COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Good afternoon, 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 Danny Ismail, Senior Analyst at Green Streets. I'm 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. [Operator Instructions] So Steve, let's start with an overview of OFC and its underlying business.

Thank you, Danny. Corporate Office Properties Trust, or COPT, is unique in the REIT industry. 5 factors that sets us apart from other REITS. One, we are the only REIT that primarily serves the defense community of the United States. Because of that, we enjoy strong demand in our locations, regardless of the economy and political leadership. Our operations and cash flows are highly resilient, as has been proven during the pandemic shutdowns. We've entered an era of growth, beginning with the 3% increase implied by this year's elevated guidance and the 3% to 6% growth we expect to achieve next year. And despite the recent rally in most REIT shares, we still trade at a compelling valuation. Regarding the durability of demand for our locations, our office properties and data centers are heavily concentrated are on the United States' national defense locations, whose missions involve advanced technologies, research and development, and cyber warfare. We have 167 defense properties that contain 18 million square feet and generated 88% of our annualized rental revenue. Our major government demand drivers 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; a secure DoD campus in San Antonio, Texas; and the U.S. Navy, which we serve out of 3 locations, including the Navy Yard in Washington, D.C.; Redstone Arsenal in Huntsville, Alabama, where we are a partner with the Arsenal's garrison. Notable missions at the Redstone Arsenal include Missile Defense Agency, the program executive office of missiles and space, the program executive office of aviation, NASA, Army Materiel Command and multiple law enforcement and intelligence functions and increasingly, FBI operations. And last but not least, data center shells in Northern Virginia for hyperscale cloud computing. The common threads of our defense/IT locations are the permanence of their locations and the essential roles in supporting high-priority missions of national security, which include intelligence, surveillance, reconnaissance, missile defense, space operations, law enforcement and cybersecurity. Proximity to the mission is essential for our defense tenants. Because of the security requirements our tenants comply with, they cannot perform mission work at home. Due to our concentration of assets around mission-critical defense locations, our cash flows are not correlated with broader economic or political trends. And as our performance during the pandemic has shown, they are highly durable and resilient. Operationally, none of our office or data center properties were subject to pandemic shutdowns. The vast majority of our buildings are either in secure campuses, contain high security SCIF environments or operate pursuant to other high security standards. The preponderance of our tenants require employees to work in our properties, allowing only a small portion to work from home. Accordingly, our utilization rates remained high and are trending back to pre-pandemic levels. Specifically, half of our portfolio is back to normal utilization. Another 40% is running at or above 50% utilization with a current weighted average estimate of 63%. And only 10% of our portfolio is lightly utilized, with daily attendance of roughly 20%. Our rent relief and rent collections have been minimally impacted by the shutdowns. As shown on Slide 11, our rent combinations remain below 1% of annualized rental revenues and our rent collection rates in the second and third quarters, without adjusting for rent relief granted, were above 99.5%. Our ability to lease space has been virtually unaffected by pandemic shutdowns as well. Vacancy leasing volumes trended a bit lower during the shutdowns, but have rebounded since September, and we expect solid leasing volume in the fourth quarter. In terms of development leasing, we've completed build-to-suits in 3 different defense/IT locations, the National Business Park, Redstone Gateway and our San Antonio Secured Campus, evidencing not only the depth, but the breadth of demand through the pandemic shutdown period. With the leasing we are completing this quarter, we are on track to complete at least 1 million square feet of development leasing this year. Lastly, we are on pace to achieve record tenant retention above 80%. This retention rate deserves highlighting, because we typically achieve sector-leading renewal rates in any given year. This is because the Defense/IT tenants invest heavily in their spaces, which creates high barriers to exit, and supports our uniquely high kind of retention. As shown on Slide 6, we've renewed 79% of the expirations in our Defense/IT locations during the past 5 years. Through the first 9 months of this year, we renewed 84% of expiring space and are on pace to achieve record tenant retention of 80% to 85% this year. Turning back to Slide 11. We have maintained our strong balance sheet and our investment-grade ratings and successfully raised debt and equity capital this year. Our hugely successful $400 million senior notes offering in mid-October, followed by raising $81 million of equity proceeds last month from selling joint venture interest in 2 data center shells to Blackstone, and we will raise another $85 million before year-end by completing a second transaction with Blackstone. We have nearly $700 million of liquidity currently to fund less than $250 million of development commitments. And lastly, in terms of bottom line results, we've exceeded our quarterly guidance for 3 consecutive quarters. Our ability to outperform expectations in the face of this year's challenges demonstrates the strength of our franchise. And with our third quarter results disclosure, we elevated our 2020 guidance for FFO per share above our initial target. Our revised midpoint for 2020 implies 3% growth over 2019 results. More importantly, we have such strong visibility into 2021, and we also established guideposts for FFO growth of 3% to 6%. Our outlook is based on the strength of our operations, the future NOI embedded in our highly leased 1.6 million square foot pipeline of active developments, the growth potential from pursuing the more than 2.4 million square feet of opportunities in our development leasing pipeline and our ability to access attractively priced capital with which to fund that growth. In short, we've entered an era of attractive, sustainable earnings growth. Despite the proven resilience of our franchise, our outperformance to-date and our positive outlook, our shares trade at a steep discount to fair value. As of November 17 close, our stock was trading 14% below Street average NAV per share of $31. Our dividend represents 4.1% cash yield that is supported by a conservative 65% to 70% AFFO payout ratio and our investment-grade balance sheet. And as a final reminder, the missions are building support, namely: Signals and human intelligence; missile defense; space exploration; law enforcement; and cyber activity, are driven by national and global security needs. These missions are not correlated with traditional office fundamentals. They advance irrespective of election outcomes, and they absolutely cannot be performed from remote locations. So at conclusion, our ability to generate highly leased development projects for our unique tenant base, combined with solid same-store results, assures the 3% to 6% growth we expect to achieve in 2021, and drive similar growth thereafter. With that, Danny, I'll take any questions you and the audience may have.

Great. Thank you, Steve. [Operator Instructions] And if you ask us, we will make sure that we address your question afterwards. And it looks like we have one question already, which is, what is one thing you wish the Street understood better about your business model?

Well, for years, as we reshaped our portfolio and deeply concentrated it into Defense/IT, we advised the investors in the Street that we were creating a uniquely strong, durable, resilient REIT. And the only upside I can point to from this pandemic is we've been able to prove it. In an environment where most offices, companies are struggling to pay rent, or a company get rent collected and accommodate tenant request, we've been collecting 99.5% of our rent without fail.

Great. And I think you mentioned the durability as well and not only in the face of the challenges posed by COVID-19, that other office landlords are having to deal with, but also in the face of changing political -- or just in the face of the changing political state. Can you maybe discuss how the upcoming Biden administration may impact your business in the form of changing defense budgets?

We don't believe it will have a material impact, negatively or positively, on our business. I want to share some statistical facts about the last 4 years. Defense appropriations, including the 2021 Defense appropriation. The House Armed Services Committee voted on average at 83% in favor of defense spending equal to or greater than the presidential request. And the House controlled by Democrats approved at an 81% level those defense budgets. The Senate Armed Services Committee controlled by Republicans approved the defense spending at 95% for the budget on average each year. And the Senate overall approved those defense spending budgets at 90%. So it does make a lot of headline news, but our government has been working in a strong bipartisan way to continue to increase funding for advancements in technology and capability in defense. And with the Senate and the House becoming more on par with the outcome of this election, I don't expect that to change. Moreover, listening to Joe Biden on the campaign trail, Joe assured his constituency that he would not cut the funds, but that he would shift some of the emphasis from capacity to technology advancement and innovation. And in that regard, we think it will be neutral to our larger government customer base, which is primarily in intelligence activities and incrementally positive in our Redstone and Navy support group, where we do advance -- support advanced research, development, test and evaluation of technology in support of weapon systems.

Great. And I guess the other big news of the last 2 weeks were the announcements of Pfizer and Moderna's vaccines and their relative effectiveness. I'm curious, given the resilience shown by Corporate Office's portfolio thus far, how does the vaccine impact your portfolio?

It will certainly impact the 10% of our portfolio that is lightly utilized, which is the part of our business we call regional office, it's non-defense tenants. It certainly should give them comfort to return to the office and resume their normal utilization. With regard to our defense customers, half of our buildings are at normal utilization level. And to be at that level, they have to wear protective masks and take precautionary measures. So to the extent the vaccines are effective and distributed quickly, I think it will make the quality of the work day more normal for our defense tenants.

And can you maybe discuss the development opportunities in 2021? Obviously, 2020 proved to be a very successful year in terms of development leasing. But what are the expectations for 2021?

Well, we're not prepared to set guidance until early next year. But what I can tell you is on the second quarter call in August, we revealed that we had 2.2 million square feet of new development opportunities in our development pipeline. Over the third quarter, we signed 250,000 square feet of those opportunities, and happily reported on our third quarter call in October that size of that development pipeline increased by over 200,000 square feet to 2.4 million square feet. So net-net, we identified 450,000 square feet of additional opportunities during that quarter. That pipeline of opportunities is carrying into 2021. And from that, we expect to harvest a significant amount of new development leasing, as we have for each of the last 9 years.

And earlier on in the presentation, you discussed the FFO growth range of 3% to 6% for 2021. I was hoping maybe you could discuss that range and what gets you to the lower or the higher end of the range throughout the year?

So we're working through a renewal of an 11.25 megawatt lease at our one wholesale data center. And that renewal is currently in a rolling 6-month perpetual occupancy, they probably could terminate on 6 months' notice. To give the Street and the investor community comfort, if that tenant were not to renew and vacate midyear, we would still achieve the 3% growth level. If the tenant renews at the terms we've offered, then we would be in the midpoint of that range. And if the tenant renews for the full year and our new vacancy leasing beats the conservative amount we've built into our budget, then we'd be in that 6% range or possibly higher.

Great. That's helpful. I'm curious, though, you mentioned the stock still trading at a discount to NAV, despite the rally we've seen in the last 2 weeks. Can you maybe discuss capital allocation and the best sources of your capital these days, in light of a healthy development pipeline, and where the stock is trading today?