COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Hello, everyone. My name is Camille Bonnel. I'm the office REIT analyst on the U.S. Bank of America Research Team. And I'm also joined here by my colleague, [ Dan Zinn ]. And our next roundtable session is with Corporate Office Properties Trust, but now soon to be renamed and rebranded. So I'm joined by Steve Budorick, President and CEO of the company. If you could start with the brief introduction, company overview, and then we'll get into Q&A.

Sure. I think you can all hear me. So Corporate Office Properties Trust, we're a specialized REIT, deeply concentrated, mission-critical assets to support National Defense activity of the United States government. Effective on September 15, which is Friday, we're changing our name to COPT Defense Properties to better reflect our portfolio composition and our investment strategy. The vast majority of our 194 properties are located proximate to or, in some cases, containing priority defense missions generally involving knowledge-based defense activities. The missions we support include intelligence and surveillance, cybersecurity and network activities, naval sea and air technology, missile attack and missile defense systems, army aviation and enhancements, drone aviation technology development, weapon lethality, law enforcement, terrorism explosive device technology and cloud computing. Our property locations are not typical for office company. They're proximate to United States defense installations, and they're located in Maryland, Virginia, Alabama and Texas. Our defense tenants must work in their office due to the security requirements of the missions that they conduct. Bringing our portfolio -- around 85% of our portfolio contains some level of high security operations. We renovate U.S. government campuses totaling 4 million square feet. They are antiterrorism force protected and have SCIF, which is secured compartmentalized information facilities. We have over 1 million square feet of other high security leases with the U.S. government that are not contained in campuses. Our defense contractor tenants total about 9 million square feet of their leases contained SCIF. And we have 15 data center campuses that are fenced with limited access, totaling 5 million square feet. So today, 90% of our annualized rental revenue is derived from our Defense/IT properties. Our pre-leased developments will increase that to 93% or more in the coming years as we complete construction and deliver those assets. Our Defense/IT segment is 96.8% leased, and that's the highest lease rate we've had since we started reporting the segment back in 2015. Our 3 largest concentrations of defense installations include the National Business Park adjacent to Fort Meade, Maryland; the Redstone Arsenal or Gateway adjacent to the Redstone Arsenal in Huntsville, Alabama; and our privately-owned secured campus adjacent to the Lackland Air Force Base in San Antonio. Collectively, those 3 locations are 98.8% leased, and they account for 45% of our aggregate annualized rental revenue. Adding our fully leased data center shell portfolio that adds -- we have 12 million -- 12.5 million square feet. It's 99.3% leased in aggregate and accounts for 50% of our annualized rental revenue. The U.S. government is our largest tenant. We have 108 separate leases, in over 65 different properties, totaling 5.3 million square feet and producing 36% of our annual revenue. Our defense contractor tenants in total leased 14 million square feet, and this includes over 2 million square feet of cyber defense contractors that we've accumulated over the last 8 years. In total, the defense contractors contribute 48% of our annual rental revenue. 15 of our top 20 tenants are defense contractors. Our nondefense locations provide about 10% of our ARR, and this consists today of only 5 regional office assets, and they're located on the Baltimore Waterfront, in Downtown Washington, D.C. and the CBD and then Tysons Corner. And by the way, our tenants and these assets have excellent credit profiles as well. Our strategy is simple and straightforward. We allocate capital to durable demand locations, primarily a defense demand mission locations. Our playbook is simple, we execute low-risk, highly leased developments. We maintain a strong investment-grade balance sheet. Development is key to our external growth. Commencing in 2023, the equity component of our development spend will be funded by cash from operations after the dividend. And the debt component will be funded from our line of credit. And in this case, cash from our recent debt offering that we completed last weekend. Over time, as we build up the balance on our line of credit, we replenish that capacity with longer-term financing. We're an active developer, but we're an active developer of specialized properties for our tenants. We currently are developing 1.5 million square feet. It's 92% leased. It represents 9 projects in 3 states and 3 separate development locations. Over the past 11 years, we've completed 12 million square feet of development leasing, averaging over 1 million square feet per year. And during that period of time, we've developed 88 separate properties. When completed these low-risk projects, along with those completed in 2022, will add as much as $66 million of future cash NOI on an annual basis. And that's in the rough -- driving the roughly 4% compound annual FFO growth we expect to achieve between 2023 and 2026. Our competitive platform is multifaceted. We have an operating platform with experienced credentialed workforce. Fully 1/3 of our employees are cleared at the highest level to operate facilities that conduct the most secretive missions of the United States government. Second leg is our development expertise in providing secure specialized space, including SCIF and anti-terrorism force protection. We have a 30-year track record of executing development and operations for the U.S. government and that accrues well to our shareholders. And lastly, we have advances land positions already on our balance sheet, proximate to mission-critical knowledge-based defense installations. So in summary, we're a specialized REIT. We're not correlated to the broader economy, which is why we embarked on a rebrand from Corporate Office Properties Trust, a name that we've enjoyed for 25 years, but we've evolved our investment strategy. So we've changed our name to COPT Defense Properties. Our assets have strategic features and locations. There's little risk from work from home. There's strong demand for new development and vacancy. Our new name better reflects our strategy from both an investment standpoint and our portfolio composition. And our defense concentration offers durable, recession-resistant performance, market-leading retention rates, averaging 76% over the last 5 years, which translates to very low capital costs from leasing and reliable growth for at least the next 4 years. And today, we're at a great value at $25.14, which is 10.5x our 2023 FFO. We're generating a 4.5% dividend yield, and we're trading at a 19% discount to NAV. So with that, back to you, Camille.

I think you've clearly outlined the reasoning and motivation behind the rebranding strategy. Just to confirm, will this result in any change in your marketing and outreach to clients?

No. What we hope it will do is make it easier for the [ journalist ] and investor to understand the difference between our strategy and that of a generic office company. The REIT community is very familiar with our company and our strategy, but our prior name was somewhat misleading relative to our investment strategy and our portfolio composition. So after 25 successful years as Corporate Office Properties Trust, we simplified it for investors. We look forward to our next 25 years as COPT Defense Properties.

Okay. And of course, if anyone from the audience has any questions, feel free to jump in at any time. But -- maybe starting with the demand drivers for the company. Just when we look to the 2024 President election, what does this mean for the defense industry?

So the best kept secret in Washington, is there is a bipartisan issue. And it is defense spending. And it may be the only bipartisan issue in Congress today. Since the fiscal year 2016 defense budget got passed, we've had various parties control the House and Senate Armed Services Committees, but the votes have been staggeringly unanimous in terms of supporting increased defense spending, recognizing the capacity and capability challenges that China represents as well as our obligations to NATO and the current threat of the Russian activities. So with regard to this pending election, I don't think there's a lot of outcome that could influence the strong future that we project. Both parties support increased defense spending. I think where there will be differences in policy that will largely be focused on what decisions we make supporting Ukraine in the future, and that really has no influence on the business that we invested.

And are there any other demand drivers that you see your portfolio benefiting from?

Well, we have quite a few now. In terms of locations, there are some missions that we keep our eye on in locations to the future -- for possible locations in the future. We have yet to see the confidence that the sustained spending and contractor demand would occur, and we're very comfortable operating in the locations that we have.

Are there any locations that you can specifically...

Yes, I would definitely [indiscernible]. There are companies that would act on that.

Okay. And just, I guess, this comes up in our discussion every time. The government seems to be debating a shutdown the risks around that. I guess as you think about your portfolio, what is the impact on rent collection for DoD tenants if we were to go under that scenario?

There is no impact on our business or any of our tenants business. First of all, the components of the government that we serve are priority missions. They will continue to operate even in a shutdown environment. The congressional rules, contracting rules require that our rents get paid, and they require that the defense contractor contracts get paid in a shutdown or otherwise. It tends to represent some headline noise and questions, but it has no impact on our business.

Even if it's a new contracting activity...

So to that extent, -- to the extent a contractor is waiting for the next funding from the next budget, and they believe they've won that contract, until that budget were to get funded, that new mission could not proceed. There have been years where we're awaiting a government approval of a budget to execute a lease that we're anticipating. We have no such circumstance this year.

If you look at your -- you mentioned your occupancies [indiscernible] portion of the highest since you started [indiscernible]. If you look at that absorption, any way to attribute how much of that absorption has been from new contracts as opposed to safe market share?

So over the last 24 months, remember last year, 2012, we set a record for vacancy leasing. It was almost universally in our Defense/IT segment. And year-to-date, we're on track to lease more than half of what we did last year with diminished inventory. Much of that demand is new contract wins requiring new SCIF facilities to expand programs with existing tenants that we already have. So I think quite a bit of it has come from [indiscernible] defense spending. Although that's not an information that a tenant typically discloses, observation says this is all growth.

So then what's the outlook on defense spending? The fact that these contractors are still mandated to pay you if there was a shutdown. What are potential headwinds for your business? How do you think about the risk going forward...

Well, this might be a little bit of a smart answer. But as we look towards the leasing success we've had at the National Business Park, we have 4.5 million square feet that's operating and under construction, and we're 99.5% leased, and the biggest facing space we have is under 8,000 square feet. We've been able to redirect some of the demand in the [indiscernible] Park to our nearest adjacent Park Columbia Gateway. And our activity ratio on Columbia Gateway is 150%, which means we have 50% more demand than we have inventory available to lease. So my concern looking forward, particularly in Maryland, as we secure these additional leases in Columbia Gateway that we have no inventory to lease. So we're planning to start an inventory building, which is other companies might call it a speculative office building. But a building that we need to build at the National Business Park to create inventory to continue to capture demand. So that's one of the biggest headwinds I see is that as we fill our properties, we need more inventory to lease.

Quick question. A joint venture with Blackstone earlier this year data center [indiscernible] our development pipeline. Is that Correct?

We have done several with Blackstone, the most recent this year that you're referring to.

One last question, what was the first one? I mean...

I'm getting old. Yes, 2017.

Any other plans for private capital joint ventures...

No. Actually, one of the things we've been messaging this year is with our visibility of the FFO growth, our rate of AFFO growth is actually going to be higher than our FFO growth. And that with the 2 joint ventures that we completed, one at the end of last year and one in January of this year, we see that we'll be able to fund our expected development investment, the equity component from cash flow after dividend and then accumulating the debt component on our line or currently the cash we've just raised until such time as new EBITDA comes online. So on the debt neutral basis, we'll be able to self-fund our development using only our line of credit.

So the proceeds of the senior note offering that just closed, I think, last week, you're saying that's just to really manage the terms maturity schedule?

Actually, think of it as prefunding the future debt need. So as we modeled our business by fourth quarter of next year, we anticipated we would need to raise or to term out some debt to replenish the capacity on our line of credit. Recognizing the great opportunity with this financing vehicle, we reached ahead 12 to 14 months, raised that money in advance, which allows us to substantially pay off our line of credit, retaining just a swap component to cover some hedges, put cash in the bank and have the capacity to continue to develop with both the cash -- the equity component and the debt component through 2026 when our next bond matures.

We do have questions later on your views on interest rate environment. And I guess that, to some degree, talks to how you're thinking about the balance sheet. On the point about approaching the spec development, just walk us through what are some key considerations for you to start something in today's market in terms of return, deals?

So we've historically targeted 8% cash yield on development cost. It is the threshold value to proceed with defense contractors and government assets. Our data center development, we build to a slightly more competitive yield, but we still create immense value. Those have not changed materially. Over the last 18 months, we've elevated 25 to 50 basis points, our target for development yields, respecting the cost of capital changes in the market that we've experienced. But we're still on that low mid 8% cash yield on development. Remember that our leases are all structured with escalators, and they tend to be 10- to 12-year leases on development. So our GAAP yields are substantially higher now.

And are you agnostic on the opportunity, whether it be a data center shell or SCIF or is it more like whatever...

So with regard to development, we are very happy to do both. With regard to the assets that we will hold long term, we never have and we never will consider joint venturing a U.S. government asset or our prime defense contractor assets. They represent a franchise holding an advantage that we don't share. So we've only joint venture data center shells.

And then in that case for the data center exposure, where would you be comfortable taking it?

In terms of -- so I would be comfortable if we could accumulate 20% of our revenue in the data center shell or better. We've had discussions with our Board. They're comfortable to the 20% level. We're currently below 8% with the joint venture activity we've had. So we have significant capacity to run. But the nature of those assets is very comparable to our U.S. government assets. The tenant is significantly co-invested. It's an absolute vital asset to their core business. There is scarcity in terms of replacement, and it's difficult to relocate an operating business out of that asset. So the expected full occupancy of those is very, very long term. And there's just a tremendous asset to hold in a REIT.

With respect to market [indiscernible]

For which segment or which customer...

Your debt [indiscernible]

2.25, 2.25.

Where was that...

2.25.

Surprised you're not giving anymore pricing power, just giving [indiscernible] or is it all being made up in the starting rate?

I think we're capturing plenty of value in our starting rate. And we've got a long-term relationship with this single customer. We did our first build-to-suit for them, and we signed it 2012. We delivered in 2013. And we work in harmony to shape a deal to fit their needs as well as ours and create tremendous value for our shareholders.

What do you think the start rate is now versus 2019?

On a percentage basis, probably 130%. '19, you said, probably 75%. I thought you were talking about 2012.

Can we shift gears to the leasing demand you're seeing? How has that trended into the third quarter?

Very strong. So as we sit here today, our annual goal is 400,000 square feet with diminished availability since our record leasing last year. We've executed 60% of our target. We have [indiscernible] of our target in designated as advanced negotiations, where we're working to finalize the lease. We have another 20% of that target in negotiations for leases. So the sum of those 3 is 110%. And beyond that, we have almost 0.5 million square feet of other prospects. So demand is strong. We have every confidence we're going to hit our annual goal.

And going back to locations like where missions are being located, the U.S. Space Command recently decided not to relocate. So...

No, they didn't decide that. President Biden decided that. Let's be clear.

Yes. So is there any impact to your leasing pipeline from that?

So yes, we call our development pipeline. And on the second quarter call, I represented those 1 million square feet. Today, I would represent, it's about 700,000 square feet. There are about 300,000 square feet of development opportunities that would have supported that had it been selective for Alabama. So yes, our opportunity to grow our development is somewhat diminished by the decision. My belief this decision is still not final because I don't believe Congress will fund any capital improvements or expansion of the temporary facilities that are in because of the way it was overall from a triple adjudicated process. And I think the question might be up for reconsideration after a presidential election.

And if we look at your expiry profile through 2024 seems very elevated. So if you could talk about your retention expectations and what's driving your improved outlook for 2023?

So between now and the end of, let's just go through 2025, next quarters, we have 7.1 million square feet that is maturing. 3.9 million of that 7.1 million or 55% are leases over 55 -- or 50,000 square feet. Our projected renewal on the large leases is over 95%. It's heavily represented by a couple of data center, fully leased assets, a significant amount of U.S. government leasing in several single building leases with priority defense contractor missions. So our confidence level is extremely high in retention. If you just applied our historical 70% to 75% retention on the balance, we would be our 5-year historical of 76%. We believe that our retention numbers are going to be extremely strong through the end 2025.

And you did update guidance in the second quarter around retention. So what was driving that change? Are you seeing any differences in decision-making?

No, it's just -- our tenants are -- we tend to guide conservatively. And now that we have much more clarity for this year, we expect extremely strong retention through the end of the year.

Maybe touching on the regional office. Any update there, how operations and global strategy is going?

So one of the advantages of changing our name, it's in our defined investment strategy is we're going to reclassify our -- what had been a segment regional office into other. So we'll no longer have a segment regional office. Those 5 assets we view them as future recycling opportunities. We have a full intention of recycling out of all of them, but we will be patient and wait for the right market opportunities to preserve shareholder value and then simplify our story.

But are you currently in the market on any of these assets?

No, we're not. With the current debt environment, it just won't support office leasing currently, and that could be 12 to 18 months away.

We have seen some smaller deals, smaller office buildings trade in a few months, but still, I guess, not enough confidence to go up there yet.

Not yet.

I think we have time for a few more questions before rapid fire in case anyone from the audience...

Rapid fire.

A quick question [indiscernible] more competitive? Can you sort of quantify how much more is competitive?

So most recent deals have been at 6.5 to 6.75. The most recent joint venture that we did priced at 5 48 and the development profit on that joint venture was [ around 40% ].

Just around the dividend. Your business has come a long way in transforming the portfolio. But given all the market uncertainty and the questions around access to capital, can you speak to why the Board felt it was the right time?

So the company cut its dividend in 2012 and held it constant for a decade. And the reason we did that is concurrently in 2013, we embarked on a long-term plan to reshape our portfolio to what it is today. For 7 years that our strategy translated to a more densification or a transformation of our portfolio. And for the last 5 years, it's translated into FFO growth. With the heavy amount of preleasing we have in both the properties, we just delivered in the properties that we're developing. We have sight into roughly 4% FFO growth through 2026. And our AFFO growth actually exceeds our FFO growth. So our Board recognized that we'd hit a threshold where we can internally fund the equity component of our expected development spend and increase the dividend to shareholders, which they increased by 3.6% in February. With that confidence in mind, the Board makes a decision to increase the dividend. I can't speak for the future expectation. But our trend suggests in the future, we will have to increase our dividend for both tax reasons and other reasons.

And can you comment on how often the Board tends to revisit?

I'm certain they'll revisit annually. I can't tell you what they will elect to do. I'm one of them.

Thank you. I think we only have time left for the rapid fire questions. So shoot it over. First, on the Fed, do you believe that the Fed is done hiking? Yes or no?

No.

Okay. Do you expect the Fed to cut rates in '24? Yes or no?

I don't.

That's definitely a contrarian view. Second, if real estate transactions will meaningfully pick up by, a, the fourth quarter of '23; b, first half of '24; or c, second half of 2014?

Purchase and sales transactions?

Yes.

End of '24.

Okay. And third, are you using AI today to help you run your business?

No. We forbid AI to be run on our system. Forbid. We have no particular need for it. If you participate in AI broadly, then you're exposing the data on your network to other networks. We run a very private business. We have no need for -- represents more risk than upside. Not a big fan.

And so maybe the answer to the second part of this question is obvious, but do you plan to ramp up on spending on AI initiatives?

No, I plan to ramp up on development to support AI initiatives, but not within our business.

Got it. Thank you for your time, Steve. And thank you, everyone, for joining.

Thank you.