COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Welcome to the -- clocks are all off. Good afternoon again. Welcome to the 5:10 p.m. session at day 1 of Citi's 2020 Global Property CEO Conference. This is the session between us and cocktails. I'm Manny Korchman with Citi Research, and we're pleased to have with us Corporate Office Properties and CEO, Steve Budorick. Session is for investing clients only. And if media or other individuals are on the line, please disconnect now. Disclosure is available here and on the webcast on the Disclosures tab. For those in the room or the webcast, I hope you know how to use liveqa.com at this point, but the code is Citi 2020. Steve is not here. Where is he?

He's on his way.

Paul.

I was wondering whether you're going to look up and say that he wasn't here.

I was running late. I was all flustered. Paul, I'll turn it over to you to buy time until Steve gets here.

Well...

We had somebody sing us a song this morning. Would you like to sing a song?

No. The third verse of Walk This Way. No, Steve will be here momentarily. He has some prepared remarks.

Okay.

It's been a good year. It was a good day. He must have been on the line.

Hello. We're waiting for you to give your remarks. I introduced you twice already.

[indiscernible]

The necessary way.

Steve, I'll turn it over to you to introduce your company and management team. Give us 3 reasons why investors should buy your stock today.

Do you want me to start with that?

Yes.

Okay. So item number one. So I presume everybody understands our company, and that we primarily do business with the Department of Defense and defense contractors that serve them. So reason one is we're 3 years into a significant recovery in the Department of Defense. Last year, the increases in spending accumulated to a record year of leasing in our portfolio. We set a development goal for 1.2 -- 900,000 square feet. We achieved 2.2 million square feet of development leasing, which is fully 1 million square feet more than our best year ever, which was 2010. And the second reason you should invest in our stock is at today's valuation, we're 17% below our NAV, and we're a compelling value. And then third reason is, if you look at the development leasing we achieved last year, on a square footage basis, it's equivalent to about 15% growth in our portfolio. And that represents $50 million of new NOI to our company. $20 million of that NOI will materialize in 2020, $21 million will materialize in 2021 and then another $9 million in 2022. So we're poised to deliver 2.5% growth this year and what we're calling robust growth in 2021. So should I go back to the beginning and tell them about the company or?

Give us another minute on the company .

Yes. So we are the preferred provider of this critical real estate lease, the U.S. government and their defense contractors. And our defense locations generate 88% of our revenues. We've been an operating partner to the U.S. government for over 3 decades, and they currently generate 35% of our annualized revenues. Over the past 20-plus years, we've accumulated land and property adjacent to high-priority defense missions locations. And our major government demand drivers include Fort Meade, which is the home of signals intelligence and cybersecurity. In Northern Virginia, we're adjacent to various elements of our intelligence community in a variety of locations. We own a 1 million square foot mission-critical DoD government campus in San Antonio, Texas. And then we serve the U.S. Navy in 3 locations, the large -- the most prominent of which is the U.S. Navy Yard in downtown D.C. Most importantly, right now, we're at the Redstone Arsenal in Huntsville, Alabama, where we're literally a partner with the U.S. Army developing on their land. Notable missions at the Redstone Arsenal include missile defense; the Program Executive Office of Missiles and Space; NASA; Army Material Command, which procures everything a soldier needs; and then increasingly, the FBI. And then last but not least, we've got a long and rich history of developing data center shells for a cloud computing customer in Northern Virginia, who does a lot of work with the U.S. government. The common thread of our Defense/IT locations is permanence in the locations, given their essential roles in supporting high-priority missions of national security such as intelligence, surveillance, reconnaissance, missile defense, cybersecurity, space operations and law enforcement. The proximity to the mission is the essential for our tenants and in our strategy. In the defense world we serve, there's no telecommuting or working from home. Defense/IT tenants also invest heavily in their spaces. And that creates high barriers to exit. On full-building leases, the U.S. government's renewed 100% since 1992. And over the last 5 years, we've averaged a 79% renewal rate in our portfolio, and we expect that to continue going forward. So with that, I'm open for more discussion on our company.

Perfect. The other question we've been asking everyone is ESG is of increasing importance for all company stakeholders. What's one thing your company is doing to improve your overall ESG score over the next 12 months?

So we were kind of an early leader in ESG. We adopted the GRESB standards 5 years ago. We've been a Green Star GRESB recipient for 5 consecutive years. The -- a linchpin of that is back in about 2005, we made a commitment to develop to LEED standards, LEED Silver, LEED Gold, in some cases, LEED Platinum. But we also have adapted LEED EB standards throughout our portfolio. And so we've -- we're well positioned from a ESG standpoint. We don't talk a lot about our S, our social, but our company is deeply involved in our communities for more than a decade. Among the things that the benefits we give our employees is something we call Donate 8, where the company pays every 8 hours to do a volunteer work in the community for something that benefits them. But more than that, we're a long-time participant and supporter of the United Way in Central Maryland. Last year, I actually ran the fundraising campaign for the United Way. But throughout our company, we're deeply involved in supporting their activities, which is really education, housing, health and food for the mission for every employee in our region. So it's a rich tradition at our company.

The previous management team in here described their ESG as AAA in execution and D- on disclosure. Where would you put your disclosure mark on that?

A to A+. We publish an ESG report every year.

Great. So maybe we can just quickly run through fundamentals in each of your core markets and where you see upside for those?

Sure. So we've -- to take the audience back in time, the defense department budgets started to contract in 2012. And those contractions continued through 2016, and then 2017, started to reverse trend. And during that period of time in the worst defense spending environment, since the end of the World War II, we were able to grow our defense revenues by about 18%, a bigger fraction with the government. But we also grew our defense contractor revenue in a period of time where they were contracting. With the last 2 years of higher defense -- 3 years of elevated defense spending, we're experiencing broad-based demand across all of our markets. Last year, we did 740,000 square feet of new leasing, and that was comprised of about 94 separate deals with an average of 8,600 square foot a deal. So it's -- we're in an environment now, whereas the government places the next order for a service contract or a performance contract, that contractor needs to expand. And we're experiencing that across the portfolio. So places where we see real upside. At the National Business Park, we expect to be 95% leased or better by the end of the year. With the demand we're working on right now, when leased, we're planning to be in position to develop our next building as early as 2021. Unquestionably, the fastest-growing market we have is the Redstone Gateway and the land of the U.S. Army Redstone Arsenal. We're currently building over 700,000 square feet of property that is largely pre-leased. We're building a 100,000 square foot spec building that we just started in the fourth quarter. We expect to have that about 50% leased in coming months. Northern Virginia, along the tollway, both Tysons Corner and Herndon, we've got good demand. We've got rent growth in both of those locations. We don't have a ton of space to lease, but we're able to push rate in those markets. And then we have some vacancy in the Route 28, but we've got great demand behind it. So our upside is largely -- would be materialized through faster and more leasing volume than we budgeted for. And then we're increasingly excited about a new opportunity in our wholesale data center, DC-6, and we believe we're going to sign a 3.1-megawatt lease in the next 30 to 60 days. And that was not contemplated when we set our earnings.

So you spoke about the larger budgets that should drive demand, and they have, through the leasing you've done. What should we think about as sort of the potential negatives that could throw off your portfolio? It sounds like you have longer leases. They're with the government, they're with contractors, they're sort of backed up by defense spending appropriations. Where can all that get messed up?

So we've been messaging for quite some time that our demand tends to materialize 12 to 18 months after appropriation of the defense budget. Because that money has to flow through procurement activities into the contractors' hands, and then they can lease space and make commitments. Last year's record leasing, we believe, was driven off of fiscal year 2018 budget, which was passed on May 23, 2018. We have 2 budgets that have been approved and appropriated since then. So we believe from a defense spending standpoint, we've got runway into 2021 or 2022. From what could go wrong in our portfolio this year, we have 1 major renewal that we're working on securing for 11.25 megawatts at the wholesale data center, DC-6. Failure to achieve that would make a material change in the growth that we're anticipating for next year, but we have high confidence that we're going to make the renewal.

That's it. One. That's the latest?

That's it. We have 2.4 million square feet under development right now that's 79% leased. As we finish the month of March, we expect to be 86% or 87% leased and then as those properties deliver, closer to 100% leased. So we're on a good trajectory. We don't see a lot of risk in our business plan.

So maybe we can just quickly run through the building blocks of growth for '21 versus '20? Do you want to take that or Anthony would probably do it?

Sure. Well, I just kind of dropped it on you, but I'll do it again. As we matriculate through this year, developments that are under construction will start to deliver. And this year, they'll deliver about $20 million, but then we'll get a full year impact next year. Then next year's annual impact will be $21 million additional and a full year of those leases in 2022 plus a major development for the U.S. government, $305 million development at our secure campus in Northern Virginia that will bear rent in March of 2022. So those -- and by the way, the 2.4 million square feet represents 15% of the operating portfolio we have. So as that comes online, that revenue becomes accretive to growth. And then moreover, to fund that, we oversized our sales effort last year, upsizing a target of $120 million to $150 million to $310 million in proceeds for a joint venture, which puts us in a position where we need very little development incremental capital to do $350 million of development this year. And we've already taken the dilution from that, the bigger capital risk. So we're well positioned for 2021. The one uncertain item is the renewal. When we get the renewal at DC-6, then we can start to put a framework about what that growth is going to mean for 2021.

When will you and then we know about that renewal or not?

By July. We're hoping to get it done earlier, but we're patient. And we're working in harmony with the tenant to make enrichments in our building that they've requested contemplating that renewal. So our confidence is high.

So their options are to -- the proverbial move across the street or renew with you? Or is there an option they go somewhere else completely?

So in my view, based on where we are from a time standpoint and the sheer magnitude of the operation in the building, it's 50,000 square feet of high-computing equipment. I don't think they really have an option.

Got it. Questions in the room? Realizing that you just talked about over equitizing and over selling with the data center JV, but are there other assets in your portfolio that are noncore or that you think now is a good time to get out of whether or not that puts you in an over capital or over cash position?

No. Not currently. We are doing a development in downtown D.C. It's not yet stabilized. It delivers early next year. That would be one where, at the appropriate value, we'd look to harvest profit from that development, either through a joint venture or a full-out sale. And then we maintain 7 buildings, that's 12% of our portfolio, that's not defense-oriented that create optionality to harvest those in the future. Two of those are in Tysons Corner, 2 in Herndon and 3 in Baltimore.

Okay. And your story has gotten so simple. I don't have any questions. The data center shell program?

Yes.

How big could that keep getting? How big a piece of your business would that be? And would you JV more but just you have less exposure to as it gets bigger?

So we currently -- our current revenue is about 8% from that program because of the 2 joint ventures we've already done. Having said that, we have 7 assets that are wholly owned, and we're currently...

4?

And we're currently under construction on 4. And then we have land positions to add another 5, 2 of which we expect to sign this year and deliver next, and 3 of which we expect to sign next year and deliver in 2022. So the capacity in our owned under construction assets would provide enough capital for us to fund our development for 5 years, if we needed it to. And by the way, the...

The [indiscernible]

Yes. So last year when we went to market with our JV, our objective was not only to get quick pricing that demonstrate value creation, but also to establish a programmatic partner that would be there for us if we needed that capital. We achieved both. The portfolio priced out at a 5.1% cap rate. And the partner we attracted was Blackstone REIT. And they have high interest. They love the asset class, and they have high interest in furthering their position. So we believe we've created a great relationship with a world-class group. There's ample liquidity to provide the capital we need should we choose to JV them.

But you'll probably time that capital more closely to needs than you did last year?

Correct.

So certainly, there's been discussions throughout this conference of the coronavirus has impacted business trends. I assume the way you guys sit there is saying, "This doesn't impact our business at all." Is that the right read?

I don't see any impact on our business.

Could there be an allocation of sort of whether it be talent or funds or anything else out of the programs that support your business?

So I would expect the other half of the government is where you're going to see those programs. It's going to be on health department, research monies. Remember, roughly, discretionary budget is 50% defense and 50% all else. I think those programs get funded out of all else. And time will tell whether there's a defense aspect to this, but I don't believe we're at the point now where we see that.

I got a couple here on the screen. 310 NBP status?

The government is in the approval process for leasing authority that includes that building. We expect the authority to be granted roughly in June, and the lease to be executed by the end of the fiscal year, which is September 30. So if I had to guess, I'm going to guess it's August. The confidence is high. There's 4 floors of the 6-floor building remaining. We've planned it all up. We know who the users are. We have estimates on the tenant improvement costs. We're merely awaiting the authorization and award to proceed.

And did I hear you right, you said 3 floors or 4?

4.

Okay. And then another question in here. Have you seen a meaningful increase in demand from your hyperscale tenant? And are you sourcing more data center land and at what price?

So we entered into a program, if you will, with them at the end of '17 to deliver 11 or 12 data center shells and 3 parcels of land -- 4 parcels. We have acquired all the 4 parcels. We get a little bit delayed in getting our approvals in 2018. That generated kind of outsized leasing in 2019. And the runway I described earlier with 5 additional data center shells over 2 years is on the land we've already purchased. Beyond that, we're always in discussions about their needs, but we don't want to talk about it publicly.

Sorry, what was the last?

We're always in discussions with them about future opportunities. We're confident we will get them, but I can't share any detail.

But you're not land banking in case those comps are ready, if they come to?

We've never land banked in isolation. Every time we have procured land, it's in harmony with the customer's desire and program.

What about options? Because I think the first time you did a deal, you had half the land under ---- you bought half the land, you optioned half the land. Do you have land under options in case you want to do more?

No. We've bought all the land. We have nothing under option.

What will happen to defense spend under Bernie Sanders' presidential victory?

Well, I think when Bernie wins or if Bernie wins, he'll be briefed by the Department of Defense about the relative strength of our adversaries and the relative weakness of our own defense and the impact of the deep cuts that we experienced over the prior decade. And he'll have to -- he'll recognize that the need for national defense spending is really not discretionary, and I think we'll be in a stable environment. I point to 2016 midterm elections. The House of Representatives turned over from Republican to Democrat. Since then, the House Armed Services Committee is -- votes have almost been the unanimous at the increased defense spending levels. And in each year, the House has recommended more spending than the President requested. And it's occurred in each of the last 3 years. So I believe whoever wins will get briefed on things they don't know about or comprehend today. And we really can't afford with the technical challenge that we're in to pull back on defense spending.

And then they come to you with a suitcase of cash, and we're all happy.

Exactly. Although it doesn't come in cash.

I think we've talked about Baltimore in a while. What's going on there? And how do you feel about that market?

So we're very stable. We're at 94% leased across the portfolio. We got a couple of little pockets of space left to lease. And we have demand behind that. Brent has outperformed our underwriting. We repositioned 250 West Pratt with a lobby, kind of park-like setting redevelopment, which has allowed us to push our asking rates there. And we're very satisfied with the way it's performing.

Any desire at all to buy more sort of that commodity office product? Or is that what you're just going to -- you're going to have Baltimore and this is kind of it?

No. We're good. Over time, 3 or 4 years out, I think there'll be an opportunity to harvest the profit we've created with the great pricing we got going in, and then the rental rates we've established, but we're not ready to do that yet.

And I thought you had plans to build more office sort of around the water in Baltimore. Are those plans shelved?

No. We do have a development site at Canton Crossing. It's about 11 acres, the last 11 acres on the water. We'll probably hold that no matter what our portfolio strategy is because long term, it's going to be a great opportunity. That's -- with the current opportunities we have in development, it's just not our priority right now. But if there were a large tenant that needed -- that wanted to pre-lease the building, we could go.

Any last questions in the room? All right. We can wrap with our rapid-fire questions.

Go.

Will the office sector have more or fewer public companies a year from now?

Same.

More or fewer?

All right. One fewer.

What will same-store NOI growth be for your office sector overall, not just for your company in 2021?

Just about 3%.

Where will the 10-year treasury yield be 1 year from today?

I sure as hell hope it's where it is right now. I think it will be $175 million.

And in what year will the U.S. enter a recession?

2024.

Thank you.

That was the correct answer.