Corporate Office Properties Trust (NYSE:OFC) Q4 2022 Earnings Call Transcript

Corporate Office Properties Trust (NYSE:OFC) Q4 2022 Earnings Call Transcript February 10, 2023

Operator: Welcome to the Corporate Office Properties Trust Fourth Quarter and Full-Year 2022 Results Conference Call. As a reminder, today’s call is being recorded. At this time, I’ll turn the call over to Venkat Kommineni, COPT’s Vice President of Investor Relations. Ms. Kommineni, please go ahead.

Venkat Kommineni: Thank you, . Good afternoon, and welcome to COPT’s conference call to discuss fourth quarter and full-year results and guidance for the year. With me today are Steve Budorick, President and CEO; Todd Hartman, Executive Vice President and COO; and Anthony Mifsud, Executive Vice President and CFO. Reconciliations of GAAP and non-GAAP financial measures that management discusses are available on our website in the results press release and presentation and in our supplemental information package. As a reminder, forward-looking statements made during today’s call are subject to risks and uncertainties, which are discussed in our SEC filings. Actual events and results can differ materially from these forward-looking statements, and the company does not undertake a duty to update them. Steve?

Steve Budorick: Good afternoon, and thank you for joining us. Upon of our strategic reallocation program in 2018, which deeply concentrated in our portfolio and defense IT locations, we entered into what we describe as a new era of growth. Since 2019, we’ve placed over 5 million square feet of nearly fully leased development projects in service, creating the foundation for long-term growth. During this period, we raised over $1 billion in capital, mainly from our data center shell portfolio and reinvested into other highly accretive low risk development projects. These activities coupled with a strong leasing in our operating portfolio and strategic debt refinancings delivered 4% compound annual growth FFO growth from 2018 through 2022.

Today, nearly three years after the onset of the COVID-19 pandemic, we feel the strength of our strategy has been fully ratified. Delivering reliable growth through the pandemic era with visible growth for the next four years and progressing to a new era of internally funded development. Now, let’s discuss our 2022 results. FFO per share as adjusted for comparability of $2.36 grew 3% over 2021’s exceptional results and is $0.02 higher than the midpoint of our original guidance. We completed 801,000 square feet of vacancy leasing, which is the highest annual level in 12 years, and 30% higher than 2021. Demand was broad-based across our Defense/IT locations, with particular success in the Fort Meade BW Corridor and Huntsville. The National Business Park and Redstone Gateway are both 98% leased, which represents a 300 basis point and a 600 basis point year-over-year increase, respectively.

Our core portfolio is now 95.3% leased, the highest level we’ve achieved since 2006. Defense tenants continue to commit to and renew at our locations executing their mission activities in office space. This leasing success stands in sharp contrast to the weakness in the broader office environment, which has been negatively impacted by the current economic conditions and played by space contractions stemming primarily from work for home. We achieved 476,000 square feet of development leasing. We had expected to sign a 225,000 square foot lease for a data center shell in summer, but the tenant’s approval process dragged on, and the execution slipped a few weeks. We executed this lease in January, which represented the remainder of our 700,000 square foot target for 2022.

So far in 2023, we’re off to a great start on development leasing. As noted in our press release, we signed another 193,000 square foot build-to-suit with our cloud computing customer and a 46,000 square foot build-to-suit for a new headquarters building for a defense contractor in Huntsville. Including the delayed lease from 2022, development lease and executed year-to-date totals over 460,000 square feet. And with these leases, we now have 1.5 million square feet of active developments that are 89% leased. We placed into service 1.3 million square feet of development projects, which are 99% leased, over 900,000 square feet of which was delivered in the fourth quarter. Our 2022 deliveries included 1 build-to-suit with a defense contractor at the National Business Park, five projects at Redstone Gateway leased to defense contractors, including the new Northrop Grumman campus and two data center shells in Northern Virginia.

In mid-December and in the second week of January, we closed on two new joint ventures with Blackstone on five single-tenant data center shells, raising $250 million of proceeds. We are very pleased with the valuations of these transactions, and the $190 million of proceeds from the January tranche fully funds the external equity component of our expected 2023 development investment. We now expect to fund future equity required for investment in our development pipeline from cash flow from operations without the need for further dispositions. Importantly, we can accomplish this self-funding, while maintaining our strong balance sheet and conservative leverage metrics. Any future dispositions will be strategic sales with the goals of harvesting shareholder value and more deeply concentrating our portfolio in our Defense/IT locations.

Turning to defense spending. The base defense budget for fiscal year 2023 was passed in December with a 7.5% year-over-year increase, which was 4.8% higher than the President’s budget request. Recall, the fiscal year 2022 budget passed in March included a 5.8% increase and followed by this 2023 budget passed in December, which added to 7.5%. In total, this is a $100 billion increase in defense spending or 14.3% in the last 12 months. We expect demand from the 2023 budget will materialize starting in 2024 and drive leasing volume for both our operating and development portfolios. Moving on to guidance. We’re establishing 2023 guidance for FFO per share as adjusted for comparability at a range of $2.34 to $2.42. At the midpoint, guidance implies 1% growth over 2022’s results, which includes the dilutive impacts from the elevated interest rate environment and our capital recycling timing.

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Over the past three years, a period which encompasses the pandemic and a historic rise in interest rates. FFO per share as adjusted for comparability has compounded at 5.1% annually. Following 2023’s modest growth, we continue to expect FFO per share as adjusted for comparability to grow at roughly 4% on a compounded basis between 2023 and 2026. With that, I’ll hand the call over to Todd.

Todd Hartman: Thank you, Steve. 2022 was a successful year for leasing, highlighted by our record vacancy and solid development achievements. We completed 801,000 square feet of vacancy leasing with a weighted average lease term of 7.3 years and contractual average annual rent escalations of 2.75%. This is the highest vacancy leasing achievement in 12 years, 30% higher than that of 2021, and 40% higher than our prior five-year average. In addition to the overall volume lease in 2022, our vacancy leasing strengthened our concentration in Defense/IT and was diversified among size requirement and location. Our 68 leases for the year represent a 25% increase over 2021. Our largest lease was 121,000 square feet with Lockheed Martin and Redstone Gateway, and we also executed 53 leases under 10,000 square feet.

We expanded our relationship with the U.S. government with 126,000 square feet of new leases, including 68,000 square feet for the last two floors at 310 NBP, which is now fully leased. 50% of the leased square footage was to cyber tenants, further demonstrating the strength in that sector. Our core portfolio finished the year 95.3% leased. With limited inventory available, we are setting a target of 400,000 square feet of vacancy leasing in 2023. Demand remains strong with the current activity ratio of 78% and more than 70 active prospects, and we are confident we will reach our target. 2022 leasing activity also included 1.7 million square feet of renewals. We expected to execute 2 million square feet of renewals, but three large government leases totaling 316,000 square feet were delayed into the first quarter of 2023.

We fully expect these leases will renew. Full-year retention was 72%, but that result includes a strategic relocation of a defense contractor for 58,000 square feet. Net of this relocation, the retention rate was 74%. Cash rents and renewals declined 2%. However, measuring the starting cash rent of the tenant’s expiring lease to the starting cash rent of the new lease, the annual compound growth rate achieved in these maturing leases was 2.7%. Renewal leases signed in 2022 include 2.5% annual base rent increases on average, which translates into approximately 3.5% annual growth on net rent. For 2023, we expect cash rents to be flat with guidance ranging from down 1% to up 1%, and we expect tenant retention will be especially high at 75% to 85%.

This retention expectation highlights the value of these locations to our tenants and of our strategy of concentrating assets approximate to Defense/IT locations. Our 2023 same-property pool started the year at 92% occupied, and we expect to end the year between 93% and 94%. The primary components of activity within the same property portfolio includes contractions in our regional office portfolio totaling 75,000 square feet, including a 50,000 square foot contraction by CareFirst at Canton Crossing, which will occur in the first half of 2023 and was part of the long-term renewal executed in November 2021. These contractions are more than offset by the commencement of leasing executed during 2022, including the 121,000 square foot lease with Lockheed Martin at 1200 Redstone Gateway and over 160,000 square feet commencing at the National Business Park, which includes the 126,000 square feet of new space with the U.S. government.

With respect to development leasing, the midpoint of our 2023 target is 700,000 square feet. We have executed 464,000 square feet to date, including two data center shells and a 46,000 square foot build-to-suit in Redstone Gateway or a new headquarters building for Davidson Technologies, a rapidly growing defense contractor. During 2022, we placed 1.3 million square feet of development projects into service, which are 99% leased. We expect these deliveries, along with the nearly 850,000 square feet we expect to place into service during 2023, to contribute $12 million of cash NOI this year, of which 99% is contractual. The 2022 and 2023 deliveries, when combined with contributions from the remaining development pipeline currently under construction, will contribute annualized cash NOI totaling $66 million, 94% of which is contractual.

With that, I’ll turn the call over to Anthony.

Anthony Mifsud: Thank you, Todd. Fourth quarter FFO per share as adjusted for comparability of $0.60 was at the midpoint of guidance and the full-year result of $2.36 was $0.02 higher than the midpoint of our original guidance. The same-property portfolio ended the year at 92.4% leased, and same-property cash NOI declined 90 basis points. Within this result, cash NOI from the Defense/IT portfolio increased 1.3%, offset by a decline in the regional office portfolio, driven by the large move-out of Transamerica at 100 Light Street and the rent reset on the 15-year renewal of CareFirst at Canton Crossing. In January, we announced two new joint ventures with affiliates of Blackstone on 5 data center shells raising $250 million of equity proceeds.

The transactions closed in two tranches, one in mid-December for $60 million and another in early January for $190 million. The transactions were valued at a mid-5% cap rate on forward cash NOI and a GAAP cap rate just below 6.25%. Given the market environment, we found this to be very strong pricing. The achieved cap rate was about 150 basis points over the 10-year treasury, the tightest spread to treasuries of any of the venture deals we have executed. Given the strength of pricing achieved and uncertainty in the capital markets environment, we accelerated the $190 million transaction from the fourth quarter to the first quarter. Although this change in timing reduces 2023 FFO per share by $0.01, we felt it was prudent to take any capital and pricing risk off the table related to development funding.

Separately, our partner placed secured debt on two previously formed joint ventures. The weighted average spread on these loans is almost 200 basis points higher than our line of credit, and our share of interest expense on these loans also reduces 2023 FFO by about $0.01 a share. We expect this financing will be short-term measure since the loans only have a two-year term. At year-end 2022, our floating rate debt exposure increased to 15% from 7.5% at the end of the third quarter as $200 million of hedges, which fixed LIBOR at 1.9%, expired on December 1. In mid-January, we entered into $200 million of new interest rate swaps, which fixed SOFR at 3.7% for three years, hedging a portion of our variable rate exposure. With this transaction, we expect our floating rate debt exposure will remain below 10% during 2023.

With respect to guidance, we are establishing 2023 FFO per share at a range of $2.34 to $2.42, implying 1% growth over 2022’s results. At the midpoint, this guidance takes into account positive contributions, which include $0.08 from same-property cash NOI growth of 3% and $0.10 from developments placed into service. These contributions are partially offset by $0.10 from higher interest expense based on the increased SOFR curve; a decline in capitalized interest resulting from the large volume of projects being placed into service, and the incremental interest from the venture financing, and a total of $0.06 from an increase in total G&A expenses from backfilling several open positions, market increases in wages and a reduction in capitalized labor; lower development fees, which accounts for $0.02 of this reduction as significant construction work on behalf of a tenant was completed in 2022; and accelerating the timing of the $190 million joint venture transaction.

Our capital plan for 2023 is very straightforward. We expect to invest $250 million to $275 million to complete our existing 1.5 million square feet of active development projects and commenced new starts. Development investment will be funded with the proceeds from the completed venture, cash flow from operations and our revolving credit facility. Lastly, for the first quarter, the $0.57 midpoint of our guidance range is $0.03 lower than our fourth quarter 2022 results. The decrease results primarily from the impact of higher net seasonal operating expenses, which we typically experience in the first quarter. With that, I’ll hand the call back to Steve.

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Q&A Session

Steve Budorick: Thank you. Summarizing our key messages. We completed the highest level of vacancy leasing in 12 years during 2022. We’re off to a terrific start to development leasing in 2023, having executed over 460,000 square feet thus far. Our 1.5 million square foot active developments are 89% leased, providing a strong foundation for continued FFO growth. We’ve raised the necessary capital to fully fund the equity component of our development needs in 2023. And going forward, we anticipate self-funding in our equity requirements for development investments. The outlook for defense spending remains strong as defense budget has increased roughly $100 billion over the last 12 months. We delivered our fourth consecutive year of FFO per share growth that has compounded at 4% per year since 2018.

In 2023, we’re projecting modest FFO per share growth, and we continue to expect compound annual FFO per share growth of roughly 4% from 2023 to 2026. With that, operator, please open the call for questions.

Operator: Thank you, Mr. Budorick. And it comes from the line of Jason Belcher of Wells Fargo. Please proceed.

Jason Belcher: Thank you. Hoping you could give us an update on what you’re seeing in terms of construction cost trends and also if you could just touch on how we should be thinking about development yields near to midterm?

Todd Hartman: Sure. In terms of construction cost trends, we actually have a very real-time example with the build-to-suit that we just talked about with Davidson identical building to another building that we built on the site immediately adjacent to it. And those buildings have started almost exactly two years apart. The delta in cost is 16.4%, but our rent has increased commensurately to maintain our yield on those buildings. We’re seeing, from a materials cost basis, the costs are obviously still elevated, but the increase has moderated a bit. Some of the materials, most notably steel, are actually decreasing. So, the good news is, we’re able to continue to develop yields that matter historical numbers.

Jason Belcher: That’s helpful. Thank you. And then secondly, can you give us an update on the evolving challenges you’re seeing related to power supply cuts in Northern Virginia? And any potential delays that might cause in construction of new data center properties?

Steve Budorick: Well, there certainly is a shortage of power availability in Northern Virginia that delayed somewhat the execution of the leases that we just achieved. We expect to get one additional build-to-suit done sometime in the next 12 months to 14 months, and the new power supplies that are anticipated will start to materialize later in 2023, 2024, and then 2025.

Jason Belcher: Got it. Thanks very much.

Operator: Thank you. One moment for our next question please. It comes from the line of Michael Griffin with Citi. Please go ahead.

Michael Griffin: Great, thanks. Maybe we can just touch on leasing for a sec, mainly on retention. You’re expecting a higher rate in 2023 relative to 2022. But I think, Todd, you mentioned in your prepared remarks, some of that was driven by a delay in renewals from 2022 push to 2023. I guess is that mainly driving the, sort of delta year-over-year or are you seeing a stickier nature from some of your tenants on that?

Todd Hartman: No, I don’t think it’s driving a delta year-over-year. I believe it’s a stickier nature of our tenants. Certainly, some of that renewal that moved into this year will contribute to the overall retention rate. But really, it’s more a function of our tenant base and where we’re located than it is €“ in any sort of variations from year-to-year in terms of when leases are signed.