Easterly Government Properties, Inc. (NYSE:DEA) Q1 2024 Earnings Call Transcript

Easterly Government Properties, Inc. (NYSE:DEA) Q1 2024 Earnings Call Transcript April 30, 2024

Easterly Government Properties, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Greetings. Welcome to the Easterly Government Properties First Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session between the company’s research analysts and Easterly’s management team. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Lindsay Winterhalter, Head of Investor Relations. Please go ahead.

Lindsay Winterhalter: Good morning. Before the call begins, please note that certain statements made during this conference call may include statements that are not historical facts and are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although the company believes that its expectations as reflected in any forward-looking statements are reasonable, it can give no assurance that these expectations will be obtained or achieved. Furthermore, actual results may differ materially from those described in the forward-looking statements and will be affected by a variety of risks and factors that are beyond the company’s control, including without limitation, those contained in the company’s most recent Form 10-K filed with the SEC and in its other SEC filings.

The company assumes no obligation to update publicly any forward-looking statements. Additionally, on this conference call, the company may refer to certain non-GAAP financial measures such as funds from operations, core funds from operations and cash available for distribution. You can find a tabular reconciliation of these non-GAAP financial measures to the most comparable current GAAP numbers in the company’s earnings release and separate supplemental information package on the Investor Relations page of the company’s website at ir.easterlyreit.com. I’d now like to turn the conference call over to Darrell Crate, CEO of Easterly Government Properties.

Darrell Crate: Thanks Lindsay, and thank you everyone for joining us. We are pleased with our progress this quarter as we work through opportunities. I’ll keep it brief so we can get to Q&A, but I’ve got three important messages I’d like you all to take away from this call. First, we believe there’s a path towards material earnings growth for shareholders, and we’re on it. Meghan and Allison will talk to you about the numerous drivers shortly. Second, we know the payout ratio of our dividend is high, but we also believe there is a growth path we can pursue that helps materially close that gap. We are also actively reassessing and managing our expenses. Further, we currently sit with just under $3 billion in rent coming from the U.S. government with a leases that we own today, and if that portfolio were to renew up 10% for 10 years, which are modest assumptions, we’d be collecting nearly $6 billion while facing credit rent from the U.S. government.

We believe we can offer as many dollars as we can to our shareholders, and given the creditworthiness and duration of the cash flows backing our dividends, we remain very comfortable with the periods of higher payout ratio. Third, we occupy a unique place in the broader real estate industry, owning and designing essential infrastructure for the U.S. government’s mission-critical agencies. For example, our DEA drug labs enable Homeland Security to trace and stop Sinaloa Cartel activities amid an ongoing increase in drug trafficking crimes. In 2022, fentanyl was responsible for 200 deaths every single day, and over a quarter million of Americans have died from fentanyl overdose since 2018. Let that sink in for a minute. Our facilities bolster the special agents actively combating those figures.

We’re not an office read, and this year we’re going to continue ensuring that the market understands the breadth of what Easterly offers. This may be boring, but these are the stats that I know you’re going to ask. We beat the street and reported $0.29 in core FFO per share, and we sit comfortably at the midpoint of our target leverage of 6.5x to 7.5x. We continue to acquire and develop new facilities in our portfolio. These facilities are not offices for transient commercial use. By focusing on properties leased to government agencies and their [technical difficulty], we’ve maintained the stability of our cash flow that favorable renewal spreads and seen a robust pipeline of growth opportunities. Earlier this month, we announced the acquisition of an immigration and customs enforcement information technology facility near Dallas, Texas, which enables ICE’s Office of Human Capital to modernize its IT systems and bolster its technological capabilities.

The rationale behind this deal is clear. The facility is 95% leased, has a 16.2-year weighted average initial lease term for all three tenancies, and maintains an additional 6,154 square feet available for future leasing as a value-add opportunity. All three factors enhance our cash flows, maintain significant occupancy upsides, and strengthen our definable edge as specialists in mission-critical real estate. This acquisition is in line with the existing properties in our portfolio, such as Federal Emergency Management Agency’s Tracy, California, warehouse. FEMA-Tracy is one of eight distribution centers within the United States for emergency response preparedness. Amid the ongoing threats of wildfire and other natural disasters in California, the property helps provide on-the-ground support and crucial supplies capable of mobilizing between 3 to 4 million meals and liters of water that is stored at the facility within 30 minutes.

Our Drug Enforcement Administration Laboratory in Pleasanton, California, serves a similar mission-critical purpose, providing scientific and forensic support to the DEA special agents and other law enforcement personnel who prevent the distribution of deadly drugs like fentanyl into our society, and we store over 35,000 pieces of illegal and oftentimes deadly evidence in that facility each year. Meanwhile, the DEA’s approved funding increased over 6% between 2022 and 2023, and its total headcount rose over 4% during the same period to combat the increased manufacture and distribution of controlled substances. As the government strengthens its agencies in maintaining the safety of our country, we continue to fortify their abilities through mission-critical real estate.

These purpose-built facilities serve as Easterly’s definable edge in commercial real estate and continue to be the bedrock of the shareholder value which we deliver. We will continue to pursue accretive deals, and we have no plans to sell buildings in the near future as we work to continue to expand the portfolio with high credit-worthy state and local government agencies and U.S. government-adjacent partners. Frankly, we believe Easterly is well-positioned to continue to provide value to our stockholders by developing and buying more great mission-critical buildings, continuing our strong partnership with the government, and protecting our balance sheet. We are in constant dialogue with the Board and in forward planning mode. In addition to delivering external growth, we are laser-focused on cutting operating costs this year, both of which we believe will aid in our ability to meet or exceed our 2% to 3% core FFO growth trajectory.

We’re excited to continue delivering shareholder value and enhancing our portfolio with a foundation of cash flows backed by the full-stack base and credit of the U.S. government. The future remains bright for Easterly in 2024. And now I’ll turn the call over to Meghan Baivier, the company’s President and COO.

Meghan Baivier: Thanks, Darrell, and good morning. We started off our 2024 by establishing clearly defined goals for the company, and we are on pace to deliver. We believe our government-backed cash flows have been undervalued in the public markets these past few years, and we attribute that to our recent periods of low growth. 2024 is the start of that change. We have launched our growth trajectory with the acquisition of ICE Dallas, delivering strong predictable cash flows and run rate accretion to our shareholders. We see a pipeline of opportunities that we believe will further our ability to meet our stated goals of delivering 2% to 3% core FFO growth year-over-year for years to come. For example, we are pursuing a unique opportunity to serve as lenders and buyers of mission-critical assets that we believe will further change the growth trajectory of this organization.

We look forward to keeping you apprised as this develops. In the meantime, we secured a brand-new bill-to-suit federal courthouse development project in Flagstaff, Arizona for an inaugural 20-year lease term. This important courthouse is expected to house the nation’s first-ever Native American female Federal Judge and is expected to be the company’s first-ever leased silver net-zero development project. Our in-place portfolio continues to perform as we achieve renewals at meaningful spreads. We renewed DEA Albany for another 17 years, marking the third renewal of this asset while owned by Easterly. You are probably sick of hearing me say it, but once again, this highlights just how far from the office sector we are. As Darrell mentioned, the importance of the work being performed in our buildings cannot be replicated at home, and such a dynamic is apparent in our ongoing renewal discussions.

Allison will go into greater detail, but we believe we are in a period where the duration and creditworthiness of our cash flows, the importance of our real estate, and our defined edge in serving mission-critical assets will accrue to our benefits and separate us from our peers. As we have seen notable names take down their earnings guidance, our beaten hole should stand apart from the crowd. We are excited about the opportunities for growth at Easterly. We see the growth trajectory filling in with new projects that further our mission of serving the government while also delivering attractive returns for shareholders. With that, I will turn the call to Allison.

Allison Marino: Thank you, Meghan. Good morning, everyone. I’m pleased to report the financial results for the first quarter. Both on a fully-diluted basis, net income per share was $0.05 and core FFO per share grew to $0.29. Our cash available for distribution was $25.9 million. Interest rates have certainly been a headwind for the broader real estate market. Easterly included, we seek to minimize interest expense at a time of high underlying rates, be that with a focus towards strategic treasury management or more recently, our ESG goals. We achieved a reduction in the margin spreads under the company’s amended senior unsecured credit facility as a result of hitting a predetermined sustainability metric. Easterly also continues to sit comfortably at the midpoint of our target leverage range of 6.5x to 7.5x and maintains ample capacity on our revolver while limiting floating rate debt exposure.

As Darrell and Meghan mentioned, external growth through mission-critical real estate is our primary focus, and we see a market of opportunities ahead. Our ability to manage our upcoming debt maturities, plan for capital needs, and access debt and equity markets is integral to harvesting this growth. At Easterly, we pride ourselves on a portfolio of purpose-built buildings, and we manage that portfolio with a purpose-built team. Our organization is committed to finding operational efficiencies throughout the portfolio, managing expense creep, and releasing at positive spreads. Everyone at the company contributes to furthering the mission of driving value for shareholders. Today, we are maintaining our full-year core FFO per share guidance for 2024 in a range of $1.14 to $1.16, all on a fully diluted basis.

This guidance assumes the closing of VA Jacksonville through the joint venture at its pro-rata acquisition price of $40.9 million later this year, and that we will have $100 million to $110 million of growth development-related investment during 2024. At its midpoint, this sets a path for Easterly to deliver strong core FFO per share earnings growth to shareholders this year. We believe this represents a market-leading risk-adjusted return and charts the course for delivering longstanding growth opportunities for our investors. With that, we thank you for your time this morning and appreciate your partnership. I will now turn the call back to Shannon.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from John Kim with BMO Capital Markets. Please proceed with your question.

John Kim: Thank you. In your press release, you talked about earnings growth of 2% to 3%. I think that’s a little bit lower than what you were targeting back in January. So I was wondering if there was anything that’s a headwind to earnings in the near term, whether that’s asset sales, or known move-outs that you have? Or is it simply just the spread investing has become more difficult?

Darrell Crate: Yes. No, thanks for the question. Really appreciate it. At our Analyst Day, one of the things I shared is that we’re on a path to grow 4% for the company, which – that’s what we’re working to pursue every day. I think it became clear in our discussions after Analyst Day that, given the environment that we were in, the idea of going out with 4%, it sounded like we were going to be kind of going into the wind, especially as office guidance was continuing to decline. So we modified the expectations to 2% to 3%, which seems like a very reasonable step. And given the things that we’re working on, we’re going to hit those targets, and we can – we may very well exceed them, and we’re working every day to think that happens.

So our view on the business today is the same as it was at the beginning of the year. We are going to cut costs to make our numbers. We are going to – we’ve got a terrific pipeline that continues to build, and we’re developing properties into the eights, with fantastic facilities that I think will be with the government for many decades. So as that all comes together, we’re very excited for the next couple quarters, but to be able to lay that out, which is also why we have some exuberance and optimism also about our dividend.

John Kim: Just following up on that, Darrell. I mean, the interest rate environment has changed since January. I wondered if that played into your outlook at all as well as there have been recent reports, I think there was one by the PBRB earlier, I guess it was last month on federal agencies only using 12% of the headquarter space. Is that leading to any pressure to reduce costs among government agencies? I was just wondering with…?

Darrell Crate: Again, not specifically on our term outlook, you’re absolutely right that they have a new curve it goes up a little bit. The model that we’re creating, and we’re so excited. We look at a five-year model all the time, and it gets super annoying. You see it – for that yield curve to go up, and it just means we have to work harder or cut costs make it, because we’re laying out a path for shareholders. That said, none of it kind of changes the way we work. We are just going to have to dig it a little deeper. And make it happen. And that is – that’s all within our control. There’s nothing that Easterly seems beyond reach. And to the point about space utilization, I – we are not seeing that as a dynamic in our buildings.

And what we’re going to do and sort of what Lindsay was referring to. And my – even though I said I’d be brief, I did go on to a dialogue about fentanyl. We really do – we’re going to start on our website instead of putting pretty building pictures on the outside. We’re going to start showing folks what’s on the inside. And what you see there, there’s – you will get an immediate sense that there’s no need to reduce the floor plan from everything from CVP, folks know there’s a problem on the border and nobody knows it more than if they get the border patrol people. When you look at the DEA, their budget is growing. The Sinaloa cartel is getting stronger. And we were just out in California with some people who are intensely focused on making sure the American population stay safer.

We’ve got Sentinel coming from China. That is a serious problem and people in our buildings are working on exactly that. We’re talking about facility projects, about moving walls, doing different things that. Again, facilitate mission, make sure they have the meeting rooms they need, make sure they have the secured facilities they need make sure that they have what they can, because they come together in these offices to plan and then move on their mission and making sure that they can do that in a well-maintained building that has what they need in order to make that happen. Is what we do every day, and it’s how we built it – we’re a good partner with the government, and it’s how we believe we’ve created a definable edge in what we do.

John Kim: Appreciate the color. Thanks.

Darrell Crate: Yes. Thank you. Really appreciate it. And look, the more on this call, we can get any of these sort of bisoskepticism or what’s in the news. It’s super helpful to us, because we just – it feels like we play whack-a-mole with the Department of Education is shrinking, so people think the FBI is shrinking. And I mean, our investor calls and investor meetings, it’s chronically the question with regard to work from home, governments shrinking, and then what’s happening in your buildings. And I so wish we had a competitor, a direct competitor so that we could show the good work we’re doing, because I’ve been out to aggressively touring buildings and we hear it again and again. And believe me, the government – so it’s not like the IRS sends you a nice letter every year.

So thanks for filing your taxes on time. We really appreciate it. But I would say we are getting complements from the government. And they are not quick complementors about what we’re doing and how we’re focused on facilitating mission, because we watch what they’re doing in the facilities, and we make suggestions around how we could modify this facility. One – our job one is to fight off the lessons, but we do that by deeply understanding their mission and giving them every opportunity to see, hi, we’ll move this wall. We’ll do this. We’ll do that. And would that help you? And the reality is it does and sometimes that doesn’t cost very much money at all and the government will pay for it. And so, when we are able to create the actual plan and say, hi, send us back to headquarters and here’s your rationale those projects can move forward.

And so again, that’s how we’re helping as a partner. And the more we can have investors and folks who own our portfolio, understand what we do each and every day. That’s very different than anybody else out there. I think that folks will be proud of what they own and what we’re building.

John Kim: I didn’t expect that.

Operator: Thank you. Our next question comes from Michael Griffin of Citi. Your line is now open.

Michael Griffin: Great, thanks. I just wanted to go back to the full year guidance for a second, and maybe run through kind of some additional puts and takes. So as I see it, $0.29 in the quarter, a slight beat maybe you get some accretion from the ICE deal. How should we think about kind of the cadence of earnings throughout the year? And then also, if you could provide some more color on that ICE deal in terms of overall valuation per square foot and anything on the cap rate would be helpful?

Allison Marino: Okay. I can start with what our guidance entails and what it comprises us. So our guidance reflects $0.02 to $0.03 of same-store improvement and growth in margins of 2% to 3% — $0.02 to $0.03 of G&A savings, and that is offset by $0.03 to $0.04 of interest rate headwinds from the 2023 swap reprice. And then Meghan will touch a little bit on Dallas.

Meghan Baivier: Yes. So Dallas was a little under $26 million it’s about – it’s a mid-cap at that size and that level of cap rate we’re expecting sort of run rate accretion of about a third of a penny . And so it is absolutely a piece of our ability to continue to build on our initial guidance and continue, as Darrell said, right, to grow from that a 2% to 3% to the higher mid-range, or above that range. It’s a building block in that. And as we continue through the year with strong performance in the portfolio, continuing to meet or beat that expectation is that also laid out on the same-store NOI as we look at cost structure is also a place where we could see some upside.

Michael Griffin: Great. That’s helpful. And Meghan, maybe sticking with you. Obviously, external growth is going to be a big part of the story in order to drive earnings going forward. What would you say your weighted average cost of capital is today? And what’s the minimum spread you’d need to justify investing in a property? And is it correct to think about DEA as a spread of investors today?

Meghan Baivier: Yes. So great, we look at our cost of capital today given an understanding of where we can finance in multiple avenues of the debt market as being in the mid sevens – and of course, we are looking to be a spread investor to that level. And so acquiring assets in the high sevens to mid-eight, is very much what we’re looking to do in Dallas is an example of that.

Michael Griffin: Yes. And in terms of maybe debt and equity kind of differential there, is it fair to say in your financing deal, it’s half debt, half equity or maybe greater to the equity side as opposed to the debt?

Meghan Baivier: Yes. Triangulating and looking at debt equity mix and EBITDA multiples. Yes, you’re in that sort of 50% give or take range, as we think about weighted average cost of capital.

Michael Griffin: Great. That’s it from me. Thanks for the time.

Meghan Baivier: Thank you.

Operator: Our next question is from Peter Abramowitz of Jefferies. Please proceed with your question.

Peter Abramowitz: Thanks. Yes, just to dig a little bit more into some of the comments and guidance there that was helpful, but just trying to square that with some of your comments about revisiting your expense structure. Just wondering if you could provide some brackets around kind of expense reduction, the impact that has to earnings, whether it’s kind of an absolute dollar number, or just from a margin perspective, what you’re sort of targeting?

Darrell Crate: Yes. No, it’s a great question. We’re a couple of months into really just assessing the workflow of all our systems and processes, because what we do is a little bit different than other REITs. So we are trying to – again – we spend a lot of time talking about the relationship between value and excellence. And we want to be an outstanding partner to the government, but we also want to make sure that we are executing on that in a way that has the least burden cost structure possible. And I think, we’ll see some cost savings in 2025 and beyond. So, we don’t have a target for what that’s going to be, but we’re going to find an efficiency point in everything we do from property management to how we’re financing our buildings, to how we structure our leases and how we focus on renewals.

And that combination, we will find something under each of the rocks that we pick up. And it’s a great opportunity with interest rates moving for us to just reassess everything that we do, because we’ve had some very nice growth for the almost 10 years since, we’ve been public. We continue to grow every bit of our infrastructure sort of in a way that we obtained some advantages of scale, but I think there’s more to find. And so, we’re going to be pursuing that exercise, while we’re also. I don’t mean to make it sound easy. We are going to find high-quality buildings that match what works in our portfolio that are in the high sevens mid-eights. If we had a cost of capital that was 60 basis points lower, I think it’s not unreasonable to say we’d be doing $1 billion plus of acquisitions because we’re seeing sellers – balance sheet pressures and refinancing, you’re starting to see buildings come available.

There’s one building that, gosh, we loved and was probably – the seller would not have taken anything less than 5.5% cap at one point, which is why it was a building that wasn’t for us. But we put an offer in that was 150 basis points higher than that, and there’s still a conversation to be had. And this is — we’re seeing the market move in this direction. Ad it’s our acquisitions team’s job to find a couple of hundred million dollars of buildings that are in that criteria that, meet all the criteria of being a spread buyer. And for us to use our advantage and our relationships with the agencies and on the ground in order to get our buildings built and move forward. I mean, I’ll give you 1 example. And I think the ICE Dallas is kind of buried in there, which is we do have this 6,000 square feet of extra space.

And then we call it value add, and we kind of skim through it in the script. But we do a good job at our buildings. And because of that, if there are areas to expand or there’s a way to agencies today are doing more intra-agency task force work than I’ve ever seen before. So the idea of creating a special facility that’s a joint facility — joint activity space is a terrific opportunity. Our FDA lab in Atlanta. Some of you have come to see it, but I mean it is an amazing facility. It’s – it is – it has plenty of extra room in it. And I think, it will be the premier FDA lab in the United States. And with that, there is a significant opportunity to make that a center of excellence within FDA and none of that is in our underwriting today. So I don’t mean to make the growth path sound easy, but I think between the cost structures that we’re talking about, and finding the acquisitions that are accretive on a spread basis, will get us into a place where we’re delivering some very nice growth.

Peter Abramowitz: Thanks that’s helpful. And just to touch on, I think you have three expirations remaining to address this year in the portfolio. So Allison laid out, I think, some parameters around what you’re expecting from NOI growth for the full year. Just curious if you could touch on potentially the rent roll up or roll down there. And kind of how you budgeted that into your guidance and what sort of rent assumptions you’re assuming to get to your midpoint?

Allison Marino: Yes. So Peter, we obviously we’re successful at renewing the end of the quarter, and we’ll speak again about the portfolio at the end of the year. But if I dial back to the expectations that were stated on the fourth quarter call, around the 32 leases that we had renewed regardless of whether, or not the TI has completed the expected 18 point – excuse me, 18% spread and duration of 17.2 years, right? Albany tucks in nicely with no material change to that expectation. And then as we look to the rest of 2024, we’re very optimistic about, the process ongoing at FBI Omaha, we do expect the FBI leases in Portland to be extended through a renewal auction and the rest really dropped off to sort of the material levels of leases. But broadly speaking, we remain optimistic about the renewal success within our portfolio and sustained occupancy levels.

Peter Abramowitz: Got it. That’s all for me. Thank you.

Operator: Thank you. Our next question is from Aditi Balachandran of RBC. Please proceed with your question.

Aditi Balachandran: Hi. Good morning. Congrats on the Flagstaff development announcement. Just wondering if we could get a little more information about that. If you could provide it. So I guess, where you expect to yield the budget when you’re expecting to break ground things like that?

Meghan Baivier: Sure. So the new award that we won is the court federal – board out in Flagstaff, Arizona. It’s going to be an estimated project costs just touching $35 million. And as we said, we’re developing into the ACE [ph] there. It will – it’s in design today, and it will get underway as we get into the third, early fourth quarter of this year.

Aditi Balachandran: Great. Thanks. That’s all I had.

Operator: Our next question comes from the line of Harvey Poppel with Poptech LP. Your line is now open.

Harvey Poppel: Yes. Thank you. You haven’t talked much about the initiative – new initiative you previewed maybe six, nine months ago about going into the state property market. Do you have anything to report on that?