Office Properties Income Trust (OPI) 2016 Q4 法說會逐字稿

Good day and welcome to the Government Properties Income Trust fourth-quarter results conference call. All participants will be in listen-only mode.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Director of Investor Relations, Christopher Ranjitkar. Please go ahead.

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 insights about our recent accomplishments and results for the fourth 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. 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 22, 2017.

The Company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made on 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 in 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 again can be found on our website.

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

Thank you, Christopher. Government Properties Income Trust continued to drive leasing results during the fourth-quarter of 2016, completing approximately 387,000 square feet of new and renewal leases for a 4.3% average rollup in rent. We also acquired three properties for $131.3 million since the end of the third quarter. As of December 31, GOV owns 73 properties containing approximately 11.4 million square feet that were located in 31 states and the District of Columbia.

Occupancy on both a consolidated and same property basis was 95.1%, which on a year-over-year comparison, is a 60 basis point increase in consolidated occupancy and a 30 basis point increase in same property occupancy. The weighted average lease term based upon annualized rent was 4.8 years as of December 31. The US government remains our largest tenant, and in aggregate our government tenants contributed 87.9% of our annualized rent at year-end.

Now let's review our leasing activity. As I previously mentioned, we completed new and renewal leases totaling approximately 387,000 square feet for a 4.3% average rollup in rent; a weighted average lease term of 3.3 years; and leasing concessions and capital commitments of $2.70 per square foot per lease year. Leasing activity with government tenants was almost 344,000 square feet, for an average rollup in rent of 5.7%; a weighted average lease term of 3.1 years; and leasing concessions and capital commitments of $2 per square foot per lease year.

During the full year, GOV completed 61 new and renewal leases for 1.6 million square feet that resulted in a 6.4% average rollup in rent. We also renewed 92% of our expiring square feet during the year, an outstanding tenant retention rate.

Now let's turn to acquisitions. Since the end of the third quarter, we acquired three properties containing 562,000 square feet, for $131.3 million or $234 per square foot excluding acquisition costs. These acquisitions had a weighted average occupancy of 98.5%, a weighted average lease term of 6.5 years, and a weighted average acquisition yield of 8.3%. Our largest acquisition was for a property in northern Virginia leased to three government contractors.

Considering the new administration's focus on reducing government employment and increasing defense spending, we believe the need for government contractors to lease space is likely to expand. Coupled with the limited supply of attractive acquisition opportunities for government leased properties, GOV has added well-located and strategic properties leased to our government contractors to our acquisition criteria.

Now let's review our acquisition detail. In December, we acquired an office property in Rancho Cordova, California containing 83,000 square for $13.9 million or $168 per square foot. The property is 100% leased with the state of California as the majority tenant for a weighted average lease term of 7.2 years and an acquisition yield of 9.1%. Also in December, we acquired a three building property in Chantilly, Virginia containing 409,000 square feet for $104.2 million, or $255 per square foot. The property is located directly across from the entrance to the National Reconnaissance office and is 98% leased to three government contractors for a weighted average lease term of 6.1 years, and the acquisition yield was 8.2%.

In January, we acquired one building in Manassas, Virginia containing 69,000 square feet for $13.2 million or $191 per square foot. The property is 100% leased to Prince William County, a AAA rated municipality, for a lease term of 9.1 years, and the acquisition yield was 8.6%.

Now let's review our lease expirations for the next 24 months. As of December 31, we have leases contributing approximately 20.8% of GOV's annualized rent, and covering approximately 2.1 million square feet that are subject to expiration. Based on our latest tenant discussions, we currently expect tenants contributing 2.6% of annualized rent to vacate during the next 24 months, up from 1.22% in the previous quarter.

Reconciling the two quarters, tenants contributing approximately $360,000, or 0.1% of annualized rent, vacated properties during the fourth quarter as expected, while we added tenants contributing approximately $4.3 million, or 1.57% of annualized rent, to the vacate list this quarter. The vast majority of the tenants added to the vacate list were tenants moved from the previous quarter's list of at risk tenants. The tenants we've identified to be at risk of downsizing or vacating decreased from 3.62% last quarter, to 0.82% this quarter. The decrease is largely the result of moving the Department of Justice, at 20 Mass. Avenue, from at risk to vacate and removing the National Institutes of Health from at risk, because we are actively negotiating the extension of its lease. There were no new at risk tenants added to the list this quarter.

As a reminder, these figures are the best information we have available today based upon our dialog with tenants. As negotiation with tenants evolve, we expect our disclosures to evolve as well. Both tenant retentions and attracting new tenants to our buildings remain significant areas of focus for GOV. As I previously mentioned, our tenant retention rate for the full year was 92% on 1.6 million square feet of expirations. We are proud of these results and believe they compare exceedingly well to our suburban office peer group.

I'll now turn the call over to Mark Kleifges to review financial results.

Thanks, David. I'll begin with a review of our property level performance for the 2016 fourth quarter. When compared to the fourth-quarter last year, GOV's rental income grew by approximately $4.3 million to $66 million. This change was primarily the result of higher rental income in our same property portfolio, as well as the acquisition of our property in Sacramento, California in the first quarter of 2016.

On a same property basis, our fourth-quarter rental income increased by $1.4 million or 2.3% year over year to $63.1 million. Cash basis rental income for the 2016 fourth quarter increased $1.9 million or 3.2%. Consolidated fourth-quarter net operating income, or NOI, increased by $3.2 million or 8.8% year over year to $39.9 million. Consolidated cash basis NOI for the fourth quarter was up by $3.5 million or 10%, to $39.3 million. These increases were the result of an improvement in same property net operating income and the effect of our acquisitions. Our consolidated GAAP and cash NOI margins for the 2016 fourth quarter were both up year over year to 60.5% and 60% respectively.

From a same property perspective, our GAAP NOI increased by $1.5 million, or 4% year over year, to $38.1 million. And our cash basis NOI increased by $2 million or 5.5% to $37.7 million. These increases were primarily the result of the previously discussed growth in rental income and our success in controlling operating expenses, which were essentially unchanged versus the prior year. Our same property GAAP NOI margin was 60.5%, and our same property cash basis NOI margin was 60.1% for the 2016 fourth quarter.

Normalized FFO for the fourth quarter was $41.5 million, which is down from $43.6 million for the 2015 fourth quarter. This decrease was primarily the result of increased interest expense due to the higher weighted average interest rate on outstanding debt and the decline in the normalized FFO contribution from our SIR investment, partially offset by the increase in property net operating income. Normalized FFO per share for the 2016 fourth quarter was $0.58, which is down $0.03 or 4.9% from the 2015 fourth quarter.

Adjusted EBITDA increased 6.2% to $49.4 million for the 2016 fourth quarter 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 fourth quarter, which equates to a normalized FFO payout ratio of 74.1%. We spent approximately $2.6 million on recurring building improvements and $5.5 million on tenant improvements and leasing costs in the 2016 fourth quarter. As of year-end, we had approximately $26.5 million of unspent leasing related capital obligations, and have committed to redevelop and expand an existing property at an estimated cost to complete of $15.4 million.

Turning to our balance sheet and liquidity, our adjusted EBITDA to interest expense ratio for the quarter was 3.9 times, and our ratio of debt to gross assets was 51.5% at December 31. At year-end, we had approximately $590 million of availability under our revolving credit facility.

Operator, that concludes our prepared remarks. We would like to open it up for questions now.

Thank you. We will now begin the question and answer session.

(Operator Instructions)

At this time we will pause for a moment to assemble our roster. Our first question comes from Bryan Maher with FBR and Co. Please go ahead.

Good morning, guys. That was good color on the contractor office space. That's interesting that you're going to pursue that a little bit more. Can you give us a little bit of color -- clearly you have a couple of acquisitions in the past couple of months here. Is there something changing in that environment? Is there something changing in cap rates that make that a little more attractive? And how do you think about that relative to your current leverage and where you want to keep that?

Sure, Brian, this is David. A couple of questions in there. Let me start with, we are always evaluating a number of potential acquisition opportunities. So we tend to maintain a pipeline of anywhere from 6 to 10 potential opportunities that we evaluate. Some work from across the capital perspective, some don't. It just so happened that we found three in the fourth quarter that work for us.

I think in part, what we've seen is maybe the leveraged buyer having a tad more difficulty making their yields work because financing costs have increased. We have seen some deals get awarded away from us where the seller came back when the buyer couldn't perform. I think that will have an effect on cap rates if that continues. But we haven't seen what I would consider a material change in cap rates. We just happened, in fourth quarter, to have some opportunities that work for us. Mark, I don't know if you want to hit on leverage at all?

Yes, we finished the year with debt to total gross assets of 51.5%. While we're comfortable operating the Company with leverage at these levels, I don't see us going significantly higher. I don't think we would have an appetite for taking leverage any higher than, say 55% debt to total gross book value of assets. So that probably leaves us a maximum capacity of, call it $150 million to $200 million if we decided to take it up that high.

Okay, that's helpful. And then just one other question; are you seeing any uptick in competitive construction in the marketplace?

I read that article in the Wall Street Journal this morning about landlords' inability to push rates. We had a pretty good success in 2016 pushing rates. Now, we don't tend to play in some of the gateway markets where construction is ongoing. So we really haven't seen a lot of competition from new construction for our specific portfolio.

Okay, thank you, guys.

Yes. Thank you.

(Operator Instructions)

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

Great. Thank you. So let's see -- so a few questions here. So starting with the expected move-outs and at-risk bucket, which is always a popular metric to talk about from quarter to quarter. I'm curious if you could go back to maybe this time last year and what the at-risk bucket looks like versus how many actually moved out? Because you talked about how you had 92% retention this year, which is probably maybe a little bit higher than we would've thought going into the year. Anyway you can reconcile those metrics that you give versus the retention you got in 2016?

John, that's a great question. And Mark and I are kind of looking at each other right now. I don't think either one of us remember or have in front of us right now what our vacate and at-risk looked like last year. We tend to focus on what it was the previous quarter and what it is this quarter. So we can go back and get our information from a year ago, but I'm sorry, we can't accurately answer your question right now.

What I can say is, is that, if you look at the third quarter of 2016, our total at risk and to-vacate was 4.84% of annualized rent. We had 0.1% move out during the quarter, and then we kind of reshuffled the deck from one list to the other, and we now have 3.42% of annualized rent subject to either vacate or at risk. So, my point being, we have significantly less of the two combined today because we've had some tenants that were in the at-risk bucket that we are now negotiating leases with and no longer consider them at risk. Which I think is possible.

Got it -- yes it is. And the expected move out -- just to make sure I'm looking at the transcript numbers that are right -- sometimes these aren't always right, but the expected move-out bucket is now 2.6%, up from 1.2% last quarter. The incremental there, is that a 2017 or 2018 maturity, do you expect to move out?

Most of that is DOJ at Mass. Ave, which would be a second half of 2018.

Second half of 2018. Okay. So still pretty far out. Okay. Then on a different topic, the acquisitions you guys did, obviously your strongest acquisition quarter this year so far. Was there anything unique about these acquisitions that you were able to get them at your target yields, or has pricing moved in the markets?

Yes, I don't know that pricing has moved dramatically. We have found that with non-US government tenants, our buildings leased to non-US government tenants, so municipalities, states; the yield tends to be a little bit higher and they work better for us. So if you notice the two government buildings we acquired, one was majority leased to the State of California. I think they occupy close to 80% of that building, and there's a non-government tenant that occupies the balance.

We have less competition for deals like that. Same thing with the Prince William County deal. Because it's a municipality, there just tends to be a little bit less competition. So we tend to be able to get our pricing on those transactions if the seller really wants to transact.

Okay. And then in terms of putting permanent capital on these acquisitions, what are your thoughts on raising equity at the current stock price? And then the second part of that would be, would you consider selling your ownership in SIR to raise capital?

Yes, I think in terms of the first part of your question, on raising equity, the stock had a decent run in 2016. It was up around 20%, and as of the close yesterday, we were up another 4% year-to-date in 2017. But I think we'd still like to see the run that we are on right now in 2017 go a little further before we were interested in issuing common.

Well, you're up about 6.2% year-to-date now.

6.2% as of today?

That's where you're at now. Anyway --

As it relates to SIR -- our investment in SIR, nothing has really changed from either management or the board's perspective as that being a core investment to our business. So it's not something we are contemplating selling right now as a way to raise capital.

All right. Thank you, guys.

Thank you.

(Operator Instructions)

Our next question comes from Michael Carroll of RBC Capital. Please go ahead.

Yes, thanks. David, can you give us some color on the leasing activity that you achieved during the quarter? Mainly I'm interested in the shorter leases that the government tenants signed. Do you know what their plans are three years down the road when those leases expire?

Yes, it's a bit of a mixed bag, Mike. I think I said, probably on our last quarterly call, that because the US government has such a high percentage of leases expiring over the next couple of years, they don't have adequate capacity, GSA doesn't have adequate capacity to really manage adequately long-term expansions on every deal. So we had a handful of deals that were kicked down the road, so to speak. Nothing that we are particularly concerned about from a long-term perspective. It's just helping GSA manage their backlog and work through potential opportunities.

Okay, great. And then can you talk about what type of deals would interest you where you'd be willing to push leverage to that 55% range that Mark highlighted?

Good question. I don't know that our acquisition criteria or pricing metrics are really changing much, Mike. We really are looking for buildings that we think are strategic to the tenant, where we think we can renew them at least once. And we want it to be accretive to what we believe our long-term weighted average cost to capital is. So clearly, if we're going to push leverage higher, we need to have pricing that makes sense for that long-term weighted average cost to capital.

Okay. And Mark, is there any other levers that you can pull to reduce that leverage and can you remind us what the long-term leverage target is?

I don't -- absent selling assets, I don't think there any levers that we can pull to reduce leverage. So I don't really -- absent an equity offering, I don't see that happening.

Okay. And what's the long-term target?

I think we'd like to be back down around 45% debt to total gross assets at some point over time. That's not going to happen right away. But long-term we'd like to operate to where we get leverage down to, say 45%, create acquisition capacity, ride it back up to 50%. We're comfortable operating longer-term in the 45% to 50% debt to gross assets.

Great. Thank you.

Yes.

As it appears we have no further questions, this concludes our question and answer session. I would now like turn the conference back over to David Blackman for any closing remarks.

Thank you for joining us this morning. We look forward to updating you on our first-quarter call in April. Operator, that concludes this call.

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