Earnings Call Transcript - CDP Q2 2022

Operator, Operator

Welcome to the Corporate Office Properties Trust Second Quarter 2022 Results Conference Call. As a reminder, today's call is being recorded. At this time, I will turn the call over to Michelle Layne, COPT's Manager of Investor Relations. Ms. Layne, please go ahead.

Michelle Layne, Manager of Investor Relations

Thank you, Katherine. Good afternoon, and welcome to COPT's conference call to discuss second quarter results and updated guidance for the year. With me today are Steve Budorick, President and CEO; Todd Hartman, Executive Vice President and COO; and Anthony Mifsud, Executive Vice President and CFO. Reconciliations of GAAP and non-GAAP financial measures that management discusses are available on our website in the results press release and presentation and in our supplemental information package. As a reminder, forward-looking statements made during today's call are subject to risks and uncertainties, which are discussed in our SEC filings. Actual events and results can differ materially from those forward-looking statements, and the company does not undertake a duty to update them. Steve?

Steve Budorick, President and CEO

Good afternoon, and thank you for joining us. We achieved another strong quarter with continued progress on our 2022 business plan. The successful performance and execution of our growth strategy since 2018 has positioned our company to deliver reliable annual FFO growth and long-term shareholder value. Over the past decade, we deeply concentrated investment in the property supporting priority U.S. defense missions and select mission-critical assets in regions that we collectively referred to as Defense/IT locations. At the end of the quarter, these locations generated 90% of our annualized rental revenue. Demand in these locations is driven by and correlated with national security spending and largely immune from conditions in the overall economy. Our concentration of leases to the U.S. government and high-credit contractors supporting national defense and cybersecurity missions is the foundation of our ability to generate resilient, high-quality cash flow. Our external growth strategy continues to be driven by successful preleased and low-risk development at these proven Defense/IT locations. We have an advantaged position in this unique market as the go-to landlord for specialized space satisfying government security requirements. We wisely protected our balance sheet. As a result, the current interest rate environment poses limited risk to our performance. The $1.8 billion of refinancing completed in 2020 and 2021 provide the solid foundation for us to deliver future growth from our operating and development portfolios. Our second quarter results show the strength of our strategy and execution. FFO per share of $0.59 met the high end of guidance, making this the ninth quarter out of the past 10 that we met or exceeded the midpoint of guidance. As a result, we're increasing the midpoint of our full-year guidance and narrowing the range. Leasing remains strong in our operating and development portfolios. As of June 30, our portfolio was 93.6% leased and 91.6% occupied. We completed 558,000 square feet of total leasing during the quarter. We achieved solid vacancy leasing volume with 120,000 square feet executed, equaling our 5-year average for the second quarter. Additionally, we have a large volume of leases pending execution that suggests our third quarter volume will be exceptional. The total volume included 211,000 square feet of development leasing, primarily from a 186,000 square foot full-building pre-lease. This activity brings our year-to-date achievement to 68% of our 700,000 square foot objective. Following this quarter's development leasing success, our active development pipeline now contains 1.9 million square feet of projects, all of which are Defense/IT locations. These projects are 91% leased with a high level of demand on the unleased space. The projects will deliver between 2022 and 2024, and when placed into service will produce $47 million of incremental annualized NOI that will drive further growth in FFO per share. The fiscal year 2022 National Defense Authorization Act passed with a base budget increase of 5.8%, representing the largest increase since 2018. We expect demand from this budget to manifest in our leasing pipeline in mid-to-late 2023. Recall that following the 14% increase in the defense budget that occurred in 2018, we achieved record leasing levels in new development and vacancy leasing in 2019. Moreover, current actions in the defense committees of the House and Senate suggest another healthy increase in the 2023 NDAA. These events give us confidence leasing demand will remain strong through at least 2024. Turning to inflation: the severe and rapid escalation in material prices over the first half of the year impacted development costs, increasing the year-over-year hard costs for like-for-like development projects by approximately 18%. The demand in our Defense/IT portfolio is driven by national security needs and funded mission priorities, and we have been able to negotiate rents that maintain our historical development yields. Our Defense/IT portfolio benefits from strong demand for new space and industry-leading tenant retention, and the current economic conditions have not impacted our demand or achievement, positioning our portfolio to continue to generate consistent, steady financial growth. Between 2018 and 2021, our FFO per share compounded at 4.4%. Coming off the strong 8% growth in 2021, our revised guidance suggests 2.6% growth in 2022 after absorbing the dilutive effect of the sale of DC-6. Beginning in 2023, we continue to expect growth to compound at 4% or more through 2026. So in summary, we had another solid quarter and our strong pipeline of activity and our fortified balance sheet reinforce our confidence for continued growth. With that, I'll hand the call over to Anthony.

Anthony Mifsud, Executive Vice President and CFO

Thanks, Steve. Second quarter results continue to show the strength and resiliency of our portfolio despite the uncertain economic environment. FFO per share for the quarter of $0.59 was at the high end of our guidance range. The $0.01 achievement above the midpoint was due to lower-than-forecasted G&A expenses and the timing of repairs and maintenance projects that we expect to complete in the second half of the year. The timing of the R&M projects produced same-property cash NOI results that were slightly better than our forecast, and our other property portfolio metrics for the quarter were in line with our expectations. Since we expect to complete the delayed R&M projects later in the year, we continue to forecast same-property cash NOI to be flat to down 2% for the year. This guidance assumes that the Defense/IT locations are flat to up 2%, while the Regional Office portfolio, impacted primarily by Transamerica and CareFirst transactions, is expected to be down just over 20%. Stronger-than-budgeted leasing activity has resulted in an increase in our forecasted same-property occupancy at year-end. As a result, we are tightening the range of guidance and increasing the expected midpoint by 50 basis points to 92.5%. NOI from development placed into service will continue to drive growth. We continue to expect between $15 million and $17 million of cash NOI in 2022 from completed development projects. At the midpoint, 100% of this NOI is contractual. With respect to the impact of the current interest rate environment at the end of the quarter, 86% of our debt was fixed rate and another 11% was variable rate debt swapped to fixed through year-end. The $1.4 billion of fixed-rate bonds issued last year, which have an average interest rate of 2.6% and a weighted average term of just under 10 years, significantly extended our debt maturities. Prior to these transactions, at year-end 2020, we had $1.6 billion, or almost 80% of our debt, maturing between 2022 and 2025, which included almost $1 billion of maturities in 2022 and 2023. This refinancing activity took advantage of the historically low interest rate environment and pushed our first bond maturity into the first quarter of 2026, minimizing our exposure to the current increasing rate environment. The only debt maturing prior to 2026 is a $100 million term loan later this year and our line of credit, which has an initial maturity in the first quarter of next year. We are working with our bank group on a new term loan and an extension of the maturity of our $800 million line of credit. The new term loan, which is expected to mature in 2028, will fund the repayment of the $100 million term loan and pay down a portion of the outstanding balance on our line of credit. We expect these financing transactions will close before the end of the year. With respect to the equity capital needed to fund our development investments and maintain our balance sheet strength, roughly 25% of this year's investment will be funded by cash from operations, with the remaining equity capital coming from the proceeds from the sale of DC-6 and recycling out of existing assets towards the end of the year. Finally, we are narrowing our range and increasing the midpoint of FFO per share from a prior range of $2.31 to $2.37 to a new range of $2.33 to $2.37. As a reminder, our guidance includes $0.04 of dilution from the sale of DC-6 and the increased midpoint of $2.35 per share implies 2.6% growth over 2021 FFO per share results. And now I'll hand the call over to Todd.

Todd Hartman, Executive Vice President and COO

Thank you, Anthony. Leasing activity remains strong, and we are confident that we will meet or exceed our objectives for the year. We completed 228,000 square feet of renewal leasing during the quarter for a retention rate of 58%. The retention rate was anticipated and heavily influenced by two nonrenewals. In Huntsville at 1,100 Redstone Gateway, we negotiated a 48,000 square foot reduction with Boeing, providing much-needed second-generation capacity to meet market demand. We are currently negotiating a lease with a defense contractor for the entire vacancy and expect to have that space leased and occupied in the third quarter. In Baltimore, at our Canton Crossing property, we experienced a 28,000 square foot nonrenewal. During the quarter, we executed a new lease for 15,000 square feet of this space with occupancy expected in early 2023. Cash rents for the quarter rolled down 8.10% and straight-line rents increased 7.8%. We expect renewal activity for the balance of the year to be very strong and heavily weighted to the fourth quarter and that our annual renewal volume will reach our historical average of 2 million square feet by year-end. As a result, we are increasing the midpoint of our retention guidance to 75%. Looking forward to 2023 and 2024, we expect our strong retention rates to continue. During 2023 and 2024, we have 21 expiring leases larger than 50,000 square feet, totaling 2.4 million square feet. We expect to renew more than 95% of that space. These 21 leases represent 50% of all the expiring footage in 2023 and 2024, and include 12 full-building leases for highly improved buildings, including six secured buildings leased to the United States government, three buildings leased to defense contractors and three Data Center Shell properties with significant tenant investment. The mission-critical nature of these properties and the priority missions they support inform our estimate of this high retention rate and supports our confidence in our projection for future growth. Regarding vacancy leasing, our volume of 120,000 square feet was consistent with our 5-year average for the second quarter. Demand was broad-based across all of our markets with transactions completed across our Defense/IT markets as well as in regional office. The 277,000 square feet year-to-date is 23% higher than our 5-year average, and we remain on track to meet or exceed our annual vacancy leasing goal. As Steve mentioned, we have a large volume of leases pending execution that suggest our third quarter volume will be exceptional. Development leasing totaled 211,000 square feet, and our year-to-date total is 476,000 square feet. During the quarter, we executed a 186,000 square foot 11-year build-to-suit lease with a defense contractor at the National Business Park. This is the second full-building long-term defense contract lease executed at the NBP in a little over a year. Our development leasing pipeline of 1.2 million square feet gives us confidence we will achieve our 700,000 square foot development leasing objective for 2022. Lastly, in terms of our remaining large vacancies, we are encouraged by activity levels. In our regional office segment, we are tracking more than 100,000 square feet of activity at 100 Light Street in Baltimore, and 140,000 square feet at 2100 L Street in Washington, D.C. Activity is strong, but given competitive pressures in the regional office markets, we anticipate a slower pace of lease execution. At 1,200 Redstone Gateway, we are close to executing a lease with a defense contractor for the full 11,000 square foot vacancy with commencement expected to occur close to year-end. Additional demand from contractors for space at Redstone led us to commence construction on our next 125,000 square foot inventory building, 8,100 Redstone Gateway, and we look forward to announcing leasing progress on this project in the coming quarters. With that, I'll hand the call back to Steve.

Steve Budorick, President and CEO

To wrap up, we completed the first half of the year ahead of plan and we are on track to meet or exceed our 2022 business plan. Vacancy leasing remains strong and first-half vacancy leasing results exceeded our 5-year average by 23%. Our 1.9 million square feet of active developments are 91% leased, assuring incremental NOI from these projects that will drive FFO growth in coming years. Our development leasing pipeline has 1.2 million square feet of opportunities, which we believe will translate into continued development achievements. Congress appropriated a 5.8% increase to the 2022 defense base budget, the largest annual increase since fiscal year 2018, suggesting leasing demand will continue through calendar year 2023 and beyond. Our prior-year financing activities locked in historically low interest rates and minimize our exposure to the current volatile environment. And lastly, we've delivered strong growth over the past three years and we expect to continue to deliver both FFO and NAV growth in the coming years. With that, operator, please open the call for questions.

Operator, Operator

Our first question comes from Michael Griffin with Citi. Your line is open.

Michael Griffin, Analyst

Todd, getting back to your comments on the demand at 100 Light and 2100 L: can you add any additional color on why you're seeing marginally less demand relative to last quarter? Was it any specific tenants that you might have been tracking or just less demand you're seeing in those markets? Any color there would be great.

Todd Hartman, Executive Vice President and COO

Sure. As it relates to 100 Light, we had at least one state tenant that we were working with last quarter that was offered space at a much lower rate in another building and elected to go that direction. Our remaining activity at the building is strong, and we're very encouraged by it. At 2100 L, I think it's just the vagaries of the market. We had one tenant that we were tracking elect to renew with its building, and so that kind of dropped off our list.

Michael Griffin, Analyst

Stepping back to the big picture: as it relates to defense spending, you saw the article earlier this week about the Senate Appropriations Committee seeking more funding for defense spending than the White House requested. Some of that might be related to the effects of inflation and whatnot. Is there a worry that as we get into election season, if there ends up being a divided government, you could see a slowdown in defense spending and what that would translate to for your business?

Steve Budorick, President and CEO

Let's talk about the defense pending volume. We're very confident that there will be a substantial increase for the 2023 NDAA as well as potential for some supplemental increases to deal with the impact of inflation. That confidence really comes from the high level of unity in the Senate and House Armed Services Committee votes. Both of those committees are seeking funding well above the presidential request. So we think the magnitude is going to be high and potentially further increased for inflation. Timing could be difficult. It's likely that this NDAA won't be passed by the end of September, and we'll end up in a continuing resolution, which could be delayed until after the election. Time will tell. In the last decade, I think we've only had one NDAA passed on time without a continuing resolution.

Operator, Operator

We have a question from Blaine Heck with Wells Fargo. Your line is open.

Blaine Heck, Analyst

Starting with Anthony, just on same-store NOI: are there any new offsets to the outperformance in the first half that made you reluctant to increase the full-year guidance, especially given that occupancy and retention are ahead of expectations and occupancy comps from last year could get a little more favorable as the year progresses?

Anthony Mifsud, Executive Vice President and CFO

No. The variances that we've experienced to date, especially in the second quarter, were more timing-related as it pertains to same-property cash NOI. We did have some variances in the first quarter that were more permanent in nature, but the impact of those fell within the range of guidance, and that's what we discussed on our first quarter call. With respect to the changes in occupancy and the impact on same-property cash NOI, the majority of the changes that led us to increase the midpoint of occupancy at year-end occur later in the fourth quarter, so they benefit occupancy at year-end but don't contribute to this year's same-property cash NOI. We'll get the benefit of that into next year.

Blaine Heck, Analyst

And then maybe for Steve or Todd: the data center market recently commented on challenges related to the power supply in Northern Virginia from Dominion Energy and delays that could cause in the construction of new data center properties. Are you dealing with any issues related to that? Any potential delays on your Data Center Shell projects?

Steve Budorick, President and CEO

Yes, that's a good question. The comment really refers to the construction of new transmission lines and expansion of substations beyond capacity that exists today. All of our development sites will be serviced by components of either Dominion or NOVA that are already built, and our customer has a commitment for that power. So we don't believe it will affect the timing of our lease execution.

Blaine Heck, Analyst

Lastly, thinking about the inflation we've seen this year, Steve, can you talk about how that might be affecting development costs and whether your yields are being affected on that side of the business?

Steve Budorick, President and CEO

We made a comment in our prepared remarks. NBP 550, which we just announced, shows a higher development cost than a similar project priced just over a year ago. The material component of hard costs increased about 18% year-over-year. We've been able, both at the National Business Park and Redstone Gateway, to move our rents in harmony with those increases in costs and preserve our historic yields on those assets. But each development will face a new set of market conditions, and it'll be a challenge each time we negotiate a deal.

Operator, Operator

We have a question from James Feldman with Bank of America. Your line is open.

James Feldman, Analyst

I guess following up to Blaine's question: it sounds like you can still hit your development yields with higher rents on development. Are you able to push rents in your in-service portfolio around those same assets?

Steve Budorick, President and CEO

Particularly at the National Business Park, we've had very good success locking in existing portfolio rents that are very near new development rental rates. We don't have as much second-generation space. At Redstone Gateway, for the leases for second-generation space that we're leasing, there has been significant roll-up of expiring rents to rates very close to our development rental rates.

James Feldman, Analyst

Going back to the budget, you had talked about the 2023 budget growth. Any early indication of how strong that uptake could be relative to the 5.8% for 2022?

Steve Budorick, President and CEO

Some of the information we saw suggested about 10% overall, but without more detail it's hard to handicap how that hits the base budget, which really funds the leases we negotiate. I would expect it to be at least 5% to 7%, if not higher.

James Feldman, Analyst

I appreciate the color on the large block expirations through 2024. You said you expect to renew above 95%. Can you talk about the other small portion you're worried about?

Steve Budorick, President and CEO

We said above 95%. We just have some probability that one defense contractor full-building lease may not renew fully, giving back a small portion, and a possible downsize in one of the regional office leases that is in that set of leases above 50,000 square feet over the next two years. We expect both leases to renew, but we've included a probability that one could contract up to about 50% and a defense contractor building might give back a small component, like 10,000 to 15,000 square feet.

Operator, Operator

We have a question from Steve Sakwa with Evercore ISI. Your line is open.

Steve Sakwa, Analyst

One question for Anthony: going back to the dispositions and funding for development needs, you said you have a couple of assets that you're going to sell by year-end. Can you talk about the types of assets and given the dislocation we've seen in the transaction market, where do you think cap rates are for those dispositions?

Anthony Mifsud, Executive Vice President and CFO

Our current forecast assumes that later this year we will sell two Data Center Shells that are currently holding on our balance sheet and that will generate about $80 million of proceeds. Cap rates for shells continue to seem like they're holding up in the area close to where we executed back in June of last year. Right now, we really haven't seen cap rates for those types of assets come under the same pressure that some other CBD and other office markets have.

Operator, Operator

We have a question from Dave Rodgers with Baird. Your line is open.

Dave Rodgers, Analyst

Sticking with the Data Center Shells for a moment: you said that you've got three Data Center Shells that will come up for renewal in the next couple of years. Are those wholly owned or in a JV? Is there a reason you hadn't sold those yet? Was there something interesting about those particular assets that they hadn't been pushed into a JV?

Steve Budorick, President and CEO

No, those three are in a JV.

Anthony Mifsud, Executive Vice President and CFO

And they expire in 2024, all three.

Dave Rodgers, Analyst

On the National Business Park, it seemed to be a bit weaker for a while in terms of demand and the ability to sign deals, and now it seems to be back. Is there a change in spending and funding for programs like cyber? Are there additional programs that have been added? What gives you the view that this part of the portfolio will be more consistent or grow over the next couple of years?

Steve Budorick, President and CEO

A big component to the success we're having is being fueled by cyber spending, unquestionably. We don't see that changing in the near term.

Dave Rodgers, Analyst

So same narrative: nothing really added, just that the money is getting spent, space is being committed, and no real changes on campus that threaten or help that?

Steve Budorick, President and CEO

There's certainly nothing on campus that threatens it. The increased challenges in the cyber defense and warfare environment lead us to believe that spending will continue to be strong for quite some time.

Operator, Operator

We have a question from Tom Catherwood with BTIG. Your line is open.

Tom Catherwood, Analyst

Steve, you may have already answered this, but as Todd mentioned this is your second build-to-suit in a year at National Business Park. Is the driver behind this recent increase in large-space demand the cyber spending you mentioned? Or is it some other demand driver or DoD funding source that contributed to this demand?

Steve Budorick, President and CEO

When we do these build-to-suits with defense contractors, they're very secretive about their business. Overall, that market has really been supported by expanded spending out of U.S. Cyber Command.

Tom Catherwood, Analyst

Is there an expectation that there could be more demand beyond that, or does it come in fits and starts?

Steve Budorick, President and CEO

For leasing generally, I see no abatement in demand from the cyber contractors doing business both in the National Business Park and Columbia Gateway. Since U.S. Cyber Command has been set up, it's been a constant source of growth and expansion. We have tenants that started with 8,000 square feet and are nearing the need for their own building. It's been steady demand and growth for over eight years.

Tom Catherwood, Analyst

On those three Data Center Shell leases that roll, these were kind of first-generation with your largest Data Center Shell tenant. What does that second-generation lease look like? How do rents change? Do you need to invest incremental dollars? Any early read on what that renewal might look like?

Steve Budorick, President and CEO

It's a couple of years off, so I don't want to speculate too much, but I would expect rents to increase, in part because the value of the land those assets sit on has at least tripled.

Operator, Operator

We have a question from Bill Crow with Raymond James. Your line is open.

Bill Crow, Analyst

Steve, I'm curious whether the dislocation we're seeing in the market and some delays in leasing has altered your thinking on selling some of the regional office assets, in particular Baltimore?

Steve Budorick, President and CEO

We routinely keep an eye on markets where those assets reside. Like we did with DC-6, if we see an opportunity to get good shareholder value in the capital markets, we'll consider it. But right now, I don't see market conditions being strong enough to bring one of those assets to market.

Bill Crow, Analyst

How much do you think cap rates have increased on that sort of asset?

Steve Budorick, President and CEO

There's a dearth of capital investing in CBDs right now. If you look across our portfolio, there are literally few comps to point to, except for one example in D.C. where 1900 sold at a 4.5% cap rate to a foreign investor. Buyers looking at some of the other markets are opportunistic and may be seeking cap rates about 100 basis points or more higher than they were six months ago.

Operator, Operator

Thank you. And that's all the questions we have today. I'd like to turn the call back to Mr. Budorick for closing remarks.

Steve Budorick, President and CEO

Thank you for joining our call. We will be in our offices this afternoon, so if you would like a follow-up conversation, please coordinate through Michelle. Thank you very much.

Operator, Operator

Thank you for your participation today in the Corporate Office Properties Trust second quarter 2022 results conference call. This concludes the presentation. You may now disconnect. Everyone, have a great day.