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

Hey, there. Good afternoon, everyone. Welcome to the 2:45 PM session at Citi's 2022 Global Property CEO Conference. I am Manny Korchman with Citi Research, and we're pleased to have with us Easterly Government Properties' CEO, Bill Trimble. This session is for Citi investing clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast at the end at the AV desk. [Operator Instructions] Bill, we'll turn it over to you, and I think you're going to have me on screen hopefully soon, so you can actually see me. Bill, we'll turn it over to you to introduce Easterly and any members of the management team that are there with you today, and then we'll come back for Q&A.

Thanks, Manny, and thanks, everybody, for coming today. We really appreciate it. And it's just so wonderful that Citi took the lead and having this terrific conference. We missed it very much, and thanks for getting everybody organized. I'm joined to my left by Meghan Baivier, who is our CFO and COO; and also by Lindsay Winterhalter, who is Head of our Investor Relations today. I just want to just take a quick second to take a look at 2021. I'll keep it brief. But it was such an outstanding year for us that we had a moment in our Board meeting a couple of weeks ago, but we really wanted to take a look at what we accomplished. And I think record acquisitions, $412 million for our team. Our hats are off to them. Meghan's hard work with a terrific year in the capital markets, but also a year where we saw the new JV that we created with an international global domestic. We have about 5 different names from an investor, but a wonderful partner who have allowed us to explore different ends of the market, and it's been a terrific opportunity for us, and we look forward to doing a great deal more with them in the future, which allowed us to do the very large transaction with 10 VAs this year. But I think the big theme for us has been inflation, and that's a wonderful thing for Easterly Government Properties. It's not wonderful for everyone, but it sure is from us. And if you know our leases, we're unique in that we get to move them up every year with certainly the operating expenses with the urban CPI. And secondarily, it's been unbelievable for us and our ability to negotiate with the federal government because there's one thing when we're renewing buildings that they understand is inflation because they're basically responsible for it. But luckily, they also have a printing press in their basement and are able to keep cranking on that as well. So it's been a great opportunity for us to be able to hopefully enter into some terrific negotiations in the years ahead.

Great. With that, we'll open it up with our kickoff question here. What are the top 3 reasons an investor should buy your stock instead of any other listed property company?

I think, again, I'm just going to hit it with inflation protection. It's embedded within our leases, and I think it's unique to us, and it's certainly a good thing to have with these uncertain times. I think as we've said every year, the creditworthiness of our tenant, the federal government is unique, and another great place to be certainly during troubled times, we think all the time. And finally, we've delivered a 3% to 4% earnings growth rate with a 5% dividend backed by the full faith of the U.S. government. So I think those 3, Manny, sum up what we deliver.

What do you think is the biggest growth opportunity that you guys have that the market isn't giving you credit for?

Well, I think it's going to be the inflation fuel renewals. As you know, we're based on replacement cost, not local market rents. And an FBI is a lot more expensive to build this year than it was last year, certainly up 7.5%. I was seeing reports this morning just on basic commodity pricing. And so, with this mission-critical portfolio and the construction costs of -- the only thing they can take is that, as you know, Manny, is somebody building another build-to-suit building for the tenant. And that is becoming more and more unlikely by the minute with what's going on. We're even seeing some of the developers that were sort of dipping their toes into this market exiting. And so, I think as we get to those renewal conversations with those contracting officers, they're going to try to get things squared away as quickly as possible, and we've got a lot of more room to navigate.

Maybe walk us through sort of any changes in that lease negotiation process with that as a framework. So are they trying to take longer? And are they trying to take shorter, you're trying to take longer? Are you guys aligned in just getting this done whenever it gets done? Do they actually even think about the fact that inflation is what it is?

I think that's a great question. I'd love to say that your federal government has just kind of immediately pushed on the accelerator and call up stuff on the phone and start moving things ahead. I think things are probably moving in regular order, which is the way the government usually proceeds. As you know, there's a huge stack of these leases on every one of these contracting officers desks and there's only so much time and so much effort they want to put into each one. But I think where they had reasons and many reasons we get into discussions that could take up to several years as to why we were increasing rents as to why we're doing this and that, I think it's quite clear to certainly federal employees and certainly in their own lives, what inflation is doing. And so, I think it just makes sense to them. And to answer your question, yes, I mean, I think we walk in with a little straighter and a little stronger stride when we walk or -- actually, we do it all by written word mostly. But I think our negotiations are greatly strengthened.

Use a lot more bold text.

Bold text. Angry text, yes.

Now, Meghan, as we sit here, and I know you're very good at kind of grounding us. So, as we sit here and talk about this, I want to figure out how should this translate to actual whether it be lease renewal spreads, whether it be actual cash flow? How long does this actually take to flow through? Because I know that I'm always tempted following these things to go back to my model and say, "Oh, inflation is 10%, all the leases rolling are going to be up that, but that's just not the way it happens". So help us get it back to sort of dollars and cents.

Yes. I think really, as Bill said, it's that force behind us that we walk into the room, and we come in with a bid from the government or a perspective that the government might have, and we've got an ask and we engage with them on a back and forth basis, right? It's ability for us to know that we're leaning in. We're leaning in hard because we know the development cost. Obviously, we have a development team who is better than anyone in the industry at underwriting these developments. And so, it's just that extra little bit of push in those last final rounds where we stand our ground, et cetera. And we are. We're going into these -- again, we call them negotiations, right, with an assistance to the government in justifying our lease proposal. And part of that has always been and will continue to be looking at cumulative inflation of construction costs. That wind is at our back. Maybe it's not bold print, but it's a nice chart with a hockey stick at the end, right? And so, as we think about that, wind at our back and we think about the renewals that are coming in the next couple of years, as we look at that range in the low-teens to the high-20s, right, we're going to really aim for the high end, if not above the high end. But it's also just over time, increasing the value of our portfolio. Every day, these assets get more valuable, right? So we have an ability to strike a new lease on some of them, but investors with a slightly longer-term perspective should be considering that every day, Loma Linda, right, just accretes in value for these irreplaceable buildings.

I guess, where I struggle in conversations with investors on that point, though, is that, you're actively out there buying assets as well. And I think people think of you more -- as more of an -- rightly or wrongly as more of an asset aggregator than of this growing internal cash flow, whether it be because of expense bumps or leasing. How do we bridge that gap? Like if these assets are, to your point, accreting daily, that means that you're paying up for them more every day or not. And if it's the -- or not, how do we get there?

Yes. So, to kind of circle back also to your prior question, Manny, right, what we're talking about here is the wind is at our back and creating that low single-digit, call it, 1% to 2% same-store NOI growth over time. That's what a perfectly rolling portfolio with the type of spreads that we aim to get [ wood ] garner. And that's really what sits at the base of our long-term, we say 2% to 4%. We certainly performed at the high end of that range over the last 2 years earnings growth. But you're right, that does take the acquisition engine layered on top of the renewal story that we have internally. And we've done some really interesting things in the last 6 months to continue to support our cost of capital and be able to engage on the acquisition side, right, as we have this real strong underpinning on the existing portfolio. We've got an ability to transact in what we call our bread and butter. Last year, our average cap rate was a 6% cap, but you know the big VA portfolio is at 5.25% cap, but we can certainly transact wholly owned in the bread and butter stuff. And if we see portfolios or we see large flagship assets coming closer to 5.25% and even shy of that, where we've got a fantastic relationship with a large global investor who is keen to put billions of dollars into this space where we can also continue to grow a relationship. So, I guess, really the same-store piece is the underpinning, but the pipeline is absolutely -- is critical, and we're continuing to stay active in that market.

On that last point you made there on building the relationship, that's building the relationship with who, with the investor or with the agencies or someone else?

Investor. Yes, our new global partner. Fantastic partner. Really understands these assets. Really has a perspective on them. We've talked a lot in the past years, right, about thinking about our story as a spread to treasury investment. They share that lens, which I think is really, really critical. So, continuing to grow that relationship.

And what does that look like? Is that more portfolio deals with them? Is that more single asset deals? What does growing that relationship maybe look like here?

Yes. I mean, I know -- we know that they have billions to put to work, and the return profile of our assets works well for them. The relationship with us works really well for them. And they might just -- the nature is for them to move programmatically, right? So that would be the way I think we would continue to interact with them in the future.

I've spoken to some other investors, direct investors in this space, not equity investors, and they talked about only looking at assets that had much longer lease terms than even what you guys are sort of looking at buying. What are you seeing out there, either from your own appetite for buying or what's your targeted lease term and from your competitors?

Well, as you know, the most recent portfolio that we purchased is 20 years, and I don't think it's possible to buy anything longer than that in the United States federal government. We averaged 19.5 years because 1 building is at 15. But I think as you know, Manny, for us, there's 2 sides to coin. And I think that a lot of the investors that are dipping their toes into this space, like those longer-term leases, they think they can put them on the shelf, which they can in many ways. But from our standpoint, we've got an incredible team at Easterly. And so, when we purchase a property, I'd say, we'd rather see they roll in 5 years or 4 years, and we're going to see a nice up on those properties. And we know how to go in. We know how to manage them. We know how to power spray them and we know how the federal government likes. We know the FBI likes a lawn and the DEA likes parking lots. But seriously, I think we can add a lot of value everywhere in the time frame of these leases. And so, we are rather agnostic. And in fact, we're probably going to get a better deal on the shorter-term leases, and we're probably going to add more value in those. But we -- as you know, we're almost like a laddered bond portfolio now with 89 buildings. So we have a lot of different lease lengths. And I think we're happy at anywhere on the spectrum.

Maybe we'll dive into some of those acquisitions. What does the pipeline look like today and remind us where your guidance was for the year?

Yes. And so, we've bifurcated it this year. We wanted to make sure that folks understood the difference between this portfolio that we are executing on right now, and that's very large. But we're looking at about $140 million worth of the JV, new VA outpatient clinics this year. And at the same time, we're looking at doing from $200 million to $250 million in our regular way transactions, which would look very much like the sorts of things we've been buying ever since we started our first private equity fund. So the wonderful thing here and Meghan pointed out is that, as you know, we only do accretive acquisitions. And I think that's very important. But in these times where you're seeing interest rates and cap rates going in different directions or certainly not moving where they should at some point, and we can go into the reasons for that, it's great to be able to have a partner that realizes that these assets are worth a great deal and that we can continue purchasing them, particularly, it keeps anyone else from owning them. And we don't want someone else coming in buying $630 million with the 20-year leased properties. It would be a toehold. And even though I don't think they do a very good job at -- certainly not as good a job as we can do running them, I think that they belong at Easterly, and don't forget, the value and the scarcity is the buildings. There's only about 550 of them and we really do need to own them, but we've got to do it accretively for our shareholders. And I think that's what we've been able to put together with the new JV.

Right. And if you think about the reasons that some of these owners go to sell, have those changed in recent sort of days, weeks or months?

No. I don't think -- I don't -- I tell you every year that the reasons are, Manny, and most of the owners of these buildings are regional developers and been very successful in developing on the government's behalf. And I said, I think last year, virtually that I thought the tax regime during the Biden administration would probably change and push some sales. I think that's still on the table from what I'm hearing. Obviously, Senator Manchin is in charge of that right now. But I think that also at these current prices, a lot of these owners, first of all, they're looking usually at a renewal and somewhere in the future. And so, they know that we're probably going to do a better job of it. And by the way, we'll give them credit for what we will have done on that renewal. And so, I think that -- and I also think that there's a state planning reasons for a lot of these folks and the pricing. I mean, maybe -- I don't know if we're going to top [ tick ] it, but it's pretty darn close. So we're pretty excited about what we're seeing out there, and that's, hence, those sorts of numbers that we're putting out.

Is there any exclusivity with you and the global partner that you formed that JV with? Can you do another JV with someone else if you wanted to?

Yes. No, we're not handcuffed in any way. It's a great relationship. I think they acknowledge us as the leading manager in this space. But we have flexibility.

And do they, Meghan, have any either desire or force to have some type of volume come from you over some time frame? Is that a -- let's get to $5 billion over 5 years? Is it anything like that?

Yes. There is -- I would tell you, we're not limited by them, right? Exactly. If we can change that in with a $1 billion -- they'd do it.

Right. And maybe that's more of the question. But they're not forcing you to -- or encouraging you to do that in any way beyond what you'd be comfortable doing?

No. I mean, the relationship is absolutely an agreeable one. I think we would both be interested, right, in something more programmatic, so that we understood what the goals were and an ability to continue to grow the relationship versus one-offs here and there. But no, there's no limitation to size.

There's a question here in the live QA. How is the buy box for the JV different than on balance sheet? Like what are the cap rate ranges?

Yes. So, obviously, we saw them transact with us, alongside us at a 5.25% cap. They're paying us a 40 basis point asset management fee in the joint venture. So right, that's a 4.85% cap to them, and they are thrilled. And obviously, it takes us to a 5.65% capital level where we can deliver some good accretion for shareholders. We know they're very happy with those economics. And I think that today continues to be the market. So, the box is one that accommodates the current landscape of acquisitions.

And is the determinant for balance sheet or JV pricing, asset quality, asset location? What's the filter?

It's going to be pricing for the most part, because they're going to be the highest quality assets that our JV partner interested in and usually longer-term assets. But as you get -- obviously, at quick Citi conference, you get us to $29 a share, we're not going to be able to do quite as many things with them. But I think it's fallen out just perfectly. We have different goals, and I think this partnership will work well.

Meghan, I want to go back to -- and maybe this is just semantics. Back on the [ re-Q ] call, I think there's some confusion as to the accretion from the JV. You just talked about the 5.65% sort of cap to you, and that is accretive. I was under the impression the messaging was more that it's not really FFO or accretive, maybe it's a little bit AFFO accretive. So, when you talk about accretion at a 5.65% cap, like if you were to do -- tomorrow, you woke up and your acquisitions team's dreams came true and you did another $1 billion in this JV. What's the accretion to 2022 from that, aside from your guidance of on balance sheet assets?