Office Properties Income Trust (OPI) 2013 Q2 法說會逐字稿

Good day and welcome to the Government Properties Income Trust second quarter and 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.

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 transcription, 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 expeditions as of today, July 31, 2013.

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. A 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 on our filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And now I would like to turn the call over to David.

Thank you, Tim.

For the second quarter of 2013, Government Properties Income Trust was reporting normalized FFO of $29.3 million, or $0.54 per share, compared to $24.4 million, or $0.52 per share for the second quarter of 2012. Our 20% year-over-year increase in normalized FFO is primarily the result of our accretive acquisition activity and a modest improvement in same-store results. Since April 1, we have entered one agreement to acquire a property for $12.8 million, we've executed 16 new and renewal leases for approximately 315,000 square feet, for our modest roll-down in rent of 1.4%, and we also declared a $0.43 per share distribution.

As of June 30, GOV owned 82 properties containing 10 million square feet. Our properties were 93.4% leased, up 60 basis points from the previous quarter, for a slightly longer weighted average remaining lease term of 5.4 years. In aggregate, our government tenants pay approximately 94% of our rental income and the US government remains our dominant tenant.

In addition to our strong property statistics, we also exhibited strong credit statistics at the end of the quarter. Our balance sheet was conservatively leveraged and unchanged from the previous quarter at 31.4% of total book capitalization. Our total debt to adjusted EBITDA was 3.5 times, our fixed charge coverage ratio was 8.2 times, and our $550 million unsecured revolving credit facility was 95% available to fund acquisitions and other working capital needs.

Now let's review our leasing activity. For the quarter, GOV entered 16 leases for approximately 315,000 square feet, with a weighted average lease term of 13.4 years. Our executed leases were 56,000 square feet more than our quarterly lease expirations, resulting in a 60 basis point increase in portfolio occupancy from the previous quarter, to 93.4%. Approximately 281,000 square feet of our activity was new and renewal leases for two US government tenants and three state government tenants that accounted for approximately 93% of our growth in occupancy.

We had a few notable lease transactions during the quarter. First, we executed two leases for a total of 140,000 square feet with the US Department of Energy for our two buildings in Richland, Washington. These leases were for a 20-year term and were early renewals.

Second, we efficiently leased 100% of the space vacated by the Nossaman law firm at 915 L Street to the State of California. This rapid releasing of vacant space confirms our acquisition assumption that the building's location across from the California State Capitol makes this building highly desirable to tenants in the Sacramento market.

Third, we leased 29,000 square feet to the State of Oregon at the Capital City Business Center for vacant space where no value was attributed at the time of acquisition because the space was underwritten as unleasable. Plus, we also leased 13,000 square feet of space acquired vacant in three other buildings to non-government tenants. In total, our leasing of this 42,000 square feet of acquired vacancy will result in approximately $905,000 of new annual revenue for the Company.

Our commitments for leasing capital were $5.2 million for the quarter, or $1.23 per square foot per lease year, which is more in line with our historical trend for leasing capital than in the previous quarter. Approximately $4.6 million of our leasing capital was for our activity with government tenants, which equates to $1.14 per square foot for this year.

We remain pleased with the leasing activity for our vacant space across the portfolio. In total, we have about 250,000 square feet of activity, which includes more than 100,000 square feet of space with executed letters of intent or where active lease negotiations are ongoing. Despite all of our positive leasing momentum, we do have leasing challenges ahead. For example, the FBI vacated its building in San Diego, as scheduled on July 19, for its new building, adding approximately 80,000 square feet of vacancy to our portfolio during the third quarter.

We also expect to get back approximately 65,000 square feet of space in two buildings from the CDC in Atlanta during the fourth quarter. The CDC is consolidating employees from our building as well as from buildings owned by others to relocate to US government-owned space on the CDC's headquarter campus in Atlanta. The balance of our space with the CDC, or approximately 137,000 square feet, has either been renewed, or is in the process of being renewed for 7 to 10 years.

Finally, the State of California exercised early termination options for leases totaling approximately 44,000 square feet for a building in San Diego. We expect to get this space back before year-end.

Turning to acquisition activity. In July, we entered an agreement to acquire a 228,000 square foot industrial property located in Chester, Virginia for $12.8 million, excluding acquisition costs. The property is 100% leased for 7.5 years to the US government and occupied by the US Army as a logistics center. The acquisition remains subject to the completion of due diligence, so there can be no assurance we will actually acquire this property.

During 2013, GOV has evaluated 40 separate acquisition opportunities containing approximately 8 million square feet of space. Through the underwriting process, we have elected to offer on 14 of these acquisition opportunities, and have been successful in placing one of these properties under agreement while remaining engaged on three other properties. In addition, we have five acquisition opportunities in our new business pipeline to evaluate for potential acquisition.

Although this is more detail on the acquisition pipeline than we normally provide, I think it is significant to convey that Management believes it is more important to be prudent and patient in our acquisition activity than to exhibit growth during this period of aggressive leverage buying activity. And that while accretive growth remains a key component to GOV's business plan, delivering a safe and predictable distribution to shareholders takes precedent over growth.

I will now turn the call over to Mark Kleifges, our CFO, to provide more detail on financial results.

Thanks, David.

First, let's review our consolidated property level operating results for the 2013 second 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 2013 second quarter, we owned 82 properties with 10 million square feet. This compares to 72 properties with 8.9 million square feet at the end of the 2012 second quarter. For the 2013 second quarter, compared to 2012, GOV's rental income increased $7.5 million, or 15%, to $57.3 million. And property net operating income increased $5.7 million, or 18.5%, to $36.6 million. At June 30, our properties were 93.4% leased and our consolidated NOI margin for the 2013 second quarter was 63.9%.

Turning to our same-store operating results, at quarter-end our 69 same-store properties were 92.4% leased, down 10 basis points from the prior-year quarter, but up 60 basis points from the end of the first quarter. Our 2013 second quarter same-store rental income increased by $770,000, or 1.5%, compared to the 2012 second quarter, and our same-store net operating income increased $1.1 million, or 3.5%, compared to the 2012 second quarter.

This quarter's revenue and NOI growth was largely due to the rent roll-ups resulting from the lease renewals with the Department of Justice and US Customs and Immigration Service at our Mass Avenue property in Washington, DC during the fourth quarter of 2012. Same-store operating expenses declined $300,000 quarter-over-quarter, with increased Real Estate tax expense and payroll costs offset by lower utilities, repairs and maintenance, and insurance costs.

The year-over-year decline in repairs and maintenance costs we experienced in the first two quarters of 2013 is timing related. We expect these costs to increase above a normalized run rate in the third and fourth quarter. As a result, total same-store operating expenses will likely be higher on a quarter-over-quarter basis in the second half of the year. Our same-store NOI margin in the 2013 second quarter increased 120 basis points from the prior-year quarter to 63.2%.

Turning back to our consolidated results, adjusted EBITDA in the second quarter of 2013 was $33.4 million, compared to $28.5 million in the 2012 second quarter, a quarter-over-quarter increase of 17%. Our EBITDA to fixed charges ratio remained very strong at 8.2 times for the quarter, and our debt to annualized EBITDA was only 3.5 times at quarter-end. For the current quarter, normalized FFO was $29.3 million compared to normalized FFO of $24.4 million for the 2012 second quarter. Second quarter 2013 normalized FFO per share of $0.54 was up $0.02, or approximately 4%, from the 2012 second quarter. We paid a $0.43 a share dividend during the quarter and our FFO payout ratio was approximately 80%.

During the quarter, we spent $1.9 million on tended improvements and leasing costs and $2.4 million on improvements to our properties. Turning to our balance sheet and liquidity, at quarter-end we had $467 million of debt outstanding, including $25 million outstanding on our $550 million revolver. Debt to total book capitalization was 31.4% at quarter-end.

We currently have one property under contract to purchase for $12.8 million, leaving the Company with approximately $200 million of debt capacity to fund acquisition growth before leverage would reach 40% of book capitalization. In closing, GOV's well-capitalized balance sheet positions the Company to continue to be a consolidator through accretive acquisitions in the government-leased Real Estate sector.

Operator, we are ready to open it up for questions.

(Operator Instructions)

Vance Edelson, Morgan Stanley.

One of your larger peers hosting a conference call this morning mentioned that the sequester is still a very real issue. I think they called it -- and that's in DC. Even though it's fallen out of the headlines. What are your thoughts on that? And is it having any real impact on you now?

Vance -- hi, this is David. We're really not seeing impact specifically at our properties from sequester. I would expect, in DC, the sequester is going to have an impact on overall occupancy in that market, because government contractors are likely to see some effect from sequester. Fortunately for us, we don't have any government contractors leasing space in our buildings. And the buildings we have in the DC market tend to be relatively strategic to the government tenants. So fortunately for us, it hasn't had a real effect on occupancy at our portfolio yet.

Okay. Great. And then any agencies within the federal government that you'd characterize as really being in growth mode at present? Are there are two or three that would fall into that camp?

I would say that the VA is probably in the most aggressive growth mode of any government agency right now, particularly with all of the returning veterans right now. They've had money allocated for new buildings for quite some time. And frankly, have been behind in spending that. The other agency that I would guess we've seen some growth in would be border protection, where we continue to focus on improving the buildings and the coverage that we have at the border. And my guess, that probably continues. Beyond that, I don't know that I could pick any -- of course, border protection, also US Custom Immigration Services, that's hand in glove with that. But other than that, I don't know that I would single out any other agencies as being in a growth mode.

Okay. That's very helpful.

Michael Carroll, RBC.

Thanks for the details on the acquisition pipeline, but what's the average size of the deals that you're currently engaged in? Is it similar to the deal you have under contract right now, or is it a bigger deal?

We have three that we are still engaged with. And frankly, Mike, it's all over the place. It's probably anywhere from a $20 million opportunity to a $100 million opportunity.

Okay. Are you still seeing the leveraged buyer in the market? Are they still providing you stiff competition on these deals?

Yes. We continue to see the leveraged buyer in the market. I don't know there's been a huge change in secured financing availability in the market right now. I think what we've seen some borrowers do, instead of doing 10-year financing, they've gone to 5- or 7-year financing. Or they've gone from fixed rate to floating-rate. And as a result, they're continuing to get pretty aggressive financing terms.

Okay. And then what's the status of the DOJ renewal in December?

The DOJ renewal in December in Buffalo? Or the one on Mass Avenue?

Buffalo.

Buffalo. We're done with the DOJ in Buffalo. We executed that last quarter. I think we have US CIS and Immigration and Custom Enforcement left in that building to work through, which I believe is an early 2014 expiration. But we're engaged with both of those agencies right now.

You already did a renewal for the DOE too?

Yes. The DOE in Richland?

Yes.

Yes. We executed those this quarter. Those were our 20-year renewals. Those expirations were due in the fourth quarter and we executed them during the second.

Okay. And then are there any other large lease expirations in 2014, outside of DISA?

No.

Okay. Great.

We -- it -- '14 tends to be relatively light year, and there's not much above -- I don't think there's anything above 1% of revenues.

Okay. Great.

Tayo Okusanya, Jefferies.

Just going back to acquisitions. David, if I heard you correctly, you said you guys made offers on 14 potential deals, but you're just working on 3 now. You have 5 more in the new deal pipeline? Is that correct?

That is correct.

When you talk about -- what's this new deal pipeline?

Basically, they are acquisitions that we've received offering materials for where bids aren't due yet.

Okay. Got it. Okay. I understand that. And then from an acquisition disposition perspective, this morning we had BXP on their call talk about selling 1301 New York Avenue, in a well known GSA building on a 5.2% cap rate. And when I look at the number and I fall out of my chair, saying, have things really gotten that competitive?

Is that a question?

(laughter) Question, comment -- trying to get your comment, because those cap rates -- do deals make sense at all?

I think that's probably a relatively unique property. I don't know it specifically, but I would assume is a relatively long lease remaining in that property.

Yes. There is.

It's relatively close to the White House. So that's a trophy quality-type asset. And yes, we are seeing some 5%-ish type cap rates out there in the market. Generally, what you're seeing for government space, if it's a 10-year or longer lease duration, is anywhere in the mid 6%s to low 7%s, depending upon where it's located, who the agency is, and really the quality of the real estate. But you -- so there's not a lot of 5%-ish cap rates out there, at least for government space. But the BXP property may have tenants in there that have increases in rent over time. And that will tend to result in lower going-in cap rates because you can expect a higher return over time.

Okay. That's helpful. So I guess that backdrop -- does it make sense for you guys to be selling into that, given how attractive pricing is?

We are looking every quarter at our portfolio for properties that are strategic, or where we think they're non-strategic. We don't have any occupied buildings in our portfolio that we really felt have risen to the point for disposition, but we are looking at the portfolio every quarter. And we'll make ongoing disposition decisions quarter-to-quarter.

Great. Last one from me, thanks for the color in regards to upcoming vacancies. Between the CDC space, the FBI space in San Diego, and the State of California space, how much of annual rent is that that's going to be coming offline before the end of the year?

They total about 2% of earnings.

Okay. Great. That's it for me.

Brendan Maiorana, Wells Fargo.

Mark, 2% of revenues, I guess that's what, $4 million, give or take on the --

About $4.4 million.

$4.4 million? Yes. So as you look out, you've got, that's -- I think it's 190,000 square feet if I got your numbers added up correctly. As you look at the remaining roll for the back half of the year, what portion of that do you think you can make up from new leasing? Not that maybe it's online, but at least gets signed between now and the end of the year?

Well, as I said, we've got 250,000 square feet of active lease proposals that we're working through, 100,000 square feet where we're under LOI or we're negotiating a lease. So I think we should be able to pick up, at a minimum, 50% of that through our ongoing lease activity. And it could, frankly, be better than that by the end of the year.

But is that -- David, is that apples-to-apples, because I think you've got 600,000 square feet that's expiring. So there's 190,000 of that, that's coming out, right? And then how does that -- is that all -- is that 250,000 of new leases? And 150,000 that's -- of new leasing that's under LOI or is that -- is a portion of that renewal?

Brendan, that is -- I think what I said with that was leasing opportunities for our vacant space. So none of that has to do with upcoming expirations.

It's all new leases.

It's all new leases.

Okay. Great. Okay. So maybe 190,000 comes out and hopefully you get a large portion of the 150,000 that's under LOI or lease negotiations?

Correct.

Okay. Great. Balance sheet, you guys still have a lot of the variable rate debt, and I think we've had this discussion a bunch over the past couple of years. But the -- my prior recollection of our conversations is that once rates start to move, you guys would think about trying to put in some longer-term fixed rate financing. What's the view, now that we've had treasuries that are up, call it 100 basis points, since late May?

Yes. So we're sitting at the end of the quarter with about 80% of our debt is floating rate. I don't think our view has changed a whole lot since the last quarter. We still find the short end of the curve extremely attractive, and don't think there's going to be a whole lot of movement. There hasn't been any movement, really, since the beginning of the year, and we don't see a whole lot of movement in the near-term. You're correct, there has been some movement with the 10-year treasury. We don't think the long end has gotten away from us yet, so we're still, in the near-term, comfortable with our current allocation between fixed and floating.

So can I just understand why that's the case? It -- I think David, you made a comment, which I would agree with, that you wanted surety of the distribution, which seems like that's a good strategy. You've got government tenants that are 90%-plus of your rent roll, so it should be a fairly safe cash flow. But at the same time, I [can] appreciate your view that you don't see risk that rates are likely to rise over the near-term horizon.

But it doesn't seem like that's -- your business model shouldn't be speculating on that. It would seem to me that you'd want to match out your lease duration with your rate duration, and it doesn't -- it seems like there's a pretty big mismatch between the balance sheet and the asset base. I'm just trying to understand why you wouldn't look to tap a longer-term unsecured market.

Yes. Your comments are fair, Brendan. I think Mark is right. We like the short end of the curve right now. We've got -- really our only floating rate debt is our $350 million unsecured term loan, so we're not -- while 80% of our debt is floating, we don't have a lot of debt. What we will probably do in the near-term is we're going to look at hedging strategies, because we like the short end of the curve. But it may be it makes sense at this point in time to consider some hedging strategy for that floating rate term loan, because that's still very good capital for us. And I think that's a better option right now than the 10-year fixed rate notes.

Okay. Any sense of, if you did have to do an issuance of 10-year unsecured, where you'd likely price?

I would speculate $525 million to $550 million.

Okay. All right. Great.

Mitch Germain, JMP Securities.

David, how would you characterize the deal flow, the activity in terms of the volume of the number of deals you're underwriting? You've underwritten year-to-date versus historical levels.

Yes. I would say that generally, it's down slightly over where we would have been this time last year. And it's down, probably, with somewhat lesser quality properties. I think the biggest challenge that we've had, Mitch, is just simply the amount that people are willing to pay for government-leased buildings right now. It's just - they're prices that generally haven't made sense for us.

Are these long-term buyers like, for instance, government funds, equity funds? Or are these yields seeking investors, meaning this is really a temporary competition rather than a long-term competition?

I don't know that I would consider it a long-term competition. There has been no real new capital come to market that's focused on government-leased space. I think you've got some folks that are on a leverage basis. They think owning government-leased real estate is a good risk return relative to treasuries. But I don't think it's -- I don't necessarily think it's a permanent change in the market.

And can you characterize how much your bid was below the accepted bid in many of these transactions, maybe on average?

We don't always know 100%. But we've lost deals anywhere -- we've had a number of deals, Mitch, where we just elected not to bid at all, because we just think the pricing is irrational for the Real Estate. And in those cases, we're probably 100 basis points off. I would say where we bid and lose, we tend to be 25-ish basis points, maybe sometimes 50 basis points. We do still win opportunities where we are not the high bidder, because of the assurety to close. And I think some of the deals where we're still hanging around the hoop, we're not the high bidder, but we're probably the most likely owner to get the deal done. And that helps us.

My last question, and I appreciate your time, the 250,000 square feet in the pipeline today, leasing pipeline today. You might have mentioned it, I apologize. Is that all government users?

No it's not. It's a mix. There are some government users in there. There are a lot of non-government users in there as well.

And I'll now turn it back to David Blackman for closing remarks.

Thank you, operator. Thank you, everyone, for joining the call today. We look forward to talking to you soon. That concludes our call.

Thank you. Ladies and gentlemen, this will conclude our conference call for today. Thank you for your participation, and for using AT&T Executive Teleconference. You may now disconnect.