Office Properties Income Trust (OPI) 2017 Q3 法說會逐字稿

Good morning, and welcome to the Government Properties Trust Third Quarter Financial Results Conference Call. (Operator Instructions) This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call 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 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. 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, October 31, 2017. The company undertakes no obligation to revise or publicly release the results of any revisions of 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, provide an outlook for tenant retention for the next 24 months and provide an overview of our acquisition of First Potomac Realty Trust before turning the call over to Mark to review our financial results and balance sheet.

Government Properties Income Trust delivered solid property level operating results in the third quarter of 2017. Year-over-year same property NOI and cash basis NOI was up 2.6% and 4.5%, respectively, while consolidated and same property occupancy was 95% and 94.8%, respectively, at quarter end.

During the quarter, we completed new and renewal leases totaling approximately 436,000 square feet for a weighted average lease term of 8.4 years and a 55 basis point roll down in rents and leasing concessions and capital commitments of $2.16 per square foot per lease year. Included in our third quarter leasing activity is a renewal for a 138,000 square-foot lease to the Veterans Administration in Waco, Texas, for a 33.5% roll up in rent, a lease term of 17 years and lease concessions and capital commitments of $2.64 per square foot per lease year. We believe this highlights the U.S. government's desire to enter longer duration leases and to remain in place where possible.

The positive rollout from this lease was offset by a 187,000 square foot renewal with the United Nations in New York for 2 years with leasing concessions and capital commitments of $0.68 per square foot per lease year that rolled down 7.6%.

Now let's review our tenant outlook for the legacy GOV portfolio over the next 24 months. As of September 30, we have leases contributing approximately 25.4% of GOV's annualized rent and covering more than 2.5 million square feet that are subject to expiration over the next 24 months. From these expirations, we currently expect tenants contributing 3.2% of annualized rent to vacate properties, which is substantially unchanged from the previous quarter. 3 tenants contributing 3 basis points of annualized rent vacated properties during the third quarter while we added 3 tenants that contribute 5 basis points of annualized rent to the list. The vast majority of tenants expected to vacate properties over the next 24 months are expected to do so in 2018.

The list of tenants we have identified to be at risk of downsizing or vacating remains unchanged from the second quarter and represents 77 basis points of annualized rent. As we noted previously, these tenants are primarily at risk of downsizing so we believe only 23 basis points of annualized rent is truly at risk. As a reminder, this forward look in the GOV's lease expiration schedule is the best information we have available today based upon our dialogue with tenants. Negotiations remain fluid with a number of tenants and circumstances can change. Tenant retention and attracting new tenants to our buildings remain a significant area of focus for GOV and we believe that GOV continues to have one of the highest tenant retention rates of all the companies in the suburban office sector.

Now let's turn to our acquisition of First Potomac Realty Trust, or FPO. On October 2, GOV completed the acquisition of FPO for approximately $1.37 billion. To finance the acquisition, GOV raised $494 million in net proceeds from the sale of 27.9 million shares of common equity, issued $300 million in 4% senior unsecured notes due in 2022, assumed approximately $168 million of FPO mortgage debt and funded the balance on our unsecured revolving credit facility.

As highlighted, during last quarter's call, we plan to undertake a property disposition program to repay amounts outstanding on our revolving credit facility and to reduce leverage. Although our program remains fluid, we have identified 13 legacy GOV properties for disposition that we consider non-core or where we may be able to achieve low cap rates and realize a gain on sale. We are currently marketing 10 properties for sale and expect to begin staggered closings prior to year-end 2017. If the sale of all 13 properties is completed, GOV should generate approximately $300 million in gross proceeds. In addition, we are evaluating the disposition of certain FPO industrial flex properties for marketing in 2018. The proceeds from these sales are still to be determined. But in aggregate, we still believe that our disposition program will generate between $500 million and $700 million in gross proceeds by year end 2018.

On a pro forma basis with FPO, GOV owns 113 properties or 170 buildings in 31 states in the District of Columbia containing 18 million square feet. Our properties are 94.5% leased and government tenants contribute approximately 62% of our annualized rent while all investment-grade rated tenants contribute approximately 70% of our annualized rent. We will have approximately $4.1 billion of consolidated gross assets and our average remaining lease term will be 4.8 years.

On our fourth quarter call, we will provide more detail on upcoming lease expirations and tenant retention from the consolidated portfolio. I will now turn the call over to Mark to provide more detail on our results and financial metrics

Thanks, David. Let's begin with a review of our property level performance for the third quarter of 2017. When compared to the third quarter last year, GOV's rental income grew by $5.7 million to $70.2 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 third quarter rental income increased by $1.6 million or 2.4% year-over-year to $66 million due primarily to increases in occupied space at certain of our properties as well as higher rental rates from certain lease renewals. Cash-based rental income for the 2017 third quarter increased by $2.2 million or 3.5% year-over-year to $65.9 million.

Third quarter consolidated property operating expenses increased by $2.2 million year-over-year to $29.1 million, reflecting higher same-property expenses as well as the impact of acquisitions. Same-property operating expenses increased by $597,000 or 2.2% year-over-year to $27.5 million. This increase was due primarily to higher real estate taxes and professional services fees which were partially offset by lower utilities expenses.

Consolidated third quarter net operating income, or NOI, increased by $3.5 million or 9.3% year-over-year to $41 million. Consolidated cash basis NOI for the third quarter increased by $4.2 million or 11.6% to $40.8 million. Our consolidated GAAP and cash NOI margins for the 2017 third quarter were 58.5% and 58.3%, respectively.

From a same-property perspective, our GAAP NOI increased $963,000 or 2.6% year-over-year to $38.5 million. And our cash basis NOI increased by $1.6 million or 4.5% to $38.2 million. Our same-property GAAP NOI margin was 58.3% and our same-property cash basis NOI margin was 58% for the 2017 third quarter.

Turning to our consolidated financial results. GOV's capital raising activities early in the third quarter in preparation for the acquisition of FPO acted as a significant drag on the quarter's financial results. Normalized FFO for the third quarter was $39.6 million, which is up from $38.6 million for the 2016 third quarter. Normalized FFO per share for the 2017 third quarter was $0.41, which is down $0.13 or approximately 24% from the 2016 third quarter due primarily to the 36% increase versus the prior year in GOV's weighted average common shares outstanding. We estimate that our FPO-related debt and equity offerings during the quarter had a negative $0.14 per share impact on GOV's reported third quarter normalized FFO per share.

GOV's adjusted EBITDA was $51.9 million for the 2017 third quarter and includes approximately $12.7 million of cash distributions received from our SIR investment. We spent $2.6 million on recurring building improvements and $5.2 million on tenant improvements and leasing costs in the 2017 third quarter. As of quarter end, we had approximately $26.6 million of unspent leasing-related capital obligations.

Turning to our balance sheet and leverage. On September 29, GOV borrowed $565 million under its revolving credit facility in preparation for the October 2 closing of the FPO acquisition. As a result of this borrowing and the debt and equity offerings completed earlier in the quarter, GOV ended the third quarter with approximately $1.2 billion of cash-on-hand or held an escrow with the paying agent for the FPO closing. On October 2, we used the majority of this cash to fund the consideration paid to FPO common shareholders to repay certain FPO debt and for the payment of transaction-related costs.

On a pro forma basis for the closing of the FPO acquisition and based on our preliminary FPO purchase price allocation, GOV's ratio of total debt to total gross assets was 54.6%. As David previously stated, we intend to reduce borrowings under our revolving credit facility and leverage with the proceeds from our recently initiated property disposition program.

Operator, that concludes our prepared remarks. We'd like to open the call up for questions.

(Operator Instructions) The first question comes from Bryan Maher with FBR Capital Markets.

Question on the dispositions. Can you talk a little bit about the cap rates you're seeing from potential buyers? And who those potential buyers are looking like? Is it private equity? Is it foreign money?

Yes, Bryan. We're seeing a pretty broad range of cap rates because of the types of assets that we're selling. I would say that we are selling some assets that have attracted some core owners of real estate that's leased to government tenants. We have attracted some kind of local buyers. They're kind of more market specific. And the cap rates tend to be anywhere from, call it, 5.5% to maybe an 8%, 8.5% cap rate depending upon the asset. We have a couple of buildings that we are selling that are vacant. And obviously, cap rates aren't relevant for those assets.

Okay. And given that you buy FPO for $1.4 billion and you're going to sell kind of $500 million to $700 million, what in that portfolio really attracted you to go through all this root canal to do this deal?

Well, I think that the D.C. assets in particular were very attractive to us. I think generally, having greater scale in the D.C. metro market was very attractive to us and this is an opportunity for us to weed out our existing legacy GOV assets at what we think is a good time in the market cycle to do so.

Okay. And then just lastly. Are you seeing any of the potential buyers having any issues raising capital?

I don't know that we're that far along at this point, Bryan. I will say that debt capital remains ample. And I think substantially, all of the parties that are looking at deals for us come with their own equity. So I don't think raising debt leverage at this point in the cycle is difficult at all.

The next question comes from Vikram Malhotra with Morgan Stanley.

Could you maybe give us a little bit more color on the redevelopment CapEx that you've had over the last, call it, 4 quarters? What sort of benefits are you seeing? And any specific examples? And just related to that, I think on Page 28, you've highlighted about $20 million that you'd spent on a specific property. Just maybe using that as an example to start, can you give a sense of what rent growth are you seeing there? Or what do you expect pro forma in that asset?

Yes. So the redevelopment capital that we have been spending is predominantly related to a building that we are -- we are joining 2 buildings that we own in Atlanta that are leased at CDC. One of those buildings was vacant when we entered into this new lease. And we were able to compete for the lease because we were able to join the 2 buildings through a connector to create one building, add square footage and meet the square footage requirement that the CDC has. And so we really were able to take an old building that was built in the '60s, substantially redevelop it and make it, modernize it and make it a usable property for long-term lease with the U.S. government. I don't know off the top of my head exactly what the specific return is on that. But I think we're getting somewhere in the 7% to 9% return on invested capital. I think from my perspective, we took a building that was vacant and was going to be incredibly difficult to lease that probably wouldn't have generated a lot of proceeds from the sale and are making it -- or generating a 10-year lease with the U.S. government.

Okay. That's helpful. And then just on the expirations. I know you mentioned you'd give maybe more detail. But has anything changed versus maybe the prior few quarters in your thinking in terms of retention, mark-to-market, any additional capital that you may need to spend over the next, call it, 6 to 12 months related to those expirations?

No. I think we continue to be pretty pleased with our tenant retention statistics. I mean, as an example, during the third hurdle -- quarter, I think our tenant retention was almost 100%. It was 98%, 99%. So we're having good success. As I mentioned in my prepared remarks, we entered into a long-term lease with the Veterans Administration in Waco, Texas for a nice roll-up in rent and a 17-year lease. So I think what I have seen from the government specifically is they're beginning to see the benefits in being able to enter into longer duration leases. Compared to this time last year, prospectus level leases are being reduced in square footage by substantially less amount than they were, which tells me that the increase in utilization project that the government started about 2 years ago had substantially run its course. It doesn't mean that we won't still have some risk over the near term. But I think a lot of the headwinds we've been dealing with over the last couple of years have really begun to run their course for the U.S. government.

So just to clarify that. So you're saying that all the rationalization and the gathered changes that were going through, that sort of -- you've worked through that. But you're -- on the other -- you're not seeing any signs of a turn? Meaning, they're now saying, "Okay, we've been through this process. Now, we're ready to maybe expand from here" is sort of the status quo right now?

Well, U.S. government employment still nationally has not increased. So the U.S. government is not growing employment right now. I suspect that, that could change over the next couple of years. But it's hard to say with some of the Trump administration's agenda. But I think we are going to continue to see the U.S. government to be thoughtful in space utilization with every meaningful renewal. But I believe that a lot of the low-hanging fruit has been harvested and we have much less risk, I think, in our portfolio and in this business right now.

The next question comes from Michael Carroll with RBC Capital Markets.

Dave, how far along are we in the marketing process of the $500 million to $700 million of potential sales? And what's a good expected timing of this? Is this going to happen in early or late 2018?

Well, we've got 10 properties in the market right now. I suspect that we will begin to have some closings at year end. And I think, assuming things go as expected, the majority of those 10 assets will be sold by the end of the first quarter of 2018. We have a few assets. Basically, of the 13 we've identified, 3 aren't in the market yet, and that's because we have some leasing that we're trying to finish up before we start marketing those assets. So we expect to have those in the market in the first quarter of next year. And certainly, those assets should be sold by mid-2018. The FPO assets that we're working through, I would expect that we'll have those in the market sometime during the first quarter of 2018, unless we determine that we can do some leasing in some of those assets to help grow NOI and obtain higher values. So I would expect that we will see close to $300 million by mid-2018, and then the balance should be in the second half of 2018.

Okay. Then what's the difference between hitting the bottom end of that range at $500 million or the top end at $700 million? Is that just a function of valuation? Or are there assets within the portfolio you might elect to keep?

Well, I mean, when you're selling properties, Mike, you really never know exactly what price you're going to get. And we're not a seller of all these properties at any price. And so, if for some reason, we don't get the price expectations or the prices that we expect, we may not be a seller. Which means we may pull an asset from the market and look across the portfolio to see if maybe there's something else to sell. And so I think that's why we are hedging ourselves a little bit with a range because we are going to sell assets to reduce leverage and to repay the revolver but not at any price. We're going to be very thoughtful and methodical about how that's done.

The next question comes from Mitch Germain with JMP Securities.

Just a quick question for me. I know you referenced that 3% or so moving -- exiting over the next 24 months. How should we think about how that -- from a quarterly basis, is there anything kind of lumpy in those numbers? Just -- I'm sure you've given me this information in the past, but if you can just remind me, I'd be grateful.

Sure. So let's see, Mitch. The largest...

The largest piece is about 1 point, call it, 1.4% of it in the fourth quarter of '18 is the largest piece. About 58 basis points in the first quarter, 86 in the second. Not a whole lot in the third quarter of next year.

The next question comes from James Feldman with Bank of America.

Sticking with FPO. Just wondering kind of your initial thoughts on integration and maybe potential additional synergies than you originally expected? And then can you also talk about what it does to your blended in-place cash rent bumps? And what it should do to your same-store growth profile going forward?

So let me start with integration. I think integration is going great. We closed on October 2. So we've owned the assets for about 3 weeks. And we worked very closely with the FPO team during the period from announcement to shareholder vote and close. And what I mean by that is we were actively involved in the leasing process to make sure people stayed motivated, particularly those people that were not going to be retained by us. And so we actually grew occupancy across that portfolio by 100 basis points during the third quarter, which I am very pleased with. The people that we have hired from FPO are all on board. We've been through a couple of different training sessions with them. Feedback that I'm getting from real estate services is the integration is going incredibly well. We still have open positions in the D.C. metro market which we're working to fill and expect to do so over the next several weeks.

In terms of -- we had talked about when we announced the transaction, about $11 million in G&A savings. We feel good about that. And most of that is realized day 1. Really, the only tail, if you will, that we have from FPO's G&A is we did inherit their corporate headquarters lease that runs through January 2021. Rent there is about $400,000 a year. But we're actively attempting to sublease that -- their corporate headquarters were not in an FPO-owned building. And then I think at the property level, we're still evaluating potential savings from an operating expense standpoint. But are optimistic that we'll be able to generate some savings there also.

Okay. That's helpful. And then as you think about their in-place rent bumps and your in-place rent bumps, just what do you think this does to your same-store NOI growth profile in terms of cash rent bumps? And then just generally, your ability to push rents in that portfolio versus your traditional government portfolio?

Well, I think we'll have higher annual rent bumps from the FPO assets than we generally have in the legacy GOV portfolio. Because as you know, the U.S. Government lease assets tend to be flat for the term. So I would expect that we're going to realize 1% to 3% annual increases from the FPO assets. But it's not a huge percentage of the overall portfolio. So it's not going to have a meaningful impact on internal growth.

The next question is a follow-up from Bryan Maher with FBR Capital Markets.

Just following up on Mitch's question on the 3% of vacate. What do you think that the prospects are for releasing those sites at this time?

Well, we generally think that the buildings -- so the tenants that we are generally losing have outgrown the space. And so the biggest, as Mark said, the 1.3% or 1.4% December '18, we are pretty confident that the tenant that's in that building is going to backfill the space that's being vacated by different government tenants. They need to do so if they want to continue to control the security in the building and the parking. And so we have some leverage there and think that we'll be able to re-lease that space. So I think generally, these are good buildings that, unfortunately, the governments have -- tenants have grown out of. And we'll backfill with either government or nongovernment tenants. But we will lease that space, call it, 3, 6 months.

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. Thank you for joining us this morning. Mark and I look forward to seeing some of you at the NAREIT conference in November. Operator, that concludes the call.

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