COPT Defense Properties (CDP) Earnings Call Transcript & Summary

And get started now. My name is Camille Bonnel. I'm the office and industrial analyst on the BofA U.S. Group team. Here with me, I have Jeff Spector, who heads the U.S. REIT team as well as Rachel Wu and Andrew Berger on the side. We're here to welcome you at our roundtable session with senior management of Corporate Office Properties Trust. Joining us from -- also known as OFC. And joining us from OFC we have Steve Budorick, President and CEO, on my left. And then to his left, we have Anthony Mifsud, EVP and CFO. So we like to open up these good sessions with a quick 5- to 10-minute introduction of the company before going into Q&A, and we hope that it will be an interactive session. So let me kick it off -- let's pass it over to Steve to kick it off. Thank you.

Good afternoon. Thanks for coming. Corporate Office Properties Trust is a specialized office REIT, deeply concentrated in assets support the National Defense activity of the United States government. The vast majority of our 180 properties are located adjacent to or are occupied by priority transmissions generally involving knowledge-based activities. The missions we support include intelligence and surveillance, cybersecurity and network activities, naval, sea and air technology development, missile attack and defense systems, army aviation and system procurement, German aviation technology development, weapon lethality, law enforcement and terrorism, explosive technology and cloud computing. Our property locations are not typical for office company. They're adjacent to the United States defense installations in Maryland, Virginia, Texas and Alabama. Our defense tenants must work in their office due to the security requirements of their missions. About 85% of our portfolio contains high security operations. We have 8 U.S. government secured campuses, representing 4.4 million square feet that are antiterrorism force protected and contain SCIF. We have U.S. high security leases, U.S. government high security leases and other buildings, representing 1 million square feet that is SCIF and has access control. We have 15 data center campuses with over 26 operating properties that represent 5 million square feet, and those are fenced with limited access. And then we have about 9 million square feet of lease space that contains SCIF, which is a secure compartmentalized information facility in part of that presence. The missions that require SCIF features or security cannot be performed from home. During COVID-19 shutdowns, we operated out of every building every day. Defense assets never dropped below 50% utilization. And within months of the initial shutdown, defense locations were at normal levels. We completed vacancy and development leasing throughout the shutdown period, and we collected 99.5% of our rents is billed due to the exceptional credit of the defense industry. Today, 90% of our annualized rental revenue is derived from Defense/IT locations. Our pre-leased developments will increase that to 93% or more in coming years when they're completed. The U.S. government is our largest tenant, has 250 separate leases and 150 different properties. That totals 5.13 million square feet, and it produces 37% of our annualized rental revenue. Our defense contractor tenants occupy about 13 million square feet, including over 3 million square feet of cyber defense contractor tenants. And the defense contractors contributed to 3% of our annualized rental revenue. 14 of those contractors are top 20 tenants. Our nondefense locations provide 10% of our annualized rental revenue. That really is comprised of 6 regional office assets located in the Baltimore Waterfront, Tysons Corner in Washington, D.C. These tenants have excellent credit pressures as well. Our growth strategy relies on low-risk development, and we're a very active developer of specialized properties for our tenants. Over the past 10 years, we've completed 12 million square feet of development leasing, averaging 1.1 million square feet a year. Currently, we're developing 1.9 million square feet that is 91% pre-leased. That includes 13 separate projects in 4 states. We have 5 different development locations. When completed, these low-risk projects will add $47 million in future annualized NOI. And that is a major component driving at least 4% compound growth to our FFO between 2023 and 2026. We've entered an era of reliable growth. Taking us back in history a little bit, we completed a strategic asset recycling plan from 2012 to 2017. We literally sold 11 million square feet of legacy nondefense assets, and we created over 8 million square feet of new developments during that period of time. We reduced our debt and became investment-grade rated. The price for that reform was flat FFO from 2012 to 2018. Commencing in 2019, we entered the growth phase we had envisioned. Since 2018, our FFO has compounded at 4.4% per year. 2022 will deliver 2.6% growth, diminished by another strategic asset sale of our only wholesale data center this year. And looking forward, we can confidently project FFO will grow at or above 4% per year compounded from 2023 to 2026. So in summary, we're a specialized office REIT not correlated to the broader economy. Our assets have strategic features and locations. We suffer little risk from work from home due to the secure nature of the mission. Strong demand -- we're experiencing strong demand for both vacancy and new development leasing against the backdrop of broad consensus for elevated defense spending going forward. Our defense concentration offers a durable, recession-resistant performance, market-leading retention rates, very low capital costs for leasing, reliable growth for at least the next 5 years. And we're a great value yesterday at 27.04. We're better valued today, which was 11.5x 2022 FFO. We offer a $4.25 dividend yield, and we're currently -- yesterday, we were trading at 20% discount from consensus NAV. And we have locked in FFO growth exceeding 4%. So with that, I'll take questions.

Maybe to start, you mentioned that the business isn't really correlated to the macro environment.

Substantially.

But maybe can you talk about the impact of inflation and rising interest rates are [indiscernible] on your development program?

So let's talk about inflation first. Inflation has put some pretty significant pressure on development costs, and I'll cite an example in a minute. And that is compelling us to negotiate higher rental rates to maintain our targeted development yields and overcome those costs. We did a full building build-to-suit in 2021 at the National Business Park. And we did another full building build-to-suit with a different tenant right next to our -- literally the identical building. The increase in development costs was 18% year-over-year. Now we've seen the rate of increase of materials slow in the last few months, but that shows the impact year-over-year. And that's compelled us to negotiate higher rental rates, which we have achieved, and we literally achieved the same targeted yield on both assets. From an interest rate perspective, we're fairly well indemnified from rising interest rates. As we sit here today, about 4% of our debt is floating. At the end of the year, when some hedges burn off, that will increase to about 12%. But we look forward in 2020 and 2021 and we completed 4 bond issuances for $1.8 billion, and we locked in an average interest rate of 2.5% with an average term of about 9 years. And so we're well insulated from -- in the short term, increased interest rates.

Just a follow-up on the -- can you remind everyone what the development yields are and have the -- I think you're saying they have not changed at all.

They have not. We target an 8% yield on office property or better. There are times, with our government development yields, we can beat that 8% substantially.

Is that cash? Cash on cash?

Yes, cash on cash. And in our data center development segment, we maintain a 6.25 to 6.5 initial cash yield with 2.25 escalations on the rent.

And just to confirm around the construction costs, do you lock that in at the start of the project?

Yes. So it's a little challenging to be a developer in this environment. Basically, our development teams are constantly repricing as we're negotiating with the tenant nearing the point of lease execution so that we can continue to amend our target and our rate. We're very open with them. This rate is contingent on these costs. And if our costs increase, then we're going to push our rate higher. And we've been successful in doing that, but it's rigorous. We have to work hard and at it.

So do you see any risk that -- other risks that could potentially impact that development -- pre-lease development pipeline coming up? I think you said there was about $40 million of NOI that's being generated from there.

$47 million and future NOI from the 1.9 million square feet we're currently building that's 91% leased. This year, we guided to 700,000 square feet of development leasing. We're tracking right on that target, maybe slightly more. And we see opportunities looking forward at about the same pace. We have 1.2 million square feet of development prospect activity we're managing currently. That's a healthy level for our development business.

Do you do spec development? Or do you have to have a pre-lease to serve spec before you start?

So on a rare occasion, we do development without a pre-lease, which is the definition of spec. But we like to consider a more informed demand. So currently, at Huntsville, Alabama, we have no inventory to lease. We just leased the 1 full building vacancy. We have tenants working for what remaining inventory we have to negotiate or negotiating leases. So we kicked off a modest 120,000 square foot inventory building because we have demand behind it. But if we do those, we do them one at a time. We stabilize that asset and then we progress.

And your comments on defense spending, I guess, just thinking about -- when you're thinking about your, let's say, 5-year plan, and it feels like in D.C., anything could change, right? We had a midterm election how this morning. We talked about ramifications there. We got the '24 election. How do you plan over the 5 years, knowing that, I mean, that the budget could change. But maybe I'm wrong, like how -- I guess, from your experience, like, can you share with us that thought process?

Well, first of all, the bulk of the 5-year period FFO growth is heavily influenced by what we've already accomplished. And we have targeted levels of development in the later years that we might not have identified. But we've also run scenarios of high development, target development, minimal or low development. And we're confident we can deliver within that range, and we would put those numbers out. With regard to confidence in the budget, certainly, Congress controls defense spending. But since 2017, there's been a uniquely strong bipartisan support for increases in defense spending. And it continues to this day. In March, the fiscal year DoD budget was passed with a 5.8% base budget increase. And currently, both the House and the Senate and the Services Committees are recommending defense spending in excess of the presidential request, between 6% and 10%. The world view from the backdrop is kind of increasingly obscure. The aggressiveness of adversaries is heightened. The number of adversaries is kind of increasing and the threat of a technological loss, the capability match in terms of capacity, and then the new emerging threat, the threat of weaponization of space assets gives us confidence that this is a time that this government, irrespective of the composition of the parties, will take its eye off the ball not even to mention cyber warfare.

Just coming from internal growth and [indiscernible] to sort of offsets that increase in expense in G&A. Help us generally compartmentalize.

I would say compartmentalize internal growth around 2%. 2% or more from external growth. Costs have been modeled into those numbers that we believe we could achieve or be.

Could you break down the internal growth further? Like is that -- it's just all contractual...

Rent bumps, renewals.

Offset by a possible increase in interest expense like...

So we addressed that financial situation. We've compartmentalized that floating rate pretty well.

4%, just a base case or what's the rest of the 4%?

It's 4% or better. So there's obviously an opportunity for better. And we have multiple scenarios of asset recycling, economic conditions, leasing volumes that we could all achieving up 100% [indiscernible].

I assume interest go up, your capital cost of capital. The more of expense is going into the cost of built then?

It is right.

[Indiscernible] rate development map should really be that.

Correct. And the demand tends to be driven by national security and expansion of vision and so it's just cost of business.

How do you think about the size of that development pipeline? Like what is the -- what are the -- what's the governor to that at this point?

Well, the governor has always been demand. That we -- 10 years ago, we made a commitment to be a low-risk developer. So we need either see demand or have pre-lease for us to proceed on a project, except for the almost spec buildings I talked about, which is where. And could we expand the development pipeline? Absolutely. In a low risk pre-leased basis, we certainly would.

[indiscernible].

So on a square footage basis, what we have under development is about 8%, 9% on an asset size and cost, it's probably pretty close. Well, I won't push it. I'll follow it. The point being, we're not forcing development. We're responding to market development opportunities. On a pre-lease basis, yes, we continue with the supply. The other nuance to our development businesses, we provide buildings that the U.S. government or its contractors require for national security. And if we're not there to build that asset, somebody else builds that asset, we'll never get that opportunity again. So we try to maintain a conservative balance sheet and be in a position, be nimble because once we get a U.S. government development, we'll have for 40 years occupied.

[indiscernible].

So we've got over 2 million square feet of development capacity. Our biggest land parcel from a capacity standpoint is the Redstone Arsenal, where we developed or actively developing to about 2.5 million square feet, we have 2 million square feet on that parcel alone. At the National Business Park, we've got 1 million to 1.4 million in capacity. We have 400,000 square feet in Columbia Gateway. And then we have about 600,000 square feet of development capacity within our data center shell property land bank.

[indiscernible].

We can. That is one of the scenarios we've modeled, a variety of them actually. And over time, when we get opportunities to get good value, we'd like to monetize regional assets rather than data center shells.

Our capital plan over that period of time requires about $300 million worth of equity capital in order to maintain our balance sheet leverage about $80 million this year and a little over $200 million next year. Right now, our base plan assumes that we use -- what the sources that we've used over the last several years, which are joint venturing data center shells as our base plan. The alternative to that can -- could be regional office sales. And within those models, we continue to generate the -- in excess of the 4%.

And on your data center shell projects, can you talk a little bit about the tenant appetite you're seeing there?

Well, data has more appetite than the market can deliver right now. The availability of power and the price of land has changed dramatically over the last 18 months. Land prices per acre are nearing, if not above, $3 million per acre for data center sites. And power has become unavailable within about a 2-year window. And so our tenant is a phenomenally strong growing business. And we're working with them on the projects we can deliver and helping enumerate possibilities for alternatives to continue to give them expansion of their capability.

So power seems to be the limiting factor, do you see?

It's one of them, yes.

Do you see any changes in how the government is thinking on infrastructure spending around power grids?

Severally, the government's Dominion Power and they need to invest in more capacity on transmission lines and substations.

[indiscernible] specifically to $124 million and that you said data center, development centers 800,000.

Correct.

How much of that can be developed based on total availability?

All of it.

[indiscernible].

We'll find some creative solution.

Can you speak to any examples of what that could be?

Haven't found one yet but we're working on it.

[indiscernible] can you talk about pace of leasing?

Yes. I'd love to. So we're currently in a very strong lease environment. The first half of the year, we did 277,000 square feet, which is really on pace with our 600,000 square foot target for the year. This quarter, we expect to sign 366,000, which will put us over our full year target. And we have demand from -- for our expectation that we can close 40,000 to 100,000 in the fourth quarter depending on timing, which, in summary, will put us at or above 700,000, which should be our third best vacancy leasing year vacancy in the company's history.

[indiscernible].

It does. Thank you.

Can you talk about the competitive landscape? Who are your competitors? Has it changed at all over the last 5 years? Will it change over the next 5 years?

So there's been no material change in our competitor or our competitive set. And there's no single company that has an overlay of investments that we would compete with consistently across all of our markets. So you always -- you have to get very granular in end markets. Probably our most competitive location is the Route 28 South Corridor, South of Dulles. We own a couple of million square feet of property. But by no means, we dominate that market. We have advantaged land positions and relationships with defense tenants where we tend to outperform it. But there are a lot of buildings with a lot of different owners that could compete. If you jump to, just to say, Maryland at the National Business Park, we really don't have a true competitive -- very competitive development that we dominate the demand for service to the activities at Fort Meade. And then in Columbia Gateway, there's -- we own roughly half of that park. But with our relationship and our past year and the way we manage our assets, we tend to dominate, the other owner is about 40% of the market. Columbia Gateway is an important development for us because it's kind of a unique set of attributes that appeals to cyber companies. The employees that cyber companies target want to live in downtown Baltimore. And the contract requirements to service Fort Meade activities has a radius and Columbia Gateway is the closest development to downtown within the competitive radius of Fort Meade. So it's been a real boom for the company. And the great thing about cyber companies is there's a ton of demand for their products, and they just -- you got a minute and they just keep expanding.

How do you win these transactions on the development side? Is it just -- is it price? Obviously, the reputation? Is it the relationships like who in the company leads this effort?

Well, each one of our asset managers has some development capacity that they represent the company on. Our development teams, really quite diversified and skilled. We can -- some of the assets we've developed for the U.S. government are extraordinarily complicated. And our data center shells are relatively simple, but we can develop that very quickly. So as a team, all those attributes help us win. And certainly, the surety of selecting us as your developer is a major factor with their defense tenants.

Have you shift things to expiration. Talk a little what that looks like over the [indiscernible] how the conversation is going.

Sure. So we're going to have a very strong renewal production in the second half of this year. And we should get to about 2 million square feet of renewals. We've got to the portfolio over the -- and identified the leases that expire over the next 30 months. It's 5.5 million square feet of expirations. Over half of that amount is represented by 25 leases above 50,000 feet. When you break those down, we have 11 U.S. government leases where we get 100% renewal. We have 10 defense contractor leases, 4 of them are full building, highly specialized SCIF environments. We expect very high renewal percentage within that group. Three are data center shells where the tenant is disproportionately co-invested with us and only 1 of those leases is in the regional office segment. And we kind of handicap somewhere between 50% and 75% retention with the reduction. And that is over half. The balance of the smaller leases, we would guess to be 75% retention or better. So we're very confident looking out 30 months that we'll be able to continue to marginally increase our occupancy and deliver retention at or better than our historical track record of roughly 75%.

Just given these tenants require such a unique space. You've mentioned a lot of them -- as a security reasons they have to go into the office. Can you just give us -- help us understand what is -- what causes tenants to move out of these locations?

Well, when we do lose a tenant, it's typically a loss of contract. So as an example, we had 3 buildings leased to Boeing in Huntsville, Alabama. One of those buildings was a support function for the ground missile defense system. They lost that component of the contract on recompete. Their competitor won the business, and we signed a 2-building build-to-suit deal for them in the same location. So the mission never left our part, he's switching buildings. But it's usually rightsizing of their footprint based on their current business when you get space back. The other factor that can lead into it, there's considerable amount of M&A in the defense industry. And there are times when a company will be acquired by another. The mission work tends to renew, but sometimes the administrative support is not renewed and that's component of it.

Just conscious of the time, we probably have time for one more question.

The existing center that's still out there. That's still tougher to use to be able to set the government check for Boeing building [indiscernible].

It's 100% lease. Lockheed Martin.

They're in the market, not in our park.

We're pretty excited about that in some older facilities and Cummings Research Park. This is their first movement to one of our more modern, technically efficient assets. We hope it's the front end of the trend. They're going to stay where they've historically been. This year, we had a couple of long-term 10-year leases that had escalated at above market and our first half mark-to-markets, I think minus 4. By year-end, it will be between minus 2 and 0. And it's often misunderstood, but the growth embedded in our lease structures tends to mirror market rent growth, 2.5% to 2.75%. On average, we're flat to down, let's say, 1%, sometimes 2% for a year. And then we resume the growth pattern. We don't have spiky changes in our market occupancies, have big spikes in rent or crashes, so our mark-to-markets are flat to plus or minus 1%. But our retention is extremely high. Our cost of capital is extremely low. And so from an AFFO basis, it's a very solid platform.

It's not similar to on the data [indiscernible].

Yes.

So I think we'll end it here with some rapid fire questions. We have -- first question is which of the following is the greatest macro challenge facing U.S. public REITs today? A, risk of higher rates; b, risk of a recession; or c, the rise of private equity and nontrade REITs.

Risk of recession.

Second question, which of the following is the greatest sector-specific risk? One, labor issues; two, supply; or three, liquid capital markets.

Our sector? So traditionally, it's been labor, to get cleared, skilled employees that can conduct defense mission work has always been a challenge and it continues to be so.

Finally, are you seeing any signposts of weakening demand? A yes or no question.

I can't answer yes or no. In our defense business, no. In our regional office business, I think so.

Thank you very much.

Thank you.

Thank you.

Good job.