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

[Audio Gap] Use you mic or go to liveqa.com and enter code GPC26 to submit questions. Darrell, we will now turn it over to you to introduce your company and the team, provide any opening remarks and tell the audience the top reasons an investors should buy your stock today, and then we can jump into Q&A.

Thanks, very much [indiscernible]

Can you just tap the button to turn the mic on?

Is that on?

Yes.

Red is on. I didn't know red was good. Okay. Well, we're really glad to be at this conference. Thank you so much. I would -- at Easterly Government Properties, we're just super excited about what we're building and driving toward. Our guidance this year provides a 3% growth as we've delivered for the last couple of years. So we're a consistent 3% growing firm. Our cash flows are backed majoritively by the full faith and credit of the U.S. government. Our buildings are to mission-critical agencies and facilities that support that mission. Example being at an FBI, they need antiballistic glass. They need setbacks from the road. They need fences that a tractor trailer can't drive through. That is what they need. Our buildings are young. The weighted average age of the portfolio is about 16 years. A government building lasts 40 to 50 years. When you think about stickiness and renewal, let's go back to this FBI example. Their choice at the end of a 20-year lease is to go build another one somewhere else or stay in our building. And at the end of the day, we look at the replacement cost of the building. We give a nice healthy haircut to that price of like 10% to 15% and the leases renew, and that's terrific for us, and it's terrific for the government. We're in a -- we've been in a tough space in this -- with regard to headline risk and other issues over the last year. We've had DOGE, we've had government shutdowns and people outside of what we do have a level of uncertainty. I think that's weighed on our stock and on our multiple. As we look forward, though, I can't tell you enough how DOGE is a tailwind and the rethinking of government is a tailwind for the company. Fundamentally, the more the government thinks hard about what it wants to do and save money for taxpayers, the better we are as a partner. Public-private partnership in this space is what it should be each and every day. We're very good at managing buildings. We're very good at preventing leaks in roofs. We're very good at making sure a building doesn't become obsolete. That's what real estate professionals do. The government is really good at catching criminals and finding bad food and doing all the things to protect the American people. The way that works though is, why are they not good at fixing leaks in their building? Because the Congress funds these agencies. The agencies are run by the administration. The administration has a set of priorities. Congress tends to not give enough money to agencies for political reasons or whatever else it might be. So if you're running the FDA, the FBI, the DEA and there's a budget cut, what's the first thing you're going to do? You're not going to cut your program and cut your objectives, you're going to not fix the roof. And so that is why today, we see over $85 billion of deferred maintenance in government buildings. When we look at FDA labs across the country, there are 7 of them that do have leaky roofs. The buildings are awful. That doesn't mean the FDA did a bad job. They're just not good at managing real estate. We've now built 3 labs for them. They're outstanding and the public-private partnership is really working. And we've been in this business for over a decade and have a real defined advantage and competitive edge relative to others. We have a terrific development pipeline. We're building 2 courthouses, one in Arizona, one in Oregon. We have a law enforcement lab right here in Florida that we're building. All of those are at a yield on cost that's attractive and accretive to us, even with our cost of capital challenges that we have today with the stock price, I think, trading at a 20% discount to office, we can still do these projects in a way that's accretive and be delivering the type of growth, that 2% to 3% that we promised to investors year in and year out, which, again, I think is a very attractive proposition combined with the dividend that today is a little bit over 8%. So we have a -- if our cost of capital is better, we could have -- be executing on a pipeline that is over $1 billion. We have what we need in order to, again, fulfill our promises to investors, but we're very excited. In times of disruption, our stock has done very well. The best day of our lives was when COVID came out and people know that we are a flight-to-safety, we're an anchor in a portfolio. And today, as you look at uncertainty in Iran or whatever else it might be coming our way, we're a real safe harbor. And our dividend is, again, very attractive relative to expectations for the equity markets. And we see -- if you look at just multiples and if we just do what we're supposed to do relative to office, there's about 30% of NAV appreciation that folks could imagine to capture, which makes this a very compelling time for us.

Great. Maybe just touching on a few of those points. You talked about kind of 3% FFO growth plan. You've also kind of outlined leverage around 6x. Can you just kind of walk us through kind of the major building blocks of kind of that plan, kind of just what you need to do from a leasing operations perspective and financing to kind of get to that 3% growth and hit that 6x leverage target?

Sure. Let me start off by just talking in broad structure and how we're thinking about that and why we've set those objectives, and then I will turn it over to our fabulous CFO, Allison, to talk about some of the specifics. But broadly, job one is delivering growth to investors. So that is what we will do. We will do that by accretive acquisitions, by lease renewals. We're already fully renewed through 2026, and we're focused on the '27 renewals, which is fantastic. And we'll continue to have accretive development projects. So once we've satisfied that, then one of the choices we get to make is how do we finance that growth. And that's a mix, obviously, of debt and equity. We will use as much equity as we can to get to that kind of 3% growth level, allowing us to continue to delever. We've come down from the high 7s to just about 7x now, and we'll move into the 6s over time. Why are we going to do that? Notwithstanding that we have the very best credit cash flow of credit tenancy of anybody in the REIT industry in the United States. We believe getting an investment-grade rating in the next couple of years is very important. The only metric while we think our buildings can handle more leverage than others as our scale grows and as we continue to work with the rating agencies, we're going to continue to see an investment-grade rating being something that we will capture. That will lead about 10% of growth to our FFO over the probably subsequent 5 years from when we get that rating. So the degree to which as we look forward, we anticipate growing 3% a year, add another 200 basis points to that, we really do see ourselves in the next short period of time being a -- getting into that 5% growth space. But there you go, Allison.

Thanks, Darrell. So drilling into some of that a bit more. One of the areas we create the pathway for future core FFO growth is within our development pipeline. It is -- we have 4 -- 3 active projects now. We've just recently completed our landmark $250 million FDA lab in Atlanta, Georgia. It is beautiful. All of the equipment is humming, and we were very excited to complete that project. In terms of the future pipeline, though, we're looking at yields in the 11s on a yield-to-cost perspective. That creates -- our target spread on a development project is about 150, 100 basis point spread to our cost of capital from a yield perspective. But as you can imagine, an 11% plus development yield definitely creates that room for growth. That particular project will deliver at the end of this year. It's an 18-month build time. So between the investment horizon on that as well as when we're eventually going to create FFO accretion from that is a very short time frame. Development is actually interesting from a leverage perspective as well because it's a natural delevering point for 2 reasons. So one, obviously, the cash flow and the rents come on. But two, when we're talking specifically about federal development properties, it is the receipt of what we call a lump sum reimbursement. So it's the amount that the government has contributed to the project to increase the overall value of it to build it very specifically for their own use and at the end of the project or at midway points, we receive a cash reimbursement of that amount. So those are natural delevering points as we look to the next 18 to 24 months. Our current development pipeline is scheduled to wrap up at the end of 2027. So we've got 1 end of this year, 1 mid next year, my gosh, it's 2027 already. That's crazy. And then 1 at the end of next year. So that's a natural delevering place for us to meet those long-term and medium-term objectives. In terms of drilling into the actual pipeline and what we do on a day-to-day basis versus some of these external growth metrics, in terms of leasing and occupancy and net effective rent, we target mid-90s occupancy rates and renewal rates. I would say we're -- we're at 97% today, but mid-90s is the target. And then on a net effective rent spread, we typically target mid- to high teens in terms of net effective rent. Our last 2 renewals are 20-year deals. We're able to get typically about 15 to 20 years of WALT when we execute a renewal. So every incremental renewal that we execute allows us to drive incremental growth each year. We have about 5% of our portfolio rolls in any given year. I think that speaks to 2 things. So one, our consistent ability to deliver renewal adjustments and increases to FFO, but also the safety that we don't have a massive here of 20% of the portfolio rolling, right? So it's -- it has a very small amount of risk, but a very consistent amount of upside. So for us, that's been very important. And then to Darrell's point, I think the debt markets to us remain to be incredibly constructive even if our equity cost of capital has been a bit depressed with headline risk. So while that doesn't necessarily drive leverage, it does help growth overall to look to our debt stack, drive to the cheapest cost of debt capital and really be creative about how we think about the credit and the attractive pieces of these leases being attractive in those markets.

One of the questions that we get from investors so often is, well, we cut our dividend a little over a year ago. And they say, well, why did you do that? And the very simple answer is that we were repositioning the company away from a story of safe cash flows, which is entirely true to a story of growth. And we have since going public when I was Chair of the company, we had a payout ratio that was close to 100%, why is that? Because we can forecast our cash flows farther into the future than almost any other REIT that you're going to meet with today. And that stability, we thought would translate into dividend, and we thought dividend is what shareholders would like. Turned out when interest rates went up very, very quickly, that led our payout ratio to be 100%. And it was going to take us 2 to 3 years for us to get to a place where, again, we were covering our dividend and continuing to grow. And instead of debating that with REIT investors, we decided to cut the dividend and create growth. Just by having a lower payout ratio, it creates a little bit more growth in this business. And I think we're really pleased that we've positioned ourselves this way as you can see that REIT companies are being rewarded for growth now and the ability to deliver what we think is above-consensus growth rate for office is a really exciting time for the company.

And then just kind of on the kind of same-store NOI growth piece. Can you talk about kind of your preference for state versus federal and kind of the differences in the lease structure to kind of grow that long-term same-store NOI growth rate?

I mean, when Allison and I assume the responsibilities of running the company day-to-day, one of the things that we looked at is what would make -- what satisfies investor demands, what makes what we do most appealing to our shareholders. And to that point, same-store sales growth continues to be an important metric in this industry. So to conform with that, we decided to move toward 30% of our portfolio being in state and local and what we call government adjacent. These are buildings that look exactly like what we do for the federal government. Many of them either work directly with the federal government or emulating some of the mission that federal government does in their own state. Our facilities have the same look and feel. But the great news for that 30% of our portfolio is that they have escalators like a commercial lease. So in very simple math, if 30% of our portfolio has 2% bumps in it, that's 60 basis points of same-store sales growth that we'll have year in and year out. That little nudge, while it may not sound like much, is quite differentiating with regard to positioning the company to have a growth rate that's very competitive to others so that then when you look at the stability of our cash flows that are underneath it, I think we become not only compelling on a peer-to-peer basis, but we're very compelling, even more compelling on a risk-adjusted basis.

And then just the new GSA administrator was put -- confirmed in December and several of the top kind of tenant agencies face budget pressure. You mentioned in your opening comments, the $85 billion of deferred maintenance and government buildings. How do you kind of weigh kind of the budgetary pressures and the deferred CapEx, both in terms of risk and opportunity? And just to tie that in with a question from the audience that asks, how will the continued small government policy impact the pipeline to be delivered in the next 3 years? Could those potentially be canceled?

Yes. To the last question, no. If anything, government does need to reposition its facilities in a way that, again, facilitates mission. There is nobody better, and I'm so grateful to Ed Forst who if folks don't know him, has stepped into government. I mean this is just such an American Patriot story. I mean he was the Chief Administrative Officer at Goldman Sachs. He ran Cushman & Wakefield. He is somebody who understands real estate, understands capitalism, understands capital markets, understands financing and is bringing many of those skills to a leadership position in the government. This should be no surprise to anybody that the bureaucrats in our government are terrific at making -- crazy enough, not making long-term mistakes and moving things in a deliberate way forward, bringing in this influence of Ed Forst in order to direct those resources of government in order to be more efficient for taxpayers is just a blessing. And for us, being a public-private partner to help him in his mission to satisfy and bring fantastic facilities so the government can do their work is exactly what we can do. For all the points that I was making earlier, we will keep buildings in better shape. We will not let deferred maintenance pile up, and that will allow our -- the men and women who serve American people to do their job in a better way. So we really complement Ed's desire to step into government and do this work, and we're very excited to be the partner of the evolving GSA under his leadership.

How do you think that will kind of translate kind of over the medium term? Will that present more development opportunities? Will the government look to sell more assets? Will that provide more kind of acquisition opportunities? Just kind of overall framing what that means for DEA?

I think big picture is they've got to get out of the buildings that have a ton of deferred maintenance or they've got to decide how they're going to recast them to be doing something that's mission-critical. So they will figure that out. Most of that will be in Washington, and most of that will have nothing to do with us. We don't own any facilities in Washington because we like to stay close to the mission. That said, as we look forward, there are 7 FDA labs that need to be built. There are a number of Veterans Administration day facilities that need to be built. So we're very excited about the pipeline as we work to have, again, protect the food, the drugs and the consumables that Americans have and also protect our veterans and give them the medical care that they deserve.

With their stated goals, the government's portfolio is about 450 million square feet across the United States and 150 million square feet of that is leased. So it is our belief that, that will flip the other direction. So leased will account for about 300 million square feet and owned will account for about 150 million, right? So they're never going to lease the White House. I think we can all acknowledge that part or the capital building or large landmarks. However, when we talk about deferred maintenance, it's really about their stated goals of reducing cost for the American taxpayer, and this is the way forward. We all wouldn't be at a real estate conference talking about REITs if we didn't all believe a leased alternative is the right one. So I think the government is just 2 decades late to that decision-making process. And it might take them a decade more to trade out of owned and into leased, but we are certainly their preferred partner as we look to opportunities with them.

And then you just delivered the FDA lab in Atlanta. You have 2 courthouses in the development pipeline and a law enforcement building as well. Is there a specific type of facility that you think presents the best expansion opportunity?

I think we have a special secret sauce, particularly on labs and court houses. If you look to our historical development pipeline, that's really where we shine. Building a lab is a very technical endeavor, particularly with the U.S. government or with state and local governments. I think you could continue to see us work in those 2 spaces. So for us, working with the government is about underwriting to the mission, not necessarily just labs and courthouses. Those are 2 we feel are very sticky. But we would continue to evaluate all mission-critical opportunities in the market for those where we can drive a spread to our cost of capital.

And then just maybe switching gears a little bit. Can you just talk about kind of -- or provide an update on kind of the planning around the Chicago FAA asset and what's kind of embedded there in guidance?

Sure. So many of you have heard us tell the story before, but that is probably the best performing asset investment we've ever made. I think it's returned like a 25% IRR when we bought it for $6 million, however many years ago. So we do intend for that tenant to move out at the end of their lease term. Will they stay an extra 3 months? Probably. They are already 6 years plus past our expectations on vacating. We do expect them ultimately to leave, and we are in discussions on a sale of that building when it becomes vacant. So for us, that's already in the works. in terms of what's embedded in guidance, we are expecting them at the end of this year, no later than and anything else would be gravy for '27.

And then just looking ahead to kind of the 2027 lease expirations, there's EPA, FBI, U.S. courts, Coast Guard and 2 ICE leases. How are you kind of approaching kind of renewal discussions? And kind of what are your expectations around renewals versus vacates there?

So in terms of the 2027 portfolio, I would say, on average, the government would start procurement anywhere from 18 to 24 months in advance. So we are in, I would say, preliminary stages on most of '27, but some of the later leases in '27 have not sort of come up for air yet with those tenant agencies. We're not expecting any adverse outcomes there. They're all moving along sort of in accordance with our typical expectations. And then those stats that I mentioned earlier like mid- to high teens net effective rent spreads. Renewal terms are typically about 10 to 20 years. That's about what we would expect for those as well.

And then is there any incremental kind of TIs that go in on renewals or space reconfigurations to kind of bring those buildings just up to date?

Some may have TI packages, as you can imagine, how you work changes over the course of 20 years. So a really good example is a building that we renewed 3 years ago now. They converted an old fingerprinting lab to a digital photography evidence lab. So that's a good example of where the technology they were using 10 years ago doesn't suit them today, and that's sort of what they will tend to do in a TI build-out or a TI reconfiguration. But it's not some scrap of the whole building. They'll replace some desks, they'll think about equipment, things like that.

And then just kind of pivoting to kind of back to some of the external growth, but more on the acquisitions, kind of I think you've talked about a $1.5 billion kind of acquisition pipeline. Can you just break down kind of where those sit today in terms of what stage they're in kind of under contract LOI, preliminary discussions. And I guess just you mentioned in the opening comments, kind of an 11% yield is kind of where you're seeing those assets trade. Just given the durability of the cash flows, kind of why have you seen kind of pricing change there at all? Or any change in kind of competition for kind of those opportunities?

Maybe just to broadly say, as we -- where we are today is that we feel very comfortable that the pipeline we have with the cost of capital that we have can meet the growth objectives that we've articulated to investors. That 1.5 -- when our cost of capital is where it is, digesting -- the funnel is very shallow in that as you look at $1.5 billion of deals, it takes very few of those to actually help us achieve our growth objectives, but we have to be just tenacious about working through that pipeline of opportunities with folks who would like to sell us their building, but finding ways -- finding those buildings that can meet our cost of capital and be accretive. What does that mean? That means in most cases, when we're going to be winning acquisitions, and we will, you've got a seller who is for reasons that are not about top ticking the market. So example, if in our most recent transaction, there was a set of private equity investors who bought a building, quickly repositioned it. And we were able to buy it at a price that gave them a very attractive IRR, but that IRR enabled them to go raise additional funds in the real estate business. So our speed and certainty of execution were deeply valued in that transaction, and that led to us having something that was accretive. Now there are probably 10 more deals -- if our stock is at $32, there are 10 more deals that we could have done because we could meet seller expectations. So I just want to be so clear that we are working through our pipeline. We have the number of deals that we have to look at that are appropriate for us relative to those that will be successful with this cost of capital is fewer, but we've created a pipeline that's large enough to support that and meet our growth objectives. When we look at the pipeline, I'd say a little bit more than half of it is development-related opportunities. You have a lot of merchant developers who are winning deals with the government. And then we can be a fantastic partner with our balance sheet and experience in order to help them along the way. We'll certainly be working with partners to put components of capital structure into these deals, maybe a little mezzanine debt in order to get involved in the deal, and then that will give us an ability and an inside sensibility on what we're willing to pay for it when the building is ultimately completed or when it's stabilized a year later. So it's a really exciting time, and we're an outstanding partner for a lot of folks who are in this space. And we believe all in all in that, that leads us to have what -- notwithstanding the work that we're doing, reasonably conservative growth objectives that will provide consistency and stability of cash flow to investors over time.

You kind of mentioned there the kind of getting into the debt stack with the mezzanine piece. And you've also kind of touched on your equity cost of capital. Would you look to do kind of additional JV opportunities? Or I think in the past, you've kind of mentioned relationships with sovereign wealth. Just kind of how do you think about that as you think about overall sources of capital?

Yes. I think -- yes, it's a great point. Yes, we do have 2 significant partners that are sovereign wealth-esque in what they do. We will be working with them, again, to be a good partner and work on some of our largest transactions that we're working on in order to move things forward. That can be a way that is, of course, very accretive for our shareholders, terrific for our sovereign wealth partner and provides us the ability to have even more diversification and digest some of these larger deals that may be, given our cost of capital today, a little bit outside of our range.

And then I guess just how do you -- you have the target of kind of getting to investment grade. But just given the kind of increased availability of that cost of capital and just the equity cost of capital kind of not being where you want it, how do you kind of balance choosing either kind of the JV opportunity or issuing kind of equity at a cost of capital?

It's all just about FFO accretion, I mean, in everything that we do. So we're telling investors that we're going to grow FFO 2% to 3% for as far as the eye can see. That's what we're working to do every day. We believe that we can consistently do that. Our cost of capital should improve. Comps would say that's true. And hopefully, we'll be in a place where that accelerating momentum will help us delever faster and we'll get to a place where we can get even cheaper cost of capital. And that's really what these REIT machines are meant to do. And we've created a competitive advantage in this space for well over a decade. But we are the preferred partner of the U.S. government and of agencies across the board, and we should be able to bring that value to our shareholders and translate into attractive appreciation in our stock price.

And then you kind of mentioned the $500 million on -- of the merchant development projects with the government and being able to kind of step in as a capital partner there. How are you seeing the kind of competitive landscape evolve as you kind of compete for those deals?

Look, it's -- this is a little slice of the world. And what you don't see our large development firms just decide to randomly enter this space. Most of the folks that we work with and most of the folks who are winning these deals have been in and around this space for decades. We understand the business. We can be a great partner. And with one partner that we're working with right now on the development project, as we had lunch last week, and they were very clear to say we've never taken outside capital before. We love working with you. You understand this business, you're value-add, we think about things the same way. And that's a terrific testimony. So I think as we're competing with others, our money is greener than other folks. I think we will have an opportunity to pick some fantastic deals, and we really just don't need that many given the size of the company in order to make a material difference for our shareholders.

And then one of the questions we're kind of asking every company and maybe also tie it into kind of the landscape of the federal government. But how do you -- what's your mix of like build, buy or partner and AI? How do you decide which solutions your company would build versus buy? And then just overall, how do you think about AI kind of changing the office landscape for government?

I think for us, we are -- AI is terrific for our business, I think, in a whole set of ways. Some of what you're seeing in office more broadly is folks fear that AI is going to reduce workforces and reduce tenancy. That is not going to happen in our space. AI is not going to go out and capture criminals or be able to do the work that's being done in our facilities. I'd also say that when you think about AI, not to get into a big lecture about this with a minute and 5 seconds left, but there's sort of horizontal AI, think of Salesforce, right, they are providing a service and being an AI-native company where you're using AI in your vertical to create value, you've got to be a niche -- sort of a niche business and one that has sort of deep knowledge. That's us. We have more GSA leases. We've negotiated more GSA problems than anybody out there. Our AI related to what to do and our productivity to find it in this space will be better than anybody else. We are a technology-forward as a company. So I think we're going to realize some benefits over time from that, none of which is in our guidance today. And I think that we're going to be able to do a better job optimizing with the government and helping them using AI to solve some of their problems, and they're quite receptive to that. And so we see AI is a terrific example. We already have agents doing work each and every day through Copilot and other things. Our financials are coming together with a rapid pace, and we find ourselves in a place where AI is really our friend and really giving us time to get our work done and build our competitive advantage.

Great. Thank you so much.

Thank you.