COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Good morning. This is Elvis Rodriguez, office and industrial analyst, BofA's U.S. REIT team. I'm joined today by Michael Funk and Tory Francis on our team, and we want to welcome you to BofA's Global Real Estate Conference virtual roundtable discussion with the senior management team from Corporate Office Properties Trust. OFC focuses on owning properties and develop a land near key defense installations and other knowledge-based government demand drivers and in targeted markets or select urban and urban-like submarkets with durable Class-A office fundamentals and characteristics. Joining us today from OFC are Steve Budorick, President and CEO; Anthony Mifsud, Executive Vice President and CFO; and Stephanie Krewson-Kelly, Vice President of Investor Relations. We have a large global audience joining us today. So management team -- so the management team will spend the first 5 to 10 minutes of our discussion providing an introduction to the company and an update on operating conditions. We will then move on to Q&A. We hope to make this as an interactive session as possible, so please add your questions to the Veracast platform so that we can weave them into the discussion. I would now like to turn the call over to Steve to get us started. Steve?

Thank you, Elvis. So Corporate Office Properties Trust, or COPT, is unique in the REIT industry. Our operating portfolio of office properties and data centers is heavily concentrated around the United States National Defense activity and locations. Those priority missions involve advanced technologies, research and development in cyber warfare. We have 165 defense properties located in 4 states containing 17.7 million square feet, which generate 88% of our annualized rental revenue. We're really an operating partner to the U.S. government, and have been for nearly 30 years. We are the preferred provider of mission-critical real estate leased to the U.S. Department of Defense and its defense contractors. Our major government demand drivers include the following: 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 secured DoD government campus in San Antonio, Texas. It's fully leased to the government and over 1 million square feet. We serve the U.S. Navy out of 3 locations, including the Navy Yard in Washington, D.C. And then we have a concentration at the Redstone Arsenal in Huntsville, Alabama, where we are literally a partner with the U.S. Army in our development. The notable missions at Redstone Arsenal include the Missile Defense Agency, the Program Executive Office of Missiles and Space, the Aviation and Missile Center of the U.S. Army, the Program Executive Office of Army Aviation, the U.S. Army Space and Missile Defense Command, NASA, Army Material Command and multiple law enforcement and intelligence functions, increasingly the FBI operations. And last but not least, we have concentration of data center shells in Northern Virginia that support cloud computing for government contractors. 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 include intelligence, surveillance, reconnaissance, missile defense, space operations, law enforcement and cybersecurity. In our business, proximity to the mission is essential, and it is for our defense tenants. Because of the security requirements of these missions, our tenants cannot telecommute or work-from-home. Our Defense/IT tenants invest heavily in their spaces, which creates high barriers to exit and supports our uniquely high tenant retention rates. On full building leases, the United States government has renewed 100% of their leases since our first lease was signed in 1992. Overall, our Defense/IT renewals have averaged 79% for the past 5 years. And through the first half of this year, we renewed 81% of our expiring leases, and we are on pace to achieve our record tenant retention this year. Our unique focus on Defense/IT locations should be important to investors for 3 reasons. The first is we own essential locations, for which demand has remained strong, regardless of the broader economic or defense budget trends or which political party is in control. Between 2012 and 2016, defense spending suffered the biggest cut since the end of the Korean War. Yet we achieved net gain of 18% in our defense revenues over those 5 years. Since fiscal year 2015, the DoD's base budget has increased 29%, representing compound annual growth of 5%. During the past several years of healthy defense spending, demand for our locations has propelled strong growth in our defense revenues and record leasing volumes. And from 2017 through the first half of 2020, our annualized rental revenues from our Defense/IT locations increased to 17% or 4.5% on an annualized basis. In 2019, we saw especially strong broad-based demand for our locations translate into record leasing achievement. Our development leasing in 2019 of 2.2 million square feet beat our prior annual record set in 2012 by over 1 million square feet. 784,000 square feet of vacancy leasing in 2019 was the best achievement since 2010. And the 586,000 square feet of total leasing with the U.S. government was our second highest annual volume in our history. Last year's momentum has carried us through to this year. And in 2020, we are on track to meet or surpass our goal of executing 1 million square feet of development leasing. We're on pace to achieve record tenant retention rates, north of 80%. And we're going to place over 1.8 million square feet of fully leased space from our development pipeline into service this year. Our strong performance to date has been achieved against the backdrop of the COVID-19 pandemic shutdowns. As investors consider the long-term impacts of shutdowns and the work-from-home trend, especially on office portfolios, the second reason why investors should own OFC is because our portfolio has proven to be relatively immune to pandemic restrictions and shutdowns and economic uncertainty. The most important thing to understand is the fact that the vast majority of our tenants are unable to work-from-home because of the secured nature of the work they perform. Our government and contractor tenants are considered essential businesses in every state in which they operate. All of our properties have continued to function, and our company has executed its normal workflows seamlessly throughout the pandemic in large part because most of our tenants cannot work-from-home. 85% of our portfolio house the tenants who's highly secure mission work cannot be performed remotely. This includes 65% of our space that is either located in secure government campuses that we leased to them or have the required secured compartmented information facility environments, and another 20% have other very high security requirements. These tenants cannot execute this mission work from home or unsecured locations. Because of our unique focus on Defense/IT tenants, we've outperformed the high-end of our quarterly guidance for 2 consecutive quarters. FFO per share, same-property occupancy and cash NOI growth have each exceeded expectations for both quarters. And we are on track to achieve record tenant retention between 80% and 85%. Development leasing has been solid, and our ability to complete development projects on time has advanced without delays throughout the pandemic. In terms of rent relief, we've also been largely unaffected. In the second quarter, we collected 99.6% of total billings and 100% excluding the rent relief we did grant. And for the third quarter through to last Friday, we've collected 99% of total buildings -- billings and 99.4% excluding rent relief granted. So lastly, while dozens of REITs have withdrawn guidance or suspended their common dividends because of uncertainties generated by the pandemic, we've maintained both. In short, our results remain virtually unaffected by pandemic-related shutdowns and demand for our Defense/IT locations continues to be strong. The third reason investors should own OFC is that our shares trade at a deep discount despite the fact that our earnings are very visible and are accelerating. We have 1.7 million square feet under development today that are currently 83% leased, in which we expect to be further leased when placed in the service. Our current and recently completed projects represent $50 million of cash NOI that will materialize over the next 2.5 years. Developments will contribute approximately $14.5 million of cash NOI during the third and fourth quarters of this year, bringing the total for the year from development to $22 million. And in 2021, we expect development to generate another $15 million, almost all of which is contractual. And in 2022, developments are on track to generate yet another $21 million of annualized cash NOI, over 90% of which is contractual. So in summary, 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 very healthy FFO per share growth next year. Despite the resilience of our results to date and our positive outlook for 2021, our shares continue to trade at a steep discount to fair value. As of September 15 closed, our stock is trading 22% below the Street's average NAV per share of $31, and it represents a compelling value for investors. Additionally, our dividend represents a 4.5% cash yield that is supported by a very conservative 65% to 70% AFFO payout ratio and our investment-grade balance sheet. Because of the shutdowns caused by the coronavirus pandemic, nearly every REIT is trading at compelling valuations. In this, we are not unique, but we are unique in that we are leasing into an industry whose demand fundamentals are accelerating. Our operations in new leasing opportunities are virtually unaffected by virus mitigation tactics. And we're position to deliver very healthy growth in 2021 and continuing into 2022. With that, all of us and I'm happy to answer any questions you have.

Thanks, Steve, for that great introduction. Just touching back on your comments on the biggest cuts since the Korean War in 2012 through '16, what are your thoughts or any early thoughts you have on the upcoming U.S. presidential election? Any implications that could have for space demand over the next 4 to 8 years, call it, on any of the upcoming potential administrations?

Well, elections certainly represent uncertainty each and every time they occur, but we like to refer people to the midterm elections in 2016 when the House flipped from Republican control to Democrat. As we mentioned, we're positioned to do well no matter who's in positions of leadership. Since 2016, the House Arms Services Committee, controlled by the Democrats, have had very high votes in favor of increased spending, and in several of those years, recommended spending in excess to the President's request. So we use that as a benchmark to demonstrate that the need for increased defense spending, because of those years of cuts, is very high, and it's bipartisan. Considering the comments of the contender for the Presidential seat, he hasn't spoken about defense for several months now. But when he did make comments about defense, he indicated he would preserve defense spending levels, and he considered a change in investment strategy from larger capacity to more lethality and more advanced weapon systems. And that plays to our strength in many areas. The intelligence component of our DoD clients is always stable. It's essential need, no matter who's in office. And then a shift towards technology plays very favorably to our locations in Alabama and our Navy Support portfolio, which includes advanced naval weaponry Research and development.

And then, in light of that, can you remind us sort of when funds get appropriated, how does that get spent? And any update you have from current and future government defense contract leasing, an outlook that you can share?

Yes. So our defense contractor demand tends to lag an appropriation by 12 to sometimes as much as 24 months. And that's because the increase in spending funds programs, programs are competed. In the defense contractor community, those competitions are complicated and takes some time. The winning award is frequently contested by parties that did not win. Those contests need to be adjudicated, the award finalized. And then our contractors can move out and procure the space that they need to conduct that particular increment of mission. So to that end, often, our leasing process, we call it contract contingent, we work in harmony with defense contractors, multiple locations concurrently to give them the solutions they need to accommodate the growth in their business, and we materialize leases as those awards are finalized. So given that, we expect 2021 budget to be passed likely after the election and a continuing resolution with a 2% to 3% increase, the demand from the fiscal '20 and then 2021 budgets will carry at least 2 years into the future. So that will carry us through '21 and well through 2022.

Okay. And then as you think about this expansion that has happened in defense and defense contracting, do you foresee it going into any other markets that you hope to expand into? Or how are you thinking about that?

Well, we routinely reconsider our investment strategy, but we've got advantaged land positions at priority locations. And right now, we're experiencing enough development opportunity -- really, for the last 8 years, enough development opportunity to satisfy our capital allocation resources. And these are, as I said in my comments, locations of priority missions with permanents. So right now, we're not considering any regional expansion.

Okay. And then as you think about your update that you shared in your presentation from the development leasing, can you share an update of where that demand is coming from? Any specific missions or locations within your portfolio? And then any other ones where you're seeing sort of a little bit of weakness or just less of a demand for space?

So thus far this year, our development leasing is pretty broad-based, and it's dominated by defense contractors and U.S. government activity. So the largest lease we signed was for an anchor tenant in our first secure building in Redstone Gateway, our development on the Redstone Arsenal. And then we did another -- a contract to build-to-suit there for a leading aerospace company. We did 2 build-to-suits, one in Texas, where we signed 2 build-to-suits this quarter, one in Texas and one at the National Business Park in Maryland. We did 3 expansions of our data center shell and a data center shell campuses. And then we fully expect to get another 0.5 million plus square feet by the end of the year. Thus far, we've done no full data center leasing this year. We expected that to be back ended. And we expect 1 to 2 additional build-to-suits in that space. So it's pretty widespread, Elvis.

Okay. I'll just add a question that came here from an investor. How would a Biden victory and Democratic sweep impact the outlook for your business? I know you mentioned a little bit of this, but maybe you could elaborate on a Biden and Democratic sweep.

So I think, I'll refer to the comments that candidate Biden made this summer, which was his intent to preserve defense spending, but reoriented towards more technology and less capacity. So to the extent those words are good, I don't think it would have a material effect. Moreover, I went through the detail of the House Arm Services Committee's action since 2016, which really is hard evidence that there's bipartisan recognition following the reeducation of Congress by Secretary of Defense Mattis, when he came in to lead that effort that we are in really a geoeconomic competition with China, and fundamental baseline strength we need is military superiority. And at that point in time, we can no longer claim uncontested dominance in every theater for, which we have enjoyed since the end of World War II. And that the need for investment in both capacity and technology was significant. And since then, the spending increases have been highly bipartisan. So I think it would be neutral to potentially, mildly negative. But as I said, we grew our defense revenues 19% over the 5 years of severe defense cuts. So we think we're extraordinarily well positioned.

Okay. And I have one more here. You spent a good amount of time, in your opening remarks, talking about the discount in the stock and also the disconnect between corporate office and other office companies. So what do you think the Street or investors are missing about the story that's aligned to this location to continue?

Well, if you look at the trading that's happened during the crisis, I think there's an overarching funds flow issue, and that office is just generally not being favored categorically. I think, specific to us, we have a major renewal in one of our data center assets that represents a significant amount of NOI for next year. When we achieve the renewal, we'll be in a position to give some benchmark around the growth we expect to have happen. And if the renewal were not to happen, our growth would still be positive, but not as significant as we expect. I think that's a gating issue for investors, and they're looking for us to disclose or to close that deal. And then lastly, I think, because of the many years of recycling our assets and deepening our concentration into higher quality, more durable assets, the investment community is looking for us to demonstrate our ability to grow, and we'll be doing that in the fourth quarter.

Great. And you touched upon DC-6 leasing, excuse me, and the conversations there. Are you able to share, when you mention that if the lease doesn't happen or the renewal doesn't occur, and you mentioned growth, is that FFO growth? Does that -- will that impact cash same-store? How should we be thinking about those metrics?

That will be FFO net assets, not in our same-store.

And then, while we're on the topic of data centers, can you talk a little bit about sort of your relationship with the largest tenant? And then you mentioned 2 expansions on existing land, but maybe bigger future demand from that tenant. And then lastly, Blackstone's appetite to continue to sort of acquire more assets in the JV structure that you have with them.

So I'll take the first half of that. Our cloud computing customer, we've had a very strong development relationship with them going back to 2012. And since then, we've completed more than 4.5 million square feet of build-to-suit projects for them. And land parcels that we are currently developing on, we have capacity for 7 additional very large data centers, and that demand will continue through this year and next year, potentially into 2022. We've been a valuable partner to them because of our development expertise, our speed to market, our deep understanding of technology and development, and we expect that to continue.

And Elvis, with respect to our current joint venture partners' appetite for additional investments in that space, we believe that, that appetite continues to be very strong, not just from them, but from a very large group of private equity investors. As we've gone down the road of the process of raising net equity for the year, we've received probably over half a dozen unsolicited inquiries about private equity investors' interest in investing in the data center -- portions of the data center shell portfolio. I think private equity investors believe that in today's current environment, data center shells represent one of the real estate sectors that can provide them with cash flow streams that are relatively or incredibly resilient to any of the impacts of some other sectors of real estate as have seen as a result of the shutdowns. So we're very confident that we'll be able to execute $80-plus million worth of equity capital that we had in our original plan sometime early in the fourth quarter. And we expect that to be at values that are higher than and lower cap rates than where we executed those transactions last year.

And would you say that those cap rates are 25 basis points tighter, 50 basis points tighter? Are you able to share at all how much the markets tightened or pricing tightened for those assets?

I can share that it's tightened, and I think we would rather wait till that one's sort of -- that hay is the barn.

You're going to have to get that one out of the next call, Elvis.

Thanks, Steve. I can try. I can always try. Just getting back to DC-6 and the conversations there, if we could just spend a minute, I know you've mentioned some delays from everyone working remote on getting that lease over the finish line. But are there things that could potentially derail that deal? And is it expected this year? And when would you know if they decide to walk away?

So they're not walking away. First of all, let's talk about the lease structure that exists. The original 5-year term did end at the end of July. And the way we structured the lease is it's now a perpetual 6-month lease. Unless we were to issue a notice to our tenant or our tenant were to elect to issue a notice to us, each day, we start a new 6-month term. So that's the structure we're in. Over the 5 years that our tenant has occupied the building, their business standards have changed fairly significantly, and they've become a little more bureaucratic with layers of approvals necessary. So we've already proceeded through a very long process of enrichment of our redundancy and our resiliency to meet their current standards with some modest investment on our part. We're working with our operating team on operating standards. And we're currently working on taking standards in a different format from structures that are dissimilar to ours and translating and equivalent into the documents that we use as lease documents for our asset. We've made great progress since the fall, but it's a laborious process, and we expect to get it done. I'd like to have it done by call, but certainly by the end of October. I consider -- the probability, in my mind, is 99%.

Thanks, Steve, for that. And that perpetual 6-month contract that starts every day, was that part of the original contract? Or that's a new contract that you signed in the interim?