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

Good morning and welcome to the Office Properties Income Trust First Quarter 2021 Earnings Conference Call. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Olivia Snyder, Manager, 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 first quarter of 2021 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, April 30, 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 first quarter earnings call for Office Properties Income Trust. Yesterday, we reported normalized FFO of $1.28 per share, exceeding our expectation as well as consensus estimates for the quarter. We are encouraged by our first quarter activity on the heels of strong performance throughout 2020 and we continue to be well-positioned to advance our growth strategy and deliver value to our shareholders. Following our active capital recycling in 2020 and into 2021, we have over $930 million of liquidity to support our leasing, acquisition, and development activity. Despite the industry challenges presented by the COVID-19 pandemic, our portfolio continues to perform well, rent collections continue to trend above 99%, and we believe our portfolio composition and investment strategy will continue to benefit us. Turning to acquisitions and disposition activity. The market for acquisitions continues to improve and we are starting to see an increase in deal flow for opportunities that meet our investment criteria. We have been active with a handful of transactions and remain disciplined with what continues to be a competitive investment environment. Currently, we have an active acquisition pipeline that is trending in excess of $400 million for properties in various stages of consideration and look forward to providing additional updates as opportunities advance. In 2021, we completed the sale of 3 properties for $117 million, which includes 2 previously disclosed properties sold in Kansas City, Missouri and Richmond, Virginia, for a combined $131 million. Along with the recent sale in April of a non-core property located in Huntsville, Alabama, that was a known vacate in the third quarter for $39 million dollars. The Huntsville sale eliminated the 1.4 million square foot potential drag on occupancy and significant anticipated capital and downtime for re-leasing. These efforts are aligned with our 2021 capital recycling plan focused on the disposition of $100 million to $300 million of properties, specifically buildings that are capital intensive, older buildings or sales that provide strategic value across the portfolio with the goal of investing these proceeds into newer less capital intensive buildings those intended to help reshape the tenant and geographic diversification or for opportunities to enhance yields to select development projects. Turning to leasing results for the quarter. While the long-term effects on the office real estate market remain uncertain, we continue to work closely with our tenant as they plan for re-entry and are encouraged by the momentum of our lease dialoguing activity. Current building utilization is 30% of our portfolio square footage, which we define as tenants that are utilizing at least 50% of their buildings. We anticipate tenants will continue to advance the re-entry plans into the third and fourth quarter and requirements for new and renewal leases will continue to accelerate consistent with the growing pipeline trends we have seen over the past several quarters. During the first quarter, we completed 575,000 square feet of new and renewal leasing with a 3.2% roll-up in rent, a weighted average lease term of 5.4 years, and leasing concessions in capital commitments of $2.28 per square foot per lease year. We ended the quarter with consolidated occupancy of 90.8%. Activities for the quarter was mostly contributed by federal and state agencies including a 5-year renewal with the State of Washington for 112,000 square feet, a 10-year renewal with the Commonwealth of Massachusetts for 87,000 square feet, and a short-term renewal with the federal government at our buildings in Rockville, Maryland for 109,000 square feet. While leasing over the past year has mostly been concentrated around renewal activity, we are beginning to see more activity for new lease requirements across our vacancies. Our overall leasing pipeline remains robust with discussions covering 3.1 million square feet including roughly 106,000 square feet of new and renewal leasing signed since quarter end, 481,000 square feet of current activity that is in advanced stages of negotiation, and more than 950,000 square feet that could absorb vacant space. Potential absorption is mostly concentrated in our D.C. MSA including activity in our recently renovated building in Reston, Virginia. At the same time, we are also encouraged by the uptick in tour activity across our portfolio. We believe we are well-positioned to continue to advance leasing of our vacant space given the quality of the building and their locations, including markets such as Phoenix, Arizona, San Jose, California, suburban Boston, and Northern Virginia. Each of these markets embody unique demand drivers around industry diversification, metros of higher education attainment, demographic and technology shifts in supporting economic activity many of which are considerations we value for continued growth within our portfolio. Further, we continue to make progress with our previously disclosed known vacates for 2021, which includes the mentioned sale of our property in Huntsville, Alabama, additional updates are as follows: In our Plantation, Florida property, the GSA lease expires in April and represents 80 basis points of annualized revenue. We have previously disclosed the tenant vacating upon expiration, however, this tenant has since elected to hold over for up to 12 months and we anticipate continued occupancy through Q4 2021. Despite this holdover, activity for private sector leasing has been strong with several larger users having acquired into the building. With our property and Fresno, California, the GSA is scheduled to expire in November reflecting 1.5% of annualized revenue. Plans for the tenant to vacate remain. However, we are actively marketing the property for sale and we anticipate an update on our marketing efforts will be available on future quarter. And lastly, for our property located at 20 Massachusetts Avenue in Washington, D.C., the tenant representing 2.8% of our annualized revenue has vacated the building on March 31st as originally disclosed and plans continue for advancements of our redevelopment of this property. We continue to work through our plan and look forward to providing progress updates on activity as it materializes. Overall, we are pleased with the activity we're seeing across the portfolio and trends of 3 consecutive quarters where our leasing pipeline exceeded 3 million square feet. Before I turn the call over to Matt, I would like to highlight that OPI recently received the 2021 ENERGY STAR Partner of the Year Sustained Excellence Awards. This is the fourth consecutive year that we have achieved Partner of the Year recognition and the second year, we have earned the Sustained Excellence designation in the energy management category. We are proud of this effort and commitment to our sustainability initiatives across the RMR organization. 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 first quarter was $61.8 million or $1.28 per share, which beat consensus and the high end of our estimate by $0.04 mainly due to NOI coming in higher than forecasted. CAD for the first quarter was $47.7 million or $0.99 per share. Our dividend is well covered with the rolling forward quarter CAD payout ratio of 59%. G&A expense for the first quarter was $11.3 million, which includes $5.2 million of estimated business management incentive fees. Excluding the estimated incentive fee, G&A expense was $6.1 million compared to $7.1 million for both the same period last year and the prior quarter, neither of which included any estimated incentive fee expense. The decline sequentially is mainly due to elevated costs in the prior quarter due to share grant accelerations from the retirement of 3 RMR officers and $450,000 of rent expense related to a lease obligation that expired on January 31st as discussed last quarter, which resulted in a favorable impact of $300,000 in the first quarter. Incentive fees under our business management agreement with RMR are payable after the end of each calendar year in which they are earned but are recognized in the calculation of net income in accordance with GAAP in the first, second, and third quarters if applicable. We do not include such expense in adjusted EBITDAre or normalized FFO until the fourth quarter when the final incentive fee amount is determined. The incentive fee accrued in the first quarter is based on OPI's total return in comparison to the SNL U.S. REIT Office Index over the 3-year measurement period, which commenced on January 1, 2019. OPI outperformed the index by approximately 15% with a total return of 22.4%. This equates to an annualized estimated incentive fee of $20.8 million, which represents the cap of 1.5% of our equity market capitalization. The incentive fee accrual may increase or decrease over the remainder of the year depending on how OPI performs relative to the index. Interest expense for the first quarter was $28.8 million, which was flat sequentially and up $1.6 million from the prior-year period, primarily due to proceeds from the issuance of $412 million of unsecured senior notes in 2020 that were used to repay amounts outstanding on our revolving credit facility, partially offset by secured debt repayments of $152 million during 2020. Turning to property level results for the quarter. Same property cash basis NOI decreased $1.6 million or 1.8% compared to the first quarter of 2020, slightly outperforming our guidance range of negative 2% to 4%. As expected, the decrease was mainly driven by a reduction in rental income of $1.4 million, most notably due to the tailored brand lease restructure and a decline in parking revenue of $690,000 due to the pandemic, as well as an increase in snow removal costs of $1 million, partially offset by lower utility and maintenance cost. Turning to normalized FFO and same property cash basis NOI expectations. We expect second quarter normalized FFO to be between $1.11 and $1.13 per share. As highlighted on last quarter's call, the most significant declines from Q1 are driven by the following. $0.08 due to the expiration of the GSA lease at 20 Massachusetts Avenue, $0.05 due to the dispositions of our Huntsville, Alabama property in April and our Richmond, Virginia property in January and other known vacancies we have discussed, and $0.02 due to trustee compensation expense in Q2 and higher business management fees based on our current share price. We expect second quarter same property cash basis NOI to decline between 3.5% and 5.5% as compared to the second quarter of 2020. Turning to capital expenditures in the balance sheet. We spent $11.5 million on recurring capital during the first quarter and we expect recurring capital expenditures for the full year to be between 75 and $80 million. At March 31, our leverage was 5.7x. We currently have more than $930 million of liquidity including full availability under our $750 million revolving credit facility. We have no debt maturities until February 2022 when $300 million of unsecured senior notes mature which will come pre-payable without penalty in December 2021. In closing, our balance sheet remains strong and despite pressures from the 2021 vacancies that we have discussed, we expect our dividend to remain well covered. Operator, that concludes our prepared remarks, we're ready to open the call up for questions.

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

Good morning, guys. Appreciate all that color. Couple of quick questions. On the Boston property that you bought, we noticed it's 45% leased currently, 2 questions on that. Is there any opportunity to increase that occupancy until you move towards redevelopment or should we just expect it to stay there? And secondly, is that occupancy, did that kind of weigh down the portfolio, we noticed a modest downtick in total portfolio occupancy, is Boston responsible for that?

Bryan, this is Chris. I think on the first part of your question, certainly, the goal is to go after short-term leases in the interim while we evaluate a larger plan for the consolidated assets that we put together in Boston. So I think some of the space within that building is relatively turnkey, so we expect that what we won't challenge to maybe able to kind of improve leasing on a short-term basis for that project. And then with respect to occupancy, no, I wouldn't say that, that project would limit our occupancy. I mean that's still a bit close in May. And then I think from the change in occupancy from Q4 to Q1, it's really driven by some known move-outs at a building in the Chicago sub-market where 2 tenants vacated. One vacated just as part of its natural expiration and the other vacated given in part of a renewal and downside. So we've got a long-term renewal on a larger portion of the space in the balance the downsize vacated.

And then, thanks for that update on the 4 big properties for this year. But on Mass Ave, with that property now vacated, I'm assuming you guys are definitively moving forward with the redevelopment, correct me if I'm wrong there. And if that's the case, can you give us an update at -- on your thoughts on cost and timing, has that changed since you last discussed it?

Yes, the plan right now is to continue to move forward and with respect to timing, this is looking for a Q1 2023 deliverable. And total construction costs are about $150 million and then with leasing, it's upwards of about $200 million. And we were targeting about an 8% to 10% cash return.

And then last for me. You touched upon your acquisition pipeline. I think you might have said it's around $400 million. How competitive is the bidding there, and -- on cap-rate basis and is that expected to grow meaningfully, the potential opportunity and do you see the cap-rate shifting up or down with what's going on, bigger picture in the economy, and all the discussion regarding the needs for office space?

Yes. I mean, I think the cap rates for the type of assets that we're looking at, those kind of with long-term leases, credit tenants, or other synergies around markets have continued to remain competitive. And so, there's not been a material shift in cap rates other than just a lot of capital chasing similar type assets. And so I would say that for some of the assets that we've been looking at and active on the smaller deals just have a lot of different type of buyer taking that, and so it just becomes extremely competitive. And then some of the larger deals, I think it's very similar but cap rates are really going to be consistent based on marketing and kind of some of the parameters around that. I think we've targeted cap rates in 6% to 7%. I think we showed some of that with the acquisition in Q4 of the building up in the Charlotte, MSA. But as we look at other opportunities, I mean we're seeing cap rates that are 5% and 6% as well. So I think it's really kind of part of a multi-tier strategy where we're going to stop buying some properties that are at lower and others that are at the higher range, just to kind of get to the balance we're looking for.

The next question is from Elvis Rodriguez with Bank of America.

On your lease percentage went down, but yet you had the big tenant move-out at quarter end. I'm just curious, was that tenant included in the numbers or not included in the numbers? Just want to make sure.

When do you say the occupancy went down?

The lease percentage went down about 40 basis points but you lost, call it a 220 basis point tenant at the end of the quarter, but just want to make sure if that tenant is included in the numbers or not and should we see that come out in 2Q?

Yes. I mean I think that for the quarter with that March 31st expiration, we recognize that through quarter end, and so we'll see that drop off in Q2.

And then, with that, are you able to share trajectory of what will happen with occupancy throughout the year? Obviously, it's going to dip in 2Q but where do you see sort of occupancy ending at the end of the year?

I mean at the end of the year, there's a couple of different factors that are going to impact that. Kind of most notably around some of the dispositions that we're looking at. We've talked about Fresno, that's 500,000 square feet, and so certainly, if that building transact, that will have a favorable impact to occupancy, if vacate in November, that will have a negative impact on occupancy. But I think right now with that set aside, I think occupancy for us is looking at 89%, 90%, assuming kind of all other factor are working.

And then I just have a couple of more questions but I'm happy to hop in the queue after this next one. You took a $0.16 impairment in the quarter, I know you highlighted a bit on it in the Q. But maybe if you can share any details just so we have it here on the call that would be helpful.

Yes. The impairment charge in the quarter was related to the 2 properties that we had classified as held for sale at quarter end, one of which was the Huntsville, Alabama property that we sold in April for $39 million.

Thanks. I'll hop in the queue.

The next question is from Jason Idoine with RBC Capital Markets.

I had a question just on the Boston acquisition. So I guess last quarter you guys acquired the property in Boston that was close to or sharing walls with one of your existing properties and it looks like this quarter you did as well. Both last quarter and this quarter, the occupancy rate on those 2 properties was lower. So I guess is this new acquisition in that same area with the one from last quarter in your existing assets and I guess if you are building scale there, what's the long-term goal?

So acquisition is one and the same, it's just been delayed with respect to closing given some ongoing diligence at the property. So it's the same asset. And then really what this does is that gives us about 0.7 acre within kind of a combined parcel, and I think the goal is just to evaluate what our options are. I mean we do have leases in place with the adjoining buildings that has some term on them, which gives us plenty of runway to evaluate decisions and see where the market goes. So in the near term, I think we would benefit from those in-place leases while we kind of evaluate plan. And so my guess is that any updates on opportunity for this project are likely going to be something we would see maybe next year. But a brief -- a major repositioning here is pretty far out still.

Okay. And then could you provide some color on the leasing pipeline? It sounds like it dropped about 700,000 square feet since last quarter. So just wondering if that's all due to leasing activity.

Yes, it is. I mean I think in part we converted $575,000 to executed deals, and so we're left with the $3.1 million. And so that pipeline generally ebb and flows but as I noted, I think it's been consistently above $3 million for 3 quarters which is on the high end of the range when you kind of look back over the last couple of years.

The next question is from Vikram Malhotra with Morgan Stanley.