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Edited Transcript of GOV earnings conference call or presentation 27-Apr-17 3:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Government Properties Income Trust Earnings Call

Newton Jun 4, 2017 (Thomson StreetEvents) -- Edited Transcript of Government Properties Income Trust earnings conference call or presentation Thursday, April 27, 2017 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Christopher Ranjitkar

* David M. Blackman

Government Properties Income Trust - President and COO

* Mark Lawrence Kleifges

Government Properties Income Trust - CFO and Treasurer

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Conference Call Participants

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* Bryan Anthony Maher

FBR Capital Markets & Co., Research Division - Analyst

* Michael Carroll

RBC Capital Markets, LLC, Research Division - Analyst

* Mitchell Bradley Germain

JMP Securities LLC, Research Division - MD and Senior Research Analyst

* Vikram Malhotra

Morgan Stanley, Research Division - VP

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Presentation

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Operator [1]

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Good morning, and welcome to the Government Properties Income Trust First Quarter Financial Results Conference Call. This call is being recorded. At this time, for opening remarks and introduction, I would like to turn the conference over to the Director of Investor Relations, Mr. Christopher Ranjitkar. Please go ahead, sir.

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Christopher Ranjitkar, [2]

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Thank you, and good morning, everyone. Joining me on today's call are President, David Blackman; and Chief Financial Officer, Mark Kleifges. They will provide insights about our recent accomplishments and results for the first quarter. They will then take your questions.

First, please note that the transcription, recording and retransmission of today's conference call are prohibited without the prior written consent of the company. Also, 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 GOV's present beliefs and expectations as of today, April 27, 2017. The company undertakes no obligation to revise or publicly release the results of any revisions to the forward-looking statements made in today's conference call other than through filings with the Securities and Exchange Commission, or SEC, regarding this reporting period. Additional information concerning factors that could cause those differences is contained in our filings with the SEC, which can be accessed from the SEC's website or the investors section of our website at govreit.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. And finally, we will be discussing non-GAAP financial metrics during this call, including normalized funds from operations or normalized FFO. A reconciliation of these non-GAAP figures to net income and the components to calculate cash available for distribution, or CAD, are available in our supplemental operating and financial data package, which again can be found on our website.

Now, I'll turn the call over to David Blackman to begin our quarterly discussion.

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David M. Blackman, Government Properties Income Trust - President and COO [3]

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Thank you, Christopher. And good morning. On today's call, I will review our quarterly leasing activity and our outlook for tenant retention for the next 24 months and then turn the call over to Mark to review our financial results.

Although GOV's headline normalized FFO was negatively impacted by our noncash charge at SIR due to a tenant bankruptcy, our operating results remain stable. In fact, stable is a good description of our core operations. Since the beginning of 2016, GOV's consolidated and same-property occupancy has averaged approximately 95%. And on average, we have leased approximately 395,000 square feet per quarter with a 5.7% rollup in rents; and leasing concessions and capital commitments of $2.47 per square foot per lease year. Considering the instability of our political environment and the U.S. government's focus on increasing utilization rates, we think these results are outstanding.

Now let's review our first quarter leasing activity. We completed new and renewal leases totaling 360,000 square feet for a weighted average leased term of 10.6 years, a 5.2% rollup in rent, and leasing concessions and capital commitments of only $0.59 per square foot per lease year.

Government tenants accounted for approximately 90% of our leasing activity during the quarter and included an early renewal for a [322,000] square foot lease with the U.S. Postal Service for 11 years and leasing capital commitments of only $0.24 per square foot per lease year. The property subject to this lease renewal with the U.S. Postal Service was GOV's first acquisition after our IPO in an interesting case study. We acquired this property in August 2009, with the remaining lease term of only 3.5 years. However, the building was being used as a bulk distribution center for priority mail service. And we had conviction that the use would not go away. In addition, we acquired the property for an acquisition yield of 11.1%, which we believed was appropriate for the term risk.

This recent renewal is the second lease extension with this tenant. And on both occasions, we have rolled up rent to an aggregate increase of 22.5% from the original lease in 2009. And because our capital commitments had been minimal at each renewal, we have also grown our acquisition yield from 11.1% in 2009 to 11.9% with this current extension. Although not every acquisition has the same outcome, this case study provides a good example of how our active asset management can create positive results for shareholders.

Now, let's review our tenant outlook for the next 24 months. As of March 31, we have leases contributing approximately 20.2% of GOV's annualized rent and covering approximately 1.9 million square feet that are subject to expiration.

Based on our latest tenant discussions, we currently expect tenants contributing 2.43% of annualized rent to vacate properties during the next 24 months. This is down 17 basis points from the previous quarter, primarily as a result of expected tenant move outs. We did add one insignificant nongovernment tenant that contributes only $19,000 of annualized rent to the list this quarter. The tenants we have identified to be at risk of downsizing or vacating increased from 82 basis points last quarter to 138 basis points this quarter. This increase is the result of adding the EPA's office in Golden, Colorado to the list and is a good example of how difficult it can be to provide a 24-month outlook on tenant retention.

During the past 4 quarters, we have been talking to both GSA and the EPA about this March 2018 expiration and have received both inconsistent and conflicting responses from the 2 groups. Although we still do not have a definitive notice that the EPA will vacate, we now believe that it is more likely than not that the EPA will relocate to the Denver Federal Center. It is, however, uncertain as to when this move might take place and where the capital will come from to build out this division's analytical requirements. It could potentially take longer than 24 months for this tenant to actually vacate our property. Once we have greater certainty about the EPA status, we will update our list accordingly.

With that, I'll turn the call over to Mark to review our quarterly results.

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Mark Lawrence Kleifges, Government Properties Income Trust - CFO and Treasurer [4]

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Thanks, David. Let's begin with the review of our property level performance for the first quarter of 2017. When compared to the first quarter last year, GOV's rental income grew by approximately $5.7 million to $69.3 million. This increase was primarily the result of our fourth quarter 2016 acquisitions, as well as the acquisition of our Manassas, Virginia property in January.

On a same-property basis, our first quarter rental income increased by $793,000 or 1.3% year-over-year to $62.9 million, reflecting an increase in occupied space and higher rental rates at certain of our properties, partially offset by the decline in rental income from our Germantown, Maryland property, which the Department of Energy vacated in the 2016 second quarter. Cash basis rental income for the 2017 first quarter was essentially unchanged versus the prior year and is $620,000 lower than GAAP rental income, primarily as a result of straight-line rent adjustments related to 3 leases that commenced in the second quarter of 2016.

First quarter consolidated property operating expenses increased by approximately $2 million year-over-year to $26.8 million due primarily to our property acquisitions. Same property operating expenses increased by $508,000 or 2.1% year-over-year to $24.6 million. This increase was due primarily to higher wage and benefit costs and maintenance and repairs expense.

Consolidated first quarter net operating income, or NOI, increased by $3.6 million or 9.4% year-over-year to $42.5 million. Consolidated cash basis NOI for the first quarter increased by $2.8 million, or 7.2% to approximately $41.7 million. Our consolidated GAAP and cash NOI margins for the 2017 first quarter were 61.4% and 60.8%, respectively. From a same-property perspective, our GAAP NOI increased $285,000 or 0.8% year-over-year to $38.3 million. And our cash basis NOI decreased by $526,000 or 1.4% to $37.5 million. Our same property GAAP NOI margin was 60.8%. And our same-property cash basis NOI margin was 60.3% for the 2017 first quarter.

Turning to our consolidated financial results. Normalized FFO for the first quarter was $39.9 million, which is down from $44.4 million for the 2016 first quarter. Normalized FFO per share for the 2017 first quarter was $0.56, which is down $0.06 or 9.7% from the 2016 first quarter. This decline was primarily the result of increased interest expense due to a higher weighted average interest rate on a larger outstanding debt balance and the decline in normalized FFO contribution from our SIR investment, partially offset by the increase in property net operating income. The $3.9 million or $0.05 per share decline this quarter in the normalized FFO contribution were recognized from our SIR investment, was due primarily to a noncash charge SIR recorded during the 2017 first quarter in connection with the tenant bankruptcy.

GOV's adjusted EBITDA was $51.9 million for the 2017 first quarter and includes approximately $12.7 million of cash distributions received from our SIR investment.

GOV paid a $0.43 per share dividend to shareholders during the first quarter, which equates to a normalized FFO payout ratio of approximately 77%. We spent approximately $1.8 million on recurring building improvements and $3.5 million on tenant improvements in leasing cost in the 2017 first quarter.

As of quarter end, we had approximately $24.8 million of unspent leasing-related capital obligations and have committed to redevelop and expand an existing property at an estimated cost to complete of approximately $10.1 million.

Turning to our balance sheet and liquidity. Our adjusted EBITDA to interest expense ratio for the quarter was 3.8x, and debt was 51.5% of total gross assets as of March 31. At quarter end, we had significant liquidity with $590 million of availability under our revolving credit facility.

Operator, that concludes our prepared remarks. We'd like to open the call up for questions now.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question is from Michael Carroll of RBC.

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Michael Carroll, RBC Capital Markets, LLC, Research Division - Analyst [2]

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Dave, can you give us some color on the 5% of the portfolio that's currently not leased? Is that mostly just small spaces throughout the portfolio? Or are there any large blocks in there?

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David M. Blackman, Government Properties Income Trust - President and COO [3]

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Well, we have the empty building in Germantown, Maryland that was formerly occupied by the Department of Energy. We have a small building in Albuquerque, New Mexico, that was formerly occupied by the Bureau of Land Management. And I believe those are the only 2 large blocks of space. Everything else is just dispersed in our multi-tenanted buildings.

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Michael Carroll, RBC Capital Markets, LLC, Research Division - Analyst [4]

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Okay. And then is there any prospects to lease up those large blocks? I guess it'd (inaudible) asset in Germantown.

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David M. Blackman, Government Properties Income Trust - President and COO [5]

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We continue to market for lease the asset in Germantown. We've had some prospects. The leasing cycle tends to be a longer cycle. So we think it's a good building. And we think that it will lease. But it's hard to say if that will happen in the next 2 quarters or if it will take longer than that. The Albuquerque asset, we're considering whether or not that building should be sold. It's not a very deep market. We've been trying to lease it for a while. So there are -- it's a much more shallow leasing market than it could potentially be as a sale. It's a pretty significant asset. I think we carry it for right around for $2.5 million.

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Michael Carroll, RBC Capital Markets, LLC, Research Division - Analyst [6]

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Okay, and then I believe, I guess -- correct me if I'm wrong. The tenant that you've mentioned in your prepared remarks was the EPA. Can you kind of describe what type of building they're in currently? Where that's at? And what's the prospects of releasing that space if they do end up leaving?

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David M. Blackman, Government Properties Income Trust - President and COO [7]

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Sure. So they're in Golden, Colorado, which I think is the homes of Coors Brewing. It is a -- really it's a diagnostic lab facility, where they bring in soils, water, other potential contaminants to understand what those contaminants are. It's not a hugely deep market. I mean I think our biggest challenge in releasing that space is that we're not going to know when we're going to get it back for some time. And with the government and the uncertainty of when government tenants leave buildings, you really can't market the space until you get a notice from them that they will be out by a certain date. So I would be surprised if we could really even start marketing that asset for a year. It may be longer.

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Operator [8]

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(Operator Instructions) The next question is from Vikram Malhotra of Morgan Stanley.

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Vikram Malhotra, Morgan Stanley, Research Division - VP [9]

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Just sticking to the EPA, can you give us a sense of, in that market or even just more broadly, but similar types of assets, what you're seeing on -- hearing on pricing?

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David M. Blackman, Government Properties Income Trust - President and COO [10]

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Well, it's a good question, Vik. It really -- it depends. With government leasing, there's such a broad range of cap rates for lease terms of 3, 5, 10 and 15-year terms that it's really difficult to tell you with great certainty what an asset, as an example, in Golden Colorado would sell for. We continue to see assets that are for sale with government tenants that have a 10-year or longer lease terms, trading a very (inaudible) cap rates, so call it in the 6% range. At a 5-year duration, that could bump up to an 8% or maybe even a little higher depending upon how well the building is utilized, how mission critical the agency occupant is. And your view of the ability to renew them in place for the full amount of space that they occupy. So the underwriting for shorter duration leased government buildings has gotten more complicated. I think we do a good job at that because we understand the business. Unfortunately, I think we lose a lot of deals because we understand it so well that we get outbid in a number of cases.

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Vikram Malhotra, Morgan Stanley, Research Division - VP [11]

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Okay, that's helpful. And then just on the expirations you updated us, sort of on the watchlist. But over the next 2 years, what are your expectations on mark-to-market for the tenants that you do expect to renew?

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David M. Blackman, Government Properties Income Trust - President and COO [12]

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Mark, do you -- I think we...

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Mark Lawrence Kleifges, Government Properties Income Trust - CFO and Treasurer [13]

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(inaudible)

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David M. Blackman, Government Properties Income Trust - President and COO [14]

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(inaudible) to slightly up, right?

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Mark Lawrence Kleifges, Government Properties Income Trust - CFO and Treasurer [15]

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Yes.

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Operator [16]

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The next question is from Mitch Germain of JMP Securities.

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Mitchell Bradley Germain, JMP Securities LLC, Research Division - MD and Senior Research Analyst [17]

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Has there been any change by the Government with regards to their approach towards development?

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David M. Blackman, Government Properties Income Trust - President and COO [18]

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No, Mitch, we are not really seeing agencies going out and doing build-to-suits. For example, the EPA tenant, when I said they're going to move to the Denver Federal Center, it would be to an existing building there versus build-to-suit.

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Mitchell Bradley Germain, JMP Securities LLC, Research Division - MD and Senior Research Analyst [19]

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And so has the strategy that -- the optimization strategy that was put in place, call it around 5 years ago, give or take, is that relatively unchanged under the new administration?

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David M. Blackman, Government Properties Income Trust - President and COO [20]

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It is relatively unchanged other than, I believe there's a lot less low-hanging fruit. And there's a lot less opportunity for consolidation than there was when the program started.

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Mitchell Bradley Germain, JMP Securities LLC, Research Division - MD and Senior Research Analyst [21]

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And then last one for me, just curious about the pricing environment. Obviously, no deals under contract is a bit of a sign. But have you seen any changes in underwriting and pricing?

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David M. Blackman, Government Properties Income Trust - President and COO [22]

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Not really, Mitch. I mean we're still looking at a lot of deals. And we've got a handful of deals that are in process. And we tend to get invited back to second rounds, but (inaudible) come in second or third, a fair amount. And I think a lot of that is just simply we understand this business really well. And we don't always compete with people that have the same experience level that we do.

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Operator [23]

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(Operator Instructions) The next question is from Bryan Maher of FBR & Company.

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Bryan Anthony Maher, FBR Capital Markets & Co., Research Division - Analyst [24]

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David, kind of following up on Mitch's question, are you seeing kind of -- after the Trump administration has taken root here, any concern on the part of owners out there that might free up more assets? Are you seeing more assets come to market? Or is it pretty much unchanged quarter-over-quarter?

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David M. Blackman, Government Properties Income Trust - President and COO [25]

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I would say as it relates to the government space specifically, we have not seen more space come on market than you would typically in the first half of the year. I think the market more broadly. We probably have seen more high-quality assets that Select Income REIT would look at or Senior Housing Properties Trust would look at. And I think it's a sign that people kind of view the economy as somewhere bouncing around the top. And it's time to go ahead and market their assets for sale. And I don't say that from the perspective that we see signs the economy has peaked. But there continues to be a tremendous amount of capital focused on the real estate space. And I think owners are trying to take advantage of that and sell out of properties now versus continuing to wait.

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Bryan Anthony Maher, FBR Capital Markets & Co., Research Division - Analyst [26]

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And on the back of that, are you seeing or do you get the sense we may be seeing, a change in cap rates in the next couple of quarters?

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David M. Blackman, Government Properties Income Trust - President and COO [27]

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It's a good question. I mean where we have seen a little bit of a pullback has been on leveraged buyers. But by and large, treasuries have kind of stabilized. And don't seem to be ticking up as much. And when treasuries were going up, spreads were becoming more narrow. So there have been a handful of deals that we -- that's come back to us where it was awarded to a leverage buyer and their debt financing changed, and they couldn't close. But I wouldn't say that's prevalent to the extent that it would have a substantial impact on the cap rates.

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Bryan Anthony Maher, FBR Capital Markets & Co., Research Division - Analyst [28]

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And when those deals come back to you, how much of a lower price typically comes with that? Is it 2%? Is it 5%? Is it 10%? And are you still then coming in second or third on those kind of rebids?

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David M. Blackman, Government Properties Income Trust - President and COO [29]

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Typically, what happens, Bryan is they come back to us and ask us if we would reconfirm our last bid. Depending upon how much time has passed and how much of the lease has burned off, we may confirm our last bid, or we may actually reduce it a little bit. We've had -- I think we've had a couple of deals that have come back to us, where we've actually moved forward on them, not necessarily GOV, but some of the (inaudible) managed companies. But again if -- I wouldn't say it's pervasive in the market.

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Bryan Anthony Maher, FBR Capital Markets & Co., Research Division - Analyst [30]

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And just lastly, what's the typical time lag between when you put in your first bid and then clearly you don't get it, but then they come back to you. Is that a couple of months, is it a couple of quarters?

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David M. Blackman, Government Properties Income Trust - President and COO [31]

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I would say in most cases, it's 3 to 4 months.

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Operator [32]

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And this concludes our question-and-answer session. I'd like to turn the conference back over to Mr. David Blackman for any closing remarks.

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David M. Blackman, Government Properties Income Trust - President and COO [33]

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Thank you for joining us this morning on the GOV first quarter earnings call. We look forward to seeing some of you at the NAREIT Conference in New York in June.

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Operator [34]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.