Select Income REIT's Management Discusses Q1 2014 Results - Earnings Call Transcript

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 |  About: Select Income REIT (SIR)
by: SA Transcripts

Select Income REIT (NYSE:SIR)

Q1 2014 Results Earnings Conference Call

April 25, 2014 01:00 PM ET

Executives

Jason Fredette - Director, IR

David Blackman - President and COO

John Popeo - Treasurer and CFO

Analysts

Young Ku - Wells Fargo

Rich Moore - RBC

Jon Petersen - MLV

Operator

Good day and welcome to the Select Income REIT First 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, Tony. 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 formal remarks 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.

Also note that 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 beliefs and expectations as of today, April 25, 2014 and actual results may differ materially from those that we project.

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 the factors that could cause differences is contained in our filings with the SEC, which can be accessed from our website sirreit.com. or the SEC’s website. Investors are cautioned not to place undue reliance upon any forward-looking statements.

In addition, we will be discussing non-GAAP numbers during this call including normalized funds from operation or normalized FFO a reconciliation of these non-GAAP figures to net income and the components to calculate cash available for distributions or CAD are available in our supplemental operating and financing data package which again can be found on our website.

Now I would like to turn the call over to SIR’s President and COO, David Blackman.

David Blackman

Thank you, Jason. The first quarter of 2014, Select Income REIT generated continued solid performance. For the quarter we increased same property net operating income or NOI 3% from substantially flat year-over-year occupancy of 20% average rollout and rents from leasing activity and a 50.8% average increasing rents from Hawaii rent resets.

After the quarter close, we also completed the acquisition of two mainland properties a compelling acquisition yield that we believe enhance shareholder value. As of March 31, 2014, SIR has 48 properties containing 26 million square feet. Our properties were 95.7% leased, up 20 basis points from the previous quarter, driven by our leasing activity in Hawaii. Hawaii remains our most significant investment representing 41% of our property NOI and 68% of our own property square feet. We continue to drive strong same property results from our leasing and rent rate reset activities in Hawaii. For the quarter, we increased same properties NOI in Hawaii by 7.6% on a year-over-year comparison.

Now let's review our activity for the quarter. During the first quarter, we executed to lease renewals for a 123,000 square feet for essentially no change in rental rates and 11.5 year weighted average lease term and leasing capital of less than one penny per square foot per lease year. We also executed four new leases for 83,000 square feet for a 48.4% roll up in rent and weighted average lease term of 13.7 years and leasing capital of $0.50 per square foot per lease year.

Our leasing activity this quarter included both space leases and land leases. Specifically, we executed space leases during the quarter for 2,000 square feet in Sand Island Center while the remaining of our lease activity were land leases in Mapunapuna.

For the remainder of 2014, SIR has 16 expiring leases in Hawaii for approximately 226,000 square feet and approximately $1.1 million of annualized rent. We expect to renew in place all of our expiring leases expect 3,100 square feet of space leases in Sand Island Center. In addition, we have generated almost 400,000 square feet of perspective leases in Hawaii, which includes a 121,000 square feet where prospective tenants have executed letters of intent or where lease negotiations have been completed and documents are out for execution.

As a result, we remain optimistic in our ability to continue to increase occupancy at the company. We also generated a strong rent reset quarter from Hawaii land leases. SIR executed 18 separate rent resets for 592,000 square feet, increasing rents by $1.5 million, a 50.8% increase from previous rents. All of the executed rent resets during the quarter were properties located in the former Damon Estate.

At the quarter end, we had 20 leases remaining to reset during 2014, which included 3.6 million square feet of land and approximately $8 million of in place rent that we expect to increase approximately 25% on average. Since quarter end, we have reached agreement on 12 of these resets and are in active negotiations with remaining 8 tenants.

The industrial market supply dynamics in Hawaii continue to support strong growth in market rents. Consistent with previous periods, we remain bullish on our ability to maintain high occupancy and grow rents through leasing and rent reset activity in the former Damon Estate properties. Market fundamentals in the Campbell Industrial Park are also strong, particularly in comparison to the U.S. mainland and support royalty market rents albeit at a slower pace. The Campbell Industrial Park is also where the bulk of our vacant land is located and is the primary focus of our leasing and marketing efforts.

Turning to our acquisition activity. We continue to seek growth for our mainland portfolio through the selective acquisition of properties that are strategic to tenants or where tenants have invested significant capital.

Since January 1st, SIR acquired two such properties containing 987,000 square feet for an aggregate purchase price of $208 million excluding acquisition cost. These acquisitions were 100% leased for a weighted average remaining lease term of 14.5 years acquired at an average cost per square foot $211 and at a weighted average acquisition cap rate of 8.6%.

In April, SIR completed an acquisition in April in Naperville, Illinois containing 820,000 square feet for an aggregate purchase price of $187.5 million. The purchase price per square foot for this acquisition was $229 and the acquisition cap rate was 8.7%. We acquired this class A headquarter quality property in a sale lease back trends, sale lease transaction from Tellabs, Inc., who entered a 15 year lease of closing.

Tellabs was acquired in late 2013 by private equity firm as part of a roll up strategy in the optical networking space. All the [TE Firm’s] operating subsidiaries are parted to our lease and on an aggregate basis, the company has the second largest optical networking business in the U.S. This property will serve as the company’s global headquarters.

SIR also acquired in April a 167,000 square foot office/warehouse in Mahwah, New Jersey for $20.5 million. The purchase price per square foot for this acquisition was $167, the acquisition cap rate was 7.6% and the remaining lease term was 9.1 years. The property is 100% leased to NET-A-PORTER and serves as the company’s North American headquarters and distribution center. NET-A-PORTER which is the world’s premier online luxury fashion retailer has invested heavily in the property.

As we discussed in our previous conference call, the acquisition market for single tenant net lease properties is aggressive due to an abundance of debt and equity capital available for core real estate investments. While we maintain an active pipeline of acquisition opportunities, it has become more difficult to identify long-term net lease properties that are both strategic to tenants and that meet our pricing criteria. As a result, we expect our acquisition pace will be slower for the remainder of this year than previous years unless the market dynamics change.

In summary, we remain pleased with the performance of our leasing and rent reset activity and our ability to once again increase our quarterly distribution rate to shareholders. We remain focused on our business plan of acquiring single tenant, net lease office and industrial properties and growing our Hawaii rents.

We believe this will result in a safe, predictable and increasing distribution to our shareholders. I will now turn the call over to John Popeo, our CFO to provide more detail on first quarter results.

John Popeo

Thank you, David. Looking first to the income statement, first quarter rental income increased by $7.6 million year-over-year, our Hawaii leasing and rent reset activity accounted for approximately 15% of this total, while the acquisitions we have made over the past year accounted for most of the remainder. Tenant reimbursements and other income increased by nearly $1.6 million, real estate taxes and other operating expenses increased by $2.1 million and depreciation and amortization grew by $2.6 million over the prior year period. These increases are primarily related to our Mainland acquisition activity plus increases in recoverable and other operating expenses at our same store properties.

Our general and administrative costs increased by approximately $2.5 million year-over-year. Approximately 72% of this increase reflects the increase in accrued estimated incentive management fees. As a reminder under our amended management agreement with RMR which went into affect on January 1, 2014 and incentive management fee will be earned only of SIR’s total shareholder return exceeds that of the SNL U.S. REIT Equity Index.

SIR’s total shareholder return for the first quarter was nearly double that of the index. Of course of this level of outperformance as reduced in future quarters or if we were to underperform our accrual amounts would be reduced or reversed. Because the calculation of 2014 incentive fees won’t be finalized until year end, we have a eliminated estimated incentive fees from our calculation of normalized FFO and we expect to do the same for the second and third quarters until calculations are final at year end.

Operating income increased by 8.7% year-over-year to $28.3 million and adjusted EBITDA increased by 19% year-over-year to $40.2 million. Our $3.4 million of interest expense for the first quarter primarily reflects amounts outstanding on our $750 million revolving credit facility and our $350 million term loan.

Net income for the first quarter of 2014 was $25.1 million compared to $22.6 million for the first quarter of 2013. During the quarter we paid $416,000 of recurring CapEx, including costs related to own buildings in Hawaii. Development and redevelopment costs totaled only $78,000 for the quarter and reflect the road and building construction work at various mainland properties during the quarter. Normalized FFO was $36.4 million or $0.73 per share for the first quarter of 2014, compared with $30 million or $0.76 per share for the year ago quarter and $33.2 million or $0.66 per share last quarter.

Again quarterly normalized FFO excludes estimated incentive management fees. The increase in normalized FFO from the fourth quarter of 2013 reflects a full quarter impact from acquisitions completed during Q4 of 2013 plus seasonal contingent rent receipts from one of our Hawaii tenants during the first quarter of 2014. Excluding this seasonal contingent rent, normalized FFO for the first quarter of 2014 would have been approximately $0.70 per share.

Same-store NOI increased by 3% year-over-year, primarily reflecting rent resets in Hawaii, which more than offset mainland legal expenses related to current tenant disputes and non-recurring revenue recognized during the first quarter of 2013.

Earlier this month, we announced that we are increasing our quarterly dividend for the fourth time since our IPO in March of 2012. Our new $0.48 per share quarterly dividend rate represents a yield of approximately 6.2% based on yesterday's closing stock price.

Turning to the balance sheet. On March 31, we held $204 million of unrestricted cash, reflecting amounts drawn on our revolving credit facility at the end of March, that were used to fund the acquisitions in early April that David discussed a few minutes ago. Rents receivable of $58.5 million includes $52.2 million of accumulated straight line rent accruals as of quarter end. Other assets include our investment in affiliate insurance company, acquisition deposits and prepaid real estate taxes and other expenses, the $5.1 million in other assets from December 31st, to March 31st reflects increases in prepaid real-estate taxes and other operating expenses.

Accounts payable and accrued expenses include $8.1 million of environmental reserves at properties located in Hawaii. The $600,000 decrease in security deposits reflects an allocation to cover unpaid rents in the real-estate taxes related to the default that we discussed on our previous conference call. This Mainland tenant is responsible for approximately 2% of our annualized rent and we’ve been drawing down their security deposits to cover all unpaid amount. If this default doesn’t not resolve by the middle of 2014, the tenant security deposit is expected to be depleted and we may begin to experience a reduction in mainland revenue and NOI. We are in active litigation with the tenant over the default. As a result we are limited in the details we can provide at this time.

Moving on our total debt to book capitalization ratio at March 31st, was 37.3% and our fixed charge coverage ratio was 12 times. Our revolver has the maturity of March 2016 plus a one year extension option and our term loan and mortgage debt have maturity dates in 2017.

As of the end of the first quarter we had $345 million drawn on our revolving credit facility. Considering our revolver of approximately 50% drawn we will likely explore various options to reduce amounts outstanding on our revolver with fixed rate debt, equity or a mix of both in order to free up capacity for future investment opportunities.

That concludes our financial recap, operator would you please provide instructions for the question-and-answer session.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions). And our first quarter will come from Vikram Malhotra with Morgan Stanley. Please go ahead.

Unidentified Analyst

Hi this is [Lenin Park] on for Vikram. Just some questions on the rent resets in the Hawaii. The 50% in the first quarter, you would assume 25%, I believe while they were in negotiation, is that going to have an impact going forward?

David Blackman

Yes. What we have said on previous calls was that we expected the annualized increase in rent from resets during the year to be 25% on average. And so what I don’t want you to do is compare one quarter to what we expected to happen throughout the entire year. I guess the real point is what we expect the increases to be for the remainder of this year will obviously be less to get us to that average of 25% for the year.

Unidentified Analyst

Okay. So the 25% is for the full year, not for the remains record.

David Blackman

Well, the 25% that I have said in my prepared remarks is what we expect for the remainder of this year.

Unidentified Analyst

Okay. So that is for the remaining three quarters.

David Blackman

Right and what we have said previously was there was kind of 20% to 30% for the full year.

Unidentified Analyst

Okay. And then just going through the acquisition environment and what your pipeline is looking like today, can you just take us through that real quick?

David Blackman

Sure I mean we have a reasonably active pipeline, call it 10 to 12 deals probably on market value of around $300 million, nothing at this point that I would say we are close to we’re continuing to see acquisitions traded very aggressive cap rates and we are finding that it is becoming more and more difficult for us to be competitive on price. What we [tend and] like and where we tend to be the most competitive sale lease back transactions where there is a long-term lease and we can negotiate reasonable annual increases in the rents.

Unidentified Analyst

Okay. And just lastly the seasonal contingent rent that you noted in your remarks could you just explain that a little and just explain the impact on your FFO?

David Blackman

Sure. The seasonal rent this represents percentage rent that we can only recognize under GAAP during the first quarter of each year when the rent is actually paid and we recognize the similar amount last year. So it’s an apples to apples comparison year-over-year.

Unidentified Analyst

Great, very helpful. That’s all from me thank you.

Operator

Thank you. Our next question in queue will come from Young Ku with Wells Fargo. Please go ahead.

Young Ku - Wells Fargo

Great, thank you. David so $300 million of acquisition expectation for 2014 I think you said. How much additional capacity do you think you have on your balance sheet without needing issue addition property equity?

David Blackman

Yes, Young I think the previous question that was asked was what our pipeline look like. And I told him that the answer was that we had about $300 million of market down in the pipeline. We don’t have at this point anything that we are close on, we are not working to put anything under agreement, we continue to look at acquisitions, but I think beyond what I have said that we expect acquisitions to be slower this year then in previous years because of the aggressiveness of the market is really much of guidance as I can give you on what I think our acquisition pace is going to be for the rest of the year.

Young Ku - Wells Fargo

And in terms of how much capacity you guys do think you’ve?

David Blackman

Well, I mean, our revolver is about 50% use. So we have got plus or minus $350 million of availability under it, our leverage is somewhat moderate at this point, but as John said in his remarks we are looking at capital market options to repay that facility.

Young Ku - Wells Fargo

Okay, that’s helpful. And John so I think you just mentioned kind of the mainland same store NOI decline year-over-year, part of that is being impacted by litigation cost, what is the magnitude of that impact?

John Popeo

Well, same store NOI and the mainland declined by around 229,000, I would say above the 100,000 or so is probably litigation [return still] related. In addition in the prior year in the first quarter of 2013 we have, what I recall non-recurring revenue of about $100,000 which was just an escalation to us from various tenants from the mainland.

Young Ku - Wells Fargo

Okay, great thanks. And somewhat related regarding this litigation you said that’s the percent of revenue. How much of that is in square footage and where is that asset located?

John Popeo

Unfortunately, we're not going to be able to share those kind of details with you at this time, just given where we are (inaudible).

Young Ku - Wells Fargo

Okay. Asked a little bit different way, and this was where I was going to. David, how would you kind of characterize the asset and kind of what are the prospects for trying to backfill that asset if the tenant were to kind of move out?

David Blackman

Sure, good question. We’ve had a lot of conversations with not only our property manager, but also with leasing brokers in the market. And fortunately for us that property is located in a market right now that has very favorable supply demand characteristics. So, they’re landlord finally right now. We think that we can re-lease that building with little downtime, say six months or so. We think there probably would be maybe a roll down in rents if we had to go out and lease it right now. But we think that by and large it’s a pretty landlord favorable market where the building is located.

Young Ku - Wells Fargo

Got it, great. And one last from me, I'm not sure how much you can disclose, but have you had any discussions with the CommonWealth entity regarding their ownership of SIR's income?

David Blackman

No, we really haven't at this point and I don't know if you saw the 8-K that we filed a while ago, where we revoked the registration rights on the shares with them. We did that because of the change of control and because of the fact that there was no board in place and it remains somewhat uncertain as to what the management team's expectations were with those shares. We did say in the letter that we welcome an opportunity though to [have] with them and understand what their expectations are and we can readdress the registration rights at that time.

Young Ku - Wells Fargo

Okay. Thank you.

Operator

Thank you. (Operator Instructions). And next in queue is Rich Moore with RBC. Please go ahead.

Rich Moore - RBC

Hi. Good afternoon guys. When we look at the 18 Hawaiian land rent resets that you had in the quarter, were 16 of those resets from prior periods and 2 of those from 2014 upcoming expirations, is that correct?

David Blackman

That is accurate, Rich.

Rich Moore - RBC

Okay. And so the remaining 16 that you guys have Dave from resets from prior periods, are those -- are the 12 that you have I guess recently identified and recently concluded agreements are 12 of those in that 16 or they in 4 that are remaining for that were expiring this year?

John Popeo

In terms of 16.

Rich Moore - RBC

In 16, so those will probably go up 50% roughly is that right, is that kind of the same group that whole bunch of 32 previous ones are similar I guess in that way and that we should see similar sorts of increases in the rent?

John Popeo

Not necessarily. I think all 20 that are listed as still pending on average will generate what David mentioned (inaudible) 25%, so a little lower than the ones that had settled in the first quarter.

Rich Moore - RBC

Okay. Yes, I was just thinking John that if that, it’s a smaller square footage amount from those 16 from the previous period that are remaining, so if all those hit in the second quarter you’d actually have the big bump in the second quarter and then everything would be -- the remainder of the year would be the soft part, but you’re saying sort of go out ratably I guess over the year with the 25%?

John Popeo

Yes. Rich, one thing to keep in mind though is those 16 that are listed in the supplemental, we’ve already accrued revenue for them based on an estimate. So for your modeling purposes, you should not be incorporating an increase rents, it’s already baked in to financial states.

Rich Moore - RBC

Okay. Yes, good point. Thank you. Okay, thank you. And then the incentive fee was that just in rent or was that in other income?

John Popeo

It’s in G&A.

David Blackman

Total expense?

Rich Moore - RBC

No, the percentage rent?

John Popeo

Yes that’s rent...

Rich Moore - RBC

(Inaudible).

David Blackman

Yes, that was a similar amount in the prior year.

Rich Moore - RBC

Right, okay great. And then on the thing you can’t talk about on this tenant and the mainland, one clarification I’m just curious about when his rent runs out or his security deposit runs out, is anything to has to leave at that point?

David Blackman

We have not filed to a [bit] to tenants. We are seeking other means of litigation at this point. We’d hope that we come to mutually beneficial resolution. So what it means when security deposit runs out and they are not paying rent is that we won’t be able to recognize any revenue. I don’t think that changes our stance on a litigation. The reason it’s taken so long is more an issue with the courts I think than anything else at this point. For some reason, the judge has been unavailable for like 90 days, so nothing has really happened in the litigation. So we will hope that over the next kind of 60, 90 days, we get some movement and get closer to resolution.

Rich Moore - RBC

Okay. And I guess what I am thinking is if you guys don’t get a resolution will he be out by the end of the year, and so then we think about six months of down time from there is that…

David Blackman

Yes, I wouldn’t necessarily assume that, I mean again I don’t think that we are changing our pact on the litigation at this point. What we are doing is we are taking advantage of the security deposit that we put in place when this building was acquired for exactly the purpose that you get security deposits to pay rents when a tenant is in the fault. We are going to continue to work through the litigation to try to find resolution and hopefully that means that we will get the tenant to pay back rents that will get the security deposit replenished and the tenant will remain in the building and serve the remaining term that’s leased. If things change from a litigation perspective, then we will obviously notify people at that time but at this point nothing else has changed.

Rich Moore - RBC

Okay, good. Thanks guys.

Operator

Thank you. (Operator Instructions) And next in queue is Jon Petersen with MLV. Please go ahead.

Jon Petersen - MLV

Great, thanks. I was hoping to get maybe a little for modeling purposes a little more understanding behind the incentive fee. So I think this quarter you outperformed the SNL impact by about 7% or so. And I guess first of all is that based on total return or is that based on price return? And then kind of second is your stock stays flat, SNL equity stays flat for the rest of the year, is that meaning kind of the zero impact to the G&A for the rest of the year, is it a $2 million impact to G&A quarterly for the rest of the year? Just help me better understand how that math works?

John Popeo

Sure. First of all, the answer to your first question is total return and again if we assume that the return performance this quarter for SIR as well as the SNL Equity Index stays the same, what we recognized during the first quarter was one quarter’s worth, a prorated amount of the full year calculation. So if everything stays exactly the same, you see a similar amount accrued in the second, third and fourth quarters.

Jon Petersen - MLV

Okay, right. That’s helpful. And then you guys talked a little about debt and kind of what kind of raise in equity going forward. I mean you have 300 -- almost $350 million on your line of credit right now, you also have the term loan that is floating. And then you guys think, you got portfolio of assets with long term leases. I would think that you’d want to tie that up with long term debt to kind of fix under spread. How you guys think over the next few years the process goes of converting a lot of this floating rate debt into fixed rate debt, is that a multi-year profit, is that a multi-year process (inaudible) to happen more in near term?

John Popeo

Well, you bring up a very good point, of course floating rate debt represents, it’s very high right now, represents around 98% of total debt and about 35% of total assets. Clearly as you mentioned, it doesn’t make sense to run our company over the long term on these levels. But over the longer term, I could SIR with a mix more in line with say investment grade rating metrics including maybe floating rate debt around 10% to 15% of total assets and maybe a mix of mortgage on unsecured debt accounting for the balance of total debt. But as far as what is the timeline to affect this sort of capital [set] business plan, probably 1.5 year, 2 year proposition.

David Blackman

Yes Jon, what we said previously and I don't think anything has really changed, is that, we don't intend to take out our unsecured term loan with fixed rate debt. We think that’s a permanent part of our capital strategy, the revolving credit facility is obviously in acquisition line, we're going to be in and out of that. We expect that we will improve our ratio of fixed to floating rate debt by adding fixed rate debt to the balance sheet. And that's part of what we're doing now as we assess the capital markets on what our next move will be, is looking at options for fixed rate debt, looking at the equity markets and considering what the right way to move forward is.

Jon Petersen - MLV

Okay, alright. That makes sense. And then one final question. So, in terms of CommonWealth ownership, so you deregistered the shares so that limits their ability to sell the shares. So does it also limit their ability to vote in terms of a consent solicitation type process?

David Blackman

Well, there is no ability to do a consent solicitation at Select Income REIT. We don't have in our bylaws the right to remove trustees without cause. So, it’s kind of a move point from that perspective.

Jon Petersen - MLV

Okay, fair enough. Thank you.

Operator

Thank you. And at this time, I'll turn the conference back over to President, David Blackman for closing remarks.

David Blackman

Thank you Tony. Thank you for joining our call today. We’re currently scheduling meetings for institutional NAREIT conference in June and look forward to seeing many of you at that time. Tony that concludes the call.

Operator

And ladies and gentlemen, that does conclude your conference call for today. We do thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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