Good morning, and welcome to the Office Properties Income Trust Second Quarter 2022 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Kevin Barry, Director of Investor Relations. Please go ahead..

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 Bilotto; and Chief Financial Officer and Treasurer, Matt Brown.

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 OPI's beliefs and expectations as of today, Friday, July 29, 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, opireit.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, cash available for distribution, or CAD, adjusted EBITDA and cash basis net operating income, or cash basis NOI.

A reconciliation of these non-GAAP figures to net income are available in our supplemental operating and financial data package, which also can be found on our website. In addition, 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. With that, I will now turn the call over to Chris..

Thank you, Kevin, and good morning, everyone. Welcome to the second quarter earnings call for Office Properties Income Trust. Last night, we reported second quarter results that reflect solid financial growth, strong leasing momentum and continued progress on our capital recycling plans.

Normalized FFO and same-property cash basis NOI exceeded our prior year results in the high end of our guidance range. We are pleased with our strong quarterly performance. However, broader office fundamentals remain in a period of transition. Tenants continue to assess their longer-term space needs and the balance of a hybrid work environment.

National vacancy remains elevated and office utilization continues at a modest pace. We anticipate market fundamentals will remain in transition over the next several quarters.

As part of our ongoing commitment to offering best-in-class options to tenants, we have selectively deployed capital into our properties over the years, focused on better operations, market-specific tenant experiences and sustainability.

Through our manager, we have local professionals specifically focused on our real estate in each market and have certified building engineers managing maintenance of our properties with the highest level of care.

This has positioned many of our properties to be a first consideration with tenant tours and we believe our pipeline activity and corresponding new leasing activity over the past several years are a result of this proactive investment despite the noted market uncertainty.

During the second quarter, our leasing activity increased sequentially to 679,000 square feet, and same-property occupancy increased 50 basis points over the prior quarter to 94.3% attributable to new leasing activity and advancement of our disposition program for noncore assets.

We continue to take a disciplined and thoughtful approach to our capital recycling efforts with the goal of reducing capital expenditures and improving our portfolio's geographic footprint and operating fundamentals.

Since the beginning of the second quarter, we sold or agreed to sell noncore properties or properties where we believe value has been maximized for aggregate proceeds of $167.9 million that contained over 1.7 million square feet at an average age of 18 years.

For assets we continue to market, we have seen some spinning of the buyer pool, along with volatility and pricing expectations in light of macroeconomic changes and in certain real estate market conditions.

As a result, we are moderating our expectations for the pace of our 2022 property dispositions and now anticipate aggregate 2022 sales proceeds in the range of $100 million to $200 million.

We remain committed to utilizing capital recycling proceeds to manage leverage levels and strengthen our portfolio and anticipate dispositions to continue as we move into 2023. Turning now to the second quarter in more detail.

We completed 18 deals for 679,000 square feet of new and renewal leasing with a 4.9% weighted average roll-up in rent and a 9.2-year weighted average lease term. Quarter-over-quarter leasing volume increased in excess of 18% and by 23% over Q2 2021.

Government agencies accounted for approximately 30% of our total leasing volume followed by tenants in the government contractor, life science and medical industries.

Since the first quarter of 2021, new leasing activity contributed to close to 1.2 million square feet, which we believe represents the highlighted initiatives with how we manage our buildings and is a good indication of tenants appetite to commit the space.

We ended the quarter with investment-grade rated tenants, representing approximately 63% of annualized rental revenue. Turning to highlights from second quarter leasing transactions. In Chantilly, Virginia, we executed a lease renewal with a defense contractor for 159,000 square feet.

This represents a key strategic win in which OPI secured a renewal for a mission-critical location at a 10% roll-up in rent and a now a 17-year term. We renewed 168,000 square feet in Florence, Kentucky, occupied by the GSA at an 11% roll-up in rent in an 5-year term.

And in Naperville, Illinois, we signed a new lease with a health care equipment manufacturer for 86,000 square feet at a modest roll-down rent in an 8-year term. Looking ahead to OPI's upcoming lease expirations, approximately 4% of our total annualized revenue is scheduled to expire during the back half of 2022.

We are actively managing through a limited number of known vacates including our previously discussed tenant located in a vibrant and growing submarket of Denver, Colorado, resulting in a net impact of 135,000 square feet and 80 basis points of annualized revenue.

We continue to build interest from a variety of prospects looking to lease portions of the buildings. Beyond the Colorado lease, our remaining 2022 rent roll is comprised of mostly smaller tenants and properties currently being marketed for sale.

Looking ahead to 2023, roughly 13.5% of OPI's annualized revenue is scheduled to expire with the largest known vacate being a tenant located in Washington, D.C. CBD, representing 2% of annualized revenue and a lease expiration during the back half of the year.

Given the timing for this expiration later in 2023, we have ample time to market the building and are well in the plan to support lease-ready initiatives for what is currently a Lit Gold Class A property in a prominent submarket of downtown D.C.

While expirations may be somewhat mitigated by asset sales, renewal conversations with many of our tenants have been positive, and we anticipate strong leasing momentum will continue for the remainder of the year.

OPI's expiration schedule also presents an opportunity in this high inflationary environment to rightsize rents and reset base year expense agreements to grow the top line. Our current leasing pipeline remains strong with the balance of new and renewal deals, healthy lease term and mark-to-market growth potential in the high-single digits.

We have over 3.2 million square feet of active prospects of which 1.6 million square feet is attributable to new leasing. Today, we are in advanced stages of negotiation with nearly 670,000 square feet, which includes over 250,000 square feet of potential new tenants.

We are reaffirming our expectation for the year-end 2022 occupancy of 89% to 90%, along with expectations for roll-ups -- rent roll-ups of 5% to 7%. Turning to development. Our redevelopment efforts in Washington, D.C. and Seattle, Washington, both remain on track.

Despite broad industry challenges associated with rising construction costs and longer lead times for materials, we continue to work towards a favorable stabilized year return on cost of 8% to 10% for 20 Mass Ave and 10% to 12% in Seattle and plan to deliver both projects in April of 2023.

We believe the rigorous planning and disciplined execution of these projects have positioned us releasing success, cash flow growth and long-term value creation. Tenant tours and preleasing interest remain active at both locations as each project takes shape.

Before turning the call over to Matt, I wanted to comment on 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.

For example, earlier this year, OPI was recognized as an ENERGY STAR Partner of the Year for the fifth consecutive year and a Gold Level 2022 Green Lease Leader. We are proud of the progress we continue to make to strengthen OPI's sustainability practices and enhance our ESG transparency and disclosure.

You can find links to the report and a tearsheet specific to OPI's highlights on our website at opireit.com. I will now turn the call over to Matt to review our financial results..

Thanks, Chris, and good morning, everyone. Our results for the quarter exceeded our expectations and improved over the same period last year.

Normalized FFO increased 6% year-over-year to $58.9 million or $1.22 per share exceeding the high end of our guidance range by $0.09 mainly due to managing our operating expenses and the timing of certain expenses such as repairs and maintenance.

CAD increased 12% year-over-year to $37.8 million or $0.78 per share for the second quarter, resulting in a rolling 4-quarter CAD payout ratio of 66%. Earlier this month, we declared our regular quarterly distribution of $0.55 per share, which represents a current quarter CAD payout ratio of 71%.

Same-property cash basis NOI increased 1% compared to the second quarter of 2021 and beat our guidance range of down 2% to 4%. The increase was driven by rental income growth due to an increase in occupancy year-over-year, free rent during the 2021 period and increased parking income.

Looking ahead to our normalized FFO and same-property cash basis NOI expectations in the third quarter. We expect normalized FFO to be between $1.12 and $1.14 per share.

The decline compared to Q2 is mainly driven by $0.05 due to a $2.2 million termination fee earned in the second quarter with the balance accounting for expected increases in operating expenses.

This guidance takes into account our planned disposition activity and includes a range of $24.5 million to $25.5 million of interest expense and $6.9 million to $7 million of G&A expense during the third quarter. We expect same-property cash basis NOI to be flat, plus or minus 100 basis points as compared to the third quarter of 2021.

Turning to capital expenditures and the balance sheet. We spent $20.8 million on recurring capital and $40.3 million in redevelopment capital during the second quarter.

We continue to expect 2022 recurring capital to approximate $100 million plus or minus $10 million and redevelopment spend to approximate $200 million to support our 20 Mass Ave and Seattle redevelopment projects. In Q2, we repaid approximately $325 million of debt with cash on hand and borrowings under our revolving credit facility.

We intend to continue to pay down debt with our property disposition proceeds and ended the second quarter with $546 million of total liquidity, including $520 million of availability under our revolver.

More than 90% of our $2.5 billion of outstanding principal balance is fixed at a weighted average interest rate below 4% and over 97% of our debt is unsecured.

Our exposure to rising interest rates is limited to our revolving credit facility, and we have no senior notes maturing until May 2024, leaving us well positioned to support our priorities going forward. Operator, that concludes our prepared remarks. We're ready to open the call up for questions..

[Operator Instructions]. The first question today comes from Bryan Maher with B. Riley..

A couple of quick questions.

On the $3 million plus of active pipeline for listing, how much of that do you think comes to fruition over the next 3 to 4 quarters, considering the expirations you have coming up in 2023 and 2024? And are you seeing any sense of urgency on the part of tenants to maybe lock in leases? I think we've talked about this before, fearing inflation might drive those prices higher..

Yes. Thanks, Bryan. This is Chris. I think from tenants kind of pushing to kind of lock in leases, I would say that it's very much just tied to kind of overall plans for office space, I think, more so than kind of driving rate. And so that is, in many ways, kind of dictating kind of how they think about timing.

As we think about kind of our expirations over 2022 and even into '23, I guess, it could be hard to kind of articulate as to kind of how those leases may be signed and kind of the lumpiness with the process with respect to signing an LOI, negotiating a lease document, et cetera.

But I think to provide a little bit more color, I would say, so if we look at 2022, we've got about 4.2% of our annualized revenue expiring. Subsequent to quarter end, we signed about 345,000 square feet, which includes 2% of those expirations. And so when we kind of sum it up, we have 2% accounted for.

We talked about the 80 basis points tied to the Colorado lease vacating; we're selling some properties as part of our capital recycling program, which accounts for about 70 basis points; and then we have some new lease activity as well that are signed as part of that 345,000 square feet.

And so I think that kind of just shows some of the cadence at least coming right out of Q2 and how we're addressing 2022. For '23, as you've seen, we have about 13.5% of our annualized revenue expiring.

And I think the highlights there are the 2% of known vacate on the back half of the year, as I just mentioned in our prepared remarks, we're selling about 60 basis points and then I would say we're in advanced conversations with a lot of those expirations, representing about 4% of our annualized revenue.

And depending on the circumstances, it's not signed until it's signed, but those could be leases that we're able to get in front off for execution in Q3 and Q4 this year. So really what that does, that leaves us with about 7% of our annualized revenue in 2023 that we continue to work through.

And I think I would also note on that, most of those leases are expiring in Q4, for example, of next year. And so it's not surprising to where we sit today knowing that a lot of that hasn't matured to the extent some of these other ones have because they're still a ways out.

But I think what that means in our view is whether there's upside in rents with that remaining 7% or some fallout, it's not something that we would expect will impact 2023 too much just given the timing of those expirations..

Got it. And then as it relates to the disposition, I know that you curtailed your expectations from $400 million to $500 million to $100 million to $200 million.

What kind of discounts were potential buyers looking for on some of the stuff that maybe you were out there shopping around that you've since pulled? And given that you have net debt to gross asset value of around 49%.

With the pullback in disposition expectations, are you comfortable hanging out at that kind of 40%, 49%, 50% level for a while?.

So I'll take the first half, and I'll turn it over to Matt. But I would say that it varies depending on the physician strategy. So we do have some buildings that have been out in the market that have shorter walls, and I would say, in some cases, buyers are kind of sitting on the sidelines altogether.

For some of the more stabilized assets, a good example is 1 that has some long lease term that we were selling in the Midwest. And as we were kind of concluding diligence, the buyer came back and wanted a 10% discount on the price.

And so I mean for us, in specific, given that this particular property has longer term, and there is -- we're pretty disciplined in how we want to approach these. We're not necessarily in a rush to run out and kind of sell an asset at a discount, just given kind of where we are. So it really runs the full gamut.

But I would say that, that 10% discount is a good indicator based on what we've seen more specifically. And I'll turn the other portion over to Matt..

Yes, Bryan, on net debt to gross assets in the high 40s, even into low 50s, we are comfortable running the company at those levels while we reduced the expectation on 2022 dispositions..

[Operator Instructions]. The next question comes from Ronald Kamdem with Morgan Stanley..

This is Tamim [ph] in for Ronald Kamdem. Just wanted to ask about the recurring CapEx guide. I know it reaffirms relative to last quarter. Maybe really it does imply a ramp in the second half of this year.

Could you talk about what's driving that ramp relative to the first half of the year? And then also, how to think about the recurring CapEx? How should think about [indiscernible] the context of lease expirations and whatnot?.

Sure. So our full year guidance for '22 is $100 million, as we noted in prepared remarks, for recurring capital. We've spent about $32 million to date. So we have about $68 million remaining, and that's spread pretty evenly in our forecast for Q3 and Q4.

The reason it's higher is, 2022, we've done a lot of leasing activity, and we're trying to get ahead of 2023 leasing as well. So that's really the reason of the increase over the first half of the year.

And then beyond '22, for now, I would say that, that $100 million recurring capital remains a good estimate, and we'll provide updates on our Q3 call as we continue fine-tuning the budget for 2023..

And if I could just ask a follow-up there.

How do you feel about -- if the CapEx is say, $100 million next year, I do see kind of the AFFO payout ratio, there's some upward pressure on it depending on kind of what you expect for AFFO? How do you feel about the dividend and how safe that is?.

Yes. We've -- ever since the merger back in 2018, we set a payout ratio of about 75%. I think every quarter since the merger, we've been well below that. So we've been very comfortable with our dividend we expect to see a little pressure on that with recurring capital and the lease expirations in '23.

But where we sit today, we're comfortable with our dividend..

The next question comes from Michael Carroll with RBC Capital Markets..

Sorry if I missed this. But Matt, in your prepared remarks, you talked about a $0.05 termination fee.

Can you remind us and provide some color what that is driven? Where is that related to?.

Sure. So we knew about that when we gave guidance with Q2 earnings for Q2. So that was factored into our range of $1.11 to $1.13 that we had provided. But it was a tenant contraction in Columbia, Maryland. The tenant is likely to sign an 8-year renewal, but they did give back about 50% of the space in exchange for a $2.2 million termination fee..

Did they sign an 8-year renewal? Or is that still under discussion?.

It has been signed, I think, subsequent to the quarter..

Okay.

And then are there any other tenants within your portfolio that you're having discussions about termination options or specific tenants that have approached you saying that they're needing to downsize some of their space?.

Not specifically. I think some of the larger ones that we've experienced over the last couple of quarters were either you saw kind of the F5 downsize that hit Q1, which was much more strategic with respect to that redevelopment in Seattle from a timing perspective.

But other than that, there's nothing material on the horizon that we can speak to today..

I know you talked about the known move-outs that are going to occur towards the end of 2023. But what about the rest of the 2023 lease expirations? I mean, how have those discussions gone? And are tenants -- do you feel confident that they're going to renew? Or we're going to have some more move-outs in the beginning of '23.

Just don't know about them yet?.

I mean, look, it's hard to say ultimately what will happen. I think we'd like to think. We have a pretty good indication on kind of what's going on at least in the near term, which we've kind of alluded to somewhat.

I think right now, kind of the -- based on the breakdown I provided earlier, we've got about 7% that's unaccounted for, with the majority of that really being kind of in the back half of the year.

I mean other than the 2% I noted later in the year, we have 60 basis points with the tenant that is expected to vacate at the end of Q2 next year, and that's a property that we're also -- we have in the market as part of our capital recycling.

But outside of that, it really just -- it's smaller tenants, and it's just a function of kind of where conversations go with them. So again, I think just kind of recapping, we've got about 7% that we're still working on where the balance, I think we have a good indication of what's going on..

The next question comes from Bryan Maher with B. Riley..

Just while we have you, can you give us an update on leasing activity at 20 Mass Ave and maybe early indications on what's going on with Seattle since we're less than a year out from those properties coming online?.

Good question, Bryan. So we have about 250,000 square feet plus or minus kind of activity between the 2 properties. I would say, for Seattle, Washington, we're pretty far down the road with a large user for close to 1 full building of the 3. And so I think -- hopefully, we'll be in a position we can talk about that kind of in the next couple of months.

And so that would be kind of a life science user within 1 of those buildings that we're converting. And we also have some other kind of smaller and larger users across the portfolio that are -- excuse me, across that property that are in various ranges of discussions.

And then for 20 Mass Ave, as we've talked about, we're 54% pre-leased in that building, and we've got kind of a range of tenant activity more early stages. I think with that property in specific, we just completed the topping off of the project and close the building.

And so now we're kind of starting to see more tenants come to the table given that there's kind of a known indication on timing and the building having come together. So we look forward to providing more updates on that property in the near term as well..

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

Thank you for joining the call..

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