COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Good morning, everybody. This is Bill Crow, Managing Director of Raymond James. I'm really pleased to present the Corporate Office Properties Trust company I've known for past 20 years now and had a tremendous amount of respect for through the years. And I think they have got a really unique storyline here in the midst of what looks like a crazy year. And with that, I'm going to introduce the company. Of course, we have CEO and President, Steve Budorick; Todd Hartman, Executive Vice President and Chief Operating Officer; and Anthony Mifsud, CFO. Again, Bill Crow from Raymond James. With that, Steve, I'd like to turn it over to you to provide an introduction, to those that are online, to the company and some of the things that the company is focused on.

Thank you, Bill. Well, briefly for anyone new to our story, Corporate Office Properties Trust or COPT provides real estate solutions to the U.S. government and its contractors, most of whom are engaged in national security, defense and information technology-related activities. Our defense location support key installations whose missions have been and continue to be DoD spending priorities. Our major government demand drivers include Fort Meade in Maryland, whose mission's about signals intelligence and cybersecurity. We also support various elements of the intelligence community in Northern Virginia and a variety of locations. We have a portfolio of data center shells in Northern Virginia that support hyperscale cloud computing. We have a top security government campus in San Antonio, Texas, and we support the U.S. Navy, which we serve out of 3 locations that support both NAVSEA and NAVAIR missions. We're also at the Redstone Arsenal in Huntsville, Alabama, whose notable missions include the Missile Defense Agency, the Program Executive Office of Missiles and Space, the Program Executive Office of Aviation, NASA Marshall Space Flight Center, Army Materiel Command and multiple law enforcement and intelligence functions and increasingly the FBI operations. Our defense locations generate roughly 90% of our annualized revenues, and we are the only REIT dedicated to serving the defense community in the United States. And there are 3 main reasons investors should invest in our unique franchise. We have resilient operations, which have proved to be uncorrelated to economic or office fundamentals. And we have a proven track record of low-risk development, which creates value and in sharp contrast to most office REITs is driving an FFO growth and our compelling valuation. Regarding the resiliency of our cash flows, demand for our defense locations is highly durable and not correlated to general economic trends. Our locations represent clusters of specialized office and data center facilities around defense installations. The common threat among these locations are the permanence of the location and their central roles in supporting the high priority missions of national security. Proximity to the mission is essential for our defense tenants. And because of the security requirements, these defense tenants cannot perform mission work at home. Demand at these defense installations is driven by defense budgets and not the general economy. And as our operating performance showed during the pandemic shutdown, our cash flows are not correlated with the broader economic trend and are highly durable and resilient. Operationally, none of our office or data center properties were subject to shutdowns. And because 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 and at the moment. The high secure defense missions being executed at our locations absolutely cannot be performed remotely. In strong contrast to other REITs, we not only maintained our 2020 guidance, we increased it. That ultimately exceeded that elevated guidance for the year, and we generated FFO per share that was 4.4% higher than 2019 results. Demand for new facilities also remained strong throughout the pandemic. And we met our pre-pandemic goal of completing 1 million square feet of development leasing last year. This leads me to the second reason investors should invest in OFC. Our ability to complete large volumes of development leasing annually drives our FFO per share and NAV growth. We pursue low-risk development opportunities at our defense locations where demand is driven by defense spending and mission growth that advance irrespective of election outcomes or the broader economic environment. National security continues to be well funded as evidenced by the 5.4% increase to the DoD's budget implied by the President's 2022 budget request. Since 2012, we've executed an average of 1.1 million square feet of development leasing each year. And by extension, on average, we have placed 1 million square feet of fully leased property into service each year since 2013. We entered 2021 with strong leasing momentum for developments and approximately 2 million square feet of potential opportunities in our development leasing pipeline. We've made great progress year-to-date. We executed roughly 460,000 square feet of development leases, including 2 large build-to-suits with contractors in 2 different markets. We expect to meet or exceed our 1 million square feet of development leasing target this year. This combination of stable existing property results and growth from low-risk development enables us to generate sustainable, highly visible growth. We grew our FFO by 4.4% in 2020, and we've already raised our outlook for 2021 by $0.03 to a midpoint of $2.22. Our company's expected 3% to 6% growth in 2021 compares very favorably to the 1.7% average decline in FFO per share investors expect from other office REITs this year. So our outlook for 2021 is based on the contractual NOI embedded in the record level of 1.8 million square feet of fully leased developments we placed in the service last year, plus new NOI from 800,000 square feet of active development projects we'll place into service this year and our ability to access attractively priced capital with which to fund that growth. In terms of funding our growth, we have maintained a flexible and investment-grade balance sheet and have proven our access to capital remains strong. Last week, we raised $107 million of equity by joint venturing 2 data center shells with Blackstone. If our stock were to continue to remain discounted to NAV, we have another $800 million of equity value we can tap by joint venturing additional wholly owned data center shells over coming years. And earlier this year, we enjoyed a highly successful $600 million senior notes offering that was nearly 9x oversubscribed and represented the best 10-year unsecured note pricing in our company's history. The fixed income clearly appreciates the resiliency of our cash flows and our low-risk development platform and price guard notes better than our credit ratings. Despite the proven resilience of our franchise and our positive growth outlook, our shares trade below fair value. As of yesterday's close, our stock was trading 8% below the Street's average NAV per share of $31.50. Our dividend represents a 3.8% cash yield that's supported by conservative 60% to 70% AFFO payout ratio and our investment-grade balance sheet. So in conclusion, we have a unique franchise for a national defense. 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 and not the general economy. And these missions absolutely cannot be performed from remote locations. We have a decade-long track record of executing over 1 million square feet of development projects for our unique tenant base each year, and the cash flows from which assures the 3% to 6% growth we expect to achieve in 2021, and it will drive similar growth thereafter. Because of this, our current stock price represents a compelling value. With that, Bill, I'll take any questions you or the audience may have.

Steve, appreciate the detailed remarks and kind of a little bit of history of the company and where it's headed over the next several years. I do want to remind folks that are participating online they can ask questions via the question bar in Zoom, and we will address those if we have time. Steve, I thought we could get this question out of the way first since it's perhaps most timely. We saw yesterday that there was an M&A transaction in which Blackstone acquired QTS. I assume that there will be a little to no impact on your relationship with Blackstone and the joint ventures and prospective joint ventures with your data shells -- data center shells you have formed, but maybe you can address that.

Yes. I would not anticipate that, that acquisition would substitute for what they see attractive in our data center shell platform. Although QTS is a data center provider, the nature of their assets is significantly different than, say, the kind of nature of those that were joint venturing. But even if it were to have an impact, we have multiple parties deeply interested in that investment platform with extremely strong financials and credentials. It would not be a risk to our company's ability to continue to raise development cash internally.

[ And you do know of preponderance of ] tenants require their employees to remain in the office during the pandemic, right. That all makes sense with what we expected. But you also had tenants that weren't subject to working from the office, specifically London and some of your Baltimore properties as an example. And so I was curious what you're seeing as far as return to work goes. Have we seen any concrete movement back into the office?

So let me reiterate some stats, Bill. Even at the peak of the pandemic, our defense buildings were roughly 50% occupied or more. The missions rotated half of their crew each week and required longer hours. So half the employees worked longer each week. Now the time we got to October of 2020, fully half of our portfolio was back to work in full. The buildings are operating normal. 40% of our portfolio was averaging around 70% attendance. And only 10% was lightly attended. And to your point, those primarily were 3 assets in Baltimore. So some of the tenants are returning to work in Baltimore. It trails a bit behind other parts of our portfolio, largely because of the Baltimore specific requirements are lagging those in Maryland and Virginia, and they are slower to drop their restrictions. But as we sit here today, 90% of our portfolio is basically normal.

I know your tenant -- your core tenant base has far greater things to worry about than strong [ efficiency ] and things like that. Are you noticing any changes in configuration and any request for changes to adapt to a post-COVID environment?

So within several, if not many, of our defense tenants, we supported them by creating plexiglass shields on workstations to address concerns they had about transmissions. But from a square footage utilization standpoint, we have not experienced any tenant that elected to spread things out further or partially rotate any defense tenant with work from home. And as a matter of fact, last year, as the pandemic was hitting, we were working to finalize a new significantly large lease with the U.S. government. And the planning for that space have been done before the pandemic. And as pandemic broke out, we needed -- we were working to close that lease. It was fascinating to see that, that government user did not make any change to their office layout because of the pandemic. We ultimately built out the original plan and they occupied in August. Moreover, right now, we're working on a build-to-suit project for a major defense contractor. And that contractor has requested parking density that exceeds all of the other parking densities of the over 1.5 million square feet we developed at that same location. So we're just not seeing an impact on office utilization.

See if I remember going to a Corporate Office Properties Investor Day. As a matter of fact, you drove me from the airport to the event. And we started -- that was really a great introduction to cyber attacks and some of the efforts that were going on from other parts of the world to make intrusions into our intelligence. Given the headlines of the ransomware attacks and cyber intrusions, kind of, the rising tensions with Russia and some other areas, isn't that ultimately going to play right into your company's hands?

Yes. We will definitely be a beneficiary of increased spending, in particular that spending that's allocated to the Department of Defense and focused on foreign national or proxy for national entities because Fort Meade is the home of U.S. Cyber Command, which is combat and command of the U.S. government in the DoD focused on cybersecurity. Since cyber -- U.S. Cyber Command was stood up at Fort Meade in 2010 or '11, we've completed over 3.7 million square feet of new leases with cyber companies, primarily in and around Fort Meade.

All right. You have mentioned before your guidance assumes 1 million square feet, correct me if I'm wrong, development leasing this year. And if I use my interpretation of some of your remarks, it seems like that should be readily achievable. You'd be disappointed if you didn't do better. Do you have a mid-year update for us?

Sure. Well, just yesterday, we signed 183,000 square foot build-to-suit with a Fortune 100 company. We're under confidentiality till our announcement is approved. But later this week, we'll be pleased to identify that. That build-to-suit is at the National Business Park immediately adjacent to Fort Meade. With that lease, we're at 465,000 square feet of achievement this year already. Behind it, we're working with 2 different defense contractors, each with a need for 2 build-to-suit or significantly pre-leased assets. And the combination of those 4 deals that we're working on, plus the 2 majors we've completed, represent the bulk of our 1 million square foot target. We've got a variety of lesser things we're working on. But we have great line of sight into 1 million square feet or more.

All right. Speaking of line of sight, how is your line of sight looking for the renewal of the 11.25 megawatt user at DC-6?

See -- I see it clearly, Bill.

We hope to see it for about a year now. So where are we in that process?

Well, we've made great strides. I've been saying this for about a year, but this tenant is so big. They really just didn't have resources focused on this renewal, which they do now. We've completed all the deal points. We're working on finalizing the document. We would like to have to close by the end of the month, but we're very confident we'll be closed shortly thereafter, if not by June 30.

Okay. Terrific. I appreciate that. And terms should be as you kind of broadly outlined in the past I assume?

That's correct.

Okay. Perfect. Steve, you mentioned 4% FFO growth last year, 3% to 6% in the guidance for this year. And today, in your remarks this morning you talked about, you should be able to sustain that sort of 3% to 6% growth going forward. Is that right? That's what we think about as a sustainable kind of intermediate term growth expectation?

Yes. That's exactly right, in the 3% to 6% range, with 2% to 3% coming internally and then the balance coming from contributions from new developments placed in service. There'll be years where it's a little higher, a little lower, but the trend line is at 3% to 6% range.

Steve, you mentioned that the stock is underappreciated or undervalued or both, I guess. And I'm just curious why you think that is. And what can you, as a management team, do to close that gap, for example, to NAV, which I think, in our case, is pushed really too downwards?

Well, I think if you track our stock price over the last year, we outperformed office, but office underperformed other sectors. And I think we got caught up in a tide of funds flow to other sectors. And earlier this year, I think, you could see some -- the reopening trend emerge, where some of the companies had been hit harder than us last year were benefiting from a contrarian view that they would recover quickly. But I think that's played out. And as you look forward, we're the only office company in this projecting growth after a year of growth in pandemic. And the strength we have is unique. And we just need to keep illustrating the difference and fundamentals of our company from other office companies.

We have a question that I think is pertinent to that discussion that was written in from an investor. And they wanted you to talk about the -- your thoughts about Baltimore as a potential source of funds.

So we have 3 assets in Baltimore. Each one of them have a unique value creation story. We invested in the Baltimore in 2015 to accelerate our migration out of nondefense suburban locations. And it was an opportunity to move a large amount of capital and get out of a risk environment we no longer liked. As we look forward to the next couple of years, we think there is opportunity to start recycling some of the capital we have in Baltimore and moving that back into our development platform. So it's something we're thinking about today. But it's certainly a possibility over the next several years.

Steve, I think I've been back away with the company and I think most people view the Colorado exposure as a net negative. And I think there was not reluctance when the company moved into Huntsville, Alabama, which wasn't as obvious to us as it was to you. And I'm just curious, the success at Huntsville, is that emboldening you to look at any other parts of the country, whatever regions, San Diego with their [ mill ]. And maybe too much guns and ammo than intelligence, but are there pockets in this country that we may not think of that you're exporting?

So we routinely review the locations that received the most funding. And at this time, my answer is no. We don't have another location that we're interested in moving to, primarily because we have $300 million of development opportunity in the parcels we own each year, and we're focused on creating the value there.

Your cost of capital seems to be kind of flattening now here after benefiting from lower interest costs. Looks like that's kind of flattening a little bit. Your stock price has been in a bit of a range. But the cost to construct these new properties continues to go up pretty dramatically. And I'm just -- I assume we're not in necessarily a great position to push rents for non-DoD tenants. Can you talk about that balance that you want to grow through development? Development costs continue to rise. And are you able to push up the rents to maintain your yields?

Well, so the short answer is yes. But we also have had some surprising results. So jumping to my second comment. During 2020, there was a lot of narrative about increasing development costs. But we actually punched out several of our active developments and generated savings from our budgeted development plan, in essence, boosting the yield that we realized on projects we had started before 2020. And as we sit here today, certainly, we have to price higher cost into our development plans. But we've been able to achieve the threshold yields that we have traditionally received outstanding slightly higher price. And the reason for that is the strength of demand. The mission needs exists. And if the price is a little high -- a little higher than it was a year ago, that's not been a factor in us completing our development deals.

And you guys continue to turn to data center shell sales, maybe Baltimore, when the time was right to fund this development pipeline? Or do you anticipate that you'll have to, especially if the stock were to catch up a little bit with NAV? But will that then open up equity as a more obvious source of funds?

Yes. Our base plan is and has been for the last 5 years to incrementally fund new development or match fund it with equity issuance when our share price is fairly valued. And with the recent performance of our shares, we're still 8% below NAV, but we're getting closer to the point where it's good economic value to issue equity and keep our development properties wholly owned. So to the extent we can access that capital, we will and increments and match fund our spend, but it's entirely focused on the development pipeline.

Great. I don't know, half hour goes quickly, and I'm being given the hook. So I just want to use 10 seconds to tell you how much I appreciate you taking the time to do this and asking me to participate in. And I look forward to the next few years and election to growth of the company. Steve and team, thank you very much.

Thank you, Bill.

Thanks, Bill.

Thanks, Bill.

Well done. And thank you all for attending.