Government Properties Income Trust's CEO Discusses Q3 2012 Results - Earnings Call Transcript

| About: Government Properties (GOV)

Government Properties Income Trust (NYSE:GOV)

Q3 2012 Earnings Call

October 30, 2012 1:00 PM ET

Executives

Tim Bonang - VP, IR

David Blackman - President and COO

Mark Kleifges - Treasurer and CFO

Analysts

Michael Carroll - RBC Capital Markets

Jamie Feldman - Bank of America

Chris Caton - Morgan Stanley

Operator

Ladies and gentlemen, good day and welcome to the Government Properties Income Trust Third Quarter 2012 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 Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Tim Bonang

Thank you. Joining 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 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 October 30th, 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 that not to place undue reliance upon any forward-looking statements.

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

David Blackman

Thank you, Tim. For the third quarter of 2012, Government Properties Income Trust is reporting normalized FFO of $25.6 million or $0.54 per share compared to $23 million or $0.51 per share for the third quarter of 2011.

For the nine-months ended September 30, 2012, we’re reporting normalized FFO $75.1 million or $1.60 per share compared to $63.5 million or $1.51 per share for the same period of 2011. Our 11% and 18% increases in normalized FFO for the quarter and nine-months ended September 30, 2012 is driven substantially by our creative acquisition activity.

Since July 1, 2012, we have acquired or entered into an agreement to acquire nine properties for an aggregate purchase price of $167 million. We also declared a $0.43 per share distribution in October, which is a $0.01 per share increase in our previously quartered distribution rate. And also in October, we sold 7.5 million common shares in a public offering raising a $167 million in net proceeds.

As of September 30, 2012, GOV earned 82 properties containing 10 million square feet. Properties were 92.4% leased for a weighted average remaining lease term of 5.4 years. The US government remains our largest tenant and combined with 10 state government tenants in the United Nations account for almost 94% of our aggregate annual rental income.

In addition to our strong property statistics, in pro forma for our October equity offering, our balance sheet is conservatively leveraged at 30% of total book capitalization and our $550 million unsecured revolving credit facility has zero amounts outstanding providing us substantial capacity to make accretive acquisitions and to fund working capital needs.

Turning to leasing activity. During the quarter GOV entered 10 leases for 312,000 square feet with a weighted average leased term of 9.3 years. We have approximately 49,000 square feet of negative absorption during the quarter, most of which was associated with non-government tenants and substantially all the non-renewals have been discussed on previous earnings calls.

Our commitments for leasing capital were $6.7 million or $2.32 per square foot for lease year. Approximately 260,000 square feet of our third quarter leasing activity was renewals for four US government leases and one state government lease.

While our rental rates for our aggregate leasing activity for the quarter was substantially flat, our weighted average rental rates with our government tenants rolled down 4.2%. Our weighted average lease term was approximately 9.4 years and leasing capital for our government tenants was $1.51 per square foot per lease year, roughly 35% less than the leasing capital per square foot per lease year for our aggregate quarterly leasing activity.

The remaining 52,000 square feet of our third quarter leasing activity was with non-government tenants including a 47,000 square foot new lease for space we acquired vacant.

Perspective leasing activity for our vacant space across the portfolio is robust. We are also having active renewal conversations with tenants for leases expiring during the remainder of this year and for all of our 2013 lease expirations. As a result, we are optimistic that current dynamics with our tenants will result in a higher renewal rate at our properties.

Turning to acquisitions; since July 1st we acquired eight properties with 843,000 square feet for an aggregate purchase price of $152.1 million and have one property under agreement to acquire with 78,000 square feet for an aggregate purchase price of $14.5 million, all excluding acquisition cost.

For these eight previously disclosed properties we acquired during the quarter, the average purchase price per square foot was $181, the average acquisition cap rate was 7.9% and the average remaining lease term was 10.6 years.

In July, we acquired an office property and stock in California with 22,000 square feet. The property is 100% leased to the US government and occupied by the Department of Immigration and Customs Enforcement, for a remaining lease term of 14.7 years. The purchase price was $8.3 million and the acquisition cap rate was 8.8%.

Also in July, we acquired a dream property portfolio consisting of one office property in Atlanta, Georgia, another office property in Jackson, Mississippi and one industrial property in Ellenwood, Georgia with a combined 553,000 square feet. These properties are 100% leased to the US government and occupied by the Department of Homeland Security, the FBI and The National Archives. The weighted remaining lease term for this acquisition was 11.5 years, the purchase price was $88 million and the acquisition cap rate was 8.1%.

In September we acquired three office properties in Boise, Idaho with a combined 181,000 square feet. These properties are 100% leased to the US government and occupied by the National Resource Center and the Department of Homeland Security for a weighted average remaining lease term of 9.4 years. The purchase price was $40.2 million and the acquisition cap rate was 7.4%.

Also, in September we acquired an office property in Kansas City, Missouri with 87,000 square feet. The property is 100% lease to the U.S. government and occupied by the FBI for a remaining lease term of six years. The purchase price was $15.7 million and the acquisition cap rate was 7.5%.

Finally, in November, we entered into an agreement to acquire an office property in Windsor Mill, Maryland with 78,000 square feet for $14.5 million. The property is a 100% leased to two tenants of which 90% is leased to the U.S. government and occupied by the Centers for Medicare and Medicaid.

The acquisition remains subject to our satisfactory completion of due diligence and other customary closing conditions and as a result we can provide no assurance that we will acquire this property.

In September, Congress passed the Public Buildings Reform Act of 2012, which in intended to improve the efficiency of federal space, reduce the size of the U.S. government footprint, eliminate waste and increase transparency and accountability. The bill encompasses both owned and leased space and includes the following relevant components. The requirement that the GFA offset any requests for new space with an equal reduction of space through 2016, the requirement that GFA reduce space inventory by 1 million square feet a year for three years, which is less than a 1% reduction in the U.S. government’s aggregate space utilization over that three year period.

The creation of a maximum ramp for below perspective level leases and the requirement to notify Congress of any build-to-suite project that is not historically required congressional oversight.

By and large we see little risk to our business model from these new congressional oversights for U.S. government real estate. In fact, we are encouraged by the new below perspectives level congressional approval for build-to-suits projects which further strengthens existing landlords' ability to renew tenants in place.

Considering that we own less than 3% of the U.S. government leased space, we remain bullish on our ability to continue to generate accretive growth through acquisitions, while supporting our business strategy of providing a safe and predictable distribution to our shareholders from a stable revenue.

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 third quarter. Because of our acquisition activity, we once again experience significant quarter-over-quarter increases in both rental income and property net operating income.

At the end of the 2012 third quarter, we owned 82 properties with 10 million square feet compared to 67 properties with 8.3 million square feet at the end of the 2011 third quarter.

For the 2012 third quarter, GOV’s rental income increased $8.2 million or 18% to $54.1 million and property net operating income increased $4.9 million or 17% to $33.7 million compared to the 2011 third quarter. At September 30, our properties were 92.4% leased and our consolidated NOI margin for the 2012 third quarter was 62.2%.

Turning to our same store operating results, at quarter end our 64 same store properties were 91.9% leased down 4.6 percentage points from the prior year quarter end but down only 20 basis points from the end of the 2012 second quarter.

Our 2012 third quarter same store rental income declined by $1.9 million or 4.1% compared to the 2011 third quarter and our same store net operating income declined by $1.2 million or 4.3% compared to the 2011 third quarter. Our same store NOI margin in the 2012 third quarter declined 10 basis points from the prior year quarter to 62.6%.

GOV’s quarter-over-quarter same store operating results continue to be negatively impacted by the exploration of our lease with the Henry M Jackson Foundation at our Rockville, Maryland property in September 2011.

In the first quarter 2012, exploration of our leases with the CDC in Atlanta, the DEA in Tucson and the FBI in Phoenix. Excluding the impact of these expired leases, our same store operating results this quarter were generally stable with occupancy relatively unchanged and slight increases in rental income and net operating income on a quarter-over-quarter basis.

Turning to our consolidated results, adjusted EBITDA in the third quarter of 2012 was $30.1 million compared to $26.1 million in the 2011 third quarter. A quarter-over-quarter increase of 15%. Our EBITDA to fixed charges ratio remained very strong at 6.7 times for the quarter and our debt to annualized EBITDA was 5.1 times at quarter end.

For the current quarter, normalized FFO was $25.6 million compared to normalized FFO of $23 million for the 2011 third quarter. Third quarter 2012 normalized FFO per share of $0.54 was up $0.03 or 6% from the 2011 third quarter. During the quarter we spent $4.4 million on tenant improvements and leasing costs and $3 million on improvements to our properties.

Turning to our balance sheet and liquidity, at quarter end we had $611 million of debt outstanding and our debt to total book capitalization was approximately 41%. In October, we sold 7.5 million common shares in a public offering, raising net proceeds of approximately $167 million that we used to repay all amounts outstanding under our $550 million revolving credit facility. As adjusted for this equity offering, our debt to book capitalization at the end of the third quarter was only 30%.

In closing, GOV remains a conservatively capitalized company with 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 opportunities for future growth.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from the line of Michael Carroll of RBC Capital Markets. Please go ahead.

Michael Carroll - RBC Capital Markets

Guys, it sounds like the company is having some good traction, retaining its government tenants, but may be not as good of traction with the non-government tenants, is that a fair comment to say and do you expect that to continue?

David Blackman

I think that’s generally a fair comment Mike. We have a much higher, as in most companies, you have more turnover with non-government tenants than you do with government tenants and so I don’t think there is any difference. In our portfolio the big difference would be, is that the non-government tenants are a small percentage in our buildings and a very small percentage across the portfolio.

Michael Carroll - RBC Capital Markets

And can you give us a sense of, I guess the rest of your non-government tenants lease maturity schedule over the next couple of years, is it meaningful, anyway?

David Blackman

It is not meaningful, for the remainder of this year, we have basically six leases that are still subject to expiration or we're working on renewals where they're all government tenants. So we don't have anything really for the rest of this year.

Next year, we only have about 6.7% of our revenue, subject to lease expiration and that is substantially all government tenants. We’ve got a couple, small non-government tenants, but they tend to be a 1,000 to 3,000 square foot tenants.

Michael Carroll - RBC Capital Markets

And then David on your last call, I believe you indicated that leasing activity nearly doubled from 1Q to 2Q. How is it gone from 2Q to 3Q?

David Blackman

You’re talking about perspective leasing opportunities?

Michael Carroll - RBC Capital Markets

Exactly, yes.

David Blackman

Yes, we continue to have above 300,000 square feet of perceptive leasing activity across the portfolio. It tends to be a mix of both government and non-government tenants. So that's up slightly from what it was in the second quarter. We have converted some of the prospects that we had in the second quarter to either letters of intent or have leases out for signature. We got a few leases that we actually executed, so, I am pretty optimistic that we're going to continue to have positive absorption in our vacant space and we're starting to begin to lease some of the space that we acquired vacant which I think is real positive because that’s accretive to our numbers.

Michael Carroll - RBC Capital Markets

And then can you remind me how GOV insures its properties? Didn't GOV make a small investment in insurance company a few years ago?

David Blackman

Yes. We own roughly 15% of affiliate insurance company, which is basically an equal percentage of all the RMR related public companies to include REIT management. I'm assuming where you’re going is what the effects of hurricane standing was on insurance.

Michael Carroll - RBC Capital Markets

Yes, exactly.

David Blackman

At this point, I think it is too early to tell, we obviously across the RMR franchise have a number of properties in Pennsylvania, Delaware, upstate New York. And I have not heard a report at this point in terms of damages and potential loss.

Michael Carroll - RBC Capital Markets

So then I guess GOV and RMR companies basically self-insure their portfolio, is that fair?

David Blackman

No it’s only for a certain layer of the insurance company of the insurance coverage. Most of the catastrophic type coverage in the larger loss amounts have been seeded out to non-related insurance companies.

Operator

Our next question will come from the line of Jamie Feldman of Bank of America. Please go ahead.

Jamie Feldman - Bank of America

I was hoping we could talk a little bit more about some of your big explorations and just an update, I think it’s a question I ask every quarter. So do you want to discuss the big ones and then whatever you don't hit, I can have follow-up like 20 Mass Avenue, USCIS, the usual?

David Blackman

Yes, so 20 Mass Avenue, that represents almost 7% of our rental income and that’s an exploration for the rest of the year. It’s basically two leases. The Department of Justice is working through the approval of a prospectus. They are downsizing, well let me say that differently. U.S. custom and emigration services is the tenant in that building and there were occupying roughly 12,000 square feet that was leased to the Department of Justice. And so we are working through documenting a formal lease with USCIS to take the space that they have been actually been occupying but was lease to Department of Justice.

And then DOJ doesn’t have an approved prospectus yet, so they are working through an approval, likely going to be somewhere around the five year renewal with virtually no capital other than lease commission. Expectation is that DOJ will ultimately exit this property, so that USCIS can occupy 100% of it.

And so obviously, we are working with USCIS on their renewal as well creating flexibility for them. They continue to grow as DOJ expanse. That’s probably what’s taking the most time and working through this renewal is trying to or orchestrate USCIS taking the 100% of the property with minimizing the level of downtime that we might have in the building.

At this point, we’re optimistic that we’ll have no downtime. The good news is, we’re likely to going to have close to a 40% roll up in rent and I suspect that we will get USCIS’ lease executed this year, but the Department of Justice probably will probably end up and hole over and we won’t get that done till next year.

Jamie Feldman - Bank of America

And they both have 40% or is one of them driving it?

David Blackman

No. We’re basically currently kind of negotiating equal increases in rent.

Jamie Feldman - Bank of America

All right. And then moving on to the next, what’s your next largest next year?

David Blackman

Next year our largest lease exploration is the U.S Postal Service in Nashua, New Hampshire. And that lease is out for execution. We expect to have that back. It’s basically a five year renewal roll down in rent. But, when we acquired that property, I think we paid almost 12% camp rate knowing that we will have an above market lease and that we would have a roll down at renewal. So, that’s nothing, nothing real new there.

Jamie Feldman - Bank of America

What’s the percentage roll down?

David Blackman

Percentage roll down is around 30%. And I guess actually you know what, I say that was our largest maturity, I think our actually our largest exploration is the Department of Energy in Richland, Washington. They occupy two buildings in Richland and we’re currently negotiating a longer term renewal with them. So, we’re pretty comfortable with the direction that is heading and I think the rents there will be slightly down to flat.

Jamie Feldman - Bank of America

Okay. And then, just going through a couple more here so, the National Business Center?

David Blackman

National Business Center, that lease was renewed for 10 years.

Jamie Feldman - Bank of America

Okay.

David Blackman

It’s substantially flat lease.

Jamie Feldman - Bank of America

So not the 5% GAAP rent roll down, that you guys have been talking about?

David Blackman

That was a part of the third quarter leasing activity and part of that roll down was from them.

Jamie Feldman - Bank of America

All right, so that's baked in.

David Blackman

Yes.

Jamie Feldman - Bank of America

And the IRS in Kansas?

David Blackman

IRS is in Oklahoma City, not Kansas.

Jamie Feldman - Bank of America

Oh I am sorry, 158,000 square feet?

David Blackman

Yes. We’re currently working with them on renewal. One of the challenges of that lease like some of the others is, there are four other agencies that occupied space as part of the IRS lease, and the IRS wants us to go direct with those other agencies. So we’re kind of managing through that process. The complicating factor is, is we've got three different contracting officers that we’re working with to manage that renewal. But ultimately we expect a pretty healthy roll-up in rent with that lease renewal.

Jamie Feldman - Bank of America

Okay. Yes, I think in the past you’ve talked about $2 to $3 a foot, that’s still pretty good?

David Blackman

Yes, that lease was a pretty odd lease. It was a 20 year lease and at 10 year there was a substantial roll down in rents and that substantial roll down took it well below market. So we’re not working through getting it back up into that market round.

Jamie Feldman - Bank of America

And then Rockville?

David Blackman

Rockville, we have renewed the FTA in their space. That was a second quarter lease renewal and that was a 7.5% roll up in rent.

Jamie Feldman - Bank of America

That’s already baled into the third quarter number?

David Blackman

That was a second quarter renewal. So that’s genius, so we had a full benefit of that after the third quarter.

Jamie Feldman - Bank of America

And so any others that you’re kind of waiting on or that are stuck in government limbo at this point?

David Blackman

Not really.

Jamie Feldman - Bank of America

Even though the number is going forward?

David Blackman

Not really. We’re working through the CDC for renewals next year, for a few of their buildings. But, we are not really waiting on congressional approval at this point for any leases where we have kind of reached an agreement on business terms. I am sure as we get closer to some 2013 explorations; we may have some issues, but like for example Richland, Washington with the Department of Energy, that’s an October 2013 exploration. And then the other near 1% lease exploration is the Department of Justice in Buffalo, New York and after December 2013 exploration. So we don't have any real front end loaded stuff that we are kind of worrying about potential holdover right now.

Jamie Feldman - Bank of America

Okay. And then the postal service in New Hampshire in February, you think do you expect this slight roll down or that's flat?

David Blackman

No, we're kind of expecting around 30% roll down on rent there, but that again, that was the one that we acquired this thing at near 12% cap rate and expected that as part of a renewal.

Jamie Feldman - Bank of America

Okay. And then just thinking about the acquisition pipeline, how big is it right now and then I know you guys just raised capital on, you said your credit line's clear but what do you guys think is your capacity at this point before you need more capital?

David Blackman

I think our capacity is a lot.

Mark Kleifges

Yes, our debt to book capitalization post equity offering is down to 30%, that gives us probably roughly $250 million of acquisition capacity before we bump up against a 40% debt to total book capitalization, so we've got a lot of dry powder if you will.

Jamie Feldman - Bank of America

Okay. And then what’s the pipeline right now?

David Blackman

Pipeline's pretty good. I mean it's about what it normally is, although the interesting thing is it’s substantially all federal leases today. We really don't have much in the way of state in there at all, but we've got some deals that we like, where we're working through a strategy on how we might offer on those, so I think its helping.

Jamie Feldman - Bank of America

Okay. And then finally you had mentioned, it seems like you’re getting more rent rolls down and government. Is there something going on with government leasing in general that you’re seeing more pressure? Are those were just leased specific in the quarter?

David Blackman

I think its lease specific. There are some markets around the country that are weaker than others, for example we have more pressure in Lakewood, Colorado, just because there is a fair amount of vacant space in that market. So I wouldn't necessarily read it into a broad U.S. government issue, but more as a market specific in terms of where we had lease expirations.

Jamie Feldman - Bank of America

I assume it's harder in the secondary and B markets. Is that a safe assumption?

David Blackman

Yes, it's kind of the good news, bad news. There aren't always good buildings that the government could move to, but even if they don’t have the ability to move, you still have to be mindful of what market rents are in that particular market area.

Operator

Our next question will come from the line of Chris Caton of Morgan Stanley. Please go ahead.

Chris Caton - Morgan Stanley

Just wanted to follow-up on Jamie’s questions on leasing. Can you talk a little bit about the CapEx required to lease the vacant properties that you’re working on now versus renewals? So how should we expect maintenance capital as a trend both leasing, TI’s, et cetera for 2013 or just in general in the near term?

David Blackman

Well, maintenance capital, we’re still thinking about capital in that $0.50 per square foot across the portfolio for replacing HBAC doing elevator modernizations and our energy initiatives, so no real change on maintenance capital.

And the answer to your question about tenant improvement dollars for vacant space is, it depends. Every building is a little bit different, some buildings have space that are in better shape than others, you know and some buildings require a level of building improvement in addition to tenant improvements in order to make it ready for a new tenant. So I guess generally, I would say that we should expect $30 to $40 a square foot potentially for tenant improvement dollars for leasing vacant space. It could be as low as $20 a square foot, it could probably be as high as $50 square foot, but it really depends on the specific building and that market and that would be for probably a seven year type lease.

Chris Caton - Morgan Stanley

Great and then leasing capital would be on top of that due generally of brokers involved in transactions.

David Blackman

Generally there is a broker involved in the transaction. We have a broker that represents us and a lot of tenants these days come to us being represented by brokers. So that commission be as high as 6%, but when we talk about leasing capital, we talk about tenant improvement dollars, as well as lease commission.

Chris Caton - Morgan Stanley

Great. And then just one, and then I’ll come back to hurricane Sandy, can you describe how you are insured against disaster recognizing that it seems like it doesn’t flow through to the insurance company you own. But can you just describe your insurance?

David Blackman

We have a layered insurance program. Our insurance program is a layered risk program where we have basically an insurance broker that advises us on how to distribute the risk across various insurance companies. Affiliates Insurance Company which is the company that we own, a percentage of takes a level of risk in that entire risk sharing arrangement. Their risk tends to be backed by cash deposits and we have a lot of capital in this company to support its regulatory requirements and potential losses. So most of the risk that we have is insured by A.M. Best A or better rated, insurance companies. It just happens that we own a company that takes a small portion of that risk sharing agreement.

Mark Kleifges

Right and GOV’s income statement impact will be limited to any deductible that we have in that specific property.

David Blackman

Right.

Chris Caton - Morgan Stanley

Great. And then last question from me on the acquisition pipeline. We’re hearing, pricing differential on properties like these given leased term, say below or above 10 years. Are you still seeing that and if so, where does GOV want to be across that price differential or where is your acquisition pipeline across that price differential?

David Blackman

Chris, I agree with your comment that U.S. government leased properties with 10 year or greater remaining lease duration tends to have more aggressive cap rates. I mean you can see we had two acquisitions during the quarter that were kind of mid sevens for cap rates which is pretty aggressive for us. We offset that with a couple of acquisitions that had eight and to high eight cap rates and I think that’s the way you will see us look at acquisitions. There is the analysis around any individual acquisition relative to your cost to capital, but we also want to look on a portfolio basis, are we taking the appropriate level of risk relative to lease expirations. And getting the appropriate yield across, call it five to ten acquisitions versus just an individual property acquisition.

Chris Caton - Morgan Stanley

So you're comfortable being kind of on either side of a ten year term?

David Blackman

We're comfortable being on either side of their ten year term. Where you see us do acquisitions that have less than a ten year duration, you should expect that we have done a fair amount of diligence around our expectations on renewal for that government. If we don't feel like the renewal for that government tenant is 100% or near 100%, we likely won't make that acquisition. So there are probably first or second generation space that is approaching the end of its primary lease term, where we think there is a high probability that they will remain twice.

Operator

(Operator Instructions) There are no further questions in the queue. And I would now like to turn the conference call back over to Mr. David Blackman for any closing remarks.

David Blackman

Thank you all for joining our third quarter conference call. We will be attending the (inaudible) Conference in San Diego in November and look forward to connecting with many of you there. Thank you. That concludes our call.

Operator

Ladies and gentlemen, that concludes our conference call for today. On behalf of today’s panel, we’d like to thank you for your participation. Thank you for using AT&T. Have a wonderful day, you may now disconnect.

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