Corporate Office Properties Trust

F:WX7

Earnings Call Transcript 2022-Q2

[Operator]

Welcome to the Corporate Office Properties Trust Second Quarter 2022 Results Conference Call. As a reminder, today's call is being recorded.

At this time, I will turn the call over to Michelle Layne, COPT's Manager of Investor Relations. Ms. Layne, please go ahead.

[Michelle Layne, Investor Relations]

Thank you, Katherine. Good afternoon, and welcome to COPT's conference call to discuss second quarter results and updated guidance for the year. With me today are Steve Budorick, President and CEO; and Todd Hartman, Executive Vice President and COO; and Anthony Mifsud, Executive Vice President and CFO.

Reconciliations of GAAP and non-GAAP financial measures that management discusses are available on our website in the results press release and presentation and in our supplemental information package. As a reminder, forward-looking statements made during today's call are subject to risks and uncertainties, which are discussed in our SEC filings. Actual events and results can differ materially from those forward-looking statements, and the company does not undertake a duty to update them.

Steve?

[Steve Budorick, President and CEO]

Good afternoon, and thank you for joining us. We achieved another strong quarter with continued progress on our 2022 business plan. The successful performance and execution of our growth strategy since 2018 has positioned our company to deliver reliable annual FFO growth and long-term shareholder value. Over the past decade, we deeply concentrated investment in the property supporting priority U.S. defense missions and select mission-critical assets in regions that we collectively referred to as Defense/IT locations.

At the end of the quarter, these locations generated 90% of our annualized rental revenue. Demand in these locations is driven by and correlated with national security spending and largely immune from conditions in the overall economy. Our concentration of leases to the U.S. government and high credit contractors supporting national funds and cybersecurity missions is the foundation of our ability to generate resilient high-quality cash flow.

Our external growth strategy continues to be driven by successful preleased and low-risk development at these proven Defense/IT locations. We have an advantaged position in this unique market as the go-to landlord for specialized space satisfying government security requirements. We wisely protected our balance sheet. And as a result, the current interest rate environment poses limited risk to our performance. The $1.8 billion of refinancing completed in 2020 and 2021 provide the solid foundation for us to deliver future growth from our operating and development portfolios.

Our second quarter results show the strength of our strategy and execution. FFO per share of $0.59, met the high end of guidance, making this the ninth quarter out of the past 10 that we met or exceeded the midpoint of guidance. As a result, we're increasing the midpoint of our full year guidance and narrowing the range. Leasing remains strong in our operating and development portfolios. As of June 30, our portfolio was 93.6% leased and 91.6% occupied. We completed 558,000 square feet of total leasing during the quarter. We achieved a solid vacancy leasing volumes with 120,000 square feet we executed equaling in our 5-year average for the second quarter. Additionally, we have a large volume of leases pending execution that suggests our third quarter volume will be exceptional.

The total volume included 211,000 square feet of development leasing, primarily from 186,000 square foot full building pre-lease. This activity brings our year-to-date achievement to 68% of our 700,000 square foot objective. Following this quarter's development leasing success, our active development pipeline now contains 1.9 million square feet of projects, all of which are Defense/IT locations.

These 91% -- these projects are 91% leased with a high level of demand on the unleased space. The projects will deliver between 2022 and 2024, and when placed into service will produce $47 million of incremental annualized NOI that will drive further growth in FFO per share. The fiscal year 2022 National Defense Authorization Act passed through the base budget increase of 5.8%, representing the largest increase since 2018.

We expect demand from this budget to manifest in our leasing pipeline in mid-to-late 2023. Recall that following the 14% increase in the defense budget, that occurred in 2018, we achieved record leasing levels in new development and vacancy leasing in 2019. Moreover, current actions in the defense committees of the House and Senate suggest another healthy increase in the 2023 NDAA. These events give us confidence leasing demand will remain strong through at least 2024.

Turning to inflation. The severe and rapid escalation in material prices over the first half of the year impacted development costs, increasing the year-over-year hard costs for like-for-like development projects by approximately 18%. The demand in our Defense/IT portfolio is driven by national security needs and funded mission priorities. And we have been able to negotiate rents that maintain our historical development yields.

Our Defense/IT portfolio benefits from strong demand for new space and industry-leading tenant retention and the current economic conditions have not impacted our demand or achievement, positioning our portfolio to continue to generate consistent, steady financial growth. Between 2018 and 2021, our FFO per share compounded at 4.4%, coming off the strong 8% growth in 2021, our revised guidance suggests 2.6% growth in 2022 after absorbing the dilutive effect of the sale of DC-6.

Beginning in 2023, we continue to expect growth to compound at 4% or more through 2026. So in summary, we had another solid quarter and our strong pipeline of activity and our fortified balance sheet reinforce our confidence for continued growth.

With that, I'll hand the call over to Anthony.

[Anthony Mifsud, CFO]

Thanks, Steve. Second quarter results continue to show the strength and resiliency of our portfolio despite the uncertain economic environment. FFO per share for the quarter of $0.59, was at the high end of our guidance range. The $0.01 achievement above the midpoint was due to lower than forecasted G&A expenses and the timing of repairs and maintenance projects that we expect to complete in the second half of the year.

The timing of the R&M projects produced same-property cash NOI results that were slightly better than our forecast and our other property portfolio metrics for the quarter were in line with our expectations. Since we expect to complete the delayed R&M projects later in the year, we continue to forecast same-property cash NOI to be flat to down 2% for the year.

This guidance assumes that the Defense/IT locations are flat to up 2%, while the Regional Office portfolio impacted primarily by Transamerica and CareFirst transactions, is expected to be down just over 20%. Stronger than budgeted leasing activity has resulted in an increase in our forecasted same-property occupancy at year-end. And as a result, we are tightening the range of guidance and increasing the expected midpoint by 50 basis points to 92.5%.

NOI from development placed into service will continue to drive growth. We continue to expect between $15 million and $17 million of cash NOI in 2022 from completed development projects. At the midpoint, 100% of this NOI is contractual. With respect to the impact of the current interest rate environment at the end of the quarter, 86% of our debt was fixed rate and another 11% was variable rate debt swapped to fixed through year-end.

The $1.4 billion of fixed rate bonds issued last year, which have an average interest rate of 2.6% and a weighted average term issuance of just under 10 years, significantly extended our debt maturities. Prior to these transactions, at year-end 2020, we had $1.6 billion or almost 80% of our debt maturing between 2022 and 2025, which included almost $1 billion maturities in 2022 and 2023.

This refinancing activity took advantage of the historically low interest rate environment and pushed our first bond maturity into the first quarter of 2026, minimizing our exposure to the current increasing rate environment. The only debt maturing prior to 2026 is a $100 million term loan later this year and our line of credit, which has an initial maturity in the first quarter of next year.

We are working with our bank group on a new term loan and an extension of the maturity of our $800 million line of credit. The new term loan, which is expected to mature in 2028, will fund the repayment of the $100 million term loan and pay down a portion of the outstanding balance on our line of credit. We expect these financing transactions will close before the end of the year.

With respect to the equity capital needed to fund our development investments and maintain our balance sheet strength, roughly 25% of this year's investment will be funded by cash from operations, with the remaining equity capital coming from the proceeds from the sale of DC-6 and recycling out of existing assets towards the end of the year.

Finally, we are narrowing our range and increasing the midpoint of FFO per share from a prior range of $2.31 to $2.37 to a new range of $2.33 to $2.37. As a reminder, our guidance includes $0.04 of dilution from the sale of DC-6 and the increased midpoint of $2.35 per share implies 2.6% growth over 2021 FFO per share results.

And now I'll hand the call over to Todd.

[Todd Hartman, COO]

Thank you, Anthony. Leasing activity remains strong, and we are confident that we will meet or exceed our objectives for the year. We completed 228,000 square feet of renewal leasing during the quarter for a retention rate of 58%. The retention rate was anticipated and heavily influenced by two nonrenewals. In Huntsville at 1,100 Redstone Gateway, we negotiated a 48,000 square foot reduction with Boeing, providing much-needed second generation capacity to meet market demand.

We are currently negotiating a lease with a defense contractor for the entire vacancy and expect to have that space leased and occupied in the third quarter. In Baltimore, at our Canton Crossing property, we experienced a 28,000 square foot nonrenewal. During the quarter, we executed a new lease for 15,000 square feet of this space with occupancy expected in early 2023.

Cash rents for the quarter rolled down 8.10% and straight-line rents increased 7.8%. We expect renewal activity for the balance of the year to be very strong and heavily weighted to the fourth quarter and that our annual renewal volume will reach our historical average of 2 million square feet by year-end.

As a result, we are increasing the midpoint of our retention guidance to 75%. Looking forward to 2023 and 2024, we expect our strong retention rates to continue. During 2023 and 2024, we have 21 expiring leases larger than 50,000 square feet, totaling 2.4 million square feet. We expect to renew more than 95% of that space. These 21 leases represent 50% of all the expiring footage in 2023 and 2024, and include 12 full building leases for highly improved buildings, including six secured buildings leased to the United States government, three buildings leased to defense contractors and three data Shell properties with significant tenant investment. The mission-critical nature of these properties and the priority missions they support inform our estimate of this high retention rate and supports our confidence in our projection for future growth.

Regarding vacancy leasing, our volume of 120,000 square feet was consistent with our 5-year average for the second quarter. Demand was broad-based across all of our markets with transactions completed across our defense IT markets as well as in regional office. The 277,000 square feet year-to-date is 23% higher than our 5-year average, and we remain on track to meet or exceed our annual vacancy leasing goal. As Steve mentioned, we have a large volume of leases pending execution that suggest our third quarter volume will be exceptional.

Development leasing totaled 211,000 square feet, and our year-to-date total is 476,000 square feet. During the quarter, we executed a 186,000 square foot 11-year build-to-suit lease with a defense contractor at the National Business Park. This is the second full building long-term defense contract release executed at the NBP in a little over a year. Our development leasing pipeline of 1.2 million square feet gives us confidence we will achieve our 700,000 square foot development leasing objective for 2022.

Lastly, in terms of our remaining large vacancies, we are encouraged by activity levels. In our regional office segment, we are tracking more than 100,000 square feet of activity at 100 Light Street in Baltimore, and 140,000 square feet at 2100 L Street in Washington, D.C. Activity is strong, but given competitive pressures in the regional office markets, we anticipate a slower pace of lease execution. At 1,200 Redstone Gateway, we are close to executing a lease with a defense contractor for the full 11,000 square foot vacancy with commencement expected to occur close to year-end. Additional demand from contractors for space at Redstone led us to commence construction on our next 125,000 square foot inventory building, 8,100 Redstone Gateway, and we look forward to announcing leasing progress on this project in the coming quarters.

With that, I'll hand the call back to Steve.

[Steve Budorick, President and CEO]

To wrap up, we completed the first half of the year ahead of plan and we are on track to meet or exceed our 2022 business plan. Vacancy leasing remains strong and first half vacancy leasing results exceeded our 5-year average by 23%. Our 1.9 million square feet of active developments are 91% leased, assuring incremental NOI from these projects that will drive FFO growth in coming years. Our development leasing pipeline has 1.2 million square feet of opportunities, which we believe will translate into continued development achievements. Congress appropriated to 2022 defense base budget with a 5.8% increase, the largest annual increase since fiscal year 2018, suggesting leasing demand will continue through calendar year 2023 and beyond. Our prior year financing activities locked in historically low interest rates and minimize our exposure to the current volatile environment.

And lastly, we've delivered strong growth over the past three years and we expect to continue to deliver both FFO and NAV growth in the coming years.

With that, operator, please open the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Michael Griffin with Citi. Your line is open.

[Michael Griffin, Citi]

Todd, maybe getting back to your comments on the demand at 100 Light and 2100 L. Can you add any additional color on sort of why you're seeing, I guess, marginally less demand relative to last quarter? Was it any specific tenants that you might have been tracking or just less demand you're seeing in those markets? Any color there would be great.

[Todd Hartman, COO]

Sure. Well, as it relates to 100 Light, we had at least one state tenant that we were working with last quarter that was offered space at a much lower rate than another building and elected to go that direction. Our remaining activity at the building is strong, and we're very encouraged by it. And at 2,100 L, I think it's just the vagaries of the market. We had one tenant that we were tracking, again, elected to renew with the building, and so that kind of dropped off our list.

[Michael Griffin, Citi]

And then kind of stepping back, maybe big picture. I know Steve, you kind of mentioned this in your prepared remarks, but just -- as it relates to defense spending, you saw the article earlier this week about the Senate Preparations Committee seeking more funding for dispense spending than the White House kind of requested. Some of that might have been related to the effects of inflation and whatnot. I guess, is there a worry maybe as we get into election season, if there ends up being a divided government that you could see kind of a slowdown in that defense spending and maybe kind of what that translates to for your business? .

[Steve Budorick, President and CEO]

No. So let's talk about the defense pending volume. We're very confident that there'll be a substantial increase for the 23 NDAA as well as potential for some supplemental increases to deal with the impact of inflation. And that confidence really comes from the high level of unity in the Senate and House Arm Services Committee votes. Both of those committees are seeking funding well above the presidential request. So we think the magnitude is going to be high and potentially further increase for inflation. Timing could be difficult. It's likely that this NDAA won't be passed by the end of September, and we'll end up in a continuing resolution, which could be delayed until after the election. Time will tell. But in the last decade, I think we've only had one NDAA passed on time without a continuing resolution. .

[Operator]

We have a question from Blaine Heck with Wells Fargo. Your line is open.

[Blaine Heck, Wells Fargo]

Starting with Anthony, just on same-store NOI. Are there any new offsets to the outperformance in the first half that made you reluctant to kind of increase the full year guidance, especially given that it seems like occupancy and retention are ahead of expectations and occupancy comps from last year could get a little bit more favorable as the year progresses? .

[Anthony Mifsud, CFO]

No, the variances that we've experienced to date, especially in the second quarter, were more timing as it related to the same impact on same office cash NOI. We did have some variances in the first quarter that were more permanent in nature, but still the impact of those fell within the range of guidance, and that's what we had discussed on our first quarter call. With respect to the changes in occupancy and the impact on same office cash NOI, the majority of the changes in -- that led us to increase the midpoint of occupancy at year-end really occur later in the fourth quarter, so they benefit occupancy at year-end, but don't contribute to this year's same office cash NOI, we'll get the benefit of that into next year. .

[Blaine Heck, Wells Fargo]

And then maybe for Steve or Todd, what of the data center recently commented on challenges related to the power supply in Northern Virginia from Dominion Energy and delays that could cause in the construction of new data center properties. So just wondering if you guys are dealing with any issues related to that? And any potential delays that could cause on your Data Center Shell projects?

[Steve Budorick, President and CEO]

Yes, that's a good question. The comment really refers to the construction of new transmission lines and expansion of substations beyond capacity that exists today. All of our development sites will be serviced by components of either Dominion or NOVA that are built and our customer has a commitment for that power. So we don't believe it will affect the timing of our lease execution.

[Blaine Heck, Wells Fargo]

Lastly, just thinking about the inflation we've seen this year, Steve, can you talk about how that might be affecting development costs and whether your yields are being affected at all on that side of the business?

[Steve Budorick, President and CEO]

We made a comment in our prepared remarks. NBP 550, which we just announced yesterday, if you look at our supplement, it's 14.4%. More expensive than NBP 550, which we lacked in the pricing on just over a year ago. The material component of the hard costs increased 18% year-over-year, we've been able both in the NBP, and Redstone Gateway, to move our rents and harmony with those increases in costs, and preserve our historic yields on those assets. But each development will face a new set of market conditions. And it'll be a challenge each and every time we negotiate a deal.

[Operator]

We have a question from James Feldman with Bank of America. Your line is open.

[James Feldman, Bank of America]

I guess following up to Blaine's question. It sounds like you can keep, you can still hit your development yields, with higher rents on the development. But are you able to push rents in your in service portfolio around those same assets?

[Steve Budorick, President and CEO]

Well, particularly at the NBP, wherever, very good success. Locking in existing portfolio rents that are very near or new development rental rate. We don't have as much second generation space. In Redstone Gateway, for both of the leases for second gen space that we're leasing, has significant roll up some of the expiring rents that they had, that are very close to our development rental rates.

[James Feldman, Bank of America]

And then, going back to the budget, you had talked about companies on the 23 budget growth. Any early indication of just how strong that uptake could be, is it you know, more or less than the 5.8% for '22?

[Steve Budorick, President and CEO]

So some of the information we saw was 10% overall, without more detail, it's hard for us to handicap how that hits the base budget, 51 base budget, which by one base budget, which is really what funds the leases that we negotiate, but I would expect it to be in at least 5% to 7%, if not higher.

[James Feldman, Bank of America]

And then finally, I appreciate the color on the large block expirations through '24. And if you said you expect to renew 90% good deed goes unpunished. So can you talk about the other 10%?

[Steve Budorick, President and CEO]

We said above 95%. And we just have some probability that one of the defense contractor full buildings may not quite renew all giving back small portion and a downsize in one of the regional office leases that is in that set of leases above 50,000 square feet over the next two years.

[James Feldman, Bank of America]

Okay. So it sounds like one lease is really what you're worried about?

[Steve Budorick, President and CEO]

And by no means all of it. We expect both leases to renew the regional office we expect or we released built in the probability that it could contract and up to about 50%. And then fence contractor building, maybe a small component like 10,000 or 15,000 square feet.

[James Feldman, Bank of America]

And when did those expire?

[Steve Budorick, President and CEO]

I believe both of those are in '23, '24, sorry.

[James Feldman, Bank of America]

Okay. So '23, you have no concerns sounds like?

[Steve Budorick, President and CEO]

No.

[Operator]

We have a question from Steve Sakwa with Evercore ISI. Your line is open.

[Steve Sakwa, Evercore ISI]

I guess one question for Anthony. Just to go back to what you talked about on the dispositions and the funding for the development needs. You said you have a couple of assets that you're going to sell by year-end. Can you just sort of talk about the types of assets as are and given the dislocation we've seen in the transaction market? Where do you think cap rates are for those dispositions?

[Anthony Mifsud, CFO]

So our current forecast assumes that later this year we venture to Data Center Shells are currently holding on that generates about $80 million worth of proceeds. Cap rates for shells continue to seem like they're holding up in the area close to where we executed back in June of last year. So right now, we really haven't seen cap rates for those types of assets come under some of the kind of pressure that some of the other CBD and other office markets have.

[Operator]

We have a question from Dave Rodgers with Baird. Your line is open.

[Dave Rodgers]

Just sticking with the data center Shells just for a moment. You said that you've got three data Shells that will come up for renewal in the next couple of years. Are those wholly owned? Or had you sold those? And I was curious if they were still kind of on the balance sheet. The way I read it is, was there a reason you hadn't sold those in? Was there something interesting about those particular assets that they hadn't been pushed into a JV?

[Steve Budorick, President and CEO]

No. Those 3 are in a JV.

[Anthony Mifsud, CFO]

And they expire in 2024, all three

[Dave Rodgers]

And then maybe a final question just for Steve. I don't know those of us that have followed it a long time. NBP was a very strong part of the story. It seemed to for a while be a little bit weaker in terms of demand and the ability to sign deals and now it seems to be back in terms of the health of that part for you guys. .

Is there a change in the spending and the funding for programs like cyber? Are there additional programs that have been added? And really, I guess, what I'm trying to get at is, is that tail going to be substantially more consistent or grow over the next couple of years in your mind around what's really been a marquee property for you guys?

[Steve Budorick, President and CEO]

Well, a big component to the success we're having is being fueled by cyber spending unquestionably. And we don't see that changing in the near term.

[Dave Rodgers]

So same narrative. Nothing really added to that. Just finally, the money is getting spent. The space is being committed and no real changes kind of on-campus that either threaten or help that.

[Steve Budorick, President and CEO]

Well, there's certainly nothing on campus that threatens it. And the increased challenges of the cyber defense and warfare environment lead us to believe that spending will continue to be strong for quite some time.

[Operator]

We have a question from Tom Catherwood with BTIG. Your line is open.

[Tom Catherwood, BTIG]

And you may -- Steve have already answered this question with response to Dave's question. But as Todd mentioned, this is obviously your second build-to-suit in a year at National Business Park is the driver behind this kind of recent increase in large space demand, the cyber that you were mentioning? Or is it some other demand driver or DoD funding source that really contributed to this demand?

[Steve Budorick, President and CEO]

I think, well, it's possible for us to know for sure. When we do these build-to-suits with defense contractors, they're very secretive about their business. But overall, that market has really been supported by expanded spending out of U.S. Cyber Command.

[Tom Catherwood, BTIG]

And is there an expectation that there could be more demand beyond that? Or does it just kind of come then fits and starts?

[Steve Budorick, President and CEO]

Certainly, for leasing generally, I see no abatement in demand from the cyber contractors doing business both in the NBP and Columbia Gateway. Since U.S. Cyber Command has been set up, it's been a constant source of growth and expansion. We have tenants that are nearing needing their own building that started with 8,000 square feet. It's been a steady state of demand and growth for over 8 years.

[Tom Catherwood, BTIG]

And then last one for me is on those three Data Center Shell leases that roll, I think these are the ones that were kind of in your first generation with your largest Data Center Shell tenant. And the question when you first started was always what does that second-generation lease look like? What -- how do rents change? Do you need to invest incremental dollars? Do you have an expectation or at least an early read of kind of what that renewal might look like when you get to that point?

[Steve Budorick, President and CEO]

Well, it's a couple of years off, Tom. So I don't want to -- but I would expect rents to increase for another reason than the value of the land that those assets sit on has at least tripled.

[Operator]

We have a question from Bill Crow with Raymond James. Your line is open.

[Bill Crow, Raymond James]

Steve, I'm curious whether the dislocation we're seeing in the market and maybe some of the delays in leasing has altered your thinking on selling some of the regional office assets, in particular Baltimore?

[Steve Budorick, President and CEO]

Well, we routinely keep an eye on markets where those assets. And like we did with DC-6, if we see an opportunity to get good shareholder value in the market, the capital market that exists, we'll consider it. But right now, I don't see that market condition being strong enough to bring one of those assets to market.

[Bill Crow, Raymond James]

How much do you think cap rates have increased on that sort of asset?

[Steve Budorick, President and CEO]

I think there's a dearth of capital investing in CBDs right now. If you look across our portfolio, there are literally no comps to point to, except for DC, where 1900 sold at a 4.5% cap rate to a foreign investor. And I think the buyers that are sitting looking at some of the other markets are rather opportunistic, and looking to pay maybe 100 basis points -- get a cap rate 100 basis points or more higher than they were, say, six months ago.

[Operator]

Thank you. And that's all the questions we have today. I'd like to turn the call back to Mr. Budorick for closing remarks. .

[Steve Budorick, President and CEO]

Thank you for joining our call. We will be in our offices this afternoon. So if you like a follow-up conversation, please coordinate through Michelle. Thank you very much.

[Operator]

Thank you for your presentation today -- for your participation today in the Corporate Office Properties Trust second quarter 2022 results conference call. This concludes the presentation. You may now disconnect. Everyone, have a great day.