Good morning, and welcome to the Government Properties Trust Third Quarter 2018 Financial Results Conference Call. [Operator Instructions] Please note, this event is being recorded. .

I'd now like to turn the conference over to Brad Shepherd, Senior Director of Investor Relations. Please go ahead. .

Thank you, welcome to Government Properties Income Trust call covering the third quarter 2018 results. Joining me on today's call are David Blackman, President and Chief Executive Officer; and Mark Kleifges, Chief Financial Officer. .

In addition, we are joined by Jeff Leer, who has been appointed as Chief Financial Officer and Treasurer, effective January 1, 2019. .

Today's call includes a presentation by management, followed by a question-and-answer session with analysts. I would like to note that the transcription, recording and retransmission of today's conference call, without the 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, Thursday, November 1, 2018.

And actual results may differ materially from those projected in any forward-looking statements. .

GOV undertakes no obligation to revise or publicly release the result of any revision to 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 on GOV's website at www.govreit.com, or the SEC's website. Investors are cautioned not to place undue reliance upon any forward-looking statements. .

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

Reconciliations of net income attributable to common shareholders to these non-GAAP figures, and the components to calculate them are available in our supplemental operating and financial data package found on GOV's website. .

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 tenants at risk or expected to vacate, provide an update in our disposition activity and discuss the proposed merger with Select Income REIT before turning the call over to Mark to review our financial results and balance sheet. .

For the third quarter of 2018, Government Properties Income Trust executed 182,000 square feet of new and renewal leases for a 40 basis point roll down in rent, a weighted average lease term of 8.1 years, and leasing concessions and capital commitments of $4.41 per square foot per lease year. .

While our leasing volume with government tenants was low, we are pleased to report that the trend for 10-year and longer lease renewals continues. .

During the quarter, we executed 18,000 square feet in 2 separate leases for a weighted average lease term of 19.7 years. .

GOV also continues to have a strong leasing pipeline, excluding the properties held for sale, we have over 2 million square feet of active deals. This includes more than 766,000 square feet of potential new leases, of which almost 300,000 square feet would absorb vacant space in our buildings. .

Now let's review leases at risk for renewal for the next 12 months. As of September 30, and excluding properties held for sale, GOV had leases contributing 17.6% of annualized rent that are subject to expiration during the next 12 months. Of these expirations, we expect tenants contributing 3.2% of GOV's annualized rent to vacate at lease expiration. .

This is an increase of 127 basis points from the previous quarter after adjusting 39 basis points for tenants that vacated as expected, and 166 basis points for newly identified tenants we expect to vacate, which includes transitioning tenants from our at-risk category this quarter. .

Five government agencies contribute 44% of the aggregate annualized rent expected to vacate, with 2 agencies contributing the vast majority of the government total. These 2 agencies are the Department of Justice in Washington D.C. and the EPA in Golden, Colorado, both of which have been previously disclosed.

The DOJ vacated in October, and the GSA continues to explore options to absorb this space for at least the next 12 months in order to retain control of the building security. .

The EPA is expected to relocate to the Denver Federal Center by year-end, and we have begun marketing the building for sale. .

In addition to the tenants we have identified as vacating, we have identified tenants that contribute 271 basis points of GOV's annualized rent to be at risk of downsizing or vacating over the next 12 months.

This is a 181 basis point increase from the previous quarter after adjusting 40 basis points of annualized rent that was transferred to the vacate category, 8 basis points of annualized rent for tenants now projected to renew, and 230 basis points for 3 government tenants added to the category this quarter. .

The largest at-risk tenant contributes approximately 200 basis points of our annualized rents, is the U.S. government and is new to the at-risk category this quarter. The remainder of the at-risk tenants are small with no one tenant contributing more than 40 basis points to GOV's annualized rent. .

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. We did not close any property sales during the third quarter. However, we did enter agreements to sell a property in Washington D.C. for $70 million, and a 1.6 million square foot portfolio in suburban Metro D.C. for $201.5 million.

In October, we also entered an agreement to sell another 1.6 million square foot portfolio in suburban Southern Virginia for $167 million. These are the buildings we have classified as held-for-sale. .

Assuming these 3 sales close as expected, GOV will have completed $590 million of property sales since the acquisition of First Potomac and will have met the guidance we provided for using asset sales to permanently finance the acquisition. .

Turning to the merger plan. There is a fair amount of information available to the public regarding the pending combination with SIR, including our joint investor presentation from the announcement on September 17, and the First Amendment to the preliminary joint proxy filed with the SEC on October 26.

So rather than rehashing the information that has already been disclosed, I'm going to provide an overview of the combined company, summarize accomplishments since the announcement and outline the principal reasons why we believe the merger should be supported by GOV's shareholders. .

The merger will combine SIR with GOV to form what we believe to be a leading national office REIT with increased scale, enhanced tenant and geographic diversification, a well-laddered lease expiration schedule, a broader investment strategy and a company with one of the highest percentages of rent paid by investment grade rated tenants in the office sector.

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GOV will be the surviving entity and will change its name to Office Properties Income Trust, or OPI, upon closing the merger. .

On a pro forma basis, as of September 30, 2018, the combined company will own 213 buildings containing 30.2 million square feet, located in 38 states in the District of Columbia that will be 92% occupied with a weighted average remaining lease term of 5.8 years. .

Approximately 66% of the company's annualized rent will be paid by investment grade rated tenants, and only 29% of our annualized rent will expire between 2018 and 2021.

The combined company is expected to pay a dividend based upon 75% of cash available for distribution, which is estimated to be between $0.50 and $0.60 per share per annum and which is also expected to provide the combined company with greater financial flexibility and a greater ability to increase the dividend over time.

The investment strategy for the combined company will focus on office properties in highly desirable markets that have strong economic fundamentals to support growth. We expect to acquire both single-tenant buildings and multi-tenant buildings.

Single-tenant building acquisitions will be for properties that are strategic to tenants and will include build to suit properties, corporate headquarters and buildings where tenants have invested meaningful capital. They will also need to have a minimum remaining lease term of 7 years. .

Multi-tenant building acquisitions will be buildings primarily leased to government tenants and for government agencies with high security requirements or where the agency's mission is strategic to the building's location.

We also expect to focus primarily on first-generation buildings where we believe getting at least one tenant renewal is more likely and where ongoing capital needs will be more modest. .

A key component of our investment strategy will be the implementation of a capital recycling program, in which the company expects to prune between $100 million and $300 million of properties annually to reinvest in properties that are expected to improve the average age of our portfolio, the weighted average remaining lease term and tenant retention prospects, and to manage ongoing capital requirements.

This is also expected to create accretion to cash available for distribution over time. .

Now a quick review of what we've accomplished since the merger announcement, and what is expected to occur as we approach the merger closing. On October 9, we sold all our 224.9 million common shares of SIR and used the net proceeds of approximately for $435 million to repay outstanding debt. .

On October 26, a First Amendment to the preliminary proxy was filed to address comments received from the SEC. Once the proxy is declared effective, we will set a shareholder meeting date for GOV's shareholders to approve the issuance of shares to SIR shareholders.

The threshold for this approval is an affirmative vote by a majority of votes cast at the shareholder meeting. We expect the merger will close by December 31, 2018. .

There are numerous reasons why we believe the combination of GOV and SIR is in the best interest of GOV to include the enhanced portfolio characteristics of the combined company that I've already discussed.

However, we believe, the most important reasons are that the combination is expected to be significantly accretive to GOV's cash available for distribution and that GOV's shareholders will receive a significantly higher dividend from the combined company than what GOV's shareholders would expect to receive if the merger does not occur. .

I'll now turn the call over to Mark, to review financial results and the balance sheet. .

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

In the third quarter, GOV's consolidated cash net operating income or cash basis NOI, increased by $22.3 million or approximately 55%, 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 basis NOI growth. .

On a same property basis, third quarter cash NOI increased $771,000 or 2%. Same property cash rental income increased approximately $1.1 million or 1.6%, compared to the third quarter last year, while same property operating expenses increased $287,000 or 1%. Our same property cash basis NOI margin was 58.4% in the third quarter.

Although same property occupancy decreased by 80 basis points to 94.6% at quarter end, we were able to achieve same property cash NOI growth as a result of the impact of rent increases from recent lease renewals, the burn-off of free rent concessions for certain leases, and only modest expense growth. .

Turning to our consolidated financial results. Normalized FFO for the third quarter was $53 million, which is up 33.7% from $39.6 million for the 2017 third quarter. This increase was primarily the result of the FPO acquisition, which closed in October 2017. .

Normalized FFO per share for the 2018 third quarter was $0.53, which is up $0.12 from the 2017 third quarter.

Normalized FFO per share was favorably impacted this quarter by the timing around capital raising activities in the third quarter of last year, when GOV issued 27.9 million common shares to pre-fund a portion of the FPO acquisition, which did not close until the subsequent quarter. .

G&A expense for the third quarter was $22.4 million, which is up $19 million from the 2017 third quarter.

G&A expense in the third quarter includes $16.2 million of incentive management fee expense accrued in the quarter, based on the outperformance of GOV's common shares versus the benchmark index from January 1, 2016 through the end of the third quarter. This expense accrual is not included in the calculation of our third quarter normalized FFO. .

As a reminder, the ending share price used to calculate total return for the incentive fee is based on the highest tenth consecutive day average closing price over the final 30 days of the measurement period.

This methodology had the effect of excluding the drop in GOV's share price following the announcement of the potential merger with SIR in the quarter-end calculation. .

As calculated as of October 31, there is no incentive fee payable by GOV for 2018. .

Turning to capital expenditures and the balance sheet. In the 2018 third quarter, we spent $6.7 million on recurring building improvements and $4.1 million on tenant improvements and leasing costs. As of quarter-end, we had approximately $34 million of unspent leasing-related capital obligations. .

At September 30, GOV's ratio of debt to total gross assets was 56.1%. And for the quarter, debt-to-annualized adjusted EBITDA was 7.3x.

Pro forma for the repayment of debt with proceeds from the sale of our investment in SIR common shares and the 20 properties under contract for sale, debt to total gross assets was 43.2% and debt to annualized adjusted EBITDA was 6.4x for the quarter. .

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

[Operator Instructions] And the first question comes from Bryan Maher with B. Riley FBR. .

Quick question on the sales asset outlook for 2019.

Has that changed at all as it relates to what you're looking to market in 2019? And are you seeing any change in cap rates when you have discussions with potential buyers?.

Sure Bryan, good question. We've spent a fair amount of time looking at the assets we identified for sale in 2019 as part of the merger. And it began the process of getting broker opinions of value and marketing plans, so we can be prepared to hit the market in early 2019.

We haven't really seen any change at this point in terms of cap rate expectations. Definitely, on the acquisition side, we are seeing assets continue to trade at relatively low cap rates, and there has been no increase in cap rates as rates have increased. I don't know that it's sustainable, but as of today, we're not seeing a change in pricing. .

And can you share with us the cap rates achieved on the assets that are pending closing? Or do you prefer to wait till they close?.

Yes, Bryan. We typically wait until they close. So we should be able to do that at year-end's earnings announcement. .

And then as it relates to the vacate properties, there seems to be a couple of new ones in there from the government.

What kind of reasoning are they giving you on the vacates?.

Another good question, Bryan. You don't always get a reason. We added a relatively large lease to the at-risk category this quarter. And it's really -- we added it to the at-risk, because it's really unclear as to whether or not they're going to renew or not.

We -- I think, there's still a chance that we can renew them or another government agency in that place. But we would rather be conservative in how we look at that. When I look at the at-risk report, substantially, all the tenants that we've identified at-risk are potential downsizing.

And so we're still seeing a little bit of an effect from the increase in utilization rates. And a couple of buildings where we may have had the GSA under a single lease, but there were 5 or 6 agencies that were occupying space in the building, and we're now breaking them out into individual leases. .

And then lastly for me. How should we think about the next couple of weeks as we approach a vote on GOV and SIR? I mean, it would seem that the SIR votes are effectively in the bag with you guys controlling 30% of that vote. But we're increasingly getting calls from GOV shareholders, asking the prospect for the vote on the GOV side to not go through.

So how are you thinking about that? And how are you planning on marketing this deal to investors over the next several weeks?.

Sure, it's another good question, Bryan. We have a high degree of confidence that we will get the shareholder vote for both GOV and for SIR. Quickly, the threshold for the SIR vote is 50% of outstanding shares, of which GOV and insiders control about 30% of those shares. So we're pretty well positioned as it relates to SIR.

On the GOV side, it's 50% of votes cast at the shareholder meeting. So we obviously have to get a quorum. But the threshold there is much lower. And if you look at GOV's top 10 shareholders, they control almost 50% of outstanding shares.

So our expectation is that once Glass Lewis and ISS publish, which will be after we set a shareholder meeting date, we will reach out to our top investors and begin to have conversations. Because most of them really won't focus until such time as ISS and Glass Lewis publish. So I think we're pretty well positioned on both sides, Bryan.

And again, we are highly confident that we will get the vote on both sides. .

And the next question comes from Adam Gabalski with Morgan Stanley. .

I just had a quick question on some data in the proxy statement. It looks like in the financial prospects for a standalone GOV, in 2019 and 2020, there's some pretty significant CapEx spending built in there. I was just wondering if you could talk a little bit about where that money is going and what your thoughts are around that capital allocation. .

Well, Adam, a lot of that capital is leasing capital. And it obviously, has a lot to do with our continued leasing velocity, which has been strong. And as you can see during the quarter, our capital ticked up a little bit at $4.41 per square foot per lease year.

Now that's not necessarily what all leases are going to be at, but as we are seeing with the U.S. government, the trend is to do longer duration leases. So this quarter, we had almost a 20-year weighted average remaining lease term for the leases executed. And that has an impact on capital.

So that combined with the fact that just the volume of leases that are expiring in 2019 and the $34 million of capital that we have committed, but is unspent, is really what's driving that.

Does that make sense?.

Yes, absolutely. I appreciate the color there. And then just on the mark-to-market on leasing for non-government tenants this quarter was pretty much flat.

I was just, sort of, wondering where you, kind of, see that tracking into the leasing that's coming up in '20 -- 4Q '18, early '19? And what you, kind of, estimate that embedded mark-to-market is within the current portfolio?.

Yes. It's -- honestly, the experience that we've had with our non-government tenants has been more roll downs in rent, I mean, if you look over the last 4 quarters, we've had more roll downs than roll ups. I think, in the Q, which we typically discuss our expectation for the next 12 months, we think it's flat to slightly down. .

And this is the end of the question-and-answer session, so I would like to return the floor to David Blackman, for any closing comments. .

Thank you. Before concluding today's call, I'd like to take a moment to congratulate Mark on his retirement and thank him for as many years of service at RMR, and for his contributions to our managed companies. Mark's expertise and contributions have been essential to RMR's growth and success. Mark, you've been a great partner and a trusted adviser.

I think, I speak for everyone at RMR in wishing you a joyful retirement. .

Operator, that concludes our call. .

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