Office Properties Income Trust Q1 2023 Earnings Call Transcript

Quartr
Provided by Quartr
April 27, 2023

There are 6 speakers on the call.

Operator

Good morning, and welcome to the Office Properties Income Trust First Quarter 2023 Earnings Conference Call. All participants are in a listen only mode. After today's presentation, there will be an opportunity to ask questions. I would now like to turn the call over to Kevin Barry, Director of Investor Relations. Please go ahead.

Speaker 1

Thank you, and good morning, everyone. Thanks for joining us today. With me on the call are OPI's President and Chief Operating Officer, Chris Bellotto and Chief Financial Officer and Treasurer, Matt Brown. Just a moment, they will provide details about our business and our performance for the Q1 of 2023, 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.

Speaker 1

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 OPI's beliefs and expectations as of today, Thursday, April 27, 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 The Securities and Exchange Commission or SEC, which can be accessed from our website, opireit.com or the SEC's website. Investors are cautioned not to place undue reliance upon any forward looking statements. On today's conference call, we will be discussing the planned merger with and therefore, we'll not be taking questions about the merger.

Speaker 1

In addition, we will be discussing non GAAP numbers during this call, including normalized funds from operations Our normalized FFO, cash available for distribution or CAD and cash basis net operating income or cash basis NOI. A reconciliation of these non GAAP figures to net income are available in our enhanced earnings release presentation that we issued last night, which can be found on our website. We believe this combined presentation of information will be helpful for analysts and investors to efficiently digest information about our company and our results. And finally, we will be providing guidance on this call, including normalized FFO and cash basis NOI. We are not providing reconciliation of these non GAAP measures as part of our guidance because certain information required for such reconciliation is not available without unreasonable efforts or at all, such as gains and losses or impairment charges related to the disposition of real estate.

Speaker 1

I will now turn the call over to Chris.

Speaker 2

Thank you, Kevin. Good morning, everyone, and thank you for joining the call today. Before I review OPI's performance for the Q1 of 2023, I want to start by briefly discussing current office fundamentals, Our decision to reduce our quarterly dividend and our recently announced merger with Diversified Healthcare Trust. OPI has demonstrated solid operating performance performance results through 2022 are attributed to several factors, including our diversified real estate holdings, Our geographical footprint with properties in many premier growing markets and reflective of our leasing performance, our strong tenant roster with investment grade Tenants representing 63% of our portfolio, continuation of our capital recycling initiatives and our strong balance sheet. As we stand here today, we are looking at post pandemic return to office trends, which continue at a gradual pace across Major U.

Speaker 2

S. Markets providing a bright spot for improving office fundamentals. However, headwinds in the office sector remain with added pressure as Results of corporate cost cutting, elevated sublease space, a challenging financing environment and continued macroeconomic uncertainty. National office leasing volume declined for the 3rd consecutive quarter through Q1 and much of the sector's occupancy gains achieved over the past several years has been given back through negative absorption. Financing continues to be an obstacle for the investment sales market Widening credit spreads are putting additional pressure on office valuations.

Speaker 2

These challenges will likely lead to declining cash flows and asset values, which may take years to stabilize. Recognizing these challenges, earlier this month, we announced a reduction in OPI's quarterly dividend. We recognized the value of the dividend to our investors The decision was not made lightly. It was the result of careful consideration on the part of the company and its Board of Trustees based on several factors, Including the challenging outlook confronting the office sector, tenant retention risk, a rising CAD payout ratio Approaching 100% and in excess of our target coverage ratio and our focus on capital preservation to support leasing activity and complete our 2 redevelopment projects. With these factors in mind, we made the decision to lower the dividend to a sustainable level of $1 per share annually.

Speaker 2

While this decision was communicated at the same time as the merger announcement, it was independent of our merger plans and reflective of our outlook for OPI on a standalone basis. It provides increased liquidity to navigate office headwinds and to fuel capital projects that we expect will OPI's competitive positioning as a path to increase returns in the future. Earlier this month, we also announced plans to merge with Diversified Healthcare Trust, providing us with a tremendous opportunity to create a larger, scalable and more diversified REIT. This transaction combines 2 institutional quality portfolios and better positions us to navigate office sector headwinds while providing embedded near and Addition of attractive MOB and Life Science properties as a complement to our established office portfolio, access to additional capital sources With a more favorable interest rate outlook, including low cost GSE and agency debt and access to an institutional quality portfolio of senior living communities benefiting from growth through favorable healthcare sector tailwinds and a turnaround strategy currently underway. As a result of this combination, We expect the transaction to be accretive to OPI's normalized FFO, CAD and leverage during the second half of twenty twenty four and ultimately maximizing long term value for our shareholders.

Speaker 2

Turning now to our Q1 leasing results. That new leasing activity will increase over the next several quarters as tenants reengage on their office plan needs along with 725,000 square feet of activity in advanced stages of negotiation. Portfolio occupancy increased 170 basis points year over year to 90.5 percent and we completed 203,000 square feet of leasing with a balanced mix of new and renewal leasing. This activity resulted in a weighted average lease term of 6.8 years and leasing concessions and capital commitments of $6.37 per square foot Several leases at our property in Greater Washington DC where we signed 2 strategic leases totaling 128,000 square feet, one with a key tenant downsizing and another to backfill the available space. We expect our leasing spreads will normalize as activity progresses throughout the year.

Speaker 2

Looking ahead to OPI's upcoming lease expirations, we continue to actively manage through proactive re leasing efforts to address elevated lease expirations during the second half of twenty twenty three and into 2024. In 2023, lease expirations represent approximately 10% of our annualized rental income, a decrease of 90 basis points compared to the end of 2022. Annualized revenue for 2023 expirations is comprised of the following. Net known vacates for the balance of the year are trending close to 6% of annualized rental income, approximately 80 basis points represents planned dispositions The balance of 3.5 percent is expected to renew. Our leasing pipeline includes approximately 2,700,000 square feet of potential leasing activity With more than 1,100,000 square feet attributable to new leasing and 782,000 square feet of potential absorption, the outlook for our projected includes a rent roll up of 6% to 8% and an average lease term of 8 to 10 years.

Speaker 2

Turning to our developments. Our mixed use redevelopment in 20 Mass Ave in Washington DC is scheduled to deliver in the coming months. With the project near completion, 4% pre leased to an anchor tenant, the Royal Sonesta Hotel, which intends to begin well-being guests to this flagship location this summer. Additionally, our life science redevelopment in Seattle remains on track to deliver later this year. In addition to the 84,000 square feet signed at this Property late last year, we will deliver 1 full lab building with move in ready spec suites, providing a needed outlet for small to medium companies with near term space needs And therefore reducing the timeline for lease up and acceleration of NOI performance.

Speaker 2

Across both projects, our development leasing pipeline includes more than 1,000 square feet of active proposals. Beginning as early as June 2023, we will see gradual NOI improvement related to both projects as tenants began to reimburse operating and tax expenses during their free rent periods.

Operator

Before I turn

Speaker 2

the call over to Matt, I want to acknowledge the recent publication of the RMR Group's annual sustainability report, which provides a comprehensive overview of our managers' commitment to long term ESG goals. We are deeply committed to enhancing OPI's corporate sustainability practices and continue to advance initiatives that will position the company to thrive over the long term. For example, we recently garnered recognition as an Energy Star Partner of the Year for the 6th consecutive year and a sustained excellence honoree for the 4th year in a row. This recognition underscores our dedication to operating properties that benefit our tenants and communities. You can find links to the report and a tear sheet specific to OPI's highlights on our website atopireit.com.

Speaker 2

I will now turn the call over to Matt to review our financial results. Thanks, Chris, and

Speaker 3

good morning, everyone. Normalized FFO for the Q1 was $52,700,000 or $1.09 per share, a penny below our guidance range. This compares to normalized FFO of $54,500,000 or $1.13 per share for the Q4 of 2022. The decrease on a sequential quarter basis was primarily driven by higher utility expenses and interest expense. G and A expense for the Q1 was $5,900,000 as compared to $5,800,000 in the previous quarter.

Speaker 3

Same property cash basis NOI decreased 4% compared to the Q1 of 2022 in line with the low end of our guidance range. The decrease was mainly driven by elevated free rent levels related to 2022 leasing activity and operating expense increases, Most notably utility costs due to inflationary pressures and expenses previously paid by tenants now being paid by OPI as a result of tenant downsizes. On a rolling 4 quarter basis, CAD decreased sequentially by approximately 16% to $2.21 per share, resulting in a payout ratio of 99.5%. While our historical payout ratio had been well covered since the beginning of 2019, We began seeing pressure in the Q4 of 2022 and with lower tenant retention levels in 2023, another year of elevated CapEx requirements In worsening office fundamentals, the dividend rate was becoming unsustainable. As a result, and as Chris previously discussed, earlier this month, we reduced our quarterly dividend Enhancing OPI's liquidity and financial flexibility.

Speaker 3

Turning to our outlook for normalized FFO and same property cash basis NOI Expectations in the Q2 of 2023. We expect normalized FFO to be between $1.07 $1.09 per share. This guidance includes a range of $6,100,000 to $6,200,000 of G and A expense, which includes expected annual trustee compensation. We expect same property cash basis NOI to be down 5% to 7% as compared to the Q2 of 2022, mainly driven by 2 full building vacates since the beginning of the prior year period and increased inflationary pressure on operating expenses. Turning to the balance sheet.

Speaker 3

At quarter end, our outstanding debt had a weighted average interest rate of 4% and a weighted average maturity of 4.7 years. Over 90% of our debt is fixed rate. We ended the quarter with $528,000,000 of total liquidity including $5,000,000 of availability under our credit facility. In connection with the proposed merger with DHC, we plan to recast our $750,000,000 revolving credit facility and have commenced initial discussions to move this process forward. We believe the improved scale and diversification of the combined Company will result in the successful recast of OPI's revolver.

Speaker 3

Turning to our investing activities. Since the beginning of the year, we sold 3 vacant properties containing 89,000 square feet for $5,400,000 and are currently under agreement To sell 1 vacant property containing 107,000 square feet for $4,900,000 Our capital recycling to date has been impacted by the current transaction environment and we expect our activity to be somewhat muted until market conditions improve. We spent $17,600,000 on recurring capital and $49,500,000 in redevelopment capital during the Q1. 2023 CapEx guidance is currently $100,000,000 to $110,000,000 of recurring capital and approximately $140,000,000 $150,000,000 of redevelopment capital. Before we turn the call over to Q and A, as a reminder, we will be taking questions related to OPI on a standalone basis.

Speaker 3

We have not yet filed a preliminary joint proxy and registration statement and therefore will not be taking questions about the merger. That concludes our prepared remarks. Operator, we are ready to open the call up for questions.

Operator

Thank you. We will now begin the question and answer session. Today's first question comes from Bryan Maher with B. Riley Securities. Please go ahead.

Speaker 4

Good morning, Chris and Matt. I guess I can throw out maybe half my questions I had, so I'll tighten it up. The can you walk us through slowly the occupancy outlook for this year? So We're starting off at 90.5 percent total occupancy, 93.5 percent same store. We have a series of known vacates that you discussed.

Speaker 4

Obviously, you'll try and backfill some of those with leasing activity. And then we also have 20 Mass Ave in Seattle coming online. How do you think that the year progresses from an occupancy standpoint?

Speaker 2

Thanks, Brian. I think historically we provided the range of 88% to 90%. And some of that is predicated on our ability to sell assets that we currently have in the market are those that we were projecting to bring to the market. And so I think as we sit here today, based on what we're seeing, we're looking at kind of the low end of that guidance being kind of the target today. What I'll add is that most of the expirations for 2023 where we Have known vacates are scheduled to occur in November or at year end.

Speaker 2

And so the impact On performance is heavily weighted towards the back half of the year with occupancy then following. So That's where we're at today. And I think again, an important piece of that is our ability to sell certain assets. The ones that we've talked about are mostly vacant and so that has a direct impact to occupancy.

Speaker 4

Okay. And then when we think about the credit facility, can you give us any update as to kind of the timing and what the Size might be of that new facility and is that needed to be completed before a potential merger?

Speaker 3

So Brian, it's a good question. Let me just first address the maturity of the revolver absent the merger. So Right now, the revolver matures at the end of July. However, we do have a 6 month extension option to push out that maturity to January of 'twenty four. A recast or amended revolver is a condition of closing the merger.

Speaker 3

So we have started our Discussions with Wells Fargo on that. They are preliminary. We are expecting a proposed term sheet from the bank group in the coming days. So it's in process. And I think as we progress into 2023, there'll be more to provide as it relates to the revolver.

Speaker 3

Okay.

Speaker 4

And kind of circling back to fundamentals, did I hear you correctly say that you expected 6% to 8% rent roll ups For this year 2023?

Speaker 2

The 6% to 8% roll ups is attributable to our leasing pipeline. And so I think historically for 2023, we've talked about 4% to 5% roll ups. And I think some of that I think we'll stick to that for now, but I think a lot is going to be predicated on how this pipeline matures. As we talked about with the Q1 results and the roll down, I mean, that was heavily concentrated for a couple of specific deals. And so We expect that will normalize and then we'll see improvement on overall rent spreads as we execute on some of this pipeline.

Speaker 2

But it's a lumpy process. So it's not exactly something quarter to quarter that we have definitive projections on Just given the timing it takes to negotiate some of these leases.

Speaker 4

Okay. And just on the periphery of the DAC transaction, I don't know if you can answer this or not, but We know Vanguard and BlackRock own an awful lot of shares of both DHC and OPI. Is it safe to expect that A, they'll be able to vote on the transaction and B, that they'd probably follow the guidance of ISS and Glass Lewis, etcetera?

Speaker 2

We're not going to speculate today. As we mentioned, we're in the process now of the filings of the S-four and the proxy. And I think as we get through that, there'll be more kind of color on kind of next and expectations.

Speaker 4

Okay. And just last for me on Seattle. I think you said something about having 1 lab building completed by over in 4Q For prospective tenants, is that above and beyond the leasing activity you've already communicated with Sonoma Biotherapeutics?

Speaker 2

That's correct. Yes, I mean Sonoma, that is expected A transact in the form of them finishing and moving in Q4 and then we're assuming some speculative leasing to occur With the spec suites that we're delivering. And so it's a lighter touch, and we think more of that will transact As we get into 2024.

Speaker 4

Okay. Thank you.

Operator

And our next question today comes from Ronald Candon with Morgan Stanley. Please go ahead.

Speaker 5

Hey, good morning guys. This is Tamim on for Ronald. Maybe just a question on development again. You talked about the Seattle development and expected move in The Q4 of this year, maybe just on 20 Mass Ave, an update on timing of when you expect the move ins actually occur. I understand that It's completed in the Q2, but just from a revenue recognition point of view, how should we think about that for the rest of the year?

Speaker 5

Thank you.

Speaker 2

Yes. No, it's a good question. So for 20 Mass Ave, we have the hotel representing 54% of the leasing. We expect to deliver at the end of Q2 and at which point the lease on that side would commence. So let's just call it early Q3.

Speaker 2

And with that, the tenant is going to have 18 months of free rent. And so The benefit to the property during that timeframe is the reimbursement of operating expense. So we'll start to see some of the recovery of The cost outlay that's occurring today. And then from a lease up perspective, what we've talked about is a trajectory of roughly 18 months For kind of lease up of the balance of the property. And so we're in advanced not advanced stages.

Speaker 2

We have several tours that have taken place Across the property and also have several proposals out to tenants. And so I think at this stage, we don't have anything definitive, But hopefully in the next few quarters, we'll have feedback on the status of those proposals.

Speaker 5

Great. And then just

Operator

on leasing, I think you

Speaker 5

guys mentioned in the In the prepared remarks, expectations for a sequential increase throughout the year. So is that based off of the current pipeline and Most of that's locked in or how much of that is just expectations for things to improve versus kind of what you guys already have locked in?

Speaker 2

Yeah, the number I provided on advanced stages, just north of 700,000 square feet, advanced stages for us Present signed LOI or those who are negotiating a lease document. And so look, there's risk, but I think we feel like the risk is somewhat mitigated at that stage. So I would imagine that we'd start to see a good portion of that mature for Q2.

Speaker 5

Great. Thank you, guys. Go ahead.

Operator

Thank you. And ladies and gentlemen, this concludes our question and answer session. Would like to turn the conference back over to Chris Bellotto for any closing remarks.

Speaker 2

Thank you for joining the call today. We look forward to seeing many of you at NAREIT and other industry conferences

Operator

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.

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