COPT Defense Properties (CDP) Earnings Call Transcript & Summary

All right. Good afternoon, and welcome to our Global Real Estate Conference roundtable session with COPT Defense. Your new name. I have joining me with today, President and CEO, Steve Budorick. My name is Camille Bonnel, and I'm the office REIT analyst here at Bank of America. Just for the benefit of the group, it would be great if we can start with a high-level overview of the company, and then we'll go into Q&A.

Okay. Well, thank you, Camille. COPT Defense Properties is a specialized REIT, deeply concentrated mission-critical assets. That's National Defense activity in the United States Government. The vast majority of our 201 properties are located adjacent to or occupied by priority defense missions generally involving knowledge-based activities. Some of the missions we support our intelligence and surveillance, cybersecurity and network activity, naval sea and air technology development, missile attack and defense systems, army aviation and enhancements and cloud computing. Our property locations are not typical for an office company. They're proximate to United States defense installations in Maryland, Virginia, Alabama and Texas. Our properties are improved for top secret mission work. 80% of our portfolio contains high security operations. We have 8 U.S. government secured campuses, totaling 4 million square feet that are antiterrorism force protected and contained SCIF, which is Secured Compartmentalized Information Facilities. Behind that 4 million square feet, we have another 1 million square feet of U.S. government high-security leases that are SCIFed and access controlled. We own 12 cloud computing campuses totaling 6 million square feet, there are funds with limited access. And we have 6 million square feet of defense contractor leases that contain SCIF. Additionally, a notable difference is defense tenants must work in their office due to security requirements. And today, 90% of our annualized rental revenue, our ARR is derived from our Defense/IT properties, notably our Defense/IT segment is 96.7% leased. Our 3 largest defense concentrations include those properties around Fort Meade, Maryland; the Redstone Arsenal in Huntsville, Alabama; and the Lackland Air Force Base in San Antonio. If we add to that our fully leased data center shell portfolio, we have over 18 million square feet that is 98% occupied in aggregate and accounts for nearly 75% of our ARR. The U.S. government is our largest tenant by revenue. They have 96 separate leases in 70 different properties totaling 5.5 million square feet and producing 36% of our annualized rental revenue. Our defense contractor tenants lease over 14 million square feet. This includes roughly 2.5 million square feet of defense, cyber contractors and 16 of our top 20 -- of our top tenants are defense contractors. Our nondefense locations provide about 10% of our ARR, and this really consists of 5 assets located in the Baltimore Waterfront, Tysons Corner in Washington, D.C. Our tenants in these assets have excellent credit postures, but we do plan to recycle these assets as market support reasonable sale values. Our strategy is simple. We allocate capital to durable demand locations adjacent to priority defense installations. The playbook is straightforward. We execute low risk, highly preleased development, redevelopment or in some cases, repositioning, and we maintain a strong investment-grade balance sheet. Development is and has been our primary external growth activity. Over the past decade, we've delivered over $2.5 billion of successful developments averaging over $250 million a year. We're currently developing 6 projects with a total cost of $380 million that are 74% pre-leased and represent 960,000 square feet. One completed these low-risk development projects along with those that we completed in 2023, will add an additional $37 million a future contractual cash NOI on an annual basis. The net NOI contribution will be driving at least 4% compound FFO growth between 2023 and 2026. Our sources of capital to fund our external growth, currently, our equity component, we're funding through cash from operations after payment of our dividend and our debt component for the next 2 years. Initially, it will be from cash on hand when we'll have about $100 million in cash and then subsequently at our line of credit. Long term is our line of credit reaches capacity. We term that out with unsecured notes. Our competitive advantage is really 4 pillars. They held of 5 fingers. Our operating platform fully 1/3 of our employees are experiencing credential to operate high secure facilities. Our development expertise, we've developed millions of square feet of advanced properties, including SCIF, antiterrorism force protected, data center and mission-specific critical facilities. We have an over 30-year track record serving the highest secure functions of the U.S. government. And of course, we have advantaged land positions adjacent to critical knowledge-based defense installations. So in summary, we're a specialized rig. We're not correlated with the broader economy. Our assets to have strategic features and locations. There is little or no risk from work from home and there's strong demand for new development and vacancy. There's 4 points we like investors to leave with today is, one, our leasing activity is very strong. We will beat our 400,000 square feet of vacancy leasing that we projected for the year. Two, we've achieved self-funding of our development pipeline at a rate of approximately $250 million a year of incremental investment. Three, we will meet or beat our FFO growth target of 4% compounded between 2023 and 2026, irrespective of what interest rates do; and fourth, defense spending outlook is incredibly strong. It's compounded at 4.6% over the last 9 years. It's compounded at 6% over the last 3 years. And yet, today, as a percentage of GDP represents only 2.9% versus the country's long-term average of 4% to 4.5% in the post Vietnam era. And by the way, it's up $100 billion over the last 2 years. And with that, I'll turn it back to you.

Well, Steve, you've highlighted how the asset base has transformed, but not only that, a year ago, you did undergo a brand refresh. So I was wondering if you could talk a little bit about that. How has this been received by your customers and investors?

Sure. Well, first, let me give you the background. We have been Corporate Office Properties Trust. Our tenants know us as COPT. And so we recognize we have immense brand value in the acronym COPT. So we wanted to keep that so our tenants know we were. But as we've morphed the company, we're really a defense property company. So we have COPT defense properties. The reception has been incredible, both well, in 3 ways. Our employees love it, our investors greatly appreciate the clarity in the name, and the analysts have been very complementary as well. So it's been really well received.

And just given we had the debate last night in...

And Camille, promised higher defense spending. I wrote it down.

So you think she's the winner?

No. But it's the first time I heard her say.

Well, that was my question. What are the key policies that are on your radar.

Well, our world is really -- it's the defense spending pace and commitment by whatever leadership would enter that white house. We've handicapped our opportunity set of -- from good to great and good being we'll continue the measured pace of increases 3.5% to 4.5% on average each year or potentially much higher depending on what the outcome of the election was.

And just on that side around the contract awards, do you see any pickup heading into or slowdown with deals being done?

No. Really, our deal pace tends to be timed with the expiration of the spending authority under an appropriation. So for instance, we came back from Labor Day, and we've got awarded 2 government leases because they have to get that money committed by the end of the month, and there could be potentially some other activity that follows it. Heading into election, the next defense appropriation probably won't occur until next year, but that's just a timing issue, not an ultimate outcome issue

So is that being pushed out from one in normally...

Well, it's legally supposed to be done by September 30. In my 13 years with the company, it's happened onetime. Generally, it's completed after continuing resolution . In the last election, they kicked the -- they continue -- they passed a continuing resolution to get it to December and then another one to get it, it ultimately has got appropriated in May. But they'll push it beyond the election, the clear of the deck. And then with the new President coming in, I would expect whichever wins, we'll want to weigh in on that budget. So I would expect it somewhere in the March time frame.

And so for the benefit of those who haven't followed the company through prior election cycles, during that time, did you see a difference in your ability to signed leases?

Not at all. The bulk of our activities is defense contractor, their cycle is that directly related to a particular appropriation when new programs are funded by an appropriation, we don't see the demand through the contractor side, usually for 12 to 18 months until after those awards because they are formulated into specific performance contracts. Those are competed. Winners are typically selected, often contested, adjudicated and then ultimately finalized. So that lag tends to even out the pace of leasing. And government leasing tends to be in the June through September time frame as they reach the end of their fiscal year.

Got it. I mean can you touch on the demand and leasing pipeline you're seeing into September?

Yes. So we're real pleased to share it in today's conference meetings that since our earnings call, our leasing activity pipeline strengthened by 15%. Overall, we have prospects for 110% of the vacancy we have. Within our Defense/IT segment, it's 112%. But that's a 15% increase in just, call it, 5 or 6 weeks. Moreover, in the last week, I mentioned 2 government awards where we've also been advised of a couple of other lease wins. So year-to-date, we're at 330,000 square feet of vacancy leasing against the goal of 400, and we have about 145,000 square feet in what we call advanced negotiations where we're trading paper and would expect to close it. So we're looking at a likely outcome closer to 500,000 square feet for the year, if not more, which would be 25% outperformance.

Well, and then on the development side, are you seeing a similar pickup that encompass...

One of those leases I mentioned, were awarded from the U.S. government. It's 40,000 square feet for RG8100, which leaves us about 30,000 square feet of vacancy. We have some good prospects. We've been advising the Street since May that will be really fourth quarter oriented towards our development leasing achievements and we're right on track.

And then on potential defense agency relocations, we've -- it seems to have come and go. I was just wondering if there is any that are being discussed in your markets or that you have an eye on?

Well, there's much anticipation on the final home of Space Command. The Space Command location was initially established by the Air Force, while President Trump was still President, and he approved that command being located at the Redstone Arsenal. We went through a very formal process. Subsequent to the election, that decision was contested by individuals in Senate. It was readjudicated and redetermined to go to Redstone Arsenal. It was again contested. It was again adjudicated and for a third time, selected Redstone Arsenal. President Biden a little over a year ago, signed an executive order overturning the 3 levels of assessment of the best place and kept it in Colorado Springs. This election, if Donald Trump were to win, I would expect that executive order to be overturned. And the ultimate decision of the Air Force to be respected and it would be put back in Redstone Arsenal. That would be a net positive for us, we believe.

Your same-store this year, is it all-time high or

Pretty close.

Is there a giveback next year that expense -- that will solve this expense or does that take, what a happens?

Well, so the expense component, tell me what the weather is going to be, and I'll answer that question. There's a little over $1 million in savings from expenses. Some of it is from free rent burning off and developments that were placed in service that are now on same store. There's a timing component on a tax contestation that we won that will have an ongoing effect, but smaller because the true-up occurred this year. And some of it is just gets solid growth. A big component has been less free rent in our renewal negotiations, which I would expect to continue given our markets.

But you do anticipate generally higher growth with that usual growth historicall.

A little stronger than normal, yes. Great question.

And is there anything on the OpEx side that you can drive further efficiencies?

I wouldn't count on that. The seasonal expenses are our biggest swing being in the Mid Atlantic, we can get pounded with many small snow events, and those are very expensive because of the nature of our portfolio. We have mild winters and generate favorable variances. So much of our -- about half of our portfolio is net leased, so it doesn't flow through.

And so to sustain this level of same-store NOI growth, do you need to keep up that development program? Or are there other ways?

Well, some will come from increased occupancy as we continue to drive our leasing as we have this year to higher levels. And then our run rate is probably 3.5% to 4% -- 3% to 3.5%. And then as we deliver new developments and they become same-store, there's usually an uplift from there.

And can we go back to retention? I think you had...

We love retention.

You have put an update around the leasing costs and benefits you have from your high retention. Could you just walk us through that?

Sure. Well, first of all, the reason we like to emphasize that our markets are very stable over a long period of time because we're associated with defense installations. So they tend to have better growth in our leases and our markets don't dip nor sore. They're very steady. So from time to time, investors will say, "How come your mark-to-markets are relatively flat on retention?" That's because those leases have been growing at a compound rate and we'll continue when we renew them. We like to counter the argument and demonstrate that the AFFO efficiency of retention is far more powerful than mark-to-market and a portfolio that has industry average of 40% retention. So for instance, this year, we've elevated our guidance from 80% to 85% of retention. And it just has a massive impact on cash flow because your tenant improvements are significantly lower. You don't suffer downtime, you don't have to issue incentive levels of free rent, and it's just far more efficient cash-generating structure.

A question from the audience.

The Navy support being below, is there something specific there?

No, we had one defense contractor at Maritime Plaza, near the end of the year it give us back a reasonably big chunk of space. We just leased a big chunk of that space to the U.S. Navy to bring some SCIF facilities to the building. And we actually have some emerging opportunities that are going to be pretty good for this quarter or early next quarter. So just call it a seasonal dip. I believe it will come back.

Okay. And then just the 10% other, which should be non defense [indiscernible]

So we really don't see an opportunity to sell that in the current environment. There's very little debt for office investment to the extent of a borrower could get a debt commitment. It's going to be a pretty high interest rate. The investor is going to look for a spread from their interest costs to their cap rate, that means low proceeds. We have no need for the capital. We are in a great position to continue to add value by leasing up with vacancy we have and wait for the right market.

Is there any dynamic change in [indiscernible]?

So we stabilized 2,100, which were thrill growth. We're 92% leased. We've got a very long weighted average lease term, so we can be patient and wait for great value on that. And we're happy to report we've got more demand in our Downtown Baltimore assets that we have in over a year. We just got awarded one smaller lease, 20,000 square feet, competing for a couple of other larger ones that could be meaningful. So we're pretty focused on putting some hay in the barn in there.

Okay. What changed out there that kind of spur this demand.

It really is, it's the state of Maryland. State of Maryland has had an owned campus on the fringe of Downtown Baltimore that's just absolutely dilapidated. The prior governor, Larry Hogan made a decision not to rebuild and to take that -- those uses, break them up and put them into the commercial inventory. So that's absorbing quite a bit of space and creating an opportunity for the few landlords that are wealth capital -- capitalize like we are to fund tenant improvements and lease up to some buildings.

Can you talk about Franklin Center, the recent acquisition you did?

Yes. Love to talk about Franklin Center. So for those of you that aren't familiar, we're able to buy 200,000 square foot Class A building, LEED-Gold certified completed in 2008, 55% leased ongoing in cash yield of 11.2%. We spent $70 a square foot for an asset as replacement costs would be closer to [ $400 ]. The opportunity really arises from an out-of-state landlord trying to compete in our backyard with our defense franchise. And although we don't own 100% of Columbia Gateway, we own about a little over half. We capture over 80% of the defense contractor work because our relationships, our expertise and just our overall franchise dominates and so that the owner of real estate had other uses for capital, and they are leaving the market. We're able to pick up that asset and overlay our franchise. And so whereas it's been 45% vacant for over 5 years, we have demand at almost 2.5x the amount of vacancy we bought. So we have 90,000 square feet to lease. We've got about 240,000 square feet of prospects. We anticipate as we get into the fourth quarter, we have some real positive news. And ultimately, this is going to be a great asset for us and a nice return for our investors.

Just connections that you have contact in the industry. Did you just market it better. How do you go from 45% vacent to more demand?

It's our franchise. So defense tenants know that we can accommodate their needs, we can operate the building appropriately, we can support them in constructing their SCIF. We like to point out that one of the contractors awarded the opportunity to build SCIF. There are 25 critical steps that they have to do, we can do 20 of them. So we bring a value proposition that landlords that aren't deeply experienced as we are, we bring a service level that they can't compete with. And then lastly, there's a 30-year relationship with Trust. We've -- our typical tenant is in 3 different markets, at least 4 leases, our lease concentrations that's tough for somebody who is not in this business, especially that landlord was really more triple-net relying on third-party services to compete with. But when Paul signs the leases, then we'll be a little worse -- or Britt -- sorry. Paul.

Are there more opportunities like that or is that...

There are a couple of things that we're looking at that I don't talk about.

Okay. But there's not..

But we have an earnings call come up, so you might want to listen.

But you don't see more landlords that are not necessarily local or [indiscernible] Colombian Gateway [indiscernible] ownership structure...

It's pretty heavily concentrated with one private owner that we have a great relationship with. We work in harmony and community and development issues, but we tend to win the defense deals and he doesn't, but...

So it's not like there's a bunch of like out of state people that are...

Not in that market, but there are some other opportunities. We have our eyes on, that are similar and we have an earnings call in the end of October.

Do you guys compete with the national landing market and did you spend that in term of that SCIF space and...

They have been, not like what we have in our portfolio. Their space tends to be more headquarters of defense contractors and the forward-facing marketing groups that deal with the Pentagon. Historically, Crystal City, they call National Landing now that's where those concentrations were. Before the last break, there were some very heavy demand drivers there. Army Material Command, which procures everything. U.S. soldier in the army uses or relays upon used to be there. It has got break to the Redstone Arsenal. Similarly, Defense Information Systems Administration, this is the networks of the DoD used to be in the landing, it got back to [ 4B ]. So we've noticed a couple of publicly traded companies using our language to talk about their defense tenants. But the difference is our leases are mission work, and they're not overhead. And we've been very disciplined for going on 9 years that we only want the mission work. Don't want accounting departments. Don't want marketing. We want the heavy SCIFed environment.

And Steve, with the investment opportunities on the horizon, your development program, I was just wondering where you see the portfolio in 5 years' time, will you have a larger data center exposure more weighted in certain geographies?

It's tough to give you the outcome. I project continued opportunity to develop at the pace we have, $250 million, call it, plus or minus a year. Certainly, there's going to be increased growth in Redstone Arsenal. The National Business Park, we expect our data center shell portfolio to continue to grow. I remind investors that we have now achieved self-funding on our development. So we no longer have to look to that portfolio as a recycled candidate with joint ventures to fund development. So I think its share will increase the exact percentages, I wouldn't want to guess and be wrong about it.

But if you think about the capital markets and access to financing, you're picking up a bit or improving, how do you -- I guess, at what point would you consider using or raising capital to start funding your development?

It's certainly those 5 assets that we don't want to own any more are marketable. But we're not going to recycle capital and our very strong defense IT franchise because that's the strength of the company. It's delivering exceptional performance, it has delivered great performance through the COVID crisis, through the interest rate checks, and through the highest inflationary period we've had since the end of the '70s, early '80s. That strength of our REIT, and we're going to keep it.

Okay. So there's no kind of spread that you're thinking of like development rent versus whatever cost of capital?

Well, to the extent our opportunities exceed our ability to fund from cash flow if we weren't able to recycle capital with the 5 assets, I've referred to. We hypothetically could joint venture some of our data center shells. But our base plan is to fund internally. And in the future, recycle some of those 5 assets.

Okay. Is there anything that's come up over your discussions today that we haven't covered?

No. We just talked a lot about our leasing pickup of 15%. And the fact that we're going to handily beat our annual goal of 400,000 square feet. Other than that, it's very positive meetings today.

Great to hear. Well, we just have 3 rapid fire questions for you before we wrap up. So just to begin, with the Fed expected to cut, if you agree with that. When do you expect transactions will pick up in...

Capital?

Investment transaction?

Yes. In our, call it, regional office markets. I still think you're 15 months out, if not 18.

All right. You'll have to do the math there, Andrew. And then how would you characterize the demand for space today, improving, steady or weakening?

Improving.

And around AI spend next year?

Holy Cow. $800 million or more.

We're just more interested to know if you're planning to increase...

In our world, no, we're not investing in AI per se. We'd like to develop for AI, but I don't think we're planning on AI as an investment for our business. No.

Do you benefit from the AI growth and...

Ultimately, I have confidence we will. Right now, it's a developing technology. Someday, it will become a reliable technology. And there's no doubt in my mind that technology will be applied to defense and intelligence challenges. When and where, I'm not going to hazard a guess. Incrementally, I think our data center shell development will -- our opportunities set could be influenced by opportunities driven by AI.

It's still very early.

Yeah.

Okay. Well, thank you, everyone.

Thank you.