Select Income REIT

Select Income REIT (Nasdaq: SIR) is a REIT which owns directly or indirectly through its subsidiaries, including its majority owned subsidiary, Industrial Logistics Properties Trust, or ILPT, properties that are primarily leased to single tenants. As of March 31, 2018, SIR’s consolidated portfolio included 366 buildings, leasable land parcels and easements with approximately 45.5 million rentable square feet located in 36 states. SIR owned 100 of these buildings and leasable land parcels with approximately 17.0 million rentable square feet, which are primarily office buildings, and ILPT owned 266 of these buildings, leasable land parcels and easements with approximately 28.5 million rentable square feet, including 226 buildings, leasable land parcels and easements with approximately 16.8 million rentable square feet which are primarily leasable industrial and commercial lands located in Hawaii. ILPT was SIR’s wholly owned subsidiary until January 17, 2018, when it completed an initial public offering of its common shares and became a publicly traded REIT. SIR remains ILPT’s largest shareholder and, as of the date hereof, owns 45.0 million, or approximately 69.2%, of ILPT’s outstanding common shares.

Phone: 617-796-8320

Rich Moore: Hello everybody. I guess we're about ready to start. I guess we're at the 3:00 mark. Thank you all for coming. I'm Rich Moore, head of RBC's research team. Could someone shut the door back there, if you would please?

 I'm pleased to have with us, this afternoon, the management of Select Income REIT. That's ticker SIR on the New York Stock Exchange. We have with us David Blackman, president and C.O.O. and we have John Popeo, treasurer and C.F.O., and David I'd like for you to give us a little bit of an overview if you would and then we'll open it up for questions guys.

 David Blackman: Yeah, I'm going to be brief because there's a number of people here and I want to give everyone a chance to ask questions if there are any. We are a REIT that is focused on owning single tenant, net-leased office and industrial assets. We own about 120 properties, roughly 45 million square feet of real estate, and we're the largest owner of industrial lands in the state of Hawaii. We have roughly a billion dollar investment in land in Oahu, which is where roughly 70% of all commercial activity in the Hawaiian islands takes place. We've been public since 2012. We're roughly $4.5 billion in total asset value and we're trading at a relatively high dividend yield right now. We're about 8% dividend yield as of Friday.

We have a relatively long weighted average remaining lease term of 10.4 years. The average age of our assets are about twelve years, which is pretty young for a net lease company, and we've got a very well laddered lease expiration schedule. Roughly 13% of our leases expire between now and the end of 2021. About 39% of our rent comes from investment-grade rated tenants. So with that, I'll open it up for questions 

Rich Moore: All right guys, do you have any questions? Yeah, please.

 Question 1: I was wondering, what percent of your net lease properties, exclusive of Hawaii, have built-in escalators?

 Rich Moore: Okay, one second. The question is, what percentage of your rents have built-in escalators? You guys might want to use that microphone at some point because we're web-casting.

John Popeo: For the most part our mainland office and industrial leases include escalators that range anywhere from one to two percent per year.

 Rich Moore: Any other questions? Yeah, please.

 Question 2: In terms of market value [inaudible 00:03:02]

 Rich Moore: Market value of the assets, how would you assess?

 David Blackman: Sure, I think if you think about market value of the real estate, over the last 18 to 24 months, you have seen a relatively dramatic rise in real estate values, particularly single tenant net lease and particularly assets that have a ten year or longer lease durations. A lot of that's been driven by the leverage buyer. Financing is much more readily available today than it was three years ago. As a result, when we first went public in 2012, we acquired a lot of assets in 2013, 2014, really at average cap rates of 8% and above. A lot of those assets today would trade at significantly lower cap rates if we were a seller of those assets. We're not, because we like that built-in yield that we have on those assets because we think they're core to the tenants and we're think they're strategic to our business.

 We have been kind of bumping along a very high asset level pricing for, really, the last twelve months and it's been relatively stable.

Question 2: I have an additional question, if I may, in light of that what are you looking at outside [inaudible 00:04:42]

Rich Moore: For acquisitions? What areas are you looking at for acquisitions?

David Blackman: We look at a lot of acquisitions right now. We are currently in a position where our leverage is at the high end of our target range. We also have a stock price that trades at what we think is a high dividend yield, which means that our cost of equity is relatively expensive. We have been very cautious in making further investments right now because we've reached that point where we've got roughly $200 million of dry capacity before we would want to go back to the equity markets and raise equity. We don't think there's a rush to spend that money. We think that we've had some recovery in our share price over 2016 and that being patient will reward us, and so we're not really actively looking to accelerate growth right now. We're looking across the country and we're looking to find assets where we think we can get an average yield somewhere between 7.5 and 8.5%.

Rich Moore: Okay yeah, please.

Question 3: Can you speak a little bit about your leverage policy [inaudible 00:06:06].

Rich Moore: The question is leverage policy and your strategy on the balance sheet.

John Popeo: Sure, so as of today we stand at around 53% at the total book value, which is historically high. Relatively speaking a lot of the other triple net leased REITs are also running leverage a little high and there's really no mystery behind it. It's really the state of the capital market for all of us right now.

We are investment grade rated. We speak to the rating agencies on a regular basis. They have no issues with the fact that our leverage is above 50% and that's for the most part a reflection of the quality of the portfolio now and as David mentioned a couple minutes ago, the fact that we don't have any significant near-term lease maturities. The portfolio's in really good shape. We issued a billion and a half senior unsecured notes when we closed the acquisition of CCIT in January 2015. We really have no near-term maturities except for around $40 million of mortgage debt that comes due in December 2016. After that, the first tranche of those senior notes comes due in February 2018.

Our hope is that the equity markets continue to improve, particularly for SIR. As David mentioned, we've had a good trajectory so far this year. Stocks pinging between $24 and $25 a share. We'd like to see it go up a little higher. At some point, we would like to take leverage down, but we're in no hurry. We're not under the gun by any stretch of the imagination. 

As far liquidity goes, we have a little less than $300 out on the revolver right now. It's a $750 million revolver that doesn't mature for another three years with a one year extension option. We're in good shape. As far as the overall capital stack goes, floating rates, that represents roughly 15% total assets. Secure debt represents about 6% of total assets. It's really right where we want to be as far as a mix between floating, fixed, and mortgage debt. Clearly the goal is to bring leverage down to the 50% level in the intermediate term and maybe a little lower over the long term.

Rich Moore: Okay, yeah please.

Question 4: What is the rationale for the investment by Government Properties and what is their long term intention?

Rich Moore: The question is, why did Government Properties buy a big slug of your stock and what's their long term intentions?

David Blackman: That's a good question. Select Income REIT was a subsidiary IPO through Commonwealth REIT. Commonwealth retained shares in the company, actually more than 50% of the outstanding shares at the IPO. When The RMR Group transitioned management of the company to the Sam Zell organization, it became apparent that it was not a core investment for the new Equity Commonwealth. They offered to sell those shares to The RMR Group or one of its affiliated companies. 

There is a very similar investment thesis between Government Properties Income Trust and Select Income REIT in that both companies invest in assets that have very durable and sustainable income streams. On top of that, Government Properties Income Trust was really looking for investments that had limited capital requirements. GOV has roughly 60% of its leases expiring in the next five years so it anticipates that it will have a relatively high leasing capital requirement. The ownership of those shares, the strong dividend that has high growth potential, was attractive to them. For GOV, it's a long-term core investment and an opportunity to get a durable income stream that doesn't have ongoing capital requirements.

Question 4: So they have no option to acquire stock or warrant [inaudible 00:10:42].

David Blackman: They do not have any option to acquire stock or warrants in the future. If they wanted to buy shares they would have to go out in the open market, the same as anyone else.

Rich Moore: Good questions guys. Anything else out there? All right, well I'll ask you guys, obviously for a triple net company, external growth is important. You guys have mentioned that you have a certain amount of liquidity and I'm wondering, what are you looking at in the pipeline? What do you see out there if its still office focused, industrial focused, and maybe give us some thoughts on the pricing and how that might have changed over the past few months.

David Blackman: When we went public, our strategy was really that we own this incredibly core group of properties in Hawaii that had wonderful, internal growth. Our assets in Hawaii have a lease structure that allow us to reset rents to market every five to ten years and that's done based upon the market value of the real estate. Over time, we have a certain number of assets every year that have rent resets. Since we've gone public, we've grown rents in Hawaii, on average, about 40% through rent resets

What we also said at the IPO was that there's really not an opportunity to buy a lot of assets in Hawaii. Not a lot of land sells on a fee-simple basis and what does sell tends to sell at very low cap rates. Our external growth was going to be from buying office and industrial assets on the U.S. mainland. That's really what we did and that's what the acquisition of Cole Corporate Income Trust did for us, was allowed us to buy some very high quality assets on the U.S. mainland that were heavily focused on office. Office tends to be what we think as more core for our mainland portfolio and what we have acquired more of since we have gone public. 

What we tend to do is we look for assets that we think are core to our tenants. We think that if you own assets where there's a strategic reason why that tenant is there, that you are more likely to renew them in place and the value proposition for us is to renew that tenant in place versus having to replace them. We spend a fair amount of time in our underwriting diligence trying to get comfortable that it is a core asset to that tenant. We also focus on lease terms for office that are no less than seven years and for industrial assets that are no less than ten years.

What we have found in the market today is there's a relatively large differential in pricing for assets that have ten year remaining lease terms and longer. For example, we recently looked at an acquisition opportunity for a fifteen year lease, new building, in New Jersey for an investment grade rated tenant and the expected pricing on that asset was going in cap rate of 5.5%. Whereas, on an asset that's somewhere between seven and ten years that maybe is a five to seven year-old building, we probably could acquire that somewhere between a 7 and 7.5% going in cap rate. There's clearly much more focus today in the single tenant net lease market for long dated leases with high investment grade rated companies and investors are willing to pay up for that.

Rich Moore: Any concentration in terms of tenants?

David Blackman: We have a pretty well laddered top ten investor list. We have roughly fifteen tenants that represent more than 1% of our rent. Our top tenant is a law firm called Shook Hardey. We have their headquarters in Kansas City. They represent just under 4%, followed by Tellabs, followed by Amazon, followed by Bank of America, Noble Energy. We've got some pretty good credits in there. I would say it's pretty well diversified, pretty well laddered with no real concerns from a concentration perspective. 

We're also pretty well geographically diversified. We own assets in 35 markets. Texas is our largest concentration of assets, but it's pretty well diversified between Houston, San Antonio, and the Dallas-Fort Worth Metroplex.

Rich Moore: It sounds like you're saying that it's not so much about being capital constrained, necessarily, but you're not finding the right asset with the right maturity length in terms of the lease, the right pricing, etc. Is that accurate?

David Blackman: I think that's a pretty accurate statement, Rich. Where we are from a leverage perspective, we think the investments that we are making should be compelling and it is very difficult to find assets that we think are compelling from a long-term, risk adjusted, cost of capital. We've been cautious and we don't feel like we need to rush into making acquisitions right now.

Rich Moore: With the pricing environment where it is, and you mentioned that you might want to bring down your leverage to some extent, would you consider some dispositions as well? As part of the strategy, take advantage of the high pricing environment?

David Blackman: We think there's always a strategy around dispositions. Before we buy an asset, we develop a long-term strategic business plan for that property which includes developing a ten-year cash flow model. We review those on a quarterly basis and then we formally update them on an annual basis. We are in the process of going through our business plans for their annual update right now and expect that we will uncover a handful of assets for potential disposition through that process.

By and large, our assets are core to our business. We believe that the vast majority of our assets are strategic to the tenants and we have very high probability of renewing those tenants in place. We do think there are some properties where we've had some recent renewals where we maybe have a maximized value for that asset, or where we think we may have difficulties in the future. Those are the assets that we'll look to dispose of over the next year or so, probably less than $100 million so it won't have a material impact on leverage, but it will help us recycle our capital into assets that we think have better long-term value.

Rich Moore: Okay. Questions? Yeah, we've got a bunch. Please.

Question 5: What's going on in terms of international investment in Hawaii. Particularly by the Asian countries [inaudible 00:18:45]

Rich Moore: International investment in Hawaii by Asian countries, and I assume others as well.

David Blackman: Hawaii is a very attractive market, particularly for the Japanese and the Chinese, who are pretty active in those markets. They tend to be all cash buyers. They tend to be willing to pay relatively low cap rates. What they have been mostly focused on are buying improvements. A lot of it is our buildings that are subject to ground lease. They tend to be focused heavily on the hospitality sector. International and Asian investors have been active in that market, but not necessarily buying land like what we own.

Rich Moore: The question back there, please.

Question 6: You mentioned [inaudible 00:19:45]

Rich Moore: That's a good question. I don't think I can summarize it.

David Blackman: The question is, is there a value proposition in selling some assets that have long weighted average remaining lease terms and buying assets with shorter weighted average remaining lease terms and I would say yes within reason. One of the things that we have done, and we did when we bought Cole Corporate Income Trust is we significantly de-risked our business. We created substantial scale for the company, over $4.5 billion in total assets, and we also added a lot of investment grade tenants to our portfolio and we lengthened the weighted average remaining lease term. We think that's important to investors into single tenant net lease companies, so we don't want to substantially sell off our long dated leases to create more risk in the business that might make our company less attractive. 

We think the better way to do it is to, maybe on the margin, go out and buy some buildings that have shorter remaining lease terms while holding on to your assets that have long weighted average remaining lease terms. That's a good question.

Question 7: I remember, it was probably a couple years ago, you had that asset in Hawaii where you didn't renew the lease. I think you knocked down an old building because you owned the land under all the buildings, and then you redid a brand new mini storage.

David Blackman: That was Commonwealth REIT.

Question 7: Well, it was in Hawaii.

David Blackman: It was in Hawaii, but that property was owned by Commonwealth REIT and never became part of Select Income.

Question 7: Okay, well the question would be, are there any assets in the Hawaii portfolio where you could, instead of just waiting for a reset, it has a higher and better use? Like the shopping center deal.

David Blackman: We have looked at some assets like there where we thought there could be a higher and better use because of change in demographics or change in circumstances. The interesting thing is that it's incredibly expensive to develop in Hawaii and we can get a significantly higher return by just owning the ground and letting someone else take that development risk. That's kind of been our focus. We certainly keep an eye on the possibility on maybe taking a parcel and creating high-density residential because, clearly that's a higher and better use. But I think it's more valuable to the Select Income shareholders to do that as the ground leaser than it is as the developer of the improvements.

Rich Moore: Yeah, please.

Question 8: [inaudible 00:23:19]

Rich Moore: How has the management of triple net assets actually done, in general?

David Blackman: All real estate needs to be managed. Somebody needs to hire the landscaper, somebody needs to pay the electricity, somebody needs to pay real estate taxes, and that's what property management companies do. The RMR Group has its own property management group and we focus on managing office and industrial assets for all of our managed REITS. By and large, we manage the buildings for all of our net leased tenants. It also allows us to build deeper relationships with them because we have employees that interface with the tenant at various levels and so they're building those relationships, which we think helps us renew tenants in place.

There are some circumstances where the tenant has the right to self-manage and then they will either do it themselves by hiring people to maintain the HVAC system, to do all the accounting for the improvements, or they may go out and hire a third party. By and large all of our tenants are managed by a professional group and we do the vast majority of all the property management for the properties we own. 

Question 8: [inaudible 00:25:11]

David Blackman: We do not manage buildings where we don't own the real estate. We don't do third parties.

Rich Moore: Another question out there. We're getting under five minutes guys so if you have something, jump in. I think I'd be remiss if I didn't ask you to comment on your dividend policy because the yield on SIR is very juicy right now. It's even been juicier when the stock was even lower but now the stock's recovered a great deal, and still the yield is quite high. How do you guys view the safety of you dividend and future potential actions with regard to the dividend?

John Popeo: The dividend is very well covered today. At the end of the first quarter of 2016, I think we were around 67% covered and on an AFFO basis, probably around 74 or 75%. Shortly after our IPO we were raising the dividend pretty much every other quarter. Shortly after the CCIT deal in January of 2015, we pretty much went with a recurring dividend at the level we're at today and as David mentioned earlier, the dividend level is just above 8%. We do have some room to raise the dividend, but it just doesn't seem prudent at this point in time and it's not because we expect to have a whole lot of cap ex that will cause our payout ratio to deteriorate, it's just with an 8% dividend level, it's very healthy relative to the REIT peer group in general.

Our hope is to begin to schedule periodic and consistent dividend increases. As I mentioned earlier, we do have built-in rent steps in most of our mainland leases and, in addition, we expect our Hawaii rent reset schedules to kick in again. We don't have any rent resets in Hawaii scheduled for 2016, but the cycle begins over again in 2017 and beyond. We're hopeful that we'll see a repeat performance, as David mentioned earlier, since our IPO we had around 40% rent increases from historical resets over the past four years and if you believe land values will continue to increase on the island of Oahu, and we do, rents in general are based on land value so we expect and hope that we'll see some continued internal growth in Hawaii. That all translates into additional cash flow and the ability to continue to raise the dividend in the future.

David Blackman: When we first went public, our land holdings were a significant part of our investments. You don't get depreciation on land holdings so, in many respects, we were increasing the dividend pretty rapidly to make sure we retained REIT status. Since we've acquired more buildings, we have better sheltering through depreciation, which has allowed us to slow down the amount of growth in the distribution. We talk about it at every quarter at our board meetings, but frankly the thing that has inhibited us the most in increasing the dividend has been the high yield. We are starting to normalize back to a level that's more appropriate, so I think it's probably going to get more view over the next six months or so as to whether or not it's appropriate to do another dividend increase.

Rich Moore: Okay, so safe to say at the moment, no change to policy for the next quarter or so.

David Blackman: No change to policy is expected, but certainly something that gets a lot of view.

Rich Moore: Okay, well we're down to 20 seconds. We'll take one more if you guys have a quick one. Otherwise, David and John thank you both and thank you all for coming.

David Blackman: Thank you very much.



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