Welcome to the Corporate Office Properties Trust second quarter 2022 results conference call. As a reminder, today's call is being recorded. At this time, I will turn the call over to Michelle Layne, COPT's Manager of Investor Relations. Ms. Layne, please go ahead.
Thank you, Catherine. Good afternoon, and welcome to COPT's conference call to discuss second quarter results and updated guidance for the year. With me today are Steve Budorick, President and CEO, Todd Hartman, Executive Vice President and COO, and Anthony Mifsud, Executive Vice President and CFO. Reconciliations of GAAP and non-GAAP financial measures that management discusses are available on our website in the results press release and presentation and in our supplemental information package. As a reminder, forward-looking statements made during today's call are subject to risks and uncertainties, which are discussed in our SEC filings. Actual events and results can differ materially from those forward-looking statements, and the company does not undertake a duty to update them. Steve?
Good afternoon, and thank you for joining us. We achieved another strong quarter with continued progress on our 2022 business plan. The successful performance and execution of our growth strategy since 2018 have positioned our company to deliver reliable annual FFO growth and long-term shareholder value. Over the past decade, we've deeply concentrated investment in the property supporting priority U.S. defense missions and select mission-critical assets in regions that we collectively refer to as defense IT locations. At the end of the quarter, these locations generated 90% of our annualized rental revenue. Demand at these locations is driven by and correlated with national security spending and largely immune from conditions in the overall economy. Our concentration of leases to the U.S. government and high credit contractors supporting national defense and cybersecurity missions is the foundation of our ability to generate resilient, high-quality cash flow.
Our external growth strategy continues to be driven by successful pre-lease and low risk development at these proven Defense/IT Locations. We have an advantageous position in this unique market as the go-to landlord for specialized space satisfying government security requirements. We wisely protected our balance sheet, and as a result, the current interest rate environment poses limited risk to our performance. The $1.8 billion of refinancing completed in 2020 and 2021 provide the solid foundation for us to deliver future growth from our operating and development portfolios. Our second quarter results show the strength of our strategy and execution. FFO per share of $0.59 met the high end of guidance, making this the ninth quarter out of the past 10 that we met or exceeded the midpoint of guidance.
As a result, we're increasing the midpoint of our full year guidance and narrowing the range. Leasing remains strong in our operating and development portfolios. As of June 30th, our portfolio was 93.6% leased and 91.6% occupied. We completed 558,000 sq ft of total leasing during the quarter. We achieved the solid vacancy leasing volumes with 120,000 sq ft we executed equal to our five-year average for the second quarter. Additionally, we have a large volume of leases pending execution that suggests our third quarter volume will be exceptional. The total volume included 211,000 sq ft of development leasing, primarily from a 186,000 sq ft full building pre-lease. This activity brings our year-to-date achievement to 68% of our 700,000 sq ft objective.
Following this quarter's development leasing success, our active development pipeline now contains 1.9 million sq ft of projects, all of which are at Defense/IT locations. These projects are 91% leased with a high level of demand on the unleased space. The projects will deliver between 2022 and 2024, and when placed into service, will produce $47 million of incremental annualized NOI that will drive further growth in FFO per share. The fiscal year 2022 National Defense Authorization Act passed with a base budget increase of 5.8%, representing the largest increase since 2018. We expect demand from this budget to manifest in our leasing pipeline in mid to late 2023.
Recall that following the 14% increase in the defense budget that occurred in 2018, we achieved record leasing levels in new development and vacancy leasing in 2019. Moreover, current actions in the defense committees of the House and Senate suggest another healthy increase in the 2023 NDAA. These events give us confidence leasing demand will remain strong through at least 2024. Turning to inflation, the severe and rapid escalation of material prices over the first half of the year impacted development costs, increasing the year-over-year hard costs for like-for-like development projects by approximately 18%. The demand in our defense IT portfolio is driven by national security needs and funded mission priorities, and we have been able to negotiate rents that maintain our historical development yields.
Our defense IT portfolio benefits from strong demand for new space and industry-leading tenant retention, and the current economic conditions have not impacted our demand or achievement, positioning our portfolio to continue to generate consistent, steady financial growth. Between 2018 and 2021, our FFO per share compounded at 4.4%. Coming off the strong 8% growth in 2021, our revised guidance suggests 2.6% growth in 2022 after absorbing the dilutive effect of the sale of DC Six. Beginning in 2023, we continue to expect growth to compound at 4% or more through 2026. In summary, we had another solid quarter and our strong pipeline of activity and our fortified balance sheet reinforce our confidence for continued growth. With that, I'll hand the call over to Anthony.
Thanks, Steve. Second quarter results continue to show the strength and resiliency of our portfolio despite the uncertain economic environment. FFO per share for the quarter of $0.59 was at the high end of our guidance range. The $0.01 achievement above the midpoint was due to lower than forecasted G&A expenses and the timing of repairs and maintenance projects that we expect to complete in the second half of the year. The timing of the R&M projects produced same property cash NOI results that were slightly better than our forecast, and our other portfolio metrics for the quarter were in line with our expectations. Since we expect to complete the delayed R&M projects later in the year, we continue to forecast same property cash NOI to be flat to down 2% for the year.
This guidance assumes that the Defense/IT locations are flat to up 2%, while the regional office portfolio impacted primarily by the Transamerica and CareFirst transactions is expected to be down just over 20%. Stronger than budgeted leasing activity has resulted in an increase in our forecasted same-property occupancy at year-end. As a result, we are tightening the range of guidance and increasing the expected midpoint by 50 basis points to 92.5%. NOI from development placed into service will continue to drive growth. We continue to expect between $15 million and $17 million of cash NOI in 2022 from completed development projects. At the midpoint, 100% of this NOI is contractual.
With respect to the impact of the current interest rate environment, at the end of the quarter, 86% of our debt was fixed rate, and another 11% was variable rate debt swapped to fixed through year-end. The $1.4 billion of fixed rate bonds issued last year, which have an average interest rate of 2.6% and a weighted average term at issuance of just under 10 years, significantly extended our debt maturities. Prior to these transactions, at year-end 2020, we had $1.6 billion, or almost 80% of our debt maturing between 2022 and 2025, which included almost $1 billion maturities in 2022 and 2023.
This refinancing activity took advantage of the historically low interest rate environment and pushed our first bond maturity into the first quarter of 2026, minimizing our exposure to the current increasing rate environment. The only debt maturing prior to 2026 is a $100 million term loan later this year and our line of credit, which has an initial maturity in the first quarter of next year. We are working with our bank group on a new term loan and an extension of the maturity of our $800 million line of credit. The new term loan, which is expected to mature in 2028, will fund the repayment of the $100 million term loan and pay down a portion of the outstanding balance on our line of credit. We expect these financing transactions will close before the end of the year.
With respect to the equity capital needed to fund our development investments and maintain our balance sheet strength, roughly 25% of this year's investment will be funded by cash from operations, with the remaining equity capital coming from the proceeds from the sale of DC Six and recycling out of existing assets towards the end of the year. Finally, we are narrowing our range and increasing the midpoint of FFO per share from a prior range of $2.31-$2.37, to a new range of $2.33-$2.37. As a reminder, our guidance includes $0.04 of dilution from the sale of DC Six, and the increased midpoint of $2.35 per share implies 2.6% growth over 2021 FFO per share results.
Now I'll hand the call over to Todd.
Thank you, Anthony. Leasing activity remains strong, and we are confident that we will meet or exceed our objectives for the year. We completed 228,000 sq ft of renewal leasing during the quarter for a retention rate of 58%. The retention rate was anticipated and heavily influenced by two non-renewals. In Huntsville, at 1,100 Redstone Gateway, we negotiated a 48,000 sq ft reduction with Boeing, providing much needed second generation capacity to meet market demand. We are currently negotiating a lease with a defense contractor for the entire vacancy and expect to have that space leased and occupied in the third quarter. In Baltimore, at our Canton Crossing property, we experienced a 28,000 sq ft non-renewal. During the quarter, we executed a new lease for 15,000 sq ft of this space with occupancy expected in early 2023.
Cash rents for the quarter rolled down 0.8% and straight-line rents increased 7.8%. We expect renewal activity for the balance of the year to be very strong and heavily weighted to the fourth quarter, and that our annual renewal volume will reach our historical average of 2 million sq ft by year-end. As a result, we are increasing the midpoint of our retention guidance to 75%. Looking forward to 2023 and 2024, we expect our strong retention rates to continue. During 2023 and 2024, we have 21 expiring leases larger than 50,000 sq ft, totaling 2.4 million sq ft. We expect to renew more than 95% of that space.
These 21 leases represent 50% of all the expiring square footage in 2023 and 2024, and include 12 full building leases for highly improved buildings, including six secured buildings leased to the United States government, three buildings leased to defense contractors, and three data center shell properties with significant tenant investment. The mission critical nature of these properties and the priority missions they support inform our estimate of this high retention rate and supports our confidence in our projection for future growth. Regarding vacancy leasing, our volume of 120,000 sq ft was consistent with our 5-year average for the second quarter. Demand was broad-based across all of our markets with transactions completed across our defense IT markets as well as in regional office.
The 277,000 sq ft year-to-date is 23% higher than our five-year average, and we remain on track to meet or exceed our annual vacancy leasing goal. As Steve mentioned, we have a large volume of leases pending execution that suggest our third quarter volume will be exceptional. Development leasing totaled 211,000 sq ft, and our year-to-date total is 476,000 sq ft. During the quarter, we executed a 186,000 sq ft, 11-year build-to-suit lease with a defense contractor at the National Business Park. This is the second full building long term defense contractor lease executed at the NBP in a little over a year.
Our development leasing pipeline of 1.2 million sq ft gives us confidence we will achieve our 700,000 sq ft development leasing objective for 2022. Lastly, in terms of our remaining large vacancies, we are encouraged by activity levels. In our regional office segment, we are tracking more than 100,000 sq ft of activity at 100 Light Street in Baltimore and 140,000 sq ft at 2100 L Street in Washington, D.C. Activity is strong, but given competitive pressures in the regional office markets, we anticipate a slower pace of lease executions. At 1200 Redstone Gateway, we are close to executing a lease with a defense contractor for the full 121,000 sq ft vacancy, with commencement expected to occur close to year end.
Additional demand from contractors for space at Redstone led us to commence construction on our next 125,000 sq ft inventory building, 8100 Redstone Gateway, and we look forward to announcing leasing progress on this project in the coming quarters. With that, I'll hand the call back to Steve.
To wrap up, we completed the first half of the year ahead of plan, and we are on track to meet or exceed our 2022 business plan. Vacancy leasing remains strong, and first half vacancy leasing results exceeded our five-year average by 23%. Our 1.9 million sq ft of active development are 91% leased, assuring incremental NOI from these projects that will drive FFO growth in coming years. Our development leasing pipeline has 1.2 million sq ft of opportunities which we believe will translate into continued development achievements. Congress appropriated the 2022 defense base budget with a 5.8% increase, the largest annual increase since fiscal year 2018, suggesting leasing demand will continue through calendar year 2023 and beyond.
Our prior year financing activities locked in historically low interest rates and minimized our exposure to the current volatile environment. Lastly, we've delivered strong growth over the past three years and we expect to continue to deliver both FFO and NAV growth in the coming years. With that operator, please open the call for questions.
Thank you. As a reminder, to ask a question, press star one one. Please stand by while we compile the Q&A roster. Our first question comes from Michael Griffin with Citi. Your line is open.
Hey, thanks for taking the question. Todd, maybe getting back to your comments on the demand at 100 Line 21 L or 2100 L . Can you add any additional color on sort of why you're seeing, I guess, marginally less demand relative to last quarter? Was it any specific tenants that you might have been tracking or just, you know, less demand you're seeing in those markets? Any color there would be great.
Sure. Well, as it relates to 100 Light, we had at least one state tenant that we were working with last quarter that was offered space at a much lower rate in another building and elected to go that direction. Our remaining activity at the building is strong and, you know, we're very encouraged by it. At 2100 L, I think it's just the vagaries of the market. We had one tenant that we were tracking, again, elected to renew with another building, and so that tenant dropped off our list.
Okay. That's helpful. Then, kind of stepping back maybe big picture. I know Steve, you kind of mentioned this in your prepared remarks, but just as it relates to defense spending, and, you know, we saw the article earlier this week about Senate Appropriations Committee, you know, seeking more funding for defense spending than even The White House kind of requested. You know, some of that might have been related to the effects of inflation, whatnot. Is there a worry maybe as we get into, you know, election season, if there ends up being a divided government that you could see kind of a slowdown in that defense spending and maybe kind of what that translates to for your business?
Let's talk about defense spending volume. We're very confident that there'll be a substantial increase for the 2023 NDAA, as well as potential for some supplemental increases to deal with the impact of inflation. That confidence really comes from the high level of unity in the Senate and House Armed Services Committee votes. Both of those committees are seeking funding well above the presidential request. We think the magnitude is gonna be high and potentially further increased for inflation. Timing could be difficult. It's likely that this NDAA won't be passed by the end of September, and we'll end up in a continuing resolution which could be delayed until after the election. Time will tell. In the last decade, I think we've only had one NDAA passed on time without a continuing resolution.
Okay. That's it for me. Appreciate the color.
Thank you, Griff.
We have a question from Blaine Heck with Wells Fargo. Your line is open.
Thanks. Good afternoon. Starting with Anthony, just on same-store NOI, are there any new offsets to the outperformance in the first half that made you reluctant to kind of increase the full-year guidance, especially, you know, given that it seems like occupancy and retention are ahead of expectations and occupancy comps from last year could get a little bit more favorable as the year progresses?
No. The variances that we've experienced to date, especially in the second quarter, were more timing, which are related to the same impact on same-office cash NOI. We did have some variances in the first quarter that were more permanent in nature, but still the impact of those fell within the range of guidance, and that's what we had discussed on our first quarter call. With respect to the changes in occupancy and the impact on same-office cash NOI, the majority of the changes that led us to increase the midpoint of occupancy at year-end really occur later in the fourth quarter, so they benefit occupancy at year-end but don't contribute to this year's same-office cash NOI. We'll get the benefit of that into next year.
Got it. That's helpful. Maybe for Steve or Todd, one of the data center REITs recently commented on potential challenges related to the power supply in Northern Virginia from Dominion Energy and delays that it could cause in the construction of new data center properties. Just wondering if you guys are dealing with any issues related to that and any potential delays it could cause on your data center shell projects.
Yeah, that's a good question. The comment really refers to the construction of new transmission lines and expansion of substations beyond capacity that exists today. All of our development sites will be serviced by components of either Dominion or NOVEC that are built, and our customer has a commitment for that power. We don't believe it'll affect the timing of our lease execution.
Okay, very helpful. Lastly, you know, just thinking about the inflation we've seen this year, Steve, can you talk about how that might be affecting development costs and whether your yields are being affected at all on that side of the business?
Yeah, we made a comment in our prepared remarks. NBP 550, which we just announced yesterday. If you look at our supplement, it's 14.4% more expensive than NBP 550, which we locked in the pricing on just over a year ago. The material component of the hard costs increased 18% year-over-year. We've been able, both in the NBP and Redstone Gateway, to move our rents in harmony with those increases in costs. Preserve our historic yields on those assets. Each development will face a new set of market conditions, and it'll be a challenge each and every time we negotiate a deal.
Very helpful. Thanks, guys.
Thank you. We have a question from James Feldman with Bank of America. Your line is open.
Thank you. I guess, following up to Blaine's question, you know, it sounds like you can still hit your development yields with higher rents on the development. But are you able to push rents in your in-service portfolio around those same assets?
Well, particularly at the NBP, we're having a very good success at locking in existing portfolio rents that are very near our new development rental rate. We don't have as much second-generation space in Redstone Gateway, but both of the leases for second gen space that we're leasing have significant roll-ups from the expiring rents that they had and are very close to our development rental rates.
Okay. Going back to the budget, you had talked about confidence on the 2023 budget growth. Any early indication of just how strong that uptick could be? Is it, you know, more or less than the 5.8% for 2022?
Some of the information we saw was 10% overall, but without more detail, it's hard for us to handicap how that hits the base budget, the 051 base budget, which is really what funds the leases that we negotiate. I would expect it to be in at least 5%-7%, if not higher.
Okay. Finally, I appreciate the color on the large block expirations through 2024. I think you said you expect to renew 90%. No good deed goes unpunished. Can you talk about the other 10%?
We said above 95%.
Okay.
We just have some probability that one of the defense contractor full buildings may not quite renew all, giving back a small portion and a downsize in one of the regional office leases that is in that set of leases above 50,000 sq ft over the next two years.
Okay, it sounds like one lease is really what you're worried about.
Two.
Oh, sorry, two. Okay.
By no means.
All right.
All of it, we expect both leases to renew. The regional office we expect, or we've at least built in the probability that it could contract and up to about 50%. The defense contractor building may be a small component, like 10,000 or 15,000 sq ft.
Where, when do those expire?
I believe both of those are in 2023.
2024.
2024. Sorry.
Okay. 2023, you have no concerns, it sounds like.
None.
Okay, great. Thank you.
We have a question from Steve Sakwa with Evercore ISI. Your line is open.
Thanks. Good afternoon. I guess one question for Anthony, just to go back to what you talked about on the dispositions and the funding for, the development needs. You said you have a couple of assets that you're gonna sell, by year-end. Can you just sort of talk about the types of assets those are? Given the dislocation we've seen, you know, in the transaction market, you know, where do you think cap rates are for those dispositions?
Our current forecast assumes that later this year, we venture two data center shells that we currently wholly own that generates about $80 million worth of proceeds. Cap rates for shells continue to seem like they're holding up, you know, in the area close to where we executed back in June of last year. Right now, we really haven't seen cap rates for those types of assets come under some of the kind of pressure that some of the other CBD and other office markets have.
Great. Thanks. That's it for me.
We have a question from David Rodgers with Baird. Your line is open.
Yeah, good afternoon. Just sticking with the data center shells just for a moment. You said that you've got, was it three data shells that will come up for renewal in the next couple of years? Are those wholly owned, or had you sold those? I was curious if they were still kind of on the balance sheet. The way I read it is, was there a reason you hadn't sold those then? Was there something interesting about those particular assets that they hadn't been pushed into a JV yet?
No, those three are in a JV.
Okay.
They expire in 2024, all three of them.
Okay. That answered that. Maybe final question just for Steve. I don't know, those of us that have followed it a long time, you know, NBP was a very strong part of the story. It seemed to, for a while, be a little bit weaker in terms of demand and the ability to sign deals. Now it seems to be back in terms of the health of that park for you guys. You know, is that a. Is there a change in the spending and the funding for programs like cyber. Are there additional programs that have been added?
Really, I guess, what I'm trying to get at is that tail going to be substantially more consistent or grow over the next couple of years in your mind around, you know, what's really been a marquee property for you guys?
Well, a big component to the success we're having is being fueled by cyber spending, unquestionably. We don't see that changing in the near term.
Same narrative, nothing really added to that, just finally the money's getting spent, the space is being committed, and no real changes kinda on campus that either threaten or help that?
Well, there's certainly nothing on campus that threatens it. The increased challenges of the cyber, you know, defense and warfare environment lead us to believe that spending will continue to be strong for quite some time.
All right. Thank you.
We have a question from Tom Catherwood with BTIG. Your line is open.
Thanks so much. Good afternoon, everyone. You may, Steve, have already answered this question with your response to Dave's question. As Todd mentioned, this is obviously your second build-to-suit in a year at National Business Park. Is the driver behind this kind of recent increase in large space demand the cyber that you were mentioning, or is it some other demand driver or DoD funding source that really contributed to this demand?
I think it's impossible for us to know for sure. When we do these build-to-suits with defense contractors, they're very secretive about their business. Overall, that market has really been supported by expanded spending out of U.S. Cyber Command.
Got it. Is there an expectation that there could be more demand beyond that, or does it just kinda come in fits and starts?
Certainly for leasing generally, I see no abatement in demand from the cyber contractors doing business both in the NBP and Columbia Gateway. Since United States Cyber Command has been set up, it's been a constant source of growth and expansion. We have tenants that are, you know, nearing needing their own building that started with 8,000 sq ft. It's just been a steady state of demand and growth for over 8 years.
Got it. Appreciate that, Steve. Then last one from me is on those three data center shell leases that roll. I think these are the ones that were kind of in your first generation with your largest data center shell tenant. The question when you first started was always what does that second generation lease look like? You know, how do rents change? Do you need to invest incremental dollars? Do you have an expectation or at least an early read of kind of what that renewal might look like when you get to that point?
Well, it's a couple years off, Tom, so I don't wanna. I would expect rents to increase, for no other reason, than the value of the land that those assets sit on has at least tripled.
Got it. Appreciate it. Thanks, everyone.
We have a question from Bill Crow with Raymond James. Your line is open.
Hey, good afternoon. Steve, I'm curious whether the dislocation we're seeing in the market and maybe some of the delays in leasing has altered your thinking on selling some of the regional office assets, in particular Baltimore?
Well, we routinely keep an eye on markets where those assets sit. Like we did with DC6, if we see an opportunity to get good shareholder value in a market, the capital market that exists, we would consider it. Right now, I don't see that market condition being strong enough to bring one of those assets to market.
How much do you think cap rates have increased on that sort of asset?
I think there's a dearth of capital investing in CBDs right now. If you look across our portfolio, there are literally no comps to point to except for D.C., where 1900 N sold at a 4.5 cap rate to a foreign investor. I think the buyers that are sitting, looking at some of the other markets are rather opportunistic and, you know, looking to pay maybe 100 basis points, get a cap rate 100 basis points or more higher than they were, say, six months ago.
Yeah. Makes sense. Thanks. That's it for me.
Okay. Thanks, Bill.
Thank you. That's all the questions we have today. I'd like to turn the call back to Mr. Budorick for closing remarks.
Thank you for joining our call. We will be in our offices this afternoon, so if you'd like follow-up conversation, please coordinate through Michelle. Thank you very much.
Thank you for your participation today in the Corporate Office Properties Trust second quarter 2022 results conference call. This concludes the presentation. You may now disconnect. Everyone, have a great day.