COPT Defense Properties (CDP) Q2 2019 Earnings Report, Transcript and Summary

Welcome to the Corporate Office Properties Trust Second Quarter 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, Crystal. Good afternoon and welcome to COPT's second quarter 2019 conference call. With me today are Steve Budorick, President and CEO; Paul Adkins, Executive Vice President and COO; and Anthony Mifsud, EVP and CFO.In addition to the supplemental package and press release related to our results, we posted slides on the Investors section of our website to accompany management's remarks. On our website and in the results press release, you will find reconciliations of GAAP and non-GAAP financial measures management discusses. At the conclusion of management's remarks, we will open the call for questions.Statements made during this call may be forward-looking within the meaning of the Safe Harbor of the Private Securities Litigation Reform Act of 1995 and 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.I'll now hand the call over to Steve.

Thank you and good afternoon. We had very productive first seven months during which we achieved three high priority strategic objectives. In development leasing, we signed 1.7 million square feet to-date, a new record for single year. We exceeded our prior record by over half million square feet and we still have five months remaining in the year. As a result, we have more than doubled our expectation for full-year development leasing in 2019 from our initial guidance levels. Second, in the quarter we tied our all-time quarterly record for vacancy leasing and were on pace to meet or exceed our best annual volume for the year.And third, we created a strategic joint venture arrangement with Blackstone to fund our 2019 development investment needs and most of the equity for our expected 2020 development spend. Importantly, the JV creates a valuable relationship we can rely on to generate future capital recycling, if necessary in a highly cost effective manner to ensure funding of our expanding development opportunities.The healthy defense spending environment underpins the robust demand for our defense IT locations and our ability to convert this broad based demand in the strong leasing volumes well suits the outlook for future FFO growth. Last week, Congress agreed on a two-year budget deal that, when appropriated will continue to grow defense spending at fiscal 2020 and 2021. The House passed the agreement last week and the Senate is expected to pass it this week. The two-year bipartisan agreement raises the final two years of spending caps put in place by the Budget Control Act of 2011 removing the possibility of future sequestration cuts and reducing the likelihood of continuing resolutions.The very visible bipartisan support to restore and fund our national defense continues to instill confidence among government users and defense contractors to invest in growth which includes facility planning.As demonstrated by our record leasing results in the quarter and year-to-date, we continue to benefit from being the preferred provider of Real Estate Solutions to government users and defense contractors engaged in national security, defense and IT related activities including cyber security. Moreover we see strong growth in all five of the categories of demand, we've outlined on prior calls.The first category is defense contractor incremental expansions which continued to accelerate. In the second quarter, we completed 245,000 square feet of vacancy leasing, matching our best ever quarterly volume. Vacancy leasing at our defense IT locations with 76% of the quarter's volume and exceeded the entire amount of vacancy leasing executed in the second quarter of 2018.Second category is deferred U.S. government leasing. During the second quarter, 92,000 square feet of our vacancy leasing was with the U.S. government in the Fort Meade area. For the first half of the year, we completed five leases with the U.S. government totaling 126,000 square feet representing a third of our total vacancy leasing. The third category is speculative development in markets where demand is observed via available inventory and supports modest speculative development.Redstone Gateway is one of the two markets where we see current speculative opportunity, the two spec buildings we started last year are both 100% leased. Every square foot of operating space in Redstone Gateway is leased and the 440,000 square feet of contractor build leads under development are 95% leased. Since we have no uncommitted inventory later this quarter we expect to break ground on our next 100,000 square foot spec building to capture highly visible defense contractor demand.The other market that supports speculative development is a Discovery District at the University of Maryland. Last quarter we placed 5801 University Research Court, our most recent spec development in that business park in service. That building is 100% leased and given the strong demand we continue to see for this metro served location, we recently kicked off 105,000 square foot spec development. Among the many prospects we are pursuing is a fast growing provider of cyber security training that we expect will prelease 25% of the project. The fourth category is build-to-suit major preleases with defense contractors positioning for growth. Demand for preleases and full building build-to-suits emerged last year and continues.Excluding the data center shells, this year we've completed more than 400,000 square feet of major prelease and build-to-suit leases with defense contractors for new facilities. This activity includes a multi-building campus for Yulista, defense systems and solutions division recently won a nine-year $4.7 billion contract from AMRDEC at Redstone Arsenal. In our data center shell business, we’ve signed five leases this year. The first four completed the 11 facility pipeline we announced in 2017. In aggregate that program encompass 220,000 more square feet and committed 40 million more dollars than originally planned which roughly equals one extra data center shell.The fifth lease is the first of another half dozen or so additional opportunities with this customer on land, we already control and demand for data center shells continues to be strong and our recent joint venture transaction demonstrates the value proposition of that development platform. We monetized profits in seven of these assets and are recycling the proceeds into an expanding set of development projects, creating value for shareholders and providing a highly cost effective capital source.The fifth demand drivers is the government returning to long-term planning and expansion at our secured campuses. Negotiations are advancing well with multiple government users to fill 100 Secured Gateway in Huntsville and discussions are progressing with other government users that require new facilities elsewhere. In fact approximately one-third of the transactions in our shell development pipeline involve new facilities for government users.So in summary, we have seen a rapidly expanding set of leasing opportunities resulting from the past few years of defense spending increases. The outlook for defense spending remains bright and should fuel strong demand for our defense IT locations for years to come. Referring to Page 25 of our supplemental package, we have 2.1 million square feet of active construction projects underway. As we place this pipeline of highly preleased developments in the service between now and the end of 2021, we expect the additional EBITDA to generate modest FFO growth in 2020 and impressive growth in 2021. With that, I'll turn the call over to Paul.

Thank you, Steve. At the end of the second quarter, our 19 million square foot core portfolio was 94.1% leased, the highest level in 18 months and a 40 basis point increase from last quarter. We expect a strong leasing momentum to drive additional occupancy gains. Within our operating portfolio in the second quarter and first half of this year, we've leased twice the vacant footage than we did during the same period last year, 61% of second quarter's vacancy leasing was in the Fort Meade/BW Corridor subsegment which was 92.5% leased at the end of the quarter.In the market, we are tracking 500,000 square feet of activity against these 600,000 square feet of unleased space. At the National Business Park, we are 91% leased representing an increase of 140 basis points over last quarter just 3.8 million square foot park contains only 365,000 square feet of unleased space against which we are in various stages of pursuit with roughly 230,000 square feet of demand.Looking at our other subsegments. In leasing executed in July, our 706,000 square foot of operational space in Huntsville is 100% leased. In San Antonio, our 953,000 square foot mission-critical campus remains 100% leased. Our 1.2 million square foot Navy support portfolio was 93% leased at the end of the quarter marking a 180 basis point increase over last quarter. We are working 66,000 square feet of demand against the remaining 85,000 square feet of vacancy and expect to see more space absorb before year-end.Our 2 million square foot NoVA Defense/IT portfolio was 88% leased at the end of the quarter which is down relative to the first quarter due to expected return tenant turnover. We have already backfill 25% of the non-renewals and are in advanced negotiations with another 50%. For the sub-segment as a whole, we have 245,000 square feet of unleased space against which we are working in equal amount of demand.Lastly and our regional office portfolio with the 46,000 square feet of leases signed in the second quarter, our Baltimore portfolio of three inner harbor office towers is now 94% leased and we are tracking 75,000 square feet of new demand. Our four metro serviced buildings -- served buildings in Northern Virginia were 84% leased at the end of the quarter and we are in discussions with prospects to absorb up to a third of the 100,000 square feet of unleased space. In terms of new construction, the 2.1 million square feet of projects under development are 83% preleased when placed into service, this pipeline will increase our total portfolio by 11%.Furthermore, we expect each project to be substantially or fully leased when they are placed in the service between now and the end of 2021. In the second quarter, we placed 606,000 square feet into service that were 100% leased bringing our total through June 30 to 787,000 square feet of fully leased space.Before year-end, we expect to place another 100,000 square feet of leased space into service for an annual achievement of nearly 900,000 square feet. Our ability to consistently deliver development projects that are highly leased supports cash flow growth and is the key to our value creation. Our shadow development pipeline contains up to 2.3 million square feet of potential transactions. We have a high degree of confidence that we will execute on another 300,000 to 400,000 square feet of leases before year-end which supports the increase of our development leasing goal for the year from the previously elevated target of 1.4 million square feet to the new goal of 2 million square feet. With that, I'll hand the call over to Anthony.

Thanks Paul. The continued strong demand for new developments and our elevated development leasing goal have resulted in a corresponding increase in our development spend guidance. We are increasing our estimated investment for the year by another $75 million to a new range of $400 million to $450 million. This is one and a half times our initial expectation which was to invest $250 million to $300 million in developments this year. During the quarter, we contributed 90% interest in seven of our data center shell properties to a joint venture with Blackstone Real Estate income fund raising gross proceeds of $238 million.Based on our average yield on cost of 7.2% pricing on the seven assets equated to a profit margin of approximately 45%. In order to fund the increased level of development investment, we increased the percentage on the first seven assets contributed to the venture and have executed an agreement to contribute two additional data center shells in early December to our Blackstone JV. selling a higher percentage interest and two extra assets increases our disposition guidance for the year to $300 million which is twice the level of asset sales anticipated when we established guidance in February.Second quarter FFO per share of $0.52 exceeded the high-end of guidance by a penny and was driven by stronger than anticipated same-property cash NOI growth of 4.5% and higher lease termination income. Same-property cash NOI exceeded our internal forecast and was driven in part by lower than expected operating expenses which included the timing of our R&M costs. Based on the 4.5% increase in same-property cash NOI for the first six months and our forecast for the remainder of the year which includes investing the deferred R&M costs, we are increasing our same property cash NOI growth for the full-year from our prior range of 1.5% to 3% to new range of 2.75% to 3.25%.Regarding year-end same-property occupancy. The closings on the Blackstone joint venture removes 100% leased assets from the same-property pool and reduces year-end same-property occupancy by 60 basis points. Accordingly we are tightening our guidance from a prior range of 92% to 94% to a new range of 92% to 93%. Tenant retention was 81% in the quarter and 78% for the six months. Both of which exceeded our full-year guidance of 70% to 75% and we are increasing our tenant retention target to a new range of 75% to 80%.Cash rents on renewals in the quarter rolled down 3.3%, similar to the first quarter the roll down was driven by a couple of transactions where annual rent increases on long-term leases compounded in excess of market rent growth. I want to discuss the impacts of tenant retention and renewal rates in more detail to keep the importance of these metrics in the proper context.Although we prefer market rents to keep pace with our embedded rent steps, the fact is that our higher retention rates more than offset the rate compression. I refer you to the analysis on Slide 11 of our deck. Without accounting for downtime which would magnify these results, this analysis reveals that renewing 78% of expiring leases with a 4.6% roll down produces 8.8% more revenue and avoid spending a minimum of $600,000 of CapEx relative to achieving a 65% retention rate and 5% cash rent growth. Quite simply our consistently high retention rates as shown on Slide 10 reduce CapEx investment, avoid potentially lengthy downtimes and therefore benefit AFFO in current and future periods. The structural rent growth in our leases will recapture the lost rate over time and the CapEx savings is a permanent benefit.In terms of renewing rents guidance for the balance of the year. We are in advanced negotiations on several large 2020 expirations that we expect to renew before the end of the year, these early renewals were not part of our initial guidance and the expiring rates have escalated above market. Incorporating actual results with these renewals into our forecast, we now expect renewing cash rents to roll down between 4% and 5% for the year. Last but perhaps most important, we are reiterating our guidance for FFO per share for the full-year in the range of $2.01 to $2.05. We are establishing third-quarter guidance of $0.49 to $0.51. Even though we have doubled our expected dispositions for the year which net of interest savings causes an additional $0.015 of dilution in 2019. We expect our existing operations to more than make up for this.With that, I'll turn the call back to Steve.

Thank you, Anthony. Recapping today's call, we've had a great first half of 2019 then we're looking forward to finishing the year with strength. Our occupancy fundamentals are gaining ground. We're on pace to achieve our highest vacancy leasing level in our history. We've already set a new record in annual development leasing and we're guiding to a record shattering 2 million square feet for 2019.We expect to invest above $425 million in our development activities or a 54% increase above the midpoint of our initial guidance. Our active development pipeline contains 2.1 million square feet of highly prerelease projects that represent more than 10% growth in our portfolio size when delivered. We've recycled development capital demonstrating impressive margins and valuations in our development activities. And importantly, we've raised sufficient capital to fund 2019 development activity and most of 2020’s expected investment. Clearly the succession of the increased Department of Defense based budgets. Commencing with the fiscal year 2017 budget passed in May of 2017 had materialized and a greater opportunity for both our operating portfolio and our development business and within the timeframes we set forth in early 2018.We attribute the elevated demand we're now experiencing to the fiscal year 2018 budget appropriated in March of 2018 and that demand continues with strength in the second half of the year. Given the fiscal year 2019 defense budget was passed only 10 months ago and the recent two-year bipartisan agreement is in the process of being passed and the mission critical nature of our defense IT locations is unique in our industry. We have great confidence that our shareholders will continue to benefit from the strength of the national security investments of our country for at least the next three to four years. The strength of our capital recycling effort this year propels our company towards supporting elevated development investments with diminishing incremental equity capital needs and ultimately beyond an inflection point where we can self fund development and deliver impressive annual FFO and cash flow growth. With that operator, please open up the call for questions.

Thank you. [Operator Instructions] And our first question comes from Craig Mailman from KeyBanc Capital Markets. Your line is open.

Thank you. Anthony, I think you touched on it with the R&M costs being diverted a little bit but could you just break down the 75 basis point increase in guidance here into the components?

Well the components are made up of some faster lease occupancy for leasing that was tenants into occupancy from leasing that was done last year and there were some operating expenses that were lower than expected in the first and second quarter that are permanent. Most of them relating to the net impact of weather related expenses both snow as well as energy.

Okay. Then I know the rent spreads are coming down because of some early renewals. If we were to think about just kind of rent spreads and commencements for this year versus 2020 kind of how would those two buckets look?

Not sure, they'd look any different. I mean there is some of the early renewals that we're experiencing won't impact our cash NOI until next year. But there's I'd say there's two-thirds of our renewals that relate to expiring leases within the current year and roughly a third that are early renewals. So some of it's probably roughly two-thirds, one third.

Hey Craig to put a little finer point on that where we stand year-to-date, 91% of our leases in aggregate rolled within the guidance we set forth or with cash rent roll down less than 2% only four leases that we included one early renewal renewed outside of our guidance. In total they renewed at about 9.1% combined. The important point of those four deals they were larger, they were coming off very long terms and had escalated higher. We retained $10.5 million of rent by renewing them and we gave up one. But if you look at the big picture, we say $10 million to $20 million from potential downtime we avoided at least $8 million to $10 million of CapEx risk. So next year the preponderance of our leases will likely roll in that zero to minus two. But there may be an occasion where a bigger longer term lease comes to maturity or maybe early that could deviate from that.

That's helpful. Thanks for the color. And then just lastly I know you guys have $300 million to $400 million of debt lease in the full-year and how much of that is related to a potential JEDI award versus just increased defense spending you guys are talking about on just the office side?

So to the best of our knowledge, none of the planned developments we're doing in Cloud computing anticipate the JEDI contract, that contract is expected to be awarded in August. There are only two competitors that are qualified to service it and we'll understand I think in August how that turns out and what the implications are for our company or thereafter.

So none of the $300,000 to $400,000 potential incremental before year-end is really data centers that is more traditional?

That's absolutely true. We don't expect to sign another data center lease this year. So our current development mix with the two deals we just signed year-to-date achievement is about 70% data centers as we look to the end of the year that mix should be 60-ish percent and possible as low as 50%.

Okay. And just one last one. Anthony on your ability to kind of continue to shelter gains on additional data center contributions, how much more can you put into that before you run special dividend concerns if any?

We have a lot of sort of tax planning that's gone on this year to eliminate the need for a special dividend this year and all of those are on track to get completed before the end of the year. We would continue to have some cushion beyond that probably some significant cushion beyond that because we would still maintain most of if not all of our fifth quarter dividend deduction.

Great. Thank you.

Thank you. Our next question comes from Manny Korchman from Citi. Your line is open.

Thanks guys. Anthony, you sort of touched on this in your closing remarks but how do you think about continued sales or JVs versus tapping the public equity markets especially since you guys do have an active ATM out there?

I think as long as we continue to trade in the public markets below net asset value and we can harvest and recycle our data center shell assets in the kind of structure, at that kind of pricing and kind of development margins that we executed in the second quarter, we would continue to do that in lieu of going to the market and issuing under our ATM getting that capital source was not only a goal to raise the capital for this year but it was to find a partner who could become a programmatic partner for us going forward and we're confident that we have found that partner.

Thanks. And if we think about your shadow development pipeline, I think you had 2.3 million square feet. Can you give us at least a rough breakdown of the makeup of the markets or asset types how much of that is the data center builds versus office space?

Roughly 50% is data center, 50% is defense contractor or other office space, it's distributed throughout our portfolio but there's a strong concentration in Redstone Gateway and then there's roughly a third of the volume represents U.S. government facilities, we're working with users to plan for the future.

Thanks Steve.

Thank you. Our next question comes from Blaine Heck from Wells Fargo. Your line is open.

Thanks. Just to follow-up on that last one, Steve. It seems like thus far you've built relatively small buildings at Redstone Gateway but is there an opportunity to take advantage of the momentum there and maybe do some larger properties?

Well so we've had some discussions that would involve larger properties on a build-to-suit or major pre-lease basis. In terms of our expectation of starting another building this quarter without a significant pre-lease, we would manage our speculative commitment to 100,000 square feet or so at the time and we've got ample land and with building to that size, we can fulfill the 4.5 million square feet of potential. So we're about managing shareholder risk.

All right, that's helpful. Then just digging into your top 20 tenants and those that are next to roll and maybe some of this is included in early renewals but it looks like Kratos and Accenture are coming off within the next year and some larger ones. Northrop, Boeing, Booz Allen and say the next couple of years Paul or Steve is there any color you can give on those specific leases and your expectations or negotiations you might be having at this point?

Well the one I will call out is Kratos which will be a non-renewal. That lease was signed to other users years ago. So although we may retain tenancy we'll book part or all that we'll book it as new leasing. The other ones I think are open issues.

Yes, the other one is the expectation is as you can tell by our chart in the slide deck, we expect to renew those leases.

Okay, helpful. And then on Page 8 of the presentation, you guys referenced 900,000 square feet of demand from defense contract awards that you're tracking. Can you just give some more color on those requirements, when were those contracts awarded and how many contracts are actually driving that 900,000 square feet?

While the 900,000 square feet is an aggregate of the demand across all of our subsegments that are at Defense/IT locations. So there is that’s just the summary of the active deals that we're pursuing. It's obviously numerous contracts that they're related to but it's not a direct correlation to five contracts or something like that it really represents the broad based demand across our various locations.

Got it. All right. Thanks guys.

Thank you. Our next question comes from Jamie Feldman from Bank of America. Your line is open.

Great, thank you. I want to ask you a little bit about just the platform and your ability to manage all of this incremental development, should it continue to grow. I mean do you think that based on your current headcount in Land Bank and platform across your markets, what's your capacity to keep growing or do you think you need to beef up the company even more?

Well we made a decision in the last six months to beef up our Redstone Gateway team, so we've added one body and a second shortly. Beyond that, we have great scale in our data center shell development team. So we’re fine there and we’ve got, I don’t think we will have any material additions to our headcount to support this elevated demand or continue in the future.

Okay and then for Anthony as you think about funding with dispositions especially to the data center JV, I mean you are there any limitations on how much you can contribute per year and can you give a sense of pricing on the two assets that you guys are going to contribute or just how the pricing is structured for that JV?

Sure, there’s really no limitation here. We have done a total. We've a total of 26 either operating or under construction data center shells with the 13 that are in ventures today plus the two we expect to contribute at the end of the year, we'll have 11 that continue to be wholly owned assets. I think our only restriction is really time as we make sure that those assets have sort of reached their hold, 24 month hold dates from placed in service from a tax standpoint. Other than that there's really no restriction on the timing or the amount that we could sell. It's really how much we need to sell to not just meet the funding of our expected development investment but maintain and continue to marginally improve our leverage over time.So I think we're fine with respect to having a stable of assets that we can continue to tap into. With respect to pricing, the cap rate on the two data center shells that will close into the venture in December have a very small premium and cap rate to what we did in June because to get the commitment from our venture partner. But still in that same low five range.

Okay. And then maybe an update on the Washington D.C. developments leasing?

Sure. At 2100 L, we currently have six active prospects totaling 260,000 square feet for the 90,000, 100,000 square feet of office space we have left. So we're 50% preleased, the building is pouring the seventh floor out of 10 that will be topping off the next couple of months. And so with that activity, we remain optimistic that we will deliver substantially leased, the earliest that we can perform tenant work is April of next year, so that's when we'll begin the Morrison & Foerster build out. But overall the climate is competitive but we're confident that the superior trophy attributes will that do compete well.

Okay. Thank you. And then I guess just finally in the Blackstone JV seems like it's going pretty well, I mean what's your appetite to start similar structures with other investors for maybe more of the Defense/IT type assets?

Well we don't have any appetite to joint venture or Defense/IT assets beyond the data center shells.

Okay, all right. Thank you.

Thank you. Our next question comes from Dave Rodgers from Baird. Your line is open.

Hello Dave.

Along the way, any updates on 310 timing conversations incremental leasing et cetera.

So we missed the first half of your sentence, you want to start from the beginning.

Yes, sure. Sorry about the connection. Just on 310 NBP, I don't know if I may have missed it or had a bad connection earlier and missed something along the way. Just any update on leasing expectations there?

So we expect our opportunity to fully leased building to occur before year-end.

Great. That's helpful. Do you talk about kind of what gets you comfortable with spec development it’s been a while since you've done that. And would you do expect on the government side or is this purely defense contractor or is it more location driven kind of some thoughts around that?

Well first let's just separate the government. Most of the government customers we serve, we have to start the building before it can be leased like 100 Secured Gateway at the Redstone Gateway development. We have the condition, we call informed demand. We understand there are needs available and where the funding sources are and we move forward as we typically have with that kind of development.With regard to spec, it was pretty clear in our comments. There's only two developments we have currently where we're comfortable going to spec. The first is at the University of Maryland where we're completely leased, we do have some development achievement milestones and we've got great demand for product down there, it’s pretty exciting location. And the second is Redstone Gateway literally we have not a square foot in all of Huntsville that we can lease through a prospect that we have significant demand in conversations ranging from modest to very large. So it's clearly a very comfortable bet to kick off a 100,000 square foot building on spec based on the numerous conversations we're having.

That's helpful, appreciate that color. And then maybe just lastly for you or for Anthony, Steve. With regard to your comments you've been pretty consistently I think in the beginning you're talking about 2021 FFO growth kind of starting. It looks though that with your development pipeline completion stabilization expectations that most of that growth should actually begin to occur in the second half of 2020. So I guess I just wanted to ask a more pointed question do you expect some of the leases to take a little bit longer or there more maybe dilution coming or is it really you're just looking at a full-year versus kind of when that contribution really starts to kick in. Just wanted to kind of get a better sense for that second half of 2020?

Well, you can see a ramp up in the second half of 2020, you can see full-year impact in 2021. You just put in context that we doubled our capital raise, we doubled our full-year dilution from that capital raise, we expect good growth next year and then the full impact to occur in 2021.

Great, thank you.

Thank you. Our next question comes from Rich Anderson from SMBC. Your line is open.

Hey thanks. Good morning or afternoon.

Welcome back Rich.

Thanks Steve. So with market consensus NAV number out there is 31. Do you have any comment about that at that number?

I think our comment on that would be that we believe the value of the company is higher than that based on where we believe the cap rates for our assets are compared to the cap rates that are retained in some of those valuations that make up consensus.

Okay. So the stock clicks 3101 we’re not looking for an equity offering from you guys, I guess this is my point.

Well certainly not this year with what we've completed. We mentioned in their comments, we've put a substantial amount of the capital needs for 2020 away.

Yes. So speaking of capital raising and I would argue you have two program programmatic partners in the Shell business now but I'm curious when you look now at your Inner Harbor assets in Baltimore, 94% leased. What is your thought about them long-term particularly now that we've learned that the city is rat-infested?

All right. Well I can come back with any comment on the politics. I will say like every great city, Baltimore clearly has some issues in challenging neighborhoods. But it also has very solid business community with great organizations and citizens dedicated to the city. So as for our three buildings in the Inner Harbor, we're very pleased with their performance and with our investment. Back in 2015, we invested into the reorganization trend in and around the harbor which continues to be very successful.All the residential developments that we were anticipating back then is completed. They've all had great success in that dynamic that supports the CBD and our investments continues to be strong. So in my last comment, buildings are 94% leased and it marks a new high in occupancy, so we're very satisfied with the buildings. Long-term they are non-defense assets, we do have value creation theories and programs involved in all three that we're executing on and there may be a day when the best move for our shareholders is to harvest that value. But it's not in the next 12 to 24 months.

Okay. Thank you. Anthony may be or whomever is the $300 million of dispositions is that -- just to clarify that's entirely the Blackstone joint venture arrangements? Correct.

That's correct.

Okay. And then when you talked about the escalators exceeding market rent growth and hence the rent roll downs at expiration. Is that a condition that can stay in perpetuity or will at some point you'll need to see escalators come down to better reflect what is happening in the marketplace?

I think we continue to see a benefit from getting the escalators over time because we're even though we're having these rent roll downs on our renewals, you compare our first year cash to first year cash on leases, we're still seeing rent growth over the life of the leases. So what we'd rather continue to get and negotiate for those higher -- continued high increases each year.But clearly as we sort of outlined, the benefit of our higher tenant retention more than outweighs the impact of cash rent roll downs even when those roll downs are at market and we believe we'll continue to experience those high levels of retentions and by doing that we avoid downtime that could be undefinable in terms of how long it is as well as higher tenant allowance and in some cases even building capital.

Let me just throw a quick point. Our average leases call it five or six years and 90% of our leases are rolling within our guidance of 0 to minus 2 about a third of them roll up, a third to 40% is flat to positive and some are mildly negative. It's the rare lease that is compounded for eight or 10 years where we see a mark-to-market that's a bit painful and it disproportionately shows in our annual guidance. But we see no change in our ability to negotiate and capture good rent growth in our structure which we've demonstrated creates start rents growth in our portfolio.

Okay. And then lastly Steve what did you mention that you thought continuing resolution was probably off the tail? I don’t remember exactly how you put it but it wasn't a complete no. I'm curious is there some language in there to that end?

We did more than imply that. We stated that in our narrative, it really speaks to the activity that occurred last year that you see breaking moves right now with the bipartisan agreement, start identifying and agreeing on components of the total budget and passing them individually. Last year before the end of this fiscal year at least three of the budget sectors were already passed before we hit September 30. The narrative that we hear is that we'd like to see defense and several others pass before the end of September 30 if not all of them.

Okay, all right. Thank you.

Thanks Rich.

Thank you. Our next question comes from Tom Catherwood from BTIG. Your line is open.

Thank you very much. Sticking with the leasing and the leasing roll down questions. So either Anthony or Steve, is it correct to say that were it not for the early renewals that you did the 2020 renewals, that leasing spreads would have been within the prior guidance. Is it just that dragging it down?

Well there is a big early renewal in the first quarter that set that quarters roll down, it would have been much closer to our guidance without them.

Okay. And is it back…

Like I said, we would have been at guidance, but we would have been plus or minus point.

Okay. And is it sounds like it's just the duration of those leases that causes that substantial roll down. Or is it market location does that factor in or is it pretty consistent across your markets as far as kind of how far below market these leases are?

It's really duration.

Okay. And what I'm really trying to get at is you spoke a lot about the incredible demand, Paul spoke about kind of the demand that you're tracking against the vacancy. Obviously leasing volumes are as high as they've ever been but does the market still remain relatively flat. Is there something in your markets that needs to change from a vacancy standpoint or just a competitive standpoint to start getting some positive momentum not on the leasing front but I mean on the rent front or this kind of just flatness it's the way it's going to be?

Well, firstly, I can't talk about rent growth on all markets in the same way. Some of our markets were already experiencing rent growth through what we had 12 or 24 months ago and others less so. But in all instances in my career when you see increases in rates, it needs to be preceded by 12 to 24 months of strong absorption, when the supply availability drops that’s when you can see leverage to command higher rate then we're at the front end of that recovery. So 12 to 18 months, 24 months from now we expect to be in a better spot than we are. In the meantime, we are managing to maximize cash flow growth from our assets and as we demonstrated on our Exhibit, the best way to do that is not lose our tenants.So if we have to on occasion take a roll down to keep that retention, you can't grow our rent that you don't keep and the capital avoidance is really where the value comes in effective rents are much better. So that's where we look at it.

Totally fair. And along those lines Steve do you then again because there is more demand even though we're not 12 to 24 months down the road, do you get some more flexibility in your negotiation whether it's being able to capture longer terms or higher annual bumps on these leases that you're doing now?

Hey Tom, it’s Paul. I would say that we do get a little bit more leverage in our negotiations with the increased demand. And as Steve said, we're really this is just beginning to ramp-up. This is sort of the demand uptick from the FY 2018 budget that we're seeing. So we’re focused mostly on the velocity of increasing our occupancy in our portfolio. The terms aren't moving demonstrably better for us nor are they obviously deteriorating. So it's just increased demand in with minor improvements in select submarkets in terms of terms so that we can dictate slightly better terms.

Got it, got it. Okay and then last one from me Steve you mentioned something interesting at the very end of your remarks, I didn't hear it fully but you mentioned getting towards self funding. So you've obviously set up this programmatic joint venture, you're going to have increasing cash flows as you deliver the developments that are in place right now. But how do you think about that comment you made with self funding in terms of A what it might take to get you to that point and B kind of what level of annual investment you could support on just a self funding basis?

Well I’m not going to let you pin me down on exact numbers for years but as we model our business going forward with the oversized capital raise this year, the prefunding of a significant amount of what we need next year. To maintain higher development levels than we've averaged over the last eight years, we need increasingly less capital on new capital for equity on the annual basis and we project day one, we'll be able to support a very high level of development with our internal funding.

While maintaining our current if not improving our current leverage levels.

So thank you for that Anthony.

We're referring to an inflection point. We've come a long way to get our debt where it's at great value. We've recycled on a few instances but there's real leverage in the profitability of the development and we've recycled and there's that leverage impacts future cash flow, we're gaining ground.

Understood. All right, thanks everyone.

Thank you, Tom.

Thank you. Our next question comes from Jon Petersen from Jefferies. Your line is open.

Great, thanks. So you had a little conversation earlier I think with Rich on NAV, I'm curious if you could talk more about cap rates. So obviously we've seen interest rates come down but clearly there's also some momentum in the business that you guys focused on. So I know a couple of years ago you put some research out on your page with some cap rate guidelines, I was curious if you can comment on whether if you were to update that today would those cap rates be down up the same?

Well, one thing I will say, we demonstrated the cap rate on our data center shells and Anthony you want to take the rest of the question?

Yes, we'll be updating that piece based to incorporate some other transactions that have occurred in our markets over the last 12 months. But our expectation is and based on transactions that have been executed that those cap rates would be sort of marginally lower than what they were on the last piece we put out. Yes, I think the one area we will continue to have a debate and conversations with investors and analysts is around the value of our government buildings.We believe those government assets and if we could demonstrate that our data center shells assets are valued in the range where that cap rate was priced, we're pretty confident that our government secured government portfolio would price with a cap rate inside of where our data center shells are. So I think that's where we will continue to mine for comparable transactions. But they're just difficult to find to support where we believe that the value of that portfolio resides.

Okay. And then yes you guys have done a lot of work on leverage to bring it down. You're currently at BBB minus. It could come across all the rating agencies but I think you've got positive outlooks that at least two of the three of them. So I guess what do you still have to do to get upgraded to that BBB flat notch. Is it just a matter of waiting and then I guess once you get there, I guess maybe what sort of different strategies will you take to extract those interest savings?

Well I think it’s different to each agency. Yes, I think some of the -- one of the agencies we need to maintain a lower leverage profile for a long extended period of time to offset what they see as geographic and tenant concentration concerns.I think other agencies they have clearly come around and come to appreciate the value of our franchise and the value of what that concentration means with respect to the stability of cash flows within our portfolio. So I think with the two that we're on positive outlook on there is the possibility over the next 12 to 18 months of moving those to BBB flat. But again there's every time, we think where there's somehow the goal, the goal line moves. But I think we're clearly moving in the right direction and all of the commentary we've received from the agencies is very, very positive.In terms of how we capitalize the company, I don't think we would -- I think we would continue to structure our debt portfolio in a similar manner to what we have today where the vast majority of our debt is in fixed income public market and would continue to tap that market to fund the debt component of our investment opportunities.

Great. That’s all from me. Thank you.

Thank you. Our next question comes from Bill Crow from Raymond James. Your line is open.

Good afternoon guys. Steve real quick, does the success at Huntsville encourage you or embolden you to continue to put energy into looking for new markets?

Well we haven't done the new market research for a couple of years now but when we've done it in the past, we really made the conclusion that we've picked the best markets for our shareholders that there's long-term growth opportunities in all of them. And so we're not currently seeking an expansion market with the environment that's accumulated since the increases in the defense budget, conversations with government and defense contractors at our locations, we feel we have significant opportunity growing in front of us.

You don't have your tenants coming to you telling you to start working in a certain market or anything like that or there’s no obvious next?

From time to time, we’ve been asked by tenants to consider a one-off in a different market since 2013 or 2014, we've refused those.

Okay, all right. Congratulations. Thank you.

Thanks Bill.

Thank you. And our next question comes from Chris Lucas from Capital One Securities. Your line is open.

Good afternoon everybody. Nice quarter, Steve. Just a couple of detail questions on 7500 and 7600 Advanced Gateway the project scope increased just some color on the background of what happened between sort of when you got the lease signed in the second quarter to today?

We’re just advancing the planning for the campus, we’ve introduced a really talented design team to help plan for a long-term efficiency realization with that customer and we're just refining the need as we get through the details of the design.

Should we interpret this as a move towards a more dense campus based on the demand that you're seeing there?

Well certainly this campus is build-to-suit campus is going to be pretty compact as part of the efficiency. And in terms of the overall development, yes I think you're going to start to see us creating more density than you would expect.

Okay, great. Thanks. And then on the recent data center leases that were signed subsequent into the quarter, are the economics consistent with a prior set of deals or is there any change particularly given the fact that rates are down and there's an established cap rate for the value of those assets et cetera?

No change at all, Chris.

Okay. And then the last question for me just on the timing to deliver, you’re moving from single storey to multi-storey, does that how does that extend the sort of start to finish timeframe?

It’s tough to answer. Teams are extremely good at getting the building once we have all the land conditions established, our delays have been more in getting permits and storm water issues but I don't think it takes us materially longer period of time maybe a month extra to do a two storey over one storey.

Okay. And actually let me ask one other question which is you talked about spec in some markets, have you given the dynamics of the particularly the Northern Virginia data center market, have you thought about doing spec development on data center shells.

No, we have not considered that.

Okay, that’s all I have. Thanks.

Great. Thank you, Chris.

Thank you. And I’m showing no further questions from our phone lines. I'd now like to turn the conference back over to Mr. Budorick for any closing remarks.

Thank you for joining our call today. We're in our offices this afternoon, so please coordinate any calls to Stephanie, if you like to follow up with us. Thank you for participating.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. You may all disconnect. Everyone have a wonderful day.