Easterly Government Properties, Inc. Q2 FY2022 Earnings Call

Greetings, and welcome to Easterly Government Properties Second Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, 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 the 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 those 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 contained in Item 1A, Risk Factors of its annual report on Form 10-K for the year ended December 31, 2021, which was filed with the SEC on February 28, 2022, in its quarterly report on Form 10-Q for the quarter ended June 30, 2022, to be filed with the SEC on August 2, 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 operations of the company. The company assumes no obligation to update publicly any forward-looking statements whether as a result 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.

Good morning, everyone, and thank you for joining us for the second 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. We had another strong quarter at Easterly Government Properties. We continue to add high-quality mission-critical assets to grow and diversify our portfolio. Like others, we are seeing a shift in the market. It seems we are entering a period of price discovery for our assets. We are optimistic about the effect this market dynamic will have on our business, particularly in the medium and long term. We're seeing marginal buyers exit the market, and we believe that there are developers in our space that have bid on projects with the expectation that cap rates would continue to decline. They may find themselves overextended as these projects approach completion. We expect both of these dynamics will have a positive effect on our ability to gain strategic assets over the next 24 months. Further, during times of uncertainty, we believe our strategy delivers predictable results to investors. We concentrate on mission-critical assets that serve enduring missions. During challenging times, our assets become more relevant and valuable. The individuals we serve cannot work from home, critical response functions cannot be executed from home offices, and if a recession is near, crime-related activities will likely rise. These agencies that we serve will be called to action. Our facilities will be serving their occupants effectively. While the asset side of our balance sheet is well-curated, our liability structure also provides investors with confidence. Meghan has done a great job trimming out our debt. Additionally, we have limited rollovers in the next several years. We do hear questions about the effects of inflation on the value of our assets. As many of you know, our leases have provisions that protect our investors from accelerating operating costs. Inflation also improves the value creation related to renewal activity. Meghan will further describe some of the positive effects that inflation has in our portfolio. We're pleased with how the company is positioned as we look forward, and we'll continue to execute our business strategy with the intent to deliver safety and stability to our investors. The goal is to deliver an attractive risk-adjusted return to our shareholders that is backed by tenants that represent the full faith and credit of the United States government. With that, I'll turn the call over to Bill to give you insights into the second quarter results.

Thanks, Darrell, and good morning. Thank you for joining us for our second quarter earnings call. Starting with acquisitions during the second quarter, Easterly, through our joint venture, acquired the fifth and sixth brand-new VA facilities located in Birmingham, Alabama, and Marietta, Georgia. They are part of our previously announced 10-building portfolio. And subsequent to quarter-end, we were pleased to add the seventh facility to the portfolio, VA Columbus, a brand-new VA facility located in Columbus, Georgia. Currently, the remainder of the assets in the VA portfolio continued to deliver as planned, and we expect the JV to close on approximately $145 million of this portfolio throughout 2022. In addition to the VA properties, Easterly had two wholly owned acquisitions during the second quarter. The first was the National Archives and Record Administration Warehouse in Broomfield, Colorado. NARA Broomfield is a build-to-suit warehouse constructed in 2012 and is 100% leased to the General Services Administration on behalf of NARA, pursuant to a 20-year lease, which does not expire until May of 2032. NARA Broomfield is one of 18 facilities strategically located throughout the country that holds permanent and temporary records created by federal agencies across seven states. To ensure the preservation of these important documents, the facility was specifically constructed to the exact needs of the National Archives, providing for optimal environmental controls and maintaining certain setpoints for both temperature and humidity. Aside from its important building attributes, it is also worth noting that our acquisitions team funded part of this acquisition through the issuance of operating partnership units at an accretive price of approximately $21 per unit, once again demonstrating the strength of an upgraded structure. Our second wholly owned acquisition in the quarter was an FBI field office located in Tampa, Florida. Remaining true to our original thesis of owning Class A mission-critical facilities, FBI Tampa defined this investment criteria with an in-place lease that does not expire until November of 2040. This 138,000 square foot trophy asset is enhanced by a number of important security features including, but not limited to: perimeter fencing, controlled access, blast protection, security setbacks, vehicle barriers, magnetometers, and SCIF space. With this acquisition, Easterly now owns 13 or just under 1/4 of the 56 FBI field offices located throughout the country. We continue to monitor the acquisition pipeline as we believe we are now seeing cap rates backing up from the bottom as the market's cost of capital has shifted. We continue to see potential CAD-accretive NAV-enhancing transactions and will remain focused on only the best opportunities within our niche market. And as discussed last quarter, private equity understands the unique nature of the GSA lease structure that protects us as landlord from inflation-induced operating cost increases and have gotten more active in the space. We believe this heightened interest drives value in the Easterly portfolio and introduces additional momentum into 2022. Turning to leasing updates, our asset management team continues to secure renewals that lengthen the duration of our government-backed cash flows and enhance the portfolio's NAV. In the second quarter, we renewed the ICE facility located in Louisville, Kentucky, for a new 15-year non-cancelable lease term. This renewal, coupled with the FBI Birmingham and EPA Kansas City executions from the first quarter, represents three successful re-leasing exercises in the first half of 2022. The remaining renewals for 2022 include the DEA laboratory in Dallas and the FBI field office in Little Rock, both of which we are considering strong strategic assets in the Easterly portfolio. As of quarter-end, negotiations on both leases are well underway, and we look forward to providing updates in future quarters. Finally, our FDA laboratory is now in the final stages of design drawings, which should lead to a restart in the near term. We estimate this facility will be delivered in the second quarter of 2025. In closing, we had a strong first half of the year, and expect the trajectory to continue into the second half of 2022. The Easterly team will continue to execute on its disciplined strategy of acquiring the most important assets leased to the federal government. We will work with the GSA and underlying tenant agencies on upcoming renewals and look to non-speculative development opportunities that can provide attractive returns. With that, I thank you for your time this morning and I'll turn the call over to Meghan to discuss the quarterly financial results and capital markets execution.

Thank you, Bill. Good morning, everyone. It was another strong quarter for Easterly, and we are pleased to share our results and how we view the company's positioning in the current market environment. As of June 30, we owned 93 operating properties, comprising approximately 9 million lease square feet, either wholly owned or through our joint venture, with one additional development project in design totaling approximately 162,000 square feet. Through the acquisition of newer facilities, the weighted average age of our portfolio remains young at 13.9 years. Successful long-term renewals at existing properties have also allowed us to sustain a lengthy weighted average remaining lease term of 9.9 years. As previously mentioned, maintaining a young portfolio age and a long weighted average remaining lease term is reflective of our strategy of owning relatively new build-to-suit assets with enduring missions. We believe this strategy provides us with distinctive future cash flow visibility, which in turn allows us to prudently manage the company's balance sheet and support our accretive acquisition and development project pipeline. Turning to our second quarter results, 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 also $0.33. Our cash available for distribution was $29.5 million. Turning to the balance sheet, at quarter-end, the company had total indebtedness of approximately $1.3 billion, with approximately $307 million available on our line of credit for future acquisitions and development-related expenses. As of June 30, Easterly's net debt to total enterprise value was 40.5%, and our adjusted net debt to annualized quarterly pro forma EBITDA ratio was 7.2x, with a weighted average debt maturity of 6 years, and over 88% of all outstanding debt fixed at attractive levels. I am pleased with our company's positioning as we navigate a rising rate environment. With a focus on leverage, I would like to touch on how we view our balance sheet positioning as we enter the second half of 2022. As Bill noted, we believe now is a good time to actively look at recycling capital. There is strong embedded value in the portfolio that we believe is being recognized by private players in our market. We ended the quarter with leverage of 7.2x, a level that was a deliberate decision by the company as we have approximately $92.5 million in proceeds of unsettled forward equity available to us. Consistent with standard practice, we will inform the market if and when deals are completed. We like how the balance sheet is positioned, and we are watching the market evolve. We believe Easterly is armed with the right set of tools to navigate the second half of the year and beyond. This quarter, our Board approved an inaugural stock repurchase plan of up to 5%, or approximately 4.5 million shares of the company's outstanding shares. The stock repurchase plan, the previously mentioned unsettled forward equity, and our strong banking relationships will ensure we remain aligned with our consistent commitment to allocating capital in a way that drives the greatest value for shareholders. The company and its shareholders view Easterly as a steady REIT, and we intend to continue being the consistent and dependable segment of the real estate sector we have always been. And finally, as Darrell and Bill mentioned, an inflationary environment serves as a real strategic benefit for Easterly compared to other REITs. Due to the build-to-suit nature of our assets, the cost of constructing another facility upon lease expiration is increasingly less desirable for the government, and our existing asset is further distinguished as the natural cost-effective renewal option for the GSA and the underlying tenant agency. Further, the unique nature of our leases allows for NOI protection; while base rent in most of our leases is flat, GSA leases generally contain an operating expense base which grows uncapped with increases in urban CPI, thus protecting us against NOI degradation in an inflationary environment. To be clear, the relevant urban CPI index as of June 30, 2022, was 9.8% higher than one year ago. Turning to our earnings guidance, the company is maintaining its FFO guidance per share on a fully diluted basis in a range of $1.34 to $1.36. This guidance is predicated upon $200 million 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, we thank you for your commitment to our thesis and appreciate your partnership. I will now turn the call back to Doug.

Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. Our first question comes from the line of Michael Griffin with Citi.

Darrell and Bill, you talked a little bit in your prepared remarks about cap rates and how you're seeing them maybe expand a little bit. Could you expand on that a bit? Have you seen any assets trade, quantifying where you're seeing cap rates and maybe where you expect it to trend in the near term?

Well, I think we've certainly seen 25 basis points of movement. I think, Michael, the thing is it's sort of an uncertain time. Things are moving right now. We did see the FBI Baltimore transaction fall apart earlier this year. So I think what we really are trying to do is figure out when we get a real balance and can figure out what the actual pricing should be. I think, as Darrell mentioned, we see a lot of opportunities out there. Our acquisitions team is doing all of their work. But until things settle down, we want to make sure that we are not the elephant in the swimming pool, making a lot of splashes out there. The bid-ask spread is probably a bigger range than we've seen in a very long time.

Great. That's helpful. And then just maybe a quick question on office utilization. I know you mentioned that it's maybe not affecting you as much relative to traditional office peers, but I feel that every other week, you may see some headlines around the federal government trying to bring people back into the office, and this might be starting to go in fits and starts. Can you quantify the percentage of your portfolio that might be impacted in that delayed return to the office?

Well, I think the great news is our folks have been working throughout the pandemic, so it's not really a factor for us. I will say about 85% of our buildings are those build-to-suit facilities that have very heavy usage, like the FBI's that Darrell alluded to, and the DEA laboratories that have really necessitated the presence of personnel the whole time. As more of our plain vanilla missions are about 15% of the overall portfolio, and they are occupied as well. I think though that as you heard President Biden mention in the State of the Union address last winter, the efficiency of the federal government may be compromised by working from home and that there's been a huge backlog over the years of COVID and that the government does better work in their office space, which is probably not a huge surprise to all of us. So we're not particularly impacted; luckily, those buildings that we categorize as more plain vanilla in our portfolio have mostly been renewed for substantial 15-year terms in just the last several years. So we're pretty happy to be where we are right now, and those build-to-suit facilities are humming along all the time as they have been throughout the entire pandemic.

Our next question comes from the line of Michael Carroll with RBC Capital Markets.

Bill, with your comment that cap rates are kind of up about 25 basis points and you're still trying to figure out what the right valuations are, should we expect that investment activity for DEA is going to slow at least in the third quarter? Is that fair? And will it pick back up in the fourth quarter to meet your guidance?

Well, I think the question is when things will change; we don't know yet. I can't say if we'll see a development in a couple of weeks or if it will take a month. However, I notice a lot of activity happening, and it's likely that sellers will recognize it's a better time to sell now rather than later. We will proceed carefully, ensuring that any actions we take are at least neutral or positive in terms of funds from operations or cash available for distribution. We will stay on our current path while being mindful of potential opportunities. Nevertheless, we need to see some certainty and clarity in the market before making large commitments. More updates will follow.

Okay. Is there, I guess, risk to the investment guidance? I know you have about another $110 million to allocate to that. Is that something that you're willing to defer into 2023 if the market valuations don't settle out by then?

Well, I can't comment now on what’s going to happen next year, except the fact that I think we're seeing plenty of opportunities. So far and steady as you go from our standpoint. There are a lot of uncertain factors out there, and I think that we're probably the most certain of the people following right now with what we're seeing.

Yes, this is Darrell. I mean something I'd add is this is really where market position favors the folks who occupy a dominant position, and that's us. You do have these developers who all have Excel spreadsheets. Folks are beginning to look at interest rates and understand where the water gets kind of above their heads, and we've had more calls with folks offering us an opportunity or a partnership to be involved in their projects. As we've seen in the past, that ultimately translates into people needing help in ways that can be very accretive to our shareholders. So none of that is going to abate soon. I think we really could see some activity; again, our acquisitions, you can't predict by week or month, as they can be few in numbers, so they're lumpy. But that said, the conversations that are happening are productive, and I think we're very confident in the medium to long-term about the changes in these dynamics and what it means for shareholders.

Okay. Great. And then can I go back to, I guess, the transaction market? I know Bill and Meghan both mentioned that you're looking to potentially recycle capital now. What type of assets are you looking to sell? And what are the valuations on those specific properties? I'm assuming that you've already been having discussions on those, given that it implied that something could happen in the back half of the year?

In today's market environment, we see this as a potential option. Over the years, as we have acquired valuable portfolios and buildings, some of those properties may not align with our core missions. While these buildings could be great for other government owners, they may not fit within the strict criteria we maintain. This presents a natural opportunity for us, and we would consider it if the pricing and market conditions are favorable. Although I cannot provide specifics at this moment, it is something we are monitoring and will discuss when there’s more clarity. It's important to note that the properties we might consider selling would likely not include those in the FBI zone, but could be more standard buildings or those with missions that present geographical challenges for us as a REIT.

Okay. Great. And then just one last question for me. Could we get an update on Atlanta? I understand it's been in the design phase for a while now. Is there an expectation that construction can begin soon?

Yes, I'll start and then go to Meghan. The answer is finally. It's important for everyone on this call to remember that we engage in nonspeculative development. This project was moving forward as our third FDA laboratory just before COVID began. The government had many priorities and many people were working from home, which caused some delays that were certainly not ideal for anyone. However, thanks to our team, Mark, Baivier, and Mike Ibe have worked diligently to get this back on track with the federal government. I believe in the upcoming quarters we will discuss the renewal of onsite personnel and the construction of this remarkable laboratory for the FDA. So yes, I think we're finally at that point. It has involved a lot of effort; the challenges haven't stemmed from our side, but I think the government now understands the urgency to move forward. I’m confident in saying that this will be underway in the near future.

Our next question comes from the line of John Kim with BMO Capital Markets.

You had mentioned price discovery and cap rate expansion back in your last call in June. Since that time, the ten-year rates compared to June have come down 70 basis points. I was wondering if your appetite is more tied to ten-year than typical office assets, or is it purely based on funding costs?

John, it's Meghan. Obviously, there is definitely a correlation to ten-year rates. I think we also see a little more tying in the private market participants to something more in the 5% to 7% range in terms of how they think about their financing today. So absolutely, everyone in our market is looking to those base rate spreads as we settle in here to where cap rates are starting to normalize.

And again, it's not a precise science. But as we've looked over time and we think about a 100 basis point movement in the ten-year—think of that as being sort of 14 to 17 basis points in cap rate. I mean that's in the classroom, and the real world is different. But if you’re using regressions and other factors, that's the kind of correlation that you can imagine.

Given the price discovery and increased acquisition opportunities that you're seeing, are you less inclined to buy back shares on your share repurchase program than when you first instituted it?

I mean the answer is no. I think it's a tool that's in our toolbox. As we talk about potential dispositions and we look at the environment that we're moving into, we're going to have every corporate finance tool available to maximize return for our shareholders.

Just to clarify on capital recycling, are these purely going to be third-party sales? Or is there an opportunity to sell assets into your joint venture?

Yes. Currently, we'd be considering third-party sales. Obviously, we do have a joint venture partner who is very eager to continue to deploy capital into this space, and we're always looking for opportunities to continue that relationship as well. But that's outside the scope of this potential capital recycling.

As you identified this opportunity, did any components of your strategic target change, and that's the reason for the sales at this time?

No. I think that's one thing that we're trying to adhere to, and I would say absolutely no changes in that area. One thing to reiterate is the competitive environment for buying these properties. There are a couple of folks out there that we have heavily sparred with for the last 10 to 12 years who are knowledgeable. A whole lot of new players emerged in the last 12 to 18 months that simply cannot get financed in this market. From our standpoint, we're pleased that several of these players have dropped out, which bodes for terrific opportunities, as Darrell mentioned. So we’re excited about the prospects for being able to manage this market much more effectively than we have been able to for the last 18 months.

Our next question comes from the line of Peter Abramowitz with Jefferies.

Within the acquisition markets, are there any portfolio deals that are out there that you've been looking at? And even if one that you're not considering, have you observed any difference in pricing between those and one-off single assets?

Well, I think we've always said there are a number of larger portfolios out there. This is probably not the time you're seeing a lot of that occurring. However, people do value portfolios more as it's difficult to put some great buildings together right now. I think there's a premium on portfolio acquisitions, and we've enjoyed several of them, as you noted. Of course, our joint venture opportunity that we're still purchasing now. There is definitely a premium for portfolios.

Okay. Regarding the development side, I know there's a fair amount of legwork here with FDA Atlanta, as you mentioned earlier. Just wondering if you could go into a little more detail on the broader opportunity set and what we could expect potentially over the next year.

Well, I think this is going to be a really exciting area. You've got a couple of things going on. As Darrell mentioned, some of the smaller regional developers in this space are having trouble getting financing. The government has been slow. Initial indications of what they need in a new development project can change. These smaller developers cannot figure out what the pricing will be for the next one, two, or three years. You've seen it in Atlanta, imagine if you were a small developer with a construction loan trying to get that building done. The government understands that pricing is only going up. Inflation isn't their friend, and so they're going to want to move quicker on some of these development projects in the next several years. I think there's going to be more room for the successful developers that we know, including ourselves, to see some great opportunities. Many of these smaller developers will likely be selling to larger players like us. We will be standing by with a lifesaver and ready to help out, as we've done in the past. The FEMA opportunities were excellent examples of how our development team took on projects from other developers. So I’m quite excited about what we might see in the next several years.

Our next question comes from the line of Michael Lewis with Truist.

Your cash flow growth the last handful of quarters has been quite strong. It looks like a lot of that is due to capital expenditures going down on a year-over-year basis. I might have expected the opposite due to inflationary pressures and growth in the portfolio. Could you just talk a little bit about what's happening on the CapEx front and cash flow growth?

Mike, absolutely. The dynamic you're seeing over the last couple of quarters in terms of FFO conversion down to FFO adjusted and CAD is coming from a couple of places. One, as we've worked through some renewals over the course of last year, our free rent burden has lifted a bit in the first half of the year, to the tune of about $2 million. You also need to factor in that we've talked about this for years, but the effect of the amortization of above and below-market leases continues to be a headwind to FFO growth, creating more conversion to cash. This contributes approximately another $1 million when you consider the 6-month year-to-date year-over-year comparison. As for CapEx, we really look to think about over a more medium-term arc, trying to live in that $1 to $1.50 per foot. We will obviously often wait for renewals to occur to ensure we're fully up to speed on some of our maintenance capital items. That may ebb and flow, but over the longer term, you are going to continue to see that $1 to $1.50 per foot range.

So do you expect cash flow growth to be better than FFO growth? Or is it tough to determine that at this point?

Yes. When I look out over the next two to five years, that dynamic on the above and below burning off, along with the effect of continuing to buy younger assets, which require less in terms of maintenance capital, leads me to expect that.

Great. And then just last for me, a clarification on how the expense reimbursements work. I think you, Meghan, said something about the CPI. I understand CPI escalators when they're applied to rent, but for expenses, don't you just get expense reimbursement based on what the actual expenses are over the past year? I'm not sure what the CPI has to do with that. Maybe I heard wrong or misunderstood.

No, I appreciate the question. Let's set the record straight on that. Inherent to our rent is an agreed-upon OpEx base. Every year, starting from the first year, that base—let's call it, $8 a foot—accrues growth on a compounded basis annually with urban CPI. At the end of the lease year, the year-over-year index comparison is made, and that increase is added to the OpEx base for the ensuing year. So no, it's not actually tied to actual operating expenses, but we are well matched in terms of our current base and accumulated reimbursement above that base to our actual operating expenses. Thus, we have that insulation from NOI degradation by virtue of being well matched.

Okay. I understand. So I guess it's possible for properties to say their taxes or utilities don't grow as much as the CPI. It still would be CPI applied to that base here. And to your point, you're kind of protected from an overall inflation standpoint?

Yes, that's right. It's a broad CPI index and has proven today to be providing the protection that we would expect it to.

Our next question comes from the line of Bill Crow with Raymond James.

Based on your comments on competitors kind of pulling back in the marketplace and price discovery, just given your dominance in the space, I'm wondering if it doesn't make sense for you to pull back further and for longer, maybe help push rate yields on acquisitions up even further?

Well, Bill, I think that we are definitely not going to be the group, the last group standing to validate expensive prices. So you can figure that we have our foot on the brake and the accelerator. We're not going to keep marking the market all the way as the cap rates increase. We're going to be very careful there. We agree that there's no reason to shoot ourselves in the foot by paying ridiculous prices in the market. As for the timing, when the turnaround occurs, there's a whole lot of reasons you might be heading into a recession. Opportunities can move quicker than we even see. So rest assured, we're not on the sidelines; we're eagerly watching but will not run in until we see the right places being sold.

We have 12 months from the end of the quarter to settle our forward equity.

Great. And then this is not really a comment on Easterly. But it's amazing how the last couple of decades in times like this, where stocks are going down, it helps management to identify non-core assets. I'm curious whether you had thought about capital recycling last year or the year before as a viable source of financing instead of just hitting the equity markets.

I think we've always thought of it. Boy, don't we wish we had all thought of this on maybe December 15 or executed something on that date. We balance many different things, and new knowledge comes in all the time. You're right; during these periods of downturns, it's a wonderful opportunity to go through and figure out what's core and non-core to our particular business, and that's what we're doing right now.

There are no further questions in the queue. I'd like to hand the call back over to Darrell Crate for closing remarks.

Thank you, everyone, and thanks for joining the Easterly Government Properties Second Quarter 2022 Conference Call. We appreciate your time this morning, and we look forward to keeping you appraised of future developments as they occur.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.