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

We'll go ahead and get started. Good morning, everybody. I am Bill Crow. I come to you from Raymond James. I cover the hotel, office, industrial and kind of assorted different strategy REITs as part of our team. Very pleased this year, first of all, to be back in front of anybody, because it's been a weird 3 years, 2 or 3 years, but it's -- and it's great to see everybody in person again. Second of all, to be here and introduce Easterly Government Properties. We've covered since the IPO back in what feels like '16 or '15?

'15.

'15. Time flies. Bill Trimble to my immediate right. [Technical Difficulty] to Bill is Meghan Baivier, I always mess up that name, Baivier, who is their CFO and COO. So we have 3 positions represented here today. And I guess I always find it helpful, first of all, to just take an informal approach to these meetings and let you all ask questions as you may have them.

Second of all, Bill, if you want to just spend a couple of minutes describing who you are? What differentiates you?

Absolutely. And I think when it comes to differentiation, we are the most differentiated group probably here today. We only have one tenant, as you probably know, our United States Federal Government. We have a few -- actually, we have a few delis and a few spots, too, but mostly, just the United States Federal Government. And we've really been doing the same thing since 2010 when this idea came to fruition as a private equity fund and we went public, as Bill mentioned, in 2015. And we have really stayed to our knitting, and that is to try to find the absolute finest bullseye properties that are leased to mission-critical agencies in the United States Federal Government. So I always try in these meetings to say something new and different, but I think I'd get dinged if I said something new or different, so I will stick to the knitting and say that it has been a wonderful experience, and we continue on that opportunity.

So just help us understand who those tenants are? More specifically, what agencies make up the bulk of your tenant base?

So the United States Federal Government has 500 agencies, departments and bureaus, which surprises some people but doesn't surprise a lot of other people. It's massive size. It's the largest employer in the world and the largest office tenant in the United States. We are interested only in about 3 dozen of those agencies and not surprisingly, they're ones that we believe that whether you're a Democrat or Republican, you agree it's a fundamental mission in the United States. So we call them, I don't want to say probably a nice positive term, gun-toting agencies. A lot of them FBI, DEA, the federal courts, so FDA laboratories are very important. So these are missions that really need to be handled in buildings, secure buildings, often Level 4 buildings located all throughout United States.

So that's really what makes your -- I'll call them office properties, just to kind of throw them into a bucket, differentiated from more generic office properties. So they're purpose-built. Is that fair?

Absolutely, Bill. They're purpose built. 85% of what we have are build-to-suit properties, and all through the pandemic, our folks are still coming into work. Not only our folks, your folks, I guess, were coming into work. FBI not able to arrest people from their living room or their basement, and also doing all the federal courts and all those other important missions, collecting the taxes and so on and so forth. So they were busy and operating during the pandemic.

And I guess we should look at government as a growth business. Is that how you think about it from a -- I know development, for example, is not necessarily a real big part of your -- I mean, it is a part of your story, and we can get to that. But are they growing their footprint in a way that will kind of set a path for you going forward?

I think that's why we really concentrate on those 3 dozen agencies. Because I think, overall, the government sort of grows with the size of the country. I think it's just -- that's how it happens. But we don't want to be sort of adrift in a huge -- waiting for the tide to take us one way or the other. We're really looking for those agencies that we can look out for 25 to 50 years that are going to have missions, that are going to necessitate them having support buildings and continuing to expand during that period of time. And the government itself, just to give you an idea of the entire budget for the GSA, which is General Services Administration, administers almost all of our buildings, is -- was $5.5 billion in '21. It's $5.85 billion in this year, so $350 million increase, and I can tell you that's all going to leasing. The amount that they're spending on all of their buildings is only 100 -- they got -- it was $130 million or something. So you can imagine how $130 million is going to work on 175 million square feet, not so well. So basically, the footprint is in the lease space, and that's where it's going to continue to go.

Can we -- there's a lot of money floating around there. We were talking about that earlier today, whether it's a Blackstone or a Starwood or a myriad of other domestic and global players. But you have, what I viewed historically, as kind of a competitive advantage in sourcing deals as well as on the development front. Maybe you can describe what gives you an advantage against just folks with money?

Well, I think when we started, and we did this back in 2010 as we sort of put together a purpose-built organization with interesting verticals in it that I think is unique. We have government experts, but all those experts also have private sector experience as well. And so we immediately went out and cataloged every building the United States leases, and that's a very large number, it's about 7,000. And that's how we got to the 500 GSA and then later, the 50 brand new VA outpatient clinics that would be part of that, a little under $30 million -- $30 billion in value. And so we got the opportunity to get to know every single one of these owners of these buildings that, not surprisingly, are a lot of times regional developers that have been very successful and to learn how to build on the government's behalf and might own anywhere from 1 to 10 or 11 of these facilities. And so to come into our business from the outside is difficult because, a, you got to know who all the people own the buildings; b, you've got to have a relationship with them. And I think this has been an area that has not been as institutional, Bill, or some of the other areas that you are familiar with. And so a lot of times, these were sort of syndicators. We call them doctors and dentists that we were competing with certainly in the early years. And so I think we've built a really credible reputation of being able to underwrite these facilities and to execute on those transactions. And I think that's really held us in good stead to date. I think we're still probably 50% off market when we're making our purchases.

So let's talk about the lease structure, because I think people are trying to figure out where does -- and I'll call you a net lease REIT, and I think you probably would play yourself somewhat of a net lease REIT.

Modified gross.

Modified gross. But I think there's 2 or 3 different aspects to that. First of all, you've got longer duration leases without bumps, but you're protected on the expense front as well. And I think it's worth -- given the inflationary environment and the rises and the increasing interest rate environment, it's worth exploring what gives you not only protection but would also provide some growth.

Sure. And it's interesting, we would talk about our lease structure for a good 5, 6 years, and it just kind of plays over this aspect of our lease structure to be obviously become highly critical in this inflationary environment. But our leases are comprised of a shell rent that generally doesn't have any bumps. We obviously set a real estate tax space in our lease, and so we're responsible for real estate taxes. But increases in real estate taxes above that base year get passed on to the government. And then we also set an operating expense base in the first year, and that operating expense base accretes every year with urban CPI. And so if urban CPI is up 8.5% in a particular year, the subsequent year, our OpEx base goes up by 8.5%. So to the extent that we can keep our actual operating expenses right inside that CPI level, we may even get a little bit from that spread between the base and our actual expenses. Certainly, it provides insurance for NOI shrinkage over the term of the lease. So obviously, very critical in the last year, as you all might imagine. But then sort of once we get to the end of the lease, obviously, what this environment has also done for us this inflationary environment, we joke a bit. We sort of [ love and push ] because it is absolutely turning the wind at our backs in the renewal conversation. We come to our renewal conversations, we put on our developer hat. Our tenants' only option is to stay in our asset or having another one purpose built for them. And so we look at that replacement cost, we obviously have a development team. We have a unique ability to create those insights and understand what the alternative there may be in a re-leasing process for the government and deduce where in that spread we can come in, maintain a discount to replacement cost, but get a nice pop from that expiring flat show.

So when you say it's the only alternative is -- and that goes back to that earlier point, which is these properties have laboratory facilities or jail cells or courtrooms.

No jail cells.

No jail...

We don't do jail.

Nobody stays overnight.

[indiscernible] overnight.

We never ourselves, yes.

But that's really -- so the fact that we are seeing an extreme amount of turmoil in traditional office space is kind of beside the point for you all, right? It's...

Relevant occupancy or absorption rates in the markets where our assets exist in the office or in whatever subsector you may want to look is truly irrelevant to us because at best that facility would need to redevelop itself, right? You had a vacancy in the building. It would need to redevelop itself and be able to accept a ton of TI for the government -- on the government's behalf to be able to service the mission of the tenant.

So the risk really as you get to the end of the lease, the mark-to-market, given what we've seen in inflation, and development cost is fairly significant.

It comes to play, by the way.

Yes.

The developer even is willing to put in the...

It's an important one. We've seen them...

We're seeing developers sort of back out of that process because it's -- you've been on the government's time line, right, and that ability to truly forecast the cost in a time line where you're mainly not building for 12 to 24 months, we're seeing some reticence for the developers.

So how often does that happen though that you lose a tenant to a new building?

We have...

One.

One in the history of the company and it's a small 30,000 square foot building.

So you are also active on your own development side. And are those going to take -- take tenants that were in other buildings? Or is this an expansion of an existing facility? Or could you talk about that?

Yes. So the predominance of our development has been in the FDA laboratories. And there is a very old FDA laboratory footprint that is being remissioned. And Bill can talk a little bit about how we diligence and understand the tenant agencies and when those remissioning events happen, and having a young portfolio is critical to insulating against that. But nevertheless, the FDA is moving through a programmatic redevelopment of its laboratories. So they're moving out of very old, outdated facilities into the new assets that we're building.

Talking about the increase in interest rate environment. How is that impacting your acquisition yields? And maybe has the playing field changed at all as far as the number of participants, who those participants are? Anything that you're seeing there.

Great question. And I would say that I've said -- I say the same thing every year. I might say something just a little bit different this year in that some of the most pristine assets out there, some of the larger assets, think our recent FBI purchase in your neighboring town of Tampa. These assets are being pursued by international capital now. They're very interested in long-term nature of the leases. And so we've seen some new players, especially in the new buildings, for the first time in the market. Our predominant competitors have been several private equity funds that have been raising money depending whether they're in or out of the market. We still have a better cost of capital than both of them, so we can buy things accretively where they can. I'd say, overall, the interest rates in the market. I think we are -- we've seen every one of your asset classes probably start -- the cap rates start moving up. I'd say that we are skedaddling right now at probably the lowest cap rate. It might look like it might start moving. It depends on whether you're looking at super-duper bullseye properties or what we call the plain vanilla assets. But I think that we probably will see a turn here at some point. Meghan, anything?

Yes. No, I think we've seen those levered IRRs really compress. There's been a bid for the stability in these assets relative to the uncertainty of office, and so we're sort of -- we're dancing right around some of the lowest cap rates that you've seen in the space.

Is there any pushback from the government, having a foreign owner of a FBI building?

Yes. The -- usually, obviously, it's a U.S. organization that will own it. But they're not as happy about it as having a domestic owner, but our Salt Lake City, FBI, was owned by the Qataris. And I will tell you that there's no way anybody is going in any of our facilities unless they're being accompanied by an FBI agent, so I think they've got a good handle on that. They're not particularly worried about it. If you are in some countries or sort of on the No Fly List, you cannot own an FBI facility.

They can't develop them.

They can't develop them. They don't -- yes, just assume the bugs don't get placed in there at the beginning of construction, so.

And fair enough. You talked about cap rates potentially bottoming here. At what -- what's a good average cap rate on a bull's eye building for your portfolio?

Why don't we take one -- it's an interesting transaction, I think, which is the FBI in Baltimore. I grew up in Baltimore, I'm familiar with Baltimore. And maybe not -- the moniker Charm City might not be true, but in any case, that FBI went under contract with the [ 5.15% ] cap. There's only 9 -- 8 years left on the lease.

Not to you. You didn't buy it.

Not to us. It might have fallen out, but we think it will go again at that cap rate, and so I think this is an older facility. It was built in what May...

15 years ago.

15 years ago, not in the great section of town at all, out by the Social Security Administration on the Beltway. And if you look at our cap rate right now for our entire company, it's probably a little north of 6%. So there is a fundamental disconnect on what's going on in the public and private markets when it comes to valuation in a particular space.

We'll take a second and see if there are any questions in the audience.

[indiscernible]

Let me just repeat the question so everybody can hear it. The question is on the CPI adjustment on the expense front, and whether it's more difficult for you to operate in a higher CPI environment or a lower CPI environment. I believe I got that correct.

[indiscernible] easier, definitely easier in a higher rate environment. Yes.

And I think in renewal, and I'm going to say, I think in renewals, too, the lease contracting officer who's basically in charge of your renewal, the one thing they understand -- obviously maybe understand 2 or 3 things. But the thing they really understand is the cost of inflation. The government does because they're very much a part of it. So when they had arguments before as to why they didn't think you needed to renew 25% up or 20% up or whatever it might be, that is much more difficult today. And as we've said, if you're competing against the developer that can't figure out the risks involved with interest rates, it's a wonderful position to be in going forward.

Why do you think is spread between the private and public market persists, I mean, the market is [indiscernible].

Yes. So...

It probably should be.

Should be.

Yes. I mean, when we look at our joint venture partner, for example, that partner is very emblematic of this private market bid for our assets. And I think, put plainly, there's a much stronger bid for growth amongst the public investors today, right? There's just this -- the time horizon, the investing time horizon is different. The ability to leverage assets is different. And so those -- that -- I think that's just creating the sort of just in preference time, time horizon, hurdles in the public market versus a lot of where the bids are coming from in the private market.

I think I've worked with the group for a long, long time. I will tell you that more times than not, the private market valuations are higher than the public market valuations and across all different sectors. I'm not sure exactly why that exists, but it does. Maybe higher use of leverage or something on the private side, but they tend to bid more aggressively on assets. Let's talk about capital allocation for a second, because you've got a couple of different things you can do. Obviously, the acquisitions have grown this company from very small to very sizable in the 6 years or so, 6, 7 years that you've been public. You've got a couple of development projects that you have been underway, but now you've talked about share repurchases. I think there's questions each quarter about the dividend? And maybe you could talk about how you're prioritizing this and the opportunities that may lie ahead?

Sure. So with this dynamic, we just spoke about in the private versus the public markets, right? It's a natural question for us to come to and look at our own portfolio and say, what is -- is there an opportunity to recycle some capital? Should we be thinking about what the private market might value a particular subset of our assets relative to the public market in addition to watching for the acquisition pipeline and where opportunities might be out there? So I would tell you that shame on us if we weren't looking at that right now in terms of our ability to perhaps recycle some capital, so that's certainly a conversation that's always ongoing internally. With that, we did announce a share repurchase authorization that our Board put in place last quarter. It's another toolkit in our tool bag right now. And so whether we are going to need to be responsive on the recycling side of things or just step back and actually think about our balance sheet and where leverage can reasonably fit another ongoing conversation. But good to have the tool should we want to use it. That's the focus right now on how we're thinking about.

How do you see the dividend growing over the future?

Yes. I mean, we -- we have always felt that the right strategy for this business, given the stability of the cash flows, is to have a relatively high payout ratio compared to the other REITs walking around in these hallways today. That has -- unwaved, we've been unwavering about that. That will continue, and expect that to continue to be the case. It's a very healthy dividend today. It's always been our expectation that as we continue to strive to earn -- grow earnings over time, the dividend with follow, and there's no need for that payout ratio to really create any sort of buffer to the growth.

So when you came public, you had a string of years, call it, 3 or 4 where you didn't have much in the way of lease expirations, and so it was hard to prove out the thesis of this mark-to-market that existed. Can you talk about kind of the lease expirations over the next couple of years and how that might drive your future growth?

Yes. You're right. That's just the nature of when a lot of these assets were built. They were all built in the early 2000s. They've been now, in the last couple of years, come up on their expiration. And when we look at our bull's-eye properties, we're looking at an opportunity to get high teens to low 20s type spreads. And we are seeing that, obviously, the easier assets to renew in the portfolio include some that aren't -- that are a little more plain vanilla, and those will renew quickly with little TI. Obviously, the bulls-eye type assets are going to require some TI at the moment to really look at the assets for the next 15, 20 years and ensure that they are getting what they need to keep it to mission. But that thesis has played out and we expect it to continue to play out, particularly again with that inflationary tailwind that we're experiencing. So this asset class historically has renewed kind of 94% to 96% of the time, if you're -- we don't sleep at the wheel, obviously built an organization here that is purpose-built to underwrite and then renew these assets. So we strive every day for 100% now.

And just so investors can get -- kind of think about the future growth, I think you've gone out with forecast of 2% to 4% growth for this year. I think that's been fairly consistent, 2% to 3%, 1% to 3%, somewhere in that range. Annual FFO per share growth plus the dividend, plus you're creating some NAV through your acquisition and development projects. That's the right way for people to think about it longer term?

Yes. It is the right way sort of, I think I would say, sort of inverse to maybe what you're going to hear in the triple net space where you're going to hear that low 2% to 3% dividend yield with the flip on the growth. But we have a market that we are constantly now looking to acquire within, but that market is not a multi-trillion dollar market. And so that is -- we're always active. We've proven an ability to stay very active year in and year out. But that's something that we feel we don't actually want to go out and be, what we call, the elephant in the swimming pool go, hoover up $1 billion worth of assets, create the new 4.75% cap rate in our space. We just don't think that's the right formula for long-term shareholder value growth in the company.

So how big is the acquisition opportunity? You talked about 7,000 assets out there that you looked at. Clearly, most of those wouldn't fit your strategy and your quality barriers. What -- what's left to acquire out there?

Sure. So it's about -- it's a little under $30 billion worth of buildings in our entire universe. Obviously, there's some other large portfolios out there. So if you ask where we're going to be 5 years from now, I think we'll probably, at some point, own one of those portfolios. I don't know the exact timing of that, but I think that's naturally what had occurred at some point with some very high-quality portfolios. We have always said our as Meghan mentioned, our growth rate at a level that we could do off-market and marketed transactions to hit those numbers every year, and I think we've been very successful doing that. Obviously, with our large acquisition of a brand-new VA outpatient facility portfolio with our joint venture partner, we were able to put a large number of assets in the bag, so to speak, and do wonderful things, I think, for the metrics of our entire portfolio, while at the same time going out there and doing sort of the ones and twos. But I will assure people in this room, we do have a number of rules. And one of them is we do -- we don't do non-accretive acquisitions. We don't think that makes a lot of sense, and we've been very careful there. So we're not going to do a flurry of acquisitions just to look terrific. We are going to be very careful, we're being measured. And right now, we are looking, as the FBI, Tampa proved, at only the most pristine assets that are expensive. We're not going to go out and overpay for something. It just doesn't make sense.

Right. More chance for questions from the audience.

[indiscernible]

Yes. This is something we looked at last year, and to Meghan's point, putting new tools in the toolbox. And it became clear to us that we want -- with this finite universe, we want to control all those pristine assets Because that, in the end, is the value of our enterprise. And so when we were seeing last, I think, sort of last year, this time last year, that was more and more difficult to purchase. That some of these properties were going at the 5 -- under 5 1/4 cap, 5 cap, and so on and so forth. And that some global, very educated investors were interested in spending down into [ 450, 475 or 485 ] into these and thought it was a very good transaction and then paid us a handsome management fee, which would allow us to do them accretively and keep those assets under control. It was a real win for us. Obviously, we're not doing -- our partner is not doing this for just those 10 assets, they'd like to do 10x this and can. And so for us right now, I think it's quite easy because you can look at those super expensive assets that might be a longer term, 10 to 20 years, they would love to own those at 50-50 with us and have us handle and manage them. And then on those other assets that might be a little higher cap rate that look more like their average portfolio company, that's -- we do those on our own balance sheet. So there's really no conflict when it comes to making those purchases as to whether the shareholders are going to own them 100% or they're going to own 50%.

Just one follow up. [indiscernible] can you kind of relate those things together?

Sure, I'll do my best. I think they're not at all, it's with one another, it's probably the starting point, right? So we opened up an ability to go into that lower cap rate, higher flagship quality asset by creating the joint venture partnership and that relationship which can grow. So think of that as we're now able to do deals that we might not have been able to do before, so additive, not in conflict with doing the deals that we've done for 7 years as a public company. And so while we've now got the benefit of both sides driving that long-term earnings growth for us. And then the recycling capital, what I would tell you is just sort of on top of that, right? So that's going to be an ability to create a little bit of -- perhaps a little bit of NAV accretion, right? Because that's -- those are going to be -- we're not going to be selling if we were selling asset at [ 4.75% ] asset today, right? So that's going to be about up-tiering the whole portfolio. And I don't want to get into the details, but we look to do that in a cash flow. Neutral, minimized cash flow position.

Can you talk about the FDA opportunity, talk about how the remissioning were initiated? How many buildings are there and how are you undertaking this?

It's a huge undertaking, probably about 9 throughout the United States. FDA has not been on the cover of Good Government Magazine here in the last little bit, as you've noticed. So they kind of get their ducks in a row, but the labs are extremely important. We've developed -- this will be our third. We've won every one. We're not going to win them all, but they are tremendous opportunities. And obviously, we will be bidding on them. We think the government will probably own themselves a couple of them. But other than that, we think it's a terrific pipeline, probably one a year and starting in another year or so.

We are out of time. I'd like to thank the management team for the presentation today. Thank you all for joining us.