Office Properties Income Trust (OPI) 2014 Q2 法說會逐字稿

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

Thank you Rhonda. Good afternoon everyone. Joining me on today's call are President and Chief Operating Officer, David Blackman, and Treasurer and Chief Financial Officer, Mark Kleifges. In just a moment they'll provide some formal remarks about our second quarter financial results. This will be followed by a question and answer session.

I'd like to first note that the recording and retransmission of the conference call is prohibited without the prior written consent of the Company. Also 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, August 6th, 2014, and actual results any differ materially from those 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 conference 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 any forward-looking statements. And finally, we'll be discussing non- GAAP numbers during this conference call, including normalized funds from operations, or normalized FFO, a 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 at our website. And now I'll turn the call over to David Blackman to begin our quarterly discussion. David.

Thanks Jason. For the second quarter of 2014, Government Properties Income Trust delivered strong operating performance. We increased occupancy for the ninth consecutive quarter, entered new and renewal leases for a 16% rollup in rent, acquired or entered into agreements to acquire five properties, and entered into agreements to sell two properties. On a year-over-year comparison, we also increased normalized FFO per share by $0.03, and generated a 2% increase in same property net operating income, or NOI.

As of June 30th, GOV owned 71 properties containing 11 million square feet in continuing operations. We increased occupancy at our properties to 95.5%, up 40 basis points from the previous quarter, and 140 basis points from the second quarter of 2013. We also increased year-over-year same property occupancy by 90 basis points, as a result of our consistent leasing efforts. GOV's weighted average remaining lease term based upon revenue was 4.9 years. The US Government continues to be our largest tenant and combined with 11 state governments and the United Nations, contributed 93% of our annualized rental income.

Now let's review or second quarter activity. GOV generated 17 new and renewal leases for approximately 204,000 square feet, with a weighted average lease term of 5.1 years, which represents 12,000 square feet more lease space than our quarterly lease expirations. Combined with our acquisitions, our executed leases enabled us to increase occupancy 40 basis points from the previous quarter. Our executed leases included approximately 159,000 square feet for four US Government tenants that resulted in a 26.5% roll-up in rent, a weighted average lease term of 4.8 years, and leasing capital commitments of $5.67 per square foot per lease year.

Our leasing with non-government tenants included 13 transactions for approximately 46,000 square feet that resulted in a 12.8% roll down in rent, a weighted average lease term of 6.2 years, and leasing capital commitments of approximately $3.58 per square foot per lease share. We remain active generating leases for the vacant space across our portfolio. Currently we have about 245,000 square feet of prospective lease activity that includes 47,000 square feet of executed letters of intent, and leases executed during the third quarter. Despite our positive leasing momentum, it is unrealistic to expect all of our tenants to renew leases at expiration. For the remainder of 2014 we expect tenants occupying about 122,000 square feet of space, and that contribute 1.5% of rates to vacate. The primary tenant vacating is the Food and Drug Administration, or FDA in Rockville, Maryland, who is expected to relocate to a Government-owned building in December. This tenant occupies 100,000 square feet, and represents 1.3% of rents. Until recently, the FDA had been expanding their rental property, however, the FDA has been consolidating departments into White Oak for more than five years, so in many respects, this continued consolidation is not a surprise. This property is well located to attract both government and non government tenants, so we are confident in our ability to re-lease the property in a reasonable timeframe. As we've discussed on previous earnings calls, GOV continues to work through its capital recycling program. We have two properties held for sale, and that are categorized in discontinued operations. Our property in Falls Church, Virginia, is under agreement to sell for $16.5 million, compared to a net book value of $12.3 million. This property is being rezoned to multifamily use, which is a condition of the closing. As a result, we do not expect this sale to occur until mid-2015. Our former FBI facility in San Diego has a net book value of $11 million, and is under agreement to sell for $12.5 million. This sale is subject to customary due diligence and closing conditions, and is expected to occur prior to year-end. At this time we do not have any other properties identified for disposition.

Turning to acquisitions, during May we completed two previously-announced acquisitions containing 580,000 square feet, for an aggregate purchase price of $134.8 million, including the assumption of $83 million of mortgage debt and excluding acquisition cost. The cost per square foot of these acquisitions was $232, the weighted average remaining lease term was five years, and the weighted average acquisition cap rate was 8.5%.

In May we acquired a property containing 174,000 square feet for $22.5 million, excluding acquisition costs. This property is 94.6% leased to the Commonwealth of Virginia, for a weighted average remaining lease term of 3.8 years, was acquired at $129 per square foot, and an acquisition cap rate of 9.3%. The property is located in Richmond, Virginia, and was used by the Commonwealth to consolidate six agencies into a single location. The building is well utilized, has a high parking ratio, and is easily accessible to numerous amenities. As a result, we believe the Commonwealth will remain at this property well past its lease expiration.

Also in May we completed the acquisition of two buildings for $112.3 million, including the assumption of $83 million in mortgage debt and excluding acquisition costs. This property is located in Reston, Virginia, is 100% leased to the US Government for 5.3 years, was acquired at a cost per square foot of $276, and an acquisition cap rate of 8.3%. This is a high security property that is considered strategic by the Government, and is examined to be occupied long-term. We have also entered agreements to acquire three office properties containing 231,000 square feet for $52.7 million. The properties are 100% leased to the US Government, and the states of Washington and Arizona, the acquisitions remain subject to customary due diligence and closing conditions, so there's no assurance we will actually acquire these properties. Finally, in July we purchased 21.5 million common shares of select income REIT for $677.5 million, plus $11.3 million in accrued dividends. We're excited about this transaction because we believe this makes GOV's already safe distribution more secure.

Select is a $2 billion net lease REIT also managed by RMR, so we know the company well, the Company currently operates with a debt to book capitalization of 23%, has the lowest dividend payout ratio in the net lease sector at 61% of normalized FFO, has a weighted average remaining lease term of 10.6 years, and a history of consistently increasing its distribution rate. In addition to this investment being immediately accretive to GOV shareholders, we believe the investment in Select will deliver consistently growing cash returns without future capital requirements, and is an investment with valuation upside. Considering the uncertainty in the business of leasing to Government tenants today, we believe the stability of the investment in Select is valuable to GOV shareholders.

In summary, we're pleased with our results of operations and our activity during the quarter. While we have many leasing challenges ahead, we believe our future is bright in providing shareholders a safe and predictable distribution. I'll now turn the call over to Mark Kleifges, our CFO, to provide more detail on our financial results, and our permanent financing plans for investment in Select income REIT.

Thanks, David. Let's begin with our property level operating results which were strong for the 2014 second quarter. When compared to the 2013 second quarter, GOV's rental income increased $6.5 million, or 11.6% to $62.4 million, approximately 16% of this increase was driven by same-property rental income growth, with the remainder coming from our recent acquisitions. Property net operating income for the 2014 second quarter grew $4.6 million, or 12.7% year-over-year to $40.4 million. Similar to our rental income, approximately 15% of this increase was driven by same property growth with the remainder coming from acquisitions.

Our consolidated GAAP and cash NOI margins for the 2014 second quarter were 64.6% and 64.1% respectively. Same property GAAP and cash NOI margins were 64.1% and 63.7% respectively for the quarter. On a consolidated basis as of June 30th our properties were 95.5% leased, which is up 140 basis points from 94.1% a year ago. Much of this increase came organically as same property occupancy grew 90 basis points year-over-year to 95% as of June 30th. Adjusted EBITDA for the second quarter of 2014 was $37.4 million, an increase of 10.2% in the 2013 second quarter. As a result, our adjusted EBITDA to interest expense ratio remained very strong at 7.2 times for the quarter, and our debt to annualized EBITDA was only 4.9 times at quarter end.

Normalized FFO for the second quarter was $31.5 million, or $0.57 per share, which is up from $29.5 million, or $0.54 per share for the 2013 second quarter. We paid a $0.43 per share dividend during the second quarter, equating to a normalized FFO payout ratio of approximately 75%. During the second quarter, we spent $2.3 million on tenant improvements and leasing costs. At quarter end, we had approximately $16.5 million of unspent leasing related capital commitments. We also spent $1.8 million on improvements to our properties during the second quarter.

Now turning to our balance sheet, as of June 30th, our debt to total book capitalization was 43%, and approximately $355 million remained available under our $550 million unsecured revolving credit facility. As David mentioned, in early July GOV purchased 21.5 million shares of Select Income REIT, or SIR, for approximately $689 million, using proceeds from a new $500 million unsecured term loan, and borrowings of $189 million under our revolving credit facility. The new term loan bears interest at the rate of LIBOR plus 175 basis points, and matures in July 2015. We have already paid down a substantial portion of the term loan balance through the equity offering that we completed late last month. Including the full over allotment option which was exercised by the underwriters, the net proceeds of this offering totaled approximately $350 million, representing approximately 50% of the SIR investment. Pro forma for the SIR investment and this offering are debt to total book capitalization was approximately 45% at June 30th.

In the months ahead, we will look to the debt markets to long term finance the remainder of the term loan, and a portion of our revolver with fixed rate unsecured senior notes. From a modeling perspective, we will account for our investment in SIR under the equity method of accounting, and therefore will recognize our proportionate share of SIR's normalized FFO.

In closing, we are pleased with our operating results in the second quarter, especially given the challenges that we have seen in the government leasing sector in recent quarters. That concludes our prepared remarks. Operator, we are ready to open it up for questions.

Operator Ladies and gentlemen, we will now conduct a question-and-answer session, (Operator Instructions). And we do have a question, our first question comes from Michael Carroll with RBC Capital Markets. You may go ahead.

Can you give us an update what you're seeing on the acquisition market? Last quarter you indicated competition was fairly fierce from the people adding leverage to the deals, and it was difficult to get them done, but it seems like activity has picked up for you this quarter?

Yes, it's a good question, Mike. So the two acquisitions that we closed during the quarter, one of them, the large one, the one that was in Reston, Virginia, we had been working on that transaction for almost a year, so that isn't necessarily reflective of current market conditions. And the acquisitions that we have under agreements, we think we have those at reasonably favorable cap rates, we have seen a little bit more activity in the market, but there continues to be a lot of transactions that we look at where our pricing on a transaction is substantially below where other market participants will price it. So the market continues to be pretty aggressive. We have had better success with some of the acquisitions we've been chasing recently.

Are you comfortable with your ability to release those assets, the terms seem fairly low?

Well, the one in Richmond, Virginia, which has a 3.8-year remaining lease term, as I mentioned in my prepared remarks, that was the Commonwealth of Virginia consolidated six agencies into that building. It's located in an area that has some very attractive retail amenities, and it has an exceptionally high parking ratio. So the Government utilizes it well. I would be very surprised if we didn't renew them in place. But because of the amenities, because of the quality of the building, because of the parking ratio, yes, we would be very comfortable if we had to re-lease that building should they not renew. But again I think that's remote.

Alright. And then can you also explain your reasoning for buying the SIR shares? How does that fit your strategy and are you going to move away from the Government focus that you have been doing since the IPO?

Yes, Mike, we don't really view the investment in SIR as a strategy shift. We're going to continue to remain focused on acquiring buildings leased to Government tenants, and leasing our buildings to Government tenants. I think the rationale for the investment is really pretty well laid out in our prepared remarks, which I would be happy to go back and reiterate if you felt that would be helpful.

Are you going to be a long-term holder of the SIR shares?

I think as we look at this investment today, we consider it a long-term investment.

Okay. Great. Thanks.

(Operator Instructions). We do have a question from Young Ku with Wells Fargo. You may go ahead.

Great. Thank you. I just want to go back to the SIR question a little bit. Will there be a forgive fee, base management fee forgiveness for the rate that you just raised, regarding the SIR share purchase?

Well, there is no business management fee paid on the investment in SIR, if that was your question.

But you'll be getting, or RMR will be getting additional fees from the equity that you just raised, is that correct?

Well, the business management fee --

This is Mark. The fee is going to be, is calculated, the base fee is calculated based on the lower of investments, the cost of investments in real estate, and total market capitalization. So, no, we won't be, most likely the investment in real estate will be lower than total market capitalization after the SIR transaction, therefore we'll only pay base management fees on investments in real estate. So the equity offering would have no impact under that scenario on base management fees.

But the equity portion that you're going to be accounting for on your balance sheet, there will be incremental kind of fees associated with that?

No, there will be no incremental fees associated with that.

No, no.

That doesn't fit the definition of an investment in real estate under the management contract.

Okay. Thank you. That's helpful. And an additional question. It doesn't make sense to finance this purchase with all equity because you're essentially putting leverage on already-leveraged vehicles. I was just wondering if I can get your take on that?

Well, I think, Young, we look at the capital allocation on our portfolio as a portfolio, so as we use debt and equity to finance our business, we're doing it based upon our portfolio investments, we're not trying to necessarily match fund transactions. So GOV was relatively lowly-levered before our investment in SIR, we remain a relatively lowly-levered company after the initial step in our permanent financing plan at 45% debt to book capitalization. So I think you should think about it more from more from a portfolio theory perspective, than you should a matched funding of an investment.

Okay. And so on a pro forma basis, after this transaction, where would you guys peg your kind of leverage in your balance sheet capacity for incremental acquisitions?

Well, I think the equity offering that we completed at the end of last month brought our leverage down to where we're comfortable operating the Company, which is at about 45% debt to total book capitalization. And given the acquisition pipeline that David discussed, and the fact that we don't have a lot in the pipeline today, we don't see ourselves needing to raise additional equity in the near term, absent a change in our outlook for the acquisition market.

Okay. And could you just provide the pro forma leverage post the transaction?

After the acquisition of SIR and the equity offering, leverage is at 45% of total book capitalization.

Okay. Got it. Thank you.

Our next question comes from Mitch Germain with JMP Securities. You may go ahead.

Good afternoon. David, talk to me if you could about your role. Obviously you serve more than one role in the RMR organization, and you're involved with SIR, so what was your involvement in the purchase?

Well, when this opportunity was presented to GOV to invest in SIR, we formed a special committee of independent trustees to evaluate the transaction, and those trustees engaged a financial advisor, as well as a legal advisor to evaluate the transaction. So in essence, my role was really limited to none. It was all evaluated by the independent trustees with the support of a financial advisor and legal counsel.

And it seems like I know you've stressed the fact that the dividend is secure here, I guess I'm just curious, it seems like a big investment to keep the dividend flat. Maybe just talk around kind of what was your reaction when they approached you that this deal was happening?

I think was very positive on the opportunity, I think highly of Select Income, and the assets that it has owned. I think there is a tremendous amount of upside in that company. So I thought it was positive for both companies. I think it was a good transaction.

Alright. And then maybe just shifting gears, you mentioned the FDA move-out. That's new, I believe, to the story. I don't think that was mentioned last quarter. I guess my thoughts it was originally that most of your move outs were going to be centered on non government, and here you have a Government tenant that kind of somewhat surprised you with a move-out. When you're looking at your expirations over the course of the next 12 to 18 months, are there any further surprises that you guys could be approached with?

Mitch, we maintain a watch list of tenants that have future lease expirations that we pay a close attention to, and I think in our last earnings call, we had mentioned that we had, I forget the exact amount but it was around 100,000 to 150,000 square feet of tenants that we had some concern about. FDA was one of the tenants was that was in that concern list because we knew of the consolidation that was going on at White Oak. We had conversations with this Agency where they had indicated at one point that they may not renew, then they came back and changed their mind, so we were getting mixed signals from them, so we didn't feel like it was appropriate to say that they were going to move out, but once we got formal notice from them during the second quarter, we felt it was appropriate to let the market know that in fact was going to happen. As we look out into 2015, we have lease expirations that represent 10.6% of our revenue, and of that, we have on our watch list about 1.3% of those tenants. So we expect that we're going to have a very high renewal rate in 2015, we don't expect that we're going to have 100% renewal rate, but I think we're going to do better than most of our peers.

Thank you very much.

Yes. Thank you.

(Operator Instructions). It looks like a follow-up question from Young Ku with Wells Fargo.

Hi there. Just a quick housekeeping item. So the assets that you guys are planning to sell, that is held for sale, is that generating any income? Because it looks like you guys had some income from discontinued ops in the third quarter, and I didn't think it was generating any NOIs?

Yes, so, the property in Falls Church, Virginia, had a tenant in it, that had a lease that was effective through July of this year, so we did have revenue during the second quarter on that asset, but do not expect that we would have, I guess we'll have some revenue during the, very little revenue during the third quarter. But that was a tenant that we've been talking about for a long time. It is the Defense Information Services that was part of the BRAC program, and that he had relocated to Fort Meade, gosh I think it was in 2012. They had tried to find a replacement for us, but it basically sat vacant while they paid rent.

Great. Thank you.

Yes.

And we do have a question from Jon Petersen with MLV Company. You may go ahead.

Hi. A few housekeeping things, the FDA moving out, exactly when is that going to happen?

They move out in December, Jon.

Okay. And then on your leasing spreads in the quarter for the Government tenants, can you remind us what market that was in that you got the 26% positive leasing spreads?

Yes we actually had four separate leases with Government tenants during the quarter. The big tenant would have been the Bureau of Prisons in Kansas City. That was a 36% roll-up in rent. We also had a 36% roll-up in rent with the Veterans Affairs in Falling Waters, West Virginia. Now the Bureau of Prisons roll-up included the amortization of some tenant improvement dollars, so that rent includes some capital that we are in essence financing for the Government. But nonetheless, we're very, very pleased with the average roll-up that we're getting from our Government tenants, particularly when we continue to see roll downs from our non government tenants.

Okay. And then just looking on the 2015-year lease expiration, are there any large tenants like the Prisons or the Veterans Affairs where you're expecting those sort of roll ups?

No, when I look at our watch list, Jon, the largest tenant that gives me some concern represents less than 1% of rents. Yes, roll ups?

I'm just trying to figure out in turns of leasing spreads. The last couple of quarters it has been pleasantly surprisingly high. I'm just trying to think about how to think about this going forward?

It's hard to tell, Jon. Our lease expirations are pretty well spread out across the country next year, and I think it's too early to tell at this point because it's a negotiation, whether we're going to have meaningful roll ups or roll downs. But generally I think our rents tend to be below market, so with the Government, we would expect to have more roll ups than roll downs.

Okay. I read an article recently a few weeks ago that the Government is going to try to push back a little bit more on their rents, that they feel like they're not being aggressive enough in their renewals negotiations. Have you seen any more aggressive pushback from the Government in terms of rental rates, or is that just kind of a fluff article I was reading?

No, the Government's been very focused on its rental business for a couple of years now, so the negotiations have been long, they've been difficult, but one of the things you have to keep in mind is, the rents that we have with the Government tend to be flat for five to ten years, and so because they haven't had growth in them, and the markets are recovering and we're starting to see some growth, in many cases our rents are below market because they were market when they were entered into, and they've been flat for five, seven, ten years.

Alright. That makes sense. Alright. Thanks for the color. I appreciate it.

Yes.

And we will now turn the call over to President David Blackman. You may go ahead.

Thank you Operator. Thank you for joining our second quarter conference call. We look forward to talking to you again at a later time. Thank you.

That does conclude our conference for today. Thank you for your participation, and for using AT&T Executive Teleconference Services. You may now disconnect.