COPT Defense Properties (CDP) Earnings Call Transcript & Summary

This is a little unusual, Manny, but I'm going to enjoy it.

Welcome to the delayed 2:45 p.m. session at Day 2 of Citi's 2022 Global Property CEO Conference. I'm Manny Korchman. We're pleased to have with us Corporate Office Property Trust CEO, Steve Budorick. Session for Citi clients only, if media or other individuals online, please disconnect now. Disclosures are available on the webcast and at the AV desk. Everyone, please contribute questions to Live QA. If you haven't figured that out yet, I can't help you. Steve, I'll turn it over to you to introduce the company, any members of management that are there with you today and then we'll go to Q&A.

So I'm Steve Budorick, CEO of Corporate Office Properties Trust. With me is Todd Hartman, Chief Operating Officer, Corporate Office Properties Trust. I'll tell you about the company. So thank you. Corporate Office Properties Trust are capped. We provide real estate solutions to the U.S. government and its contractors engaged in national security, defense and information technology related activities. Our Defense/IT locations support key defense installations whose missions have been and continue to be DoD spending priorities. Our major government demand drivers include Fort Meade in Maryland. These missions involve signals, intelligence and cybersecurity, various elements of the intelligence community in Northern Virginia in a variety of locations. We also have data center shell development program in Northern Virginia supporting hyperscale cloud computing. We have a top security government campus, which is a demand driver in San Antonio, Texas, that exceeds 1 million square feet. We support the U.S. Navy out of 3 locations that support both NAVAIR and AFC. And then at the Redstone Arsenal, our fastest-growing development is Redstone Gateway. And the notable missions at the arsenal includes Space Command, Missile Defense Agency, the Program Executive Office of Missiles and Space, the Program Executive Office of Army Aviation, NASA, Marshall Space Flight Center, Army Material Command and multiple law enforcement and intelligence functions on the base. Our Defense/IT locations generate roughly 90% of our annualized rental revenue and we're the only REIT dedicated to serving the defense community of the United States. 3 main reasons investors should invest in our unique franchise are the essential mission-critical operations that we support, which have proven to be resilient because they are not correlated to economic or office fundamentals. Our 4% compound annual growth and our 10-year track record of low-risk development execution and today, a compelling valuation. A key theme for our company is resiliency. Demand for our defense locations is highly durable and it's not correlated to economic trends. Our defense locations represent clusters of specialized facilities around defense installations. Demand is driven by defense budgets and not the general economy. Common threads among our Defense/IT locations are the permanence of the locations and the missions and their central role in supporting high-priority and security needs of the United States. In our business, proximity to the mission is essential for the defense tenants. And because of the security requirements with the missions they conduct, our defense tenants cannot perform their mission work at home. Contractual rent increases from our existing portfolio and our development and leasing are the main drivers of our 4% plus compound annual growth and we pursue low-risk development opportunities at our defense locations. Again, the demand is driven by defense spending and mission growth and that demand advances irrespective of the broader economic environment. National Security continues to be well funded with fiscal year 2022 NDAA projected to increase by 5.8% this year. Since 2012, we've executed an average of 1.1 million square feet of new development leasing each year. And by extension, on average, we've placed 1 million square feet of lease development into service each year since 2013. We entered 2022 with a strong leasing momentum for developments and 1.8 million square feet of potential opportunities in our leasing pipeline, our development leasing pipeline. We expect to execute at least 700,000 square feet of development leases this year. Our existing property results plus the growth from our low-risk development enables us to generate sustainable, highly visible growth. We grew FFO per share by 4.4% in 2020 and by 8% in 2021. Our 2022 guidance implies 2.2% growth, but that also absorbs the dilutive effect of selling a $220 million asset to simplify our capital allocation. Our track record to generate -- we're on track to generate 3% to 5% annual growth going forward. Importantly, over the next 3 to 4 years, development will be funded increasingly by free cash flow from operations. And in 3 to 4 years from now, we expect to be in a position to fund our development activity at the rate we've been maintaining with the free cash flow from our operations. So said another way, in a few years, we expect to generate 3% to 5% growth on a leverage-neutral basis without the need for external equity or recycling. 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 17% below the Street's NAV per share of $33.50. Our dividend represents a 4% cash yield and is supported by a conservative 65% to 70% AFFO payout ratio and our investment-grade balance sheet. So in conclusion, we have a unique franchise supporting national defense. The missions are building support driven by national and global security needs, not the general economy. That mission work absolutely cannot be performed from remote locations and we have a proven track record of executing large volumes of pre-lease development to drive our FFO growth. So with that, I'll turn it back to you, Manny.

Right. Thanks, Steve. As I sit here and listen to all that, I can't help, but think and I'll just -- I'll ask it and you can take whatever way you want. Is this company simply better off being private? Like what is the public market sort of doing for you? You've got all this growth that you can fund internally. You haven't really bought back stock or issued stock. The dispositions, even if you're done with them, they've been funding a lot of developments. So just as you sit there as the CEO of this public companies, is that the right structure for you guys to be at today?

I'm not prepared to say we should be a private company. I think we will, in the long term, be a very well-performing public company. Do recall that we executed a massive strategic reallocation plan starting in 2011. We literally sold half the assets the company owned at that point in time. We replaced that 11 million square feet of generally suburban office property with new high-value developments. And as we proceed with our plan and what we shared in our one-on-ones, is we see the day where we can self-fund our development and generate good growth for an office company that should approximate 5%. And I think the market will respond and react to it. We're prepared to continue to execute until that time.

In terms of the disposition plan, you guys have done a fantastic job of getting out of those noncore assets. I seem to remember that more recently, you've spoken about potentially exiting the regional office properties. Is that the last thing left that if you were to prune this company, any more that would be it? Or are there other assets in there that don't belong?

No, that wouldn't be -- those assets are performing well. We have maintained them in our portfolio in our effort to achieve a posture of growth, which we now have. And in that posture of growth, we have capacity to start to recycle out of those assets and support growth and not dilute our earnings. And so our objective is to harvest that capital and reinvest it in our development as base plan, but we have alternatives that we can also use like joint venturing data center shells. Hopefully, in another year, selling our 2100 L Street development a fully stabilized posture or tapping the ATM if we were fairly valued.

Is there -- let's say all that work, let's say you sold 2100 L, you sold the Baltimore office assets. Can you accelerate the development program? Or is that going to then challenge this idea of more low-risk development, would you have to do more spec at that point?

Well, we cannot push the pace of development because our development is concentrated on defense missions. So we support growth, we support the government's needs. Now, the pace of development is -- potentially could increase. This year's 5.8% increase in the NDAA is substantially bigger than the last 3 years where we've been at 2% to 1% growth. Following the restorative 14% increase in 2017, we generated 2 million square feet of development in 2019 and we set records for our vacancy leasing. The events in Ukraine currently -- they created a pretty confusing picture, but clearly, our defense strategy is going to have to respond and we'll see what opportunities that could possibly generate.

I was going to ask that question. Is it a matter of your tenants being too busy to make those kind of decisions? Or are they separate people and it doesn't really matter what else is going on in the world?

What kind of decisions are you referring to?

Decisions that -- leasing decisions with you. Are they actively -- you've got, obviously, the government and contractors are kind of preoccupied right now. Are they still dedicating the same amount of brainpower to figuring out their next real estate decision with you that they would have been 3 years ago?

Yes, the groups we work within the government don't conduct mission per se, right? They're part of the administration. Our planning for U.S. government facilities is very long term. We signed a full building build-to-suit in October that we have helped the government plan for several years. We had to compete for it and we won it. But that's probably 4 years of effort. So a lot of the activity we do with the government is forward-looking. They know what they have and what they need and we're a solution they can use.

How many of those types of processes are you involved in right now?

So some of them exist on campuses. So I would say probably 5% is the right number.

Would that sort of a year to 4 years from now of getting it done?

4 years?

You said to keep about 4 years, right, so that's kind of...

At least 3 of the 5, I think we can accomplish in the next 4 years.

Okay. You usually talk about DC-6, I feel like I've had a hole about what I can talk about?

In case the listeners didn't learned, we sold DC-6 at a 5.1% cap rate and all the analysts talked about what's the dilution.

It was dilutive.

What's that?

It was dilutive?

It was, but we're still achieving 2.2% growth.

Correct?

I remind you, Manny, that for 10 years, people have been beaten on me to sell that asset. I waited until we get good value. And just as a reminder, we took that to market in 2015. And the price was $100 million less than we achieved. And this management team is just not going to walk away from shareholder value. We're going to fight for every dollar and we did, and we got $222 million plus retained some of the income that we couldn't transfer.

Right. In terms of the resiliency comment, do you think investors are really missing that? Do you think that that's lost on them?

So we just did an investor survey and it was interesting, a lot of positives. There's lot of enthusiasm in the story, but you always get some negative comments. And I'm not sure they're missing it, but they're not appreciating it. The theory that comes out is we're not going to recover from COVID because we didn't get hurt by it. And another office company might get a more rapid recovery and we're producing good steady growth. I don't know how to argue that viewpoint. I only know that we can execute through it and we will.

Right. So is that what you think causes this valuation disconnect that you spoke about earlier? Or is there more to...

Undoubtedly, the feedback was constant through the year.

But that was more of a -- if I were to hear that, that's more of a -- you're fully valued. The future is going to be harder, right? And you're saying you're at a 17% discount to consensus NAV. It feels like there's more to it than just -- you're not going to bounce back as hard as others?

No, that's the major theme that came out of the investor survey. But one of the techniques we were using today is showing not as specifically quantified but a 5-year projection of what our growth can be. And we show it down -- we show our worst scenario under deep recession and the potential of our baseline plan and it's been very effective.

Right. The data center shell program, remind us how much land do you have left there? And how many more of the shells you can build and how you back roll that program?

So we have 3 sites that will accommodate 4 assets that in total will be about 1 million square feet. At this point in time, we're not motivated to buy additional land because our customer is managing their takedown of what we've already purchased. Data center land in Northern Virginia has gotten extraordinarily expensive. Recent closing prices have been at $3 million an acre. A good site would need about 50 acres and that's a lot of capital to tie up without a known demand. So we're going to manage to more of a just-in-time program as we see the demand, work in harmony with our customer and move out by the land, so that we can monetize it quickly. But we're not going to build up land inventory at that price level.

And how much value creation is there, Steve, beyond just -- it sounds like there's land value creation just from holding it as long as you were having an option to it as long as you have and then once you build it, what is the absolute value creation on those sites?

In terms of future rent or the value of the assets.

You're planning to JV them, right? So future rent is less relevant for you.

Our development margin has been 50% of profit.

Okay. What have you seen in your office assets as whether we call it occupancy or census more recently? Has everyone been coming back in?

So our portfolio was heavily occupied during the pandemic. The defense sector moved to a 50-50 rotation as the pandemic emerged. Some groups called it black and gold, some red and blue, but they alternated their staff on weeks and our run hours were longer. So they have to work in their secure environment. So they're putting in longer days, but rotating 50-50. By October 2020, those locations were essentially back to full occupancy and they have been. The portion of our portfolio that's been affected by the pandemic conditions is a regional office. And I would say that's recovered to about 33% and was as low as 10% back in 2020.

Talk about any large lease expirations you have coming up?

So this year, we have a couple of large lease expirations that are U.S. government. We expect 100% renewal. We have 2 defense contractors exceeding 100,000 square feet and we expect about a 70% retention.

Where can we expect rents to go on those -- on all those bases?

So the non-renewing space this year in defense is in the Redstone Arsenal, where we had 120,000 square feet back. The mark-to-market from expiring to new is plus 10% or possibly higher.

Is there a TI load that goes with that, that you're going to have to put in to get that?

There will be some TI, but it won't be a base build level of TI. I would guess, 5 years somewhere in the $15 to $20 range.

Any impacts due to just rising construction costs or inflation to that?

Say that again.

Any impacts from just rising construction costs or inflation that are driving that higher?

Well, certainly pressuring the development program, but we've been able to negotiate through it. Last year, we did 2 build suites for Northrop Grumman. Prices were escalating. We're able to achieve their appropriate rent to hit our development yields. This year, we're looking currently to finalize 2 additional build suites. And in both cases, we have maintained our development margin target. But that will be ongoing as inflation continues, it's a point of emphasis for our development teams.

What's your #1 ESG priority for 2022?

So we've had a sound ESG program. We were 6 consecutive years as the GRESB Green Star. In 2021, we kind of did a deeper dive as to where our results are being scored. We implemented some new policies that are improving, that's going a bit, things like a human rights policy and no slave labor, things that we didn't have, but we would have never done. And this year, we're really focused on identifying environmental risk and opportunity pursuant to the climate change task force directives. So it's -- we've been building to LEED standards since 2002. Half of our portfolio has been developed in the last 10 years and now we're enhancing the disclosure and risk kind of component from the investor.

You spoke about the high -- the 4% dividend yield and a reasonably low AFFO payout. How much do you expect that to go up? Is that going to track AFFO growth? Or could investors get better than that?

AFFO will outpace FFO over the next 5 years by several percent.

What about dividend growth?

Say that again.

Dividends -- the dividend on the growth.

We just went through a 5-year planning exercise and we included our tax planning. So our tax requirements will or should require an increase in our dividend by 2026. And we've had discussions with our Board. We haven't finalized on the plan, but we're talking about ramping into that dividend increase over '24, '25 and then meeting what we need to in 2026.

Why wouldn't the dividend be raised before 2024 with the amount of new cash flow that you're coming -- that you have coming into the portfolio?

Well, we're trying to reach the point where we can self-fund development without recycling high-value assets. And we can see that point in 2025 or '26, where we can achieve both and raise dividends. We create tremendous value through development through the data center shells and the government leases that value creations in the 50% range. So our office buildings, it's in the 20% to 30% range. And we think the best use of that capital until we've reached the self-funding status to continue to create that value in our assets.

Okay. That's -- those are my questions. Any questions in the room or on the Live QA before we go to rapid fire here. All right. We'll go to rapid fire. What will same-store NOI growth be for the office sector overall in 2023?

Well, '22, I think, is going to be negative, so 2%.

Off of a negative comp?

Yes.

What will the 10-year treasury yield be a year from today?

2%.

And will the office sector have more or fewer public companies a year from now?

I would suggest likely one fewer.

Thank you very much.

Thank you. Great interview, Manny. Appreciate it.