Earnings Call Transcript - ILPT Q2 2022

Operator, Moderator

Good morning, and welcome to the Industrial Logistics Properties Trust Second Quarter 2022 Earnings Conference Call. I would now like to turn the conference over to Kevin Barry, Director of Investor Relations. Please go ahead, sir.

Kevin Barry, Director of Investor Relations

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 second 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, July 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.

Yael Duffy, President and COO

Thank you, Kevin, and good morning. Before I review ILPT's performance for the second quarter of 2022, I would like to start by discussing the announcement earlier this month that we have temporarily reduced ILPT's quarterly cash dividend. We recognize the value of the dividend to our investors, and the decision was not made lightly. As you know, earlier this year, ILPT closed on the strategic acquisition of Monmouth Real Estate Investment Corporation with significantly enhanced ILPT scale, tenant base and geographic diversity. As we discussed on our call last quarter, our long-term financing plan predominantly included property sales and the sale of an additional equity interest in ILPT's consolidated joint venture. However, as interest rates have increased, debt rates have significantly higher than projected, leading to a meaningful deterioration in real estate market conditions, with buyers seeking steep discounts on marketed properties, or, in many cases, walking away from transactions. As we are not a distressed seller, we have decided to remove the 30 Monmouth properties totaling 4.9 million square feet from the market and plan to reengage in marketing efforts when debt and capital markets normalize. Additionally, we have paused discussions with potential partners for the Mountain Industrial joint venture. We continue to believe in the strength of these properties and the robust industry tailwinds underpinning demand for our real estate. Accordingly, we plan to remain disciplined when considering future sales of properties or equity interest to ensure that we maximize value. As it is taking us longer than we originally expected to complete our long-term financing plans, we felt it was prudent to temporarily reduce the dividend to provide us with short-term flexibility. The reduction of the dividend preserves approximately $20 million of cash flow per quarter, which will enhance the nearly $300 million of cash we had on hand at the end of June. Additionally, it provides us time to evaluate alternatives to repay our bridge facility. These alternatives may include enduring longer duration debt, exploring additional joint venture opportunities with properties where fixed rate debt is already in place, and asset sales. To be clear, ILPT continues to operate business as usual, and all leasing efforts and capital projects are progressing as scheduled. Now turning to portfolio fundamentals and operating results. As of June 30, 2022, ILPT's consolidated portfolio included 412 warehouse and distribution properties in 39 states, totaling approximately 60 million square feet with occupancy of nearly 99%. The total portfolio has a weighted average remaining lease term of approximately 9 years with 78% of our revenues coming from investment-grade tenants or subsidiaries or from our secure Hawaii land leases. During the second quarter, ILPT continued to benefit from favorable operating trends, which included record leasing activity of 3.9 million square feet at weighted average rental rates that were 61.3% higher than prior rental rates for the same space. Normalized FFO per share was $0.43 and same-store cash NOI grew 2.6% year-over-year. We executed 8 new leases for approximately 2.7 million square feet at an average roll-up in rents of 104.7% and 22 lease renewals for approximately 1 million square feet at an average roll-up in rents of 29.1%. In total, new and renewal leasing yielded a weighted average roll-up of 82.8%. New leasing activity was driven by 2 leases with Home Depot in Hawaii for approximately 2.5 million square feet at an average roll-up in rents of 110.3%. By way of background, last year, Home Depot submitted a request for proposal for an 84,000 square foot ground lease for its retail operations. As discussions progressed with the RMR Group's property and asset management teams, a strategic opportunity emerged with Home Depot committing to a larger retail footprint of nearly 300,000 square feet, as well as a 2.2 million square foot parcel, which will serve as a warehouse and distribution hub. We are thrilled to expand our relationship with Home Depot, an A-rated investment-grade tenant across 3 states and totaling 3.4 million square feet. Home Depot ranks as our third largest tenant, representing 5.7% of ILPT's lease square footage and 4.4% of annualized revenues. Renewal leasing activity included 5 lease extensions with FedEx for approximately 396,000 square feet at an average roll-up in rents of 17.2%. I highlight this as I believe there is a misconception in the market that all FedEx leases are above market, which we do not believe to be true. As we work through the portfolio and see firsthand the intense market demand and record low vacancy in the market where our properties are located, we continue to achieve roll-ups in rent as these leases expire. We spent $3 million on recurring capital expenditures, including $2.6 million, or just $0.07 per square foot per lease year, attributable to tenant improvements and leasing commissions. Additionally, we spent $7.1 million on development activity, predominantly related to multiple parking lot expansions for FedEx. As a reminder, by partnering with FedEx on these projects, there is an opportunity for ILPT to grow rents ahead of natural lease expirations while achieving a return on capital of 8% to 10%. Now turning to our leasing opportunities. Given all we have accomplished over the last year, with nearly 100 leases signed, totaling 7.1 million square feet, only 2.2% of total annualized revenue is set to expire during the second half of 2022. As such, our focus is on addressing lease expirations in the upcoming years where approximately 22% of ILPT's portfolio is scheduled to roll by the end of 2025. We believe there is ample opportunity to maximize mark-to-market rent growth and increase cash flows consistent with the 39% roll-up in rents we achieved over the past 12 months. Our leasing pipeline includes 33 deals for approximately 4 million square feet, and we anticipate a near-term conversion of approximately 25% of our pipeline, given that roughly 1 million square feet of current activity is in advanced stages of negotiation or lease documentation. Before turning the call over to Rick, I wanted to make you aware of the recent publication of the RMR Group's Annual Sustainability Report. The report highlights insights, accomplishments, and data regarding our managers' commitment to long-term ESG goals. Also, for the first time, there is a sustainability supplement focused specifically on ILPT. We are proud of the progress made to strengthen ILPT's sustainability practices and enhance our ESG transparency and disclosure. You can find links to the complete report as well as the ILPT sustainability supplement on our website at ilptreit.com. I'll now turn the call over to Rick to review our financial results.

Richard Siedel, Chief Financial Officer

Thanks, Yael, and good morning, everyone. During the second quarter, total portfolio same-property NOI grew 10.8% from the prior year. This reflects the favorable impact of approximately $3.4 million due to the noncash write-off of a below-market lease that we terminated in order to execute one of the new leases with Home Depot. On a cash basis, same-property NOI increased 2.6% year-over-year, driven by a 3% increase in Hawaii and a 2.1% increase on the Mainland. This growth was due to higher rental rates and contractual rent steps in our leases across the portfolio. Adjusted EBITDA increased nearly 100% year-over-year to $80.8 million, which reflects our same-property NOI growth and the Monmouth acquisition. Interest expense came in at $77.5 million during the second quarter. This includes approximately $34.4 million of amortization of financing fees, of which $30.3 million related to our bridge loan facility used to fund the acquisition. The balance of $43.1 million is related to cash interest expense. Second quarter normalized FFO was $28.3 million or $0.43 per share, which includes the favorable impact of approximately $0.05 per share related to the write-off of the below-market lease obligation I mentioned a moment ago. Net loss for the quarter was $151.3 million, which included a noncash impairment charge of $100.7 million. This charge was related to our decision not to sell in the current environment and subsequently reclassified 30 properties from held for sale to held for use due to the deterioration of the real estate transaction market caused by rising interest rates. While we have seen stable and strengthening operating trends throughout our portfolio, the accounting rules required that we adjust the properties to fair value upon reclassification. Our estimate of fair value was partially based on the offers we received, as well as trends we are seeing in the financing and transaction markets. We continue to believe in the long-term prospects of these properties and are not willing to transact in the current environment. Turning to our balance sheet and financing activities. At the end of the quarter, we had total consolidated debt of approximately $4.5 billion. It had a weighted average interest rate of 4.2% and a weighted average maturity of 4.1 years. The components of the debt included a $1.4 billion bridge loan facility at a floating interest rate of 4.2% that matures in February of 2023, $1.4 billion of JV CMBS loans at a floating interest rate of 4%, and approximately $1.7 billion of fixed rate loans with a blended interest rate of 4.2%. While interest rates have continued to increase since the end of the second quarter, it is important to note that we do have interest rate caps in place that begin to protect us against further increases in interest rates, if SOFR exceeds 2.7%. We ended the quarter with $292 million of cash on hand and debt to annualized adjusted EBITDA of 12.4x. As Yael mentioned, the implementation of our long-term plan to finance the Monmouth acquisition is taking longer than expected. Since we committed to the acquisition, the term SOFR forward curve for the end of 2022 has increased by approximately 300 basis points. To allow maximum short-term flexibility as we evaluate alternatives to repay our bridge facility, we reduced our quarterly dividend to $0.01 per share. This equates to more than $20 million of cash flow in each quarter and provides us with sufficient cash reserves to give us refinancing options and continue operating business as usual. That concludes our prepared remarks. Operator, please open up the line for questions.

Operator, Moderator

Our first question will come from Bryan Maher with B. Riley FBR.

Bryan Maher, Analyst

And maybe just sticking with the debt for a moment since you just addressed it. The cash on hand and the availability of the dividend for the next couple of few quarters, do you suspect that the combination of those two items when we get to February of next year, assuming you haven't layered on another JV partner and assuming you haven't sold any assets, would give you the capital available to get into some type of refinancing agreement with the banks to address the bridge loan?

Richard Siedel, Chief Financial Officer

Thank you for the question, Bryan. Yes, that's correct. We are very optimistic about our assets. We are currently working with the banks to update appraisals and complete the necessary steps to secure debt. It's encouraging that the CMBS market is open. While we do need to navigate some price discovery, it's a positive sign that the market is available. We are keeping a close watch on these developments. Additionally, we have other options to explore refinancing with our bank group and more. The extra liquidity from the dividend reduction provides us with added flexibility. We don't need to finance at the same loan to value ratio; we can lower it if that would help us secure a better refinancing price. We believe this was a wise decision. Ultimately, the key takeaway is that our assets are strong.

Bryan Maher, Analyst

And on the JV partner, I believe Yael, maybe you said that, that has paused. Is there just 1 JV partner in addition to the 1 already onboarded in the mix? Or is there more than 1 potential second JV partners you're speaking with?

Yael Duffy, President and COO

So we have been talking to multiple groups, and we were, I would say, further along with one additional partner. But as with the volatility in the interest rates and the JV does have floating rate debt in place, I think we just felt it was best to pause conversations until things stabilized.

Bryan Maher, Analyst

Okay. And maybe last for me. On this 30 MNR assets that you kind of withdrew from marketing, is it safe to say that at some point, you plan on remarketing those in the next couple of few quarters? Might you market some, but not all, and maybe just keep some for the long term? I mean, what are the thoughts there over the next maybe 6 to 12 months on those 30 properties?

Yael Duffy, President and COO

I believe we are adaptable. It really depends on the state of the markets. We consider these to be excellent assets that represent the broader Monmouth portfolio. The issue we faced was that we had proceeded to award 27 out of the 30 properties, and we arrived at a price reflecting the $100 million impairment mentioned. However, the buyers are now requesting further price reductions due to market volatility, which we feel is unjustified considering the quality of these assets. Additionally, there are no guarantees that they won't return with more requests for reductions. We remain very confident about these properties and are open to holding onto them if that is our decision.

Operator, Moderator

Our next question will come from Michael Carroll with RBC Capital Markets.

Michael Carroll, Analyst

Yael, in your prepared remarks, you mentioned that you might consider joint venturing other properties. Has that process begun? Have you identified any other properties for potential joint ventures?

Yael Duffy, President and COO

So we haven't identified anything yet, but we do have 203 properties, both on the Mainland and in Hawaii that have $1.7 billion of fixed-rate debt in place at an interest rate of approximately 4.2%. So I think that just presents us another opportunity, if our potential partners are easy with the floating rate debt.

Michael Carroll, Analyst

I guess when does that process start? Like if you started that now, I mean, how quickly could you execute a JV deal?

Yael Duffy, President and COO

So again, I think we haven't gone down the path yet. And I think for the same reasons why we took the other properties and halted discussions with potential partners for the Mountain Industrial, I think it really will be further down the line if we need to.

Michael Carroll, Analyst

Okay. And then can you talk a little bit about the interest in the Hawaiian portfolio? I'd imagine that there would be some interest within those assets. I mean, would you look harder to joint venture some of those properties to pay down the bridge loan?

Yael Duffy, President and COO

I don't believe we would take that approach to pay off the bridge loan. Our first step would likely be to secure longer-term debt to repay the bridge facility, as this gives us more flexibility. Additionally, the properties in Hawaii hold significant value. We've observed notable growth in rental income and enhanced our credit profile. Given the limited availability of industrial land in Hawaii, with a vacancy rate of around 1%, we wouldn't consider entering into any joint venture unless it was at premium pricing.

Michael Carroll, Analyst

Okay. And then can you talk about the refinancing options that you have for the bridge loan? It seems like that's your #1 goal. I mean, when could something be announced there?

Yael Duffy, President and COO

I think we'll definitely have something done before February '23.

Michael Carroll, Analyst

And what's the current rates that are being quoted on refinancing that?

Yael Duffy, President and COO

We don't have rates yet.

Richard Siedel, Chief Financial Officer

It's a little early to put a price on it at this point, Mike. We are watching the market pretty closely. Back in February, we were 276 or so basis points over SOFR. We saw a transaction in the market last week around 300. So it's possible that it's a little higher, but again, really great quality assets. We'll see where it lands, and we'll look to provide those updates as we can.

Michael Carroll, Analyst

Okay. And then, Rick, I know you mentioned that you could reduce the LTV to probably get a little bit of a better rate. I mean what's the LTV that the bridge loan is based off of right now? And how far would you have to reduce that to get a more attractive rate?

Richard Siedel, Chief Financial Officer

It's a good question. I guess, it will depend on where the market is. But I mean, the good news, again, Mike, is that the markets are open. And we do have cash on the balance sheet in order to bring down the LTV. So we've got some flexibility, and the dividend further adds to that. The bridge loan was probably in the mid- to high-70s loan-to-value. So we have the ability to bring it down to a more conservative number and to get the refinancing done, but we're going to evaluate all our options.

Michael Carroll, Analyst

Okay. And then, Rick, can you talk a little bit about the credit facility? How's the discussions of the reimplementing a credit facility for the company?

Richard Siedel, Chief Financial Officer

Yes. We have made significant progress on the credit facility and are nearly ready to move forward. However, the finalization depended on executing the sale of our joint venture interest in the 30 properties, which did not occur due to changes in interest rates and market conditions, although this was not due to any issues with our banking partners. Our lenders have been excellent throughout this process and many are still disappointed that the deal did not close. We will continue to assess our options and aim to maintain flexibility, positioning ourselves well for the future.

Michael Carroll, Analyst

Okay. Can you talk a little bit about the Home Depot lease, which seems to be the larger lease affecting your leasing statistics? When did that lease start? Have they begun paying cash yet? Is that why your straight-line rent increased significantly this quarter compared to the previous quarter?

Yael Duffy, President and COO

Yes. So for the larger of the 2 deals, there was 1 for 300,000 square feet and 1 for 2.2 million square feet. And so the larger of the leases actually doesn't commence until another tenant's lease expires in early 2024. So they did a proactive strategic lease to make sure that they got that property.

Michael Carroll, Analyst

Okay. So how much will earnings increase next quarter? It seems that most of the leasing activities are expected in 2024, so the near-term earnings won't be significantly affected.

Yael Duffy, President and COO

We have 3.5 million square feet coming up on the Mainland in '23, and another 4 million in '24. So we still have good opportunities to continue to drive rents in the coming years.

Richard Siedel, Chief Financial Officer

Mike, overall, from an earnings perspective going into next quarter, the results of the portfolio are continuing to be really strong, but the interest headwinds are real. So based on where interest rates are today, we expect to see further deterioration in FFO. But again, I mean, I think we're being pretty transparent about looking to move forward and refinance the floating rate debt that we have.

Operator, Moderator

Our next question will come from James Feldman with Bank of America.

Unidentified Analyst, Analyst

Could you discuss the changes you're observing regarding deal repricing and the trends in cap rates for the assets you had on the market before you stopped marketing?

Yael Duffy, President and COO

So I think we're seeing generally a 50 to 75 basis point swing in cap rates. And again, I think that's the initial in that range as the initial. And then I think buyers are being opportunistic and coming back and asking for additional discounts, just assuming that some sellers are desperate to sell, which we are not.

Unidentified Analyst, Analyst

Okay. Great. And then can you talk about what a 50 or 100 basis point increase in interest rates would mean for your interest expense or FFO per share?

Richard Siedel, Chief Financial Officer

Yes. We mentioned last quarter that every 50 basis points increase in SOFR results in about $0.04 of FFO per quarter. This will continue, although it's challenging for us to increase by 50 basis points from our current position. As of yesterday, SOFR was 2.32%, and our caps activate at 2.7%. Once we reach another 40 basis points or so, we will begin to benefit from the caps. The general rule is that every 50 basis points corresponds to approximately $0.04 of FFO.

Unidentified Analyst, Analyst

Okay. Great. And then are you seeing a pullback in leasing activity from any of your tenants? And specifically, what you're seeing from investment-grade tenants versus noninvestment-grade?

Yael Duffy, President and COO

No, I believe that our demand has remained strong throughout the pandemic, and despite the inflationary environment and rising interest rates, there seems to be a shortage of supply, and demand continues to persist.

Operator, Moderator

Our next question will come from Tom Catherwood with BTIG.

William Catherwood, Analyst

Just trying to triangulate a few things here. So you mentioned 27 of the 30 assets were in contract. So I get the buyers trying to retrade and then pulling them off the market. For that $100 million impairment, was that kind of representative on the pricing on the 27 assets? Or is that across the full 30 that you pulled from the market?

Yael Duffy, President and COO

We valued the full 30 assets at approximately $725 million when we acquired the Monmouth portfolio. However, after negotiations with buyers, we estimated their value at $625 million. Since we agreed to sell 27 of the 30 properties for that $625 million, and they were initially held for sale before being placed back into service, we needed to adjust for the difference in valuation.

William Catherwood, Analyst

Got you. So let me just clarify that. So the $625 million was for the 27 assets?

Yael Duffy, President and COO

It was for the whole 30.

William Catherwood, Analyst

I want to clarify the timing because something feels off. The Monmouth deal was announced on November 5, and it closed at the end of February, which is 3.5 months later. When did those packages for the 30 assets become available in the market?

Yael Duffy, President and COO

So we began marketing them almost simultaneously with when we closed and if you might recall, I think we talked about this at NAREIT. We had originally planned to sell either 1 large portfolio or 2 portfolios. And I think that's when the markets started to erode. And so our brokers suggested that we try to market them individually or in small clusters because they thought we'd be able to maximize value. So we had come to an agreement, as I mentioned, on 27 of the 30 properties, I would say, in late April and May. And the buyers kicked off diligence. We were working through legal docs. And as everybody was going through the process and working towards closing, these buyers, a lot of them, some withdrew altogether and others came back and asked for meaningful price adjustments, 10% or more. And really provided us with no assurances that they weren't going to come back to the table and ask for more of a price reduction as they completed their diligence as interest rates continued to rise. And it just was something we couldn't get behind because we really feel that these are really good assets and assets that ILPT would be happy to continue to own. So that was kind of the background of why we pulled them.

William Catherwood, Analyst

Got it. Understood. And then kind of final one for me. Yael, you mentioned in your prepared remarks, this market impression that the FedEx leases are above market, and that was not the case in the 2 that you addressed this quarter. In general, when you look at that portfolio now that it's under your umbrella, do you have a sense of where those assets overall, the FedEx ones are per market? And then kind of maybe more broadly, do you have a sense for your Mainland portfolio overall, what that looks like on a mark-to-market basis?

Yael Duffy, President and COO

Yes. We completed five lease renewals with FedEx this quarter. The impact varies by market and the rent that's expiring, as some rents include amortized tenant improvements. Generally, the markets with FedEx locations are seeing rent increases, and we continue to advocate for this. FedEx tends to be cautious about including annual increases in their lease agreements, but our team is actively working to secure those when possible. Additionally, concerning Monmouth, we have not faced many vacancies; we only had one empty building upon acquisition and a few more we expect to regain. Since Q2, we've executed one lease and have seen rental increases of 10% to 15%, with some cases reaching 20% in those Mainland properties.

William Catherwood, Analyst

Got it. And just on those amortized TIs, is that all of the FedEx leases? Is that half the FedEx leases?

Yael Duffy, President and COO

No, I think maybe 25% have it. However, as market rents have increased, we have been able to bridge the gap and recoup it during renewals. It might not be a 30% increase, but it is still a 5% increase.

Operator, Moderator

Our next question will come from Connor Siversky with Berenberg.

Connor Siversky, Analyst

I just wanted to touch again on the comments related to that 60 to 75 basis point increase in some of the cap rate estimates on those properties that were previously held for sale. Just considering that all of those lease terms, the durations, weren't the same for the Monmouth portfolio, was there any material difference in those assets with shorter durations versus those, let's say, the 15 or 30-year lease term? What I'm trying to get at here is to see if there was less of a movement in the shorter duration leases versus the longer ones.

Yael Duffy, President and COO

It's an interesting question because we often note that having long-term leases used to be advantageous, but now as market rents have been increasing, buyers and investors are more inclined towards shorter leases. It was a mixed situation; some buyers, particularly smaller local players, preferred long-term leases for steady cash flows. Overall, the increase was typically around 50 to 75 basis points across the board.

Operator, Moderator

Our next question will come from Mitch Germain with JMP.

Mitchell Germain, Analyst

I think you might have just answered it, Yael, but was there any sort of characteristics about the profile of the buyers you were talking to?

Yael Duffy, President and COO

We had 10 unique buyers, and I would estimate that at least 50% of them were institutional, along with some local players.

Mitchell Germain, Analyst

Last question for me. Given your commentary about additional JV, can we just interpret it that if it's not in a JV right now that the property could potentially be a candidate or a JV candidate, anything that's wholly owned? Is that the way that we should be thinking about this now?

Yael Duffy, President and COO

I think that's a fair way to look at it.

Operator, Moderator

This concludes our question-and-answer session. I would like to turn the conference back over to Yael Duffy, President and Chief Operating Officer, for any closing remarks.

Yael Duffy, President and COO

Thanks, everyone, for joining us on the call today. ILPT's operating performance remains solid, and we expect demand for our properties to persist as we execute on our financing plans. We look forward to providing you with updates on our progress and speaking with you soon. Thank you.

Operator, Moderator

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