Office Properties Income Trust (OPI) 2012 Q2 法說會逐字稿

Good day, and welcome to the Government Properties Income Trust second quarter 2012 financial results conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Thank you, and good afternoon. Joining me on today's call are David Blackman, President and Chief Operating Officer, and Mark Kleifges, Treasurer and Chief Financial Officer. The agenda for today's call includes a presentation by management, followed by a question and answer session. I would note that the recording and retransmission of today's conference call is strictly prohibited without the prior consent of the Company.

Before we 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 other securities laws. These forward-looking statements are based on GOV's present beliefs and expectations as of today, August 2, 2012. The Company undertakes no obligation 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 normalized funds from operations or normalized FFO For reconciliation of normalized FFO to net income, and the components to calculate AFFO, CAD or FAD, are available on our supplemental operating and financial data package found on our 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 filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements. Now I would like to turn the call over to David Blackman.

Thank you, Tim. Before discussing our second quarter results, I wanted to acknowledge that yesterday, GOV's common shares traded down 4% on trading volume that was almost 30 times more than our 90-day moving average. We have been told by the New York Stock Exchange, our specialists, and several large institutional trading desks that GOV was one of approximately 150 companies affected by electronic trading technical issues at Knight Capital Group, a large designated market maker. While the NYSE elected to cancel transactions in 6 securities due to these technical issues, GOV was not one of these securities. At this time, we do not have any information on this situation, other than what has been made available to the public.

So let's review our second quarter results. For the second quarter of 2012, Government Properties Income Trust is reporting normalized funds from operations of $24.4 million or $0.52 per share, compared to $21 million or $0.52 per share for the second quarter of 2011. For the six months ended June 30, 2012, we are reporting normalized FFO of $49.5 million or $1.05 per share, compared to $40.5 million or $1.00 per share for the same period of 2011. Our 16% and 22% increases in normalized FFO for the quarter and six months ended June 30, 2012 is driven substantially by our accretive acquisition activity.

Since April 1, 2012, we have acquired 7 properties for an aggregate purchase price of $125.2 million. We also declared a $0.42 per share distribution in July. As of June 30, 2012, GOV owned 74 properties containing 9.1 million square feet. Our properties were 92.2% leased, for a weighted average remaining lease term of 4.8 years. The US Government remains our largest tenant, and combined with 10 state government tenants and the United Nations, account for almost 93% of our aggregate annual rental income. In addition to our strong property statistics, our balance sheet remains conservatively leveraged at approximately 35% debt to total book capitalization, and EBITDA covered interest expense 7 times. At quarter-end, our $550 million unsecured revolving credit facility had $27 million outstanding, making 95% of the credit facility available to support the Company's acquisition activities and other working capital needs.

During the quarter, GOV entered 14 leases for 206,000 square feet with a weighted average lease term of 4.7 years. This was approximately 20,000 square feet more than expiring leases during the quarter. Our leasing capital was $2.7 million or $2.74 per square foot per lease year. Approximately 160,000 square feet of our quarterly leasing activity was with 4 US Government agencies, and 1 state government agency. Our weighted average roll-up in rent with our government tenants was 10.9%, for a weighted average lease term of approximately 4 years, and leasing capital for our government tenants of $3.07 per square foot. The remaining 46,000 square feet of our second quarter leasing activity was with non-government tenants. Prospective leasing activity for our vacant space across the portfolio remains active. In addition, we are having active renewal conversations with tenants for leases expiring during the remainder of this year, and for our modest 2013 lease expirations. As a result, we remain optimistic that current dynamics with our tenants will result in high renewal rates at our properties.

Turning to acquisitions. As I mentioned earlier, since April 1, we have acquired 7 properties with 750,000 square feet for an aggregate purchase price of $125.2 million, excluding acquisition costs. The average purchase price per square foot for these acquisitions was $167. The average acquisition cap rate was 8.4%, and the average remaining lease term was 10.9 years at the time of acquisition. In June, we acquired 2 previously disclosed office properties in Everett, Washington, containing 112,000 square feet. These properties are 100% leased to the State of Washington, and occupied by 7 divisions of the Department of Social and Health Services for a remaining lease term of 8.4 years. The purchase price was $20.4 million, and the acquisition cap rate was 9.3%.

Also in June, we acquired a previously disclosed office property in Albany, New York containing 64,000 square feet. This property is 100% leased to the State of New York, and occupied by the Department of Agriculture on a remaining lease term of 6.8 years. The purchase price was $8.5 million, and the acquisition cap rate was 8.6%. In July, we acquired a previously disclosed office property in Stockton, California, with 22,000 square feet. The property is 100% leased to the US Government, and occupied by the Department of Immigration and Customs Enforcement for a remaining lease term of 14.7 years. The purchase price was $8.4 million, and the acquisition cap rate was 8.8%.

Finally, in July, we acquired 1 office property in Atlanta, Georgia, and another in Jackson, Mississippi, and 1 industrial property in Ellenwood, Georgia with a combined 553,000 square feet. These properties are 100% leased to the US Government, and occupied by the Department of Homeland Security, the National Archives, and the Federal Bureau of Investigation. The weighted average remaining lease term for this acquisition was11.5 years at the time of acquisition. The purchase price was $88 million, and the acquisition cap rate was 8.1%.

We are pleased with our acquisition momentum, and remain bullish on our ability to generate accretive growth through acquisitions. We also believe that our stable revenue continues to support our business strategy of providing a safe and predictable distribution to shareholders. I will now turn the call over to Mark Kleifges, our CFO to provide more detail on our financial results.

Thanks, David. First, let's review our consolidated property level operating results for the 2012 second quarter. Because of our acquisition activity, we once again experienced significant quarter-over-quarter increases in rental income and property net operating income. At the end of the 2012 second quarter, we owned 74 properties with 9.1 million square feet, compared to 64 properties with approximately 7.6 million square feet at the end of the 2011 second quarter. For the 2012 second quarter, GOV's rental income increased $8.2 million or 19% to $50.3 million, and property net operating income increased $4.5 million or 17% to $31.1 million compared to the 2011 second quarter. At June 30, our properties were 92.2% leased, and our consolidated NOI margin percentage for the 2012 second quarter was 61.9%.

Turning to our same-store operating results. While we experienced declines in occupancy, rental income and net operating income in our same-store portfolio this quarter, the declines were principally limited to 4 of our properties, and the direct result of the previously disclosed expiration of our leases with the Henry M Jackson Foundation at our Rockville, Maryland property in September 2011, and the previously disclosed first quarter 2012 expiration of our leases with the CDC in Atlanta, the DEA in Tucson, and the FBI in Phoenix. Excluding the impact of these expired leases, the operating performance of our properties this quarter was stable, with occupancy relatively unchanged. And slight increases in rental income and net operating income on a quarter-over-quarter basis, at the remainder of our same-store properties.

At quarter-end, our 58 same-store properties were 91.6% leased, down 4.6 percentage points from the prior year quarter but up 30 basis points from the end of the first quarter. Our 2012 second quarter same-store rental income decreased by approximately $2.2 million or 5.5% compared to the 2011 second quarter, but was up approximately $190,000 excluding the lost rental income this quarter from our 4 expired leases. The $2 million or 7.9% decline in quarter-over-quarter same-store net operating income was approximately $140,000 less than the NOI decline this quarter resulting from our 4 expired leases. Our same-store NOI margin in the 2012 second quarter declined 160 basis points from the prior year quarter to 61.2%, also as a result of these lease expirations.

Turning to our consolidated results for the quarter, EBITDA in the second quarter of 2012 was $28.5 million, compared to $24.2 million in the 2011 second quarter, a quarter-over-quarter increase of 18%. Our EBITDA to fixed charges ratio remained very strong at 7 times for the quarter, and our debt to annualized EBITDA was only 4.1 times at quarter-end. For the current quarter, normalized FFO was $24.4 million, compared to normalized FFO of $21 million for the 2011 second quarter. Second quarter 2012 normalized FFO of $0.52 per share was unchanged from the 2011 second quarter. During the quarter, we spent $905,000 on tenant improvements and leasing costs, and $1.9 million on improvements to our properties.

Turning to our balance sheet and liquidity, at quarter-end we had $471 million of debt outstanding, and our debt to total book capitalization was approximately 35%. As of today, after closing our 2 July acquisitions, we have $112 million outstanding under our $550 million revolving credit facility. In closing, GOV remains a conservatively capitalized Company with a secure cash flow stream, that we expect will allow us to pay a consistent dividend. In addition to our stable base, we remain optimistic about the Company's growth outlook growth for the remainder of 2012. With that, operator, we are ready to open up it up for questions.

Okay.

(Operator Instructions).

Your first question comes from the line of Mitch Germain from JMP Securities. Please go ahead. Mitch Germain, your line is open.

Hi, how are you?

Hi, Mitch.

I saw that the lease duration on the recent acquisitions seemed to be a little shorter than what we have normally seen out of you. Is that a function of the product that is available for sale right now?

Are you talking about lease renewals or for the acquisition?

On the acquisition, I think it was what, about a five-year average term? Meaning -- (multiple speakers)?

Yes, I think it was a little bit longer than that, Mitch. Let me go back and look (multiple speakers) real quick.

A little longer than that? Okay.

Real quick.

Weighted average remaining lease term was 10.9 years.

Yes.

Oh, okay. Sorry about that. I must have misheard you then, my bad.

Yes.

Can I get some details then, on the investment pipeline, please?

Sure. We got -- we got a handful of deals in the acquisition pipeline. They tend to be weighted right now towards GSA deals. What we have been finding over the last 90 days or so, is more GSA deals. They tend to be relatively new generation properties that were build-to-suit, and they tend to be owned by developers or institutional investors. So we are evaluating a number of deals, and in most cases we feel like the properties can be accretive to our portfolio, assuming we can buy them at the right price.

Have you changed your underwriting criteria at all over the last year?

We really haven't changed our underwriting criteria. I think the one thing that we have looked at, because we have had the opportunities to buy some properties at higher cap rates, in the high 8%s and 9%s, we think it provides us an opportunity to take a bit of a bar bell approach with acquisitions and take advantage of some of the high 7%, low 8% opportunities with long-term GSA leases. So, we were probably a little more aggressive on some of these longer-term GSA properties, than we were maybe six months ago. But we are still really focused on average cap rates in that 8% to 9% range.

I apologize, David, I missed your prepared comments. How would you characterize the leasing environment these days?

I am very pleased with the lease environment right now. Last quarter when we did our call, we had plus or minus 150,000 square feet of prospective leases in our pipeline, that were anywhere from, proposals outstanding to LLIs being negotiated, to leases being negotiated. At the end of this quarter or today, that number is close to 300,000 square feet. And that's after executing one of those leases that we talked about last quarter, and one of the larger leases actually going away completely.

So I feel pretty good about the activity. I mean, we're seeing good activity at 1401 Rockville Pike. We are seeing good activity at 330 South 2nd Street in Minneapolis, and we're seeing activity at Ruffin Road in San Diego, which is a property we acquired that had almost 50% vacancy. I think that is all good and I'm pleased with the rates, and the quality of the tenants that we're having conversations with.

And last quarter, I think you mentioned about 100 bps of potential occupancy decline, that you had seen in -- of the rest of the year. Where does that stand now, in terms of how you feel about the remaining renewals (technical difficulties)?

We feel pretty good. I would say maybe it would round up to 100 bps, but the real number is less than that. And we will -- we don't have anything to disclose in terms of tenants we don't expect to renew leases that we haven't previously talked about. So, and on top of that, our conversations with tenants for our expirations for the remainder of this year and then going into 2013, have become more positive over the last couple of months. So, we are very pleased with the prospect of continued renewals across our portfolio. So, I think that's all very good.

Thank you.

(Operator Instructions).

Your next question comes from the line of Michael Carroll. Please go ahead.

Hi. How are you thinking about your exposure to the Federal and State governments right now? What's the ideal breakout between the two, and where do you see the better opportunities at?

Well, today, we're probably 65% US government. And I would guess that, we want to be somewhere between -- I guess Mark's telling me we're 73% on an NOI basis. So we want to kind of between that 65% and 80% band for US Government leases. We have had some interesting opportunities -- acquisition opportunities with state governments. Today, we really don't have much in the way of state leased opportunities in the portfolio. So I think it's an opportunity for us to continue to kind of grow our GSA exposure.

What's the pricing difference between the two right now?

The difference, if you have properties with identical leases, maybe 50 basis points in a cap rate. The real differentiation between cap rates in this market today is on lease terms, and the break point tends to be 10 years. So, for a property that's less than 10 years leased, you are going to get a much higher cap rate than one that is 50 to 20 years lease.

With the leasing activity in your, I guess your non-government bucket, was that with an existing tenant? And how do you think about doing leases with non-government tenants?

Well, we lost the Henry M Jackson Foundation at 1401 Rockville Pike in the fourth quarter of 2011. It was roughly 60,000 square feet, and we have backfilled part of that space with another non-government tenant, a roughly 21,000 square foot lease was exercised during the second quarter in that location. That's a building that is roughly -- when we acquired that building, it was roughly 60% government leased, 40% non-government leased. So, it's always had a number of non-government tenants in it. Basically what we are doing is we're replacing a non-government tenant with another non-government tenant.

So, I think the good thing about our strategy is we have no limitations on leasing vacant space to government tenants. And in today's environment, it makes sense for us to look at both government and non-government tenants for our vacant space. As we get buildings that are no longer majority leased to government tenants, we will consider whether those should be disposition opportunities for the Company. But we want to maximize revenue and maximize leasing. So, we are going to look at the full range of potential tenants for our vacant space.

David, I believe you said in your comments, and correct me if I'm wrong, that you had good renewal opportunities with meaningful rental rate bumps. If I'm hearing that correctly, can you give me some color around that? Maybe the magnitude or the location of those types of leases?

Yes, I don't think in my prepared remarks I mentioned anything about rental rates. But I think -- when I look at the leases that are expiring for the rest of this year and into the 2013, and I look at where we are negotiating renewals, we are approximately flat to slightly up across the portfolio. We have a handful of leases that we are negotiating, where we are going to have rolldowns.

We are expecting large rollups at 20 Mass Avenue and that is going to offset some of the rolldowns we might get elsewhere in the portfolio. What we experienced last quarter was a 10.9% rollup in rents with our government leasing activity. I don't expect that to continue in perpetuity. But I do feel like we have enough opportunities to grow rents with some of these expiring leases, that we are going to be up, you know, between now and the end of 2013.

Very good. Thanks, guys.

Yes.

Your next question comes from the line of Young Ku from Wells Fargo.

Yes, thank you. David, could you give us the cash cap rate, weighted average cash cap rate for the acquisitions you guys made?

Young, we have never disclosed those, and I don't think that is something we want to start doing. We focused on the GAAP rate, and we disclosed that in our supplementals. And I think that's probably where we want to continue our disclosures.

Okay. I mean, the reason being, if you're talking about 8.4% GAAP cap rate, and call it maybe 50 basis points lower for a cash cap rate, and another 50 bps for your base management, I am just trying to see if I can get your thoughts on, of where your cost of capital is, versus where you are investing your money today?

Well, in many respects, our leases tend to be flat over the lease term. So you are not going to see -- it's going to be rare for there to be a 50-basis point differential between cash and GAAP rates in our Company.

Okay, that's fair enough. I know this isn't something that you typically do, but given where your stock is trading and the implied cap rate, I mean I would think that the stock be would be better used for the capital, versus buying new assets, with essentially no growth at these types of yields.

Are you suggesting that we should use our capital to buy back shares?

That would be a better economic choice then -- I would think so. I am just wondering what your thoughts are.

Yes, I -- for companies like REITs that have to pay out substantially all their taxable income, it really doesn't make sense to use your capital to buy back equity. If I thought I could buy back equity, I guess at substantially lower prices than where I could issue it later, maybe that makes sense. But I think that, that's a risk proposition that we have not entertained, and don't feel like it makes sense for us to entertain. We are a Company that owns real estate, and wants to grow through accretive acquisitions. When you look at our cost of capital long-term, we have the ability to do that.

Got you. Fair enough. Just one last question from me, I noticed just a few quarters ago, I think that you talked about 20 Mass at renewal, maybe rolling up rents, by around $10 a square foot. Given what's going on in DC, I'm just wondering what the update is on that, kind of rent bump?

We just executed last quarter, a lease at 625 Indiana Avenue at $49 a square foot, and our rents at Mass Avenue are between $36 and $40. So I think we still feel good about that.

Got it. Thank you.

Your next question comes from the line of Jamie Feldman from Bank of America Merrill Lynch. Please go ahead.

Hi. This is actually [Ji Sang] here from -- I'm here with Jamie. Just a follow-up question on the expirations, can you walk us through each of the large specific expirations you still have for the rest of '12 and '13? Then just give us some update on how your conversations are going for each of the large expirations?

I can. 20 Mass Avenue, we have got two tenants in there, one expires in September, the other one in October, and we are negotiating renewals with both of those tenants. Lakewood Corporate Center, we have 3 buildings leased to the National Business Center. Those leases expire at the end of August, and we are also negotiating a renewal there, and expect to have executed leases probably in September.

I think the next one would be the FDA at 1401 Rockville Pike. That lease expired at the end of September, and we have already executed an early renewal with them, at a roll-up in rents. At Oklahoma City, we have got the IRS in that facility. We are deep in negotiations with them, and several other agencies that they sublease to at that property.

The -- we have got the South Carolina Department of Labor Licensing in Columbia, South Carolina. They have a lease expiration at the end of August. Initially, they had told us, and I believe we've disclosed this to the market, that they were going to stay through year end, but wanted to consolidate into a State-owned property. They have realized they have no space available in State-owned properties, and we are now negotiating a renewal with them.

We have another State of South Carolina tenant in Columbia, South Carolina, and we executed -- that lease matured at the end of August -- or matures at the end of August. We have executed a renewal with them. And then we had two tenants at 330 South 2nd Street that had lease expirations July 31, and we have executed leases with both of them. Those were both GSA tenants. That really hits all of our 2012 remaining lease expirations.

And no expected move-outs from any of these -- these larger expirations, it sounds like that?

That is correct. I mean, we had disclosed last quarter a couple of tenants that we expected not to renew, and there is absolutely no change to that list.

Do you have any large expirations in 2013?

In, 2013, we've got the US Postal Service in Nashua, New Hampshire, that 321,000 square feet, and we have a lease out for execution to renew that for five years. We have two buildings in Richland, Washington that are leased to the Department of Energy, and we are pretty deep in a negotiation for a renewal for those properties with the Department of Energy. That's actually October of '13, so we have got a long way, away for that one.

We've got the CDC in Atlanta in three buildings, I believe, that have renewal -- that have expirations in April, and we are having conversations on all three of those buildings for renewals. And then in January of next year, we have got a lease with the State of Maryland that expires, and we have a lease out for execution with them right now. And then the last one would be, we have the Department of Justice at -- in Buffalo, New York, and we are currently working through the renewal process with them as well. So we got -- I think we have got 7.2% of our rent subject to lease expirations in 2013. And as we sit today, we don't have any tenants that we expect would move out, or not renew in place.

Okay. I'm sorry, just one more follow-up on this topic. The about 100 basis points occupancy loss you expect towards the end of 2012, those are just from the smaller vacancies, not any larger blocks?

That's right. We have got a tenant in 330 South 2nd Street that we knew was going to move out. They represent about 2% of rents. We had a law firm in Memphis that represented about 0.3% of rents that has moved out. Then we have got a law firm in Sacramento that represents about 2% of rents that we talked about previously. And we are actually in discussions with another tenant in that building to actually take all that space. And so, yes, they are all, they are all less than -- actually they are all less than 0.5% of revenue.

Thank you.

Your next question comes from the line of Dan Donlan from Janney Capital Markets. Please go ahead.

Thank you, and good afternoon.

Hi, Dan.

So -- one to the GSA. I am just kind of curious, they have been on Capitol Hill and they have been under fire recently. Is this kind of much ado about nothing, in terms of how it impacts your ability to negotiate leases with them?

Not really. I mean, anything that is a prospective level lease -- so in kind of broad terms, any lease that has annual rent of more than $2.5 million has to be approved by the Office of Management and Budget, and both the Senate and the House. Those leases are taking significantly longer to work through, because of a lack of focus in Washington.

I mean, a good example is the Lakewood Corporate Center. We have got 212,000 square feet in Lakewood, Colorado, that is leased to the National Business Center. Two of those three leases are prospectus level, and we have been negotiating over a year to get those done. We are probably end up executing a lease for renewal, 30 to 60 days after the expiration. So it gets done, but it takes much more effort and more time on our behalf to get it done.

Okay. And then, has any of the negative rhetoric, has that pushed up cap rates at all? Or have you started to see maybe more people start to move to the sidelines from the acquisition side, is becoming less competitive? What is your view on investment activity?

I think a lot of investment activity today is being driven by leveraged buyers. You can get 10-year secured financing today at 70% leverage at 4%. So, you can buy a property at 6% cap rate, and get a 200-basis point positive spread on your investment. So, if rates -- if interest rates and borrowing costs weren't as low as they were, you would probably see some pressure on cap rates. But because of the inexpensive capital to borrow money, the acquisition market continues to be pretty aggressive. So, we have had to be selective, on what we want to acquire.

Okay. And then just, how do you think about equity on a going-forward basis? Given where your stock price is, you would seem to be pretty dilutive to issue down here. What is your view on using debt or equity?

Dan, this is Mark, I think where we sit today, I think we would have to look at debt. We are obviously not real excited about where the stock price is, from a new issuance standpoint. We still have about $440 million available on a revolver today. So there's no pressure to raise additional capital. And while we are getting close to bumping up against that 40% debt-to-total book capitalization that -- where we want to run the Company on a long-term basis, we are comfortable going above that for a period of time. So -- so I don't think -- until we see the stock price get to a more reasonable level, we are probably going to be looking to finance acquisitions on the revolver.

Okay. Makes sense. That's it for me. Thank you.

Thanks, Dan.

And at this time, there are no further questions. I would like to turn the call over to David Blackman.

Thank you for joining us on our second quarter conference call. Mark and I will be attending the Bank of America Merrill Lynch Real Estate conference in September, and hope to connect with many of you at that conference. Thank you.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation, and for using AT&T executive teleconference. You may now disconnect.