COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Good morning, and welcome to our session today with Corporate Office Properties Trust. We appreciate you joining us for day 2 of the conference and kicking us off -- kicking it off here with our first office panel of the day. So joining today from OFC are Steve Budorick, President and CEO; Todd Hartman, Executive Vice President and COO; and Anthony Mifsud, Executive Vice President and Chief Financial Officer. We do like to keep these interactive. So as always, we do have the Veracast system set up. So if you have any questions, feel free to enter them into the system as we go. And I'm going to turn the call over to Steve for a quick overview of the company. Well, first, I want to thank OFC for joining us today and for the conference. We know you'll have a productive round of meetings, and we'll have a productive session today. And now I'm going to turn it over to Steve for a quick overview of the company and any update that the company wants to provide at the conference.

Thank you, Jamie. So Corporate Office Properties Trust, or COPT, we provide real estate solutions to the U.S. Government and its contractors engaged in national security, defense and information technology-related activities. We're the only REIT dedicated to serving the defense community of the United States. Our Defense/IT locations account for roughly 90% of our revenues, and our key defense installations whose missions have been and continue to be DoD priorities. Our major government demand drivers include Fort Meade and Maryland, whose mission is about signals, intelligence and cybersecurity. We serve various elements of the intelligence community in Northern Virginia and a variety of locations. We also have a data center shell portfolio in Northern Virginia that supports hyperscale cloud. And we have a top security government campus in San Antonio, Texas. We support the U.S. Navy, which we serve on the 3 locations that support both NAVSEA and NAVAIR missions. In our fast-growing location at the Redstone Arsenal in Huntsville, Alabama, whose notable missions include Missile Defense, Program Executive Office of Missiles and Space, Program Executive Office of Aviation, NASA, Army Material Command, and multiple law enforcement and intelligence functions. The common threats among our Defense/IT locations are the permanence of those locations and their central roles in supporting high-priority national security missions. Proximity to the mission is essential for our defense contractor tenants. And because of the security requirements, our defense tenants cannot perform mission work at home. Demand at these defense installations is driven by defense budgets and not the general economy. As our operating performance showed during the pandemic shutdown, our cash flows are not correlated with broader economic trends and they're highly durable and resilient. The 3 main reasons investors should invest in are our unique franchise. The first is the resiliency of our operations. Last year, we collected 99.9% of gross rents. We placed 1.8 million square feet of fully leased new developments in service, and we outperformed our elevated guidance for the year. The second reason is our proven track record of low-risk development that drives FFO per share growth. Since 2012, we've executed, on average, 1.1 million square feet of development leasing each year. and by extension, on average, we've delivered over 1 million square feet of fully leased space into service since 2013. The third reason is our compelling valuation. Our franchise is positioned to generate attractive low-risk FFO per share growth regardless of the economic environment. We grew our FFO per share by 4.4% in 2020, during a national pandemic. And thus far, we've raised the midpoint of our outlook for 2021 by $0.07 to $2.26 per share, which represents 6.6% growth over 2020 results. So despite the proven resilience of our franchise and our positive growth outlook, our shares are trading below fair value. As of yesterday's close, our stock is trading 16% below The Street's average NAV per share. And our dividend represents a 4.1% cash yield is supported by a very conservative 65% to 70% AFFO payout ratio and an investor-grade balance sheet. So in conclusion, we have a unique franchise for the national defense. The missions are building support, are driven by national and global security needs, not the general economy. And these missions absolutely cannot be performed from remote locations. We have a decade line track record of executing over 1 million square feet of development projects each year for this unique tenant base. The cash flows from which assures the 6.6% growth we expect to achieve in 2021 and will drive solid 3% to 5% annual growth thereafter because of all these factors, resilient, low risk growth, less than attractive safe yields, our shares represent a compelling valuation. So with that, Jamie, we'll take any questions you have.

Great. Thanks, Steve. Very helpful overview. So I guess just focusing on one of your last comments, which is just growth. You've got some moving pieces as we head into next year, the DC-6 renewal, the potential DC-6 sale lease expiration, it sounds like there will be a move out in Huntsville. Can you just talk about the kind of key components of growth as we head into next year and where you stand on some of those items?

The bulk of the growth is going to be fueled by developments being placed into service this year that will drive FFO next year. Negative factors against that growth, but they've already been accommodated in our models. We do have a large move up in Huntsville, Alabama of 121,000 square feet due to a contract loss by one of our tenants, where we have great demand behind it. Our demand level is almost 2x the inventory we have, and we should have backfills in place, at least a 50% basis or more by midyear. With regard to DC-6, the lease negotiation on the renewal is in a very positive position. We expect to wrap it up in the next 30 days, if not sooner. And currently, selling DC-6 is not part of our capital plan. Our capital earnings for this year will be through some joint ventures of [ shells ], and they have already been accommodated in our projections.

Okay. That's very helpful. So you don't think you'll be signing DC-6 in -- over the near term?

We will evaluate that annually going forward. But right now, it's not part of our plan.

Okay. And can you talk about the DC-6 lease itself now that it's almost at the goal line, in terms of -- versus your expectations for the rent roll down and pre-rent period and duration? I know I get asked that a lot. How long is this lease actually going to last?

So the -- in terms of the rental rate, it's rate at the level we've been communicating through the last almost a year, and they represent about a 10% roll-down from the expiry rate they had paid. And I might add, it's still above the initial rate of the first lease that expired almost 7 years ago. The term will be 3 years, with some significant extension options, and we expect to have a close shortly.

Thank you. So what was the term on the initial lease versus the 3 years?

Initial lease was a 5-year term.

Okay. Why do you think it's going to 3?

Well, our customer has a policy of 3-year leases on renewals, and we've agreed to accept that. But I must add the entire industry has moved to shorter-term leases. If you take a look at the recent M&A activity with QTS being purchased by Glaxo, the reported average lease term in place is 3.8 years of that portfolio.

Okay. And then do you think that changes cap rates on these assets, the shorter lease durations? And what have you seen in terms of pricing?

Well, we're not in the market. So I really can't speak to pricing. But I would say, factors supporting lower cap rates. This asset is in -- Northern Virginia is the #1 data center market in the world. It's a tremendous asset if you're into it. Basically, it's in tremendous shape. And its original design has a lot of attractive features for another operator should we sell it. And then lastly, we have a significant amount of available power in a market that's kind of run out of power. The utilities in Northern Virginia have been so burdened by the growth in the market. The critical power access is a significant challenge in our property and sight as an abundance of that.

Okay. And this is not a candidate to contribute to the JV?

It really doesn't have the attributes the JV investors looking for.

Okay. All right. I had a question come in from an investor. They're interested in knowing the strategic direction the company will take with regard to your traditional office properties focused in Baltimore. Why keep the portfolio, if it's not a driver of growth? And how did the performance of these properties differ from your national security portfolio during the COVID-19 lockdown time frame?

So let me take those answers in the reverse order. There are 3 buildings in Downtown Baltimore, about 1.5 million square feet. That's the one part of our portfolio that was likely occupied during the pandemic can behave more like the other national office companies, with a significant fraction of the tenants working from home. In terms of rent collections, it was equally as strong as the rest of our portfolio because it's a tremendous credit we have in the tenants in those buildings. With regard to the strategic view on those assets, we've messaged for quite some time that in 2023 or maybe 2024 that we view them as a recycled candidates, and we will be monitoring market conditions, looking for an optimal time to begin recycling out of that portfolio.

What type of demand do you have for those assets or early conversations in terms of interest?

So one thing I would like to point out when we get questions about those assets is, how well performing they are right now? Those 3 buildings are 94% leased as we sit. We've had, what I would call, like leasing activity in the last 12 months, but that's primarily because we have no space to lease or very little. We will be getting 150,000 square feet back on the first day of next year. And that space is of uninvested based in Downtown Baltimore. It's premier building with epic views from the upper floors, and the space that we're getting back is the top of the building. Demand for that space now that it's public, the tenant is relocating, has been very high. We've got roughly 100,000 square feet of demand, 80,000 to 100,000. And about half of that with occupancy expected in the middle of the year. So as we near the date where we'll have possession of that space, we expect demand to improve further.

What are terms like economics, like on leases in Downtown Baltimore right now, like leasing spreads, CapEx, pre-rent?

So CapEx is probably $7 per square foot per year of term. Leasing spreads on this particular [ chapter ] space from the expiring rent of the current tenant to the start rent of the future tenant, I would guess, down up to 10%. And then free rent is really driven by turmoil. But it's fairly reasonable in Downtown Baltimore.

So like a month per year, is that standard, I don't know, where Baltimore stacks up?

I would say a month on the outside.

At the high end?

Yes.

Okay. Anything else people should be thinking about with those assets before we move on? I guess how do you think about the dilution, or I know it's a '23 event, but use of -- like what's the magnitude of a deal? And how do you think about the use of proceeds, any tax implications?

No, we're not going to have a tax challenge, we're in a very great tax position. We modeled a potential sale, and depending on the dynamic response of our other capital allocation decisions, it could be $0.01 to $0.02 dilutive or $0.01 to $0.02 accreted depending on how we responded with our other capital rates.

Okay. So you don't think that's a -- as people are modeling out the company in growth, you don't think that's a meaningful driver or a drag or benefit in the out years.

No, because of our robust development program and our need annually to recycle some capital, this is just a different recycling decision than the ones we've made. And depending on how we let our debt level respond, it won't have a material impact on our growth trajectory.

Okay. All right. So let's focus on the core business here. You may have said it quickly and I missed it, but did you say what you think your -- you talked about 6% growth this year and then I think I heard you say a growth rate going forward, or did I mishear that? I just wanted to think -- sorry, go ahead.

We conservatively guide to 3% to 5% annual growth.

So rolling into '22, that's still kind of a number you're comfortable with?

Yes, we're comfortable in the 3% to 5% range.

Okay. And so what would put you at the low end versus the high end of that range for next year?

Well, it's really leasing, Jamie. How much leasing we put together in the end of this year, how much NOI contribution we can benefit from that next year. We do have, as I mentioned earlier, 2 larger nonrenewals, 1 in Alabama, 1 in Downtown Baltimore, and what progress we make in our current inventory that will all contribute to the amount of growth we can deliver.

Okay. So maybe if you can talk a little bit more about the backfill leasing. What does the pipeline look like in Huntsville? The press release is coming out of the company, it just seems like things are very strong there. So can you talk about both the demand for the space you're getting back and then also some of the new developments you've announced? And what that pipeline could look like going forward?

Sure. We've had tremendous response to the availability of a quality existing asset with the nonrenewal. We've probably got 2 to 2.5x demand relative to space available. Two larger defense contractors are eager to get control of the building for a significant initial lease with expansion. And so I would expect we'll have an opportunity to get leases in place in the first half of next year. With regard to demand for the location overall, we signed a build-to-suit lease, where we announced signing over 206,000 square foot build-to-suit for the U.S. Government on Monday. And later in this quarter, we expect to announce another major pre-lease/build-to-suit with another defense contractor for over 250,000 square feet. With the execution of that lease, we'll be back in a position where we have virtually no inventory available to meet market demand. And as I said at the RG 1200 that we're getting back, we have twice the demand as we have inventory. So it's our expectation we'll start another [ spec ] or building -- another speculative building to accommodate that surplus demand probably in the fourth quarter.

So for people who aren't as familiar with Huntsville, can you just talk about the demand drivers in that market and what makes it so unique and why you're seeing such demand in growth right now?

Sure. I mentioned in my comments, but the rents on Huntsville is a center of excellence for the U.S. government generally. It's hosted by the U.S. Army and it focuses on very high technicians, including missiles, space, both the intelligence and technology components of those 2 elements. In host, the Army Material Command, which is the procurement function for everything the U.S. army buys, it's the original home of the U.S. Space Program, where Wernher von Braun and his team of scientists developed our entry into space, the NASA Marshall Space Flight Center [indiscernible]. But it's also deeply concentrated group of scientific missions involved in research, development, test and evaluation of advanced systems in both missiles, space, aviation and weapons technology. So it's a recent driver. It's -- the base has about 46,000 employees and only about 1,000 of them were from the U.S. military, steeply concentrated in scientists and engineers.

Okay. That's helpful. And it's definitely a lower rent market than your stuff around Baltimore and Washington. How should we think about the incremental dollars spent there? And what kind of yields you can get versus other markets you're active in?

So our yields are very attractive in Huntsville. Initial yields are generally at 8% average yields. And this most recent U.S. government lease, our average cash yield would be just shy of 10%. And those are comparable to the development margins we deliver in Maryland, in BW corridor next to the transmissions we have here. But the overall rent is generally lower because it's so cost effective to do business in Alabama. It's more of the operating expense component than the capital cost.

Okay. So maybe taking a step back here, there's a big focus in Congress on infrastructure spend, can you just give us your latest thoughts on how you think defense and what would flow into your portfolio fits into the spending we're seeing today?

Well, so the funding you see on the news and the headlines temporarily includes defense. So if you really want to understand what's happening with defense, you have to focus on the work that allow us on Senate Armed Services Committees. And those committees have been supportive of strong and increasing defense budgets in the past and currently. This year's budget has that been sold by any means, we'd expect it to be a roughly 2% growth on the overall defense budget. But interestingly, the President's request shifting more funds to the base DoD budget, which is really the run of the budget we operate in and a second line potentially 4% to 5% growth in defense. All the other programs that are kicking around in the news, they're not going to materially affect our business.

And nothing -- I know some of the infrastructure is tied to technology infrastructure. Anything that might fit into your wheelhouse on the data center side or anything else kind of high-tech or that's just not going to impact you?

Not that I'm aware of. I wouldn't want to make that statement.

Okay. And then there's also been a lot of news around the GSA, the new head of the GSA coming in and talking about really slashing space leased and moving as much as she can to owned properties. Can you talk about how you -- what your exposure is to those types of GSA leases that might be at risk? And what your thoughts are around how that might impact both your portfolio and the markets you're in?

Yes. So I'm really glad you asked the question, because it's not something that I delivered in our remarks. We have almost 4 million square feet of U.S. government leases and almost -- well, the vast majority are not with the GSA. We have, in total, 6 leases that represent 142,000 square feet that are procured through the GSA. To put those 6 leases in perspective, they're about 1% of our government revenue, about 0.4% of our company revenue and about 0.7% of our portfolio. Each of those leases have high likelihoods of renewal and continuing in their locations because 3 of them support adjacent government facilities. One is a [ cord ] system, one is present system, and then third is defense protective, it's a protection service and the location of our building is vital to that mission. And of those 6 leases, 40% of the space is renewed in the last 12 months for 5 years or more, 32% has over 3 years remaining and one lease, we expect to renew next year, which is 28%. The bottom line is our government leases are prepared through either the Department of Defense or other agencies that have their own procurement authority, at least the kind of facilities they need, in the locations they need them, to serve their national security missions. So we don't anticipate to get affected by the discussion about the GSA.

And what about general market conditions? I mean, I think one of the things that's always been a little surprising is just the market rent growth and you've got these high security assets, sticky tenants, but the leasing spreads tend to be relatively flat. And if you start to see pressure on maybe not your portfolio, but other portfolios around you, in Northern Virginia, BWI corridor from GSA shrinking, what do you think that does to your ability to push rents?

So in particular here in Maryland, there's not a lot of GSA that could lease space, that could compete with our defense locations. The deep concentration of GSA leases is in Washington, D.C. We don't have assets that we'll compete with them. We only have 3 buildings currently in the district, two of them serve the U.S. Navy. They're immediately adjacent to the Navy Yard. They're highly occupied because of their value for defense contractors conducting Navy missions. In the GSA, submarkets are further north and west and where that's at. Then we have one trophy building we're leasing. It's an entirely different price point value proposition than GSA space. So overall, I would expect DC in the GSA contraction will have some significant pressure in the B and C class assets, but I don't see it affecting our portfolio.

And then 2100 L, how is progress leasing that at this point?

Progress is slow. We have about 80,000 square feet we seek to lease. The 1 debt asset in CBD DC, the leasing activity was significantly affected by COVID. The volume of activity has picked up. We do have several, roughly 80,000 square feet of prospects. The timing and pace of negotiations in that market is very slow. So we're focused on it, but we don't expect much progress by the end of the year.

Okay. Does that impact your guidance at all?

No.

Okay. All right. And then I guess, just maybe, Anthony, if you don't mind talking through kind of capital needs. Any refinancing opportunities that might be accretive as we think about our model the next year or so? And then also, where do you stand on your contributions to the data center shell JV?

Okay. So on the financing side, so over the past 12 months, we issued $1.4 billion worth of new fixed income bonds at the lowest rates the company has ever issued at. And we used that capital to essentially refinance some higher rate bonds and bank loans that we had to push out our debt maturity ladder and that had some significant interest savings that we're benefiting from this year. In terms of equity capital, we executed one joint venture with Blackstone in June of this year. We have plans to do one additional venture on 2 data center shells in Manassas in the fourth quarter of this year, and we'll raise about $70 million worth of equity capital. The market for those assets continues to be incredibly strong from private equity investors. We executed our deal at the beginning of June at a 4.7% cap rate on corporate NOI. And cap rates have continued to compress even since then, with a deal in the market that was executed after our deal that was in the high 3s. So we believe that valuations and investor demand for those assets continues to be very high. So we expect to benefit from that market compression of cap rates and increase valuations as we go forward to execute that deal. Overall, we're in a great capital position. We have the access to the equity capital we need through the venture structure of our data center shells, with over $700 million worth of equity we can tap into in that venture structure. And on the debt side, clearly, the fixed income investors have recognized the performance of the company and the transactions we've executed over the past 12 months. And the pricing that we've achieved on those transactions have been at spread levels that are a notch, if not a notch plus higher than where the agencies are rating the company. But our spreads were in line, if not quite slightly better than other BBB flat, BAA2 graded companies. So from a capital position, we're in great shape.

Okay. And then just to confirm, so if market prices move on the data centers, you can -- you benefit from that. None of this is pre-priced, prenegotiated?

We only have one obligation to Blackstone, and that's to present them an offer that we put together for any data center shells that we intend on selling. So we present to them an offer on when we're ready to sell. They either accept or reject that offer. If they accept it, we move forward, and if they reject it, we go to market.

Okay. We only have a couple of minutes left here. I do want to -- there's a couple of more questions that come in. Number one, have you changed any of your occupancy assumptions from the most recent presentation with second quarter earnings in terms of your occupancy outlook for year-end or things are still pretty static?

Yes, things are in line with what we expected at the end of July.

Okay. And then a follow-up discussion -- a follow-up question to the Baltimore. Is the reason you're targeting 23%, 24% for the sales so that you can get those buildings backfilled? Or would you try to sell them with vacancy?

I prefer to get the leases in place. We're going to get some space back next year. We have very high confidence we'll backfill and prefer to sell when they come in place. We have to expect a buyer to price through the lease up. And then one thing I would note, when we're ready to recycle and anticipate we will recycle individually in that as a portfolio. So we're going to take 3 buildings to the market as we see opportunities on individual assets to maximize proceeds, we'll bring them one at a time.

And do you see redeploying in Baltimore? I know that the markets kind of shifted to different submarkets from downtown, traditional downtown on Light Street, or are you done? Like this is all going into high security, defense development and assets?

Well, not to go too deeply in the history. Our move in Downtown Baltimore in 2015 was moved to accelerate our elimination of commodity suburban risk. So we actually did -- call it a match trade, accelerating in our suburban sales and repositioning that money from a suburban commodity market to an urban market. Those buildings have performed very well. They've been very stable. But in that period of time that's expired, our development opportunities now are far more exciting in defense. So as we recycle, we will not be investing in Baltimore. We'll be putting that money into defense IT assets.

This isn't your chance to go into Chicago either? As a whole...

Chicago is a tough market. You got to pick your submarket closely. But no, I don't see us going back to Chicago.

They're going to buy a bar in Chicago. That's what it's going to be. No, just kidding. Okay, so thank you very much. What was that?

Other income is one of our [indiscernible].

There you go. You got to do. Okay. So thank you for the today's session, very helpful, and we are going to wrap up with 3 rapid fire questions. So the first one, which of the following is the greatest challenge facing U.S. Public REITs today: a, Fed action and higher rates; b, supply chain issues, which include labor and logistics causing higher inflation; or c, flows to non-traded REITs.

I'd say, a, on a risk basis.

Okay. Over the next 5 years, which markets will outperform, Urban, Coastal or Sun Belt?

Defense. All right. I would say Sun Belt, unquestionably.

And then for your company's office plans post pandemic, will you: a, have no change from prepandemic; b, leave it up to your individual teams; c, offer hybrid; or d, go full remote.

A, no change. We're already back in the office.

Okay. All right. Well, Steve, Todd, Anthony, thank you very much for your time. Greatly appreciate you attending the conference and good luck with your meetings today, and we look forward to continuing the conversation with you.

Great. Thank you. Well done, Jamie.