Corporate Office Properties Trust's CEO Discusses Q1 2014 Results - Earnings Call Transcript

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Corporate Office Properties Trust (NYSE:OFC)

Q1 2014 Earnings Conference Call

April 25, 2014 12:00 ET

Executives

Stephanie Krewson - Vice President, Investor Relations

Roger Waesche - President and Chief Executive Officer

Steve Riffee - Executive Vice President and Chief Financial Officer

Steve Budorick - Executive Vice President and Chief Operating Officer

Wayne Lingafelter - Executive Vice President, Development and Construction

Analysts

Craig Mailman - KeyBanc Capital Markets

Jamie Feldman - Bank of America

Emmanuel Korchman - Citi

Brendan Maiorana - Wells Fargo

Michael Knott - Green Street Advisors

John Guinee - Stifel

Michael Carroll - RBC Capital Markets

Tom Catherwood - Cowen

Dave Rodgers - Robert Baird

Tayo Okusanya - Jefferies

Operator

Welcome to the Corporate Office Properties Trust First 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, COPT’s Vice President of Investor Relations. Ms. Krewson, please go ahead.

Stephanie Krewson - Vice President, Investor Relations

Thank you, Mark. Good afternoon, and welcome to COP’s conference call to discuss the company’s first 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; 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 the 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.

I’ll briefly highlight one disclosure item in the current supplement related to Arborcrest, our office park in the Greater Philadelphia market. As we indicated at the beginning of our last call, we decommissioned 785 Jolly Road after Merck moved out at the end of February in anticipation of redeveloping the property. Until our redevelopment plans are finalized, we will present this property in our land bank, which is summarized on Page 24 of the first quarter supplement.

Before turning the call over to management, let me remind 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 release space under favorable terms, regulatory changes, government actions and initiatives, 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.

Roger Waesche - President and Chief Executive Officer

Thank you, Stephanie. Good afternoon everyone. As our first quarter results illustrate, we are on track to meet our strategic objectives for 2014, the first of which relates to occupancy. We began the year well-leased and based on the level of demand we are tracking we forecasted modest improvements in same office occupancy for the year. As Steve Budorick will discuss in more detail, we are solidly in line with those occupancy and leasing expectations.

Our second objective for this year is to continue creating significant value for shareholders with our development pipeline. Going into this year, we outlined four potential developments and have already started construction on three of them. Next month, we will start the fourth building, which is significantly pre-leased to a cyber security-related tenant.

We remain confident that this year’s second quarter will mark the bottom for our quarterly FFO per share and that leasing in both our operating portfolio and our development pipeline will generate higher quarterly results hereafter. With the passage of the Bipartisan Budget Act, the business environment for defense contractors in particular has improved and supports our positive leasing outlook.

As a reminder, the act established the base DoD budget for fiscal ‘14 and ‘15 of approximately $500 billion, which is flat relative to fiscal ‘13 defense spending levels. The act also removed the requirement for across the board cuts so that spending can now be allocated to fund priority projects. So even though spending will be flat this year and next, certain programs will receive greater allocations. For example, in this fiscal 2015 budget proposal the President requested a 10% increase in the DoD’s cyber security budget to $5.1 billion.

Our portfolios clustered around defense installation whose submissions are aligned with the DoD’s high-tech spending priorities. We are well positioned to win a significant amount of the growing cyber related demand both from contractors serving the DoD and from high-tech companies fulfilling the commercial applications of cyber security. We have certain advantages when competing to earn this business including strategic land positions in the region increasingly referred to as Cyber Valley, the scope and scale of our appropriately credential personnel and our track record of success in providing facilities for more security conscious tenants. These advantages combined to make us uniquely positioned to meet cyber demand.

With that, I will turn the call over to Steve Budorick to update you on our leasing activity.

Steve Budorick - Executive Vice President and Chief Operating Officer

Thanks Roger. At March 31, our total portfolio is 89.8% occupied or 70 basis points higher than year end 2013 levels and our same office portfolio is 89.9% occupied, up 50 basis points in the quarter. Occupancy gains in the first quarter outweighed non-renewals in nearly every one of our markets. And we are encouraged by the improving fundamentals we see in our sub-markets. Half of our portfolio is located in the Baltimore, Washington corridor. These sub-markets continue to demonstrate improving conditions, positive absorption, solid prospect activity and improving occupancy rates. Concessions remain balanced and reasonable with stable rental rates, diminishing availability of large blocks of space and steady demand.

In Northern Virginia five of the six sub-markets in which we operate experienced positive absorption in the quarter. Moreover, since the budget control act was passed in January we have experienced significant increase in prospect activity. Our two largest vacancies in Northern Virginia are 3140 Fairview Park and 7770 Backlick Road. Both buildings are new and adjacent to defense segment demand drivers. We signed a 19,000 square foot lease in 3140 Fairview Park early during the quarter and we are encouraged by increased activity levels at both properties. In summary we are pleased with our activity levels generally and confident market activity will support our business plan for 2014.

Looking at first quarter results, we leased a total of 446,000 square feet including 144,000 square feet of renewals. Our 56% renewal rate is consistent with our expectation to renew on average 60% of expiring leases for the year. Additionally more than half of the non-renewing space this quarter will be absorbed by new and expanding tenants later this year or said another way we are in the process of finalizing new and expansion leases to absorb roughly 60% of the square footage that did not renew this quarter.

On our February 7 call we reported our revenue at risk to achieve the midpoint of our 2014 full year guidance was $10.2 million, down from $11.1 million at the beginning of the year. Currently our revenue at risk is down to $6.7 million. We are in negotiations on approximately $4.5 million of this revenue leaving only $2.2 million of unidentified revenue at risk. With strong demand we have already captured and are in the process of pursuing support our expectation that the same office occupancy will end the year modestly higher than January 1 levels despite previously disclosed non-renewals.

Development leasing which includes redevelopment leasing totaled 176,000 square feet in the quarter and included a 90,000 square foot lease with KEYW an existing cyber security tenant that has leased 74% of a new building that we will start in Arundel Preserve to accommodate their growth. In fact, KEYW already is indicated that they may lease the remaining floor of the building. Average lease terms on total leasing in the first quarter were a solid 7.1 years. Lease terms on renewals averaged four years. And new and development leases averaged 7.1 years and 9.7 years respectively.

We believe customer enjoying this to make long-term commitments, evidences, growing confidence in their businesses. Before turning the call over to Steve Riffee I’ll update the incremental NOI we expect to recognize in the future from development leasing. On our last call we reported on 19 recently completed and active development projects that would add an incremental $44 million to future cash NOI.

Accounting for first quarter releasing today those 19 buildings are forecasted to generate $46 million of incremental cash NOI. Of this $46 million, $26 million of NOI is associated with executed leases and therefore has no risk. These leases contributed $1.6 million to the first quarter cash NOI and will contribute total cash NOI of $9 million in 2014. We continue to actively work on transactions to generate the remaining $20 million.

Three of the development starts with that on Page 22 of the supplement are intended for government users. They total 511,000 square feet and once leased should account for more than half of the $20 million of the currently uncommitted future NOI. This $46 million of future NOI from the pipeline of projects demonstrates the strength of our development platform and its ability to generate strong returns and earnings for our future growth.

On that note I’ll turn things over to Steve Riffe.

Steve Riffee - Executive Vice President and Chief Financial Officer

Thanks, Steve, and good afternoon everyone. First quarter FFO per share was $0.48, $0.01 above the high-end of our guidance. Our AFFO payout ratio for the quarter was a conservative 69%. We attribute our outperformance to $0.02 of higher than budgeted development fee income in the first quarter, $0.01 of which was just the timing difference and $0.01 of which was upside to our original annual guidance.

Although we incurred higher snow removal and utility cost these overages will largely offset by higher recovery and one-time property type refunds. Specifically we spend $6 million on snow removal, which was $3.5 million more than we budgeted. We also incurred $700,000 of utility cost in excessive budget. Offsetting these overages were $2.7 million of increased tenant recovery and $0.5 million of one-time property tax refund and another $0.5 million of other expense savings. This resulted in a net unfavorable operating expense in the quarter of roughly $500,000 or about $0.50.

Our same office portfolio in the first quarter represented 92% of our core square footage and core NOI. Excluding lease termination fees same office cash NOI was essentially flat with the first quarter 2013. Without the increased net snow removal cost and the one-time real estate tax refund same office cash NOI would have increased 1% over the prior year. Within the same office pool building, serving our strategic tenant niche represented 81% of same office cash NOI and ended the quarter 94.5% occupied.

For the first quarter these properties same office cash NOI excluding lease termination fees increased 3.3% over the first quarter of 2013. We continue to maintain the conservative balance sheet to fund future growth. At March 31 our debt to adjusted book ratio was 43.5%. Our debt to EBITDA was 6.8 times and our fixed charge coverage was 2.9 times. We expect to create additional borrowing capacity to fund investment in development and resolving a $150 million non-recourse loan that is secured by two buildings in Northern Virginia. The process will take several months to finalize and although the cash economics related to these buildings no longer our factor, we do not expect to transfer title of these properties until later in the year. Our 2014 guidance reflects this assumption.

I’ll finish my remarks with some color on our full year and second quarter 2014 guidance. For the full year we are raising the low end of our prior guidance range by $0.01 to reflect the portion of development piece in the first quarter that were above our annual expectations. Our revised range of FFO per shares adjusted for comparability is now $1.85 to $1.92.

We continue to forecast a conservative AFFO payout ratio for the full year of approximately 80%. For the second quarter we expect FFO per share as adjusted for comparability to be between $0.43 and $0.45. We forecast same office occupancy to be essentially flat in the second quarter. So to reconcile our first quarter 2014 diluted FFO per share of $0.48 to the midpoint of our second quarter 2014 range of $0.44 subtract the $0.02 of upside from the development piece in the first quarter. Then subtract another $0.02 to account for dilution for the move-out of Merck from Arborcrest at the end of February and the April 1 removal of the NOI and interest expense associated with the two properties we’ll likely convey to satisfy the related CMBS loan.

Importantly we continue to expect that second quarter FFO per share will be the low point of our quarterly results. In the third and fourth quarters we expect internal growth from modest same office occupancy gains and the in-place development NOI to generate prior FFO per shares adjusted for comparability than our forecasted second quarter results.

And with that I’ll now turn the call to Wayne.

Wayne Lingafelter - Executive Vice President, Development and Construction

Thanks, Steve. I’ll make a few brief remarks about the development and redevelopment portfolios which currently stand at 1.6 million square feet. Let me start by highlighting two buildings we placed into service during the quarter in which no longer are listed on Page 22 of this supplement. The first building 1100 Redstone Gateway in Huntsville Alabama is 100% leased to Boeing and is the third of a three building campus we built to accommodate their consolidation in the Redstone Gateway. The second building placed into service in the quarter was 15395 John Marshall Highway in Haymarket Virginia.

The building is also known as COPT DC-11 and is fully leased to a single tenant pursuant to a 10 year lease. Also in Northern Virginia we anticipate delivering this COPT DC-9 in the third quarter. This building will be 100% occupied by a single tenant also pursuant to a 10 year lease. At the request of the tenant this delivery has been accelerated by approximately nine months from the second quarter of 2015 to the third quarter of this year.

Based on an executed lease for 74% of the building we will start construction in May on 7880 Milestone Parkway, the next contractor building in Arundel Preserve. The tenant KEYW is a defense IT contractor who is building an Advanced Cyber Research And Training Lab. Three of the projects under construction are intended to fulfill anticipated government demand. As those of you who have covered our company for a while already know our government customers do not procure through the GSA, so we must build certain projects speculatively in order to have the opportunity to earn the business.

The three current projects are located in the National Business Park at Century Gateway in St. Antonio Texas and on land we own in Northern Virginia. Each project is adjacent to a strong government demand driver and designed to accommodate cyber-related and or high-tech uses. These factors bolster our confidence but each building will be fully leased in the coming quarters.

Finally I’d like to highlight a few positive developments at Arborcrest, our redevelopment project in the Plymouth Meeting submarket of Philadelphia. We began redeveloping in 2009 and have completed three buildings totaling 514,000 square feet that in aggregate are 95% leased. We recently executed a lease for 79% of the fourth building shown on Page 23 of this supplement as 731 Arbor Way and anticipate lease commencement in the first quarter of 2015. We continue to experience strong demand for the limited space available in the project.

We expect to average a 10.5% yield on the $104 million incremental investment we’ve committed to the redevelopment at Arborcrest. Based on these attractive returns and the demand we see for modern efficient office space we expect to redevelop the buildings recently vacated by Merck. We will refer to this building in the future as Woodlands and assuming demand remains strong, expect to commence construction after finalizing our redevelopment plans.

And with that I will turn the call back to Roger.

Roger Waesche - President and Chief Executive Officer

Thank you, Wayne. In summary, the first quarter marked a strong start for the year. Our operations are at a positive inflection point and we are pleased that our portfolio occupancy is improving in all of our markets, demand for newly developed space in our strategic tenant niche and in select sub-markets is strongly growing and occupancy gains from leases already executed or in the process of being completed will drive FFO higher beginning in the third and fourth quarter s of this year. With that operator please open up the call for questions.

Question-and-Answer Session

Operator

Thank you, Mr. Waesche. (Operator Instructions) Your first question comes from the line of Craig Mailman from KeyBanc Capital Markets. Please proceed.

Craig Mailman - KeyBanc Capital Markets

Good afternoon guys. I apologize if I missed this, just want to go back to KEYW and the expansion, are they staying in the space they are currently now or are they relocating, I guess another way is that a net expansion for them or is it going to be net-net a smaller absorption for you guys in the future?

Steve Budorick

It’s expansion Craig. There is one small component of the leases we have with them that they will move into this but it’s a minor part of it. The bulk of this is expansion.

Craig Mailman - KeyBanc Capital Markets

Okay, they are in MBP now?

Steve Budorick

No they are not. They are in Arundel Preserve and another location we call The Commons.

Craig Mailman - KeyBanc Capital Markets

Okay. And then just more broadly Steve maybe you can update us on where the prospect pipeline is I think last quarter you said about 775,000 square feet. And then I guess just more broadly it sounds like your primary contractor tenant base is getting obviously conditions are improving there just curious has the mindset changed at all with them or are they taking the perspective space ahead of contract awards or is everyone still being pretty prudent with their space needs?

Steve Budorick

Okay I will try to handle all those points Craig. On the same basis we reported that pipeline previously we are about 875,000 square feet now and since we had those discussions about 425,000 has been signed. And we continue to work on the balance of it and its promising outlook. With regards to the contractor view point there has definitely been a significant increase in activity and showing in demand. We continue to be pretty conservative and keep their eye on contracts awards or re-completes before making commitment, but expectations are significant higher than they were throughout last year.

Craig Mailman - KeyBanc Capital Markets

I mean I guess it’s a bit earl in the year and I guess some of the contracts are going to be kind our hitting later but as you guys stand here versus the end of last year are you feeling better about the prospects of exceeding your occupancy guidance at this point or I know you are saying that everything is coming in line with your expectations but are you getting the sense, the gut feeling that maybe things could break open a little bit lighter here as the year progresses or is it just too early maybe we need another three to four quarters of the budget kind of flowing through?

Steve Budorick

Yes, I think it’s a little early to project a breakout if certainly there is improvement in attitude and activity we are confident we can achieve this year’s plan and looking forward we anticipate improvement but it will take time to emerge.

Craig Mailman - KeyBanc Capital Markets

Great. And then just one last quick one I think on the build to suits I guess you guys outlined is three do you say the fourth one you guys have a good visibility on or that you already signed something that’s going to start next quarter?

Steve Budorick

Well, the fourth is the KEYW that we have not yet started and with three are on the supplement that Wayne pointed out in NBP, San Antonio and Northern Virginia. Those are in process.

Craig Mailman - KeyBanc Capital Markets

Great. Thank you.

Steve Budorick

That is for government.

Operator

Your next question comes from the line of from Jamie Feldman from Bank of America. Please proceed.

Jamie Feldman - Bank of America

Great. Thank you. I was hoping you guys can give us an update on tenants you think are at risk of moving out and just potential down sizing among the contractors, how should we think about your portfolio both for the end of the year and even beyond in terms of large tenants at risk?

Steve Budorick

Well, I will remind you that at the end of this year we are losing roughly 150,000 square feet in Westfield as our tenant there moves to a building they built for their own use. And then with regard to kind of tenant decisions on renewal, it’s really continues to be a resetting of the equilibrium where we do have tenants that are continuing to get smaller and more efficient, but increasingly, we are expanding tenants as well. So, there is kind of the mix.

Wayne Lingafelter

I think Jamie an important point is that we will still have some setbacks like aerospace at the end of this year, but we now are comfortable with the activity level of re-tenant leasing that we can keep even and make progress towards our 93% goal and then of course on top of that we have got our development pipeline, which is creating value for the company.

Jamie Feldman - Bank of America

Okay, thanks. And so, I guess – and then beyond 2014 are there large move-outs we should be thinking about as we are thinking about 2015?

Wayne Lingafelter

Well, in 2016, we have MITRE for 150,000 square feet in Tyson’s Corner. That’s probably somewhat at risk because of the campus that they have in that around the corner from there that they maybe expanding, that’s 150,000 square feet. That’s the one that comes to mind at this point.

Jamie Feldman - Bank of America

And you said 2016?

Wayne Lingafelter

Correct.

Jamie Feldman - Bank of America

Okay. And then I guess turning to Steve Riffee, there has been some questions just on what’s changed in your back half of the year guidance. Can you just talk about it from the last time you provided guidance how you are thinking differently in terms of pennies per share for the third and fourth quarters?

Steve Riffee

Yes, let me do that Jamie. Just talking about our guidance, we $0.01 of the outperformance in the first quarter because of the development fees was a shift from the second half of the year. So there is $0.01 that moved to the first quarter that we originally had in the second half of the year. Then we raised the bottom of our annual guidance range for $0.01 fees that really represent outperformance for the whole year. And we are being somewhat conservative but not adding that $0.01 to the top of the range also. The rest of our guidance for the year is otherwise unchanged.

Jamie Feldman - Bank of America

Okay. So, there is no change to your core outlook?

Steve Riffee

Correct.

Jamie Feldman - Bank of America

For the rest of the year, okay. And then just finally can you guys talk about what you are seeing outside your strategic portfolio in terms of just more traditional office and how that may have changed in the quarter positive or negative?

Steve Budorick

Outside of the strategic portfolio, we continue to see improving conditions. Our Baltimore East submarkets, we have got good activity. And we have been pleased with our leasing over the four quarters and we continue to see improvement.

Jamie Feldman - Bank of America

Okay, alright. Thank you.

Operator

Your next question comes from the line of Emmanuel Korchman from Citi. Please proceed.

Emmanuel Korchman - Citi

Hey, guys. Just wondering how are you seeing tenants either make their decisions or how is the decision-making process changed given the amount of available inventory when they are out there looking for space?

Wayne Lingafelter

Well, I think it depends on the location. So, in the Baltimore/Washington corridor, there is no large box of space in order for somebody to obtain a large box of space. There have to be unknown move out if somebody not fully utilizing their space or somebody would have to build the building. Further, Virginia is a little different. There is – there are plenty of large box of space in Northern Virginia and I do think it’s a competitive market. And so we have got to respond and be aggressive in that particular market and submarkets. Although I will say that the submarkets that we are operating in are a little better than the overall Northern Virginia market like the Herndon market and even the Route 28 South market.

Emmanuel Korchman - Citi

Great. And then on the datacenter, any news you can share there?

Steve Budorick

We did not complete a transaction this quarter. We have about 14 to 21 megawatts of active prospects that we are working with. We have had some – are in the process of some very comprehensive discussions and we are confident we are moving in the right direction.

Emmanuel Korchman - Citi

And are those in your sort of traditional defense or government type user or just general data center use?

Steve Budorick

Larger chunks of that demand is associated with contract integrators serving the U.S. government but there is a component that is not government oriented.

Emmanuel Korchman - Citi

Alright. Thank you very much.

Operator

Your next question comes from Brendan Maiorana from Wells Fargo. Please proceed.

Brendan Maiorana - Wells Fargo

Thanks. Good afternoon. I am not sure if this is for Steve or for you Steve Budorick, but the occupancy outlook Steve Budorick I think you mentioned that your expectation by the end of 2014 would be that the same store pool would be higher than where you began the year and to your credit you moved it up 50 basis points in the first quarter from where you were at year end so is that – did I hear that commentary correctly and is that kind of the expectation for occupancy maybe sort of flattish from where we stand today?

Steve Budorick

Where we projected was a modest increase from Europe from year end levels and we will continue to make progress in the next few quarters but we do have a large move out that’s going to occur in the fourth quarter that’s almost 150,000 square feet and that’s going to pushes back towards where we started the year?

Brendan Maiorana - Wells Fargo

So maybe I just don’t – maybe my recollection is off I thought that when we had talked maybe a couple of quarters ago that the expectation was that the year end number which I think the original year end number included the 785 Jolly Road, the Merck move out and the aerospace move out that likely you would kind of start at that number, dip down from Merck and dip down from aerospace but kind of make that back and get kind of flat to those number but I guess as you are reporting it 785 has gone into redevelopment or land so that gets stripped out of the pool and it sounds like maybe there is a reduction of if we included that in the pool occupancy is lower at year end ’14 than it would be at the end of ’13 is that correct?

Steve Riffee

Brendan, this is Steve, let me help at the beginning when we gave our guidance on the last call, Stephanie was clear that we were decommissioning Jolly Road so apples-to-apples Jolly Road was not in the numbers that we were talking about at the beginning of the year numbers to the end of the year. Then we are saying that even though we are absorbing aerospace in the fourth quarter we will end up with same office occupancy above the beginning of the year levels. And we have already made some of that progress and actually it will go up a little bit where we have to absorb the aerospace moving out and so it will go up a little bit higher absorb the aerospace move into November and still end up higher than we began the year.

Roger Waesche

Brendan we should also just be real clear that 785 Jolly Road was a never in the same office portfolio. It was in the overall portfolio occupancy, but it was never in the same office. So we didn’t get the benefit this quarter by taking that project out of service.

Brendan Maiorana - Wells Fargo

Okay and so it wasn’t in the same office at 12/31/13?

Roger Waesche

That’s correct.

Brendan Maiorana - Wells Fargo

Okay, alright, thanks. And then just last one so Roger you mentioned that cyber has got good activity how much of your portfolio would you say is directly impacted by demand for cyber and then how much of it do you think is kind of indirectly impacted by all the positive things that are happening on the cyber front?

Roger Waesche

Well, the Baltimore/Washington Corridor represents approximately 50% of the company’s square footage so I would say that all of that square footage is in play for cyber opportunities whether it’s at the National Business Park, Arundel Preserve, Columbia Gateway and in fact we do have a couple of cyber tenants who have taken occupancy in the last couple of quarters in Columbia Gateway in our portfolio and then even Airport Square. So I think all of the Baltimore/Washington Corridor and then of course San Antonio also has a cyber opportunity it’s possible we will have a little bit of that opportunity in Northern Virginia. I mean they are pushing hard to try to grow their cyber presence in that region but we are not counting on that at this point.

Steve Budorick

Brendan 65% of the development leasing we did this quarter was cyber-related, 10% was strategic or defense and 75% of the total was internet.

Brendan Maiorana - Wells Fargo

Okay. And then I guess just the other kind of your other region, San Antonio, Huntsville, and then kind of the few things elsewhere that’s kind of not cyber impacted, is that correct?

Steve Budorick

There is a component of cyber in San Antonio. So that is a cyber market if you will, not so much Huntsville.

Brendan Maiorana - Wells Fargo

Okay, great. Thank you.

Operator

Your next question comes from the line of Michael Knott from Green Street Advisors. Please proceed sir.

Michael Knott - Green Street Advisors

Hi, guys. Curious, I think you may have touched on this a little bit, but can we just talk a little bit about the outlook for your Northern Virginia portfolio? It’s obviously an outlier on the rent roll down side and then on the new leasing side, it’s got again a notable outlier in terms of leasing costs compared to your other markets. So just curious is there light at the end of the tunnel in this market or is it still just kind of hand to hand combat for a while, how do you feel about it with your existing portfolio?

Steve Budorick

Let me peel those two points that you pointed out on our statistics back a bit. With regards to the renewals, we did an early renewal with the 35,000 square foot tenant in the Westfield submarket this year that’s in the statistics. And that tend to head to the place for 10 years. The lease has escalated for a long period of time and the market reset drove the change in the cash rent roll down higher than we typically experienced. Had we not done that lease, our rent roll down would have been 3.5% negative on the cash basis. And we looked at that as a defensive strategy to get this tenant locked in through 2021 in a market where we know there is going to be vacancy and we are getting 150,000 square foot back at the end of the year. So we are just getting ahead of the curve there.

With regard to the leasing cost on the new lease, that was in 3120 Fairview Park. Concessions are high on new leasing in Virginia, but I remind you that building is in raw condition. So we had to build it from basically concrete slab and it’s a very long lease and so there is a higher commission component to that deal.

Michael Knott - Green Street Advisors

Okay that all makes sense except on the new leasing the number I am seeing was 5.8 year lease term, is that a blend of the long deal you decided and something else?

Steve Budorick

No, you are correct. That is the 5.8 year.

Michael Knott - Green Street Advisors

Okay. And then Roger, I think I may have heard you say this earlier about 93%, but I was going to ask if you could remind us, you guys have stated previously a longer term or I guess medium term occupancy target and I think maybe for ‘15 or ‘16, I was just going to ask if you could remind us what that number is and how you feel about getting there over the next couple of years?

Steve Budorick

Hey, Michael, can I go back to the PowerPoint?

Michael Knott - Green Street Advisors

Sure.

Steve Budorick

If you look at that, you are looking at the wrong line, it’s 11.1 years. The new lease was – it’s in the development column, it’s 11.1 years.

Michael Knott - Green Street Advisors

Right, pardon me, thanks.

Steve Budorick

Alright, sorry, I will turn over to Roger.

Roger Waesche

So with respect to the 93% goal right, that’s a 3-year goal and probably in a perfect world we would do it sooner rather than later, but I think a linear progression is probably good both for the company. And so if we can – if it’s 4% to get there or so, if we can do it 1-1/3% a year for three years and get it to 93% we would be happy.

Michael Knott - Green Street Advisors

Okay, that’s helpful. And then just two other quick ones for me, on your top tenant list, and I noticed from an earlier question, Roger your response you didn’t mention this, so I assume it’s just fine, but on the top tenant list, L3 I think is listed as having six months of term left and it’s a decent sized tenant. Can you just talk about whether that’s going to be renewed shortly or how you feel about that one?

Roger Waesche

Right. We renewed them in the month of April. So that will show up in the second quarter statistics, 156,000 square feet.

Michael Knott - Green Street Advisors

Okay, thanks. And then last one is on the development schedule, you have the two somewhat cryptically described Northern Virginia projects I know there is some purposeful required non-disclosure there but just curious can you talk about the prospects for the non-lease – excuse me un-leased development there of those two?

Steve Budorick

We have confidence we will lease it this year.

Michael Knott - Green Street Advisors

Okay and you guys have not disclosed where, what part of Virginia that is, correct?

Steve Budorick

No we haven’t.

Michael Knott - Green Street Advisors

Okay, that’s it for me. Thanks.

Operator

Your next question comes from the line of John Guinee from Stifel. Please proceed.

John Guinee - Stifel

Great, okay. Thank you. First question I guess Steve Riffee when is your preferred shares redeemable your H and L?

Steve Riffee

The H are callable now John.

John Guinee - Stifel

How about the Ls?

Steve Riffee

Three years from June, so June of ‘17.

John Guinee - Stifel

Okay, so that’s in the bag there is lot of FFO growth but most of it’s not available until ‘17, why not call the H series now?

Steve Riffee

We will keep evaluating it right now from just a source and use of capital allocation we haven’t decided to do that but it is something that would probably make sense at some point John.

John Guinee - Stifel

Okay. And then the 1st Mariner Bank building Roger is your is – does the lease survive whatever is going on with the 1st Mariner Bank?

Roger Waesche

That’s right. Our lease was with the bank and not with the holding company. The holding company was put in bankruptcy, so that the bank would be sold, the bank was sold. Now recall we have down sized our 1st Mariner risk in that building over the last couple of years by having CareFirst take on the largest part of their occupancy so with respect to 1st Mariner although it will be a well capitalized bank going forward. We have 40,000 square foot exposure in that building.

John Guinee - Stifel

Okay. And then Wayne when Merck becomes Woodlands does that building get scrapped down to the dirt or do you try to do something with the steel frame or do you decide to do something keeping the skin in place what’s the magnitude of the redevelopment?

Wayne Lingafelter

John we are looking at all of those options I would say right now that there is probably a bit of bias to kind of duplicate the success we have had at the Hillcrest neighborhood which would suggest that we take it down do the steel frame and the slab and then rebuild from there. But you will know that the configuration of that building is a bit different so we have got to look at it closely and make sure that we can create viable long-term office space and we are right in the middle of that analysis and we will keep you updated on that as it progresses.

John Guinee - Stifel

Okay and then on the same subject and this is just out idle curiosity, if you look at Page 23 your incremental development cost of Arbor Way, Pecan Court, Alexander Bell Drive, Arbor Way again is in $140 to $155 a square foot range, what are you doing are all these where you are taking them down to the steel or are you taking them all down to the dirt or what’s the magnitude because this clearly not paint and carpet for $150 a foot?

Wayne Lingafelter

Yes, you are right it’s certainly not John that’s we are pursuing a strategy there to work with our secured customers in the market. So there is a little bit more of an investment that has to go into that in order to create ATFP condition. We have a line of sight on demand that we think over time will materialize in that sub-market if we can produce seats that are secured.

Steve Budorick

That comment was with respect to Pecan Court John.

John Guinee - Stifel

Yes, okay, Pecan Court but Blue Bell – okay so Blue Bell is all the way down to the stell frame, Pecan Court is something unique, how about Alexander Bell Drive?

Wayne Lingafelter

The big thing there is we are increasing the square footage. Today the building is 39,000 square feet. We are increasing the square footage to 52,000 that’s why this per square foot seems higher.

Steve Budorick

And upgrading the curtain wall, we are basically giving it the utility of a new building using the structure that we have in older property.

John Guinee - Stifel

Okay. And then last question is if I look at Page 11 and hind sight is always 20-20 but North Gate Business Park sort of held 50%, Patriot Ridge. Is there a sense that these markets are, they are what they are and they are not going to get any increased demand related to the particular tenant or government agency or is there still light at the end of the tunnel where there maybe additional demand down the road for the contractors?

Steve Budorick

Well, let’s deal with North Gate initially. There was significant amount of speculative development contemplating a very large frac relocation. And roughly a third of that frac emerged in the last few years with the budget environment we have all looked through in shorter term contracts. Over the long-term, two or three years, we think that will improve. With regard to Patriot Ridge, it’s really directly related to the impasse that occurred last year. Since the Budget Control Act has been passed, our activity is way up from what it was in 2013. We now have demand that exceeds the availability that we have in the building and things are normalizing quicker.

John Guinee - Stifel

Great. Alright, thank you very much.

Operator

Your next question comes from the line of Michael Carroll from RBC Capital Markets. Please proceed.

Michael Carroll - RBC Capital Markets

Thanks. Steve, of the 14 to 21 megawatts of activity that you are tracking at DC6, how much of that would you characterize as promising?

Steve Budorick

Promising, I would say 4 to 6.

Michael Carroll - RBC Capital Markets

Which is last quarter did you say 5 to 8?

Steve Budorick

Yes. I am just kind of pulling the number off the top of my head, I didn’t look at it, but we have been in very comprehensive discussions with several larger requirements that are seeking a very high quality of technology to support these uses. And it’s the same number.

Michael Carroll - RBC Capital Markets

Okay. And then how should we think about I guess the timing of this activity say if you sign 4 megawatts in the second half of ‘14, when does the tenant actually take space and when would rent actually commence?

Steve Budorick

There are several tenants involved. One could start paying rent in the mid third quarter and others would really face it in 2015.

Michael Carroll - RBC Capital Markets

Okay. And then as we move into 2015, should we expect a more stable pace of activity for DC6 or will it stay kind of lumpy like it has been?

Steve Budorick

It’s hard to predict. These are large decisions by major corporations or associated with competitions for government contracts. It’s a slow sales cycle. So, I think it will improve in pace, but continue to be lumpy.

Michael Carroll - RBC Capital Markets

Okay, great. Thank you.

Stephanie Krewson

Operator?

Operator

Yes.

Stephanie Krewson

Next call please.

Operator

Your next question comes from Tom Catherwood from Cowen. Please proceed.

Tom Catherwood - Cowen

Yes, good afternoon everybody. One question in general on the Northern Virginia assets that will likely going to be transferred back to lenders towards the end of the year. As we think about the assets that were transferred in 2013, you guys had mentioned how it was a kind of thing where it was tough to get lenders or servicers’ attention until the loans actually went into default. With the move-out of Northrup and CSC having happened in April, are you getting more attention from the lenders now and kind of how are those discussions going?

Steve Riffee

Well, maybe just to correct something you said, the loans last year never went into default. We have requested and we are able in that case to work with the special servicer. What we couldn’t do was agree on a discounted payoff or buyout and ultimately decided to convey the properties to the lender in the form of the deed in lieu.

Tom Catherwood - Cowen

Got it.

Steve Riffee

This one we actually have not been able to get the master servicer that is transferred to the special servicer in advance. And as of April 1, when tenants moved out of those buildings, the cash flows in the property no longer were sufficient to the service the debt. So now we do have a technical default, which should trigger the master servicer to transfer to the special servicer. That hasn’t happened yet. The default has, but not the transfer to the special servicer. We will be likely to be working with the same special servicer as before. So we will again try to negotiate a good economic solution for all parties, but it’s likely and our guidance assumptions assumes that ultimately we will end up conveying those properties as well.

Tom Catherwood - Cowen

Got it. It makes a lot of sense. And then the second question I have is kind of more a theoretical one and it may not affect you, because it maybe more of a CBD issue, but for years and years GSA has discussed the moving of government contractors into owned space, there has been edicts put down that this has to happen and then nothing was funded, so nothing really happened. And it seems like there is more news out there these days that this is actually going to get funded that something may really happen. So my question to you guys is a) is this something that could really happen or is it just kind of the talk and b) is it something that could potentially impact you or is that more again of a kind of a downtown issue?

Steve Budorick

Well, we don’t do much GSA leasing. I think it’s really a downtown issue that you are talking to. There are occasions in circumstances where contractors exist inside government owned buildings in our component of the business, but it’s relatively minor and increasingly we see that those contractors being squeezed out not pulled in, but we don’t think….

Tom Catherwood - Cowen

Got it. Alright, got it, thanks a lot. That’s it for me.

Operator

Your next question comes from the line of Jamie Feldman from Bank of America. Please proceed.

Jamie Feldman - Bank of America

Great, thank you. Just a follow-up. So I think you guys did a good job walking through the submarkets that are exposed to cyber, but I guess the flipside of the question is can you walk through the submarkets and percent of the portfolio that are actually exposed to where you think there may still be defense cuts and kind of the deteriorating part of the defense budget as opposed to the growing?

Steve Budorick

Well, we don’t have a lot of current exposure, for instance, in Huntsville, Alabama, we don’t think that, that particular location has any significant risk. We just created the new campus for billing and we have one other building that’s in the process of getting leased. Probably, Northern Virginia would still be the one with the biggest exposure, but we are – as we have said before we think we are late in the innings on the contractors rightsizing their space requirements to their new business model. So we think we are towards the end of the exposure.

Jamie Feldman - Bank of America

It’s really just Northern Virginia at this point?

Steve Budorick

Right.

Jamie Feldman - Bank of America

Okay. And then I guess just taking a step back, if you look out several years here, we are just coming off of the first period in a long time, where we actually have a budget and contractors are making decisions. I know you guys don’t like to give – make lofty projections, but just what do you think – what kind of growth could you see, not necessarily for your earnings or anything like that, but just in terms of the total pool of demand for the kind of space you would be able to build or even competitors would be able to build based on the fact that we are at the very early stages of kind of a defense spending recovery for tech?

Roger Waesche

Well, today, we have $375 million under construction or redevelopment on our asset base, that’s like 8%. So I mean that’s a pretty sizable number. So if we could maintain a 5% add to our asset base for new highly – high quality, well-located buildings going forward we will be very happy.

Jamie Feldman - Bank of America

Okay. And you think the market would be there for that based on what you are seeing and what you could see?

Roger Waesche

You are never sure. I mean, it’s an uneven business. Development opportunities aren’t linear. And currently, we have been in a good start where we have had pretty nice buildup for the last three years in terms of demand. And we still think there is some pent up demand for our customers as we move into the next couple of years.

Jamie Feldman - Bank of America

Okay, alright. Thank you.

Steve Budorick

Can I throw in a comment? The one trend that we have experienced over the last two years is customers demand for higher quality buildings that need efficiency objectives and operating objectives. And that’s really fueled our development pipeline. And I remind you that just few quarters ago we talked about something called our shadow pipeline, which was four or five development opportunities. All five of those have been now moved into our development pipeline that’s reported in the supplement. Then we continue to engage in conversations with other customers for development opportunity for the future. So we see a continued opportunity to develop in the medium term.

Jamie Feldman - Bank of America

So where would you put that shadow pipeline today?

Steve Budorick

We are not characterizing the shadow pipeline today, but there are several projects that we are talking about with various people and locations that are pre-shadow pipeline.

Jamie Feldman - Bank of America

Okay. Alright, great, thank you for the color.

Steve Budorick

Thank you.

Operator

Your next question comes from the line of Dave Rodgers from Robert Baird. Please proceed.

Dave Rodgers - Robert Baird

Yes, good afternoon. And maybe for Roger or Steve Budorick, I mean, you talked about your development pipeline 75% I think you said of the first quarter leasing and the development pipeline with cyber or strategic defense, which is kind of great to hear. The pipeline to Jamie’s question continues to be pretty robust, but when we look at Northern Virginia with aerospace and MITRE potentially and WTP, the asset there and the problems that you are having I guess maybe with tenants that are electing for other options. I mean, what are the alternative options for some of the existing buildings. Clearly, the growth is coming on the development side, but are you still able to backfill old contractor space with new contractors or is this really going to have to go out to the market and are we going to see this redevelopment pipeline continue to get bigger? I am just trying to get a sense for the aftermarket bid for the older strategic assets that you have?

Steve Budorick

Sure. If you take our portfolio in Northern Virginia and you strip out 3120 and 7770, we have had some turnover, but we are generating new leases in much of those contractors. For instance and those buildings are currently roughly 92% leased or we have good deal flow in what vacancy we have. With the budget environment last year, it was difficult to get leasing into the raw space at those two buildings because that requires a longer term decision and that confidence wasn’t there. We see that confidence is appropriate.

Dave Rodgers - Robert Baird

And the backfilling that you are doing on the strategic defense side, I mean, are these contracts or these projects going to equal to the mission-critical nature of the previous or existing tenants in those spaces? I mean, essentially asking if you are shifting kind of the more strategic nature to the development pipeline and these become a little bit more commoditized contracts?

Steve Budorick

Not at all. As a matter of fact, since the Budget Control Act, the number of prospects that we have worked with in Northern Virginia looking for SCIF is at a high I haven’t seen for 18 or 24 months in the existing portfolio.

Dave Rodgers - Robert Baird

Okay. And then maybe just shifting to the development, any pressure on the development returns? It doesn’t sound like if at any pressure just given that rents and kind of that part of the country have been under pressure, TIs, LCs up a little bit. So, any pressure on development returns?

Wayne Lingafelter

Dave, it’s Wayne. I would say, generally the guidance we have offered in the past for an average yield in the 9% range is holding up. As Steve said, the demand for new efficient space I think is a big part of the support for that.

Dave Rodgers - Robert Baird

And consistent returns for data as well?

Wayne Lingafelter

Yes.

Dave Rodgers - Robert Baird

Okay, great. Thank you.

Operator

Your next question comes from Tayo Okusanya [Jefferies]. Please proceed.

Tayo Okusanya - Jefferies

Doing as well as it has that capital markets still pretty good, any thoughts around acquisitions or is there just not anything attractive to you at this point?

Roger Waesche

Well, the markets that we compete in for acquisitions are very competitive today. There are lot investors with lower cost of capital and different longer term horizon than we may have for our underwriting. So at this point, we are sort of out of the infill core acquisition market. We have got to be patient and let the capital cycle change and then opportunities may present themselves, but today even with cheap debt and where our equity cost of capital as we still think we are better allocating our capital to our development pipeline.

Tayo Okusanya - Jefferies

Okay. At what kind of cap rates do acquisitions start to look more attractive to you though?

Roger Waesche

Well, that really depends on the location and the quality. Obviously, there is a big difference between urban infill and high-quality suburban. And so I think we would want to be again because if we can earn nine on our development pipeline, we need to be at least not more than 150 basis points lower than that.

Tayo Okusanya - Jefferies

That’s helpful. Thank you.

Operator

I would now like to turn the call back to Mr. Waesche for closing remarks. Please proceed.

Roger Waesche - President and Chief Executive Officer

Thank you all again for joining us today. If your question did not get answered on this call, we are all in our office today and available to speak with you later. Thank you. Good day.

Operator

Thank you for your participation today in the Corporate Office Properties Trust first quarter 2014 earnings conference call. This concludes the presentation. You may now disconnect. Good day.

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