Rmr Group Inc. Q3 FY2022 Earnings Call

Good day, and welcome to the RMR Fiscal Third Quarter 2022 Earnings Conference Call. Please note, today's event is being recorded. I would now like to turn the conference over to Michael Kodesch, Director of Investor Relations. Please go ahead, sir.

Good afternoon, and thank you for joining RMR's Third Quarter of Fiscal 2022 Conference Call. With me on today's call are President and CEO, Adam Portnoy; and Chief Financial Officer, Matt Jordan. In just a moment, they will provide details about our business and quarterly results followed by a question-and-answer session. 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. 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 RMR's beliefs and expectations as of today, August 5, 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, which can be found on our website at www.rmrgroup.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we may discuss non-GAAP numbers during this call, including adjusted net income, adjusted earnings per share, adjusted EBITDA and adjusted EBITDA margin. A reconciliation of net income determined in accordance with U.S. generally accepted accounting principles to adjusted net income, adjusted earnings per share, adjusted EBITDA and the calculation of adjusted EBITDA margin can be found in our earnings release. And now I would like to turn the call over to Adam.

Thanks, Michael, and thank you for joining us this afternoon. We are pleased to report another strong quarter of financial results with adjusted net income of $0.59 per share and adjusted EBITDA of $29.4 million, representing sequential quarter increases of 18% and 14%, respectively. As an alternative asset manager focused primarily on core commercial real estate, RMR's unique structure remains highly attractive in today's operating environment. Our competitive advantage is rooted in over 35 years of experience in managing commercial real estate as well as our large size and scale, which includes over 2,100 properties located throughout North America. This expertise is especially important today as we navigate the ongoing macroeconomic challenges related to rising inflation, increasing interest rates, and slowing economic activity. These trends have resulted in significant reductions in commercial real estate transaction activity as buyers and sellers adjust to this new environment. While we have historically seen increases in AUM from growth in our existing publicly traded equity REITs, the last 2 years have demonstrated our success in raising private capital to grow our AUM away from these equity REITs. From almost $0 of private capital under management just 2 years ago, we have built a platform that currently has almost $4 billion of private capital assets under management. Access to private capital markets gives RMR an additional path for continued growth, especially during times like these with pronounced market volatility. With that said, there remains significant revenue opportunity within our publicly traded equity REITs. For the third fiscal quarter, almost 75% of our revenues came from our managed public real estate capital clients, with our publicly traded equity REITs representing the vast majority of these revenues. Based on the capital structures of these equity REITs today, there is significant durability and limited downside to the revenues we generate from this AUM. Moreover, there is significant fee revenue upside without the need to grow AUM at these equity REITs, as we are highly incentivized to increase their respective share prices. To put this in perspective, if we close the gap between enterprise value and the historical costs of the underlying assets, we could generate approximately $53 million of incremental revenues annually with close to 100% flow-through to EBITDA. Ultimately, this two-pronged approach—growing internally and externally through both public and private capital markets—enhances RMR's ability to thrive within almost any economic environment. Furthermore, our operating results this quarter highlight the benefits of this approach. RMR arranged almost 5 million square feet of leases on behalf of our clients this quarter, more than doubling the previous quarter's activity with a weighted average lease term of approximately 19 years and an average roll-up in rent of almost 26%. Almost 80% of this quarter's leasing activity was executed at ILPT-owned assets, highlighting the continued robust demand for industrial and logistics properties and supporting our recent focus on acquiring well-leased and attractive industrial assets. Earlier this year, ILPT closed a strategic acquisition of Monmouth Real Estate Investment Corporation, which includes approximately 26 million square feet of high-quality, e-commerce-focused industrial assets. ILPT's consolidated portfolio of well-located assets is currently 99% leased by strong credit quality tenants with a 9.2 years weighted average lease term. On prior calls, we discussed ILPT's long-term financing plans for the Monmouth acquisition. We alluded to the sale of additional equity interests in an industrial joint venture that includes Monmouth assets and property sales. However, given the current interest rate environment, which has led to a meaningful deterioration in real estate market conditions, ILPT made the decision to pause any discussions with potential joint venture partners and buyers of assets. In conjunction with these decisions, ILPT reduced its quarterly dividend to preserve liquidity in the short term. We are confident that ILPT will weather these short-term challenges as the core operating fundamentals remain robust and represent strong tailwinds until permanent financing solutions are put in place. OPI recently reported strong results this quarter that included growth in both same-property cash NOI and normalized FFO. Despite this quarter's strength, office fundamentals remain in a period of transition as tenants continue to assess their longer-term space needs and possible hybrid work environments. Over the last 3 years, OPI has carefully curated its portfolio, recycling capital into stronger, well-leased core assets while continuing to have the security of the U.S. government as one of its largest tenants. Despite headwinds in the office space sector, we remain encouraged by OPI's leasing trends, and our internal tenant activity metrics suggest OPI is experiencing tenant engagement across its portfolio that exceeds national office sector averages. Turning to our hotel and service retail businesses. At TravelCenters of America, the business was remarkably strong with adjusted EBITDA of almost $123 million this quarter, representing a 67% year-over-year improvement. While inflation and a possible recession represent potential headwinds, TA has established a resilient business model that should withstand possible pressures on operating margins in the future. At SVC, growth in normalized FFO and adjusted EBITDA reflects the continued benefits of SVC's portfolio diversity, a distinguishing factor when compared to other hotel-focused REITs. Just under half of SVC's assets are in the service retail sector led by TA. As I previously highlighted, TA's results continue to reinforce the strength of SVC's service retail portfolio, with aggregate coverage of its net lease portfolio's minimum rents being a very robust 2.8 times as of June 30. Regarding SVC's owned hotels, the portfolio has benefited from ongoing improvements to lodging industry fundamentals. Specific to SVC, hotel average daily rates this quarter were at historical peak levels, and RevPAR growth exceeded the broader hotel industry average by over 18%. Since the beginning of the year, SVC has sold 59 hotels for almost $510 million and repaid $500 million of senior notes. The strength of SVC's results has led to it now being in compliance with all debt covenants, well ahead of prior expectations. DHC reported yet another sequential quarter of NOI growth in its same-property shop segment due primarily to rate increases and occupancy stabilization. A year ago, DHC began the process of transitioning management of 107 communities to new third-party regional operators, which was completed late last year. This quarter, occupancy in the transition communities increased 210 basis points, and NOI continues to improve, both positive signs that these regionally focused operators are driving improved operating results. During the quarter, DHC repaid $500 million of 9.75% debt, sold an additional 10% equity interest in its existing Boston life science property joint venture, and is making progress towards regaining compliance with its debt covenants. We are encouraged by recent trends at DHC, and with continued capital investments in DHC's senior living assets and the recently announced restructuring plan at AlerisLife, we are hopeful that DHC's operating results will continue to improve in the coming quarters. Finally, at our commercial mortgage REIT, Seven Hills Realty Trust, we continue to believe that the business has attractive long-term growth prospects. During the quarter, Seven Hills' portfolio remained default-free, and with new originations, its aggregate committed capital was $735 million at quarter end. We expect that Seven Hills will benefit from the current rising interest rate environment because its portfolio consists of 100% floating rate loan investments, which leaves it well-positioned for continued earnings growth. In closing, our public and private managed vehicles collectively have over $37 billion in assets under management today, which represents over $1.3 billion of growth per year on average since going public 7 years ago. As I highlighted earlier, there also remain significant opportunities for revenue growth without any AUM growth through share price improvements at our existing publicly traded equity REITs. Additionally, we remain optimistic that there are ample opportunities to grow private capital AUM either organically or through possible M&A activity in the years to come.

Thanks, Adam, and good afternoon, everyone. In the third fiscal quarter, we reported adjusted net income of $9.8 million or $0.59 per share and adjusted EBITDA of $29.4 million, both representing significant sequential quarter increases in each metric finishing above the midpoint of our guidance. Total revenues were $53 million this quarter, which was over $7 million higher on a year-over-year basis and almost $4 million higher on a sequential quarter basis. The sequential quarter increase in revenues was primarily attributable to the full quarter impact of ILPT's Monmouth acquisition, increases in construction management fees, and fee growth tied to the continued strong operating performance of Sonesta and TA. Looking ahead to the fourth quarter, we expect to generate between $50 million and $52 million of revenues based on the current enterprise values of our managed equity REITs as well as our expectations of continued increases in construction management fees. Turning to expenses for the quarter. Cash compensation this quarter was $32.2 million, which was an increase of $500,000 sequentially, and our corresponding cash reimbursement rate improved slightly this quarter to approximately 44%. While wage inflation and labor scarcity both remain a headwind, especially in Greater Boston, our employee retention rates have remained ahead of industry benchmarks, and we continue to leverage technology, secondary hiring locations, and select outsourcing solutions to mitigate these headwinds. Looking ahead, we expect cash compensation to remain at approximately $32 million for the fourth quarter, and our reimbursement rate to remain at 44%. As a result of these collective expectations, guidance for the fourth quarter remains unchanged, with adjusted earnings per share forecasted to range from $0.57 to $0.60 per share, and adjusted EBITDA should range from $28 million to $30 million. RMR's quarterly dividend of $0.40 per share remains well-covered at a current payout ratio of approximately 55%. We closed the quarter with almost $200 million in cash and continue to have no debt. We believe our balance sheet leaves us positioned to pursue a variety of strategies to expand our platform. Before we begin the question-and-answer portion of the call, I would like to first acknowledge RMR's recently published sustainability report. Our sustainability report provides a comprehensive overview of our long-term ESG goals, including RMR's zero emission promise, whereby we have pledged to reach net zero greenhouse gas emissions across the properties we directly managed by 2050, with a target of reaching a 50% reduction by 2030. We would encourage those listening to go to RMR's sustainability website where readers can see a collective overview of the successes we've had thus far in driving energy, emissions, water, and waste reductions, as well as our contributions to the communities we operate in and the investments we are making in our people. That concludes our formal remarks.

Today's first question comes from Bryan Maher with B. Riley FBR.

A couple of questions for me. On the Sonesta front, we know that you bought, well, Sonesta bought four properties in Manhattan earlier this year in conjunction with SVC's contribution. Do you have any thoughts on Sonesta's growth trajectory kind of going forward over the next year or 2 as it relates to buying more hotels in gateway markets?

Sure. Bryan, thanks for that question about Sonesta. Yes. Sonesta, you're right to focus on Sonesta; it really has had a great quarter and is really showcasing the improvements they're having in the operations, especially over the last quarter into the summer. Regarding specifically to your question about how it's planning to grow, I would say the real focus at Sonesta is on growing its franchising business. We're not ruling out that it could also make outright acquisitions of hotels, but I would say the focus is really on growing its franchise, specifically the number of hotels that franchise. It has a solid base of about 1,200 hotels, roughly 300 that it manages itself and around 900 that are franchises. Its franchising business is really starting to pick up pace, and I expect that's going to be the majority of where you'll see unit growth coming. And again, just to tie it all back together, that's, of course, as we grow revenues at Sonesta that benefits RMR. And as we grow cash flow at Sonesta, that indirectly helps SVC through its 34% ownership in Sonesta. So that's principally how we're thinking about growing at Sonesta, and we feel pretty good about it.

Okay. And then over the years, you've talked a lot about acquisition opportunities. You have a lot of cash on the balance sheet. I think if memory serves me that might have slowed down a little bit, but you were getting inbound inquiries that you were looking at. Is there anything going on there given the capital markets dislocation of the past couple of months and talk on Wall Street of weakness because there's no deal activities? Is that ramping up at all with people approaching you to revisit some of that?

I'm not sure ramping up is the right word, but we are in discussions or have had discussions with groups. Just to recap for you, maybe less so, but for others, Bryan. In 2020 and 2021, we had a very concerted outgoing engagement where we were actively calling our partners. We were reaching out, asking for meetings. Really beginning in the last 6 months or so, we've been stepping back, not so much making outbound calls, but rather sitting back and waiting for inbound calls. And they have been occurring. I would say every quarter, we receive one, two, or three inquiries either from groups we’ve talked with in the past that circle back to want to check-in or discuss at a high level about something, and/or there’s something going on where a potential acquisition has actually retained an adviser and is engaged in a process. Of course, we're on the short list of folks that they would contact. So there's nothing imminent to speak of in terms of we are not in the process of negotiating a purchase and sale agreement or anything like that. But we have regular dialogue; it comes and goes. But I'd say, on average, every quarter, there are at least a couple of conversations that occur.

Yes. Just two more for me. On the JV front, which you referenced in your prepared comments, which has really grown quite a bit over the past couple of years. Can you talk a little bit more about the JV partners or potential partners? Has that broadened out over the past year or two as whatever sovereign wealth funds or other large private capital sources have seen what you've done and want to participate in that? Can you give us some more color on that?

Well, there's nothing to point to specifically in terms of we're suddenly taking on a mandate with a new partner. But I can tell you that, yes, very much so, we have had increasing dialogue over time with groups. I would say the groups that we are focused on talking to, with whom we've had the most conversations, tend to be other sovereign wealth funds, and that’s because—and I think this is a positive development—the sovereign wealth funds we are doing business with have referred us to other sovereign wealth funds, sometimes without our prompting. There’s no greater compliment than that; they express enjoyment in the relationship and suggest us to others. So we immediately gain a solid audience through that, and that has happened on several occasions already. We have also mentioned a couple of quarters ago that we have had a more direct and focused effort in engaging family offices and high net worth individuals. There have definitely been several conversations with that sort of constituency of potential partners that have occurred as well. So I’d say the dialogue is progressing well. That’s why you’ve heard us tactfully mention a couple of quarters ago that we’re focused on growing it internally or organically rather than relying on jump-starting it through M&A. It doesn’t mean we won’t engage in M&A; it just means that we are increasingly gaining confidence that we can continue to grow the business or grow that AUM through that channel, simply by doing it ourselves.

Okay. And just last for me. You're sitting on almost $200 million in cash. Thinking about a year ago, you did that big $7 per share special dividend. Clearly, you don't have the nearly $400 million you had a year ago. But is there any thought as we look out over the next quarter or two of a potential special dividend or otherwise returning capital?

Yes. It's probably a little early for us to have any serious dialogue around that at the Board. I think what we've been considering is using that capital sort of similarly to the prior question about private capital sourcing. As we think about growing private capital AUM and additional separate managed accounts, joint ventures, possibly engaging in fundraising around a specific fund of some sort, we think that some of that capital could be used for co-investment. If you're going to put a vehicle together, in the simplest example, you typically put a couple of hundred million dollars of equity together as a sponsor, which usually looks for some sort of investment. As you start off in that business, your co-investment will probably be a little larger than it might be when you're more established. That’s why we keep that money in reserve; it helps us consider these types of strategies as opportunities present themselves. As I said, we’re open to opportunities and while the M&A is opportunistic, we do receive inbound calls. Some of them lead to interesting conversations. We prefer to maintain that liquidity if any of those conversations actually come to fruition.

And ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Adam Portnoy for any closing remarks.

Thank you for joining us today. Operator, that concludes our call.

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.