Easterly Government Properties, Inc.

Greetings. Welcome to the Easterly Government Properties Fourth Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session between the company's research analysts and Easterly's management team. To ask a question during the session, analysts will need to press star 1-1 on their telephone. They will then hear an automated message advising their hand is raised. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Lindsey Winterhalter, Head of Investor Relations. Please go ahead.

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 attained 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 at the FCC and in its other FCC 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.easterlyrate.com. I would now like to turn the conference call over to Daryl Crate, CEO of Easterly Government Properties.

Good morning, everyone, and thank you for joining us for the fourth quarter conference call. Today, in addition to Lindsay, I'm also joined by Megan Bevere, the company's president and COO, and Allison Marina, the company's CFO and CAO. We're pleased with the earnings results for 2023, and we look forward to continuing to deliver predictable earnings to our shareholders, supported by our foundation of leases backed by the full faith and credit of the United States government. As you saw in our guidance, we are executing on a path for strong core FFO growth in 2024. Alison will speak to that in more detail. Needless to say, we're excited to share our outlook with you. For over a decade, we have been honing a definable edge in the mission-critical facilities that serve our government. Our goal is to use that edge to provide our shareholders with a stable, predictable cash flow stream. By specializing in these mission-critical properties, Easterly can play an important role in supporting essential functions for the United States government and its adjacent partners. While office REITs contend with remote work threatening their occupancy outlook, and portfolio growth, easterly facilities remain critical to the safety and security of our government agency partners. Accordingly, this provides that stability we seek for our investors. While we are discussing predictability, let me address our dividend. We fully acknowledge our higher than average payout ratio, and we are confident in our ability to maintain and grow our dividend. Our disciplined approach to prudently managing our balance sheet, our unique long-term visibility of cash flows, and the creditworthiness of our U.S. government tenancies continue to serve as sources of stability and growth. The CapEx in our buildings is predictable, and the demands for capital expenditures by our tenants are not excessive. Our view is to return as much cash flow to investors as is reasonable as a strong steward of their capital. The leases we have today provide $2.9 billion of rental income, backed by the full-facing credit of the US government. With only one renewal of all of our assets to only a 10-year term at a 10% spread, these aggregate cash flows will be just under $6 billion in rent. And as Megan will share when she discusses our renewals to date, you will see those assumptions are quite modest. Given the strength of this cash flow, we are confident in our ability to provide healthy dividends to our investors for the years to come. What also sets us apart from typical office REITs is our commitment to customization. Our buildings are equipped and fortified with infrastructure and security protocols to ensure uninterrupted operations for key government agencies, such as the Drug Enforcement Administration and the Federal Bureau of Investigation. To reiterate, these assets have one important trait in common. They all help fulfill important government missions that cannot be accomplished from home. For example, drug enforcement agents require secure labs to analyze and store confiscated contraband. FBI agents must investigate crimes in person and at facilities designated for their use. Our facilities continue to support the work that ensures the safety of the country And as a result, 97% of our properties remain leased. It's clear to us that as we explore how to best collaborate with other state and local agencies, we find additional facilities with similar longevity with the added benefit of lease escalations. We see potential to grow our holdings of government and government adjacent assets with lease escalations to approximately 15% of our portfolio. We can further apply our definable edge in development properties for both government tenants and government adjacent tenants that have similar facility needs to our most tenant improvement intensive buildings. We're keenly aware of investors seeking the opportune moment as assets in liabilities reprice. With accelerated interest rates and liquidity drying up in the bank market, this development segment is taking the lead on repricing. A pipeline of opportunities lies ahead, where we believe we can engage in these products accretively at our current cost of capital. All of this leads to our commitment to grow Easterly Core FFO on a trajectory of more than 2% for the foreseeable future. We believe we are positioned to deliver a consistently growing Core FFO cash flow stream, which in turn would allow us to increase our dividend and continue to deliver strong results for our shareholders. This is an exciting time for Easterly. We're seeing a pipeline of mission-critical opportunities in 2024 and beyond, while also building a portfolio with a foundation of cash flows backed by the full faith and credit of the U.S. government. Thanks for your time this morning. Now I'll turn the call over to Megan to discuss opportunities for growth in 2024 and beyond.

Thanks, Daryl, and good morning. Thank you for joining us for our fourth quarter earnings call. 2023 was a productive year for Australia. The deal market returned, and we were able to transact on several accretive acquisitions during the second half of the year. In total, Easterly acquired, either directly or through the joint venture, four properties leased to tenants that include the United States Judiciary, the Department of Veterans Affairs, the Department of Homeland Security, and the State of California for an aggregate pro rata contractual purchase price of approximately $80.4 million. Easterly now owns, directly or through the JV, 90 properties totaling 8.8 million leased square feet. Our portfolio remains young with a weighted average age of 14.6 years, and our duration of cash flows remains enduring with a weighted average remaining lease term of 10.5 years. As mentioned on prior calls, we have always viewed Easterly as the mechanism to access high credit quality cash flows through the lens of real estate income derived from one of the world's most stable economic entities, the United States government. The most recent example of that is found in today's development landscape. Here, we are observing a stark contrast between the limitations faced by private developers and the resources available through a public rebalance sheet. Private developers, constrained by financial considerations, are encountering challenges in accessing the substantial capital required for ambitious building projects. The complexities of securing financing, coupled with market uncertainties, appear to be impeding private developers' ability to embark on large-scale projects. In contrast, Easterly's fortified balance sheet and enduring financing partner relationships emerge as a potential reservoir of capital. Easterly possesses the tools and capacity to leverage various debt and equity markets and tap into diverse revenue streams to finance projects. With that background, we are currently pursuing an attractive set of opportunities with private developers to serve as a partner and help finance and subsequently own a pipeline of mission critical assets primarily leased to the U.S. government. Turning to the company's wholly owned development activity, Our FDA Atlanta project continues to progress nicely with an estimated 150 workers on site daily. We expect that the project will cost approximately $229 million and deliver in the fourth quarter of 2025. Approximately $150 million of the total cost will be tenant improvement reimbursed by the federal government via lump sum payments. We anticipate receiving an approximately $25 million reimbursement payment in the third quarter of 2024. and the remaining $125 million upon completion and acceptance of the space by the government. We look forward to providing you with meaningful updates in the coming quarters as we make progress on this 162,000 square foot, state-of-the-art laboratory, 100% pre-leased to the United States government for a non-cancellable term of 20 years. With such a substantial TI investment in this project, we anticipate this facility will serve the needs of the government for an excess of 50 years. Turning to cash flow predictability, during the fourth quarter, Easterly renewed GSA Clarksburg, a 70,000-square-foot facility, for a new 15-year term that commenced in January 2024. For the entirety of 2023, we renewed 100% of our expiring leases for a combined 4.4% of annualized lease income at year end, all for a weighted average term of 16.4 years. These results serve as a stark contrast to our Office Street brethren. Further, as is customary on our fourth quarter earnings calls, we'd like to discuss our releasing successes as of year end. Due to the unique nature of our leases, final renewal rents cannot be ascertained until the exact amount of TI dollars required by the government at renewal is known and the TI work is complete. As such, there can be a lag in providing releasing data relative to the point at which we have signed a renewal lease. As of December 31, 2023, we have renewed 32 leases since IPO. Of that 32, 18 are renewals for which TI work, if any, has been completed and accepted by the government. The other 14 are renewals with pending TI projects. This combined 2.18 million square feet across 32 renewals includes VTO Arlington, IRS Fresno, and various smaller leases in Buffalo. When we exclude these assets, the average rent spread achieved on the remaining renewals is anticipated to be 18%, including an estimated $40 per square foot of TI utilized by the government. The weighted average total renewal term for these leases was 17.2 years. In closing, we believe the essential nature of our assets, observed building utilization trends, and the demonstrated strength of our renewals big volumes for the necessity of our portfolio and the dependability of our underlying cash flow. We are seeing prospects for attractive growth, and we believe Easterly is well-positioned to transact and pursue unique opportunities to enhance the enterprise. With a solid NOI supporting our platform, we hope our listeners today appreciate the unique nature of our business. With that, I thank you for your time this morning, and I will turn the call over to Allison to discuss the quarterly and year-end financial results.

Thank you, Megan. Good morning, everyone. It is my pleasure to be joining you this morning and report the company's strong quarterly and year-end consensus meeting results. Given the predictability of cash flows and the certainty of our leading role in this market, we believe Easterly is poised for growth in 2024. I am pleased to report that at year-end, Easterly's portfolio performed solidly. We have leverage at the midpoint of our target range, less than $80 million drawn on our revolver, and only 6% floating rate debt exposure. For the fourth quarter, all on a fully diluted basis, net income per share was 4 cents, and core FFO per share was 28 cents. Our cash available for distribution was $21.9 million. For the full year, net income per share was 20 cents, Core FFO per share met consensus at $1.14, and cash available for distribution was $94.8 million. With an eye to the balance sheet, it is important for us to stagger debt maturities and manage our interest rate risk. We've thoughtfully managed our assets and liabilities, ensuring that we're well positioned to address 2024 maturities and capitalize on emerging opportunities. As you can see from our fourth quarter and full year results, Our balance sheet reflects stability and strategic foresight. The strains of the company's cash flows are backed by the full faith and credit of the United States government. This allows us to achieve a better cost of capital through a lower cost of debt. While we can be quickly lumped in with our office peers and broader sector weakness, the superior credit of our U.S. government tenants and forecastability of our cash flows separates Easterly from other office rates. Our commitment to financial prudence is reflected in our recent announcement of our inaugural investment grade BBB credit rating from KBRA. We finalized the rating in the fall of 2022 and have maintained it since that time. We believe this will serve us well as our capital needs expand. While growth is at the heart of our strategy, we view the momentum behind that growth as a key differentiator for Easterly. There is power in our working capital management, which is reflected in achieving ongoing property operating expense savings, managing G&A creep, and releasing at positive spreads. We have taken a disciplined approach to operational efficiencies and tenant engagement. With this backdrop, our focus remains on growing the portfolio at opportune moments. Particularly when compared to private developers and other real estate owners, the advantages of being a public company are central to our growth strategy. As Megan shared earlier, we have access to a diverse pool of debt and equity sources, which allows us to acquire accretively and maintain a cost of capital advantage, even when others may be faced with constraints. Turning to 2024, we are introducing our full year core FFO per share guidance on a fully diluted basis in a range of $1.14 to $1.16. This guidance assumes the closing of VA Jacksonville through the joint venture at its pro rata acquisition price of $40.9 million, and that we will have $100 to $110 million of gross development-related investment during 2024. At its midpoint, this sets the path for Easterly to deliver strong core FFO per share earnings growth to shareholders in 2024. We believe this represents a market-leading risk-adjusted return and charts the course for delivering long-standing growth opportunities for our shareholders. With that, we thank you for your time this morning and appreciate your partnership. I will now turn the call over to Shannon for questions.

Thank you. As a reminder to analysts, to ask a question, you will need to press star 11 on your telephone. Please stand by while we compile the Q&A roster. Our first question comes from the line of Michael Griffin of Citi. Please proceed with your question.

Great, thanks. Daryl, you said you remain committed to the dividend, at least in the near and medium term, but if I look at, I guess, expectations for 24 and 25, 24 and then probably consensus on 25, it seems like you know, the dividend is not near kind of that coverage level. I guess, is it a function of executing on external growth to grow earnings? You talked about the 2% kind of expectation for the near term. Is it throttling down CapEx? Just how do we get comfortable around a more normalized payout ratio going forward?

No, no, great question. You know, and I think as we, you know, one of the things I was trying to emphasize in my prepared remarks is the predictability of our cash flow, you know, well, you know, with a very, very, you know, horizon far in the future. And so as we look forward, we see, you know, with our existing portfolio, we can, of course, you know, grow into our dividend as we have lease renewals. But you're exactly right. We can trim a little capex to manage CAVs. and we're also working hard on avoiding the gna creep and continue to uh to cut expenses in order to make that so and as i said we're looking at and as yes we sort of discussed on our analyst day we're seeing some real opportunities in the in the development market and you know and sort of individual assets in the wholly owned asset area where we can buy some things accretively so We feel very good about our earnings this year. And then if you continue to take the trajectory that we're giving, we're guiding to and push it out, you know, sort of one or two more years, I think you'll see that we are in a nice place with our dividend. And we feel that our business, given the predictability and the stability of the cash flows and the long enduring nature, you know, of our lease obligations, that getting as much cash to shareholders is the right way to folks who invest in DEA.

Great. That's helpful. And then maybe turning to guidance, I noticed you hadn't incorporated expected acquisitions into the full year guide. You had historically done it, I think, in 22 and 21, maybe not so last year. But you've talked about this pipeline that you're seeing. Can you maybe quantify how many acquisitions you're looking to do this year, I imagine that would help move the needle on earnings and maybe where you're seeing cap rates or return hurdles on those acquisition targets.

Good morning, Griff. We're prudently not including it in our guidance just for everybody to be able to understand the growth potential embedded in the assets we own going into the year. We will close on our remaining VA in the joint venture. And what I would say, looking at the acquisition market today, there is robust levels of potential deal flow in the market. And we are engaged with numerous sellers, in particular on the wholly owned acquisition side of the house, in addition to the developers who are facing needs that would be more sort of longer term over the next couple of years. So we see value in that market kind of in the mid 7% type cap rate range, which is a level that we look to be able to transact at accretively and continue to contribute to the growth for shareholders. But I think going into this year, as that market continues to build, I would say over the course of the spring and summer, we're really excited about the ability to add that onto what is already a platform of growth.

It's great. I'd like to just say it again because I think it's such an important point. Our guidance this year does not include us having to buy anything. And the market that we're seeing to provide a little bit more color is that the bid-ask spread on cap rates is wide, but there's opportunities to pick off buildings. The timing of that is uncertain, but as Megan said, we're transacting at accretive levels in those mid-sevens, and we will look forward to increasing our guidance as we find those opportunities. Given where the market is, given the positioning, and given that we want investors to just understand the track that we're on, we're being conservative in how we are bringing things forward and only talking about guidance about things that we feel are certain and don't require things outside of the four walls of this office in order to make that guidance a reality.

Great. That's good for me. Thanks for the time.

Thank you. Our next question is from John Kim of BMO Capital Markets. Please proceed with your question.

Thank you. I just wanted to clarify on your guidance of $100 to $110 million of development-related investments, that that's the financing that you're providing to private developers? And I'm wondering what's the yield you're expecting on it?

Hi, John. It's Allison. So for that guidance, that is purely FDA Atlanta, which is our previously announced development. And we're targeting yields in the mid-sevens on that, as we discussed last quarter.

Okay. So the development financing is not in your guidance? Correct.

No. The opportunity set for these sort of private developers looking for capital, that would also, to Daryl's prior point, you know, be additive financing. as we look to engage with those folks.

And just to clarify, I think Daryl mentioned that the financing you're providing are projects you plan to own once they're complete?

You broke up a little bit, but yes, these are assets that we would be looking to own at completion as well.

Okay. What leverage level can you get to to maintain your investment grade rating from KBRA?

Yeah, they're very comfortable with our six and a half to seven and a half times range. Not that we'd be looking to do this, but I think opportunistically we could certainly sit at the higher end of that, if not a little bit in excess. But that's a range that they're abundantly comfortable with.

Again, that excess leverage would come from developing these buildings and would, again, be repaid with lump sums or long-term leases.

Right. Okay. My final question is just a follow-up on Michael's on the dividend. Your payout ratio on CAD was 118% last year. If you assume growth of 4% per annum, that'll take about five years to cover it. I'm assuming some of these developments loans that you provide are probably not going to be cash on a cash basis as far as the yield. Why not address the dividend now as you're going through more of a growth strategy rather than a stability and high yield focused strategy that you've had previously?

Yeah, I mean, John, we're really taking a long, long view on this. And we have the the fortunate ability to do so given the types and the nature of assets that we have in our portfolio. So as Daryl said earlier, we're really going to look at all the levers we have with regard to our quote-unquote same-store portfolio to manage the payout levels. But we're not looking just one, two quarters ahead. We're really looking one, two years ahead. And the opportunity that we see in front of us is one that we think we can sort of bridge into nicely.

Okay. I mean, I would argue a pad ratio above 100% shouldn't persist for more than a couple years, but we can talk about offline. Thank you.

Thank you, John. Thank you. Our next question is from Michael Carroll of RBC. Please proceed with your question.

Yeah, thanks. Megan, I know you touched on this in your prepared remarks, but how many leases are you currently on waiting on the TI build-out before those rent escalators can be realized? I mean, should we see... I mean, is it a meaningful amount where there's some more embedded organic growth that's not realized in your fourth quarter numbers now, but it will be realized once those TI projects are complete in the new rent asset?

Yeah, Mike, it's... It's from a single tenant perspective, it's 11. Then you've got a couple other smaller leases in Buffalo. So it's 14 total leases for over a million square feet that are still going through the TI build-out process.

How much, I guess, rent or incremental rent does that represent that could flow in through numbers?

We can isolate that for you, Mike. But, you know, we don't know just yet where those full all-in rents are going to land. So we've held back on that. But that subset, you know, really is the subset of assets that we're looking for increases, you know, north of 25% on. So it's a considerable tailwind with regard to the growth we're talking about over the next one to two years.

Okay, and then that's going to come online in 2024 and 2025, so it's a two-year type timeframe before that stuff gets kind of realized?

Yes, the vast majority of that we expect to come on over the course of 2024, primarily in the back half of 2024. A bit of it could be expected, you know, 20% or so to flow over into 2025.

Okay. And then on the investment side, I mean, how do you plan on funding, I guess, new deals? I mean, before you can kind of pursue some of those transactions that you highlighted, does DEA need to raise equity to kind of fund that? Is that kind of what we should be expecting? So how aggressive you get really depends on where your cost of capital kind of trends?

Yes, so we look to each deal with a mix of debt and equity tailored to that deal, but generally we look to acquire 75 debts wide of our cost of capital considering both debt and equity sources.

And yeah, Mike, with our forward equity position today, yes, we look at deals relative to, as Allison said, the marginal cost of capital for the company and relative to that deal, but incremental external growth will require additional new capital.

Okay. And are you comfortable with your current leverage metrics right now? I mean, would you want to kind of trend lower from that seven, seven plus type range to a more midpoint of your longer term target?

So we're sitting right at seven times from an adjusted net leverage perspective. And so that's a very, obviously very comfortable place for us.

Okay, great. Thank you.

Thank you.

Thank you. As a reminder, to ask a question, you will need to press star 11 on your telephone. Our next question is a follow-up from Michael Griffin of Citi. Please proceed with your question.

Thanks for taking the follow-up. Just a quick question on the guidance. Curious if there is any capitalized interest embedded in the 2024 guide.

So as we continue to build out FDA Atlanta, yes, incremental borrowings would would draw interest that we would be able to capitalize. So no change in that expectation. Obviously, all developments are treated that way.

Great. Thanks.

Thank you.

Thank you. Our next question is from Michael Lewis of Truist Securities. Please proceed with your question.

Thanks. I'm sorry if I missed this. I got on a little late. did a few shares in the forward offering. I just wanted to ask about the pricing, right? The pricing on the shares was below consensus NAV by material amount. And I know this is a dangerous question, but how do you think, you know, about a price that you wouldn't issue below? Or, you know, how do you kind of think about protecting the equity value?

Yeah, it's a balance obviously, Mike. I think we're seeing opportunities where equity, in that low $13 range, makes a ton of sense. And those are certainly assets that are going to come wide to that type of implied cap rate weighted up to cost of capital. And so, to the extent we see those opportunities, and they are maybe opportunistic, we will look to bring them in. They're consistent with our portfolio and help resume that that growth path that we're looking to get back on.

Okay. And then, I guess this is a follow-up to a follow-up. You know, just on the dividend, the, you know, you talked about the predictability of cash flows in relation to the dividend policy. But, you know, obviously, when you set this dividend, you know, you didn't predict, obviously, that you'd be, you know, material below your cash flow. You raised the dividend in 3Q21. You haven't covered it since 3Q22. you know, I, I get, you know, the, the, you know, the company is built for this stability and I know the dividend is a big piece of that, but I guess this goes back to kind of the other questions people ask, you know, I, I get to answer this. It sounds like you're willing to fund this for, for a, you know, a material amount of time. Um, just, just confirming, I guess.

Yeah. No, I mean, the, the, the answer to that is yes. I mean, it's, it's not a, um, We don't look at it as a material amount in the context of some of the opportunities that we're seeing. And we're aware, not blind to the issue or the dollars, but as we look out, again, with $6 billion of government money that's going to, as we release, it feels like there's no uncertainty in the future. I think sometimes we debate maybe we should give guidance for the next five years just to sort of put it out there. And as we look at these development opportunities and some of what we see in the pipeline, we feel very good that we're going to get to a place that covers the dividend and also continues to grow it.

Really appreciate it. Thank you.

Yeah, no, thank you. And we really appreciate the question too. I mean, because it is something we are different than office and it is that predictability and stability. And we're not just saying it. I mean, if you look at the term of the leases and real dollars that are coming in, our business operates over years, not quarters. And And we think the dividend is an important part of the story, and I don't think we're being dogged about it. I just think in the context of the business, the profile, and the cash flows that we have over these coming years, we feel very comfortable with where the dividend is.

Thank you. Our next question is from Bill Crow of Raymond James. Please proceed with your question.

Hey, good morning. I'm Daryl. And given the question line, not only this quarter, but past quarters, are you increasingly feeling like a little bit of a round peg in a square hole from the REIT perspective? Is it the right strategy for this company to keep that REIT wrapper?

What was the last word you said, Bill?

I'm sorry. I'm just wondering about the longer term, whether that REIT structure is the right place for Easterly.

Yeah, no, I think it's a very good question. But I think that, again, having the profile of the cash flows that we have, we've always expected there to be a little bit more appreciation because we are the most secure set of cash flows of any of the REITs that are out there. And only but for maybe 10 days during COVID did we see the real premium of that certainty and stability. I think there are things that we can do on our cost of debt. I mean, you see when we sit with debt providers and we talk about our business, we're strongly encouraged to put more leverage on the company or understand that that's a capability. And we do have, you know, strength in that full-facing credit backing of some of our rent profiles. So I think we can be, you know, clever on that front in finding some solutions where we can be very competitive relative to other REITs, you know, on our cost of debt. I think that we also, as you know, putting 15% of our portfolio into state and local and government adjacent, we think it's smart because we can find buildings with similar close credit rating, very high credit rating, and with escalations. And we do think if we're adding another 80 to 100 basis points in our core FFO, more in line with the expectations of REITs broadly. I think it's sometimes our point of view, I would sort of go out on a limb and say, I think if we ask our analysts to pick the stock that they want to hold for 20 years, I think lots of folks might pick us. But I think if you're picking a stock for a quarter or for two quarters, we're rarely going to be that darling. We're mindful of the capital that we're receiving. We're mindful of what's going on in the REIT space. We do think modifying the cash flow stream in the core FFO, so it rhymes a little bit more with REITs and REIT expectations is certainly a strategic goal for the company. And if we can solve a little bit of the debt riddle, which I think we're well underway in doing, we can get to a place where we're delivering some really great risk-adjusted returns, you know, for investors. And, you know, I look at the stock with a 9% dividend, and I just think it's a lot of value. And, you know, I've shown that with buying my own shares, and I'll continue to do that too.

Yeah, very good. Appreciate the answer.

Thank you. No, thank you for the question.

Thank you. I would now like to turn the conference back to Daryl Crate, CEO of Easterly Government Properties, for closing remarks.

Great. Thank you, everyone, for joining the Easterly Government Properties fourth quarter 2023 conference call. I'd like to thank our investors and stakeholders for their continued support and trust in our company. We value your confidence, and we're committed to delivering sustained long-term success for you.

This concludes today's conference call. Thank you for participating. You may now disconnect.