Office Properties Income Trust (OPI) 2012 Q3 法說會逐字稿

Ladies and gentlemen, good day and welcome to the Government Properties Income Trust third-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 the Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Thank you. Joining 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 the 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 written 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, October 30, 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 in 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.

Thank you, Tim.

For the third quarter of 2012, Government Properties Income Trust is reporting normalized FFO of $25.6 million, or $0.54 per share, compared to $23 million, or $0.51 per share for the third quarter of 2011. For the nine months ended September 30, 2012, we are reporting normalized FFO of $75.1 million, or $1.60 per share, compared to $63.5 million or $1.51 per share, for the same period of 2011. Our 11% and 18% increases in normalized FFO for the quarter and nine months ended September 30, 2012, is driven substantially by our creative acquisition activity.

Since July 1, 2012, we have acquired, or entered into an agreement to acquire, nine properties, for an aggregate purchase price of $167 million. We also declared a $0.43 per share distribution in October, which is a $0.01 per share increase in our previously quartered distribution rate. And also in October, we sold 7.5 million common shares in a public offering, raising $167 million in net proceeds.

As of September 30, 2012, GOV owned 82 properties containing 10 million square feet. The properties were 92.4% leased, for a weighted average remaining lease term of 5.4 years. The US government remains our largest tenant, and combined with 10 state government tenants and the United Nations, account for almost 94% of our aggregate annual rental income. In addition to our strong property statistics and pro forma for our October equity offering, our balance sheet is conservatively leveraged at 30% of total book capitalization, and our $550 million unsecured revolving credit facility has zero amounts outstanding, providing us substantial capacity to make accretive acquisitions, and to fund working capital needs.

Turning to leasing activity -- during the quarter GOV entered 10 leases for 312,000 square feet, with a weighted average lease term of 9.3 years. We had approximately 49,000 square feet of negative absorption during the quarter, most of which was associated with non-government tenants, and substantially all the non-renewals have been discussed on previous earnings calls. Our commitments for leasing capital were $6.7 million, or $2.32 per square foot per lease year. Approximately 260,000 square feet of our third-quarter leasing activity was renewals for four US government leases, and one state government lease.

While rental rates for our aggregate leasing activity for the quarter was substantially flat, our weighted average rental rates with our government tenants rolled down 4.2%. Our weighted average lease term was approximately 9.4 years, and leasing capital for our government tenants was $1.51 per square foot per lease year, roughly 35% less than the leasing capital per square foot per lease year, for our aggregate quarterly leasing activity. The remaining 52,000 square feet of our third-quarter leasing activity was with non-government tenants, including a 47,000-square foot new lease for space we acquired vacant.

Prospective leasing activity for our vacant space across the portfolio is robust. We are also having active renewal conversations with tenants for leases expiring during the remainder of this year, and for all of our 2013 lease expirations. As a result, we are optimistic that current dynamics with our tenants will result in a high renewal rate at our properties.

Turning to acquisitions -- since July 1 we acquired eight properties with 843,000 square feet, for an aggregate purchase price of $152.1 million, and have one property under agreement to acquire with 78,000 square feet, for an aggregate purchase price of $14.5 million, all excluding acquisition costs. For these eight previously-disclosed properties we acquired during the quarter, the average purchase price per square foot was $181, the average acquisition cap rate was 7.9%, and the average remaining lease term was 10.6 years. In July, we acquired an 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 $8.3 million, and the acquisition cap rate was 8.8%.

Also in July, we acquired a three-property portfolio consisting of one office property in Atlanta, Georgia; another office property in Jackson, Mississippi; and one 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 FBI, and the National Archives. The weighted average remaining lease term for this acquisition was 11.5 years, the purchase price was $88 million, and the acquisition cap rate was 8.1%. In September, we acquired three office properties in Boise, Idaho, with a combined 181,000 square feet. These properties are 100% leased to the US government, and occupied by the National Resource Center and the Department of Homeland Security, for a weighted average remaining lease term of 9.4 years. The purchase price was $40.2 million, and the acquisition cap rate was 7.4%.

Also in September, we acquired an office property in Kansas City, Missouri, with 87,000 square feet. The property is 100% leased to the US government, and occupied by the FBI for a remaining lease term of six years. The purchase price was $15.7 million and the acquisition cap rate was 7.5%. Finally, in November we enter into an agreement to acquire an office property in Windsor Mill, Maryland, with 78,000 square feet, for $14.5 million. The property is 100% leased to two tenants, of which 90% is leased to the US government, and occupied by the Centers for Medicare and Medicaid. The acquisition remains subject to our satisfactory completion of due diligence, and other customary closing conditions, and as a result we can provide no assurance that we will acquire this property.

In September, Congress passed the Public Buildings Reform Act of 2012, which is intended to improve the efficiency of federal space, reduce the size of the US government footprint, eliminate waste, and increase transparency and accountability. The bill encompasses both owned and leased space, and includes the following relevant components -- the requirement that the GSA offset any requests for new space with an equal reduction of space through 2016; the requirement that GSA reduce space inventory by 1 million square feet a year for three years, which is less than a 1% reduction in the US government's aggregate space utilization over that three-year period; the creation of a maximum rent for below-prospectus level leases; and the requirement to notify Congress of any build-to-suit project that has not historically required Congressional oversight.

By and large, we see little risk to our business model from these new Congressional oversights for US government real estate. In fact, we are encouraged by the new below-prospectus level Congressional approval for build-to-suit projects, which further strengthens existing landlords' ability to renew tenants in place. Considering that we own less than 3% of the US government-leased space, we remain bullish in our ability to continue to generate accretive growth through acquisitions, while supporting our business strategy of providing a safe and predictable distribution to our shareholders from a stable revenue.

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 third quarter. Because of our acquisition activity, we once again experienced significant quarter-over-quarter increases in both rental income and property net operating income. At the end of the 2012 third quarter, we owned 82 properties with 10 million square feet, compared to 67 properties with 8.3 million square feet at the end of the 2011 third quarter. For the 2012 third quarter, GOV's rental income increased $8.2 million, or 18%, to $54.1 million, and property net operating income increased $4.9 million, or 17%, to $33.7 million compared to the 2011 third quarter. At September 30, our properties were 92.4% leased, and our consolidated NOI margin for the 2012 third quarter was 62.2%.

Turning to our same-store operating results, at quarter-end, our 64 same-store properties were 91.9% leased, down 4.6 percentage points from the prior-year quarter-end, but down only 20 basis points from the end of the 2012 second quarter. Our 2012 third quarter same-store rental income declined by $1.9 million, or 4.1%, compared to the 2011 third quarter, and our same-store net operating income declined by $1.2 million, or 4.3%, compared to the 2011 third quarter. Our same-store NOI margin in the 2012 third quarter declined 10 basis points from the prior-year quarter, to 62.6%.

GOV's quarter-over-quarter same-store operating results continued to be negatively impacted by the expiration of our lease with the Henry M. Jackson Foundation at our Rockville, Maryland, property in September 2011, and the 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, our same-store operating results this quarter were generally stable, with occupancy relatively unchanged, and slight increases in rental income and net operating income on a quarter-over-quarter basis.

Turning to our consolidated results, adjusted EBITDA in the third quarter of 2012 was $30.1 million, compared to $26.1 million in the 2011 third quarter, a quarter-over-quarter increase of 15%. Our EBITDA to fixed charges ratio remained very strong at 6.7 times for the quarter, and our debt to annualized EBITDA was 5.1 times at quarter-end. For the current quarter, normalized FFO was $25.6 million, compared to normalized FFO of $23 million for the 2011 third quarter. Third-quarter 2012 normalized FFO per share of $0.54 was up $0.03, or 6%, from the 2011 third quarter. During the quarter we spent $4.4 million on tenant improvements and leasing costs, and $3 million on improvements to our properties.

Turning to our balance sheet and liquidity, at quarter-end we had $611 million of debt outstanding, and our debt to total book capitalization was approximately 41%. In October, we sold 7.5 million common shares in a public offering, raising net proceeds of approximately $167 million that we used to repay all amounts outstanding under our $550 million revolving credit facility. As adjusted for this equity offering, our debt to book capitalization at the end of the third quarter was only 30%.

In closing, GOV remains a conservatively-capitalized company with 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 opportunities for future growth.

That concludes our prepared remarks. Operator we are ready to open it up for questions.

(Operator Instructions)

Michael Carroll, RBC Capital Markets.

It sounds like the Company is having some good traction retaining its government tenants. But, maybe not as good of a traction with non-government tenant. Is that a fair comment to say, and do you expect that to continue?

I think that is generally a fair comment, Mike. We have a much higher -- as in most companies, you have more turnover with non-government tenants than you do with government tenants. And so, I don't think it's any different in our portfolio. The big difference is that the non-government tenants are a small percentage in our buildings, and a very small percentage across the portfolio.

And can you give us a sense of the rest of your non-government tenants lease-maturity schedule over the next couple of years? Is it meaningful in any way?

It is not meaningful. For the remainder of this year, we have basically six leases that are still subject to expiration, or we are working on renewals with. They are all government tenants. So we don't have anything, really, for the rest of this year. Next year we only have about 6.7% of our revenue subject to lease expiration, and as that is substantially all government tenants. We've got a couple of small non-government tenants, but they tend to be 1,000 square foot to 3,000 square foot tenants.

Okay. Dave on your last call, I believe you indicated that leasing activity nearly doubled from 1Q to 2Q. How has it gone from 2Q to 3Q?

Are you talking about prospective leasing opportunities?

Exactly. Yes.

Yes, we continue to have above 300,000 square feet of prospective leasing activity across the portfolio. It tends to be a mix of both government and non-government tenants. So, that is up slightly from what it was in the second quarter. We have converted some of the prospects that we had in the second quarter to either letters of intent, or have leases out for signature.

We have got a few leases that we actually executed. So, I'm pretty optimistic that we are going to have -- continue to have positive absorption in our vacant space, and we are starting to begin to lease some of the space that we acquired vacant, which I think is really positive because that is accretive to our numbers.

Great. And then, can you remind me how GOV insures its properties? Didn't GOV make a small investment in an insurance company a few years ago?

Yes. We -- roughly 15% of Affiliates Insurance Company, which is basically an equal percentage of all the RMR-related public companies to include the REIT management. I'm assuming where you're going is, what the effects of Hurricane Sandy was on insurance?

Yes, exactly.

And (inaudible) loss. At this point, I think it's too early to tell. We obviously, across the RMR franchise, have a number of properties in Pennsylvania, Delaware, upstate New York, and I have not heard a report at this point in terms of damages and potential loss.

So then, I guess GOV and the RMR companies basically self-insure their portfolio? Is that fair?

No, it is only for a certain layer of the insurance company -- insurance coverage. Most of the catastrophic-type coverage in the larger loss amounts have been seeded out to not-related insurance companies.

Okay, perfect. Thanks.

Jamie Feldman, Bank of America.

Thank you. I was hoping we could talk a little bit more about some of your big expirations and just get an update. I think it is a question I ask every quarter. So, do you want to just go through the big ones and whatever you don't hit I can follow-up -- like, 20 Mass Ave., USCIS, the usual?

Yes. So, 20 Mass Avenue is really, I mean that represents 6% almost 7% of our rental income, and that is in expiration for the rest of the year. It is basically two leases. The Department of Justice is working through the approval of a prospectus. They are downsizing -- well, let me say that differently.

US Custom and Immigration Services is the other tenant in that building, and they were occupying roughly 12,000 square feet that was leased to the Department of Justice. And so, we are working through documenting a formal lease with USCIS to take the space that they have actually been occupying, but was leased to the Department of Justice. And then, DOJ doesn't have an approved prospectus yet, so they are working through an approval. Likely going to be somewhere around a five-year renewal with virtually no capital other than lease commission.

Expectation is that DOJ will ultimately exit this property so that USCIS can occupy 100% of it. And so, obviously, we are working with USCIS on their renewal as well, creating flexibility for them to continue to grow as DOJ expands. That is probably what is taking the most time in working through this renewal is trying to orchestrate USCIS taking 100% of the property without -- with minimizing the level of downtime that we might have in the building.

At this point, we are optimistic that we will have no downtime. The good news is, we are likely going to have close to a 40% rollup in rent, and I suspect that we will get USCIS' lease executed this year. But, Department of Justice probably will probably end up in holdup where we won't get that done until next year.

And, they both have 40%, or is one of them driving it?

No, we are basically currently negotiating equal increases in rent.

All right. And then, moving onto the next, what is your next largest, next year? Next year, our largest lease expiration is the US Postal Service in Nashua, New Hampshire. And, that lease is out for execution.

We expect to have that back; it is basically a five-year renewal, rolldown in rent. But, when we acquired the property I think we paid almost a 12% cap rate, knowing that we would have an above-market lease and that we would have a rolldown at renewal. So, nothing real new, there. And then -- go ahead.

What is the percentage rolldown?

The percentage rolldown is around 30%. And, actually, I say that was our largest maturity. I think, actually, our largest expiration is the Department of Energy in Richland, Washington. They occupy two buildings in Richland, and we are currently negotiating a longer-term renewal with them. So, we are pretty comfortable with the direction that it is heading. And, I think our rent there will be slightly down to flat.

Okay. And then, just going through a couple more here. So, the National Business Center?

National Business Center, that lease was renewed for 10 years.

Okay.

Yes, it was substantially flat -- substantially flat lease.

So, not the 5% gap rent rolldown that you have been talking about?

That was a part of the third-quarter leasing activity and part of that rolldown was from them.

All right, so that's already baked in.

Yes.

Any IRS in Kansas?

IRS in Kansas is in negotiation at this point. Or excuse me IRS is in Oklahoma City, not Kansas.

I'm sorry, 158,000 square feet?

Yes, yes. We are currently working with them on renewal. One of the challenges of that lease, like some of the others, is there are four other agencies that occupy space as part of the IRS lease, and the IRS wants us to go direct with those other agencies. So, we are managing through that process. The complicating factor is we've got three different contracting officers that we are working with to manage that renewal. But ultimately, we expect a pretty healthy rollup in rent with that lease renewal.

Okay. Yes, I think in the past you've talked about $2 to $3 a foot? That's still pretty good?

Yes, that lease was a pretty odd lease. It was a 20-year lease, and at 10 years there was a substantial rolldown in rent, and that substantial rolldown took it well below market. So, we are now working through getting it back up to that market rental.

And then, Rockville?

Rockville, we have renewed the FDA in their space. That was a second-quarter lease renewal, and that was a 7.5% rollup in rent.

That's already baked into the third-quarter number?

That was actually -- that was a second-quarter renewal. So, that -- we had a full benefit of that for the third quarter.

Any others that you are waiting on or that are stuck in government limbo at this point?

Not really.

Can you pull the numbers going forward?

Not really. We are working through the CDC for renewals next year, for a few of their buildings. But, we are not really waiting on Congressional approval at this point for any leases where we have reached an agreement on business terms. I'm sure as we get closer to some 2013 expirations, we may have some issues.

But, for example, Richland, Washington, with the Department of Energy, that's an October 2013 expiration. And then, the other near-1% lease expiration is the Department of Justice in Buffalo, New York, and that is a December 2013 expiration. So, we don't have any real front-end-loaded stuff that we are worrying about a potential holdover right now.

Okay. And, the Postal Service in New Hampshire in February, you said you do expect a slight rolldown? Or, that's flat?

No, that's -- were expecting around a 30% rolldown in rent there. But, again, that was the one that we -- we acquired this thing at near 12% cap rates, and expected that as part of a renewal.

Okay. And then, just thinking about the acquisition pipeline, how big is it right now? And then, I know you just raised capital and you said your credit line is clear, but what do you think is you're capacity at this point before you need more capital?

I think our capacity is a lot. Mark?

Yes. Our debt-to-book capitalization post-equity offering is down to 30%. That gives us, probably, roughly $250 million of acquisition capacity before we bump up against the 40% debt-to-total-book-capitalization. So, we've got a lot of dry powder, if you will.

Okay. And then, what is the pipeline right now?

The pipeline is pretty good. It's about what it normally is. Although, the interesting thing is it is, substantially all federal leases today. We really don't have much in the way of state in there at all. But, we've got some deals that we like where we are working through a strategy on how we might offer on those. So, I think it's helping.

Okay. And then, finally, you had mentioned it seems like you're getting more rent rolldowns in government. Is there something going on with government leasing in general that you are seeing more pressure, or those were just lease-specific in the quarter?

I think it is lease-specific. There is some markets around the country that are weaker than others. For example, we have more pressure in Lakewood, Colorado, just because there is a fair amount of vacant space in that market. So, I wouldn't necessarily read it into a broad US-government issue, but more as a market-specific, in terms of where we had lease expirations.

And, I assume it's harder in the secondary and B-markets? Is that a safe assumption?

Yes, some of the secondary markets where there are -- it has got to be good news, bad news. There aren't always good buildings that the government could move to. But, even if they don't have the ability to move, you still have to be mindful of what market rents are in that particular market area.

All right. Thanks.

Chris Caton, Morgan Stanley.

Just wanted to follow up on Jamie's questions on leasing. Can you talk a little bit about the CapEx required to lease the vacant properties that you are working on now, versus renewals? So, how should we expect maintenance capital to trend both leasing, TIs, et cetera, for 2013. Or, just in general in the near term?

Well, maintenance capital, we are still thinking about capital in that $0.50 per square foot across the portfolio for replacing HVAC, doing elevator modernizations, and our energy initiatives. So, no real change on maintenance capital.

And, the answer to your question about tenant improvement dollars for vacant space is, it depends. Every building is a little bit different. Some buildings have space that are in better shape than others. And some buildings require a level of building improvements, in addition to tenant improvements, in order to make it ready for a new tenant.

So, generally I would say that we should expect $30 to $40 a square foot, potentially, for tenant improvement dollars for leasing vacant space. It could be as low as $20 a square foot; it could probably be as high as $50 a square foot. But, it really depends on the specific building and that market. And, that would be for probably a seven-year type lease.

Great. And then, leasing capital would be on top of that? Do you generally have brokers involved in the transactions?

Generally there is a broker involved in the transaction. We have a broker that represents us; a lot of tenants these days come to us being represented by a broker. So, that commission fee is as high as 6%.

Okay.

But, when we talk about leasing capital, we talk about tenant improvement dollars, as well as lease commissions.

Great. And then, I want to come back to Hurricane Sandy. Can you describe how you are insured against the disaster, recognizing that it seems like it doesn't flow through to the insurance company you own, but can you just describe your insurance?

We have a layered insurance program. Our insurance program is a layered-risk program where we have, basically, an insurance broker that advises us on how to distribute the risk across various insurance companies.

Affiliates Insurance Company, which is the company that we own a percentage of, takes a level of risk in that entire risk-sharing arrangement. Their risk tends to be backed by cash deposits, and we have a lot of capital in this company to support its regulatory requirements and potential losses. So, most of the risk that we have is insured by A.M. Best -- A-or-better-rated insurance companies. It just happens that we own a company that takes a small portion of that risk-sharing agreement. Is that --

Right. And GOV's income statement impact will be limited to any deductible that we have at a specific property.

Right.

Great. And then, last question for me on the acquisition pipeline. We're hearing pricing differential on properties, like the given lease term, say, below or above 10 years. Are you still seeing that? And, if so, where does GOV want to be across that price differential? Or where's your acquisition pipeline across that price differential?

I agree with your comment that US government-leased properties with 10-year-or-greater remaining lease duration tends to have more aggressive cap rates. You can see we had two cap rates -- two acquisitions during the quarter that were mid-7%s for cap rates, which is pretty aggressive for us. We offset that with a couple of acquisitions that had 8% and high-8% cap rates. And, I think that is the way you will see us look at acquisitions.

There is the analysis around any individual acquisition, relative to your cost-to-capital. But, we also want to look, on a portfolio-basis, are we taking the appropriate level of risk relative to lease expirations, and getting the appropriate yield across, call it, 5 to 10 acquisitions, versus just an individual property acquisition?

So it's -- you're comfortable being on either side of that 10-year term?

We are comfortable being on either side of that 10-year term. Where you see us do acquisitions that have less than a 10-year duration, you should expect that we have done a fair amount of diligence around our expectations on renewal for that government. If we don't feel like the renewal for that government tenant is 100% or near 100%, we likely won't make that acquisition. So, there is probably first- or second-generation space that is approaching the end of its primary-lease term, where we think there is a high probability that they will remain in place.

Great, David. Thanks very much for your comments.

(Operator Instructions)

There are no further questions in queue, and I would now like to turn the conference call back over to Mr. David Blackman for any closing remarks.

Thank you all for joining our third-quarter conference call. We will be attending the NARI conference in San Diego in November, and look forward to connecting with many of you there.