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Select Income REIT (NYSE:SIR)

Q4 2013 Earnings Conference Call

February 20, 2014 1:00 pm ET

Executives

David Blackman - President & COO

John Popeo - Treasurer & CFO

Jason Fredette - Director, IR

Analysts

Vikram Malhotra - Morgan Stanley

Young Ku - Wells Fargo

Jon Petersen - MLV & Co.

Operator

Good day and welcome to the Select Income REIT 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. Jason Fredette. Please go ahead.

Jason Fredette

Thank you, Cynthia, and welcome to the call everyone. Joining me on today's call are David Blackman, President and Chief Operating Officer; and John Popeo, Treasurer and Chief Financial Officer.

The agenda for today's call includes a presentation by management followed by a question-and-answer session. I would note that the recording and retransmission of today's conference call is strictly prohibited without the prior written consent of the company.

Before we begin today's call, I would like to read our Safe Harbor statement. 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 SIR's present beliefs and expectations as of today, February 20, 2014.

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.

Actual results may differ materially from those projected in these forward-looking statements. 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 from investors section of our website www.sirreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements.

In addition, we encourage investors to review the supplemental operating and financial data package that we posted to our investors section. Our fourth quarter supplemental includes a couple of changes compared with prior periods. First, as David will explain shortly, we have reclassified our properties. We also are now including a full property list in the supplemental to provide investors with additional insight into our portfolio.

Please note that some metrics that we discuss on today's call such as normalized funds from operations or normalized FFO and cash available for distribution, otherwise known as CAD, are non-GAAP metrics. Reconciliations of these figures to GAAP are contained in the supplemental.

And now, I will turn the call over to SIR's President and COO David Blackman.

David Blackman

Thank you, Jason, and welcome to the fourth quarter and year-end earnings call for Select Income REIT.

To begin, I would like to review our business strategy which is to invest in single-tenant, net lease office and industrial buildings in the continental U.S. and lease lands in Hawaii. The long term net lease structure of our Hawaii properties and our ability to reset rents to market rate every 5 to 10 years makes SIR unique in the net lease space. The structure has resulted in an average annual increase in rents from resets since 2004 of 35% at an average increase of nearly 50% since become a public company in 2012. In fact, our executed REIT resets during 2013 grew annual rental income by approximately $0.06 per share.

In addition to our internal growth opportunities in Hawaii, we have also successfully grown the company through the acquisition of single-tenant net lease office and industrial properties in the continental of U.S.

Our acquisition strategy is focused on office properties that have a minimum remaining lease term of seven years and industrial properties that have a minimum remaining lease term of 10 years.

Generally, we try to acquire buildings that are strategic to the tenant. Strategic properties tend to be corporate headquarters, sale-leaseback transactions and properties where tenants have invested meaningful capital that we believe incent them to renew leases.

Before discussing our properties I'd like to highlight that we reclassified our property count during the quarter in an attempt to make it easier for analysts and investors to understand our investments. For example, we reclassified our 229 properties in Hawaii to 11 properties. We did this by grouping together as individual properties. Our lease lands or owned buildings in the Campbell Industrial Park, Mapunapuna or Sand Island which is generally how we discuss our Hawaii investments.

As a result of this property count reclassification, SIR now owns 48 properties that comprise 26 million rentable square feet. Our properties are highly occupied at 95.5% for a weighted average remaining lease term of 10.8 years.

Our 11 Hawaii properties which are 93.4% occupied represent about 40% of our fourth quarter rental income and our property net operating income or NOI. And our 37 main land properties, which are 100% occupied represent about 60% of our fourth quarter rental income and NOI.

All of our vacancy is in Hawaii which we believe represents an opportunity for future internal growth. In fact, we have a prospective leasing pipeline of more than 250,000 square feet that includes more than 80,000 square feet of letters of intent and prospects where active lease negotiations are ongoing.

Now I'd like to review our activity. For the year, SIR executed 25 new and renewal release for 884,000 square feet for a weighted average remaining lease term of 13.1 years and a 21% rollup in rent.

For the year, we also executed 26 rent resets releases in Hawaii growing annual rental income by $5.4 million to $7.9 million or an average increase of more than 47%. Consistent with our net lease strategy in Hawaii, our leasing capital commitments were low at $1.5 million or only $0.13 per square foot per lease year.

In addition to our leasing and rent reset activity for 2013, SIR also acquired 11 buildings across seven properties comprising $1.4 million square feet for $384.8 million, excluding acquisition cost. These properties were 100% occupied for a weighted average remaining lease term of 10.7 years at an average cost per square foot of $267 and we are acquired in an average acquisition cap rate of a 0.4%.

For the quarter, SIR executed 11 new and renewal leases for 644,000 square feet for a weighted average remaining lease term of 14.3 years and an 18.2% roll up in rent. Our quarterly rent reset activity in Hawaii included five leases for a 43.3% increase in annual rental income. Our capital commitments released in during the quarter were $510,000 or only $0.06 per square feet per lease year.

Our lease expiration schedule is well laddered with less than 1% of rent expiring in 2014. In fact, all of our expiring leases are for properties in Hawaii until the third quarter of 2015. In 2014, we also have 38 leases that are subject to rent reset which includes a number of rent resets that are not yet completed in the previous year.

These rent resets include $10.9 million of annual rental income that is projected that he reset to rent on average more than 25% greater than existing rents. Note, however, that a substantial portion of our increased rent subject to reset in previous periods are being accrued in our GAAP income statement.

During the quarter, we acquired five buildings across three properties comprising 351,000 square feet for $82.9 million excluding acquisitions costs. These properties were 100% occupied for a weighted average remaining lease term of just less than nine years at an average cost per square feet of $236 and were acquired at an average acquisition cap rate of 7.8%.

In October, we acquired a previously disclosed office building in Vernon Hills, Illinois containing 100,000 square feet for $18 million. The purchase price per square foot for this acquisition was $180. The acquisition cap rate was 7.4% and a remaining lease term with 10.3 years. The property is 100% leased to Baxter Healthcare Corporation as its IT hub for Baxter's nearby corporate headquarters campus. Baxter is an A rated public company engaged in the bioscience and medical products industry.

In December, we acquired two properties consisting of four buildings in San Jose, California containing 251,000 square feet for $64.9 million. The purchase price per square feet was $259. The acquisition cap rate was 7.9% and the weighted average remaining lease term is 8.5 years. The properties were 100% leased to three tenants that include Sunpower, which is headquartered the property and is a multibillion dollar public company that is a leading developer and manufacturer of high performance solar products.

Ciena Corporation, which is a multibillion dollar public company in the network communications business specializing in enterprise network solutions and extreme networks which is headquartered at the property and is a $500 million public company that provide network infrastructure equipment and services for enterprises, datacenters and service providers.

On our third quarter earnings call, we discussed proposed changes to our business management agreement with REIT Management & Research that have been completed and became effective January 1st of this year. We believe these changes further align management's financial strengths with those of shareholders and the changes include, one, we are now paying the base management fee on the lower of a historical property cost or service market capitalization. Previously the base management fee was determined by historical property cost. Two, we are now paying 10% of the base management fees RMR in SIR common shares instead of 100% in cash. Three, we are now calculating RMR incentive management fee based upon the relative outperformance of SIR's total return as compared to the total return of the SNL REIT Equity Index.

Previously the incentive management fee was based upon the growth of SIR's FFO per share. Incentive management fee will be measured on a three-year rolling period and the fee will be paid if the total return per share of SIR is negative. If earned the incentive fee will be paid entirely in shares at best ratably over three years and the shares are subject to a call back in the event of a financial restatement.

And four, we also limited from the business management agreement our right of first offer to acquire properties being sold by another RMR mandatory that meet our investment criteria.

In summary, we remain pleased with our losing activity, our ability to continue to programs through rental resets in Hawaii and are optimistic that our leasing and rent reset success in 2013 will continue in the 2014. This should position the company well to consider continued distribution increases.

Our acquisition phase has slowed primarily as a result of aggressive asset pricing due to the abundant availability of debt and equity capital for core investments. We do not expect this dynamic to change materially during 2014 and as we remain discipline in our acquisition underwriting we expect our acquisition phase could slow further in 2014 compared to previous years. Also as a result of the aggressive pricing for core investments, we expect to consider the implementation of a capital recycling program during 2014. While this program is not expected to result in the sale in a material number of assets, it is expected to help us balance our long term cost of capital and to maintain a portfolio of quality investments.

I would now like to turn the call over to John Popeo, our CFO, to provide more detail on our financial results.

John Popeo

Thank you, David. Looking first to the income statement, fourth quarter rental income increased by $10.4 million, tenant reimbursements and other income increased by $3.1 million and real estate taxes and other operating expenses increased by $3.2 million compared with the fourth quarter of 2012. The increase in all three categories primarily reflect the acquisition of 11 properties since October, 2012 through December 31, 2013. The increase in depreciation and amortization and in general and administrative costs primarily reflects acquisitions since October, 2012.

For the fourth quarter of 2013, operating income increased by 32%, adjusted EBITDA increased by 35% and normalized funds from operations or FFO increased by 41% compared to the fourth quarter last year.

Interest expense primarily reflects amount outstanding on our $750 million revolving credit and our $350 million term loan.

Net income for the fourth quarter of 2013 was $24.1 million compared to $17.2 million for the fourth quarter of 2012.

We have 38 leases in Hawaii that are scheduled for reset during 2014. These 38 resets currently represent $10.9 million of annual rent. During the quarter, we accrued estimated rental rate increases for 29 of 38 pending reset that have effective dates prior to December 31, 2013.

During the quarter, we paid $778,000 of building improvement capital, tenant improvement capital and leasing cost which includes cost related to rent reset and leasing activity in Hawaii.

Development and re-development cost totaling $1 million reflect road and building construction work at various properties during the quarter.

Normalized FFO was $0.67 per share for the fourth quarter of 2013 compared to $0.71 per share in the prior year.

Same-store NOI increased by 3.4% this quarter primarily reflecting resets in Hawaii.

In January, we declared a quarterly dividend of $0.46 per share which equates to a solid 6.5% yield based on our current share price. Since our IPO less than two years ago, we've raised our quarterly dividend rate three times for an aggregate increase of around 15%.

Turning to the balance sheet, on December 31, we held $20 million of unrestricted cash. Rents receivable of $55.3 million includes approximately $48.7 million of accumulated straight line rent accrual as of quarter end.

Other assets include our investments in affiliate insurance company, and prepaid real estate taxes and other expenses. Accounts payable and accrued expenses include $8.2 million of environmental research at properties located in Hawaii.

The $1 million decrease in security deposit reflects an allocation to cover unpaid rents and real estate taxes related to a default by one of mainland tenant that is responsible for approximately 2% of our annual rent.

As of December 31, 2013, pursuant to the lease we have applied a portion of this tenant's security deposit to cover all unpaid amount. Since January 1, 2014 we have continued to access the tenant security deposit to cover the tenant's current rental obligation. If this default is not resolved by the middle of 2014 the tenant security deposit is expected to be depleted. At this point, we are in active litigation with the tenant over the default. As such, we're limited in the details we can provide at this time. We will continue to report details on this matter as appropriate.

The company continues to maintain a conservative financial profile. At quarter end, debt contributed 30.9% of our total book capitalization and our fixed charge coverage was at 11.1 times. In January, 2014, we prepaid a $7.5 million 5.69% mortgage note that was scheduled to mature in 2016. Our revolver has a maturity date of March, 2016 with a one-year extension option and our term loan and mortgage debt have maturity dates in 2017.

As of the end of the fourth quarter we have $159 million drawn on our revolving credit facility. As of today, our $750 million revolving credit facility has $170 million outstanding leaving $580 million available to support our acquisition activity and other working capital needs.

As of December 31, 2013, over 95% of our outstanding debt was floating rate debt with a compelling average interest rate of 1.6%. And none of our current debt matures until 2017 assuming exercising of our one-year revolver extension option. However, we plan to begin exploring various that add longer term fixed rate debt for the balance sheet, a capital stack strategy more inline with our longer term business plan.

We may also consider moving corporate leverage higher than in prior quarters in order to capitalize on today's attractive borrowing rates and to minimize shareholder equity dilution.

Overall, we are very pleased with our quarterly and annual result.

That concludes our prepared remarks. Operator, we'd now like to take questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions).

And we will go to the line of Vikram Malhotra with Morgan Stanley. Your line is open.

Vikram Malhotra - Morgan Stanley

John, could you give us a little more color on the land rent resets? You mentioned you have accrued for 29 of them. Can you maybe just give us some sense of -- in '14 you expect kind of majority of them to get resolved? And then just the 25% assumed rent increase that seemed a bit lower than what you've kind of achieved in '13. And I know in '14 the locations of the reset change a bit so that percentage will change, but I'm assuming most of these that you did accrue are for '13. So can you just give us a little more color on what -- how you think the land reset will get resolved on the percentage you're applying within accrual?

John Popeo

Sure. Say about 19 or 20 of the total reset schedule to be settled in 2014 have effective date, primarily January 1, 2013. What we do is we accrue or we basically estimate based on recent settled resets what the fair market rent will be and then we back it -- back off a little bit. We make a conservative accrual for those 19 or 20 resets that have effective dates in 2013. So the point I'm really trying to make is, the 2013 numbers already have include rental rate increases on those 19 or 20 resets some of which are still on arbitration, but we are very confident that we will achieve the same performance of good solid increases when those are finally settled.

I think the reason the total -- when you combine the 2013 reset performance and layer it on top of the pending 2014 of the projected 2014, one key factor in arriving at the 25% or 30% projected increase is you have a higher target reset increase for the '13 over the '14 and that's because the 2013 resets were primarily in the Damon Estate. In 2014, the unsettled resets are primarily in the Campbell Estate, which generate lower reset percentages.

David Blackman

Yeah, but I think we said on the third quarter call that we projected our 2014 resets to be more in the range of 20% compared to the 40% to 50%. As it relates to kind of settling these, as of today we have reached a business agreement on 20 of the 38 rent resets. And they are in documentation and we've got a number that are in active negotiations as well. So we are reasonably confident that we are going to be plough through these. Recall that we had some litigation last year on 25 I think of our resets, where they had filed to do a consolidated appraisal process and that really delayed our ability to settle those resets by at least six months. So, we expect to catch-up here relatively soon.

Vikram Malhotra - Morgan Stanley

Okay, great. And then just one more, on the capital recycling, can you may be give us a little more color on may be what type of assets or by location are you considering or is on that list what's -- may be a broad range in terms of what is your budgeting and what potentially what cap rate you would estimate to do those sales at?

John Popeo

Yeah. We are very early in the process right now. Vik, I would tell you that you should expect if we do sell any properties they will be mainland properties and they will probably be assets where we think it may be expensive to renew that tenant in place. Or maybe they are not fully utilizing the building and we think they may want to downsize at renewal. So what we are going to try to do is critically look at the portfolio, identify potential challenges and if we think it is the right time to do so to move them off the balance sheet.

Vikram Malhotra - Morgan Stanley

And use of proceeds is it primarily recycling into other assets?

John Popeo

Yeah. I mean, if we have outstandings on the revolver we'll obviously use the proceeds to repair the revolver, but I would hope that we are ultimately trade out of lower quality assets into higher quality assets.

Operator

Thank you. Our next question will come from the line of Young Ku from Wells Fargo. Your line is open.

Young Ku - Wells Fargo

David, as of last quarter I think there was a little less than 300,000 square feet of expirations for rest of the comp for Q4 '13, but it looks like almost 700,000 square foot actually expired during the quarter, was there something else that we didn't know about?

David Blackman

Let me make sure I understand the question, Young . So you --

Young Ku - Wells Fargo

The Q3 supplemental it says that remaining expirations for the rest of '13 was 287,000 square foot, but this quarter its most like 676,000 square foot actually expired. So I was wondering if there was a early expiration baked into that number.

David Blackman

I'm not aware that we had an early expiration. I don't know whether we remove somebody early and maybe that's what happened as we had an expiration that was schedule to hit in the first quarter or that we ultimately reset or not reset but removed in the fourth quarter and maybe that's why it accelerated.

Young Ku - Wells Fargo

Okay, I see. Got it, okay. Thanks for that. And just one last question from me. I know you can't really talk too much about tenant in default in mainland but could you perhaps give us an indication in terms of when you planned to do a (inaudible), I mean, what's kind of like the ultimate come back could come from that? I mean, would you have to release the space longer term?

David Blackman

Yeah, I think that we will reach a conclusion on this in a relatively short time period. I'm hopeful that we ultimately reach a conclusion with this tenant that allows them to stay in the space and continue to operate there. So that's our goal. What we have done at this point is we've filed litigation to enforce all the tenant obligations under the contract and we hope to get this settled relatively quickly. So that it's mutually beneficial to those out there and the tenant.

Young Ku - Wells Fargo

Okay. I suppose the outcome could come so that you might have to restructure the lease so that the rents not get below that?

David Blackman

I suppose that is a possibility. Again, we are in litigation at this point to enforce the terms of the agreement. And I think it would be inappropriate for us to get into a tremendous amount of detail that could create challenge for us to negotiate an appropriate resolution of this.

Operator

Thank you and with that I would like to turn over to -- sorry. I think I have one more question in queue. That will come from the line of Jon Petersen - MLV & Co. Your line is open.

Jon Petersen - MLV & Co.

Great, thanks for letting jumping right at the last minute. But I just wanted to -- in terms of modeling, I'm looking at kind of the operating expenses and real estate taxes as some of those is up about $1 million sequentially. I know most of that gets pulled back in reimbursement revenue, but it's like top line revenues only up $500,000. Is there anything one-time in the expenses that we need to be aware of this quarter in terms of going forward and do adjust for it?

David Blackman

You are correct. I mean this quarter we did have a slight increase in same-store real estate taxes that were fully recovered and you can see that when you look at the same-store analysis in the operating supplement. Basically, same-store main NOI is flat and slightly down by like $46,000, but revenue was up by around $290,000. That's our real estate taxes.

Jon Petersen - MLV & Co.

Are those one-time catch up real estate taxes or is that just reflected as higher tax rate --

David Blackman

Higher tax rates, you can probably model in higher tax rates. Again it's not going to have any impact on NOI.

Jon Petersen - MLV & Co.

Okay. And then in terms of acquisitions, not really Hawaii, but in terms of kind of the mainland stuff that you have been doing throughout the year and the cap rates at least on your half a dozen sample size had been steadily declining throughout the year. I mean, what are you guys seeing in the market and expecting in terms of the cap rate that you can get on acquisition?

David Blackman

Yes, I think in our prepared remarks we said that we thought there was a risk that our acquisition pace could slow, and that's really because the asset price has gotten pretty aggressive. And we are seeing a number of opportunities that once we get into our underwriting, we run our model, we understand the asset, we think the risk return for those assets just aren't appropriate for us. And so we are passing on a lot more deals today than we have in the past. We are trying to remain disciplined and buy as many assets as we can kind of in that 8% and higher cap rate range. I think we can do the occasion deal kind of 7.5% to 8%. But by and large I think we want to buy assets that are 8% and above.

Jon Petersen - MLV & Co.

Okay. Does that -- as we look at potential rising cap rate environment, which we seem to have constantly flirting with, is that going to change your return hurdles from 8% to maybe higher if we do see the 10-year get up into the 3s and 4s?

David Blackman

Well we try to look at a weighted average long term cost to capital for the company where we take into consideration our cost of equity and what we think our long term cost of debt is. So if one of those components tends to get more expensive then we will obviously have to moderate our expectations on cap rate as well. But at this point, I don't really see anything changing in terms our weighted average long term cost of debt. And I would hope as we continue to mature as a public company, our long term cost of equity will actually go down and improve. So a lot of it depends on where our stock trades and where we think we can finance the company long term.

Operator

Thank you our next question comes from the line of Rich Moore with RBC Capital Markets. Your line is open.

Unidentified Analyst

Hey guys, good afternoon. This is actually Neil Mocken[ph] and I'm on with Richard Moore II. Two main questions. One, it looks like you guys had usually higher lease expirations during the quarter. I don't know if that's from renewals that got pushed forward, typically not common thing in the long term nature the leases you have, but who is back cutting those? Especially, I'm referring to Hawaii. Who is taking those new leases? Is there good demand for them? And then should we expect more of those elevate actually this year?

David Blackman

Yes, I think that's a similar question to what Vik asked or not Vik, but Young Ku asked relative to having showing higher lease expirations in our fourth quarter than what we projected in the previous quarter, and we had spent time digging into that. And we believe that probably what happened is we had an early renewal of a tenant, and that's what happened, but other than that we really don't have any additional color that we can share with you.

Unidentified Analyst

Sure. That makes sense. And then lastly spreads have been really good. As of late I think around 18%. What other spreads, what kind of spreads you see going forward in 2014 in particular?

David Blackman

Yes, well, I think the answer is it depends. And not to be cagey or anything but we had an 18% being roll up in rents for the fourth quarter leasing activity and obviously that's obviously, that depended upon a lot on what the current rates are for the leases that are expiring. Assuming -- well, we -- I guess the way to answer that would be to say Hawaii continues to be a very strong market. The airport industrial market, which is Mapunapuna and Sand Island, continues to have vacancy rates kind in that 2% or less rents. So we have a fair amount of pricing power in those markets.

Campbell Industrial Park, that submarket tends to have higher vacancy rates and there is less pricing power there. So a lot is going to depend on where we have leases expiring whether they are in Mapunapuna and Sand Island or the Campbell Industrial Park. In Campbell, I would expect that we are going to have much more moderate increases in rents. They could be flat, they could be up 10% but again it depends a lot on what the rents are in place that are expiring. And yes, wish I could be more specific it is just hard to say.

Operator

Thank you. And I'm showing no other questions. So with that I would like to turn the conference back over to Mr. David Blackman for any closing comments.

David Blackman

Thank you, operator. And thank you for joining our fourth quarter conference call. We will be attending the Wells Fargo Real Estate Conference in New York next week and hope to see some of you there. Operator, that concludes our call.

Operator

Thank you. And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using the AT&T Executive Teleconference Service. You may now disconnect.

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