Easterly Government Properties, Inc. (DEA) Earnings Call Transcript & Summary

Everyone, welcome to the 2:20 p.m. session at Citi's 2020 Global Property CEO Conference. I'm Manny Korchman with Citi Research, and we're pleased to have with us Easterly Government Properties, CEO, Bill Trimble; and Chairman, Darrell Crate. This session is for investing clients only. And if media or other individuals are on the line, please disconnect now. Disclosure is available up here and on the webcast under Disclosures tab. For those in the room or the webcast, you can live -- sign into liveqa.com, enter code citi2020 to submit any questions or raise your hand. Bill, Darrell, who's taking this? Who's introing? Bill, I turn it over to you to introduce your company and management team, provide the audience 3 reasons why investors should buy your stock today, and then we'll go back to Q&A.

Thanks, Manny. It's a real pleasure to be here. And as Manny mentioned, I'm joined by my Chairman, Darrell Crate; also by Meghan Baivier, our CFO; and by Lindsay Winterhalter, who is in charge of Investor Relations and ESG. The 3 things why investors should take a look at us. Well, I think that it's certainly clear that we have the highest credit tenant agency -- tenant in the world as our -- in every one of our buildings. The United States Federal Government has never defaulted in the history of the United States. And I think in these trying times, I think that's certainly an advantage we might have over some other folks. Our cost of capital has never been more attractive than it's been in the last several weeks. And I think we understand here that, that gives us the opportunity to only increase our efforts to continue buying bull's eye targeted properties that are accretive but will continue to diversify our overall portfolio. And third, because of the apolitical nature of Easterly Government Properties, which is a prime tenet when we set up the firm even in the private equity days in 2010, looking forward to this uncertain election, we believe that in either case, we will do quite well. In one case, it's the same as we're doing now. And the other, if you look at the possibility of greatly expanding the United States Federal Government, they're going to have to house those folks somewhere. So we're very pleased with how we're positioned right now.

Thanks for that. We've got one more opening question. I don't know if Lindsay is going to have to swing around the table or if somebody else wants to take it. But ESG is of increasing importance for all company stakeholders. What's one thing your company is doing to improve your overall ESG score over the next 12 months?

Well, we're certainly going to do more than one thing over the next year. And as you know, Manny, it's been very important to us, ESG, since we first started. The Federal Government is one of the leaders in the environmental sustainability and, in fact, has a large number of requirements for all new builds and their properties, which we've been a part of, allowing us to have the largest LEED-certified portfolio leased to the Federal Government. But beyond that, we've put together a team internally that Lindsay runs for us, was made up of every division of our firm, so that we can make sure that we do the best job possible for the Federal Government and for our shareholders. I think it's important to note that the Federal Government here is very much in there. We're all about the ENERGY STAR rating, and we're going through an auditing all of our buildings right now. So far, so good. It looks like we're actually performing better than we thought we were. When you look at -- one thing I think is very important is also the diversity within our firm and with our Board. And we're very pleased to announce last week our second female member of our Board, which will bring us to 50% of our independent directors, Tara Innes who joined us, and we're really excited to have her input over the years to come.

Thanks for that. So just going back to your opening remarks, I don't think that you've ever spoken about cost of capital as being a constraint on your acquisition flow in the past. You talked about sort of utilizing the cost of capital now to accelerate that acquisition. Can you help me reconcile those sort of 2 thoughts?

Sure. And I think that you've seen us purchase buildings, including a large portfolio several years ago since we've all been associated with each other in sort of that mid-6% cap range. And we've probably floated down on average to about a 6.3%. That's all we've seen in our market. It doesn't move particularly quickly. But what we're talking about is that there are a subset of -- we're in the bull's eye. I would imagine the absolute center of the bull's eye, and those would be properties that would feel like a brand new FBI facility in a very attractive urban location or near-urban location. Let's just take one like San Diego FBI-type. We do own several of those, but those tend to trade at lower cap rates, probably closer to 5.95% to 6%, somewhere around there. And I think we're really prudent. We took the direction from our Board that we were not going to go and do deals that were not accretive. I will tell you, there's a very big difference between $19 a share and $24 to $25 a share when it comes to how many pennies we can earn as shareholders. And so that's what you're going to see us do. But we're going to continue to be careful not to drive pricing up in front of us and be prudent.

And I guess, your sort of company MO is to not talk about cap rates on acquisition. If and when you do deals that are sort of going down into other area, are you going to tell us about the fact that they're going to...

We actually -- and there are several answers to that. We actually do, obviously, inform, Manny, instantly of everything we do after we've done it. But we do disclose that. We try to be careful so that we're not -- it's a limited group of sellers in this market, and we really don't want to go out there or have the government really getting into any of our purchases and sales and so forth. But we will certainly tell you exactly what we pay for some of those premium assets, which we have in the past with our Loma Linda acquisition, which was at a lower rate.

Switching to development, which you didn't really talk about. How does that fit into your growth puzzle?

Meghan?

Sure. So today, we have 2 developments in the pipeline. We've got 1 that's estimated to deliver in the back half of this year. That's FDA Lenexa and then the FDA Atlanta is slated for late 2022. And these projects are multiyear projects. So we are always in the hunt for our next development, but we've gotten up onto that wave of delivering sort of 1 a year and look forward to continuing that pace, Manny.

And the pipeline there for future developments?

Sure. So as you know, the FDA is modernizing its lab portfolio. There's been 3 of those awarded to date. We've won all 3. We're a great partner to the government in these lab products, and so we look forward to future opportunities in that pipeline. We also are looking towards FEMA. We expect there may be some opportunities in the FEMA space as well that we're watching. So there's no deal that's posted that is appropriate for us that we're not going to try and bid on.

And is there...

And there are about 7 labs that the FDA is going to consider redoing. So getting a lion's share of those is our goal.

And this might be a little bit premature just given the news flow, but is there an opportunity in the CDC labs or anything like that, that might come out of what we're seeing in corona right now?

Well, I think that Darrell was. We switch off on ribbon cuttings when we deliver a building. And, Darrell, when was that building -- the latest laboratory slated for start?

2004.

So they bid it out in 2000 and...

It usually takes about 15 years from conceptualizing to our delivering. We tend to know about 8 to 9 years in advance of the delivery. So we -- I think we can improve upon that, but maybe a couple more years.

So we'll have corona update 1,452 million by the time we have that 1 completed, I'm afraid.

But if the CDC would like to buy a building, we're probably best suited to do it for them. Send your letters now.

Just for the people that aren't in the room, can you talk about sort of just the different asset classes within the portfolio, labs, courthouses, office buildings, et cetera, hospitals? Sort of how all of that fits into this umbrella of the government lease trumping sort of the property-type?

Sure. It's important to note that the Federal Government leases 550 million square feet a year, which is twice New York City, to give you the scale. And we're interested in a much smaller subset of that, which is through the GSA, the General Services Administration, which encompasses about 7,000 buildings in the United States. We further cut it down to a select group that we think are going to renew about 95% of the time. And that gets us down to about 500, about $23 billion, $24 billion in value and 75 million square feet. Additionally, we are targeting about 50 of the brand-new VA outpatient clinics. The VA not on the cover of good Government Magazine for the last 30 years has actually come up with an interesting program that they, both the Democrat and Republicans over the Obama administration, passed where they started building outpatient clinics that are able to triage veterans. There's 22 million of them, by the way. It's the largest health care system in the world. So if you think that private sector is going to handle that, they're not, but they will handle certain parts of it. And these outpatient clinics, there are no beds. This is purely for the day, our veterans can go in there and get blood checks, mental health, prosthetic work and all the sorts of things that you can do on an outpatient basis. So if you take that group of buildings, there are a number of agencies, about 3 dozen, that we're interested in. Not surprisingly, they are what we call the gun-toting agencies, so FBI, DEA, CBP. We don't house anybody overnight, if anybody cares about that, unless they want to be housed overnight. And then we also think federal courts are an area of growth, and we own a number of those. So I think you'll see every one of our buildings has something in common, which is whether it's a Democrat or Republican in power, we would all agree that they are a fundamental measure of the United States. And each one of the buildings, so about 75% of our buildings are specifically built-to-suit with special features and functionality that make it literally impossible for that mission to be conducted in another building unless a building was built for them. So our properties are valued on replacement cost, which is different than you'll see usually in triple net.

Meghan, there's something you and I have spent quite a bit of time on, but I think people still sort of misunderstanding your business, but there's this concept of lump-sum payments and sort of how the cash makes it from the government to you or how is -- at least it's accounted for. Can you sort of help explain what the concept is and terms that somebody in the room who might understand?

Sure. We'll stay out of the leasing. Yes, sure. So when the government has a building built for them, they will fund it through 2 different ways. A portion of the building, which is called the warm shell plus a base tenant improvement allowance is one portion of the building. And then the remainder of the cost that's required to complete the building, the government, the tenant agency will actually bring to the table in a lump-sum fashion. So we will build the entire building. We'll finance that entire construction, and then a portion, the lump sum piece, will actually be repaid to us with the fee upon completion of the asset. And then in some instances, we are getting progress payments on us. We're not waiting for the full lump sum to be completed, maybe -- and in the case of Ale -- Lenexa, rather, we are getting 50% progress payments on that lump sum. So what you have in the case of Alameda, for example, that building was just over $80 million to construct. $52 million of that was in the lump sum bucket. So this is a $1,200, $1,300 a foot laboratory, but the piece that's actually going to be paying rent is obviously only about 1/4 of it. And so that's the piece that will generate rent on a perpetual basis, but the value it took to create that asset is the full $80-plus million. And that's really important when you can then get to 20 years from now, or in the case of some other acquisitions, obviously, a much shorter time period. When we talk about how renewals are driven by replacement cost, that whole sum of money would have to be brought to bear to replace that asset.

And so -- maybe that's a good segue to talk about just renewals and tell us how the government approaches that? And then how far in advance you might know about them nonrenewing and -- the good stuff?

Yes. So it varies. But the government can -- it's generally sort of 1 to 2 years in advance of renewals starting to -- turning to work on them. It's a very open competitive process that we participate in, but we certainly stand with our existing assets in this place to compete. So when we are going through these renewal processes, the government may be armed with basic market information for Class A, Class B office in a market, and it's our -- through our information that we try to present to the government, we give them the argument that, that contracting officer needs to have to, say, Class A, Class B office in Albany is irrelevant. We're talking about renewing an FBI facility in Albany and what it would take to replace that asset. And so we'll bring information for the contracting officer and what it takes to rebuild that, what cumulative inflation has looked like since the last building was built for them. And so let's say, and we'll talk about FBI omni because that's when we spoke about on our call that -- to reconstruct that asset, may take -- I'm just going to say, $60 a foot, and in places in the $30 range. And so where that thing gets renewed, it's going to be somewhere in between those 2. It's going to be discount to the replacement cost, but it's not a conversation about local office rents.

And so if we were to play out the bear case there though, and you were to have a nonrenewal, how do you guys think about sort of the nongovernment-lease worth of the buildings that you guys own?

I think it very much depends on the building. And if you look at a spectrum from plain vanilla office space, where, obviously you're being careful to figure out what local rents are, it's going to go to the private sector, all the way to the most complex laboratory on the other end of the scale. So I think the best way to describe is maybe take an FBI or something like that, which would be our bread and butter, FBI field office. And we'll take maybe San Antonio, which is a newer FBI field office located in the Northwest of the city. And right now, they're in at about, the federal government, $32 a square foot is what they're leasing for San Antonio, which is the sixth largest urban area in the United States, which surprises folks, is at about $26 a foot. And so I imagine we'd probably stay vacant for a year or so, and we'd have to do some work, but we probably would roll down to $26 a foot. The new folks wouldn't need the gun room, but they could. I mean the rest of it is just a very attractive corporate office building, so that would be fine. Interestingly -- but there is a 94% chance that's not going to happen, even if our team doesn't do anything. So the higher likelihood is that if you look at our Salt Lake City FBI, which is the same builder, very much the same size. Salt Lake is the 13th largest city in America. That rent is up well over $45 a foot. So that's what you -- the greater expectation is you're going to see a large increase in the rent rather than the other way around. And we were looking at our laboratories, the Alameda laboratory that we just built. The last one was in place for decades with the FDA, has been leased by the private sector almost immediately because, interestingly, our laboratories are much more sophisticated than the most sophisticated private laboratories. So for them, it's an easy switch. So that's a good market for those buildings. We'll talk about that in 40 years, but...

Any questions in the room? Bill, just on that point for a second. So if you've got a lab that's in high demand in an area that are -- well-built building lab space, the private market is willing to pay more. Do you, as a company, that sort of markets the fact that you're U.S. government-leased, you've got the full faith and promise of the government behind you, all that stuff, do you lease it to the government or do you take a higher rent and lease it to the private sector?

Well, as you know, it is -- we only get a shot at that 20 years from now, which will be the first time any of those leases roll. So I would imagine that the federal government at that point will give us a very attractive offer on re-leasing that space. And we'll take it, would be my guess, probably because of the size, and it will probably be a prospectus lease at that point, probably 27 months in advance. So my guess is we'd very much just re-lease it to the federal government.

From a company infrastructure perspective, how much bigger could you get without sort of adding bulk to the -- whether it be G&A or just other company infrastructure?

Well, I'll let Meghan answer that.

No. We are very much at scale today. So as we continue to grow, we'll need to build other asset management platform with some junior level folks, property accountants need to be added and so forth. But we really, from the top down, are at scale at this point.

We've got a question here on the liveqa. Your guidance is for $200 million of 2020 acquisitions. If your cost of equity remains where it is today, how large could that number be? And what is the dividend policy going forward?

Mr. Crate?

I mean there is -- we will maintain expectations at kind of $200 million a year. Just stepping back, one of the things that we're promising to shareholders is if you look out over a horizon of 7 to 10 years, that we're going to be delivering 1.5% to 2% growth in a very consistent way. Stability is the word we want you to think of most when you think of this portfolio and what we do. It's why we've stayed so disciplined to that bull's eye strategy and why we continue to underwrite to that bull's eye with a tremendous amount of rigor. That said, there are surprises that are going to be heading along the way. There are $2 billion of portfolios that are out there. And in this environment, those portfolios are owned by individuals. Those individuals tend to be folks who are in their 70s. They built these through being a real estate developer or some other sort of way in which they were building their career. Those individuals, obviously, are not corporations, and they get more concerned about uncertainty than a corporation would. We're approaching environment today in this year where we do have this very low cost of capital that you point out -- point to, Manny. But in addition, interest rates are very low, the 10-year treasury is almost to the point. So if you're -- if you've been in this game for 10, 20, 30 years and you see the 10-year treasury at a point, your instinct is going to be, "I can't imagine how much lower it can go." And so this would be an opportune time for you to think about selling our building versus not. Add to that a Bernie Sanders factor, add to that the coronavirus, add to that all the types of uncertainties that we're layering on in 2020. It was -- this is a time where we can walk into an office with a stable stock and make the case that now should be the time for you to think about selling. And if you're not going to sell now, what sort of factors in the environment are you looking for in order to put your building for sale? So when we look at those portfolios that are in that $2 billion, those can be $200 million, $300 million, $400 million portfolios. And getting 1, 2 or 3 of those would not be unimaginable to me. That said, it would be irresponsible for us to set investor expectations at anything higher than our steady-state rate because these decisions are going to be made by individuals. Over time, we should own all of those portfolios, but we never know when. But we do know that we are a buyer of choice among owners of buildings because we provide certainty and lots of clarity to getting a transaction completed. And we should be the natural buyer given our cost of capital relative to other folks that are out there. So while I took a very long winding way to not exactly answer your question, I think I've given you the landscape in which we're in. And we are ready to travel and knock on doors, and we're going to give it our best shot because we think the time is now for these sellers. Hopefully, they agree with us, but maybe they won't. We don't -- we'll see.

Maybe I'll ask the question a little bit differently. If we're sitting here on December 31 and you've only closed $200 million of acquisitions, are you happy with that or disappointed with that?

Well, I mean I love all the people in my family, but I can't control what they do every day. And I...

You can still [ make it up ] so hence the question.

Yes. I know. You got to love all humans. I think this is how it works. Of course, I would be disappointed. I mean -- but I just know that over time, these buildings should naturally flow to this portfolio. If you look at our total addressable market, it's over $20 billion. We own a material portion of it, but there's a long way to go without needing to drift outside that bull's eye. And that will happen over time. I mean we've got the right team in place, as you know, Bill does an unbelievable job of maintaining the talent verticals of finance, of acquisition, of asset management, of government within our internally managed street. And so as we look out, we've identified these buildings, we know who those owners are and it really is just -- it's got to be a matter of time because investors gratefully -- and investors have rewarded us with the currency that we asked for when we went public. Remember, this company was founded as a private equity business, and we had successfully raised private equity funds. But we quickly realized that to be the most well-positioned competitor in the space, going into the public markets was the right answer. And that was the decision we made in 2015. Investors have stayed with it and rewarded us. And so they gave us what we're looking for, and we should be able to go out into the world and be the dominant owner of these portfolios.

Have you had any success doing OP Unit deals? I know we've spoken about them in the past. But are sellers looking for those?

Yes. We've used them in 2 transactions in the past, both the Military Sea and Treasury Birmingham. And it's a currency that while not every seller is interested, they might be a serial developer looking for cash, but we certainly approach all sellers with that. It makes a lot of sense for a lot of folks. And as the stock continues to perform well, it's actually a great backdrop for these folks. That's a positive signal to them. And so it's something we always bring to the table kind of deal.

And then just to circle back to my earlier question, how do we think about the dividend going forward?

Sure. So we're a company that believes that we will always have a higher-than-industry average payout ratio. I think that's appropriate with this risk profile. And we look forward to continuing to grow that as earnings grow over time.

Just going back to acquisitions. Your comments felt to me like they were more about sort of single sellers, maybe a few assets. What about big portfolios? Do they sort of follow that same -- you don't really know when they're going to happen...

I think that's certainly the case, yes. I mean I would -- I mean it's going to -- I mean it's going to be 5 to 10 years probably to get those portfolios into our clutches. And we really base things on 1s and 2s, for the most part. And by the way, I think we do a great job of doing that. We've got plenty of capacity. And we certainly know each one of those properties is pristine and is going to do very well in our portfolio. As you get to the larger portfolios, obviously, you've got to have different looks because some of it, as Darrell says, you don't like some of your kids as much as some of the others, so you've got to do really strict underwriting on them. And so from that standpoint, they're a little more of a challenge than you'd get in the 1s and 2s.

I'd also add. We frequently talk about individual sellers because those are the acquisitions that are on the margin for us. For much of the history of the firm, 80% of our purchases were in off-market transactions. These are cultivations that take 4 months to 4 years in order to move them along. And so as we look out, as Bill will frequently say, we never want to be the elephant in the swimming pool. We did not charge into this market with all this money and just buy, buy, buy. That's part of it -- we're disciplined to the bull's eye. We're very disciplined financially. And the last thing we want to do is push that accelerator too hard and create the NAV for all these buildings to grow. So that being the case, it is these sellers that own portfolios that we've worked with for years, developed a high level of trust, that will end up -- that is product that's outside of the ebb and flow of the normal broker market. So that's where we're most focused.

Just to help give us some context, what's the transaction volume that actually gets completed in this space on an annual basis? So if you're targeting $200 million as an easy number, that's of a market that transacts $2 billion, $4 billion, $200 million or $500 million?

Well, it depends on the deal flow. It depends on the bull's eye and non-bull's eye. I will tell you from a standpoint of the bull's eye, we're pretty much doing it all, with very few exceptions. I think we didn't do FBI Denver. That's the only building that we didn't do that would fit. Why? Because it wasn't accretive enough for us at the time. It would be today.

Did that transact?

It did transact. But the difference is, I think, is that -- as Darrell pointed out, we do so much of the mining ourselves that we can actually control a certain size of the sales every year and are not dependent on broker transactions. The flip side of that is there is a finite number of buildings and the broker transaction comes up, we certainly want to play. And we -- and that's why we'll go to $200 million, $300 million, $400 million because that building will probably not come up again if we don't buy it at that time.

And again, you never know what your competitors think. But our sweet spot is buildings that are $40 million, $50 million and up to about, let's say, $200 million. It's about $200 million. There's other large REITS, there's USAA. It's a different competitive circumstance. Below that kind of $30 million, $40 million, you've got Dr. Dennis syndicates and groups of high net worth individuals coming together to buy base for -- to transition family wealth. So that's the space that we've been for individual bite-sized buildings. And it's a place where -- again, we're in a lot of markets that any of us have observed. We have an ability to throttle in, throttle out and keep the price rational relative to the broader real estate market.

We've got another question on the screen. What pushback do you get from investors on investing your stock? And do you see that changing over the course of this conference?

One of the things I've really learned at this conference and -- is that we have -- we spent a lot of time with investors. As anybody knows who's called, we try to be hyperresponsive. We stride to serve many very well. And we are trying to be as transparent as we can be without selling our market on our conference calls. But what's been curious even just in our meetings today is realizing that we can do even a better job of communicating the stability of what we do to investors. And it's been interesting to see the kind of epiphany that some folks are having that, "Oh, you're -- I'm proud, you're the #1 stock in our Bernie basket." That's very interesting. It's the, "Hey, I noticed that with coronavirus, well, nothing is going to change in your business as long as all of us don't get it." But it's a -- it's seeing people starting to reflect that back in a way that we really haven't heard before. And so I can easily imagine we're going to do a -- double down our efforts to be -- communicate during this time. But I also can see a re-rating of these stocks because this is a time where folks are going to see how our stock reacts to this adversity. And I think people will start taking a differentiated underwriting approach. And what becomes clear as we look over the next 10, 20 years, it's going to be moments like this that continue to take that premium to treasuries on our yield down, down, down, down, down. So that's what I learned.

Great. Questions in the room? Well, I'm done with my list. So let's wrap it with these rapid-fire questions.

Got it.

Lindsay hates these questions. She says she doesn't fit in any of these categories. Okay. Let's get to the -- let's get to these other ones. What will the 10-year treasury yield be 1 year from today?

1.8.

And what year will the U.S. enter a recession?

2021.

That's a long thinking for next year.

We think a long way out there, right, Manny. In fact, with recession, the thing that's interesting is people have asked us, is it going to be ones in Washington, D.C.? Well, Washington, D.C. has nothing to do with us from a recession standpoint. So for us, there actually never is a true recession because the government just keeps chugging along.

All right. That's it for me. Thank you.

Okay.

Thank you.