Industrial Logistics Properties Trust (ILPT) Earnings Call Transcript & Summary

Hello, and welcome to the Industrial Logistics Properties Trust First Quarter 2023 Financial Results Conference Call. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Stephen Colbert, Director of Investor Relations. Please go ahead, sir.

Good morning. Joining me on today's call are Yael Duffy, President and Chief Operating Officer; and Brian Donley, Treasurer and Chief Financial Officer. Today's call includes a presentation by management, followed by a question-and-answer session with analysts. Please note that the recording and retransmission of today's conference call is prohibited without the prior written consent of the company. Also note that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on ILPT's beliefs and expectations as of today, April 26, 2023, and actual results may differ materially from those that we project. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call. Additional information concerning factors that could cause those differences is contained in our filings with the Securities and Exchange Commission, or SEC, which can be accessed from our website, ilptreit.com or the SEC's website. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we will be discussing non-GAAP financial numbers during this call, including normalized funds from operations or normalized FFO, adjusted EBITDA and cash-based net operating income or cash basis NOI. A reconciliation of these non-GAAP figures to net income and the components to calculate cash available for distribution are available in our supplemental operating and financial data package which can be found on our website. With that, I will turn the call over to Yael.

Thank you, Stephen, and good morning. I would like to begin by highlighting the enhanced earnings release format that we issued last night. We believe this combined presentation of information will be helpful for analysts and investors to efficiently digest information about our company and results. On today's call, I will review ILPT's operating and leasing performance and then turn the call over to Brian to provide an update on our financial results. We started the year with continued demand for our high-quality portfolio, consistent with the trends we saw throughout 2022. Same-property cash basis NOI grew by 3.2% compared to the same period last year. We executed new and renewal leases for 1.1 million square feet and total occupancy remained healthy at 98.7%. Before we get into the details of the quarter, we wanted to make you aware that Home Depot, our third largest tenant exercised its termination rights on a 2.2 million square foot land parcel in Hawaii that they agreed to lease from us last year. The lease was executed in June of 2022 and allowed for a due diligence period that was scheduled to expire on March 31. We remain in active discussions with Home Depot regarding this site but have also reengaged broader leasing efforts. This lease termination had no impact on our financial results as we continue to recognize rent from an existing tenant that leases the site through March 2024, which we believe gives us ample time to re-lease the property prior to the tenant's lease maturities. Turning to our operating and leasing results. ILPT's consolidated portfolio includes 413 warehouse and distribution properties in 39 states, totaling approximately 60 million square feet with a weighted average remaining lease term of approximately 8 years. During the first quarter, we entered 12 new and renewal leases for approximately 1.1 million square feet at a weighted average lease term of 8.9 years. This activity resulted in GAAP and cash leasing spreads of 15.1% and 9.5%, respectively. The impact of this activity is an increase of $1.4 million in annualized rental revenue, of which 75% will go into effect in 2023. These results continue to showcase our ability to generate organic cash flow growth while maintaining portfolio stability. Renewals on the Mainland drove most of our leasing for the quarter, including 3 renewals with FedEx, our largest tenant that totaled 587,000 square feet with weighted average roll-up in GAAP and cash rents of 14.1% and 12.6%, respectively. Earlier this month at its DRIVE investor event, FedEx announced that it plans to consolidate its operating companies into 1 organization, which will merge FedEx Express, Ground and several other of its operating companies into Federal Express Corporation. Our leasing and asset management teams have a strong relationship with FedEx decision makers who have committed to having an open dialogue with us as they work through their plans. Furthermore, over 75% of our FedEx portfolio and the associated $96.9 million in annualized revenue is secure given its long-term lease with expirations in 2027 and beyond. Looking ahead, approximately 18% of ILPT's portfolio is scheduled to roll by the end of 2025, primarily driven by our Mainland properties. We are currently tracking 27 deals in our pipeline for more than 2.5 million square feet. We anticipate a near-term conversion of 62% of our pipeline, given that 1.6 million square feet of current activity is in advanced stages of negotiation or lease documentation. Once executed, we expect these leases will yield average rollups in rent of 20% on the Mainland and 30% in Hawaii, further illustrating the strength of our portfolio. Before turning the call over to Brian, I wanted to make you aware of the recent publication of the RMR Group's Annual Sustainability Report. The report highlights insights, accomplishments and data regarding our managers' commitment to long-term ESG goals. We are proud of the progress made to strengthen ILPT's sustainability practices and enhance our ESG transparency and disclosure. You can find links to the complete report as well as an ILPT specific tearsheet on our website at ilptreit.com. Brian?

Thank you, Yael, and good morning. Starting with our consolidated financial results for the first quarter of 2023. Normalized funds from operations were $7.9 million or $0.12 per share, a decline of $19.7 million compared to the prior year quarter. The major drivers impacting normalized FFO over the prior year quarter was higher interest expense, partially offset by a $29.3 million increase in NOI. Adjusted EBITDAre increased 53.6% year-over-year to $80.7 million. These changes were a result of our acquisition and related financing activities of Monmouth in 2022. Total portfolio same-property cash basis NOI for the first quarter increased 3.2% year-over-year. The increase this quarter was driven by the favorable change to reserve for uncollectible rents of approximately $850,000, and an increase in percentage rents earned at 1 of our Hawaii properties. Interest expense increased $29.8 million over the prior year quarter as a result of our financing activities related to the Monmouth acquisition in 2022. As a reminder, we have interest rate caps for our $2.6 billion of floating rate loans and rates continue to exceed the strike rates fixing our interest through the initial maturities in 2024. Our current estimated quarterly interest expense run rate is approximately $71 million, consisting of $58 million of cash interest expense and $13 million of noncash amortization of financing costs, including the interest rate caps. Turning to our balance sheet, including extension options, ILPT's weighted average debt maturity is 6 years with no maturities until 2027. As of March 31, our total debt that either carried a fixed rate or is fixed through interest rate caps with a total weighted average interest rate of 5.4%. We currently have $61 million of cash on hand, excluding the cash held by our consolidated joint venture and amounts escrowed under our debt agreements. Capital expenditures for the fourth quarter were $4.9 million, including $2.5 million of development costs, $2 million of tenant improvements and leasing costs and $400,000 of building improvements. In closing, we're focused on our operations and continue to monitor market conditions for potential dispositions and deleveraging opportunities. Our portfolio remains strong with an exceptional tenant roster, near full occupancy and rising rents across our portfolio, and we expect that ILPT will continue to benefit from industry demand for high-quality industrial real estate. That concludes our prepared remarks. Operator, please open the line for questions.

[Operator Instructions] And the first question comes from Bryan Maher with B. Riley FBR.

Yael and Brian. Maybe a question for Brian to start. On the interest rate, it's a big topic these days and you kind of walked through the cash component and the noncash component. As we think out to 2024 and let's assume that you exercise your extension options and you have to make -- pay for new caps. How should we think about that noncash component of the amortization and the cost of the new caps? And let's just to say, assume you have to do that at today's rates, how should we think about interest expense next year under that scenario?

Thanks, Bryan. It's a good question. As we look at the interest rate caps and how that accounting works, you're essentially buying down the interest to maintain the same strike rate for the next 1-year period. If we were to buy a cap today, I would estimate a 1-year cap based on today's SOFR curve anywhere from $10 million to $20 million. It's a very volatile market and interest rates, as you know, can change on a whim. But the way that will work is the amortization of the current cap will expire, and I will note, especially on the CMBS loan we did in September, that cap was very expensive, $50 million. So the amortization of that cap -- there could be a favorable change in what we're recognizing for interest expense if the cap for 1 year is cheaper. So that's the best guidance I can give today that -- hopefully, the rates continue in the forward curve continues to decline and the price of those caps decline because they're not cheap today.

Right. That's helpful. And another company that we cover here last year, bought some caps or some hedges or did something. I'd have to go look it up. last year knowing that caps would expire this year on loans that they were going to extend. Is there anything that you're looking at, given the tenure at 3 40 today that you could do today that would lock in something for an extension for next year.

Yes. That's a good question. It's not something we're considering. I think all pundits would say that interest rates are expected to decline at some point in the future. And the forward curve is what drives the pricing on a cap. It's something we talk to different people on what that could look like in a year. And for us, we're going to give it some more time and let the backdrop settle in, hopefully, over the next few quarters.

Okay. And maybe shifting gears. Can you elaborate a little bit more, maybe, Yael, on the Home Depot termination. It seems like you're still engaged with them? Are they just simply looking for a lower price? And maybe how deep is the bench of potential tenants to take that space if you can't come to an agreement with them?

Thanks, Bryan. This was a unique circumstance. We generally don't allow for diligence periods and termination rights in our leases. And with Home Depot, this is a very large parcel of 2.2 million square feet, and they had done some diligence, as I think we mentioned earlier, they are planning on putting a warehouse and distribution facility on this site. So they just needed a little more time on their planning. And so as I mentioned, they didn't give us the reason why they terminated, but I think they realized that the site would be really essential as they grow their network, and they remain interested. But as I mentioned, we have started engaging the broader market. And I think the reasons why Home Depot like this site and other Mainland retailer would also find it attractive and I think our chances are good in this park, the parcels in James Campbell Industrial Park. And as of Q1, it had less than 0.5% of vacancy. So I think that provides us with a competitive advantage to re-lease it.

And just last for me. You mentioned the 27 deals that you're tracking, 2.5 million square feet for the next couple of years re-leasing? You said something about a 62% conversion anticipated. Am I to assume from that, that the properties or tenants that you've engaged in the 38% aren't looking to renew and what are the prospects for those properties?

No, that's actually not what I meant. So we have, in our pipeline, in '23, '24 expirations, we actually have very minimal expirations in the next couple of years. And so that's mostly '23 and '24, and we just have -- we've engaged with them early and the ones that are 62% likely to execute are just the ones that we have assigned LOI over and we're negotiating a lease.

Okay. If you had to put some kind of probability on the level of renewals from those that are expiring, give or take, 5 percentage points? What do you anticipate that being?

Yes. So currently, today, we only know of 3 properties where the tenant is likely to vacate, and it represents less than 0.5% of ILPT's annualized revenue, about 240,000 square feet.

And the next question comes from Mitchell Germain with JMP Securities.

I appreciate the new disclosures. I wanted to talk about revenues. Brian, I know you talked about a reserve and a percentage rent from Hawaii. So assuming the reserve is kind of a onetimer, what about the percentage rent? Is that just going to be a onetime benefit in the quarter?

Yes, that tenant pays percentage rent annually and that tenant -- they've a significant increase in their revenues that were up in the percentage rent. It could repeat next year, but it's a percentage rent that could be -- could disappear as well. So it's not something we'll necessarily project for, but we were seeing some form of percentage rent in that tenant annually.

What's the dollar value of that?

Yes. We had an increase of $680,000 and change year-over-year, quarter-over-quarter.

Okay. So about $1.5 million of revenues this quarter that are nonrecurring. Is that the way to think about it?

Yes.

Okay. I saw Par Pacific entered your top tenant list. Anything you can provide some perspective there?

No, I think it's just with Home Depot, with that lease terminating, that was 2.2 million square feet, they just moved up in the ranks.

Got you. Okay. And you talked about the leasing spreads, Yael, 9%, but then you referenced FedEx was a bit higher. I think it was 12%. And I think it looks like FedEx was about half of your leasing in the quarter. So kind of what was on the lower end, anything specific that we should be noting there or any trends that we should be worried about?

No. As you know, when we do renewal leasing, especially in Hawaii, those are smaller rents. And so in certain instances, the roll-ups just aren't as big, and we had a couple of leases in Hawaii on the renewal.

Okay. Given where your cost of debt is today, is there any thought about maybe pursuing some one-off sales now that the market is at least kind of digesting the higher rates and seems to be stabilizing a bit?

Yes. We're constantly evaluating opportunities. We've had a lot of inbound inquiries from opportunistic buyers looking and we're evaluating all of those on a case-by-case basis. I think there's still a period of price discovery. Transaction volume is considerably down year-over-year, I think, upwards of 55%. So I think if the opportunity presents itself and it makes sense, we will. But I think we're still holding tight and we're going to be patient until we have a little more data.

[Operator Instructions] And the next question comes from Aditi Balachandran with RBC Capital Markets.

Can you talk a little bit more about what you're seeing in the transaction market right now? And what exactly would need to happen or change for you to bring some into the market?

Yes. I mean, we have really a big network of brokers, capital market brokers. We have acquisitions and dispositions team that are very close to the market. And I -- there just hasn't been a lot of deals closing. And so again, I think until there's more price discovery, I think we're just waiting. So I mean, again, I think from what we hear, things might start to open up in Q2, Q3 and as interest rates kind of settle. I think the banking crisis kind of put a little bit of a slowdown in the process. So hopefully, in the next 1 quarter or 2, we'll have more data.

Okay. Got it. And is it fair to assume that you're thinking about like some of the outright asset sales? Or what are your thought process on that?

I think any way we can maximize value. I think we're open to a portfolio. But again, I think with financing being hard to come by, I think that's a limited buyer pool. So again, we have a robust team that can execute on individual sales, and we're fine to go that route if we can maximize value.

And next question is the call from Mitch Germain with JMP Securities.

Sorry, I couldn't help myself. Yael, what happened with Home Depot in Illinois? I know you talked about Hawaii.

Yes. So they came to their natural lease expiration. When we actually brought them on this portfolio, we knew that to be a known vacate. We're in active discussions with another tenant, and we're hoping to be able to lease it this quarter.

And we also have follow from Bryan Maher with B. Riley FBR.

Yes. Just a quick one. As it comes to thinking about potential dispositions or JV partner or putting assets into JVs that you've already established -- are you still actively engaged in those JV partners, sovereign wealth funds that you had dialogue with or worked with in the past? And what's their level of interest currently?

As you know, we have a couple of JVs in place, and we're in active discussions with them because we're managing the JVs with that for them. But for bringing on additional partner, especially for the Mountain JV there's been no discussions. As you can see from our financial and supplemental disclosures that JV is not currently cash flowing. So it would be hard to make it attractive for a new partner.

And would you ever entertain bringing on a new JV related to the Hawaii assets. I know those have been kind of the crown jewels in the RMR Complex for 20-ish years. But given the fixed rate debt on that, and valuation as you can tell me maybe north of $1.5 billion. What would the appetite be there for ILPT?

Yes. I think we're -- I mean, we're really evaluating anything that can help with our deleveraging. So that's not off the table, but we're not in any active conversations right now.

And can you share with us what you think that, that property is worth currently in Hawaii, maybe give or take $100 million.

I think your assumption was correct, if not a little low.

And this concludes our question-and-answer session. I would like to turn the call over to Yael Duffy, President and Chief Operating Officer, for any closing remarks.

Thank you, everyone, for joining us on the call today. We look forward to speaking with many of you at NAREIT in June.

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your phone lines.