COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Welcome to the 11:40 a.m. session of Citi's 2024 Global Property CEO Conference. I'm Michael Griffin with Citi Research, and we're pleased to have with us COPT Defense Properties 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 go to liveqa.com and enter code GPC24 to submit any questions if you do not want to raise your hand. Steve will turn it over to you to introduce COPT and your team provide any opening remarks, and then we'll get into Q&A.

So thanks for attending or listening. To my right is Anthony Mifsud, our Chief Financial Officer; at my left, Britt Snider, our new Chief Operating Officer. He's been with the company for about 4 months, and we're thrilled to have him. I'll talk a little bit about the company now. COPT Defense Properties is a specialized REIT, deeply concentrated in mission-critical assets that support national defense activity of the United States government. The vast majority of our 198 properties are located in adjacent to or are occupated by priority defense missions generally involving knowledge-based defense activities. The missions we support include intelligence and surveillance; cybersecurity and network activity, naval, sea and air technology development; missile attack and defense systems; army aviation; drone aviation technology development; weapon lethality; law enforcement and terrorism explosive technology; and, of course, cloud computing. Our property locations are not typical for an office company. They are proximate to U.S. defense installations in Maryland, Virginia, Alabama and Texas. Our properties are improved for top-secret mission work. 85% of our portfolio contains high security operations. And that ranges from 8 U.S. government secure campuses that contain 4 million square feet that are fully anti-terrorism force protected and have SCIF improvements, SCIF stands for secured compartmentalized information facility. Another 1.4 million square feet of U.S. government high-security leases outside of those campuses that are SCIFed and access controlled. We have 15 cloud computing campuses, collectively housing 6 million square feet, which are fenced with limited access. And then, of course, we have over 9 million square feet of defense contractor leases that have SCIFed. Additionally because of the security measures defense tenants must work in their office due to the security requirements. Today, 90% of our annualized rental revenue, or ARR, is derived from our Defense/IT properties. Our pre-leased developments will increase that figure in coming years. Our Defense/IT segment is 97.2% leased. It's the highest rate since we started reporting the metric as the segment in 2015. Our 3 largest concentrated defense locations include the National Business Park in Maryland, the Redstone Gateway in Huntsville, and the Lackland Air Force Base in San Antonio. And those 3 concentrations combined are 99% occupied in aggregate, and they account for 45% of our annualized rental revenue. If you add our fully leased data center shell portfolio, we have 13.5 million square feet, that's 99.4% occupied and in aggregate, accounts for over half of our annualized rental revenue. The U.S. government is our largest tenant, as measured by revenue. We have 96 separate leases in 69 different properties totaling 5.5 million square feet, producing 36% of our annualized revenue. Our defense contractor tenants leased 14 million square feet. This includes roughly 2.5 million square feet of cyber defense contractor tenants. In total, defense contractors contribute 51% of our annualized rental revenue. 15 of our top 20 tenants are defense contractors. We continue to have a few nondefense locations that provide roughly 10% of our annualized rental revenue. This consists of 5 assets that we refer to as regional office located in the Baltimore Waterfront , Tysons Corner and Washington, D.C. CBD. Our tenants in these assets have excellent credit postures as well. But we do plan to recycle these assets as market conditions support reasonable sale values. Our strategy is to allocate capital to durable demand locations adjacent to priority defense installations emissions. Our playbook is simple. We execute low-risk, highly pre-leased development, redevelopment or in some cases, repositioning. We maintain a strong investment-grade balance sheet. Development is the primary external growth activity for our firm. And we are now able to self-fund the equity component of our development using cash flow from operations after the dividend. The debt component is funded using our line of credit initially and then we placed some unsecured long-term financing. This year, we have over $165 million of cash on hand from the exchangeable notes offering we completed in September. We've been an active developer of specialized properties for our tenants for the past 20 years. And over the past 10 years, we've delivered over $2.5 billion of successful developments averaging over $250 million a year. We're currently developing 5 projects. Total costs, $325 million. Those 5 projects are 91% leased and represent 820,000 square feet. When completed, these low-risk projects, along with those completed in 2023, we'll add $37 million of future contractual cash NOI on an annual basis, and that will drive our roughly 4% compound FFO growth between 2023 and 2026. Our competitive advantage is really represented by 4 pillars of strength. Our operating platform, which is -- includes experience and credential workforce that in many cases are embedded in the missions they support. Our development expertise which includes SCIF properties, anti-terrorism force protected, data center and other mission-critical facilities. A 30-year track record, as a builder for the United States government and defense contractors and then the operator of those facilities when finished. And of course, our advantaged land positions where we thought ahead and accumulated land proximate to the mission-critical knowledge base defense missions that we serve. So in summary, we're a specialized REIT that is not correlated to the broader economy. Our assets have strategic features and locations. There is little or no risk from work-from-home, and there is strong demand for new developing and vacancy. We have 4 main points that we'd like investors to leave with relating to our outlook. We continue to project FFO per share growth of roughly 4% between 2023 and 2026 irrespective of interest rates. We've achieved self-funding the equity requirements for our development investments on a leverage-neutral basis. We commenced dividend increases in 2023 for the first time in over a decade. And the increased dividend -- and we increased the dividend again by 3.5% last month. We're one of only two office REITs to raise the dividend during 2023, and we raised it again last month. And finally, the outlook for defense spending remains incredibly strong. The defense budget increased by $100 million or 15% over the past 2 years. We expect it to increase another 3.3% this year, and clearly, the global threat environment continues to escalate. With that, I'll turn it back to you, Michael.

Thanks for that overview, Steve. We're starting each of these roundtables with the same opening question. What are the top reasons investors should buy your stock?

So I kind of just went through them but I go through them again. Our defense concentration strategy offers long-term durable demand and tenant retention. Our retention rates over the past 5 years averaged 77%. We're supply protected due to our advantaged land positions. We have very low capital costs from leasing because of the strength of the demand. We've proven and are forecasting predictable growth from external development and visible growth for the next 3 years in our forecast. We're at great value at $24.56, which is 9.8x 2024 FFO, which is near a 10-year low. We have a 4.8% dividend yield and a 19% discount to consensus and AV. We've also raised the dividend in 2 consecutive years. Our gross trajectory suggest future increases. And this is just a great entry point by our shares. Since 2019, our FFO per share has increased by 19% and our FFO multiple is contracted from 14x to 9.8x today, and that represents a very attractive price or entry point.

We've got a question right here from the audience.

Yes. Just -- so historically, you've talked about the defense contracts budget being a driver of demand for your business with a lag. And I'm just wondering if any of the conflicts around the world, the incremental defense spending, aid packages change anything about either the discussions, the requirements of the agency around any potential business for you guys?

So in the short term, we do expect to get an opportunity in the next few months. That's directly tied to the volume of needs in some of these global conflicts without getting specific. But longer term, I think what's fascinating is, particularly if you look at Ukraine, there's been some pretty innovative methods and systems developed by the Ukrainians that have delivered some pretty surprising results to the Russians. And I think whenever there's new technology developed and deployed that creates an opportunity to expand that technology but also a requirement to determine how to defend from those innovations. So I think in the long term, there will be a bigger boost. But generally, we are knowledge-based research, development, test and evaluation system, weapon systems, development and activities with surveillance, reconnaissance. So they will be well funded and those -- certainly, the need for those things will grow, but there's no particular expansion besides what I referred to you that I could talk to.

Maybe just segueing on that toward future congressional funding. It seems like there has been bipartisan support historically for increased defense spending. But are there ever any worries we're in an election year, this year as an example, that a shift in control of Congress will affect appropriations towards the defense budget?

I don't -- I have no worries. So currently, the house is controlled by the Republicans before that, it was controlled by Democrats. Over the -- since 2017, the votes in both Armed Services Committees have not been quite unanimous but very close to unanimous irrespective of which party control it. The one truly bipartisan issue in D.C. is the need for defend spending. And if anything, the outcome of the election, I would think might influence the magnitude to a higher level, but certainly in the same direction.

Do you worry that we've heard news supports about Republican members of Congress maybe trying to hold up additional aid to Ukraine could maybe changes in sentiment around some of these geopolitical complex impact defense spending needs?

I don't think so. So the monies that are being allocated to Ukraine are outside of the DoD spending. The DoD budget is to develop, maintain and innovate the systems we need to defend on our country. So whether Ukraine gets funded more or less, I don't see it affecting the trajectory of U.S. DoD spending.

Maybe just turning to leasing right now. You exceeded your target for 2023, and it seems like you've got a strong pipeline heading into 2024. How have conversations on the leasing front, both for renewals and potentially vacancy leasing. How are they going with tenants? And what type of tenants are you seeing most of the demand from?

So in last year, we did 452,000 square feet of vacancy leasing versus the goal that we set at 400,000. The 2024 target we've set at another 400,000 and that's an aggressive target given the fact that our defense portfolio is 97.2% leased. This part year-to-date, we've executed about 90,000 square feet. So we're on track to meet or beat our target. And we do have a very strong pipeline. Our overall pipeline is 65% of demand versus our available inventory. But then our defense sector, it's 82%. And demand has really been driven by mission growth. If you break down our last year leasing, that 452,000 square feet was 60 separate leases with an average of 7,500 square feet, largely driven by admission expansion due to the funding. In terms of what's the nature of the demand we're seeing for the last really 15 to 18 months and continuing today. So a significant amount of demand for SCIF facilities or expansions of SCIF facilities is the cyber and defense activity really is rallying to the challenges of the environment.

Do you think COPT can benefit from this growing boom that we've seen in terms of AI usage? I think about something like your cybersecurity tenants could use it? Or is there a big demand tailwind that comes from that?

So I will not suggest there's going to be a huge tailwind because I don't really have that information. But what AI does, it facilitates speed and processing information or decisions. To the extent that AI returns an effective tool unquestionably the DoD will rely on that to enhance their ability to manage all the information around the world that our intelligence community has to monitor there. So I can't tell you exactly when or where, well unquestionably the DoD will deploy AI as it becomes a reliable tool.

We had a question come in over live QA. Can you comment on the re-leasing spreads over the last 12 months and then expectations for the year ahead? And then has there been any cost escalations associated with that re-leasing?

So over the last year's leasing spreads were positive about 1.6%, expiring cash rent to starting cash rent. But it's a metric that in our market is kind of overweighting. If you look at our leases, they have embedded growth in the lease structure and our rents grow every year even in the government part of the lease. So historically, we'll grow at 3% to 3.5% of the leases. Our mark-to-market over the last maybe 4 years has been flat to slightly negative and then we resumed the growth last year. That was positive mark-to-market. This year, we conservatively guided to flat on mark-to-market. But again, you got to look at the growth embedded in the lease structure as opposed to onetime adjustments in some markets in the joint.

In terms of tenant retention, you're expecting about 80% for 2024, which is above the historical long-term average. What's driving this greater retention? And how best can you capitalize on it?

Well, for the last decade, we've averaged over 70%. For the last 5 years, we've averaged 77%. If we're guiding to 80%, there's a pretty good likelihood that we're going to be 80%. And what's driving it is the tenants need to be in our buildings, adjacent to the customers that they serve and the fact that they have co-invested to create these secure environments that can't be moved. So to put some numbers around it, from now to the end of 2025, we have 6.2 million square feet of leases that expire, 3.3 million square feet of those leases are over 50,000 square feet, which we call large leases. That's 57% of the total in terms of annual rental revenue. And that said, a 3.3 million square feet of leases, we expect over 95% retention. And 75% of that 3.3 million is represented by full-building U.S. government leases. In our 32-year history of leasing full buildings to the government, we've never had one non-renew. So our expectations are very high.

Maybe just turning to external growth opportunities. You obviously talked about the current portfolio being very highly leased, your current development pipeline is very highly pre-leased as well. What would make you look to start a new development now? Are the capital costs still too prohibitive to do so? Or do you think you can make the math work and get the yield you would want in order to take a new one?

So our capital costs are high, but construction costs have increased quite a bit over the last 3 years as well, but we've been able to move our rent levels with both the capital and cost of construction. Our inventory strategy is playing out as we speak, is when we have high occupancy and little inventory available with visible demand and we start buildings. So this quarter, we started at the National Business Park. NBP 400. It's 140,000 square foot building, and we'll spend about $65 million to develop. We did it because the NBP parcel of land, is a 4.3 million square foot development, it's 99.4% leased. Our largest vacant space is 7,800 square feet. We literally have no inventory to handle the contractor demand. So we started the building there that we would call inventory. Similarly, at Redstone Gateway, we're 98% leased over that 2.3 million square foot business park. We started one building in January 50,000 square feet, high-bay, technical facility, that saw 20% pre-leased. We expect that to lease up pretty smartly. And then we're finishing the leasing on RG 8100, which was our inventory building we started last year. It's 42% leased today, we expect it to stabilize in June or so. And we're already preparing our next building, our RG 8500, which will be 150,000 square feet to continue to deliver supply for that market.

Then maybe on Redstone specifically, are you seeing more future opportunities to develop behind defense? Or is it mainly along kind of right-out road where a lot of your stuff is that you're seeing the development opportunities?

So we just completed and delivered building in line with defense for the U.S. government. Looking out the next 24 months, I would say, substantially in favor of outside defense supporting contractor work.

And are there any potential acquisition opportunities? I mean you talked about being in your core markets where you're really the biggest player. But I think about something like Cummings Research Park in Huntsville or maybe some areas kind of adjacent to NBP, would you look to do one-off acquisitions or just stay kind of in your core clusters?

Well, we hypothetically would do an acquisition in some of our markets. But the opportunity set, I would consider very small. It would have to have an extremely good land position like our assets. If there's any tenancy in it, it would have to be defense IT tenancy. And then from an investment standpoint, it's going to have to be at least an 8% to 8.25% cash yield on investment or I wouldn't divert the money away from our development program. So it's a possibility, but certainly not the core expectation of our growth.

Are there any worries about the increased power cost in Northern Virginia and how that might impact your data center shell business?

So it's not the cost. It's the availability. The data community went in Northern Virginia for its very competitive cost. And there's frankly a lot of room for costs to actually go up and still be competitive with other regional markets. But there's just no power available. Both of our companies are tapped out. They're having difficulty sources in past for high-voltage distribution into the market to handle expansion. So it's really a supply, not costs. And then of course, lands gotten extraordinarily expensive with the new high watermark just reported this week of $3.7 million an acre for data center development land. So it's difficult to grow long on land without certainty of power. So that market is kind of at a standstill for a while.

Then maybe just thoughts around other markets. Are there any that you've done on your radar that maybe you'd look to move into maybe a Colorado Spring, something like that or other markets that might have a heavy military presence?

We evaluate other markets regularly, and I would never tell you which one I'm evaluating before I went there.

Got you. We -- there are a lot of investors that have been focusing more on ESG as of recent. Can you talk about some recent ESG initiatives that COPT has undertaken?

So our ESG program really goes back almost 20 years. We've been developing buildings to lead certification since the early 2000s. So as we know, we continue to seek LEED certification. We have over 65 buildings currently, several of the developments were completed are awaiting their final certifications from LEED. And we've also operated to LEED EV standards for years. Over the last couple of years, we just received our 9th consecutive GRESB Green Star rating. Last year, we were a regional leader. We're announced as a regional leader by Sustainalytics. And then we've completed our second TCFD report, and we rate very highly. So we do what we can, where we can.

Your balance sheet remains in a pretty favorable position at net debt-to-EBITDA below the office peer benchmark. If the right opportunity came along, could you look to take leverage up? Or are you comfortable with kind of where the metrics stand now?

So our long-term goal is to actually drive that leverage metric down. But the reason we want a healthy cushion and so we have capacity to respond to a large opportunity, should that opportunity arise. So I certainly believe we have quite a bit of latitude to go up in leverage for the right opportunity, with an understanding over the long term, we want to bring it back down to the 6 or hopefully, lower in the future.

You touched on, I guess, in your prepared remarks a little bit about the regional office portfolio, which has now been classified as other. You're going to be judicious about when you look to exit that portfolio. But have you started to see any buyer interest in any of the assets and maybe a timing on when you could exit those?

So I've not seen any buyer interest, although we have not marketed them. We monitor the capital sources in the markets where we have those assets. There's very little financing for office investment currently. I don't believe we'll get a robust bid until a buyer can borrow money to buy the asset. So I would guide people to expect 18 to 24 months before those conditions improve. And it will really be tied to the ability to borrow money.

And on the leasing side for those businesses, is there any tenant demand or interest to lease the properties? Or is it still pretty challenged?

So you have to go asset by asset or lease to -- market by market. So we've got reasonably strong demand in Tysons Corner. We've got a niche building there with a smaller floor plate. Great views to the market. It sits the top the highest point in markets adjacent to the retail amenities. In Downtown D.C., we signed a big lease at 2100 L, 41,000 square feet, we're negotiating the lease that will stabilize that asset at 92%, which is a big achievement for us. In Downtown Baltimore, we have some demand, but it's pretty tough and very competitive. We've acquired this space to lease in that market because of some contractions related to COVID, it will take a couple of years for us to lease to get some traction...

We had a question here from the audience.

Yes. Just want to follow up on the data center question. Where are you guys relative to power for your opportunities or potential needs there?

So last year, we signed 3 build-to-suit developments. And those consume the 3 parcels of land we had remaining in our land bank support data center shell development. So anything forward, will need to source both land and power. I wouldn't expect anything in the next 12 months.

Okay. And then just is there any other opportunities for you guys in any other locations for expanding your government relationships or relationships with defense contractors?

Are you talking about new markets?

New markets, yes.

So there's several that we keep an eye on, Jordan, but I will not identify for you. It's a possibility, but we're very selective. It's going to be a mission that fits our strategy, it's going to be [indiscernible] of long-term funding and growth and a good personal land to develop those.

Is that -- would you consider those a near-term, medium-term opportunity at '24, '25, '26, what's your...

Let say, middle and I won't give you year.

Steve, where do you see the greatest growth opportunity in your portfolio? Is it National Business Park? Is it Redstone? Is it Lackland? Where are you seeing the most opportunities?

So over the next 2 years, I'm undoubtedly it's Redstone Arsenal. 75% of the demand that we consider in our pipeline would be at the Redstone Arsenal and 25% at the National Business Park. We are developing NBP 400. That's our last parcel that sits fully prepared for development as we manage what we call parcel of land, to get that land ready for another 1 million square feet. So I think we'll do one building this year and get that leased up and then probably late '25 be ready to go on parcel of land.

And Steve, what's the #1 thing you're spending your time on most these days?

There is not one thing. Getting our new sale up speed is a high priority, and he's done a great job. Of course, I have to manage the Board and the investor activities. But I'm always focused on the business and how do we continue to grow the platform.

Great. Well, if there are no more investor questions, I have my rapid fire to end the session. What is the best real estate decision today, buy, sell, develop, redevelop or pause?

For us, it's developed and/or redevelop if we get an opportunity.

What do you expect same-store growth to be for the office sector overall in 2025?

'25?

Yes.

Flat to minus 2.

And lastly, will there be more fewer or the same number of publicly traded office REITs a year from now?

Same.

Great. Thank you so much.

Thank you.