ILPT (2019 - Q3)

Good morning, and welcome to the Industrial Logistics Properties Trust Third Quarter 2019 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. Olivia S

Thank you, and good morning, everyone. Thanks for joining us today. With me on the call are ILPT's President, John Murray, Chief Financial Officer, Rick Seidel; and Vice President, Yael Duffy. In just a moment, they will provide details about our business and our performance for the third quarter of 2019, followed by a 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 ILPT's beliefs and expectations as of today, Tuesday, October 29, 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, ilptreit.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, adjusted EBITDA 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 John.

Thank you, Olivia. Good morning, and welcome to ILPT's third quarter earnings call. This morning, we reported third quarter normalized FFO of $28.5 million or $0.44 per share. As of the end of the third quarter, ILPT's portfolio consisted of 300 warehouse and distribution properties with 42.7 million square feet located in 30 states that were 99.5% leased, up from 99.3% last quarter. Approximately 42% of ILPT's annualized rental revenues come from 16.8 million square feet of industrial properties located on the land of Oahu in Hawaii.Our Mainland portfolio consists of 74 properties with 26 million square feet located in 29 states that are 100% leased. We remain focused on bringing leverage down to our long-term target range. Last week, we obtained a 10-year $350 million, 3.33% interest-only fixed-rate loan secured by a portfolio of 11 Mainland properties, which Rick will discuss in more detail later in the call.This is the first step towards a joint venture transaction, which we continue to actively pursue and hope to close in the fourth quarter. Currently, private capital seems to be valuing real estate investments more favorably than the public markets, and we believe this transaction may demonstrate once again the value and quality of our portfolio. Given this new loan secured by the 11 Mainland properties and the loans secured by Hawaii properties, which we announced earlier this year, seeking an investment-grade credit rating for ILPT is not a strategic priority.With confidence that a JV is likely in the near term, during the third quarter, we completed the acquisition of 2 multi-tenant Class A industrial logistics buildings totaling 392,000 square feet for $32.1 million. Properties are located in Columbus, Ohio, near Rickenbacker International Airport, with immediate access to I-270, Rickenbacker's cargo facilities and rail services. The properties are newly built in 2017 and 2018, with attractive characteristics, such as 32-foot clear height, LED lighting with motion sensors and best-in-class loading ratios. The properties are 100% leased with a weighted average lease term of 4.4 years. The primary tenant is Expolanka, also known as EFL or Expo Freight, a global third-party logistics provider that specializes in storage, distribution and multimodal transportation.Also occupying the buildings are TwinMed, medical supply distributor, Forward Air Solutions, a transportation and logistics provider for the air freight market; and William R. Hague, a distributor of water filtration devices. We continue to selectively evaluate acquisition opportunities, even while we manage our leverage down to more normal levels. However, the market for e-commerce-focused industrial properties is very competitive and pricing is aggressive. So I do not anticipate additional significant acquisition activity for the balance of 2019.I'll now turn the call over to Yael to discuss our leasing activity.

Thanks, John, and good morning. As of the end of the third quarter, our top 3 tenants are Amazon, FedEx and Procter & Gamble, representing 14.2%, 4% and 3.7% of total annualized rental revenues, respectively. Investment-grade-rated tenants or subsidiaries of investment-grade-rated parent entities make up 61% of our Mainland revenues.Looking at the entire portfolio, nearly 3/4 of revenues come from those investment-grade-rated tenants or subsidiaries or from our secure Hawaii land leases. Our top 3 markets after Hawaii of 42% are Indiana, Ohio and Virginia, representing 9.7%, 8.9% and 5.1% of our total annualized rental revenues, respectively. As you would suspect with a portfolio that is over 99% occupied, leasing activity in the third quarter was minimal. In Hawaii, we entered new and renewal leases for approximately 99,000 square feet at rents that were 13.4% higher than prior rents for an average lease term of 16.1 years. While the 13.4% roll-up may appear lower than our historical averages, it should be noted that the majority of this activity replaced the lease that was signed in May 2018. As such, this roll-up represents strong growth in less than 1.5 years. Leasing capital and concessions for the third quarter were just $0.44 per square foot per lease year.As mentioned last quarter, 1 Hawaii leased for approximately 1.2 million square feet and $1.9 million of annualized rent was scheduled to reset in 2019. The tenant has chosen to go to arbitration to determine market rent and the hearing is scheduled for early Q1 2020. We expect to see a roll-up in rent and will receive any back due rent increases plus interest.On the Mainland, we have no significant near-term lease expirations with only 10 basis points of total annualized rents expiring over the remainder of 2019 and less than 1% expiring in 2020. We have already begun discussions with these tenants and expect to see renewals and market rents.Turning to capital expenditures. We have made significant progress on the Toro expansion project with $5.2 million of redevelopment capital being spent in the third quarter. As you may recall, we are adding 194,000 square foot expansion to Toro's existing 450,000 square foot distribution facility to accommodate the tenants growing needs. The approximately $15 million project is expected to be complete in December and will result in increased rents of approximately $1 million beginning in 2020.We also invested $1.6 million in recurring capital associated with building improvements on the Mainland for parking lot and roof replacements as well as for site upgrades.I'll now turn the call over to Rick to provide details on this quarter's financial results.

Thanks, Yael, and good morning, everyone. Normalized FFO for the third quarter of 2019 was $28.5 million or $0.44 per share, up from $0.39 per share for the third quarter of 2018. Adjusted EBITDA for the quarter was $43.8 million, up 48% year-over-year. Total rental income for the third quarter of 2019 increased by $20.5 million to $61 million, representing a 51% increase over prior year results. This increase primarily reflects our acquisition activity as well as increases from leasing, rent resets and real estate tax expense reimbursements. This quarter also included a $2 million charge against revenue or $0.03 per share, primarily related to straight-line rent receivables following a tenant default in Hawaii. Our team is working with the tenant to see if a settlement can be reached or if we need to gain possession of the parcels, so we can begin to find new tenants for this space.Total portfolio same-property cash basis NOI increased by 2.4% over the prior year as a result of a 2.9% increase in Hawaii same-property cash basis NOI and a 1.8% increase in Mainland same-property cash basis NOI. This reflects increases in rents from new and renewal leases executed over the past year and contractual rent steps in our leases.General and administrative expenses for the third quarter totaled $4.5 million and depreciation expense was $17.6 million. These expenses have increased from the prior year as a result of our acquisition activity.As John mentioned, last week, we obtained a $350 million mortgage loan secured by 11 of our Mainland properties containing an aggregate of approximately 8 million square feet located in 8 states. We were able to term out a portion of the balance of our floating rate revolving credit facility with this 3.33% 10-year interest-only mortgage, which lowered our borrowing costs and increased our fixed-rate debt to 79% of total debt and increased our average maturity to over 7.5 years as of September 30, 2019. Following the closing of our second large secured financing this year, we believe we have demonstrated our ability to raise attractively priced long-term capital to fund the accretive acquisitions completed earlier this year. And do not believe seeking an investment-grade credit rating would significantly reduce our cost of capital.Interest expense in the third quarter increased by $10.6 million year-over-year to $14.7 million, primarily due to higher debt balances. We finished the quarter with $650 million outstanding on our revolver, resulting in debt to adjusted EBITDA of 7.8x. As John stated earlier, we hope to sell an equity stake in some of our properties to a joint venture partner in the coming months that would reduce our leverage below 7x and demonstrate the value of our Mainland properties. However, even without a joint venture, we continue to operate the business comfortably at our current leverage level, thanks to our stable, predictable and growing cash flows and well-covered dividend at just a 75% normalized FFO payout ratio.That concludes our prepared remarks. Operator, please open up the line for questions.

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

A question on the potential JV, what are you thinking about there with timing? I know you said fourth quarter, but would it be later in the fourth quarter or possibly slip into the first quarter? And secondarily, what type of investors are you speaking with on this? Are they sovereign wealth funds? Are they private equity, what's the type of participant in that?

Our current expectation is that this will close in the fourth quarter and it won't slip, but it's not closed yet, so anything is possible. We've -- we're focused on -- at the present time on sovereign wealth funds as potential JV partners.

And would it take a form similar to what we saw with SNH with the Vertex Pharmaceutical headquarter in Boston, maybe like a 40% or 49% position where you guys keep the majority?

Yes. Initially, yes, that -- we expect it to be similar to the Vertex joint venture that SNH did, with an investment approximately in that range, around 40-ish percent. And -- but I think we're going to -- we're -- aiming to structure this so that we could add additional partners, whereas I think the Vertex joint venture is just one partner. We may have more than one partner in this joint venture.

And you alluded to some tie in between the recent refinancing of the Mainland properties, the 11 properties. Is it just those 11 properties that would be participants in the JV? Or would it be open to many more properties?

The current plan is those 11 plus 1 other property. However, we hope that -- we -- to structure the transaction so that we could potentially grow it. So...

Okay. And then lastly for me, real estate taxes seemed a little bit higher than our expectations for the third quarter. Is there something going on there? Should we consider that kind of the run rate? Or was the third quarter an anomaly?

Bryan, this is Rick. We saw about a $3.6 million increase in real estate taxes, $2.6 million of that was related to acquired properties, and there was about $1 million in comparable property increase. The vast majority of that, almost all of it is related to increased assessment in Hawaii, where taxes went up over 22% or so. So pretty substantial. I certainly don't think we'll see that type of increase again. But this may be the new normal. The good news for us is that the vast majority of our real estate taxes are recoverable under our leases, where -- it's over 90% that's recoverable from tenants. So we're obviously going to work with tenants to appeal the values where we can to try to bring the tax burden down, but this is probably normal for now.

Our next question comes from Mitch Germain with JMP Securities.

So are you creating a fund that you're just going to sell assets that you currently hold? I know you mentioned the 11 plus 1. But or will this be a potential coinvestment fund, where it creates a future growth vehicle that you'll be acquiring new assets as identified?

Yes. It hasn't closed yet. We're still negotiating some of the finer points. But we're hopeful that when we finally have reached agreement, it will be a vehicle that we can use to grow our portfolio as well and not just to finance -- not just a way of financing these 12 properties. So it may be that we add other properties from our portfolio to the joint venture over time. It may be that we acquired new properties with -- through the joint venture vehicle. We may acquire new properties and then subsequently put them into the joint venture vehicle. It really depends on a lot of factors, including where our share price is and market conditions in the public markets as well as in the private markets.

Okay, that's helpful. Rick, you said that the investment-grade rating won't reduce your cost of capital, and I totally understand that. But wouldn't it diversify your sources of capital?

It would. But again, I think as we look at the capital stack for this entity, we think we can get a lower cost of capital using a combination of secured debt and JV equity than we could if we were to try to go the traditional unsecured route. Unsecured is obviously attractive, preferable for property owners because you don't need to seek lender approval or -- for any leasing or major decisions, but at the end of the day, it's really about allocating capital and the lower the cost of capital is the more successful we can be. So that's why we've done this. I mean previously, we did the Hawaii financing. We thought the CMBS execution was important there, we wanted the market to understand the appraisals and the value of those properties because I think it was misunderstood.We think that story has gotten out there a bit. And now for this most recent financing, it was really just about lowering our cost of capital. It's not every day, we can close on a fixed-rate, 10-year loan and repay the revolver and have accretion. I mean we borrowed at 3.33% and our average revolver borrowing for the past quarter was 3.7%. It's a little bit lower than that now. But it was still positive to pay it back so.

Yes. Okay. The 2018 lease, the Hawaii lease that you signed this past quarter, was that a -- I might have missed it. Was that a short-term renewal and then you entered into a longer-term discussion, and you already got a portion of the upside in that short-term renewals. Is that the way to think about it?

This is Yael. Actually, what happened was we've mentioned last quarter that the tenant had gone into default. And so we got the space back, and we're able to lease it within 1 month. And so that's why we had the roll-up in such a short time.

Got you. Excellent. And then just on the default that you referenced this quarter. I guess so you're not adjusting for the charge. Is that the way to think about it?

No. So no, we wouldn't adjust for a charge. I mean these things happen from time to time. You hope it doesn't, but it does. I mean the big difference this year versus last year, last year, the geography was that charges like that went through expense, is bad debt expense. And this year, it's a reduction of revenue. So this quarter's numbers don't include any annualized rental income for these 4 parcels that this tenant leases because we determined it was not probable that we collected. So we took this $2 million charge. A lot of it was future straight-line rent. But similar to the story that Yael just mentioned, I mean the good news is there is a lot of demand for space in these regions, or these areas, submarkets of Hawaii. So we're hopeful that we'll get these released as well, or we'll reach a settlement with the tenant. I mean we're not opposed to that, but from an accounting standpoint, this quarter, we needed to take the charge.

So just to understand this the right way. FFO, there's no FFO impact other than the space was vacant, and then the impacts on AFFO. Is that how I should think about it? Or is there an FFO impact?

There is. I mean it's unfavorable to FFO this quarter as well. We took a charge, that whole charge is about $2 million. The majority of it is future straight line, so that wouldn't have a cash NOI impact but our GAAP NOI is impacted by it, obviously, which is why we printed the small negative number this quarter. We also do have the current rent that we've reserved for. So we took no credit for the revenue this quarter. The tenant is still in the space and is trying to negotiate a settlement. So we are hopeful that we'll get some of that back in the future. But the accounting rules are pretty conservative when it comes to recognition of this stuff so.

Great. So it's sitting rental income basically effectively where the charge is, correct?

Correct, yes.

Our next question is a follow-up from Bryan Maher with B. Riley FBR.

Yes. I just wanted to follow-up to see what your thoughts were on the Prologis's $12 billion acquisition of Liberty and what that kind of means for the space, if you think that there's going to be more M&A? And I believe the cap rate was kind of like a mid-4s, and you guys are trading, give or take, around 7%. So can you just give us a little thought on how we should think about you guys in the sector relative to Prologis' very acquisitive the past year?

My initial reaction was it's another statement of how undervalued ILPT is. But it's clear that in REIT land, size is an important factor. Blackstone and Prologis are by far, the 2 largest owners of institutional owners of industrial real estate. And it makes the acquisition landscape, very competitive. So I think you're going to continue to see both of those companies growing aggressively, both through acquisition and investing in their existing portfolios. But I think that there's still plenty of room. It's a big space in the real estate sector. And I think there's plenty of room for everybody to make transactions, but it's just -- I think it just makes things -- makes the market continue to be aggressively priced. So I don't expect that you'll see ILPT acquiring any additional properties this quarter, this coming quarter. We're going to continue to focus on leverage. But we're watching the market. We're underwriting properties. But we are seeing seller expectations are for aggressive pricing. So we're being careful about what we do and what we don't do.

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

Thank you for joining us on the call today. We look forward to hopefully seeing a bunch of you at the NAREIT conference in November. Thanks.

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