Earnings Call Transcript - DEA Q3 2022

Operator, Operator

Greetings and welcome to Easterly Government Properties' Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Lindsay Winterhalter. Thank you. You may begin.

Lindsay Winterhalter, Host

Good morning. Before the call begins, please note that certain statements made during this conference call may include statements which are not historical facts and are considered forward-looking within the meaning of the Private Securities Litigation Act Reform 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 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 the company's most recent Form 10-K and Form 10-Q 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, 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 tab 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.

Darrell Crate, Chairman

Great job. Thanks Lindsay. Good morning, everyone, and thank you for joining us for the 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. During the quarter, we entered a new phase in the real estate market. Rates are rising quickly; how fast is uncertain. The transaction market has slowed, and there is a gap between buyer and seller expectations. Cap rates are readjusting. Of course, none of this will adversely impact our tenant credit quality, our occupancy or our dividend. Having rent that is backed by the full faith and credit of the U.S. government, coupled with managing the portfolio for consistency and stability, should provide certainty for our investors, particularly during uncertain times. So, that leaves me to the forward-looking question: how can we use this period to enhance our portfolio and add value for our shareholders? First, we are enhancing the institutional quality of our portfolio by disposing of a set of assets that are either in remote locations or with agencies where we do not see an ability to build a defined edge in serving our agency client. These are fine agencies, but at this time, we believe concentrating on what we know best will enhance our ability to add value. Second, we're using the proceeds from the disposition to pay down most of our outstanding floating rate debt. We have been disciplined about terming out our liabilities to match our assets, and that favors us in these times of interest rate uncertainty. Third, we're maintaining meaningful liquidity in order to purchase assets that may be owned by landlords experiencing some financial distress. We have found ourselves at a disadvantage relative to developers over the last several years. They have been projects assuming an exit with ever-lower cap rates that worked for them longer than we imagined. That is over. Liquidity will start to dry up. Some will need a partner to complete their projects. Not mentioning specifics, but we will be ready should this opportunity present itself. And lastly, we're actively bidding on transactions in a way that reflects the new cap rate environment. I don't imagine that we'll get much done in the next quarter or two, but I do imagine the market will reprice, and we will find ourselves with our liquidity ready to acquire additional accretive quality assets. So, we're pleased with how our portfolio is positioned as we look forward, and we will 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's backed by tenants that represent the full faith and credit of the United States government. And with that, I'll turn the call over to Bill to give you insights into the third quarter activities.

Bill Trimble, CEO

Thanks, Darrell and good morning. Thank you for joining us for our third quarter earnings call. Starting with acquisitions during the third quarter, Easterly acquired a 28,900 square foot U.S. District Courthouse located in Council Bluffs, Iowa. This Courthouse, a build-to-suite facility that delivered in 2021, is 100% leased to GSA on behalf of the Judiciary for a 20-year non-cancelable term that does not expire until 2041. As part of the Eighth Judicial Circuit, this property serves the Western Division of the Southern District of Iowa, a district that we created over 140 years ago. This facility, located just across the river from our National Park Service and FBI Omaha facilities, provides strong geographic efficiencies for our asset management team. With the enduring mission of the U.S. Judiciary, adding another Courthouse to our portfolio undoubtedly strengthens the overall caliber of Easterly's assets. In addition to the wholly-owned acquisition activity, Easterly, for our joint venture, purchased our seven brand new VA facility located in Columbus, Georgia, which is part of our previously announced 10-building VA portfolio. From this roughly 68,000 square foot facility, the VA is able to provide an enhanced range of services to the approximately 30,000 surrounding veterans that reside close to the Georgia-Alabama state line. Like nearly all of the properties in this VA portfolio, VA Columbus sits on a brand new 20-year lease that does not expire until 2042. We continue to expect the remainder of the assets in the VA portfolio to deliver as planned and we expect the JV to close on a total of approximately $145 million of this portfolio in 2022. We are maintaining an active presence in the acquisition market. But with careful consideration for the changing backdrop and rising cost of capital, we acknowledge this is a moment where the markets are undergoing a transformation. Interest rates are rising this year at a pace this country has not seen in nearly two decades. There are inflationary pressures and we feel it is prudent to stay acutely aware of opportunities but not chase deals for the sake of portfolio growth. That said, there are competitive advantages in this niche GSA market. As previously mentioned, the GSA leased structure protects us as landlords from inflation-induced operating cost increases. Further, as Darrell mentioned, we believe in maintaining liquidity on the balance sheet as we estimate there may soon be a unique opportunity to help regional developers who have found themselves overextended and need an exit strategy. This is very similar to what we did with the FEMA Tracy Development several years ago. By pursuing only the most selective acquisition opportunities in this environment, we are strengthening the balance sheet for future development prospects, which has always been the most equated use of our capital. Finally, turning to this morning's announcement, at a time when the transaction market is nearly paused, Easterly is pleased to report we've executed our first portfolio disposition with an experienced private buyer of GSA leased real estate. The disposition portfolio is comprised of 10 buildings, approximately 668,000 leased square feet with a weighted average age of 14 years as a core rent. Meghan will go into further detail on the use of proceeds and how this disposition was the right course of action for Easterly at this time, but the sale only makes the remaining 85 properties in the Easterly portfolio even more reflective of our bullseye ownership strategy. Through this sale, our weighted average remaining lease term, our annualized lease income per square foot, and visibility of cash flows are all improved, which ultimately enhances the NAV of the portfolio. This sale, in turn, supports our stable dividend currently at a highly attractive yield. In the end, Easterly is left with a more bullseye-oriented portfolio with a tighter geographical footprint and larger average property size. 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 third quarter, we renewed the DEA drug laboratory located in Dallas, Texas for a new 17-year lease term. We also renewed the FBI field office located in Little Rock, Arkansas for another 20-year lease term. With a combined weighted average renewal term of 19 years, the importance of these two facilities for the U.S. government is apparent. I congratulate the asset management team on continued strong renewal executions, and we look forward to providing updates in future quarters for 2023 renewals and beyond. Turning to operations, the third quarter of 2022 was notable for an ESG perspective, as Easterly released its inaugural ESG report. This report, which can be found on our corporate responsibility page, is a notable step in our company's ESG trajectory. For the first time, Easterly has committed to certain environmental and social goals including a 10% reduction in energy and a 5% reduction in water use by 2030, a commitment to increase DEI hiring and training practices across the company, 90% participation in charitable giving or volunteering by 2025, and finally, implementation of an employee engagement survey with at least 90% participation for Easterly employees. We feel good about establishing these important goals for our company and continuing to be strong corporate citizens for our employees, shareholders, and the communities we serve. You can expect this report will be updated, and progress towards these goals will be tracked on an annual basis. Many thanks to our Director of Sustainability for leading this effort and delivering a report that captures the company's increasing ESG initiatives so well. In closing, this has been an important quarter for Easterly. We have renewed our largest 2022 lease expirations for a weighted average duration of 19.3 years, providing the company with increased certainty and duration of cash flow for future dividends. We added bullseye assets, both wholly-owned and through the JV, increasing the overall quality of our portfolio. We made significant strides in our environmental sustainability and corporate responsibility efforts through the publication of our inaugural ESG report. And subsequent to quarter end, we executed the company's first portfolio disposition, which simultaneously strengthens the company's balance sheet and portfolio profile. We look forward to keeping everyone apprised of future endeavors as we close out the year. And with that, I thank you for your time this morning and will turn the call over to Meghan to discuss the quarterly financial results.

Meghan Baivier, CFO and COO

Thank you, Bill. Good morning, everyone. At a time when the market is bringing companies' balance sheets into greater focus due in part to rising interest rates, I am pleased with the strength of our portfolio and the actions we've taken to recycle capital, enhance our leverage profile, and position ourselves for opportunities to come. As of September 30th, we own 95 operating properties, comprising approximately 9.1 million leased square feet either wholly-owned or through our joint venture, with a weighted average age of 14 years and a weighted average remaining lease term of 10.1 years. Pro forma for this morning's disposition announcement, portfolio metrics look even stronger, with a revised portfolio size of 85 operating properties and 8.4 million leased square feet, either wholly-owned or through our joint venture. Our new weighted average remaining lease term is enhanced to 10.3 years and reflects the company's bullseye investment thesis. At quarter end, the company had total indebtedness of approximately $1.4 billion representing a net debt to annualized quarterly pro forma EBITDA ratio of 7.4 times, with approximately $177.8 million outstanding on our line of credit. In total, this represents just over 14% variable rate debt for the company. With the completed sale of the 10-property disposition portfolio subsequent to quarter end, we expect net proceeds will be used to pay down outstanding debt obligations, taking Easterly's adjusted net debt to annualized quarterly pro forma EBITDA ratio down to 6.9 times as of September 30th. Furthermore, we will have extinguished a mortgage with a rate well above the company's weighted average at MEPCOM, Jacksonville. We will have reduced the company's floating rate exposure from 14.1% to 1.3% of all outstanding debt obligations; improved the company's weighted average interest rate by eight basis points; lengthened the weighted average maturity of outstanding debt obligations to 6.1 years; and added capacity for future acquisitions and development-related expenses by recycling non-bullseye assets. When combined with approximately $92.5 million of unsettled forward equity, these actions translate into a well-positioned balance sheet for the company in a time of rising rates. Turning to our third quarter results all on a fully diluted basis, net income per share was $0.01, FFO per share was $0.32, and AFFO as adjusted per share was also $0.32. Our cash available for distribution was $28.5 million. And finally, turning to our earnings guidance in connection with the announced disposition and the changing reality in the capital markets, we are revising our FFO guidance per share on a fully diluted basis to a range of $1.26 to $1.28. This guidance is predicated upon a number of factors, including no additional wholly-owned acquisition activity beyond the approximately $107.7 million already completed year-to-date, the closing of properties in the VA portfolio totaling approximately $145 million at the company's pro-rata share, the completed sale of all 10 properties in the disposition portfolio, and no additional material development-related investment in 2022. Like the majority of our REIT brethren, we plan on issuing our 2023 guidance in connection with our Q4 and year-end 2022 earnings results. Given the slowing transaction market, the increased cost of capital, and general uncertainty in the capital markets, we feel it is prudent to withhold guidance until we have greater clarity on the market and our ability to drive earnings growth for our shareholders in a rapidly evolving environment. With that, we thank you for your commitment to our thesis and appreciate your partnership. I will now turn the call back to the Operator.

Operator, Operator

Thank you. At this time, we will be conducting a question-and-answer session. Our first question comes from the line of Michael Griffin with Citi. Please proceed with your question.

Michael Griffin, Analyst

Thanks. Maybe going back to the guidance comment. Just seeing if you run rate 4Q expectations through to 2023, it would imply a deceleration, I guess, relative to 2022. Meghan, I know you just talked about how you didn't provide guidance for 2023, but I mean, is this how we should be thinking about it with the framework kind of going into it? And any additional color or commentary you could provide here would be great.

Meghan Baivier, CFO and COO

Sure. So, with regard to this year's guidance, really the shift is due in equal parts to interest and deal volume, as well as the run rate dilution from the disposition for a large portion of the fourth quarter. So, yes, as we go into 2023, considering the run rate affected disposition and the forward curve would be the primary two drivers of how we start off looking at 2023.

Michael Griffin, Analyst

Okay, cool. That’s sorry.

Meghan Baivier, CFO and COO

So, we'll issue formal guidance in February.

Michael Griffin, Analyst

I appreciate the clarification on that. Regarding dispositions, it seems that being a forced seller in this market isn't necessary. I understand you're evaluating the flooding debt situation, but my calculations suggest a low seven percent disposition cap rate, compared to an implied cap rate of around mid-six percent. Following up on that, could you provide some insights into why this transaction was timely? Any additional information you could share would be useful.

Bill Trimble, CEO

Yes, good morning. It's important to recognize that while we value all of our properties, our portfolio consists of a variety of missions, locations, and sizes. Many of the buildings we recently sold were in remote areas, making it challenging for our asset management team to manage them effectively. Additionally, these properties were primarily in the 30,000 to 40,000 square foot range, which isn't a good fit for our company. Most importantly, they did not align with our core strategy, which is crucial. We focus on sectors we understand well, such as judiciary and Homeland Security agencies, which have been strong components of our portfolio. We've aimed to develop a solid portfolio, and there is an informed buyer interested in these assets. Another factor to consider is the recent changes in cap rates. We witnessed a significant decrease in cap rates from last November to March, dropping from the sixes to the low fives, affecting all types of properties, including those we would not consider investing in. Currently, we are seeing a reversion to what we experienced over the past decade, characterized by varied pricing across the market. Our properties, such as laboratories and federal courthouses, will command lower cap rates, while more basic properties appear to be losing steam. Therefore, while these sold buildings are quality assets, they do not fit within our main portfolio. Meghan, do you have anything to add?

Darrell Crate, Chairman

I guess I would just also say, as you look at these times of uncertainty, we want to position ourselves to have liquidity. And while we think that the price for building was a good transaction, having that liquidity for the opportunities that are coming as we looked at 2023, of course, we're uncertain on the timing of those opportunities. But those opportunities are ahead of us, and we just want to be very well-positioned to see them.

Michael Griffin, Analyst

And it's a low seven dispo cap rate, is that right around in the right ballpark, give or take?

Bill Trimble, CEO

That is. Yes.

Michael Griffin, Analyst

Okay, great. Thanks so much, guys. Appreciate it. Thanks. That’s it for me.

Operator, Operator

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

John Kim, Analyst

Thank you. It seems like you've had more of a refined strategy on what your bullseye target is. And there's been some cap rate compression on that in recent months until recently. But just given your cost of capital and interest rate environment, it's not really conducive for acquisition. What is your strategy on achieving earnings growth? Is that really on the back burner for now?

Meghan Baivier, CFO and COO

Yes, I think we would not necessarily agree with the premise that there isn't an opportunity for this market to normalize and our cost of capital to be in line with where that market is normalizing and our ability to go back and do what we've done for eight years and acquire it accretively to drive external growth, John.

Bill Trimble, CEO

I believe, John, that is what will happen. It may take one quarter, two quarters, or even three quarters; we don't know. However, it's clear what the future holds, and that is why we are positioning ourselves to take advantage of it.

John Kim, Analyst

I thought Bill mentioned earlier that the plain vanilla assets are where you can see some corporate expansion, that's where you could get some creative acquisitions to be pursued that route, but it doesn't seem like they call in that way.

Bill Trimble, CEO

No, I think we are not going in that direction. And I think most of the acquisitions that you see in that area for us have been part of a portfolio, and so we've always been John bullseye, bullseye, bullseye. I think the animal how many times appears in speech every time, but we really like to drive to that. And there's been questions asked, I think one note came out asking about occupancy or when is the government going to get back? The government has been in our buildings the entire time, which I'd like to point out to folks, and they have important missions. But I think the world is changing. At some point, I can't forecast what's going to happen 15 years from now or 10 years from now, but we do know that the FBI, the laboratories, the courthouses are going to continue to be occupied and extremely valuable, and more important, very expensive and difficult to replace. So, that's the area that we're going to spend our time in, and it just seemed a natural moment to also close some liquidities in for the balance sheet.

John Kim, Analyst

On the rising operating expense this quarter, I realized something that's probably weather-related. But I was wondering if you had that figure on a same-store basis? And how you feel about managing those costs into 2023?

Meghan Baivier, CFO and COO

Can you repeat the first half of the question, John, what about the same-store basis quarter-over-quarter?

John Kim, Analyst

Yes, I mean, the OpEx you have on the total portfolio basis, but I was wondering if you had that same-property basis?

Meghan Baivier, CFO and COO

In the quarter, same-store NOI decreased from the previous quarter due to a spike in utilities in August, which we have since seen moderate in September. This decrease fully offset the contribution from the deals completed in the second quarter and the annualization, resulting in a $1.3 million offset. Additionally, the rising interest rates accounted for a decline of about $0.01 in quarter-over-quarter FFO.

John Kim, Analyst

Do you expect inflationary pressures next year keeping that expense number elevated?

Meghan Baivier, CFO and COO

I mean, I think we all appreciate the inflationary environment we're in, but over time, our leases reiterate do provide for that inflation protection. They may not be able to insulate for a one-month spike such as we had in August, but over the arc of time, our base is well matched to our expenses, and we are effectively keeping OpEx growth inside of current inflation levels.

John Kim, Analyst

That's great. Thank you.

Operator, Operator

And our next question comes from the line of Michael Carroll with RBC. Please proceed with your question.

Michael Carroll, Analyst

Yes. Thanks, Meghan. Just staying on the OpEx I guess question that John was asking about. It looks like OpEx was up about $2.6 million sequentially. But your recoveries were roughly about $700,000? I mean, was that difference just really driven by the seasonal nature of August, or is that going to continue going forward?

Meghan Baivier, CFO and COO

So, Mike, remember the tenant reimbursements line item you see in our financials is not the OpEx space reimbursement; that is embedded in rental income, that's related to those interim tenant improvement projects that we perform on behalf of the government. So, nevertheless, to get to your question: we are, excuse me, same-store OpEx growth this year is sub-8%, and we do expect to be able to, as I said in my prior comment, continue to effectively hedge that with our base.

Michael Carroll, Analyst

It seems that total revenues increased by about $1.4 million, but there remains a significant gap between that increase and operating expenses. I believe this is mainly due to the seasonal fluctuations, and as we progress into the fourth quarter or first quarter, the rise in operating expenses should not be as pronounced. Therefore, you can expect to see some benefits from this over the next four quarters. Is that correct?

Meghan Baivier, CFO and COO

Yes. So, again, just to keep the details tight, our same-store NOI quarter-over-quarter did decline $1.3 million due nearly entirely to the utility spiking, right? We do expect that to revert as we move into the fourth quarter.

Michael Carroll, Analyst

Okay. And then just related to the asset sales, I guess, did you change your definition of bullseye property? I was surprised that you had so many non-bullseye properties within your portfolio. I mean, I guess outside of these sales, how many do you have left that you would consider selling and that you don't want in your portfolio? It doesn't fit your criteria?

Bill Trimble, CEO

We are currently satisfied with our position. Our largest renewable assets have been sensitive to terms over the past few years, particularly with 15-year terms. This largely encompasses the assets we categorized as such. Throughout this time, we have consistently adhered to our principles, focusing on buildings that possess mission-critical bullseye properties. This will be reflected in our purchasing decisions, and any potential future sales will likely fall within the plain vanilla category.

Michael Carroll, Analyst

Would you consider these assets plain vanilla or would you consider them just non-bullseye properties?

Bill Trimble, CEO

I believe we share the same perspective on this. Bullseye isn't a strict category, and some properties are closer to the edge than others. This has been an opportunity to refine our focus on the edge of bullseye properties. We are concentrating on a few agencies where we can truly have a competitive advantage in serving our clients. During challenging times, it's essential to tighten our focus and ensure we are concentrating on what we excel at, which is creating liquidity for upcoming opportunities. This context explains the actions we've taken over the past three to six months.

Michael Carroll, Analyst

The non-bullseye properties in your portfolio are standard properties, likely including the IRS building in Fresno and some Social Security buildings that you are satisfied with due to the lease term.

Bill Trimble, CEO

Yes, we're very pleased with those and the lease term. It's worth mentioning that the IRS recently received an $80 million check. I'll remind everyone on the call that the IRS is the last entity you want to get a call from, as they oversee national compliance. But yes, that would be an example of a standard type of property.

Michael Carroll, Analyst

Okay, great. Thank you.

Bill Trimble, CEO

Thanks.

Operator, Operator

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

Michael Lewis, Analyst

Thanks. This is good timing because I wanted to follow-up on Mike Carroll's question. I had some of the same thoughts. When I looked at the portfolio of 10 properties, one of these is an SBA 81,000 square feet in College Park, Maryland. One of them is a VA, 30,000 square feet in Baton Rouge; one of them is leased to IAS 25,000 square feet in Pittsburgh. And so I think those are probably bullseye agencies. And I'm just wondering how this portfolio came together. Did you market this and find a buyer, or did you negotiate with the buyer about what properties were in the portfolio and which ones were out? I'm just kind of curious how it came together.

Meghan Baivier, CFO and COO

Yes. Mike, it was a well-considered, well-compiled portfolio, and it was competitively put into the market. We had a lot of interest from named competitors. We speak out regularly and feel very good that we found a very efficient fair value perspective on the portfolio.

Michael Lewis, Analyst

Okay. So, you didn't swap properties in and out?

Meghan Baivier, CFO and COO

No, we didn't. No, we did not.

Michael Lewis, Analyst

Okay, and then on the guidance, does it assume that all of the sales proceeds are used to repay debt? And as part of that, I'm wondering what debt you can get? And at what cost? Because you don't have any maturity for the next 12 months, and there was only $6 million of debt on the portfolio.

Meghan Baivier, CFO and COO

Yes, that's right, Mike. It is our plan to pay down our line with proceeds. We obviously had $177 million outstanding at the end of the quarter. When you look through to the end of the year and the closing of the 10th property, also with the consideration of completing our VA portfolio acquisition target, that does nudge you $50 million on the revolver. So, adequate capacity there. And should we need it, a lot of continued support following us in finance secured markets.

Michael Lewis, Analyst

Okay, that makes sense. Lastly, I have another question about guidance. You lowered the guidance for this year by $0.08, and I understand that half of this is due to lower acquisitions and capital markets, while the other half is due to dispositions. When I consider the dispositions, it seems like the impact is from just two months, and that's before you even redeploy the proceeds.

Meghan Baivier, CFO and COO

Sorry if you ensure that it is roughly $0.04 due to the rates, $0.03 on wholly-owned transactions that are no longer in our guidance, and about $0.01 for the disposition impact.

Michael Lewis, Analyst

Okay, I missed that. Yes, that answers my question. Perfect. All right. Thank you.

Meghan Baivier, CFO and COO

No problem. Thank you.

Operator, Operator

And we have reached the end of the question-and-answer session. I'll now turn the call back over to Darrell W. Crate for closing remarks.

Darrell Crate, Chairman

Great. Thank you, everyone and thanks for joining the Easterly Government Properties third quarter 2022 conference call. We hope this call has been helpful and we look forward to speaking to you all again soon.

Operator, Operator

And this does conclude today's conference, and you may disconnect your lines at this time.