Good morning, and welcome to the Office Properties Income Trust Third Quarter Financial Results Conference Call. [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; Chief Financial Officer and Treasurer, Matt Brown; and Vice President, Chris Bilotto. In just a moment, they will provide details about our business and our performance for the third quarter of 2019.

We will then open the call to 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 us our 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, November 1, 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 basis 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 CAB, 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 third quarter earnings call for Office Properties Income Trust. As Matt will discuss in greater detail, this morning, we announced normalized FFO per share of $1.45, which beat consensus estimates by $0.05 per share.

We also announced solid third quarter leasing activity with almost 760,000 square feet of new and renewal leases for an average lease term of almost 13 years, a 5% roll up in rent and leasing capital of only $1.82 per square foot per lease year.

In addition, we increased consolidated occupancy by 170 basis points from the second quarter of 2019 to 93.3%. Chris will provide greater detail on these results when he reviews our operations.A major strategic focus for 2019 has been rightsizing our leverage.

Year-to-date, we have sold or entered agreements to sell 60 buildings for $731.5 million at a cap rate of 5.6% for buildings that have an average age of 22 years and average occupancy of 71% and an average remaining lease term of 4.5 years. These key portfolio metrics are less favorable than the portfolio metrics of OPI's consolidated portfolio.

We also eliminated more than $170 million of capital costs at OPI over the next 5 years by selling these assets.At the end of the second quarter, we sold 12 buildings for $298.1 million. And as of today, have agreements to sell 10 buildings for $135.9 million.

In July, we sold all of our common shares in The RMR Group for net proceeds of $105 million, which increases our aggregate asset sales proceeds since the end of the second quarter to more than $400 million.

Not only have these asset sales improved a number of key property metrics for OPI, we also reduced our leverage ratio to 6.2x, which is below the midpoint of our targeted range.

Assuming we sell the 10 buildings under agreement for $135.9 million, our pro forma leverage declines to approximately 6x, which is the low end of our targeted range.As a result of achieving our leverage target during the third quarter, we are transitioning our principal strategic focus from deleveraging to acquiring core properties with proceeds from asset sales, which we refer to as our capital recycling program.

The goal of our capital recycling program is to create long-term dividend growth by acquiring properties with higher cash flow after capital costs than properties we are selling.

As additional benefit, we expect our capital recycling program will reduce the average age of our properties, extend the weighted average term of our leases, improve the prospects of renewing tenants and help us shape the geographic and tenant diversification across our portfolio.Our acquisition team is busy identifying single-tenant buildings with average ages of 10 years or less that are encumbered with first-generation leases for 7 years or longer terms and that are located in markets where we believe we can grow rent over time.

We also expect to continue acquiring buildings leased to government tenants, which can be both single-tenant and multi-tenant buildings, but most importantly, where the agency occupant has high security requirements, which we believe improves the prospects of renewing tenant leases.

This is an exciting transition for our company, and we look forward to updating you on our capital recycling progress during future calls.I will now turn the call over to Chris Bilotto to review OPI's leasing activity and operating statistics.

Chris?.

Thank you, David, and good morning, everyone. As of September 30, OPI's portfolio consisted of 200 buildings containing 27.3 million square feet with a weighted average lease term of 5.7 years. During the quarter, occupancy increased 170 basis points from the second quarter to 93.3%, primarily as a result of our property sales.

63.9% of our annualized rent is paid by investment grade-rated tenants, which we believe is one of the highest percentages of revenue from investment grade-rated tenants in the office REIT sector. The U.S.

government remains our largest tenant, accounting for 25.8% of annualized rent and no other tenant accounts for more than 3% of annualized rent.Turning to our leasing and operating results for the quarter.

During the third quarter, we continued our strong leasing activity, entering into new and renewal leases for 759,000 square feet with a weighted average lease term of 12.7 years, leasing concessions and capital commitments of only $1.82 per square foot per lease year and a weighted average rollup in rent of 5%.

Year-to-date, our leasing activity has generated a weighted average rollup in rent of 5.5% and a weighted average lease term of 9.1 years, helping to advance our goals of driving internal growth and extending our consolidated weighted average lease term.As a result of our third quarter leasing activity, we anticipate a full year 2019 rollup in rent, instead of rents remaining flat for the year.

We continue to have a robust leasing pipeline as we are in active discussions with tenants for more than 2.1 million square feet of space, including 336,000 square feet that would absorb vacant space across the portfolio.Now to highlight a few leasing transactions that helped drive third quarter results.

We had entered into new -- we entered into 2 large renewals of government tenants, one is a 20-year transaction with the Defense Intelligence Agency for a 16.9% roll up in rent on a 266,000 square foot single-tenant building. The other is a transaction with the Department of Homeland Security for 170,000 square feet for approximately 5 years.

In one of our West Coast buildings, we renewed a nongovernment tenant and 61,000 square feet with a 58% roll up in rent and a weighted average lease term of 7.8 years.

We believe these renewals complement OPI's business plan for having high tenant retention and for lengthening our consolidated weighted average lease term.As we continue our deleveraging efforts, we will continue our focus on tenant retention and operations through leveraging The RMR Group's asset and property management teams.

We believe the combination of our experience and RMR's local presence in more than 30 offices across the U.S. provide a distinct advantage for having competitive buildings, tracking market trends and demand drivers and building strong relationships with both our tenants and leasing brokers.Turning to operations.

We are harnessing new technologies and data analytics to drive operating efficiency and to be a market leader in environmental sustainability. An example of these efforts is the use of real-time energy monitoring and data analysis to manage our energy performance in approximately 25% of OPI's portfolio.

Phase 1 of this effort has resulted in a year-to-date reduction in energy consumption of 6 million kilowatt hours that has a payback of less than 1 year.

Implementation of this program has resulted in measurable operating expense savings of $800,000 year-to-date, limits OPI's exposure to increasing energy costs and supports OPI's initiative to reduce portfolio's carbon footprint through its sustainability efforts.In addition to receiving a number of property-level environmental awards this year, both OPI and The RMR Group earned the distinguished ENERGY STAR Partner of the Year Award.

The RMR Group also won the Real Estate Management Excellence Award for Employee and Leadership Development from the Institute of Real Estate Management and -- at its 2019 Global Summit in September. This award recognizes RMR's programs and initiatives for recruitment, onboarding, retention and professional development.

We believe the breadth of strength and recognition of these programs help RMR attract and retain high-quality employees and are a testament to the benefits we receive from RMR shared services platform.I will now turn the call over to Matt Brown to provide an overview of our financial results, balance sheet and capital needs.

Matt?.

Thanks, Chris, and good morning, everyone. OPI's results for the third quarter and 9 months ended September 30, 2019 include the impact of the merger with Select Income REIT, or SIR, which closed on December 31, 2018.

In addition, OPI has sold $585 million of properties during the 9 months ended September 30, 2019, including $287 million during the third quarter. The impact of these events has driven the majority of the changes in OPI's consolidated financial results as compared to the same period in the previous year.

As a result, our discussion on consolidated results will focus on changes as compared to the second quarter of 2019.Earlier today, we reported normalized funds from operations, or normalized FFO, for the third quarter of $69.7 million or $1.45 per diluted share.

This compares to normalized FFO of $79.3 million or $1.65 per diluted share for the second quarter of 2019.

The decline in normalized FFO on a sequential basis is a result of our property dispositions during the third quarter, and certain items that increased net revenue by approximately $8.2 million or $0.17 per diluted share in the second quarter that were discussed on last quarter's call.G&A expense for the third quarter was $8 million, which compares favorably to G&A expense of $8.7 million for the second quarter of 2019.

The decline in G&A expense is mainly the result of a reduction in our business management fee paid to RMR due to the reduction in our total market capitalization from the debt we paid with disposition proceeds, partially offset by appreciation in OPI share price.

As of September 30, OPI did not accrue any estimated business management incentive fees.Interest expense for the third quarter was $32.4 million, a decline of 8.4% as compared to interest expense of $35.3 million in the second quarter of 2019.

The decline in interest expense is mainly the result of $711 million of debt repayments during the 9 months ended September 30, 2019, including $375 million repaid in the third quarter, net of borrowings on our revolving credit facility.Now turning to property level results for the quarter.

We have included quarterly pro forma same-property information in our earnings release and supplemental as if the SIR merger had closed on January 1, 2018. On a pro forma same-property basis for the third quarter of 2019, property cash basis net operating income, or NOI, declined 7.1% compared to the third quarter of 2018.

The decline was mainly driven by a decline in same-store occupancy of 250 basis points from 95.8% at September 30, 2018, to 93.3% at September 30, 2019, and the collection of previously recorded bad debts of $2.6 million in the third quarter of 2018 due to a tenant settlement.

On the property operating expense front, we incurred increases in real estate taxes, repairs and maintenance and insurance costs, offset by a reduction in utilities of approximately $612,000, mainly due to the efforts of RMR's corporate engineering and sustainability team that Chris previously mentioned.I'd like to take a moment to highlight the efforts of RMR's real estate tax abatement program through which its managed companies benefit from aggressive pricing due to the size of the RMR managed companies platform.

Over the past 5 years, this program has successfully reduced aggregate assessed value by $1 billion for all companies and has generated real estate tax savings in excess of $20 million.

OPI's benefit from this program over the past 5 years is approximately $700 million in assessed value reductions and real estate tax savings in excess of $13 million.I will now switch focus to discuss capital and ongoing deleveraging efforts.

We spent $27 million on recurring capital during the third quarter, including $11 million on building improvements and $16 million on tenant improvements and leasing costs. Our recurring capital is below our 2019 estimate, mainly due to the timing of leasing capital.

This has created greater cushion in our current CAD payout ratio than our target payout ratio of 75%.

As of quarter end, we had approximately $56.5 million of unspent leasing-related capital obligations, of which 45% represents tenant managed TIs and $17 million cannot be spent until future years.Lastly, as it relates to capital expenditures, it is important to note that we have eliminated approximately $87 million of future capital over the next 5 years from properties we have sold during 2019.

As mentioned on last quarter's call, in July, we sold our 2.8 million shares of The RMR Group and received net proceeds of approximately $105 million, which was used to pay down our term loan. At September 30, OPI had $210 million outstanding on our $750 million revolving credit facility.

During the quarter, we repaid the $170 million remaining on our term loan and repaid our $350 million unsecured senior notes that were due in August 2019, with proceeds from asset sales and borrowings under our revolving credit facility.As David previously stated, we are pleased to announce OPI's net debt to annualized adjusted EBITDARe is within our long-term target range and ended the quarter at 6.2x.

We currently have $185 million outstanding on our revolving credit facility, which we plan to reduce with the proceeds from the property currently under agreement to sell.Operator, that concludes our prepared remarks. We're ready to open the call up for questions..

[Operator Instructions]. The first question will be from Mitch Germain with JMP Securities..

You previously had talked about year-end occupancy level, I think it was like a mid-91% area. I know you've got a pretty elevated amount of expirations in the fourth quarter for just a traditional quarter. I guess more than next year's number.

How do we think about how that plays out over the course of the next couple of months?.

This is Chris. I think the way we want to look at that is over the next 4 quarters, we have about 2.7% of revenue that'll expire due to tenant vacancy. Roughly $1.5 million of that is revenue in 2019.

And so as noted in our remarks earlier, we're in active discussions with tenants that represent about 2.1 million square feet with absorption potential of 336,000 square feet. So we see kind of that as a measure to help drive occupancy..

Yes. So Mitch, as we finish the year, we expect that we're going to have some tenants move out and assuming no new absorption, we could have about 100, 120 basis points of pressure on occupancy at year end. And then maybe another 120 basis points in 2020..

That's helpful. David, I really appreciate all the color on asset sales. I think some of the sales that you had mentioned that were completed were part of the original FPO deleveraging plan.

So I guess what I'm trying to figure out is, as of last quarter, you said you've got about $630 million of sales that were targeted for the SIR-GOV merger, and I'm just kind of curious where that $630 million stands.

Or has that $630 million changed?.

So Mitch, in the number I quoted, the $761 million, roughly $195 million of that completed the deleveraging from the First Potomac acquisition. The balance is associated with deleveraging from the merger with SIR.

We have, in addition to the 10 properties we have under agreement to sell for $135.9 million, we have another 8 buildings that we are actively marketing, which would have proceeds of anywhere from, call it, $50 million to $100 million.

We've also identified a few other properties that would be targeted as part of our capital recycling program, where we are talking with brokers, evaluating their marketing plans and trying to decide who we might want to hire to sell those assets..

Excellent. That's great color. My last question is -- the February notes that are coming due in 2020, I think it's $400 million at 3.6% coupon. I'm curious about what your plan is for that..

This is Matt. So today, we have $185 million outstanding on our line of credit. We have about $136 million of properties under agreement to sell. So we have plenty of capacity on our line of credit to pay down those $400 million of notes coming due in February..

So the goal is to pay them off rather than to reissue something?.

At the current moment, yes..

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

This is Jason on for Mike.

I'm just wondering, what are the expectations for closing of these additional dispositions? And will the properties that are still under agreement, are you planning on having those closed by year-end? Or some of those going to push into 2020?.

Yes, good questions. So the properties that we have under agreement are all in various stages of diligence right now. I think the vast majority would close by year-end, but we have a couple that could close in January or February.

But I would expect that assuming diligence completes as expected, they will all be closed by the time we have our fourth quarter earnings call. It's hard to say on the stuff that we're marketing. I think the real takeaway is that we have achieved our target leverage. We are now more focused on replacing assets as we sell assets.

So we are actively looking to buy properties and to do it in a way that increases our cash available for distribution..

Got you.

So the additional properties that are being marketed then, we shouldn't necessarily expect those to come in a big chunk like you've been doing over the last few quarters that might be a little more opportunistic and not all at once?.

Yes. I think that's generally correct. I mean what we have marketing right now is not what I would consider material. So it's not going to have a big impact on FFO or CAD. And assuming we are successful in identifying assets to buy, you will see us begin to replace that FFO and CAD..

Okay. And then last question. It's not that you're turning your eye towards deployment, just wondering kind of what's your plan on the acquisition front.

What type of capital recycling opportunities you're seeing in the market? And if there's any specific markets that specifically are catching your eye?.

We are predominantly focused on live-work-play markets, where we believe there's employment and population growth that will help drive our ability to grow rents over time. Those tend to be markets like a -- southeast markets like North Carolina, some of the -- Texas markets like Austin.

Those are the types of markets that we find attractive right now, mostly because we think we can grow rents over time, which we think is important..

Our next question comes from Adam Gabalski with Morgan Stanley..

Just as you've gotten a little bit deeper into the asset disposition plan, can you just talk a little bit about what you're seeing as far as pricing relative to your initial expectations? Did it come in a little above? A little below? Or sort of roughly in line with what you were expecting?.

Well, I think when we first started talking about our disposition program, we had talked about selling assets at an average cap rate of between 7% and 7.5% and what we have sold year-to-date at a 5.6% cap rate. So I think we've been reasonably pleased with the pricing for the assets we've sold..

Great. And then just one more. I know you talked a little bit about the moving pieces for occupancy at year-end and into 2020.

Are there any major known move-outs over the next 12 months, where the tenant's already communicated to you that they're planning to vacate that are going to become potential hold in the portfolio?.

Yes. I think Chris talked about approximately 2.7% of rents would be expiring over the next 12 months that we think are with tenants that will vacate. Approximately 1.5% of that would be in the fourth quarter with the balance being in 2020..

[Operator Instructions]. The next question comes from Bryan Maher with B. Riley FBR..

A lot of helpful information there.

On the dispositions that you have under contract, are they also at a similar, roughly, 5.6% cap rate or something different?.

The 5.6% cap rate includes those properties that are under purchase and sale agreement currently..

Okay. Great. And then on your balance sheet with leverage now down around 6.2, headed, it seems closer to 6x.

I'm assuming that secures your investment-grade rating on the REIT?.

Yes. S&P published a report on us last week, reaffirming our investment-grade rating with a stable outlook. We expect Moody's to go to committee in the next month or so. And that's where we are currently..

Okay.

And then can you talk a little bit about what the potential for rent increases are on the portfolio once the dispositions are completed, as we look out to 2020 and 2021?.

Yes. I mean I think that we're still looking at that 2% to 3%, which is the number that we've continued to talk about. I think that's consistent kind of with what we're seeing with just the overall roll up in rent with leases that are being completed..

Yes, Bryan, a lot of that depends on how the economy continues to perform. I mean I read a piece this morning where an economist is expecting continued growth in GDP over the next 3 to 5 years. If that is true and plays out that way, that will help us continue to drive rents.

But if you see a contraction in the business cycle quicker than that, that will obviously have pressure on rents. To kind of circle back on the investment-grade rating, Moody's has not been clear with us as to how they expect committee to go. We feel like we've done what they've asked of us to do.

Our leverage is well online, and we're turning our eyes to our growth. So we're relatively optimistic, but we still -- we obviously don't control what Moody's decides to do with our rate..

Okay. And then kind of lastly for me, a two part question.

What is the supply outlook looking like in your key markets? And where do you see the biggest opportunities over the next 12 to 18 months to drive occupancy higher?.

Well, I would say there's 1 market in the country where there is supply growth that could have a negative impact on us over the next, call it, 3 years, and that's Sacramento, where there's a couple of buildings being built downtown. That's really the only market that we have exposure to with increasing supply.

So I think that's why in Chris's comments, we're relatively bullish on our ability to grow rents..

Ladies and gentlemen, 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, operator. When we announced our merger with Select Income REIT, we said we would sell assets to reduce our leverage ratio to between 6 and 6.5x, and we have done exactly that. We are now transitioning our attention to a capital recycling program that we expect will create long-term dividend growth and positively reshape our portfolio.

This is in addition to our continued commitment to successfully operating our properties, renewing leases, growing rents and leasing vacant space across our portfolio. Thank you for joining us today. Operator, that concludes the call..

And thank you, sir. The call has now concluded. Thank you for attending today's presentation. You may now disconnect..