COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Good morning, and welcome to the Corporate Office Properties Trust Presentation. Thank you for joining us. Before we begin, I hope everyone is healthy and safe. My name is Chris Lucas, lead REIT analyst with Capital One Securities. I am pleased to introduce today's panel. With me are Steve Budorick, President and CEO; Anthony Mifsud, EVP and Chief Financial Officer; and Stephanie Krewson-Kelly, VP of Investor Relations. So Steve, let's just start with an overview of Corporate Office Properties Trust and how the year has started for the company?

Sure, Chris. So Corporate Office Properties Trust is the preferred provider of mission-critical real estate leased to the U.S. Department of Defense and its defense contractors. Our Defense/IT locations generate 88% of our revenues. We've been an operating partner to the U.S. government DoD for nearly 30 years, and they currently generate 35% of our annualized revenue. Our major government defense concentrations include Fort Meade in Maryland, whose missions involve signals intelligence and cybersecurity various elements of the intelligence community in Northern Virginia in a variety of locations. We have a secure DoD campus in San Antonio, Texas, and we serve the U.S. Navy in multiple locations, including the Navy Yard in Washington, D.C. Our most exciting development location currently is the Redstone Arsenal in Huntsville, Alabama, where we're actually a partner with the U.S. Army. The notable missions on the Arsenal include the Missile Defense Agency, Program Executive Office of Missiles and Space, the Aviation and Missile Center, Program Executive Office of Aviation, U.S. Army Space and Missile Defense Command, NASA, Army Material Command and multiple law enforcement intelligence functions and increasingly FBI operations. And last but not least, our data center shells in Northern Virginia are developed for a leading cloud computing government contractor. The common thread among our Defense/IT locations is the permanence of those locations, given their essential roles in supporting high priority missions of national security, which primarily are intelligence, surveillance, reconnaissance, missile defense, cybersecurity, space operations and law enforcement. Because proximity to mission is essential for our defense tenants and because of the security requirements of their missions, there's no telecommuting or working from home. Defense/IT tenants invest heavily in their spaces, which creates high barriers to exit. For instance, on full building leases, the U.S. government has a 100% renewal rate since 1992. And overall, our Defense/IT tenants have renewed an average of 79% for the last 5 years. And we expect similarly strong results going forward. Our unique focus on Defense/IT locations should be important to investors for 3 major reasons. The first is the defense industry has enjoyed healthy spending growth and bipartisan support for several years, and we expect that trend to continue. Since 2015, the DoD's base budget has increased by $144 billion, representing compound annual growth of 5%. And in 2019, we saw strong broad-based demand for our locations that translated into record leasing achievements. A record development leasing of 2.2 million square feet in 2019, beating our prior record set in 2012 by 1 million square feet. We achieved 784,000 square feet of vacancy leasing during the year, and that was the best since 2010. And the 586,000 square feet of total leasing with the government was our second highest annual volume in our history. In 2020, year-to-date, we've completed 265,000 square feet of development leasing, and all of those achieved in the second quarter during the COVID shutdowns. The second, primary reason investors should be interested is our operations and our cash flows have proven to be resilient during this ongoing coronavirus pandemic. The essential nature of the missions at our defense locations and our tenant base have largely insulated our results from the impacts of the shutdowns and social distancing measures enacted. The first quarter results exceeded the high end of guidance by $0.02. Our leasing has been solid and our 2.2 million square feet of active developments have advanced without delay. In terms of rent relief, we've also been largely unaffected. We collected 98% of April billings and 99.4%, excluding the rent relief we granted. And thus far, in May, we've collected 97% of total billings and 99%, excluding rent relief granted. On our first quarter call, we lowered the midpoint of our 2020 guidance by only $0.01 or 0.5%, and that was simply a precaution for potentially unforeseen events that could come from the shutdown. The third reason investors should own OFC is that our earnings are accelerating. We have 2.2 million square feet under development currently that is 86% leased, which we expect to be fully leased when we place it into service. These projects represent $50 million of future cash NOI. Approximately $20 million will be placed into service this year, 98% of which is contractual. In 2021, we expect the current development projects to generate another $21 million. And in 2022, we expect the current developments to generate yet another $9 million of annualized cash NOI. And that $9 million is 100% contractual. So in sum, we expect our highly leased development pipeline and our highly stable existing operations to produce 1% to 3% FFO per share growth this year and even more robust growth next year. So my last comments, Chris, is that as of the May 28 close, our stock is trading 19% below the Street's average NAV of $31 a share, and that represents compelling value. And our dividend represents 4.4% cash yield that is supported by a conservative 70% AFFO payout ratio and our investment-grade balance sheet. Because of the coronavirus pandemic, nearly every REIT is trading at compelling valuations and this company is not unique. But we are unique in that we are leasing it to an industry whose demand and fundamentals are accelerating, our operations and our new leasing opportunities are minimally impacted by the shutdowns, and we are positioned to deliver robust growth in 2021. So with that, I'll turn it back to you, Chris.

Thank you, Steve. I guess just following up on the tailwinds that you're enjoying right now. Maybe you could give some context for the defense and intelligence spending budgets, the increases more recently in the last several years and where we stand as it relates to how those budgets are impacting demand? And how much more space you have, how much more sort of tailwind time do you have with these recent budgets?

Sure. So last year, the 2019 record leasing volume, we really attributed to the significant -- I think it was a 14% increase in the fiscal year 2018 budget. Then fiscal year 2019 was passed with about a 3% -- 4% increase, and fiscal year '20 was passed with another 3% increase. And we expect '21 to pass with a 2.5% to 3.5% increase as well. And because of the lag between the passage of an appropriated budget and the demand materializing in our portfolio, we've got about 2 to 3 years of demand pent up from the already appropriated budgets thus far. So we expect to have good leasing in 2020 and through 2021, well into 2022. Chris, can you hear us?

Sorry. Thank you for that. I guess I just wanted to follow up on -- you talked about the development leasing you've had to date, and I guess, just wanted to get an update as to where you stand relative to some of the leasing activity that you were hoping to get for the first quarter call and where that stands at this point, if there's anything new or incremental there?

So we achieved all 5 of the leases that we are hoping to have for the first quarter call. One was a full building build-to-suit in Huntsville, Alabama, 3 specialty data center developments for our cloud computing customer. These are smaller support facilities on existing campuses. And then we signed a lease for some options based at 2100 L. And then most importantly, we signed the large U.S. government anchor tenant lease for our development in Redstone Gateway, which is -- 100 Redstone Gateway. That's now about 80% leased.

Great. And then I guess, just in general, given the transition for the year as it relates to the start of the year leasing, then we have the impact of COVID and we're starting to come out of that now. I guess maybe if you could talk a little bit about on your existing vacancies, what sort of traction are you getting? What sort of showings is occurring? What sort of tenant interest are you gaining right now?

So first, let me talk about what we've achieved. Our first quarter, we had significant leasing, and we actually beat our first quarter of last year by 13%. In the second quarter, we haven't achieved as much. I don't have an actual number for you. The process has really been slowed by the shutdowns. And frankly, new showings have really not occurred because brokerage community are all respecting the shutdowns. So that activity we expect to generate some pent-up demand as we return to operating levels. But our pipeline continues to be very strong. And that our activity ratio, the amount of prospects we have compared to the overall vacancy that we possess, continues to be over 75%.

Great. And then I guess, just as it relates to rent commencements and timing for tenants that have sort of been -- has any -- do you have any tenants that have been caught up in sort of the shutdowns or been impacted at all by construction delays or permitting or anything along those lines?

Happily, very few. We had one small tenant who -- the release was scheduled to commence on May 1, but they couldn't get a mover to move them. So we agreed to defer that to June 1, and there may be a couple of other smaller similar situations. But happily, our developments, all 2.2 million square feet, we've been able to maintain the schedules that we had established before the shutdowns, and our deliveries are on track.

And then I guess -- I appreciate that. Then can we just go back to the rent collection efforts? Obviously, your numbers have been very, very high. You had a de minimis amount of rent relief. Maybe you could talk a little bit about your approach to the rent relief request that you've gotten and kind of where you stand just aggregate for the first 2 months of the quarter?

I want Anthony to take this one.

So Chris, we've had really 2 different baskets of rent relief. One in the form of plus or minus 3 months of abatement where most of those tenants are the small mom-and-pop delis that support our office parks and provide the amenities that we've tried to bring to those office parks. And in that instance, we have probably less than 0.2% of annualized rental revenues that are part of that component of rent relief, where we've given a 3-month abatement. But for that, we have gotten an extension of -- on their lease for 24 plus months. So we've given the abatement upfront. And for that, we've gotten an extension. We think there are important amenities to provide for our office parks, so we think working with those tenants in order to help them bridge this -- the shutdown impact was important. The second group is really a group of tenants who have asked for 3 months of deferral. So we're giving up to 3 months of deferral. And most of those start to pay back that deferred rent in -- late in the fourth quarter or in the beginning of the first quarter of next year. So a plus or minus 9 month delay in getting that 3-month rent, and then that rent is paid back over a 9 to 12-month period. Those combined with the first category are less than 3 -- .75% -- points of 1% of annualized rental revenue. So it's still a less than 1% of our annualized rental revenues in total relief. And those tenants are really just trying to bridge the shutdown impact. Their businesses are going to come back strong. And it's really just providing them an opportunity to bridge the 3-month shutdown. All of that has really culminated in what we have is really strong total cash collections. And as Steve said, for May, we're almost at 99% of our cash collections for the total billings that we have for our portfolio less that rent relief. So really the shutdown is demonstrating the permanence of our tenant base and how resilient it is in terms of our cash flows.

And one last comment on the rent relief, Chris. As the shutdown started to occur and we started to hear from our retail tenants, we conceptualized the plan and we brought it to them proactively. And the reason we did that is that, as Anthony said, they're valuable part of the overall value proposition to our tenants. And we recognize that we need to help them get through this period of time because if we lose those tenants and we emerge into the recovered environment, the restaurant community is not going to be in a position to expand for quite some time. And we want to make sure that we keep our tenants alive and healthy in our portfolio.

Super. Thank you. And then, I guess, Anthony, while I've got you, maybe you could talk a little bit about the capital plan and sources and uses this year? And how that plan may have changed, as Steve noted, the share price is trading at a pretty steep discount to NAV. Sort of walk us through the current thinking.

Sure. So for -- on the uses side of the equation, the vast majority of our investment is capital being allocated to the development pipeline. Our current forecast is for that to be about $300 million to $350 million of total investment for the year. About $100 million of that was invested in the first quarter. So on average, $225 million left to invest for the balance of the year. Our plan -- our total plan really hasn't changed in terms of the amount of capital that we're looking to raise, equity capital. We started the year with a $70 million to $90 million requirement, and we're still in that same range. And when we put that guidance out, we had spoken about either using the ATM as a way to fund that equity or to use the platform of wholly owned data center shells to raise that equity capital. Given where we are right now, we're moving more towards the latter than the former. And based on the feedback that we have from existing and other private equity capital investors, who have invested in those assets previously, we think there is a high demand for those data center shell assets to become a venture partner and provide that plus or minus $80 million worth of equity capital. As private equity investors are looking for opportunities, and they want to invest in some sectors of real estate, it seems like industrial and data center shells are their favorite sector type right now. And we can -- we have a platform that can provide not just the equity capital we need for this year, but also as those data center shells continue to come online in the next several years, we have over really $700 million worth of equity that we could tap into between now and 2023 to continue to fund the equity requirements of the development pipeline. If that's really what we needed to do. So right now, we're -- we think we're well positioned to raise that equity capital and continue to sort of maintain the leverage levels that we have on the balance sheet.

But one last comment, Chris, is we don't need to do anything today. So in the current environment with the share price where it is we're just going to take our time, allow the recovery to occur. And we'll make our final decision in the third or fourth quarter as to which source we'll use.

Thank you. I guess just a follow-up on that is, as it relates to pricing, how has pricing changed on those assets, if at all, had rates down. Obviously, a different overall capital markets environment. Just kind of curious as to whether or not there has been any price change there.

Well, we won't know until we finish a transaction. But our expectation is we'll achieve comparable pricing to what we did in 2019.

Very good. Steve, on a bigger-picture question, I think probably the most important issue facing the office environments, but a lot of conversation about what does the future of the office environment look like? How does utilization look? I know it's very early, we're sort of in mid pandemic as we sit today, but you do have a really interesting seat in terms of what you're looking at. You've got some urban high-rise office buildings, you've got suburban locations for commercial tenants. Obviously, a lot of work with specialized tenants between government contractors and the U.S. government. Curious if any lessons you've learned from the U.S. government exposure and the contractor exposure may be relevant to sort of how the office utilization and office environment evolves? And then also just sort of, as it relates to the commercial side, what if anything is on your plate as it relates to how to reopen those -- or get those buildings open for tenants down the road?

Okay. Chris, I think I'll take that in layers. And let me start with the U.S. government. First of all, the U.S. government use -- has always been a very high-density user in our facilities, and I see no scenario -- and because of the secured nature of their work, they can't work from home. So if the outcome of this pandemic suggests more social distancing at work, if anything, I would expect the U.S. government to need more space, not less, because they're very concentrated currently. The second layer would be the defense contractors. And similarly, I would expect them to have pressure to expand, not contract. Again, secure work can't be done at home. So they can't work remotely. And it's an outcome of the defense spending cuts from 2011 to 2016, the defense contractors went through a contraction cycle and got very efficient in their use of space. You may recall during that period of time, contract awards changed from best value to lowest cost. And that compelled the contractors to get very efficient in their space utilization to drive down their billing rates. Since 2016 and the recovery in defense, our new leasing has been driven by expansions in defense contracting. And curiously, or interestingly, our average lease size ranges from 7,000 to 9,000 square feet. And that illustrates that as their businesses achieve new opportunities, they had to take additional space to expand and accommodate that. So I just don't see a scenario where they can -- they can't work from home. And if they need more social distancing, they're going to have to expand. And then with regard to just general office tenants, like we have in Downtown Baltimore, a bit of a coin toss. There's narrative of larger companies thinking about moving to part remote working over 3 to 10 years. But there's also many experts that suggest that's not the preferred way to run a company and that the high-density configurations that commercial tenants have moved to would need more space to socially distance as well. So the -- time will tell, but I'm very confident our company won't be affected in a significant way by working from home primarily because of the high concentration in defense and government.

Okay. Thank you for that. I guess, just maybe as a follow-up as it relates to -- you talked about splitting the workforce as a way of sort of taking the density down, other things that you need to do in terms of making tenants feel safe as it relates to cleanliness and programs that you'll need to engage in, in order to get the tenants comfortable to get back to work in the buildings. Just curious as to whether or not those add up to anything meaningful in terms of cost that the company will bear? Or are these things that the tenants will end up bearing?

So thus far, we've not had an increase in staffing levels in our cleaning operations or our maintenance operations. We have put a heavy focus on surfaces in public areas, elevator buttons, washrooms, door handles, things of that nature. Some tenants have requested deep cleans of their suite. Those are pass-through expenses when they do that. So we don't see a material change in our cost structure that will occur. And in terms of making people comfortable, we've got public displays, storyboards in every lobby that reinforces CDC best practices for accessing public spaces safely. And we've delivered that message to the tenants in multiple formats but -- that every visitor sees that as they walk into the buildings.

Thank you for that. I guess, just kind of interested in terms of you've got a brand-new building that's delivering at 2100 L. You've got a major law firm anchor tenant. You've got some additional space there to lease. A, what sort of -- recognizing that it's been a very difficult environment to get tenants to look, is there any -- what sort of traction are you getting at that building at this point? And b, just as it relates to sort of how people are thinking about future layouts, is any of that coming up in conversations at this point at that building?

It has not yet in terms of change in configuration of space. So we're just phasing out the base building construction crew and phasing in the tenants, tenant improvement construction crew. To my knowledge, they've made no chance -- no change to their space plan and their utilization, and they're commencing construction as we speak. I might add, Chris, when you get back Downtown, you should tour it because I got through it about 2 weeks ago, it's spectacular. In terms of leasing traction, we did sign a lease, I think, this week or late last week, for some of the option space we have set aside for our anchor tenant, their 5-year space, that's 5,000 square feet. We have several prospects interested in space. But that evaluation process in each case has really been put on hold until DC opens up and those tenants return to work. So longer term, we'll see what the impact looks like. But currently no change in the anchor tenant space plan and some moderate progress in leasing.

Thanks. And then for my last question. Just -- I'd be remiss if I didn't at least ask about the tenant renewal at DC-6. Is there any update there that you can share? Or are we still sort of on track to a summer renewal?

We're on track for summer. The process is progressing. We've -- I think I've talked about their request for some enhancements to the resiliency in their suite. We're about 90%, 95% done with that. There's one small project that we're wrapping up. And then we're advancing a new document form at their request. And we expect we'll get done in June.

Great. I guess just to wrap up then, Steve, anything else that you want to share that would provide investors with a reason to invest in Corporate Office Properties Trust?

Well, I'll just reiterate the key themes. Our business is linked to an economy that's driven by the defense budget primarily. And we see no change in the underlying demand or growth in the primary economy we serve. Secondly, our performance is going to be literally or practically unaffected by these shutdowns. The change in our cash flows is de minimis at best. And then as we proved this quarter, our developments are continuing to lease. We projected 1 million square feet of development leasing this year, and we're very confident we're going to hit that number. So we're largely unaffected. And then lastly, the 2.2 million square feet we have under development is on track and 86% leased, and that's going to generate $20 million of incremental NOI to contribute to this year, then $21 million and then another $9 million. And that represents a great opportunity for growth that we consider robust.

Thank you, Steve, Anthony and Stephanie.

Thank you, Chris.