Industrial Logistics Properties Trust Q3 FY2022 Earnings Call

Good morning, and welcome to the Industrial Logistics Properties Trust Third Quarter 2022 Financial Results Conference Call. All participants will be in listen-only mode. Please note this event is being recorded. I would now like to turn the call over to 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 and Treasurer, Brian Donley. In just a moment, they will provide details about our business and our performance for the third 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, October 26th, 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 are available in our supplemental operating and financial data package, which can also be found on our website. With that, I will now turn the call over to Yael.

Thank you, Kevin, and good morning. Before we start, I would like to welcome Brian Donley, who joined ILPT as our Chief Financial Officer and Treasurer on October 1st. On today's call, I will provide a summary of our financing and deleveraging plans and review our third quarter operating and leasing performance. Brian will then provide details on our financial results and balance sheet before we open the call to questions. In September, we closed on a $1.2 billion debt package that enabled us to fully repay the bridge loan facility used for the Monmouth Real Estate Investment Corporation acquisition. While the pricing on this debt is wider than the pricing of the bridge loan, interest rates and market spreads have continued to rise. Additionally, we are pleased with the outcome of this transaction. We believe continued demand within the industrial sector, coupled with our high-quality investment-grade portfolio, allowed us to execute during a challenging time in the debt market. Importantly, this refinancing extended our weighted average debt maturity to over four years and provides us time and flexibility to execute on our deleveraging plans. As we have discussed on prior calls, our plan may include relaunching the marketing campaign of the 30 properties previously identified for disposition, resuming discussions with potential partners for an equity interest in ILPT's Mountain Industrial joint venture, or exploring additional joint venture opportunities with properties where fixed debt is already in place. As we work through these strategies, we will use available proceeds to pay down debt and improve leverage. Now turning to portfolio fundamentals and operating results. As of September 30, 2022, ILPT's consolidated portfolio included 413 warehouse and distribution properties in 39 states, totaling approximately 60 million square feet, with a weighted average remaining lease term of approximately nine years. Occupancy at quarter end reached 99.2%, up 30 basis points on a sequential quarter basis. As we are in a time of economic uncertainty, we are encouraged that 78% of our revenues come from investment-grade tenants or subsidiaries or from our secure Hawaii land leases. During the third quarter, we entered new and renewal leases for approximately 1.7 million square feet at weighted average rental rates that were nearly 77.5% higher than prior rental rates for the same space, reflecting record quarterly leasing spreads. The impact of this activity is an increase of $4.8 million in annualized rental revenue, which showcases our ability to generate organic cash flow growth while maintaining portfolio stability. We executed five new leases totaling approximately 543,000 square feet for a weighted average lease term of 7.4 years. Included in this activity was a five-year lease for a 368,000 square foot warehouse and distribution building in Ohio that we acquired vacant as part of the Magnus acquisition. In under six months, we were able to leverage industry and broker relationships to lease this building to an investment-grade rated tenant with minimal concessions. We signed four new deals in Hawaii totaling 175,000 square feet at a blended roll-up in rent of 62%. As Brian will discuss later in the call, we recorded a bad debt reserve of $1.2 million this quarter related to one tenant, which leaves three parcels within our Hawaii portfolio. Almost immediately, we were able to execute new leases with replacement tenants at an average roll up in rent of 68%. These results continue to highlight the scarcity of land, persistent demand, and the value of our Hawaii real estate. Renewal activity was also strong with nine executed leases for approximately 1.1 million square feet, primarily on the Mainland, and an average roll-up in rent of 26.1% with a weighted average lease term of 3.7 years. As asking rents continue to increase, we are selectively completing short-term renewals with certain tenants to take advantage of market conditions. For example, we signed 760,000 square feet of renewal activity in the Columbus market, which has experienced record low vacancy and rent growth of nearly 20% year-over-year. By completing three-year renewals, we were able to achieve a 40% roll-up in rent while allowing for further growth. Now turning to our leasing opportunities. With minimal lease expirations for the remainder of 2022, our focus continues to be on the future. Approximately 20% of ILPT's portfolio is scheduled to roll by the end of 2025, mainly driven by our Mainland properties. Given the strength of the industrial sector, we feel confident that our active leasing pipeline will position us to maximize mark-to-market rent growth and increase cash flows. Our pipeline includes 36 deals for 3.6 million square feet, of which roughly 1.4 million square feet are in advanced stages of negotiation or lease documentation. Once executed, we expect these leases will yield an average roll-up in rent of 20% on the mainland and 40% in Hawaii, further illustrating the strength of our portfolio. I will now turn the call over to Brian to review our financial results.

Thank you, Yael, and good morning, everyone. Starting with our consolidated financial results for the third quarter of 2022. Normalized funds from operations were $14.9 million or $0.23 per share, a decline of $15.4 million compared to the prior year quarter. Adjusted EBITDA increased approximately 85% year-over-year at $76.1 million, primarily as a result of our acquisition of Monmouth. The major drivers impacting normalized FFO over the prior year quarter were higher interest expense, partially offset by a $38 million increase in NOI, primarily from the Monmouth portfolio. Total portfolio same-property cash basis NOI for the third quarter decreased 1.9% year-over-year. This includes a negative impact of $1.2 million of bad debt reserves related to the Hawaii leases that Yael mentioned earlier. Excluding these charges, consolidated same-property cash basis NOI increased 1.2%, primarily due to our leasing activity and contractual rent steps. Interest expense increased $80.7 million over the prior year quarter, including a $45.6 million increase in cash interest expense and a $35.5 million of non-cash amortization of financing fees, of which $31.4 million was related to the bridge loan facility that we paid off at the end of the quarter. G&A expense increased $4.4 million over the prior year quarter, primarily as a result of our larger scale following the Monmouth acquisition. Turning to our balance sheet and financing activities. In September, we successfully closed on a $1.2 billion mortgage financing and used the loan proceeds and cash on hand to pay out borrowings under our $1.4 billion bridge loan facility. The new financing is secured by a portfolio of 104 industrial properties totaling 18.6 million square feet across 31 states. It is comprised of a $1.1 billion mortgage and $135 million mezzanine loan. The loans are interest-only five-year floating rate loans with two-year initial terms and three one-year extension options and carry a total weighted average interest rate of SOFR plus 393 basis points per annum. We also entered into an interest rate cap limiting SOFR to 2.25% through October 2024, effectively fixing the interest rate on the entire CMBS loan at 6.18%. This new financing extends our weighted average debt maturity to 4.4 years and allows for a portion of the borrowings to be prepaid without penalty. Including extension options, ILPT now has no debt maturities until 2027. As part of the loan agreements, we have maintained flexibility to repay debt, as we further execute on our deleveraging priorities. Assuming short-term interest rates continue to rise and our caps remain in the money, our current quarterly cash interest expense run rate is approximately $59 million. Non-cash amortization of financing costs is projected to be approximately $6.7 million in the fourth quarter. Turning to investing activities. As previously disclosed, our consolidated joint venture acquired one of two properties that were under agreement by Monmouth for $38 million during the quarter. The JV terminated the contract for the second committee property, given the market volatility seen over the last few months. We spent $8.5 million on capital expenditures during the third quarter, including $5 million for development costs, $2.2 million of tenant improvements and leasing costs, and $1.3 million of building improvements. Regarding the common dividend, we expect to maintain the current quarterly distribution rate of $0.01 per share to preserve liquidity and allow for short-term flexibility until we improve ILPT's leverage profile. Our financing plans are subject to market conditions and the timeline to accomplish our goals is currently uncertain. We believe ILPT continues to own a strong real estate portfolio with an exceptional tenant roster and dependable cash flows. We look forward to providing updates on our progress in the future. That concludes our prepared remarks. Operator, please open the lines for questions.

We will now begin the question-and-answer session. The first question is from Bryan Maher of B. Riley Securities. Please go ahead.

Good morning, Yael and Brian. A couple of questions. Maybe just start with the dividend. Yael and Brian, at what leverage level would you start to deleverage through asset sales or joint ventures? Do you think the Board would start to contemplate reinstating at least some compelling dividend?

Brian, good question. It's something at the front of everybody's minds here, where resets are only paying a penny. I think our deleveraging plans have a lot of moving pieces and different formations that could happen. But we need to reduce interest down a few terms. We're at a debt-to-EBITDA over 13 times right now and until we're in the single digits, I don't think it's a real conversation. So we'll keep reevaluating every quarter and we'll see where we're at, but it's not going to happen until late 2023 at the earliest.

Okay. Given your observations in the marketplace and your conversations with the joint venture partners about the Monmouth assets and the sales process, which involves around 30 properties, when do you think you might realistically be able to reconnect with those partners to start removing assets, or is it still too early to determine?

Hi Bryan, I believe it's too early to provide a definite answer. We have been talking with brokers and some of our industry peers, and it seems everyone is just anticipating a return to normalcy. I understand this may be a subjective viewpoint, but we've seen a 40% decrease in transaction volume from Q2 to Q3. Buyers are hesitant to purchase until they feel the market has bottomed out, while sellers who aren't in distress are reluctant to sell under pressure. Therefore, I think the upcoming quarters will clarify what the new normal will look like.

Okay. And just two more quick ones, are you guys seeing any rent pushback on those increases that you're implementing?

None.

Okay. And then lastly, maybe for Brian, the OpEx. I think it was $8.4 million, $8.5 million, somewhere in there. Is that a good run rate for now until we see either asset sales or the deconsolidation of the joint venture?

Yeah. That's a pretty good proxy this quarter. There are some seasonality type numbers in there, and we do recover a large percentage of the operating costs that run through our P&L. So we should factor that in for modeling purposes.

The next question is from Mitchell Germain of JMP Securities. Please go ahead.

Thank you, and good morning. The Hawaii backfill potentially credit upgrade there? Is there any sort of color you can give us?

Yeah. So as I mentioned, it was one tenant who leased three parcels. They actually had a natural lease expiration of October of 2022. They wanted to renew one of the three parcels and we felt there was an opportunity to release to better credit tenants, which we've actually been able to accomplish. Both of the three parcels were leased to investment-grade tenants.

Great. Is there a timing differential we should be aware of?

Not, the new leases will go into effect on November 1st.

Great. I appreciate it. Brian mentioned some flexibility on the mortgage, the new financing. And I'm curious, can you pay down, like can you pay down the mezz? Is that kind of what you're talking about, or can you pay down the principal of the entire – maybe just provide some perspective on how that can work going forward?

Yeah, what was negotiated is that we could repay 20% of both loans as part of that deal, which is roughly $250 million with no penalty.

With no penalty.

Correct.

Great. And you guys had mentioned some color around some of the flexibility you have with regards to deleveraging. Are we just talking about the Mainland, or can you will you possibly look to capitalize on some of the Hawaii properties?

Yeah. We have fixed debt in place on both the Mainland and in Hawaii. So I think we can be selective if we decide to go down presenting additional joint venture opportunities either way.

Got you. That's helpful. And then last one for me, Brian. I just want to make sure I understand the one-timers this quarter. You've got the $1.2 million that gets adjusted out, there's some OpEx noise, and then you gave us a run rate of around $66 million or so for interest for next quarter. Is that the way to think about it?

That's correct. This quarter has the rest of the noise from the bridge loan facility, which was adjusted out of FFO.

Great. I appreciate everything. Thank you.

Thanks.

The next question is from Tom Catherwood of BTIG. Please go ahead.

Thanks. Good morning, everybody. Maybe sticking with the bad debt. I understand the $1.2 million. But obviously, if we compare to Q2, it's down around $4 million on a rental revenue basis. Is that just GAAP adjustments? Is the $1.2 million just the cash bad debt, or is there something else that was dragging down that rental revenue this quarter?

Yeah, it's a great question. Q2 actually had a one-timer to the positive. It was $3.5 million of below-market lease value that was written off related to a tenant that was turning over. So Q2 was artificially inflated, and then you had the bad debt in Q3 of the $1.2 million. So we net those two items out, and that's a better run rate.

Got it. I appreciate that, Brian. And then I assume the backfill you mentioned, the blended 68% for those three spaces in Hawaii, I assume that was in October, so that didn't hit 3Q numbers. Is that a fair assumption?

Yes, that's exactly right.

Okay. Then you've laid the scenario. I appreciate your commentary around potentially bringing 30 assets back to market looking at additional joint ventures and maybe looking to do more JVs in the fixed-rate assets. But not rushing into anything because of what's going on in the market. But it seems like a basic question, but how long can you wait? Is there a point in time where you say we need to start to transact just to bring this leverage down?

I think we have time to be patient. We all know that the bridge was looming over us with a maturity of February 2023. So the fact that we were able to refinance out of the bridge, I think again provides us time to be patient. So I don't think we're going to prematurely do something that isn't in our best interest.

All right. Then maybe, Brian, how is the debt cross-collateralized? And does that limit what is available to sell outright now, or do you have some flexibility there?

We have some flexibility. I mean, there are certain parts of the portfolio that have mortgages, and we'd have to look at what we could get for that in total proceeds. But each loan tranche, the overall CMBS, as we outlined is inclusive of 105 assets and the Mountain JV floating rate debt has its own portfolio. But there are options around that that we can look to pull different levers to raise capital.

So maybe to say it another way, the 30 assets that you had first brought to market and then pulled before you did the refinancing, does the refinance issue reduce that pool of 30 assets, or could those still be available to go out to market?

Yeah. Those are still available to go to market. That’s right.

Got it. And then last one for me, thinking bigger picture strategically with the relationship with the RMR Group. In a normal operating environment, the discussion around one of the benefits of RMR is the resources, the scale. You've talked often about the large funnel when it comes to seeing more acquisitions and being able to underwrite more. When it gets to a situation like this where it's all hands on deck and trying to delever and trying to manage through a challenging market and situation, what is the interaction with the RMR Group? And is there a benefit that scale brings in this type of environment, not just a normal operating environment?

Yes. I think even more so in today's environment, we are in a time of economic uncertainty. I think asset management, property management, accounting, I mean it’s all hands on deck.

Yes. I would add that the CMBS financing had a direct correlation. Our banking relationships and the ability to execute out such a large transaction was a huge benefit having RMR behind us.

So you do think when the capital markets or the investment sales market open back up, you'll be able to move swiftly on that front just to delever because of that? Is that the benefit of that relationship as well?

Absolutely.

Got it. Appreciate it. Thanks everyone.

Thanks, everyone, for joining us on the call today. We look forward to speaking with many of you at NAREIT in the coming weeks.

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