Industrial Logistics Properties Trust Q1 FY2022 Earnings Call

Good morning, and welcome to the Industrial Logistics Properties Trust First Quarter 2022 Earnings Conference Call. I'd now like to turn the call over to Mr. Kevin Barry, Director of Investor Relations. Please go ahead.

Good morning, everyone, and thank you for joining us today. With me on the call are ILPT's President and Chief Operating Officer, Yael Duffy; and Chief Financial Officer, Rick Siedel. In just a moment, they will provide details about our business and our performance for the first quarter of 2022, followed by a question-and-answer session with sell-side analysts. First, I would like to note that the recording and retransmission of today's conference call is prohibited without the prior written consent of the company. Also note that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on ILPT's beliefs and expectations as of today, Wednesday, April 27, 2022, and actual results may differ materially from those that we project. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call. Additional information concerning factors that could cause those differences is contained in our filings with the Securities and Exchange Commission, or SEC, which can be accessed from our website, ilptreit.com or the SEC's website. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we will be discussing non-GAAP numbers during this call, including normalized funds from operations or normalized FFO, adjusted EBITDA and cash-based net operating income or cash basis NOI. A reconciliation of these non-GAAP figures to net income and the components to calculate cash available for distribution, or CAD, are available in our supplemental operating and financial data package, which also can be found on our website. With that, I will now turn the call over to Yael.

Thank you, Kevin. Good morning, everyone, and welcome to the first quarter earnings call for Industrial Logistics Properties Trust. I will start with an update on the acquisition and integration of Monmouth Real Estate Investment Corporation, summarized key metrics for the combined portfolio, review first quarter leasing activity and look ahead to 2022 and 2023 leasing opportunities. On February 25, we completed the acquisition of Monmouth, marking a significant milestone for our company and creating a stronger ILPT with the addition of 126 high-quality, e-commerce-focused mainland properties, which provide increased tenant and geographic diversity. Since we announced the transaction last fall, there have been substantial changes to the macroeconomic, geopolitical and financing environment. Despite these challenges, we believe this acquisition will enhance ILPT's growth prospects over the long term as industrial markets and operating fundamentals remain strong. In the first quarter of 2022, new U.S. industrial leasing activity surpassed 200 million square feet for the sixth quarter in a row. National average asking rents reached $7.89 per square foot, a 15.2% increase year-over-year and the national vacancy rate dropped to a record low of 3.3%. These metrics are the result of tenants needing to expand as they look to capitalize on robust e-commerce growth while increasing inventory levels to meet consumer needs and protect against potential supply chain disruptions. These are trends we are seeing firsthand. As an example, in Hawaii, with an industrial market vacancy rate of 1.4% and the lowest in recorded history, tenant space is a daunting challenge to lease suitable options for their growing businesses. Tenants are now being proactive and working to identify availability before it becomes public. In the past year, we have helped 8 of our existing tenants in Hawaii grow into additional ILPT-owned properties. Our portfolio is well-positioned to take advantage of these market dynamics through tenant retention, mark-to-market opportunities and leveraging expanded tenant relationships to enhance ILPT's cash flows in the years ahead. Due to the efforts of our manager, the RMR Group, the integration of the Monmouth properties into ILPT is complete. With over 30 offices and more than 600 employees across the United States, just about every part of the RMR organization contributed to this seamless effort, whether it be a personalized introduction to each new tenant in the portfolio, onboarding of capital projects or hiring brokers to assist in leasing efforts. As you may be aware, FedEx, our top tenant, has committed to a goal to reach carbon-neutral operations by 2040. Key steps to achieving this include a focus on alternative energy and more efficient energy usage in its facilities, vehicles, aircraft and other business operations. RMR on our behalf has engaged with FedEx on a strategic level to ensure we align with its long-term sustainability and growth plans. We believe many of our properties are well-equipped to support FedEx's sustainability initiatives with key attributes, including rooftop solar energy adaptability, ample space to accommodate electric vehicles and charging stations, energy-efficient lighting and the potential to achieve LEED certification. By partnering with FedEx on these projects, there will be an opportunity for ILPT to grow rents ahead of national lease expirations. The last and only outstanding component of the Monmouth acquisition is the reduction of debt. This effort, which Rick will review in more detail, includes selling an additional equity interest in our newly formed joint venture and the disposition of 30 legacy Monmouth properties, consisting of 4.9 million square feet. The properties held for sale are representative of the larger portfolio, geographically diverse, located in markets experiencing rent growth and leased to high-quality tenants. The properties are currently on the market, and we expect to begin closing on sales in the second half of the year. Turning to portfolio fundamentals. As of March 31, 2022, ILPT's consolidated portfolio consisted of 412 warehouse and distribution properties in 39 states, totaling approximately 60 million square feet with occupancy just under 99%. Our Mainland portfolio includes 186 properties in 38 states, totaling 43 million square feet that are 98.9% leased. The balance of the portfolio is comprised of 17 million square feet of industrial land and properties in Hawaii. Occupancy in Hawaii increased to 98.7% at quarter-end, which represents a 170 basis point improvement compared to the prior year. The total portfolio has a weighted average remaining lease term of approximately 9 years. More than 75% of our revenues come from investment-grade rated tenants with subsidiaries or from our secure Hawaii land leases. ILPT's top 10 tenants represent 48% of our total annualized rental revenues with FedEx, Amazon and Home Depot, representing 30%, 7% and 2% of annualized rental revenues, respectively. FedEx and Amazon are both key components of the supply chain as e-commerce is projected to increase to approximately 35% of total U.S. sales by year-end 2025; our properties are well positioned to benefit from growing e-commerce volumes. During the first quarter of 2022, we continued to build on the strong momentum from 2021 with solid property-level operating results. Same property cash basis NOI grew 3.1% compared to the same quarter a year ago and same property occupancy increased on both a sequential and a year-over-year basis to 99.3%. Leasing activity, which was supported by attractive industrial real estate fundamentals and persistent demand for ILPT's properties, was strong. Overall, first quarter leasing totaled 885,000 square feet and resulted in a 27.9% roll-up over prior rents and marks the 10th consecutive quarter of double-digit growth. We executed 17 new rental leases for 829,000 square feet with an average lease term of 8.9 years. Of the approximately $3.5 million spent on recurring expenditures in the first quarter, $3.4 million or $0.65 per square foot per lease year was attributable to tenant improvements and leasing commissions. In the quarter, we signed 7 new leases in Hawaii for 281,000 square feet at an average roll-up in rent of 61%. It is important to note though that rent growth in our portfolio was not limited to Hawaii. Our results also include a renewal of a 167,000 square foot property in Northern New Jersey for a 29% roll-up in rent with no lease incentives or tenant improvement concessions. Lastly, we completed 56,000 square feet of rent resets with tenants in Hawaii that were 36% higher than prior rental rates. Turning now to our leasing opportunities. We intend to continue to capitalize on the attractive operating environment to deliver favorable leasing outcomes. While near-term expirations are minimal, with 3.6% of total annualized revenue scheduled to expire this year, we believe there is embedded opportunity for growth within our existing portfolio. With approximately 30% of ILPT's portfolio scheduled to roll by the end of 2025, our leasing pipeline is active, and we are currently tracking 52 transactions for approximately 6.3 million square feet. We anticipate a near-term conversion of approximately 65% of our pipeline, given that roughly 4.1 million square feet of current activity is in advanced stages of negotiation or lease documentation. Once executed, we expect these leases will yield average roll-up in rent of 20% on the Mainland and 50% in Hawaii, further illustrating the strength of our portfolio. Finally, we are proud of the progress we continue to make to strengthen ILPT's corporate governance. In March, we welcomed June Young as the newest member of our Board of Trustees. June has more than 30 years of experience in supply chain management and corporate logistics across multiple industries in a range of Fortune 500 companies. We look forward to benefiting from her insight and experience. I will now turn the call over to Rick.

Thanks, Yael, and good morning, everyone. I'll begin with a review of our first quarter financial results and then provide further detail on our financing activities and balance sheet. Total portfolio same property cash basis NOI for the first quarter increased 3.1% year-over-year. This includes a negative impact of approximately 200 basis points of charges related to a pending lease termination in Hawaii. This strategic lease termination gave our team the opportunity to negotiate a new lease with an investment-grade rated tenant at a substantial roll-up in rent to backfill approximately 300,000 square feet. This lease is nearly in final form, and we expect it to be included in our second quarter leasing results. Excluding these charges, same property cash basis NOI in Hawaii increased 8.5%, driven by strong leasing activity over the past year. On the Mainland, same property cash basis NOI grew by 1.9%, primarily due to contractual rent steps. Adjusted EBITDA came in at $52.5 million, an increase of approximately 30% year-over-year, which reflects our same property NOI growth and the Monmouth acquisition. First quarter normalized FFO was $27.6 million or $0.42 per share. Our normalized FFO per share was adversely affected by the following: $0.03 due to ILPT's sale of 6 properties to our unconsolidated joint venture at the end of 2021 and $0.03 due to $1.7 million of charges recorded related to the lease termination I mentioned earlier. Turning to our financing activities and balance sheet. To finance the Monmouth acquisition, we entered into a new joint venture with an institutional investor for 95 Monmouth properties or the Mountain Industrial JV. The investor contributed $587 million for a 39% equity interest and ILPT and the JV incurred an aggregate of $3.5 billion of new debt. In connection with the closing of the acquisition, we terminated our revolving credit facility, which was scheduled to expire in June. We ended the quarter with $275 million of cash on hand and debt to annualized adjusted EBITDA of 13.2x. Interest expense was $41 million during the first quarter. This includes approximately $20 million of amortization of financing fees related to our bridge loan facility and the mortgages used to fund the acquisition. The balance is related to cash interest expense. Looking forward, we are focused on reducing leverage by executing a 3-part strategy. First, we are in active discussions to sell additional equity interests in the Mountain Industrial JV. Second, as Yael mentioned, we are marketing 30 former Monmouth properties for sale. We expect to generate gross proceeds of over $700 million at average cap rates in line with our acquisition. And third, we plan to enter into a new revolving credit facility, which will be used to repay a portion of the bridge loan and provide us with additional flexibility in the future. We are confident that these activities will be successful in significantly reducing ILPT's leverage to approximately 8x debt to EBITDA before the end of 2022. In summary, we are excited about the acquisition and the opportunity in front of us to accelerate growth and strengthen ILPT's competitiveness. With enhanced scale and a high-quality portfolio of industrial assets, ILPT is well positioned to take advantage of the intense demand environment, robust industry fundamentals, and strong secular tailwinds to drive long-term growth. We look forward to updating you on our progress. That concludes our prepared remarks. Operator, please open up the line for questions.

The first question comes from Bryan Maher, B. Riley Securities.

Rick, I was hoping you could clarify something for me. Expenses ran a little bit higher than we were modeling for in 1Q. Was anything related to that Hawaii tenant and lease that you just talked about impacting that? Or were there any kind of one-time items related to Monmouth that we should take into consideration when modeling OpEx and G&A for the balance of the year?

Thanks, Bryan. It's a good question. We did have a few kind of seasonal one-time items, such as snow removal, things like that during the first quarter that you would typically expect to see, obviously less so in Hawaii. But there wasn't anything in particular related to that tenant in OpEx; however, we do have small items that come up from time to time that we'll address. We did go through a pretty extensive financing process, so we had a lot of third parties on-site doing things like that. So there's been elevated activity throughout the portfolio, but we're really happy with where we've landed. On a go-forward basis, I would say there's not much to really bring to your attention from a G&A perspective. It's pretty typical. If you're looking at seasonality in the second quarter, there are typically Trustee share grants that are a second-quarter item. But otherwise, it should be pretty minimal going forward.

And then as it relates to the spike in interest rates we've seen over the past couple of months and other macroeconomic and geopolitical events. Is there anything that's transpired in any meaningful way that kind of changed your outlook on the ability to get from kind of A to Z from when you announced the Monmouth transaction late last year?

Bryan, it's Yael. So I think our plan is to be out of the bridge by the end of the third quarter. Again, we have a couple of different ways we can do that: the additional equity from the joint venture, the selling of the 30 properties, the new revolver that Rick talked about, or cash on hand. So between those four factors, we're hopeful to be out of the bridge by Q3.

Were there any first quarter vacates in the portfolio that might have affected occupancy, considering you maintain very high occupancy rates? Is there anything unusual about the vacates or the timing of the Monmouth acquisition that could have had an impact on the occupancy numbers you reported?

No. When Monmouth joined us, occupancy was at 97.9%, which was high but still below our legacy numbers. However, since then, we were under a letter of intent for one of the vacant spaces. We are optimistic about getting that lease finalized in the second quarter, which should restore occupancy levels.

And then just last from me, on the 30 properties that you're planning to sell, how is it that those properties are different than the 95 that you're keeping? I mean, is there any kind of differentiating factor there that you singled out those 30?

No. They're really representative of the larger portfolio. We try to do a mix of non-FedEx properties and FedEx properties, in all the markets where we're seeing good activity and strong population growth, like Florida, Georgia, South Carolina, Arizona. So really indicative of the bigger picture.

And maybe just one more if I can. Trying to add the other JV partner by, let's say, the second half of this year in order to get leverage down from, I think 13x times to 8x. I mean, that really is key that a partner's going to take this over 50% and thus the deconsolidation of the debt from the balance sheet. Is that correct?

Correct.

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

I was hoping you could provide some additional color on that lease termination charge in Hawaii. Did ILPT pay roughly $0.03 off of your share count to remove a tenant?

Yes. We had a long-term lease in place with a tenant whose principal ended up passing away, and they were looking for an opportunity to sublease their parcel. We ended up finding a replacement tenant and doing a direct deal with them. As part of that, we had to terminate the lease. That's the history behind it. But it's a really good opportunity because the existing tenant that we terminated was non-investment grade, the new replacement tenant will be investment grade, and it's a national brand that people will recognize. It really increases the profile of our Hawaii portfolio.

And then can you kind of describe the difference between the absolute rent of the new tenant coming in versus the alternate, how much of a change is that on an annual basis?

Mike, just one thing to point out. Of the $1.7 million of charges, it's about half and half writing off straight-line rent for the future along with current revenue. So the old revenue was about $700,000 a year and the new lease is expected to be close to $1.1 million.

And when does that actually commence, Rick? Did those leases commence sometime in the second quarter? Is that fair? So the old rents rolling off and then simultaneously the new rents rolling on?

Yes. We're anticipating mid-May for the new lease start date.

And is this the reason why the difference between the Hawaii and same-store GAAP in cash NOI was growth or change was so different due to this termination?

That's right. The GAAP includes the full $1.7 million of charges, while the cash would exclude roughly half of the straight-line rent write-off.

And then just going back to the sale of the remaining, I guess the non-core Monmouth asset and then bringing on the new JV partner. Has the interest in those assets changed given the increase in interest rates, especially given that these are assets that have long lease terms on them? Has the higher interest rates pushed those cap rates a little bit higher than when you acquired them?

We are marketing the properties individually and have observed significant interest from various groups. Currently, we have more than 150 unique investors showing interest. We have seen demand for both individual properties and portfolios, usually consisting of 2 or 3 properties grouped by location. Many of these buyers are able to purchase and make bids on a cash basis, which means the current debt market situation hasn’t influenced their decision-making much.

And what about the new JV partner? Would you expect that you could sell a similar stake as the first one at a similar valuation? What happens if it comes in at a different valuation, just given the macro environment that we're in today?

So we are in discussions already, and as of today, the valuation is the same as the first partner, and the stake is somewhere between 20% to 40%. So we haven't seen any retrading.

And then just the last one for me, can you kind of describe or give us some guidance on the FFO run rate that we could look at today post the Monmouth sale and JV? Is there a way to think about what this post-transaction run rate will be?

Sure. I think it's a little bit before and after the bridge financing, which is still outstanding. Our model has next quarter looking pretty similar to this quarter. One key sensitivity is interest rates; every 50 basis points increase in interest rates will cost us about $0.04 of FFO while the bridge is outstanding. However, after we complete the property sales, that amount will change to just $0.01 per share of FFO. We are looking forward to executing the sales and moving forward with getting out of the bridge. For the most part, the portfolio is performing really well, and the team has completed the integration and we feel confident about the direction it's heading.

And the next question comes from Mitch Germain, JMP Securities.

The asset management fee for the quarter, that doesn't include the joint venture, right? That's separate from RMR. Is that the way to think about it?

It's kind of neutral from an RMR perspective. While the joint venture has similar management agreements to ILPT, while it's consolidated, ILPT gets a credit against its fee for any fees paid by the venture. So it's essentially neutral or a pass-through, basically.

I think you mentioned around $700 million in asset sales. You're holding the purchase price allocation, which includes $24 million in severance for those properties. So essentially, is what you paid for them what we should expect you to sell them for? Is that how we should think about it?

That's right.

And then, regarding the joint venture, when you sell that stake and get below 50%, does it become unconsolidated? Or is there any sort of language that gives you guys full authority and that will keep it consolidated, how should we think about that going forward?

I think it's a pretty standard joint venture, pretty consistent with our previous venture. So questions about consolidation, I'm always a little hesitant to answer without talking to the accountants because it can get pretty technical sometimes. But our expectation is that if we go below the 50%, we will likely deconsolidate the joint venture.

And the existing party is a party to your other JV, is that the way to think about it?

So the one that's already in place is an existing partner.

I'd like to turn the call back over to Ms. Yael Duffy as we have no more questions; she is the President and Chief Operating Officer, to close the call.

Thanks, everyone for joining us on today's call. We look forward to seeing many of you at NAREIT and other industry conferences this summer.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.