Office Properties Income Trust (OPI) 2015 Q4 法說會逐字稿

Welcome to the Government Properties Trust fourth quarter financial results conference call. All participants will be in a listen-only mode. (Operator Instructions). Please note that this event is being recorded.

I would now like to turn the conference over to Mr. Tim Bonang, Senior Vice President. Please go ahead, sir.

Thank you and good morning, everyone. Thank you for joining us for the Government Properties Income Trust fourth quarter call. Joining me on today's call are President David Blackman and Chief Financial Officer Mark Kleifges. They will provide insight about our recent accomplishments and results for the fourth quarter and then we will take your questions.

First, please note that transcription, recording, and retransmission 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 beliefs and expectations as of today, February 18, 2016. 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.

And finally, we will 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 can be found on our website.

Now I would like to turn the call over to David Blackman. David?

Thank you, Tim. Today Government Properties Income Trust announced normalized FFO of $0.61 per share. We also announced continued robust leasing activity in our first property acquisitions since September 2014, both of which I will review in greater detail in a moment.

As of December 31, 2015, GOV owned 71 properties in continuing operations, containing 10.7 million square feet, that were located in 31 states and the District of Columbia. Both consolidated and same property occupancy at quarter-end was 94.5% which in comparison to the third quarter of 2015 was 100 basis points higher as a result of almost 110,000 square feet of positive absorption.

GOV's weighted average lease term based upon revenue was 4.4 years as of December 31. The US government remains our largest tenant and when combined with 12 state governments, our municipal tenants and the United Nations contributed 92.8% of our annualized rents at quarter-end.

As I mentioned at the outset, we were active leasing during the fourth quarter, dominated by new and renewal leases with government tenants. Our total executed leases were 205,000 square feet, which included ten leases for a 13.1% average roll down in rent, a weighted average lease term of 6.4 years and leasing capital commitments of $8.56 per square foot per lease year.

Our leasing capital was higher than normal in part due to a large lease commissions and free rent for the 101,000 square feet lease executed with Montgomery County, Maryland at our 1401 Rockville Pike property. Approximately 93% of our leasing was with government tenants, which included two executed leases for approximately 191,000 square feet that resulted in a 13.4% roll down in rent, a weighted average lease term of 6.5 years, and leasing capital commitments of $9 per square foot per lease year. Again, the roll down in rent was largely the result of the Montgomery County, Maryland lease, as the new lease is being compared to a short-term lease we had with the FDA that was above market due to its short duration.

We signed eight leases with nongovernment tenants for only 14,000 square feet resulting in a 7.6% roll down in rent, a weighted average lease term of 5.1 years, and leasing capital commitments of $2.58 per square foot per lease year.

We continue to maintain an active pipeline of potential new leases. Our pipeline includes approximately 225,000 square feet of potential new leases, of which 150,000 square feet are leases that are subject to letters of intent or have been executed since quarter-end.

Moving to our capital recycling activity. We have selected of potential buyer for our property in Falls Church, Virginia and are working through negotiations of a purchase and sale agreement and buyer due diligence. The sale is subject to rezoning the property to multifamily, but we expect the process to be relatively short as a result of work completed by a previous potential buyer.

We have completed the marketing process of our 35,000 square feet office property located in Savannah, Georgia, have selected a buyer for the building, negotiated purchase and sale agreement and the buyer has commenced its due diligence. Assuming the deal transacts as expected, the sale of this property should close before the end of summer.

Since quarter-end, we acquired a 339,000 square feet LEED Platinum 28 story office tower in downtown Sacramento for $79.8 million or $235 per square foot, excluding acquisition costs. The property is 86% leased, majority occupied by the State of California and the acquisition yield was 7.1%. We expect to grow our acquisition yield to approximately 9% over time as we stabilize building occupancy to the mid to high 90% range and generate meaningful event parking revenue from activity at the new arena located one block from the property.

As with past earnings calls, we will continue to provide insight into our expiring leases for the next 24 months. As of December 31, 2015, we have leases contributing approximately 23.1% of GOV's annualized rents and covering approximately 2 million square feet that are subject to expiration. Based on our latest tenant discussions, we currently expect tenants contributing 2% of annualized rent to vacate, with the vast majority occurring in 2016. This compares to 2.1% of annualized rent categorized as to vacate during the previous quarter.

Reconciling the two quarters, tenants contributed 21 basis points of annualized rent, vacated properties during the fourth quarter as expected, while we added new tenants contributing 11 basis points of annualized rent this quarter, all of which are nongovernment tenants. The tenants we have identified to be at risk of downsizing or vacating this quarter did not change from the previous quarter and stands at 86 basis points. This at-risk bucket is heavily weighted to 2017 and remains dominated by the Bureau of Land Management in Cheyenne.

Recall that we expected this tenant to downsize not vacate. Also recall that we executed a two-year renewal for this tenant during the third quarter to give GSA time to determine a long-term occupancy plan for the agency. Considering the GSA's large leasing backlog, it is likely that we will experience other short-term renewals over the next 24 months to give GSA time to determine longer-term occupancy plans. Although this creates a level of uncertainty for GOV, we believe that expertise in the government leasing arena and our access to capital will work to our benefit in these situations.

As a reminder, these figures are the best information we have available today based upon our 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 expirations schedule demonstrates best-in-class disclosure practices. Tenant retention and attracting new tenants to our buildings remain significant areas of focus for GOV.

I would now like to 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 fourth quarter. When compared to the fourth quarter of last year, GOV's rental income declined by approximately $2.9 million to $61.7 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 fourth quarter rental income decreased by $512,000, or 80 basis points, year-over-year to $61.7 million.

Consolidated fourth quarter net operating income, or NOI, declined by $3.8 million or 9.5% year-over-year to $36.7 million. Consolidated cash basis NOI for the fourth quarter was down by $3.9 million, or 9.9%, to $35.7 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.

Our consolidated GAAP and cash NOI margins for the 2015 fourth quarter were both down year-over-year to 59.5% and 58.7% respectively. From a same property perspective, our GAAP NOI declined by $2.2 million or 5.8% year-over-year to $36.7 million and our cash NOI declined by $2.4 million or 6.2% to $35.7 million. These declines were primarily the result of increased vacancies and higher property operating costs. Our same property GAAP NOI margin was 59.5% and our same property cash basis NOI margin was 58.7% for the 2015 fourth quarter.

Normalized FFO for the fourth quarter $43.6 million, which is up from the $40.7 million for the 2014 fourth 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, lower G&A expense, and dividend income received from our investment in RMR. These increases were partially offset by the property net operating income I previously noted. Normalized FFO per share for the 2015 fourth quarter was $0.61, which is up $0.03 or 5.2% from the 2014 quarter.

Adjusted EBITDA was $46.5 million for the 2015 fourth quarter and includes approximately $12.5 million of cash distributions received from our SIR investment. We paid $0.43 per share dividend to shareholders during the fourth quarter which equates to a normalized FFO payout ratio of approximately 71%. We spent approximately $5.3 million on recurring building improvements and $5.1 million on tenant improvements and leasing costs in the 2015 fourth quarter. As of year-end, we had approximately $12.7 million of unspent leasing related capital commitments. As a result of these unspent commitments, and the higher level leasing activity forecasted for 2016, we expect our TI and leasing spend in 2016 to exceed 2015 amounts.

Turning to our balance sheet and liquidity. Although leverage at year-end remained above both historical levels and our long-term target, we remain comfortable operating the business at these leverage levels. Both our adjusted EBITDA to interest ratio and our total debt to annualized adjusted EBITDA ratio remains strong at 5.15 times and 6.2 times, respectively. The total debt to the gross book value of real estate and the market value of our SIR shares was 47.4% at December 31. At year-end, we had a significant liquidity, with $633 million of availability under our revolving credit facility.

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

(Operator Instructions). Our first question comes from Mitch Germain of JMP Securities. Please go ahead.

Good morning guys. Is the government still in this adopting this attitude toward real estate where they are looking for optimization? Or are we in the latter innings of this cycle?

Mitch, that's a good question. I would say that the government remains focused on their freeze the footprint criteria, which really is requiring agencies to justify consolidation as they try to grow space in certain locations. They are continuing to try to increase utilization rates where appropriate. But I think we are very late in the game as it relates to their ability to continue to rightsize their space or to consolidate.

Got you. And just your willingness to take on some of that leasing risk on the acquisition -- what gives you confidence in your ability to bring occupancy after stabilization in that asset?

It's the US government that is primarily focused on increasing utilization rates. The building we bought in Sacramento is majority leased to State of California. We have seen the State of California expand in the Sacramento market. The Sacramento market is actually reasonably vibrant right now. They are in the midst of completing a downtown basketball arena. I think they expect to have, call it 175 events a year at that arena, which will, I think, spur growth downtown over time.

We are actually having conversations with three existing tenants and one new tenant at that building right now. In fact, we are working through documentation with four tenants to expand or take new leases in the building right now. And we have another two tenants that we are talking with about expanding in the building. So we are actually having meaningful conversations that we think will get us to stabilization pretty quickly.

The other thing that we think we could do -- we are about a block away from the arena, if we can capture even 5% of the parking revenue associated with events, we will generate $200,000 of additional NOI. And so combined with the leases that are in conversation and that parking revenue gets us pretty close to stabilization.

Great. Last one for me and I apologize if I missed it. What sort of proceeds should we expect from those asset sales that are pending?

Mitch, we didn't disclose that because we continue to negotiate purchase and sale agreements. Our policy has typically been not to disclose pricing until we have a signed contract. So we hope to have those done relatively shortly and we will be able to talk about that freely on our next call.

Thank you.

Yes.

And our next question comes from Mike Carroll of RBC Capital Markets. Please go ahead.

Hi guys, this is actually George on with Mike. How active is the investment market right now? And are you still seeing significant competition from the leveraged buyers?

Yes. I would say as we look at potential acquisition opportunities across all the RMR companies, we see the lease amount of potential acquisition opportunities that meet GOV's criteria. A lot of what we have been seeing in the government lease space right now tend to be relatively small buildings. They tend to be properties that are selling $4 million to $5 million and less which we have not been chasing. So we haven't had as many opportunities, but we have also been focused on being pretty conservative in our underwriting criteria at this point as well.

All right. And then how competitive was the bidding process on the recent acquisition?

It was as competitive as I would normally expect. We have less competition on buildings leased to state tenants, because a lot of our competitors on the federal side don't have the ability to buy buildings leased to states. But there was an auction process held by a brokerage firm. I am sure we weren't the only potential buyer that submitted an offer and we had to be competitive to buy the asset.

All right. And then can you -- yes, go ahead.

Well, I just wanted to mention that we own other buildings in Sacramento. We have another building downtown, 915 L Street, which is relatively close to this. And we have some office properties in the suburbs as well. So we have staff in Sacramento. We know that market very well and are pretty confident of our ability to be successful in that market.

Okay. Can you remind us of your long-term leverage targets and how high you are willing to push leverage?

Well, historically we have operated with debt to total book capitalization of 45% to 50%. We were closer to 55% at year-end. If you kind of look at a pro forma for the Sacramento acquisition, we were right around 56%. I don't see us going the whole lot higher than that.

Okay. Do you have any plans to lower those numbers?

Longer-term, sure. But the only way to do that is through the issuance of equity and that's just not something that's attractive to us at the current share price of GOV.

Okay. (inaudible)

So we are comfortable operating the company at this leverage level until we get a recovery in the share price.

All right. And then last one for me. Just what drove the higher property operating expenses this quarter? Was a related to true-up or just recurring expenses?

Yes. The big driver this quarter was maintenance and repairs expense which were up quarter-over-quarter over $1 million, close to 34%. When you look at the causes for that, it's not isolated to a handful of properties. It was broad-based across our 71 properties. I think we are just in a situation where we had a high number of properties where cyclical repair work was scheduled for this quarter. We also had some unexpected or emergency repairs that came into the quarter. I think for the year, maintenance and repairs expense was up over 5%. So it's a trend that's been there all year. We expect repairs and maintenance to moderate in 2016. In fact, we would expect year-over-year expenses to go down.

All right. Thank you.

Yes.

Our next question comes from Jon Petersen of Jefferies. Please go ahead.

Great. Thanks. On the CapEx, you mentioned it was higher because of the Rockville Pike property. Did you say and maybe I missed it, what that number per square foot would have been the leasing costs without that property?

I did not say where it was without that property nor have I calculated it. What I will tell you is the Rockville, Maryland property's CapEx per square foot per lease year as above $10 a square foot.

Okay. All right. That's helpful. Sorry, how many square feet was that lease?

It was right around 101,000 square feet.

Okay. And I guess if we look into next year and the 2% at-risk which was weighted more towards 2016, are there any large leases, I guess aside from that because those guys are vacating, but in terms of renewals, are there any large leases like the Rockville lease going forward we should expect going into next year that will drive CapEx higher? I think that it generally would be higher in 2016 but are there any large pieces we should be looking for?

Yes. we have a lease that we are reasonably close to executing with a US government tenant, with GSA, that includes the addition of about 60,000 square feet of additional space and that will help us drive our CapEx a little bit higher. I think that's probably the biggest single project we have, we expect. Mark?

Yes. I think you have to realize that leasing activity in 2016 -- we have about a little over 800,000 square feet of leasing activity this year. We have got 1.1 million square feet of expirations in 2016. Plus you add in some early renewals we are expecting and this potential lease transaction that David just discussed, and we could be up close to two times the leasing activity in 2016 versus what we did in 2015. So we could see a pretty sizable jump in CapEx commitments. Now how much of that actually gets spent in 2016, we don't fully control. But the expectation should be that we will have increased TI and commission spend in 2016.

All right. I guess I get to what I am trying to get, because I did the same math too, I mean it looks like you are obviously you are going to do a lot of leasing this year. But if leasing square feet is doubling, should be expecting CapEx to double? It sounds like no, because you won't have something as significant as Rockville, but am I interpreting that incorrectly?

Yes. I don't think --

Yes. I don't think commitments will double as a result of that leasing activity, no. It could get skewed higher than you would expect it if we are successful with the leasing transaction that David talked about.

Okay.

But that we are adding 60,000 plus square feet of new space and you are basically leasing 90,000 square feet, well --

60,000 of the existing.

60,000 of existing and then it's 45,000 of new space?

I think that's right.

Yes. So we will get absorption in the company and new revenue that we don't currently have today. So it's all new space lease for the company. So it's a positive transaction and it's a long-term lease. And it's a roll up in rent, compared to where it used to be.

Okay. All right. That's helpful. And then just one more question. You mentioned in your at-risk portfolio, the largest one is Bureau of Land Management in Cheyenne and you guys are expect them to downsize. Can you give us any parameters on, if they do stay but downsize, are we talking about 25% reduction or 50% reduction?

Yes. We are still waiting for the agency to formalize a housing plan, but our expectation is they downsize in the 20% to 25% range.

Okay. All right. That's helpful. Thank you.

And our next question comes from Brendan Maiorana of Wells Fargo. Please go ahead.

Thanks. Good morning. David, so just broadly on leasing new space. As you have elaborated and Jon was asking about the CapEx on the Rockville Pike deal was high. But if you are thinking about, if you got a backfill at 2% of the portfolio, what do you think normalized CapEx dollars are to backfill space that's occupied today, but will move out, but you have got to put new tenants in the door?

Well, it's a good question, Brendan, but it's a real hard question to answer because it depends a lot on the tenants who move out of that space, the condition that space is in, what market parameters are. Our portfolio is geographically diverse. We are in 31 states and the District of Columbia and each market is a little bit different in terms of what market CapEx is. I will give you a broad answer, but it's a broad answer and I think that you should expect that our TI and lease commissions on normalized basis are going to be $3 to $5 per square foot per lease year.

And Mark, I don't know if you have a different view?

No. I think that's it.

Okay. So it could be, if you can stretch out terms, you could be sort of in that $40 to $50 a square foot range, if you are doing more medium or shorter-term deals like $5 to $7, it could be a little bit lower. And did you mention, the BLM space, was that going to be a high TI dollar amount as well? Or was that just the backfill of may be some of that space, if you can get it?

Well, so we expect the BLM to downsize probably 20% to 25%. We don't know when it's going to really happen. So we don't have the ability to even begin marketing that space at this point.

Okay. And I guess, maybe with respect to the renewals, it sounds like you get probably on these shorter-term deals you probably get a lot of reprieve in terms of CapEx because I would imagine there is not going to be any TI or a leasing commission associated with a short-term renewal. I guess the question would be, when the GSA figures out what they want to do longer term and you are able to strike some longer term deals, do you think renewals will carry large TI packages as well? Or do you think that's going to be more consistent with what you have posted in the past few years?

Yes. I think it's going to vary depending upon how that agency changes its utilization rate and how much of an open floor plan they go to, meaning how much will it change the current configuration of the space. And obviously the more changes of the current configuration of the space, the higher your TI dollars are going to be. So again you are asking good questions that are very difficult to give you accurate answers on, but you could have some situations with GSA where you are going to be above that $5 per square foot per lease year and you could be $6 or $7 dollars because you are changing configuration of the space dramatically.

Right. Okay A couple of just or just a quick one for Mark. So the two acquisitions that were done post year-end, assuming you --

One acquisition.

One, I thought there was two. Okay, sorry. The one that was done, that was done on the line and so maybe your pro forma balance on the line is around $200 million or something like that? Are you comfortable carrying that? Any financing outlook, anything on the financing front that you expect to do in 2016 if you are not particularly active in terms of acquisitions or dispositions going forward?

Yes. So the line, since year-end, we made the one acquisition of the Sacramento property for $80 million. We repaid a mortgage for about $23.5 million. So we got about $221 million out on the line. We are going to repay another mortgage for $83 million beginning March. So it will take us up to about $300 million out. We are comfortable. It's a $750 million line and we are comfortable carrying that amount on the line.

In terms of second part of your question, financing transactions for 2016, that's something we continue to monitor, evaluate whether to take some of our floating-rate debt refinance to fixed or to enter into a swap for part of our floating-rate debt or maybe even an interest rate cap. And those are things that we just continue to evaluate. But no definitive plans at this time.

Okay. All right. Thanks for the time, guys.

Yes.

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

Thank you for joining us this morning on our earnings call. Operator, you may terminate the call.

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