The RMR Group Inc. (RMR) Earnings Call Transcript & Summary

Good day, and welcome to The RMR Group Fiscal Third Quarter 2021 Earnings Conference Call. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Michael Kodesch, Director of Investor Relations. Please go ahead, sir.

Good afternoon, and thank you for joining RMR's third quarter of fiscal 2021 conference call. With me on today's call are President and CEO, Adam Portnoy; and Chief Financial Officer, Matt Jordan. In just a moment, they will provide details about our business and quarterly results, followed by a question-and-answer session. 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. 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 RMR's beliefs and expectations as of today, August 6, 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, which can be found on our website at www.rmrgroup.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we may discuss non-GAAP measures during this call, including adjusted net income, adjusted earnings per share, adjusted EBITDA and adjusted EBITDA margin. A reconciliation of net income determined in accordance with U.S. Generally Accepted Accounting Principles to adjusted net income, adjusted earnings per share, adjusted EBITDA and the calculation of adjusted EBITDA margin can be found in our earnings release. And now I would like to turn the call over to Adam.

Thank you, Michael. Good afternoon, thank you all for joining us. This quarter, I'm pleased to report adjusted net income of $0.47 per share, an increase of 27% on a sequential quarter basis and 24% on a year-over-year basis. Further, adjusted EBITDA of $24.4 million represents a 16% increase on a sequential quarter basis and a 25% increase on a year-over-year basis. Our results this quarter highlight the significant progress we've made over the past year navigating the pandemic. As it reflect on the last 15 months, one of the lasting impressions I come away with is the resiliency of our platform and the commitment of our people to this organization. To begin today's quarterly commentary, I want to start by discussing what we're seeing across the commercial real estate sectors we manage and how some of our key operating metrics are trending. As of today, over 70% of the U.S. adult population has received at least one dose of the COVID vaccine. U.S. airline traveler totals are at the highest levels seen since the beginning of the pandemic. And we are experiencing increased office utilization rates at the properties we manage. In terms of organic AUM growth, due to the combination of increasing levels of capital being allocated to commercial real estate investments generally and historically low interest rates. We continue to experience significant competition for acquisition at our client companies, most notably in the industrial, life science and high-quality office property sectors. Illustrations of the competitive landscape for deploying capital most impactful in our company, ILPT, our private industrial fund and the Tremont mortgage platform, as each of these groups has over $500 million of dry powder to put to work. For example, this quarter alone, our organization has screened over $6.6 billion in industrial deals. And we underwrote approximately $3.5 billion of debt financing opportunities. Nevertheless, we continue to remain disciplined in our underwriting in the face of a very competitive market environment. From an operating perspective, this quarter, we saw many positive signs, most notably continued leasing momentum across our platform. This quarter, we arranged over 2 million square feet of leases on behalf of our client companies with a weighted average lease term of over 11 years and an average roll-up in rent of just over 9%. We believe the office workplace remains a critical part of most businesses and our continued leasing velocity reinforces this belief. I also would like to take a moment to highlight our expanded development capabilities, which is important as growth through acquisitions becomes more difficult. Over the last few years, we have taken on increasingly larger scale development projects with OPI's 20 Mass Ave redevelopment, a great current example of our expanding capabilities. This project is a 427,000 square foot RMR managed redevelopment project in Washington D.C., with total cost of approximately $200 million that is expected to be delivered in the first quarter of 2023. Finally, as it relates to the strength of our tenants, we remained pleased with cash collection rates that continue to hover at approximately 99%. Additionally, in an environment of elevated inflation, our clients remained well positioned with over 80% of our leases at RMR managed assets having inflation protection measures such as contractual rent bumps or CPI adjustments. I'd now like to highlight some of the recent notable activities at our client companies. In May, OPI raised $300 million of senior unsecured notes and used the proceeds to pay down higher cost debt. This offering was 6x oversubscribed, which is a positive indication of interest in OPI and commercial office real estate generally. In June, OPI acquired 2 Class A office properties for a total of $550 million and commenced the redevelopment of 20 Mass Ave, which I highlighted earlier. We expect OPI will continue its successful strategy of recycling capital into higher quality and better performing assets, which has increased the portfolio's weighted average lease term, decreased OPI's CapEx burden and expanded the company's footprint into faster-growing markets. As previously announced, DHC and Five Star amended their management agreements, which allows for the transition of 108 senior living communities from Five Star to a diverse group of best-in-class operators. This process is well underway and should be completed by calendar year-end, as DHC has already announced that 76 communities are under agreement to be managed by 4 new operators. The transition of these communities should ultimately be mutually beneficial and leave each respective client company better positioned. DHC's same-property shop occupancy experienced its first sequential quarter increase since the pandemic began. We believe senior living will benefit from many fundamental tailwinds, including limited supply growth and a rapidly growing target demographic that supports demand for senior living over the next decade. Turning to SVC, and more specifically, its hotel portfolio that is managed primarily by Sonesta. Since the conversion of 205 hotels over the past 3 quarters, Sonesta has been able to deliver significant improvements in occupancy, room rates and REVPAR. These positive trends, which have occurred despite the ongoing pandemic and the disruption of transitioning hotels from other managers have resulted in SVC reporting positive hotel EBITDA this quarter for the first time since the first quarter of 2020. As currently one of the largest hotel brands in the United States, Sonesta continues to invest in its infrastructure and franchising capabilities, positioning it very well for the future. At travel centers of America, which is also one of SVC's largest tenants, they reported adjusted EBITDA of $73.5 million this past quarter, an increase of 82% compared to the same period in 2019. These results highlight the progress TA has made in its business since the beginning of 2020. Before I turn to our cash deployment initiatives, I want to note that RMR Mortgage Trust and Tremont Mortgage Trust remain on track to complete their merger with shareholder votes scheduled for mid-September. As a reminder, we expect the combined platform to benefit from enhanced scale with fully invested assets expected to approach $1 billion as well as to be immediately accretive to both sets of shareholders, provide increased shareholder liquidity and reduce their respective cost of capital. We ended the quarter with approximately $400 million in cash. And as mentioned last quarter, our Board continues to assess potential alternatives for excess cash beyond what is required to fund growth initiatives. It remains our expectation that the most likely form of a return of capital to shareholders will be in the form of a special onetime dividend later this year. With regards to our growth initiatives, we remain committed to organically building relationships with providers of private LP capital. And we continue to dialogue with a handful of potential real estate private M&A targets. We are hopeful to announce progress on each of these initiatives for growth in the coming months. Finally, as I mentioned last quarter, we have begun building our own internal capital markets team to expand into other sources of private capital, such as family offices and high net worth investors and expect to announce more regarding this initiative on our next quarterly earnings call. I'll now turn the call over to Matt Jordan, our Chief Financial Officer, who will review our financial results for the quarter.

Thanks, Adam, and good afternoon, everyone. This quarter's results were robust, characterized by strong momentum across many of our key operating and financial metrics. We recorded sequential quarter and year-over-year increases in every headline metric, the majority of which were also in line with our guidance for the quarter. I'll plan to spend most of my prepared remarks detailing the drivers behind our results as well as expectations for the fourth fiscal quarter. Management and advisory services revenues increased for the fourth straight quarter, with revenues reaching $45.5 million, a $3.5 million increase on a sequential quarter basis. This increase was primarily driven by the following factors: first, the average enterprise value at OPI, DHC and SVC increased meaningfully this quarter, adding almost $1.9 million in incremental revenues. Secondly, for many of the reasons articulated by Adam earlier, our managed operators had strong operating results, which in turn led to approximately $1.6 million of incremental fees. And lastly, as typically occurs over the course of each calendar year, construction activity across our clients increased sequentially, which in turn generated approximately $800,000 in incremental construction management fees. Looking ahead to next quarter, we expect management and advisory service revenues to be between 46 and $47.5 million under the following assumptions: first, no material changes from July 2021 average enterprise values across our managed equity REITS. Secondly, revenues from our managed operators are expected to be flat as growth at Sonesta and TA is expected to be muted by declines of Five Star as they transition DHC communities to other operators. And lastly, continued increases in construction activity across the platform that should generate approximately $1 million in incremental revenues. This meaningful increase in construction management fees is primarily due to next quarter being our first full quarter, realizing incremental fees from recent amendments to our management agreements with DHC and SVC that provides for RMR to oversee all major capital projects and repositionings at hotels and senior living communities for a 3% fee. Moving to incentive fees from our managed equity REITS. OPI continues to accrue an incentive fee for calendar 2021. As a reminder, we only record incentive fee revenue at December 31st of each year. However, if June 30th had been the end of a measurement period, we would have earned an annual incentive fee of approximately $22.2 million. With regards to the calculation of our incentive fees, we were recently informed by S&P Global that the SNL indices we benchmark our REITs against will be discontinued effective August 7th. We are currently working with S&P to identify an alternative with the goal of finding REIT indices that most closely replicate the performance of the expiring legacy SNL benchmarks. Turning to expenses for the quarter. Cash compensation of $30.5 million and our cash reimbursement rate of 43% this quarter were both flat on a sequential quarter basis. Based on our headcount assumptions, statutory payroll tax withholding limits being reached and post-pandemic vacation usage. Next quarter, we expect cash compensation to be approximately $30 million. As it relates to equity-based compensation, with our fiscal year-end approaching, RMR share awards to officers and employees will occur in September. Based on RMR's historical grant levels, we expect approximately $500,000 in incremental equity compensation next quarter, the large majority of which is not recoverable. As Adam noted earlier, adjusted EBITDA this quarter was $24.4 million, an increase of 16% on a sequential quarter basis. Our adjusted EBITDA margin this quarter was 51.1%, a sequential quarter increase of 300 basis points. Our adjusted EBITDA margin getting back over 50% illustrates the operating leverage of the platform and our earnings potential as we experience service revenue growth. Looking ahead to next quarter, we expect adjusted earnings per share to range from $0.48 to $0.51 per share and adjusted EBITDA to be between 24.5 and $26.5 million. Before we go to questions, I would like to highlight that we recently ranked first on the BOMA International 360 performance program standings. We always look to highlight our vertically integrated platform and believe this to be a differentiator when meeting with potential sources of private capital. RMR's national real estate operations teams focus solely on our clients' assets. And we remain proud of our investments in sustainability, continual education and training of our team members and maintaining superior relationships with our tenants. That concludes our formal remarks. Operator, would you please open the line to questions?

[Operator Instructions] Today's first question comes from Bryan Maher with B. Riley FBR.

A couple of questions from me. And first of all, congratulations on what seems like we're turning the corner on a lot of different levels here. Given, we've listened to obviously all of the calls, most of your managed REITs have sizable chunks of liquidity. And we continue to hear, as you mentioned, Adam, the difficulty in buying assets at reasonable prices. That all being said, and with ILPT and TA and others having some land available, how deep is the appetite or willingness to develop ground up at RMR versus continuing to chase assets at really low cap rates?

Thanks, Bryan, and good afternoon. That's a really good question. And I'm glad you picked up on it from the prepared remarks because it is a growing part. Development activity, redevelopment activity has been becoming a bigger part of the whole RMR story. I would say, it's still a minority part of our story. It's still a small part. But I think it's going to grow over time. At the very least, I think to be a significant or major commercial real estate operator, investor, manager in this country, you have to have significant development capabilities sort of as a minimum. And we've sort of been developing that internally through hires and growing a much larger department within RMR that's focused on development. I would say, in the short to medium term, most of the development activity that is occurring is sort of ancillary to our existing real estate holdings. And that's in the form of, when you have 2,200 properties in every state in the country and then also in Canada and the Caribbean, you have a lot of different properties, a lot of different periods going through a lot of different cycles. And there's obviously a handful of properties that their useful life may have expired and that the area around them have developed into other locales. That would mean that that real estate would become much more valuable if it was converted into something else. And that's sort of the -- what I call the low-hanging fruit that we've been most focused on. That's what you're seeing at 20 Mass Ave. That's what we saw when we talked about the Torrey Pines redevelopment that happened at DHC, that's largely completed. It was over $100 million. That's what you see when you hear SVC talk about doing something in the Nashville market on a site that is currently a travel center. That site itself could be upwards of $1 billion mixed-use for the 5 million square foot redevelopment. So I think it is going to become a bigger part of what we do. In the industrial side, you'll probably notice, we have a -- our first, what I'd call a relatively modest development going on down in the Dallas market that we indicated. At ILPT, we bought the land from an affiliate company and are going to be developing that into industrial. I think it will continue to be a growing part of our business going forward. I don't think it's going to overtake just the traditional buying core real estate managing core real estate. I think that's going to be the lion's share of what we do for the foreseeable future. But I do think there'll be more and more sort of opportunities to what I call build to core. And that's really what we're doing. We're building products to core real estate with pretty healthy returns. Eventually, medium to long term, this is probably years away. I could see us deploying buying vacant lots, vacant land, buying properties specifically with the idea that you would tear down or redevelop or to develop something on that. I think that's more longer term. You could see us do it maybe the first place you might start to see us do something like that on a limited basis, might be in and around the industrial. And what we're seeing there just because of the competition for industrial acquiring, industrial properties. But that sort of gives you a flavor for what we're doing around development and redevelopment.

Do you think we could see a scenario where within your private investment vehicles or yourself personally buying and developing land of the various uses that the managed REITs target with the endgame that the managed REITs are a takeout such that the REITs don't have the overhang of non EBITDA generating capital at work?

It's certainly possible, Bryan. I put that as less likely. And I'll tell you why? It's not because I'm not confident in our development capabilities or being able to do it. It's obviously a related party transaction if RMR was to build something and then try to sell it into the REITS. And fortunately or unfortunately, we have a lot of related party existing relationships. And whenever we engage in further related party transactions, they're generally difficult to explain in the marketplace. And for whatever reason, they're often looked at some groups of investors look at them skeptically. So I'm not sure that's really the way we're thinking about it or plan to do it. If we did start buying greenfield, again, the first place you might see it. And this is not going to be meaningful, might be in and around industrial. But if we did that, it would be on ILPT's balance sheet. We probably won't do that, let's say, on RMR or personally or outside and then try to sell it to ILPT.

Okay. And just shifting gears. So clearly, it looks like from this week's earnings that DHC and SVC have probably turned the corner here with a lot more positive outlook for the next 12 to 18 months. With what you're seeing kind of internally, who do you think accelerates faster out of the downturn DHC or SVC?

I love your question, Bryan. It's a funny way to -- I haven't thought of it that way. Yes, but a horse race. Look, both of them, you're right. DHC and SVC are the 2 REITS. They have most been negatively impacted by what's happened with COVID. And they're both going through -- you're correct. The second quarter -- second calendar quarter, results for both those companies was very good. And we are -- as you're right, it does feel like we sort of turned the corner and things are getting better. There are so many variables that are at play as we think through the fall and into 2022 that affect how both those companies come out. And of course, it's all comes back to COVID. On the SVC side, it's about how fast does business travel come back and does the delta variant sort of make that harder as we get into the fall for business travel to come back. And the question -- the answer is nobody really knows, but everyone suspect it's going to have some impact. On the DHC side, it's the same thing. If COVID becomes a bigger part of the story in the U.S. economy, then, does that hinder the ability to see occupancy grow. The good news is, I think both businesses are going to improve as we get further into '21 and certainly into '22. It's very hard to say at what rate. That's I think what we debate and what we spend a lot of time thinking about is the speed of which the recovery will happen in both. Both are recovering and both are expected to keep recovering and getting positive. It's just very hard to say which one is going to do it faster. And so that's the basic answer.

And our next question today comes from Jim Sullivan of BTIG.

So Adam, I'd like to just kind of follow on to some of the questions that Bryan had and start with capital allocation. The -- in terms of the development activity as opposed to acquisitions. Presumably, there's a risk premium there. And I'm curious if you could explain to us how you think about that, what kind of hurdle rate you have for development, number one. And then, I guess, when you think about it in connection with the alternative of acquisitions in a very expensive environment, where your -- how far off are you from the market if you've underwritten a lot of products and maybe advance to the second and third rounds. How far off do you find the market from where you're willing to put capital into acquisitions?

Thanks, Jim. I think we are not far off. And we are winning transactions. It's just -- it's a very broad funnel at the top. And you have to basically go through a lot of processes. Some that are more widely marketed than others to sort of get to that deals that we win. Obviously, this past quarter, we bought $550 million of very high-quality office properties. And we announced some small acquisitions at ILPT on the industrial side. So we are able to make acquisitions. And I think we will be able to grow through acquisitions going forward. In terms of our capital allocation risk premium, again, we have the -- the reason I said to the earlier question about focused on development at incumbent legacy properties is we have a built-in often low basis in the land and the product in the real estate as it exists today on the balance sheet. And so it helps us in terms of getting that good return on a development. Meaning, if we were to just buy a vacant parcel in the same location of some of these properties, the development potential would be factored into their cost of the land or the greenfield. And so that can eat into your returns. So part of the reason we're focused on trying to do development activities on what I call incumbent properties is because we have that built-in low basis, and it's easy to get to their hurdle. Generally speaking, what are we building towards? High single-digits on a core return for development, high single digits. Now does it depend on if it's industrial or if it's office or even if it's going to be mixed-use or even if it's some other asset type, it sort of varies. But generally speaking, across the board, we're targeting high single-digits. But that's incorporating the fact that we already have a low basis in the real estate. So that's how it helps to get a good return for that client company when we put the additional capital to work. Hopefully, that answers?

No. Yes, thank you for that. One other alternative in terms of capital allocation. And obviously, we've seen it, especially with some of the multifamily REITs is to have an active developer capital program or structured finance book. We've seen companies like SL Green do it in office and Main Street Retail and UDR and others do it in multifamily. And you have your mortgage REITS, which do a different type of business I believe. But I'm just curious whether you've kind of taken a serious look at starting a developer capital program when you provide that mess level to the developers and sometimes we retain an option to buy the property at the end of the steroids. Is that something that you're looking at?

Jim, it's something we're not seriously looking at. We have looked more -- it's related to what you're talking about takeout commitments. Meaning, rather than just providing the financing as part of the development phase with a takeout attached, we have looked in circumstances of just committing to a forward takeout for a developer. I think we probably do that before we commit to the financing, especially if it's on a spec basis, even the forward commitments that we've looked at and haven't done. I'm just telling what we've looked at has been around developments that have usually a tenant in Tow. Meaning, it's a build-to-suit and/or subject to getting the building leased before we could take a takeout. Yes, you can get some cap rate discount or however you want to think about it, it's a little better. But of course, you're -- it's the time value of money. It's when is that takeout going to be done is how we've thought about. So specifically answer to your question, no, we haven't looked at it that way in terms of prime mess financing for development. We still, on the lending side, which you're right, it's related to what you're talking about. We find we have a pretty robust pipeline. And I think we can get a lot of money out to work, looking just sort of at this transitional value add, light value-add bridge loans. And we're seeing that on a risk-adjusted basis, we feel more comfortable putting money there at the moment.

And then, final question for me regarding the PE platform. When the RMR was talking about a major investment in PE, the PE platform a while ago. Ultimately, you scaled that back and to the point where you -- the lion's share of the cash will go to at a special dividend. And I'm just curious, you guys have investigated presumably a lot of opportunities in terms of a PE platform. And I'm just curious whether the issue was that pricing expectations for the sellers were just too rich or whether there was simply an absence of opportunities where there would be kind of a good meeting of the minds or marriage in terms of the personnel that -- whose platform you would be buying?

Sure. It's a good question. Just to be clear, I would not say it's completely off the table. I was more optimistic that that was going to be our primary way of growing the private capital business some quarters ago. My -- our thinking around that has shifted a little bit more, where I think we have a very good opportunity and we'll be successful growing it internally or organically ourselves. I mean we talked about that in the prepared remarks. We are having advanced discussions with being able to put, hopefully together, and I still believe this number, billions of dollars to work in and around private capital that we will organically place. That all being said, we haven't completely put aside the idea of doing something with that -- with through M&A. And to-date, the reason we haven't done something is not because of price. I would say to-date, we entered this market. It's now several quarters, maybe a year or 2 that we've been doing this now, and we had lots of discussions. I would say as much as this has been about us being very choosy about what we want to acquire. And more specifically, I don't think you're going to see us buy. And this gets really nuanced within the industry, a shop that is heavily reliant on closed-end funds that do opportunistic investing in real estate. That's a bridge too far from what we do and shops that are focused on that. And that's the majority of the private real estate -- private real estate shops that exist out there. Our focus has been just we are more interested in dealing with folks that are more -- they're investing sort of more core real estate, less closed end funds, maybe more separate managed accounts. And that just fits better. It's just -- it's a better -- there's a lot more synergies with what we do in our organization with a firm like that. And so we've narrowed the focus to be that. And I think it took us a while to figure this out that this is what we wanted to do as an organization. If we were going to do this from an M&A perspective and be successful at an M&A from doing this on an M&A perspective. And so to-date, the firms we have talked to that are me check all the boxes meet that criteria have been -- it has not been about price. It's been more about we want to do a control transaction. And that's not just financially, but to a certain extent operationally. We think we can bring, for example, significant synergies to bear on an organization like I've identified on expenses. And so the seller has to be comfortable with that sort of arrangement as we go forward. And so it hasn't been priced. It's just been more meeting of the minds, culturally getting together with groups and also us being more picky and being very choosy about what it is we are willing to buy.

And our next question today comes from Kenneth Lee at RBC Capital Markets.

Just one about the larger scale developments. You mentioned that this is an area that could grow over time. And you're also mentioning that you are right now ramping up your capability. Just wondering, if you could just perhaps give us a better sense of the potential time frames involved where you can reach that level of capability and where we could start to see more meaningful contributions?

Yes. I don't want to put too much -- I don't want to overstate the level of contribution that this business could be providing here in the short to medium term as we get in. When I say short to medium term, 2021, 2022, probably well into 2023. This is, one development takes a long time when -- and the specialty type of developments we're talking about. For example, 20 Mass Ave development, we mentioned in our prepared script. This is something that's a $200 million project. It started. It's not going to be delivered to Q1 2023. We have a handful of other projects of sort of the same scale that as I think about it, those projects, it will start in the coming years as we get into '22, into '23. Those projects will begin on the scale like what we're talking about. So I think it's an important capability for an organization like ourselves. And I think as time goes on, as years from now, I think this could be something that's quite -- it could become more meaningful. Maybe we're somewhat around conservative. What I'm trying -- what we're trying to do is sort of build up our capabilities over time. And I think it also sort of helps legitimize us in the eyes of investors that we're sort of a full service, vertically integrated real estate company that can do all types of things, real estate, with the focus generally that we're generally focused on core real estate, either buying, managing or building the core real estate. That's really our focus. And so I don't want to overstate it. Again, not to pick on industrial, but that could be the one place that you could see a small uptick in this stuff, where we could start maybe doing some more development there. And again, it would be development the core. I like to see us walk before we run. We have one development project going on down in Dallas. It's going to be, it's a $10 million project all in if that. And I really like to see us do it successfully before we start greenlighting many more projects. So it's going to be a process we go through. But I do think it will be -- it's important for us for multiple reasons, and someday could be a bigger part of our story.

Got you. That's very helpful. And one follow-up question if I may. You mentioned in the prepared remarks about the S&P REIT indexes being discontinued. Could you just talk a little bit more about what you see could be the potential impact to incentive fees given the calculations used a 3-year measurement periods?

Yes. Good question, Ken. So pretty similar to our prepared remarks. This is something we've learned from S&P in the last 3 or 4 weeks. We're in the process of assessing alternatives. To be fair, the ultimate goal is to find an index, an alternative with S&P or otherwise that very closely mirrors what we have today with the hope that there will not be a significant change to where the current incentive fee is trending, whether it'd be the SNL index or a replacement index. So that's our goal. And I think we'll have more to say on this at our next earnings call or in advance of our next earnings call. But we need to go through a process where we talk to both the RMR Boards and the respective REIT boards over the next few weeks as we identify alternatives.