COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Good afternoon, everyone. Welcome to Citi's 2021 Global -- sorry. Welcome to Citi's 2021 Virtual Global Property CEO Conference. I'm Manny Korchman, Citi Research. We're pleased to have with us Corporate Office Properties and CEO, Steve Budorick. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast. For those joining us here today, if you'd like to ask any questions of management simply type them into the question box on the screen, they'll come directly to me anonymously, and I'll do my best to weave them into the session. Steve, with that, I'll turn it over to you to introduce the folks in the room there with you. Give us a quick overview of who OFC is, and then we'll go back to Q&A.

Sure. So with me on my left is Scott Hartman, Corporate Office Properties Trust Chief Operating Officer; then on my right is Anthony Mifsud, our Chief Financial Officer. Corporate Office Properties Trust is an office REIT, a REIT that specializes in developing and owning assets for United States Department of Defense activities. We're headquartered in Maryland. We have concentrations in Northern Virginia, Washington, D.C., Alabama and Texas.

Great. Coming out of the pandemic, if an investor were to choose only one real estate stock to own, why should that stock be OFC?

Well, there are 3 reasons, Manny. Primarily is through the pandemic, we were able to demonstrate the resiliency of our operations. Our tenant profile and credit profile is amongst best in the office industry. And last year, during the pandemic, we were able to collect 99.5% of our rents, and our rent concessions totaled less than 1% of our annualized revenue. 2020 represented our ninth consecutive year of producing over 1 million square feet of new development leasing, which is done in a low-risk, pre-lease or build-to-suit fashion, and that creates real value for shareholders and drives growth. And the third reason right now is we have a compelling valuation. We're trading about 13% under our net asset value. And for a company that can -- performed so well and has demonstrated its ability to grow through a pandemic, it's a compelling opportunity to buy.

Maybe if we start at the last one first. As you sit around the management table and the Board table, and that question comes up, why do we trade at a discount? What reasons are you able to come up with?

Well, our discount is higher today than it was a year ago, and our earnings are higher than we anticipated a year ago. I think that we've been trading more with the office sector and that the individual investors haven't discriminated enough between our performance and the sector's performance and we're very comfortable with the business plan we have this year. We're going to be able to continue to differentiate our operations from theirs, and we hope to enjoy the benefit of our share price.

Do you think there will be any outsized benefit of getting rid of sort of whatever regional office is left and solely focusing in on the more niche or specialty, which does make up the bulk of your portfolio?

Yes. Just to recall, 9 years ago when I joined the company, over half of our portfolio is commodity lease suburban, and we embarked on a long-term restructuring plan. And during the next 7 years, we sold half of the company's portfolio. We sold 11 million square feet. One of the moves we did to accelerate our exit from commodity suburban is we bought a couple of buildings in Downtown Baltimore, and we maintained possession of 2 buildings in Tysons Corner and an existing asset in Downtown Baltimore. As we recycled so much of our company out, we put some capital into those assets to allow us to continue to deliver the earnings we're -- our shareholders were expecting while our development program ramped up. Since that period of time, we've also developed over 11 million square feet. [ In our end ] position where our development achievements footnote last year, we placed 1.8 million square feet of development -- completed developments into service that were 100% leased. As we look forward the next couple of years, that creates an opportunity first to recycle some of the regional office assets and deepen our concentration in defense.

And so what Steve is driving at, that timing, why not do that sooner? Is it a matter of where to put those proceeds to work? Is it a matter of the market not being receptive of those assets? Is there something else that's stopping you?

Well, each asset has its own story. Some of those assets have some leasing achievements we need to complete before they're optimal for marketing. And then frankly, I think the asset market for those properties will strengthen relative to what we saw last year.

Right. And then if we look at the resiliency of that cash flow of that small amount of income that was an issue in 2020, when does that come back or get addressed in a different way?

So about 1/3 of that, correct me if I'm wrong, were concessions we made to the -- to the amenities in our parks. One of the consequences of locating near defense missions is that you're not in an urban environment. And foodservice is an important offering in our portfolios to keep our tenant satisfaction high. Additionally, some of those were health club facilities. So in those cases, we needed to keep them alive. They're a valuable part of our value proposition to tenants. We structured those concessions as free rent with lease extensions and we partnered with them, openly suggesting we're in it with you, and we want to keep you in business. When we move through this pandemic, we're still partners, we work together. And the other 2/3 were deferments for tenants that had short-term cash flow needs. About 10% of those deferments were repaid by the end of the year, and the balance will be collected this year through early next year.

Todd, welcome to your first Citi conference. Unfortunately, it's usually nicer and involves a lot more sun and sand but I'll take what we can get. Any observations that you could share since joining OFC as to maybe positive and negative surprises versus when you planned to walk in?

Sure did. No, I -- well, certainly, the positive surprise, and it's not really a surprise, is the culture of the organization. I think it's outstanding and learning, the people even more so as time goes on and getting to know everybody has been a great pleasure, and I look forward to continuing to work with them going forward. I wouldn't say that's a real surprise. Throughout the interview process, got to know plenty of them. But -- just so it's a great culture.

And what about the portfolio itself? When you're doing your homework on OFC, as investors do, and then you get there. What's sort of different or I don't want to use the word surprise again, but I'll use it, from what you anticipated?

Well, it's not a surprise. Again, I think the resiliency of the portfolio is among the best in the industry. And the size of the portfolio is rather large with 170 plus properties. So it takes time to get to know them all. That's probably the biggest early challenge. But over time, and we'll get to know the properties better.

Late last year, early this year, mostly late last year, there was a lot of questions about the impact to your portfolio from the election and who controls what within government. Those discussions have abated. Do you see any actual shift in the conversations you're having with entities that you lease to?

Not at all. As a matter of fact, this year's appropriation both in the House and Senate Armed Services Committees was highly bipartisan. It has been for the last 4 years, really, but in particular, the 2 before this election, where we had split control of the House and Senate. Communications out of the White House and from Capitol Hill is to continue to invest incrementally 1% to 2% in the strong defense budgets that we have. And increasingly, it's been some of the appointments that the President has put in have started to communicate their commitment to the recognition that the advancement of Chinese weaponry and military capability is and continues to be a threat. And so it's really been no impact. The program continues.

Right. Switching to leasing. You talked about your successes over the last 9 years in that development leasing. Anything that could be or should be different about 2021?

Well, I'll take development, and I'll let Todd take operating. From a development standpoint, we guided to 1 million square feet. And right now, our visibility on that 1 million square feet is very high. We're negotiating multiple leases as we speak and our confidence of hitting our goal is above 95%. Our confidence in exceeding the goal is about 75%. So our development demand is strong. We've got a 2.1 million square foot development pipeline that's active and there are multiple scenarios that would cause us to meet or beat the 1 million square feet.

And on the operating portfolio, we're very encouraged about the demand since the beginning of the year. We have activity on about 80% of our available space. And it's been increasing since the start of the year. We're back to showing brokers -- doing live tours with brokers and also live broker events. So it's a great start actually to 2021.

Any updates on DC-6?

Status quo as we discussed on the call. We've made some real progress and some of the requests for physical enhancements. And we are in the process of negotiating a new lease document and the structure our customer, as a national presence, has asked us to move towards. We're very confident the customer will stay in the building. We're in a permanent structure that has a 6-month termination option for either party, but we're working in harmony to get to a renewal structure.

Then on your fourth quarter call, you talked about that potentially happening at the beginning of the second quarter. Is that timing still appropriate to think about?

They've slipped a little bit. Our counterparts on the other team are national in scope and very busy. So they apologize for being difficult to schedule time with, but we continue to think we'll get it done in the second quarter.

One of those things was more important to you than it is to them. What's this -- this thing [ laughs at itself ]?

Well, you can't push a rope. They've been a great tenant and a good partner. So we're working in harmony. And if their pace is slower than ours, we can accept it.

So Steve, just to clarify, the temporary lease, for lack of a better term, that they're in now will stay in place until you sign a permanent lease with them. But your comment on -- you're working with them as a partner, does that mean that you're going to discount that in this interim period? Or they're paying the higher rent now and then it's just getting pushed forward? So instead of happening in April or May, you were talking about June, July, am I understanding all that correctly?

Correct. And they are paying full rate under the existing agreement that we have. We've offered a discount for a longer-term extension. And when we sign that, then we'll market to that rate.

And is that June, July an appropriate way to think about what might happen now?

Yes.

Okay. And then is 310 NBP, is that development or is that operating, which one wants to talk about? Is that Todd or is that...

A little bit of both. We'll book that as development leasing because it can only be leased to the U.S. government. So it's essentially set aside. But it is in our same-store results. We expect to get 2 floors -- at least for 2 of the 4 floors executed first half of the year, the remaining 2 in the second half of the year.

Is there more or less -- more confidence, less confidence, equal confidence as to that level of leasing versus a few weeks or months ago?

Equal.

Okay. And then can you just give everyone on the line a reminder of where you are in the data center development program?

Well, we have been developing for our cloud computing customer since 2012. During that period of time, we've done 4.8 million square feet about 20 to 29 build-to-suits. Last year, we executed 2 of those. We have land parcels that we own that will accommodate 5 to potentially 6 additional data centers. That capacity is about 1.2 million square feet. We're working with them to negotiate at least 1 lease this year, potentially 2, and we continue to look forward to delivering the remainder of the build-to-suits on the inventory we own and beyond.

And where are you in discussions to find additional land sites to keep this program going?

So we routinely provide the customer with briefings on availability of land parcels. We're not in a position with them right now where we're moving out to procure any because we have a significant amount of capacity on what we already own.

I assume that you've been sort of scouting the market anyway. Is there that opportunity should you decide to expand the program?

Unquestionably, there's opportunity. That opportunity has got to be matched with the customer's program. So ultimately, they dictate the where, we help them find the exact parcel, and it's been kind of a cooperating partnership, if you will.

And just looking at that -- the success of that data center shell program, any chance you'd expand it to either other tenants or other markets or expand it in a different way?

We would gladly expand it with other tenants provided we could stay with the capital structure that we enjoy with our current customer, in which we're providing a real estate -- we're providing land, structure, and they're investing in the MEP. And we have and are having current conversations with others, showing them the benefit of our structure.

And I guess that's opposed to you sort of building out the -- up until the actual processing equipment. So you power and you'd cool it versus just the shells you're building now?

No. We prefer to stay with the shell structure.

Right. I'm saying, the alternative would be the more classic data center structure where you're powering and [ following ] it.

The alternative would be a fully developed Tier 3 data center where the tenant provides their racks and equipment and the asset is fully developed.

And I guess, just from a putting capital to use perspective, especially since you've been able to JV the assets, why do you feel like the risk profile is enhanced in or elevated in that type of structure?

On a build-to-suit basis, we probably invite a joint venture partner and a single-tenant asset, build-to-suit basis, invite a joint venture partner to help us finance. But from a capital concentration standpoint, fully developed data center is very capital-intensive. Ultimately, that's not the business we want to be in, being a data center company, if you will, and we prefer the measured investment we do in our shell program.

I guess if we just step back and say, if I'm an investor looking at OFC and that pitch is a big American flag on the face of the report leasing to defense contractors, the defense elements of the U.S. government. You've got this data center program that perhaps is sort of outside of that scope anyway? Why would taking it one step further intensifying the amount of capital that's put into a single data center, especially on a pre-lease basis, really change sort of -- why do you feel like that's taking it way outside the bull's eye when you're already sort of outside the bull's eye?

Well, we don't feel like we are outside the bull's eye because our customer is a defense contractor period. That's not the only thing they do but they are a major contractor, the DoD and the US government. So it's a slightly different product type. Overall life cycle, we have a fully developed wholesale data center. At some point in time, we might get that back and need to release it. That's the threshold we don't want to cross over, is to be leased in a multi-tenant data center. We like our build-to-suit single tenant model.

Let's see if there's anyone here in the audience [ that are showing this ]. Anthony, capital plan for the year? 8-K came out just as we're sitting down to this meeting, pricing the issuance of a bond, anything else that we should know about going on?

So on the debt side, we issued $600 million worth of 10-year notes last Wednesday. That we had -- was part of our plan, actually was slightly lower than that. We had gone out to the market looking to raise about $400 million worth of 10-year notes. We got extraordinary reception from the fixed income market, where we had an order book that was -- that topped out at $3.5 billion from some sort of the highest quality fixed income investors in that sector. And that gave us the opportunity to not only upsize transaction in terms of proceeds from $400 million to $600 million, but also the pricing power to compress the spread from what was initially talked at 175 basis points over the 10-year to executing the deal last Wednesday, at 140 over. So we issued $600 million at a coupon of 2.75%. We're using that money to tender and/or redeem our outstanding '23 and '24 bonds. So the 8-K you just saw is the closing of the tender for the '23 bonds. The tender for the '24 will close tomorrow, and then the bonds and the tender will close and fund on Thursday, at which point we intend on announcing the redemption for any untendered bonds. So the -- it pushes out our maturity ladder pretty significantly, reduces our overall debt cost of capital, increases our fixed charge coverage to the sort of mid- to high -- mid-high 5x and is a sort of outstanding transaction for the company and the fixed income community and the almost 60 investors we talked to [ pleading ] into that transaction. Understood the resiliency of the company's cash flows during the last 12 months, saw it as a significant positive just compared to some other folks in the office sector and really priced our transaction at a BBB flat Baa2 ratings level. This is a notch higher than the agencies have us right now. And I think gives us a lot of ammunition to go to the agencies and talk to them about really where the credit should be rated and that issues that they've brought up since 2013 about our geographic and tenant concentration risks are really the positives that we've been trying to tell them they are, and that the last 12 months has really proven that out. And the reception from the buy investors have really improved now.

All right. Any other activity on the capital front that you're battling with?

The side of the table, we -- our guidance includes about $225 million worth of equity from additional joint ventures of data center shells. We have -- at the end of the year, we have a portfolio of wholly owned data center shells that are either operating or the 2 that are under construction. That based on the 4.95% cap rate we achieved with Blackstone last year, have a gross value of a little over $650 million. So we have, based on our longer-term plan, just from that resource, the capital to fund the development pipeline really for the next, call it, 5 years, while actually not just maintaining, but slightly reducing leverage over that period of time. So we feel like that continues to be a very cost-effective way to raise the equity capital when there's a dislocation on the public side of how our common equity is being valued.

That 4.95% that you did that with, is that contractual to add into with other deals? Or is there a live pricing element to that?

There's a live pricing element of that. So we have the obligation to go to them first with an offer to buy at a valuation that we determined. So -- and they have the right to say yes or say no. But that's based off of what we believe the current market value of those assets are at the time that we go to that.

How much do you think they've moved since then?

Probably 10 to 20 basis points, maybe. And the 4.95% is 25 basis points from where we executed in 2019. So we did the first deal with BREIT at a 5.2%, so cap rates have compressed over that 12-month period by 25 basis points. I'm sure it's a full 25 by now, but it's probably compressed a bit more since we did the deal last year.

So in the session prior to this, I hosted Easterly, Darrell and Bill. And Bill said -- Bill sends his regards to you guys but he said he never sees you looking at the same assets that he does. Is that a part of the world that you've had any interest in exploring, the sort of triple net long government leases?

No. We -- first of all, from a capital allocation standpoint, look at our history. We've been able to invest $250 million a year in defense-oriented government contractor cloud computing buildings. The GSA world is a little bit of a different world, and one of the striking differences is the lease structure and they tend to be flat. So we don't need to be everything to all people. That's a good investment. They've got a great program. We consider them colleagues. But we like value creation to low-risk development. With our defense customers, our leases have escalations, and it works very well on our structure.

All the other office meetings that I've been hosting, we're talking about the office of the future, including the work-from-home elements, including the density elements, all that stuff. Do you have those conversations with your tenants? Or is it kind of -- they've got their model and it's worked for them and they're bringing people back because they have to. And that's kind of it.

That's pretty much it. We have a tenant in Baltimore that we think is going to move to more of a work from home. That's outside our defense niche. But just one. As a matter of fact, I've been sharing this anecdote over the last couple of days. But we're working on build-to-suit with the defense contractor at a new facility for new mission and consolidation of some other assets. And their request for parking is 15% higher than our typical contractor development requirement. So here we have defense contractors operating through a pandemic and they're planning a new building and they want 15% more density, if you will, in that asset.

Interesting. And you think that, that's a direct relationship with butts and seats versus some other function that we're not thinking about from a parking perspective?

Indeed.

So we've been asking each REIT here, as they think about their ESG priorities, what are your top 3 priorities to improve your ESG score going into next year?

Well, we've got a great ESG story. I think we're going to -- we are upping our game and the comprehensive -- be more comprehensive in the way we report. But we feel like we're a leader in the office segment. We need to tell our story a little better. We are making some enhancements to our Board to improve our governance scores. There have been 2 announcements recently. We added 2 new board members. And next year, we'll have 1 retirement, which will improve that overall score.

With that, maybe we'll go to our rapid-fire questions here. When we're all sitting together physically in Florida a year from now, what will be the one thing that will have surprised people the most about your business over the prior 12 months?

Well, I practiced this. We're not [ remiss ] of some surprises. We're in the business of [ set and be ]. But I think the surprise will be just how little affected our portfolio continues to be from COVID, work from home, any of the discussions that surround the rest of the office community.

What do you think your corporate travel budget will be in 2022 as a rough percentage of what you spent in 2019?

107%.

He's going to hold you to that, Anthony. 107%.

Well, we're a big believer in face-to-face contact with investors, in a face-to-face contact with our customers, and we look forward to getting back to in-person conferences [ in large numbers ].

What will same-store NOI growth be for the office sector overall in 2022?

2%.

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

1.25%.

Anthony, I don't know, what was that reaction? Is that a -- you can rewatch it on camera later. You and Steve can have a conversation over that reaction.

Yes. We've got a little running joke there.

Thank you, guys. Good seeing you.

Yes, Manny.

You too, Manny. Take care.