COPT Defense Properties (CDP) 2016 Q2 法說會逐字稿

Welcome to the Corporate Office Properties Trust second-quarter 2016 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 proceed.

Thank you, Mark. Good afternoon and welcome to COPT's conference call to discuss the Company's second-quarter results for 2016. With me today are Steve Budorick, President and CEO; and Anthony Mifsud, Executive Vice President and CFO. In addition to the supplemental package and press release related to our results, we have posted a flipbook to our website to accompany management's remarks. As management discusses GAAP and non-GAAP measures, you will find a reconciliation of such financial measures in the press release and on the Investors section of our website. At the conclusion of management's remarks, the call will be opened up for your questions.

We remind you that statements made during this call may be forward-looking 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 risk, uncertainties and other factors. Please refer to yesterday's press release and our SEC filings for a detailed discussion of forward-looking statements. With that, I will turn the call over to Steve.

Thank you, Stephanie, and good afternoon. We are on track to achieve the three major goals of our 2016 plan. Which are to generate same office cash NOI growth of at least 3.5%, to sell $440 million of assets to fund low-risk development and to further strengthen our balance sheet. Based on performance to date and confidence in our outlook, we increased the bottom of our full-year guidance range by $0.04 and, as a result of the significant progress made on asset sales, we've narrowed the top end by $0.02.

As summarized on slide 4, we had a strong second quarter. FFO per share of $0.52 exceeded our initial expectations set in April. Solid operations drove a 5.1% increase in same office cash NOI in the quarter and 5.7% growth during the first six months. The improving operating environment in our defense IT markets, which generate 86% of our revenues, is a major contributor to our same office performance and evidences the rebounding fundamentals in our markets.

Timing of dispositions accounted for one-third of the upside for the second-quarter results. Our initial Q2 guidance called for completing $120 million of asset sales and, while our timing was slightly delayed, the valuations we are achieving and that accrued as a benefit of our shareholders, are worth the wait. Last week we completed $148 million joint venture involving six of our data center properties. We monetized $74 million of equity and realized a 25% profit margin on the 50% interest we sold.

Additionally, we have $194 million of sales under contract with diligence completed and nonrefundable deposits posted. Plus another $75 million under contract that should close by year-end. The $80 million of sale proceeds we have raised to date, plus closing on the $269 million that are hard or under contract, will bring us to within less than $100 million of achieving our disposition goal. In short, we remain confident in our ability to execute on planned dispositions.

During the quarter, we leased a total of 1 million square feet, comprised of 508,000 square feet of renewals, 115,000 square feet of new leases on vacant space, and 382,000 square feet in development projects. In the first half of the year, we completed 1.6 million square feet of leasing, which included 756,000 square feet of renewals, and 249,000 square feet of vacancy lease-ups, 67% of which was to defense IT tenants. Of the 248,000 square feet that did not renew, we have backfilled 41%.

For the first six months, we also leased 546,000 square feet in development projects, which puts as well on track to meet our goal of leasing 700,000 square feet in new developments this year. Our leasing in 2016 is outpacing 2015 production by 42% and has improved in all three categories, renewals, new leases and development. Our confidence in our leasing forecast stems in part from the depth and breadth of our shadow-development pipeline shown on slide 5 and leasing activity on recently completed projects.

The competitive advantages we have and the value proposition we offer defense IT tenants in terms of our land positions, our development capabilities and our credentialed workforce that operates secure facilities are unique in the REIT space and impossible to replicate quickly. The transactions in our shadow development pipeline represent a solid runway of external growth from build-to-suit and highly preleased projects that, in turn, will fuel years of attractive cash-flow growth.

Digging deeper into our leasing stats from the quarter, average lease terms and leasing capital were also in-line with expectations. Further demonstrating the return to a normal operating environment among defense contractors, we're averaging five years of term on new and renewing leases and 10 years of term on development leasing.

Our capital commitments on renewals continued to be among the lowest in the office sector. In the second quarter, we averaged $8 a foot on renewing leases and for the first half, $10 a foot.

Lastly, GAAP rates on renewals grew 10% in the quarter and year to date. Cash rents on renewals rolled down a modest 0.8% in the quarter and were flat year to date. Combining leasing for the first half of the year with the remaining 2016 expirations, we continue to expect cash rent spreads to roll flat to down 2 percentage points.

However, during the second quarter, we advanced opportunities to de-risk our 2017 and 2018 lease expiration schedules by negotiating long-term extensions on select leases well before their scheduled expirations. These three large early renewals, shown on slide 7, involve approximately 275,000 square feet, the largest of which is a 2018 expiration with a tenant in our regional office segment in Northern Virginia. The short-term impact of completing these leases will be a reduction in our cash spreads on renewals in 2016 from our prior range of 0% to negative 2% to a new range of negative 5% to negative 6%.

The long-term advantage of executing lease deals is that we preserve asset values by extending the expirations of these leases for 12 years on average, with strong credit tenants. This prudent asset management tactic resolves 13% of our 2018 expirations, avoids lengthy downtimes and removes future earnings volatility by creating stable, durable cash flows. Continued stable demand from the government and improving demand from defense contractors translated into a robust tenant retention rate of 82% in the quarter and 75% for the first six months both of which are ahead of our guidance range of 65% to 70%.

Based on our forecast, which includes the three large early renewals just discussed, we are increasing our tenant-retention guidance for the year to between 70% and 75%. Improving demand across our portfolio, solid leasing economics and strong renewals all combined to support our same-office outlook. For the year, we continue to forecast same-office cash NOI growth of at least 3.5%. Equally important, looking at 2017, we forecast solid tenant retention in incremental leasing that should generate same-office cash NOI growth of at least 3%. With that, let me hand the call over to Anthony.

Thanks, Steve. Second-quarter diluted FFO per share as adjusted for comparability of $0.52 was $0.03 above the midpoint of our original guidance. $0.01 is attributable to the delay on asset sales. $0.01 was related to the timing of R&M projects that are expected to be incurred in the third and fourth quarters and $0.01 related to operating-expense savings. Cash-rent commencements drove same-office cash NOI 5.1% higher in the second quarter and 5.7% higher in the first six months.

We completed two financing transactions referenced on slides 14 and 15. In May, we refinanced a $36 million secured loan at M Square for the $45 million 10-year loan with a fixed interest rate of 3.8%. On July 1, we used our line of credit to retire a $162.5 million secured loan that bore interest at 7.25%. In September, we will draw the remaining $150 million of capacity on our December 2015 term loan, which bears interest at 3.7%, to pay down our line.

Slide 14 depicts our debt maturity schedule, approximately 92% of our debt is fixed rate and our total debt has a weighted-average maturity of 5.8 years. Additionally, we have no balloon maturities until 2019.

As Steve mentioned, we are on track to achieve this year's disposition goal. Last week, we monetized $74 million of equity by joint venturing six fully operational data center shells in a 50-50 joint venture with an affiliate of GI Partners. Including our first-quarter land sales, we have raised approximately $80 million from asset sales so far in 2016. When combined with the $269 million of assets that are hard or under contract, we have $349 million of dispositions, or 79% of our $440 million disposition goal that are completed or near completion.

At June 30, our debt-to-EBITDA improved to 6.6 times and our debt-to-adjusted book was 43.8%. Our goal is to achieve a debt-to-EBITDA of 6.1 times and a debt-to-adjusted book ratio of 39% by year-end. Based on our current projections, when we complete the remaining sales to fulfill our disposition goal, we will meet or slightly outperform our 2016 balance-sheet goals.

Slide 16 of our presentation summarizes our updated guidance. We expected diluted FFO per share as adjusted for comparability for the third and fourth quarters to be between $0.50 and $0.52. For the full year, we are tightening our range and increasing the midpoint by $0.01, to $2.01, which is flat versus 2015 results. Importantly, we continue to forecast 4% to 6% AFFO growth this year.

Asset sales in the third quarter account for the $0.01 difference between the $0.52 we reported in our second quarter and the $0.51 midpoint of our third-quarter guidance. We expect results in the fourth quarter to be flat sequentially as the dilution from the remaining asset sales offsets increased EBITDA from operations and from development projects.

My final point involves the impact that asset sales will have on same-office occupancy at the end of the year. You recall that we began the year by marketing over $600 million of assets to ensure the best execution for shareholders. As slide 9 shows, the initial portfolio of assets we intended to sell in 2016 had an average occupancy of between 75% and 80%. Average occupancy is on the actual bundle of assets we have sold or are likely to sell is between 93% and 94%.

Based on our same office pool, because our same office pool is going to be different than our original budget, based on this change in the composition of sale assets, we're adjusting our guidance for same-office occupancy at year-end from the original range of 93% to 95% to a new range of 92% to 93%. What is important to note is that our modification to same-office occupancy for the end of 2016 is not based on the leasing performance of the underlying core portfolio, but rather on the combination of assets being sold. With that, I'll turn the call back to Steve.

Thank you, Anthony. Before opening the call to questions, I'll briefly summarize the themes of our collective comments. Our corporate objective is to deliver competitive total returns to shareholders. We will do this by operating with lower levels of risk in our portfolio and balance sheet that ensure stable, predictable growth.

In 2016, we expect to deliver competitive same-office growth of 3.5% or more to continue to delever our balance sheet, both with asset sale proceeds and through the addition of new EBITDA from developments already executed and to relentlessly pursue and win low-risk development opportunities, predominantly for defense IT tenants at proven locations. Importantly, after we achieve our 2016 disposition goal, investors should expect more muted asset sales going forward. We will sell buildings opportunistically and on a one-off basis rather than programmatically.

All else being equal, the combination of attractive risk-adjusted growth, modest ongoing deleveraging, and recovering fundamentals will enable the company to increase FFO and NAV per share going forward. With that, operator, please open the call for questions.

(Operator Instructions)

Craig Mailman.

Good afternoon. Just on the sales, looking at what's happening to the same-store guidance, it sounds like you guys have $600 million that 75% to 80% lease, but what you're actually able to offload is low 90%s lease. Can you just talk to the disposition market and the appetite for the kind of value-add assets in your target markets?

Sure. We've been pleased with the overall opportunity to create a healthy market to sell assets. Some of our delay was driven by the fact that larger suburban deals, there were not a lot of buyers for larger suburban deals, so we broke up our White Marsh portfolio into components and we're very pleased with the results we're getting there. We explored a couple opportunities to sell in Northern Virginia, and we didn't receive the kind of pricing that we had hoped to receive and we elected to accelerate the sale of Arbor Crest in Philadelphia this year, as opposed to in the future, and we are pleased with the pricing and under contract and hard on that asset. So overall, it's been reasonably good.

And, Craig, just one finer point, the one thing to make sure you understand is that the change has to do with the assets that were contemplated in the same office pool at the beginning of the year first and we still had a basket of assets that were held for sale at the beginning of the year. The occupancy on those assets that were held for sale were 83%. Those assets are moving and are being sold, so it's really on the incremental component between what was held for sale at the beginning of the year and what we intended to sell at the beginning of the year versus what we intend to sell now.

Okay. Are you seeing a move in cap rates for suburban in Northern Virginia to the upside?

It just was not a very deep ARPO, Craig.

Got you. Okay. And then, on the leasing side, outside of the development and the shadow pipeline, can you talk about the velocity of activity in the balance of the existing vacancy?

Sure. So I'm very pleased with our building prospect levels at the portfolio sets where we need leasing. So in the northern Virginia portfolio, we've got about 10% of our vacancy working towards leases in the very near term and about 52% represented by the prospect activity behind it.

Our Navy support group, we have a really strong improving demand profile at those buildings. We expect to have Maritime Plaza over 90% by the end of the year and we're having good progress in the other two components. And then, many of the remaining development leasing pockets that we have, we've got good demand building on all of those projects. So moving into the second half of the year, I'm pretty excited.

And then, just lastly on the leasing that you guys did for 2018 expirations, it seems like you may have had the upper hand, given improving fundamentals in your markets. Is the decision -- did they come to you and basically say, if we don't work something out, we may leave in 2018 and you guys locked them up and these may be ultimately assets that you sold? I'm just trying to get at, why take the rent roll-downs that you did this far away from expiration?

Well, the one deal that really moved the rent roll-down is a Northern Virginia deal. It's about 150,000 feet and it's the one market where we wanted to ensure that we had stability. The other two we could have completed and not changed our guidance much, if at all.

And as we looked at our 2018 expirations schedule, the top-10 tenants represent 55% of the 2.1 million square feet we have rolling. Grabbing two of those and pulling them forward significantly stabilizes the entire renewal rate for that year. And we have really strong reason to believe the other 8 large tenants will renew. And, in essence, we could lock in about a 95% renewal and 55% of 2018, by taking two nondefense renewals and getting them done early. So we elected to do that.

Great. Thank you.

Manny Korchman, Citi.

Hey, guys. So on that same line of questioning, I think you made a comment earlier about locking in or creating value by doing these lease renewals. Am I reading too much into it to think that these assets then could be part of your for-sale portfolio. Or are you just saying that you want to derisk them for your own portfolio?

Derisk them for our own portfolio. And particularly in Northern Virginia, there's still a lot of vacancy. That marketplace is very competitive. You know that we've had some large non-renewals in the past. We had an opportunity to assure that doesn't happen and we moved aggressively to lock it in.

Thank you. And then the data center relationship, is that a bigger or longer-term relationship that you'd feed other assets into and maybe look to do assets together or is this a one-off and you'll be revisit when other opportunities come up?

But well, we're creating a great relationship with GI Partners and we'll be exploring ways to continue to work with them. A fantastic group of individuals with a like-minded investment strategy, so it's definitely an option.

Great. That was it for me. Thank you.

Jamie Feldman, Bank of America.

Thank you. Stephen, your comments you said a couple times it's improving operating environment with rebounding fundamentals. You said continued stable demand from the government and improving from contractors. Can you just talk about what you're seeing today that's changing? And what gives you so optimism on the future?

It's just demand driven by the contract flow in the defense segment. So I think I spoke a little bit to the Navy support group. We've had more vacancy than we would prefer to have in that area and we realized pretty slow demand in 2015 and first-quarter 2016. And our asset manager for that portfolio is making some very significant progress and has better deal and prospects flow than we've seen for a long time; and that's driven almost entirely with government or defense-contractor activity, so that's a great representation of what's recovering across the portfolio.

Okay. And then, would you say the second quarter across the board for contractors had changed or just a couple pockets here and there?

No. I mean, it's representative of what we're seeing in a variety of locations that we've got strong prospect ratios relative to the vacancy that we have.

Okay. And then, we see this continued drag in cash-leasing spreads, but positive on GAAP. Can you talk about the lease structures in terms of rent bumps that are baked into some of these leases you are seeing and is that improving at all?

Well, if you look on our leasing stats, we started to disclose our bumps each quarter and I want to say 2.85% this quarter on the gross, which in a stable-expense environment allows us to exceed 3% on a net.

Okay. And that's even for the early renewals, the big ones?

Yes. They'll have similar structures.

Okay. And then, you guys took a big impairment in the quarter. Can you talk about that? And then also, just any other initiatives as the newly appointed CEO that we should be thinking about at the company?

Sure. With regard to the impairments, several components were driven from a change in estimated value on land that we plan to sell. And those will largely be offset by gains we're going to realize in the third quarter. And a large component change was driven by a change in the whole period on our Aberdeen portfolio; so my view is that we'd like to exit that market in the future. And that drove a change in our impairment treatment and we booked that this quarter.

Okay. And then any other initiatives at the company under your leadership we should be thinking about?

Well, we are laser-focused on getting our occupancy up and addressing the vacancy we have. That's not necessarily new. I've done some reorganization of our executive team, to better align resources with the business units that relies on them and driving forward the kind of mindset that we want to be better, faster and cheaper.

Okay. Do you have an update on the COO search?

I'm very pleased. We've got four prospects. We've narrowed the field it down to four very qualified individuals and over the next four weeks or so I think we're going to be able to resolve a final selection.

Okay. Great. Thank you.

Thank you, Jamie.

Jed Reagan, Green Street Advisors.

Hey, guys. So just talking about the cash releasing spread outlook, can you give a sense for what the roll-downs, roll-ups might be on the big blocks outlined on page 6 of the presentation? If you can just sort of hazard, are those going to be in the red or where do those fall?

Just a minute Jed. I have to flip to page 6. The government should be positive so there's one deal that we'll be wrapping up in 2016 and two in 2017. The 198,000 square-foot renewal is Northern Virginia; it'll be negative, but modestly negative. And the 152,000 square foot deal is the MBP. That should be positive.

Okay. Thanks. And any update on the status of developments held for government lease? Any visibility on lease-up prospects there?

Sure. We continue to work with both customers. They both have needs for the buildings. I guess we're all a little frustrated in their ability to get funding in FY16.

As we sit here today, the budget did not clear the House and Senate; so when Congress convenes in September, they'll probably move to a continuing resolution which will push that FY17 budget approval in all likelihood to December of 2016. So I would expect lease actions to occur, if that schedule is maintained, second to third quarter of next year. But, the big point is, both customers have needs, are working hard to get them leased; and when we get them leased, they will be leased for a very long time.

Okay. That's helpful. And then, on the dispositions, it looks like there's still some under-leased suburban office assets out there. Are there some of those that you hope to get leased up before you bring those to market or might you just sell some of those higher vacancy buildings and let someone else fight that fight?

It is kind of a mix. There are a few assets that we need to drive some leasing in before will bring them to market, the set of four buildings in suburban Baltimore and another set of two buildings that we're focused on. But by and large, we are selling a mix of well-leased and some lease-up, partially vacant buildings.

Okay. That's it for me. Thank you.

John Guinee, Stifel Nicolaus

Great. A couple things. First, nice quarter, congratulations. Drill down a little bit on the impairments. I understand the land impairment was about $15 million. It looks like the asset impairment is $55 million, but I think you only have around maybe 240,000 square feet at Aberdeen proving ground. But I don't know how you get $55 million of impairment on 240,000, square feet. Is that correct?

John, only a component of the $55 million is Northgate, so about $34.5 million, $35 million of the $55 million operating-property impairment related to those three assets.

$34 million is Northgate?

That's correct.

And the other $20 million-odd is what?

The significant component of the remainder is broken out between two assets. One, several years ago the Company embarked on a couple of assets were under the theory that they could take an industrial building and turn it into a flex office industrial. And we still have one of those assets left in Northern Virginia, and about $8.5 million of the impairment related to that asset which we have in the market now in several bids on; so we have a clear view of value on that asset. And another, a little over $6 million related to the old Merc building up in Blue Bell which was the only asset in Arbor Crest that was not impaired as a part of the initial impairment of the Arbor Crest assets several years ago.

So essentially, as you're not selling a number of the-- as you're selling White Marsh and you're not selling Northern Virginia, you're selling Arbor Crest which is Merc and so there's an impairment on that one? But that's correct.

John, just to be clear, though, we have the bulk of White Marsh under contract. We have one set of four buildings that are not.

Okay. And then, continuing on the same office portfolio, original guidance was you were basically selling a lot of vacancy at 75% to 80%. And now you're selling a lot of occupancy at 93% to 94%. That would imply to me that you're selling a higher-quality asset pool than originally planned. Is that a correct assumption?

Yes. The big change is the decision to sell Arbor Crest which was 100% leased, four building, 650,000 square feet, where we had intended to complete the fifth redevelopment in the asset that we just impaired because we're selling it, and then exit the Philadelphia markets in the future; then we decided to move that up into 2016 and get it done now.

Okay. And then, you had mentioned a cash roll-downs in 2016 of zero to 2% and then with these early renewals you said a 5% to 7% cash roll-down; is that in 2017 and is that for just those assets or for the entire portfolio in 2017?

It's 5% to 6%.

5% to 6%, okay

And that will be the 2016 results after we add the three early renewals to the zero to minus 2% that we had planned to do at the beginning of the year.

Okay. Great. All right. Thanks for that clarification and then a couple comments is, on the inventory buildings, a little frustrated with the customers, et cetera, et cetera. When they are in a position to actually take down buildings because the continuing resolution dollars are made available, are you the only game in town? Or will you still be in an RFP competitive-bid process with other buildings that are suitable for what I'm assuming is the CIA and the NSA?

No comment on the customers. With regard to the NOVA B that sit behind the fence, we have to negotiate a market deal. There's certain tests, but there really won't be competition for that. And then, at the MBP, hypothetically, there could be competition, but we think we're in a really strong position.

Got you. Okay. And then, as we all know, when you are doing these defense contractor renewals, I'm assuming because that's what I've been told, is every one of them has early terminations. If you were to take the lease term that is quoted, let's say it's 5 years, and actually plug-in the early termination, does that take 5 years down to 4.5 or 2.5 years?

It's too general a question to answer, John. But in most cases, if there is an early term, we try to tie it to a specific contract.

Okay.

And to the extent, John, there is an early term, there is most likely a penalty on the tenant side to reimburse us on amortized tenant allowance and leasing commissions to give them the right to terminate.

Okay. And then lastly, your debt-to-EBITDA number is you're talking about going down from 6.5 to 6.1. What is that debt-to-EBITDA if you actually added in $200 million of preferred? Does that take the 6.5 and the 6.1 up to 6.8 or does it take it up to 7.3, 7.4?

If you include the preferred as debt? Is that what you're asking?

Exactly.

Yes. It probably takes it up to 6.6, 6.7.

So 6.1 goes to 6.6 or 6.7?

But that should be about the size.

If you include the preferred as debt, John.

Got you. Okay. Thank you very much.

Thank you, John.

(Operator Instructions)

Rob Stone, Evercore.

Hey, guys. Most of my questions have been answered, but I was wondering if you could touch on Baltimore a bit. Speak to what you're seeing in West Pratt and 100 Light. And then also, if there are any updates at Canton Crossing. Thanks.

Sure. Well, we're fully leased at 250 West Pratt. We have one very small parcel that we have a tenant we're negotiating with and the rental rate on that proposal or negotiation is a couple bucks ahead of where we had pro forma of the building, so we're pleased with that opportunity.

We had one chunk of space to lease at 100 Light. We leased it at about 9% over our pro forma on a rental-rate basis; that tenant will take occupancy in October. Our parking results are very positive at 100 Light. We're beating our own plan by about 28% year to date.

Everything's going very well with regard to Canton Crossing, we did get our plan approved by the city of Baltimore. And we continue to work towards the mixed-use development that we have toured you through recently.

Thanks, Steve. That's all for me.

All right, Rob. Thank you.

I would now like to turn it back to Mr. Budorick for closing remarks.

Thank you all for joining us today. If your question did not get answered, we are in the office and available to speak with you. We look forward to the next call. Thank you.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.