Easterly Government Properties, Inc. Q3 FY2023 Earnings Call

Greetings. Welcome to the Easterly Government Properties' Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session between the company's research analysts and Easterly's management team. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Lindsay Winterhalter, Head of Investor Relations. Please go ahead.

Good morning. Before the call begins, please note that certain statements made during this conference call may include statements that are not historical facts and are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although the company believes that its expectations as reflected in any forward-looking statements are reasonable, it can give no assurance that these expectations will be obtained 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 the company's most recent Form 10-K filed with the SEC and in its other SEC filings. The company assumes no obligation to update publicly any forward-looking statements. Additionally, on this conference call, the company may refer to certain non-GAAP financial measures such as funds from operations, core 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 at ir.easterlyreit.com. I'd now like to turn the conference call over to Darrell Crate, Chairman of Easterly Government Properties.

Good morning everyone and thank you for joining us for this third 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. As we've been discussing for several quarters, the real estate market is in flux, and this uncertainty has created an environment of opportunity for Easterly in 2024 that we intend to capitalize on. Increasing defense needs, onshore technology and bringing and providing public safety are key objectives for the nation. Our mission-critical facilities are needed now more than ever. As the government addresses these needs, there are facilities that need to be built. We are a natural partner to work with developers on these projects and find ourselves being approached as a known leader in our space. We are differentiated from many REITs and better positioned for this forward environment. Our revenue is incredibly stable and forecastable as we have long-term leases with an average remaining term of over a decade and we have no credit concerns about our very high credit quality tenants. These attributes give us access to capital while others, particularly in the office sector, may face impaired financing sources. While the economy may be slowing and patterns of work may be changing, the world, as we see in the headlines each day, is becoming less safe. These projects need to be completed, and we can work with developers to own these attractive projects with long-term leases on terms that are favorable to our shareholders now and into the future. And with that, I'll turn the call over to Bill to give further insights into our portfolio.

Thanks Darrell and good morning. Thank you for joining us for our third quarter earnings call. It has been a productive quarter for Easterly. The deal market returned, and we were able to transact on several accretive acquisitions during the quarter and subsequent to quarter end. Easterly, through its JV, closed on VA Corpus Christi, nine of 10 assets in the VA portfolio with an initial lease term of 20 years with the United States Federal Government. We are very pleased with the stability of the cash flow brought to our growing portfolio. Further, subsequent to quarter end, we announced the acquisition of our first state government lease deal located in Anaheim, California. This facility is 100% leased by tenant agencies in the state of California, including the Department of Industrial Relations and Employment Development Department. This public-facing facility contains core hearing rooms used for adjudicating workers' compensation claims as well as training rooms for further employment opportunities. With a weighted average expiration date of January 2034, this facility has been occupied by the State of California since 2009 and recently underwent a renewal process post-pandemic, whereby the tenants demonstrated their continued need for the facility by executing several leases with a weighted average lease term of 10.7 years. As mentioned on the prior call, we have always viewed Easterly as the mechanism to access high-quality cash flows through the lens of real estate with the goal of delivering long-term growth to our shareholders. We have spent considerable time expanding our credit analysis. We learned that the U.S. government is joined by a number of states with very high credit ratings. Long-term leases renewed post-pandemic carry a higher degree of comfort and security, which is a key component of the strategy we have executed all along. This asset is a prime example of the output from those observations. Also, subsequent to quarter end, we closed on two additional properties, both leased to the U.S. government. The first is a nearly 100,000 square foot recently renovated facility leased to the Transportation Security Administration and Customs and Border Protection, both residing under the Department of Homeland Security and sitting on leases that can provide occupancy of up to 15 years through 2038. Referred to as DHS Atlanta, this facility serves as a strategic asset to its underlying tenants given its proximity to Hartsfield-Jackson International Airport in Atlanta, Georgia. With over 93 million passengers using this airport in 2022, it is ranked the busiest airport in the world. Given its proximity to the airport and the specialized buildout of the facility, including a 50 by 18-foot airplane fuselage housed within the building, this asset helps with all of the DHS's primary goals of keeping America safe. Finally, the second federally leased asset we acquired subsequent to quarter end was an approximately 35,000 square foot United States District Courthouse located in Newport News, Virginia. As part of the Eastern District of Virginia's Newport News division, this courthouse features 2008 build-to-suit LEED-certified construction and has a new 10-year firm lease that does not expire until 2033. The facility houses district judges, senior district judges, and magistrate judges and is responsible for the cities of Newport News, Hampton, and the counties of York, James City, Gloucester, and Matthews. Given the highly sensitive operations housed within the courthouse, the facility was constructed according to the specific requirements of the U.S. Courts and the United States Marshals Service, meaning strict federal building and security standards, including isolated prisoner movement, a 50-foot perimeter of security setback, progressive collapse construction and blast-resistant exteriors. Our acquisitions team has been busy since the time of our last earnings call, and in total, Easterly has acquired either directly or through the JV four properties for an aggregate pro-rata contractual purchase price of approximately $80.4 million, which is comprised of $62.2 million of wholly-owned acquisitions and an $18.2 million pro-rata joint venture closing. Easterly now owns directly or through the JV, 90 properties totaling 8.9 million square feet. Turning to development, our team has made a lot of progress in recent months. We are pleased to report we have now defined a schedule for the completion of the FDA Atlanta project, which is currently estimated to deliver in 4Q 2025. With approved budgets in hand, our team is fully mobilized on-site and actively engaged in the construction process. Through effective dialogue and partnership with both the GSA and the FDA, we have estimated that the development project will cost approximately $227 million, with approximately $151 million of this total cost to be reimbursed by the federal government in lump sum payments. We anticipate receiving an approximately $25 million reimbursement payment in 3Q 2024 and the remaining $125 million upon completion and acceptance of the space by the government. We look forward to providing meaningful updates in the coming quarters as we make progress on this 162,000 square foot state-of-the-art laboratory, which is 100% related to the United States government for a non-cancelable term of 20 years. Looking ahead, while we are pleased with our ability to accretively grow the portfolio, our acquisitions team remains highly engaged with potential sellers of assets that meet our strict credit criteria and carry long-standing leases with the government. We have observed more signs in this past quarter than ever before, indicating developers need assistance to fund their pipeline projects, as their access to capital has become particularly constrained. Easterly is currently reviewing several prospects that might afford these developers some relief while also generating attractive opportunities for our shareholders. Before turning the call over to Meghan, I want to spend a moment discussing the underlying credit of our primary tenant, the United States government. As interest rate headwinds continue to strain private companies, we believe it is important to spend some time focusing on the unique nature of the NOI that supports our business and just how different it is from many other REITs currently facing tenant credit and retention challenges. It is our belief that our focus on mission-critical government-leased assets has served us well in terms of retaining our tenants and maintaining the stability of our cash flow. Because our focus is unwavering when it comes to the mission-critical nature of our assets, our time horizon and stability of cash flow is far greater than many REITs. We recognize this is a very different reality than our current office REIT designation may lead some to assume. Since the pandemic, we have routinely been asked questions about the utilization rates at our facilities. Through anecdotal evidence and by talking with our property managers, we have known that they were occupied throughout the pandemic. Because our facilities are overwhelmingly mission-critical and often house highly sensitive government information, we are not privy to the data generated from daily arrival and departure card swipes, as one might see in the private sector. We know this is an important metric and, in an effort to work around this operational hurdle, we engaged in a private internal study where we compared the electrical usage at the buildings we owned in all of 2019 (pre-pandemic) and all of 2022 (post-pandemic), that are occupied by one of our top three tenants, the VA, the FBI, and the DEA. With the assumption that electrical usage serves as an indicator of building utilization, through this study, we observed consistent levels of electrical use with a margin of less than 1% pre and post-pandemic. In other words, based on this data, we believe that the operational usage of these facilities was nearly equivalent in 2022 after the pandemic as it was in 2019 before the pandemic. We are not surprised by these findings, given our highly differentiated strategy from the rest of the office sector. We believe the mission critical nature of our assets, observed building utilization trends, and the demonstrated strength of our renewals speak volumes for the necessity of our portfolio and the dependability of our underlying cash flow. In closing, we are seeing prospects for attractive growth and we believe Easterly is well positioned to transact and pursue unique opportunities to enhance the enterprise. With a solid NOI supporting our platform, we hope our listeners today appreciate the unique nature of our business. With that, I thank you for your time this morning and I will turn the call over to Meghan to discuss the quarterly financial results.

Thank you, Bill. Good morning everyone. I am pleased to report that Easterly's portfolio performed solidly in the third quarter, and our balance sheet at quarter end remains strong with leverage below the midpoint of our target range, zero drawn on our revolver and no current floating rate debt exposure. With this backdrop, our focus remains on growing the portfolio at the opportune moment. For the quarter ended September 30th, we owned 87 operating properties, comprising approximately 8.6 million leased square feet, either wholly-owned or through our joint venture with a weighted average age of 14.5 years and a weighted average remaining lease term of 10.4 years. Through the acquisition of newer buildings and the renewal of key leases for the long term, Easterly has been able to maintain its young portfolio age and even grow the weighted average remaining lease term since the third quarter of 2022. Further, during the quarter, Easterly renewed two important leases, one at the DEA facility in Birmingham, Alabama and the other at the courthouse in Del Rio, Texas. Easterly looks forward to continuing to serve as the preferred landlord to the government after these leases commence for terms of 15 years and 17 years, respectively. For the third quarter on a fully diluted basis, net income per share grew to $0.06 and core FFO per share was $0.29. Our cash available for distribution was $24 million. At quarter end, the company had total indebtedness of approximately $1.2 billion at a weighted average interest rate of 4%, a weighted average maturity of five years, and with 100% of all outstanding debt fixed at attractive levels. This represents an adjusted net debt to annualized quarterly pro forma EBITDA ratio of 6.7 times, which is below the midpoint of our target range. During the quarter, we executed on several debt and equity related activities. First, we funded the $50 million delayed draw feature on our 2018 term loan facility and used the proceeds along with cash on hand to repay all borrowings under our $450 million revolver. Furthermore, given the company's previously announced forward starting swaps entered into in February of this year, as of quarter end, Easterly carries no floating rate debt on its balance sheet, further insulating our shareholders from interest rate volatility. Easterly also settled 1.7 million shares of forward equity raised on the company's ATM at a net weighted average combined sales price of $19.83 per share, helping us fund the recently acquired assets Bill described at accretive levels to the organization. Turning to the company's 2023 guidance, we are maintaining our full year 2023 core FFO per share guidance on a fully diluted basis in a range of $1.13 to $1.15. This guidance reflects the closing of VA Corpus Christi through the joint venture at its pro-rata price of $18.2 million and the three additional wholly-owned assets acquired subsequent to quarter end, for a combined total price of $62.2 million. The guidance further assumes up to $15 million of gross development-related investment during 2023. With that, we thank you for your time this morning and appreciate your partnership. I will now turn the call back to the Operator.

Thank you. Our first question is from Michael Griffin of Citi. Please proceed with your question.

Hey thanks. On the acquisition pipeline, I'm curious if you can delineate between the federal agencies that have been your bread and butter versus the state agencies that you're looking to go more into. Is one more attractive than the other, or do they both have their own benefits?

Good morning. I believe we are experiencing plenty of both and have seen ample opportunities in both areas. Michael, as I've mentioned previously, I see the state as just another agency within the federal government framework. Therefore, I think most of the opportunities will continue to arise from the federal side.

That's helpful. And then I'm curious if you can just comment on the dividend. I mean I know the payout ratio still remains elevated. How should we think about that on a go-forward basis?

Hi, it's Meghan. It's certainly our experience that our leases provide unique forward planning capabilities. We can look out further than the typical office REIT today. We're really at a place today with a real opportunity, as Darrell and Bill indicated, and growth can be accretive. Furthermore, our liabilities are not repricing tomorrow with the swaps we put in place earlier this year. So we're very attuned to this issue. We'll stay focused on what's best for shareholders, but that's the backdrop today.

Thank you.

Thank you. Our next question comes from John Kim of BMO Capital Markets. Please proceed with your question.

Thank you. Bill, you mentioned developers in the market needing some kind of assistance or relief that you're able to provide. Are you thinking more on a JV basis, mezzanine financing, or potentially taking out the developments once complete?

I believe we have been actively exploring some promising opportunities that align with our expertise and are considered key pipeline opportunities. Although I've mentioned this in previous earnings calls, I feel we have reached a point where our positioning in the capital markets makes us an attractive partner, particularly for buildings that may serve our interests in the long run. Meghan and the team have been diligently assessing these opportunities.

Yes, I think, John, there are a myriad of structures that could make sense for Easterly and could be accretive to shareholders. I think we're going in with a very open approach on how to best play in this opportunity.

And what kind of return thresholds are you looking at versus cap rates on recent investments?

Yes, I mean today, obviously, at current levels, we're looking at a cost of capital that's north of 9%. And from a yield perspective, obviously, today can break even in the low level 9%.

Okay. Can you walk us through the yield expectations on your developments? I know it's a little unique with the reimbursement. But how should we look at it as far as the yield you're expecting on your $76 million net spend on the development side?

Yes, and we're really pleased to have Atlanta back on track, moving job site mobilized, the government is excited to be back in this process with us once again. What I can tell you is that we have worked with the government to ensure that we are back to looking at yields similar to where we underwrote this asset a couple of years ago. So, think of that back into that kind of 100 to 150 basis point spread to where that type of asset could be acquired when we underwrote it back in 2019.

The yields would have increased just given the change in interest rates?

Yes, I mean the structure that we're able to underwrite is that you can hold your economics, but working with the government to improve your economics can get tricky.

Okay. Just one final question, a follow-up to Michael on the dividends. Sometimes, REITs are influenced by the capital markets, your stock is yielding 9.7% today, which is a huge spread versus the tenure on a very similar credit. How much does the capital markets and your stock price influence or change the way you view the dividend policy?

I'm not actually sure what the question is. So I think the simplest answer is no, we're not looking to the capital markets to determine our dividend policy. As Meghan mentioned, we are in the process of evaluating great opportunities for the company. As you've noticed, we have one of the most predictable revenue streams among REITs in the United States. The opportunity, and Meghan has done an excellent job pricing our liabilities, makes us confident that we have plenty of chances to deliver an excellent return for shareholders, which we believe will be recognized by the capital markets.

Great. Thank you.

Thank you. Our next question is from Bill Crow of Raymond James. Please proceed with your question.

Hey, good morning. Meghan, one for you. How much could you acquire on balance sheet before you hit the upper end of your guardrail for leverage, assuming of course no equity issuance?

Sure, I think that's the type of cap rate environment we're seeing today, right? You're going to be kind of in that $150 million to $200 million range.

Okay. And that's a pretty firm ceiling, I assume, at this point?

We've always been committed to running a BBB profile balance sheet. I think that there's no intent to change that.

Yes, I just like to make a comment, Bill, is that one, and I want to make it very clear that we're differentiated with regard to our access to capital markets today compared to many REITs because of this durability of cash flow. So, when we're looking at leverage and leverage ceilings and talking with debt providers, I can't get into specific conversations, but we hear again and again from various sources in the capital markets that given what we're doing and what we're looking to do, these are very financeable projects, and our opportunity to take on leverage with comfort with debt providers is very high.

Yes, I think that's absolutely true and especially true in the private market. But I think as a public REIT, you have another contingency out there that would probably not necessarily agree that higher leverage is better at this point. Let me shift over to the leases that were signed in the quarter, the DEA, the courthouse in Del Rio, and then the ones that were signed on the asset acquisitions that extended the length to another 10 years, what were the economics of that lease from old lease rate to new lease rate change?

Yes. So, Bill, we typically try to create full transparency at the end of the year, but we're very proud of the renewals we continue to post post-pandemic and in this typical office backdrop. So, what I would share with you is Birmingham and the Courthouse in Del Rio are bang on the center of our target range, and right around that 20% level on a net effective spread and that's for a 16-year new term.

So, up 20% from the expiring. And what about the ones that were signed prior to the change in ownership?

Are you referring to the Anaheim, Atlanta?

Yes, you mentioned the acquisitions where the tenants have just signed a new lease extension. I'm just curious how those economics were.

Yes, I'll have to follow up with you on that, Bill, and I don't have that on my fingertips.

Okay. All right. And then finally for me, I think you've had a decent sized debt maturity next year. Are there extension options on that, or what are you thinking about from the cost of redoing that debt? I think it's $100-some-odd million.

We have two components: a $100 million term loan with part of our bank syndicate and just over $50 million in mortgage. We consistently set ourselves apart from the banks, which are currently scrutinizing their office portfolios. What I hear repeatedly is that there are no credit issues, and given our strong market position and growth potential, we are seen as a valuable long-term partner. I feel confident about our ability to maintain our banking relationships. Regarding the mortgage, we currently have capacity on our revolver and will keep reassessing our entire debt structure to find the best refinancing options. We definitely have the capacity to manage it effectively.

Are you in discussions about those maturities? And can you give a sense for how much the interest rates may gap up?

Yes, in conversations on the term loan expecting consistent spreads there and not looking to refinance the mortgage on that existing asset, looking to roll that into the broader context.

Perfect. Thank you all.

Thank you.

Thank you. Our next question is from Aditi Balachandran of RBC Capital Markets. Please proceed with your question.

Hi, good morning. I know, Bill, you touched on this in your prepared remarks. But can you go into a little more detail about your outlook for the next one or two years? And what types of deals you're looking to target?

Absolutely. I think it's important to note that we had a nice slow run, and we took advantage of it over the summer. We saw some great opportunities for accretive transactions. We've been very consistent in saying we're not interested in doing things that aren't accretive. Right now, the market is slightly shocked by recent increases in interest rates, so the sellers may have gone back into their shells for a little while, but I'm sure they'll be back out soon like they were before. In the next several years, you're going to see incredible development opportunities. I'm quite sure of that. We're going to continue to see accretive opportunities, primarily federal, but also some interesting state ones as well. So, we expect to see opportunities and will pursue them in an accretive manner.

Got it. And I guess just how different are development cap rates from acquisition cap rates, assuming the development cap rates are much higher, but just for an idea?

We've got two things metering in there. We obviously want to be accretive from our cost of capital on one end, and we realize the risk inherent in development and we need a premium for that as well. I think we've always done that, and the great news is anything we're going to do will obviously have a signed lease and will result in a fabulous building. So I think from that standpoint, it will continue to be the highest and best use of our capital.

Great. Thanks.

Thank you. Our next question comes from the line of Peter Abramowitz of Jefferies. Please proceed with your question.

Thank you. I apologize if I missed this point, but could you talk about what the going-in yields were for the wholly-owned acquisitions, both the federally and state agency leased?

Good morning Peter. I think you're going to see that pretty close across the board on those, which certainly at the time was accretive when we raised the capital to do it.

Got you. And there wasn't much of a difference there in terms of yield?

Not particularly. No, no.

Okay. Got you. And then just a question on the Anaheim asset. So it is your Department of Industrial Relations and Employment Development Department. Can you talk a little bit more about actually what goes on in this facility, specifically regarding what you say here about training rooms for furthering employment opportunities?

Yes, they're adjudicating. So, think of it almost as a court that handles these compensation claims. That's one that we looked at hard and realized that it is something that is certainly not going to be going away anytime soon, and we were particularly gratified to see the renewal close post-pandemic. I think you're going to see that common thread in every building we buy, that there is a real need for this mission, which has been verified after the pandemic. I think that's probably a new attribute that we'll demand in our bull's eye.

Okay. I guess I was a little more curious in the second part about training rooms for furthering employment opportunities. Can you give more color on that part of what goes on with the asset and what makes it kind of remote work resistant?

Well, if you're doing it, I think they like to bring the folks in. It's a public facility, and they're helping individuals who are obviously in a situation in California. They are probably at the leading edge of ensuring that everyone gets the maximum support from the state. I have not sat in that room, Peter. We could join. You come out with me. We can observe it, but I believe from all indications, it is an ongoing mission and an important one to the State of California.

Got you. That’s helpful. Thank you.

Thank you. I would now like to turn the conference back to Darrell Crate, Chairman of Easterly Government Properties for closing remarks.

Thank you, everyone, for joining the Easterly Government Properties' third quarter 2023 conference call. I'd like to thank our investors and stakeholders for their continued support and trust in our company. We value your confidence and we're committed to delivering sustained long-term success to our shareholders.

This concludes today's conference call. Thank you for participating. You may now disconnect.