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

Welcome to the 8:10 AM session of Citi's Global Property CEO Conference. I'm Michael Griffin with Citi Research, and we're pleased to have with us Easterly Government Properties and CEO, Darrell Crate. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the website and at the AV desk. [Operator Instructions]. Darrell, I'll turn it over to you to introduce Easterly and the team, provide any opening remarks, tell the audience the top reasons and investors should buy your stock, and then we'll get into Q&A.

Sure. Well, Griffin, I really appreciate you hosting such a great event here. I also appreciate the fantastic audio, so we can all have the voice of god in this room. We're really excited at Easterly Government Properties. I mean we're very -- we're unique in the REIT sector. Obviously, we're dominated by government leases and our lease role is guaranteed full faith and credit by the U.S. government. We have developed a competitive advantage, definable edge in this space over the almost 10 years that we've been doing this business. And we're just focused on acquiring, developing, managing secure commercial real estate for the United States government. And what that means is we're working with agencies like the Drug Enforcement Administration, the Federal Bureau of Investigations, the Veterans Administration. These are all government agencies that have an enduring mission. They're not going away. They're not influenced by which political parties in charge today. They are services that need to be provided by the United States government to its citizenry. The other enormous advantage is that government grows, it always grows. I mean you can hear on the news and people complain about the government is getting fleeced or whatever it may be. The reality is that government grows with population. You even look back to the Reagan administration. And that is the time the government has shrink the most in the last half a century. And it still grew positively. So that means we're immune to these economic cycles that are -- that I think folks are worried about, particularly related to office. And we find ourselves in a terrific position with financial markets of being challenged, especially in the development space that somebody with our balance sheet and with our expertise, I think we can provide a growth rate that's superior to what we've done over the -- again, I think in recent past, but we're very well positioned to deliver the growth rates that we've talked about on our calls, which is greater than 2% certainly this year and for the years to come.

Maybe just starting off with kind of the macro environment. You touched on the issues may be facing traditional office and what people might think about with government office employment, but that's really not Easterly strategy. Can you talk a little bit about the differentiated nature of your platform and your portfolio and why it shouldn't get mixed on, I guess, with traditional office?

Yes, I mean -- because if you look -- I mean, one of the biggest factors facing office, and we happen to be in the office index for just reasons that are unaccountable to me, but it's true. And if you look at work from home, I mean, gosh, 70% plus of companies are looking at some hybrid method of employees being in the office, out of the office. 20% American commercial real estate space was vacant in the third quarter of '23. That's just not the case at the FBI. And it's refined to saying, you can't catch criminals from your basement, and you can't store drugs that you seized in your wine cellar. I mean you've got to shop at work. These facilities do actually help them achieve mission. And as we've looked at the utility rates because we can't check out the swipe cards of the FBI. But as we look at the utilities, the use of the building, we see that folks have not been working from home in these critical government agencies, and we think that's an enormous differentiator to the office market generally.

You talked about the stability of your cash flow stream over the next couple of years being very attractive and steady. Why does this look so attractive to you now given that there are some REITs out there that have greater earnings growth?

Yes. I mean our stability is exactly what is we are -- we're immune to the economy. I mean it does not matter to us if there's a soft landing or hard landing a crash landing, whatever it may be. I mean, as we look forward, we have just under $3 billion of leases on our desk with 1 renewal at a modest renewal rate, that gets to almost $6 billion. So our cash flows are forecastable. It clear to us, we probably have the most predictable revenue and earnings stream of any REIT that's at this conference. And so we can tell you how we're going to grow and what we're going to do, and compare that to the others. And if you just look at the underlying certainty, I think it's a very attractive opportunity, especially where the dividend yield is today.

And to that end, guidance implies a slight increase in earnings for 2024 relative to '23. What can you do, be it on the internal and more external growth front to drive earnings even higher?

Yes, we guided last week core FFO for the full year 2024 from a range of $1.14 to $1.16, which at its midpoint represents slight earnings growth year-over-year. And that is predicated only on the acquisition of our [ 10th and ] Final joint venture property as well as $100 million to $110 million of gross development spend on our FDA Atlanta asset. The guidance does not contemplate any additional acquisitions yet. However, we are seeing a strong pipeline of growth, and we'll seek to increase guidance in conjunction with those deals materializing. And in the meantime, we're focused on internal growth factors like managing G&A, identifying property, operating efficiencies and maintaining our investment-grade balance sheet, which allows us to access a lower cost of debt.

Maybe just starting to touching on external growth opportunities. It does seem like deals are coming back to the market, at least a bit more and the pricing seems pretty favorable. How are you positioning yourself to capitalized on these opportunities?

One of the biggest opportunity sets we see today are these mission-critical assets that need to be developed by the government regardless of the economic backdrop that we're up against today. These are properties, just like those we own in our portfolio today, FBI field offices, VA outpatient clinics and being able to address the needs in our space that developers have by bringing capital to help finance and ultimately own those assets is where we see one of the biggest opportunities for Easterly in the coming quarters and years.

And I also wanted to highlight that this morning, you announced that you've been rewarded a 20-year noncancelable lease for the development of a Courthouse in Flagstaff, Arizona. How does this fit in with Easterly development and long-term site sustainability traction?

Yes. I mean as we look at the Courthouse, we're really proud of this win and I think it earmarks the wins to come. As we look through the bidding process, it was clear that our definable edge in this space is what enabled us to win that award. It's also exciting because it is our first net zero project. And as we look forward, obviously, ESG priorities are going to continue to have a varied importance to the U.S. government, but it's terrific to be able to bring this project forward and show our commitment to sustainability goals.

And then Darrell, I'd be curious to get your thoughts. Do acquisitions or development opportunities make more sense right now?

I mean it's development hands down. I mean because if you look at developers in particular, what -- in this market, maybe just stepping back for a second, developers that we've competed with for the last 1, 2, 3, 5 years basically Fed made money free. These assets can be -- have been able to be materially levered in the private markets. So for us to compete with them, they've just had very high leverage, and they could put 10% down really some very, very attractive financing terms. That's gone. So today, we find ourselves in from a financing advantage and experience advantage, and that certainly provides an opportunity because these developers need to develop, but standing next to us, I think we can do a really great job for the U.S. government and do some real terrific things for our shareholders as well.

And for those development opportunities, are they contracts awarded by the government? Or maybe just talk us through kind of the process and procedures would go to develop some of those facilities?

Yes. I think there's 2 ways to look at this. One, there's projects that are awarded by the U.S. government, which is what is always we've done in the main. But as we've been sharing, given post-COVID and the government looking to onshore a set of capabilities that are critical to the U.S. government, we are finding that we won't take probably 10% to 15% of our portfolio and develop it into what we're calling government adjacent, which would be very high credit names who work incredibly close with the government. But we're finding the facilities that they are now being asked to develop or very similar to the facilities that we own and that we've developed in the past. So we're finding that to be a very nice partnership. We're also grateful because those leases, the way they're structured instead of being structured in the government flat lease way will be -- will have escalations. So that finally, we can talk a little bit about that sort of same-store sales growth that's going to be programmed in for years to come.

And for the actual development of these buildings, how does it compare to, say, building a traditional office product?

Yes. For us, it's the same. I mean traditional office product is what it is, but we don't build those. For us, we have a tremendous number of features and build-outs, that again, facilitate the mission of the tenant agency. And you look at FDA labs, are they on track to build 10 FDA labs over the next decade or so. We won the first 3, and we're completing our project in Atlanta. We're going to all go down there probably, I think, on Wednesday and take a look at it really well. But this is an almost $300 million project, and it will be the highest performing FDA lab in the country in Atlanta, Georgia.

To that end, you've talked favorably about a lot of the agencies, you had exposure to. You mentioned the FBI, FDA, DEA, et cetera. Are there any agencies in particular that you would like to expand your presence with going forward?

I mean it's not just that our ticker symbols DEA, and that's principally because they wouldn't give us FBI. But the DA is a terrific agency for us to work with. They -- we continue to be able to build buildings that really facilitate mission, and it's been a terrific private-public partnership, and we continue to see that grow, along with we're hopeful on these FDA labs that will be built in the future as well.

And you've noted in the past that the market for GSA-leased properties remains pretty fragmented, and you're of the few notable players in the space. I guess what difference differentiates the Easterly strategy relative to those competitors? And how can you expect to gain more market share in years to come?

Yes. I mean, we understand this space better than anyone else. And I mean it goes back to the founding of the company. We started as an alternative private equity real estate manager, and we go to -- go to those conferences, and we started by raising $100 million because we trotted over to our friends at Angela Gordon and some other terrific folks in New York. And we asked about these government leases. And we found that not only they but all the commercial real estate folks out there had a misunderstanding of how you work the government who are frustrated in how the contract negotiations were. There wasn't a deep understanding of what government contracting officers are allowed to do and not allowed to do. And it was very clear that they also didn't like single-tenant buildings. And that's true in the commercial space. But for us, we noticed we could develop a definable edge working with each of these agencies, understand what their specific needs are. And over the last decade, we've had a keen understanding and it's facilitated our work. We have received many letters of accommodation from the government, from the agencies for the work that we do. And so as a public-private partnership, I think we've crafted something special that serves the American people well and also serves our shareholders with the stability and the enduring nature of the cash flows.

Yes. I'd say in addition to some of the operating expertise we bring to this space, right, the differentiator for us over the coming years that we really believe it's going to be the balance sheet and access to capital, right? We've got a syndicate of banks that are very supportive of the strategy. We have access to the CMBS market, but we also have access to different debt capital sources as a result of being a public REIT, notably the private placement unsecured market as we do run an IT balance sheet.

Maybe touching on the balance sheet then for sticking with you, Meghan. Leverage is currently about 7x net debt to EBITDA, you've done a good job of managing it. If the right opportunity came along, could see leverage tick up? Conversely, where is kind of your long-term target leverage range or maybe Allison can answer it?

Sure. So we have stated we're comfortable operating in the 6.5% to 7.5% net debt to adjusted EBITDA range, and we sit comfortably within that range today. With some of these nonspeculative development projects on the horizon, we'd be comfortable operating at the top end of that range. I think that speaks a lot to the forecastability of our cash flows and our understanding of our balance sheet. We've discussed this with KBRA as well who has provided our stable investment-grade outlook and they are comfortable with that number as well. So we certainly feel like that range is appropriate given our needs.

Maybe just sticking with capital allocation, with shares that are currently trading at a slight discount to NAV versus historical premium. How does this factor into your capital allocation decisions for this year ahead?

Yes. So I think we're always looking at the ability to use our equity to spread and invest. And so as we look out and when we think about the opportunities, not only in the GSA focus but also staying local in these government adjacent. The nature of the deal profiles may look different. And I think you'll see us look to efficiently not do dilutive deals. And where that means you saw us raise some equity in the mid-$30 range in the fourth quarter. That equity we can absolutely put to work in some of these development opportunities and potentially acquisition opportunities and drive FFO growth for shareholders.

So we really need to just look at the spread investing opportunities as opposed to the issuance of equity at a slight discount to NAV. It seems like the opportunities that you see ahead kind of justify the issuance. I know it's a small amount.

Yes, I think it's on the margin growth. But yes, I think it's really important that we are able to capitalize on those opportunities to continue to bring great assets into the portfolio and grow earnings for shareholders and the platform has had ability to grow in this moment, where perhaps the equity is more volatile than we've seen in the past.

Maybe just turning back to the portfolio. It's a very unique lease structure. I think that most people are kind of understand what the traditional office space. Can you remind us how the structure of these leases with government tenants might be different and help insulate them from inflationary effects. I think you've got a good slide here -- Your recent investor deck that highlights the growth potential. So maybe remind us about what the average typical lease term is as well as any concessions in terms of free rent, tenant improvement dollars, how that's allocated?

Sure. So like our peers, these are modified gross leases. However, we have a few key differentiators that are important to highlight. The first is term. So first-generation leases tend to have a 15- to 20-year noncancelable term associated with them. And renewals have often seen 10- to 15-year terms associated with them. So that longevity again, goes back to the forecastability of cash flows. Similar to our peers, they do have a real estate tax base, which we then receive escalations on. And I think may be different than our peers, we do have operating expense escalations that are [ pegged ] to CPI and the urban wage index versus some calculations. So I think for us that -- that protects us against any inflationary impacts of running the buildings, and I think helps us ultimately look out more years than others. In terms of renewals in general, sorry -- as we've recently disclosed in our earnings call, we had renewed 32 leases since IPO. And of that 32, 18 are renewals for which there was either completed TI work or no associated TI work and the other 14 renewals do have pending TI projects. So that's a bit different than the market and that we will receive rents related to TI work once the projects are completed. And when we look to the combined 2.18 million square feet across the renewals, excluding PTO - Arlington and IRS - Fresno, we are seeing average rent spread achieved on the remaining renewals is around 18%, and that reflects about $40 a foot of TI utilized by the government. We would say that there is not meaningful free rent, maybe a little bit different than our peers.

And how does the tenant improvement procurement process through the government work?

When you say tenant improvement in the Middle East TI project?

Right, correct.

Yes. So there's a really interesting dynamic that occurs in our buildings during the term of the lease. The government in order to keep these assets up to mission, they'll often elect to put millions of dollars into our assets for project -- management projects for a fee and as a result, that asset then has that improvement embedded in it, which only accrues to our benefit on renewal.

Griffin, this is like me visiting you on the weekend, and loving where you live. And I'm like, Griff, I love your property so much, I'm going to build a house right here. I'm going to use it for a little bit of time. And when I leave, I'm going to give you the keys. That's how it works.

That's very helpful. I know you also note in your Investor deck, kind of the different regions across the country that you work in, I think Regions 1 through 9. Is there any difference maybe operating or owning facilities in each of those different areas that investors should be cognizant of?

Yes and no, right? So the GSA lease is uniform across the country. But as working with people can be different. Each region has its own culture, its own staff. And so we do learn. It's a huge piece of what our competitive advantage is on the group of folks that we have running these assets that we understand how each of the regions operates, what their sensitivities are, where we even go down to the individual lease contracting officers that we work with how to work best with each one of them. But yes, some are -- it can be very entertaining to try and figure out how to interface with each of them.

Maybe 1 for you, Darrell. You've started the role as CEO since the beginning of the year. Obviously, you played a very integral part in Easterly's history. But now that you take a more hands-on day-to-day approach. What are your goals in terms of maximizing shareholder value?

Yes. I mean I think number one is increasing the growth trajectory of the company. So I think that is number one, and I think that's congruent with the times, and we -- and you're hearing about that opportunity. And our whole team has focused on changing that trajectory because it's critical for what we can do, and we've got a terrific opportunity in front of us. As you know, I had some -- life in and around government for a while, so spend some more time getting close to those government agencies. I think we can work more closely with Congress with OMB with each of the agencies because there is the private partnership between what we do and what government needs is robust and meaningful and really does save the taxpayers, material amounts of money. I mean if you've ever visited a government building that the government owns, it is -- their deferred maintenance is the -- it's everywhere. And just by us maintaining our buildings, focusing on keeping them up to speed, that means that those agencies really connect their mission. Candidly, a lot of people make fun of the government. If they get slow or the government is this or the government is that. The reality is that the government can't be wrong. And that is why government move slowly, and we should all be grateful for it because sometimes some people more or less confident might be in charge of an agency rather than more. And so that slow moving really is the check and balance that makes things work. And so us as a private partner being able to cultivate those good decisions and bring ideas forward, because good ideas win. And this is why when we talk about building a definable edge in our space, understanding the agencies' needs. We can bring these ideas forward. We can execute on them quickly. And that makes the partnership work. And I think we could spend a little bit more time talking with the leaders of these agencies in Congress and OMB in a way that would facilitate the partnership and I think really help government deliver its mission to the American people.

Do you think it's a positive or a negative that Easterly does have publicly traded comps in your space?

Well, I think it's terrible because we'd be beating them, and then people would understand the power of what we do because -- and I don't say that and that's not intended to be arrogant. This is like, I will just tell you, every day very focused on what we do. As you can hear Meghan speak, we know these lease contractors. That's not a buddy-buddy crony familiarity comment. I mean we know how people need to get their work done. The regions of the GSA across the U.S. are different. They have different cultures. I mean it's just like at Sydney Bank. You've got a different culture in your New York office versus somewhere else. And -- so we're sensitive to those nuances. And as we said, government is a shared governance structure. So there's nobody -- there's no one decision maker. We have to work with the agency. We have to work with Washington. We have to work the GSA, and really helping them get organized and getting all of their questions answered is what we focus on. So I don't know anybody else who could catch us with regard to knowledge and expertise and where we are. We can certainly have a first-mover advantage in that. We identified the space we harped it out. And I would say we're executing and in a way that investors would be impressed by. And if we had another peer, we'd see that in our re-leasing would be better. I mean you look at our occupancy, it's fantastic. And you look at capital deployment, we actually do focus on the corporate finance part of what we do. And I'd match that. I post that up against anybody else. And I also just humbly say that as we think about what we're trying to do for shareholders and driving results for shareholders, we're deeply committed deep into the organization to do exactly that. So it would be really nice to have a peer because competing with net lease or competing with office, I mean we're always -- it's not a peer-to-peer comparison. So we talk about stability, we're the best credit tenant that's out there. But if you look at the risk-adjusted returns that we can deliver over time. There's any stock in this industry that I would own for 10, 15 years, it's ours. And that's not that -- I mean we're doing our job every day. But it's just the thesis of how capital is being applied and the return and the risk that's associated with it that I think should be very attractive to folks.

We had a question come in from Live QA. Can you remind us who the competitors you're mainly seeing out there in the space, just given there aren't any public peers that really invest in the properties that you do?

Sure. We have 2 large institutional type competitors, one NGP, National Government Properties based in the D.C. area as well. We've also got Boyd Watterson, who is a -- this is a component of a larger asset management platform and out of the Midwest. And then the segment really starts to get more fragmented after we see those 2 guys.

Darrell, you talked earlier about looking at government agencies that might not be at the federal level, but more so in the state, I believe you did a deal with the state of California in Anaheim recently. How attractive and large is that market that you can capitalize? And how do you think that those acquisitions within the portfolio will be more add-on type of things will you see your strategy shift toward investing more on the state level agency into these.

I mean I think a natural evolution of our company is we're of the scale, we're again adding 10% to a portfolio can be meaningful. If we think about $300 million to $500 million of those buildings in our portfolio and you look at the effect, it can be profound. I mean, these -- the lease -- the way the leases are structured in These state leases as they have escalations. You have to, again, broaden your underwriting sort of detail. And there are certain states that are in terrific financial condition, and there are some that are not. But state governments also have enduring missions that they need to deliver to citizenry. And we -- given the depth of work that we've done for over a decade in the federal government space, we do understand state government and working with them to find properties that work for our investors and again, help our FFO stream is where we're going to move forward.

Would you ever look at international opportunities like Canada or Western Europe, areas like that?

Yes. I mean we don't have to because if you look at the total addressable market that we've expanded in, I think we've tripled, quadrupled the total addressable market that we can look into. And that's important because we've always had a rigorous discipline about the buildings that we buy, the portfolio that we build and having a large total addressable market allows you to be picky and pick some of the very best opportunities. And there is more than enough fantastic assets in the U.S. for us to buy.

I'd be curious to get your thoughts. You obviously talked about the mission-critical nature of your facilities. I feel like when people hear about government at the office, we think about kind of the bureaucrats you might see in D.C. that are believed are still working remotely. If there were a shift in getting more of those kind of workers back to the office, do you think that would help impact people's kind of perception of Easterly? Or just so educating investors about what your priority missions are?

I mean there's 2 separate issues there. One is the substance, right? Because I mean, the substance, we need just need to focus on our cash flows. It's enduring, and work from home does not have an effect on us. But your question around perception, I think, is an insightful one because there is an act in Congress. I think it's called the SHOW UP Act that they brought forward. And so they are going to bring people back to work. And I think as that happens, just as we get many questions about work from home and government not showing up, people will assume that more people are showing up our buildings and it will bring more health to our sector.

We had a question come in here from live QA. Given the opportunities that you're seeing out there, what are you seeing in terms of both acquisition cap rates and development yields?

Sure. On the acquisition side first, where we are seeing deal straight. And I would first say the market today feels like it felt back in the summer of last year. Really bid-asks were narrowing and we got a couple of deals closed in October before the 10-year [indiscernible] that type of constructive market is what we are seeing today on the acquisition side. And I would tell you, we see transaction cap rates sort of in the low to mid-7s. And so as we look to development, that's always been a space where we look to earn a 100, 150 basis points spread to sort of seem like asset in the acquisition market, and so that puts you north of 8%.

Meghan, do any particular capital sources, be it debt or equity or a mix of 2, just really want a particular kind of stand out that might make sense for acquisitions maybe in the year ahead or so?

Yes. I mean, with our desire to keep leverage in that 6.5 to 7.5x range, right, we're going to need both. And so what we're working really hard is cultivating on the debt side. We've got some really good partners with the lifecos and ensuring that we're working with them to find the most efficient way to leverage the underlying government cash flows. We obviously have a lot of appreciation in that market for the REIT structure and the broader portfolio at Easterly. But sort of every day, we're working on making sure we're looking for the right marginal cost of debt. And I think the opportunities in the growth areas, we continue to post against that through the year is going to really support the equity.

ESG has become a very important topic of mind for many investors. Can you just highlight maybe some current ESG initiatives that Easterly is undertaking?

First of all, we last year did join GRESB and reported into that framework. We also achieved still sustainability-linked credit facility levels last year as of the first of this year, we were able to announce that we achieved our necessary third-party verification, resulting in a 1 basis point improvement in our spread. But nevertheless, again, an important commitment to what underlies that. We're also working internally on systems that will help support sort of the inventory of our equipment so that we can address on the CapEx side improvements on the sustainability front as we progress through typical maintenance capital planning over the next 5 years. And out of the EBIT into the S, we did implement an employee engagement survey last year, and we're really, really pleased with the participation in that hitting 90%.

Darrell, what's the #1 thing you're spending most of your time in these days?

Yes. No. I mean it's working on figuring out this growth strategy as we bring it forward. There is this a terrific development opportunity and we're going to spend the remainder of the week looking at sites, looking at opportunities, and that is -- that takes a lot of time.

Great. I don't know if we have any questions from the audience. I have my 3 rapid fires to end the session. What is the best real estate decision today? Buy, sell, develop, redevelop or pause?

Develop, develop, develop.

What is your expectation for same-store growth or the government office/hybrid, triple net REIT in 2025?

We expect that to be roughly 2%.

And do you expect more fewer or the same number of companies in your sector a year from now?

The same.

Wonderful. Thank you so much.