Office Properties Income Trust Q2 2024 Earnings Call Transcript

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Provided by Quartr
August 1, 2024

There are 6 speakers on the call.

Operator

Good morning, and welcome to the Office Properties Income Trust Second Quarter 2024 Earnings Conference Call. All participants will be in listen only mode. Please note, this event is being recorded. I would now like to turn the conference over to Kevin Barry, Senior 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, Yael Duffy and Chief Financial Officer and Treasurer, Brian Donnelly. In just a moment, they will provide details about our business and our performance for the Q2 of 2024, followed by a question and answer session with sell side analysts. 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 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, August 1, 2024, 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, opireit.com or the SEC's website. Investors are cautioned not to place undue reliance upon any forward looking statements.

Speaker 1

In addition, we will be discussing non GAAP numbers during this call, including normalized funds from operations or normalized FFO and cash basis net operating income or cash basis NOI. A reconciliation of these non GAAP figures to net income are available in OPI's earnings release presentation that we issued last night, which can be found on our website. And finally, we will be providing guidance on this call, including normalized FFO and cash basis NOI. We are not providing a 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. I will now turn the call over to Eil.

Speaker 2

Thank you, Kevin, and good morning. I will start with an overview of our portfolio, review 2nd quarter leasing results and upcoming lease expirations before providing an update on our property dispositions. Before I begin, I would like to highlight that in the first half of the year, OPI completed $1,300,000,000 in secured financing. Most recently in June, we finalized a private debt exchange that reduced OPI's total debt by nearly $300,000,000 while reducing our upcoming 2025 debt maturities from $650,000,000 to $499,000,000 which Brian will discuss later on this call. Now turning to the quarter.

Speaker 2

OPI's portfolio consists of 151 properties totaling 20,000,000 square feet with a weighted average remaining lease term of over 6.5 years. Our portfolio generates $483,000,000 of annualized revenue and is diversified by industry and geography with over 60% of our revenues coming from investment grade tenants or subsidiaries. We ended the quarter with same property occupancy of 89.9%. Through our secured financing initiatives, 62 properties totaling 10,000,000 square feet within our portfolio are encumbered under our debt agreements. On a consolidated basis, encumbered assets account for $286,000,000 of annualized revenue, are 94% leased and have a remaining weighted average lease term of nearly 8 years.

Speaker 2

Our unencumbered assets portfolio consists of 89 properties totaling 10,000,000 square feet, provides annualized revenue of approximately $197,000,000 are 73% leased and have a weighted average lease term of 4.6 years. As we have shared previously, our known vacates in 2024 2025 are heavily concentrated within this portfolio of assets and will negatively impact our results in the coming quarters. In the second quarter, we executed 208 1,000 square feet of new and renewal leasing, which resulted in a weighted average lease term of 4 years. Renewals drove almost 90% of our leasing activity, including a short term extension with an insurance provider in Washington, D. C.

Speaker 2

For 60 2,000 square feet at a 3% roll up in rent and a 5 year renewal with the GSA in Phoenix, Arizona for 32,000 square feet and a 6% roll up in rent. Subsequent to quarter close, we renewed a 554,000 square foot lease with an investment grade single tenant user within our encumbered portfolio that was scheduled to expire in 2026. While we had previously forecasted that this renewal would happen, we are pleased that it has been finalized and the property will be long term leased into 2,037. Looking ahead to OPI's upcoming lease expirations. The office sector continues to face headwinds associated with the impacts of work from home as well as macroeconomic and political uncertainty.

Speaker 2

Throughout the country, we face pressure in our releasing efforts with minimal tenants in the market to absorb large blocks of vacant space. Most markets are experiencing negative net absorption, declines in asking rents and heightened competition. Washington DC, where OPI has its largest concentration, has a market vacancy rate of over 22%. The upcoming election creates additional volatility as government tenants are hesitant to engage in long term space planning discussions given the uncertainty surrounding return to work mandates. Our 20 Mass Ave development, which sits in the Capital Health submarket, has not been immune to these challenges.

Speaker 2

The office question has seen limited leasing interest, especially in recent months, and we are evaluating next steps required to maximize value. However, despite an investment to date of nearly $300,000,000 we believe based on broker opinions of value that the property would trade for under $100,000,000 if we are to pursue a sale. In the second half of twenty twenty four, 1,800,000 square feet is scheduled to expire with an additional 2,000,000 square feet expiring in 2025, comprised predominantly of properties leased to single tenants. As we have long telegraphed, 1,700,000 of the 1,800,000 square feet expiring in 2024 will not renew and we currently expect an additional 1,300,000 square feet will also vacate in 2025. In total, known vacates over the next 18 months account for $70,000,000 of annualized revenue or 14.5 percent of OPI's total annualized revenue.

Speaker 2

The U. S. Government represents the highest percentage of these known vacates, accounting for 32% of annualized rental income, followed by the financial sector at 26% and the technology sector at 20%. Within the government sector, none of the properties being vacated are specialized building facilities or serve mission critical needs for government agencies. Over time, we expect the non specialized portion of our government revenues will continue to decline as the GSA seeks to consolidate office space into government owned buildings, while reducing its reliance on leased properties.

Speaker 2

Our current leasing pipeline totaled 2,200,000 square feet, of which approximately 26% could result in positive net absorption. We've been planning to mitigate the impact to occupancy and associated carry costs through property disposition. While many of our single tenant properties that have become vacant could be converted to multi tenant, the cost and downtime would be significant, which would put further burden on OPI's liquidity. Office dispositions are challenging in this economic environment, where the property valuations have been negatively impacted since the pandemic and financing is not readily available to buyers. At OPI, we face additional obstacles given the properties we are marketing for sale are vacant or soon to be vacant, which further reduces the pool of potential buyers.

Speaker 2

Additionally, as we evaluate any sales, we must consider the impact the potential disposition will have on our operating metrics and debt covenants. Given these hurdles, we are pleased to report that we currently have 12 unencumbered properties totaling 1,400,000 square feet under agreement to sell for an aggregate sales price of $93,500,000 This group of disposition assets has a total occupancy of 54 percent with the remaining lease term less than 3 years. We hope to close on these transactions by year end. While we have identified additional properties for disposition, our projection for disposition proceeds in 2024 remains at the $100,000,000 we referenced last quarter due to the challenges in the market I have described. As we look ahead, we remain focused on tenant retention, attracting new tenants to our properties, executing on our property dispositions and continuing to evaluate strategies to navigate OPI's upcoming debt maturities.

Speaker 2

With that, I will now hand the call over to Brian to review our financial results.

Speaker 3

Thank you, Yael, and good morning, everyone. Starting with our financial results for the Q2, we reported normalized FFO $33,200,000 or $0.68 per share for the quarter, which exceeded the high end of our guidance range by $0.04 per share, largely due to lower than expected operating and general administrative expenses. This compares to normalized FFO of $38,300,000 or $0.79 per share for the Q1 of 2024. The decrease on a sequential quarter basis was driven by higher interest expense and lower NOI. Same property cash basis NOI decreased 7.7% compared to the Q2 of 2023, which also came in better than our guidance range of a decline of 15% to 17% due to lower than expected operating costs and certain properties being classified as held for sale as of June 30.

Speaker 3

The year over year decrease was mainly driven by tenant vacancies. Turning to our outlook for normalized FFO and same property cash basis NOI expectations for the Q3 of 2024. We expect normalized FFO to be between $0.45 $0.47 per share. The decrease sequentially from Q2 was primarily driven by lower rental income, higher seasonal operating expenses and increased interest expense related to our debt exchange transaction. Our current estimated quarterly interest expense run rate is approximately $43,000,000 consisting of $41,000,000 of cash interest expense and $2,000,000 of non cash amortization of financing costs.

Speaker 3

We expect same property cash basis NOI to be down 5% to 7% as compared to the Q3 of 2023, driven by tenant vacancies, elevated free rent, specifically related to the lease renewal we executed in July that Yael referenced and increased operating expenses. This NOI guidance does not include any potential changes to our same store portfolio. Turning to our investing activities, we spent $30,100,000 on recurring capital and $3,900,000 on redevelopment capital during the Q2. Our 2024 full year CapEx guidance remains unchanged with total capital spend expected to be approximately $100,000,000 comprised of $22,000,000 of building capital and $78,000,000 of leasing capital. We currently have 15 properties with a carrying value of $109,000,000 classified as held for sale at quarter end.

Speaker 3

We took a $132,000,000 impairment charge during the quarter to write down the carrying value of 13 of these 15 properties to their estimated fair value. 12 of these properties are under agreement for sale for $93,500,000 that we expect to transact by year end. We are continuously evaluating the portfolio for disposition opportunities that may improve our liquidity and financial metrics and we are in various stages of the process to bring additional properties to market. Turning to the balance sheet. As of June 30, we had $160,000,000 of total liquidity, including $147,000,000 of availability under our credit facility, which we expect to use to fund our operations and future leasing activity.

Speaker 3

We currently have $117,000,000 of committed leasing related obligations. In mid June, we completed a private debt exchange and eliminated almost $300,000,000 of debt principal by exchanging $865,000,000 of outstanding senior unsecured notes for $567,000,000 of new 9% senior secured notes due 2029,501,500,000 common shares. Our new 9% senior notes are secured by 19 properties with a gross book value of $716,000,000 as well as second liens on the 19 properties that secure our credit agreement. We ended the quarter with $2,300,000,000 of outstanding debt with a weighted average interest rate of 7.1% and a weighted average maturity of 5.2 years. Our next maturity consists of $499,000,000 of senior unsecured notes due in February 2025.

Speaker 3

We are focused on evaluating all potential strategies to address this maturity and continue to work with our 3rd party advisor, Moelis and Company, on evaluating the different options available to us as well as the impact each option would have on OPI's leverage, debt covenants and liquidity. We look forward to providing you with further updates on our as our plans progress. That concludes our prepared remarks. Operator, we're ready to open up the call for questions.

Operator

We will now begin the question and answer Our first question is from Bryan Maher with B. Riley FBR. Please go ahead.

Speaker 4

Thank you and good morning. A few for me today. As you move through the second half of twenty twenty four and close on these dispositions and receive those proceeds, is there anything that precludes you from taking those proceeds and immediately starting to buy back 2025 notes at the meaningful discount that they currently trade at?

Speaker 3

Brian, good morning and thanks for the question. That's something we're evaluating here now. We're looking at all different options to be able to pull in those notes, whether it be via cash or exchanges or other options as we talk with our advisor, as I mentioned in the remarks. So that's our immediate focus. It's a large amount coming due in February and we're going to do everything we can to sort of get this in short order.

Speaker 4

And then as we think about the debt exchange that you just completed, I think that there's like $46,000,000 I might be off a little bit balance that's still available for more exchanges. Are you seeing any traction from owners of your 2025 paper to possibly take you up on that sometime in the next couple of few months?

Speaker 3

Yes, that too is something we're looking at very closely and we're having discussions with various groups, but that is something that is definitely on the table as we try to utilize the maximum amount of notes that we had offered the 610, which I think is around $43,000,000 left of capacity. Yes, we are looking to use those.

Speaker 4

Okay. And then as it relates to your comments on 20 Mass Ave, I guess I'm a little perplexed there, the commentary that you would only get $100,000,000 I mean, when we look at the recent transaction of Apple Hospitality buying the ACDC Hotel just a few blocks away a couple of months ago, I believe they paid like $500,000 per key. I think it was 2 18 keys there. And I've toured 20 Mass Avenue. It's a great hotel, large rooms, new fresh, can't believe for a second you probably couldn't get 600 a key for that.

Speaker 4

If you sold it just as a hotel, forget the office space that's empty, which would get you like $165,000,000 just for the hotel component. So where are the brokers coming up with this $100,000,000 It's just when you've just spent $300,000,000 on it, it's pretty hard to get my head around that.

Speaker 2

Thanks, Brian. Trust me, if we could sell the property today for the valuations that you believe we would be thrilled, I think there's a couple factors that the brokers are taking into account. First, the hotel has been open less than a year, so it's still in its ramp up period. Additionally, the office component, that provides 45% vacancy on the whole site. And I think there is I think it's impairing the value of the property in whole, because I think any potential buyer has a hard time underwriting what it would take to re lease that property or to lease that property as office given the challenges in D.

Speaker 2

C. For the office market. The specific market has vacancy of over 26%. So I think it's a long ramp up to lease the office component. And then if a potential buyer was to convert the whole property into more hotel rooms, there's significant cost associated with that.

Speaker 2

So I think the property you're referencing was a stabilized asset and this isn't today.

Speaker 4

I understand that. But I mean, is that one of the options that you are considering? You made a comment about considering options for that space. Are you considering maybe converting those 3 floors to hotel given that there clearly is a market for hotel, forget for a second that it's only been open for 9 or 10 months. Is that something that you're thinking about doing to maximizing the value of that property?

Speaker 2

We're trying to understand what the cost would be. I don't know that OPI would do that on itself right now given where we are, but it is something that we're evaluating to see what the cost would be and then also both the ramp up would be if we were to hold it as office and try to lease it.

Speaker 4

And can you share with us who the tenant was who renewed the 554,000 square feet?

Speaker 2

Yes. It was actually Bank America. They're one of our top five tenants.

Speaker 4

Okay. And maybe one last for me and I'll jump back in the queue. We get leasing activity reports and news from the Greater D. C. Area.

Speaker 4

It seems like a big law firm Brown and Redneck just signed a new lease in DuPont Circle, just came across my desk this morning. Are you seeing any early shoots of improvement in demand in that market? And I think that when we look at the election, forget who you're backing, I mean, do you I mean, do you see any movement whatsoever that the federal employees will get back to that market sometime in the next year or 2?

Speaker 2

Based on what we're seeing at our own properties, that are especially the non specialized portion, where it's mostly office, we are not seeing employees back at work even 50% capacity today.

Speaker 4

Okay. Thanks. I'll hop back in

Operator

The next question is from Ronald Kamdem with Morgan Stanley. Please go ahead.

Speaker 5

Hey, good morning, guys. This is Tameen for Ron. Just a question on the operating metrics by collateral pool page that you guys have in the supplemental, I found it really helpful. If I add the remaining unsecured properties, there's about 10,000,000 square feet and it looks like the occupancy for those assets blends to about 7,000,000 square feet. And if I just take your disclosure about 2,000,000 square feet expected to vacate, that brings you to about 50% occupancy on those buildings.

Speaker 5

Can you guys maybe just talk about where you expect NOI to trend on an annualized basis for that pool of assets assuming the 2,000,000 square feet that you guys are that you guys referenced on that page actually vacates?

Speaker 3

Yes, it's a great question. Thank you. The properties that are held for sale, the 15, with about 2,000,000 square feet, they were 53% occupied as of quarter end. They generated about $20,000,000 of annualized NOI for the trailing 4 quarters, only $4,000,000 in Q2 and that's continuing to decline as some of these tenants have such a short waltz, but the NOI is going to be burning off. We're only projecting $2,000,000 of revenue for Q3 and those properties will start generating losses, which is part of why we're disposing of them.

Speaker 3

So take those out of the equation, our occupancy is still tracking where it is today overall in the mid to high 80s.

Speaker 5

Got it. And then just on the 2,200,000 square foot pipeline, how much of that relates to properties currently unencumbered?

Speaker 2

It's about half unencumbered.

Speaker 5

And is most of that renewal or is it any new leasing as well?

Speaker 2

It is. It is. Of the $2,200,000 in the total pipeline, about $1,400,000 of it is related to renewals.

Operator

The next question is a follow-up from Bryan Maher with B. Riley FBR. Please go ahead.

Speaker 4

Great. Thank you. Given the commentary on asset sales, are any of the properties that you're considering selling to reduce debt or maybe address the $4.99 Are any of those encumbered properties at all? And I'm assuming if you sell any of the encumbered properties, do all the proceeds from the asset sale have to go towards the debt it's encumbered on?

Speaker 2

I'll start and Brian can add. So all of the properties we're looking to sell or are under agreement are all unencumbered?

Speaker 3

Yes. And as far as whether or not we decide to pursue sales on anything that's part of a debt transaction, yes, there are factors that could impact such as if we were to sell something out of the credit agreement, pool of properties that could affect our availability of the total revolver capacity. So again, unencumbered assets are where we're focused. We just entered into some of these debt transactions that are backing these. So it's unlikely we'll sell anything out of the encumbered pool.

Speaker 4

And who are the buyers that you're talking to? Is it people that they're just looking for distressed properties and hoping for a market turnaround? Are they planning on doing office to residential conversions? I mean, who are these buyers?

Speaker 2

So it's a mix, Brian. It's a good We have some owner users and those are actually worth wealth when we have owner users because they pay a premium. And then we also have some value add investors and some potential developers. So it is it does appear to be a mixed bag of buyers.

Speaker 4

Maybe one last one for me for Brian. Look, the expense part of the income statement looked pretty solid. Expenses coming in fairly meaningfully below our expectations. Is there anything going on there per se that would continue that trend or was there any anomalies that we should be thinking about?

Speaker 3

It was a mixed bag, Brian. Q2, we had some successful tax appeals that we had now projected at a handful of properties as we continue to evaluate and appeal taxes across country as part of our normal process. So we were successful in a couple of that was about, call it, dollars 1,600,000 where we difference to our projections. We had some projects that I think will just defer were deferred from Q2 to Q3. So we'll see some increase in Q3.

Speaker 3

As I mentioned sequentially, we're expecting costs to be up and we'll also see some increased utilities as the summer months are impacting Q3. So really it was a mixed bag, some of it is deferrals, some of it is one time and some of it is just savings.

Speaker 4

Okay. Thank you.

Speaker 3

Thank you.

Speaker 2

Thank you.

Operator

The next question is a follow-up from Ronald Kamdem with Morgan Stanley. Please go ahead.

Speaker 4

Hey, just a follow-up to

Speaker 5

that previous question. So the Life Science development, those are encumbered assets. But given some of the commentary on 20 Mass Ave and what you guys think that's worth, what are the broker conversations suggesting the life science development could be worth if you've had any conversations on those assets as well?

Speaker 2

So I think given that those are life science properties, I think the valuation of what we've put them into the debt agreements is still holding true once stabilized. So it's a little hard to it's very much apples and oranges given one is office and one is lab.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Yael Duffy for any closing remarks.

Speaker 2

Thank you for joining us on the call today.

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Office Properties Income Trust Q2 2024
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