COPT Defense Properties (CDP) 2013 Q2 法說會逐字稿

Welcome to the Corporate Office Properties Trust second quarter 2013 earnings conference call.

As a reminder, today's call is being recorded.

At this time, I will turn the call over to Stephanie Krewson, COPT's Vice President of Investor Relations.

Ms. Krewson, please go ahead.

Thank you, Stephanie.

Good afternoon and welcome to COPT's conference call to discuss the Company's second quarter 2013 results.

With me today are Roger Waesche, President and CEO; Steve Riffee, Executive Vice President and CFO; Steve Budorick, EVP and COO; and Wayne Lingafelter, EVP of Development and Construction.

As management discusses GAAP and non-GAAP measures, you will find a reconciliation of such financial measures in a press release issued earlier this morning, and under the Investor Relations section of our website.

At the conclusion of management's remarks, the call will be opened up for your questions.

Before turning the call over to management, let me remind all of you 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, actual results may differ from those projected.

Factors that could cause actual results to differ materially include, without limitation, the ability to renew or re-lease space under favorable terms, regulatory changes, changes in the economy, the successful and timely completion of dispositions, acquisitions and development projects, changes in interest rates, and other risks associated with the commercial real estate business, as detailed in our filings with the SEC.

I will now turn the call over to Roger.

Thank you, Stephanie, and good afternoon everyone.

Our second quarter was strong along many fronts.

Development leasing is firmly ahead of plan and leasing in our operating portfolio is in line with expectations, despite the lack of clarity on future defense spending levels.

We are realizing better NOI margins at our properties and we continue to improve our balance sheet.

Therefore, even in light of the uncertainties surrounding defense spending, we are increasing our guidance for FFO per share, as adjusted for comparability, for 2013 to a range of $1.92 to $1.97.

The second quarter also presented a few new challenges that we will manage through over the next several quarters.

First, it is unlikely that the sale of our portfolio of properties held for sale in Colorado Springs will close in the third quarter.

When we made the decision to monetize this portfolio, the buildings were 77.8% occupied and generated about $12 million of annual cash NOI.

Today, these same buildings are 88.3% leased with additional leasing in process that will increase the annual cash NOI to $15 million.

Because of our strong leasing success in Colorado Springs over the last 18 months, the delay in the disposition process is an acceptable intermediate outcome.

We remain committed to exiting Colorado Springs, but we will do so in an orderly, rational fashion that ensures our shareholders receive fair value.

The second challenge that emerged during the quarter relates to some new vacancy that we now expect to realize in our operating portfolio.

Many defense contractors completed their space rationalizations ahead of the anticipated budget cuts while others were still in the process of rightsizing.

The onset of sequestration has clearly accelerated the decision making of this latter group.

As a result, we are forecasting a modest uptick in our portfolio vacancy over the next few quarters from June 30 levels.

We have been successfully managing the shrinking space needs of customers for several years, owing to the tepid economic recovery and lack of clarity around defense spending.

Although some customers are likely to give back a bit more space than we originally forecasted, others are beginning to expand operations or are looking to capture operating efficiencies by consolidating into one of our newly developed buildings.

Accordingly, the modest increase in near-term vacancy spurred by sequestration is very manageable, especially when weighed against the long-term value creating events that have been taking place in our development pipeline.

In the second quarter alone, we increased our development pipeline by two fully leased buildings, aggregating nearly 400,000 square feet.

We also increased the pipeline's pre-lease level from 62% on March 31, to 74% on June 30.

Of the 1.5 million square feet currently under construction, only 407,000 square feet are not committed, and we have good visibility on demand for much of that space.

So even though sequestration is causing some customers in our strategic niche to reduce their space needs in a few locations, others have had their contracts awarded or affirmed and need efficient new facilities that are adjacent to their government customer.

I'll wrap up my opening remarks with a few comments about the federal budget negotiations and the implications for the DoD's budget.

The sequester kicked in on March 1, which had the impact of reducing fiscal year '13 defense spending by $37 billion.

While our politicians don't agree on much, they do agree that allowing the defense budget to continue to absorb the $52 billion of annual sequestration cuts is not in the best interest of the country.

This common ground is borne out by the fiscal 2014 budget proposals put forth by each party.

The President's fiscal '14 proposed baseline defense budget is $526 billion, a $1 billion reduction from fiscal '13, and ignores sequestration.

Congress has proposed a slightly higher reduction.

Lower projected deficit for this year has lessened the urgency to compromise so it's possible that sequestration cuts remain in the DoD's budget for fiscal '14.

However, we think it is more likely that Congress and the White House will finally compromise regarding the DoD budget even if a broader budget compromise is still months or years away.

Notwithstanding the budget cuts and constraints, the continued positive for COPT is the Company's strategy and portfolio are aligned with DoD spending priorities.

For example, cyber security funding is currently slated to be increased in fiscal '14 by as much as 20% and our locations supporting knowledge-based defense installations stand to gain from sustained strong support for an ever-expanding cyber program.

On that note, I will turn things over to Steve Riffee to discuss our second quarter results and our revised guidance for the second half of the year.

Steve?

Thanks, Roger, and good afternoon everyone.

Second quarter diluted FFO per share, as adjusted for comparability, was $0.52, which equaled the midpoint of our revised and increased guidance range.

The $0.05 outperformance over our original guidance was due to $0.02 of higher-than-normal development fees and modestly lower G&A, and $0.03 of property NOI, of which $0.01 is recurring savings in operating expenses resulting from energy saving programs and continued efficient property management practices; another $0.01 came from one-time savings on items such as property tax refunds; and $0.01 related to repair and maintenance expense we expect to incur in the second half of the year.

At June 30, our same office portfolio represented 86% of total consolidated square feet.

Excluding lease termination fees, second quarter 2013 same office cash NOI grew by 1.6% over the second quarter of 2012, which was slightly ahead of our expectations.

Including lease termination fees, same office cash NOI rose 3.5% over the prior year period.

Within the same office pool, strategic buildings, namely those that are adjacent to government demand drivers as well as those primarily leased to government and defense IT tenants represented 77% of the total same office cash NOI.

During the second quarter 2013, these strategic buildings were 94.8% occupied on average, and ended the quarter 95.4% leased.

For the strategic properties, same office cash NOI including lease termination fees increased 2.9% in the second quarter, and excluding lease termination fees, increased 2.3%.

Turning to the balance sheet.

We had another active quarter.

In April, we redeemed our $85 million of Series J Preferred Shares that paid a 7 5/8% dividend.

In May, we completed our debut bond offering.

We issued $350 million of 10 year, unsecured bonds at a yield to maturity of 3.6%.

With the proceeds, we repaid $100 million of our term loans and then in June, we successfully tendered for nearly all of the $186 million of senior exchangeable notes that were outstanding.

The tender accounted for the majority of the $0.24 loss on the early extinguishment of debt in the quarter.

The annual FFO per share benefit from buying back those notes is approximately $0.05.

Subsequent to the close of the quarter, we closed on a renegotiated $800 million line of credit, lowered its pricing and extended the maturity date to July 2017.

On $550 million of our term loans, we also lowered pricing and negotiated extension options.

We're grateful for the continued support of our bank group.

All this activity, combined with our first quarter equity offering, has improved balance sheet and operating metrics from the beginning of the year.

As of June 30, the Company's debt-to-adjusted EBITDA ratio has improved to 6.9 times from 7.2 times during the fourth quarter 2012.

Also, our fixed charge coverage has improved over year-end 2012 levels.

Our longer-term balance sheet objectives include lowering leverage and further extending our debt maturities.

Earlier this month, we issued 1.5 million shares of common stock through our ATM.

The average price per share was $26.05, and our net proceeds were $38.5 million.

We continue to monitor the long-term debt markets to determine the appropriate time for transactions that will extend out our debt ladder.

Now turning to guidance.

In this morning's press release, we increased our previously issued guidance for 2013 diluted FFO per share, as adjusted for comparability, of between $1.83 and $1.93, to a new range of between $1.92 and $1.97.

We are establishing third quarter 2013 diluted FFO per share guidance at a range of $0.47 to $0.49.

Now, to get to our third quarter range, take the $0.52 we reported in the second quarter and subtract the following items -- $0.02 from higher-than-normal development fees and G&A savings; another $0.01 from the one-time operating expense savings in the second quarter; and a $0.01 related to the delayed timing of R&M spend in the second quarter.

Subtracting these $0.04 of one-time items implies FFO per share for the third quarter of $0.48.

When combined with our revised full-year guidance range, our third quarter guidance implies an FFO per share range for the fourth quarter of between $0.45 and $0.48.

Three factors are driving the wider range in the fourth quarter -- the ultimate timing and execution of the sale of operating properties in Colorado Springs; the modest amount of new vacancy, and whether or not we [term] out any more debt before year end.

With that, I'll now turn the call over to Steve Budorick.

Thanks, Steve, and good afternoon, everyone.

The Washington-Baltimore Regional Office market continues to experience the effects of a slow economic recovery, a contraction in federal spending and occupancy requirements and uncertainty resulting from the now four-year-old environment of continuing resolutions and sequestration spending reductions.

Regional suburban vacancies continue to be in the 16% to 17% range and year-to-date net absorption regionally was slightly negative at mid-year.

Macro trends continued to include consolidation, intensification, short-term extensions, and flight-to-quality when longer-term decisions are made.

Submarket results are highly varied across the greater Washington, DC region and roughly half the submarkets experienced positive absorption year to date.

Of the 73 regional submarkets tracked by CBRE, 18 experienced negative absorption in excess of 50,000 feet, representing a combined total negative absorption of 2.7 million square feet whereas the region, as a whole, experienced negative 615,000 square feet.

The remaining 55 submarkets, when isolated from the worst performing submarkets, produced almost 2.1 million square feet of positive absorption year to date.

These facts support the proposition that BRAC dislocations are concentrated in a few submarkets and overall flight-to-quality is rewarding the best submarket locations.

The Baltimore and B-W Corridor portion of the region is experiencing relatively strong demand, an increasing number of tenant expansions and longer lease terms.

The demand has been stronger than expected in several submarkets including Columbia, the Fort Meade area and White Marsh.

We're exceeding our leasing objectives in the B-W Corridor and attribute this momentum to growth in cyber, healthcare and professional services.

The Northern Virginia submarkets in which we operate are generally well positioned.

Demand has improved in the small commercial and defense contractor tenant segments and our team has executed over 75,000 square feet of new and renewal leases in our same office portfolio, commencing in 2013.

On the other hand, there are a few large defense contractors who are downsizing or deferring long-term decisions until sequestration has resolved.

Accordingly, we have assigned a low renewal probability on a few locations and expect some attrition on 2014 expirations.

In terms of leasing, during the second quarter, we leased over 1 million square feet, including 460,000 square feet of new development space.

Our revenue at risk is to achieve the midpoint of our guidance is only $5.2 million, and we have transactions in progress for $4.4 million, leaving just under $800,000 of unidentified revenue at risk.

In terms of economics on renewing leases, during the second quarter, our GAAP rents on renewals increased by 6.2%, and cash rents declined by 2.2%, both of which were consistent with our expectations.

During the quarter, 50% of renewing leases rolled up on a cash basis, including most of the renewals in Maryland.

12 leases rolled down during the quarter, the largest of which was in Northern Virginia.

We continue to see demand for new properties in strategic locations.

Our development leasing goal for 2013 was 400,000 square feet.

We did 100,000 square feet in the first quarter, and over 460,000 square feet in the second quarter, putting total development leasing for the year well over 0.5 million square feet.

During the second quarter, we signed two 10-year, full building leases, aggregating 395,000 square feet in new projects in Northern Virginia.

We also leased 37,000 square feet at NBP 420 to two tenants, taking that development project from 0% leased at the end of March to 27% leased at June 30.

The upside to our 2013 guidance is not dependent on this or other 2013 development leasing, the NOI from which won't kick in until 2014 and 2015.

However, the development leasing activity we have announced does evidence a continued improvement in demand that began several quarters ago, which bodes well for COPT's growth.

We refer to suites that have been vacant more than 18 months as stubborn vacancies.

Year to date through June 30, we leased 195,000 square feet of stubborn vacancy.

These suites had a weighted average downtime of 33 months, and require average leasing costs of about $38 a square foot, which is slightly higher than typical re-tenanting costs but not unexpected.

We achieved a weighted average lease term of 6.2 years on stubborn vacancies so we've locked in above average lease terms as well.

On balance, the second quarter leasing was extremely positive.

One setback during the quarter, however, occurred at Arborcrest, a redevelopment project in Blue Bell, Pennsylvania.

Recently, Merck informed us that they will not be renewing the lease on their 218,000 square foot building when it expires in February of 2014.

The Merck lease represented approximately $2.7 million of annual NOI, or roughly $0.03 in annual FFO per share.

Recall that we intend to monetize our investment in that project once the redevelopment is far enough long to maximize our exit value.

We are evaluating the impact of the Merck vacancy on the timing of our value creation and sale process and we'll provide updates as appropriate.

Before turning the call over to Wayne, let me give a brief update on COPT DC-6, our wholesale data center in Manassas, Virginia.

The second quarter was rather unproductive in Northern Virginia with very few new deals.

We estimate the Northern Virginia market now has about 14 megawatts of wholesale capacity in Tier 3 properties competitive to DC-6.

We are currently tracking prospects representing about 10 megawatts of demand and the users behind that demand continue to be methodical in their decision-making.

We expect demand to strengthen in the later part of the year in Virginia and nationally as it did in 2012.

Earlier this week, we announced a 2-megawatt lease with a Fortune 100 global consumer electronics and technology company.

The lease start date is in the fourth quarter of 2013 and based on the 9 megawatts of existing build out, increases the facility's percentage lease to 70%.

Although the rate was modestly below market, we were able to [densify].

So on a per square foot basis, it was a good transaction for us and the customer.

We continue to be optimistic regarding both our wholesale and our co-location leasing opportunities in 2013 and look forward to updating you on future leasing progress.

With that, I'll turn the call over to Wayne.

Thanks, Steve.

I'll highlight changes to the construction pipeline which now totals 1.5 million square feet and is 74% leased.

I'll also add color about some of these active projects.

First, we completed the base building construction on 139,000 square feet in NBP 420 in April.

As Steve mentioned, that building is now 27% pre-leased.

Our tenants are scheduled to complete their interior improvements and take occupancy in the fourth quarter of this year.

Second, we began development work on a speculative 159,000 square foot office building in Northern Virginia early in the second quarter.

Subsequent to the commencement of these development activities, the project was fully leased to a strategic tenant.

Also during the quarter, we announced what essentially is a redevelopment to suit of a building we purchased for a customer in Haymarket, Virginia.

Finally, three projects in the pipeline, two of which are fully leased, remain on schedule and are expected to deliver in the second half of this year.

No projects were transferred to the operating portfolio during the second quarter, but two projects, 7175 Riverwood Road in Columbia, Maryland, and the first building at Patriot Ridge in Springfield, Virginia, are slated to be transferred to the operating portfolio during the third quarter.

Riverwood Road is fully leased to a strategic tenant and Patriot Ridge is about 50% leased.

Although the lease-up at Patriot Ridge has been delayed, we continue to view it as a promising, highly strategic project.

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

Thanks, Wayne.

I'll conclude by highlighting a few points.

Yes, sequestration is here and it has further impaired the defense industry's ability to conduct business, especially in Northern Virginia.

However, not every agency and not every submarket in the greater Washington, DC market, which includes Northern Virginia, is feeling the effects of sequestration the same.

In the B-W Corridor, which accounts for over 50% of our NOI, our submarkets are stable or they are improving, as evidenced by our strong leasing statistics.

In Northern Virginia, which accounts for 18% of our NOI, the situation is mixed.

On the one hand, leasing remains tepid at Patriot Ridge and slow to materialize, but we believe this will change once bargains are forged inside the Beltway.

On the other hand, we are seeing robust demand for new development at other locations in Northern Virginia.

While Washington is hashing out a long-term budget solution for the country, we'll continue to aggressively compete for every lease and continue to strengthen our balance sheet.

Our portfolio is aligned with programs and missions within the DoD that appear to be slated for only modest budget cuts or in the case of cyber, robust budget increases.

We've executed over 1.8 million square feet of development leasing in the past six quarters.

The positive economics from this extensive value-add activity will continue to improve our NOI in 2014 and beyond.

With that, operator, please open up the call for questions.

Thank you, Mr. Waesche.

(Operator Instructions)

Jordan Sadler from KeyBanc Capital Markets.

Hi, Roger.

Hi, Steve.

This is for you on the sequester.

Your color was helpful.

Wanted to -- curious about what you're hearing and seeing from your tenants regarding expectations for next year.

I mean, what sounds like internally we're hearing from our analysts that contractors are suggesting that they would expect next year to be tougher on the sequester.

I know we're focused on '13 right now but just curious on your thoughts on that.

Well, clearly the sequester kicked in on March 1 so we are experiencing it as I said $37 billion in this current fiscal year.

That grows to $52 billion when you have a fully phased in year beginning in fiscal '14, October 1 of 2013.

I would say that we are experiencing, what we have been experiencing for the last three or four years, with budget uncertainty, with continuing resolutions and now sequestration having been put into effect.

And so people have been rationalizing their business models, adjusting their cost structures and we feel like we are, as we've said before, in the fifth or sixth inning at least of that rationalization.

What we are now experiencing a little bit is some people wanting to accelerate their situations, extend leases and give back some space.

So we've been entertaining that to try to be proactive and try to preempt further difficulties down the road.

But I think generally speaking, there's still uncertainty out there.

So until the uncertainty goes away, people are still going to be cautious with their decision-making and space taking and we just have to live with that.

But we have been living with it for a long period of time.

It's all about how you're positioned in the DoD budget and fortunately, we've been -- we're better positioned than the budget as a whole, as manifested by our 1.8 million square feet of development leasing over the last six quarters.

It does sound that way, given some of the leasing -- the development leasing you've signed.

On the data center and DC-6, the 2 meg, it's -- I think Steve, you said modestly below market rent.

What does that mean?

Is that a below market rent for a wholesale lease or for a co-lo lease?

Yes, it's a little aggressive for a wholesale lease.

The important point there is that we worked very closely with this particular customer to achieve a mutually beneficial configuration and we were able to move them into our data center in very high density.

So all things being equal, they're stacked into about 80% of the space that you would expect a 2-megawatt user to require and that helps us to achieve a nice yield on that and give them the pricing they needed to deploy that particular use in their business model.

Given that you've got north of six, north of two-thirds of this thing knocked down, I'm curious, one, what your prospects are for the remaining third and then propensity to commission the other half?

Well, as I mentioned in the prepared remarks, we're tracking about 10 megawatts of leasing currently, and that's in various stages.

We are getting very excited about some of the activity around our co-location leasing which is really targeted at our government vertical, if you will, government and defense.

And so reasonably optimistic we're going to have some transactions in that vertical that are going to start consuming some additional power.

So optimistic about what we can do in the next two quarters and we are planning to be ready to add additional power when we get another 1.5 meg or so committed.

Josh Attie from Citi.

There were three things I heard in the prepared remarks that I thought you could provide more color on.

The vacancy that you see coming, Colorado Springs sale and also the ATM issuance.

Maybe we could start with the vacancy.

Where in the portfolio is it and how much in terms of square footage do you see as being at risk over the next six or 12 months?

Well, Josh, working with two large customers right now on rationalizing and rightsizing their footprint for the new sequestration environment.

One of those is 150,000 square foot lease of which 103,000 will be extended and roughly 50,000 we're considering taking back this year whereas the contract would not obligate us to do that until next year.

And then there's another that will produce about 30,000 square feet over the next two quarters.

So they're relatively modest but there are a few.

Now, having said that, I do want to point out that if you look at our new leasing this year, what we've done in the first half, about 327,000 square feet, is about 1.7% of our overall 19 million square foot portfolio.

And we do have good backlog of deals that we're working on in our existing assets.

So we're not exactly sure where things are going to shake out.

We're just giving you a heads up that we may be taking some space back with big customers.

And then lastly, when you look at occupancy, we're about to add in the coming quarter two buildings from our development pipeline into our stabilized portfolio and they will add about 0.7% of additional vacancy as well that will move that stat down.

So should we interpret that as there's -- it sounds like maybe 100,000 square feet that you think may come back to you and that's the issue?

Or that you feel less comfortable with the defense contractors in your portfolio generally and beyond that 100,000 square feet, there may be more?

I think the former more than the latter.

Okay.

On Colorado Springs, can you just explain to us, A, what happened, why is the sale being delayed?

And also from an accounting perspective, is Colorado Springs going to remain discontinued operation?

And then also lastly, what the impact of the delay in sale is on guidance?

Let me start with the transaction itself and then Steve can talk about guidance and discontinued operations.

First of all, I want to be clear that we want to exit the market.

We're not retreating the strategy.

What we want is reasonable, not optimal value.

Our shareholders have already suffered.

That portfolio's now stable and it's actually improving.

We do have the newest portfolio in town.

No new supply, because rents don't support new construction.

Right now, it's what we would call a capital markets issue and not a real estate fundamentals issues.

The issue is that we are selling into fear.

Our investors can't underwrite sequestration or defense budget segmenting like COPT can.

COPT would actually be the natural buyer of this portfolio because of our ability to underwrite the market and the different nuances of the defense budget.

But we're the seller.

And also, unlike the balance of our SRP where we didn't say what assets we were selling, we clearly communicated to the market that we wanted to sell this project and we wanted to sell it in this time frame and so that really hurt our leverage.

So what all we're trying to do now is to take some pressure off the deal for a little bit of time so that we can have an orderly sale of the project.

With regard to the held for sale accounting, the determining factor as to whether it's classified as held for sale as to whether we believe it will still sell within 12 months.

We haven't changed that assumption with regard to guidance.

The -- when you look at the fourth quarter range, we're assuming now that the deal wouldn't close until some point in mid-fourth quarter, at -- to be at the low end of the range and if we don't get it closed by the end of the year, we would be at the higher end of the fourth quarter range.

Okay.

Obviously keeping that versus the third quarter, that has a positive effect on the guidance versus what it was previously?

Yes.

We've increased the overall guidance for the year and tried to give you a new set of parameters for the fourth quarter.

Okay.

Roger, if I could just clarify something that you said.

You said it was a capital markets issue but also selling into fear and the sequester.

Was it that Treasury yields moved up and impacted cost of capital or is it -- was it more fundamental that buyers are concerned about leasing?

I think it's both.

I think, obviously, we were willing to take a discount to exit and then interest rates rose their ugly head in terms of and so it gave a buyer a reason to come back and want a different price.

And so, again, we just want to walk away for a little bit of time and let things settle down and then move forward either in a bulk basis or selling it off in pieces.

Okay.

And just lastly on the ATM.

I know you mentioned on the call but if you could just repeat because I didn't catch all the numbers.

How much did you issue, at what price and also when?

We issued after June 30, so we're still in the month of July, so that would tell you we issued in the month of July.

1.5 million shares common stock through the ATM; the average price was $26.05.

And our net proceeds were $38.5 million.

Okay.

And what was the -- I know you've had the ATM since last November and you haven't issued it at all and you've talked about it as being just an opportunistic source of capital.

What was the rationale for using it now?

Well, as we've announced a lot of success in the development leasing, we've increased our development spending estimates by $15 million above our prior range.

We feel really good about our development leasing momentum and opportunities and so we want to make sure that we keep up with our balance sheet metrics and capitalize our growth.

So we used the ATM to get a little bit ahead of it.

Okay.

Did any -- did the delay in the sale of Colorado Springs impact the decision at all to raise more equity?

We have a little extra equity above the increased development spend for the year, so it probably somewhat hedges that if we end up slowing down the sale just a little bit or have to sell it in more than one piece.

Brendan Maiorana from Wells Fargo.

Steve, Steve Budorick or Roger, so I just wanted to clarify on the vacancy.

So you've got the two tenants which are 80,000 square feet, maybe more that you get back and then it's also Merck in metro Philly and Blue Bell and that's the change so that's about 150 basis points to your overall occupancy or vacancy, maybe that you didn't expect three or six months ago?

Right.

And we also talked about placing Patriot Ridge into service.

Back in the beginning of the year, we felt we would have leasing on that project, when the balance of it went into service, so we're putting 120,000 square feet into service this quarter, which, that alone, represents 0.6% of our portfolio.

Doesn't look like our occupancy will necessarily go down this quarter, but end of the year, first quarter, we could see a reduction and that's why we wanted to highlight that to our investors.

Yes.

That's helpful.

And just those two tenants that, that -- the two tenants in Northern Virginia where it sounds like you're negotiating to get back some space but also renew.

Those were '14 expirations.

Was the outlook for the expirations in '14 likelihood that you'd renew all of the space and now you're getting some of it back or is it more just an accelerated timing, you get it back this year versus you previously thought you'd probably get it back next year?

Yes, it's more of an accelerated timing.

We expected to get some back from both.

We're just working with them to solve problems on their side.

And the space is good space and we're being compensated in our negotiation so we want to get that space and bring it back to market quickly.

Sure.

Steve, is this space in Westfields?

It's not.

Okay.

Can you provide an update on the negotiations with CSC and Northrop in Westfields?

Well, I think we previously disclosed that Northrop has terminated, and they'll be vacating 150,000 square feet from 15010.

CSC is under lease through March 15 or 30.

And we have no further information to report about that negotiation.

Both -- Brendan, both of those tenants are in one building, Washington Tech Park 1 and 2, which is a complex that we did a financing on, a $150 million CMBS loan in 2007, and so that works out to be $225 a square foot.

So at some point, we're going to have to work something out with the lender on that particular project.

Okay.

And then, okay, the new development that was -- that you guys started in Northern Virginia, that's 100% leased, is that in an existing park?

I recognize you're being purposefully vague in the supplemental.

But just wondering if that's an existing park or somewhere new.

Brendan, it's Wayne.

And we're going to continue to be somewhat vague about that and it's really -- we're going to defer detail, largely at the customer's request at this time.

So I'm not able to offer any additional color to you right now.

John Guinee from Stifel.

All right.

All right.

Well, nice quarter, guys.

Wayne, is building up in Blue Bell, the Merck building, is that, that two-story brick building in the woods?

It is, John.

Is that going to be a scrape or is there any chance of getting someone else to take that space?

Well, there's always a chance.

We just started to look at what our options are and we're going to consider the full range of options as we look at that.

I think Steve's team is looking closely at a re-lease scenario and our team will consider the redevelopment options.

That famous line from Dumb and Dumber, there's always a chance.

Okay.

Second is, I think most people maybe have your data center, DC-6, at about 50% of book.

My recollection is that the total development cost, so when you guys bought that just under three years ago, it was about $14 million or $15 million per megawatt.

According to Todd Weller and our data center guys here, basically the cost to develop wholesale space right now is about $7 million to $8 million a megawatt but you guys are doing a fairly below market lease to generate some activity.

Is the right value for the DC-6, 30% of replacement cost?

40% -- I mean, 30%, 40%, 50% of original development cost?

Well, John, we still list the ultimate cost of the development at around $200 million, and that's for the 18 megawatts.

Sure.

Okay.

And we're still saying that we think we will achieve a 7.5% to 8% yield on that money and so if you capitalize that, it ultimately should be worth more than whatever, 30%, 40%, 50% of our book value.

But we have a lot of work to do to get to that value.

Okay.

And then essentially you've got two CMBS loans, one is Washington Tech Park and then another is the $145 million collateralized by assets in both Colorado Springs and the Baltimore Washington Airport market.

Effectively, if those go back to the lender at $145 a foot and $225 a foot, is that a good deal for you or how do you look at that?

It would be a good NAV deal for our shareholders.

It really gets down to can we create a loan scenario where it would be even more optimal for our customers and shareholders in the long run.

But you're right, the sale -- the putback to the lender at $225 a square foot and $145 a square foot would be a good transaction for our shareholders.

Tayo Okusanya from Jefferies.

Just going back to Colorado Springs again.

Could you talk a little bit just in regards to the price differential you are seeing in regards to where you thought you would be?

Because you've been very public about the number you were looking for versus where bids for the portfolio seem to be coming in.

Yes, obviously it's a difficult discussion to have over the public airwaves because the deal is in play and our prospective buyer or buyers could be listening or get access to this call.

So I'm really challenged to lay the deal parameters out over the phone.

So I have to respectfully hold back from that discussion.

That's -- okay.

And then also pricing DC-6 where you guys were talking about being below market.

Could you give a sense of just how below market you are just to generate interest and start to get traction in that market you were.

A little more than 10% to 15% or so.

Very helpful.

Thank you.

There's another point I want to reiterate.

And a big chunk, when you calculate a yield, is the cost of the facility.

We were able to configure this user in a very dense way, such that 20% of the infrastructure that you would normally allocate at a market rate we retained to create income with other customers.

So we feel, on a yield basis, this is right in line with our expectation and so we gave a lower rate but a higher configuration and it was mutually beneficial, just so we're clear.

Jamie Feldman from Bank of America-Merrill Lynch.

How would I -- was just hoping you could discuss the -- I think I missed what you said the growth rate was for cyber security in 2014.

20% in the budget, so last year in the DoD's cyber budget was $3.9 billion This year, the budget proposal is $4.7 billion.

Now, that's not the entire cyber budget.

The entire cyber budget is about $13 billion.

So there's about $8.3 billion in the civilian agencies including Department of Homeland Security, et cetera.

So there is a $13 billion total cyber budget.

So how should we think about that budget and that growth as it relates to your development opportunities and even some of the stronger submarkets that Steve was referring to earlier in the call as we think about what is the opportunity from here?

Well, we do think that the whole cyber industry, both the government and the private sector that's helping the government with the government part and then the whole private sector part of cyber still has a tremendous amount of growth in front of it.

You probably read about Cisco's acquisition of Sourcefire here in Columbia for $2.7 billion this past week, and so we've got a tremendous cyber opportunity and growth vector that's just really getting itself going.

And we've obviously benefited from that from the last couple of years in development leasing but we continue to see tenants, in particular, a lot of small tenants winning contracts to assist the government with their cyber concerns.

So you did a lot of leasing in the quarter.

Can you talk more about your leasing backlog and what you're still working on and how that may compare to what you've put to bed recently?

I would characterize the backlog in the operating portfolio as consistent with the volume that we produced over the first two quarters.

I was just looking over deals that we think we can close by the end of the year and I'm not going to give you a number, but it's right in line with what we've been achieving.

And with regard to development, we're working with several groups.

We continue to see good demand for new buildings.

We don't make projections over our baseline target for the year which was 400,000 but we're optimistic.

We have additional development opportunities brewing that are going to continue for several quarters.

And are there certain parts of the land or submarkets where you're seeing a shift in demand or is it still consistent with what you've done in the past?

Are you referring to leasing or development?

On the development side.

I'm just trying to get my head around the next couple years, if we are -- obviously sequester has been rough and continuing resolution has been rough but if things are coming -- if you feel like business is coming back a little bit here, how should we think about the next couple years of what you can do?

Well, I'm not going to quantify that.

But what I can tell you is we have good activity in and around Columbia, near Fort Meade, on NBP and potentially in Virginia with additional work there, and potentially Huntsville or another market.

But there's -- there are many prospects we're working with on new development projects right now.

Michael Knott from Green Street Advisors.

Just on some of the vacancies, you're talking about with some of your bigger customers and from Merck, were those new to you since just the last call, so it's the rate of change on what some of your customers are -- have been talking about changed since the last call or NAREIT?

The Merck is new.

That was the exercise of a termination right.

I would say the magnitude of change with regard to the space we're talking about taking back hasn't accelerated.

We knew we were going to get about 50,000 back from a tenant that has 150,000-ish.

But their request to us accelerated and they asked us to do it earlier than we had otherwise anticipated.

So timing moved up.

Magnitude didn't change.

Okay.

And then Steve Riffee, just on -- I'm not sure if I heard you mention any update or change to the same store NOI guidance for the year.

I think it had been zero to 2 but can you just -- do you have any update there?

Well, we've reported now two quarters that we've done well on the margin, focused as much on operating expenses as opposed to our original revenue assumptions.

The second half of the year assumes that, that margin generally continues, although there were some one-items that I broke out mathematically in terms of a run rate and all.

But for any unusual items that come up, et cetera, I think we're comfortable saying that it will be positive for the year, modestly positive, so we just did 1.6% in this quarter.

So I think it's probably close -- somewhere close to 1%, but it's not going to be negative; it's not going to be zero.

You're looking at the midpoint is what you're saying?

Yes.

Okay.

And then just on the earnings guidance, the FFO guidance, I'm just trying to ascertain what it would have been with the acceleration of some of this giveback combined with the Colorado Springs.

If Colorado Springs had been progressing as you expected, would guidance have stayed the same?

Well, it's about a $0.01 a month for the entire portfolio of Colorado Springs, from a give-up of FFO.

So we probably have assumed that it closes a month later, so that's probably $0.01 difference.

Okay.

And then on Colorado Springs, if I recall correctly, you talked about initially the cap rate on the sale was maybe going to be somewhere in the 9% range, so it seems like the buyer is probably re-trading for an even higher cap rate than that given what happened to interest rates.

So my question is given the improved fundamentals there, the improved NOI, the fact that you are the natural buyer, why not just tell the buyer to get lost and keep Colorado Springs for awhile?

Well, we may do that.

But again, we want to exit the market over time.

We're not -- we still -- we're not going backwards on our strategy.

We don't see the long, long, long-term growth in that market in our niche business so it's really just about getting reasonable value for our shareholders.

Can I ask -- I think we had read recently, I forget where we had seen it but there was mention of you acquiring land in, I think, in Chantillly in Northern Virginia from Duke.

Is there any comment on that?

What I can comment on, Michael -- it's Wayne, is that we're not making any comment on the seller but we did acquire 31 acres in Westfields.

And we saw it as an opportunity to assemble a 60-acre business park which long-term, we think is a very nice, strategic fit for us.

So as we work through our capital recycling, we took an opportunity to put ourselves in what we think is a positive position for the future.

Do you have the cost per buildable square foot on that?

It's complicated, Michael, because it's like we talked about on the last call when we bought land from NBP.

The fact that we can merge two parcels together allows us to reduce the amount of setbacks and increase the square footage.

Each 30-acre parcel couldn't have created as much FAR as the combined 62 acres can.

So on an FAR basis, it's a market deal.

We're still working through the final planning on that as well, so --.

Michael Carroll from RBC Capital.

What was the impetus that drove the accelerating leasing activity in the development pipeline this quarter?

Could you ask it again?

I'm not sure I understood.

What drove the strong leasing activity in the development pipeline this quarter?

I know that there has been -- it seems like it's accelerated much more over the past couple quarters versus what you have been doing.

When you're doing full building lease, development leasing, it's lumpy.

We just ended up with two full building leases in the same quarter.

But I can tell you we've -- we're working with other prospects for full building leases as well.

They're not correlated, I can tell you that much; two very different demand profiles.

Okay.

Then Steve, did you mention that you expected development activity to accelerate in the second half of the year at DC-6?

Did I hear that correctly?

Well, I'm not -- accelerate is not the word I would use.

I'm optimistic that we can achieve additional leasing and that statement was particularly referenced at the co-location segment, not the wholesale.

The wholesale deals take a long time to develop.

Okay.

That gives you confidence in that statement was just the activity that you're seeing right now?

Yes.

Do you expect that to lead into 2014, too?

The activity?

Yes.

Yes, I actually expect it to, on the co-location side, to continue to build.

Remember, we just started marketing this property in that way really at the end of 2012.

We're doing a much better job of marketing it and particularly, in the vertical that we're shooting for, which is government defense, integrator community.

Dave Rodgers from Robert W. Baird.

I missed some of the earlier call.

So I apologize if this is redundant, but in terms of the data center lease I heard that you had said you had done it slightly below market.

Is that a deal -- and I understood the density that you talked about, Steve.

But is that a deal where you expect to be able to tie-in other customers in terms of being able to do more base rent plus power plus cross-connect type of a deal or is this an isolated customer?

This is going to be an isolated customer, Dave.

Okay.

And I didn't hear either was can you talk about how the business has been from a non-government or non-contractor perspective?

Are you feeling any better about some of the assets that you have that are exposed in those areas?

You're not talking about data now, you're talking about office?

Sorry, I switched, yes.

Yes, all right.

Trying to hang with you, Dave.

Yes, actually, demand's been good.

What we talked about, again, in Virginia, I mentioned on the call that it's really the small tenant and Commercial basis type of tenant, we see pretty strong activity out of and we signed some nice leases.

Also, with some of the smaller defense contractors in and around Columbia, Fort Meade and White Marsh, we actually have pretty good demand from the Commercial segment as well as the segment that's tied to cyber defense.

Okay.

Then the thought about with some of this expansion, I mean, does enough of the activity out there give you enough confidence to maybe branch again away from some of the government contractor and government business that you've been doing and retilt up the exposure of your portfolio to more of the core DC market given its struggles today, but the opportunity for it to potentially recover here over the next couple of years?

Yes, Dave, the answer is yes, we obviously are looking at opportunities that aren't 100% tied to our niche business but if we were to entertain them, they wouldn't be around suburban office, they would be more in in-fill locations.

Would that be acquisitions and/or development?

And do you have any thoughts internally about retargeting what the non-government exposure should be as a percentage of the total when you think of your core, super core and non-government?

No, I think, obviously, we're going to invest in as many good strategic opportunities as we can and as many other really good real estate investments that we can.

The percentages will be what they are.

Today it's 70/30, maybe it goes down to 65/35 or 75/25.

But for now, given the land we have and the embedded growth around strategic knowledge-based defense installations, we think that part of the business will continue to grow.

(Operator Instructions)

Josh Attie from Citi.

I just had a follow-up question.

It seems like you've had really good success this quarter and last quarter with new build to suit projects or new projects added to the pipeline that are fully leased.

But you've had a lot -- it's been a lot more challenging to lease the unstabilized existing assets in the portfolio and also the existing assets in the development pipeline.

Maybe what are some of the reasons for that?

Is it location-driven?

I'm just trying to get a better understanding of the overall demand environment because it seems like those two things are kind of or sort of disconnected.

Well, I would just say that the places where we've had some difficulty or delay are associated with different bases than those ones where we're having good success.

So we've had some challenges up in Aberdeen with the one unstabilized property there or two of them.

We're actually having some modest success now that we're hopeful we can announce in a quarter.

But I think it has to do with the impact of the budget on the underlying mission on a per base basis.

I can tell you in Springfield, we're adjacent to a demand driver.

At some point, we're very confident we're going to lease the building.

We've planned every square foot in it with multiple customers who are at pause, waiting for some clarity on spending coming out of that particular area.

But you'll see that we've been regularly putting away space at NBP.

We put away 27% of the building that we're just now finishing and we see continued demand in and around this area where the funding's more clear and it's cyber-driven.

So it sounds like it's location more than anything else.

Yes, I think it all goes back to many of the comments that Roger made in the speech about getting some clarity around releasing the funds in the DoD, defense area, long term.

When the clarity comes, we think the demand will come.

Thank you.

We have no more questions.

I'd now like to turn the call back to Mr. Waesche.

Thank you all again for joining us today.

If your question did not get answered on this call, we are in the office and available to speak with you later.

Thank you very much for participating.

Good day.

Thank you for your participation in the Corporate Office Properties Trust second quarter 2013 earnings conference call.

This concludes the presentation.

You may now disconnect and have a great day.

Thank you.