Good morning, and welcome to the Office Properties Income Trust First Quarter 2019 Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Olivia Snyder, Manager 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 Executive Officer, David Blackman; and Chief Financial Officer and Treasurer, Jeff Leer. In just a moment, they will provide details about our business and our performance for the first quarter of 2018.

We will then open the call to your question-and-answer session with 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, May 3, 2019, 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, and cash-based net operating income, or cash basis NOI.

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 also can be found on our website. And now, I will turn the call over to David..

Thank you, Olivia, and good morning. Welcome to the first quarter earnings call for Office Properties Income Trust. On today's call, I will discuss our leasing activity for the quarter and provide an update on our disposition program before turning the call over to Jeff Leer to provide an overview of our financial results and balance sheet.

As of March 31, OPI's portfolio consisted of 212 buildings containing 30.1 million square feet that were 89.6% occupied, with a weighted average lease term of 5.9 years.

65.7% of our annualized rent is paid by investment-grade rated tenants, which we believe is one of the highest percentages of investment-grade rated tenants in the office REIT sector. The U.S. government is our largest tenant, accounting for 25.8% of annualized rent, and no other tenant accounts for more than 2.9% of annualized rent.

We generated strong leasing results during the quarter in our new and renewal leases for more than 825,000 square feet for a weighted average rollup in rent of 12.8%, a weighted average lease term of 7.5 years and leasing concessions and capital commitments of $4.67 per square foot per lease year.

Almost 600,000 square feet or approximately 70% of our executed leases were for terms of seven years or longer. Now let's review our dispositions. We advanced our disposition program during the first quarter, having closed on $268.5 million of property sales. This includes the sale of a 34-building portfolio located in suburban Metro D.C.

for gross proceeds of $198.5 million and the opportunistic sale of 501st Street in Washington, D.C. for $70 million, which is more than $540 per square foot. By selling 501st Street, we eliminated approximately $26 million of budgeted capital in 2019 and 2020 to renovate and re-lease the building.

We also eliminated a drag on earnings as we estimated it could take up to three years to stabilize the property. We continue managing through the sale of 33 properties where the proceeds will be used to reduce leverage to our long-term target.

One property valued at approximately $15 million was removed from our marketing campaign this quarter, while we negotiated potential building expansion and lease extension with a tenant.

For the remaining 33 properties in the disposition program, six properties are either under agreement or have been awarded to buyers and purchase agreements are being negotiated for $75.4 million in aggregate. Under normal circumstances, we expect the property to sell within 60 days of executing an agreement.

22 properties have had at least one round of offers, and we are relatively close to selecting buyers. Our typical sales process includes two rounds of offers and interviewing the top bidders before selecting a buyer. Five properties have first round offers scheduled within the next two weeks, and buyers should be selected by the end of May.

Overall, we are encouraged by the market interest in our disposition properties and believe we are well positioned to discuss the completion of a number of property sales on our next earnings call.

Once we complete the sale of these 33 properties, we expect to roll into a capital recycling program that shape our key portfolio metrics to manage ongoing capital requirements and to reenter the acquisition market for accretive growth.

We expect our acquisitions to focus on first-generation buildings because we believe tenants have a higher probability of renewing leases in these buildings and capital requirements will be lower.

This is expected to have a positive impact on occupancy and our long-term cash accretion, which we believe will contribute to maintaining our well-covered dividend. I will now turn the call over to Jeff to provide an overview of our financial results and balance sheet.

Jeff?.

Thanks, David. OPI's results for the first quarter of 2019 represent the full quarter impact of the merger with Select Income REIT, or SIR, which closed on December 31, 2018. As David previously discussed, in conjunction with the merger with SIR, OPI also closed on $268.5 million in asset sales during the quarter.

The impact of these events has driven the majority of the changes in the overall financial results as compared to the same period in the previous year. Our focus for this presentation regarding trends will be geared towards comparisons on a same-property basis.

In addition, we have included quarterly pro forma same-property information in our disclosures as if the SIR merger had closed on January 1, 2018. Now turning to property level results for the quarter.

On a same-property basis, for the quarter ended March 31, 2019, rental income decreased $1.9 million or 2.1% year-over-year and pro forma same-property cash basis NOI was $107 million, or a 2.8% decline on a year-over-year basis. Both of these comparisons were driven by overall declines in occupancy.

Turning to our overall consolidated first quarter financial results. The results were positively impacted by a non-cash unrealized gain of $22.1 million attributable to OPI's investment in the RMR Group Inc., a $22.1 million gain on the sale of 501st Street in Washington, D.C.

in March, offset by a $3.2 million non-cash impairment charge, primarily related to one of our buildings under agreement for sale. Normalized funds from operations, or normalized FFO for the first quarter was $73.3 million or $1.53 per diluted share.

G&A expense for the quarter was lower than that of the same period in the previous year due to the reduction in base business management fees which are currently being calculated under market capitalization because it is lower than the historical undepreciated cost of assets.

As of March 31, 2019, OPI did not accrue any estimated business management incentive fees. Based on OPI's current share price and base business management fees being calculated on market capitalization, we would expect G&A expense to be within a range of $7 million to $9 million on a quarterly basis for the remainder of 2019.

I would now switch focus to discuss capital and ongoing deleveraging efforts. We spent $4.3 million on recurring building improvements and $12.2 million on tenant improvements and leasing costs in the first quarter of 2019. As of quarter end, we had approximately $63.6 million of unspent leasing-related capital obligations.

At March 31, OPI's ratio of debt to gross assets was 57.5% and we had $80 million outstanding on our $750 million revolving credit facility. We used proceeds received from our property sales in Q1 to pay down $257 million of principal debt, which included reducing unsecured floating-rate debt by 44% to an outstanding balance of $315 million.

OPI's debt to annualized adjusted EBITDA was 6.9x at quarter end. As we've previously stated, during 2019, we intend to reduce our leverage with the proceeds from our property disposition program to achieve our target debt-to-EBITDA of 6x to 6.5x. Operator that concludes our prepared remarks. We're ready to open the call up for questions..

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Bryan Maher of B. Riley FBR. Please go ahead..

Yes. Good morning and excellent quarter. On the occupancy front, dipping below 90%, David, I think I recall you saying in the last quarter or so that you're expecting, with all of the asset sales, that ultimately we'll end up seeing an occupancy improvement, but we could see some vagaries along the way.

Do you still think that that's the case and that we should be nicely into the 90s by year-end?.

Yes. Bryan, I definitely agree with that. I think we'll be above 90%. I mean the average occupancy on the disposition properties is below 80%. So as we continue to sell assets, that will have a positive impact on occupancy. We also have a pretty strong leasing pipeline right now.

We've got well over 2 million square feet of leases that are in various stages right now. Of that, I think we've got over 400,000 square feet that could absorb vacant square feet and help improve our occupancy. So I think we're pretty well positioned right now to actually start turning occupancy around.

Great.

And then as you're working through the sales process in the first half of this year, are cap rates on what you sold and or kind of in the process of selling currently kind of in line above or below what you thought as we entered the year?.

Bryan, I think they're generally in line. I think that as I look at the broader acquisition market, there is some softening in what I consider high core space. So long-term lease, credit quality tenants, there's less capital chasing those deals today. That tends not to be what we're selling.

If I look at what we have under agreements or where we have received offers, and I aggregate that together and look at the third quarter NOI, we will likely achieve a cap rate on our sales below 8%. So I'm pretty encouraged by that and feel like we're pretty well positioned right now..

All right.

And then, as it relates to the economy, which has been pretty much, for lack of a better word, on fire, and with employment rates low? How is that impacting your discussions with potential buyers? Do you feel like you're coming with a little bit more strength to the table than maybe you would've been in December when things were a little bit more uncertain?.

It's a good question, Bryan, and I don't know that I would say it's materially different at this particular point. I think the one thing I think in the back of everybody's mind is we're 10 years into a cycle, and that's a long time into the business cycle.

So while the economy looks very strong and the numbers that we're seeing are encouraging, I think everybody continues to be somewhat skeptical about continued long-term growth..

Okay.

And then I think, and I might be wrong with this, I think you have about 10% of the annualized rental income expiring in 2019? I know that there's a lot of moving parts with the asset sales, and some of these might be involved there, but do you have any thoughts on the amount of vacates in that 10%?.

I'm pretty encouraged by the active leasing pipeline we have right now, Bryan. And we don't have - I think we have one tenant that we think will vacate sometime during 2019 that represents more than 1% of rent. So I think we're going to have a pretty good year for tenant retention and continue to be a market leader in that stand..

And then just last for me. On your RMR shares, I wouldn't think that you'd be a seller at current levels for RMR. But I just want to clarify that you're delevering down to the 6%, 6.5% range.

Would that not include the assumption that you would sell the RMR shares?.

Right now, we believe that we can achieve the low end of our long-term target on leverage without selling the RMR shares..

Thanks David. That's all for me..

Great. Thank you..

The next question comes from Mitch Germain of JMP Securities. Please go ahead..

Good morning. So David, just confirming that the D.C.

portfolio was part of the FPO deleveraging strategy, right? So the 33 assets are basically going to equal around the $750 million that you targeted on sales, right?.

That is correct..

Okay, great.

Are you selling any portfolios, or are these individual asset sales?.

We have a few small portfolios, Mitch. When I say small, they are anywhere between two properties and four properties, but in all circumstances, we may be marketing two to four assets together in one book with a single broker, but we are entertaining individual bids on those properties as well..

And it seems like you're selling assets with some leasing needs and some capital needs.

Is that - how did you kind of characterize - what sort of criteria did you use to identify which assets are the ones that are for sale versus to retain in the portfolio?.

Mitch, we selected a handful of properties with good tenants that are very well leased, with a pretty good weighted-average remaining lease term. And those are some assets that I consider a little bit more core. And then we've also got some in here that maybe are little bit older.

They're well occupied, but there a lot of capital that may be needed to spend over the next three to five years. So it's a pretty good mix. What I consider upper-tier assets, middle-tier assets and then we've got five or six - I guess, we have four vacant properties that we're selling..

Got you. Federal government 26% when you factor in some of the state, obviously much higher.

Is that along the lines with what you're looking for in terms of tenant mix? Or is there a thought about reducing some of the government exposure?.

Well, we substantially reduced our government exposure by combining GOV and SIR. We went from kind of 46% U.S. government exposure down to our current level. So I think we've gotten pretty decent diversification.

I think from our perspective, we are more focused on the type of government buildings we acquire going forward, meaning that they have may be higher security requirements, they're younger buildings so that we spend less capital and we have a higher likelihood of renewal. So I think that's more our focus than trying to say we maintain our U.S.

government exposure above 20% to 25%..

Got it. Thank you..

Thank you..

The next question comes from Vikram Malhotra of Morgan Stanley. Please go ahead..

Hey, guys. This is Adam here on for Vikram. I just wanted to talk a little about your capital recycling comments in the prepared remarks. You said you're going to start to roll into that as the disposition program kind of wraps up.

Is that the type of thing where we could kind of see start to be more active even towards the end of this year and maybe have that sort of benefiting FFO in 2020?.

Yes..

And so do you have any - just to quickly follow-up, any idea on - just relating to your leverage target, how you'd be planning to fund the incremental acquisitions, and if you'd be sort of comfortable taking debt up after bringing it down with the asset sales if you see accretive deals in the market?.

Adam, I think there's a reasonable probability that during the third quarter, we'll have leverage down below 6%. And the idea of the capital recycling program - excuse me, 6x.

The idea of the capital recycling program is to create CAD accretion by selling some assets that may be a little bit older and may have higher capital needs, into assets that are longer duration lease, younger and have less capital needs.

So while we may not ultimately grow substantially our total assets, we expect that we would grow our CAD through the capital recycling program.

Does that make sense?.

Yes, absolutely..

Yes. It's a repositioning of the portfolio to a different asset age..

Correct..

Got it. And then just one more. It looks like part of the beat this quarter came from lower property operating expenses.

Can you just sort of talk about how you kind of see that trending moving forward now that you have the GOV and SIR portfolios integrated and just sort of reconcile what you kind of put in the pro forma numbers that you've put in last quarter's supplemental, and then sort of the way things shook out this quarter and any sort of variances that you've seen?.

one, lease type and our ability to pass back certain costs to our tenants; and two, it's about how we continue to try to maintain certain staffing levels and our utility expenses at the property level..

Got it. Thank you..

The next question comes from Michael Carroll of RBC Capital Markets. Please go ahead..

Yes. David, I wanted to touch on, I guess, the acquisition targets that you're currently looking at.

I'm assuming that you're looking at deals in the marketplace, if you're thinking about deploying capital towards the end of this year, maybe the beginning of next, what type of first-generation buildings are you looking at? What markets are they in? And what's the targeted cap rates we should assume for those types of deals?.

It's a good question, Mike. I would say, what we are looking at are first-generation single-tenant buildings. And I would say, buildings that tend to be three to five years old that have seven to 10-year remaining lease terms. We're also looking at some multi-tenant buildings that have both U.S. and state governments in it.

They tend to be tenants that we believe will be sticking to the building and buildings where we don't think they're going to be material capital needs on an ongoing basis.

I would say, the cap rates, they're going to be anywhere from, call it, a mid-six to a mid-seven is what we're looking at, and a lot of that is going to depend upon the accretion we think we could create through the capital recycling program and where we ultimately get leverage to..

Okay. And there are markets that you're looking at, or you're looking at top-tier type markets, kind of in and around the D.C.

area where you're having a lot of exposure today, or pretty much throughout the country?.

We are generally not looking in gateway markets. I would say, we're looking in more primary and secondary markets. We will look at stuff in the D.C. Metro market, but we're not - we have a fair amount of exposure in the D.C. Metro market and really aren't looking to substantially grow in that market at this time..

Okay. And then can you talk a little bit about the capital that you've already committed, I guess, on the TI side? I believe it was - you said, $63 million in your prepared remarks.

I mean is that related to leases that have already been signed and commenced? And when should we expect that capital to actually be deployed into the portfolio?.

Hi, the answer to that is, yes, that's capital we've committed to. It is tenant directed, so it's a little bit of a challenge to predict when it will be spent. We try to monitor closely with our tenant base, but it's fairly hard to gauge when they'll actually request those funds..

And those are tenants that are currently paying your rents and are in the portfolio today?.

Correct..

Okay. Great, thank you..

The next question comes from Jon Petersen of Jefferies. Please go ahead..

Great, thanks. Just curious, when you guys announced the merger with SIR, you guys talked about an AFFO payout ratio of 75%, which kind of, now that we know the dividend, kind of back into a number there.

Just curious if you guys are still kind of comfortable with that payout ratio and if you're trending better or worse, and then kind of along those same lines, I think last quarter you talked about $60 million to $80 million of CapEx is what we should expect for the year. Just curious, if that is also tracking.

And I guess what all lines are included in that $60 million to $80 million? Does that include leasing commissions or not?.

Yes. So I think the - we look at CAD payout ratio on an annualized basis. And I believe our target today is, as said, where we believe we can achieve a 75% CAD payout ratio on an annualized basis.

And then for your second question related to capital, we gave a range of $60 million to $80 million, and included in that was building improvements as well as certain - it was mostly building improvements, lease commission, that type of activity..

Okay. And then - so $750 million of dispositions. I'm curious, once you get through that, a lot of that will be the stuff that's sellable today. I think David, you had mentioned early that there are some properties out there that still may be require a few years of investment and make sense to sell out in the future.

So I hope you can help us kind of put maybe a percentage on your portfolio or maybe a dollar value of how much of the portfolio will still be “non-core” once you get through this $750 million program?.

That's a good question Jon. I don't know that we would have a significant portion of the portfolio that would necessarily be non-core. And I think that will change over time as we had better insight into the likelihood of renewing tenants in place and what the capital requirements are going to be.

So I think it's difficult to put a percentage on that because I think that the percentage that's going to change over time. I guess the way I would look at it is we've targeted a capital recycling program in the $100 million to $300 million per year range. And so that's probably the better way to think about it..

Okay, all right. That's helpful. All right. Thank you very much..

Okay. Thank you..

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

Thank you for joining us today. We look forward to updating you on our continued progress in reshaping the company on our next quarterly earnings call. That concludes today's call..

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