Corporate Office Properties' (OFC) CEO Steve Budorick on Q2 2016 Results - Earnings Call Transcript

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Corporate Office Properties Trust (NYSE:OFC)

Q2 2016 Earnings Conference Call

July 29, 2016 12:00 PM ET

Executives

Stephanie Krewson-Kelly - IR

Steve Budorick - CEO

Anthony Mifsud - CFO

Analysts

Craig Mailman - KeyBanc Capital Markets

Manny Korchman - Citi

James Feldman - BofA Merrill Lynch

Jed Reagan - Green Street Advisors

John Guinee - Stifel Nicolaus

Rob Stone - Evercore ISI

Operator

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.

Stephanie Krewson-Kelly

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 on 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 maybe 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 risks, 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.

Steve Budorick

Thank you, Stephanie and good afternoon. We are on track to achieve the 3 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 condiments 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 the same office cash NOI in the quarter and 5.7% growth during the first 6 months. The improving operating environment in our defense IT markets which generates 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 to the second quarter results. Our initial 2Q guidance called for completing a $120 million of asset sales and while our timing was slightly delayed, the valuation we are achieving and that accrued to the benefit of our shareholders are worth the wait.

Last week we completed a $148 million joint venture involving 6 of our data center properties. We monetized $74 million of equity and realized a 25% profit margin and the 50% interest we sold. Additionally, we have a $194 million of sales under contract with diligent completed in on-refundable 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 to under contract will bring us to within less than a $100 million of achieving our disposition goal. In short, we remain confident in our ability to execute on planned dispositions.

During the quarter, we released a total of 1 million square feet comprised with 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 of vacancy lease up, 67% of which was to defense IT tenants. Off the 248,000 square feet that did not renew, we have backed out 41%. For the first 6 months, we also lease 546,000 square feet in development projects which puts us well on track to meet our goal of leasing 700,000 square feet of new development this year.

Our leasing in 2016 is outpacing 2015 production by 42% and has improved in all 3 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 to defense IT tenants in terms of our land positions, our development capabilities and our credential workforce that can operate secure facilities, are unique in the REIT space and impossible to replicate quickly. The transactions in our shadow development pipeline represented solid runway of external growth from build the suite and highly prelease 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 and new and renewing leases and 10 years of term on development leasing. Out capital commitment and renewals continues to be among the lowest in the office sector. In the second quarter we average $8 a foot on renewing leases and for the first half $10 a foot.

Lastly, GAAP rates on renewals grew 10% in the quarter year-to-date cash runs 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 explorations, we continue to expect cash runs 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 explorations schedules by negotiating long-term expansions on select leases well before their scheduled explorations. 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 these deals is that we preserve asset values by extending the explorations of these leases for 12 years on average with strong credit tenants. This prudent asset management tactic resolves 13% of our 2018 expiration, avoids lengthy downtimes and removes future earnings volatility by creating stable, durable cash flows.

Continued stable demand from the government and improving demand from the defense contractors translated into a robust tenant retention rate of 82% in the quarter and 75% for the first 6 months, both of which are ahead of our guidance range of 65% to 70%. Based on our forecast which includes a three large early renewals just discussed, we are increasing our tenant retention guidance for the year and 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 met hand the call over to Anthony.

Anthony Mifsud

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 cent is distributable 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 the operating expense saving. Cash rent commencements drove same office cash NOI 5.1% higher in the second quarter and 5.7% in the first six months.

We completed to financing transactions referenced on Slides 14 and 15. In May we refinanced the $36 million secured loan M square with a $45 million 10-year loan with a fixed interest rate of 3.8%. On July first we used our line of credit to retire a $152 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% that paid 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 nearly 5.8 years. Additionally, we have no balloon maturities until 2019. As Steve mentioned, we’re on track to achieve this year disposition goal. Last week we monetize $74 million of equity by joint venturing six fully operational data center shells in a 50-50 joint venture with affiliate of GI partners. Including our first quarter land sales, we have raised approximately $80 million assets sales so far in 2016.

When combined with the $259 million of assets that are hard or under contract. We’ve $349 million of dispositions or 79% of our $440 million disposition goal, that are completed or near completion. At June 30 our debt-to-EBIDTA improved to 6.6 times and our debt-to-adjusted book was 43.8%. Our goal to achieve debt-to-EBITDA at 6.1 times and that to adjusted book ratio of 39% by year end. Based on the current projections, when we complete the remaining sales to fulfil our deposition goal, we’ll meet a slightly outperform our 2015 balance sheet goals.

Slide 16 of our presentation summarizes our updated guidance. We expect 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 one penny to $2.01, which is flat versus 2015 result, 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 $0.52 we reported in our second quarter and the $0.51 midpoint of our third quarter guidance. We expect result in the fourth quarter to be flat sequentially, as the dilution from the reaming asset sales offset increased EBITDA from operations and from development projects.

My final point involves the impacted asset sales will have on same office occupancy at the end of the year. Recall that we begin 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 sale in 2016. At an average occupancy of between 75% and 80%. Average occupancies on the actual bundle of assets that we have sold or are likely to sale 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 sales assets we are adjusting our guidance for same office occupancy yearend from the original range of 93% to 95% to a new range of 92% to 93%. What is important to notice 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 will turn the call back to Steve.

Steve Budorick

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 de-lever our balance sheet both with that asset sales proceeds and through the addition of new EBITDA from the developments already executed and to relentlessly pursue and win lower risk development opportunities predominantly for defense IT tenants at proven locations.

Importantly after we achieve our 2016 disposition goal investors should expect more muted assets sales going forward. We will sell buildings opportunistically and on a one-off basis rather than programmatically. All else being an equal. The combination of attract of 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.

Question-and-Answer Session

Operator

Thank you, Mr. Budorick. [Operator Instructions] The first question comes from Craig Mailman. Please proceed.

Craig Mailman

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

Steve Budorick

Sure. We've been pleased with the overall opportunity to create a market, a healthy market 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 of 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 assets. So overall it’s been reasonably good.

Anthony Mifsud

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 and we still had a baskets 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.

Craig Mailman

Okay, I guess are you seeing a moving cap rate for suburban in Non-Virginia to be upside?

Steve Budorick

It just was not a very deep buyer pool Craig.

Craig Mailman

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

Steve Budorick

Sure, so I am very pleased with our building prospect levels at a portfolio set where we need leasing. So on the Northern Virginia portfolio, we’ve got about 10% of our vacancy working towards leases in their 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 maybe with the remaining development leasing packets that we have, this has got good demand building on all of those projects. So moving in for the second half of the year, I am pretty excited.

Craig Mailman

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?

Steve Budorick

The one deal that really moved the rent roll-down is the 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 exploration schedule the top ten tenant represents 55% of the 2.1 million square feet, we have rolling, the grabbing two of those and following them forward, significantly stabilizes the entire renewal rate for that year and we have really strong reason believe the other eight large tenants will renew and in absence, we could lock in about a 95% of renewal and 55% of 2018, by they are taking two non-defense renewals can get down early, so we like to do that.

Operator

The next question comes from Manny Korchman from Citi. Please proceed.

Manny Korchman

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 de-risk them for your own portfolio?

Steve Budorick

Do risking for our own portfolio and particularly in Northern Virginia this go out of vacancy that marks place is very comparative. You know that we 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.

Manny Korchman

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 revisit when other opportunities come up?

Steve Budorick

No we’re creating a great relationship with GI partners and we will be exploring ways to continue to work with them. Fantastic group of individual with likeminded investment strategy source, it’s defiantly an option.

Operator

Your next question comes from James Feldman from Bank of America. Please proceed.

James Feldman

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?

Steve Budorick

It’s just demand driven by contract flow in this plane segment. So I think I spoke little bit to the Navy support group, we’ve had more vacancies and we would prefer to have it in that area and we realized pretty slow demand in 2015, and first quarter ’16. And our asset manager for that portfolio is making some very significant progress and has better deal and prospects flow then we seeing for a long time and that’s driven almost entirely with government or defense contractor activity. So it’s a great representation of what recovering across the portfolio.

James Feldman

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

Steve Budorick

I mean its representative of what we’re seeing in a variety of locations that we’ve strong prospects ratios relative to the vacancy that we have.

James Feldman

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?

Steve Budorick

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

James Feldman

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

Steve Budorick

Yes, they'll have similar structures.

James Feldman

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?

Steve Budorick

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

James Feldman

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

Steve Budorick

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

James Feldman

Do you have an update on the COO search?

Steve Budorick

Very pleased, we’ve got four process -- we've narrowed the field 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 selections.

James Feldman

Okay. Great. Thank you.

Operator

Your next question comes from Jed Reagan from Green Street Advisors. Please proceed, sir.

Jed Reagan

So just talking about the cash releasing spread outlook, can you give a sense for what the roll-down to 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?

Steve Budorick

Hang on Jed, I got to flip to Page 6. The government should be positive, so there is one deal that will be warping up in 2016 and 2017. The 198,000 sq. foot renewals Northern Virginia it will be negative but modestly negative and the 152,000 sq. foot deals that NVP that should be positive.

Jed Reagan

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

Steve Budorick

Sure. We continue to work with both customers, they both have needs for the buildings, I guess we all are little frustrated in their ability to get funding in fiscal year 2016. As we sit here today the budget did not clear the House and Senate, so when Congress convenes in September they will probably move to continuing resolution, which will push that 2017 fiscal year budget approval in all likelihood to December of '16. So I'd 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 lease and when we get them leased they’ll be leased for a very long time.

Jed Reagan

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?

Steve Budorick

It's kind of mix, there a few assets that we need to drive some leasing in before we’ll bring them to market, set of four buildings in suburban Baltimore and another set of two buildings that we are focused on. But by and large we selling the mix of well leased and some lease up partially vey comparable.

Jed Reagan

Okay that’s it for me, thank you.

Operator

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

John Guinee

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?

Anthony Mifsud

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.

John Guinee

$34 million is Northgate?

Anthony Mifsud

That’s correct.

John Guinee

And the other $20-odd million is what?

Steve Budorick

The reminder is -- significant component of the remainder is broken up between two assets. One, several years ago the Company embarked on a -- couple of assets were under the theory that they could take industrial building and turn it into a flex office industrial. And what we saw had 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 and several bid on, so we have a clear of value on that asset. Another little over $6 million related the old Merc building up in Blue Bell which was the only asset in Arbor Crest that was not impaired as part of the initial impairment of the Arbor Crest assets several years ago.

John Guinee

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?

Steve Budorick

That's correct, just to be clear though, we have the bulk of White Marsh under contract. We have one set of four building that are not.

John Guinee

Okay. And then, continuing on the faced with 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?

Steve Budorick

The big change is the decision to sell Arbor Crest which was a 100% lease for building 650,000 square feet, were 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 market in the future and we decided to move that up in 2016 and get it done now.

John Guinee

Okay. And then, you had mentioned a cash roll-downs in 2016 of 0% 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?

Steve Budorick

It’s 5% to 6%.

John Guinee

It's 5% to 6%.alright, okay?

Steve Budorick

And that will be the 2016 result after we add the three early renewals to the 0 to minus 2 that we had plan to do at the beginning of the year.

John Guinee

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?

Steve Budorick

No comment on the customers, with regard to the NOVA B that sits behind a fence. We have to negotiate the market deal, there is certain tests, but they really won’t be competition for that and then, at the MBP, hypothetically there could be competition, but we think we're in a strong position.

John Guinee

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, every one of them has early terminations. If you were to take the lease term that is quoted, let's say its five years, and actually plug-in the early termination, does that take five years down to 4.5 or 2.5 years?

Steve Budorick

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

John Guinee

Okay. And then --.

Anthony Mifsud

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.

John Guinee

Okay. And then lastly, your debt-to-EBITDA number is you're talking about going down from 6.5 to 6.1. What’s that debt-to-EBITDA if you actually added it 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?

Steve Budorick

If you include the preferred as debt?

John Guinee

Exactly.

Anthony Mifsud

That it probably takes it up to 6.6 to 6.7.

John Guinee

So 6.1 goes to 6.6 or 6.7?

Steve Budorick

That should be about 6.5.

Anthony Mifsud

I mean if you include that preferred as debt have.

John Guinee

Got you. Okay. Thank you very much.

Operator

[Operator Instructions] Your next question comes from Rob Stone from Evercore. Please proceed.

Rob Stone

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.

Steve Budorick

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

We had one chunk of space to lease at a 100 Light. We leased it at above 9% over our pro forma and the rental rate basis that tenant will take occupancy in October. Our parking results are very positive that the 100 Light, we’re beating out own plan by about 28% year-to-date and everything is gone very well.

With regards to Canton Crossing we did get a plan approve by the City of Baltimore and we continue to work towards the mixed-use development that we have toured you through recently.

Rob Stone

Thanks, Steve. That's all for me.

Operator

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

Steve Budorick

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. Look forward till the next call. Thank you.

Operator

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

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