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

Good morning, and welcome to the Office Properties Income Trust Third Quarter 2021 Earnings Conference Call. [Operator Instructions] Note, this event is being recorded. I would now like to turn the conference over to Kevin Barry, Director 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 third 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, October 29, 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. With that, I will now turn the call over to Chris.

Thank you, Kevin, and good morning. Welcome to the third quarter earnings call for Office Properties Income Trust. Yesterday, we reported third quarter results that reflect continued execution on our financial and operating objectives. Normalized FFO came in at $1.24 per share, exceeding the top end of our guidance range and consensus estimates for the quarter. Same-property cash basis NOI grew 1% year-over-year and also performed better than expected. We took action to strengthen our balance sheet with 2 bond offerings that favorably impacted our debt maturity schedule, and we ended the quarter with more than $800 million of total liquidity. Our portfolio continues to perform well, and we remain well positioned to advance our core business strategies, focused on the enhancement of the overall quality and geographic footprint of our portfolio through our capital recycling efforts, driving healthy portfolio absorption, cash flow growth and retention through proactive asset management and leasing, strategic development or major repositioning of properties, providing for higher risk-adjusted returns and continued advancement of our sustainability initiatives across our portfolio. Turning to our portfolio reshaping efforts. We are making steady progress on our capital recycling program. As a reminder, our focus is on reducing OPI's aggregate capital needs, improving the average age of our properties, better positioning properties in strong markets to grow rents and improving the likelihood of lease renewables. To that end, we continue to market properties, representing close to $275 million in value with an average age of 23 years, an average occupancy of 61% and a negative 5-year average cash contribution yield. We intend to use these proceeds to both reduce leverage following our recent investment in 2 core properties located in Chicago and Atlanta and to reinvest into our portfolio. Year-to-date, we sold 6 properties for $227 million that contained approximately 2.6 million square feet at an average age of 25 years, an average occupancy of 96% and a weighted average lease term of 1.2 years. As a result, we have eliminated approximately $98 million of budgeted capital over the next 5 years with a negative 5-year average cash contribution yield and accretive outcome with our reinvestment of these proceeds. Turning to an update on our leasing results. We reported solid leasing momentum with 659,000 square feet of new and renewal leasing, an increase of 37% above the trailing 12-month average, along with a weighted average lease term of 10.9 years and leasing concessions and capital commitments of $6.40 per square foot per lease year. New leasing activity increased sequentially and represented more than 40% of our total Q3 activity. Rent roll up for the quarter was flat. However, year-to-date, we are up 7% and continued to trend in line with our projections. We ended the quarter with consolidated occupancy of 89%, and our total leasing activity improved OPI's overall portfolio remaining lease term to 6 years. Since last quarter, we have seen an uptick with tenants and their employees returning to the office with utilization across the portfolio increasing to 38%, and we anticipate this will continue to escalate through the remainder of the year and into early 2022. We remain focused on proactive communications with our tenants to be a landlord of choice as they continue to evaluate their needs upon reentry. These efforts focus on both near-term expirations, along with strategies for expiring tenants over the next several years. Representative outcomes of this effort include a 13-year renewal and downsize with Micro Focus, a top 20 tenant expiring in 2024, complemented with a new lease to a university for health professionals for 170,000 square feet with a 15-year term, providing additional stability with the combined term at the property in excess of 13 years. In Sunnyvale, California, we completed a 10-year renewal with a full building user for 96,000 square feet with an original expiration in late 2022. In Chesapeake, Virginia, we completed a renewal with our full building tenant for 107,000 square feet in a term of 5.8 years. Our leasing pipeline remains robust with discussions covering more than 3.6 million square feet with a healthy mix of new and renewal activities with attractive lease terms and proposed rent roll-ups. This includes more than 670,000 square feet in advanced stages of negotiation with an additional 172,000 square feet that has since been executed subsequent to quarter end. This is the fifth consecutive quarter where our leasing pipeline has been in excess of 3 million square feet, which highlights a growing interest from tenants across our portfolio. We currently expect to finish the year with occupancy around 89% and a 5% to 7% roll up in rent. Turning to progress on upcoming expirations. We continue to make progress with our upcoming expirations and known vacates, supported by a healthy lease pipeline, inclusive of 1.4 million square feet or close to 6% of potential absorption across the portfolio. For 2021 expirations, we previously discussed the vacancy of our GSA tenant located in Plantation, Florida and have since signed a new lease this quarter for 70,000 square feet with a 10-year term, which represents over 50% of the building. Activity within this market remains robust, and we are in conversations with various tenants, presenting a positive outlook for further leasing within the building. In Sacramento, California, the state of California will be vacating roughly 158,000 square feet in November 2021, representing less than 1% of annualized revenue. This Class A building is located in Sacramento CBD is one block from the Golden 1 Center, the home of the Sacramento Kings and entertainment district. The building amenities and lead platinum designation make it an attractive destination for space not previously available in the market. We have varying levels of activity for the building, including conversations with state agencies and private sector tenants. And as previously disclosed, F5, a tenant in Seattle, Washington, representing 2.2% of annualized revenue, will be vacating in 2022, and we have plans for a redevelopment of this campus, which I will highlight in a moment. Turning to our development. We continue to make steady progress on our redevelopment project at 20 Massachusetts Avenue in Washington, D.C. and remain on track to deliver in Q1 2023. The development is currently 54% pre-leased, and we have varying levels of early-stage interest from a variety of tenants, including technology, consulting services, legal and related uses and look forward to providing updates in future quarters. We are also advancing plans to redevelop our property at Elliott Avenue in Seattle, Washington, that is currently leased to F5 through July of 2022. Our plan for this 300,000 square foot campus is to convert 2 of the 3 buildings to life science while maintaining an office use for the third building. The greater Seattle market continues to climb the rankings as a premier life science cluster, given its access to venture capital funding, major universities, access to an educated talent pool, combined with its existing tech presence. Rental rates for life science uses have increased more than 15% year-over-year and current demand continues to outpace supply in the market. We feel we are well positioned to deliver a premier Class A development, offering an extensive amenities package, campus connectivity with an outdoor experience in both LEED and Fitwel certifications. Our current schedule includes commencement of construction in 2022 with a planned delivery in early 2023. Total construction and leasing costs are expected to be close to $140 million, generating a stabilized return on cost of 10% to 12%. Currently, we are in advanced stages of negotiations with tenants representing close to 60,000 square feet, a solid start towards advancing this development. Turning to operations. We are proud of the progress we continue to make, enhancing OPI's energy and sustainability program and remain fully committed to elevating our ESG profile. In 2021, our real-time energy monitoring program has yielded close to $1.7 million in year-to-date cost savings. We are on track to end the year with approximately 5.7 million square feet of LEED-certified buildings, an increase of 1.25 million square feet and plans continue toward advancement of these initiatives into 2022, along with the introduction of new programs, such as Fitwel strategies across the portfolio. 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 third quarter was $59.6 million or $1.24 per share, which beat consensus and exceeded our guidance. CAD for the third quarter was $30.9 million or $0.64 per share, resulting in a rolling 4-quarter CAD payout ratio of 69%. The G&A expense for the third quarter was $448,000, which includes the reversal of $6.6 million of previously accrued estimated business management incentive fees. This reversal represents the amount that the estimated incentive fees as of June 30 exceeded the amount estimated as of September 30. Excluding this reversal of fees, G&A expense was $7.1 million, consistent with the same period last year and the prior quarter. The incentive fee accrued is based on OPI's total return in comparison to the index over the 3-year measurement period. OPI outperformed the index by 3.8% with a total return of 18.7%. If September 30 was the end of the measurement period, the incentive fee owed to RMR will be approximately $6 million. The incentive fee accrual may increase or decrease over the remainder of the year depending on how OPI performs relative to the index. As a reminder, incentive fees 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. Interest expense for the third quarter was $26.9 million, a decrease of $2.1 million from the prior quarter, primarily due to our accretive bond offerings in May and August and subsequent redemption of higher interest rate debt. In September, we issued $400 million of 3.45% 10-year bonds and use the proceeds to repay all amounts outstanding on our revolving credit facility. We expect interest expense to be between $27 million and $28 million during the fourth quarter. These debt refinancing activities have strengthened our balance sheet, increased the weighted average remaining term of our debt to approximately 6 years and reduced our weighted average cost of fixed rate debt. In aggregate, these 2021 opportunistic offerings, raising over $1 billion in proceeds will result in net interest expense savings of $5 million annually. We ended the quarter with more than $800 million of total liquidity, including full availability on our $750 million revolving credit facility. We expect fourth quarter normalized FFO to be between $1.17 and $1.19 per share, excluding incentive fees that impact normalized FFO in the fourth quarter and $1.05 to $1.07 per share, including our current estimate of incentive fees of $6 million, which represents $0.12 per share. Turning to property level results for the quarter. Same-property cash basis NOI increased 1% compared to the third quarter of 2020 and came in better than our guidance range of flat to down 2%. And this increase was primarily due to a decrease in operating expenses of $1.1 million, mainly a decrease in real estate taxes as a result of successful appeals and reductions in asset value at certain of OPI's properties in 2021 as part of RMR's abatement program and lower repairs and maintenance costs. The RMR managed real estate tax abatement program has saved OPI approximately $7.5 million since the beginning of 2018. We expect fourth quarter same-property cash basis NOI to be negative 1% to negative 3% as compared to the fourth quarter of 2020. Turning to capital expenditures on the balance sheet. We spent $26.3 million on recurring capital and $13.3 million on development capital during the third quarter. The main contributor of the development spend was from our 20 Mass Ave project that incurred $11.3 million in the quarter. We expect recurring capital expenditures for the full year to be between $75 million and $85 million. At September 30, our leverage was 7.3x. We expect to dispose of noncore properties under our capital recycling program to repay debt and manage our leverage levels and have approximately $300 million of properties in various stages of disposition, including 2 vacant land parcels that were sold earlier this week for $28.5 million. 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.

A couple of questions for me. Starting with the point of clarity. On the Plantation Florida property, I think you mentioned in your prepared comments that you re-leased about half of the space, 70,000 square feet for 10 years. Was that back to GSA? Or is that to another tenant?

That's to a private sector tenant, Bryan.

So is GSA still planning on vacating the whole building? And do you have a date for that?

So they are. And so I think right now, we had originally talked about them vacating the full building in December of this year. It looks like that's now trickling into early next year with them to vacate. So that would leave approximately 65,000 square feet that they would vacate kind of when you net out the new lease we've done.

And then you talked a lot about -- you have $800 million in liquidity. You want to keep an eye on your leverage, which I think is at 7.3%. In conjunction with those 2 things, what is your acquisition appetite going forward? And I know to some extent, it has to do with successfully closing on the $300 million in dispositions that you have in the pipeline. But can you give us some view as to what you expect over the next 2, 3, 4 quarters?

We can kind of talk, Matt and I. I would say we're just coming off the 2 acquisitions, which we've discussed and certainly have kind of jumped into the deleveraging program supported by our capital recycling. As noted, we have the $300 million that we're currently focused on and kind of continue -- want to continue to advance that going into next year as well. And so that you'll continue to see. I think from an acquisition standpoint, we're always kind of looking in the market. I think it's a little bit kind of more tame today just given that we don't necessarily have a [indiscernible] of a pipeline of acquisition opportunity just because of where we're focused and kind of the markets we want to be in. And so I think it's going to be somewhat muted kind of in the near-term versus kind of having a broader acquisition strategy.

Okay. And then you talked a little bit about the expirations coming up and the potential for re-leasing those. And it seems like you're a bit ahead of the game approaching 2022, '23 and '24. Do you have any thoughts on what we might see kind of in aggregate as far as rent roll-ups or roll downs go?

I mean from a rent roll up, we're targeting the 5% to 7% this year. I think our pipeline is showing good roll-ups, but I think we're going to kind of have to wait until we get into next year to see how some of that shakes out. I mean there's still a lot of moving pieces with tenants getting back into the office and kind of finalizing decisions around space and some of that may impact the overall metrics downstream. But I think for the most part, we feel pretty good about where we're going to end the year. And so far, it looks like we're continuing down the path with roll-ups of these what our pipeline has currently. Okay.