Office Properties Income Trust (OPI) 2013 Q4 法說會逐字稿

Good day and welcome to the Government Properties Income Trust fourth 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 your host, Director of Investor Relations, Mr. Jason Fredette.

Thank you, Greg, and good afternoon, everyone. 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 like to 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, I'd like to read our Safe Harbor statement.

Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other Securities Laws. These forward-looking statements are based on GOV's present beliefs and expectations as of today, February 18, 2014. 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.

Additional information concerning the factors that could cause those differences is contained in our filings with the SEC which can be accessed from the SEC's website or the Investor Section of our website at www.govreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. We encourage you to access the supplemental operating and financial data package that we have posted to the investor section of our website. Our fourth quarter supplemental includes a couple of additional enhancements compared with our prior reports.

First, we have reclassified what we report as properties. Previously, our property count reflected the number of buildings in GOV's portfolio. While we continue to disclose our total number of buildings in the supplemental, we are now consolidating buildings that are in the same office park as the single property. We also are now including a full property list in the supplemental to provide investors with additional insight into our portfolio. In addition, we are including cash net operating income or cash NOI in our financial tables.

Please note that metrics such as cash NOI, normalized funds from operations or normalized FFO and cash or funds after distribution, otherwise known as CAT or FAD, are non-GAAP metrics. Reconciliations of these figures to GAAP are contained in the supplemental. And now I'd like to turn the call over to David Blackman.

Thank you, Jason, and welcome to the fourth quarter and year-end earnings call for Government Properties Income Trust. To begin, I'd like to review our business strategy which is to invest in building majority leads to government tenants. Our tenants are primarily the US government, 11 state governments and the United Nations. In aggregate, these tenants pay approximately 93% of our annual rental income. The non-government tenants in our buildings tend to be amenities like food service providers or tenants that find a strategic advantage in locating near government tenants like law firms and lobbyists.

Our 68 properties comprise 10.3 million rentable square feet and are highly occupied at 94.8% for a weighted average remaining lease terms of 5.4 years. Our properties are also geographically diverse across 31 states and the District of Columbia. Five states and the District of Columbia each account for 5% or more of our annual rental income and include: Maryland at 13.2%, California at 11.5%, Washington, DC at 10.3%, Georgia at 9.8%, New York at 8.8% and Massachusetts at 5.8%. Approximately half of the institutional quality US government leases in the nation are located in the DC metro market, so we also consider our exposure to the DC metro market which is approximately 23% of our annual rental income. Our DC metro market buildings are also highly occupied at 97%.

As was the case in 2012, 2013 presented challenges for companies that deal with public sector. For example, the polarization of the Federal Government continued and resulted in the lowest number of approved legislative bills by any Congress in more than 20 years. Sequestration resulted in mandatory spending cuts. Freeze the footprint forced every agency to reconsider its real estate requirements and of course the Federal Government actually shutdown for 16 days in October. As a result, decision making at the Federal Government was lethargic, our agency occupants delayed or cancelled expansion plans, and utilization rates dominated discussions between Congress, GSA, and federal agencies.

In contrast to federal leasing, debt and equity capital was abundant in 2013 resulting in cap rate compression and aggressive asset pricing that was generally unappealing to us. Despite these challenges, Government Properties Income Trust performed well. We expanded occupancy by 120 basis points year-over-year. We executed new and renewal leases on 1 million square feet for an 8.7 year weighted average remaining lease term, and we generated a 6.8% aggregate roll up in rent. More than 80% of our 2013 leasing activity was with government tenants on 19 leases for a 10.7% roll up in rent which included leasing capital of $2.17 per square foot per lease year.

Our leasing accomplishments for the year included leasing in full our property at 12 Executive Park in Atlanta that the CDC vacated in 2012, expanding our relationships with the State of California at 915 L Street in Sacramento, and the State of Oregon at the Capital City Business Center in Salem, and creating leasing momentum at 330 Second Avenue South in Minneapolis by executing a redevelopment plan at that property. We also instituted an effective capital recycling program during 2013, identifying five properties for disposition. As of today, we've completed the sale of two properties for $18.5 million in gross proceeds, we've executed agreements to sell two properties for approximately $21 million, and we continue to market one property.

Finally, during 2013, we acquired five properties consisting of eight buildings that contain 671,000 square feet for approximately $100 million or $148 per square foot and an average acquisition cap rate of 8.8%. These acquisitions were 100% occupied for a weighted average remaining lease term of 8.3 years and contained a mix of US government tenants and state government tenants. Now, let's review our fourth quarter activity.

Our leasing momentum remains solid. For the quarter, GOV entered new and renewal leases with government tenants for approximately 126,000 square feet with a weighted average lease term of 3.4 years, a 2.5% roll up in rent, and leasing capital commitments of approximately $595,000 or $1.37 per square foot per lease year. We also entered new and renewal leases with non-government tenants for approximately 133,000 square feet with a weighted average lease term of 11.1 years, a 23.3% roll down in rent, and leasing capital commitments of $8.8 million or $5.91 per square foot per lease year. The vast majority of our non-government leasing was for the full building at 12 Executive Park in Atlanta.

Emery University has entered a lease for 11.5 years to consolidate several departments into one property. The use will be approximately 60% clinical. While Emery's tenant improvement package is substantial, the net effective rent is accretive to the value of the building and our total capital costs are covered within one-third of the lease term. Combined, the weighted average lease term of our fourth quarter leasing activity was 7.4 years for an 8% roll down in rent and leasing capital commitments of $4.89 per square foot per lease year. We also remain pleased with the leasing activity for our vacant space across the portfolio. In total, we have about 300,000 square feet of perspective leasing activity which includes more than 40,000 square feet of space with executed letters of intent over active lease negotiations are ongoing.

Turning to our acquisition activity for the fourth quarter. Since October 1, we've acquired six buildings across three properties that contain 314,000 square feet for $68.7 million, excluding acquisition costs. These properties are 100% leased for a weighted average remaining lease term of 10.1 years, have an average price per square foot of $219, and an average acquisition cap rate of 8.4%. In October, we acquired an office building in Rancho Cordova, California, containing 94,000 square feet for $21.2 million excluding acquisition costs. The purchase price per square foot for this acquisition was $226. The acquisition cap rate was 9%, and the remaining lease term was 13.7 years. The property is 100% leased to the State of California and is occupied by the Department of Consumer Affairs.

In November we acquired a four building office property in Fairfax, Virginia, containing 171,000 square feet for $31.5 million, excluding acquisition costs. The purchase price per square foot was $184. The acquisition cap rate was 8.6% and the weighted average remaining lease term was 4.9 years. The property is 100% leased and the majority tenant is the State of Virginia on behalf of the Northern Virginia Community College for Administrative Offices.

Finally, in December we acquired an office building in Montgomery, Alabama, containing 49,000 square feet for $16 million, excluding acquisition costs. The purchase price per square foot for this acquisition was $325. The acquisition cap rate was 7.2% and the remaining lease term was 15.5 years. The property is 100% leased to the US government and is occupied by the Social Security Administration as an adjudication office.

Since October 1, GOV also entered agreements to acquire two properties containing approximately 490,000 square feet for $133 million, including the assumption of $97.6 million of mortgage debt and excluding acquisition costs. These potential acquisitions are 100% leased to the US government and remain subject to the debt assumption and other closing conditions, so there could be no assurance these properties will be acquired.

On our third quarter earnings call we discussed proposed changes to our business management agreement with REIT Management and Research that have been completed and became effective January 1 of this year. We believe these changes further align Management's financial interest with those of shareholders and the changes include: one, we are now paying the base management fee on the lower of our historical property cost or GOV's total market capitalization. Previously, the base management fee was determined by historical property costs. Two, we are now paying 10% of the base management fee to RMR in GOV common shares instead of 100% in cash.

Three, we are now calculating RMR's incentive management fee based upon the relative out performance of GOV's total return as compared to the total return of the SNL REIT equity index instead of the growth of GOV's FFO per share. The incentive management fee will be measured on a rolling three-year period and no fee will be paid at the total return for share of GOV is negative. If earned the incentive fee will be paid entirely in GOV shares that invest ratably over three years and the shares are subject to a claw-back in the event of a financial restatement. And, four, we also eliminated from the business management agreement our right of first offer to acquire properties being sold by another RMR managed REIT that meet our investment criteria.

While we are optimistic that the economy is beginning to show signs of improvement and dialogue in Washington appears to be left polarized, we anticipate that 2014 will present its share of challenges. For example, should capital remain plentiful and interest rates modest, asset pricing is likely to remain aggressive. Under this scenario, you should expect continued activity in our capital recycling program and a continued disciplined acquisition strategy consistent with our 2013 acquisition accomplishments.

We also expect the US government will continue to focus on increasing utilization rates across its occupied real estate. This could result in tenants in our buildings renewing leases for less space than they currently occupy. We have not, however, budgeted a decline in occupancy during 2014. Instead, we intend to remain vigilant with our tenants to maximize occupancy and aggressively back fill space when necessary.

Finally, during 2014, we expect to add more fixed interest rate debt to our balance sheet to more fully utilize our conservative financial position by modestly increasing leverage and to continue to maintain our investment grade debt ratings. I would now like to 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 fourth quarter.

For the fourth quarter, GOV's rental income increased $3.6 million or 6.7% to $58.3 million with substantially all of this increase coming from the seven property acquisitions that we completed since the start of the 2012 fourth quarter. GOV's property net operating income increased $1.2 million or 3.5% to $35.7 million for the fourth quarter compared to 2012 with the increase in net operating income that resulted from our acquisition activity partially offset by lower same-store NOI. At year-end our 68 properties were 94.8% leased and our consolidated fourth quarter GAAP and cash NOI margins were 61.3% and 60.9% respectively.

Turning to our same-store operating results, at year-end our 61 same-store properties were 94.3% leased, up 90 basis points from the prior year end and up 10 basis points from the end of the 2013 third quarter. For the year, our leasing activity with Emery University in Atlanta, the State of Oregon in Salem, and the State of California in Sacramento more than offset the loss of the CDC at two of our Atlanta buildings and the State of California in San Diego.

Our fourth quarter same-store rental income increased by nearly $400,000 or less than 1%. On a cash basis, rental income increased nearly $600,000 or 1% in the fourth quarter. The increase in rental income between quarters was primarily due to the higher cash base rents and escalation income which was partially offset by lower tenant reimbursement income and straight line rents. Same-store net operating income decreased approximately $1 million or 3% and our NOI margin declined 230 basis points to 60.8%. On a cash basis, NOI for the fourth quarter declined nearly $900,000 or 2.5%.

The decline in same-store NOI was largely the result of the impact of the fourth quarter move outs by the CDC in Atlanta and the State of California in San Diego, and the increases in real estate taxes, property staffing costs, and insurance expense. For the year, rental income at our 53 same-store properties increased $2.8 million or 1.4% and net operating income increased by just over $800,000 or less than 1%.

Turning back to our consolidated results, adjusted EBITDA in the fourth quarter was $32.7 million, an increase of approximately 1%. Our EBITDA to fixed charges ratio remain very strong at 7.4 times for the quarter and our debt to annualized EBITDA was only 4.6 times at year end. For the quarter, normalized FFO of $28.2 million was essentially unchanged compared to normalized FFO of $28.1 million for the 2012 fourth quarter. Fourth quarter 2013 normalized FFO per share of $0.52 was down from $0.53 for the 2012 fourth quarter due to a slightly higher number of outstanding shares in the most recent quarter. We paid a $0.43 per share dividend during the fourth quarter of 2013 and our FFO pay out ratio was approximately 83%.

During quarter we spent $5 million on tenant improvements and leasing costs, including approximately $2.6 million associated with our lease with Emery University. Although we have only 361,000 square feet of leases expiring in 2014, we entered the year with unspent leasing-related capital commitments of approximately $14 million. As a result, we expect our TI-related spend to remain at this higher level during the first half of 2014. During the fourth quarter of 2013 we also spent $5.4 million on improvements to our properties, including $1.1 million of costs incurred in connection with our efforts to reposition our 330 Second Avenue South property in Minneapolis.

Turning to our balance sheet and liquidity, at year end our balance sheet remained conservatively leveraged at 37.7% of total book capitalization and $393 million of our $550 million unsecured revolving credit facility was available to fund acquisitions and other working capital needs. We currently have two properties under contract for an aggregate purchase price of $133.1 million, including the assumption of $97.6 million of mortgage debt. Pro forma for the acquisition of these two properties and the sale of three properties classified as discontinued operations, debt to total book capitalization would have been approximately 41% at year end.

In closing, although we expect there to be additional challenges in the government lease sector in 2014, we believe GOV is well positioned to both manage through these challenges and to take advantage of opportunities to grow through accretive acquisitions. Operator, we're ready to open it up for questions.

(Operator Instructions)

Your first question comes from the line of Jamie Feldman from Bank of America.

Hi, guys. It's actually Stephen with Jamie. So, I have two questions. You talked about the two give backs, the one in Atlanta with TDC and the other one with the State of California. Have you guys seen any like momentum in terms of backfilling that space?

And then my second question is could we just get an update on any, if you have any other new known move-outs in 2014 in your portfolio or if you have any leases that have yet to commence in 2014 that we should be thinking about? Thanks.

So, let's see, Stephen. The first question as it relates to leasing momentum on the give backs, those occurred in the fourth quarter, so we haven't had them back very long. We do have a tenant that currently resides in the same business park as our San Diego property that is showing some interest in that space. It's very early in the process, but there is some momentum there, so we've had some showings on the CDC space in Atlanta but nothing material at this point or no LOIs that I'm aware of on that property.

As it relates to leases for 2014 that have yet to commence, I am not aware of any. We did have some executed leases in the first quarter that obviously we didn't account for at this point.

Effective in 2014. So, signed in the fourth quarter.

Right, right. And as it relates to known move outs, we have I think -- when we look at our leases expiring between now and the end of 2017, we have approximately 188,000 square feet of space that we expect will not be renewed. That is substantially all non-government tenants and it tends to be to some extent it's people downsizing versus completely moving out, but it's a relatively small percentage and again that's over kind of between now and the end of 2017.

Okay, thanks. That helps, thank you.

(Operator Instructions)

Next, we'll go to the line of Young Ku from Wells Fargo. Please go ahead.

Great, thank you. David, the 188,000 square feet of potential move out you said it's between now and 2017, exactly when do you think that's going to hit?

Well, for example, I mean what we expect in 2014 is less than 30,000 square feet, so some of it will happen beyond 2014.

Is that mostly concentrated in a year like 2015 or 2016?

It's -- 2015 is when 188,000, call it 150,000 probably hits sometime in 2015.

Okay. Got it.

And again, they tend to stay more concentrated in non-government tenants.

Okay, thanks for that. And for Q4 2013, like Mark said, the CapEx costs were a little bit higher and by our calculation you guys overfunded the dividend by a little bit and you said that it's going to tend to be higher in the first half of 2014, so how do you kind of think about dividend versus where your FAD levels will be for 2014?

Well, I think really the second half of 2013 we had higher CapEx spend and pushed up against or went over on a pay out ratio basis over 100%. We were slightly under for the year. I would think looking forward into 2014 I think with the $14 million or so of carry forward carryover CapEx, I would expect our pay out ratio to be at or slightly above our CAD/FAD to be slightly above -- or, I'm sorry, the dividend to be slightly higher than CAD or FAD, but for the year we would expect the dividend to be covered by CAD/FAD. So, it's the first half of 2014 higher pay out ratio.

We also have only about 315,000 square feet of leasing during 2014, so we expect our leasing capital going into 2015 to be relatively modest, and we would also expect that our CAD coverage of the dividend to be much better in 2015 than what we had in 2013.

Okay, so 2015 is a pretty big year in terms of lease expiration, so what you're saying is you don't expect to spend a lot of capital to renew most of those?

No, that's not anything close to what I said. What I said was that we expect to have less capital spend in 2014 that carries into 2015. You don't always spend the capital in the same year than what you commit the capital for leasing.

Right, okay.

We will have meaningful capital in 2015, but a big chunk of that will get spent in 2016.

Okay, thank you. Thanks for the clarification, and one last question regarding the two buildings that you guys have agreement to purchase in Reston, Virginia. Can you provide a little bit more detail in terms of what kind of term is left in that deal and what kind of cap rate that you guys will be purchasing that at?

Yes, we typically don't announce cap rates until after we have closed an acquisition. What I will tell you is that the cap rates are within the range of the kind of 8% to 9% where we like to buy buildings, so I think they're consistent with other acquisitions that we have done over the last 24 months or so.

They're in top markets. They are 100% leased to the US government. They tend to be very high security oriented buildings, which is in part why the cost per square foot on those buildings are just a tad higher than what we have done in the last quarter.

How many years of the term is left?

They tend to be 2019-ish type lease expirations.

Okay, great, thank you.

Your next question comes from the line of Mitch Germain from JMP Securities. Please go ahead.

Hi. Good afternoon. Just curious, David, I know that you typically have a bit of an ebb and flow in the size of your acquisition pipeline. I think it kind of declines after year end. Is that typical and how would you characterize the size of it today versus kind of maybe where you were in the fourth quarter or maybe where you were a year ago?

So, Mitch, the deals we announced in the fourth quarter are transactions that we had been working on for quite some time, longer than normal. I would say these are deals that we've been working on for six months, so I think that's a fact that's probably worth getting out there.

The pipeline today is okay. The challenge that we have right now is that what we are seeing tend to be Federal Government leases with greater than 10 year remaining lease term and sellers that have cap rate expectations that tend to be below 7%, and those don't tend to work well for us, so we're looking at a lot of deals, but we're also dismissing a lot of those because we just don't think the pricing make sense for us. And I think that will be one of our challenges this year in terms of continuing to provide growth for the portfolio.

And are you seeing a lot of levered buyers back in the market?

There's a lot of leverage available in the market and we tend to compete with a number of levered buyers in this sector.

Great. And then last question for me. Dispositions, I know that some of these back fills will be with non-government tenants. Is the goal as we've seen with some other situations with you guys in the past, is a goal maybe to be disposing some of that non-government exposure in the future?

Well, what we've said in the past, Mitch, is that as we get buildings that are no longer majority leased to government tenants that they should be something that we consider for disposition. At this point, we haven't presented any additional potential disposition assets to the Board, but consistent with the strategy that we've articulated, we want to make sure that our properties continue to be majority leased to government tenants over time. Does that make sense?

Yes, perfect. Thanks, guys.

Your next question comes from the line of David Shamis from Jefferies.

Good afternoon, guys. You mentioned in your prepared remarks you expect to increase leverage and issue fixed rate debt during the year. Just wondering if you could talk a little bit about your leverage targets and also of the new debt that you're expecting during the year, how much is coming from the new assumed mortgages from the acquisitions versus new unsecured debt?

Yes, well if you look at where we are today at the end of the year, leverage was just under 38% and that was split; 15% was fixed rate, 85% floating. We've got, as we mentioned, $133 million of acquisitions that will include the assumption of close to $98 million of fixed rate debt, so after we close on those two acquisitions and if you assume the sale of the three properties that are in assets held for sale, at that point leverage would be about 41% and it would be 73%/ 27% or so split between floating and fixed.

I think our intention would be say the next $125 million to $150 million of acquisitions that we would initially fund those on the revolver and then take the revolver out with permanent financing in the form of unsecured 10-year notes, and if you kind of pro forma all that, at that point we would be closer to a 50/50 split on fixed versus floating debt and leverage would be about 45% of total book capitalization. So, when David spoke of higher amount of fixed rate debt and slightly higher leverage, that's kind of how we got there was through that kind of thought process.

Okay, that's helpful.

And if you kind of look back we typically kind of run the Company around 30% to 35% leverage and at 40% leverage we kind of headed back to the equity market. I think today we're pretty comfortable given the stability of our income of operating around 45%. That still gives us a leverage that's below a lot of our peers and it gives us kind of a debt-to-EBITDA run rate of below 5 times which we think is pretty safe.

Okay. And then where do you think you could issue 10-year debt today and, also, what's the rate on the mortgages that you're going to be assuming?

I think we could issue 10-year today in the 5% area. The mortgage debt that we're assuming, the $14.6 million mortgage that -- call it 588 and the $83 million mortgage is at 555, and those will be the cash interest amounts. Obviously with GAAP accounting we'll have to mark those to market, so I would assume for GAAP purposes the interest rate will be lower than the cash interest.

Okay, thanks a lot guys.

At this time there are no further questions. I'll turn the call back over to David Blackman. Please go ahead.

Thank you for joining the fourth quarter conference call. We're attending the Wells Fargo Real Estate Conference in New York next week and hope to see some of you there. Operator, that concludes our call.

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.