Office Properties Income Trust (OPI) 2017 Q4 法說會逐字稿

Good morning, and welcome to Government Properties Income Trust fourth quarter financial results conference call. 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.

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

First, please note that any 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 26, 2018. 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. Before I begin, I would like to address the news release this morning announcing the unexpected passing of Barry M. Portnoy, the founder of the RMR Group and one of our managing trustees. This is a tragic loss for RMR and all its managed companies, including GOV. Barry's vision and inspiration for our company will be greatly missed. We are sad for Barry's family and the many people Barry considered friends and colleagues and those whose lives he deeply touched. The day-to-day work of operating our properties and running our business continues under the same high standards that Barry set for us.

Now let's continue with the task at hand. On today's call, I will review our quarterly leasing activity, discuss our forecast for tenant retention and provide an update on our capital recycling activities, before turning the call over to Mark to review our financial results and balance sheet.

Government Properties Income Trust closed on the acquisition of First Potomac Realty Trust, or FPO, on October 2, so the 2017 fourth quarter is the first quarter with combined results. As I mentioned last quarter, the integration of the FPO properties into GOV is complete, and we are generally pleased with the results relative to underwriting. On a combined basis, GOV owns 108 properties or 167 buildings, containing approximately 17.5 million square feet, excluding our 2 unconsolidated joint ventures.

Occupancy was 94.2% on a consolidated basis and 94.8% on a same-property basis at quarter-end, which is down from 95.1% and 95.2%, respectively from the 2016 fourth quarter. Our leasing volume for the quarter was strong, completing new and renewal leases, totaling approximately 520,000 square feet for a weighted average lease term of 5.1 years, a 3.3% roll up in rent and leasing concessions and capital commitments of $2.11 per square foot per lease year.

Our leasing with government tenants during the fourth quarter totaled almost 280,000 square feet for a weighted average lease term of 5.5 years and 8% roll up in rent and leasing concessions and capital commitments of $1.25 per square foot per lease year. As you can see, our government leasing continued to be a meaningful part of our fourth quarter activity and is attractive business for GOV.

Now let's review our tenant-retention expectations. Beginning this quarter, we are revising our disclosures for tenant-retention expectations to a 12-month outlook as a result of having a higher percentage of nongovernment tenants at our properties. We believe this will provide a more accurate and consistent disclosure, considering that it is rare to begin renewal discussions with a private-sector tenant prior to 6 months before expiration.

We debated eliminating this disclosure because we believe people tend to focus on the negative impact and have lost sight of the fact that GOV may have the highest tenant-retention rate in the suburban office sector. For 2017, we retained 88% of our tenants on approximately 1.7 million square feet of expiring leases, which we believe is outstanding. As of December 31, we have leases contributing approximately 11.3% of GOV's annualized rent and covering approximately 1.7 million square feet that are subject to expiration over the next 12 months. From these expirations, we expect tenants contributing 4.9% of annualized rent to vacate at lease expiration. The vacating tenants include 3.6% of annualized rent from government tenants and 1.3% from private-sector tenants. The largest vacating tenant is the Bureau of Prisons, who was a full-building user in Washington, D.C. that contributes approximately 1.9% of annualized rent and whose lease expires March 31, 2018. This is a buildings we acquired from FPO. We underwrote the tenant vacating prior to year-end 2017, and we are in advanced dialogue with a full-building replacement tenant. The vast majority of the private sector tenants that we expect to vacate at lease expiration are tenants in FPO properties that we underwrote vacating as part of our acquisition analysis. They also tend to be small tenants in spaces that we believe are highly marketable.

In addition to the tenants we have identified as vacating, we have identified tenants that contribute 55 basis points of GOV's annualized rent to be at risk of downsizing or vacating at lease expiration. One tenant is a government agency that contributes 6 basis points of annualized rent. The remaining tenants are relatively small private-sector tenants. As I say every quarter, our outlook into GOV's lease expiration schedule is the best information we have available today based upon our dialogue with tenants. Tenant negotiations are fluid, but 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 continue to have a commendable tenant-retention rate for a suburban office company.

Now let's turn to our capital recycling activities. In conjunction with our acquisition of FPO, we announced a disposition program to permanently finance a portion of the transaction and to manage our leverage. As stated previously, we have identified 13 legacy GOV properties we are either marketing for sale or expect to market for sale in the near future. This month, we received board consent to market 19 additional properties for sale. We are gathering brokers' opinions of value and perspective marketing plans for these additional properties and expect to begin a marketing process within the next 60 days or so. Although we do not expect to sell every property we market for sale, GOV's guidance for asset sales remains between $500 million and $700 million in gross proceeds by year-end 2018.

As you may have noted in our earnings release this morning, we have entered agreements to sell 3 properties for approximately $39 million. We will update you further on our first quarter earnings call in May as we make further progress.

I will now turn the call over to Mark to review our financial results and metrics.

Thanks, David. As a reminder, the acquisition of First Potomac Realty Trust was completed on October 2. As a result, the consolidated financial results I will be discussing include the impact of this acquisition for a full quarter.

Now let's begin with the review of our property-level performance for the fourth quarter of 2017. For the fourth quarter, GOV's consolidated rental income was $107.2 million, an increase of $41.1 million. This increase was primarily the result of the FPO acquisition and our fourth quarter 2016 acquisitions. On a same-property basis, fourth quarter rental income increased by $735,000 or 1.1% year-over-year to $66.3 million. In cash basis, rental income increased by $1.5 million or 2.3% year-over-year to $66.6 million.

Fourth quarter consolidated property operating expenses increased approximately $15 million year-over-year to $41.1 million, reflecting the impact of acquisitions and a modest increase in same-property operating expenses. Same-property operating expenses increased by $362,000 or 1.4% year-over-year to $26.3 million, due primarily to higher real estate taxes.

Consolidated fourth quarter net operating income, or NOI, increased by $26.2 million to $66.1 million. Consolidated cash basis NOI for the fourth quarter increased by $25.1 million to $64.4 million. Our consolidated GAAP and cash NOI margins for the 2017 fourth quarter were 61.7% and 61% respectively. From a same-property perspective, our fourth quarter GAAP NOI increased $371,000 or 0.9% year-over-year to $40 million, and our cash basis NOI increased by $1.1 million or 2.9% to $40.1 million. Our same-property GAAP NOI margin was 60.3%, and our same-property cash basis NOI margin was 60.2% for the 2017 fourth quarter.

Turning to our consolidated financial results. Normalized FFO for the fourth quarter was $49.2 million, which is up from $41.5 million for the 2016 fourth quarter. Normalized FFO per share for the 2017 fourth quarter was $0.50, which is down $0.08 or approximately 14% from the 2016 fourth quarter. Normalized FFO this quarter was negatively impacted by the $8 million or $0.08 per share decline versus the 2016 fourth quarter in the amount of normalized FFO we recognized from our investment in Select Income REIT, or SIR. The year-over-year decline in SIR's normalized FFO was due primarily to its recognition of $25.6 million of business management incentive fee expense in the 2017 fourth quarter. The decrease in SIR's FFO had no impact on GOV's cash flows as the $12.7 million of cash distributions we received from our SIR investment in the 2017 fourth quarter were unchanged from the 2016 quarter.

GOV's adjusted EBITDA was $73.5 million for the 2017 fourth quarter, which is up from the $49.4 million for the 2016 fourth quarter, due primarily to our FPO and other property acquisitions. We spent $6.6 million on recurring building improvements and $11.1 million on tenant improvement and leasing costs in the 2017 fourth quarter. As of quarter-end, we had approximately $31.3 million of unspent leasing-related capital obligations.

Turning to our balance sheet and leverage. As I previously noted, on October 2, we closed the acquisition of FPO. We financed the $1.37 billion acquisition primarily with cash on hand from our common share and senior note offerings completed earlier in the year, borrowings under our revolving credit facility and the assumption of approximately $168 million of FPO mortgage debt. At December 31, GOV's ratio of debt to total gross assets was 55.5%, and we had $570 million outstanding on our $750 million revolving credit facility. As David previously stated, during 2018, we intend to reduce borrowings under our credit facility and our debt leverage with the proceeds from our property-disposition program.

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

(Operator Instructions) The first question comes from Bryan Maher with B. Riley FBR.

A couple of quick questions. [DNA] was materially higher than we had thought in the quarter, and we did make an effort to try and capture FPO in there. Is there anything extraordinary going on with DNA that we should be thinking about as we model for 2018?

Bryan, this is Mark. The break -- the big increase there, I think, was probably higher than what you had modeled because there was about $200 million, $230 million of the purchase price for FPO was allocated to in-place leases, and those have a relatively short amortization life. So you're going to see increased amortization here for 2018 as a result of that purchase accounting. We've detailed in the footnotes to the 10-K, which will be filed later today, the breakdown of the purchase price allocation. And we've also disclosed the remaining -- or the estimated useful lives of those assets. So that should help you out in your modeling.

And then just as it relates to GOV's stock price and dividend yield here, it seems really unusual, even we when we compare against some of the other RMR REITs, and certainly against other REITs that we track. Do you guys have any thoughts on what's going on there? Because it's probably one of the single-most calls inbound I'm getting.

It's a good question, Bryan. I don't know that I really have an answer for you. I mean, the stock price is -- or I guess the dividend yield on this company has been, what I think, abnormally high for some time. It has not enticed buyers into the stock. But I don't really have an explanation for you. I mean, if you have thoughts, we're happy to hear them.

Isn't it, though, consistent? I think I've been with you when you've had question from the buy side on this. The thought process on the dividend is to not cut the dividend even if it's running kind of close on the coverage ratio just because of the signal that, that sends. Do you have a thought there? Or do you want to leave that for the board?

Well, the board, as you know, reviews the dividend every quarter. They absolutely are current on where we are from a coverage perspective, and they remain comfortable with the current payout. So I don't anticipate that changing.

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

This is Kim Hong on for Jamie. So you guys have some sizable lease expirations in the next 2 years, can you speak more about the biggest expirations you have next year and any progress you've made so far? And any color you can provide on the FPO 10 largest expirations through '18, that would be very helpful.

Yes, thanks for your question. I think if you go back and look at the transcript from today's call, you will see that we've provided good information on lease expirations over the next 12 months. And that's really all we're prepared to discuss.

Okay. And then the second question is, when do you expect to start realizing the full accretion from the FPO acquisition on a normalized basis? And are you thinking of any property acquisitions in 2018?

Well, I'll talk about the potential acquisitions for '18. As we have been relatively clear on past calls, we're very focused right now on reducing leverage to be in line where the rating agencies would like to see leverage. And so we're more focused on our disposition program right now and reducing leverage. We -- I suppose, we could make some insignificant acquisitions throughout the year, but my guess is we're going to be focused more on asset sales than we are on acquiring new assets.

Okay. And then the last question is on, since you mentioned leveraging down, how are you managing your floating rate debt exposure? And I'm wondering if you're going to have a sizable earnings impact from the higher debt costs this year.

Yes, we had -- at year-end, we had about $1.1 billion of floating rate debt, that's a combination of our 2 term loans and our revolver borrowings. Our expectation is that we'll bring the revolver borrowings and our floating rate debt down significantly through the property-disposition program. And once completed, we're comfortable with the amount of floating rate debt we'll have. Now obviously, in an interest rate -- rising interest rate environment, we will -- our operating results will have a negative impact to the extent that rates continue -- short-term rates continue to rise.

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

David, I was hoping you could run through an update on your sales process. I know you mentioned it a little bit in your prepared remarks, but are you still working through the legacy GOV assets right now? And what's the clarity on the FPO assets that you plan on selling towards, I believe, the back half of this year? Any update on that would be great.

Sure. Yes, Mike, we are definitely continuing to work through the legacy GOV assets. We've got -- as we've mentioned, we've got the 3 assets that are under contract to sale. We've got some other properties that are in the market where we're working through potential offers. And then we've got 3 or 4 assets that we wanted to complete some leasing on, and we're just now starting to bring those to market. As it relates to the FPO properties, the recent approval we got from the board to market an additional 19 properties includes properties that we acquired from FPO. So I would say, assuming things go well with the opinions of value and the marketing plans and we get in the market within 60 days or so, you should begin starting to see results from that in the second half of the year.

And where are those properties at on the FPO properties? Are they in specific locations? Are they not necessarily the office buildings? Is there any common theme among the properties you want to sell with FPO?

Yes, we don't like to get in a great level of detail on the properties that we're selling until we kind of get into the market with them rather than trying to potentially harm our negotiations or our marketing plan. So I think we kind of said all that we are prepared to say right now as it relates to those sales. But we'll -- we should be able to give you more detail as we get into the market.

Okay. And then can you remind us where you want to bring leverage down to?

Yes, we want debt-to-gross assets to be 50% or lower and debt to EBITDA between 6.5 and 7x.

Okay. I know with the other companies that RMR manages, I think the target that the rating agencies wanted was the 6.5x net debt to EBITDA. Did the agencies want the same type of target for GOV too?

Yes, obviously, they evaluate every company on a standalone basis, but yes, 6.5 to 7x is what the agencies are for GOV.

Great. And then, Mark, just last question, can you -- what is being valued on the base management fee right now? Is it the total market capitalization of the company? And should we expect G&A to kind of trend a little bit lower if the stock price stays where it is?

GOV is actually -- the base fee is actually being calculated on real estate investments.

Still?

Yes, because we don't earn -- RMR doesn't earn a fee on the SIR investment, so market value tends to be -- total market capitalization tends to be higher than total real estate investments.

The next question comes from Jon Petersen with Jefferies.

Just more of higher level questions. So Congress recently increased the caps on the budget defense and then just kind of some on more of the broader budgets. I'm curious what opportunities you think that might open up in terms of typical GSA office leases. And then also, I think, last year, sometime you guys had bought a couple of buildings that were leased to contractors, defense contractors. I'm curious if we might see more of that in 2018 if the defense guys have more money?

Yes, John, good questions. I think, as I've read about some of the information about the budget, it appears that defense contractors, specifically northern Virginia, will benefit from this budget. And that is good for us. We do own assets in northern Virginia. And so we look forward to seeing that market continue to get tighter, which we should be able to benefit with higher rents and higher occupancy. Again, I think, as it relates to future acquisitions, we are not budgeting that we're going to buy a lot during 2018. I think we would certainly consider buying some properties that are leased to government contractors. But again, I don't think we are going to -- you're not going to see us buy a whole lot during 2018.

Okay. And I guess, if we think on the sales side of things, is -- how is demand for government lease assets trending, and again, given this backdrop of maybe a little bit looser purse strings out of DC, do you expect things to get even better in terms of pricing?

Yes, we've been reasonably pleased with the sales process heretofore and the number of folks that are looking at assets. And we think that the buildings that we are selling, that are leased to government tenants, have attracted a lot of attention. So I think it's all positive.

The next question comes from Mitch Germain with JMP Securities.

Mark, just -- I know you talked about the incentive fees with Select Income REIT. Is the way to think about the quarter it's really, I don't know, like $0.52, $0.53, if that fee didn't exist? Just trying to understand kind of what more of a normalized number is for earnings?

Yes, well, the impact on -- as I think I mentioned in prepared remarks, the impact on GOV's reported normalized FFO as a result of Select Income recording the $25.6 million incentive fee in the fourth quarter was $0.08 a share, or about $8 million. Absent my -- I don't have the ability to project how much, if any, incentive fee SIR is going to incur in 2018. I will point out, though, that the incentive fee all gets recorded for FFO purposes in the fourth quarter. So I would expect in the first 3 quarters of the year that GOV's share of SIR's normalized FFO will get closer to where we've been on a historical basis during 2017.

Great, that's helpful. And David, I think you had mentioned your team's [held] assets for sale -- so the 3 that are under contract, that would kind of -- would that make it 10 or is 13 in addition to the ones that are under contract?

No, the 13 includes those 3 under agreement, so that would make it 10.

So if I consider the 13 plus the other 19 from FPO, are you confident that, that -- does that take you into the forecasted range for dispositions?

Yes. If you take the sales prices that we have for properties as well as the things, the values that we have seen, we are squarely within that range of $500 million to $700 million of asset sales.

Great. And I really truly apologize, I know, David, you mentioned on the role, how much of rents was the Bureau of Prisons, please?

1.9%. And again, that was the property that we knew the Bureau of Prisons was vacating when we started the acquisition process so not a surprise. In fact, we've probably been surprised to the good in that they've stayed in the property longer than expected. And it's a well located asset, and we have had a lot of demand for that space.

And you have another 1.7% from the GOV side, is there any bulkiness to those expirations or...

There is no real bulkiness at all to that.

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, operator, and thank you for joining us today on the call. That concludes the conference.

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