Select Income REIT's Management (SIR) on Q1 2016 Results - Earnings Call Transcript

| About: Select Income (SIR)

Select Income REIT (NYSE:SIR)

Q1 2016 Earnings Conference Call

April 26, 2016 10:00 AM ET

Executives

Christopher Ranjitkar - Director, Investor Relations

David Blackman - President and Chief Operating Officer

John Popeo - CFO

Analysts

Vikram Malhotra - Morgan Stanley

Rich Moore - RBC Capital Markets

Jamie Feldman - Bank of America/Merrill Lynch

Operator

Good morning. And welcome to the Select Income REIT's First Quarter 2016 Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note that this event is being recorded.

I would now like to turn the conference over to Christopher Ranjitkar, Director of Investor Relations. Please go ahead.

Christopher Ranjitkar

Thank you and good afternoon, everyone. Thanks for joining us today. With me on the call are President, David Blackman and Chief Financial Officer, John Popeo. In just a moment, they will provide details about our business and our performance for the first quarter of 2016. We'll then open the call to your questions.

First, I'd 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, April 26, 2016, 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.

Additional information concerning factors that could cause those differences is contained in our filings with the Securities and Exchange Commission or 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’ll be discussing non-GAAP numbers during this call, including normalized funds from operations or normalized FFO and cash-based net operating income or cash basis NOI. 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 in our website.

And now, I'll like to turn the call over to David.

David Blackman

Thank you, Christopher. Select Income REIT delivered strong performance during the first quarter of 2016; driven by our acquisitions and strong leasing results we increased normalized FFO per share by 5.7% and same property cash NOI by 1.8% year-over-year. During the quarter we also executed leases totaling 480,000 square feet for a weighted average lease term of 15.8 years, leasing capital commitments of $1.66 per square foot per lease year and 13.9% average roll up in rent.

We believe these results demonstrate the strength of our property management and leasing platforms and the strategic nature of our properties. We ended the quarter with 119 properties containing 44.7 million square feet that are 97.8% leased and located in 35 states. In comparison to the first quarter of 2015, same property occupancy was unchanged at 96.4%. We did however grow same property GAAP NOI by 1% and same property cash NOI by 1.8% year-over-year. During the quarter we entered three new leases for 42,000 square feet that resulted in a 19.7% roll up in rent, a weighted average lease term of 21.9 years and leasing capital commitments of only $0.38 per square foot per lease year.

We also executed six lease renewals for 438,000 square feet that resulted in a 13.6% average roll up in rent, a weighted average lease term of 15.3 years and leasing capital commitments of $1.83 per square foot per lease year. This included earlier renewals for two Mainland tenants. We extended a 101,000 square foot lease from 2017 to 2026 and we extended a 227,000 square foot lease from 2023 to 2030. Leasing capital commitments for these two early renewals $2.79 per square per lease year on a weighted average lease term of 13.7 years and a weighted average roll up in rent of 9.7%.

Recall that we do not have any schedule rent resets during 2016 but that we remain focus on working with tenants that have resets in 2017 and 2018 to conclude these as soon as possible.

Now let's turn to acquisitions. As we've discussed previously we continue to take a conservative approach on making investments. We are focused on acquiring mainland properties that we believe are strategic to tenants and that provide compelling risk adjusted returns. As a result of aggressive asset pricing, we are declining a high percentage of opportunities and our acquisition pace has slowed. Our only investment this year is the purchase of our joint venture partner's 11% interest in a 344,000 square foot property in Duluth, Georgia for $3.9 million. This property is a 100 leased to Primerica Life Insurance Company through June 2028. Post this transaction 100% of SIR's properties now wholly owned.

Now let's review our upcoming lease expirations. SIR has 1.3% of its annualized rent subject to lease expiration in 2016. As we mentioned last quarter two of our Mainland office tenants are now -- are not expected to renew. While we've engaged brokers to lease both of these properties we are considering both disposition and redevelopment strategies for one of these assets. As our strategic direction becomes more clear for this property, we will provide additional information.

SIR continues to have an exceptionally well laddered lease expiration schedule with less than 13% of our annualized rent expiring between now and the end of 2021. And as demonstrated by our first quarter results, we are also actively engaged in extending out our lease expiration schedule with the expectation of maintaining high occupancy at the company and a long weighted average remaining lease terms.

In summary, we are pleased with the continued successful execution of our business plan and remain optimistic for our future.

I'll now turn the call over to John Popeo to provide more detail on first quarter results.

John Popeo

Thank you, David. And good morning, everyone. I will begin with a brief review of the income statement.

Total revenues increased by over 24% year-over-year to $117.2 million for the first quarter of 2016 with most of this growth related to our acquisition of CCIT in late January 2015. When compared with the first quarter of 2015, rental revenue from our Mainland properties grew by over 31% to $93.9 million, while Hawaii rental revenue grew organically by over 8% to $23.3 million.

Real estate taxes and other operating expenses increased by over 33% year-over-year to $23.2 million in the first quarter of 2016, reflecting our CCIT acquisition and modest increases in general operating expenses throughout our compatible properties.

Before I go on I'd like to highlight that we have increased the level of disclosure this quarter in our supplement. We are now breaking out our Mainland properties by office and industrial. We believe this additional disclosure will provide greater insight and increase visibility into the performance drivers of our company.

For the first quarter 61% of SIR's GAAP NOI came from Mainland office properties, 19% from Mainland industrial properties and 20% from properties in Hawaii. Consolidated NOI increased by nearly 22% year-over-year to $94 million, while cash basis NOI grew by 23% year-over-year to $87 million, again reflecting our CCIT acquisition. As David mentioned, same property cash basis NOI increased by 1.8% year-over-year primarily driven by our Mainland portfolio.

Acquisition-related costs in 2015 reflect cost associated with our acquisition of CCIT. Operating income for the first quarter of 2016 was $53.5 million, up from $25 million for Q1 of 2015. Adjusted EBITDA grew by approximately 23% to $87.4 million.

Interest expense for the first quarter of 2016 was $20.6 million, up from $14.2 million in the prior year. This increase reflects interest expense related to the $1.45 billion of fixed rate senior unsecured notes that we issued in early February 2015 and nearly $268 million of mortgage debt that we assumed with the CCIT acquisition.

During the quarter, we paid $3.3 million on recurring CapEx. The majority of this total related to early lease renewals with Mainland tenants.

Normalized FFO attributed to SIR for the first quarter of 2016 was $66.3 million or $0.74 per share, up from $56 million or $0.70 per share for the first quarter of 2015. This 18.4% increase primarily reflects property acquisitions and leasing activities. During the first quarter of each year we received annual percentage rent from one of our industrial tenants in Hawaii based on the value of refined oil they transport over one of our properties.

Current year percentage rent declined by approximately $700,000 or $0.01 per share from $1.5 million last year to approximately $800,000 received this year. The decline reflects the worldwide reduction in the price of fuel. I think it's also worth noting that excluding annual non recurring percentage rent SIR's normalized FFO run rate this quarter would have been $0.73 per share.

As of March 31, we had $328 million outstanding on our $750 million revolving credit facility and $350 million outstanding under our term loan. Finally, our fixed charge coverage ratio was 4.2x as of March 31, while our EBITDA to interest ratio was 6.8x.

That concludes our formal remarks. Operator, would you please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions]

And our first question comes from Vikram Malhotra of Morgan Stanley. Please go ahead.

Vikram Malhotra

Thank you. Just to clarify on the -- that the CapEx related to the renewals. It seems pretty elevated even on per square foot per year basis. Can you maybe just elaborate on what that was and why that was high?

David Blackman

Vik, I am not sure I agree with you that the CapEx seems high. It is high relative to what we've been running. But recall that the only leasing that we've really done since becoming a public company has been in Hawaii where typically our only CapEx in Hawaii are legal fees associated with documenting a renewal. We did 438,000 square feet of renewals, a big chunk of that was with Mainland tenants. And even the early renewals that we did which had a 10 plus -- it was 13 year weighted average remaining least term, was under $2.90 per square foot per lease year. So because our leases tend to be long and the CapEx tends to be a function of the length of a lease term, I think these numbers were actually pretty modest particularly when you think about how much the lease commission is and it being based upon the rent received over the lease term. So we are pretty pleased with the amount of money we actually have to spend on our buildings to renew tenants. And think that the numbers are pretty good.

Vikram Malhotra

Okay. Fair enough. Can you maybe just revisit or update us in your thoughts about dispositions? I remember few quarters ago you had some plans then you sort of push them out. Can you maybe give an update on how you are thinking about the portfolio and dispositions?

David Blackman

Sure. We continue to look at the portfolio, trying to identify properties that we think are good disposition candidates. At this point, we haven't put anything in front of the board that we are recommending for sale. But we'll continue to look at dispositions. My guess is we will have some disposition activity this year but it will be modest.

Vikram Malhotra

Okay. And then just last one for me. So given the movement the stock price maybe just update us on your thoughts on the balance sheet and the mix between just equity and debt going forward in case you do fund acquisition?

John Popeo

Well, Vik, the good thing is we have only $328 million out on our $750 million revolving credit facility. Of our total debt of around $2.4 billion we only have a small $40 million mortgage that's too in 2016. Other than that maturities are very well laddered. The acquisition pipeline is very skinny at this point. Leverage as we mentioned on the past two or three calls is a little higher than our historical average. But we are comfortable where leverage is right now. I don't think we'd be very comfortable issuing equity to drive down leverage at today's equity prices. And so I think we are in a good position to wait things out till the equity markets recover and be in a position to take advantage at that point.

Operator

[Operator Instructions]

Our next question comes from Rich Moore of RBC Capital Markets. Please go ahead.

Rich Moore

Hi, guys. Good morning. So for the disclosure the extra seems to NOI disclosure I think it's very helpful. On those re-leasing things that release that you did this quarter in the Mainland properties, why did those come about that they are renewing so early when the lease didn’t expire for some time?

David Blackman

Well, the one we didn’t -- that had an expiration date of 2017 is probably nine months early to expiration. And when you have single tenant building you tend to begin having dialogue with them a year or so ahead of expiration. And I think for that particular case I think the tenant clearly has a strategic reason to stay in that building. They wanted to go ahead and lock down a longer remaining lease term. So that they could spend capital and continue to operate the business. And I think the same thing for the other lease as well, the one that we extended from 2023 to 2030, that is the US headquarters for that particular company. And there is a strategic reason why they are there and they just wanted to make sure that they can continue to occupy that space for the next till 2030.

Rich Moore

Okay. It sounds good and the re-leasing spreads were quite nice. Is there other more opportunities maybe thing like that out there in the portfolio?

David Blackman

We will continue to dialogue with our tenants to try to push out lease expirations where we think it make sense for us. As you can probably tell from looking at our lease expirations schedule, in 2022 I think we have a little more than 10% of our leases expiring. And so our goal would be to soften 2022 by continuing to well push lease expirations out. So this is clearly a focus of the company right now.

Rich Moore

Okay. Good. Thanks. And then you had mention that maybe in Hawaii there would be some development opportunities and I guess maybe even elsewhere as well not just Hawaii but certainly you talked about Hawaii. Any update on your thought process around that potential.

David Blackman

Yes. We are working with our consultant on a particular site in Hawaii, trying to button down what we think the total cost is going to be. So that can present a well thought out plan to the board. We are still early but it's still definitely something that we are looking at.

Rich Moore

Okay. Good. Thank you. And then John would you have any interest in terming up the line at this point? I mean obviously you have more capacity on it than the balance but it's pretty nice -- or it has been a pretty nice interest rate environment.

John Popeo

Yes. I don't think so Rich. I think we are happy with the rate on our revolver as everyone probably knows at this point it's priced at LIBOR plus 105 basis points. And rate of 1.4% today on $328 million outstanding is -- we think it's good, it adds to the complexion of our capital stock nicely. Our percentage of floating rate at as a percentage of total debt falls right within in our opinion a sweet spot for what the rating agencies are looking for. And it gives us the flexibility to pay it down when the time is right.

Rich Moore

Okay. Good. And last thing from me guys is I sort of heard different views on whether pricing is changing for assets. Some people are saying it looks like certain type of assets are coming down in price. Other saying there is really no change. What do you guys think? I realized you haven't really closed on any but what do you think when you kind of look at the acquisition environment?

David Blackman

It's a good question, Rich. I mean if you read Real Capital Analytics, their first quarter report came out and they said that acquisition volume was down about 20% year-over-year. But that asset prices were flat. I was a little bit surprised. My sense from watching the market and staying close is that pricing for very high quality, Investment Grade rated tenants with 10 years or greater remaining lease terms has remained pretty stable. But once you get kind of below that 10 years level I think cap rates have actually widen at that. Not probably more than 25 basis points but I do think that for some of the shorter or higher risk tenants pricing has widen out of debt.

Operator

And our next question comes from Jamie Feldman of Bank of America/Merrill Lynch. Please go ahead.

Jamie Feldman

Thank you and good morning. I guess following up to the last question and tying to the commentary you made on the last conference call about some of the dispositions you had in the market that you pulled because the pricing or because the buyer demand. Can you just give us an update on either a; some of the assets you maybe trying to sell, how those are going? Or b; just if you were to make those comments today about the disposition markets what would you say?

David Blackman

Yes. So last quarter we talked about the portfolio, FedEx properties that we pulled from the market. And what we saw with that portfolio was that FedEx buyers tend to be credit and term buyers. We had a weighted average remaining lease term in that portfolio of seven years and because it was below 10 years the pricing did not meet our expectations. And so we pulled it because we think we have the ability to renew those tenants in place, extend out those lease durations and create value for the company. As I said earlier, we don't have anything that we present to the board right now for potential dispositions. So there is really nothing to say as it relates to what we are seeing in the market for disposition because we don't have anything out there right now.

Jamie Feldman

Okay. And then can you talk more about the two expirations? You said you may redevelop one of the sites and may sell. Just more color on where those assets are and the different option.

David Blackman

Yes. So both of the properties where the tenants aren't renewing are in the Boston metro markets. One of the property is kind of the 495 Corridor, we are considering whether or not that property get redeveloped to maybe on alternative use or whether or not we market the asset for sale and lease simultaneously. Right now we are in the market with both of those assets with leasing brokers trying to lease the space. But one of them we think has potential redevelopment opportunity or it might just be an opportunity to opportunistic sell the asset and reinvest that cash into something else.

Jamie Feldman

And where is the second asset?

David Blackman

They are both Boston metro market.

Jamie Feldman

Both 495?

David Blackman

No. One of is 495 the other one is a kind of northern suburbs.

Jamie Feldman

Okay. And when are those leases expire?

David Blackman

They are both 2016. I think once -- I think one second quarter and one is third quarter.

Jamie Feldman

Okay. And then do you have a sense of -- I mean if you look at your internal growth it has been kind of that 1.5%, 1.75% range. You don't have lot of expiring; you had some good leasing spread this quarter. Your occupancy is kind of full. How do you think about internal growth potential over the next couple of years?

David Blackman

Well, we have had very good internal growth from rent reset and leasing in Hawaii over the last couple of years. It's kind of unfortunate that one of our greatest problems we have right now is we don't have enough lease expirations coming up over the next couple of years. I think we are seeing good increases in rent as we renew tenants. We also think we will continue to have a very high tenant retention rate. But it is we don't have a lot of lease expirations over the next few years. So we are not going to get huge pots in cash NOI from releasing spreads because we just don't have enough opportunity to re-lease space. We are continuing to focus on leasing in Hawaii where we have some vacancy. And that may provide some opportunity but we think about our internal growth more than kind of 2% range with maybe some exceptions.

Jamie Feldman

Okay. And then finally can you talk about the 0% lease, rent reset in Hawaii this quarter? And whether that -- I think that was one off but how does that outlook look to the future?

David Blackman

Jim, we don't have any rent resets in 2016. Last quarter we got an early reset for 2017 but we don't have any reset so it was 0% because there were none.

Jamie Feldman

And then when you think about the 2017 or 2018, I mean what do you think mark-to-market is right now?

David Blackman

We don't have any reason to believe that it's any different than what we've experienced over the last couple of years which is averaged around 40%.

Operator

And ladies and gentlemen, that concludes our question-and-answer session. I'd like to turn the conference back over to David Blackman for any closing remarks.

David Blackman

Thank you for joining us on today's call. We look forward to meeting with some of you at the NERI Conference in June. Operator that concludes the call.

Operator

And ladies and gentlemen, the conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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