Office Properties Income Trust (OPI) 2014 Q3 法說會逐字稿

Good day and welcome to the Government Properties Income Trust third 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, Nick and good afternoon everyone. Joining me on today's call are President David Blackman, and Chief Financial Officer, Mark Kleifges. In just a moment they'll provide some color about our third quarter financial results. This will be followed by a question and answer session.

I'd first like to note that the recording and retransmission of today's 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, October 30, 2014 and actual results any differ materially from those that we project.

The Company undertakes no obligation to revise or publicly release the results of any revision to 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 financial metrics during this 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?

Thank you, Jason. For the third quarter of 2014, Government Properties Income Trust delivered improving year over year results in both consolidated and same property operations.

We increased same property revenue by 1% on a 50 basis point increase in same property occupancy and consolidated cash NOI by 14.2% primarily as a result of accretive acquisitions.

We also generated solid leasing with our government tenants, rolling up rent 7.8% on three leases containing 140,000 square feet. This includes a lease with GSA for the Social Security Administration who is a new tenant at the property, leasing space formerly occupied by the State of South Carolina.

As of September 30, GOV owned 72 properties containing approximately 11 million square feet in continuing operations. We increased consolidated occupancy at our properties to 95.4%, up 80 basis points from the third quarter of 2013. GOV's weighted average lease term based upon revenue was 4.8 years.

The U.S. Government continues to be our largest tenant and combined with 12 state governments and the United Nations, contributed 93% of our annualized rental income.

Now let's review our third quarter activity. GOV generated eight new and renewal leases for approximately 168,000 square feet with a weighted average lease term of 5.6 years. Our executed leases included approximately 140,000 square feet in three U.S. Government leases that resulted in a 7.8% rollup in rent, a weighted average lease term of 5.2 years and leasing capital commitments of $1.04 per square foot per lease year.

Our leasing with non-government tenants included five transactions for approximately 28,000 square feet that resulted in a 31.4% roll-down in rent, a weighted average lease term of 7.7 years and leasing capital commitments of $6.15 per square foot per lease year.

We continue to maintain an active pipeline of prospective tenants. Currently, we have about 320,000 square feet of prospective leases that includes 45,000 square feet of leases executed during the fourth quarter and executed letters of intent.

One of the new leases executed in the fourth quarter is with GSA for the Defense Contract Management Agency in San Diego. This lease is at a property that was previously occupied by the State of California which has been vacant for less than one year. This is a good example of how our reputation and expertise in the government leasing market creates revenue opportunities for the Company. We are pleased the building is once again a government occupied property.

On our last call we identified certain tenants that contribute 1.5% of rents to vacate during the fourth quarter. One of those tenants has renewed and the vacating percent of rents is now less than 1.4%. The primary tenant vacating is the FDA in Rockville, Maryland which we previously disclosed.

Looking forward to 2015 and 2016 lease expirations, we current expect tenants contributing approximately 1% of rents to vacate and we have identified tenants that contribute an additional 1.2% of rents that we believe are at risk. This compares to 23.6% of rents subject to expiration during that 24 months period. If that holds true, GOV's retention rate would exceed 90% which is high relative to other office REITs who tend to consider a tenant retention rate of 65% to 70% a success.

Turning to our capital recycling activity, in September we closed on the sale of our former FBI facility in San Diego, California for $12.1 million and recorded an $800,000 gain. The property was vacant and had a trailing 12 month negative carry of approximately $455,000.

At the end of the third quarter, GOV had two properties held for sale. As previously disclosed, our property in Falls Church, Virginia is under agreement to sell for $16.5 million compared to our net book value of $12.3 million. The property is being rezoned to multifamily use which is a condition of our expected mid-2015 closing.

Also during the third quarter we received noticed from GSA of the government's intent to exercise a lease/purchase option for $31 million on a property they occupy in College Park, Maryland. The sale is subject to customary closing conditions and is scheduled to close during the first quarter of 2015.

The trailing 12 month cash NOI for this property is $5.8 million and our internal rate of return on this investment is approximately 10%. This is the only property in our portfolio where a tenant has a purchase right.

Turning to acquisitions, in September we acquired a property containing approximately 67,000 square feet for $13 million excluding acquisition costs. This property is 100% leased to the State of Arizona for a weighted average lease term of 10.6 years and was acquired for $194.00 per square foot and an acquisition cap rate of 8%. The property is located in Phoenix and occupied by Northern Arizona University for classrooms and administrative offices.

As previously discussed, we purchased 21.5 million common shares of Select Income REIT during the quarter. We continue to believe this long term investment makes GOV's already safe distribution even more secure. We also believe that Select's pending acquisition of Cole Corporate Income Trust will make Select a stronger company, further strengthening the dividend we receive on this investment.

In addition, the cash dividends we receive from Select and the fact that this investment does not have ongoing capital requirements is expected to help GOV further its business plan of owning and leasing buildings to government tenants.

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

Thanks, David. Let's begin by looking at our property level performance in the 2014 third quarter. When compared to the year ago quarter, GOV's rental income increased $7.8 million or 13.8% to $64.2 million.

As David mentioned, same property rental income increased by 1% year over year, the remainder of the growth coming from our acquisitions since October 1, 2013.

Property net operating income for the 2014 third quarter grew $5.5 million or 15.9% year over year to $40.1 million. Similar to our rental income, the majority of this growth was generated through our acquisitions with same property NOI up .5% year over year.

Our consolidated GAAP and cash NOI margins for the 2014 third quarter were 62.5% and 62%, respectively. Same property GAAP and cash NOI margins were 61% and 60.7%, respectively, for the quarter.

On a consolidated basis, as of September 30, our properties were 95.4% leased, up 80 basis points from 94.6% the prior year. Similar to the second quarter, much of this increase came organically as same property occupancy also grew 50 basis points year over year to 94.9% as of September 30.

Adjusted EBITDA for the third quarter of 2014 was $50.5 million. Excluding the contribution from SIR we grew adjusted EBITDA by 13.9% year over year. Our adjusted EBITDA to interest expense ratio was 5.7 times for the quarter while our debt to annualized EBITDA was 5.3 times at quarter end.

Normalized FFO for the second quarter was $39.8 million or $0.61 per share which is up from $27.5 million or $0.50 per share for the year ago quarter.

We reported $12.9 million of normalized FFO this quarter related to our investment in Select Income and received distributions from SIR of $10.3 million in the quarter. As a reminder, at September 30 we owned a 35.9% interest in SIR and recognized our proportionate share of SIR's normalized FFO under the equity method of accounting for the period July 9 to September 30.

We paid a $0.43 per share dividend during the third quarter which equates to a normalized FFO payout ratio of 70.5%. We spent $3 million on improvements to our properties during the third quarter. We also spent $2.3 million on tenant improvements and leasing costs which is consistent with the prior two quarters. At quarter end we had approximately $9.4 million of unspent leasing related capital commitments.

In terms of the balance sheet, at September 30 our debt to total book capitalization was 44.9%. During the third quarter we completed a follow on equity offering that netted the Company approximately $350 million and we also issued $350 million in unsecured senior notes that are due in August of 2019 at an interest rate of 3.75%. The proceeds of these offerings allowed us to pay off the term loan that was used to partially fund our purchase of Select Income shares and to reduce amounts outstanding under our revolving credit facility.

As of September 30 we had approximately $185 million outstanding on our revolver, leaving us with approximately $365 million of capacity on this $550 million facility.

Operator, that concludes our prepared remarks. We are ready to take any questions.

(Operator Instructions) At this time we will go to the line of Michael Carroll with RBC Capital Markets. Please go ahead.

David, what was the recent for the company to terminate the Lorton and Lacey investments?

I'm sorry, Mike?

The two terminated acquisitions.

Oh, the two terminated acquisitions, sure. So, we terminated both of those, both for concerns about the acquisitions. One of them had to do with the disclosure around parking. When we got into diligence we found out that parking was substantially different. We do a pretty thorough job of diligence and if we find stuff that makes us concerned about the investment as a long term contributor to the Company, we will terminate the acquisition and that is what happened here.

Okay and then how would you describe the acquisition market today? Are you still finding deals that are attractively priced or are levered buyers still pretty active, bidding up acquisitions over your target?

Since Labor Day we have built up a very strong pipeline of potential acquisitions with properties that I would say are pretty high quality and they all look pretty interesting to us. The market continues to be aggressive. I expect that we will bid on these acquisitions and we may win a few, we may lose a few but the market hasn't changed a lot. We are still seeing pretty aggressive bidding from levered buyers.

Okay and are there any assets within your portfolio that you are looking at selling given that over the past couple of quarters that you indicated that you may start selling more assets over time.

We are looking at the portfolio, Mike. We haven't identified anything we want to present to the Board at this point and I don't know that we are going to find anything that we feel like needs to be done right away but we are taking a hard look at the portfolio right now.

We'll go to the line of Tayo Okusanya with Jefferies. Please go ahead.

First of all, the asset that the U.S. Government purchased, could you just talk a little bit about the rationale behind why they decided to exercise that option?

It's hard to explain the rationale of the U.S. Government. I think that it was at a compelling price for them to buy the asset. It is really pretty rare when they can get money allocated from Congress to do something like that and I think the options like this that they have in their portfolio are pretty limited. I am sure that the analysis was what is their long term occupancy cost buying this asset versus the cost of leasing.

Okay, that's helpful. Then as you start to think about your 2016 rules, I am sure you are starting [job] negotiations with some of your tenants. There were a couple of them where you weren't quite sure whether they would renew or not. Can you just give us an update on kind of where things stand with that?

We, in our prepared remarks I think we said we have 1.2% of rents for our 2015 and 2016 tenants that we think are potentially at risk and we had an additional 1% that we feel are going to move out. We've got 23.6% of rents subject to expiration during 2015 and 2016 and we feel like we are set to have continued high retention with our tenants.

Right, but of that 23.6%, you are thinking 2.3%, probably there is some risk associated with that?

Yes, that is correct.

Got it, that's helpful. Last question, from a Select Income REIT perspective, apart from just the investment you have in the company today, on a longer term basis is there any interest in actually buying assets from SIR or is that kind of part of the longer term plan or is that part of longer term strategy because we have seen SIR sell assets to other RMR related companies in the past.

Tayo, SIR doesn't have any buildings in their portfolio right now that would fit our criteria and the fact of the matter is I don't know that we would seriously consider a related party transaction so I would say the answer is no for either side.

(Operator Instructions) We will now go to the line of Jon Petersen with MLV and Company.

Since the Select Income call on, I guess it was Monday, obviously we saw the thing that happened with ARCP yesterday. You kind of mentioned in your prepared remarks that you are still confident with the CCIT acquisition but does this kind of give an opening where you want to look further at the portfolio and the accounting issues there and maybe it gives Select Income or you as a shareholder kind of an out in terms of getting ? given how Select Income's stock has performed, is this something that maybe you guys would want to walk away from or encourage SIR to walk away from?

Jon, I think it is probably best if you schedule a call with Jason Fredette to talk about SIR. Right now, we are here to talk about GOV.

As the largest shareholder, I assume you guys have a vote in terms of when it comes up to vote so just from that perspective.

From GOV's perspective and we entered into a voting rights agreement, we are highly supportive of the transaction and continue to be supportive of the transaction.

And you said 1.2% of tenants you think will move in 2015 and 2016. What percent of that was FDA? I think you said in the past but just for my own notes.

The FDA we think moves out in the fourth quarter of this year. I think it is December. They represent 1.3% of rent and we have just another .5% that we think we are going to lose during the fourth quarter as well. I think it is 1.37% of rents we expect to move out this year.

(Operator Instructions) We will go now to the line of Brendan Maiorana with Wells Fargo.

Hey David, I just wanted to follow up. I think I know the answer. So, FDA is 1.3% and then in 2015 and 2016 you've got an additional 1.2% at risk and then 1% that is likely to move out, right? We add the 1.3% to the 2.2% in '15 and '16, correct?

That is correct, yes.

Okay, great. Any disclosure on the pricing cap rate of the purchase option for the government for the building?

It is $5.8 million of trailing 12 month NOI versus sales price of $31 million.

It's a bargain.

It's a cap rate where we would buy the asset back. One of the reasons I disclosed our IRR on that was to make it abundantly clear that when we bought this asset we knew that purchase option was in place and we priced it accordingly.

Right, okay, understood. If you can find some 19% cap rates out there I think you guys should act on it so good luck.

You would positively ride on that?

I would, I would, well presumably if it was a good asset. And then just with respect to acquisitions and market deals that are out there, you guys are, if you look at leverage it is sort of between 40% and 45% depending on if you are using book or market cap. I think that is kind of in line with your longer term range. How do you guys think about the pricing for acquisitions that are out there relative to your cost of capital and as it was asked earlier, funding that, do we assume that there is some portion of equity that is likely or do you think asset sales could make up the funding needs for what you are looking to buy?

I am going to let Mark answer part of that question. I think we have been relatively disciplined in our approach on acquisitions based upon cap rates out there. What we have done has kind of been in that 8% range. We have dipped below, a little bit below 8% on occasion but we expect we will remain relatively disciplined in our approach on acquisitions. We do have, during the quarter we got $12.1 million from the sale of a property. We bought an asset for $13 million. We've got $31 million coming in during the first quarter. We have nothing under agreement right now. Right now, I think our asset sales are funding our acquisition opportunities and we hope that we get to the point where we can use some of the availability under our revolving credit facility to continue that.

But I guess to be clear, from a leverage perspective, do you want to move leverage up or you are just saying you would like to kind of find your equity to become more attractive and use equity plus debt to help fund and to grow the asset base?

Brendan, this is Mark. I think our capacity today is probably limited to the proceeds from known asset sales. Additional asset sales, if we were to identify additional acquisitions we would have to underwrite those with the assumption that they would be funded with a mix of common equity and debt.

Yes, and I guess if I am inferring from your comments, maybe where shares are trading now, it probably seems like some issuance of equity relative to the market cap rates that are out there, that is not an attractive source of capital.

Brendan, when we underwrite acquisitions we are using our current share price as the [equity] component because we always look at our weighted average cost of capital so it makes acquisitions more challenging right now.

And then just lastly, just kind of back to the outlook in terms of occupancy. If you've got FDA moving out and you've maybe got some pressure with some other tenants that might move out although as you point out, it is small, that 350 of tenants that are in the leasing pipeline, is most of that to backfill what are the likely move-outs?

We've got 45,000 square feet that was either executed during the fourth quarter or under letter of intent and we are working through lease documentation so we know we are going to have 45,000 square feet backfilled. We have some pretty good prospects. In fact, the FDA hasn't moved out yet and we've got a very strong prospect to backfill that space.

I think we have done a very good in leasing across our portfolio over the last two years and I don't see anything on the horizon that would change the success we've had in bringing those to the table. I'd like to also point out that we are not only bringing non-government tenants to the table but we are bringing government tenants to the table to replace some of the government tenants that have moved out.

I think our leasing team does a great job. My expectation is that continues.

So let me kind of put it into basic terms if I'm hearing you correctly. It sounds like you feel like you could probably end next year at a comparable level in terms of an occupancy rate as to where you are now even though you've got FDA that is out and probably some other tenants next year that move out as well.

We'll probably end this year around 95% occupancy. We are obviously not going to win 100% of our prospective leasing pipeline. I think we will win probably better than our fair share and I think we should run at flat to maybe slightly up occupancy by the end of 2015. We are working through the budget process right now. It hasn't completed yet but all indications are we feel good about the leasing momentum that we have.

We'll go now to the line of Mitch Germain with JMP Securities.

I am just curious, I know the last couple of quarters and maybe this is more a blanket statement than anything. I know we saw some roll-downs in the non-government tenant leasing so I'm curious, is that a reflection of the market or is that a reflection of the fact that some of those buildings have a high percentage of government tenancy and you struggle to maintain the occupancy in those spaces?

We have a building in Minneapolis that was majority leased to government tenants that we have renovated and we have been backfilling some of that space with non-government tenants and on a comparable basis, we are getting lower rents with non-government tenants than government tenants. It's not always the case. We had higher than market rents that we are backfilling with market rents and unfortunately, it just tends to be a roll-down in that building at this point but I think the non-government leasing market is improving and I expect that we are going to begin to start to see some better leasing results with non-government tenants across the portfolio.

And we will go to the line of Tayo Okusanya with Jefferies.

My follow up question has been answered. Thank you very much.

At this time I will turn the conference back to President David Blackman.

Thank you. We look forward to seeing many of you next week in Atlanta. Operator, that concludes the call. Thank you.

With that, that does conclude our conference today and we thank you for your participation and for using AT&T Executive Teleconferencing. You may now disconnect.