Office Properties Income Trust (OPI) 2014 Q4 法說會逐字稿

Good day, and welcome to the Government Properties Income Trust fourth-quarter financial results conference call. This call is being recorded.

At this time for opening remarks and introductions, I would now like to turn the conference over to Director of Investor Relations Mr. Jason Fredette. Please go ahead, sir.

Thank you, Christy, and good afternoon, everyone. Joining me on today's call are President David Blackman and Chief Financial Officer Mark Kleifges. They'll provide insight about our recent accomplishments and results, and will then take your questions.

Please note that the transcription, recording, and retransmission of today's conference call is prohibited without the prior written consent of the Company. 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 20, 2015. 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 the SEC's website or the investor section of our website at govreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And finally, we will be discussing non-GAAP financial metrics during this call, including normalized funds from operations, or normalized FFO. 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.

Now I will turn the call over to David Blackman to begin our discussion. David?

Thank you, Jason. For those new to our story, Government Properties Income Trust is focused on owning and acquiring buildings that are majority leased to government tenants. In aggregate, 93% of our rent is paid by government entities, which are comprised of the US Government contributing nearly 70% of rent on behalf of 39 agencies, 12 state governments contributing nearly 20% of rent on behalf of 31 agencies, and the United Nations, which contributes just over 4% of our rent.

We believe GOV's strategy has distinct advantages. First and foremost, we believe the credit worthiness of our tenant base is unparalleled in the REIT space. Many of our peers would be proud to have 50% of their rents coming from investment-grade tenants. We at GOV have well over 90% of our rents coming from investment-grade tenants.

In addition, government tenants have historically occupied space significantly longer than private-sector tenants. In fact, the US government historically occupies the same space for more than 20 years on average, which adds to the security and stability of our income.

That being said, the US Government leasing environment has become more challenging in recent years. This is due, in large part, to changes that are being implemented by the general services administration, or GSA, which oversees nearly all the federal government's leasing activities. The GSA has been placing an emphasis on reducing the amount of occupied space per federal employee, and consolidating into owned buildings where available. At the same time, competition for owning US government-leased properties has intensified, compressing acquisition cap rates, and making it more difficult to purchase properties at compelling yields.

Amid this challenging backdrop, Government Properties Income Trust has continued to perform solidly. In 2014, we maintained strong occupancy, and once again, generated rent roll-ups from our government tenants. For the full year, GOV executed 632,000 square feet of new and renewal leases for a weighted average lease term of 5.4 years, with leasing capital commitments of $3.64 per square foot per lease year, and rental rates that were 6.7% higher than previous rental rates.

Both consolidated and same-property occupancy was flat year over year, going from 94.8% in 2013 to 94.9% in 2014 on a consolidated basis, and from 94.6% in 2013 to 94.5% in 2014 on a same-property basis. This level of occupancy remains compelling and enviable for a company that primarily owns suburban office buildings.

GOV acquired four properties during 2014 containing 730,000 square feet. The purchase price for these acquisitions, excluding acquisition costs, was $167.5 million or $229 per square foot. The average acquisition cap rate was 8.4%, and the properties were 99.3% leased for a weighted average remaining lease term of 5.4 years at the time of acquisition. Nearly 80% of these properties were leased to the US government, while the vast majority of the remaining buildings were leased to the Commonwealth of Virginia and the state of Arizona. We also made a strategic investment in Select Income REIT in mid-2014, which has been accretive to both FFO and CAD.

From a balance sheet perspective, we further enhanced our liquidity by replacing our unsecured revolving credit facility and term loan with new facilities in 2014 that increased our borrowing capacity, extended our maturities, and lowered our borrowing costs. In addition, GOV priced an inaugural investment-grade senior notes offering, issuing $350 million in senior unsecured notes due August 2019 at a fixed coupon of 3.75%. This, in turn, reduced our percentage of floating-rate debt from 37% of total assets to 23%.

For the fourth quarter of 2014, GOV delivered improving year-over-year results in both consolidated and same-property operations. By increasing rental rates at our properties, we have increased same-property GAAP NOI by 2.2% and cash NOI by 2%. Our rent roll-ups and our accretive investments help us grow fourth-quarter consolidated GAAP NOI by 13.5% and cash NOI by 12.8%.

As of December 31, GOV owned 72 properties containing approximately 11 million square feet in continuing operations. GOV's weighted average lease term based upon revenue was 4.9 years. We generated 12 new and renewal leases during the fourth quarter for approximately 198,000 square feet, with a weighted average lease term of 5.4 years, and a 7.5% roll-up in rent.

Our executed leases included approximately 164,000 square feet in three US government transactions that resulted in a 7.8% roll-up in rent, a weighted average lease term of 5.6 years, and leasing capital commitments of $3.02 per square foot per lease year. This included a lease with the GSA for the Defense Contract Management Agency, which is a new tenant at our previously vacant property in San Diego. Our leasing with non-government tenants during the quarter included nine transactions for approximately 34,000 square feet that resulted in a 5.8% roll-up in rent, a weighted average lease term of 4.5 years, and leasing capital commitments of $3.82 per square foot per lease year.

Turning to our capital recycling activity: At the end of the fourth 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. This property is being rezoned to multi-family use, which is a condition of our expected mid-2015 closing.

As we also previously disclosed, the GSA exercised a lease purchase option to acquire a property they occupy in College Park, Maryland. This sale closed on February 18 for $30.6 million in proceeds, excluding closing costs.

As I mentioned at the outset, the acquisition market has become increasingly competitive in recent quarters. While we continue to have an active pipeline, we did not close an acquisition during the fourth quarter of 2014.

As we move forward in 2015, we plan to maintain our stringent underwriting process, and continue to focus on making investments that are accretive to GOV shareholders. We also are intensely focused on maintaining strong occupancy across the portfolio.

In 2015 and 2016, 20.5% of our leases are due to expire. Of these 2015 and 2016 lease expirations, we currently expect tenants contributing approximately 2% of rents to vacate. This includes seven government tenants and six non-government tenants. All but one of these tenants occupy space in multi-tenanted buildings, and the largest vacating tenant contributes 0.6% of rents through the first quarter of 2016.

We have also identified 11 tenants that contribute 3.4% of rents that we believe are at risk of downsizing or vacating. Again, most of these tenants occupy space in multi-tenanted buildings, and the vast majority of these tenants have leases that expire in the second half of 2015 and the second half of 2016. We believe our estimate of at-risk tenants is aggressive, as we have included 100% of the rent for those tenants at risk of downsizing where the likely reduction in occupied square feet is approximately 20% or less.

The aggregate occupied square feet of our known vacating and the at-risk tenants over this two-year period is approximately 630,000 square feet. That is about the same square footage [released] during 2014, which we believe makes this a manageable challenge, as we expect to win more battles than we lose, ultimately maintaining a tenant retention rate above industry norms for suburban office companies.

We also have an active pipeline of leases for prospective new tenants. Currently, we have about 380,000 square feet of potential new leases that include approximately 27,000 square feet of leases under letters of intent or out for execution. We also believe we will continue our successful track record of increasing rents with our government tenants at renewal.

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

Thanks, David. Let's begin by looking at our property-level performance for the 2014 fourth quarter. When compared to the year-ago quarter, GOV's rental income increased $6.4 million, or 10.9%, to $64.6 million. On a same-property basis, quarterly rental income increased by 1.3% year over year.

Consolidated net operating income, or NOI, for the 2014 fourth quarter grew $4.8 million, or 13.5%, year over year to $40.5 million. Consolidated cash basis NOI for the fourth quarter grew at a similar rate, increasing by $4.5 million, or 12.8%, to $39.7 million. As a result, our consolidated GAAP and cash NOI margins for the 2014 fourth quarter were 62.7% and 62.2%, respectively.

Considering the challenging government leasing environment, we were pleased with our same-property GAAP and cash basis NOI performance for the quarter, with GAAP NOI increasing by 2.2% year over year to $35.6 million, and cash NOI up 2% to $35.1 million over this same period. This resulted in same-property GAAP NOI margin of 61.6% and the same-property cash NOI margin of 61.2%.

On a consolidated basis, our properties were 94.9% leased as of December 31, down 50 basis points from September 30, but up 10 basis points year over year. The sequential decline was primarily the result of the FDA vacating approximately 100,000 square feet at our Rockville, Maryland, property in December, which we previously disclosed. Despite this move-out, our same-property occupancy of 94.5% on December 31 was down only 10 basis points from year-end 2013.

Adjusted EBITDA was $51.9 million, and our debt-to-annualized-EBITDA ratio was 5.2 times for the fourth quarter. As of December 31, our adjusted-EBITDA-to-interest-expense ratio was 5.5 times.

Normalized FFO for the fourth quarter was $40.7 million, up 44% from $28.2 million from the 2013 fourth quarter, primarily as a result of our property acquisitions and our investment in SIR. On a per-share basis, normalized FFO grew nearly 12% from $0.52 per share in the year-ago quarter to $0.58 per share for the 2014 fourth quarter, with most of the accretion again stemming from our property acquisitions and our investment in SIR. During the fourth quarter of 2014, we received cash distributions from SIR amounting to $10.3 million; and this contribution will increase going forward, as SIR expects to raise its quarterly distribution from $0.48 to $0.50 per share in the 2015 second quarter.

As a result of SIR's acquisition of Cole Corporate Income Trust in late January, our ownership position in SIR has been reduced from approximately 36% to approximately 24% of SIR's shares outstanding. We continue to view SIR as a compelling investment for GOV that we believe both enhances the security of our cash flows, and provides us the opportunity to grow our future cash flows.

We paid a $0.43-per-share dividend to GOV shareholders during the fourth quarter, which equates to a normalized FFO pay-out ratio of approximately 74%. We spent approximately $1.9 million on building improvements, and $5.2 million on tenant improvements and leasing costs in the 2014 fourth quarter. As of year end, we had approximately $7.5 million of unspent leasing-related capital commitments.

Turning briefly to the balance sheet and liquidity, at December 31 our debt to total book capitalization was 45.5%. As David mentioned, during the fourth quarter we improved our liquidity by replacing our revolving credit facility and term loan with new facilities that provide increased borrowing capacity, lower interest rates, and extended maturities. We replaced our $350-million term loan with two new term loans totaling $550 million, and utilized the net proceeds from these new facilities to repay all amounts outstanding on our old $550-million revolver. Our new revolver provides $750 million of borrowing capacity at an interest rate margin that is 25 basis points below that of our old facility. These new facilities, combined with the successful completion of our inaugural unsecured senior notes issuance in August, have improved GOV's financial flexibility going forward.

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

(Operator Instructions)

We'll begin with the line of Vance Edelson with Morgan Stanley. Please go ahead.

Just a few questions. You mentioned the increased competition for acquisitions. Could you share with us who you mainly find yourself bidding against?

Is it the aggressive bids from levered buyers? Is it sovereign wealth accounts that might be interested in the cash flow? Any change in that aspect over the past several months?

Yes, Vance, it's a good question and you really nailed it. The levered buyer is very focused on owning buildings leased to the US Government, and they can get leverage at 70%, sometimes 75% at pretty aggressive financing rates. For the long leased assets in gateway markets, you do see some sovereign wealth that are very focused on unlevered yields that could be 6% and below. So that is the vast majority of the competition that we see.

Okay, and overall you would say the demand is stronger in the tier 1 versus the tier 2 markets given what you said about the gateways?

Yes, I think buyers of government leased buildings probably focus more on duration of lease than they necessarily do on markets. And what sells most aggressively are buildings with 15-year leases and the occasional 20-year lease you see out there. We have a better -- we compete better when the remaining lease term is in that eight to ten year remaining time period.

Okay, great makes sense. And then on the rental rate change of 7.5%, that metric has been lumpy in the past. It was strong this quarter, but it's typically up one quarter and potentially down the next. Do you think you might be able to string together a few positive quarters now, or will that likely remain variable?

I think leasing always tends to be variable. I think generally we find our leases below market at expiration. But leasing generally is very lumpy, and it's very difficult to predict.

Okay got it, and then just one more from me. The leasing costs and the concessions they were up just a bit, which ends a nice downward trend that had been in place since late 2013. Do you think this is the beginning of an upward trend or more of an aberration? Overall where do you see that metric trending from here?

Well, our -- are you talking about commitments or actual dollars spent?

I was looking more at the leasing costs.

If you go back and look at the last 4 quarters, you're right the trend is down, and with the exception, I think we were $2.20 per square foot per lease year in the third quarter, and so we're up above that this quarter. But we're still below where we were in the fourth quarter of 13 and the first quarter of 14.

For the year we were at $3.64 per square foot per year. Fourth quarter was obviously below that at $3.13. The $3.64 was up from 2013, where we were at about $2.90 per square foot per year. And I would -- our current thinking is that for 15 we're going to trend more towards 2013 costs than 2014 costs.

Okay. That's very helpful. I will leave it there. Thanks.

Thank you.

(Operator Instructions)

Next we will go to the line of Michael Carroll with RBC Capital Markets. Please go ahead.

David, can you touch on the leases that are at risk? What's the average rental rate for those spaces? And can you break out the 650,000 square foot number you gave between the known vacancies and the expected downsizing?

I can't give you specific rental rates for the various tenants that we have on our list of known and at risk, but again I think generally we think we have an opportunity to roll rents up in the portfolio. As for your second question, I guess what I was trying to articulate was we have about 630,000 square feet of tenants that we think will vacate or are at risk over the next 2 years. That's roughly equivalent to one year of our average leasing when you look at 2014.

So while I think we're providing good insight into how we look at the risk of the business over the next two years, I think that risk is very manageable based upon our current activity, our prospective leasing pipeline, and how we have performed over the last couple of years with our leasing business. Did that answer your question?

Of those assets or the tenants that are at risk is that including your entire space?

Oh, I understand. Yes, that includes the entire space, not just necessarily the 20% we think they might down size.

So of that 650,000 -- or 630, how much of that do you expect to actually lose?

It's hard to answer a question when it's at risk, because what that means is we're in the process of negotiating what the ultimate space would be. The GSA is maybe working through prospectuses. So I can't give you a specific answer, but what I will, I guess the guidance I would give you is, for those who we think are going to down size, they probably aren't going to down size more than 20%, and when we look at the at-risk tenants, half of those are down sizes, versus half of them we think we have a risk of keeping them in the building at all.

And, Mike, this is Jason one other thing, just to clarify. So 630,000, that figure is both the at risk as well as the ones that are known. So the known right now is about one third of that total, so 200,000-ish square feet, if that is what you were asking.

That's perfect, thanks, Jason. And then can you give us some color on the current pipeline? I know you touched about it a little bit in the call. Did you mention the size of the deals that you're currently looking at, and what are the makeup of those deals? Are they mostly federal buildings and or state buildings?

Our pipeline today is about $250 million of potential acquisition opportunities, and I believe it is 100% leased to US Government tenants. I don't think we have any state leases in that pipeline.

And then what's the typical deal that GOV is able to source and end up winning? Is there less competition on those deals? Do you have a certain competitive advantage on those types of acquisitions?

I think where we have found ourselves to be more competitive on lease terms that are less than 10 years, and where we tend to have comfort is when that remaining lease term is longer than 5 years. So I would say in that 5 to 10 year remaining lease term. We also tend to have somewhat of a competitive advantage on buildings leased to state tenants, because a lot of our competitors for the US Government leased buildings don't buy buildings leased to state tenants.

So then of that $250 million pipeline, is that most of that has lease terms remaining between 5 and 10 years?

It's a mix.

Okay, great thanks.

Our next question comes from Charles Croson with Jefferies. Please go ahead.

Hi, good afternoon. Thanks for taking the questions.

Just going back to the leases at risk, I know you don't want to give out rental rates and such, which is understandable, but if you can give us a sense of those that are downsizing and those that could potentially vacate, let's say in the example that you do manage to get some pretty good wins out of this and keeping them in the space, do you have a sense of whether those rents will have to roll down, whether you will have to do some above average tenant concessions? Can you give us a better flavor of that?

Yes, I think generally, we have an opportunity to roll rents up across the portfolio, and that would include buildings where we think we have tenants that might potentially down size or that we think might move out. With the GSA, the rent concessions and tenant improvement allowances aren't as big a factor as what GSA and Congress is mandating as it relates to increasing utilization rates across the portfolio. So I don't necessarily think that we're going to have larger capital commitments for leasing or have to roll rents down necessarily to keep these tenants in place.

I think we tend to own buildings in pretty good markets, and as you know, the leasing environment has been improving. So I think we'll have an opportunity to lease space and lease space at higher rents, generally.

Okay, that's helpful.

And then next question I have is on the acquisition pipeline, of that $250 million, what in that do you feel comfortable with that you'll secure, and what do you think might get away? Can you parse that out a little bit?

No, actually, I think it's very difficult to know exactly where we're going to be competitive. Every deal tends to bring a number of potential buyers to it and it's hard to predict when somebody decides that they just want to own a building more than anybody else. We tend to be very consistent in how we underwrite and how we bid on buildings. But it's the other people I have a very difficult time predicting.

Okay that's helpful. And then just last one from me, if the acquisition environment gets more competitive, does a potential increase in your stake at SUR become more attractive? Is that something that would be on the table?

I don't necessarily think that we look at investing in SUR versus buying buildings as mutually exclusive. I think we're primarily focused on buying real estate that's majority leased to government tenants, and that's where we spend the vast majority of our time, so and that's the piece of the business that we want to grow.

Okay, alright that's helpful. Thanks for taking the question.

Certainly.

Thank you. Our next question comes from Mitch Germain, JMP Securities. Please go ahead.

Good afternoon. David, any push-back from tenants in terms of lease term? Is it -- are you fighting to keep that five-year-plus, or has it just kind of been steady?

Mitch, one of the most encouraging things coming out of GSA right now is their focus on trying to lengthen the lease terms as they have leases coming up for renewal. So I'm hopeful that, that will put us in a position to actually have some longer duration leases as we renew tenants in place. But the current commissioner is very focused on trying to use 10 year leases as the standard, and something less than that as the exception, which is a complete reversal of where we are today which I think is encouraging.

And coming out of 2014 and into the year, I know we've talked about acquisitions and the competitive environment. How do you feel about your pipeline today, relative size of your pipeline versus last year?

I think the relative size is good. What is, as I said earlier, what's difficult to predict is just how aggressive our competitors are going to be as they look at these same opportunities we're looking at.

Great and then last from me, last call you mentioned another FDA move-out this year for the fourth quarter. That still something we should expect?

No, we had the FDA moved out of our building in Rockville Pike in the fourth quarter of 2014, and that was something that we had talked about for a couple of quarters. But, no, we don't have another FDA tenant that we expect to lose.

Let me ask it a different way. Was there a bigger move-out plan for the fourth quarter? I just was circling back to your last quarter's comments, so I thought there was another fourth quarter move-out this year that we were -- that was planned.

No, we did not -- no, nothing in addition to what we've already talked about.

Cool. Thank you.

Yep.

(Operator Instructions)

I would now like to go to the line of Christopher Ku with Wells Fargo. Please go ahead.

Thank you, it's Young Ku here. Just want to go back to leases at risk which totaled 430,000 square feet. Could you maybe provide additional color regarding how much is from Federal Government, State Government, and non-government?

We have our at-risk tenants represent 3.4% of rents, which is for 2015 and 2016. That includes 11 separate tenants, 4 of which are non-government tenants, 7 of which are government tenants, and I think of those 7 government tenants, 2 are State and the balance would be the US Government.

Okay, that's helpful. Do you have a sense on when you will probably get better visibility in terms of quantifying the actual move-outs or contractions?

Well remember, we're giving you insight two years forward, which I doubt you get from a lot of your -- from a lot of the companies you cover. One of the things we're trying to do is give you real-time updates as we're negotiating our leases. And so all of this is a moving process, and we're fighting a good battle here. And we'll continue to give you updates every quarter. But I think what we're giving you today is our best insight as to what we see over the next 24 months.

I see. That's fair. How would you characterize the assets in this bucket? Are they older vintage assets that would you potentially consider selling, or are these new product that you could probably chart that sale sooner?

I think these are kind of the average buildings in our portfolio and some of them are in the D.C. metro market, some of them are outside that area. I think by and large we feel pretty good about our ability to lease these buildings.

We may have a building here and there that we think the rental rates and the capital required to release it may not be economic, and we might consider selling the building. But at this point we haven't made a determination that any of the buildings in the known move-outs or the at-risk would be buildings that are going to be sold.

And remember; for the known move-outs, only one of those buildings is a single tenant building. All the rest of them are in multi-tenanted buildings, so it doesn't have a great impact on the building. It's just, what we're trying to do is give you insight into the revenue across our Company that is at risk.

Okay thank you for that. And just one last question from me.

Given your ownership stake in SUR which is around 24% today, if they were to issue additional equity would you potentially consider buying additional shares just to keep that 24% ownership stake?

We have not had any discussions about trying to buy shares in SUR should they decide to do an additional equity offering.

Maybe asked a little bit different way, I mean you talked about how the acquisition environment is pretty competitive, so just wondering if you still think there's value in select income.

I think there is still value in select income.

Okay. Thank you.

We do have a follow-up from Mr. Charles Croson with Jefferies. Please go ahead.

Thanks for taking the follow-up. Just a follow-up on the federal budgets. I know this is floating out there from the Whitehouse and such, but I'm just curious whether that is translating into anything with the GSA or your tenants in terms of potentially better outlook or anything. Do you have a sense of that?

Yes, I think -- it's a good question. One of the challenges that our tenant agencies have had over the last four years has been that there hasn't been a budget, which is typically their guidebook as to how they're going to run their business long term. So just the sheer fact that we may have a budget will give them guidance into how they can grow their business. So I think that's very positive, and that will allow us and GSA to enter into longer duration leases.

I think the other thing that is important is the government outlook is to grow employment over the next 12 months. I think they've recently come out and expect to grow by about 72,000 employees over the current budget period. So that will be positive for real estate occupancy as well.

Okay that's helpful. And if I can just sneak one more in, you talked about acquisitions. Any more dispositions that you -- or do you have a disposition pipeline for 2015? And then on top of that, given what the FDA has purchased, do you have any other tenants in your portfolio with an option to purchase assets that you feel might exercise that in the near future? Thank you.

We don't have any other tenants that have fixed purchase options. I think we might have one that is a state lease, but it's, I think, 10 years out, and -- but we don't have anything that is at risk at this particular point. We have not presented any other potential dispositions to the board at this point. I suspect that we will continue to look at that on a quarterly basis. And when we find buildings that we think make sense to sell, we'll present it to the board and you'll know that on the next earnings call.

Okay. Great. Thanks again for the follow-up questions.

Certainly.

And we do after follow-up from the line of Mitch Germain with JMP Securities. Please go ahead.

Sorry, the question has been asked already. Thanks.

Okay, Mitch.

Thank you. I will now turn the conference to President David Blackman.

Great thank you; I appreciate everyone joining the call today. Operator that concludes our call. Thank you.

That does conclude your conference for today. Thank you for your participation. You may now disconnect.