The RMR Group Inc. (RMR) Q3 2018 Earnings Report, Transcript and Summary

Good day, and welcome to The RMR Group third quarter 2018 financial results conference call. All participants will be in listen-only mode [Operator Instructions]. After today's presentation, there will be an opportunity to ask question [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Tim Bonang, Senior Vice President. Please go ahead.

Good morning, and thank you for joining us today. With me on the 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 performance for the third quarter of fiscal 2018. They will then take questions. I would like to note that the recording and retransmission of today's conference call is prohibited without the prior written consent of the company. Also note that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on RMR's beliefs and expectations as of today, August 08, 2018 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 any differences is contained in our filings with Securities and Exchange Commission or SEC, which can be accessed from our Web site, rmrgroup.com, or the SEC's Web site. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we will be discussing non-GAAP numbers during this call, including adjusted earnings per share, adjusted EBITDA, adjusted EBITDA margin and adjusted EBITDA margin. A reconciliation of net income determined in accordance with U.S. Generally Accepted Accounting Principles to adjusted earnings per share, adjusted EBITDA and the calculations of adjusted EBITDA margin can be found in the news release we issued this morning. And now, I would like to turn the call over to Adam Portnoy to begin our quarterly review. Adam?

Thanks, Tim. And thank you to everyone for joining us this afternoon. For the third quarter of fiscal year 2018, which ended on June 30th, we reported adjusted net income of $9.3 million or $0.58 per share, which represents an increase of $0.10 per share or 21% compared to the same period last year. Year-over-year results also generated growth across the company with solid increases in assets under management, revenues and EBITDA during the quarter. In addition to this quarter’s solid operating results, we recently made good progress in our stated goal of diversifying our revenues and assets under management with the recently announced launch of the RMR Office Property Fund, our first real estate investment vehicle that is targeting private investors. This fund is a private open end real estate fund, focused on making investments in office properties throughout the U.S. Initially, the Fund will primarily be focused on investments in middle-market multitenant office buildings located in core urban infill and suburban locations and non-gateway U.S. markets. The Fund will be marketed to private investors with targeted annual returns of 8% to 10% through a combination of current income and long-term capital appreciation. As far as the launch of the Fund, RMR is committing $100 million and the Portnoy Family Office, or ABP Trust, is contributing $206 million of unencumbered office properties to the Fund. We are hopeful that the Fund will be well received by investors who may appreciate the high alignment of interest we have with the Fund. The middle-market office focus is also something we have significant experience with, and the Fund’s investment focus does not significantly compete with any of our managed equity REITs. We expect RMR’s $100 million commitment to be utilized over the course of the next 12 months. Through the use of this capital and a modest amount of leverage, the Fund has an immediate $300 million worth of buying power. And we expect the Fund to reach over $500 million in total assets without the need to raise additional third-party capital. As this is a new business endeavor for RMR, we expect it to take some time to raise additional capital. But our long-term goal is that the Fund may have at least $1 billion in gross assets under management within the next five years. Turning back to our results for the quarter and activities at our client companies. From an operations perspective, our client companies had another strong quarter. On a combined basis, we ranged over 800,000 square foot of leases on behalf of our managed equity REITs for weighted average lease term of just under seven years and a weighted-average roll up on rent of 2.3%. We also supervised approximately $21 million in capital improvements at our managed equity REITs during the quarter. Some of the more noteworthy highlights across our client companies during the quarter include the following. IOPT reported strong results this quarter that included 218,000 square feet of leasing activity, which resulted in weighted-average rental rates that were 34.5% higher than prior rental rates for the same space and weighted average lease term of over 11 years. IOPT saw same property cash basis NOI increase 3.3% and announced the acquisition of 240,000 square foot industrial property in the Miami market area for $43 million, its first acquisition since its January 2018 IPO. SNH performed well during the quarter with same property cash basis NOI increasing almost 1% despite headwinds from its senior leaving portfolio. SNH remain focused on recycling capital by selling the last remaining property leased to sunrise for a gain of approximately $80 million, and selling two other communities including a skilled nursing facility previously leased to Five Star of approximately $22 million in aggregate. GOV saw same-property cash basis NOI increase by 5% and total leasing activity of almost 400,000 square feet, including 185,000 square feet leased to government tenants at a weighted average rent role up to over 4%. GOV also continued to deliver on its stated disposition plan, selling properties for aggregate proceeds of $129 million during the quarter, resulting in total year-to-date dispositions of $149 million. At TravelCenters of America, on-fuel revenues increased by over $20 million compared to the same period last year, primarily due to growth in TA's truck service business. Lastly, because RMR is releasing its earnings in advance of some of its client companies, I can only touch on some activities that have already been publicly announced. This quarter, HPT raised its regular quarterly cash distribution on its common shares by $0.01 to $0.53 per common share. HPT also amended and restated its $1 billion unsecured revolving credit facility and $400 million unsecured term loan. At Tremont management continues building on its recent loan origination momentum by issuing loans totaling $33.3 million during the quarter. And after quarter end, Tremont announced the closing of $55.2 million in aggregate new loans. As previously announced, RMR has agreed to waive its management’s fee from Tremont for the two year period, beginning July 1, 2018. We believe this waiver provides Tremont the time to fully execute on its business plan. In the long-term a stronger Tremont will be able to continue growing and in turn generate increased revenues for RMR. Management fee revenues from Tremont represented approximately $250,000 this quarter. In closing, since June 30, 2017, we have formed three new client companies in three different real-estate businesses. All of which may lead to enhance growth and revenue and assets under management in future, and we continue to work towards finding additional strategic growth initiatives going forward. We also continue evaluating possible acquisition opportunities. Though it remains important than any potential deal be complementary to our existing operation and generate accretive returns. As I highlighted last quarter, depending upon our use of capital in the coming months, we are also considering possibly returning some of our cash to shareholders in the form of a higher dividend rate. I'll now turn the call over to Matt Jordan, our Chief Financial Officer who will review our financial results for the quarter.

Thanks Adam. Good afternoon, everyone. This quarter, we reported net income of $0.52 per share and adjusted net income of $0.58 per share, with this quarter's results reflective of $0.04 per share of separation costs for retiring RMR executives and $0.02 per share of transaction costs associated with the formation of the RMR Office Property Fund. The growth in adjusted net income is primarily due to the impact of GOV's acquisition of First Potomac Realty Trust, or FPO and the recent reductions in federal tax rates. Management services revenues were $47.3 million this quarter, which represents a $2.7 million increase on a year-over-year basis, driven primarily by incremental service revenues from GOV's FPO acquisition. On a sequential quarter basis, revenues increased almost $800,000 due to growth in construction management fees as construction volumes at managed REITs was up almost $6 million, as well as TA non-fuel revenue increases, driving incremental business management revenues. As it relates to incentive fees, we are only able to record revenue for incentive fees at December 31st of each year. If June 30th has been the end of amendment period, we would've earned $47.5 million in incentive fees as it relates to the measurement period that ends on December 31, 2018, or over $95 million on a full year basis. Total reimbursed payroll and other costs were $13.7 million, of which $11.7 million was reimbursed cash compensation and $2 million was equity based compensation. Reimbursed cash compensation represented 41% recovery rate, which was consistent sequentially and an increase of over 300 basis points on a year-over-year basis. The year-over-year increase was largely due to recoverable headcount increases, driven by GOV's acquisition of FPO. Turning to expenses for the quarter. Total compensation and benefits expense was $32.7 million, which includes recurring cash compensation of $28.6 million, $2.3 million in share based payments and $1.7 million of separation costs. Cash compensation of $28.6 million is an increase of $4.9 million on a year-over-year basis and $500,000 on a sequential quarter. The year-over-year increase in cash compensation is primarily attributable to GOV's acquisition of FPO and the related need for property level headcount additions, as well as wage, benefit and bonus inflation. The modest sequential increase in cash compensation is attributable to headcount additions and continued growth in employee compensation. Looking ahead, we expect this quarter’s cash compensation to be a proxy for future quarters based on our current operations. I’d also highlight that annual RMR restricted share grants occur each September in conjunction with our fiscal year-end with one fifth of all awards vesting when granted. Accordingly, consistent with prior years, our fiscal fourth quarter will include incremental RMR stock compensation expense. Last year, this expense was approximately $1 million, the majority of which is not recoverable. As it relates to the RMR Office Property Fund, RMR will receive annual fund administration fees equal to 1% of the Fund's net asset value, and property management fees equal to 3% of rents collected from real estate owned by the Fund. We are currently projecting the Fund will have a nominal impact on fiscal 2018. And for fiscal 2019, the Fund is expected to provide approximately $4 million of incremental service revenues and approximately $0.15 of net income per share on an annual basis. These projections represent our best estimates and remain subject to change based on variable, such as fund raising, acquisition opportunities and RMR infrastructure cost required to support the Fund. Finally, we ended the quarter with $280 million of cash on hand before considering our $100 million commitment to the RMR Office Property Fund, and we continue to have no debt. That concludes our formal remarks. Operator, would you please open the lines for questions.

We will now begin the question-and-answer session [Operator Instructions]. The first question comes from Mitchell Germain of JMP Securities. Please go ahead.

Adam, who is the target for fund raising for the Fund? Is it high net worth, is it family officer, is it the institutions? I mean how do you foresee the next level of fund raising to take those?

It's all of the above, Mitch. It's family offices, high net worth individuals, institutions. That being said, it's my belief that we will likely get more attraction in the family office high net worth RIA channel than the institutional channel in the first and beginnings to the Fund. There might be some smaller institutions that would come in. And of course we’re not going to preclude marketing to institutions. I just think that the sales lead time for private equity and private investors in these types of funds is more much longer. And I think that it's being our first fund, I think we will likely pick up more traction from private investors, family offices than large institutions. That's not to say as time goes on that we won't eventually raise capital from large institutions. I just don't think it's going to be a high hit ratio show in the year we go into the fund. So that's how we’re thinking about it.

And what's the characteristics of the property that’s being contributed?

Of the 15 -- this 15 properties going in, they all meet the characteristics that we've outlined for the fund in a sense they’re middle market, they’re bigger than 50,000 square feet, they’re all multi-tenant office buildings, they’re all located in, what I've describe as, non -- principally non-gateway markets. But urban infill or closed in suburbs locations in and around the Northern Virginia market, the Austin market. Those are the two largest groups of properties. There are some properties around the Boston market. There are some properties -- one property just outside to Philadelphia. That's genuinely the characterization. They’re all multitenant properties. I'd say that two of the properties are single tenant properties, but they’re principally multitenant middle market office buildings that ABP or the Portland family office has owned for some of these properties for several years, some of those properties were bought just in last few years.

And was the contribution based on an independent appraisal?

Yes, the committee of RMR’s Board of Directors made up of only the independent directors that are un-complicit with RMR ABP hired -- we negotiate basically with them and we reached agreement. And they used and that they hired an independent third-party appraiser to help them in valuing the property. And that was the group that -- that's how we went about the transaction. So yes, independent third-party helped an independent committee of RMR determine the value with us for those properties to go in. And just to recap if they are going -- they are going in an 8.5% cap rate.

So I guess if I look back a couple years when you created RMR, or when you took RMR public, I should say. You wanted to grow your AUM in your – the REIT fund. You were talking about an office fund commercial mortgage. You've almost done everything that you set out to do based upon your original growth strategy. I know you, you said ou may be using some of your cash, either for dividends or acquisitions. I'm assuming that's another asset management type platform. But what is next on the strategic front for RMR?

You’re right. We’ve largely been telegraphing to the market for the last couple of years since RMR became public that getting into commercial mortgage space, getting into the private fund space -- private fund space focus more on the office side. The one other leg of the stool that we’ve talked about is really the securities management side of business. We have a small securities management side of the business. We haven't really been able to grow that business much. I think that’s the next part of the business that we’d be turning to see if we can try to figure out a way to grow that business. That said, of all businesses that we’ve tried to launch and grow, that might be the toughest that’s an industry that’s dealing with lot of fee compression, lot of money flowing into passive strategies. And so it ties into another thing you said, which is acquisitions. We haven't made much acquisitions. I can tell you, we’ve looked at a lot of stuff but we said no and walked away from many, many things. But the one area that I think we might make an acquisition or I could see it happening could be in the securities management side. There are some smaller to medium size players in the marketplace that they themselves might be looking for capital to grow or may have reached a limit in terms of how big they can get. And they could be interested in joining a larger platform like ourselves. And that could be an interesting possible acquisition. That being said, of course acquisitions around other asset management platforms more generally look at, and we’ll opportunistically look at those as they become available. But again, it's a pretty high bar for us to execute on something more general like to make, it has to really be complementary, really add value, it also have to be dependent upon making sure is very accretive to RMR to go forward. So that’s what's next on how I’m thinking about it.

[Operator Instructions] The next question comes from Bryan Maher of B. Riley FBR. Please go ahead.

Two things, first housekeeping, Matt, could you give us incentive fee calculations that you put out there -- and today, I think you said something 40 something million and then 90 something million. Can you walk through that again real quick?

Yes, the gross number would be $95 million for the full year, and that assume SIR, GOV and SNH are paying a fee, no fee from HPT and ILPT. So the 47.5% number recorded in the script was the half year projection.

And then when it comes to the RMR Office Property Fund, it seems like a billion dollar should be pretty achievable, one would think in five years, especially with where you’re getting off to a start at. Does terms for the property management fees at 3% and 5% for the cost of construction are improving. Are those the same terms that you’ve used for the externally managed REITs currently?

Yes, specifically, that’s exactly the same terms. We specifically did not want to deviate from what we use for the equity REITs. So the terms are identical. The asset management fee, the 1% and net asset value, is calculated differently. That would be equivalent to the business management fee, let's say, for the equity REITs that’s done differently. And that’s done differently, because the way that fee is typically marketed or the convention for that type of fee in the private fund space is just different, so its 1% in net asset value, net assets under management on the business management fee. But the property management and the construction management fee are identical terms to what it is with the equity REITs.

But there is no incentive fee on that though?

Correct, that’s another big difference between this fund and the equity REITs. There is no built in incentive fee. We spend a lot of time trying to design the fund that we thought would be marketable, and track it to private investors to a large group of -- a large audience of investors. And we felt -- it didn’t make -- we didn’t think including incentive fee was really going to work. And that’s largely because we’re talking about a core fund that’s really shooting for high single digit, most funds, competing funds that are core funds that are shooting for high single digits, don’t have incentive fees. And so we didn’t want to have something that wasn’t going to be consistent with the market when we launched our first fund.

And I’m surprised that the contributed assets currently has no debt on them, I mean surely they didn’t have -- surely they had some debt on them before. Was it just paid off recently before they were contributed?

The majority of properties for the majority of the time we’ve owned them has not had any leverage. There has been some leverage on them overtime but it was no -- for the short period of time -- for the short-term before they were contributed, we didn’t specifically repaid any debt. They were all unencumbered several months before they went into the Fund.

And then as far as what you're going to buy and I see the description there and Mitch had some good questions on that. I was curious as to why you wouldn’t also include some Class A urban office, let's say, for instance like the Vertex headquarters in Boston, which was a good trade for SNH? Is it something that you might eventually move into? Or are you just seeing the returns on your current targets better than urban market where it might rely on exit strategy to realize the upside?

The fund is focused on office generally, so there’s no prohibition on what we can buy and across the country that’s office. What we've stated is our current focus is what I’d call middle-market, bigger than 50,000 square feet but less than a $100 million in asset value. So think of a few 100,000 square-feet urban is closed in suburb building that goes for tens of millions of dollars, not hundreds of millions of dollars. We think that today, in today’s market those types of properties offer a higher risk adjusted returns then you can get in core downtown call gateway city markets, New York City, Midtown Manhattan, I think great properties, it’s just on a risk-adjusted return basis given what we’re seeing. And again, we get the benefit of RMR well over 35 offices around the country, 1,700 properties we manage, 30 billion. We see a lot of different asset types and we have a long history of investing in office properties. We think today focusing on the middle-market, focusing on -- getting away from the top four, five cities in America -- when you get away from the top four, five urban centers, we could be buying in those downtown markets away from those top four five markets, but also close-in suburbs. And I think there's a lot of good value to be had in buying these buildings at fairly very good risk-adjusted returns. So that’s just today, in today’s market, what we plan to be focusing on over the next 12 to 24 months. Three four years from now, we could be turning around, it could be a different market environment and the fund, because it’s mandate general office, we could turn around and say, hey in this environment, we think it makes sense to be focused on gateway core office towers. But today that’s not where we’re primarily looking at.

And lastly from me, I'm sure, Adam, you’ve talked about this with friends and colleagues in family offices and other asset managers over the past, let's say, six to 12 months. Would you lead us to believe that the $1 billion is probably the conservative estimate? And if that's true, where do you really think that this could go to in the next five to 10 years assets wise?

Well, we once have gotten into this or committed capital or put this much contribute properties unless we believe that this could be a multibillion-dollar endeavor for us. It just wouldn’t be worth the energy, the effort and the money frankly, unless we believe it could be a multi-billion-dollar enterprise. I don’t know if the $1 billion is conservative. This is a new endeavor for us. We’ve had, as you’ve guessed correctly, a lot of conversations with family offices and in participants in that marketplace around this. We think we’ve designed something that will be attractive to investors. But until you’re out there doing it, and it is our first quarter fund you really don’t know. And I do note the sales process can be long. And so maybe I’m being conservative in saying a billion in five years, but I think if we at least get to a billion in five years, that's minimum required to call the success. I want to temper everybody's expectation. We may not see an investment from a third party in this fund for over a year. It may take that long for us to build up traction. But I do believe, once we build traction, once we get to that billion dollar mark and I just don’t know how long it's going to take to take two three years, it could take four five years. But once you get there, I believe the velocity in the fund raising will pick-up. You got to remember, it’s our first fund marketing to private investors. Yes, we have a long-track in the public markets and we’re going to obviously talk a lot about that with private -- with the family office, but it is our first fund. And so I am just perhaps being somewhat conservative, but also trying to be realistic.

The next question comes from Owen Lau of Oppenheimer. Please go ahead.

I do have one follow-up on the Office Property Fund. I just want to get more clarity on the $4 million guidance and $0.15 net income per share next year. And I know it depends on the fund raising and acquisition opportunity. But can you also give more color about your assumptions of the fund raising effort. I know Adam just mentioned it may take a year or so to rent this thing up. But can you give us more color on the assumption of when you give out those $4 million and $0.15 guidance? Thank you.

Yes. And just to be clear, those are incremental numbers. So as you can imagine where earning fees from those properties today that are being contributed so the $4 million of incremental fees next year assumes when we get to the end of next fiscal year, the Fund will have a NAV of somewhere around $325 million, which as you can tell from that number, assumes a limited amount of third-party fundraising as Adam has outlined. That assumption in the $0.15 of earnings then assumes that we have about $1.9 million of incremental infrastructure costs, including third-party providers that we have put RMR’s $100 million commitment to work throughout the year, and we’ll start receiving dividends on that. The fund is committed to about 4.5% dividend rate. So we’re assuming cash flows and dividend income from the Fund. And then as an equity method investor, we would obviously get our proportionate share of their earnings. So those are some of the key assumptions. I don’t know if that’s helpful.

Yes, I think that’s very helpful. Thank you. And just one more from me. I heard some bank saw an intense competition from non-bank lenders in the CRE lending space. I just want to get your sense, Adam and Matt, about the opportunistic in this space when you look across maybe the opportunity last quarter or going forward? Thank you.

Of all the markets we’re in and that we operate in, I would say it is pretty interesting what's going on in the CRE commercial real estate lending market. It is -- it's always been a very competitive market and I think it has become even more competitive. Some of that’s driven by the fact that a lot of money, private funds, especially have been raised, specifically focused on lending in the commercial real estate sector, especially over the last couple years. And that’s coupled with the fact that commercial real estate transaction volume year-over-year has been declining modestly over the last couple of years. They get a lot more capital that’s been raised for the space. And typically these types of financing, not always but a large amount of the financings, happen in and around transactions. And you’re seeing a slowdown in transaction volume at the same time. So it's a typical supply demand imbalance where you got a lot raise earmarked for specific sector and there’s less transaction volume to put the capital to work. So I would tell you, yes, your assumption that there is been increased competition is a hundred percent correct, in our view. There is very high competition. And you're seeing that in the length of time it has been taking us to make loans in our Tremont business. We have announced so far publicly four loans, and it's taken us much longer than we originally had hoped to get that money out as largely as a result of the fact that there is a lot more competition in the marketplace for those loans. So I agree with your assumption. There is a lot of competition in the marketplace.

So do you see, going forward, maybe looking over the next two or three years. Do you see that it’s the trend Tremont can take more business from bank in the CRE lending space?

I think they are not taking so much business from banks, because they have a type of lending that you typically see a Tremont view and many of the private capital has been focused more on what is called transitional bridge lending. That type of lending the banks just typically shied away from over the last several years. I don't see them going back into that market. What is really a result of all this is I just think everyone's returns expectations on lending have come down. The good news in the commercial real estate lending space that -- on the commercial side, this is different than residential. But on the commercial side what I've seen is that lending standards haven’t been loosened materially. That's a good thing. What that’s very different than what we saw in the ‘06 and ’07 timeframe during last financial crisis, we saw a lot of loosening of credit standards. So what I’ve seen among ourselves and our competitors is people are pretty much sticking to their guns on the credit metrics and the underwriting standards but pricing has come in and so that’s where you’re seeing the competition. And so what's really is result of all this, I think there was -- I think a lot of people when they got into this space over the last couple years was expecting a certain level of return. I think that level of return is to be tempered just because of the level of competition. So I think that's really what's going on.

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

Thank you for joining us. We also look forward to updating you on our progress during our fourth quarter conference call. Operator that concludes our call, thank you.