Office Properties Income Trust (OPI) 2015 Q3 法說會逐字稿

Good morning and welcome to the Government Properties Income Trust Third Quarter 2015 Conference Call. All participants will be in a listen-only mode. (Operator Instructions) After today's presentation there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Tim Bonang, Senior Vice President. Please go ahead, sir.

Thank you, Dan, and good morning, everyone. Joining me on today's call are President David Blackman and Chief Financial Officer, Mark Kleifges. Today's call includes a presentation by management followed by a question-and-answer session. I'd also note that transcription, recording, and re-transmission of today's conference call are prohibited without the prior written consent of the Company.

Also, 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 lease and expectations as of today, October 29, 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 Investors section of our website at govreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements.

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 package, which can be found on our website.

Finally, I would like to note that when we first issued the third quarter news release earlier this morning, we referenced to an agreement to acquire an office property with five buildings located in Richmond, Virginia, majority leased to the Commonwealth of Virginia and the US Government. Late yesterday, as a result of diligence, we terminated this agreement. At 9:44 we issued a corrected version of the news release that removed this reference.

And now I would like to turn the call over to David Blackman to begin our quarterly discussion. David?

Thank you, Tim. Today Government Properties Income Trust announced a normalized FFO of $0.59 per share. The highlight of the quarter, however, was our continued strong leasing activity, which I will review in greater detail in a moment.

As of September 30th, GOV owns 71 properties containing 10.7 million square feet located in 31 states in the District of Columbia. Consolidated at same property occupancy at quarter-end was 93.5%. These figures are down 190 basis points and 180 basis points, respectively, year-over-year, driven by non-renewals primarily in our US government buildings that have been previously identified. The vacating agencies include the FDA in Rockville, Maryland; the Bureau of Land Management in Albuquerque; the FBI in Savannah; and the Social Security Administration in Woodlawn, Maryland.

GOV's weighted average lease term based upon revenue was 4.5 years as of September 30th. The US government continues to be our largest tenant, and when combined with 12 state governments and the United Nations contributed 92.8% of annualized rent at quarter-end.

As I mentioned at the outset, we were active leasing during the third quarter with government tenant renewals comprising the vast majority of our volume. In total, we executed 207,000 square feet of leases, which included 18 leases for a 10.7% rollup in rent, a weighted average lease term of 3.3 years, and leasing capital commitments of $2.56 per square foot per lease year.

Approximately 75% of our leasing was with government tenants. This included five executed leases for approximately 155,000 square feet that resulted in a 17.4% rollup in rent, a weighted average lease term of 2.4 years, and leasing capital commitments of $0.40 per square foot per lease year.

Our largest government lease was a short-term renewal with the Bureau of Land Management in Cheyenne, Wyoming. This renewal was for only two years in order to allow the agency time to complete a housing plan for the property. This is included in our list of at-risk tenants, as we expect the agency could downsize by up to 20% as part of a longer-term renewal. They currently occupy 122,000 square feet in the building.

We signed 13 leases with non-government tenants encompassing 52,000 square feet for a 6 basis point rollup in rent, a weighted average lease term of six years, and leasing capital commitments of $5.10 per square foot per lease year. All seven of our new leases executed during the quarter for approximately 31,000 square feet were with non-government tenants.

I am also pleased to say that our leasing momentum continues. Since quarter-end, we executed a new lease for slightly more than 100,000 square feet, and we have more than 300,000 square feet of renewals that have been either executed, are out for signature, or under a letter of intent.

The 100,000 square foot new lease was executed since the quarter-end will backfill the space the FDA vacated in Rockville, Maryland, less than 12 months ago. The new tenant is Montgomery County Maryland, and the lease term is 10 years.

Moving to our capital recycling activity -- during the quarter, a potential buyer for our property in Falls Church, Virginia, terminated the agreement to acquire the property for $16.5 million. We are marketing the property and will provide further updates as our activities progress.

We are also actively marketing our 35,000 square foot property located in Savannah, Georgia. We expect the marketing period to continue for at least another 45 to 60 days and we'll update you with our progress on our next quarterly call. Recall this property is located in the Savannah historic district, and the highest and best use is a boutique hotel or multi-family housing.

The acquisition market for buildings to lease to government tenants remains aggressive. While there are plenty of potential acquisition opportunities, liberal underwriting by lenders has allowed the leverage investor to push pricing to levels that are uneconomic for GOV. As a result, we have become less competitive in the current environment.

During the quarter, we terminated two potential acquisitions for $26 million to an inability to conclude diligence to our satisfaction. Although disappointing, we strongly believe that sometimes your best acquisition is the one you don't make.

On our last earnings call, we provided insight into our lease expirations for the next 24 months and intend to provide a rolling 24-month update on earnings calls, going forward. Over the next 24 months we have leases contributing approximately 20% of GOV's annualized rent and covering nearly 1.8 million square feet that are subject to expiration. Based upon our latest tenant discussions, we currently expect tenants contributing 2.1% of annualized rent to vacate with the vast majority occurring in 2016.

This compares to 2.4% of annualized rent expected to vacate during the previous quarter. Reconciling the two quarters, tenants contributing 70 basis points of annualized rent, vacated properties during the third quarter, as expected, while we reclassified tenants contributing 40 basis points of second quarter annualized rent from our at-risk category to our vacate category this quarter.

The tenants we have identified to be at risk of downsizing or vacating this quarter contribute approximately 86 basis points of our annualized rent compared to 1.7% of annualized rent the previous quarter. This at-risk bucket is heavily weighted to 2017 and is dominated by the Bureau of Land Management into Cheyenne that I previously mentioned we expect to downsize. Again, reconciling to the previous quarter, we added one tenant representing 6 basis points of annualized rent while reclassifying 40 basis points of annualized rent to the two vacate categories as I previously mentioned.

As a reminder, these figures are the best information we have available today based upon current lease negotiations. As negotiations with our tenants evolve, we expect our at-risk disclosure to evolve as well. Similar to our retention rate, which we believe will remain well above the norm for our office REIT peers, we believe the level of insight that we are providing about our lease expiration schedule demonstrates best-in-class disclosure practices.

Tenant retention and attracting new tenants to our buildings remain significant areas of focus for GOV. As I previously mentioned, we continue to have strong lease momentum, having executed a number of leases since quarter-end.

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

Thanks, David. Let's begin with a review of our property level performance for the 2015 third quarter. When compared to the third quarter last year, GOV's rental income declined by approximately $2.1 million to $62.1 million. This change was primarily the result of the sale of our property in College Park, Maryland, in the first quarter of 2015.

On a same-property basis, our third quarter rental income increased by $124,000 year-over-year to $61.8 million. Consolidated third quarter net operating income, or NOI, declined by $3.2 million, or 8.1% year-over-year to $36.9 million. Consolidated cash basis NOI for the third quarter was down by $2.8 million, or 7.1% to $36.4 million. Both of these amounts were impacted by the sale of our property in College Park, Maryland, in the first quarter. Increased vacancies, including the FDA moveout at our Rockville, Maryland, property in December 2014 and higher property operating costs.

As a result, our consolidated GAAP in NOI cash -- cash NOI margins for the 2015 third quarter were both down year-over-year to 59.4% and 59%, respectively. From a same-property perspective, our GAAP NOI declined by 5.2% year-over-year to $36.7 million, and our cash basis NOI declined by 4.2% to $36.3 million primarily as a result of the 180 basis point increase in vacancy as well as an increase in property operating costs.

Our same property GAAP NOI margin was 59.4%, and our same property cash basis NOI margin was 58.7% for the 2015 third quarter.

Normalized FFO for the third quarter was $41.9 million, which is up from $39.8 million for the 2014 third quarter. This increase was primarily the result of the higher amount of normalized FFO realized in the 2015 quarter from our investment in Select Income REIT, which more than offset the decline in our property level performance.

Normalized FFO per share for the 2015 third quarter was $0.59, which is down from $0.61 per share for the 2014 third quarter due to the higher weighted average share count in the 2015 quarter.

We received distributions of approximately $12.5 million from our SIR investment in the third quarter. We paid a $0.43 per share dividend to shareholders during the third quarter, which equates to a normalized FFO payout ratio of approximately 73%.

We spent approximately $2.2 million on recurring building improvements, and $2.7 million on tenant improvements and leasing costs in the 2015 third quarter. As of September 30th, we had approximately $8.6 million of unspent leasing-related capital commitments.

Turning to our balance sheet and liquidity, although leverage at quarter-end remained above both historical levels and our long-term target, we remain comfortable operating the business at these leverage levels for the near term. Both are adjusted EBITDA-to-interest ratio, and our total debt-to-annualized adjusted EBITDA ratio remains strong at 5 times and 6.3 times, respectively. In addition, we have significant liquidity with $636 million of availability under our revolving credit facility at quarter-end.

Operator, that concludes our prepared remarks, and we're ready to take questions.

Thank you, we will now begin the question-and-answer session. (Operator Instructions) Mitch Germain, JMP Securities.

David, help me out here. I'm just trying to understand the risk to vacate and the at-risk. So maybe just a different way to ask, because I know you gave -- you went over that a couple of times is -- 2.1% in your mind, is planning to vacate? And then how much is, in your mind, at risk? Is that a different way to think about those two buckets?

Yes, so, Mitch, what we -- the way we're looking at this is if a tenant has given us notice that they intend to vacate, it goes into the to-vacate category. If we are negotiating a renewal or having conversations with a tenant, and we're uncertain as to whether we're going to be able to renew them in 100% of the space, then it is at risk.

And so for this quarter, we have 2.1% of our annualized rents where the tenant has given us notice that they will vacate. Not in all circumstances do we know the exact date, but we do know that at some point they will vacate the property.

And then we have 86 basis points of rent where we are negotiating renewals where we're uncertain as to whether we will renew them in 100% of the space. Does that help?

It helps a lot. So last quarter, if I'm not mistaken, you had 2.1% identified to vacate, and 1.7% at risk. So maybe can you help me reconcile --

Hold on, Mitch. We had 2.4% last quarter that was scheduled to vacate.

Oh, okay. I'm looking at the transcript so sometimes that is not -- sometimes they have different numbers. But so 2.4 was at risk -- sorry, scheduled to vacate last quarter, and then what was the at-risk last quarter?

1.7%.

Okay, so then just take me from 1.7% to 86 basis points.

Sure. We had 70 basis points of tenants -- we have rent contributed from tenants equal to 70 basis points. Excuse me -- we had 40 basis points of rent that we re-categorized from at-risk to the to-vacate category. And then we added 6 basis points.

40 basis points reclassified to vacate, and we added six.

Yes.

All right, I'll take it offline because I'm still not sure there. And then the low CapEx in the quarter -- I'm assuming that contributed to that short-term lease. Is that why it was low?

I'm sorry, I missed the first part of the question.

The CapEx -- or the leasing CapEx, sorry, in the quarter?

Sure. Yes, it was low because of the short-term renewal. We really didn't have any CapEx associated with the BLM in Cheyenne.

Because you're, like, in a -- excluding that lease, is there a better predictor of where the CapEx was in the quarter?

I would say -- if you go back and look at our history of tenant improvement capital, it really has been all over the place depending upon whether it's dominated by government tenants or non-government tenants.

So if you look at, kind of, the difference -- if you look at where our non-government tenant capital was this quarter, that was relatively high. So I would think that consistently we're going to be in that $3 range, although I think next quarter we're going to -- with this 100,000 square foot tenant, we're going to have higher capital because it's a 10-year lease.

For the last 12 months, Mitch, we've been running $2.50 per square foot per lease year. Actual year-to-date this year is about $1.94. Kind of, where I would expect us to be for the year is probably in between those two numbers -- $2.25 or so square foot per lease year.

Okay, great. Just two more for me. One is there's a couple of tranches of mortgage debt. You might have even mentioned it that are expiring next year. What are the plans for that?

I think initially we've got an $84 million mortgage maturing in April of next year, and a $23.5 million mortgage in August of next year. I think initially we'll take those out on the line and, at that point, hopefully, we'll have a sufficient amount out on the line that we could refinance that on a long-term basis.

Great. And then just the last one for me is the property -- the asset sale that fell through -- some thoughts on what happened there?

We had -- are you talking about the one within the first press release? Or are you talking about the one (inaudible) --

The one that was on the first press release and not on the second. I'll let you guys -- somebody else asked that one. I care more about Falls Church.

In all cases, it's really just been an inability to satisfactorily conclude buildings. Not always the same reason, but it's -- whether it be something about the leases that we didn't like, whether it be something about the tenant interview we didn't like, whether it be capital, that the property being higher than what we had underwritten, and we couldn't reach a satisfactory conclusion with the seller. So in all cases, it's something that we uncovered during diligence that was unexpected.

Michael Carroll, RBC Capital Markets.

Could you guys give us some color on why the government tended to like to renew such a short-term -- or have such a short term on that? Do they expect to exit that property at the end of the lease?

No. It's an interesting property, Mike, so we have a single lease with GSA where the primary tenant is Bureau of Land Management. There's actually six or seven agencies, I think, that co-habitate in that building under that single lease.

The BLM intends to downsize, although they haven't concluded as to what the magnitude of the downsize will be, and they want to separate it out into multiple leases. So they needed time to figure out what their real strategy was.

Okay, was the reason why the spread was so strong was because of the short term?

No, I think we just were getting rents to market.

Then related, too, I guess, the terminations of the contracts of the purchases and the sales. Does the volatility in the capital markets play a role in any of those deals?

No.

Okay. And then last question, and it kind of related back to leverage. I know it continues to pick up a little bit higher. I guess, how do you think about leverage right now? Do you believe there's a need to reduce that? Does that impact your ability to go out there and deploy capital?

Well, in terms of -- as I mentioned, where leverage is slightly above our historical averages in our long-term targets. Part of what's driven up -- we've historically looked to debt to total book capitalization, and that metric has been somewhat skewed by the GAAP accounting for our SIR investment, where we took the big write-off last quarter. And under GAAP you can write things down that you account for on the equity method, but you never get to write them back up.

So I think prospectively and probably because of that nuance, it probably makes sense to focus more on debt to gross book value of real estate assets and the market value of SIR shares and even that you're looking at things that that metric read about 48% leverage at quarter-end, which is still slightly above our target. We'd want even that metric to be down closer to 45 or lower.

But, clearly, the price of GOV's common stock, we're not going to go raise equity at this time to bring leverage down with the stock trading where it is. And, as I said, we're comfortable operating at this leverage level for the foreseeable future.

Does the high leverage make -- or, I guess, changes your view on how you can deploy capital to market?

Well, clearly, our cost of capital influences our ability to bid on properties to where it makes economic sense for us to acquire it. So it does have an impact, sure.

Vance Edelson, Morgan Stanley.

I'm trying to get a feel for the federal government mindset on leasing. One of the things I recently heard is that sequestration caused a lot of decision-makers to overshoot by reducing leasing and cutting back on space, and that has created some semblance of pent-up demand. Do you have any thoughts on that dynamic?

Vance, we have said before that we think the downsizing that some of the government agencies have done has gone beyond where it should go. And so I'm not surprised to hear that you kind of heard that in the market as well.

There continues to be pressure from Congress to justify the amount of occupancy. So I can't point to anything specific where an agency has come back and said, "Hey, we need to take more space compared to what we initially agreed to," but I'm not necessarily surprised by your comment.

Okay, it makes sense. And then for the canceled sale in Falls Church, I believe you haven't really commented on that yet. It sounds like what you were talking about was why you didn't buy what was in the original press release. But what's the reason the Falls Church sale fell apart? Was that a building-specific issue that the buyer had or something more related to the prospective buyer itself?

Yes, it was 100% related to the prospective buyer. They did not have any issues with the building whatsoever.

Okay, perfect. And then you mentioned the aggressive acquisition environment, and I think you mentioned lax lending standards out there. Can you give us a feel for who the competition is most recently? Are we talking about foreign capital? Are there any trends you can point to there?

Yes, I would say that predominantly is acquirers that are using more leverage than we use. And it used to be a year ago, kind of, max leverage was around 60%. The government space right now, because of the credit quality of the US government, and the paying upon the lease term, you can get 75% to 90% leverage. And so when you consider you can get, call it, even 80% leverage, and that cost of debt is around 4%, 4.5%, it makes it very hard for someone to buy assets who is trying to manage leverage at 50%.

Sure. And do you have any feel for who these buyers are who are going to 88%, 90% leverage?

It's rare that we actually know who we lose to. I tend to categorize them as leverage buyers. It's folks that are using high degrees of leverage, which tends to be funds and private investors.

Jon Peterson, Jefferies.

Just -- I know everyone's talking about these terminated acquisitions, but just a -- I know you guys don't particularly talk about cap rates until you close on a property, but since you now terminated them behind you, can you give us a sense of what yields you were going to get at these acquisition prices?

We are targeting yields for acquisitions that would allow us to generate what we think are good risk-adjusted returns for us. And today that tends to be a cap rate that is above an 8 and below, probably, a 9 or 9.25.

Is it fair to say that these properties kind of fell within that range? That wasn't the reason you terminated them because it was below that?

Everything has been consistent with where we're targeting of yields right now.

Okay, that's fine. And then I was just kind of curious -- so you've got 2.1% of rents that you expect to vacate and then a little bit more at risk. One of your peers, Corporate Office Properties, has had two instances recently where a tenant has -- they know it's moving out, and they decided they're just going to sell the building rather than deal with the down time and the CapEx to release it. How much do you guys think about that in terms of that 2.1% that you know is going to vacate? For some of those buildings is it better to just go out and market the buildings? Take the proceeds and maybe use those proceeds to delever down from that 48% level, which is a little above where you'd like to be?

Yes, well, honestly, the reason we're selling Savannah and Columbia Pike is for that reason. We just didn't feel like it was economic for us to try to release those properties. Of the 2.1% of rent where we have tenants on our to-vacate list, only one of them is a single-tenant building. So, obviously, when you're losing -- actually, that's not true. Two of them were single-tenant buildings.

So if we're losing a 5% or 10% tenant in a building, we're obviously going to, probably, try to re-lease that space and own the building. But when we have a building that's single tenant, and the government elects to move out, clearly, we're going to spend some time assessing what the cost and the down time would be to re-tenant that building and whether or not we can get an appropriate risk-adjusted return on any additional capital required to lease the space.

And, I guess, so in terms of those two buildings that are single tenant, have you already, kind of, gone through that process and decided you're going to take the risk? Or you're still trying to figure out what you want to do?

Well, one of them -- we're not 100% sure when the tenant is going to leave. So we have hired a broker in that case, and we're working through a marketing plan. So we're going to give it some time to see what we might be able to uncover.

On the other one, I think we're still working through a modified business plan to determine whether or not it makes sense to sell it or makes sense to try to release it.

(Operator Instructions) I am showing no further questions. I would like to turn the conference back over to David Blackman for any closing remarks.

Thank you, and thank you for joining us on this morning's call. We look forward to seeing some of you in Las Vegas next month at the NAREIT conference. Good day.

Thank you, and the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.