COPT Defense Properties (CDP) 2014 Q3 法說會逐字稿

Welcome to the Corporate Office Properties Trust third quarter 2014 earnings conference call. As a reminder, today's call is being recorded. At this time, I will turn the call over to Stephanie Krewson-Kelly, COPT's Vice President of Investor Relations. Ms. Krewson-Kelly, please go ahead.

Thank you, Sarah. Good afternoon and welcome to the COPT's conference call to discuss the Company's third quarter 2014 results and our outlook for the remainder of the year. With me today are Roger Waesche, President and CEO; Steve Riffee, Executive Vice President and CFO; Steve Budorick, EVP and COO; Wayne Lingafelter, EVP of Development and Construction; and Anthony Mifsud, SVP of Finance and Treasurer.

As Management discusses GAAP and non-GAAP measures, you will find a reconciliation of such financial measures in the press release issued earlier this morning under the investors 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 you that statements made during this call may be deemed forward-looking statements within the meaning of the Safe Harbor of the Private Securities Litigation Reform Act of 1995 and that actual results may differ materially due to a variety of risks, uncertainties and other factors.

Please refer to today's press release and our SEC filings for a detailed discussion of forward-looking statements. I will now turn the call over to Roger.

Thank you, Stephanie, and good afternoon everyone. Third quarter FFO per share as adjusted for comparability of $0.48 was at the high end of our guidance range. Importantly, third quarter results were 9% higher than the $0.44 we reported in the second quarter, evidencing that our quarterly FFO per share did indeed bottom in the second quarter and is now rebuilding.

As Steve Budorick will detail our overall portfolio is 91.5% occupied and 93% leased. Supply remains in check in each of our markets, and demand continues to firm along three lines. Our US government customers and defense IT contractors continue to need modern, efficient, strategically located properties to execute their missions.

Traditional office tenants in the healthcare, education and professional services industries are going in and around the BW corridor where over half our properties are located. And cyber security companies, both large and small, continue to establish beachheads and expand operations in Maryland's Cyber valley, the center of which is US Cyber Command at Fort Meade.

In the third quarter, for example, 213,000 square feet or 45% of our new and development leasing was cyber related. Market fundamentals have s been building toward a more favorable leasing environment for several quarters. Supply has been limited in our sub markets, and demand has been building consistently.

Beginning in 2015, occupancy gains and improving leasing economics in the majority of our markets will combine with new EBITDA from value-added development to drive annual FFO and NAV per share gains. With that, I'll turn the call over to Steve Budorick.

Thanks, Roger. I'll start by providing some color on occupancy gains in the quarter. At September 30, our total office portfolio was 93% leased and 91.5% occupied. The 220 basis point increase in occupancy relative to the June 30 levels reflects 130 basis point increase related to new tenants taking occupancy, a 15 basis point increase related to placing NBP 312 and DC 9 into service and the decline in vacancy from the sale of eight buildings during the quarter.

At September 30, our same office portfolio of 161 buildings was 93.3% leased and 92.1s% occupied. Same office occupancy increased 130 basis points during the third quarter, reflecting occupancy gains that were broad-based throughout our portfolio. The positive leasing momentum we've experienced since the passage of the Bipartisan Budget Act continued in the third quarter as evidenced by our solid leasing volume and economics.

In the third quarter, we executed a total of 857,000 square feet of new and renewal leasing at an average term of almost seven years. This was our third consecutive quarter of longer lease terms, bringing our nine month average term to 6.8 years. Total leasing included 384,000 square feet of renewals.

The associated 82% renewal rate for the quarter was in line with our expectations and increased our renewal rate for the year to 74%. The expect the full year renewal rate to be about 65%, reflecting non-renewals we identified in our initial 2014 guidance.

The largest of these non-renewals is the 153,000 square foot aerospace lease which expires at the end of November. We are working with several prospective tenants interested in back-filling the space because of its proximity to the nearby demand drivers. Cash rents on renewals in the quarter were essentially flat.

One quarter does not a trend make, but our general feeling is that we should have better pricing power in several sub markets in a few quarters. New leasing volume in the quarter was also strong. We retenanted 174,000 square feet in the operating portfolio and completed 300,000 square feet of development leasing.

In the first nine months of the year, we executed just under a half a million square feet of development leases. This met our full year goal. Based on discussions with our tenants and our prospect activity, we expect solid leasing in our operating portfolio in 2015.

Before turning the call over to Steve Riffee, I'll briefly summarize the incremental NOI we expect to recognize in the future from development and redevelopment leasing. Today we have 22 recently completed and active development and redevelopment projects that, when stabilized, are forecasted to generate annual cash NOI of $48 million. This $48 million -- of the $48 million, $33 million of NOI is associated with executed leases and, therefore, has no risk.

These executed leases contributed $5 million to cash NOI in the nine months ended September 30. Of the remaining $15 million of potential cash NOI, more than half will be accounted for when we lease the two projects that are under construction and intended for government users.

We believe the execution of these leases is likely to occur in the first half of 2015. The $48 million of NOI from the pipeline of projects demonstrates the strength of our development platform and our ability to generate attractive returns for our shareholders.

Looking ahead to potential new starts, our Shadow development pipeline now exceeds 1 million square feet. We are discussing real estate solutions with existing and potential new customers for eight projects throughout our portfolio. We may or may not capture all of this demand, but we do look forward to providing more color on the ones we capture in coming quarters.

On that note, I'll turn things over to Steve Riffee.

Thanks, Steve, and good afternoon everyone. FFO per share as adjusted for comparability for the quarter was $0.48. Modestly higher NOI and other fees and income enabled us to come in at the high end of our guidance range. Our AFFO payout ratio for the nine months ended September 30 was 81%. For the full year, we project an AFFO payout ratio of 80%.

Our same office portfolio represented 89% of total square footage and 90% of our total cash NOI. And cash NOI from the pool grew by 90 basis points over the third quarter of last year.

Turning to our balance sheet. In the quarter, we monetized nearly $60 million of low and non-yielding assets from the Whitemarsh portfolio. We also focused on resolving the $150 million loan that is secured by two office buildings in Northern Virginia and consistent with prior guidance we expect to convey these two buildings in exchange for extinguishing the debt this fourth quarter.

Our balance sheet and credit metrics continue to improve. During the quarter, our debt to adjusted book ratio declined from 43.9% to 42.8%. Our adjusted debt to EBITDA ratio decreased from 7.1 times to 6.7 times, and our fixed charge coverage ratio increased from 2.6 times to 2.7 times. We are affirming our fourth quarter guidance for FFO per share as adjusted for comparability of between $0.48 and $0.50.

We expect same office cash NOI to grow 350 to 400 basis points relative to the fourth quarter of 2013. For the full year, our guidance for FFO per share as adjusted for comparability is now $1.87 to $1.89. And with that, I will now turn the call to Wayne.

Thanks, Steve. I'll start by making a few brief remarks about the development and redevelopment portfolio which currently stands at 10 buildings encompassing 1.1 million square feet that are 51% leased. We placed two fully leased buildings into service during the quarter which are, therefore, no longer listed on pages 24 and 25 of the supplement. NBP 312, a 125,000 square foot government building and D C9 at Ashburn Crossing in Northern Virginia, a 110,000 square foot build to suit.

During the quarter, we started construction on 7400 Redstone Gateway, a single story, 69,000 square foot flex building that will be joined to 7200 Redstone Gateway. The resulting 131,000 square foot property will serve as the regional headquarters for DRS, the second major defense contractor to relocate its Huntsville operations to Redstone Gateway to serve the various missions at the Redstone Arsenal. We anticipate the full property lease will commence early in the third quarter of 2015.

Finally, I'd like to highlight the significant progress we made this quarter in disposing of non-strategic land. This capital recycling activity was comprised of two transactions which generated gross proceeds of $28.2 million and a gain on sale of approximately $5.5 million. In the larger of the two transactions, we generated value above our investment basis through a development strategy which included enhanced entitlements, modest infrastructure investment and out parcel leasing.

This same approach will be applied to certain parcels in our non-strategic land portfolio, increase the value of that land and improve its marketability. The third quarter dispositions reduced the non-strategic land bank by 25% and lowered our investment in these positions to approximately $60 million. We currently have two additional parcels under contracts for sale at a combined value that exceeds $20 million.

While these contracts do have certain due diligence contingencies, we are encouraged by the buyer's progress and believe the sales could close in the first half of 2015. And with that, I'll turn the call back to Roger.

Thank you, Wayne. Our third quarter results mark the beginning of new growth for COPT. Our portfolio is well-leased and we expect 2015 to be another strong leasing year. Our development platform is uniquely positioned to benefit from cyber security growth.

Demand for you new space to accommodate growth or to reap operating efficiencies remains strong. Each of these factors bolsters our expectation for higher FFO and NAV.

Before opening up the call for questions, I'd like to take a minute to acknowledge the coming leadership change in senior leadership. As we announced last week, Steve Riffee will be leaving after he fulfills his contract on March 31, and our Treasurer, Anthony Mifsud, will become CFO effective April 1. I'd like to thank Steve publicly for his devotion to this Company, for his leadership, and for his friendship over the last eight years. We could not have accomplished all that we have without you. Thank you, Steve.

Many of you have already met Anthony, who joined COPT in 2007 and has be instrumental in affecting the balance sheet accomplishments with Steve. Anthony was a finance executive with the Rouse Company for 15 years before joining us. He is a well respected member of the COPT team and will be a strong CFO.

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

(Operator Instructions)

Our first question here comes from Craig Mailman from KeyBanc Capital Markets.

Steve Budorick, maybe just go back to your comments about better pricing power over the next several quarters. As we look out at the 2015 roll, could you maybe just give us what you think the embedded mark-to-market is for those leases and maybe the markets that are closest to flat or maybe positive?

Sure. We're experiencing the most weakness in Northern Virginia. And those on a cash basis are rolling down 5% to as much at 9% on a cash basis. On the Maryland side of the river, we have much stronger pricing power. And in the third quarter, 65% of our leases rolled positive. And in aggregate, that 65% rolled up 1.94%. So I think that helps demonstrate the statistics we've been experiencing. And we're feeling strength building on the Maryland side.

All right. So if you had to put a percentage on that 13% that's rolling, where do you think it shakes out? I know you haven't given 2015 guidance, but just kind of gut feeling.

My gut is, down 2% to down 3%.

Okay. And then you mentioned the two remaining development sites that are vacant. Sounds like it's going to be first half 2015 deals. When do you think those would take occupancy?

Usually about a year after when we execute the leases because the tenant fit-out is very complicated. And we'll be finishing the shells on those in the first quarter of 2015, and then they'll be eligible for lease.

Where are you seeing the most demand for new starts? Assuming those get done, you are pretty much leased up. I'm assuming KEYW takes the remaining space at Arundel. Where are you looking to start new product?

Several sites in Northern Virginia, in Maryland, in and around NBP, potentially at Columbia Gateway, and potentially in Huntsville.

Craig, it's Wayne. I'd just add to that.

Steve made the reference to the million-square-foot Shadow pipeline. As he said, it's geographically diverse. It's important to know it is all strategic demand that we're tracking. Depending on how much of that we are able to execute on, it's very well pre-leased.

Okay. That's helpful. Just one last one. Any update on Patriot Ridge and 3120 Fairview -- any activity there?

Yes, we have activity at both. I think in the first quarter, we talked about increases in showings that were starting to occur as the Bipartisan Act got passed. That's translated into some pretty significant awards out of various agencies around Fort Belvoir. Those contract awards totaled about $8 billion. We have multiple groups now looking at planning, waiting for the actual task orders to be awarded under that new wave of contracts that got awarded.

So we're feeling in another quarter or two that we should be in a position to start booking leases at Patriot Ridge. We've had reasonably good activity at the 3120 Fairview. We've put some space away this year. We're working with a couple users right now, one of which would essentially put the building away. It's early in that competition, but we have line of sight on opportunities.

Okay. Do you think the midterm elections at all will have impact one way or another on demand that you're seeing?

I don't feel that the election has impacted demand. I do feel that the increased flow of contracts in multiple locations has kind of swelled our operating leasing pipeline to a pretty high level right now. Much of it's contract contingent, but there's a lot of activity.

Great. Thank you.

Our next question comes from James Feldman from Bank of America.

Great. Thank you.

I think if you look at last after-quarter conference call, Steve Riffee, you were saying maybe 1% to 1.5% same store NOI. How are you trending now?

I think we're going to be good relative to the forecast that we had all year, Jamie, with the 350- to 400-basis-point same store growth in the fourth quarter. So we feel good about the numbers that we put out there for the year.

You think you'll still be above 1% for the full year?

Yes.

I think you're trending like 0.2% for the first nine months.

I think the fourth quarter is going to make a big difference. It was back ended for us.

Okay. And then I know they're pretty small leases, but can you just talk a little bit about some of the occupancy loss at St. Mary's and King George and on the DC river front? I guess just more generally, what's going on in those sub markets and how you feel going forward?

St. Mary's and King George, there's a lot of contract turnover with the new contract awards. You're losing a tenant and then capturing a tenant. It will be a lot of churn, but we feel pretty good. I want to say that my St. Mary's backlog is 185,000 square feet of various prospects we're working with as those contract competitions roll through. But we feel like we're going to come out of it pretty well.

And then similarly, it's not quite as active at Maritime, but there's good contract activity. And we're working with a few groups that believe they're going to win and expand in our building.

And then I guess back to the election question that Craig had asked. If you think about -- let's say the entire Congress goes Republican. Would that change anything for you? Or is there any buzz about what that might mean for contract activity?

There really isn't. Generally, speaking over time, the Republicans have been a little more hawkish on defense spending. So we would expect that that would prevail. But we don't see a big change.

What's driving defense spending is all the challenges that we're facing in the world with Isis and Russia and China and the Middle East, et cetera, et cetera. So it really is not political. It's more the circumstances in the world.

Okay. And then where would you say leasing activity is trending so far in the fourth quarter?

It's good. The renewals that we expected to get, we're getting. And we've got, as Steve said, a pretty strong pipeline on the development side that hopefully we'll have some significant announcements in the fourth quarter on pre-leasing.

Thank you.

I was just going to point out that our operating portfolio pipeline is now up to about 785,000 square feet. And that's after we've already leased 680,000 since we started measuring that about a year ago. Of that 784,000, (sic, see above, "785,000"] we've got 30% of it under lease request, which is an internal term, where we're moving the documentation. And it's probably increased 10% to 15% since the last call.

Just to be clear, you're saying 784,000 [sic, see above, "785,000"] of lease is in discussion.

Active prospects where we believe we have a 50% chance or better to win the business.

Okay. That's outside of the development pipeline?

That's outside of development. That's all operating.

All right. Very helpful. Thanks.

Our next question comes from Michael Bilerman from Citi.

It's actually Manny Korchman here with Michael.

It looked like your TIs were a little bit elevated in the quarter, especially on some of the smaller deals. I was wondering if you could tell us what's happening there.

We ran a little hot on TI in the quarter. There are a couple of reasons for that.

In Northern Virginia, we dealt with some space that rolled over that had been occupied for a very long time by a law firm, where we took it down to bare space and then re-let it. We did about 68,000 square feet of first-generation leasing, much of that getting at the stubborn parts of the portfolio. First-generation means while we have owned it or since we have built it, it never got leased.

And then in and around Fort Meade and Columbia Gateway, we did do 50,000 square feet with cyber tenants. And some of the smaller ones, we allocated a little more TI to help them configure their spaces the way they need to have them for the long-term -- very technical build outs. So there are kind of three sources.

With your discussions of ramp in cyber security business, should we expect that trend to hold going forward?

I don't really think so as you get through the bulk of the portfolio. As I mentioned, some of the spaces where we were addressing these cyber tenants were buildings that had been occupied for a very long time and were turning over. So more of a raw condition construction.

But as you get through the bulk of the portfolio, again, in the NBP where we have newer quality buildings, you don't see that kind of TI at all.

Great. Thanks.

Our next question comes from Brendan Maiorana from Wells Fargo.

Steve Budorick, I apologize if I missed this,. But I think on previous calls, you'd stated that you think you thought occupancy was likely to drop in Q4 -- I think somewhere between 50 and 100 basis points, given the Aerospace's move out. Is that still the expectation kind of from September 30 to December 31?

Yes, absolutely. We've been saying that for almost a year. We will be getting 150,000 square feet back from Aerospace and about 50,000 square feet back from CSC in Huntsville. So we should drop to just below 91% same office.

Having said that, we have good activity behind both those expirations, quite a bit of activity looking for SCIF requirements. In and around Westfields, there's been a lot of contract activity and awards. So we're feeling pretty good about our opportunity to backfill Aerospace in coming quarters or through the year. And then about a third of the space we're getting back from CSC, we're already negotiating a lease on in Huntsville. And we have good prospects for the balance of it.

Okay. Great. And with respect to the embedded gains on the development or recently-delivered projects that you talked about. You said you had -- this may be for Steve Riffee or Steve Budorick. I think you mentioned $5 million had been realized year to date. I think previously you guys expected $9 million to be realized during 2014. So do we get $4 million from those projects that will hit in the fourth quarter?

And then how should we think about when the remaining $33 million that's signed comes into NOI?

Brendan, we've realized $5 million through the first three quarters. And the total for the year will be close to $9 million, $8 million and change to $9 million. And so the balance of the $33 million would then hit in 2015 and 2016.

And any sense of is it more weighted towards 2015, back half of 2015 kind of into 2016? Just trying to think about how we should think about the progression of NOI growth from those signed leases.

It's spread out. But again, it's all signed. So it's just a matter of how fast we can get the tenants in. And some of that depends on the tenant. And, as Steve said earlier, some of them are tricky and complicated buildouts.

So it's really an execution issue. Obviously, we're working feverishly to get tenants in as fast as possible.

Okay. Fair enough.

Last one, Wayne. I think you mentioned eight development potential projects that you're talking to. Probably not all of those hit. But that would strike me as maybe if you did have all of that and maybe if some additional projects were to hit, it seems like maybe the rate of development could be a little bit higher than the $200 million or so a year that you have kind of targeted as a mid-level run rate. Is that fair?

Yes, I think that's fair, Brendan. We've guided between $200 million and $250 million, and I think your observations are fair. If we're successful with a higher percentage of those eight that we're tracking, we'd certainly be at the high end of the range. Some of them have timing that stretches a little bit out into 2015 that would mitigate it a bit, but it's on the high end.

Okay. All right. Thanks a lot.

Our next question comes from Dave Rodgers from Baird.

Yes, good afternoon.

Steve Budorick, maybe first question for you. You talked about some contract rollover, which is pretty typical in your business. But I guess following all the issues we've had with government budgeting, are you seeing anything different in the way that contracts are being allocated?

I guess I'm thinking particularly on how the new contract awards might deal with real estate, or how those new tenants are thinking about real estate relative to the old tenants. Are you seeing any downsizing in the way contractors are using space on an apples-to-apples contract basis?

We've been experiencing some downsizing for the last couple of years, Dave. You still see that from time to time. A contract rolls over from old to new, and the new one starts a little more conservatively than the old one rolled out.

Notwithstanding that, we've been gaining grounds on the overall portfolio because our activity levels are high. And there has been a lot of turnover as the government has gotten more focused on getting the lowest-priced technically-acceptable award criteria implemented as opposed to the best value. And we're on top of those awards and getting on the contractors to backfill when it impacts us.

Steve, maybe sticking with you, I think there's a 310-basis-point difference between your leased and occupied, just in the regional office component. I think it's smaller in your strategic. Within just that regional office component, when does this come in? And how much of that really benefits the same store -- if you have any of those numbers or at least some general thoughts around that?

From a timing standpoint, the spreads between lease and occupied, you'll see that over the next couple of quarters. And it will have positive influences on same store.

And it will have positive influence; but remember, we're going to get quite a bit of space vacating in this fourth quarter that we have to backfill again. We just talked about that rollover with Aerospace and CSC. Good contract activity behind it, but it's going to take a few quarters to get that leasing done.

And beyond this fourth quarter and the two known moveouts that are about 200,000 square feet, any other known moveouts that are new -- that you found out in the last 30, 60, 90 days?

No, we're looking pretty solid for 2015.

Okay. Sounds good.

Lastly, on the data center side, you just finished one of the -- call it core development for the data center project. Can you talk a little about any additional activity at DC 6? Any additional core development opportunities if that's kind of in your eight that you're looking at? And then can you remind me of the remaining lease term at DC-6?

Let's take it from the top.

We are anticipating opportunities to do additional build-to-suit developments. There's some element of that in our Shadow development pipeline.

With regard to DC-6, we did not book or sign a contract in the quarter. But we are feeling very, very good about where we stand with the prospects that we have. We got a verbal award yesterday. That means nothing until we sign it. But a very important defense contractor has given us the verbal consent that they're going to put an important piece of business in our building. We're excited about that.

And then behind that, we've got enough demand to actually fill the building, 12 to 23 megawatts that we consider active or decision pending. And all of that activity is along the orientation that we've been describing all year, which is towards government and contractors or institutions that are looking for a very high level of data center reliability.

And would these be in your 50%-or-greater confidence that you indicated earlier?

Some portions of that are.

Okay.

I would say 3- to 5-megawatt level, I'm pretty confident we're going to win.

Great. Thank you.

(Operator Instructions)

Our next question comes from John Guinee from Stifel.

Great. Okay. Thank you very much.

Refresh my memory, Wayne. If I'm looking at your development pipe, 310 Centennial Way, is that inside the fenced area; or is that outside the fenced area at NBP?

John, today it's built outside the fence. It's targeted for a government user. So if we're successful in that pursuit, then it will be moved inside the fence line.

And then at $300 a square foot, is there anything unusual there? Or is that just development cost with structured parking, et cetera?

Well, I think you touched on probably the most important part of that basis; and that's it is fully-structured park. So it's got a full complement of garage cost included in that $300.

And then when you look at the Nova A & B, $280 and $260 a square foot, is that surface, or is that structured parking, or is there anything unusual in the development of those assets?

There's nothing unusual in the development of that in terms of their scope. It is a strategic customer, so it's comparable in that respect to the 310 building. It does have a combination of surface and structured parking. So some of the lower basis that you're picking up on there is the result of that surface parking portion.

This is a curiosity because, Steve, you probably never go there; and most people wouldn't know where it is. But if I look at St. Mary's and King George County, 874,000 square feet, basically over half the space - 440,000 square feet -- either lease expiration fourth quarter or in 2015. Is the nature of the tendency down there just month-to-month or year-to-year leases, or is there something unusual there?

During the period of constrained spending, a lot of contracts were extended on short-term basis -- one- to two- to three-year renewals. And so that's kind of piled up. Where we had to go short-term and match lease terms with the contracts that people had. As we move to a more normal contracting environment, it will start to spread out.

But there's no other development by somebody else in that market that's changing the dynamics of those two markets?

Not at all.

Okay. And then last question.

I'm looking at page 19. BWI corridor, 20 leases expiring, $37.73. Is that pretty much the market rate in that 456,000 square feet? Or are there some very full leases in that number that skew it high?

Well, there is a customer embedded in a lot of that square footage that runs with a much higher operating expense component than a normal tenant does. And so those leases are grossed up for the fact that they require, in some cases -- well, in many cases -- 24/7, 365, and higher level of immediate service to make sure the buildings are operating well.

Great. Okay. Have a nice weekend. Thank you.

Thank you.

Thanks, John.

It looks like there are no further questions in queue. So I'll turn the call back over to Mr. Waesche for closing remarks.

Thank you all for joining us today. If your questions did not get answered, we are available to speak with you. Thank you and good day.

Thank you for your participation today in the Corporate Office Properties Trust Third-Quarter 2014 Earnings conference call. This does conclude the presentation. You may now disconnect. And have a great day.