Office Properties Income Trust (OPI) 2017 Q2 法說會逐字稿

Good morning, and welcome to Government Properties Income Trust's Second Quarter Financial Results Conference Call.

(Operator Instructions)

At this time, for opening remarks and introductions, I would now like to turn the conference over to the Director of Investor Relations, Mr. 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 second 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, August 1, 2017. 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 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. And good morning.

On today's call, I will review our quarterly leasing activity, our outlook for tenant retention for the next 24 months and an update on our proposed acquisition of First Potomac Realty Trust before turning the call over to Mark to review our financial results.

During the second quarter, we completed new and renewal leases totaling approximately 288,000 square feet, for a weighted average lease term of 7.2 years, a 13.5% rollup in rent and leasing concessions and capital commitments of $1.19 per square foot per lease year. Our leasing to government tenants continued to drive our operations, as approximately 236,000 square feet of our leasing was with government tenants for a weighted average lease term of 8.1 years, a 15% rollup in rent and leasing concessions and capital commitments of only $0.85 per square foot per lease year.

Now let's review our tenant retention outlook for the next 24 months. As of June 30, we have leases contributing approximately 22.1% of GOV's annualized rent and covering almost 2 million square feet that are subject to expiration during the next 24 months. Based upon our latest tenant discussions, we currently expect tenants contributing 3.2% of annualized rent to vacate properties during the next 24 months. This is up 77 basis points from the previous quarter. There are several changes to the vacate list this quarter, including moving the EPA property in Golden, Colorado, which represents 58 basis points of annualized rent, from the list of at-risk tenants; adding 2 government tenants that represent 66 basis points of annualized rent; adding 4 nongovernment tenants that represent 23 basis points of annualized rent; moving 1 nongovernment tenant that represents 2 basis points of annualized rent to the list of at-risk tenants; and having 3 tenants that represent 67 basis points of annualized rent vacate properties as expected.

We expect 36 basis points of lost annualized rent for the remainder of 2017, heavily weighted to the third quarter; and 284 basis points of lost annualized rent for 2018, of which approximately 70% will be in the fourth quarter. The 3 tenants we have identified to be at risk of downsizing or vacating decreased 61 basis points from 138 basis points of annualized rent last quarter to 77 basis points of annualized rent this quarter. This decrease is largely the result of moving the EPA property in Golden, Colorado to the vacate list. These 3 tenants are primarily at risk of downsizing, so of the 77 basis points of annualized rent on the list of at-risk tenants, we believe only 23 basis points of annualized rent is truly a flight risk.

As a reminder, the information we provide on to-vacate and at-risk tenants is the best information we have available today based upon our dialogue with tenants. Negotiations remain fluid with a number of our tenants, and circumstances can change. Tenant retention and attracting new tenants to our buildings remain a significant area of focus for GOV.

Now let's turn to our announced acquisition of First Potomac Realty Trust or FPO.

As we announced in June, GOV will be acquiring FPO for approximately $1.4 billion. Since announcing the transaction, GOV has completed a common equity offering for almost 28 million shares, raising approximately $494 million. On July 20, we also completed a senior unsecured note issuance due August 2022 for $300 million. After assuming certain FPO mortgage debt, GOV will need to fund approximately $410 million from our $750 million unsecured revolving credit facility to complete the transaction.

To fully finance the FPO transaction on a long-term basis and to manage our leverage, GOV plans to implement a property disposition program. When underwriting the acquisition of FPO, we identified approximately $300 million of FPO properties that we believe could be noncore and sold. However, we also believe it is prudent to live with the FPO properties for some time period before making the decision to sell any of these to-be acquired properties. We have also identified a number of legacy GOV properties for which we have board approval to explore selling. We are obtaining broker opinions of value and marketing plans on these properties and expect to have properties in the market to sell after Labor Day, with the expectation of closing some sales prior to year-end 2017. We expect to have the full disposition plan executed before year-end 2018.

In aggregate, we expect to raise between $500 million and $700 million from property sales to complete our long-term financing plan of FPO and to reduce GOV's leverage to levels consistent with maintaining our investment grade ratings.

Our criteria for identifying legacy GOV properties to sell includes buildings we consider noncore to our company, properties that may be challenging to remain leased to government tenants and properties with high capital requirements that deliver low returns on invested capital. Please be aware that we do not plan to discuss specific properties on today's call, as we believe that could place GOV and our shareholders at a disadvantage in maximizing value from these potential property sales.

We remain excited about integrating the FPO properties into our company and having a number of talented First Potomac employees join The RMR Group. We believe our increased exposure to Washington, D.C., the long-term accretion and the increased scale from acquiring First Potomac will have enduring benefits to GOV and our shareholders.

With that, I'll turn the call over to Mark to review our financial results.

Thanks, David.

Let's begin with the review of our property-level performance for the second quarter of 2017.

When compared to the second quarter last year, GOV's rental income grew by $5.8 million to $69.9 million. This increase was the result of both growth in same-property rental income and the effect of acquisitions. On a same-property basis, our second quarter rental income increased by $1.9 million or 2.9% year-over-year to $65.9 million due primarily to the impact of both new leases for previously vacant space and increased rental rates from certain lease renewals. The cash-basis rental income for the 2017 second quarter increased by $1.3 million or 2.1% year-over-year to $65.4 million.

Second quarter consolidated property operating expenses increased by $2.8 million year-over-year to $27.3 million, primarily reflecting higher same-property expenses as well as the impact of acquisitions. Same-property operating expenses increased by $1.5 million or 6.3% year-over-year to $26 million. This increase was due primarily to higher wage and benefit costs and utilities expense.

Consolidated second quarter net operating income or NOI increased by $3 million or 7.7% year-over-year to $42.6 million. Consolidated cash-basis NOI for the second quarter increased by $2.6 million or 6.5% to $42 million. Our consolidated GAAP and cash NOI margins for the 2017 second quarter were 60.9% and 60.5%, respectively.

From a same-property perspective, our GAAP NOI increased $342,000 or 0.9% year-over-year to $40 million. And our cash-basis NOI decreased by $190,000 or 0.5% to $39.3 million. Our same-property GAAP NOI margin was 60.6%, and our same-property cash-basis NOI margin was 60.1% for the 2017 second quarter.

Turning to our consolidated financial results. Normalized FFO for the second quarter was $42.4 million, which is down from $43.4 million from the 2016 second quarter. Normalized FFO per share for the 2017 second quarter was $0.60, which is down $0.01 or 1.6% from the 2016 second quarter. This decline was primarily the result of increased interest expense due to a higher weighted average interest rate on an increased debt balance, partially offset by the increase in property net operating income.

GOV's adjusted EBITDA was $52.2 million for the 2017 second quarter and includes approximately $12.7 million of cash distributions received from our SIR investment.

GOV paid a $0.43 per share dividend to shareholders during the second quarter, which equates to a normalized FFO payout ratio of approximately 72%.

We spent $4.5 million on recurring building improvements and $2 million on tenant improvements and leasing costs in the 2017 second quarter. As of quarter end, we had approximately $24.9 million of unspent leasing-related capital obligations; and have committed to redevelop and expand an existing property prior to commencement of the lease, with an estimated cost to complete of $5.5 million.

Turning to our balance sheet and liquidity. Our adjusted EBITDA-to-interest expense ratio for the quarter was 3.7x. And debt was 51.3% of total gross assets as of June 30. At quarter end, we had significant liquidity with $595 million of availability under our revolving credit facility.

Operator, that concludes our prepared remarks. We're ready to open it up for questions.

(Operator Instructions) The first question comes from Michael Carroll with RBC Capital Markets.

David, can you provide us some additional details on the plan to fund the FPO deal? I know you talked about a little bit of the disposition plans, but can you give a sense of the timing of when can you complete the GOV sales and when you can complete the FPO sales?

Sure. So we're in the process right now, Mike, of getting broker opinions of value and marketing plans. And we expect to have all of those in this week, which we will then reevaluate with the board and decide which properties we move forward with and then begin to prepare operating materials to go to market. So we will -- we expect to have a number of properties in the market after Labor Day, with the expectation that we will close some of those assets by year-end. My guess is we're going to want to have closed the acquisition of FPO; and spent a quarter or so with those assets to make sure we understand the condition of the properties to the best of our ability, to understand the tenants' likelihood to renew. We need to make sure we fully evaluated where the value opportunities are and determine which value-creation strategies we may want to employ before we market certain assets. So I think it will be the second half of 2018 before we really start -- before we make final decisions on what to sell at FPO. It could be earlier but probably second half of 2018. My guess is, by the end of the second quarter of 2018, we will have sold substantially all of the GOV assets that we intend to sell. Is that helpful?

Okay. Yes, it is. And Mark, how do you think about leverage today? And I guess, if you close the FPO deal before these asset sales get completed, are you comfortable in that high-50% leverage range? And where would you like that to trend over time longer term?

Yes, Mike, we're comfortable running at that higher leverage level for a while. We've discussed our long-term financing plans with the rating agencies, and we believe that they're comfortable with those plans also. Our long-term goal is, after we complete the asset sales, we want debt-to-EBITDA to be in the 6.5x area. And we want debt-to-total gross assets to be at 50% or below.

Okay. And now how close are you to your covenants on your debt that you push leverage too high?

We're comfortable with where we'll be under both our bank debt covenants as well as our public debt covenants.

The next question comes from Bryan Maher with FBR Capital Markets.

Just kind of a quick question regarding the asset sales. And I know you don't want to get property specific, but do you anticipate that skewing more suburban properties or more lower-cap urban properties?

It's a good question, Bryan. I would say that it's probably going to skew a little bit more towards suburban properties. There may be a couple of more urban assets that we consider selling, but when you think about the criteria that are articulated, a lot of that is going to be suburban-type assets.

The next question comes from Jamie Feldman with Bank of America Merrill Lynch.

As you think about the company going forward, I know, with the FPO acquisition, you changed the verbiage a little bit, where you went from calling yourselves a government landlord to a "government in D.C. area" landlord. Can you just talk about, when you think about the sales, what you think portfolio composition might look like? And then just now adding this D.C. area landlord to your title, how do you think about the business growing over time?

Sure, Jamie. So composition post asset sales, I -- we're going to sell some suburban GOV properties. We're probably going to sell some suburban FPO properties, although that's not finalized. So we may have a little bit higher concentration of D.C. metro -- D.C. urban assets, unless we find something compelling about selling a couple of those assets. So it's really hard to tell you exactly what the composition is going to look like until we meet back with the board and finalize the disposition plan. On a go-forward basis, Jamie, I think what we intend to do is look a little more broadly at acquisition opportunities in the D.C. metro market. What that means is we will look at government contractor opportunities in the D.C. metro market. We'll look at certainly government lease opportunities. There may be some compelling general office opportunities that we will consider in strategic locations around metro stops and around hubs where government and government contractor tenants want to be. I don't think it's going to be a huge change, but it does broaden the opportunity for us in that D.C. metro market.

Okay. And then strategically and as you think about your team, do you have the people in place to run a more traditional office portfolio rather than something focused on government tenants? Like, what are you thinking in terms of personnel changes?

Well, the RMR platform, which is our manager, does all of our property management, does all of our asset management. I mean we have been managing general office as well as other types of properties for almost 30 years, so I think we have pretty good experience within The RMR Group platform to manage buildings that aren't just simply leased to government tenants. We do intend, as I have mentioned a couple of times, to hire people from the FPO platform. And we think that will be -- add some good experience to our property management team. But I think we're in pretty good shape.

Okay. And then do you see expanding in other markets with more traditional office here?

Outside of the D.C. metro market, at this time, no.

Yes, okay. And then I apologize. I jumped on a couple minutes late. Can you just walk through the known move-outs, the numbers? I heard you say 284 basis points in '18 weighted toward the fourth quarter, but do you mind just running through those numbers again?

Sure. So give me a second here, Jamie. So what we expect -- so for the rest of 2017, we have 36 basis points of annualized rent that we expect to vacate. That will occur heavily weighted in the third quarter of this year. For 2018, we believe we're going to have 284 basis points of lost annualized rents, and 70% of that will occur in the fourth quarter.

And then you're pretty firm on these numbers. Are there -- and then is there stuff that you're still negotiating? Like, what's the total in play...

This is -- that's information we have available today. I mean we got -- we've got 20 -- we have 2 million square feet of space that is expiring over the next 24 months. We're having multiple negotiations with a lot of tenants, so we do expect things to change from quarter to quarter. What we do is, when we know we have a tenant leaving, we disclose that, but yes, you can expect there will be changes over the next 24 months to these numbers.

Okay. And then does that include the FPO assets?

It does not include the FPO assets.

Do you have an idea of known move-outs there?

Jamie, I mean, we don't own those assets. It would be inappropriate for me to talk about their properties at this particular point in time.

The next question comes from Nick Stelzner with Morgan Stanley.

This is Nick Stelzner filling in for Vikram Malhotra. So just sticking to the leasing over the next few years, can you talk -- or I guess, looking out over 2018 and '19, can you talk about some of the larger tenants maybe that you don't know as known move-outs but you're in conversations with right now and how those conversations are going?

I mean what we're disclosing and what we will continue to disclose is the tenants that we think are at risk and the tenants that we expect to vacate. I don't think it's appropriate to talk about where we are in negotiation with specific tenants that don't fall into either one of those categories.

Okay, that's fair. And then on the mark to market, it was pretty strong in the quarter. And I may have missed this at the beginning of the call because I jumped on late, but I guess, what drove that? And what are your expectations for mark to market going forward over the back half of the year and then into 2018?

Yes, I mean, we -- pretty consistently over the last couple of years, we've been able to grow rents with our government tenants. This quarter, of the 288,000 square feet that we leased, 236,000 square feet were with government tenants. And they were up 15% compared to the broader portfolio, up 13.5%, so clearly the government tenants are continuing to drive our growth. And Mark, do you want to talk about what we expect over the next 12 months or so?

Yes. In the next months, 12 months, we expect a slight roll down in rents, when we look at the market today. Now I want to qualify that: We thought that going into the year, and we've been up both quarters. So it's a tough thing given the different, various markets we're in, but when we -- as we sit today, we think a slight roll down for leases expiring in the next 12 months.

The next question comes from Jon Petersen with Jefferies.

Just thinking about some of the asset dispositions. One thing you talked about is properties that might be in that potential bucket of GOV legacy properties or ones where you expect the lease to -- or leases that are expiring soon, and you expect to have to spend a fair amount of CapEx. So just given that backdrop, it sounds like with the majority of the bucket we should be expecting cap rates that are probably higher than what your typical acquisition cap rate is in terms of an exit cap rate, which would mean they're kind of somewhat dilutive to FFO even though they might be accretive to AFFO because you're saving money on CapEx. Is that a fair way to think about the way you guys are thinking about that bucket?

Jon, I think that's they will -- we will definitely have some assets that will be more accretive on an AFFO basis and an FFO basis, but it's a pretty broad range of properties, so I think you're going to see cap rates that may be as low -- be below 6%. And you may see some cap rates that are 9%. And that's probably a good range. Your average is going to obviously fall somewhere in between that.

Okay, all right, that's good to know. And then at the -- with the at-risk bucket, I'm just curious. Is there a lease or 2 in there that are kind of the largest that we should be aware of? I'm just kind of curious if we could highlight 1 or 2 leases that make up a significant chunk of that 77 basis points? And about what quarter do those expire?

Of the at risk?

Of the at risk, yes.

Yes, sure. So it's only 3 tenants -- or excuse me, 3 buildings. It's Bureau of Land Management we've obviously been talking about for some time period. They are having a very difficult time finalizing a housing plan. That's a tenant -- or that's a building where we have one lease in Cheyenne, Wyoming. We have, I don't know, 8 or 9 different tenants under that lease. It represents 65 basis points of rent. We think that they're going to downsize kind of 25-ish percent, so the real at risk there is 17 basis points. That lease expires in the third quarter, but we've extended that a couple of times while they have worked through their housing plans. So it would be -- we're -- I think we're currently working with them on a longer extension at this point, so my guess is we're going to probably kick this can down the road at least another 12 months while they work through their housing plan. And then...

Okay. And then third quarter, you mean third quarter '17 as the expiration, or third quarter '18?

Third quarter '17 is the expiration, but I -- but we're working on an extension to give them more time to execute their housing plans.

And that actually leads right into what my next question was. With a lot of these move-outs and at-risk tenants, I know the government, sometimes has a tendency to stick around even after the lease expires as they're trying to figure things out. I guess, how much of this -- is that -- is there a significant portion of tenants besides Bureau of Land Management, what you already said, that you would expect them to kind of, I guess your word there was, to keep kicking the can down the road might they not actually move out in the next 24 months?

So from like our vacate list?

Yes, from your vacate and at-risk lists, yes, yes. So how much of those guys do you expect to kick the can down the road a few quarters maybe?

Yes, I'll give you an example, Jon. We have one tenant on the at-risk list, but it's not a big tenant but they're a government contractor. And they're on a month-to-month basis right now because they're working through the renewal of their contract. We expect that they're going to renew, but because they're month to month and haven't finalized their contract with the government, we consider it at risk. We have moved some tenants from the vacate to the at risk. And we've had some tenants that were expected to vacate, where they have withdrawn their vacate notice because they either couldn't find a place to go or they just -- they made a mind shift in terms of what they wanted to do. We have some tenants in -- that we're working with in 2019 where we think that they're probably going to end up extending even though they initially didn't want to have renewal conversations. So it's real difficult at this particular point in time to be definitive on a lot of tenants in the portfolio.

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 on this morning's call. That concludes our call, so you can disconnect the lines. Thank you.

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