Corporate Office Properties Trust (NYSE:OFC)
Q1 2016 Earnings Conference Call
April 29, 2016 12:00 ET
Stephanie Krewson-Kelly - Vice President, Investor Relations
Roger Waesche - President and Chief Executive Officer
Steve Budorick - Executive Vice President and Chief Operating Officer
Anthony Mifsud - Executive Vice President and Chief Financial Officer
Craig Mailman - KeyBanc Capital Markets
Jamie Feldman - Bank of America
John Guinee - Stifel
Michael Carroll - RBC
Welcome to the Corporate Office Properties Trust First 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 go ahead.
Thank you, Jasmine. Good afternoon and welcome to COPT’s conference call to discuss the company’s first quarter results for 2016. With me today are Roger Waesche, President and CEO; Steve Budorick, Executive Vice President and COO; and Anthony Mifsud, EVP and CFO. In addition to the supplemental package and press release related to first quarter results, we have posted a flipbook on our website that accompanies 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 today’s press release and our SEC filings for a detailed discussion of forward-looking statements.
With that, I will turn the call over to Roger.
Thank you, Stephanie. Good afternoon, everyone. The positive momentum with which we ended 2015 carried into a solid first quarter, the results of which are summarized on Slide 4. FFO per share of $0.47 was in line with our expectations and same-office cash NOI grew a very strong 6.4%. Additionally, cash rent spreads on renewing leases turned positive and GAAP rent spreads were in the low double-digits. These and other aspects of our first quarter results affirm that real estate fundamentals in our markets are rebounding.
Our dispositions are progressing and we are pleased with the depth and quality of the potential buyer pools. We have over $600 million of assets in the market to ensure we hit our disposition goal of $440 million this year and also have optionality on what we sell. Interest from all-cash and leverage buyers is strong and we are confident that we will hit our target. By extension, we have a high degree of confidence that we will achieve our year end leverage targets with sufficient proceeds to also fund development, nearly all of which will be at Defense/IT locations that serve critical missions involving intelligence, surveillance, reconnaissance, and cybersecurity aspects of ensuring national security.
With that, let me hand the call over to Steve.
Thank you, Roger. I will begin by providing more color on our same-office cash NOI results. As Slide 4 shows, same-office cash NOI grew 6.4%. Now, that space givebacks by defense contractors have abated, we expect same-office cash NOI results to continue benefiting from this stability. Based on the strength of our results and our confidence in our leasing forecast, we are increasing our guidance for same-office cash NOI growth for the year by 50 basis points to between 3.5% and 4%. Leasing activity in our markets continues to rebound. We see increased demand in our Defense/IT locations for new, efficient space from contractors who in response to DoD budget clarity now operate the more normalized business environment.
Job growth in the Mid-Atlantic, where 90% of our assets are located, led the country in March. Based on data from the Bureau of Labor Statistics, the Mid-Atlantic region produced over 91,000 office-using jobs last month, representing an annualized increase of 11.6%. Among the 14 markets that compose the region, Baltimore ranked first, producing over 21,000 office-using jobs for an annualized increase of 18.6%. The majority of the job gains were in the private sector predominantly professional and business services.
Fundamentals in the B/W corridor, where over 50% of our portfolio is located, continue to strengthen. Within the quarter, our Class A vacancy in the Howard County stands at 6.6%, which is the lowest rate since 2000. Big blocks of space command a premium because they are scarce. These fundamentals support an increase in net effective rents and we are also pursuing build-to-suit opportunities for cybertech companies that are quickly outgrowing their current space.
We leased 545,000 square feet in the quarter. Rents on renewals grew at nearly every segment averaging 2% on a cash basis and 11.4% on a GAAP basis. Our original guidance for the year for cash rents to roll down between 3% and 2%. Based on first quarter results, we now expect a more modest roll down and are revising our guidance on cash rent spreads on renewals to between negative 2% and negative 1%. Tenant retention in the quarter of 64% was in line with expectations. Three quarters of the non-renewing space was or is in the process of being backfilled by new tenants with expanding business opportunities. For the year, we continue to forecast a retention rate of 65% to 70%, including 100% renewal rate on the large lease expirations this year, which are shown on Slide 7.
Moving to Slide 8, we completed 163,000 square feet of development leasing in the first quarter and have great confidence that we will achieve and in all likelihood exceed the 700,000 square feet of development leasing in our 2016 plan. This confidence in development leasing is based on the depth of our shadow development pipeline shown on Slide 10. Most of the demand revolves around Redstone Gateway and our data center shell business. We are also pursuing opportunities to pre-lease the final redevelopment building at Evercrest, which will support a stronger disposition valuation. The transactions summarized on this slide represent a solid runway of external growth from build-to-suit and highly pre-leased developments.
With that, I will turn the call over to Anthony.
Thanks, Steve. First quarter diluted FFO per share as adjusted for comparability of $0.47 was in line with the midpoint of our guidance. Same-office cash NOI growth of 6.4% exceeded our internal forecast. Nearly 200 basis points of that growth, was due to cash rent commencements. We also benefited from lower seasonal operating expenses versus the first quarter of 2015.
I would like to highlight capital markets activities and our balance sheet and credit metrics, which are addressed on Slides 11 and 12. In March, we sold $5.7 million of land in Colorado Springs. In May, we expect to complete the refinancing of the secured loan at M Square. This 10-year fixed rate $45 million financing will be priced at approximately 3.75%. At March 31, our debt to EBITDA was 6.9x and our debt to adjusted book was 43.6%. These ratios and other balance sheet statistics exhibit seasonality, with the first quarter statistics typically exhibiting the highest levels. By year end, we expect to improve our debt to EBITDA to 6.1x and our debt to adjusted book ratio to 39% as pre-leased development projects come online and as we pay down debt with asset sale proceeds.
Slide 12 depicts our debt maturity schedule. Approximately, 88% of our debt is fixed rate and our total debt has a weighted average maturity of nearly 6 years. Additionally, we have no unfunded balloon maturities until 2019.
Slide 13 provides our sources and uses of capital for the year. As Roger highlighted, we are marketing over $600 million of transactions in order to ensure we complete the $440 million of sales in our 2016 plan. Because negotiations are in progress, we are not going to comment on specifics today and instead will press release and discuss transactions as we complete them in the coming months.
Slide 14 summarizes our second quarter and full year 2016 guidance. Diluted FFO per share as adjusted for comparability for the second quarter is expected to be between $0.48 and $0.50. For the full year, we are reiterating our prior guidance of $1.95 to $2.05. I would remind listeners that while the midpoint of our full year guidance for FFO per share is essentially flat versus 2015 results, we continue to forecast AFFO growth in excess of 4%. To get from the $0.47 in our first quarter to the $0.49 midpoint of our second quarter guidance, add $0.03 for NOI resulting from higher occupancy and lower seasonal operating expenses and subtract $0.01 to account for the sale of a portfolio of assets in May.
With that, I will turn the call back to Steve.
Thank you. I want to remind investors that the global landscape is increasingly dangerous making the need for more and better intelligence as great today as anytime in our history. The rapid growth of cybercrime compounds the need for increased intelligence, analysis and technology. Our real estate is well positioned to serve mission expansion and knowledge-based defense installations like Fort Meade, as well as growth in demand from defense contractors who require proximity to their government customers.
Over the past 5 years, we have transformed our portfolio and balance sheet dramatically. 5 years ago, 50% of the square footage we owned was in commodities suburban office space and 50% was in our Defense/IT niche. Today, 86% of our operations support mission-critical Defense/IT demand drivers summarized on Slide 19. As importantly, we have zero commodity suburban office buildings in our core portfolio. Our core regional office portfolio now contains 7 buildings, all of which are in urban or mass transit served locations.
Our balance sheet transformation during the past 5 years is equally as important and dramatic as changes in our portfolio. We reduced leverage from a debt to EBITDA ratio of 8.8x at March 31, 2011 to 6.5x at the end of 2015 and we will further reduce this ratio to 6.1x by the end of this year. In 2013, we earned an investment grade rating from all three major rating agencies, a critical accomplishment that lowered our weighted average cost of capital. We are committed to achieving our leverage targets this year and to operate the company at our targeted levels going forward.
In summary, the three major tactics we are executing on this year: monetizing selected assets, strengthening our balance sheet and funding low risk development are equally important interlays components of our plan. In the coming quarters, you should expect to see us deliver same-office cash NOI growth of 3% or more, grow externally only through low-risk development and sell at least $440 million of fully valued assets. The main point you should take away from this call is that we are more focused and better positioned to capture incremental development opportunities today than at anytime in our history.
I will hand the call back to Roger at this point. But before doing so, I want to thank you, Roger, for having the foresight to recognize and the courage to execute on the company’s transformation beginning in 2011 and thank you for allowing me to be your partner in realizing this shared vision.
Thank you, Steve. To those of you who know me would never choose me of having the gift for gab, so I just like to thank everyone, Steve, Anthony and all the COPT employees and the investment community for making these last 30 years both challenging and wonderful. I am grateful for and humbled by the journey I have had with COPT.
With that, operator, please open up the call for questions.
Thank you, Mr. Waesche. [Operator Instructions] And our first question comes from the line of Craig Mailman with KeyBanc Capital Markets. Please proceed.
Thanks, guys. And Roger, just want to wish you good luck and thanks for all your help over the years. And I guess just starting out here, the rent spread numbers were encouraging here, but obviously, guidance, while it was moderated, didn’t at least go to flat at the best scenario. Just curious, was there anything kind of one-time or that just skewed the 2% higher this quarter that gave you guys pause to think that it could trend better over the year than still negative 1% to 2%?
It’s really the mix of leasing, Craig. We had significant amount of leasing in the B/W corridor, where our conditions are stronger. Later in the year, we are going to have some leasing renewal activity in our Navy support group that won’t be quite as strong.
Okay, that’s helpful. And then just looking at the development pipeline, NOVA B and 310 Sentinel have been – I know you guys are waiting on the government leasing there for a while. Should we read into it that it’s taking this long or is there something else going on there?
There are two separate situations, Craig. With regard to 310, it was just a longer procurement cycle. That activity is in process and we expect it to be resolved this summer or third quarter. With regard to NOVA B, there was a change in the ultimate user of NOVA A, which really propels us to win NOVA D on a build-to-suit, but we had already built B and now we are working with that customer to put a related entity into NOVA B. So, it was a delay but a good news delay.
Okay. And then just lastly on the sales, it sounds like you guys are having good momentum. Any specific reads you could give us on what buyers are kind of looking at from the financing standpoint? Are you getting any pushback or more financing contingencies? And as we think about the $440 million for the balance of the year kind of with what you guys have visibility on, what do you think is a good timing assumption?
So Craig, this is Anthony. We have not had any buyers have any difficulty in the financing markets and the transactions that we have in the market. We have some transactions that are all-cash buyers for those who are looking to put their capital stacked together debt and equity, we have not had any issues with those buyers accumulating those stacks as they have gone through the process. And we continue to be encouraged by the depth of the market that we see and the number of buyers looking at each of the individual assets that we have in the market. With respect to timing, we have for the $440 million I would still expect sort of an average number for the year, so you can average that over the balance of the 9 months for sort of planning an impact to FFO for the year.
Great, thank you.
And our next question comes from the line of Jamie Feldman of Bank of America. Please proceed.
Great, thanks and good afternoon. So I guess, terms of the leasing spreads, can you talk about what you think on GAAP leasing spreads? I know you gave guidance for cash. Well, how do you think those might be for the rest of the year?
For GAAP leasing spreads, we would expect them to be sort of in the 7% to 8% range for the entire year.
Okay, it sounds good. And then just thinking about slide – the slide with the large expirations, I think it’s Slide 7 can you talk more about the two in ‘17 that are in the TBD bucket and just latest thoughts?
Sure. Well, there is actually three buildings, two are U.S. government buildings, one at the NBP, one in Howard County. It’s just early in the cycle for them to be processed. They will be funded with 2017 money and will be renewed. The last building listed, the 152,000 square foot building labeled TBD is a large contractor at the National Business Park just competing on a major contract. If they win it, we anticipate them keeping the building. If they lose it, we would expect to get about half of that space back. But I would point out there is only one other competitor and that competitor would need the space. So, we are pretty confident we are going to be in good shape there.
Okay. And then thinking about your development starts for this year and thinking about the pipeline that you have currently, as we think ahead to ‘17, do you think you could have as robust a pipeline it starts just based on what you are seeing on your comments at the end of the call about demand for cyber and Defense/IT? Just want to tie those two things together.
Yes. We really do believe that we can maintain the pace that we have currently listed on our development schedule through next year. We have significantly more development opportunity in conversations or early discussions than we list on our shadow development pipeline. So, we have high confidence we will continue to be able to develop successfully.
Okay, thanks. And Roger, all the best. Thanks for all your help over the years.
And our next question comes from the line of John Guinee with Stifel. Please proceed.
Great. First and foremost, Roger, you did a great, great job and you added a lot of value over the last 30 years. I am sure everybody at Corporate Office is very sad, but you can leave with your head high.
Second, Steve, we talked yesterday, it’s kind of explained to people how sausage is made with the NSA as we discussed and it’s out in the local markets, Airport Square, 10 and 20 referred to as Air Square. NSA just vacated and then also Annapolis Junction. BXP just announced giving back an asset because of an NSA vacation. Why are they vacating and where are they going?
First of all, I am not acknowledging those three letters. The U.S. government is in Air Square 10 and 20. We used to own those buildings, John and we understood before I joined the company that long-term, those buildings would not support the users that were in them and they are being relocated to other secured campuses at the government leases. They are moving to more efficient campuses like we have at NBP, where they can put multiple buildings in a campus that achieve economies of scale from their security. With regard to Boston Properties’ building, I am not sure I really want to touch that, but that building is developed with a different kind of occupancy model. That contemplated renting space by the seat. And having the landlord, in essence, provide all of the tenant improvement and systems for a secure operating environment. And I believe that the government customer is just weaning themselves off of that rental model.
Perfect. Great, thank you very much.
And our next question comes from the line of Michael Carroll with RBC. Please proceed.
Yes, thank you. Steve, could you give us some color on the shadow development pipeline that was kind of highlighted? Are you seeing more activity pickup there given the new DoD budget that’s been set?
Well, unquestionably, if you look at the magnitude that we have listed down at Redstone Gateway, there is quite a bit of discussions and activity in play, even exceeding the amount that we listed and that’s driven by the improved spending environment with DoD and the need for new efficient space and having both government and contractors confident that they will get the funding they need to address their mission needs and new buildings. But additionally, at the National Business Park, we pre-leased half of 540. We have tenant demand for the balance of it. And also in our Northern Virginia locations, both from the data show standpoint and our government customers, we continue to have discussions about further demand.
Great. Thanks. And Anthony, can you remind us what the long-term leverage metrics are and will the planned asset sales, will that help you achieve that or is that the only plan to achieve those leverage targets?
So, our leverage targets that we have outlined will really be accomplished by the end of the year with the proceeds from the asset sales. So, our targets of where we want to operate the company long-term are debt to EBITDA of 6x and debt to adjusted book in the 38% to 39% range. By year end, we expect to be down to those levels, which again will be achieved with additional proceeds from the asset sales above and beyond what we need to fund the development pipeline.
Great, thank you.
I will now turn the call back to Mr. Waesche for closing remarks.
Thank you all for joining us today. If your question did not get answered, most of us are here in the office and available to speak with you later today. Good day.
Thank you for your participation today in the Corporate Office Properties Trust first quarter 2016 earnings conference call. This concludes the presentation. You may now disconnect. Good day.
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