The RMR Group Inc. (NASDAQ:RMR) Q2 2023 Earnings Call Transcript May 7, 2023

Operator: Good morning and welcome to the RMR Group Fiscal Second Quarter 2023 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Melissa McCarthy, Manager of Investor Relations. Please go ahead.

Melissa McCarthy: Good morning and thank you for joining RMR’s second quarter of fiscal 2023 conference call. With me on today’s call are President and CEO, Adam Portnoy; and Chief Financial Officer, Matt Jordan. In just a moment, they will provide details about our business and quarterly results, followed by a question-and-answer session. 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. 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 RMR’s beliefs and expectations as of today, May 4, 2023, 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, which can be found on our website at www.rmrgroup.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we may discuss non-GAAP numbers during this call, including adjusted net income, adjusted earnings per share, adjusted EBITDA and adjusted EBITDA margin. A reconciliation of net income determined in accordance with U.S. generally accepted accounting principles to adjusted net income, adjusted earnings per share, adjusted EBITDA and the calculation of adjusted EBITDA margin can be found in our financial results.

On today’s call, we will discuss the planned merger between OPI and DHC in our prepared remarks. OPI and DHC have not yet filed a preliminary joint proxy and registration statement with the SEC, and therefore, we will not be taking questions about the merger. In addition, we will discuss the planned acquisition of TA by BP. As a special meeting of TA shareholders to approve the merger takes place on May 10, we will not be taking questions on this transaction either. And now I’d like to turn the call over to Adam.

Adam Portnoy: Thanks, Melissa and thank you all for joining us this morning. In the second fiscal quarter of 2023, we continue to navigate a challenging economic environment for commercial real estate. Despite this turbulent backdrop, we are pleased to report solid financial results highlighted by adjusted earnings per share of $0.49, adjusted EBITDA of $25.3 million and an annual dividend of $1.60 per share that remains secure and well covered. Collectively, these results are a reflection of our diverse client base and durable business model. As it relates to operating fundamentals across our platform, we are proud of the tireless efforts of our employees to drive continued value at our managed assets with RMR ranging almost 2 million square feet of leasing on behalf of our clients at a weighted average lease term of over 9 years during the quarter.

This leasing velocity across our managed portfolio resulted in a quarter end consolidated occupancy rate of almost 96%. Calendar year 2023 so far has been marked by three milestone events among RMR’s client companies, all of which look to address the unique opportunities and challenges certain of our clients face as we look to position them for long-term sustainable success. First, in February, TA announced that it entered into a definitive agreement to be acquired by BP for $1.3 billion. TA has been on a transformational journey over the last 3 years, and we are pleased with the 84% premium this transaction represents for TA shareholders. There is a special meeting of TA shareholders scheduled for May 10 to approve the transaction. And earlier this week, TA announced that both ISS and Glass Lewis came out in support of the transaction.

Assuming TA gets the requisite shareholder approval, the sale is expected to close on May 15. Second, in March, AlerisLife announced that ABP Trust successfully completed a tender offer and an 85% premium to the prior 30-day average trading price. We believe that AlerisLife, now a private company, will be able to enhance its focus on operational excellence and best position the company to successfully deliver on its business plan. Lastly, in April, two of our perpetual capital clients, DHC and OPI announced an agreement to merge and change the combined company’s name to Diversified Properties Trust. The merger will create a diversified REIT with a broad portfolio, defensive tenant base and strong growth potential. Financially, the merger is expected to be accretive to both entities’ leverage and cash flow.

The combined entity is expected to provide a sustainable annual dividend of $1 per share with the potential for dividend growth in the future. As it relates to DHC, it is facing a number of serious near-term challenges, driven largely by debt covenant restrictions that prevent it from issuing or refinancing debt. This problem is exacerbated by DHC having $700 million of debt coming due in early 2024, and DHC does not expect to be debt covenant compliance before this debt comes due. As a result, 1 of the biggest benefits of this merger for DHC is that upon its completion, the combined company will be in debt covenant compliance and can access regular way refinancing of its debt maturities. In addition, while the SHOP recovery is underway and trending favorably, it is not happening fast enough and further capital is needed, in addition to debt refinancing capital to fund investments in DHC’s portfolio to help drive the ongoing turnaround in the senior living properties.

Finally, DHC also benefits from the merger with OPI by immediately providing a significant increase in its dividend for shareholders. After the merger, DHC does not anticipate reinstating its regular dividend until 2025. As it relates to OPI, they are facing a number of current and longer-term challenges as office sector headwinds are likely to negatively affect office owners for the foreseeable future. More specifically, the financing environment for office properties is and expect it to remain very difficult for the foreseeable future. One of the biggest benefits of the merger for OPI is that it provides it with greater access to capital sources, including low-cost government and agency debt. OPI’s office portfolio will also require increased capital investments in the coming years, and OPI was facing an unsustainable dividend rate prior to the merger announcement.

By merging with DHC, OPI gains access to an attractive unencumbered portfolio of medical office buildings and life science properties and we expect OPI will benefit long-term from the expected eventual recovery in DHC’s SHOP portfolio. Turning to other highlights of notes across our clients. During the quarter, SVC further enhanced its financial profile by redeeming its June 2023 senior notes using the proceeds from a $610 million issuance of net lease mortgage notes. In light of the challenging capital markets environment, we are pleased with this financing and believe it’s attributable to the strength and positive outlook of SVC’s retail portfolio. SVC is also expected to benefit from BP’s acquisition of TA as SVC will receive approximately $379 million in cash from the transaction.

SVC also strengthens its tenant credit characteristics because the amended travel center leases will be guaranteed by BP’s A- credit ratings. SVC’s hotel portfolio also continues to experience positive operating fundamentals with robust increases in occupancy, ADR and RevPAR. With all facets of SVC’s business improving, we believe SVC is possibly on a path to generate incentive fees to RMR in the future. At Seven Hills Realty Trust, our publicly traded mortgage REIT we believe there remains significant opportunities to grow this part of our business. Seven Hills’ portfolio remains default free, a testament to our disciplined underwriting and asset management capabilities. In addition, with the recent pullback by many regional banks, Seven Hills has seen its pipeline well over $1 billion in possible transaction, whether it be at Seven Hills or a new private capital vehicle.

We believe our successful lending platform leaves us well positioned to possibly grow this type of AUM for RMR in the future. With almost $200 million in cash and no debt, we believe our durable business model affords us the benefit of patients to take advantage of strategic opportunities that we believe will result from the ongoing market volatility. I’ll now turn the call over to Matt Jordan, our Chief Financial Officer.

Matt Jordan: Thanks, Adam and good morning, everyone. For the second quarter, we reported adjusted net income of $8.1 million or $0.49 per share and adjusted EBITDA of $25.3 million, with both measures being in line with our quarterly guidance. This quarter’s adjusted EBITDA margin of 50% yet again highlights the highly efficient and scalable platform RMR has in place. Total management and advisory service revenues were $48.2 million, which was down $1.4 million sequentially. This decrease was primarily attributable to seasonal declines at TA and Sonesta as well as a decrease in construction management fees as large redevelopment projects at OPI and DHC wound down. In regards to the financial impact to RMR from the TA transaction, TA currently represents approximately $4 million in quarterly revenues.

The loss of this revenue will be offset over time by a number of factors, which includes the favorable impact to our management fees from the increase to SEC share price subsequent to the TA transaction announcement, as well as approximately $1 million in annual compensation savings and the resulting interest income from the $100 million in cash RMR will receive in connection with the TA transaction. As it relates to next quarter, based upon the current average enterprise values of our managed equity REITs, projected construction volumes and an expected closing date of May 15 for the TA transaction, we expect to generate between $45 million and $47 million of management and advisory service revenues next quarter. This guidance excludes approximately $45 million in termination fees that we expect to receive upon completion of the TA transaction.

Turning to expenses. Recurring cash compensation was approximately $34.5 million, an increase of $1.3 million sequentially and due primarily to payroll tax and 401(k) contributions resetting on January 1. This quarter, we recovered approximately 43% of our cash compensation from our clients. Looking ahead to next quarter, we expect recurring cash compensation to be approximately $34 million with a projected reimbursement rate closer to 44%. G&A expense of $9.5 million this quarter includes approximately $500,000 of costs related to annual Board of Directors share grants and approximately $600,000 or $0.01 per share of technology transformation costs. On a normalized basis, G&A should be approximately $9 million next quarter, excluding technology investments.

We closed the quarter with almost $200 million in cash. In connection with the TA transaction, we expect to receive approximately $100 million from the sale of the TA shares RMR owns and the termination fee I touched on earlier. As such, we expect to end next quarter with approximately $300 million in cash. Aggregating all the prospective assumptions I outlined earlier, next quarter, we expect adjusted earnings per share to range from $0.46 to $0.48 per share and adjusted EBITDA should range from $23 million to $25 million. Before we begin the question-and-answer portion of the call, I would like to first acknowledge the publication of our annual sustainability report. The report highlights the many accomplishments and programs that drive our organization each and every day.

As we’ve highlighted previously, RMR is publicly committed to reducing greenhouse gas emissions at assets we have operational control over by 50% by 2030 and to attain net zero emissions by 2050. Through calendar 2022, we have already achieved almost a 35% reduction in greenhouse gas emissions through energy efficiency measures, sustainable habits and renewable energy programs. We encourage those listening to go to the Sustainability section of RMR’s website, where you can see a collective overview of our environmental programs contributions to the communities we operate in and the investments we make in our people. Secondly, as Melissa highlighted earlier, we cannot address questions regarding either the planned merger between OPI and DHC or the planned acquisition of TA by BP.

Operator, would you please open the line to questions?

Q&A Session

Operator: And our first question will come from Bryan Maher of B. Riley Securities. Please go ahead.

Bryan Maher: Thank you and good morning, Adam and Matt. I guess it’s going to be a short Q&A session today for you with – I am talking about the deals. But kind of related to that, we noticed our G&A numbers were a little light relative to what you reported in the second fiscal quarter. Is any of that really being driven by legal or advisory fees or is that being accounted for elsewhere?

Matt Jordan: No. G&A, when you back out the two large items this quarter, our run-rate this quarter is actually $8.4 million. So we feel pretty good actually where G&A landed, but you got to exclude the director share grants and the other $0.5 million or so of technology transformation costs, which we back out of adjusted EBITDA.

Bryan Maher: Yes. But I got to believe you have had some pretty high legal and advisory costs, where would those be going? Are they going into the actual managed REITs and OpCos?

Matt Jordan: Correct. The REITs would be absorbing those costs, not RMR.

Bryan Maher: Got it. And then we hear what you are saying as it relates to office challenges on financing and DHC’s incurrence test. But can you give us any color on the appetite of some of the sovereign wealth funds that you’ve dealt with in the past as to stepping up to the play should any of the managed REITs need further JV asset sales into those JVs or other type of capital where your deep-pocketed relationships could step up and help over the next 6 to 12 months if needed?

Adam Portnoy: Sure, Bryan. Yes, I think the relationships we currently have are very much open for business. As we’ve stated before, we have some good – very good relationships with some very large Asian sovereign wealth funds. I would say that the issue is that while they are very much open for business, their returns expectations have increased. And so therefore, pricing around assets that we could be put into a JV may not be very attractive for us. I think we could explore it. But based on our understanding and preliminary conversations with them about what they are doing and how they are looking at investments. I’m not sure it would be a very attractive alternative for our companies today. So it’s not something I anticipate we see a lot of going forward.

You also have to keep in mind that some of the assets that would be most attractive and available to go into those JVs, good or bad, maybe some of the better assets that we have that are currently generating a lot of the cash flow that helps our companies specifically DHC or OPI or any of the REITs. And by removing that very healthy cash flow, yes, you get a near-term liquidity boost but you lose out on the cash flow going forward. So you’re sort of – you’re solving a short-term problem, but you may be not solving a longer-term problem because you still – you got to replace that cash flow. And that becomes exacerbated if the pricing for the asset into the JV or sale regardless isn’t high. And today, the environment we’re in, it’s available, you can sell assets and the sovereign wealth funds we’re dealing with are open for business, but I don’t think the pricing would be particularly attractive or really work to solve a lot of our products.

Now in a pinch, if we really got against the wall, and we didn’t want to absolutely go into complete default on our debt. I suppose we could do it for a short-term to pay off the debt maturity itself, but it won’t solve the covenant issue because we will lose cash flow.

Bryan Maher: Right. Now would that be aside from, let’s say, ILPT where you had wanted to put another 40% slug into the JV, I guess it was the Mountain JV and sell the sale of 30 assets. Aside from what you just talked about with respect to JVs and asset sales there, is the game plan still to move forward with deconsolidating those 90, 95 properties out of ILPT and giving that stock kind of new legs for life here?

Adam Portnoy: That would definitely be the plan. Unfortunately, as ILPT discloses is in its financial package, and I think as they talked about on their call, that joint venture does not currently cash flow because the – of rapid rise in interest rates and the floating rate debt that we put in place to finance the Mountain JV. So while we do not anticipate there being a need for capital calls into the joint venture, it is not throwing off a significant – it’s not throwing off any cash flow. And therefore, for a core or core plus investment, which most investors when they invest in a core or core plus portfolio, it’s not a particularly high return, but they are looking for stability. Part of that stability is a current income.

We are not in a position that we can offer a current income in that portfolio. So we do not believe it would be attractive to any potential – other additional joint venture partner. So yes, we’d love to sell an interest in that to somebody and deconsolidate it. We don’t believe, and I think ILPT addressed this on their call as well as it’s – we try to highlight in some of the materials that ILPT puts out in its supplemental. It’s not practical to believe that’s going to happen.

Bryan Maher: Right. But with the industrial REITs that we track, it seems like everybody is having a lot of success with driving renewal rates pretty impressively higher still in the 20% ZIP code. So it seems like it’s only maybe a matter of time that organically ILPT should be able to raise NOI to kind of get you out of that scenario, especially if one were to believe the 10-year rates where they are trading currently if interest rates were to kind of backtrack 12 to 18 months from now. It seems like there is a clear sign of light out of the situation. It’s just going to take time. Is that correct?

Adam Portnoy: There is. It’s a question of time. We’re blessed with the fact that we have a very high – very well occupied, very high credit quality tenant base, roughly 99% leased to very – majority investment-grade rated tenants, well located properties, newer properties. The average lease term is 9 years. So the issue is that we don’t – and every lease that does come up for renewal, we are rolling up, and we’re rolling them up significantly. The problem is we don’t – if there is a problem, it’s just – there is just not a lot that’s renewing every year. And so we’re sort of blessed and cursed with that portfolio because we just don’t have enough leases rolling. I agree with your conclusion and what you’re saying, Bryan, that eventually, it will grow out of it.

But we’re talking unfortunately years not months or quarters for it to grow out of it because it’s going to take that much time for the leases to roll – enough leases to roll to create enough increase in NOI to really move the needle.

Bryan Maher: Got it. Just last for me. I don’t think I’ve seen anywhere and maybe you’re yet to disclose it. But when OPI and DHC do merge, have you identified what the new benchmark index would be for that combined entity?

Adam Portnoy: We have not. It’s an interesting nuance question, and we have discussed it preliminarily at the Board level. I will tell you that on a combined basis, the majority of the assets would be office, office, including medical office and life science. That all being said, I think that’s something that the Board of the combined company will likely take up after the completion of the merger, we will consider that more seriously.

Bryan Maher: Got it. Thank you.

Operator: And our next question will come from Ronald Kamden of Morgan Stanley. Please go ahead.

Unidentified Analyst: Hey, good morning, guys. This is Tim on for Ronald Kamden. Yes, maybe just following up on the previous question. You guys talked about higher return hurdles in the private markets. Just understand asset sales and whatnot may not help the covenants. But just in terms of expectations for pricing relative to maybe where the stocks trade on a public market, could you guys comment on that at all?

Adam Portnoy: So based on implied cap rates that the stocks are currently trading at, they do seem quite a bit wider than where even at the higher cap rate environment we’re living on a private – in the private market. I’m not talking about the merger itself, but one of the things that we’ve certainly been quite negatively affected by between the OPI DHC merger is the drop in the stocks at OPI and DHC, that’s had a direct impact on RMR’s cash flow and perhaps a significant direct negative impact. And so I do believe they are trading quite a bit wide of where you would see private valuations be for some of those assets. The issue is in the private markets is it’s very hard to determine value, especially around the office because there is very little trading activity going on in the marketplace.

Generally speaking, anything that has the word office today feels like whether it is good office or bad office or well located in newer buildings or older buildings is just negatively viewed across the board. And so everything gets thrown out with it. I believe, and I hope this to be true over the coming quarters or years that what’s happened – what happened, I think, an analogy in the retail sector over the last decade will start to happen in the office sector where you – investors, lenders, finance providers, we will start bifurcating between good office assets and bad office assets. And I think the good office assets, which frankly, we have a portfolio that is majority A class buildings and were happen to have a portfolio that’s not heavily located in gateway markets, which used to be where everybody wanted to be, and I’m not sure that’s the right place to have a large portfolio today in office in gateway markets.

I think you’re may be better served having a diverse portfolio and Class A office buildings in suburban markets across the country, especially in the Southeast and Southwest, which we have a large portion of properties. So it’s a long way of answering your question that yes, I think our stocks are not reflecting sort of intrinsic value. But I think a lot of stocks today are not reflective of intrinsic value because there is not a lot of transactions that people can point to, to come up with real value and even in the private marketplace.

Unidentified Analyst: Great. That makes sense. And then, obviously, without getting into detail about the RMR or the OPI and DHC transaction. Just in terms of access to DHC financing, I understand I was one of the impetus for the transaction in general are one of it. Just in terms of some of the underwriting standards and whatnot that will be looked at just because from my understanding, the SHOP ortfolio is fully stabilized, will that be looked at kind of on a pro forma basis or just on trailing results? How are you thinking about that?

Adam Portnoy: So just to make sure I understand the question, how does – in the SHOP portfolio, how does, let’s say, the agencies look at financing those assets?

Unidentified Analyst: Yes, exactly.

Adam Portnoy: Yes. So they revised their financing criteria over the last few years. And the good news is we have a large portfolio of senior living assets. And although they are struggling but improving, obviously, with over 200 roughly 30 assets, roughly senior living assets, we obviously have many assets that are performing fine. Unfortunately, we get more assets not performing fine. So you don’t have to take the entire portfolio. You can take a group of assets based on historical and the agencies have become a little bit more forgiving in the way they do the underwriting, where they may – they will just look at maybe the most recent quarter and then annualize that, keeping in mind your projections, they won’t take the last 12 months.

And so there is an opportunity, and the agencies have been doing this largely because they – this is largely something that came out of the pandemic because they recognized that in the recovery for a lot of senior living assets. If you look back 12 months, you were going to have a pretty low underwriting – ability to underwrite. Now they are more willing to look at just one quarter back, which might – obviously, if things have been improving over many quarters, the most recent quarter, hopefully, is the best quarter and then you annualize that, and that’s what you use for the underwriting. We’re optimistic that there is a portfolio of assets within the DHC portfolio that will provide for significant capital or financing to be able to be put on those assets that we are not able to access today at DHC.

And that again, I said in my prepared remarks, I’m just repeating it, is one of the benefits of the transaction is on a combined basis, you’re in debt covenant compliance. That’s a huge thing that I think a lot of investors sort of brush aside about the covenants. It’s very onerous. We’re not allowed to finance new debt. We’re not allowed to finance, refinance expiring debt, you just can’t issue any debt. And by being in compliance, we can then access that what I think very, very liquid, open and cost-competitive financing. And if you’re – especially if you’re in the office sector, if you have access to that funding window, I think you are at a competitive advantage in the marketplace.

Unidentified Analyst: Great. And maybe just a follow-up, if the underwriting is based on quarterly results I guess, the logical thing to do would be to wait until maybe the second half in ‘24 before you actually access the DHC financing, just to show kind of stabilized results. Is that kind of the right way to think about it or..

Adam Portnoy: I think we have to wait. Yes, this is getting a little ahead of ourselves is planning a little bit too far out. I think we are – we could be in a position to put financing in place if we chose to in early ‘24. We could be in a position to do so. The question you’re asking is, would you do so? And the answer is I don’t know, but I do know that we could, by early ‘24, in my belief, do so and do so in a sizable way if we had to. So it’s there for us, whether we choose to do, it’s a different question that you’re asking, but we can.

Unidentified Analyst: Great. Thanks, guys.

Adam Portnoy: Sure.

Operator: The next question is a follow-up from Bryan Maher of B. Riley Securities. Please go ahead.

Bryan Maher: Great. Thanks. So Adam, you opened up that door for me on the SHOP financing question, which I think we understand here pretty well. When we look at roughly $4 billion in unencumbered SHOP assets within DHC, we were thinking something along the lines of maybe you cherry pick out $1.4 billion, $1.5 billion of the better-performing NOI accelerated from renovations last year properties to do a tranche in early 2024 to take out the 2024 debt for OPI and DHC. And then maybe you do another one a year later after other SHOP NOI assets have moved northward and can support that debt. Is that unrealistic to be thinking in that way?

Adam Portnoy: You’re actually in the right thinking about things correctly, Bryan. Those are all things we can do. I will just put some markers out there for you to be thinking about. Obviously, we want to be very careful in terms of if we access that market picking the most mature properties that we are financing them too early in their recovery. We want properties that are largely recovered, and we’re not leaving some financing on the table. $1.4 billion, $1.5 billion in ‘24 sounds a little heavy to me, to be honest. But if we did something that large, I think we’d be taking some assets that were not fully recovered in leaving financing on the table. The other benchmark to keep in mind is there are limits to how much secured debt we can ultimately put on the portfolio because remember, we do not want to – because every time we put secured debt on, when we’re moving those assets on the unencumbered asset pool.

And we still have unsecured bonds that have unsecured debt covenants. And so yes, we have significant room to add secured financing well into – well past the $1 billion, but there is a limit to how much we can put on. And so think about that. I’m not sure you could say something like $1.5 billion, and then there is another $1.5 billion. I think you can start really stressing covenants for the unencumbered bonds that will still be in place. So that’s – those are just some sort of reactions and markets for you to think about.

Bryan Maher: Right. But I got to believe that if you just did in the first half of 2024, a pledge – and when I say $1.5 billion, $1.4 billion pledge, $1.4 billion, $1.5 billion to take out $1 billion cash your other debt will trade more favorably and one would have to believe that the bank groups associated with OPI and DHC combined company would have a sigh of relief and be much more agreeable to just simply refinance debt that comes to on a go-forward basis after you’ve maybe tapped, I don’t know, the first $0.5 billion or $1 billion of agency debt. Is that correct thinking?

Adam Portnoy: Bryan, that is correct, thinking. Yes, I think in the near-term, we have a bias towards thinking about putting agency debt on sometime in ‘24. The timing is a little open. It’s a little ways away. So we’re not quite sure exactly when. But some time in ‘24, and that’s right. Our hope is that we would then have more regular way access to the unsecured market going forward after that. That would be the sort of base business plan. But a lot – that has a lot of assumptions in that base business plan that we have to see come true.

Bryan Maher: Perfect. Thank you. That’s helpful.

Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Adam Portnoy, President and Chief Executive Officer, for any closing remarks.

Adam Portnoy: Thank you all for joining us on today’s call. We look forward to speaking with you again in the future.

Operator: The conference has now concluded. Thank you for attending today’s presentation, and you may now disconnect.