Good morning, and welcome to Government Properties Income Trust Second 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 the Director of Investor Relations, Mr. Brad Shepherd. .

Thank you. Welcome to Government Properties Income Trust call covering the second quarter 2018 results. Joining me on today's call are David Blackman, President and Chief Executive Officer; and Mark Kleifges, Chief Financial Officer. Today's call includes a presentation by management, followed by a question-and-answer session.

I would like to note that the transcription, recording and retransmission of today's conference call without prior written consent of GOV are strictly prohibited. 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 upon GOV's present beliefs and expectations as of today, August 2, 2018. GOV undertakes no obligation to revise or publicly release the results of any revision to forward-looking statements made in today's conference call other than through the filings with the Securities and Exchange Commission or SEC.

In addition, this call may contain non-GAAP numbers, including normalized funds from operation or normalized FFO and cash based net operating income or cash NOI.

Reconciliations of net income attributable to common shareholders to these non-GAAP figures and components to calculate AFFO, CAD, FAD are available in our supplemental operating and financial data package found on GOV's website at www.govreit.com. Actual results may differ materially from those projected in any forward-looking statements.

Additional information concerning factors that could cause those differences is contained in our filings with the SEC. Investors are cautioned not to place undue reliance upon any forward-looking statements. I'd now like to turn the call over to David. .

Thank you, Brad, 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 property disposition activity, before turning the call over to Mark to review our financial results and balance sheet..

For the second quarter 2018, Government Properties Income Trust delivered strong property level operating results growing year-over-year same property cash NOI by 5%. At quarter-end, consolidated and same property occupancy was 94% and 94.6%, respectively.

We executed 396,000 square feet of new and renewal leases during the second quarter for a 60 basis point roll-up in rent, a weighted average lease term of 6.2 years, and leasing concessions and capital commitments of $2.79 per square foot per lease year.

We also experienced another strong quarter of leasing with government tenants, executing 185,000 square feet of new and renewal leases for a 4.1% roll-up in rent, a weighted average lease term of 8.6 years, and leasing concessions and capital commitments of $1.87 per square foot per lease year.

GOV continues to have a strong leasing pipeline, with active deals that exceeds 2 million square feet. This includes more than 750,000 square feet of potential new leases, of which over 225,000 square feet would absorb vacant space in our buildings..

Now let's review our tenant retention expectations. As of June 30, we had leases contributing 12.4% of GOV's annualized rent with tenants occupying 1.7 million square feet that are subject to expiration over the next 12 months. Of these expirations, we expect tenants contributing 4.7% of GOV's annualized rent to vacate at lease expiration.

This is a reduction of 33 basis points from the previous quarter after eliminating 75 basis points of annualized rent associated with tenants that vacated as expected during the second quarter.

Included in the vacating tenants are 4 government agencies that contribute 325 basis points of annualized rents, with the 2 largest agencies contributing almost 90% of the total. As discussed previously, these 2 agencies are the Bureau of Prisons and the Department of Justice, both occupying space in Washington D.C.

The Bureau of Prisons has been in holdover since 2017 and are now expected to vacate by the end of September. We had been negotiating a lease for a full-building user for this property, but are now opportunistically considering other options..

DOJ is expected to vacate in the fourth quarter of 2018, but the U.S. government is exploring options to absorb DOJ space for at least another 12 months in order to continue to control security in the building.

In addition to the tenants we have identified as vacating, we have identified tenants that contribute 118 basis points of GOV's annualized rent to be at risk of downsizing or vacating over the next 12 months.

This is a 49 basis point increase from the previous quarter, after transitioning 13 basis points of annualized rent to the vacate category, and removing 6 basis points of annualized rent from the at-risk category after renewing a tenant lease..

The largest at-risk tenant is a U.S. government agency that contributes 48 basis points of our annualized rent that is expected to downsize its occupied square feet by about 40%, and is new to the at-risk category this quarter..

The remainder of the at-risk annualized rent is contributed primarily by small private sector tenants..

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

Now let's turn to our property disposition activity. In May, we closed on the sale of 2 office buildings that were disclosed as under-agreement during the first quarter. The 2 buildings sold for $129 million, increasing our total asset sales for the year to $150 million. Our office property in Manhattan sold for $118.5 million or a 5.9% cap rate.

The other office building is a building located in suburban Sacramento, California that the tenant is vacating. We sold this property for $10.8 million or a 15.7% cap rate, as the tenant is currently paying an above-market rent. GOV is currently marketing numerous other properties, including 2 large portfolios.

We have completed the first round of marketing for both portfolios and have found the offers to be sufficiently within the range of the broker guidance to continue with the sales process. We have also executed a letter of intent to sell the property for $70 million.

While the sale of this property remains subject to numerous conditions, we believe this sale could close early in the fourth quarter of 2018..

Based upon the progress of our portfolio sales and our other marketing activities, we remain comfortable with our guidance to complete between $500 million and $700 million in total asset sales by year-end 2018..

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

Mark?.

Thanks, David. Let's begin with the review of our property level performance for the second quarter of 2018..

In the second quarter, GOV's consolidated cash net operating income, or cash NOI, increased by $24 million or 57% compared to the same quarter last year. While most of this increase was due to the First Potomac acquisition, our legacy properties also contributed to this quarter's cash NOI growth..

On a same property basis, second quarter cash NOI increased approximately $2 million or 5%. Same property cash rental income increased approximately $1.9 million or 3% compared to the second quarter of last year, while same property operating expenses remained flat..

Our same property cash NOI margin improved as well with a 120 basis point increase to 61.7%. This positive same property performance is the result of our team's leasing efforts over the past 12 months, resulting in tenant retention rate of 83% and 125,000 square feet of new leases signed in the same property portfolio over that time..

Turning to our consolidated financial results. Normalized FFO for the second quarter was $51.3 million, which is up 21% from $42.4 million for the 2017 second quarter. Normalized FFO per share for the 2018 second quarter was $0.52, which is down $0.08 from the 2017 second quarter.

$0.06 of this decline was a result of a decrease in the amount of normalized FFO per share we recognize from our investment in Select Income REIT or SIR common shares. The decline in SIR's 2018 second quarter normalized FFO was due primarily to a noncash write-off associated with a tenant default..

As a reminder, in calculating GOV's normalized FFO, we include our ownership share, which is currently 27.8% of SIR's normalized FFO. Although changes in SIR's normalized FFO impact our reported FFO, they have no impact on the amount of cash distributions we receive from our SIR investment..

EBITDA for both the 2017 and 2018 quarters includes $12.7 million of cash distributions received from SIR. G&A expense for the second quarter was $4.4 million, which is down 12.6% from the 2017 second quarter. G&A expense in the second quarter includes the reversal of $2.2 million of incentive management fees accrued in the first quarter.

The benefit of this reversal is not included in the calculation of our second quarter normalized FFO..

In the 2018 second quarter, we spent $4 million on recurring building improvements and $5.5 million on tenant improvements and leasing costs. As of quarter-end, we had approximately $32.6 million of unspent leasing related capital obligations, of which we expect to spend approximately $21 million during the remainder of 2018.

As of June 30, GOV's ratio of debt to total gross assets had declined to 55.4%. And for the quarter, debt to annualized adjusted EBITDA was 7x, down from 7.7x last quarter. On a run-rate basis, taking out EBITDA related to the second quarter dispositions, debt to annualized adjusted EBITDA was 7.1x.

This decrease in leverage was the result of our repayment of debt with proceeds from the sale of 2 properties in the second quarter..

During the remainder of 2018, we intend to further reduce leverage with the proceeds from our property disposition program..

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

[Operator Instructions] The first question comes from Bryan Maher of B. Riley FBR. .

Quick question. I didn't quite catch the CapEx and tenant improvement numbers.

I think you said $4 million in CapEx in the second quarter and $5.5 million of tenant improvements, is that correct?.

Yes, the numbers -- $4 million of building improvements, $5.5 million of tenant improvements and leasing costs. .

Okay.

And what is the outlook for -- kind of the quarterly run rate expectation, excluding tenant improvements for the next couple of quarters? So the building improvements, kind of, quarterly, is that -- $4 million an appropriate run rate?.

I think, historically, what's happened with our properties is, we've had -- our CapEx has probably been more back ended in the second half of the year. There's always been a higher run rate. If you look back at last year, we'd, only through the first 2 quarters, only incurred about 1/3 of our total spend for the year.

And I would -- my expectation right now is we're, kind of, in the same place. I'd expect to see a ramp-up in BI in the second half of the year from where we were during the first 6 months. So I'd say that run rate is higher than where it's been. .

All right. That's helpful.

And then with respect to the 2 portfolios that you're marketing, whereby the initial bids seem sufficient, I guess, in your words, to continue down the path, can you give us any color, not necessarily the specific cap rates associated with those potential portfolio sales, but do the cap rates give you more comfort in not having to consider a dividend cut?.

It's an interesting question, Bryan. Those portfolios are going to be somewhere, on a combined basis, around -- approaching $400 million would be my guess. I don't know that we will be sufficiently concluded with our disposition program to say that the dividend can remain unchanged.

Remember, a big challenge that we have continues to be the leasing capital and our lease expirations. So I think as it relates to the dividend, nothing has really changed for us. The dividend is safe for the remainder of 2018. We'll reevaluate it during the first quarter of 2019.

By then, we would expect to have leverage consistent with where we want it to be and have a pretty good idea of what the expectations are for tenant improvement and leasing capital for the next 12 months. And we'll make a decision at that time. .

The next question comes from Jamie Feldman of Bank of America Merrill Lynch. .

This is Kim Hong on for Jamie. David and Mark, I appreciate the tenant movements and move-outs in your prepared remarks. But could you just give us the specific update on the Bureau of Prisons? I think last quarter you said that they were going to move out in -- on March 31, but they seem to be still in the portfolio. .

Yes, it's interesting. They seem to be having a hard time getting into their new building. We were expecting them -- when we underwrote the First Potomac acquisition, we had underwritten them leaving the building by 12/31/17. So it looks like we're going to get about 9 months of additional holdover rent. And that holdover rent grows by about 5% a month.

So right now, we're expecting to have them out by the end of September. That obviously could change. But it does appear that they're getting close. .

Okay. And since the FPO acquisition, your office portfolio is now 1/3 occupied by nongovernment tenants.

Have you made any changes to your leasing team and leasing strategies, since this tenant base is different from government tenants? And do you expect the percentage of nongovernment tenants to grow even more than now?.

We have always, from a leasing perspective, hired both government-specific brokers and private sector brokers to make sure that we have the right team representing our buildings. So our strategy hasn't changed as a result of acquiring First Potomac.

I would not expect any material changes in the percentage of government and private sector tenants across our portfolio. As you know, we aren't actively pursuing acquisition opportunities. We are selling some buildings that are occupied by government tenants. That will create some changes in the ratio of government and private sector tenants.

But I don't think it's going to be a material change over the next 12 months. .

Okay.

And the last one for me is, can you discuss the rationale behind the asset sales this quarter? I think in the prepared remarks, I think I heard that one of the assets you sold, there was a pending vacancy, but just what were your thoughts in selling the 3?.

Well, as we've been saying for, I guess, close to a year now, we have a number of assets that we're selling. The assets that we've identified to sale -- to sell are either properties that we think we can create compelling gains on a sale or they are properties that, we think, are challenged for a long-term hold.

And I would say that one of the properties we sold during the second quarter was a compelling gain and the other one was a challenged asset that we didn't think investing capital on a long-term basis would generate appropriate return for shareholders. So we elected to sell it now. .

The next question comes from Adam Gabalski of Morgan Stanley. .

Just want to dive a little bit deeper into the Bureau of Prisons. You talked about maybe considering other options other than a single tenant taking the whole building now.

Just with them extending maybe to September and now starting to look at different options for backfilling that space, what does that do to the time line of getting a new stable tenant in there as far as later quarters in 2019?.

Yes. I think that we are considering whether it makes sense to redevelop that asset or potentially sell it. And I would hope that we can give you better guidance on our third quarter earnings call. .

Got you. Understood. And then just 1 more.

Just on the mark-to-market for nongovernment tenants this quarter coming in at negative 4.6%, is that sort of any big onetime leases that maybe skewed that number to the downside? Or is that something that you're kind of seeing as maybe a broader headwind as far as fundamentals?.

I do not think it's a broader headwinds We've had a fair amount of leasing with some of the First Potomac assets. And it's really hard when you're leasing space that was vacant at acquisition to really be precise in your roll-up roll-down. So I wouldn't consider it broader headwinds. .

The next question comes from Jim Lykins of D.A. Davidson. .

Just a couple things.

First of all, with the 2 portfolios being marketed, is there anything else you can tell us regarding the timing? And also, are those -- can you give us any color on whether or not those are the legacy properties or some of the -- ones you acquired from FPO?.

Sure, Jim. We have already expected that we would get those closed by year-end 2018. We feel like we are on track to do that. I think it's probably a late fourth quarter close, but I do feel like we can get them sold this year.

And these -- I think as we have talked about before, we are selling some of the flex assets that we acquired from First Potomac. And these larger portfolios are acquired properties from First Potomac. .

Okay.

And also the reversal on business management incentive fees, any color on that? Can you just walk us through why the reversal?.

Yes. We -- at the end of each quarter, we calculate where we are with respect to any incentive management fee liability. And at the end of the first quarter, we, I think, were up about over the index by a little over 7%. And that outperformance had declined to about 1% at the end of the second quarter.

So when we remeasured liability at quarter-end, we had to reduce the amount of the accrual. .

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

Thank you, operator, and thank you for joining us on today's call. Mark and I look forward to seeing many of you at some of the upcoming conferences in the fall. Thank you. .

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