Office Properties Income Trust (OPI) 2016 Q3 法說會逐字稿

Good morning and welcome to the Government Properties Income Trust third-quarter 2016 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 Christopher Ranjitkar, Director of Investor Relations. Please go ahead, sir.

Thank you and good morning, everyone. 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 third quarter. They will then take your questions.

First, please note that the transcription, recording, and retransmission of today's conference call are prohibited without the prior written consent of the Company. So 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, October 27, 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 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. 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 on our website.

Now I'll turn the call over to David Blackman to begin our quarterly discussion. David?

Thank you, Christopher. During the third quarter of 2016, Government Properties Income Trust continued to focus on leasing. Year to date, we have completed approximately 1.2 million square feet of new and renewal leases for a weighted average lease term of 10.3 years and a 7.8% roll-up in rent. Also during the quarter, GOV executed an agreement to acquire one property for $13.2 million with a high-quality government tenant.

As of September 30, GOV owned 71 properties containing approximately 11 million square feet that were located in 31 states and the District of Columbia. As a result of our leasing activity, consolidated occupancy increased 150 basis points year over year to 95%, and same-property occupancy increased 140 basis points to 95.2%.

GOV's weighted average lease term based upon annualized rent was 4.8 years as of September 30. The US government remains our largest tenant, and in aggregate, our government tenants contributed 92.4% of our annualized rent at quarter end.

Now let's review our third-quarter leasing activity. We executed new and renewal leases totaling more than 136,000 square feet for a weighted average lease term of 6.8 years, a 2% average roll-up in rent, and leasing capital commitments of $3.71 per square foot per lease year. New leases totaled almost 61,000 square feet for a weighted average lease term of 7.4 years, an average roll-down in rent of 13%, and leasing capital commitments of $6.00 per square foot per lease year.

Although non-government tenants remain less than 8% of our annualized rent, they dominated our third-quarter new leasing activity. Lease renewals totaled approximately 76,000 square feet for a weighted average lease term of 6.3 years, an average roll-up in rent of 17.6%, and leasing capital commitments of $1.57 per square foot per lease year. Our third-quarter lease renewals were dominated by government tenants.

Moving to our investment and capital recycling activity, in July we entered an agreement to acquire a 69,000-square-foot property in Manassas, Virginia, for $13.2 million excluding acquisition costs. The property is 100% leased for 9.5 years to Prince William County, a AAA-rated municipality. The acquisition is scheduled to close in January 2017 and remains subject to the reaffirmation of due diligence and closing conditions. So we can provide no assurances the acquisition will close.

During the quarter we also entered an agreement to acquire transferable development rights for $2 million that grants GOV the right to expand the property we own in Washington, DC, by approximately 96,000 square feet. This is part of our long-term strategic plan for the property, and we do not expect to commence redevelopment of this asset until some time around 2019.

As we disclosed in our last quarterly call, we sold our 35,000-square-foot property in Savannah, Georgia, in July for $4 million and provided seller financing for $3.6 million. Our property in Falls Church, Virginia, remains under agreement. The buyer's escrow deposit is non-refundable unless certain zoning entitlements are not obtained, and the sale is expected to close during the first quarter of 2017.

As always, we continue to evaluate the portfolio to identify additional opportunities to recycle capital. We also continue to evaluate potential acquisition opportunities for buildings that we believe provide compelling risk-adjusted returns. We maintain an active pipeline and are reasonably confident that GOV will win its fair share of opportunities over time.

As with past earnings calls, we will continue to provide insight into our expiring leases for the next 24 months. As of September 30, we have leases contributing approximately 24% of GOV's annualized rent and covering approximately 2.1 million square feet that are subject to expiration. Based upon our latest tenant discussions, we currently expect tenants contributing 1.22% of annualized rent to vacate during the next 24 months, slightly down from the 1.23% in the previous quarter. Reconciling the two quarters, tenants contributing approximately $14,000 of annualized rent vacated properties during the last quarter, as expected, while we added one new tenant contributing $12,000 of annualized rent to the list this quarter.

The tenants we have identified to be at risk of downsizing or vacating increased from 3.51% last quarter to 3.62% this quarter. This increase is the result of adding one new at-risk tenant that is a government agency we expect to reduce its occupied space from 13,000 square feet to 9,000 square feet. Other than this one addition, our at-risk list has not changed from the prior quarter.

As a reminder, these figures are the best information we have available today based upon our dialogue with tenants. As negotiation with our tenants evolve, we expect our disclosures to evolve as well. Similar to our tenant retention rate, which we believe exceeds the tenant retention rate of our suburban office peers, we believe the level of insight that we are providing about our lease expiration schedule demonstrates best-in-class disclosure practices. Both tenant retention and attracting new tenants to our buildings remains significant areas of focus for GOV, which is underscored once again by our solid lease and resort results for the year.

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

Thanks, David. Let's begin with a review of our property level performance for the third quarter of 2016. When compared to the third quarter last year, GOV's rental income grew by approximately $2.4 million to $64.5 million. On a same-property basis, our third-quarter GAAP rental income increased by $226,000 year over year to $62.3 million, and same-property cash rental income decreased $223,000 year over year to $61.5 million.

Consolidated third-quarter net operating income, or NOI, increased by $668,000, or 1.8% year over year, to $37.6 million. Consolidated cash basis NOI for the third quarter increased by $152,000, or 0.4%, to approximately $36.6 million. Our consolidated GAAP and cash NOI margins for the 2016 third quarter were 58.2% and 57.5%, respectively.

From a same-property perspective, our GAAP NOI declined by $552,000, or 1.5% year over year, to $36.4 million. And our cash basis NOI decreased by $1 million, or 2.7%, to $35.5 million. Our same-property GAAP NOI margin was 58.4%, and our same-property cash basis NOI margin was 57.7% for the 2016 third quarter. For the first nine months of 2016, same-property cash basis NOI was up 1.2%, and we expect same-property results to be positive for the full year.

Normalized FFO for the third quarter was $38.6 million, which is down from $41.9 million for the 2015 third quarter. Normalized FFO per share for the 2016 third quarter was $0.54, a decrease of $0.05, or 8.5%, from the 2015 third quarter. The decline in normalized FFO this quarter is due primarily to the increase in interest expense resulting from our senior note offering in May and the impact of rising short-term interest rates on our floating-rate debt.

Adjusted EBITDA increased by $1.3 million, or 2.8% for the 2016 third quarter, to $47.1 million, and includes approximately $12.7 million of cash distributions received from our SIR investment. We paid a $0.43-per-share dividend to shareholders during the quarter, which equates to a normalized FFO payout ratio of 79.6%. We spent approximately $3 million on recurring building improvements and $6.3 million on tenant improvements and leasing costs in the 2016 third quarter. As of quarter end, we had approximately $21.6 million of unspent leasing-related capital commitments, of which we expect to fund $8 million in the fourth quarter.

Turning to our balance sheet and liquidity, our adjusted EBITDA-to-interest-expense ratio for the quarter was 3.7 times, and total debt to total gross assets were 48.9% as of September 30. At quarter end, we had only $25 million outstanding under our $750 million revolving credit facility.

That concludes our formal remarks for the quarter. Operator, we'd like to open the call up for questions.

(Operator Instructions.) Jamie Feldman, Bank of America Merrill Lynch.

So I guess, Mark, if you commented that your interest rate was higher on the senior notes and then the floating-rate debt, the first question is maybe just can you quantify that, how much of it came from each? And then I guess bigger picture, as we start to see the 10-year tick higher, how are you guys thinking about locking in some of that floating-rate debt, and what's your comfort level with keeping it floating versus fixed?

So interest expense was up just a little short of $3.5 million for the quarter. About $3 million of that was a result of a senior note offering, the difference between the interest rates on those senior notes and the interest rate on our revolver, which we paid down with proceeds from that offering as well as a couple of mortgage notes that we paid off earlier in the year. And then about $400,000 of the increase was a result of the increase in interest under our senior notes during the quarter. That's due to a rise in -- those notes -- the term loans, I'm sorry -- and those two term loans price off of a spread above LIBOR. And LIBOR for the year is up about 11 basis points or so.

In terms of floating to fixed, the senior note offering, we were able to increase our fixed-rate debt to about 55% of total outstandings. I think where we sit today, we're comfortable there. Our expectations, while we do expect short-term interest rates to increase, we don't think the increase is going to be dramatic. And just to put it in perspective, we have $575 million of floating-rate debt at the end of the quarter. A 25-basis-point increase in LIBOR is about $1.4 million, or $0.02 a share. So the impact's not -- given our outlook on interest rates, we don't expect the impact to be significant.

And then can you talk more about the positive GAAP leasing spreads, the positive leasing spreads for the government leases signed this quarter? What were those leases, and is that sustainable at that level?

Yes, we didn't really talk specifically, Jamie, about -- we didn't break out government versus non-government. What we talked about was is that the fact that the majority of our renewal activity was with government tenants. So we ended up doing about five leases and about 62,500 square feet with government tenants during the quarter. That increase in rent was about 10.5%. And it really varies from lease to lease, from market to market, in terms of where we have opportunities for increases in GAAP rents.

The one challenge that we have at times is we have some rents that are -- some leases that are expiring where we may have had amortization of tenant improvements in place, where we're not amortizing tenant improvements going forward. And that's typically where you'll see rents to be flat to slightly down. So I think by and large, because the US government leases are flat during the term, unless there's amortization of tenant improvements that to some extent skew the in-place rent at expiration, we're going to get some level of increase.

Okay. And then finally for me, I saw an article about IRS shutting down operations in Fresno. Is that your building, and can you talk about what the impact might be there, longer term?

Sure, Jamie. We have not had any dialogue with GSA or IRS about the property in Fresno. We have been made aware of some media reports that they have given their employees notice for that building and one other one in the country. But they will be shutting down at the end of the lease term and after the tax season. I think our lease in Fresno goes through the end of 2021, so it would be some time in 2022 that they would want to vacate that premises. Obviously, it's a large contributor for GOV, but we have quite a bit of time before there will be any impact on us or our numbers.

We do have one property that is leased to the IRS in Florence, Kentucky, that is a relatively small building that is storage for the IRS. They will be closing their Covington, Kentucky, processing center as well, and we may be impacted by that move as well. But again, that's, I think, 2019 tax season where that would take effect.

So there's no near-term impact on GOV at all. So we have plenty of time to work through any potential impact.

Okay. And when you think about that Fresno building, is it something you'd want to own long term? Assuming they were to move out, how do you think you would handle or you would try to -- what would your strategy be for the asset?

We haven't really finalized the strategy for that asset at this point. I thin, as I said, we've got until 2022 to put a strategy in place, so we're going to do some analysis on that market, what we think the impact on that market will be, alternative reuses on that building. You know, the IRS has a lot of other space they occupy in the Fresno market. It's conceivable to think that they may want to backfill those existing IRS employees into our building because it's a lower rent, it has free parking, and it's a much easier building for their employees. So I guess stay tuned, and we'll update you as we have more information.

Okay, all right, great. Thank you.

Bryan Maher, FBR.

Just a couple of quick questions. Other expenses in the quarter was a bit higher than we were expecting. Is there anything going on there?

Yes, Bryan, this is Mark. They were up. They were a bit higher this quarter. I think it was a few things that drove that, some of it one-time items such as cyclical painting for a couple of tenants, as well as just we had an increase in salaries and benefits expense over the prior year, where we had a number of open positions. But we'd expect growth in other operating expenses to moderate in the fourth quarter. For the year, we've done a pretty good job managing expenses. Total operating expenses on a same-property basis are up only 1.7% through the first three quarters. So we've been fairly successful in managing that, and I'd expect growth in operating expenses to moderate in the fourth quarter.

Okay. And just as another article that we have seen -- I guess it was in the Washington Business Journal -- on the FBI determining in the next few months, I guess, where their new headquarters will be, a $1.8 billion project. Granted, that's a little ways down the road, but does that impact you guys at all in the Washington, DC, area?

Bryan, we don't anticipate that would have any impact for us. We have one building leased to the FBI in Stafford, Virginia. It's the headquarters for the Behavioral Analysis Unit. They need to be near Quantico, and we're right across the entrance from Quantico. So we feel pretty good about that particular location and don't think we'll be impacted.

Okay, thanks a lot.

Mitch Germain, JMP Securities.

David, it seems like whenever you guys do some leasing with non-government tenants, some of the statistics are a bit challenged in terms of spreads and TIs. Is that, generally speaking, is that something that you think is an accurate statement?

Mitch, I think it's an accurate statement. I mean, the US government in particular tends to pay higher rents than private-sector tenants. Part of that's due to their security requirements. We also tend to have slightly higher tenant improvement costs with non-government tenants, which generally is just an upgrade to the quality of the tenant build-out. That is why you see us very focused on trying to renew government tenants in place and backfilling vacant space with government tenants versus private-sector tenants.

And where do you think we stand with regards to this whole optimization plan from the government? Is it latter stages at this point? What's your view there?

I think -- it's a good question, Mitch, and I'll give you my opinion. It's always hard to know exactly where things stand, because this has become very political. I think on the one hand, Congress will continue to focus on increasing utilization rates and trying to save as much money as they can in leasing real estate. With that said, I think the vast majority of buildings around the country that are occupied by GSA-related agencies are meeting or have met their utilization rates. So I think we're in certainly the latter half, maybe the seventh inning, of government right-sizing their space.

Great. And last for me, there's two vacant properties. Maybe (A) what sort of prospect activity are you seeing there, and (B) either one of those potentially going to hit a -- become a disposition candidate over time?

We're working on leasing plans, and we've had some showings on both of those spaces. We are also taking a hard look at whether we think it makes sense to own those buildings long term or go ahead and move them out as dispositions. So we may have an update for you on the next earnings call, but we're thinking through both of those strategies right now, Mitch, to see what makes the most sense for the Company.

Thank you.

And ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to David Blackman for any closing remarks.

Thank you for joining us this morning. Mark and I will be at the NAREIT conference in November and hope to see many of you there. Operator, that concludes our call.

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