COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Welcome to the 3:40 p.m. Tuesday session at Citi's 2023 Global Property Conference. Global Property CEO Conference. I'm Michael Griffin with Citi Research, and we're pleased to have with us Corporate Office Properties Trust and CEO, Steve Budorick. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those in the room or the webcast, you can sign on to liveqa.com and enter code GPC 23 to submit any questions if you do not want to raise your hand. Steve will turn it over to you to introduce OFC and any members of management with you here today, provide any opening remarks, and then we'll get into Q&A.

So with me is Van comment in any tell me out... any. Vice President of IR and Anthony Mifsud, -- we have very easy names in this company, our CFO. And I'm Steve Budorick, CEO. So thank you briefly for anyone new to our story, Corporate Office Properties Trust or captive specialized office REIT, deeply concentrated in assets to support the national defense activity of the United States government. The vast majority of our 194 properties are located adjacent to or are occupied by priorities transmissions generally involving knowledge-based defense activities. The missions we support include intelligence and surveillance, cybersecurity and network activities, Avis and Air technology development, missile attack and Defense Systems, Army Aviation and Systems procurement, drone aviation technology development, weapon lethality, law enforcement and terrorism explosive technology and cloud computing. Our property locations are not typical for an office company. They are adjacent to United States defense installations in Maryland, Virginia, Alabama and Texas. Our defense tenants must work in their office due to the security requirements. 85% of our portfolio contains high security operations. We have 8 U.S. government secured campuses that total over 4 million square feet that our antiterrorism force protected and fully skipped, which is secured compartmentalized information facilities. We also have 1 million square feet of U.S. government high-security leases that are not in antiterrorism force protected buildings but they're access controlled. We have 15 data center campuses with 5 million square feet that are fenced with limited access, and we have over 9 million square feet of leases that contain Skip facilities in our more routine office buildings in great locations. During the COVID in '19 shutdowns, we operate in every building every day. And our defense assets never dropped below 50% utilization. Within months of the pandemic arrival, our defense locations were operating at normal occupancy levels. We completed vacancy and development leasing throughout the shutdown period, and most partly reflected 99.5% of rent as billed during that period of time. Today, 91% of our annualized rental revenue or ARR is derived from the Defense/IT locations. Our pre-leased developments will increase that to 93% or more in the coming years. The U.S. government is our largest tenant. We have over 85 separate leases and over 60 different properties, totaling 5.1 million square feet, and that produces over 35% of our annualized rental revenue. Our defense contractor tenants leased 13 million square feet. This includes over 3 million square feet of cyber defense contractor tenants. Defense contractors contribute 47% of our ARR and 15 defense contractors are in our top 20 tenants. Our nondefense locations provide 9% of our ARR. This really consists of 5 assets that we call regional office assets, 3 located in the Baltoro Waterfront, 1 in Tysons Corner and 1 in Washington CBD. Our tenants in these assets have excellent credit postures as well. Our growth strategy relies on low-risk development, and we are a very active developer of specialized properties for our tenants. Over the past 11 years, we've completed 12 million square feet of development leasing, averaging over 1 million square feet per year. We're currently developing 1.5 million square feet that is 89% pre-leased. That includes 10 projects in 3 states and 4 development locations. When completed, these low-risk projects, along with those completed in 2022, we'll add $66 million of future cash NOI on an annual basis, and that will be driving roughly 4% compound FFO growth between 2023 and 2026. Looking backwards between 2012 and 2017, we completed a strategic asset recycling plan. We sold 11 million square feet of legacy nondefense assets. We created 8 million square feet of new developments, and we reduced our leverage 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, FFO per share has grown at 4.4% compounded. In 2023, we expect to deliver 1% FFO growth. This modest growth was diminished by 2 factors: the elevated interest rate environment and $190 million Blackstone joint venture, we executed early in January rather than at the end of the year, which, by the way, completely funds or the equity component of our expected development spend in 2023. We have 5 main points we'd like investors to leave with related to our outlook. We continue to expect FFO per share growth will increase on a compound basis of roughly 4% between 23% and 26% despite the rise in interest rate environment. We expect AFFO per share will exceed FFO per share growth during that period. We anticipate self-funding our equity requirements for development investments from this point onward on a leverage-neutral basis. And we recently announced a 3.6% increase to our dividend. Our first in over a decade, which indicates the high level of confidence we have in our business. And finally, the outlook for defense spending remains strong. This defense budget has increased roughly $100 billion or nearly 15% over the past 12 months. So in summary, we're a specialized office REIT, we're not correlated with the broader economy. Our assets have strategic features and locations. There is little, if not no risk from work from home. There's a strong demand for our new development and vacancy leasing. Our defense concentration offers durable recession-resistant performance market-leading retention rates, very low capital costs from leasing and reliable growth for at least the next 4 years. With that, we consider ourselves a great value at today's pricing, trading at roughly 10x 2023 FFO. We have a 4.5% dividend yield, and we're trading at a 21% discount to NAV. With that, I'll open up for questions.

Thanks, Steve. We're starting off each one of these sessions with the same question. I think you touched on some of it in your prepared remarks, but what are the top 3 reasons investors should buy Cops stock today?

So the top 3 reasons are reliable, durable, predictable growth. I thought I'd just give those for reasons, but I'll begin. We're a very defensive stock in that not only is our customers in defense, but our business is sound financed by the -- basically the defense activity in the United States and aligned with priority missions that will be funded in good times and bad.

Maybe just starting with that strong correlation with defense spending, you've talked about and highlighted over the years, you pointed that, call it, 4% expected CAGR over the coming years. Is there may be a worry just given that we're in a divided Congress this year that worry about a recession, did this impact funding needs for the tenants that you serve? And do you see this having any impact on your portfolio?

I don't have great concern about any impairment to the budget -- the defense budget for 2 reasons. First of all, in the last 12 months, those budgets have increased by $100 billion. Even if they were to freeze at that level, that is very strong funding to operate our business. And secondly, even going back to the election in 2016 in the fiscal year 2017 NDAA, we've had strong bipartisan support to increase defense spending each and every year and that bipartisan support exists currently today. The defense spending increases were initiated by the publican party. Over the last 2 years, the Democratic Party is controlled, both chambers of the house, and they have pushed forward higher funding amounts than the President requested. And then lastly, big picture, we spend about 2.5% of our GDP on defense. China spend 7. It's not a sustainable relationship and our Congress people are recognizing that outstanding other deficit issues, our defense spending needs to be maintained.

So then one could argue if per se, we go back to the Reagan administration where defense spending was about 5% to 7% of GDP. The underlying spend there continues to benefit your business. I'm not saying that's happening overnight by any chance, but the strong correlation there that you talked about.

Correct.

Great. Let's just talk on leasing for a bit. You started off the year pretty strong, particularly on the development side. How are you thinking about the cadence of leasing velocity throughout the year, both in terms of development and the vacancy leasing fronts?

So with regard to vacancy, we've guided to about 400,000 square feet, which is half of what we delivered last year. The principal reason for that is we have inventory left to lease. Our core portfolio is 95.3% leased in our defense portfolio is 96.7% leased. Within that $400,000, there's about 50,000 that we expect to do in our regional office portfolio. And that should occur ratably over the 4 quarters. We expect to get about 100,000 signed in the first quarter. With regard to development leasing, we had 3 build suits that we announced in January. -- To data center build-to-suit data center shell build and suits for our large cloud computing company and 1 new defense contractor headquarters at Teresina. We guided 700,000 square feet for the year. It's really conservative from a timing standpoint. We expect an opportunity to do one more data center build-to-suit this year. But should that be delayed because of delivery of timing issues that affect the cadence of that development. We could still make our 700,000 square feet with what we expect to do in the defense sector.

We had a question come in from LiveQA here. Just on the regional portfolio assets, specifically for Baltimore. I know there's probably been some softer demand for that traditional office relative to your core defense IT tenant base. But I mean any thoughts, I might have missed this just around what the expectation for these properties are? And any sense of maybe a buyer pool, disposing of them at some point? Anything you could enlighten there would be helpful.

So we have no affirmative plan to sell those assets other than 2,100 Al Street. That's trophy asset in downtown D.C. We're basically on lease away from stabilizing the asset. We have reasonable expectation we might get that leased this year. And if that were the case, we believe that market has potential liquidity to get incurred value on a sale. The other 4 assets, we don't believe the financing market would support a sale of at this point in time. But long term, over the 7 years that I've been CEO, the 11 years I've been with the company, we've taken our defense concentration from roughly 50%. 7 years ago, it was 25% or 75%. We're down to 9%. We are on a trajectory and we expect to continue to improve the relationship with defense to regional office.

Great. Maybe getting back to tenant retention. I think you're expecting about 80% or so for 2023, which seems to be slightly above recent trends. What is driving this greater retention rate? And how do you expect to capitalize on this?

How do we expect to what?

Capitalize on this?

Well, what's driving it is a heavy concentration of lease maturities in our defense IT assets. And one of the compelling advantage of these assets is they are closely aligned to critical missions. The tenants need to be proximate to the mission to serve them, and our tenants are heavily co-invested in their space. So for the next 24 months, we have roughly 5 million square feet that's going to roll. Half of that is represented by 21 leases over 50,000 square feet. 19 of those leases are either U.S. government data center shells or defense contractor buildings and those 19 buildings we expect to release at our 19 leases at 99%. We have 2 regional office leases that also have maturities. One we know we're going to get back 50,000 square feet because it's the end of a restacking of a 15-year renewal we did in 2021. And we have about a 60% handicap on another nondefense kind of that's half of our role. And in total, that's going to be over 95%. The other half is equally compelling statistics, but we expect to do very well.

And then maybe just on your tenant base from a leasing perspective from your development and vacancy leasing execution expectations for this year. Is there anything that tenants might be asking for that they might not have been, call it, 6 to 12 months ago? Or any commentary around that would be helpful.

No Within the defense business, -- we've got a very stable supply and demand environment and tenants on undue leverage upon us. The one issue that they are seeking routinely is access to SCIF space, which is very scarce and hard to come by, and that's good for us because that drives vacancy leasing and buildings that don't currently have it. Within the regional office portfolio, we have to admit. The demand is less urgent, more patient and tenants are working through thoughtfully what their long-term needs for Officer. So we're expecting a lower cadence of progress, but we do expect to make progress.

And just on the SKIFF comment for the uninitiated, how cumbersome of process? Is it to develop those for tenants to get in those? I seem to recall something that there needs to be some government official on-site at all times when those things are being built. So maybe just talk about the process as they go into...

So they're kind of the catch '22 of the intelligence community. To win a contract, you need to have SKIFF, can't get a skip unless you have a contract -- to have a skiff, first of all, I asked me authorized or sponsored by one of the IC community members. They have to approve the construction, during construction, the work has to be supervised by independent third parties that are employed by the government security teams. I'd like to joke that it looks like a Chicago Streets and sanitation job for every one person working their watching when completed and these SKIFF s have advanced features. So they have barriers within the well so they can't be penetrated. They have boiled to prevent eavesdropping or any electronic monitoring. They have doors that are equivalent to a safe, some of them have to have the windows blocked up. It takes really 2 years to build and serve by a SKIFF. Once they skiff is certified, if it's ever breached, it's of no value and it has speed span. So the SKIFF is a very important element of our long-term north of 70% retention experience.

Is there -- is foreign investment allowed in SKIFF? I imagine there must be some national security concerns if some foreign entity were looking to invest in that, but maybe regulatory things like that.

Pens contractors could not operate secure missions and assets owned by a foreign entity or the government for that banner.

Great. That's helpful. Maybe just switching over to the development pipeline. You touched on the proceeds from the data center shell joint venture to lock up your funding needs for this year, but just how are you thinking about development on a go-forward basis as a growth opportunity given that we've seen rising impact costs, impact yield? Or any color around that would be helpful.

So we fell a little short of our goal last year due to a timing issue. We've guided to 700,000 square feet for this year. We could very well exceed that pretty significantly. Over the last decade, our average development leasing has been about 1.1 million square feet. So we expect overall, call it, 700,000 to 900,000 square feet on a go-forward basis. But more importantly than that, it's spend will be at least $250 million to $300 million looking forward, that's kind of the spend ratio that we've had.

And then just on additional growth opportunities, you talked about your markets not really being those, we think of as traditional office markets, whether it's NBP, the data center shell business, Redstone down in Huntsville, maybe Lachlan, -- where do you see the greatest opportunity? Or are there opportunity sets kind of within each of those areas?

Well, -- there's really 4 areas over a longer term. We have a high security campus in Northern Virginia. We identified the location of but we have substantial capacity to expand that campus and a customer who desires the full completion of it. Resonarsel has been our fastest producing Reston Gateway development over the last 5 years. We've -- over the last 6 years, we've done about 2 million square feet of new development on that campus, and we have 3.4 million square feet of additional development capacity. So that would be a big player. At the National Business Park, we've done over the last 3 years, on each larger 100% preleased assets for defense contractors. The park is now 98% leased. We have one parcel of space, over 20,000 square feet, and that's over 4.5 million square foot park. So we expect to start the development this year for inventory, and we have reasonable expectation we have additional build-to-suits in the next 24 months. And then in the data center shell segment, we signed 2 leases on land we owned this year. We expect to sign on this year on our remaining parcel. And we are actively working with that customer to identify additional sites to provide inventory.

And then just on Redstone specifically, the development opportunities that you talked about, they're both inside -- in front of and behind the fence, right? And is there any difference in developing either in front of or on a military installation?

Well, in terms of tenancy, it's going to be a U.S. government user inside the defense. Defense contractors will be outside the fence. We currently have about 500,000 square feet developed out of what we initially expected to be 1 million square foot campus inside defense, and we're actively working with our partner, the U.S. Army to provide some additional capacity for demand that we expect to arrive in the next several years. Outside defense, we have roughly 3 million square feet of capacity on land. And costs are a little cheaper outside defense because they're not anti-hear a horse protected, but the stickiness of the tenants of the mission is the same.

And to that end, what makes Huntsville so attractive? I mean, I think it's a market that maybe not a lot of people think about, but I know that the GDP there per capita is well above kind of the rest of Alabama. You've got a large number of PHs, I mean they call it Rocket City for a reason. So just the growth opportunity set there. And I don't know if there's been any update on the Space Command moving there.