Industrial Logistics Properties Trust Q2 FY2023 Earnings Call

Good day, and welcome to the Industrial Logistics Properties Trust Second Quarter 2023 Financial Results Conference Call. All participants will be in a listen-only mode. Please note, this event is being recorded. I would like now to turn the conference over to Stephen Colbert, Director of Investor Relations. Please go ahead, sir.

Good morning. Joining me on today's call are Yael Duffy, President and Chief Operating Officer; and Brian Donley, Treasurer and Chief Financial Officer. Today's call includes a presentation by management followed by a question-and-answer session with analysts. Please 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, July 26th, 2023 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 financial numbers during this call, including normalized funds from operations or normalized FFO, adjusted EBITDA and cash-based net operating income or cash basis NOI. This quarter, we are also introducing our calculation of cash available for distribution or CAD. A reconciliation of these non-GAAP figures to net income is available in our supplemental operating and financial data package, which can be found on our website. And with that, I will turn the call over to Yael.

Thank you, Stephen and good morning. On today's call, I will review ILPT's operating and leasing performance and then provide an update on our disposition activity before turning the call over to Brian to discuss our financial results. As we enter the second half of the year, we remain encouraged by the continued demand for ILPT's high-quality portfolio and the strength in industrial real estate fundamentals. In the first six months of 2023, we signed 32 leases totaling more than 3.1 million square feet at weighted average rental rates that were 23% higher than prior rental rates for the same space. The impact of this activity is an increase of $4.8 million in annualized rental revenue, of which more than half will take effect in the second half of 2023 or in 2024. These results, along with a tenant retention rate of 87%, showcase our ability to generate organic cash flow growth while maintaining portfolio stability. As of June 30th, 2023, our portfolio, which consists of 413 warehouse and distribution properties, achieved 99.1% occupancy, representing a 40 basis point increase sequentially. During the quarter, we executed 17 new and renewal leases and three rent resets for nearly 2 million square feet at a weighted average lease term of 8.9 years. This activity resulted in GAAP and cash leasing spreads of 29.6% and 10.2%, respectively. Highlighted in these results is the robust activity within our Hawaii portfolio. With a market vacancy rate under 1%, strong tenant demand and minimal new construction in the pipeline, we have been able to take advantage of mark-to-market opportunities. We executed 855,000 square feet of leasing in Hawaii at weighted average rental rates that were 41.7% higher than prior rents, including five new leases totaling 195,000 square feet at increases in rent of 62.2%. Leasing in our wholly-owned Mainland portfolio was also strong with total leasing of approximately 428,000 square feet including 1 new lease and three renewals at weighted average roll-ups in rent of 50% and 36%, respectively. Looking ahead, 12 million square feet or 16% of ILPT's total annualized revenue is set to expire through 2025. We believe there is ample opportunity to increase cash flows consistent with the 30% roll-up in GAAP rents we achieved over the past 12 months. Turning to transactions, among the most frequently asked questions we receive is when we expect to resume our disposition program to reduce leverage. Based on what we are seeing firsthand and through discussions with brokers, we believe the market has slowly begun to thaw as investors look for opportunities to deploy capital. We consistently receive unsolicited offers for the high-quality properties in our portfolio. However, given we are not a distressed seller, it isn't as simple as finding a buyer. As we evaluate each opportunity, our ability to transact is dependent on pricing and the impact to our financial position. For each offer we may receive, we compare the potential transaction price to the allocated loan amount under our debt agreements and confirm that we can maintain the required debt service coverage ratios. Additionally, potential tax gains and the impact to our overall liquidity needs to be considered. As such, disposition opportunities have been limited in this challenging sales market. Given these obstacles, we are happy to report that we currently have three properties, two that are encumbered totaling 762,000 square feet under agreement to sell for an aggregate sales price of $65.3 million. We hope to continue to improve our financial position with additional disposition opportunities. However, we expect activity to be limited in the short term. I'll now turn the call over to Brian.

Thank you, Yael and good morning everyone. Starting with our consolidated financial results for the second quarter of 2023, normalized funds from operations was flat on a sequential basis of $0.12 per share, a decline compared to the prior year quarter, primarily as a result of our higher interest expense incurred under our floating rate debt instruments. Cash available for distribution in Q2 was $9.8 million, and adjusted EBITDAre was $81.3 million for the quarter. Our leasing activity generated increases in cash rents for our comparable portfolio of $1.8 million or 2% per year, year-over-year. However, our rent growth was partially offset by operating expense increases, which resulted in a net 50 basis point increase in total portfolio same-property cash basis NOI for the second quarter. Comparisons of same-property GAAP NOI were negatively impacted by a $3.4 million write-off related to a below-market lease liability in the prior year quarter associated with a lease termination. Interest expense increased by $24.6 million compared to the prior year quarter, excluding the impact of the amortization of bridge loan costs recognized in the prior year. This quarter, we executed on a cash-out refinancing within our consolidated joint venture. We entered a new $91 million fixed-rate interest-only loan secured by four properties that bears interest at 6.25% and used part of the proceeds to repay four amortizing loans with a total principal balance of $35.9 million. As a result, our current estimated quarterly interest expense run rate is approximately $73 million, consisting of $60 million of cash interest expense and $13 million of non-cash amortization of financing costs, including existing interest rate caps. Turning to our balance sheet, including extension options, ILPT's weighted average debt maturity is 5.5 years with no maturities until 2027. As of June 30th, our total debt either carries a fixed rate or was fixed through interest rate caps for total weighted average interest rate of 5.46%. As Yael mentioned, we have three wholly-owned properties under agreement for sale of $65.3 million. Assuming those transactions close, $42 million of the proceeds from two of the properties will be used to repay a portion of the $1.2 billion floating rate CMBS loan. The amount to re-lease a property from the collateral pool under this loan is the greater of 115% of the allocated loan value under our debt agreement or the net sales proceeds. We also need to maintain the overall debt service coverage ratio that was in place when the loan was underwritten. For these dispositions, ILPT can transact without needing to contribute additional cash to maintain the loan covenants. So, we currently have $71.7 million of cash on hand as well as $138.7 million of restricted cash in our consolidated joint venture. We continue to look for opportunities to build our cash reserves. Accordingly, the proceeds from the sale of the 1 unencumbered asset will be held to further enhance our liquidity. In closing, our portfolio remains strong with an exceptional tenant roster, near full occupancy, and rising rents across our portfolio and we expect that ILPT will continue to benefit from industry demand for high-quality industrial real estate. That concludes our prepared remarks. Operator, please open the line for questions.

Thank you. Good morning Yael and Brian. Just a couple for me this morning. When we think about the asset sales and building cash reserves and paying down some debt, how big of an opportunity do you think that is over the next couple of few quarters?

Good morning Bryan. I think we're reviewing opportunities as they come. Two of the properties on the disposition list came through our leasing efforts. One of the properties is vacant and the other soon to be vacant, so we haven't launched a formal disposition campaign. And so we're continuing to evaluate pricing and our portfolio and see what other opportunities we have. So, I don't have a number for you to project.

And I suspect that when you chip away at this debt with some asset sales over the next, let's say, 12 to 15 months before the first extensions would be due on some of your variable rate debt, that that's going to potentially lower the cost of future caps needed to get those extensions done. Maybe Brian, you can talk about for a second, if we were to sit here today and have to redo those caps to get the extensions, what the cost might be relative to what you had to pay last year? Just some broad stroke ideas.

Sure Bryan. And I think we talked about this last quarter. Buying an interest rate cap is a very volatile instrument. The pricing changes week to week, day to day. I think last quarter, I might have quoted something around $50 million. We consult with various experts on this and our current estimate today on the $1.4 billion floating rate debt could be anywhere from $17 million to $20 million if we were to buy that same cap. So, again, it changes with the wind, so it's very important for us to continue to build cash reserves. But to your other point, yes, if we were to chip away at the debt and repay meaningful amounts, the cost of that cap would also decline because it's based on the notional amount of principal debt that you're capping.

And just maybe two more quick ones for me. On the rent roll-ups, I mean, those were pretty juicy roll-ups for the second quarter. Yael, what do you think it would be for the full year? When we look back at 1Q, when we think about 2Q, do you have something in your mind for what you think it is for all of 2023?

I think we're hoping that it's somewhere between 25% to 30% for the year on a GAAP basis.

Okay. And just my last question. The Blackstone deal to sell $3.1 billion in warehouses and industrial assets to Prologis, when you look at that transaction, does it seem like more of a one-off on the part of Blackstone to raise capital relative to some of the capital that's been called away from them in BREIT, et cetera? Or is there something else going on there as it relates to demand for assets? And that's all for me. Thanks.

I think industrial, in general, along with multifamily, is probably the most in-favor asset class. So, if investors are looking to deploy capital, I think it's in one of those categories. So, I think it's promising for the industrial landscape. I think that deal was huge. And in speaking with brokers, they're seeing that more one-off deals are coming into the market, but they haven't seen the bigger portfolio. So, I think time will tell, and I think everybody is kind of looking for September to get here and see what that brings because generally, the summer is slow.

Thank you.

Thank you.

Next question comes with Mitch Germain with JMP Securities. Please go ahead.

Hi, good morning. I'm trying to understand some of the puts and takes in your same-property growth. And despite some of these pretty healthy rent spreads that you are getting on these leases, your revenues are only up from the prior year about less than 1% but your operating expense is up significantly more. So, I'm just trying to understand kind of when does this upside in rents begin to materialize and have a meaningful impact on your rental income?

Yes. Good morning. So, I think some of these roll-ups, we've had this historically. We're not seeing the cash impact right away because we're doing deals ahead of lease expiration. For the activities we've done so far this year, I think almost two-thirds will be in the latter half of the year and into 2024. So, I think that's impacting some of the growth, and we're not seeing it this quarter. I think also as far as the expenses go, we have some very sophisticated tenants that when they negotiate their leases, they put caps in for how much expenses can get passed back for maintenance and repairs, so I think there is a little bit of leakage on the expense side.

Regarding the expirations in the second half of the year, is there anything significant we should know about? You have maintained nearly a 90% retention rate so far, so should we expect any planned move-outs that we should be aware of?

So, we know of two known vacates in the second half of the year. Both of those properties actually have pretty good activity on them. One has assigned LOI, and the other, I think we've traded a couple of proposals with prospective tenants. So, there isn't anything that should be a needle mover in 2023.

Okay, cool. I appreciate the extra color in terms of kind of suggest kind of where mark-to-market is going. How should we think about that, though, if we bifurcate Mainland versus Hawaii?

Yes. So, as you know, Hawaii has always been really strong for us. I think 30% to 40% roll-ups in Hawaii going forward would not be surprising, I think 30% on the conservative side. On the Mainland, we had really good leasing results this quarter, almost 40% on the Mainland from a GAAP perspective and even on the cash perspective, it was 30%. I think it really depends market-to-market. We have some areas like Memphis, South Carolina that we've been seeing huge roll-ups in rent and others that have been single digits. So, I think 10% is probably a good estimate for the Mainland.

Thank you.

Thank you.

Thank you. The next question comes with Camille Bonnel with Bank of America. Please go ahead.

Hi, good morning. Just following up on, Yael, your response to an earlier question about how the leasing spread impact. You'll see that start to follow through in the back half of this year. Can you just speak to why you think tenants are willing to renew their leases so far in advance? I think in some cases, you've been signing leases like 18 months-plus, which really differs from your peers' strategies in the market currently?

Yes. So, I think in Hawaii generally, the tenants are more of they kind of wait until the last minute because they are smaller tenants, and they're just running their business and they don't have a whole team focused on their leasing efforts. For the Mainland, these are large properties that are very important to the tenant's business. They need to make sure that if they're not going to renew with us and we can't come to terms, they're going to have to move their operations. If you're 1 million square feet, it's really hard to wait six months if you have to relocate and build all the infrastructure again. So, that is, I think, generally why we're starting negotiations early. Plus we also want to have an indication if a tenant is not going to renew; we want to limit our downtime because by the time you hire a broker and start marketing it, if you need to multi-tenant the property potentially, that takes time and we're trying to limit our downtime.

That's helpful. And what are you seeing in terms of market rent growth particularly in the Mainland US?

About 10%. It varies from market to market, with some being higher and some a bit lower, but we are continuing to push rents.

And has that changed? Because I think that 10% is on an annual basis. So, have you seen any change sequentially?

No. What we've been seeing more is that tenants are taking a little longer to make a decision and I don't know if that's just the impact of the summer. Generally, this is a slow time for leasing because people are on vacation. But no, we haven't seen tenants pushing back.

All right. And lastly, do you have any update on the interest around the space in Hawaii that Home Depot was going to take in 2024?

Yes. We've officially launched it at the beginning of the month, and we've gotten a lot of inbound calls, mostly from Mainland tenants looking to have a presence in Hawaii. So, we feel optimistic that we'll be able to get that re-leased ahead of the March 2024 lease expiration.

Thank you.

Thank you.

The next question comes with Michael Carroll with RBC Capital Markets. Please go ahead.

Can you discuss your financing strategies? What is the reasoning behind issuing $90 million in secured debt and repaying the smaller outstanding balances, which I believe was around $30 million? It seems like that $30 million was set to expire around 2030. Was the intention to increase your cash reserves, or was that the primary reason for giving up that lower interest rate debt?

Hey Michael, thanks for the question. Yes, that's exactly right. It was an opportunity to actually improve our cash flow. The coupon and the interest expense on our income statement will go up because of the rate differential. But again, our new loan is interest-only versus amortizing principal payments over those other mortgages, so it was a way to capture some cash as well as improve ongoing cash flow available to the company. So, that was the thought process there.

Okay. And then on the asset sales that you announced, I guess how much NOI from those properties were generated in 2Q? I know you said 1 was vacant and 1 was soon to be vacant. But when we're looking at our models, I mean, I guess what was the trailing cap rate on those assets that we can assume kind of flows out of the run rate estimate going forward?

One of the properties is our development project in Mesquite, Texas, so that also had no cash flow associated with it. The other one, as I mentioned, was a small property that was formerly leased to FedEx that was also not cash flowing. The other one is in Indiana. It was a bigger property, 535,000 square feet that was scheduled to be vacant in June of 2024, and we had about $3 million in NOI for that property.

Is that an annualized number or quarterly?

Yes, annualized, yes.

And then Yael, when you start looking at potential asset sales, I know you said earlier that you haven't started a process yet to sell properties. I mean, do you need to start thinking about pursuing something like that before the interest rate caps expire? Or are you willing to kind of continue to kick the can down the road, waiting for a better market before you even think about bringing properties to the market to sell?

Yes, we have no urgency. We feel that we have the cash reserves to buy the caps with what we have today, the cash on hand today. So, I think we'll be patient until we get a better sense that the capital sales market has really opened.

Yes. We want to make sure we actually de-lever, but with any transaction and as we sort of outlined in our prepared remarks, there are multiple considerations before we're willing to pursue a transaction and evaluation is everything.

And what do you have to see for you to be willing to bring assets to the market? I mean, do you need to see interest rates stabilize or do you need to see them actually start to tick lower from this point?

I think it's more just to understand what the market is. I think there's still price discovery. I know the Blackstone deal was a big one but it was also a one-off and so I think we're waiting to just get more data.

Okay. All right. Thank you.

Thank you.

Thank you all. This concludes our question-and-answer session. I would like to turn the conference back over to Yael Duffy for any closing remarks. Please go ahead.

Thank you for joining us on the call today and hope to speak with many of you soon.

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