Easterly Government Properties, Inc. Q4 FY2021 Earnings Call

Greetings, welcome to the Easterly Government Properties, Fourth Quarter 2021 Earnings Conference Call. Currently, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to Lindsay Winterhalter, Vice President of Investor Relations. Thank you. You may begin.

Good morning. Before the call begins, please note the use of forward-looking statements by the company on this conference call. Statements made on this call may include statements which are not historical facts and are considered forward-looking. The company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Act Reform of 1995 and is making this statement for the purpose of complying with those safe harbor provisions. Although the company believes that its plans, intentions, expectations, strategies, and prospects, as reflected in or suggested by these forward-looking statements are reasonable, it can give no assurance that these plans, intentions, expectations, or strategies will be attained or achieved. Furthermore, actual results may differ materially from those described in the forward-looking statements, and will be affected by a variety of risks and factors that are beyond the company's control, including without limitation, those items contained in Item 1A, risk factors of its annual report, on Form 10-K for the year ended December 31st, 2021, to be filed with the SEC on February 28th, 2022, and in its other SEC filings, and risks and uncertainties related to the adverse impact of COVID-19 on the U.S. regional and global economies, and the potential adverse impact on the financial condition and results of operation of the company. The company assumes no obligation to update publicly any forward-looking statements, whether because of new information, future events, or otherwise. Additionally, on this conference call, the company may refer to certain non-GAAP financial measures such as funds from operations, funds from operations as adjusted, and cash available for distribution. You can find a tabular reconciliation of these non-GAAP financial measures to the most comparable current GAAP numbers in the company's earnings release and separate supplemental information package on the Investor Relations page of the company's website @ir.easterlyreit.com. I would now like to turn the conference call over to Darrell Crate, Chairman of Easterly Government Properties.

Thank you, Lindsay. Good morning, everyone. And thank you for joining us for this fourth quarter conference call. Today, in addition to Lindsay, I'm also joined by Bill Trimble, the company's CEO, and Meghan Baivier, the company's CFO and COO. 2021 was another strong year for the company in the portfolio. The year was defined by a record level of acquisition volume, increased FFO per share guidance, an increased dividend, strong capital markets execution, both debt and equity, the formation of a joint venture with a leading global investor, and successful releasing efforts with our primary tenant, the United States Federal Government. We continue to rigorously maintain our investment discipline of purchasing mission-critical facilities that are early in their life cycle. We have been building this portfolio of 89 buildings for the last 12 years, and today the average life of our buildings is just 13 years. While maintaining our focus on long-term quality, we were able to grow FFO per share in 2021, by a strong 4%. As you know, this cash flow's backed by the full faith and credit of the U.S. government. While we spend a significant amount of time talking about growth through acquisition, I would like to highlight the outstanding effort that produces strong, consistent results by our re-leasing and asset management group. This team has developed a definable edge in how they work with our tenant, the U.S government, to meet their unique set of needs. As we've seen over the last 20 years, there have been groups that have built GSA portfolios and chosen to service the government with folks who are trained in operating commercial office. This is not a match. The government must have a different set of tastes and preferences to achieve their goals as compared to our commercial tenants. Our team is steeped in understanding these unique needs with the goal of being the Private landlord of choice to the United States government. We're certain this platform creates enduring long-term value for our shareholders. Further, we are pleased that we can consistently deliver a strong dividend to our shareholders. Our cash available for distribution continues to grow and reduce our payout ratio as we emerge from a period of re-leasing in 2020 and 2021. We are pleased that this favorable reporting trend will continue through 2022. We'd like to take a moment to thank our board. We have an exceptional group of directors who have achieved significant success in their business endeavors, and we're grateful for their enduring engagement and guidance. Lastly, I'd like to thank our investors for their support and interest in Easterly Government Properties. We'll continue to work to deliver high-quality dividends and growth from a portfolio with the highest creditworthy tenant of the United States Federal Government. And with that, I'll turn the call over to Bill to further describe the activities of the quarter.

Thanks, Darrell. And good morning. Thanks for joining us for our fourth quarter earnings call. 2021 was an incredibly successful year for Easterly on many fronts. $412 million in mission-critical acquisitions. The launch for a new joint venture partnership with a prominent global investor, the renewal of several leases, and the bolstering of our full-size portfolio metrics on every measure, all combined to put Easterly Government Properties in a very strong position at year-end. This is a year where our acquisition team broke all records dating back to our IPO in 2015. It was a year where we raised expectations and delivered. 2021 also saw the strengthening of our team, the new CAO, a new Head of Sustainability, and our Manager of HR and DEI initiatives. I will now break down the accomplishments and milestones. In total, Easterly completed either directly or through its new JV, 12 accretive acquisitions, totaling approximately $412 million at a weighted average acquisition cap rate of 6% for the year. The weighted average remaining lease term for these 12 buildings is 16.6 years, assuming all options are exercised, further demonstrating the long-term cash flows and stability of these assets. All 12 buildings are either build-to-suit or renovated to suit for the underlying tenant agency. We've said it before, but the successful accomplishment of the mission is the guiding requirement for agencies. The ability of our facilities to aid that mission is why we have seen such a strong renewal profile since our predecessor fund bought its first building in 2010. A highlight of our acquisition team's accomplishments in 2021 was the successful announcement and subsequent initial closings on a brand-new, state-of-the-art, 1.2 million square feet, 10 building portfolio, leased entirely to the Department of Veterans Affairs. To date, we have closed on 4 of these 10 properties and expect to acquire the remaining properties during 2022 and 2023. This unique portfolio, a natural addition to our growing organization, provided a perfect opportunity for the creation of our joint venture with a Global Asset Allocator who understands the enduring nature of these assets and the meaning of full faith and credit, with a weighted average lease duration of 19.6 years. This portfolio only further differentiates us from any of our private competitors. As previously mentioned, this portfolio materially reduces the average age of our already young portfolio and extends its weighted average remaining lease term. We were pleased to add to our cash flow to investors for the long term while opening new strategic opportunities in the future. At this time, the JV is limited to adjust these 10 properties, but we look forward to further conversations. In addition to the 4 VA outpatient facilities acquired by the JV in the fourth quarter, Easterly acquired a nearly 500,000 square-foot facility, primarily leased to the United States Citizenship and Immigration Services, or USCIS, located in the metropolitan region of Kansas City, Missouri. The total weighted average lease expiration date is February of 2036, and this property serves as USCIS's National Benefits Center, we believe the long-term tenancy in this facility is predictable. Finally, in the fourth quarter, Easterly acquired an 80,000 square foot leased VA outpatient clinic located in the Midwest region of the United States. VA Midwest is a build-to-suit outpatient clinic that was recently completed in 2021. The state-of-the-art, two Green Globes certified facility is leased to the VA for an initial non-cancelable lease term of 20 years, that does not expire until May of 2041. The outpatient clinic provides a wide range of medical and ancillary services including, but not limited to, primary care, mental health, audiology, optometry, dermatology, radiology, and prosthetics. On our development status, we have previously reported that the government has reached a determination on its new program requirements for the future FDA Atlanta Laboratory Development project. The GSA and the FDA have spent the past several months working together to ensure maximum benefit from this facility and we are pleased to reengage with the government and actively proceed with next steps. Since the time of our last call, Easterly has proceeded with the redesign of the project in collaboration with the FDA and the GSA and completion of the project is now anticipated in the second quarter of 2024. Turning to leasing updates, our asset management team continues to secure meaningful renewals that lengthen the duration of cash flows. In the fourth quarter, we renewed the small business administration or SBA lease in a multi-tenanted facility located in Buffalo, New York. With a lease commencement date of August of 2022, Easterly can proceed with tenant improvement work in advance of its start date. Once the new lease commences, a brand new 17-year term, 15 years strong, will begin that can take SBA's tenancy into August of 2039. This renewal, combined with other assets year-to-date, translates into nine successful re-leasing exercises, totaling approximately 574,000 square feet or just under 7% of the annualized lease income for a weighted average lease term of 16.2 years in 2021. In closing, we at Easterly had a very productive last quarter of 2021, including another strong year for the company. We have meaningfully and assertively scaled the company's portfolio through the acquisition of bullseye assets. We executed on our highest acquisition volume year on record as a public company. We have formed a new joint venture with an experienced global partner, and we have even further refined our investment discipline of owning assets primarily backed by the full faith and credit of the United States government. With that, I thank you for your time this morning, and I'll turn the call over to Meghan to discuss the quarterly and year-end financial results and capital markets executions.

Thank you, Bill. Good morning, everyone. It gives me great pleasure to report another strong quarter, closing a very successful year here at Easterly. As of December 31st, we own 89 operating properties comprising approximately 8.6 million leased square feet, either wholly on or through our joint venture with one additional development project in design, totaling approximately 162,000 square feet. In 2021, we acquired 12 properties and sold 2. Through the acquisition of newer facilities and strategic disposition of non-core assets and the successful long-term renewal of existing property, the weighted average age of our portfolio remains young at 13.6 years, and the weighted average remaining lease term has grown to 9.7 years. Turning to our quarterly results for the fourth quarter, all on a fully diluted basis, net income per share was $0.08, FFO per share was $0.33, and FFO as adjusted per share was $0.32. Our cash available for distribution was $26.3 million. For the year ended December 31st, 2021, all on a fully diluted basis, net income per share was $0.36, FFO per share was $1.31, and FFO as adjusted per share was $1.24. Our cash available for distribution was $100 million. At $1.31 per share on a fully diluted basis, Easterly delivered at the stated midpoint of its previously increased guidance. This represents an impressive 4% growth rate year-over-year. When coupled with a roughly 5% dividend yield, we believe Easterly presents a unique opportunity for investors to receive our robust current yield, backed by the full faith and credit of the U.S. government, alongside long-term inflation protection. On that note, let me take a moment to remind those on the call that while the typical GSA lease does not provide for Chevron bumps, it does contain an operating expense base, which protects us as landlords from bearing the burden of increased operating expenses, and that's diminishing ally in an inflationary environment. Turning to the Balance Sheet at quarter-end, the company had total indebtedness of approximately $1.2 billion with nearly full capacity on our line of credit for future acquisitions and development-related expenses. As of December 31, Easterly's net debt to total enterprise value was 34.1%, and its adjusted net debt to annualized quarterly pro forma EBITDA ratio was 6.7x. With a weighted average debt maturity of 6.7 years and 97.5% of all outstanding debt fixed at attractive levels, I am particularly pleased with our company's positioning as we enter a potentially rising rate environment. On the debt side in the fourth quarter, Easterly issued the previously announced $250 million principal amount of fixed-rate senior unsecured notes. The notes were issued and sold in two tranches: Series A senior notes in the amount of $50 million with a 7-year maturity, and Series B notes in the upsized amount of $200 million with a 9-year maturity. Together the weighted average maturity of these notes is 8.6 years, and the weighted average interest rate is 2.84%. We believe raising long-term unsecured debt at such an attractive weighted average rate and maturity is an extremely powerful tool in generating value for shareholders. In terms of equity, during the fourth quarter, Easterly sold just under 4 million of the 6.3 million shares the company sold on a forward basis, in connection with an underwritten public offering that took place in the third quarter at a net price to the company of $21.64 per share. With the settlement of these shares in the fourth quarter, Easterly received approximately $85 million in net proceeds, delivering the funding needed to continue pursuing our acquisition pipeline at levels that are accretive to shareholders. At present, Easterly expects to receive net proceeds of approximately $102.7 million from the sale of an aggregate 4.7 million shares of the company's common stock that have not yet been settled, including the remaining 2.3 million shares pursuant to the company's third-quarter underwritten public offering and 2.4 million shares from the sale under the company's $300 million ATM program. Assuming these forward sales transactions physically settled in full using a net weighted average combined initial sales price of $21.87. Finally, in the fourth quarter, Easterly announced the formation of a joint venture in connection with the agreements to purchase ten assets that we referred to as the VA portfolio. As mentioned on the last call, Easterly's JV partner will retain a 47% stake in the JV and Easterly will retain a 53% stake in the JV. Easterly will also receive asset management fees from the JV partner and will be responsible for the day-to-day management of the property. This relationship with our new JV partner, we believe, demonstrates the global interest in the outside current yields of GSA assets like those in the Easterly portfolio, yields which are backed by the strength and stability of the U.S. government cash flows that underpin each lease's credit quality. We are excited by the partnership and look forward to a strong, mutually beneficial relationship for many years to come. Turning to renewal, I would like to highlight some of our releasing successes as of year-end. As previously mentioned, due to the unique nature of our leases, final renewal rent cannot be ascertained until the exact amount of tenant improvement or TI dollars required by the government at renewal is known and the TI work is complete. As such, there can be a lag in providing releasing data relative to the point at which we have signed a renewal lease. As of December 31st, 2021, we had executed 12 renewals for which the renewal TI work was complete and accepted by the government. This 12 includes PTO Arlington and IRS Fresno. When we exclude PTO Arlington and IRA Express note, the average rent spread achieved on the remaining 10 renewals was 10%, including approximately $22 per foot of TI utilized by the government. The average total renewal term for these 10 renewal leases was 15 years. I can also share, that we currently expect our single-tenant properties that have renewed, but for which the new lease has not yet commenced, or for which it has commenced, but the TI has not yet been accepted by the government, to realize an average renewal rent spread of 10% to 15%. The group of assets totaled roughly 346,500 square feet across seven properties, and each for total lease terms of 15 years to 20 years, with an average of 16.7 years. In addition to these both renewals, we executed either renewal options or long-term extensions across 713,250 square feet of our portfolio. We look forward to working with the GSA upon the expiration of these assets between years 2023 and 2026. Finally, with approximately 341,900 square feet and six leases expiring through the end of 2022, we are pleased to report we're making meaningful progress with the GSA, and we're in discussions regarding all properties at this time. We feel good about the long-term mission and tenancy of these upcoming lease expirations. Turning to our earnings guidance, as you recall, during the last quarter call, there were questions surrounding acquisitions within the JV and those outside of the JV. To provide further clarity, the company is maintaining its FFO guidance per share on a fully diluted basis in a range of $1.34 to $1.36 but expanding its disclosure surrounding the assumptions underlying this guidance. This guidance is predicated upon $200 to $250 million of wholly owned acquisitions, the closing of properties in the VA portfolio totaling approximately $145 million at the company's pro rata share, and up to $10 million in gross development-related investment during 2022. At its midpoint, Easterly remains on track to continue our record of steady FFO growth year-over-year. With that, thank you for your commitment to our thesis, and we appreciate your partnership. I will now turn the call back to Sherri.

Our first question is from John Kim with BMO Capital Markets. Please proceed.

Thank you. Good afternoon. Or good morning. Meghan, your guidance for FFO was unchanged, but you did increase the acquisition guidance to $370 million including the JV assets. Were there other components of guidance that changed to offset that acquisition target?

So, John, what that's indicative of is deals that we had expectations could have closed last year but will now be closing in 2022. So, it's not fully forward. It's deals that moved from '21 to '22.

And you talked about the leasing spreads being 10% through 2021 in 10% to 15% on leases that have not yet closed, but I'm wondering how that compares to market rents. If you signed two non-GSA tenants, would you have done a higher leasing spread?

As you know John, rates of renewal put it in GSA market and particularly within our assets are decoupled from 'office market rents' in the markets where we operate. It's really an exercise in replacement costs for that asset. And obviously we have that within our backs, particularly today. And then the inflationary environment, we see they kind of shelve themselves. It's really apples and oranges. And we think about our renewals in that context.

And how does the current inflation environment impact the discussions on leases expiring this year?

I mean, it's a great backdrop. I think everybody in the room of a renewal process understands the current dynamic, and when you truly are faced in most instances with the alternatives being a new bill, time is on our side.

To clarify, inflation is a factor that the government is aware of. In our discussions, we concentrate on the commercial net present value and internal rate of return numbers connected to our assets, while they are focused on their mission. The government recognizes that inflation affects value, and it is important to note the numerous difficulties they are facing with rising construction costs and the need to shift projects. This situation is unique, as both sides are interpreting the current market news in a similar way.

So, Darrell, do you think the GSA is open to having leases that have a higher leasing spread, so implying more than 1% growth per annum?

I think we can't know what the GSA is thinking, but we do know that as we sign a lease today, both parties are aware that inflation may be on the horizon, and the conversation is positive. We'll see how it develops.

Great. Thank you.

Our next question is from Michael Carroll, with RBC Capital Markets. Please proceed.

Thank you. I wanted to discuss the company’s sustainability goals. You mentioned in your prepared remarks that you have recently appointed a new Director of Sustainability. How does DEA approach the promotion of its ESG initiatives? There has been a report online detailing your current activities, but do you intend to release a more formal report annually, similar to what many other companies do?

Hey, Michael. Good morning. Yes, we're very excited to have hired a Director of Sustainability. For a company of our size to be at that place is an exciting moment. We have consistently been focused on the Energy Star framework. And that's the framework the government pays closest attention to. And we, obviously, have our portfolio in the Energy Star tracker. We report within that framework, but our new Director of Sustainability is very much focused today on great baselining within the company as we begin to set goals. And yes, it will absolutely be our expectation to have a formal sustainability report as early as next year.

Okay. Great. And then can you talk a little bit about the type of goals that you want to set? I'm assuming that if you're just starting to baseline now, then setting those goals are still multiple years away, how are you thinking about that?

No, it's not years away. I would say it's a 2022 priority, and we'll inform how we come out in our report for 2023.

Okay. And then how much type of information do you get from the government? Do you get all the necessary information on the environment from their type of buildings like energy usage and things like that? Are there any difficulties getting that data given the leases that you have?

No, we don't face the same difficulties that triple-net REITs do with base. No.

Okay.

We do have access today.

And then just the last one for me, can you talk a little bit about the FDA Atlanta buildings? What's the progress on that? And is there any idea of when that could officially break ground?

Earlier, we have made significant progress with FDA Atlanta, as they continue to navigate construction while dealing with inflation and finalizing their tenant improvements budgets. This has been a consistent narrative for FDA Atlanta. We feel we are at a pivotal point, and the government has adjusted the commencement date to the middle of 2024. Although we haven't officially broken ground, we are actively allocating funds as we approach the end of this year and into the next. Our budget for this year is set at $10 million for expenditures.

Okay, great. Thank you.

Our next question is from Emmanuel Korchman with Citigroup. Please proceed.

Hey, good morning. Just thinking about the comments you've made thus far on increasing costs, maybe more tactful negotiations, etc. Has that changed the competitive landscape out there? Are other developers either finding it easier or harder to make their deals pencil out?

I believe there is a small group of individuals who engage with the development stage in the context of U.S. government requirements, and it appears that this hasn't altered the competitive landscape. This specialized skill set is akin to ours in asset management, but it certainly has involved more precise calculations as rates influence these deals and how we respond to our RFPs. There has not been a significant expansion in this area.

But I think it was very helpful for those who aren't as familiar with our company. Essentially, the government has two options: renew our building or construct a new one. When you consider a new building, our accumulated depreciation gives us an advantage. Our building is functioning well, and we strive to keep both the tenant and the agency in Washington satisfied, along with the GSA overseeing these processes. Looking ahead, it is evident that construction costs are rising, which influences our negotiations. There is clearly less certainty regarding future construction costs, and contractors are unlikely to offer guaranteed prices today due to narrow profit margins. The volatility in construction costs works in our favor, benefiting our portfolio overall.

Thank you, Darrell. There has been increased pressure from the government to encourage people to return to offices. This may be less relevant for your direct agency relationships, but have you noticed any changes in building usage or resumption of discussions that may have paused while office spaces were underutilized?

Good morning, Emmanuel. It's Bill. Overall, I think the situation is positive. Our buildings are essential, and the teams working there have been operational throughout the pandemic. That said, we are observing increased interest in some of our facilities for potential future expansions, indicating that things are trending in the right direction. Our buildings are more active than they have ever been and are expected to remain so. This has been a favorable environment for us, and the government has also come to terms with the challenges faced in conducting standard operations. Most of our missions are critical, but for the missions that require in-person presence, they have acknowledged the need to carry out operations from their offices instead of remotely, which proves to be less efficient.

Thanks, all.

Sure.

Our next question is a follow-up from John Kim with BMO Capital Markets. Please proceed.

Meghan, you mentioned the increased acquisition guidance in 2022 reflects some delays that you had from last year, but last year you did exceed your acquisition guidance by about $50 million. So, I'm just wondering what if there were any other offsetting factors to that increased acquisition guidance this year that wouldn't impact your FFO guidance.

I believe we would have exceeded our number from last year by a larger margin, John. Expectations outside of the joint venture have not changed.

Where do you see cap rates on the targeted acquisitions this year?

I think it's been an interesting market. Even though interest rates are increasing, we haven't faced any difficulties in the GSA space. There's a lot of investment coming in, and I believe conditions are continuing to tighten. The pristine building portfolio we just acquired was valued at a 5 1/4 cap rate, but we are now trading closer to a 6 and a quarter cap rate, indicating a significant gap. Private markets are assessing these buildings' value, which can be supported by leverage, especially considering the United States Federal Government as a counterparty. I believe we are seeing a downward trend in cap rates in this sector. Nevertheless, we remain opportunistic and focus only on accretive transactions, and we are pleased to have our global joint venture partner supporting us in these efforts. We're adapting to the changes in the market.

And Bill, the set of assets, are you willing to do those on Balance Sheet or strictly through the JV?

Well, it depends. The bottom line is accretive, John. It just depends on which part they fall into. I think if you see some of these new buildings, they're even talking under five caps for them, so we're aware of that, and we have the capability to execute on those. But obviously, we'll do it on the Balance Sheet when the property fits that category, clearly two categories.

Great. Thanks for the follow.

We have reached the end of our question-and-answer session. I would like to turn the conference back over to Darrell for closing comments.

Great. Thank you everyone, for joining the Easterly Government Properties fourth quarter 2020 conference call. We appreciate your time, and we'll continue to work hard to deliver strong risk-adjusted returns for our shareholders for years to come.

Thank you. This does conclude today's conference. You may disconnect your lines at this time and thank you for your participation.