COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Thanks, everybody, for joining us live and in person first time in a little while. I'm Michael Lewis, Managing Director and lead office REIT analyst at Truist Securities. I have the pleasure today to introduce immediately to my right, Steve Budorick, Chief Executive Officer of Corporate Office Properties Trust as well as to his right, Todd Hartman, Chief Operating Officer. For those of you less familiar, Corporate Office Properties Trust ticker OFC, is an office REIT headquartered in Columbia, Maryland. It focuses on owning, operating and developing mission-critical facilities that support key U.S. government defense installations and defense contractors. It's an S&P 400 company with an equity market cap of roughly $3 billion. But you're not here to hear from me. So before I get to my prepared questions, maybe, Steve, for the investors out there who are a little less familiar with the company, maybe just provide a little more of a brief overview of the company and your broad strategy.

Great. So as Mike said, Corporate Office Properties Trust is a specialized office REIT, deeply concentrated in assets to support national defense activity in The United States government. The vast majority of our 188 properties are located adjacent to or are occupied by priority defense missions, generally involving knowledge-based activities. The missions we support include intelligence and surveillance, cybersecurity and network activity, naval sea technology, air technology development, missile defense and lethality, army aviation, law enforcement and terrorism explosive technology and cloud computing. The U.S. government is our largest tenant. We have 250 separate leases in 150 different properties, totaling 5.13 million square feet, producing 37% of our annualized rental revenue. 14 of our remaining 19 largest tenants are defense contractors, collectively occupying over 9 million square feet, contributing 31.4% of our annualized rental revenue. In total, our defense contractor tenants occupied 13 million square feet, included in those statistics is over 3 million square feet of cyber defense tenants. Our strategy relies on external growth from development that we consider a low-risk development program. Over the last 10 years, we've completed over 12 million square feet of new development leases, averaging about 1.2 million square feet per year. Currently, we're actively developing 12 properties, representing 1.7 million square feet of property that is 96% pre-leased. These developments will drive future FFO growth, as they are placed into service over the next 2 years. Our defense strategy delivers reliable FFO, driven by our market-leading retention rates and low tenant improvement costs that are high-value portfolio commands due to the permanent submissions our tenants conduct and support. Our company is a defense contractor, and we have a unique defense franchise. And that franchise is comprised of advantaged land positions, approximate 2 priority national defense missions, credentialed employees, clear to operate at the highest level of security measures, a 30-year relationship with priority government missions and a proven development capability experience at constructing deeply technical facilities for our tenants. No other company offers these unique capabilities at or near the scale that COPT operates.

Pretty good. So I think that makes it pretty obvious how you're different from traditional office companies, although you're classified in office. But I thought maybe given the work-from-home environment and hybrid work strategies, it might be worthwhile to just delve into that a little bit deeper. Maybe talk a little bit about the geographic clusters you invest in, the physical occupancy and usage in your buildings, the investments tenants have in those buildings and really just why you might be more insulated from some of these trends than really traditional office companies are?

Certainly. So our portfolio is clustered around priority defense installations in 4 states: In Maryland -- in Fort Meade, Maryland, supporting signals intelligence, defense networks and U.S. Cyber Command. We're at various locations in Northern Virginia. And there, we support human intelligence, satellite geospatial intelligence, technology development and multiple locations supporting hyperscale cloud computing. We have 3 U.S. Navy research and development and program management locations, one in Southern Maryland, one in Virginia and one in Washington D.C. Navy Yard. We also have a heavy concentration at the Redstone Arsenal in Huntsville, Alabama, which is supporting advanced technology development, missile defense, army aviation, army procurement, foreign weapon sales, space exploration, space defense activities and several intelligence programs. And then we have a campus of about 1 million square feet in San Antonio, Texas that is near Joint Base San Antonio and that supports a high priority operational activity of the government. The priority national defense missions require high-level security structures and improvement measures and over 75% of our portfolio contains some to all of these measures. We have 8 property campuses, including 25 properties and 4 million square feet that's occupied by the U.S. government that are designed to antiterrorism force protection standards and provision with anti-spy measures. We have another 15 campus locations occupied by defense contractors that represents almost 5 million square feet that are contained in the high security defense environments as well, another 45% of our tenant suites have, what are called, SCIF facilities, which are secured compartmentalized information facilities, that basically are anti-spy measures required to conduct mission work. So in total, over 75% of our lease space has some form of security and anti-spy measures. And the work these tenants conduct cannot be done at home. So accordingly, our tenant utilization levels throughout the pandemic were very high. And our risk of contraction from hybrid work arrangements is near 0 in our Defense segment.

So I should have mentioned upfront, I'm going to leave time for the audience to ask questions. When I was preparing my questions for NAREIT, there were a handful of, kind of, macro trends I wanted to touch on for all of the companies, one of those is inflation which is topical. So maybe in terms of the core portfolio, talk about rent escalators and the leases, anything else kind of related to inflation? And then, of course, as a large developer of properties, are you seeing inflationary pressures impacting construction costs? Are you able to maintain yield spreads in inflationary environment?

So with regard to lease structures, over 95% of our leases are triple net or have a pass-through above the base year. So accordingly, our exposure to margin loss is substantially minimalized for leases that are in place. New leasing and renewal activity expected over the next 18 months is about 1.5 million square feet, or under 7% of our portfolio. And in those cases, our teams are intent on pushing rates to capture base share increases as the cost of operating the building goes up. All of our leases have rent escalators, and the vast majority of them have fixed annual bumps. The net leases with the U.S. government -- primarily with the U.S. government escalated at 3% and the net value. The gross leases, which are representative of the defense contractors, almost 60% of our leased area, they escalate at 2.5% to 3% and the gross rent billing. So we're getting an escalation on the base year stop as well as the net. And they tend to escalate at over 3.5%, plus we have the pass-through for collection. With regard to property operations, the way we operate our portfolio is very conservative. We forward purchase our energy. So most of our locations were on fixed energy contracts for at least 2 years. And then we tend to execute operating contracts in bulk and portfolio level activity for multiple years. And we have existing contracts that will carry us through the next couple of years. With regard to construction costs, they have escalated far more than the CPI that you hear about on TV. Our year-over-year increase on like-for-like properties this year in April was 18%. And that increase requires comparable rent growth to maintain the disciplined yield targets that we have adopted. So thus far, we've been able to achieve rent growth to match cost increases, but that's really a project-by-project challenge. Fortunately, mission requirements drive demand and rent expenses are a relatively small fraction of most performance contract activity. So we believe we're pretty well hedged against inflation. And then 1 additional characteristic that we enjoy is that we have really industry-leading tenant retention for an office company with 74% average over the past 10 years and 78% retention average since 2017. The reason for that is tenants co-invest in their space to create the SCIF environments were extremely expensive and hard to get. And that, combined with our tremendous customer service, has really resulted in high retention. And then that minimizes the impact of escalating construction costs on our leasing environment.

I suppose related to inflation, I wanted to ask your thoughts about potentially being in a rising interest rate environment for a while. And maybe this is an opportunity to leave it open and let you talk a little bit about your financing strategy, how you manage the balance sheet and how higher rates might impact that strategy?

We were very active in 2020 and 2021 in our refinancing. So between September of 2020 and November of 2021, we took advantage of the lower interest rate environment and we reshaped our -- the debt portion of our balance sheet by issuing $1.8 billion of senior unsecured notes in 4 tranches with maturities between 2026 and 2033. And that debt has an average interest rate of 2.5% and an average term just over 9 years. So 83% of our debt has fixed interest rates. LIBOR or SOFR -- SOFR will affect our line of credit balance, which is basically the credit card we use and repay constantly as we're spending money to develop our properties. But our only near-term maturity is $100 million bank term loan that expires at the end of this year. We're already in discussions to renew that and our line of credit. And we don't expect to experience much, if any, interest rate increase or spread increase. And so we're well supported on our debt side and that gives us the confidence to be able to convey that after this year, where we expect to get about 2.2% growth because of a major asset sale, we fully expect our compound growth to exceed 4% for the subsequent 4 years.

So in addition to rates and inflation, I think, recession risk has entered the conversation recently. And you may have -- maybe you already answered this when talking about work-from-home risk. But maybe talk a little bit about how the company is positioned? Does risk of recession cause you to view the nondefense smaller portion of the portfolio any differently? How are you thinking about that?

So the nondefense portion of our portfolio is about 10% of our assets. And the lease maturities are very low over the next 3 years. So we have 3.9% maturing in 2023, 3.6% in 2024 and 6% of that portfolio in 2025. The bulk of our business is driven by our defense tenancy. And our strategy of concentrating in defense will make us very durable during the economic downturn. Our leasing is tied to the defense economy and the defense budgets in The United States. The fiscal year 2022 base budget was increased by 5.8%, which is the biggest increase since fiscal year 2018 with the resort of 14% bump. Following that increase in 2018, we set records for leasing in 2020 is that demand manifested itself in our leasing program. So we have very strong leasing demand right now. Our last 3 quarters vacancy leasing was about 150% of our 5-year average for those quarters. We expect this year to be a very solid year in activity and the increase in the fiscal year spending 2022 will manifest itself in strong demand in '23 and '24. So given that and given the world view and the threats from Russia and China and technical competitive capabilities, defense budgets will remain funded strongly for years, and we think we're extremely well positioned.

So you've - you sort of touched on this or maybe even answered this a little bit as well. But I sometimes get asked by investors, I don't know how to put it, but I'll say it bluntly, I guess. Is armed conflict or tension around the world, is that a good thing for the company or the stock? And given what's going on in Ukraine, intentions in other parts of the world, does that increase demand for your assets or for build-to-suit development opportunities? Or from your previous comments, it sounds like maybe defense spending is steadier in longer term than that. I know you're proud of how you've kind of been on this consistent earnings growth path now. Do these conflicts provide a boost to you or no?

So, what we are experiencing in many of our facilities is very high levels of activity, nights, weekends, and our teams have been put on what's called the critical operating level where we have to be very cognizant of the tenant's activities as we plan our maintenance around them, because they are very high levels of mission activity. But with regard to new leasing, I do not see that manifesting in our portfolio per se from the arm conflict. We're -- we really support knowledge-based defense activities. So intelligence, surveillance, technical development and capabilities, these are longer-term funded programs that will be well funded, but they won't necessarily respond to the use of that technology in an arm conflict.

I see. So before I ask my last scripted question, which is really a setup to provide some closing comments. I wanted to address one more topic that's been rapidly gaining importance for a while now. I know ESG has been important to you. You're proud of what you've accomplished on that front. Maybe just take a minute and talk about how OFC is an ESG-friendly investment.

So first, I encourage all investors, or interested investors, to read our 2021 corporate sustainability report. It's our seventh consecutive sustainability report. Our 2020 GRESB report is also available for you to research. And this -- in 2020, we again received a Green Star from GRESB. That's our seventh consecutive Green Star. So we have a robust program in pursuing LEED development that goes back to 2003. And since then, we've developed 7.6 million square feet of LEED-certified portfolio that we continue to own, and we have 1.4 million square feet of LEED development projects awaiting certification. And that represents over 65 buildings. We've been operating under LEED O&M operations and maintenance since 2010. In this year, we reported our alignment with 13 of the 17 United Nations Sustainable Development goals. We also published our formal environmental goals for intensity reduction by year 2025. And we published our first TCFD report. And that's all available on our website. So I encourage you to do more research.

Great. And so this is my favorite question. This is where I kind of ask management to do my job for me. I'll give you an opportunity to just address how you see the value proposition for investors in OFC. Why they should buy the stock today. I'll leave it open ended any comments. Any questions I didn't touch on that you'd just like to impart on everybody before I open it up for questions.

Well, I think it's a great time to buy OFC stock. At $26.75 a share at closing last night that represents 11.4 2023 FFO multiple and a 4.1% dividend yield. We entered an era of growth in 2018, and I'm not sure the market has really recognized that era of growth. But since 2018, after a long period of restructuring our company to deeply concentrated in newly developed assets at defense installations, we've compounded a 4.4% growth through this year. We sold a wholesale data center COPT DC-6 this year which will take our growth down to about 2.2%. But with our firm balance sheet and our deeply pre-leased active developments, we're confident that we can grow at 4% from '23 to '26 in the worst of scenarios and most of our modeling suggests it would be above 4%. And as I said that growth is assured by the development activity. We have 1.7 million square feet that's 90% leased today. And stay tuned, we have other announcements we expect to make. And then lastly, our business is not correlated to the overall economy. We're driven by defense budgets, and that 5.8% increase in 2022 will manifest itself for the strong demand for the next 2 years. And the world view supports stable and growing defense budgets. So it's a compelling time in my opinion to invest in OFC.

Great. So this is the part where I'll open it up to you guys. I don't know if there's any questions in the audience. Otherwise, I always come prepared. I could keep going. Anything from anyone in the audience.

Could you touch on what you see in the data centers development portfolio and which you are seeing it from development standpoint?

Sorry, I was just told to repeat it for the webcast. So the question was about data centers. And I think in your response, you'll...

Yes. The question was what are we seeing in our data center development program? So we have land positions that will support 3 additional build-to-suite data center shell assets. We're working in harmony with our tenant and the power companies to get access to the critical power necessary to support those developments. And we expect over the next, call it, 18 months that we will have access to power and we'll proceed to develop 3 additional data centers, that will be roughly 700,000 square feet.

Anyone else? So I'd like to ask about risks and opportunities. So I mentioned inflation, I mentioned rates, I mentioned recession. You've kind of addressed all those. I mean what are the things that kind of not keep you up at night, I mean one of the things on your radar that you think are risks in this environment? And then in keeping with our weaknesses or our strengths, maybe talk about some opportunities as well that excite you?

So for the next 3 years, we believe we have a very manageable lease maturity or lease turnover schedule. We have high leasing demand. We've got well-funded defense budgets, and a point I wasn't able to make earlier, we were able to demonstrate through the COVID shutdowns that we have the best credit in the industry. We collected 99.5% of our cash rents as billed because defense contractors are excellent tenants. Looking beyond that, in the 2025, 2026 environment, the one concern I have is our ability to increase or maintain our development activity level as we have for the last decade. And that's really because of the concern that the cost of materials and labor is going up so quickly that, that rent spread from an existing product could be pressured. But as I reminded the audience earlier, we have so much development active today. Our ability to grow for the next 4 years, north of 4%, is essentially locked in. Opportunities are -- the world view is not getting better, if anything, it's getting worse. And the recognition of that, our adversaries have made technical advancements that exceeded our country's expectations and elevated the awareness and the need for further research, development, test and evaluation to maintain our technical advantages. So we look forward to being well positioned to support our defense activities as those technologies are developing.

Great. Anybody else? We have a pretty good crowd for first NAREIT back, but no more questions? So this is one I didn't script for you. But I've asked you this in the past before. There's a lot of talk now, we have midterm elections coming up. Is there any governmental or political risk or you see this really as a bipartisan trend?

Well, you have to look at the votes in the House of Senate Armed Services Committees to get a good feel for where the country is on defense spending. And they've been highly bipartisan. There's been really no meaningful change in the vote tallies under this administration as they were under the prior administration. To the extent there's a significant change in the composition of the Senate and the House of Representatives, I don't anticipate that would be an anti-defense.

Yes, I think we all see that. All right. I'll give everybody else -- anybody in the audience one last chance. We covered it at all. We did it.

Good job.

Thank you, everybody, for joining. Thank you, Steave and Todd.

Thank you.