Office Properties Income Trust (OPI) 2014 Q1 法說會逐字稿

Good day and welcome to the Government Properties Income Trust first-quarter 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 and Director of Investor Relations, Mr. Jason Fredette. Please go ahead sir.

Thank you, Eva. Joining me on today's call are President and Chief Operating Officer, David Blackman; and Treasurer and Chief Financial Officer, Mark Kleifges. They will provide some formal remarks about our first quarter, and then part in our question and answer session.

I'd like to note that the recording and retransmission of today's conference call is strictly prohibited without the prior written consent of the Company.

Please note that 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 beliefs and expectations as of today, April 30, 2014, and actual results may differ materially from those that we project.

The Company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's call, other than through filings with the Securities and Exchange Commission, or SEC, regarding this reporting period. Additional information concerning factors that could cause those differences is contained in our filings with the SEC, which can be accessed from our website govreit.com, or the SEC's website. Investors are cautioned not to place undue reliance upon these forward-looking statements.

In addition, we'll be discussing non-GAAP numbers during this call including normalized funds from operations, or normalized FFO. Our reconciliation of these non-GAAP figures to net income and the components to calculate cash available for distribution, or CAD, are available in our supplemental operating and financial data package, which again can be found on our website. And now I would like to turn the call over to David Blackman.

Thank you, Jason. For the first quarter of 2014 Government Properties Income Trust increased occupancy for the eighth consecutive quarter, closed a previously-announced acquisition, and completed a previously-announced disposition. We also generated solid leasing activity with our government tenants for a roll-up in rent and no leasing capital.

Consolidated and same-property results, however, were unfortunately weak due to increased expenses associated with unseasonably cold and wet weather. As of March 31, 2014, GOV owned 69 properties containing 10.4 million square feet in continuing operations.

We increased occupancy in our properties to 95.1%, up 30 basis points from the previous quarter and 150 basis points from the first quarter of 2013. We also increased same-property occupancy by 110 basis points year over year as a result of our consistent leasing efforts.

GOV's weighted average remaining lease term is 5.1 years. The US government continues to be our largest tenant and combined with 11 state governments and the United Nations, contributed 92.6% of our annualized rental income.

Now let's review our activity for the quarter. During the first quarter, GOV generated 13 new and renewal leases for 62,500 square feet, with a weighted average lease term of 5.7 years. We executed approximately 30,000 square feet of more leases during the quarter than our quarterly leasing expirations, which combined with our acquisition activity, enabled us to increase occupancy 30 basis points from the previous quarter.

We generated 17,549 square feet of lease renewals for two government tenants that resulted in a 36% roll-up in rent, no leasing capital commitments, and a weighted average lease term of 6.8 years. GOV also generated 11 new and renewal leases with non-government tenants for approximately 45,000 square feet, that resulted in a 12.4% roll-down in rent, but weighted average lease term of 5.3 years and capital commitments of approximately $1.7 million or $6.95 per square foot per lease year.

We remain active generating leases for the vacant space across our portfolio. Currently we have about 280,000 square feet of prospective leases that include 74,000 square feet of leases executed in April, or prospective leases with executed letters of intent.

Despite our positive leasing momentum, it is unrealistic to expect all of our tenants to renew leases in expiration. For the remainder of 2014, we expect tenants occupying about 17,000 square feet of space, and that contribute less than 0.2% of rents, to vacate, all of which should occur in the second and third quarters. This includes one US government tenant that occupies 2000 square feet in Stafford, Arizona.

The US government's occupancy strategy continues to focus on reducing occupied square feet per employee in its buildings, and consolidating out of lease space and into own space where appropriate. As a result, it continues to be difficult to predict leasing outcomes with the US government for expiring leases. We also find that lease negotiations are long and lease renewals tend to remain short at three to five years.

Now let's review our capital recycling activity. As we've discussed on previous earnings calls, GOV considers disposing of properties where we have a concern about renewing a tenant in place, and where market conditions make the time required to re-tenant a property unacceptably long, or where we find the return on invested capital required to re-tenant a property unattractive.

Entering the first quarter, GOV had three such properties held for sale and categorized in discontinued operations. In February, we completed the sale of the former FBI facility in Phoenix, Arizona for $5 million, which was approximately $2.6 million more than we expected to receive in a sale.

Our property in Falls Church, Virginia, which remains leased to the US government through July 2014, is under agreement for $16.5 million. The property is being resumed to a multi-family use and the rezoning is a closing condition which is expected to take until May 2015 to complete. The last property held for sale and that we continue to market is our former FBI facility in San Diego, California.

Now let's review our acquisition activity. During March, we completed a previously-announced acquisition for one property containing 83,000 square feet for $19.8 million, including the assumption of $14.5 million of mortgage debt, and excluding acquisition costs.

This property is 100% leased to the US government for a weighted average remaining lease term of four years, was acquired at $238 per square foot, and at an acquisition cap rate of 8.6%. The property is located in Fairfax, Virginia, adjacent to the Pender Business Park that we acquired the previous quarter.

The building is a high-security property where the US government has invested heavily in its infrastructure, and is considered strategic by the agency occupant. As a result, we acquired this property with reasonably high confidence the tenant will renew the lease at or prior to expiration.

We continue to have an agreement to acquire one property consisting of two buildings for $113.3 million, including the assumption of $83 million in mortgage debt. The property is located in Reston, Virginia and is 100% leased to the US government for approximately six years.

This is another high-security property that is considered strategic by the agency occupant. The loan assumption process is nearly complete and the acquisition is anticipated to close prior to the end of the second quarter.

The acquisition market for core real estate investments remains aggressive due to an abundance of debt and equity capital. While we maintain an active pipeline of acquisition opportunities, it has become more difficult to identify properties we believe are strategic to government tenants and that meet our pricing criteria. As a result, we expect our acquisition pace will remain modest for the remainder of 2014 unless there is a change in market dynamics.

Overall we are pleased that our expertise in the government real estate space has resulted in our ability to successfully manage through the many leasing challenges presented to us this year. We remain vigilant with our tenants that have expiring leases over the next 24 months, and expect that we will have substantially more wins than losses in the foreseeable future.

We also believe our strong balance sheet will allow us to enter strategic acquisition opportunities as they are identified to support our business plan of providing shareholders a safe and predictable distribution. Now let's hear from Mark Kleifges, our CFO, who will provide more detail on our financial results.

Thanks, David. First let's review our consolidated property level operating results. For the 2014 first quarter compared to 2013, GOV's rental income increased $3.5 million, or 6.2%, to $59.8 million. Substantially all the increase in revenues was from properties we have acquired since the beginning of 2013.

Property net operating income for the 2014 first quarter compared to 2013 decreased $542,000 or 1.5% to $36.2 million. This was due to a decline in NOI at our same-store properties related primarily to severe winter weather, which more than offset the positive NOI contribution from our acquired properties. At March 31 our properties were 95.1% leased and our consolidated GAAP and cash NOI margins for the 2014 first quarter were 60.6% and 60%, respectively.

Turning to our same-store operating results, at quarter-end our 63 same-store properties were 94.7% leased, up 110 basis points from the prior year quarter-end and up 30 basis points from year-end. Our 2014 first quarter same-property rental income increased $76,000, as the impact of our successful leasing activity over the past year was partially offset by the previously-disclosed loss of the CDC in two of our Atlanta properties, and the State of California at our Sky Park property in San Diego.

In addition, revenue for the 2013 quarter included approximately $325,000 of nonrecurring retroactive rent adjustments. On a cash basis, first-quarter 2014 rental income declined $173,000, or 30 basis points from the first quarter of 2013.

As I mentioned a moment ago, the unusually severe winter weather experienced in many parts of the country during the first quarter, had a significant negative impact on our same-property operating results. Same property net operating income for the 2014 first quarter decreased $2.8 million, or 7.6%, compared to the 2013 quarter. This decline was the result of a $2.9 million, or 14.7%, increase in same-property operating expenses compared to the 2013 quarter, with utilities up $1.6 million, or 41%, and snow removal costs up $595,000, roughly double their cost in 2013.

In total, these factors reduced our 2014 first-quarter normalized FFO per share by approximately $0.04 when compared with the year-ago quarter. We are not able to recover the majority of these extraordinary expenses from our tenants, because most of our leases compensate us for increases in property operating expenses by providing for annual rent increases based on a cost-of-living index, and not based on the amount of our actual cost increases. As a result of these cost increases, our same-property NOI margin for the 2014 first quarter declined 150 basis points from the prior-year quarter to 60.6%.

Turning back to our consolidated results, adjusted EBITDA in the first quarter of 2014 was $33.7 million, a decrease of 3.8% from the 2013 quarter. However our EBITDA-to-interest expense ratio remains very strong, at 7.4 times for the quarter. And our debt-to-annualized EBITDA was only 4.5 times at quarter-end.

For the quarter, normalized FFO was $28.8 million compared to $30.5 million for the 2013 quarter. First-quarter 2014 normalized FFO per share of $0.53 was down $0.03, or approximately 5.5% from the 2013 quarter. We paid a $0.43 per share dividend during the quarter and our normalized FFO payout ratio was approximately 82%.

During the quarter, we spent $2.2 million on tenant improvements and leasing costs. A substantial amount of these costs pertain to leases executed in the 2013 fourth quarter, with Emory University at our Executive Park property in Atlanta, and with the Department of Justice at our Delaware Avenue property in Buffalo.

At quarter-end we had approximately $12 million of unspent leasing-related capital commitments. We also spent $2.2 million on improvements to our properties during the quarter.

Turning to our balance sheet and liquidity, at quarter-end our balance sheet remained conservatively leveraged at 38% of total book capitalization. And approximately $400 million of our $558 million unsecured revolving credit facility was available to fund acquisitions and other working capital needs.

As David mentioned, we currently have one property under contract for a purchase price of $113.3 million, including the assumption of $83 million of mortgage debt. We also have one property with a net book value of $12.5 million under contract to sell for $16.5 million, and are marketing for sale one property with a net book value of $11 million. In closing, we believe GOV is well positioned to both manage through this challenging period in the government-leased real estate sector, and to take advantage of opportunities to grow through accretive acquisitions.

Operator, that concludes our prepared remarks. We are ready to open it up for questions.

(Operator Instructions)

Tayo Okusanya, Jefferies.

Yes. Good afternoon, everyone. I had a question around your results. Your operating results for the quarter were actually pretty good from a leasing perspective. But I hear you guys making somewhat cautious comments about the outlook for demand for government space going forward. I'm just trying to reconcile the two. If you have such a cautious outlook, what's driving some of the occupancy gains and other things that you guys actually had in the quarter that made the operating results actually pretty good ex all the snow removal type stuff.

Tayo, that's an interesting question. What we're trying to articulate is that the US Government is basically challenging all of its agencies at lease renewal to justify the amount of space they take and what their occupancy costs are. We've been pretty successful working through that process. But we don't have the same level of visibility that we feel like we used to have with the government. And as a result, we've become more cautious, because we can't give you the same level of assurances that we felt like we could previously.

We do have a pretty broad leasing effort through our platform. We've got one individual at our Company who does nothing but focus on leasing to the government sector. But we have a very broad network of leasing activity with non-government tenants. We continue to market to both sectors. We've been successful because of where some of our buildings are located, the price point under where we are able to offer leasing. I think that kind of balances the success versus our cautious optimism.

Got it. Okay, that's helpful. And then from an acquisition perspective, again, understand the comments about markets being very competitive. Curious what you're seeing out there from a range of, again, the high-quality Federal agency type stuff that has very, very long lease terms. What kind of cap rates are out there for that stuff versus the shorter lease term, not as high-quality assets, probably with tenants that are not Federal agencies. What cap rates are you seeing on those type of assets?

Sure. If you thought about a US Government-leased building for 15 years or longer, you are probably going to see that trade for a cap rate somewhere between 5 3/4% and 6 1/2% on a going-in base, which tends to be -- cash and GAAP tend to be the same for the Government sector. And that's being driven by companies that are leveraged buyers. So they are using 75% leverage to get to some acceptable leverage IRRs. On the other hand, a state lease property that has less than five years remaining should probably trade for a cap rate between 8% and 9%. So there's a pretty big delta between the two.

And so one of the things that we spend a significant amount of time on in our underwriting process, is who the agency is that occupies the space, how strategic is that building to them achieving their mission, and what do we think the likelihood of renewal would be? At renewal would the rent go up or down? And how much capital we think we'd have to spend to keep that tenant in place.

Got it. Okay. That is all very helpful. Thank you.

Yes.

Michael Carroll, RBC Capital Markets.

Thanks. David, the 2,000 square-foot Government tenant that decided to not renew that you mentioned in your prepared remarks, did they relocate to a Government-owned space?

They did not. We're honestly not 100% sure where they're going to at this point. They occupy space in a building that we substantially renovated a few years ago for the Bureau of Land Management. They are a somewhat of an insignificant occupant in that building. They are going to stay in that Stafford market and I don't believe they have any Government-owned space in that market.

Have you noticed any of your Government tenants actually leave your space to go to Government-owned space?

I don't think we've actually had a tenant leave yet. But Jones Lang LaSalle -- or I guess they are now JLL, they are not Jones Lang LaSalle anymore. But we consider them probably the best government leasing platform in the business. They do a pretty good job of keeping us informed of what's going on in the environment. They've identified a few Federal buildings across the country where money has been spent over the last few years in order to create room to consolidate lease space.

We are fortunate in that we don't have any tenants that we think are at risk for relocation to those Federal buildings. But that's something that we monitor ongoing.

So I guess the risk to your 2015 lease expirations is fairly minimal?

Well, we think that -- we don't have any tenants in 2015 that we absolutely -- I guess that we've been given notice that they are leaving. But we have a handful of tenants in 2015 that we're nervous about. We think we're going to have some losses next year. But we can't really say definitively who they are, but we've got some risk. I don't know that they're necessarily going to relocate to Government-owned space, but we have some tenants that I think are challenging.

So most of the expirations 2015 are smaller tenants, right?

Yes. I don't think we have anybody that represents more than 1% of revenues. I think our largest occupant is 0.9%.

Okay. And then of the two assets that are currently being held for sale, how much NOI did they generate in the first quarter?

So Defense information --

Let's see. The two into Disk Ops, the Falls Church property had NOI in the first quarter of about $460,000. San Diego was a loss of $125,000, call it.

And in the Falls Church one, is that tenant leaving that's currently in the property, soon?

Yes. That tenant vacated in 2011. And we've worked with GSA to release the space but they consistently have not had any other agency to move in. So they've been paying rent on an empty building for some time.

And that lease expires when?

July of this year.

July?

Yes.

Okay. And then how is the acquisition market? I know in your comments that you talked about it a little bit. Are you more encouraged going into the rest of this year that you're going to find more deals to close?

We've got a handful of opportunities in the pipeline. Based upon the way the pipeline looks today, I'm reasonably confident we are going to close a handful of more deals. But we don't have any large transactions that we are chasing. And the large transactions that we've seen so far this year have traded at cap rates that don't work for our cost of capital. So I would anticipate it's going to be modest throughout the rest of the year.

Okay, great. Thanks guys.

Yes.

Mitch Germain, JMP Securities.

David, just curious, you mentioned this change in the leasing with shorter renewals, longer negotiation. Curious, is that changing the types of assets that you target from an acquisition perspective?

I think there's maybe two answers to the question. One, we've been talking about the challenges in the US Government lease space for a while. So I don't know that it's necessarily a change from year-end of the first quarter. I think it's something we've been dealing with for at least a year at this point.

But I think from an acquisition perspective, I think what we've concluded is a year ago we might of been pretty comfortable buying a building with five years or four year remaining lease term. Today we are much more cautious looking at something like that. Because we think that the renewal probability -- we don't necessarily come to the conclusion that the Government's going to stay in place. We think that every renewal is at risk, and we are much more thoughtful around the sustainability of that tenant in place.

Got you. And just curious, Mark, if you can provide some insight on the capital market strategy. You've got about $150 million on the line. You might have addressed it, I missed some of your comments, I apologize. But curious what the plan is to create some capacity there?

Yes. So we've got $150 million out on the line. So we have plenty of capacity, particularly given the backdrop David just gave you on the acquisition market. I think our longer-term thoughts on the revolver is the next capital markets transaction we'd like to have at GOV, would be unsecured senior notes. So in order to do that, we are going to need to have at least $250 million out on the line, so I think we're still a little ways away from any type of transaction. We do have the one acquisition under contract for about $113 million, but we're assuming an $83 million mortgage, which will finance the majority, or fund the majority of that acquisition. So I think the next transaction would be a senior notes offering, but it's still a ways off.

Thank you.

Yes.

(Operator Instructions)

Vance Edelson, Morgan Stanley.

Thanks for taking the questions. Back on the cap rates and the competition for deals and the impact that Sovereign Wells is having and so forth, is that more predominant in any of your markets in particular? For example coastal markets, while the others haven't really seen the impact yet? Or are you seeing the same level of competition even in the tier 2 markets?

Vance, we are seeing a fair amount of competition in tier 2 markets. It's a different type of competition. The buildings in tier 2 markets tend to be smaller acquisitions. They're probably more $10 million to $20 million acquisitions. So you run into either a local leverage buyer, or you run into some of our normal competitors, some of the funds that have capital raised specifically to own buildings leased to Government tenants. I would say the one thing that probably might surprise people is DC continues to be an incredibly aggressive market, particularly for buildings with long remaining lease terms. I would say that's probably a market where you're seeing the most competitive cap rates for all acquisition opportunities right now.

Okay, that's good to know. And then you mentioned the US Government strategy of looking to reduce square-foot per employee. So on the topic of densification, what inning would you say the government is in, if you had to estimate that? And is this more an issue on the Federal side than on the state side of the business?

It is more of an issue on the state side of the business -- I mean on the Federal side of the business. Excuse me. The first part of your question -- I would say that the US Government is in the tenth inning, but they think they're in the seventh inning.

Okay, all right. So moving into extra innings. And then I might have missed it, but are rent bumps moving in any particular direction? Or is that pretty much stable given the type of tenant base that you have?

It depends a lot on the market where we are seeing renewals right now. Remember that a lot of the, or substantially all of the Federal Government-leased space, the rents are flat for the term of the lease. So if we have a 10-year lease that's coming up for expiration, we should be more likely to not having a roll-up in rent because it's been flat for 10 years.

Okay. And I think you had mentioned the cost of living adjustment. That's not so much on the Federal side, in other words?

The cost of living adjustment that Mark mentioned in his prepared remarks is relative to expense. Our ability to increase operating expenses annually with the tenant.

That's it, okay. Got it. Thanks very much.

(Operator Instructions)

Brendan Maiorana.

David, I think last quarter you mentioned 150,000 square feet of known or likely move-outs. And then I forgot, I didn't hear the number of square feet moving out, but I think you said it was less than 0.2% of rent expected. So has that changed just attributable to the Falls Church property going into Disk Ops, as opposed to that was in the operating pool previously?

No, Falls Church wasn't included in that number last quarter with that 17,000 square feet approximately that we have received notice from that are going to move out this year. We have other tenants in 2015 that we are concerned about, and that we think are likely move-outs. But we haven't received notice yet. So I would tell you that, that 150,000 square feet is our watch list or our concern list. And of that one at 50,000 square feet, we know that 17,000 square feet is going away.

Okay. So just the 150,000 watch list and that's between 2014, and about 1.3 million square feet of expirations in 2015 as well?

Correct.

Okay, that's helpful. So I was listening to your comments about how you think about acquisitions. The agency, and the strategic importance of the asset to the particular agency and renewal likelihood. How do you think about the physicality of the asset when you're acquiring it? If a tenant does move out, the ability to re-let that space? How does that factor into your acquisition criteria?

Well, that's a pretty important component of it, Brendan, particularly depending upon the remaining lease term. As you probably are aware, tenant sentiments have evolved over the last couple of years, particularly as it relates to suburban office. Availability of amenities and availability of parking has become much more important. Those are obviously important factors in our underwriting as well. When we look at an acquisition opportunity, we create a 10-year capital plan on where we think we are going to spend money for building improvements, replacing the long-lived items, as well as what we think our investment's going to be for tenant improvement capital.

So that weighs into the 10-year cash flow that we prepare and what we think our levered and unlevered IR is. It also takes into consideration the downside scenario we do, which would be the tenant doesn't renew. So that's pretty critical. And our philosophy tends to be, if you can't live with the downside, don't take the risk for the upside.

Sure. It sounds like the hurdle to make your acquisitions is, the bar has been raised a bit. The track record, how would you say you've done on tenants that have moved out upon expiration in backfilling those tenants? Because I'll confess, I don't remember all the details of tenant moves, but I know there have been several instances when you've had trouble backfilling. I wonder if that's a challenge that you see in the legacy portfolio, that if you do have this increased environment of non-renewals relative to the past, that it's going to be challenging to backfill some of those legacy assets.

Yes. The buildings that probably are the most challenging to fill would be the two that the CDC moved out of in Corporate Square. We tried to lease the property in the FBI facility in Phoenix, Arizona for some time. I think that's less of an asset issue and more of a market issue. But I think the direct answer to your question is our challenges have been more with legacy assets then it has been with acquisitions. But then again, most of the acquisitions we've made have been 100% leased for relatively long durations.

Right, okay. Last one, with the thought about the Federal Government pulling back a little bit from leased square footage. Any thoughts, any updated thoughts, about what you may do with the IRS facility in Fresno which seems like it's pretty specialized? If that were an asset that maybe at some point would not be required by the IRS?

We tend to review the portfolio of all of our assets every six months or so. And we continue to address, is that an asset we want to own to lease expiration or do we want to sell it at some point prior to? So we'll continue to evaluate that a couple of times a year and make the decision at that time.

Any consideration to maybe putting a mortgage on that?

No. We could potentially -- I guess if we thought we could get a higher value for the asset because of longer duration, fixed rate debt at a low coupon. The challenge is, is use of proceeds. It would be dilutive for me to do today, because I don't have anything I can reinvest it in.

Right, okay. Thank you.

Yes.

I would now like to turn the conference over to President David Blackman. Please go ahead.

Thank you, operator, and thank you for joining our first-quarter conference call. We are in the process of scheduling meetings for the Institutional NAREIT Conference in June and hope to see many of you there. Operator, that concludes the call.

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