 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-K, which will be filed with the SEC, and in our supplemental operating and financial data package found on our website. Investors are cautioned to not place undue reliance upon any forward-looking statements.

With that, I'll turn the call over to Adam Portnoy.

Thank you, Tim. We are pleased to announce fourth quarter and year-end results for Government Properties Income Trust. We've now completed two full quarters as a public Company and are pleased with our results of operations, the strength of our balance sheet and the stability of our cash flow. We have completed or have under agreement approximately $162 million of acquisitions since our IPO in June 2009 and we are currently well positioned for growth in the future. As of today, we have no material lease maturities until the fourth quarter of 2011, no debt maturities until April 2012, a $250 million credit facility with no amounts outstanding, approximately $44 million of cash, and a continued ability to acquire government leased properties at 200 to 300 basis points above historical cap rates.

For the fourth quarter of 2009, we are reporting FFO of $0.48 per share based on a weighted average share count of about 21.5 million shares. We had no outstanding shares during the fourth quarter of 2008. For the full year, we are reporting FFO of $2.80 per share based upon a weighted average share count of 15.1 million shares. We closed our IPO on June 8, 2009, so our financial reporting prior to that date was consolidated with HRPT Properties Trust. We had no shares outstanding during 2008.

At year-end, our portfolio statistics remained exceptionally healthy. We were nearly 100% occupied, with approximately 94% of our rental income paid by the US government and four state governments. December and January were very busy and productive months for us. We acquired four properties and closed on a $210 million common share offering, which I'll provide more detail on in a minute.

First, let me highlight our fourth quarter activity. During the fourth quarter, we entered into one new five year lease with the US government to expand the Department of Energy by 14,000 square feet in a property they now occupy 100% of in Germantown, Maryland. We are providing $188,000 in tenant improvements for the expansion, and the rental rate for the expansion is approximately 25% greater than the existing rental rate for the property. This 14,000 square foot lease increases the occupancy of our initial 29 properties at the time of our IPO to 100%.

In December, we declared a common share distribution for the fourth quarter of 2009 equal to $0.40 per share. This distribution was paid to our common shareholders of record as of the close of trading on December 21st and the distribution was made on January 29th. Our acquisition activity gained momentum in the fourth quarter. Since the completion of our IPO in June, we have acquired five properties and entered into a binding agreement to acquire one additional property for an aggregate purchase price of approximately $162 million, which includes the assumption of $35.3 million in mortgage debt. These six properties include approximately 1.1 million square feet and are 99.7% occupied, with a weighted average main lease term of 7.2 years.

In addition to our acquisition in August 2009 located in Nashua, New Hampshire that we discussed on our third quarter earnings call, we closed on three acquisitions in December for an aggregate purchase price of $71.1 million and a fourth acquisition in January 2010 for a price of $28.7 million. And then finally we expect to close the acquisition of the one property currently under agreement for $43.7 million before the end of the first quarter of 2010.

Our first December acquisition is a Class A office building located in the central business district of Sacramento, California, directly across the street from the California General Assembly, with approximately 163,000 square feet. This property is majority leased to the State of California and occupied by the California Department of Finance, and it is 98.1% leased. The purchase price was $40 million and the going in cap rate was approximately 8.6%.

Our second December acquisition is a suburban office building also located in Sacramento, California, with approximately 111,000 square feet. This property is 100% leased to the State of California and is the headquarters building for the California National Guard. The purchase price was $15.1 million and the going in cap rate was 9.4%.

Our third December acquisition is a suburban office building located in Arlington Heights, Illinois, with approximately 58,000 square feet. The property is 100% leased to the US government and it serves as the national training center for the Occupational Safety and Health Administration. The purchase price was $16 million and the going in cap rate was 8.6%.

Our January 2010 acquisition is a suburban office building located in Lakewood, Colorado of approximately 167,000 square feet. The property is 100% leased to the US government and it serves as the Intermountain Regional Headquarters for the National Park Service. The purchase price was $28.7 million and it includes the assumption of a $10.5 million mortgage loan. The going in cap rate for this acquisition was 10.3%.

Our one property under agreement that we expect to acquire later this quarter is an office warehouse that contains 266,000 square feet located in Landover, Maryland. It is 100% leased to the US government and is occupied by the Defense Intelligence Agency. The property is under agreement for $43.7 million and includes the assumption of a $24.8 million mortgage loan. We've completed our acquisition diligence for this property and are finalizing a loan assumption. While there is no assurance we will acquire this property, we are currently pleased with our progress with the loan assumption.

We remain encouraged by the strength of our acquisition pipeline as we are evaluating a number of high quality acquisition opportunities for relatively new properties with long remaining lease terms. The opportunities include properties leased to both the US government and state governments and the acquisition cap rates fall within our targeted range of 8% to 10%.

Turning to our capital access. On January 14, 2010, we priced a 9.8 million common share offering at $21.50 per share. The offering closed on January 21 and we raised gross proceeds of over $210 million. The funds were used to repay amounts outstanding on our secured revolving credit facility. As a result, we currently have no amounts outstanding on our $250 million credit facility, plus we have approximately $44 million of available cash to support our acquisition pipeline and general working capital needs.

When we marketed our IPO in June 2009, we focused potential investors on the stability of our rental revenue, the safety of our dividend, and the opportunity to grow through acquisitions at cap rates above the historical average for government leased properties. We believe that the information that we're reporting today supports this investment thesis. We also are excited about our continued growth potential in 2010 because of our acquisition pipeline and our access to almost $300 million in available capital.

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

Thank you, Adam. First, let's review the results of fourth quarter operations. Rental income increased by 6.1% and total expenses increased by 19.6%, resulting in a 12.6% decrease in operating income from the fourth quarter of 2008 to the fourth quarter of 2009. Our year-over-year quarterly increase in rental income is primarily the result of receiving a full quarter of rents from our third quarter property acquisition and increases in contractual expense reimbursements from our tenants. Year-over-year, utility expenses decreased as a result of reduced utility rates in our properties. Real estate taxes increased as a result of property acquisitions and increased assessments at our properties. Note that much of our increase in real estate taxes is passed through to our tenants as contractual expense reimbursements.

Other operating expense increases are primarily the result of property acquisitions, increased repairs and maintenance expense, and above normal snow removal costs. The year-over-year comparison for G&A is a comparison of the G&A allocation to our properties by HRPT in 2008 compared to actual expenses to operate as a separate public Company. The G&A level includes approximately $150,000 in pursuit costs for an acquisition we had under agreement in the third quarter of 2009 that was terminated in the fourth quarter. Our fourth quarter G&A expense is slightly higher than expected, but a reasonable proxy for our expected run rate in 2010, excluding future acquisitions.

We also recognized $825,000 in acquisition costs associated with our fourth quarter acquisition activity. The increase in depreciation and amortization and the inclusion of acquisition costs were the result of capitalized building improvements at some of our properties and our property acquisitions during the quarter. Property net operating income increased by 5.7% year-over-year in the fourth quarter, and our consolidated net operating income margins were consistent at 64% for both the fourth quarter of 2008 and 2009. EBITDA decreased in the fourth quarter by 5.7% compared to last year, primarily as a result of the inclusion of acquisition costs and our increase in G&A expense.

Interest expense increased by a substantial percentage as a result of the amortization costs associated with establishing our $250 million secured revolving credit facility in April, and the fact that the average amounts outstanding under our credit facility for the fourth quarter of 2009 were substantially greater than the $134,000 of debt that was outstanding during the fourth quarter of 2008. Net income for the fourth quarter of 2009 was $5.4 million compared to $8.2 million for the fourth quarter of 2008. The decrease reflects the net result of a $1.7 million increase in interest expense, $825,000 in acquisition costs, a $545,000 increase in G&A expense, and a $270,000 net increase in rental income over operating expenses.

FFO was $0.48 per share for the fourth quarter of 2009 and $2.80 for the year-ended 2009, based upon a weighted average common share count of 21.5 million shares for the fourth quarter and 15.1 million shares for the full year. As Adam mentioned, we declared a fourth quarter dividend in December equal to $0.40 per common share. The dividend was paid on January 29 to common shareholders of record as of the close of trading on December 21. During the quarter, we spent $446,000 on tenant improvements and leasing costs and $1.4 million for building improvements across our properties for energy initiatives and upkeep items like HVAC upgrades, paint, carpet, parking deck upgrades, and elevator modernization.

Turning to the balance sheet. On December 31, we held $1.5 million of unrestricted cash. Deferred financing costs of $5.2 million are fees and expenses associated with establishing our $250 million credit facility that amortizes on a straight line basis through April of 2012. Rents receivable include approximately $2.2 million of accumulated straight line rent accruals as of quarter end. Other assets of $14.1 million include $7.3 million held in escrow for our two property acquisitions that were pending at year-end and our $5.1 million investment in Affiliates Insurance Company.

At the end of the year, we had $144.4 million outstanding on our credit facility. As of today, we have no amounts outstanding on our credit facility, approximately $44 million of cash, and $250 million of borrowing capacity. Upon completion of our pending acquisition, we will have $35.3 million of assumed mortgage debt, resulting in a leverage ratio of approximately 6%. Our credit facility matures in April 2012 and we have the right to extend it for an additional year to April 2013. The current interest rate on our credit facility is based upon a spread above a 2% LIBOR form and results in an all in rate of 5% based upon our current corporate leverage. We believe we are compliant with all terms and conditions of our credit facility and are operating well within these established covenants.

GOV remains a well capitalized Company without material lease maturities or any debt maturities in 2010. We are nearly 100% occupied, and approximately 94% of our rental income is paid by the US government and four state governments. As a result, our cash flow is incredibly stable to pay a consistent dividend. In addition to our stable base, we ended 2009 with tremendous acquisition momentum and began 2010 with both a quality acquisition pipeline and significant access to capital as a result of our successful equity offering in January. We are both excited and confident with our ability to have a successful 2010.

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

Thank you. (Operator Instructions). Our first question comes from Brendan Maiorana of Wells Fargo.

Good afternoon. Just wondered if you guys can give us a little bit more color in terms of the acquisition pipeline? And I think you'd mentioned it briefly, but just in terms of what we may expect for acquisition volume for 2010? And then I guess in terms of cap rates, it sounds like the deals that you did in the fourth quarter and the pending ones for the first quarter of 2010, I'm assuming that's where we should expect for 2010 as well?

Yes, Brendan. This is Adam. In terms of cap rates, you're right. It's generally as we've been stating all along between 8% and 10%. Brand new buildings with long term US government leases are in the eights. A building that might be five or 10 years old, you got at least five or maybe 10 years of a renewal of the US government and looking at more like 9%. So it's somewhere in the 8.5% and 9.5% range is generally where we're seeing things. We might do an acquisition in the low eights, and hopefully we can do a lot of acquisitions in the high nines, but I think the sweet spots are between 8.5% and 9.5% is where we're finding stuff.

In terms of volume, I know why you're asking the question, and I can appreciate it, but it's hard to give you the exact feel for how much we might do. We have a lot of capacity and looking at a number of opportunities. And unfortunately, I wish they came nice and steady every quarter. We have $50 million or $100 million and very steady, but the truth is it's lumpy. We might go a quarter and not have an acquisition, and then in the fourth quarter we might suddenly do $100 million or $150 million in acquisitions in the quarter. But I could see 2010 being anywhere from $50 million to $75 million on a real low end conservative estimate to $300 million to $400 million as a high estimate, but maybe that's -- halfway through the year I'll tell you $300 million to $400 million is not such an aggressive number. It's just very hard to give you a specific sense on how much we'll do on acquisitions and growth. But we definitely have a lot of capacity as David said. Our leverage ratio is incredibly low at 6%. I don't think we'll keep leverage at 6% going forward or forever, so I think we have a lot of capacity to grow the Company, and that's what we're trying to do.

So yes, just in terms of the leverage, the deals that you guys did or you have in the pipeline and the ones that were completed in the fourth quarter were -- you can look at it as being funded with your equity, which your equity today on the applied cap rate basis is the implied cap rate is higher than the acquisition cap rate. So it's not being accretive to earnings today. If you choose to increase your leverage over time then you should hopefully be able to get accretion to the earnings line from those acquisitions. So when should we start to see -- if we see acquisition volume of a couple hundred million dollars, should we expect that you guys are going to fund that with debt, and where do you sort of see your target debt ratios trending over time?

I think the long term trend for debt would somewhere be one-third to maybe maximum would be 50%. But I don't think we'll be running at 50%. I think the more than long term average would be between one-third and maybe 40% leverage. The question how are we going to finance our growth, I mean -- I don't think it's unfair to say that we will probably be utilizing a little bit more leverage going forward, but that doesn't mean we're never doing an equity offering ever again. It just means that we'll be I think taking leverage up over time. And as I said, I don't think we'll be back at 6%. I can't see us being back at 6% any time soon or if ever.

Brendan, I think it's safe to say the first $40 million of acquisitions, we'll probably utilize the cash on our balance sheet.

Fair enough.

And then I expect that we will absolutely draw up the credit facility -- or draw down the credit facility, depending on how you want to look at it, to do acquisitions. We're buying our property substantially unincumbered, so we do have other debt options available to us to repay the credit facility besides going back and raising additional equity, which I think is important to keep in mind as we continue to grow the Company.

Sure, and then just in terms of the cap rates you provided, I'm assuming those are GAAP cap rates. Just is there, can you offer a sense of where the cash number may come out? And then how do you feel about the growth prospects, since the properties are largely fully leased up so there's not a lot of occupancy gain that can be had? How do you feel about the growth prospects of the rents relative to the existing rent growth that you may have in your current portfolio?

Well, the typical government lease has a flat rental rate. So in most cases, you're going to find one, that there isn't straight line rent and two, that your cash cap rate and your GAAP cap rate are substantially the same. The one property we did acquire in 2009 that has non-government tenants is the building at 915 L Street in Sacramento. So we'll have some straight line rent associated with that. But substantially you will see that there's very little difference between our GAAP and our cash cap rates.

As it relates to growth potential, our real growth potential is really going to come in outer years as we have lease maturities. We're not going to see a lot of increase in rental income in this portfolio, particularly as long as we stay in an economy with little to no inflation. We actually saw a handful of our properties had negative CPI adjustments in 2009, so there's very little inflation which as you know we can pass through expense increases based upon the regional CPI index. So as long as we continue to live in a low inflationary environment, there will be limited growth in this portfolio absent leasing activity.

Okay, that's helpful. And then can you just give us an update in terms of any CDC activity in Atlanta that may be going on either as it relates to your current portfolio or the potential for development opportunities from some of the projects at the RFPs that the CDC is looking at down there?

Yes, you're correct that the CDC does have an RFP out for three different buildings. They're looking at the RFP date, original date, and [when] they decide to basically, they basically extended the deadline to submit proposals. We've been told from the CDC that the space that they plan on utilizing will not be coming from the buildings where we have the CDC as a tenant. We're being told this is expansion space and it's taking some space from another landlord in the Atlanta area. That is what we have been told. So we've been told that our buildings and our occupancy by the CDC is safe. I suspect that the CDC will eventually, if they ever make a decision, will eventually build these three new buildings at someplace in the Atlanta area. But again, I don't think it's going to directly affect us. You've got to remember, the one constant when you deal with the government is that it grows. And so half of the space I think they're planning on building is what they project to be expansion space for as they grow, so I don't see it directly affecting us.

Okay, great. Thank you.

(Operator Instructions). Our next question comes from John Guinee of Stifel Nicolaus.

Hi, how are you?

Hi, John.

A question. Kind of the way as I think you guys know, the way the government lease world works is if you're dealing with first generation leases, first generation buildings, 15 year term, Washington DC -- that's a 6% to 7% cap. At the same time if you're going out and you're doing third generation leases, third generation buildings, kind of these third and fourth tier markets, that can be anywhere to a midteens cap or just unsellable. How are you guys -- where, and the other point here is that you can always generate near term earnings and accretive deals just by going out the risk curve, out the quality curve, lower quality buildings, shorter term leases than our markets. Where is your point at which you won't do a deal in terms of quality of the building, quality of the market lease term?

John, let me try to address some of what you were talking about and then I'll answer your question directly. When you think about our portfolio, I guess if you think about what we're buying and what we're looking at, most of it is either first generation or second generation, meaning it's their first renewal option on a government leased building. Now, typically, away from the DC market, simply as you said -- the DC market is probably the strongest in the country, although we have an existing portfolio there of -- about one-third of our rents come from that market. Nonetheless, growth, it's difficult to buy in that market accretively for us. So most of our deals are first or second generation government space and I'd say outside the DC area.

Now, you asked what would we not do? Well, I think when you start talking about third generation government space or buildings with short lease terms, those are typically deals we wouldn't do. There was one exception to my rule I just said which was Nashua, New Hampshire which we did in the third quarter and that was done at about an 11% cap rate. But we felt very good about the renewal there. But that being said most of what we're looking at is very well represented by the recent acquisitions which -- the building in Arlington Heights, Illinois, that building was built less than five years ago. It's first generation spaced leased to OSHA. The building that's in Lakewood, Colorado -- that building is about 10 years old. I'm sorry, second generation, it's 10 years old, second generation space, but it's -- GSA just signed a renewal there for 10 years. That's typically what we're doing and as you say, we're not -- in this market it doesn't feel like we have to go out the risk curve very far. Nor to be honest with you are we seeing a lot of deals or are we seriously underwriting a lot of deals that have anything less than a five year lease term on it. Most of the things we are looking at 10 if not more lease years in terms of lease terms, and again it's first and second generation space.

We're looking at a lot of properties that were build to suit for the GSA, John, and we found as we observe the market and talk to people in the industry -- the government, their average lease or occupancy in a build to suit is about 30 years. So even a build to suit opportunity in a tertiary market, if it's first generation space, there's pretty high probability that building will be occupied for a long time. And so we may differ a little bit on the risk associated with that building, but I think generally, we understand where you're coming from.

Great. Thank you.

Our next question comes from Gina [Gallon] of Banc of America.

Hi, good afternoon. Can you please give a little bit more color around the capital commitments towards tenant improvements and leasing costs? They seem to have gone up and I know you mentioned the DOE space. Is this most of it or is there other stuff going on there?

Well, we did spend -- or we committed $188,000 for the Department of Energy expansion space, and that's 14,000 square feet in I think roughly 100,000 square foot building. The building needed -- or the space needed carpet and repainting, and then we also had furniture and stuff that was existing in the building that required moving, so it's a fair amount of work done to make that space good for the Department of Energy. We also did it in conjunction with the expectation that we renew the Department of Energy in the remaining portion of that building. That is our one lease government lease maturity in 2010. It was a five year expansion with the Department of Energy, and they're currently looking at extending their 2010 maturity also to 2015. But another thing that I think you'll notice is you look at historical numbers for the Company, we have a tendency to see a lot of our repair and maintenance and building improvement dollars being end up being spent in the fourth quarter. We do our budgets in the third and fourth quarter. And as a result, we do see a lot of money or a lot of dollars end up getting spent in the fourth quarter. So if you go back and look at the dollars we spent in our supplemental in the fourth quarter of 2008 the same thing. It was not a lot in the first quarter, a little bit more in the second, a little bit more in the third but then a big spend in the fourth quarter, and again it's for stuff that you expect. It's carpet, it's painting, it's a lot of energy upgrades that we're focused on right now, putting in variable controls for HVAC units, putting in automatic switches for lighting controls, things like that.

Great. Thank you for the detail.

Our next question comes from Dave Rodgers of RBC Capital Markets.

Hi, this is Mike Carroll here with Dave. My first question is with regards to your acquisitions, can you give us some color on the competition you're seeing?

Sure. Some of these acquisitions -- to be honest with you, they're off market deals. They are deals where brokers don't necessarily have the assignment, but they know the seller or the owner of the building, and they approach us because they know we are by far one of the only buyers of buildings leased to the US government and we have capital. So some of these deals -- probably half the opportunities we look at today are I guess you'd call them off market deals, where they are being shown to us quietly by a broker who's gotten the nod from the owner that they can show it to us, but may not necessarily have a mandate to go out and sell the building. So I think just the fact that we have 6% leverage, $300 million of capacity, that's more advertising -- that's the best advertising we can do in the brokerage community than any retail ad we took out anywhere. So people know about us and they seek us out. Now in terms of the marketed deals, there are still marketed deals. There's still a handful of project buyers in the marketplace. We haven't really come up against another REIT I can think of in a meaningful way for some of these deals. Most of our competition has been private buyers.

Okay, are you seeing more opportunities on the federal or state governments?

Right now, I think it's still more federal that we see, but we know about there's a large portfolio in California that's supposedly coming to market some time this quarter or the second quarter. We know, it's widely publicized, CBRE has the listing, it's $2 million -- and it's $1 billion to $2 billion portfolio that they think -- that's their valuation on it. So we know there's big state portfolios that are out there. But the stuff we've been evaluating since we have been out on the road and raised our secondary have actually all been federal buildings, all buildings leased to the federal government.

Okay, I guess my last question is can you give us a quick update on the IRS lease in Fresno? How is that looking right now?

Not a lot new to report on that property. We have a meeting set up to meet with them next quarter, so the negotiations are moving forward in earnest. But at this point there's nothing really new to report other than we know that they haven't put out a RFP to build a new building, nor do they have other buildings of size and quality in the market that they can move to. So we feel like we're in a pretty good position to continue to negotiate with them, to find appropriate middle ground on where they want to be and where we want to be.

What we're really I think, well I think it's going to come down to is do they sign the renewal for five years, or can we somehow negotiate with them to enter into a new lease for a longer period of time? And so those are two of the options that we're kicking around thinking about.

All right, great. Thanks.

Our next question comes from Chris [Cayton] of Morgan Stanley.

Hi, good afternoon. David, I think you commented on G&A and your expectations for 2010. I heard you say fourth quarter there was $150,000 in pursuit costs included in there. Was also wondering if the additional capital spend in the fourth quarter lead to some business management fees that also were potentially above normal in the fourth quarter. And is the run rate then a little bit lower or are you baking in some acquisitions in the G&A, that sort of thing?

Yes, Chris, good question. I think the simple answer is our G&A probably, assuming no significant acquisition pace change, is probably in the $5 million range for a 12 month period. Yes, you did probably have some increased fees to RMR in the fourth quarter on some of the CapEx dollars that may have gotten spent, but I wouldn't necessarily find it extraordinary. But I think, as I look at what I think 2010 will look like on a G&A basis, what we had for -- what we reported for the 2009 is comparable to what I think we'll do in 2010.

Yes, and you also have a little pick up just because of portfolios outstanding.

That's right.

Okay, thank you.

At this time there are no further questions. I'll turn the call back to Adam Portnoy for any closing remarks.

Thank you all for joining us on our fourth quarter conference call. We look forward to our continued dialogue when we provide our first quarter earnings release in early May. Thank you.

This does conclude today's conference call. We thank you for your participation and have a wonderful day.