Corporate Office Properties Trust (OFC) Q1 2023 Earnings Conference Call April 28, 2023 12:00 PM ET

Company Participants

Venkat Kommineni - Vice President, Investor Relations
Steve Budorick - President & Chief Executive Officer
Anthony Mifsud - Executive Vice President & Chief Financial Officer

Conference Call Participants

Anthony Paolone - JPMorgan
Blaine Heck - Wells Fargo
Michael Griffin - Citi
Camille Bonnel - Bank of America
Tom Catherwood - BTIG
Steve Sakwa - Evercore ISI

Operator

Welcome to the Corporate Office Properties Trust First Quarter 2023 Results Conference Call. As a reminder today's conference is being recorded.

At this time, I will turn the call over to Venkat Kommineni, COPT's Vice President of Investor Relations. Mr. Kommineni please go ahead.

Venkat Kommineni

Thank you, Michelle. Good afternoon and welcome to COPT's conference call to discuss first quarter results. With me today are Steve Budorick, President and CEO; 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 these forward-looking statements and the company does not undertake a duty to update them. Steve?

Steve Budorick

Good afternoon, and thank you for joining us. Before turning to results for the quarter I'd like to start by highlighting a few important themes. The fundamentals of our business remained very strong, as does the outlook for defense spending. We continue to see demand for new leasing and renewals at our Defense/IT locations, as evidenced by our 95% portfolio lease rate. Defense tenants working on secured programs can't work from home and that's resulting in our tenants retaining space in our portfolio. And as a result, we expect to achieve a tenant retention rate in 2023 that is at or above our 10-year record high of 81% in 2017.

We have good visibility into demand for our current and future development projects. We continue to project FFO per share growth of roughly 4% on a compound basis between 2023 and 2026. And we completed the JV equity raise earlier in the year and we now have capacity to self-fund the equity component of our anticipated development investment going forward. And lastly, based on the strength of our business, our Board approved a 3.6% increase in our dividend in February.

Now let's discuss results from the quarter. We reported first quarter FFO per share as adjusted for comparability of $0.59, which is $0.02 higher than the midpoint of our guidance. Our core portfolio remained well leased at 95.1%, which represents 100 basis point increase year-over-year.

Our Defense/IT segment is 96.7% leased, which is the highest level since we began disclosing the segment in 2015. Our first quarter operating metrics were strong. Same property cash NOI increased 8.3% year-over-year, which is the highest level in over a decade, leading us to raise full year guidance by 100 basis points at the midpoint. We executed 99,000 square feet of vacancy leasing, which is right on track with our full year target of 400,000 square feet. Our overall retention rate was 64%, with our Defense/IT locations at 78%.

Total leasing volume of 788,000 square feet in the quarter included 194,000 square feet of renewals. Cash rent spreads were slightly positive, while GAAP rent spreads were up 4.2%, driven by annual rent increases of 2.4%. Measuring the starting cash rent of the tenants expiring lease to the starting cash rent of the new lease, the annual compound growth rate achieved on these renewal leases was 3.3% with a weighted average lease term of three years.

First quarter retention rate of 64% was influenced by the impact of 55,000 square feet of expected non-renewals in our regional office portfolio. However, based on our activity and discussions with customers, we raised the midpoint of our full year retention guidance rate by 250 points to 80% to 85%. In addition, we expect a retention rate of over 95% on the 2.3 million square feet of large leases which we define as leases over 50,000 square feet expiring through year-end 2024. Included in this total is 1.1 million square feet of large leases that expire in 2023 through which we expect a 100% renewal rate.

In the first quarter, we completed 99,000 square feet of vacancy leasing with a weighted average lease term of nearly eight years. Recall, our expected leasing volumes in 2023 are lower due to our diminished space available to lease. In our Defense/IT portfolio, we have less than 700,000 square feet of inventory available which is the lowest level since 2017, despite the fact that that portfolio has increased by nearly 6 million square feet during that period.

Our vacancy leasing activity ratio remained strong at 75% with a pipeline of 950,000 square feet of prospects. Our 1.5 million square feet of active developments are 92% leased with a total estimated cost of $478 million, consisting of nine projects located in Maryland, Northern Virginia and Huntsville Alabama.

As previously announced, we signed 464,000 square feet of development leases in January consisting of two build-to-suit data center shell leases for our cloud computing customer in Northern Virginia that totaled 418,000 square feet and a 46,000 square foot build-to-suit lease for Davidson Technologies for their new headquarters at Redstone Gateway. Since then, we signed an additional 41,000 square feet of development leases which included a 27,000 square foot lease with Frontier Technology at 8100 Rideout Road bringing that property to 20% lease and a 14,000 square foot expansion with KBR at 7,000 Redstone Gateway bringing that property to 78% leased.

In total, we've completed 495,000 square feet of development leasing during the quarter which represents about 70% of our full year goal of 700,000 square feet. Our development pipeline which we define as projects we consider 50% likely to win or better within two years or less currently stands at 700,000 square feet. Beyond that pipeline, we're tracking another 1.7 million square feet of potential future opportunities which gives us confidence that we'll be able to maintain a healthy development pipeline in the near and medium term.

Turning to the defense budget. Last month, the administration submitted the fiscal year 2024 budget request which calls for a 3.6% year-over-year increase to $827 billion. Between fiscal year 2021 and 2023, the base defense budget increased by roughly $100 billion or nearly 15%. We expect demand from the 2023 budget increase will materialize in our portfolio starting in 2024, while growth from the 2024 budget will benefit us thereafter.

Included in these budget assumptions are further investments in offensive and defensive cyber related programs. The Department of Defense has committed over $13 billion to cyber activities in 2024, which is a $2 billion increase from the prior year. DoD cyber programs have driven two million square feet of cyber leasing in our portfolio over the last 24 months, which equates to 55% of the total new leasing achievement.

In February 2023, the Office of the Director of National Intelligence published a sovereign threat assessment that revealed China probably represents the broadest cyber-espionage threat to our country. And if China felt the major conflict with the US were imminent, they would be highly likely to undertake aggressive cyber operations against critical US infrastructure and military assets.

Clearly, the cyber threat environment continues to represent a significant security threat and must remain a priority investment choice. The continued need for investment in cybersecurity should support strong demand from cyber tenants in our portfolio.

And with that, I'll hand the call over to Anthony.

Anthony Mifsud

Thank you, Steve. We reported first quarter FFO per share as adjusted for comparability of $0.59, which is $0.02 higher than the midpoint of our guidance. Over half of the upside came from lower net seasonal related expenses and the remainder from the timing of repairs and maintenance expense.

As a result of these expense variances results exceeded our expectations, as same-property cash NOI increased 8.3% year-over-year, while same-property GAAP NOI increased by 3.7% year-over-year.

Included in our same-property cash NOI results was the benefit of free rent burn-off of two large tenants in the first quarter. Excluding this impact same property cash NOI increased 3.9% year-over-year.

We expect same property growth will moderate during the remainder of the year. However, driven by the first quarter's outperformance, we are increasing the midpoint of our same-property cash NOI guidance by 100 basis points to 3% to 5%.

The composition of the same property pool changed with the addition of nine new development properties which are 92% occupied and the removal of three fully leased data shells which were joint ventured.

Same-property occupancy ended the quarter at 92.1% and is expected to increase throughout the year, as leases executed in 2022 commence, including over 160,000 square feet at the National Business Park during the second and third quarters, which includes 126,000 square feet of new space with the US government and 121,000 square foot lease with Lockheed Martin at 1200 Redstone Gateway in the third quarter.

These gains will be partially offset by a previously reported 54,000 square foot contraction in our regional office segment by CareFirst at Canton Crossing in the second quarter.

The location of our Defense/IT assets has driven our exceptional leasing results, which translates into resilient and growing NOI. Our three largest concentrated defense locations which consist of the National Business Park, Redstone Gateway in Huntsville and Lackland Air Force Base in San Antonio are 98.4% leased in aggregate and account for roughly 45% of our core annualized rental revenue.

Adding our fully leased data center shell portfolio, 50% of our core annualized rental revenue comes from assets that are 99.1% leased and have rock-solid stability for years to come. Our balance sheet is well positioned to navigate the current volatility in the capital markets environment. We have no significant debt maturities until March 2026.

During the quarter, we paid off a $16 million mortgage which matured in February with our line of credit and unencumbered 7740 Milestone Parkway. Our unencumbered portfolio now represents 96% of total NOI, from real estate operations.

As a result of the interest rate swaps we entered into effective February 1st, our variable rate debt exposure declined to 2% at quarter end compared to 15% at the end of 2022. We expect our floating rate debt exposure to increase slightly over the remainder of the year, as we fund development on our line of credit but will remain below 10% throughout the year.

As previously announced, in early January, we closed on a 90-10 joint venture with affiliates of Blackstone for three single-tenant data center shells, raising $190 million of equity proceeds. The proceeds from this transaction were used to pay down the line-of-credit. And at the end of the quarter, we have 80% of the capacity of our line available.

Following the completed JV in January, we have no need to sell for joint venture any additional assets to fund our expected $250 million to $275 million in annual development investment.

Looking forward, we anticipate self-funding our equity requirements for expected development investments through cash flow from operations, while maintaining our strong balance sheet and conservative leverage metrics.

In February, we announced a 3.6% increase in our quarterly dividend which is our first dividend raise in over a decade. The dividend increase illustrates our confidence in strong FFO and AFFO growth. With this increase, we expect our full year AFFO dividend payout ratio will still be roughly 70%.

Turning to 2023 guidance, we are narrowing the range of FFO per share by $0.01 at the low and high-end and maintaining the midpoint at $2.38 per share. Although results exceeded expectations in the first quarter and the fundamentals of our portfolio continue to be very strong.

At this point in the year we are being conservative and not changing the midpoint of our annual FFO per share guidance. For the second quarter, we are establishing a guidance range for FFO as adjusted for comparability of $0.57 to $0.59 per share.

With that, I'll hand the call back to Steve.

Steve Budorick

Thank you. Summarizing our key messages, we delivered a strong quarter with FFO per share $0.02 above the midpoint of our guidance. Our Defense/IT segment is 96.7% leased which is the highest rate since we started reporting the segment in 2015.

We raised the midpoint of full year same property cash NOI guidance, by 100 basis points driven by a great first quarter. We raised the midpoint of our full year retention rate guidance by 250 basis points to 82.5% demonstrating our confidence in our renewal leasing.

We executed 99,000 square feet of vacancy leasing and we are on track to achieve our full year target. Our leasing pipeline remains strong, with a vacancy leasing activity ratio at 75% and a development and leasing pipeline at 700,000 square feet.

Our 1.5 million square feet of active developments which are 92% leased provides a strong trajectory for NOI growth over the next few years. The administration's fiscal year 2024 budget request proposed an additional 3.6% year-over-year increase or nearly $30 billion, which follows a near 15% increase over the prior two years.

We are on track to deliver modest FFO per share growth in 2023, but expect compound annual FFO growth of roughly 4% between 2023 and 2026. And we raised our dividend by 3.6% and we expect to self-fund the equity component of our development pipeline going forward.

So let me finish with an anecdote, before we open up the line for questions. Earlier this month, they attended a ribbon-cutting ceremony down at Redstone Gateway, for a two building build-to-suit campus, which we developed for a top defense contractor. The properties totaled 262,000 square feet, and they were delivered in the fourth quarter of 2022 at a total cost of over $100 billion -- $100 million, sorry.

While we often discuss the mission-critical nature of the work our tenants perform at our facilities it trips like these that really reinforce the importance of our tenants work to our national security. This campus will be home to over 1,000 employees whose primary mission is to expand our nation's missile watch and missile defense capabilities. The buildings contain office space, skip facilities, program management and engineering design space an integration, laboratory, a data center and a 350-person auditorium.

This is a great example of mission-critical work that requires specialized secure space that is adjacent to a government demand driver that, it supports and work that cannot be performed from home. We're incredibly proud to play a role in the creation in advance with such a vital facility, supporting critical defense missions of our country. We are greatly appreciative of our relationships with our government and defense contractor tenants providing them critical facilities and infrastructure, to support their national security missions.

And with that, operator, please open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Anthony Paolone with JPMorgan. Your line is open. Please go ahead.

Anthony Paolone

Thank you. So you talked about and outlined about half of your expirations being over 50,000 square feet the high retention there. Can you talk about just the roughly other half that's smaller tenants? And just any trends there that might be different than what you're seeing more broadly or things that we should watch with that half of the expirations?

Steve Budorick

No. The overall target or expectation with the midpoint at 82.5% suggests that we have just as high retention performance on smaller tenants in Defense/IT, as we do for the larger. But do bear in mind we got 50,000 square feet of regional office back year-to-date and we're going to get another block of 50 later in the year. And that regional office is a significant factor in the 82.5% retention rate.

Anthony Paolone

Okay. Got it. And then just other question, in terms of thinking about starts for the rest of this year, what's in the planning, or how should we think about that? Because it seems like, to take your development goal, you need to start something that the existing pipeline is pretty full.

Steve Budorick

That's, correct. We've got a little over I think 100,000 square feet, in our available inventory. There's multiple scenarios that could put us over the 700,000 square feet, one of which is another data center shell build-to-suit and the alternative is some additional starts in the Defense/IT locations most likely Redstone Arsenal.

Anthony Paolone

Okay. Thank you.

Operator

Thank you and one moment for our next question. Our next question comes from the line of Blaine Heck with Wells Fargo. Your line is open. Please go ahead.

Blaine Heck

Great. Thanks. Good afternoon. Just starting on guidance. It seems like there was room to move FFO guidance up given the movement in same-store NOI and retention expectations. I guess that it's early in the year. But I guess, I'm just wondering if there were any other factors other than interest rates that kind of kept you guys conservative at this point?

Anthony Mifsud

There weren't. I think what we were trying to communicate with the changes that we did make as a result of the performance in the first quarter, was the strength in the same office portfolio, as well as in the retention of our expiring leases. I think the one component of the forecast that we really have no control over is, variable rate interest.

When you look at the change in projected SOFR from where it is at the beginning of -- will be at the beginning of May through the end of the year, it's projecting to go down almost 75 basis points, if that doesn't occur that would impact our interest expense. Every 50 basis points change in interest expense, for the balance of the year is, about an additional $600,000 of interest expense. So at this point of the year, we're not at a point where we can be confident that that -- those rate reductions that are assumed later in the year will actually happen.

Steve Budorick

In general, we like to put out conservative numbers. And so there's still two quarters left to adjust that expectation, if the first quarter results flow through and interest rates remain stable.

Blaine Heck

Okay. That's fair. Steve, I was hoping you could talk a little bit about, how you're approaching capital allocation decisions more broadly in this kind of volatile environment, as you evaluate different investment opportunities from acquisitions to development and maybe even thinking about share repurchases. Do you think any of these investments provide a much more attractive risk reward profile, at this point?

Steve Budorick

Well, we continue to believe that our incremental capital allocation is best placed in new development at high priority defense locations, and it has been for the last seven years, since I took over as CEO. There have been a few opportunities to look at some, somewhat interesting acquisitions in the marketplace. But the value creation, we can deliver to shareholders through our development, is superior to that of what we could do through an acquisition and we'll continue to remain very disciplined, looking to maximize shareholder value through the development process.

Blaine Heck

That's very helpful, Steve. And I guess to that point, can you give us your latest thoughts around data center development and whether land costs, and power availability continue to be issues that could maybe impede your ability to develop more on that side of the business in the future?

Steve Budorick

So, unquestionably the availability of land, but more so the availability of power is going to limit the overall opportunity to grow the data center capacity in the market that we serve which is Northern Virginia and Prince William County.

So, I think the rate of continuing progress will be lower than it was say five years ago. But we continue to identify opportunities and work in harmony with our customers to see if we can find solutions to continue developing for them and we're pretty confident we're going to have additional development that we will book and secure for our shareholders.

Blaine Heck

Great. Thanks everyone.

Steve Budorick

Thank you.

Operator

Thank you. Our next question comes from the line of Michael Griffin with Citi. Your line is open, please go ahead.

Michael Griffin

Great. Thanks. Steve I want to go back to the prepared remarks around the defense budget. Do you have any sense the impact of the budget negotiations, the debt filling fiscal clip? I mean if they can't reach kind of an agreement with Congress, could that adversely impact that growth that you're talking about in 2024?

Steve Budorick

So, it's going to be a roller coaster ride getting through to September unquestionably. And we're in no position to project -- or to predict exactly what fencing is going to look like between the House and the Senate and the President, but it's crystal clear that the one area of broad consensus is that defense spending has to continue to increase.

And when I say defense spending, I'm not referring to anything pertaining to Ukraine to meet the global threat environment that we face today. So, it will be interesting on the budget, I can't tell you what things will be in place. But there is broad consensus that defense has to be invested in.

Michael Griffin

Got you. That's helpful. Maybe turning to Redstone. I noticed you've been winning some business from [indiscernible]. How big is this opportunity set? And then we just go behind the fence? I know you've got some entitlements to build there. Any update on this as well as space demand may be coming there?

Steve Budorick

So, overall, we have over 3 million square feet of additional development capacity inside and outside of defense I would characterize about a third of that is inside the fence. We continue to see opportunities of significant size for new facilities to meet new missions or enhanced capabilities in the marketplace. Timing of those is crystal clear in some respects.

With regard to the basin decision for Space Command, that's really in the hands of the senior commander of the Air Force at this point from what we understand. The decision was made probably going on four years ago. It's been challenged three times and each and every challenge and review Redstone Arsell comes out as the number one choice. And I think it's a matter of time. But it's a very political decision and there are multiple states that would prefer to go there. So I can't predict timing. I think it will be a -- if it's finalized in Alabama, it will be a big benefit to that market overall and I think there'll be quite a bit of opportunity for our company there.

Michael Griffin

Got you. And then just lastly on the regional office portfolio. Anthony, I think, you talked about 96% of your properties being unencumbered. Are any of the regional office assets encumbered with mortgages and like you hand back keys on it as if the potential?

Anthony Mifsud

All of the assets in the regional office portfolio are unencumbered. So there's no mortgages on any of those properties.

Michael Griffin

All right. That’s it from me. Thank you for your time.

Anthony Mifsud

Thanks, Michael.

Operator

Thank you. And moment for our next question. Our next question comes from the line of Camille Bonnel with Bank of America. Your line is open. Please go ahead.

Camille Bonnel

Hi. Just following up on an earlier question around guidance. To clarify was the driver of the FFO change on the upper range driven by interest rate variability, or can you speak to what was driving this change?

Anthony Mifsud

The penny – the reduction at the top end was really driven by the fact that we've got a quarter in the books that we even if interest rates were to -- we don't expect interest rates to decline that dramatically that would get us to the higher end of that range which would be one of the drivers that would get us there.

Camille Bonnel

Okay. Thank you for clarifying it. Most of my questions have been asked. So it that's for me.

Anthony Mifsud

Thanks.

Operator

Thank you. And one moment for our next question. And our next question comes from the line of Tom Catherwood with BTIG. Your line is open. Please go ahead.

Tom Catherwood

Thanks and good afternoon, everyone. Maybe sticking with Redstone, Steve in the past you've added some small mixed-use components now that the build out kind of across the whole campus continues to accelerate, is there any thought to carving off parcels for some other complementary uses. I think you did some of this with the hotel that was added back in I think it was either 2015 or 2016.

Steve Budorick

Good question. So we're -- we did do a second hotel land lease. That hotel is under development. It should deliver I think around year end, which will be good for the rest of the retail that we had invested in. We had also -- did a land lease with a daycare facility to support ultimately the employees of our customers on the base. And we'll do some relevant support more retail-oriented leasing to enrich the value of our development to our customers. But beyond that -- beyond convenience service we have no plans to use any of that land for anything but defense contractor and U.S. government development.

Tom Catherwood

Got it. I appreciate that Steve. And then maybe pivot over to the data center shells I think your first round of second-generation leasing is coming up soon. When do those leases roll? And did some of those re-leasing expectations factor into the higher same-store NOI guidance?

Steve Budorick

I don't -- well we have negotiations ongoing on our first renewals. And I'll just say stay tuned, but it did not factor into our change in the same office NOI.

Anthony Mifsud

The first lease on that matures is at the end of this year. So any impact of our renewal would be -- wouldn't be until 2024. And from an NOI standpoint, that property is one that is in one of the Blackstone ventures. So the impact of that for us would only be the change in rent and our 10%.

Tom Catherwood

Got it. Understood. We will follow-up on that. And then last one for me, and this is probably doesn't impact you guys but obviously, lots of distress and talks about distressed opportunities when it comes to office. Now that office is very, very different than your portfolios, and I wouldn't expect there to be distress per se in items leased to DoD or contractors. But are there any opportunities in your markets, whether it's to kind of add some tuck-in acquisitions or some additional land that you're tracking or that you think may be opportunistic within the next year or so?

Steve Budorick

Great question. So we are keeping our eyes peeled for such an opportunity. We have yet to find when that fits our requirements.

Tom Catherwood

Got it. Appreciate it, guys. That’s it for me.

Steve Budorick

Thanks, Tom.

Anthony Mifsud

Thanks, Tom.

Operator

Thank you. [Operator Instructions] And our next question comes from the line of Steve Sakwa with Evercore ISI. Your line is open. Please go ahead.

Steve Sakwa

Yes. Thanks. Good afternoon. So Steve, a lot of focus obviously on the defense IT sector, which is doing very well, as you pointed out almost 97% leased. Unfortunately, the six regional assets are only 78.5% lease. So, I was just hoping that you guys could talk a little bit about the demand you're seeing in the regional assets. And I know that that's kind of the catalyst ultimately try and get these sold, which in today's environment is not exactly the easiest thing to do, but maybe speak to the demand side of what you're seeing on the regional office.

Steve Budorick

Sure. We did sign two leases in the regional office in the quarter that added about 11,000 square feet of occupancy when the space is built. Believe it or not our pipeline for regional office is at 76.5%. So there have been some larger uses that are now in the marketplace canvasing some buildings that we can compete for them. It's too early to be overly optimistic, but there's opportunity out there that we can compete for, which is a good sign. We're down to a final decision with the tenant that's considering $2,100. We think we're competing effectively for that tenant. We anxiously await their decision and we'd love to land that lease.

Steve Sakwa

And would you sense that the demand is a little stronger in Washington D.C. or up in Baltimore or any thoughts on that or price of tenant.

Steve Budorick

So D.C.'s demand profile is pretty ugly except for the trophy office segment. And in the trophy office segment, there's diminishing supply, I think it's below 13% availability right now. And we believe our asset competes very favorably with other availability to that segment. From a volume perspective, we've got quite a bit of prospect activity in Baltimore. I don't expect those deals to move quickly. But we have a couple of larger opportunities that are very interesting.

Steve Sakwa

Okay. And then on the development side, I know you've historically said that your yields to some extent at least on the data center shells might float with costs. But can you just kind of remind us to the extent that you move forward with another data center shell development or some of the IT, defense IT. What kind of yields are you looking at today on cost and maybe what is happening with costs on the development side?

Steve Budorick

So costs have stabilized pretty materially over the last call it two quarters. Two quarters ago we were reporting that our year-over-year development on office buildings was about 21%, 22% and we have been able to drive our rents up to maintain yields in our target range with that change in cost.

We did one build-to-suit and Defense/IT year-to-date. And I would say our cash yield is 50 bps higher than it was say 12 months ago. And we've elevated our targets to try to achieve a commensurately better cash return with our increased cost of capital. Data center shells, I don't really want to discuss yields. But we look at that opportunity with the same lens trying to achieve returns that are commensurate with our increased cost of capital.

Steve Sakwa

And I guess maybe just last question. I know we sort of talked about this during the trip in D.C., but given the power issues in Loudoun County today, do you see your ability to find other I guess larger locations in the Northern Virginia area to help supplement your customers' needs for data centers?

Steve Budorick

We're working on a couple right now. It's a little preliminary talk about them because we're not under contract but I don't think you're going to see large land availabilities. It's going to be more moderate – moderate-sized parcels that require a little more creativity but we are working on several.

Steve Sakwa

Great. That’s it for me. Thanks.

Steve Budorick

Thank you.

Operator

Thank you. I would now like to turn the conference back over to Mr. Budorick for closing remarks.

Steve Budorick

Thank you, all for joining our call today. We are in our offices. So please coordinate through Venkat, if you would like a follow-up call. Thank you very much for joining us.

Operator

Thank you for participating in today's Corporate Office Properties Trust first quarter 2023 results conference call. This concludes the presentation. You may now disconnect. Have a good day.