Select Income REIT (SIR) Q2 2014 Results - Earnings Call Transcript

Jul.28.14 | About: Select Income (SIR)

Select Income REIT (NYSE:SIR)

Q2 2014 Earnings Conference Call

July 28, 2014 13:00 ET

Executives

Jason Fredette - Director, Investor Relations

David Blackman - President and Chief Operating Officer

John Popeo - Treasurer and Chief Financial Officer

Analysts

Rich Moore - RBC Capital Markets

Brendan Maiorana - Wells Fargo

Operator

Good day and welcome to the Select Income REIT Second 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, Investor Relations, Mr. Jason Fredette. Please go ahead, sir.

Jason Fredette

Thank you, Marla. Joining me on the call today are President and Chief Operating Officer, David Blackman and Treasurer and Chief Financial Officer, John Popeo. In just a moment, they will provide some context about our second quarter financial results and we will then open the call to your questions.

I would first like to note that the recording and retransmission of today’s conference call is 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 July 28, 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 factors that could cause those differences 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 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.

And now, I will turn the call over to David Blackman to begin our review. David?

David Blackman

Thank you, Jason. For the second quarter of 2014, Select Income REIT generated continued solid performance. For the quarter, we increased same property net operating income or NOI 1% and generated a 60 basis point increase in year-over-year occupancy, a 21% average rollup in rent from leasing activity and a 31% average increase in rent from Hawaii rent recess. We also completed the acquisition of two mainland properties at compelling acquisition yields that enhanced shareholder value.

As of June 30, SIR owned 50 properties containing 27 million square feet. Our properties were 96.1% leased, up 40 basis points from the previous quarter driven by our leasing activity in Hawaii and our 100% occupied mainland acquisitions. Hawaii remains our most significant investment representing about 36% of property NOI. Our leasing activity included 10 lease renewals for 148,000 square feet for a 2.7% increase in rental rates, a 3.6-year weighted average lease term and leasing capital of $0.10 per square foot per lease year. Many of our lease renewals were the result of tenants exercising contractual renewal options that had shorter lease durations and lower rent increases than market terms.

We also executed 91,000 square feet in three new leases for a 41.8% roll up in rent, a weighted average lease term of 12.5 years and leasing capital of $0.52 per square foot per lease year. All of our leasing activity was in Hawaii and resulted in a 40 basis point increase in Hawaii occupancy from the previous quarter. For the remainder of 2014 SIR has nine leases expiring in Hawaii for 98,400 square feet representing $409,000 of annualized rent. We expect to renew in place all of these expiring leases except 1800 square feet of space leases in Sand Island Center.

In addition, we have generated almost 170,000 square feet of perspective leases in Hawaii. As a result we remain optimistic in our ability to continue to increase occupancy at the company. We have also generated a strong rent reset quarter from Hawaii land leases. SIR executed 11 rent resets for 721,000 square feet increasing rents by $1.1 million, a 30.9% increase from previous rents. Year-to-date, we have grown rents by $2.6 million, which equates to rents that are 40% higher than prior to executing the rent resets.

At quarter end we have nine leases remaining to reset during 2014, which includes 2.9 million square feet of land and approximately $4.8 million of in place rent that we expect to increase by approximately 25% on average. We have reached agreement in our pending documentation on one of these resets and are actively working through the remaining eight. Note that our income statement already reflects most of the rent increases from these pending resets.

The industrial market in Hawaii continues 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 strong in comparison to the U.S. mainland and support growth in 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.

Our acquisition activity continues to focus on selective mainland properties that are strategic to tenants or where tenants have invested significant capital. Since April 1, SIR acquired two such properties containing 987,000 square feet for an aggregate purchase price of $208 million excluding acquisition costs. These acquisitions were previously disclosed. In aggregate they were 100% leased for a weighted average remaining lease term of 14.5 years or acquired at an average cost per square foot of $211 and at a weighted average acquisition cap rate of 8.6%. In April SIR completed an acquisition in Naperville, Illinois containing 820,000 square feet for a 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%. This is a Class A headquarters quality property that was acquired in a sale/lease back transaction from Tellabs, Inc. who entered a 15-year lease at closing. The property serves as Tellabs’ global headquarters who is one of the world’s leading optical networking companies.

In April SIR also acquired 167,000 square foot office warehouse in Mahwah, New Jersey for $20.4 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 has invested heavily in the property and is the world’s premier online luxury fashion retailer. The acquisition market for single tenant net leased properties remains aggressive due to an abundance of debt and equity capital available for core real estate investments. We continue to underwrite a number of acquisition opportunities, but it has become more difficult to identify long-term net leased properties that are both strategic to tenants and that meet our pricing criteria. As a result, we expect our pace of single property acquisitions for the remainder of this year could slow.

In summary, we remain pleased with our results of operations and our leasing and rent reset activity in Hawaii. We remain focused on our business plan of acquiring strategic single tenant net leased office and industrial properties on the mainland in 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 our second quarter results.

John Popeo

Thank you, David and good afternoon everyone. Let’s begin our financial review by looking first at the income statement. Total rental revenue increased by 23% year-over-year to $56.6 million for the second quarter of 2014 with most of this growth coming from our mainland acquisitions. For the second quarter, rental revenue from our mainland properties grew by 41% to $35.6 million, while Hawaii rental revenue grew by 2% to $21 million.

During the quarter, 64% of total NOI came from our mainland properties, while Hawaii contributed to the remaining 36%. Total NOI for the second quarter increased by 26% year-over-year to $46.6 million. Same-property NOI increased by 1% year-over-year to $37.3 million with both Hawaii and mainland growing marginally.

General and administrative expenses for the second quarter of 2014 declined by nearly $800,000 from the year ago quarter. As you may recall, our first quarter 2014 G&A included an accrual of approximately $2 million for an incentive management fee to RMR that was based upon SIR’s outperformance of the SNL U.S. REIT equity index or benchmark from January 1 to March 31, 2014. In the second quarter, we reduced this accrual by approximately $1.6 million based on the relative increase in the benchmark during the quarter.

As a reminder from Q1 to Q3, we exclude our estimated incentive fee from our normalized FFO calculation. If this fee is ultimately earned for a given year, we will include it in our normalized FFO calculation for the fourth quarter and full year results. Operating income for the second quarter of 2014 increased by more than 27% year-over-year to $33.7 million and adjusted EBITDA grew by 26% to $43.5 million. Interest expense for the second quarter was $3.6 million, primarily reflecting amounts outstanding on our $750 million revolving credit facility and our $350 million term loan.

Net income for the second quarter of 2014 was $30.2 million, which compares to $22.8 million for the second quarter of 2013. During the quarter, we paid approximately $800,000 of recurring CapEx, including approximately $400,000 of tenant improvement obligations under our mainland lease entered into in the prior year.

Development and redevelopment costs for the quarter totaled approximately $300,000. Normalized FFO for the second quarter of 2014 was $39.2 million or $0.72 per share, which compares with $30.4 million or $0.77 per share for the year ago quarter. The decline in FFO per share is the result of the year-over-year increase in our shares outstanding.

Turning to the balance sheet, undepreciated real estate increased by over $200 million since December 31, 2013 to $1.9 billion reflecting our Q2 acquisitions. Rents receivable of $59.6 million included approximately $56.8 million of accumulated straight line rent accruals as of quarter end. Other assets include our investment in affiliates, insurance company, prepaid real estate taxes and other expenses. We entered the second quarter with $74 million outstanding under our revolving credit facility, down from $345 million as of March 31, 2014. This reduction primarily reflects the application of approximately $277 million and net proceeds from the equity offering completed in Q2.

As of June 30, we had $19.1 million in mortgage notes payable, down from $27.1 million as of December 31 as a result of the note repayment in January 2014. Our total debt to book capitalization ratio at June 30 was 23% and our fixed charge coverage ratio was 12 times. Our revolver had a maturity date of March 2016 plus a one-year extension option and our term loan and mortgage debt have maturity dates in 2017. We believe these metrics in the quality of our portfolio position us well to seek investment grade ratings. And finally, the increase in our security deposits balance reflects the full replenishment of the security deposit from our mainland tenant that was in default as of March 31. In addition, this tenant is now current on its payment of rent.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question will come from the line of Rich Moore with RBC Capital Markets. Please go ahead.

Rich Moore - RBC Capital Markets

Yes, hi, good afternoon guys. On the troubled tenant, does that mean everything is resolved with the mainland tenant that you were talking about at the end of your remarks?

John Popeo

I have to say not everything, Rich. And as we mentioned on the last call, there is really not a whole lot we can – additional detail we can give given the fact that there are still a few things unresolved, but I think the important thing to note is that, this tenant has replenished the security deposit as we just mentioned in the prepared remarks, but in addition, they have also paid July rent. So, we are optimistic that the situation is going to stabilize.

Rich Moore - RBC Capital Markets

Okay. So, we are not sure if he is going to pay the rent going forward at this point, I guess is what you are saying right?

David Blackman

Rich, we have no reason to believe that the tenant won’t continue paying rent. We are just still working through the litigation.

Rich Moore - RBC Capital Markets

Okay, got it. Great, thanks. And then I want to ask you guys about the SIR stake that was bought by GOV, why didn’t you guys buy that back or why didn’t SIR buy those shares back from Commonwealth?

David Blackman

Rich, I guess in reality really it wasn’t offered to us as potential investment. And I think it would have been difficult to buyback a lot of shares at a price if it was higher than where we had recently raised equity.

Rich Moore - RBC Capital Markets

Okay. So, do you have any – I guess, do you have any take on what GOV is doing with those shares, I mean, why do they own those shares and why did they purchase those shares?

David Blackman

Yes. GOV has got an earnings call coming up in a weak or two and I am sure they will be more than happy to discuss that investment on their call.

Rich Moore - RBC Capital Markets

No. Have you talked with them, Dave, about what their intentions are?

David Blackman

I believe that their intention is to be a long-term shareholder.

Rich Moore - RBC Capital Markets

Okay, alright, good. Got it. Then the resets, those are all – the upcoming resets I am thinking, are those Damon, those are all Damon, Campbell is kind of done for now?

David Blackman

Rich, I think it’s a little bit of mix at this point. We have got a couple of Campbell still left for this year. And then we have got a handful of Mapunapuna. So, it’s – we are thinking on average, we probably got another 25% increase, which is baked into the income statement, but it’s a good mix of both Campbell and Mapunapuna.

Rich Moore - RBC Capital Markets

Okay, good. And then I think I asked you guys this every time, but I guess I better ask it this time too, anything cooking on the disposition front? Is there anything I mean you would like to see discarded at this point?

David Blackman

At this point, we have not presented approval to the board to dispose of any assets. We expect that we will over time. But at this point we haven’t really identified anything that we feel like needs to hit the market for sale.

Rich Moore - RBC Capital Markets

Okay, great. Thank you, guys.

Operator

(Operator Instructions) We do have a question from the line of Brendan Maiorana with Wells Fargo.

Brendan Maiorana - Wells Fargo

Hi, David and John. A question just – can you guys elaborate on the equity rates and maybe kind of the balance sheet management, how you guys think about why the raise made sense at the time it did and how you are kind of thinking about deploying that capital?

David Blackman

Sure. So Brandon at the time, we decided to go to the equity markets, we had presented financing alternatives to the Board with the help of an investment bank. We looked at a number of potential financing strategies. We had roughly half of our credit facility outstanding at the time. We had taken a hard look at looking at the debt markets, but ultimately concluded that by going out and raising debt at that time our leverage would have been in the mid to high-40s and the only way to have a use of proceeds to go back to the equity markets would be to take leverage above 50%. We didn’t feel that was prudent in light of the fact that we want to pursue an investment grade rating, so we ultimately went to the equity markets, took leverage down and expect to deploy those proceeds into future acquisition opportunities.

Brendan Maiorana - Wells Fargo

Great. So maybe I am just not remembering – what was your leverage at March 31, I don’t think it was that high?

David Blackman

Well, you have probably not taken into consideration the $208 million of acquisitions.

Brendan Maiorana - Wells Fargo

Right.

David Blackman

Which took leverage up to kind of mid to high-40s.

Brendan Maiorana - Wells Fargo

Okay. Alright. So now that leverage is low, how do you think about that opportunity set that’s out there and what do you feel like is the capacity to bring – how much more do you think you can do in terms of acquisitions and what not to bring leverage in line, but where you think you can run the balance sheet from a long-term perspective?

David Blackman

Yes. I think the balance sheet at this company can – well, I think we are pursuing the investment grade rating idea at this point. Once we managed through that, I think we will we can run this company kind of in the mid-40s leverage perspective. We have a 10.6 year weighted average remaining lease term. We have got a pretty well laddered lease expiration schedule. We don’t have really any lumpiness in debt expirations now do we have significant CapEx at this company. So we clearly can run kind of in the mid to high-40s. And we expect that that we will get there over the next year or so.

Brendan Maiorana - Wells Fargo

And so and that gives us – sorry, I just don’t have the numbers right in front of me, but that gives you how much in terms of additional debt capacity, is that $500 million or something like that if you got mid to high-40s?

David Blackman

Yes. I would say it’s – it is at least that at this point I don’t know - John, I don’t know we have done the math but.

John Popeo

It sounds about right.

David Blackman

It sounds about right.

Brendan Maiorana - Wells Fargo

And just how do you think about, you still are running variable rate debt is still kind of 95% of your debt stack, how do you guys think about maybe taking some of that variable rate debt off the table and doing an unsecured issuance is that on the table for this year?

David Blackman

I think we are hopeful that the acquisition market will remain active that we will find the right deals that makes sense for us and that will result in our ability to do an unsecured fixed rate issuance. As we have said previously we think that we need to have an appropriate amount of variable rate debt in our capital stack. We don’t necessarily want to take out the bank term loan. So what we will do is create a more appropriate mix of fixed and floating rate debt by issuing senior unsecured notes. And I think it’s obviously the acquisition market has a lot to do with it, but we remain optimistic that we will find the right deals to get us to the unsecured debt market.

Brendan Maiorana - Wells Fargo

What – and what do you think that long-term mix ought to be – and fixed versus variable?

David Blackman

Well, it will vary obviously over time. I think our goal is to try to get to at least 50-50 at this point. And then dependent upon where interest rates – what kind of interest rates cycle we are in, we will probably run between 60-40 over time.

Brendan Maiorana - Wells Fargo

Yes. And you don’t think that seems like a little bit high relative – it strikes me as a little bit higher than most of your – most REITs would run especially for a triple net kind of portfolio like yours, you don’t think maybe a little bit lower in terms of variable rate that would be appropriate for the type of portfolio that you have?

John Popeo

Maybe on the total asset – as a percentage of total assets you are probably talking more like 15%. I think that’s probably the sweet spot in the eyes of the rating agencies to maintain an investment grade rating maybe up to 15% among other things of course. But I think I mentioned on the call last quarter probably over the longer term floating rate debt could be anywhere from 10% to 15% of total assets.

Brendan Maiorana - Wells Fargo

Okay. And…

John Popeo

It’s still a young company. We are still sort of making our way through the growth process and weighing a number of different options.

David Blackman

We don’t have a lot of debt right now Brendan.

Brendan Maiorana - Wells Fargo

I understood – I mean I know your leverage is very low, so overall 10% to 15% seems more like I would expect as a percent of total assets as opposed to 50% of your debt stack at 50% leverage would suggest that would be 25% which would seem a little bit higher than I would have thought, but that seems more reasonable. Alright thanks for the time.

Operator

And at this time I will turn the call back over to Mr. David Blackman for closing remarks.

David Blackman

Thank you for joining us on our second quarter earnings call. That concludes our remarks. Thank you, operator.

Operator

Thank you. That does conclude our conference for today. Thank you for your participation and for using AT&T Teleconference service. You may now disconnect.

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Select Income (NYSE:SIR): Q2 FFO of $0.72 in-line. Revenue of $56.56M (+23.1% Y/Y) misses by $1.29M.