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Government Properties Income Trust (NYSE:GOV)

Q2 2012 Earnings Call

August 2, 2012 10:30 AM ET

Executives

Tim Bonang - VP, IR

David Blackman - President and COO

Mark Kleifges - CFO

Analysts

Mitch Germain - JMP Securities

Michael Carroll

Young Ku - Wells Fargo

Dan Donlan - Janney Capital Markets

Operator

Good day and welcome to the Government Properties Income Trust Second Quarter 2012 Financial Results Conference Call. (Operator Instructions). At this time for opening remarks and introductions, I would like to turn the call over to Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Tim Bonang

Thank you and good afternoon. Joining me on today's call are David Blackman, President and Chief Operating Officer, and Mark Kleifges, Treasurer and Chief Financial Officer. The agenda for today's call includes a presentation by management followed by a question-and-answer session. I would note that the recording and retransmission of today's conference call is strictly prohibited without the prior written consent of the Company.

Before I'll begin today's call, I would like to read our Safe Harbor statement. Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on GOV's present beliefs and expectations as of today August 2, 2012. 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.

In addition, this call may contain non-GAAP numbers including normalized funds from operations or normalized FFO. A reconciliation of normalized FFO to net income and the components to calculate AFFO, CAD or FAD are available in our supplemental operating and financial data package found on our website at www.govreit.com. Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements.

Now I would like to turn the call over to, David Blackman.

David Blackman

Thank you Tim. Before discussing our second quarter results I wanted to acknowledge that yesterday GOV's common shares traded down 4% on trading volume that was almost 30 times more than our 90 day moving average. We have been told by the New York Stock Exchange our specialist and several large institutional trading desk that GOV was one of approximately a 150 companies affected by electronic trading technical issues at Knight Capital Group, a large designated market maker. While the NYSE elected to cancel transactions in six securities due to these technical issues GOV was not one of these securities.

At this time we do not have any information on this situation other than what is made available to the public. So let’s review our second quarter results. For the second quarter of 2012, Government Properties Income Trust is reporting normalized funds from operations of $24.4 million or $0.52 per share compared to $21 million or $0.52 per share for the second quarter of 2011.

For the six months ended June 30, 2012 we are reporting normalized FFO of $49.5 million or $1.05 per share compared to $40.5 million or $1 per share for the same period of 2011. Our 16% and 22% increases in normalized FFO for the quarter in six months ended June 30, 2012 is driven substantially by our accretive acquisition activity. Since April 1, 2012 we have acquired seven properties for an aggregate purchase price of a $125.2 million. We also declared a $0.42 per share distribution in July. As of June 30, 2012, GOV owned 74 properties containing 9.1 million square feet, our properties were 92.2% leased for a weighted average remaining lease term of 4.8 years.

The U.S. government remains our largest tenant and combined with 10 state government tenants and the U.S. account for almost 93% of our aggregate annual rental income. In addition to our strong property statistics, our balance sheet remains conservatively leveraged at approximately 35% debt to total book capitalization and EBITDA covered interest expense seven times.

At quarter end, our $550 million unsecured revolving credit facility had $27 million outstanding making 95% of the credit facility available to support the company’s acquisition activities and other working capital news.

During the quarter GOV entered 14 leases for 206,000 square feet with a weighted average lease term of 4.7 years.

This was approximately 20,000 square feet more than expiring leases during the quarter. Our leasing capital was $2.7 million or $2.74 per square foot for lease year. Approximately a 160,000 square feet of our quarterly leasing activity was with four U.S. government agencies and one state government agency. Our weighted average roll-up in rent with our government tenants was 10.9% for our weighted average lease term of approximately 4 years and leasing capital for our government tenants of $3.07 per square foot. The remaining 46,000 square feet of our second quarter leasing activity was the non-government tenants.

Perspective leasing activity for our vacant space across the portfolio remains active; in addition, we are having active renewal conversations with tenants for leases expiring during the remainder of this year and for our modest 2013 lease expirations. As a result we remain optimistic that current dynamics with our tenants will result in higher renewal rates at our properties.

Turning to acquisitions, as I mentioned earlier since April 1st, we have acquired seven properties with 750,000 square feet for an aggregate purchase price of a $125.2 million excluding acquisition cost. The average purchase price per square foot or these acquisitions was a $167, the average acquisition cap rate was 8.4% and the average remaining lease term was 10.9 years at the time of acquisition. In June, we acquired two previously disclosed office properties in Everett, Washington containing a 112,000 square feet. These properties are 100% leased to the State of Washington and occupied by seven divisions of the Department of Social and Health Services for a remaining lease term of 8.4 years.

The purchase price was $20.4 million and the acquisition cap rate was 9.3%. Also in June, we acquired a previously disclosed office property in all Albany, New York, containing 64,000 square feet. This property is a 100% leased to the State of New York and occupied by the department of agriculture for remaining lease term of 6.8 years. The purchase price was $8.5 million and the acquisition cap rate was 8.6%.

In July, we acquired a previously disclosed office property and stocked in Stockton, California with 22,000 square feet. The property is 100% leased to the U.S. government and occupied by the Department of Immigration and customs enforcement. For remaining lease term 14.7 years, the purchase price was $8.3 million and the acquisition cap rate was 8.8%.

Finally, in July we acquired one office property in Atlanta, Georgia and another in Jackson, Mississippi and one industrial property in Ellenwood, Georgia with a combined 553,000 square feet. These properties are 100% leased to the U.S. government and occupied by the Department of Homeland Security, The National Archives and the Federal Bureau of Investigation.

The weighted remaining lease term for this acquisition was 11.5 years at the time of acquisition. The purchase price was $88 million and the acquisition cap rate was 8.1%. We are pleased with our acquisition moment and remain bullish on our ability to generate accretive growth through acquisitions. We also believe that our stable revenue continues to support our business strategy of providing safe and predictable distribution to shareholders. I will now turn the call over to Mark Kleifges, our CFO to provide more detail on our financial results.

Mark Kleifges

Thanks David. First let’s review our consolidated property level operating results for the 2012 second quarter. Because of our acquisition activity we once again experience significant quarter-over-quarter increases in rental income and property net operating income. At the end of 2012, second quarter we owned 74 properties with 9.1 million square feet compared to 64 properties with approximately 7.6 million square feet at the end of the 2011 second quarter.

For the 2012, second quarter GOV’s rental income increased $8.2 million or 19% to $50.3 million and property net operating income increased $4.5 million or 17% to $31.1 million compared to the 2011 second quarter.

At June 30, our properties were 92.2% leased and our consolidated NOI margin percentage for the 2012 second quarter was 61.9%. Turning to our same store operating results, while we experienced declines in occupancy, rental income and net operating income in our same store portfolio this quarter the declines were principally limited to four of our properties and the direct result of the previously disclosed exploration of our leases with the Henry M. Jackson Foundation at our Rockville, Maryland property in September 2011.

In the previously disclosed first quarter 2011 expiration of our leases with the CDC in Atlanta, the DEA in Tucson and the FBI in Phoenix. Excluding the impact of these expired leases, the operating performance of our properties this quarter was stable with occupancy relatively unchanged and slight increases in rental income and net operating income on a quarter-over-quarter basis at the remainder of our same store properties.

At quarter end our 58 same store properties were 91.6% leased down 4.6 percentage points from the prior quarter and but up 30 basis points from the end of the first quarter. Our 2012, second quarter same store rental income decreased by approximately $2.2 million or 5.5% compared to the 2011 second quarter but was up approximately a $190,000 excluding the lost rental income this quarter from our four expired leases.

The $2 million or 7.9% decline in quarter-over-quarter same store net operating income was approximately a $140,000 less than the NOI decline in this quarter resulting from our four expired leases. Our same store NOI margin in the 2012 second quarter declined a 160 basis points from the prior quarter to 61.2% also as a result of these lease expirations.

Turning to our consolidated results for the quarter, EBITDA in the second quarter of 2012 was $28.5 million compared to $24.2 million in 2011 second quarter. A quarter-over-quarter increase of 18%, our EBITDA to fixed charges ratio remained very strong at seven times for the quarter and our debt to annualized EBITDA was only 4.1 times at quarter end.

For the current quarter, normalized FFO was $24.4 million compared to normalized FFO of $21 million for the 2011 second quarter. Second quarter 2012 normalized FFO were $0.52 per share was unchanged from the 2011 second quarter. During the quarter we spent $905,000 on tenant improvements and leasing costs and $1.9 million on improvements to our properties.

Turning to our balance sheet and liquidity, at quarter end we had $471 million of debt outstanding and our debt to total book capitalization was approximately 35%. As of today, after closing our 2 July acquisitions we have $112 million outstanding under our $550 million revolving credit facility.

In closing, GOV remains a conservatively capitalized company with a secure cash flow stream that we expect will allow us to pay a consistent dividend. In addition to our stable base we remain optimistic about the company’s growth outlook for the remainder of 2012. With that operator we are ready to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Mitch Germain from JMP Securities. Please go ahead.

Mitch Germain - JMP Securities

I saw that the lease duration on the recent acquisition seem to be a little shorter than what we have normally seen out of you guys, is that a function of the product that’s available for sale right now?

David Blackman

You talking about lease renewals or for the acquisitions?

Mitch Germain - JMP Securities

No on the acquisition, I think it was what about a 5 year average term for median lease?

David Blackman

Yes I think it was a little bit longer than that, Mitch let me go back and real quick...

Mark Kleifges

Weighted average remaining lease term was 10.9 years.

Mitch Germain - JMP Securities

Okay sorry I must have misheard you there, my bad. Can I get some details then on the investment pipeline please?

David Blackman

We have got a hand full of deals in the acquisition pipeline; they tend to be weighted right now towards GSA deals. What we have been finding over the last 90 days or so is more GSA deals. They tend to be relatively new generation properties that were built and they tend to being owned by developers or institutional investors. So we are evaluating number of deals and then in most cases we feel like the properties can be accretive to our portfolio, soon we combine them at the right price.

Mitch Germain - JMP Securities

Have you changed your underwriting criteria at all over the last year?

David Blackman

We really haven’t changed our underwriting criteria; I think the one thing that we have looked at because we have had some opportunities to buy some properties at higher cap rates, in the high 8s and 9s. We think it provides us an opportunity to take a bit of a barbell approach in the acquisitions and take advantage of some of high 7, low 8 opportunities with long term GSA leases. So, we were probably a little more aggressive on some of this longer term GSA leased properties than we were maybe six months ago. But we are still really focused on average cap rates in that 8% to 9% range.

Mitch Germain - JMP Securities

I apologize David I missed your prepared comments, how would you characterize for leasing environment these days?

David Blackman

I am very pleased with the lease environment right now. Last quarter when we did our call, we had plus or minus a 150 square feet of perspective leases in our pipeline that were anywhere from proposals outstanding to LOIs been negotiated to leases being negotiated. At the end of this quarter or today that number is close to 300,000 square feet and that’s after executing one of those leases that we talked about last quarter and one of the larger leases actually going away completely. So I feel pretty good about the activity. I mean we are seeing good activity at 1401 Rockville Pike, we are seeing very good activity at 330 South 2nd Street in Minneapolis and we are seeing activity at Ruffin Road in San Diego which is a property we acquired that had almost 50% vacancy. So I think that’s all good and I am pleased with the rates and the quality of the tenants that we are having conversations with.

Mitch Germain - JMP Securities

And last quarter I think you mentioned at a 100 bips of potential occupancy decline that you had seen for the rest of the year where does that stand now in terms of how you feel about the remaining renewals thus far?

David Blackman

We feel pretty good, I would say it was maybe around up to a 100 bips, but the real number is less than that and we don’t have anything to disclose in terms of tenants that we don’t expect to renew leases that haven’t previously talked about. So, and on top of that our conversations with tenants for our expirations for the remainder of this year and then going into 2013 have become more positive over the last couple of months. So, we are very pleased with the prospect continued renewals across our portfolio. I think it's all very good.

Operator

Your next question comes from the line of Michael Carroll. Please go ahead.

Michael Carroll

How are you thinking about your exposure to the federal and state governments right now? What's the ideal breakout between the two and where do you see the better opportunities at.

David Blackman

Well today we're probably 65% US Governments. Now we guess, we want to be somewhere between, Mark tell me we're 73% on an NOI basis. So, we want to be between that 65 and 80% band for US government leases. And we've had some interesting acquisition opportunities with state governments. Today we really don't have much in the way of state leased opportunities in the portfolio. So I think it's an opportunity for us to continue to kind of grow our GSA exposure.

Michael Carroll

And what's the pricing difference between the two right now?

David Blackman

The pricing difference is, if you have properties with identical leases, it may be 50 basis points in a cap rate. The real differentiation between cap rates in this market today is on lease terms. And the breakpoint tends to be 10 years. So for a property that's less than 10 year leased, you're going to get a much higher cap rate than one that's 15 to 20 years lease.

Michael Carroll

And then with the leasing activity in your non-government bucket, was that win an existing tenant and how do you guys thinking about doing leases with non-government tenants?

David Blackman

Well we lost the Henry and Jackson Foundation at 1401 Rockville Pike in the fourth quarter of 2011. There was roughly 60,000 square feet and we backfill part of that space with another non-government tenant and roughly 21,000 square foot lease was exercised during the second quarter and location. That's a building that is roughly, when we acquired that building, it was roughly 60% government lease, 40% non-government lease. So it's always had a number of non-government tenants in it. And basically what we're doing is we're replacing a non-government tenant with another non-government tenant. So I think the good thing about our strategy is we have no limitations on leasing vacant space to government space and today's environment makes sense for us to look at those government and non-government tenants for our vacant space. As we get buildings that are no longer majority leased to government tenants, we will consider whether those should be disposition opportunities for the company. But we want to maximize revenues and maximize leasing so we're going to look at the full range of potential tenants for our vacant space.

Michael Carroll

And David I believe you said in your comments, correct me if I am wrong, but you have good renewal opportunities with meaningful rental rate bumps. I am hearing that correct, can you give me some color around that, maybe the magnitude or location of those types of leases?

David Blackman

Yes, I don't think in my prepared remarks I mentioned anything about rental rates but I think when I look at the leases that are expiring for the rest of this year, and into the 2013, and I look at where we're negotiating renewals. We are approximately flat to slightly up across the portfolio. We have a handful of leases that we're negotiating, where we're going to have roll downs. We're expecting large roll ups at 20 Mass Avenue and that's going to offset some of the roll-downs that we might get elsewhere in the portfolio. What we experienced last quarter was a 10.9% rollup in rents with our government leasing activity. I don't expect that to continue in perpetuity. But I do feel like we have enough opportunities to grow rents with some of these expiring leases that we are going to be up between now and the end of 2013.

Operator

Your next question comes from the line of Young Ku from Wells Fargo. Please go ahead.

Young Ku - Wells Fargo

David, could you give us the with average cash cap rate for the acquisitions that you guys have made?

David Blackman

Young, we've never disclosed those. And I don't think that's something we want to start doing. I think we focused on the gap rate and we disclose that in our supplemental and I think that's probably where we want to continue.

Young Ku - Wells Fargo

Okay, I mean the reason being, if you're talking about the 8.4% GAAP cap rate and call it may be 50 basis points lower for cash cap rate and other 50 bits for your base management fee, I am just trying to see if I can get your thoughts on where your cost of capitals versus where you're inviting your money today.

David Blackman

Well, in many respects, our leases tend to be flat over the lease term. So it's going to be rare for there to be a 50 basis point differential between cash and GAAP rates in our company.

David Blackman

I know this isn't typically said by you guys, but given where your stock is trading and the implied cap rate, I would think that the stock would be a better use for the capital versus buying new assets where there is actually no growth at these types of yields.

David Blackman

Are you suggesting that we should use our capital for buy back shares?

Young Ku - Wells Fargo

Without the economic reason, I mean I would think so. I am just wondering what your thoughts are.

David Blackman

Yes, for companies like lease it have to pay out substantially all of their taxable income. It really doesn’t make sense to use your capital to buyback equity. If I thought I could buy back equity, I guess its substantially lower prices and where I could issue it later. Maybe that makes sense. But I think that's a risk proposition that we have not entertained and don't feel like it made sense for us to entertain. Maybe we're a company that owns real estate and wants to grow through accretive acquisitions and we think when you look at our cost to capital long-term, we have the ability to do that.

Young Ku - Wells Fargo

I know just a few quarters ago, I think you guys talked about 20 mass at renewal, maybe rolling up rents by around $10 per square foot. I mean given what's going down in DC, just wondering what the update is on that kind of a ramp up.

David Blackman

Well we just executed last quarter a lease that 625 million avenue at $49 a square foot and our rents at Mass Avenue are between 36 and $40. So I think we still feel pretty good about that.

Operator

Your next question comes from the line of Jamie Feldman from Bank of America Merrill Lynch. Please go ahead.

Unidentified Analyst

This is actually (inaudible) I'm here with Jamie. Just a follow up question on the expirations. Can you walk us through each specific large expirations you still have for the rest of the 12 and 13 and then just give us some update on how your conversations are going for each of the large expirations?

David Blackman

I can. 20 Mass Avenue, we got two tenants in there. One expires in September, the other one in October and we are negotiating renewals with both of those tenants. Lakewood Corporate Center, we have three buildings leased to the National Business Center. Those leases expire at the end of the August and we are also negotiating the renewal there and expect to have executed leases probably in September. I think the next one would be the FDA at 1401 Rockville Pike. That lease expired at the end of September and we already executed an early renewal with them at our roll up in rents. At Oklahoma City, we got the IRS in that facility. We are deep in negotiations with them and so the other agencies that they sublease to at that property. We got the South Carolina, Depart of Labor, Licensing in Columbia South Carolina; they have a lease expiration at the end of August. Initially they had told us and I believe we disclosed this to the market that they were going to stay through year-end but wanted to consolidate into a state owned property. They have realized that they have no space or variable in state owned properties and we are now negotiating a renewal with them.

We have another State of South Carolina tenants in Columbia South Carolina and we executed that. That leaves maturity at the end of August. We've executed a renewal with them. And then we had two tenants 330 South 2nd Street that had lease expirations July 31st, and we've executed leases with both of them. Those were both (inaudible). And that really hits all of our 2012 remaining lease expirations.

Unidentified Analyst

And no expected move outs from any of these larger expirations, it sounds like.

David Blackman

That is correct. We disclosed last quarter a couple of tenants that we expected not to renew and there is absolutely no change to that list.

Unidentified Analyst

And then do you have any large expirations in 2013?

David Blackman

In 2013, we've got the US Postal Service in actually New Hampshire. That 321,000 square feet and we have a lease out for execution to renew that for five years. We have two buildings in Washington that are leased to the Department of Energy and we are pretty deep in negotiating a renewal on both of those properties with the Department of Energy. That's actually October of 13, so we've got a long way away for that one. We've got the CDC in Atlanta in three buildings I believe, that have expirations in April and we are having conversations on all three of those buildings for renewals. And then in January of next year, we've got a lease with State of Maryland that expires and we have a lease out for execution with them right now. And then the last one would be, we have, the Department of Justice in Buffalo New York and we are currently working through the renewal process with them as well. So I think we've got 7.2% of our rent subject to lease expirations and 2013 and as we sit today, we don't have any hints that we expect would move out or not renew in place.

Unidentified Analyst

Just one more follow-up on this topic. About 100 basis points occupancy loss you expect towards the end of 2012, those are just from a smaller vacancies, not any badger blocks?

David Blackman

That's right. We've got a tenant in 330 South 2nd Street that we knew was going to move out. They represent about 2% of rents. We have a law firm in Memphis that represented about 3% of rents that has moved out and then we've got a law firm in Sacramento that represents about 2% of rents that we talked about previously and we're actually in discussions with another tenant in that building to actually all of that space. And so yes, actually they are all less than half a percent of revenue.

Operator

Your next question comes from the line of Dan Donlan from Janney Capital Markets. Please go ahead.

Dan Donlan - Janney Capital Markets

To the GSA, I'm just kind of curious that you've been on Capitol Hill and they've been under fire recently. Is this kind of much ado about nothing in terms of impacts your ability to negotiate leases with them?

David Blackman

Not really. I mean anything that is a perspective level lease, so in kind of broad terms any lease that has annual rent that's more than $2.5 million, has to be approved by the office of management and budget and both the senate and the house. And those lease are taking significantly longer to work through because of a lack of focus in Washington. I mean a good example is the Lakewood Corporate Center. We've got 212,000 square feet in Lakewood Colorado that's leased to the National Business Center. Two of those three leases are perspective level and we've been negotiating for over a year to get those done and we're going to probably end up executing a lease for renewal 30 to 60 days after the expiration. So it gets done but it takes much more effort and more time on our behalf to get it done.

Dan Donlan - Janney Capital Markets

And has any of the negative rudder, has that pushed up cap rates stall or have you started to see maybe more people start to sidelines or from the acquisition side is becoming less competitive or what's your view on investment activity?

David Blackman

I think a lot of investment activity today is being driven by leverage buyers. And you can get 10 years secured financing today at 70% leverage at 4%. And so you can buy a property at 6% cap rate and get a 200 basis point positive spread on your investments. So if interest rates and borrowing costs weren't as low as they were, you'd probably would see some pressure on cap rates but because of the inexpensive capital to borrow money, the acquisitions are continuing to be pretty aggressive and so we've had to be selective on what we want to want.

Dan Donlan - Janney Capital Markets

Okay and then just how do you think about equity on a going forward basis? Given where your stock price is, it seems to be pretty dilutive issue down here. What is your view on using better equity?

Mark Kleifges

I think we'd have to look at debt. I mean we're obviously not real excited about where the stock price is from a new issuance standpoint. We still have about $440 million available on a revolver today. So there is no pressure to raise additional capital and while we're getting close to bumping up against that 40% debt to total book capitalization that we want to run the company on a long-term basis, we're comfortable going above that for a period of time. So until we see the stock price get to a more reasonable level, we're probably going to be looking to finance the acquisitions on a revolver.

Operator

And at this time there are no further questions. I'd like to turn the call over to David Blackman.

David Blackman

Thank you for joining our second quarter conference call. Mark and I will be attending the Bank of America Merrill Lynch Real Estate Conference at September and hope to connect with many of you at that conference. Thank you.

Operator

Ladies and gentlemen that does conclude your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.

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