Office Properties Income Trust (OPI) Earnings Call Transcript & Summary

Good morning, and welcome to the Office Properties Income Trust Fourth Quarter 2020 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Olivia Snyder, Manager of Investor Relations. Please go ahead.

Thank you, and good morning, everyone. Thanks for joining us today. With me on the call are OPI's President and Chief Operating Officer, Chris Bilotto; and Chief Financial Officer and Treasurer, Matt Brown. In just a moment, they will provide details about our business and our performance for the fourth quarter of 2020, followed by a question-and-answer session with sell-side analysts. First, I would like to 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 OPI's beliefs and expectations as of today, Friday, February 19, 2021, 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 opireit.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 numbers during this call, including normalized funds from operations, or normalized FFO, cash available for distribution, or CAD, adjusted EBITDA and cash basis net operating income, or cash basis NOI. A reconciliation of these non-GAAP figures to net income are available in our supplemental operating and financial data package, which also can be found on our website. In addition, we will be providing guidance on this call, including normalized FFO and cash basis NOI. We are not providing a reconciliation of these non-GAAP measures as part of our guidance because certain information required for such reconciliation is not available without unreasonable efforts or at all, such as gains and losses or impairment charges related to the disposition of real estate. Now I will turn the call over to Chris.

Thank you, Olivia, and good morning. Welcome to the fourth quarter earnings call for Office Properties Income Trust. We entered 2020 with leverage below the low end of our target range after completing our post-merger deleveraging plan, as originally outlined, which included a disposition of close to $1 billion in assets. This outcome positioned the company with a strong balance sheet and a well-diversified portfolio going into an unprecedented global health crisis that would soon impact our personal and professional lives, communities and activities from the global economy down to neighborhood businesses. Despite these challenges, we continued executing on our business and capital recycling plan, and I am pleased to report operating and financial results representative of our strong portfolio composition. Yesterday, we reported normalized FFO of $1.28 per share, exceeding our guidance range and consensus estimates for the quarter. Year-over-year, we generated same-property cash basis NOI growth of 5.1%, increased CAD by 6.5% and completed 2 million square feet of leasing activity for the year, resulting in a 6.9% increase in rent and a weighted average lease term of 7.3 years. Turning to our operating results. At the beginning of 2020, we introduced our capital recycling program with the principal goal of selling $100 million to $300 million of properties annually. Those older in age, more capital-intensive or with less remaining lease term and reinvesting the proceeds in newer, more stabilized properties that generate higher cash flows. During 2020, we sold $110.5 million of properties, which had an average age of 22 years, a weighted average lease term of 6.2 years and an average cash contribution yield of 3.6%. These sales also eliminated approximately $30.2 million of budgeted capital over the next 5 years. In January 2021, we sold 2 additional properties for $131 million, including a small warehouse facility in Kansas City, Missouri for $845,000 and an opportunistic sale of a property in Richmond, Virginia for $130 million. While not originally considered for 2021 capital recycling, the Richmond property had a weighted average lease term of 3.4 years, anticipated vacancy with the subtenant occupying more than 61% of the property, an estimated 5-year capital of $7.9 million. As conversations ensued on leasing efforts for the property, we received an offer to purchase the property at what we believe is reflective of a long-term stabilized value despite the anticipated vacancy. This sale reflects a cash contribution yield of 3.6%, providing for an accretive redeployment of proceeds into newer, stabilized properties, consistent with our capital recycling plan. We have also entered into an agreement to sell a property located in Huntsville, Alabama, that we have previously discussed as a known vacate for 2021. The tenant provided notice of their lease termination for a move-out effective in August of this year, and we have evaluated both the re-leasing and disposition strategy for the property. The sale will eliminate anticipated leasing downtime, significant capital and a potential drag on occupancy with an industrial property not core to OPI's business strategy. As previously announced, in December, we acquired a corporate headquarters property in Fort Mill, South Carolina for $35.1 million. This 150,000 square foot Class A property sits on 16 acres, was recently constructed in 2019 and serves as a tenant's corporate headquarters. The property has a remaining lease term of 10.8 years and is located in a growing market in what is considered suburban Charlotte, North Carolina. This acquisition is indicative of our core investment strategy with an average cash contribution yield of 7.4%. Lastly, we have entered into an agreement to acquire a property adjacent to one we own in the Boston CBD. This acquisition represents the final piece for assemblage of properties within the block and provides us with optionality as part of a longer-term strategy for redevelopment and a high-growth corridor of the North Station neighborhood. In the near term, we will continue operating these properties as their current use and look forward to providing updates as we evaluate opportunities for the site. We have been successful on the disposition end of our capital recycling plan and believe the low cash contribution yield on these sales to date creates ample room for OPI to reinvest in higher-yielding properties, resulting in CAD accretion as shown with the Fort Mill acquisition. Our acquisition pipeline remains healthy, and our focus in 2021 continues to be on acquiring properties we believe to be mission-critical to tenants, and those where remote work is less likely, including single-tenant headquarters, high-security government buildings, life science and medical office buildings. Turning to leasing for the quarter. During the fourth quarter, we completed 139,000 square feet of leasing with a 7% rolled out in rent, a weighted average lease term of 9.7 years and leasing concessions and capital commitments of $5.73 per square foot per lease year. We ended the quarter with consolidated occupancy of 91.2%, and the quarter's performance is in line with expectations. Timing of leasing can vary quarter-to-quarter, but we are pleased to have ended the year with strong leasing results, reflecting a 6.9% increase in rent and a weighted average lease term of 7.3 years. Subsequent to quarter-end, we completed a lease restructure with Tailored Brands located in Houston, Texas, following its approved plan of reorganization, which includes a decrease of roughly 67 basis points of annualized revenue and a reduction to their footprint. Plans are currently underway with re-leasing efforts, and we look forward to providing feedback on leasing in the upcoming quarters. Our overall leasing pipeline remains active with discussions covering 3.7 million square feet, an increase of roughly 19% in pipeline activity from the prior quarter. This includes roughly 250,000 square feet of new and renewal leasing signed since year-end, 313,000 square feet of current activity that is in advanced stages of negotiation and more than 690,000 square feet that could absorb vacant space across the portfolio. Given the circumstances with COVID-19 throughout 2020, we remain focused on our leasing activity and relationship with tenants, and we feel confident with how we have been able to navigate the pandemic. Despite broad market uncertainty and discussion around the demand for office space, our portfolio has performed well, leasing activity continues to improve, and we attribute our resilience through the pandemic, including quarterly rent collections remaining at 99% to our strong balance sheet, favorable geographic exposure, the quality of our properties, and the makeup of our tenant base with approximately 65% of annualized revenue coming from investment-grade tenants, including 39% coming from government tenants. As we look to 2021, we remain focused on the growth of our business through acquisitions, redevelopment, leasing and operational programs. In addition to those items we highlighted, we continue to advance several programs to manage operating costs, while utilization of our properties increased into 2021 and on our sustainability initiatives, which include current and proposed programs for real-time energy monitoring, lead, well and fit well programs and others which have previously earned OPI designations for the ENERGY STAR Partner of the Year Award and the Green Lease Leader Award. Before I turn the call over to Matt, I would like to acknowledge RMR's property and engineering teams for the exceptional work in 2020 to ensure the health and safety of our tenants, employees and the many programs implemented across our portfolio for a safe reentry to the office. I would also like to quickly recognize the RMR Group for being named one of the top 2020 places to work in Massachusetts by The Boston Globe. We are proud to be part of an organization that commits to building an inclusive culture, investing in the wellness and development of its employees and providing an innovative workplace. We believe that the scale and caliber of RMR's operations as well as the opportunities for advancement attract top talent, and OPI is a beneficiary of this success. I will now turn the call over to Matt Brown to provide details on our financial results. Matt?

Thanks, Chris, and good morning, everyone. Normalized FFO for the fourth quarter was $61.8 million or $1.28 per share, which beat consensus by $0.03 and the high end of our estimate by $0.02 due to NOI coming in higher than forecasted, partially offset by an increase in G&A. CAD for the fourth quarter was $42.3 million or $0.88 per share. Our dividend is well covered with a full year 2020 CAD payout ratio of 58.8%. Despite pressure from the 2021 vacancies that we have discussed, we expect our dividend to remain well covered. G&A expense for the fourth quarter was $7.1 million, down from $7.3 million for the fourth quarter of 2019 and flat sequentially. G&A expense for the fourth quarter includes approximately $600,000 of share grant accelerations from the retirement of 3 RMR officers and $450,000 of net G&A expense related to a lease obligation we assumed in connection with our 2017 acquisition of FPO. This lease expired on January 31, 2021, and will result in a reduction of $300,000 of G&A expense in Q1 and $450,000 beginning in Q2. Interest expense for the fourth quarter was $28.8 million, down from $30 million in the fourth quarter of 2019 and up $1.7 million sequentially. The sequential quarter increase is due primarily to the issuance of $250 million of unsecured senior notes in September 2020. Turning to property level results for the quarter. Same-property cash basis NOI increased $4.5 million or 5.1% compared to the fourth quarter of 2019, exceeding our guidance range of 2% to 4%. The increase was mainly driven by increased cash received from contractual rents of $3 million as a result of free rent expiring and roll-ups and rent related to leasing activity in 2020 and as well as a $2.2 million decrease in operating expenses, mainly driven by cost savings initiatives implemented by RMR in response to the pandemic. These NOI increases were partially offset by a decline in parking revenue of $800,000. We have been encouraged by OPI's strong performance throughout 2020, including full year same-property cash basis NOI growth of 2.8%. Our monthly rent collections continue to average approximately 99% and granted rent deferrals totaled $2.5 million, which is unchanged from what we reported on our Q3 earnings call. Repayment activity has been strong as we have collected $2 million or over 78% of total granted rent deferrals to date. While there was a surge in COVID cases in the U.S. over the last several months, we have not experienced an increase in deferral requests, which we believe is a testament to the resilience and strength of our tenant base. Turning to normalized FFO and same-property cash basis NOI expectations. We expect first quarter normalized FFO to be between $1.22 and $1.24 per share. The decline from $1.28 per share reported this quarter is mainly due to the January 2021 disposition of the Richmond, Virginia property, resulting in $0.03 of lower normalized FFO in Q1 and a restructure of the Tailored Brands lease effective January 1, 2021, also resulting in $0.03 of lower normalized FFO in Q1, offset by the share grant accelerations in Q4 and FPO lease expiration discussed earlier that will have a favorable impact of $0.02 on G&A expense in Q1. We expect first quarter same property cash basis NOI to decline between 2% and 4% as compared to the first quarter of 2020. We are forecasting a reduction in rental income of $2.4 million, most notably due to the Tailored Brands lease restructure that will impact cash revenue by $1.4 million in the first quarter and a decrease of $600,000 in parking revenue due to the pandemic. In addition, we are forecasting an increase in operating expenses of $1 million, most notably an increase in forecasted snow removal costs. Looking ahead to Q2 2021, we expect previously disclosed known tenant vacates and capital recycling activity to impact normalized FFO as follows: The expiration of the GSA lease at 20 Massachusetts Avenue that will impact normalized FFO by $0.06. However, we remain optimistic about a potential redevelopment that could generate cash-on-cash returns of 8% to 10%. The disposition of our Huntsville, Alabama property that is expected to impact normalized FFO by $0.02 and other disposition activity and vacancies that we expect may impact normalized FFO by $0.04. Turning to capital expenditures and the balance sheet. We spent $20.2 million on recurring capital during the fourth quarter, bringing total 2020 recurring capital expenditures to $76.3 million, and we expect 2021 recurring capital expenditures to be approximately $85 million. At December 31, our leverage was 6x, the low end of our target range. We currently have more than $900 million of liquidity, including full availability under our $750 million revolving credit facility, and we have no significant debt maturities until February 2022. We are confident that the strength of our portfolio and balance sheet provides flexibility and support to our business and safety to our shareholders as we execute on our strategic business plans in 2021. Operator, that concludes our prepared remarks. We're ready to open the call up for questions.

[Operator Instructions] The first question comes from Bryan Maher with B. Riley Securities.

Can you talk a little bit about the Technicolor disposition and how it relates to pricing relative to expectations and other opportunities you may or may not have had that with property?

Yes. Bryan, this is Chris. I think kind of going back, as you know, the tenant gave us notice to vacate effective August of this year. We originally kind of went out assembling a team and marketed the space for lease and at the same time, have an opportunity to spend a lot more time with the building and understanding kind of what the strategy could be from a leasing effort. And I think as we continue to kind of work through things, we just found that more interest came from the acquisition side and kind of coupled that with the fact that this building, despite being industrial, is really 31% manufacturing with the balance of warehouse distribution. And there's just some logistical challenges with dock doors and other things that really layered on additional capital required to reposition the asset. And I think the last caveat there is, as we started kind of looking around and seeing tenants in the market, we're seeing -- there were some bigger users maybe at 250,000 square feet, but on average, the users were 50,000 square feet. And it just became more evident that the cost to reposition versus a strategic play and selling it at a price that we think is indicative of the value given the rent rates and kind of what capital are required, we'd be in a better position to redeploy those proceeds into something more core to our business.

Okay. Great. And can you shift gears to Mass Ave asset in D.C. It's been a couple of months since you last updated us on that asset and the potential for redevelopment. Has anything changed in your thought process there?

Nothing's changed. I mean we're running dual pass. This building can support kind of the government uses that's currently in there today. We've seen some activity. We're in various levels of conversations with some government uses, certainly around the repositioning. We believe that adds additional value and provides attractive returns as well. We've been running parallel pass, meaning from a use standpoint, we have flexibility with the different types of uses we can put in there and have done some work around design and other related items. So when we get down the path, which we hope to kind of have some direction here in the near term, we're not necessarily missing a beat on timing and our ability to get out and start construction and be in a position to deliver timely.

Okay. And then when we think about kind of the 4 big assets this year with vacates, Technicolor, Plantation, Fresno and Mass Ave, if we were to back those out of the equation and just think about the core balance of the portfolio, where would you envision that occupancy being around year-end 2021, give or take?

I think a reasonable assumption at this and there's certainly a handful of variables that will play into this, just given the level of capital recycling and then where we may buy, right around 90% is probably a reasonable assumption.

Okay. And then just last for me. When we look at what's happening with New York City and a couple of other marketplaces out there, really impacted by COVID. Is there some level of discount on potential assets that would come available that could compel you into those markets? Or is there just really no appetite at OPI for that?

I think it's more around kind of our core business strategy. We just see less opportunities in a market like kind of some of these gateway cities and the CBDs. As we look at single-tenant occupied assets or kind of how we've expanded the horizon a little bit, it's not that we don't find opportunities on the peripheral, like New Jersey, in California and San Jose, where we have assets, Southern California and other markets, those are the likely candidates for opportunities for acquisitions.

The next question is from Jason Idoine with RBC Capital.

Yes. I was wondering about the Boston acquisition. It looks like that was 59% leased, but it sounds like that might be part of a larger plan. I guess what were your thoughts when pulling the trigger on that with the lower utilization? And is it okay to just assume that you're going to operate that at the current level until that other opportunity kind of presents itself?

I think that's right. I mean, ultimately, we own 2 other buildings that connect to this building. And so with the acquisition of this, and they actually share party walls, we're able to assemble about 0.7 acres within kind of the North Station's submarket. And so I think the strategy with that building is to be in a position where we have control of some of the space, and we can do short-term leasing with no capital or very little capital and so that really is the play as we evaluate longer-term options. I think it's important to caveat that with the other adjacent building, we do have term on some of the leases. And so this is not something I would expect to come to fruition in, let's just say, the next year or 2, this is probably likely a longer-term strategy.

Got it. Okay. And then in terms of the capital recycling program going forward, I know you guys have said in the past, $100 million to $300 million annually came in at the low end in 2020, but you have $170 million sold or under agreement year-to-date. So I guess what's the possibility of going above that range? I guess is that something that you guys are open to? And how open is the market today?

I mean it's not necessarily -- I don't know that we'll hit that. I think, $100 million to $200 million -- excuse me, $100 million to $300 million is kind of the range we're comfortable with. It really is on a case-by-case basis, just where we're at with opportunities and strategies. But I think at this stage, it's a comfortable range to continue earmarking.

Okay. And then last one for me. If you guys could just touch on the acquisition that was terminated in Georgia.

The Georgia acquisition, so we were originally looking at 3 buildings that's part of kind of a campus where we also own buildings. And really, this was an opportunity to try to kind of assemble a larger piece. But ultimately, when we got into diligence, I think what we found that kind of the capital required to reposition those assets and the fact that there was still other assets in the park that we wouldn't control. It just wasn't the right strategy. I think we're comfortable with the buildings the way they are. They're fully leased. And I think we're better suited just to kind of continue down the path we are there.

Our next question is from Omotayo Okusanya with Mizuho.

First question, it looks like there's an asset you guys own in Englewood, Colorado, I think the tenant is United Launch Alliance. It looks like you're trying to lease that building as well or at least it's up for lease. So is that an additional vacancy we should be thinking about in 2021?

I don't think so. I mean that lease -- that building doesn't expire until late 2022. That location is strategic in the sense that their corporate headquarters is there within the park. There are several other buildings they occupy. That building specifically has their space program in it with skipped space across a handful of floors. And so I think at this stage, I wouldn't expect that we have any insight into them vacating. I think the focus right now is on conversations to continue to keep them in the building.

Good. That's helpful. And then the Technicolor space, again, understand industrials noncore. But again, I guess when we take a look at the rents you were getting there and the sale price, it just looks like a really big cap rate. So kind of trying to wonder, even with your expectations of how much CapEx you would need to repurpose it, how you kind of look at that, that still was the best of fruit at the current sale price? I guess we're trying to figure out this idea of portfolio repositioning you're doing, you're trying to make it CAD accretive. And I guess we just struggle with the pricing on this transaction, how that ends up being CAD accretive in the longer term, given what you end up investing the proceeds into?

Yes. I mean, I think kind of looking at it, if you may recall that last year, with Technicolor, we did a restructuring of their lease I think later in the year, whereby the rent was reduced, they had a downsized right. We were trying to work with them to kind of continue to retain them in the building, albeit they had a termination right. And so their rent was adjusted to something closer to market, which I think was to the tune of about $4.9 million. And so fast forward today, I mean we look at the building despite there's being NOI, it's a vacant building. They're leaving in August. And so we're effectively starting from scratch. And I think kind of going back to some of the feedback earlier, what we found with time is there's a lot of complexities with this building. And given kind of the shallow market itself, I just -- with the capital required downtime, free rent and other elements that go into this, it really didn't make sense for us to kind of spend the time and the resources with an outcome that doesn't produce any value for the company.

Got it. And then one more for me. The Richmond asset that you sold, just remind me again, the sales price, and then it sounds like you have a top 10 tenant in that building why they're going to -- it didn't make sense to hold on to that? Was it really the pricing, the attractive pricing that kind of influenced you to kind of sell it?

Yes. I mean that wasn't part of our original plan to sell it. And again, as we continue to evaluate options, again, as I think I mentioned it's -- the lion's share of that building is currently subleased. I think for us, there was a real risk of vacancy on the horizon. And also with that building, it was a built-to-suit for the tenant at the time, and we expected there to be a roll down in rent. And so as we started looking at it, we ultimately decided that based on the offer we see, which was extremely attractive, it was a better opportunity for us opportunistically to sell that and focus on redeploying that in something more stabilized.

And you said it was a 3.6% cap rate?

Cash contribution yield, yes.

Cash contribution yield, perfect.

The next question is from James Feldman with Bank of America Merrill Lynch.

I just wanted to make sure I heard you right on some of these FFO moves. So you had said $1.22 to $1.24 in the first quarter. And then were you saying sequentially you lose about $0.12 to get to the second quarter number of like $1.10 to $1.12? Is that the right way to think about it?

That is, correct.

Okay. And so I mean how long do you think you stay at that level? Like what are the offsets that give you a little bit of upside from that $1.10 to $1.12?

Yes. I'd say that our 2021 forecast is pretty conservative. We do have a very healthy lease pipeline that Chris highlighted in the prepared remarks. So if we're successful on some of that leasing activity, that should help us. In addition, on the capital recycling front, we've sold a lot more than we've acquired. So if we can find acquisition opportunities, we'll see some upside there as well.

Okay. And does that include the G&A benefit you mentioned on the call?

It does. Yes.

That it's baked into the $1.22 to $1.24?

That's right. And that really fluctuates quarter-to-quarter. In Q2 of each year, we have trustee share grant expense. So G&A will naturally increase from the Q1 level that I had highlighted.

Okay. So that's a further drag into 2Q?

Yes.

How much do you think that goes up?

$0.01.