COPT Defense Properties (CDP) 2007 Q2 法說會逐字稿

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  • Operator

  • Good day, ladies and gentlemen, and welcome to the second quarter 2007 Corporate Office Properties Trust earnings conference call.

  • At this time, all participants are in a listen-only mode.

  • We will conduct a question-and-answer session towards the end of this conference, at which time (OPERATOR INSTRUCTIONS).

  • As a reminder, this conference is being recorded for replay purposes.

  • I would now like to turn the presentation over to your host for today's call, Ms.

  • Mary Ellen Fowler, Vice President and Treasurer.

  • Please proceed.

  • Mary Ellen Fowler - VP and Treasurer

  • Thank you and good morning, everyone.

  • Yesterday our earnings press release was faxed or e-mailed to each of you.

  • If there's anyone on the call who needs a copy of the release or would like to get our quarterly supplemental package, please contact me after the call at 443-285-5450 or you can access both documents from the Investor Relations section of our website at www.copt.com.

  • Within the supplemental package you'll find a reconciliation of non-GAAP financial measures to GAAP measures referenced throughout this call.

  • Also under the Investor Relations section of our website you'll find a reconciliation of our annual 2007 guidance.

  • With me today is Rand Griffin, our President and CEO; Roger Waesche, our COO; and Stephen Riffee, our CFO.

  • In just a minute they will review the results of the second quarter and then the call will be opened up for your questions.

  • First I must remind all of you at the outset that certain statements made during this call regarding anticipated operating results and future events are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

  • Although such statements and projections are based upon what we believe to be reasonable assumptions, the actual results may differ from those projected.

  • These factors that could cause actual results to differ materially include without limitation the ability to renew or release space under favorable terms, regulatory changes, changes in the economy, the successful and timely completion of acquisitions and development projects, changes in interest rates and other risks associated with the commercial real estate business is detailed in our filings from time to time with the Securities and Exchange Commission.

  • Now I would like to turn the call over to Rand.

  • Rand Griffin - President and CEO

  • Thanks, Mary Ellen, and good morning, everyone.

  • We're very pleased to report a strong quarterly results.

  • We generated $0.57 per diluted share in FFO for the quarter, exceeding analysts' consensus estimate of $0.54 and equating to a 16.3% increase in FFO per share year-over-year.

  • I wanted to comment on several items starting with the acquisition environment which continues to be challenging.

  • We are benefiting from our $362 million Nottingham transaction which closed earlier this year.

  • This transaction was a mid 7% yield going in and had a significant land position at very attractive pricing.

  • Through this transaction we were able to issue $155 million of common equity at $49 per share net and $26 million of convertible preferred equity.

  • We believe this portfolio is a great value add opportunity as we increase occupancy in that portfolio through 2008 and take advantage of our strategic land position.

  • Our guidance for the year does not include any other acquisitions and most likely none in the first half of 2008.

  • We have resisted participating in acquisition auctions with purchase prices below 6% cap rates.

  • Much of our anticipated strong FFO growth for the next few years will be driven by our significant development activity.

  • With regard to our tenant driven markets, we are seeing strong activity in Colorado Springs where we have a total of 476,000 square feet under construction, development or redevelopment.

  • At our San Antonio property, we have an indication that our tenant may significantly increase the size of their requirement.

  • During the quarter, we placed the 100% leased 193,000 square foot Northrop Grumman VITA building into service.

  • The second VITA building will come online this fall.

  • Including these two buildings, we now have over 1.5 million square feet of data center space operational or under construction.

  • Most of our data center space is leased to large, single tenant users that have strong credit and a need for secure space.

  • In order to operate large data centers, several of our tenants require large amounts of power and water, and we have been building to meet these requirements.

  • We recently hired additional data center expertise on staff to better support our -- largest tenant's demand for the specialized space and we are studying the potential to pursue additional opportunities for secure data center space with both existing and new tenants.

  • Looking at our land control and future development pipeline, we continue to position the Company to take advantage of the opportunities that will come from BRAC.

  • For example, we control 56 acres of land located at the North Gate at Aberdeen Proving Grounds in Aberdeen, Maryland.

  • This is the gate most utilized by contractors and is considered the best site in the area.

  • Aberdeen Proving Grounds is about 20 minutes north of White Marsh and is the recipient of a move by CECOM from Fort Monmouth, New Jersey as a result of its closure.

  • CECOM is the Army's Communications Electronics Command.

  • About 8,200 jobs will be moving on-base and approximately 12,000 jobs off-base from 140 contracting companies.

  • We recently received approval for the annexation of this site into the city of Aberdeen in Harford County.

  • We project that 740,000 square feet of office can be built at this location.

  • The site will accommodate only a portion of the 3 million square feet of demand expected from jobs located off the base.

  • We expect to start infrastructure work late this fall and expect to start the first building by mid-year 2008 with deliveries anticipated commencing in 2009 and all buildings under construction by 2010.

  • Aberdeen will be the first BRAC location in Maryland where we will see demand from contractors based on the movement of workers from Fort Monmouth, New Jersey.

  • With regard to our total development pipeline including the impact of BRAC, our preliminary estimate is a significant ramp-up in development volume based on anticipated job growth.

  • This will require over $1 billion of construction starts over the next 2.5 years for a total of 5 million square feet of office space.

  • This is double our normal volume.

  • We anticipate that 60 to 70% of this demand will be government and defense, and we expect this volume to continue into 2010 and 2011.

  • These buildings will be scheduled for delivery starting in late 2008 with the bulk to be delivered in 2010 and beyond.

  • With regard to financing current development, we do not anticipate that we need to raise equity for the balance of 2007 or for 2008 based on our preliminary projections.

  • In effect, we overissued equity as part of the Nottingham transaction.

  • We have the development land as equity and the remaining construction costs can be refinanced.

  • We are comfortable that there is more room to increase our leverage slightly to finance this construction.

  • With regard to a stock buyback, we note that a number of REITs have announced programs.

  • We also have seriously considered a stock buyback program and believe our stock is significantly undervalued.

  • However, we have completed an analysis which indicates that we can create more value for our shareholders by investing in our significant development activity yielding 10 to 11% unleveraged returns than we can from buying stock back at our current levels.

  • We believe that it's more prudent to take the long-term view.

  • However, we will continue to review our options and alternatives.

  • And with that, I'll turn the call over to Steve.

  • Steve Riffee - CFO

  • Thanks, Rand, and good morning, everybody.

  • Turning to our performance, FFO for the second quarter totaled $31.8 million or $0.57 per diluted share as compared to FFO for the second quarter of last year of $25.2 million or $0.49 per diluted share, representing a 16.3% increase in FFO on a per share basis.

  • Included in FFO is a $1 million gain for the disposition of a majority of our interest in TractManager.

  • TractManager is a company that developed an Internet-based contract imaging and management system for sale to real estate owners and health-care providers.

  • We made this investment back in the tech days and have nurtured the company along, helping to develop the real estate part of the contracting service and being patient investors.

  • TractManager was merged into another company owned by Tudor Ventures and GE Healthcare Financial Services during the second quarter.

  • As a minority investor, we had little control over the timing of the merger, but had anticipated a capital event in the third quarter.

  • As a result of the merger, we still own an interest in the Company that we are carrying at a cost basis of $128,000 and believe we have additional profit to harvest in the future.

  • We have not determined when the balance of our ownership will be sold.

  • Turning to FFO, lease terms fees of $700,000 were below our guidance and normal run rate of $1 million per quarter for terms fees.

  • The increase in FFO from last quarter sequentially is primarily a result of increasing NOI due to successful efforts to reduce costs.

  • In addition, we had two large leases in Northern Virginia that we placed into service late in the first quarter, contributing for a full quarter, and the VITA building was placed into service and the Nottingham assets contributed for a full quarter.

  • The FFO generated by our Nottingham portfolio for the quarter met our forecast and is on track to produce a $0.12 FFO contribution for the year.

  • Turning to our results from AFFO, after adjusting for capital expenditures and the straightlining of rents, our adjusted funds from operations increased 14.1% to $21.6 million for the second quarter, compared to the second quarter of 2006.

  • Pay-out ratios continued to be strong at 54% for FFO and 79.5% for AFFO for the quarter ending June 30, 2007.

  • The Company's EBITDA to interest expense ratio was 2.77 times and our EBITDA to fixed charge coverage ratio was 2.3 times.

  • With regard to earnings per share for the second quarter, we recorded earnings of $0.08 per diluted share versus $0.13 for diluted share for the second quarter of 2006.

  • Second quarter earnings were impacted by the significant increase in depreciation and amortization, primarily as a result of the Nottingham portfolio acquisition which we completed in January of this year.

  • Turning next to our same property results, for the 157 comparative properties representing 74.4% of our portfolio, same property cash NOI increased 2.9% for the second quarter of 2006 -- from the second quarter of 2006.

  • The primary driver of this result was increased occupancy, most notably in the Northern Virginia portfolio.

  • Turning to our balance sheet, at June 30, our total market capitalization was approximately $4.25 billion with $1.75 billion of debt outstanding that's equating to a 41% debt to total market cap ratio.

  • At June 30, 17% of our debt was floating, substantially lower than the 27% of floating debt that we had one year ago.

  • The total weighted average interest rate for all our debt is 5.89%.

  • During the quarter, we closed on a $150 million secured loan, with interest-only payments at a fixed interest rate of 5.65% for 10 years.

  • The proceeds were used to repay existing debt at an average blended interest rate of 6.6%.

  • During the next quarter, we expect to extend our $500 million revolving line of credit at more favorable terms.

  • Turning to equity, as Rand said, we do not believe we need to raise equity during 2007 or 2008 as a result of issuing equity for the Nottingham transaction and the purchase of the remaining interest in Interquest Park with units that were valued at $47.68 per unit coupled with our capacity under our revolver.

  • We have funded our development either through our revolver or through separate construction financing using our land as our equity.

  • As buildings are completed and as they come online, we permanently finance these assets, pulling out our equity based on the value that we've created.

  • We did this recently when we closed the $150 million [loan] where we recaptured about $50 million above our cost basis on the assets.

  • We then take this capital and recycle it into more development.

  • Despite the turbulent debt market, long-term fixed-rate financing is available at higher leverage levels for quality sponsors.

  • We feel very good about our current position and note that historically our Company has performed well in difficult equity markets, as we have the ability to tap the permanent market and increase the leverage if needed.

  • With regard to our 2007 FFO guidance, we are tightening the FFO per diluted share guidance at the low end from $2.18 to $2.20, and leaving the top end at $2.25 per diluted share, resulting in a strong growth rate range of 10.5 to 13.1%.

  • We've previously projected that a TractManager disposition would impact our earnings in the third quarter, not the second quarter.

  • We also would note that during the third quarter typically utility costs are higher, so our FFO results might be down slightly from the second quarter over all results.

  • We would then expect to finish with a strong fourth quarter's construction placed in service contributes to earnings.

  • Lastly, as has been our practice in past years, our Board will evaluate an increase to our dividend at the September Board meeting based on our projected FFO and AFFO growth for the year.

  • And with that, I'll turn the call over to the Roger.

  • Roger Waesche - COO

  • Thanks, Steve.

  • Let me first begin with a review of our markets.

  • With regard to the BWI submarket, as of June 30, within the total market of 6.4 million square feet, vacancy including sublease stood at 14.1%, up from 10.9% one year ago.

  • Approximately 730,000 square feet has been added to the market in the past year.

  • Our BWI portfolio totaling 4.4 million square feet and representing 70% of the submarket was 94% leased at June 30.

  • Turning next to the Columbia submarket in Howard County.

  • At June 30, vacancy with sublease was 14.2%, up from one year ago at 12.5%.

  • In Columbia, 300,000 square feet of new development has been added to the market in the past year.

  • Our properties in the Columbia submarket total 3 million square feet and are currently 94% leased.

  • Within COPT's Northern Virginia submarkets, the direct vacancy rate was up slightly at 10% versus 8.5% one year ago.

  • Year-to-date absorption has been 469,000 square feet.

  • Approximately 1.1 million square feet was added over the past year.

  • Our portfolio of 2.5 million square feet is 99.2% leased to June 30.

  • Asking rental rates in Northern Virginia continue to rise and are expected to continue trending up throughout 2007.

  • Looking just at Dulles South submarket in Northern Virginia, the vacancy rate ended the second quarter at 13.3%, up from 10% one year ago.

  • Within the Dulles South submarket there is currently 1.7 million square feet of speculative space under construction.

  • Our operating portfolio of nine buildings totaling approximately 1.5 million square feet is 99.4% leased and we have minimal lease rollover for the next three years.

  • Therefore, we believe that we are well protected from the impact of any potential overbuilding in this submarket.

  • Within the Colorado Springs submarket, leasing activity is increasing and office vacancies declined in the second quarter to 7.5% compared to one year ago at 8%.

  • Our properties in the Colorado Springs submarket total 808,000 square feet and are currently 96.2% leased.

  • Turning to our portfolio performance at June 30, our wholly-owned portfolio totaled 17.7 million square feet and ended the second quarter at 92.7% occupancy and 93.3% leased.

  • We did experience a slight decline in the occupancy in the BW portfolio to 93.5% versus last quarter of 94.1% due to one tenant vacating our building at 7321 Parkway Drive.

  • We are selling this building and expect to close this quarter.

  • In comparing our BW portfolio occupancy of 95.5% one year ago, we do have the impact of the Nottingham assets located in the Howard County submarket that are 90% occupied at June 30, up from 87.8% at acquisition.

  • Three of our portfolios reflect improved occupancy from one year ago -- Northern Virginia, Colorado Springs and suburban Maryland.

  • As many of you are aware, our greatest leasing challenge is in our suburban Baltimore portfolio.

  • For the quarter, our renewal activity in the Baltimore suburban portfolio was the strongest in our portfolio.

  • With regard to the Nottingham assets, you may recall that 1/3 of the leases are maturing during 2007.

  • We have been able to retain the majority of our tenants and despite the large lease rollover, have maintained our occupancy at 85.7%.

  • With regard to leasing statistics for our wholly-owned portfolio for the quarter, we renewed 476,000 square feet, equating to a 69.3% renewal rate at an average capital cost of $4.91 per square foot.

  • Average rental rates for the renewed and re-tenanted space for 612,000 square feet increased 6% for total rent on a straight line basis and increased .5% on a cash basis.

  • For renewed and re-tenanted space for the quarter, the average capital cost was $7.55 per square foot.

  • This is our lowest cost in four years and reflects pricing power in the market as well as a strong effort by our asset management team.

  • As we renew and re-tenant, we focus on net effective rents and cash flow, not just gross rents.

  • We are willing to look at all aspects of the lease structure to achieve the highest cash flow for the Company.

  • From a credit standpoint, 7.7% of our revenues come from the financial services industry sector.

  • We have exposure of .9% of our revenues to the mortgage sector including .2% to American Home Mortgage which has a loan processing operation in our Columbia portfolio.

  • With regard to acquisitions, we continue to bid on assets but are a very disciplined buyer and are not willing to change our underwriting standards.

  • We will not buy above replacement costs or at IRR's below our cost of capital.

  • We do think that the tightnecking of underwriting standards and higher spreads in the debt markets will cause some buyers to fall out of the market and may lead to increasing cap rates by mid next year, providing us the opportunity to make some acquisitions that meet our underwriting metrics.

  • To date we have seen no evidence of rising cap rates in our markets.

  • Turning to dispositions, in addition to the one BW Corridor building we are selling this quarter, we expect to sell two small buildings in New Jersey by the end of the year and one building at Princeton Tech in early 2008.

  • The remaining two Princeton Tech buildings are under contract with the existing tenant for sale by mid 2009.

  • This will effectively complete our exit of the New Jersey market.

  • We continue to evaluate assets for sale but do not own many buildings that are not located in key business parks within our core markets or our tenant driven expansion markets.

  • Our strategy is to control over time all the properties within a business park and a majority of the properties within a submarket.

  • This strategy will provide the Company with the flexibility to move tenants as they grow their business.

  • We will look to sell noncore assets once their value is maximized.

  • We have been expending considerable effort looking at tactics to optimize our existing portfolio.

  • This includes adding retail paths from land carve-outs in front of some of our buildings and densifying other locations that are adjacent to town centers.

  • We expect significant value creation over the next several years from these activities.

  • With that, I will turn the call back over to Rand.

  • Rand Griffin - President and CEO

  • Thank you, Roger.

  • With construction underway on 1 million square feet at a total cost of $212 million, these construction projects are 48% leased, reflecting the addition of two new buildings this quarter and the removal of two fully leased buildings placed in the service.

  • During the quarter we added to our construction pipeline a 110,000 square foot building at UMBC and the first building in (inaudible) preserve totaling 152,000 square feet.

  • Both of these buildings are in the BW Corridor.

  • Our development pipeline with expected starts later this year is another 1.3 million square feet at a total projected cost of $266 million.

  • During the quarter we added two buildings to our development pipeline.

  • The first is a 161,000 square foot building, 308 MBP, and the second is a 151,000 square foot building at Interquest Business Park in Colorado Springs.

  • We continue to build out Phase II of NBP with two buildings for 283,000 square feet under construction and three buildings for 477,000 square feet getting ready to start.

  • We are also very active in Colorado Springs where we have a total of 476,000 square feet that is either under construction, redevelopment or in the development pipeline phase getting ready to start.

  • This square footage represents close to 59% of our total operating square footage in the Colorado Springs market today.

  • In summary, we believe that our Company is one of the best positioned office REITs for long-term growth for a number of reasons.

  • First, we have a government and defense niche with strong creditworthy tenants that insulate the Company from credit problems in a downturn.

  • Second, our government and defense niche allows us to continue to grow in Colorado Springs, San Antonio and the BW Corridor, offsetting other markets such as Northern Virginia that may be overbuilt in the near future.

  • Third, we have strategically positioned the Company to benefit from BRAC and we expect to be a leader in capturing significant market share resulting from the influx of 60,000 net new jobs into Maryland.

  • Fourth, we control almost 14 million square feet of future development on land we own at a very low cost basis that is substantially below its current market value.

  • Fifth, our stable core markets have allowed us to maintain strong occupancy levels even as we have added new submarkets with higher vacancy to our portfolio.

  • Sixth, we have continued to build out and lease our development pipeline at relatively high yields.

  • Seventh, we have a great capital position and do not need to raise equity in the near-term.

  • And finally, we have avoided M&A transactions at low cap rates that would not create value for our shareholders.

  • With these strengths we look forward to continuing to deliver above-average FFO growth results for our shareholders which should result in improving total shareholder returns.

  • And with that, we will open up the call for your questions.

  • Operator

  • (OPERATOR INSTRUCTIONS) John Guinee, Stifel Nicolaus.

  • John Guinee - Analyst

  • Very nice job, ladies and gentlemen.

  • Thank you.

  • Virtually all my questions have been answered but just one obvious one is the BWI Corridor is a lot like Western Fairfax County in that you guys got in early and got in very smartly.

  • But now the world's sort of catching up.

  • Western Fairfax County is now horrifically overbuilt and there's a tremendous amount of product in the pipeline in the BWI Corridor in Howard County.

  • Any ideas on remaining competitive in that market?

  • Rand Griffin - President and CEO

  • John, this is Rand.

  • I mean, obviously, there are other people talking about coming into the market.

  • There are others that have taken land positions.

  • That's going to happen as markets mature.

  • We do think we have the best sites in the marketplace, particularly that can service the major customers, both existing customers at Fort Meade and the new ones coming in from BRAC.

  • We've got the lowest cost basis and we're ahead of the others in terms of development underway.

  • So, we understand there will be competition out there.

  • We're the dominant player in that marketplace and we intend to stay that way and be very aggressive in terms of maintaining our market share.

  • John Guinee - Analyst

  • Great.

  • Thank you very much.

  • Operator

  • Chris Haley, Wachovia.

  • Brendan Maiorana - Analyst

  • Good morning, guys.

  • It's Brendan Maiorana for Chris.

  • Steve, you mentioned that financing is still available for assets of your quality with tenants of your credit quality.

  • Has there been any -- or could you offer what the change in interest rates you think have been over the past three to six months?

  • And have there been any change in LTV underwriting standards?

  • Steve Riffee - CFO

  • It seems that perhaps it's gone up 40 to 50 basis points recently.

  • And I think it depends on the quality of the bar and the assets in terms of how much leverage you can get.

  • But we can get -- we've been getting and we think we can still get like 80%.

  • Brendan Maiorana - Analyst

  • Okay.

  • It sounds like you guys are okay in terms of your financing capacity for the rest of this year and '08, but Roger, it sounds like you would not -- you don't have too many assets that you would expect to sell in '09 if you needed some capital capacity there.

  • Is that a fair assessment?

  • Roger Waesche - COO

  • We're always looking at our portfolio and I think we do have a number of assets that we would be willing to sell, including some of our suburban Baltimore portfolio, obviously moving out of New Jersey and Philadelphia.

  • And we would even look to joint venture some of their stable somewhat core assets if we needed capital for development.

  • Brendan Maiorana - Analyst

  • Maybe this is getting ahead of yourselves or you guys don't want to answer this, but would that be before thinking about doing an additional equity raise potentially in '09?

  • I mean how would you guys think about an equity raise versus recycling some of your assets or selling some of your assets?

  • Steve Riffee - CFO

  • Well, I think a lot obviously can happen between now and 2009, where our stock price is selling, where cap rates are on assets in our portfolio and how stable our portfolio is.

  • So I would be speculating out into 2009 as to what we would do.

  • But obviously we would closely analyze and determine what the cheapest source of capital would be, whether that would be raising equity or selling assets and we would execute along those lines.

  • Brendan Maiorana - Analyst

  • Rand, I think you mentioned that Aberdeen Proving Ground is -- that's expected to have the first influx of jobs from BRAC, at least on-base.

  • Has that been an increase in terms of the velocity of jobs coming to Aberdeen Proving Ground relative to Fort Meade?

  • Or has the impact from Fort Meade been pushed out at all?

  • Rand Griffin - President and CEO

  • No, they're totally separate situations.

  • I mean, Fort Meade has the three groups -- the defense media and the judication groups coming in.

  • Those are primarily all from either consolidation from around the country or from Northern Virginia.

  • The Aberdeen is strictly the CECOM group that I mentioned coming from Fort Monmouth.

  • CECOM has a number of related entities, very sophisticated entities.

  • So that -- those things they take a while to unfold but in the number of meetings that I've been involved in and dealing with the companies that are talking about moving down, it's on track despite the press that you read.

  • And you can't really unwind the BRAC without tearing the whole thing apart.

  • And so we think that it's very positive.

  • The first group is on track to move and the entire move is completed in early 2011.

  • Brendan Maiorana - Analyst

  • Okay, thanks.

  • And then last, in terms of Colorado Springs, there have been in terms of your leasing there over the past few periods I think there have been some rental rate rolldowns.

  • Is that just the particular deals that have happened there?

  • And how do you think about the long-term growth rate of that market relative to some of your core markets in the BW Corridor or Northern Virginia?

  • Steve Riffee - CFO

  • I think that market is coming off a [truff] that happened because it was affiliated with Denver and the tech boom coming off of the late 1990s and in early 2000's.

  • And so when we invested in that portfolio, that market, rental rates were reasonably depressed.

  • They're starting to come back.

  • We have not had a lot of leasing activity there since we acquired the portfolio.

  • So yes, we've had minor rolldowns but has related to a very small amount of square footage.

  • So I think until we have some big renewals, we won't be able to support the fact that rental rates are increasing pretty significantly in that market.

  • Brendan Maiorana - Analyst

  • And in terms of the core growth of that market just long-term, do you think that that's roughly in-line with your other markets?

  • Steve Riffee - CFO

  • Yes, because it's coming off of a very low rental rate base.

  • Brendan Maiorana - Analyst

  • Okay, great.

  • Thanks.

  • Operator

  • Dave AuBuchon, A.G.

  • Edwards.

  • Dave AuBuchon - Analyst

  • Thanks.

  • Roger, I believe you mentioned when went through your submarkets that you thought market rents in Northern Virginia would be increasing for the balance of the year.

  • Relative to the supply that you've seen in that market can you kind of go through why you believe that will continue?

  • Roger Waesche - COO

  • Well, I have to start by saying that we have not -- we're not very active in that market right now because as you know we're 99.4% leased.

  • But we are -- obviously we have an asset manager there that's in play and getting around and understanding the dynamics of that market continuously.

  • And I think what's happened is that the -- it all has to do with replacement costs.

  • The significant cost increase on the new buildings that have been built are such that the landlords are asking pretty significant rents for them now.

  • Will somebody blink if we get enough square footage and there's not enough demand?

  • It's possible.

  • But I do expect that rental rates will increase over where they've been historically along the Toll Road and in the Dulles South market.

  • Dave AuBuchon - Analyst

  • If you care to venture a guestimate?

  • Roger Waesche - COO

  • I really don't know because we haven't been that active in the last nine months.

  • Dave AuBuchon - Analyst

  • Okay.

  • On the retail side, Roger, I believe you mentioned that you're at least thinking about adding retail pads to the portfolio.

  • Would that -- as you contemplate it right now, would OFC be the developer there or would you I guess sell off the land before?

  • Roger Waesche - COO

  • I think our goal would be to try to do land leases which would add to the NOI of that total complex.

  • And then as we sell it or finance it to realize the benefit from what we've achieved.

  • Dave AuBuchon - Analyst

  • And the time frame do you believe where you can achieve something that would be meaningful to numbers?

  • Roger Waesche - COO

  • I think it's over a number of years.

  • It takes a year or two from the time you start planning and get through planning and do carve-outs and sign up tenants and they build.

  • So I think it's a two to three year process but I do think it will be meaningful to our portfolio over that time.

  • Dave AuBuchon - Analyst

  • And do you envision this throughout your portfolio or is this concentrated mainly perhaps in the Nottingham assets?

  • Roger Waesche - COO

  • No, it's throughout our portfolio.

  • Dave AuBuchon - Analyst

  • Rand, you mentioned the data center space.

  • How deep do you think that market is and how far I guess does COPT have an interest in expanding in that area?

  • Rand Griffin - President and CEO

  • Well, we're studying it, as I said, pretty intently.

  • The interesting thing is that the data centers that were built in the late '80s and '90s are basically outdated.

  • Increasingly, there's so much computer power that it's throwing off significant heat factors.

  • The cooling of those facilities just isn't adequate enough.

  • And so we're seeing coming from our government defense as well as other tenants significant requirements.

  • And I think we differentiate ourselves from Digital or some of the other models out there and that we've seen so far very large tenants who would like to lease facilities, who do have security requirements and are typically single-tenant large buildings and very creditworthy.

  • And so we've been looking at it.

  • As I said in the script we have added some people on the data center expertise side of it and do see this ramping up.

  • We are studying it some more and we'll be able to give some further edification to it, I think, over the next several quarters.

  • Dave AuBuchon - Analyst

  • And do you believe those opportunities kind of match with your current portfolio concentration?

  • Rand Griffin - President and CEO

  • Yes.

  • Dave AuBuchon - Analyst

  • And returns -- and I know you're still studying it but you mentioned relative to whether or not you would buy back stock that your unleveraged returns in your development are 10 to 11%.

  • Do you perceive the economic returns in the data center business matching that 10 to 11% or greater?

  • Rand Griffin - President and CEO

  • I think they're probably a little higher, although what's interesting is you spend a little bit more money on this space, so pound for pound.

  • As you're doing some of these you're getting more FFO out of it, more NOI out of it because of the higher investments.

  • Because we are also probably the largest owner of secured space in the country other than the government, we have been used to those kinds of levels in our investments and returns on that.

  • We think it would match the secured space to being slightly higher than that as far as returns.

  • Dave AuBuchon - Analyst

  • Okay, and the last question.

  • Steve, I believe you mentioned that you were looking at renegotiating the lines.

  • Can you just kind of talk about where -- when that may occur and what pricing you may achieve on that?

  • Steve Riffee - CFO

  • Well, I don't think we'll talk about specific pricing while we're renegotiating but we are -- we think it -- we're hoping it will be favorable and we're thinking it will be favorable to where we've been.

  • And we're trying to get that done in this quarter.

  • Dave AuBuchon - Analyst

  • Okay, will you be also negotiating an increase in the lines?

  • Steve Riffee - CFO

  • We'll certainly consider that as we are evaluating it.

  • It's a possibility.

  • Operator

  • Chris Lucas, Robert W.

  • Baird.

  • Chris Lucas - Analyst

  • Just a couple of specific questions, starting with Steve if I could.

  • On the debt financing that was completed, were the proceeds from that fully allocated during the quarter?

  • Steve Riffee - CFO

  • Yes.

  • Chris Lucas - Analyst

  • Okay.

  • And then in terms of the G&A run rate, is the second quarter run rate -- or the second quarter rate, a good run rate going forward?

  • Steve Riffee - CFO

  • Yes, I think at the beginning of the year we said that $5 million is what we will average for the quarter.

  • In any one quarter it might fluctuate slightly but at this point we think that's a good expectation on average for the full year for each quarter.

  • Chris Lucas - Analyst

  • And then lastly, on the guidance issue, going into the year was the gain from the sale of the investment part of the original guidance?

  • Steve Riffee - CFO

  • Well, we do ranges and we had an estimate that there would be a capital event.

  • So we had a possible outcome and we also were guessing on timing like the third quarter.

  • We had that as a possibility, although it came in depending upon our estimates $200,00 to $400,000 higher than we had anticipated.

  • Chris Lucas - Analyst

  • Okay, and then I guess in terms of the second half of the year, are there any other anticipated sort of non -- what I would call non-core items that might hit the FFO?

  • Steve Riffee - CFO

  • No, although I will say that when you think about gains whether it's land sales or something like TractManager, we'll continue to be opportunistic.

  • I think we had talked about the fact that we've acquired Fort Ritchie and White Marsh and there's a lot of value to harvest.

  • That's going to be more in future years.

  • There's not a large amount of room in our expectations for gains, although the top end of the range would accommodate a penny or slightly more of potential gains if they presented themselves opportunistically.

  • Chris Lucas - Analyst

  • Okay.

  • And then, Roger, just in terms of what you're seeing in your suburban Baltimore portfolio activity, I know you're fighting through a fairly significant level of lease expirations.

  • What sort of traction are you getting beyond just dealing with those in terms of actually lifting your occupancy levels there?

  • Roger Waesche - COO

  • I think we are seeing a lot of activity.

  • We are encouraged by that.

  • I will have to admit, though, that there is some competition; not in White Marsh but in the Hunt Valley region there are some other buildings that are competing for the same opportunities.

  • But we're cautiously optimistic.

  • We have spent the past year investing some money in the buildings and we will -- we hope to bring our COPT landlord persona to the tenants and hope that they will come into the COPT portfolio.

  • Chris Lucas - Analyst

  • Okay, and then in terms of just lease spreads you're seeing -- and primarily, really, I guess in both in Baltimore and in the BWI Corridor.

  • You'd commented before about sort of looking at all aspects of the lease.

  • Were you sort of inferring from that you're willing to go lower on TI's and keep the rents down as opposed to pushing rent spreads and paying up for the TI's?

  • Roger Waesche - COO

  • Right.

  • As a leasing philosophy, we try to minimize leasing transaction costs.

  • Obviously we're willing to pay the brokers to bring tenants to us, but in terms of leasing costs, TI's, we really try hard to minimize those costs.

  • I think historically you would find relative to other landlords that we are on the very low of transaction costs with respect to leasing.

  • Chris Lucas - Analyst

  • As far as just lease spreads going forward on future expirations, what do you foresee there?

  • Roger Waesche - COO

  • I think to give it a little bit of context, about almost two-thirds of our leases are in the BW Corridor and the suburban Baltimore market.

  • Our lease structures have a couple of components to them.

  • One is that in this market we get annual increases of 2.5 to 3%.

  • And then we also have expense stops with each lease; that is, if operating expenses exceed the actual expenses for the first year, we pass those on to the tenants.

  • And so when we look at our leases from a face rate to a face rate standpoint from a cash standpoint, I think we are approximately 8% under market.

  • However, when you look at it from a total rent standpoint, that is, when you include the pass-through of operating expenses that have happened over the last five years of the lease, and take the total cash rent and compare it to the new cash rent, I think we're in the 1 to 2% range.

  • The issue there has been in operating costs.

  • During the past five year period we've had a 35% increase in utility costs.

  • And the tenants have had to absorb that cost.

  • However, so instead of our face rates at the end of the lease maturity being up about 12.5% from the annual rent increase, they're actually up about 21% because what we've been passing through the tenants.

  • So I think if rents increase as they have been in the past and they have been, and expenses stabilize, our cash rent spread changes will improve going forward.

  • And then I would add to that as a override, again, that we focus very hard on net effective rents.

  • And so we work the PI and transaction costs of the transaction significantly.

  • Chris Lucas - Analyst

  • That's very helpful, thank you.

  • And then just a couple of quick questions.

  • Rand, just in terms of strategically where you guys are, any thoughts to new markets at this point in your evolution?

  • Rand Griffin - President and CEO

  • As we had said in other quarters, when we went into San Antonio and Colorado Springs we had 10 other markets sort of on our horizon.

  • With the acquisition of the Nottingham portfolio, that's in effect like doing one of those other markets.

  • And so I think for this year we've pretty well put that on hold but are looking at, still studying that for going forward.

  • No specific timing but good activity in that regard.

  • Chris Lucas - Analyst

  • And then last question, just on the status of the option with Booz Allen.

  • Is there any movement there?

  • Roger Waesche - COO

  • They have until April 30, '08 to exercise their option.

  • At this point we're not sure whether they'll do that and what the timeframe would be if they're going to do it.

  • Chris Lucas - Analyst

  • When would you expect sort of material serious discussions to really begin if there were going to be any?

  • Roger Waesche - COO

  • Not until the end of this year.

  • Chris Lucas - Analyst

  • Okay, great.

  • Thank you very much.

  • Great quarter.

  • Operator

  • Michael Bilerman, Citigroup.

  • Michael Bilerman - Analyst

  • On the development deliveries in the quarter, when did those start income-producing?

  • Roger Waesche - COO

  • The biggest one, 193,000 square feet came on May 15 and the smaller one came on June 1.

  • Michael Bilerman - Analyst

  • And then by the same token, the stuff that's supposed to hit in the third and the fourth quarter, what's the timing of those deliveries?

  • Steve Riffee - CFO

  • In terms of the third quarter, we only have two assets delivering and one is very small.

  • It's a build to suit for the US government.

  • And that is going to hit August 1.

  • And then our headquarters building where we have some lease up is really phasing in over the extent of the quarter.

  • Michael Bilerman - Analyst

  • And then in the fourth -- the two buildings in the fourth quarter, are those early or late?

  • Roger Waesche - COO

  • Fourth quarter, we're expecting the Technology Drive in Lebanon, Virginia to deliver around November 1.

  • And our 320 NBP building, we're expecting that to deliver in mid-December.

  • Michael Bilerman - Analyst

  • And then thinking, just stepping back, Rand, you talked a little bit about the funding requirements, not having to raise equity this year or next.

  • When you step back from it in terms of the balance sheets, I guess if the development pipeline starts to ramp in terms of starts from where you are today, there's going to be time where there's going to be a lag between spend and income recognition relative to the current pace.

  • Where are you comfortable fixed charge dropping to in that sort of intermediate period in terms of increasing leverage and requiring to fund that development, that increased development?

  • Steve Riffee - CFO

  • Hi, this is Steve, Michael.

  • I think we're comfortable if we got up to leverage to value ratios of 62 to 63% and I think that's how we're thinking about it, from a market money, the assets.

  • We also watch coverage and we always want to stay above 2 on a fixed charge standpoint.

  • Michael Bilerman - Analyst

  • Do you find, I mean right now it's 2.3, 2.2-ish, is that going to drop below 2 or are you going to have a concerted effort to keep it above 2?

  • Steve Riffee - CFO

  • We don't think it will drop below 2.

  • Michael Bilerman - Analyst

  • Rand, I'd be curious on your expectation of cap rates over the next two years in terms of assets?

  • Overall.

  • Rand Griffin - President and CEO

  • As we've said, we have not seen the cap rate movement at all.

  • In fact, on the things we've been bidding on and obviously not being successful, if anything there's been cap rate compression.

  • It does appear that what's in particularly the Northern Virginia and DC marketplace that buyers have been willing to buy empty buildings at significant premiums that we view to replacement costs.

  • And they're bearing the risk of the future growth on rental rates and the future fit up costs.

  • So they're in a different league than we are, I think, in terms of their expected returns.

  • And as long as that's going on, you're just not going to see upward movement on cap rates.

  • So that's why we said we don't see any sort of viability for acquisitions well into 2008.

  • I think if you try and apply some logic to it, you should see -- and this is probably the second half of 2008 -- as this flood of money sort of works its way through the cycle rates should start to move, cap rates move a little bit.

  • And maybe at that point we'll be able to start to afford some of these acquisitions.

  • Now, our niche is we can look for things that require units or say, special situations like the Nottingham transaction where they were looking for multiple issues to solve.

  • And we'll do well in those sorts of things.

  • So I think that rates in general as you look at it will have the opportunity to finally come to the forefront in terms of their favorable capital structure next year and the ability to solve some of these other issues.

  • Over the last three, four years those issues just got blown aside with the pricing and the ability of these leverage to buy out people to move very quickly.

  • So hopefully that seems to be on the phase-out and rates will come to the forefront again.

  • But I don't think it's going to take until next year.

  • Michael Bilerman - Analyst

  • A clarification on guidance.

  • Steve, I guess at the high-end you're saying there's $0.01 or $0.02 of either land sales or other types of gains in the back half of the year?

  • Steve Riffee - CFO

  • There's room for it.

  • I don't think it will -- it may not be that high but we think maybe a penny or a little more.

  • Michael Bilerman - Analyst

  • And that's what's included in guidance.

  • What's on the lease term fee side in the back half of the year?

  • Steve Riffee - CFO

  • [This half] we expect to average are our 1.25 million.

  • 1.25 million, which is what we typically give guidance as our run rate.

  • Michael Bilerman - Analyst

  • And then, Roger, was there anything happening in the second quarter in terms of leases that may have ended or begun where you're going to pick up or lose in terms of the run rate similar to the first quarter?

  • Roger Waesche - COO

  • Nothing significant.

  • There's a little bit of adds and subtracts but on a net basis it's not going to impact the third quarter.

  • Michael Bilerman - Analyst

  • Okay.

  • Rand, just on the data center stuff.

  • How are you thinking about funding the improvements versus not?

  • And obviously the capital cost is significantly different in either case given -- I'm just wondering how you're thinking about expanding in that business and whether you'd be owning the improvements are letting the tenant do the buildout?

  • Rand Griffin - President and CEO

  • Well, I think if you take the model of what we have done to date, it's a little different than the Digital model.

  • I mean, we do build the building as opposed to buy the building.

  • The building typically has significant electric requirements, has setbacks, has the necessary security and then the water usage capabilities.

  • And so, when you look at it those are all baked into a return on the rental rates.

  • And the improvements inside where you're doing equipment, we're not doing the computers inside or the racking or things like that.

  • We're really dealing with the real estate and that's eminently financeable and we get the returns on that.

  • And that stays with the building on a long-term basis.

  • So we're very comfortable that that can occur.

  • We haven't figured out so far on the situation of the VITA buildings, where we have both of those coming online by year-end, how we want to monetize that.

  • But we're studying that in terms of the capability of those kinds of repeat deals being elsewhere and helping to accelerate the data center business.

  • Michael Bilerman - Analyst

  • And then just lastly on the development, can you just walk through again, the pipeline today is 570, how you view that growing.

  • You talked about $1 billion, I don't know if that was in excess of the 570, sort of the amount of starts are going to happen.

  • And then on the other side when you expect that deliveries start to hit, I just wanted to get a better sense of how things will shake out.

  • Rand Griffin - President and CEO

  • The billion is in excess of what's -- when we talk about development and construction activities, we have really three categories.

  • We have under construction, which you see identified on the supplement; we have under development which we anticipate will start within a year; and then we have under redevelopment which can be going on in that timeframe.

  • So when I talked about the $1 billion in additional starts, we really look for the second half of this year.

  • So you have the 1.3 million square feet is included in that in the development section.

  • And then beyond there, it goes, it ramps up pretty significantly.

  • So it's about 1.5 million of starts in '08 and over 2.5 million of starts in 2009.

  • And then that stays at that kind of level in 2010 and 2011 although we didn't try and address that in that as part of that $1 billion starts.

  • And typically when you're looking at it, you have a bell shaped curve for -- it takes you about a year to build these projects and sometimes they're producing income.

  • The VITA one, for example, is in a year you'd built it and had income.

  • And sometimes you have very sophisticated tenancy requirements and it takes another six months or so after completion of construction to be realizing the income.

  • Michael Bilerman - Analyst

  • Right.

  • And so the billing is the [265] that's under development today and then another, call it, [700 million, 800 million] of starts over '08 and '09?

  • Rand Griffin - President and CEO

  • Correct.

  • Michael Bilerman - Analyst

  • And then I assume the starts in '08 are now going to be weighted towards a late '09, '10 delivery type of timeframe?

  • Rand Griffin - President and CEO

  • Most of the '08 starts will deliver in 2009.

  • Again, a one year timeframe.

  • Michael Bilerman - Analyst

  • Okay.

  • Thank you.

  • Rand Griffin - President and CEO

  • Again, I think it's important to note that 60 to 70% of those starts are government and defense related so it's a little bit recession proof if you're looking on that part of the economy.

  • Michael Bilerman - Analyst

  • Great.

  • Thank you very much.

  • Operator

  • (OPERATOR INSTRUCTIONS) Charles Place, Ferris, Baker Watts.

  • Charles Place - Analyst

  • If you could -- looking at your leases and those that are expiring over the rest of '07 and for 2008, what do you anticipate to be a retention rate for those expiring leases?

  • Steve Riffee - CFO

  • Historically we have been in the 60 to 75% range.

  • And so I think we will be inside of that range.

  • I can't give you an exact number but looking out and understanding who some of the tenants are and what their long-term desire to be in certain locations is I think we're comfortable saying that we should be able to stay inside of our 60 to 75% range.

  • Charles Place - Analyst

  • I know that -- I think you answered this with Chris Lucas' question -- as far as looking again at those leases, are they -- I got the impression they were a little bit below market.

  • You mean you expect some positive rental rates from the renewals and new leases?

  • Roger Waesche - COO

  • Yes.

  • We'll have more GAAP increase than we will cash but yes, there will be increases on the (technical difficulty)

  • Charles Place - Analyst

  • And Roger, on the -- I missed this when you were going through the Nottingham discussion about occupancy.

  • What was the -- if you can refresh my memory -- what was the occupancy at acquisition and where is it now?

  • Roger Waesche - COO

  • The occupancy at acquisition for the entire Nottingham portfolio was 85.7% and that's where it sits today.

  • And recall that 1/3 of that portfolio had leases maturing during 2007, a majority of which we've already taken care of.

  • There's still a few leases that don't mature until the end of the year.

  • Charles Place - Analyst

  • I thought I have a note here that your occupancy was at 90%.

  • Was that just for a submarket for Nottingham today?

  • Roger Waesche - COO

  • Right.

  • For Howard County, it's 90%.

  • So obviously we are lower in White Marsh than we are in Howard County.

  • Charles Place - Analyst

  • Okay.

  • I also wanted to ask about, there's a 50 million of I believe it's mortgage debt maturing in the second half of '07.

  • Is that going to be refinanced or how are you going to address that?

  • Mary Ellen Fowler - VP and Treasurer

  • Charlie, this is Mary Ellen.

  • We have one loan -- it's actually two loans coming up.

  • One was a construction loan that can be extended and the other one is a term loan with Wachovia that can be extended -- it will be extended, actually, [throughout] $34 million.

  • Charles Place - Analyst

  • Okay.

  • And I guess your discussions with the banks and I know you've kind of touched upon this already but just to kind of hit it maybe from a different angle of has there been any increases in rates when you're out there talking about the debt financings that you're contemplating?

  • What kind of impact, if any, has the increasing credit spreads had in your discussions with banks, if any?

  • Mary Ellen Fowler - VP and Treasurer

  • I think two things are going on really in my view.

  • One is as far as the short-term money goes, and that would be the commercial bank that market, I think pricing has come in for REITs this year.

  • At least that's what happened so far.

  • And so we're anticipating that.

  • Probably with our line we'd be able to reduce our spread some still going forward.

  • I think in the permanent debt market spreads have widened, probably as Steve said, in the range of [20] to 50 basis points.

  • Although I will say that we've seen the treasury, the ten-year treasuries, have come downs some.

  • So, I think our view is we'd wait until this fall to kind of see, I think there's some settling going on in the permanent debt market.

  • And so once we kind of see where that ends up, we'll make some decisions about our next financing.

  • Charles Place - Analyst

  • Great.

  • Thank you very much.

  • Operator

  • There are no further questions at this time.

  • I would now like to turn the presentation back to Mr.

  • Rand Griffin for closing remarks.

  • Rand Griffin - President and CEO

  • Thank you for joining us today.

  • As always we greatly appreciate your participation and support, particularly in these volatile market.

  • Roger, Steve, Mary Ellen and I are available to answer any other questions you might have.

  • Thank you and have a great day.

  • Operator

  • Ladies and gentlemen, thank you for your participation in today's conference.

  • This concludes your presentation.

  • You may now disconnect.

  • Good day.