OFC - Corporate Office Properties: Elevated Attention To National Defense Bodes Well For This REIT

Summary

• Corporate Office Properties Trust operates a niche portfolio of properties leased to the United States Government and its contractors.
• Their tenant base primarily operates in a national security, defense, and IT-related capacity.
• Increased attention to national defense in the current environment serves as one continued tailwind for the company.
• Over the past year, shares have been spared from the more significant declines and volatility experienced by broader markets.
• For investors, the stock offers portfolio protection and attractive upside potential.

Corporate Office Properties Trust ( OFC ) operates a niche portfolio of properties in locations that support the United States Government (“USG”) and its contractors, most of whom are engaged in national security, defense, and information technology (“IT”) related activities.

Their top tenants are comprised of either the USG or well-known defense conglomerates, such as General Dynamics ( GD ), Boeing ( BA ), and Northrop Grumman ( NOC ).

The exposure to these tenants that provide mission-critical goods and services provides continued stability to their overall portfolio, which is comprised of both Defense/IT properties/locations, as well as more Regional Offices. The latter, however, represents less than 10% of the company’s annualized revenues.

The strong portfolio dynamics has enabled the company to trade within a tight range over the past year, down just under 3% over this period. The stock is, however, up about 9.5% since a prior update towards the end of Q3FY22.

For investors seeking protection against market volatility as well as share price upside potential, OFC offers attractive risk-adjusted value at a reasonable trading multiple.

Recent Performance and Current Portfolio Metrics

At December 31, 2022 , OFC’s core portfolio was 95.3% leased. This is up 30 basis points (“bps”) on a sequential basis and 90bps YOY. From an occupancy standpoint, the portfolio was 92.8%, representing an attractive pending commencement pipeline of 250bps.

In the same-store portfolio, core leased occupancy stood at 95%, while physical occupancy held steady at 92.4%.

During the quarter, OFC leased 692K SF of space, 173K SF of which was attributable to vacancy leasing. This brought their full year leasing volume to 3.0M SF. Additionally, retention came in at 72.2% and 72.1% for the quarter and the year, respectively.

In Q4, the company also placed into service substantially all their developments for the year, which totaled 1.3M SF in aggregate, with 917K of this attributable to the final quarter of the year. These developments were 99% leased subsequent to year end.

On their renewals, which totaled 1.7M SF during 2022, OFC reported 2% lower spreads on cash rents. The effects of this, however, were offset by annual base escalators on the signings, which amounted to 2.5%. As such, on a net basis, total rent growth translated to about 3.5%.

For the full year, OFC turned in total funds from operations (“FFO”) of $2.35/share or $2.36/share on an adjusted basis. As adjusted, this represents YOY growth of 3%. Furthermore, the figure was $0.02/share higher than the midpoint of their original guidance.

Looking ahead, management is expecting 2023 adjusted FFO to be up about 1% at the midpoint compared to 2022. This takes into account positive growth in same-property cash net operating income (“NOI”) of 3% and a $0.10/share contribution from developments placed into service.

Contributing to the strength in their same-property portfolio is expectations for physical occupancy levels of 93% to 94% at year end. This would be up from 92% at the beginning of the year. Retention is also expected to track in the 75% to 85% range. These benefits, however, are partially offset by flat expectations for cash rental growth.

Full year guidance also reflects a negative contribution from higher interest expense and a decline in capitalized interest resulting in the large volume of projects already placed into service. Despite this, the company still has about 1.5M in active development.

Liquidity and Debt Profile

At the end of 2022 and in early January, OFC closed on two new joint ventures with Blackstone ( BX ). This raised +$250M in proceeds, +$190M of which was received in January. These proceeds, thereby, fully fund the external equity component of their expected 2023 development investment.

And looking ahead, the company now expects to fund future equity commitments from recurring operating cash flows, as opposed to through dispositions. Altogether, OFC expects to spend between +$250M and +$275M in development in 2023.

In addition to the proceeds from the sale of their 90% interest, OFC has access to a revolving credit facility with a maximum borrowing capacity of +$600M. As of December 31, +$389M was available for withdrawal on the facility. Recurring operating cash flows also track in the $250M+ range, providing them with ample funds necessary to meet their recurring obligations.

All total, they operate on total leverage levels of about 40% as measured to total assets. And as a multiple of EBITDA, net debt currently stands between 5.7x on a pro-forma basis and 6.3x otherwise. Floating rate exposure did increase to 15% at the end of the year from 7.5% previously due to the expiration of one of their hedges.

But in January, they entered into a new swap agreement, which effectively fixed their exposure for three years. Variable exposure, therefore, is expected to remain below 10% through 2023.

OFC also benefits from a favorable debt ladder, which is substantially weighted towards later years. This frees up funds to be used for other capital priorities, such as their investments in developments and their dividend payouts.

Dividend Safety

OFC recently increased their quarterly dividend by 3.6% to its present level of $0.285/share. At current pricing, this represents a yield of about 4.5%.

The increase is a first after a lengthy period of hanging around its former level. Stronger portfolio metrics paired with robust leasing activity enabled this to occur, as did their generally lower payout ratio, which currently stands in the mid-40s as compared to FFO. This is better than sector averages , unadjusted, and on par on an adjusted basis.

Their adequately funded development pipeline, along with incoming commencements, will likely free up capital for additional increases in future periods, though they are limited in a sense, given the higher debt load.

Final Thoughts

Demand in OFC’s regional office properties lagged in 2022. And the units continue to experience a challenging leasing environment. Year end occupancy in the segment, for example, stood at 79% and 80.8% occupied and leased, respectively. Both represent decreases of approximately 10% from 2021 levels.

This weakness, however, was more than offset by strong tenant retention and leasing demand for space in their Defense/IT locations, which account for approximately 90% of the company’s annualized rental revenues.

Performance in this core segment was highlighted by vacant space leasing of 719K SF and the initiation of 1.3M SF of newly developed properties that were 99% leased. Overall, this contributed to the company’s highest annual vacancy leasing volume in 12 years. The total volume was also 30% higher than in 2021 and 40% higher than their prior five-year average.

Strong leasing volumes resulted in a core portfolio occupancy rate that was the highest attained since 2006. A 7.5% YOY increase in the national defense budget that was nearly 5% higher than President Biden’s budget request also serves as a favorable tailwind for future leasing volume.

It’s also worth noting that the 7.5% increase follows a 5.8% increase earlier in March. Over the last 12 months, this represents an increase of about +$100B in defense spending.

Elevated exposure to defense-focused tenants is likely to insulate OFC’s overall portfolio from the weakness in their regional office segment, which accounts for a small fraction of their total revenues.

Successful capital raises early in 2023 ensures they don’t have to rely on dispositions to fund their development pipeline. But the continued recycling out of these weaker properties remains one viable option for the company to further boost their portfolio.

At 10.7x forward FFO, shares trade at an elevated premium to other office operators, but this is justifiable, given the niche nature of their properties, which are more comparable to Easterly Government Properties ( DEA ) than other traditional competitors. Currently, DEA is fetching a multiple of nearly 12x.

At that multiple, OFC could reasonably appreciate to the $28/share range, which would imply upside of about 10% from current trading levels. Compared to consensus estimates, this is on the more conservative side, as Wall Street currently view shares fairly valued at about $30/share. This would represent upside of about 19%. For investors, this would provide attractive returns when paired with their recently increased dividend payout.

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