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Government Properties Income Trust (NYSE:GOV)

Q2 2014 Earnings Conference Call

August 6, 2014 01:00 p.m. ET

Executives

Jason Fredette – Director, Investor Relations

David M. Blackman – President and Chief Operating Officer

Mark L. Kleifges – Treasurer and Chief Financial Officer

Analysts

Michael Carroll – RBC Capital Markets

Young Ku – Wells Fargo Securities, LLC

Mitch Germain – JMP Securities

Jon Petersen – MLV & Co.

Operator

Good day and welcome to the Government Properties Income Trust’s 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 of Investor Relations, Mr. Jason Fredette. Please go ahead sir.

Jason Fredette

Thank you, Ronda and good afternoon everyone. Joining me on today’s call are President and Chief Operating Officer, David Blackman; and Treasurer and Chief Financial Officer. Mark Kleifges. In just a moment they will provide some formal remarks about our second quarter financial results, this will be followed by a question-and-answer session.

I’d like to first 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 GOV’s beliefs and expectations as of today, August 6, 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 is contained in our filings with the SEC, which can be accessed from our website, govreit.com or the SEC’s website. Investors are cautioned not to place undue reliance upon any forward-looking statements.

And finally, we will be discussing non-GAAP numbers during this conference 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’d like to turn the call over to David Blackman to begin our quarterly discussion. David?

David M. Blackman

Thank you, Jason. For the second quarter of 2014, Government Properties Income Trust delivered operating performance. We increased occupancy for the ninth consecutive quarter, entered new and renewal leases for a 16% rollup in rent, acquired or entered agreements to acquire five properties and entered agreements to sell two properties.

On a year-over-year comparison, we also increased normalized FFO per share by $0.03 and generated a 2% increase in same property net operating income or NOI. As of June 30, GOV owns 71 properties containing 11 million square feet in continuing operations. We increased occupancy at our properties to 95.5%, up 40 basis points from the previous quarter and a 140 basis points from the second quarter of 2013. We also increased year-over-year same property occupancy by 90 basis points as a result of our consistent leasing efforts.

GOV’s weighted average remaining lease term based upon revenue was 4.9 years. The U.S government continues to be our largest tenant and combined with the 11 state governments and the United Nations contributed 93% of our annualized rental income.

Now, let’s review our second quarter activity. GOV generated 17 new and renewal leases for approximately 204,000 square feet with a weighted average lease term of 5.1 years which represents 12,000 square feet more lease space than our quarterly lease expirations. Combined with our acquisitions, our executed leases enabled us to increase occupancy 40 basis points from the previous quarter. Our executed leases included approximately 159,000 square feet for four U.S. Government tenants that resulted in a 26.5% rollup in rent, a weighted average lease term of 4.8 years and leasing capital commitments of $5.67 per square foot, per lease year.

Our leasing with non-government tenants included 13 transactions for approximately 46,000 square feet that resulted in a 12.8% roll down in rent, a weighted average lease term of 6.2 years and leasing capital commitments of approximately $3.58 per square foot, per lease year.

We remain active generating leases for the vacant space across our portfolio. Currently, we have about 245,000 square feet of prospective lease activity that includes 47,000 square feet of executed letters of intent and leases executed during the third quarter. Despite our positive leasing momentum, it is unrealistic to expect all of our tenants to renew leases at expiration.

For the remainder of 2014, we expect tenants occupying about 122,000 square feet of space, and that contribute 1.5% of rates to vacate. The primary tenant vacating is the food and drug administration or FDA in Rockville, Maryland who is expected to relocate to a government owned building in December. This tenant occupies a 100,000 square feet and represents 1.3% of rents. Until recently the FDA had been expanding in our property, however, the FDA has been consolidating department in White Oak for more than five years, so in many respects this continued consolidation is not a surprise. This property is well located to attract both government and non-government tenants, so we’re confident in our ability to re-lease the property in a reasonable timeframe.

As we discussed on previous earnings calls, GOV continues to work through its capital recycling program. We have two properties held for sale and that are categorized in discontinued operations. Our property in Falls Church, Virginia is under agreement to sell $16.5 million compared to a net book value of $12.3 million. This property is being rezoned to multifamily use which is a condition of the closing. As a result we do not expect this sale to occur until mid 2015.

Our former FBI facility in San Diego has net book value of $11 million and is under agreement to sell for $12.5 million. This sale is subject to customary due diligence and closing conditions and is expected to occur prior to year end. At this time we do not have any other properties identified for disposition.

Turning to acquisitions, during May we completed two previously announced acquisitions containing 580,000 square feet for an aggregate purchase price of $134.8 million including the assumption of $83 million of mortgage debt and excluding acquisition costs. The cost per square foot of these acquisitions was $232, the weighted average remaining lease term was 5 years and the weighted average acquisition cap rate was 8.5%.

In May, we acquired a property containing a 174,000 square feet for $22.5 million excluding acquisition costs. This property is 94.6% leased to the Commonwealth of Virginia for a weighted average remaining lease term of 3.8 years was acquired at a $129 per square foot and an acquisition cap rate of 9.3%. The property is located Richmond, Virginia and was used by the Commonwealth to consolidate six agencies into a single location. The building is well utilized, has a high parking ratio and is easily accessible to numerous amenities. As a result we believe the Commonwealth will remain at this property well past its lease expiration.

Also in May, we completed the acquisition of two buildings for $112.3 million including the assumption of $83 million in mortgage debt and excluding acquisition costs. This property is located in Western Virginia, is a 100% lease to the U.S. Government for 5.3 years was acquired at a cost per square foot at $276 and an acquisition cap rate of 8.3%. This is a high security property that is considered strategic by the government and is expected to be occupied long-term.

We’ve also entered agreements to acquire three office properties containing 231,000 square feet for $52.7 million. The property is on 100% lease to the U.S. Government, and the states of Washington and Arizona. The acquisitions remain subject to customary due diligence in closing conditions, so there is no assurance we want to actually acquire these properties.

Finally, in July we purchased $21.5 million common shares of select income REIT for $677.5 million plus $11.3 million in accrued dividends. We are excited about this transaction because we believe this makes GOV’s already safe distribution more secure. Select is a $2 billion net lease REIT also managed by RMR, so we know the company well.

The company currently operates with a debt to book capitalization of 23%, has the lowest dividend payout ratio in the net least sector at 61% of normalized FFO, has a weighted average remaining lease term of 10.6 years and a history of consistently increasing its distribution rate. In addition to this investment being immediately accreted to GOV’s shareholders, we believe the investment in Select will deliver consistently growing cash returns without future capital requirements and is an investment with valuation upside. Considering the uncertainty in the business of leasing the government tenants today, we believe the stability of the investment in Select is valuable to GOV’s shareholders.

In summary, we are pleased with our results of operations and our activity during the quarter. While we have many leasing challenges ahead we believe our future is bright in providing shareholders a safe and predictable distribution.

I’ll now turn the call over to Mark Kleifges, our CFO to provide more detail on our financial results and our permanent financing plans for our investments in Select Income REIT.

Mark L. Kleifges

Thanks, David. Let’s begin with our property level operating results which were strong for the 2014 second quarter. When compared to the 2013 second quarter GOV’s rental income increased $6.5 million or 11.6% to $62.4 million, approximately 16% of this increase was driven by rental income growth with the remainder coming from our recent acquisitions.

Property net operating income for the 2014 second quarter grew $4.6 million or 12.7% year-over-year to $40.4 million. Similar to our rental income, approximately 15% of this increase was driven by same-property growth with the remainder coming from acquisitions.

Our consolidated GAAP and cash NOI margins for the 2014 second quarter were 64.6% and 64.1% respectively. Same-property GAAP and cash NOI margins were 64.1% and 63.7% respectively for the quarter.

On a consolidated basis as of June 30, our properties were 95.5% leased which is up a 140 basis points from 94.1% a year ago. Much of this increase came organically as same-property grew 90 basis points year-over-year to 95% as of June 30.

Adjusted EBITDA for the second quarter of 2014 was $37.4 million, an increase of 10.2% from the 2013 second quarter. As a result, our adjusted EBITDA-to-interest expense ratio remained very strong at 7.2x for the quarter, and our debt-to-annualized EBITDA was only 4.9x at quarter end. Normalized FFO for the second quarter was $31.5 million $0.57 per share which is up from $29.5 million or $0.54 per share for the 2013 second quarter. We paid a $0.43 per share dividend during the second quarter equating to a normalized FFO payout ratio of approximately 75%.

During the second quarter, we spent $2.3 million on tenant improvement and leasing costs. At quarter end we had approximately $16.5 million of own spent leasing related capital commitments. We also spent $1.8 million on improvements to our properties during the second quarter.

Now, turning to our balance sheet: As of June 30, our debt to total book capitalization was 43% and approximately $355 million remained available under our $550 million unsecured revolving credit facility. As David mentioned, in early July GOV purchased 21.5 million shares of Select Income REIT pr SIR for approximately $689 million using proceeds from a new $500 million unsecured term loan and borrowings of $189 million under our revolving credit facility. The new term loan bears interest at the LIBOR plus 175 basis points and matures in July 2015.

We have already paid down a substantial portion of the term loan balance through the equity offering that we completed late last month including the full over allotment option which was exercised by the underwriters. The net proceeds of this offering totaled approximately $350 million representing approximately 50% of the SIR investment. Pro forma for the SIR investment and this offering are debt to total book capitalization was approximately 45% at June 30. In the months ahead we will look to the debt markets to long term finance the remainder of the term loan and a portion of our revolver with fixed rate unsecured senior notes.

From a modeling perspective, we will account for our investment in SIR under the equity method of accounting and therefore will recognize our proportionate share of SIR’s normalized FFO.

In closing we are pleased with our operating results in the second quarter especially given the challenges that we have seen in the government leasing sector in recent quarters.

That concludes our prepared remarks. Operator we are ready to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we do have a question. Our first question comes from Michael Carroll with RBC Capital Markets. You may go ahead.

Michael Carroll – RBC Capital Markets

Hey David, can you give an update on what you are seeing on the acquisition market, last quarter you indicated competition was fairly fierce from the people adding leverage to the deals and it was difficult to get them done, but it seems like activity has picked up for you this quarter?

David M. Blackman

Yes, it's a good question Mike. So, the two acquisitions that we closed during the quarter one of them, the large one, the one that was in Western Virginia, we had been working on that transaction for almost a year so that is necessarily reflective of current market conditions. And the acquisition that we have under agreements, we think we have those at reasonably favorable cap rates. We have seen a little bit more activity in the market, but there continues to be a lot of transaction that we look at, where our pricing on a transaction is substantially below what other market participants will price it. So the market continues to be pretty aggressive. We have had better success with some of the acquisitions we have been chasing recently.

Michael Carroll – RBC Capital Markets

Are you comfortable with your ability to release those assets, the term seems fairly well?

David M. Blackman

Well, the one at Richmond, Virginia, which has a 3.8 year remaining lease term as I mentioned in my prepared remarks, I mean, the Commonwealth Virginia consolidated six agencies into that building. It's located in an area that has some very attractive retail amenities and it has an exceptionally high parking ratio. So, the government utilizes it well. I would be very surprised if we didn’t renew them in place. But because of the amenities, because of the quality of the building, because of the parking ratio, yes we would be very comfortable if we had to re-lease that building should they not renew, but again I think that’s remote.

Michael Carroll – RBC Capital Markets

Right. And then, can you also explain your reasoning for buying the SIR shares, how does that fit your strategy in, are you going to move away from the government focus that you have been doing since the IPO?

David M. Blackman

Mike, we don't really view the investment in SIR as a strategy shift. We are going to continue to remain focused on acquiring buildings lease to government tenants and leasing our buildings to government tenants. I think, the rationale for the investment is really pretty well laid out in our prepared remarks, which I would be happy to go back and reiterate if you thought that would be helpful.

Michael Carroll – RBC Capital Markets

And are you going to be long term holder of the SIR shares?

David M. Blackman

I think, as we look at this investment today, we consider it a long term investment.

Michael Carroll – RBC Capital Markets

Okay, great, thanks.

Operator

(Operator Instructions) We do have a question from Young Ku with Wells Fargo Securities, LLC, you may go ahead.

Young Ku – Wells Fargo Securities, LLC

Great, thank you. I just wanted to go back to the SIR question a little bit. Will there be a forget fee, base management fee forgiveness for the effort that you just raised, regarding the SIR share purchase?

David M. Blackman

Well, there is no business management fee paid on the investment and so, if that was your question Young.

Young Ku – Wells Fargo Securities, LLC

But you will be getting or RMR will be getting additional fees from the equity they just raised, is that correct?

David M. Blackman

Well, the business management fee –

Mark L. Kleifges

Yes, this is Mark, fee is going to be – the base fees calculated based on the lower investments, the cost of investments in real estate and total market capitalization. So, no we won't be – we will continue – most likely the investment in real estate will be lower than total market capitalization after the SIR transaction and therefore we will only pay base management fees on investments in real estate. So, the equity offering would have no impact under that scenario on base management fees.

Young Ku – Wells Fargo Securities, LLC

But, the equity portion that you are going to be accounting on your balance sheet that would be incremental, kind of fees associated with that?

David M. Blackman

No, there will be no incremental fees associated with that.

Mark L. Kleifges

That doesn’t fit the definition of an investment in real estate under the management contract.

Young Ku – Wells Fargo Securities, LLC

Okay. That’s helpful. And just an additional question, I mean, it doesn’t make sense to finance this purchase with all equity because you are specially putting leverage on already leveraged vehicle, so I was just wondering if I can get your take on that?

David M. Blackman

Well, I think Young, we look at the capital allocation on our portfolio as a portfolio so as we use debt and equity to finance our business, we are doing it based upon our portfolio investments. We are not trying to necessarily match fund transaction. So, GOV was relatively lowly levered before investment in SIR, we remain a relatively lowly levered company after the initial step in our permanent financing plan at 45% debt to book capitalization. So, I think you should think about it more from a portfolio theory perspective and you should match funding of an investment.

Young Ku – Wells Fargo Securities, LLC

Okay. So, on a performance basis after this transaction where would you guys figure kind of leveraged in your balance sheet capacity for incremental acquisitions?

Mark L. Kleifges

I think the equity offering that we completed at the end of last month brought our leverage down to where we were comfortable operating the company which is at about 45% debt to total book capitalization. And given the acquisition pipeline that David discussed and the fact that we don't have a lot in the pipeline today, we don't see ourselves needing to raise additional equity in the near term absent change outlook for the acquisition market.

Young Ku – Wells Fargo Securities, LLC

Okay and can you just provide pro forma leverage kind of post the transaction?

Mark L. Kleifges

After the acquisition of SIR and the equity offering, leverage is at 45% of total book capitalization.

Young Ku – Wells Fargo Securities, LLC

Okay, got it, thank you.

Operator

Our next question comes from Mitch Germain. You may go ahead with JMP Securities.

Mitch Germain – JMP Securities

Good afternoon. David, talk to me if I could about your role obviously you serve more than one role in the RMR organization and you’re involved with SIR. So what was your involvement in the purchase?

David M. Blackman

Well, when this opportunity was presented to GOV to invest in SIR, we formed a special committee of independent trustees to evaluate the transaction and those trustees engaged financial advisor as well as a legal advisor to evaluate the transaction. So, in essence, my role was really limited to none. It was all evaluated by the independent trustees with the support of financial advisor and legal counsel.

Mitch Germain – JMP Securities

And it seems like, I know, you stressed the fact that the dividend is secure here, I guess, I am just curious it seems like a big investment to keep the dividend flat maybe just talk around kind of what was your reaction when they approached you that this deal was happening?

David M. Blackman

Well, I was, honestly, I was very positive on the opportunity. I think highly of select income and the assets that it’s owned, I think there is a tremendous amount of upside in that company. So I thought it was positive for both companies. So, I think it was a good transaction.

Mitch Germain – JMP Securities

Alright, and then maybe shifting gears, you mentioned the FDA move out, that’s new I believe to the story, I don't think that was mentioned last quarter, kind of I guess, my thoughts it was originally that most of your move outs are going to be sending or non-government and here you have a government tenant that I guess kind of somewhat surprised you with the move out. When you are looking at your expirations over the course of the next 12 to 18 months, are there any further surprises that you guys could be approached with?

David M. Blackman

Yes, Mitch, we maintain a watch list of tenants that have future lease expiration that we say, we pay close attention to and I think in our last earnings call, we had mentioned that we had, I forgot the exact amount, but it was around 100,000 square feet, 115,000 square feet of tenants that we had some concerns about. FDA was one of the tenants that was in that concern list because we knew the consolidation, it was going on at White Oak. We had had conversations with this agency where they had indicated at one point that they may not renew. Then they came back and changed their mind. So, we were getting mixed signals from them, so we didn’t feel like it was appropriate to say that they were going to move out, but once we got formal notice from them, during the second quarter, we thought it was appropriate to let the market know that that in fact is going to happen.

As we look out into 2015, we have lease expirations that represent 10.9% of our revenue, excuse me, 10.6% of our revenue and of that we have on our watch list about 1.3% of those tenants. So, we expect that we are going to have a very high renewal rent in 2015. We don't expect we are going to have 100% renewal rent, but I think we are going to do better than most of our peers.

Mitch Germain – JMP Securities

Thank you very much.

David M. Blackman

Yes, thank you.

Operator

(Operator Instructions) And we do have a -- looks like a follow-up question from Young Ku with Wells Fargo, please go ahead.

Young Ku – Wells Fargo Securities, LLC

Just a quick housekeeping item. So, the asset that you guys are planning to sell that’s held for sale is that generating any income. It looks like you guys had some income from discontinued ops in the quarter and I don’t think it was generating any NOI?

David M. Blackman

Yes, so the property in Falls Church, Virginia, had a tenant in it, excuse me had a lease that was effective through July of this year. So, we did have revenue during the second quarter on that asset, but do not expect that we would have, I guess, we will have some revenue during – very little revenue during the third quarter. But that was a tenant that we have been talking about for a long time. It's the defense information services that was part of the bract program and they had relocated to Fort Meade, gosh I think it was in 2012, they had tried to find a replacement for us, but it basically sat vacant while they paid rent.

Young Ku – Wells Fargo Securities, LLC

Great, thank you.

Operator

And we do have a question from Jon Petersen with MLV & Company. You may go ahead.

Jon Petersen – MLV & Co.

On the housekeeping things, the FDA moving out, can you – exactly when is that going to happen?

David M. Blackman

They move out in December Jon.

Jon Petersen – MLV & Co.

December, okay. And then, on your leasing spreads in the quarter for the government tenants, can you remind us what market that was in that you got the 26% positive leasing spreads?

David M. Blackman

Yes, we had two, excuse me, we had four separate leases with government tenants during the quarter. The big tenant would have been the Bureau of Prisons in Kansas City that was 36% rollup in rent. We also had a 36% rollup in rent with the Veterans Affairs in Falling Waters, West Virginia. Now, the Bureau of Prisons rollup included the amortization of some tenant improvement dollars, so that rent includes some capital that we are in essence financing for the government. But nonetheless, we are very pleased with the average rollup that we are getting from our government tenants, particularly when we continue to see roll downs from our non-government tenants.

Jon Petersen – MLV & Co.

Okay. And then, I think it's just looking out at the 2015, your lease expirations, are there any large tenants like the Prisons and the Veterans Affairs, are you expecting those sort of rollup?

David M. Blackman

When I look at our watch list Jon, the largest tenant that gives me some concern represents less than 1% of rents. I am sorry, yes, rollups.

Jon Petersen – MLV & Co.

Yes, yes, I understand the figure on terms leasing spread, I mean, the last couple of quarters I think has been pleasantly surprisingly high, just trying to think about what – how to think about this going forward?

David M. Blackman

Yes, it's hard to tell Jon. Our lease expirations are pretty well spread out across the country next year and I think it's too early to tell at this point because of the negotiation whether we are going to have meaningful rollups or roll downs. But generally, I think our rents tend to be below market, so with the government we should – we would expect to have more rollups than roll down.

Jon Petersen – MLV & Co.

Okay. I read in an article recently few weeks ago that the government is going to try to push back a little bit more on the rents that they feel like they are not being aggressive enough in their renewals negotiation; have you seen any more aggressive push backs from the government in terms of rental rates or is that just kind of the fluff article I was reading?

David M. Blackman

No, the government has been very focused on its rental business for couple of years now. So, the negotiations have been long. They have been difficult, but one of the things you have to keep in mind is the rents that we have with the government tends to be flat for 5 to 10 years. And so, because they haven’t had growth in them and the markets are recovering and we are starting to see some growth, in many cases our rents are below market because they were market when they were in entered into and they have been flat for five, seven, ten years.

Jon Petersen – MLV & Co.

Alright that makes sense. Alright, thanks for the color. I appreciate it.

Operator

And we will now turn the call over to President, David Blackman, you may go ahead.

David M. Blackman

Thank you, operator. And thank you for joining our second quarter conference call, we look forward to talking to you again in the later time. Thank you.

Operator

That does conclude our conference for today, thank you for your participation for using AT&T Executive Teleconference Services. You may now disconnect.

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