Easterly Government Properties, Inc. Q4 FY2023 Earnings Call

Greetings. Welcome to the Easterly Government Properties Fourth 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, 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, CEO of Easterly Government Properties.

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 Meghan Baivier, the company's President and COO, and Allison Marino, the company's CFO and CAO. We're pleased with the earnings results for 2023, and we look forward to continuing to deliver predictable earnings to our shareholders supported by our foundation of leases backed by the full faith and credit of the United States government. As you saw in our guidance, we are executing on a path for strong core FFO growth in 2024. Allison will speak to that in more detail. Needless to say, we're excited to share our outlook with you. For over a decade, we have been honing a definable edge in the mission-critical facilities that serve our government. Our goal is to use that edge to provide our shareholders with a stable, predictable cash flow stream. By specializing in these mission-critical properties, Easterly can play an important role in supporting essential functions for the United States government and its adjacent partners. While office REITs contend with remote work threatening their occupancy outlook and portfolio growth, Easterly's facilities remain critical to the safety and security of our government agency partners. Accordingly, this provides the stability we seek for our investors. While we are discussing predictability, let me address our dividend. We fully acknowledge our higher than average payout ratio and we are confident in our ability to maintain and grow our dividend. Our disciplined approach to prudently managing our balance sheet, our unique long-term visibility of cash flows, and the creditworthiness of our U.S. government tenants continue to serve as sources of stability and growth. The CapEx in our buildings is predictable and the demands for capital expenditures by our tenants are not excessive. Our view is to return as much cash flow to investors as is reasonable as a strong steward of their capital. The leases we have today provide $2.9 billion of rental income backed by the full faith and credit of the U.S. government. With only one renewal of all of our assets to only a 10-year term at a 10% spread, these aggregate cash flows will be just under $6 billion in rent. And as Meghan will share when she discusses our renewals to date, you will see those assumptions are quite modest. Given the strength of this cash flow, we are confident in our ability to provide healthy dividends to our investors for the years to come. What also sets us apart from typical office REITs is our commitment to customization. Our buildings are equipped and fortified with infrastructure and security protocols to ensure uninterrupted operations for key government agencies, such as the Drug Enforcement Administration and the Federal Bureau of Investigation. To reiterate, these assets have one important trait in common. They all help fulfill important government missions that cannot be accomplished from home. For example, drug enforcement agents require secure labs to analyze and store confiscated contraband. FBI agents must investigate crimes in person and use facilities designated for their use. Our facilities continue to support the work that ensures the safety of the country, and as a result, 97% of our properties remain leased. It's clear to us that as we explore how to best collaborate with other state and local agencies, we find additional facilities with similar longevity with the added benefit of lease escalations. We see the potential to grow our holdings of government and adjacent government assets with lease escalations to approximately 15% of our portfolio. We can further apply our definable edge in the development of properties for both government tenants and government-adjacent tenants that have similar facility needs to our most tenant improvement-intensive buildings. We're keenly aware of investors seeking the opportune moment as assets and liabilities reprice with accelerated interest rates and liquidity drying up in the bank market; this development segment is taking the lead on repricing. A pipeline of opportunities lies ahead where we believe we can engage in these products accretively at our current cost of capital. All of this leads to our commitment to grow Easterly's core FFO on a trajectory of more than 2% for the foreseeable future. We believe we are positioned to deliver a consistently growing core FFO cash flow stream, which in turn would allow us to increase our dividend and continue to deliver strong results for our shareholders. This is an exciting time for Easterly. We're seeing a pipeline of mission-critical opportunities in 2024 and beyond while also building a portfolio with a foundation of cash flows backed by the full faith and credit of the U.S. government. Thanks for your time this morning. And I'll now turn the call over to Meghan to discuss opportunities for growth in 2024 and beyond.

Thanks, Darrell, and good morning. Thank you for joining us for our fourth quarter earnings call. 2023 was a productive year for Easterly. The deal market returned, and we were able to transact on several accretive acquisitions during the second half of the year. In total, Easterly acquired either directly or through the joint venture four properties leased to tenants that include the United States Judiciary, the Department of Veterans Affairs, the Department of Homeland Security, and the State of California for an aggregate pro-rata contractual purchase price of approximately $80.4 million. Easterly now owns directly or through the JV, 90 properties totaling 8.8 million leased square feet. Our portfolio remains young with a weighted average age of 14.6 years, and our duration of cash flows remains enduring with a weighted average remaining lease term of 10.5 years. As mentioned on prior calls, we have always viewed Easterly as the mechanism to access high credit quality cash flows through the lens of real estate income derived from one of the world's most stable economic entities: the United States government. The most recent example of that is found in today's development landscape. Here, we are observing a stark contrast between the limitations faced by private developers and their resources available through a public REIT balance sheet. Private developers constrained by financial considerations are encountering challenges in accessing the substantial capital required for ambitious building projects. The complexities of securing financing coupled with market uncertainties appear to be impeding private developers' ability to embark on large-scale projects. In contrast, Easterly's fortified balance sheet and enduring financing partner relationships emerge as a potential reservoir of capital. Easterly possesses the tools and capacity to leverage various debt and equity markets and tap into diverse revenue streams to finance projects. With that background, we are currently pursuing an attractive set of opportunities with private developers to serve as a partner and help finance and subsequently own a pipeline of mission-critical assets primarily leased to the U.S. government. Turning to the company's wholly-owned development activity, our FDA Atlanta project continues to progress nicely with an estimated 150 workers on-site daily. We expect that the project will cost approximately $229 million and deliver in the fourth quarter of 2025. Approximately $150 million of the total cost will be tenant improvement reimbursed by the federal government via lump sum payments. We anticipate receiving an approximately $25 million reimbursement payment in the third quarter of 2024 and the remaining $125 million upon completion and acceptance of the space by the government. We look forward to providing you with meaningful updates in the coming quarters as we make progress on this 162,000 square foot state-of-the-art laboratory, 100% pre-leased to the United States government for a non-cancelable term of 20 years. With such a substantial tenant improvement investment in this project, we anticipate this facility will serve the needs of the government for an excess of 50 years. Turning to cash flow predictability, during the fourth quarter, Easterly renewed GSA Clarksburg, a 70,000 square foot facility for a new 15-year term that commenced in January 2024. For the entirety of 2023, we renewed 100% of our expiring leases for a combined 4.4% of annualized lease income at year-end, all for a weighted average term of 16.4 years. These results serve as a stark contrast to our Office 3 brethren. Further, as is customary on our fourth quarter earnings calls, we'd like to discuss our releasing successes as of year-end. Due to the unique nature of our leases, final renewal rents cannot be ascertained until the exact amount of tenant improvement 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 31, 2023, we have renewed 32 leases since our IPO. Of that 32, 18 are renewals for which tenant improvement work, if any, has been completed and accepted by the government. The other 14 are renewals with pending tenant improvement projects. This combined 2.18 million square feet across 32 renewals includes CTO Arlington, IRS Fresno, and various smaller leases in Buffalo. When we exclude these assets, the average rent spread achieved on the remaining renewals is anticipated to be 18%, including an estimated $40 per square foot of tenant improvements utilized by the government. The weighted average total renewal term for these leases was 17.2 years. In closing, we believe the essential 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. 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 Allison to discuss the quarterly and year-end financial results.

Thank you, Meghan. Good morning, everyone. It is my pleasure to be joining you this morning and report the company's strong quarterly and year-end consensus meeting results. Given the predictability of cash flows and the certainty of our leading role in this market, we believe Easterly is poised for growth in 2024. I am pleased to report that at year-end, Easterly's portfolio performed solidly. We have leveraged at the midpoint of our target range, less than $80 million drawn on our revolver, and only 6% floating rate debt exposure. For the fourth quarter, all on a fully diluted basis, net income per share was $0.04 and core FFO per share was $0.28. Our cash available for distribution was $21.9 million. For the full year, net income per share was $0.20, core FFO per share met consensus at $1.14, and cash available for distribution was $94.8 million. With an eye to the balance sheet, it is important for us to stagger debt maturities and manage our interest rate risk. We have thoughtfully managed our assets and liabilities ensuring that we're well positioned to address 2024 maturities and capitalize on emerging opportunities. As you can see from our fourth quarter and full year results, our balance sheet reflects stability and strategic foresight. The strength of the company's cash flows are backed by the full faith and credit of the United States government. This allows us to achieve a better cost of capital through a lower cost of debt. While we can be quickly lumped in with our office peers and broader sector weakness, the superior credit of our U.S. government tenant and forecastability of our cash flows separates Easterly from other office REITs. Our commitment to financial prudence is reflected in our recent announcement of our inaugural investment grade BBB credit rating from KBRA. We finalized the rating in the fall of 2022 and have maintained it since that time. We believe this will serve us well as our capital needs expand. While growth is at the heart of our strategy, we view the momentum behind that growth as a key differentiator for Easterly. There is power in our working capital management, which is reflected in achieving ongoing property operating expense savings, managing G&A creep, and releasing a positive spread. We have taken a disciplined approach to operational efficiencies and tenant engagement. With this backdrop, our focus remains on growing the portfolio at opportune moments. Particularly when compared to private developers and other real estate owners, the advantages of being a public company are central to our growth strategy. As Meghan shared earlier, we have access to a diverse pool of debt and equity sources, which allows us to acquire accretively and maintain a cost of capital advantage even when others may be faced with constraints. Turning to 2024, we are introducing our full year core FFO per share guidance on a fully diluted basis in a range of $1.14 to $1.16. This guidance assumes the closing of VA-Jacksonville through the joint venture at its pro-rata acquisition price of $40.9 million and that we will have $100 million to $110 million of gross development-related investment during 2024. At its midpoint, this sets the path for Easterly to deliver strong core FFO per share earnings growth to shareholders in 2024. We believe this represents a market-leading risk-adjusted return and charts the course for delivering long-standing growth opportunities for our shareholders. With that, we thank you for your time this morning and appreciate your partnership. I will now turn the call over to Shannon for questions.

Our first question comes from Michael Griffin of Citi.

Darrell, you said you remain committed to the dividend at least in the near- and medium-term. But if I look at, I guess, expectations for '24 and then probably consensus on '25, it seems like the dividend is not near kind of that coverage level. I guess, is it a function of executing on external growth to grow earnings? You talk about the 2% kind of expectations for the near-term. Is it throttling down CapEx? Just how do we get comfortable around a more normalized payout ratio going forward?

One of the things I wanted to highlight in my remarks is the predictability of our cash flow over a long-term horizon. As we look ahead, we believe that our existing portfolio will allow us to grow our dividend through lease renewals. You're correct that we have limited capital expenditures to manage cash available for distribution, and we are also focused on preventing increases in general and administrative expenses while continuing to cut costs. As discussed on our Analyst Day, we see real opportunities in the development market and with individual assets in our wholly owned area, where we can make accretive acquisitions. We feel confident about our earnings this year, and if you consider the trajectory we're guiding towards and extend it over a couple more years, I believe you'll see that we are in a strong position with our dividend. Given the predictability and stability of our cash flows and the long-term nature of our lease obligations, returning as much cash to shareholders is the right approach for delivering returns for those who invest in DEA.

And then maybe turning to guidance, I noticed you hadn't incorporated expected acquisitions into the full year guide. You had historically done it, I think in '22 and '21, maybe not so last year. But you've talked about this pipeline that you're seeing. Can you maybe quantify how many acquisitions you're looking to do this year? I imagine that would help move the needle on earnings and maybe where you're seeing cap rates or return hurdles, kind of on those acquisition targets?

We are being cautious and not factoring it into our guidance so that everyone can grasp the growth potential of our assets as we head into the year. We will complete our remaining variable annuity in the joint venture. Looking at the acquisition market today, there are strong levels of potential deal flow, and we are in discussions with several sellers, particularly regarding wholly owned acquisitions, as well as developers who have long-term needs over the next few years. We see value in that market at around mid-7% cap rates, which aligns with our ability to execute transactions that are beneficial and contribute to shareholder growth. As this market builds over the spring and summer, we are quite enthusiastic about the opportunity to enhance our already strong growth platform.

I want to emphasize again that our guidance this year does not rely on making any purchases. The current market shows a wide bid-ask spread on cap rates, but there are opportunities to acquire buildings. The timing for these opportunities remains uncertain. However, as Meghan mentioned, we are completing transactions at attractive levels in the mid-7% range, and we look forward to enhancing our guidance as we identify these opportunities. Given the current market conditions and our positioning, we aim to communicate a conservative outlook, focusing only on guidance we believe is certain and does not require external factors to materialize.

Our next question is from John Kim of BMO Capital Markets.

I just wanted to clarify on your guidance of $100 million to $110 million of development related investments that's the financing that you're providing to private developers? And I'm wondering what's the yield you're expecting on it?

So for that guidance, that is purely FDA Atlanta, which is our previously announced development, and we're targeting yields in the mid-7%s on that as we discussed last quarter.

So the development financing is not in your guidance?

No. The opportunity set for these sort of private developers looking for capital that would also to Darrell's prior point be additive, as we look to engage with those folks.

And just to clarify, I think Darrell mentioned that the financing you're providing is our projects you plan to own once they're complete?

You may have been hard to hear, but yes, these are assets we intend to acquire at completion as well.

What leverage level can you get to maintain your investment grade rating from KBRA?

They are very comfortable with our range of 6.5x to 7.5x for this. I believe that opportunistically we could certainly aim for the higher end of that range, if not slightly above it, but they are quite comfortable with this range.

Again, that excess leverage would come from developing these buildings and would be repaid with lump sums or long-term leases.

My final question is just a follow-up on Michael's regarding the dividend. Your payout ratio on CAD was 118% last year. If you assume a growth rate of 4% per year, it will take about five years to cover it. I'm assuming some of the development loans you provide may not yield cash on a cash basis. Why not address the dividend now as you pursue more of a growth strategy rather than the stability and high-yield focused strategy you had previously?

Yes. I mean, John, we're really taking a long view on this. And we have the fortunate ability to do so given the types and the nature of assets that we have in our portfolio. So, as Darrell said earlier, we're really going to look at all the levers we have with regard to our same-store portfolio to manage the payout levels. But we're not looking just one, two quarters ahead. We're really looking one, two years ahead and the opportunity that we see in front of us is one that we think we can sort of bridge into nicely.

I mean, I would argue a payout ratio above 100%. It shouldn't persist for more than a couple of years, but we can talk about offline.

Our next question is from Michael Carroll of RBC.

Meghan, I know you touched on this in your prepared remarks, but how many leases are you currently on waiting on the TI build out before those rent escalators can be realized? I mean, should we see, I mean, is it a meaningful amount where there are some more embedded organic growth that's not realized in your fourth quarter numbers now, but it will be realized once those TI projects are complete in the new renaissance?

Yes. From a single tenant perspective, there are 11 leases, and then we have a couple of smaller leases in Buffalo. So, in total, there are 14 leases for over 1 million square feet that are still undergoing the TI build-out process.

How much, I guess, rent or incremental rent does that represent that could flow in through numbers?

We can isolate that for you, Mike. But we don't know just yet where those full all in rents are going to land. So we've held back on that. But that subset really is the subset of assets that we're looking for increases north of 25% on. So it's a considerable tailwind with regards to the growth we're talking about over the next one to two years.

And then that is going to come online in '24 and '25. So it's a two-year type time frame before that stuff gets kind of realized?

Yes. So the vast majority of that, we expect to come on over the course of 2024, primarily in the back half of 2024. A bit of it could be expected 20% or so to flow over into 2025.

How do you plan on funding new deals? Before pursuing some of those transactions that you mentioned, does DEA need to raise equity to finance that? Is that what we should expect? The aggressiveness of your approach will really depend on the trends in your cost of capital.

So we look to each deal with a mix of debt and equity tailored to that deal. But generally, we look to acquire 75 bps wide of our cost of capital considering both debt and equity sources.

And yes, Mike, with our forward equity position today, yes, we look at deals relative to as Allison said the marginal cost of capital for the company and relative to that deal. But incremental external growth will require additional new capital.

And are you comfortable with your current leverage metrics right now? I mean, would you want to kind of trend lower from that 7%, 7% plus type range to a more midpoint of your longer-term target? We are currently at 7x in terms of adjusted net leverage, which is a very comfortable position for us.

Our next question is a follow-up from Michael Griffin of Citi.

Just a quick question on the guidance. Curious if there are any capitalized interest embedded in the 2024 guide?

So as we continue to build out, FDA Atlanta, yes, incremental borrowings would draw interest that we would be able to capitalize. So no change in that expectation. Obviously, all development is treated that way.

Our next question is from Michael Lewis of Truist Securities.

I'm sorry if I missed this. I got on a little late. You did a few shares in the forward offering. I just wanted to ask about the pricing, right? The pricing on the shares was below consensus NAV by a material amount. And I know this is a dangerous question, but how do you think about a price that you wouldn't issue below or how do you kind of think about protecting the equity value?

Yes, it's a balance obviously, Mike. I think we're seeing opportunities, where equity in that low $13 range makes a ton of sense. And those are certainly assets that are going to come wide to that type of implied cap rate weighted average cost of capital. And so to the extent we see those opportunities and they are maybe opportunistic, we will look to bring them in and consistent with our portfolio and help resume that growth path that we're looking to get back on.

This is a follow-up regarding the dividend. You mentioned the predictability of cash flows related to the dividend policy, but when the dividend was set, it wasn't anticipated that cash flow would be significantly below expectations. You raised the dividend in the third quarter of 2021, but it hasn't been covered since the third quarter of 2022. I understand that the company is designed for stability and that the dividend plays an important role in that. This leads back to questions others have asked, and it seems you're prepared to support this for a significant period of time. Just confirming that.

The answer is yes. We don't consider it a material amount compared to some of the opportunities we're seeing. We're aware of the situation and the financial impact. With $6 billion in government funding coming our way, we feel confident about the future. Sometimes we even consider giving guidance for the next five years just to put that out there. Given the development opportunities and what we see in our pipeline, we are optimistic that we will be able to cover the dividend and continue to grow it.

Really appreciate it. Thank you.

We appreciate the question. Our business is different from office spaces in terms of predictability and stability. We're not just stating this; the terms of our leases and the real dollars coming in demonstrate that our business operates over years, not quarters. We believe the dividend is a crucial aspect of our story. We aren't being rigid about it; we simply feel confident about the dividend's position within the context of our business profile and cash flows over the coming years.

Our next question is from Bill Crow of Raymond James.

Darrell, given the question line, not only this quarter, but the past quarters, are you increasingly feeling like a little bit of a round peg in a square hole from the REIT perspective? Is it the right strategy for this company to keep that REIT wrapper?

I believe that given our cash flow profile, we've always anticipated more appreciation because we have the most secure cash flows among REITs. During COVID, there was only a brief period when we truly saw the premium associated with that certainty and stability. There are opportunities for us to improve our debt costs. When we engage with debt providers and discuss our business, they strongly encourage us to consider increasing our leverage. We have the strength of full faith and credit from our ramp profiles, which can help us find competitive solutions for our debt costs compared to other REITs. Additionally, by allocating 15% of our portfolio to state and local government-adjacent investments, we believe we can access buildings with similar high credit ratings and escalations. This strategy can potentially enhance our core FFO by another 80 to 100 basis points, aligning our cash flow profile with broader REIT expectations. I would go so far as to say that if we were to ask analysts to select a stock to hold for 20 years, many might choose us. However, for short-term holdings, we may not be the top choice. We are attentive to the capital we're attracting and what's happening in the REIT sector. Adjusting our cash flow stream in our core FFO to better align with typical REIT expectations is definitely a strategic objective for us. If we can address some of the challenges around our debt, which I believe we are making progress on, we can achieve substantial risk-adjusted returns for our investors. With a 9% dividend, I see significant value in our stock, and I have demonstrated this by purchasing my own shares and plan to continue doing so.

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

Thank you everyone for joining the Easterly Government Properties fourth 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 for you.

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