Good morning, and welcome to Government Properties Income Trust's First Quarter Financial Results Conference Call. This call is being recorded. .

At this time, for opening remarks and introductions, I would like to turn the call over to Director of Investor Relations, Mr. Christopher Ranjitkar. .

Thank you, and good morning, everyone. Joining me on today's call are David Blackman, President; and Mark Kleifges, Chief Financial Officer. They will provide insight about our recent accomplishments and results for the first quarter. They will then take your questions. .

First, please note that the transcription, recording and retransmission of today's conference call are prohibited without the prior written consent of the company. Also, 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 GOV's present beliefs and expectations as of today, May 3, 2018.

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 other than through filings with the Securities and Exchange Commission or SEC regarding this reporting period. .

Additional information concerning factors that could cause those differences is contained in our filings with the SEC, which can be accessed from the SEC's website or the Investors section of our website at govreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements..

And finally, we will be discussing non-GAAP financial metrics during this call, including normalized funds from operations or normalized FFO.

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, again, can be found on our website. .

Now I'll turn the call over to David Blackman to begin our quarterly discussion.

David?.

Thanks, Christopher, and good morning. On today's call, I will review our quarterly leasing activity, discuss our forecast for tenant retention and provide an update on our distribution program before turning the call over to Mark to review our financial results and balance sheet. .

Government Properties Income Trust ended the first quarter with 107 properties containing 17.3 million square feet, excluding our 2 unconsolidated joint ventures. Occupancy was 94.4% on a consolidated basis and 95.3% on a same-property basis at quarter end, both of which were a 20 basis point increase from the previous quarter.

We continued with solid leasing activity, completing new and renewal leases for approximately 280,000 square feet, with a 4.9% roll up in rent, a weighted average lease term of 5.6 years and leasing concessions and capital commitments of $5.13 per square foot per lease year.

Our leasing with government tenants comprised only 72,000 square feet but the weighted average lease term was 8.2 years and the roll up in rent was 20.2% on leasing concessions and capital commitments of $6.20 per square foot per lease year. .

We continue to be encouraged by the opportunities created from our acquisition of First Potomac Realty Trust. During the quarter, we entered 13 new leases containing approximately 44,000 square feet and contributing more than $1.4 million of annualized rent in space that has been vacant since the properties were acquired.

GOV also continues to have a strong leasing pipeline with more than 2 million square feet of active deals, including more than 650,000 square feet of potential new leases and almost 280,000 square feet of potential leases that would absorb vacant space in our buildings..

Now let's review our tenant retention expectations. As of March 31, we have leases contributing 10.4% of GOV's annualized rent and occupying less than 1.6 million square feet that are subject to expiration over the next 12 months. From these expirations, we expect CAD-contributing 5% of annualized rent to vacate at lease expiration.

The vacating tenants include 4 government tenants that contribute 3.6% of annualized rent. .

The largest vacating tenant is the Bureau of Prisons, who is a full-building user in Washington, D.C. that contributes approximately 1.9% of annualized rent, and this lease expired March 31, 2018, but remains in holdover.

This is a building we acquired from First Potomac where we underwrote the tenant vacating prior to year-end 2017 and where we also are in advanced lease negotiations with a full-building replacement tenant.

The balance of the tenants expected to vacate are primarily small private-sector tenants in properties acquired from First Potomac that we also underwrote to vacate in our acquisition due diligence. .

In addition to the tenants we have identified as vacating, we have identified tenants that contribute 69 basis points of GOV's annualized rent to be at risk of downsizing or vacating over the next 12 months.

This is a 14 basis point increase from the previous quarter and consists primarily of small private-sector tenants, the largest of which contributes only 22 basis points of annualized rent. .

This forward guidance to GOV's lease expiration schedule is the best information we have available today based upon our dialogue with tenants. Tenant negotiations are fluid with a number of tenants and circumstances can change. Tenant retention and attracting new tenants to our buildings remain a significant area of focus for GOV. .

Now let's turn to dispositions. We continue to make progress on our property disposition program. In March, we sold an office property in Minneapolis, Minnesota for $20 million, realizing a 4.6% cap rate on in-place net operating income. We have also entered agreements to sell 2 additional properties, with sales expected to close during May.

One is an office property in Sacramento, California for a sales price of approximately $10.8 million, and the other is our office property in New York City for a sales price of $118.5 million. The diligence period for both properties has expired. Both buyers' deposits are at risk, but the sales remain subject to customary closing conditions.

By the end of May, we expect to have closed on more than $150 million in asset sales from 4 properties. .

GOV is also marketing or working with brokers to market many other properties, including most of our flex buildings in Maryland and Virginia. Although we cannot provide assurances that we will sell every property we market for sale, our guidance for asset sales remains between $500 million and $700 million in gross proceeds by year-end 2018..

Before I turn the call over to Mark, I would like to address GOV's dividend. In recent weeks, an analyst report was issued predicting a future cut in our quarterly distribution to shareholders. This has raised concern with many shareholders and may be the reason for the recent saw-off in our share price.

Since that report, we announced our regular quarterly distribution of $0.43 per share with the full support of our Board of Trustees. .

We believe maintaining our high occupancy rate from long-term leases with good-credit tenants is important for our company and our shareholders. In doing so, GOV's continued high leasing volume has resulted in capital expenditures that have made it difficult to fully cover the dividend.

To date, our shortfall has been modest and easily supported by borrowings under our revolving credit facility..

Our ongoing disposition program has many factors that will impact our dividend coverage. These factors include the ultimate dollar of the asset sold, the cap rate or multiple for which the properties sell, and the cash contribution after capital expenditures for both the assets sold and those that GOV continues to own.

However, we recognize the importance of the dividend to shareholders, and today, management is not prepared to recommend a change in the distribution rate to our Board of Trustees even if that results in an over-distribution of our dividend through the remainder of 2018..

I will now turn the call over to Mark to review financial results. .

Thanks, David. I'll begin with a review of our property-level performance for the first quarter of 2018. .

For the first quarter, GOV's consolidated rental income was $108.7 million, an increase of $39.4 million. This increase was a result of the FPO acquisition and an increase in same-property rental income. On a same-property basis, first quarter rental income increased by $1.4 million or 2.1% year-over-year.

In cash basis, rental income increased $2 million or 3% year-over-year. .

First quarter consolidated property operating expenses increased by approximately $15.7 million year-over-year to $42.5 million, reflecting the impact of the FPO acquisition and an increase in same-property operating expenses.

Same-property operating expenses increased by $1.95 million or 7.5% year-over-year to $28 million due primarily to higher real estate taxes, repairs and maintenance and utilities expense during the 2018 period. We expect same-property operating expenses to increase at a more modest rate for the remainder of 2018. .

Consolidated first quarter net operating income or NOI increased by $23.7 million to $66.2 million. Consolidated cash-basis NOI for the first quarter increased by $22.1 million to $63.8 million. Our consolidated GAAP and cash NOI margins for the 2018 first quarter were 60.9% and 60%, respectively..

From a same-property perspective, our first quarter GAAP NOI decreased $504,000 or 1.2% year-over-year to $41.5 million. And our cash-basis NOI increased by $42,000 or 0.1% to $41.3 million. Our same-property GAAP NOI margin was 59.7%, and our same-property cash basis NOI margin was 59.5% for the 2018 first quarter..

Turning to our consolidated financial results. Normalized FFO for the first quarter was $54.1 million, which is up from $39.9 million for the 2017 first quarter. Normalized FFO per share for the 2018 first quarter was $0.55, which is down $0.01 or 1.8% from the 2017 first quarter. .

GOV's adjusted EBITDA was $73.4 million for the 2018 first quarter and includes approximately $12.7 million of cash distributions received from our SIR investment. We spent $2.7 million on recurring building improvements and $4.8 million on tenant improvements and leasing costs in the 2018 first quarter.

As of quarter end, we had approximately $32.8 million of unspent leasing-related capital obligations..

At March 31, GOV's ratio of debt to total gross assets was 56.4%, and we had $570 million outstanding on our $750 million revolving credit facility. As we have previously stated, during 2018, we intend to reduce borrowings under our credit facility and our debt leverage with proceeds from our property disposition program.

On a pro forma basis, assuming the sale of the Sacramento and New York properties under contract, debt to total gross assets would have been 54.8% at March 31..

Operator, that concludes our prepared remarks. We're ready to open up the call for questions. .

[Operator Instructions] The first question comes from Vikram Malhotra with Morgan Stanley. .

This is Adam Gabalski on for Vikram. Just wanted to talk about the expected cap rates on the dispositions moving forward with the rest of 2018. You said you had a 4.6% cap rate on in-place NOI in the property you sold in the quarter.

I'm just wondering if that's sort of the cap rate range we should expect with the rest of the expected $500 million to $700 million in dispositions. .

Yes. We haven't really put a cap rate range out there for the market. We're selling a lot of different types of assets, and I think that cap rates can vary quite a bit. So I don't think, at this point, we're prepared to give a range, but we will announce the cap rates every quarter after we close the assets. .

Okay, fair enough. And then just one more from me. As far as the synergies that you expected to realize with G&A regarding the FPO transaction, just kind of wanted to get your refresh take on how you expect that run rate to play out moving forward. .

Yes. I think we've realized, really, on day 1 most of the synergies that we expected. The one -- I guess, there's a couple of costs that had continued through today, and that's one. As part of the transaction, we assumed FPO's former headquarters lease in Washington, D.C., and we're attempting to sublease that property.

But as of today, we're still incurring about $425,000 of rental expense on that space. And then we also inherited some litigation from FPO, and we've incurred some legal fees related to that. But I think we're, at the end of the first quarter, through most of that and not expecting any material costs going forward. .

The next question comes from Jamie Feldman with Bank of America. .

I guess, just first, kind of housekeeping. Mark, you had mentioned $12 million of SIR income. Can you just walk us through? Like, as we're building our models for next quarter, what are the onetime items that hit this quarter that aren't going to continue or will continue? It's a little noisier than usual. .

On the SIR side?.

No, just in earnings overall. .

Yes. I don't know if there was a whole lot of noise, to use your term, in the first quarter. The income, from an FFO standpoint, that we've realized from our SIR investment, we pick up our proportionate share of their normalized FFO. And that was up about $1 million or 7% from where it was in the prior year first quarter.

But other than that, I don't really think there is any noise per se in the first quarter numbers. .

Okay. So in terms of a sequential run rate, there's no line items to really adjust other -- beyond... .

No. Other than normal seasonality that we... .

Yes. Repairs and maintenance may vary some, and Mark talked about the 2 G&A items that we expect to improve over time. But no, I don't think there's anything extraordinary going on. .

Okay. And then, I mean, moving on to operations. So you'd mentioned the move-out at the Bureau of Prisons.

Can you talk about the timing if you were to get a tenant back in there? How are those discussions going?.

Well, the Bureau of Prisons has not moved out yet. Indications are they're going to be in until at least May, so we kind of think we're going to get maybe 6 months more rent out of that tenant than we anticipated. And we are pretty active in negotiating our lease with a replacement.

So I think if we have any downtime, it will be a matter of weeks or months that we have downtime on. .

And they want the entire building, you said?.

They want the entire building. .

And you would recognize -- you'd recognize revenue as soon as they took over? Or is there some build-out required, renovation required?.

We would recognize GAAP revenue when they sign the lease. .

Okay.

Is that another government tenant or a federal tenant?.

It is not a government tenant. .

Okay. And then also, just maybe if you could provide some more color on the rest of the '18 expirations and maybe handicap where you think occupancy could end the year based on what you're seeing. And then if there's any '19 expirations you can talk about. .

Well, what we've provided guidance on, Jamie, is for the next 12 months so that would be through the end of March 2019. And as I mentioned, the Bureau of Prisons is almost half of that, and that, we expect to occur maybe May or June of this year. So there's really not much material beyond that. .

And then for like the remainder of '19? I know that you said this is through March. .

We're giving 12 months guidance on lease expirations, Jamie. .

Okay.

But do you have any large chunky ones to even be concerned about in the rest of '19?.

Not at this point. .

Okay. And then turning to the distribution. I mean, it sounds like you -- kind of sacred in your mind through year-end '18.

What kind of payout ratio do you need to get to before you do start to think about a cut?.

Jamie, we -- in our prepared remarks, I think we are pretty explicit on our view. And I think the results of our property disposition program is something that we need to work through before we're prepared to address it further.

But I think it's important to understand that we are comfortable with -- or we don't intend to recommend, where we currently sit today, a change in the distribution rate for the rest of this year. .

Right. I guess what I'm asking is what type of AFFO payout do you want to see.

Like what do you think the right payout ratio is for this entity?.

Jamie, I think when we get to the end of the disposition program, we'll sit down -- we'll see where we are and we'll sit down with the board. And I don't want to get too far ahead of where we are with discussions with the full board.

And I think our preference would be for this call or for today to leave -- what we said is what, I guess, we're prepared to say today.

How is that?.

Okay. All right. .

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

Most of my questions have already been asked, but can you give us a little bit of color on what your CapEx spending expectations are for 2018 and 2019?.

Well, we had -- our CapEx in the first quarter was relatively low. Total BI and leasing capital is about $7.5 million. I expect that to trend up in the remainder of the year. I think it's tough to give guidance because a lot of it is going to depend on both the timing of asset sales and what assets we end up selling.

But -- so I think, if you kind of look at what we incurred last year, recognize the fact that post FPO, we're about 50% larger from a square footage standpoint, I think you can ballpark some trends to use from a modeling perspective. .

Bryan, it's a good question. It's hard to answer. I mean, every year, when we budget capital expenditures, a big chunk of that is leasing capital, and it always includes speculative leasing on space that is either vacant or expected to have expirations during the year. And our history is we don't spend 100% of what we budget.

So I think that's why it's hard for us to give you a direct answer. .

Would you characterize some of the product that you have for sale, assuming it doesn't sell, to be more heavy CapEx than the rest of the portfolio or not?.

We have taken a pretty hard look at the capital relative to some of our asset sales. As an example, our New York asset, we have very little capital budgeted for that building in 2018 or 2019. So that's a capital-light building.

A lot of the flex buildings that we're going to market for sale in Maryland and Virginia have deferred maintenance on it that we recognized when we acquired those assets. And so part of our desire in selling those assets is to not have to spend a lot of capital on a go-forward basis. So it's a -- I guess the answer is, Bryan, it's a mix. .

Okay. And then maybe this is for Mark. You talked about some increased expense costs in the quarter, real estate taxes, maintenance, utilities.

Where are you seeing the most pressure come from those increased costs among those items?.

Well, in terms of dollar value, I mean, real estate taxes were clearly the largest increase in expenses, and it's really just due to higher assessments. On the utilities and repairs and maintenance side, it was a large -- to a large degree, it was weather impact.

Year-over-year temperatures were colder in several areas in the country and snow amounts were higher. So the incurred increased utilities expenses and snow removal costs versus the prior year first quarter. .

Okay. And then just lastly from me on the real estate taxes side. I'm assuming that RMR has a pretty aggressive appeals department in that regard.

What type of success do you guys typically have with appealing real estate tax increases?.

You're right, we do have a robust program. I don't know if I have data in front of me to characterize how successful it is. But I think every property is reviewed on an annual basis and assessments are made whether to appeal or not appeal. And I think we do -- we've been doing it for a long time, and I think we do a pretty good job of doing so. .

The next question comes from Mitch Germain with JMP Securities. .

David, I guess I was curious. I saw the progress on the sales, and I know you mentioned the flex portfolio.

What's -- are there assets out there right now being marketed?.

The flex properties, no. We're working with a couple of brokers to bring those to market, and I would expect they will be actively marketed beginning in about 2 to 3 weeks. .

Okay.

And then are there any other assets on the market as we speak right now?.

Yes. We have about 4 or 5 assets from our -- we're continuing to market from Phase 1. And then we're continuing to look at the portfolio to see if there's anything else we want to consider. .

I know you have a couple of larger move-outs that are probably more forward-looking, 2021 or beyond.

Are those the characteristics of some of the assets that might be sold here? Or is it really more core stable?.

When we started looking at our disposition program, Mitch, we really looked at assets that we -- that might be vacant now, that we thought could become vacant and the prospects of leasing them would either be difficult or the capital would be uneconomic to re-lease those buildings.

And then we also looked at some stuff where the ongoing capital requirements were higher than we wanted to spend. And then like New York as an example. That's a building that we felt we could sell at a low cap rate, we could recognize a gain and it would be very accretive to our debt-to-EBITDA ratio.

So it's really a mix of all of those various parameters. .

Great. And last one. I hate to ask this question. Just in your prepared text, you talked about the -- I think you mentioned 650,000 square feet of new leasing. Just maybe just kind of go through that again. I got on the call little late. .

Yes. No, that's fine. I was talking about our lease pipeline. We have about 2 million square feet of active deals in the pipeline. That includes 650,000 square feet of new leases and about 280,000 square feet of potential leases that would absorb vacancy in our existing buildings. .

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. David Blackman, President and CEO, for any closing remarks. .

Thank you, operator, and thank you for joining us on today's call. Mark and I will be at the NAREIT conference in June, and looking forward to meet with many of you there. That concludes our call. .

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