COPT Defense Properties (CDP) Earnings Call Transcript & Summary

Welcome to the 2:55 p.m. session at Citi's 2025 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 and disclosures have been made available at the corporate access desk. To ask a question, you can either raise your hand or go to liveqa.com and enter code GPC25 to submit questions. Steve, I'll turn it over to you to introduce COPT and the team, provide any opening remarks, tell the audience the top reasons an investors should buy your stock today, and then we'll get into Q&A.

So I'll give you a little background on our company. Thank you, Michael. COPT Defense Properties is a specialized REIT. We're deeply concentrated in mission-critical assets to support the national defense activity in the United States government. The vast majority of our 203 properties are located adjacent to and in some cases, occupied 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, missile attack and defense systems, army aviation and enhancements to them, drone aviation technology, weapons lethality, law enforcement and terrorism explosive technology and cloud computing. Our property locations are not typical for an office company. They are proximate to United States defense installations, and those installations are located in Maryland, Virginia, Alabama and Texas. Our properties are improved for top secret mission work. 80% of our portfolio contains high security operations. It includes 8 U.S. government secured campuses, totaling 4 million square feet that are antiterrorism force protected and are completed with SCIF or secured compartmentalized information facilities and our access control. We have another 1.4 million square feet of U.S. government leases that are high security. They contain SCIF and they're access control, but they're not on a campus. We have 6 million square feet of defense contractor leases that also contain SCIF, and we have 15 cloud computing campuses totaling 6 million square feet that are fenced with limited access. And additionally, this is important distinction about our company. These defense tenants must work in their office due to the high security requirements of their missions. Today, over 90% of our annualized rental revenue or ARR is derived from Defense/IT tenants. Our pre-leased developments will increase those figures in the coming years. And our Defense/IT segment was 96.8% leased at year-end. That's the highest rate since we started reporting the segment in 2015. If you look at our 3 largest concentration of defense assets, they are the National Business Park in Maryland, the Redstone Gateway in Huntsville and a campus adjacent to Lackland Air Force Base in San Antonio. These 3 locations standing alone are 97% occupied, 98% leased, and they account for 45% of our ARR. Adding our fully leased data center shell portfolio, these 4 subsegments total nearly 14 million square feet. They're 98% occupied, 99% leased in aggregate, and they account for over half of our ARR. The U.S. government is our largest tenant by revenue. We have 99 separate leases in 70 different properties, totaling 5.6 million square feet and producing 36% of our ARR. Our defense contractor tenants leased 15 million square feet from us. This includes 3 million square feet of cyber defense contractors. Defense contractors contribute 51% of our annualized rental revenue and 15 of our top 20 tenants are defense contractors. Our nondefense locations provide just under 10% of ARR today. This consists of just 5 office assets that we call regional office, and they're located on the Baltimore Waterfront in Tysons Corner and in the CBD of Washington, D.C. Our tenants in these assets have excellent credit profiles as well. And over time, we plan to recycle these assets as markets for reasonable sale values. Our strategy is very simple, and it's been steadfast for the 9 years I've been CEO. We allocate capital only to durable demand locations adjacent to priority defense installations and missions. The playbook is simple. Primarily, we execute low-risk, highly pre-leased development. On occasion, we'll do a redevelopment or a repositioning of an asset, but the key theme is low risk and highly pre-leased. We also maintain a strong investment-grade balance sheet. As I said, development is primary external growth activity. At this time, we can self-fund the equity component of our development activity using cash flow from operations after we pay our dividend. The debt component is funded off our line of credit initially and then replaced with unsecured long-term bonds as we reach levels that can be floated. We have been an active developer of specialized properties for our tenants for over 26 years. Over the past 10 years, we've delivered $2.5 billion of successful developments, averaging over $250 million per year in investment. We're currently developing 4 projects with total cost of $250 million. They are 75% pre-leased and they represent 600,000 square feet. When completed, these projects, along with those completed in 2024, will add another $29 million of future contractual cash NOI on an annual basis. When combined with our strong operating portfolio, this will drive roughly 4% compound FFO growth between 2023 and 2026. Our competitive advantage is our franchise, and it's comprised of 4 pillars. One is our operating platform. Fully 1/3 of our employees contain credentials to operate and develop the most secure buildings our nations require. The second is our development expertise. We have been developing buildings for the U.S. government for over 30 years. And that includes creating SCIF, secured compartmentalized information facilities, antiterrorism force protected assets, data centers and other mission-critical facilities. We have a 30-year track record building and most importantly, operating for the government, the highest security facilities for them and their defense contractors. And lastly, we have advantaged land positions. Our 4 founders of the company thought ahead and accumulated land in priority locations next to the most important defense missions. So in summary, we're a specialized REIT, and we're not correlated with the broader economy. Our assets have strategic features and locations. There's little or actually no risk from work from home. There is strong demand for new developments and vacancy. We have 3 main points, which I'd like to leave investors with relating to our outlook. We delivered 4.8% FFO per share growth compounded over the past 5 years. In 2025, we expect 3.5% FFO growth per share at the midpoint of our guidance. And we continue to project roughly 4% compound growth between '23 and '26, even after absorbing the impact of a refinancing of a low coupon bond in 2026. We've achieved self-funding for the equity component of our development investments on a leverage-neutral basis. And finally, we increased the dividend by 10.9% over the past 3 years. We're the only office REIT to raise the dividend in both 2023 and 2024, and we raised the dividend again in 2025, which really reflects the confidence we have in our growing FFO and AFFO. And with that, I'll open it up to you, Mike.

Thank you for that overview, Steve. Maybe just starting with the fundamentals in the portfolio. Retention remains very solid. Leasing has been strong, both in 2024 and year-to-date. You announced big lease at the recent acquisition property in Franklin Center. I know there's been some probably misconstrued worries about government efficiency initiatives and how that could impact your portfolio. So maybe you can talk about the strength of the leasing pipeline and why these DOGE things might be a misconception as it relates to COPT's portfolio?

Yes. So overview, we view the DOGE is more of a emotional overhang than a practical threat or a risk to our business. Most importantly, we've got to look at the overarching objectives of this President and his Secretary of Defense. One is peace through strength. And peace through strength contemplates deterrents, and deterrence at a level we currently do not have. And so the expectation is we need more capability, capacity and lethality in the missions that our DoD deploys. Our Secretary of Defense has openly said his priority is lethality. And when it comes to cost cutting, he wants to look at administrative, bureaucratic waste, fraud or abuse and move that money to support mission growth. So that's the overview. What are we seeing? So last year, we guided to 400,000 square feet of vacancy leasing because our portfolio is so well leased. We actually did 500,000 square feet. We exceeded our objective by 25%. And our demand right now is stronger than it was a year ago. So year-to-date with what we've signed and are in our highest probability category of signing, we have a total of about 250,000 square feet of leases that we expect to sign very shortly. And this is on March 3 or 4. We've identified more than half of the leasing we expect to do. We measure an activity pipeline weekly, which is what is some total of our prospect opportunities compared to the vacancy we have, and it's higher by about 7 percentage points today than it was last year, and it sits at 87%. Moreover, we've had some pretty interesting conversations with defense contractors, specialty functions of the U.S. government and various branches of the armed services inquiring about our ability to meet their needs to expand quickly in this environment. There will be some significant shifts in monies or increases. We expect cyber defense spending to be increased dramatically, but also Space Force, Space Command, we expect to be relocated to Redstone Arsenal. And we see opportunities in the Navy and U.S. Cyber Command. So it's a pretty exciting time from our viewpoint, which is a little surprising in some of our meetings because people are expecting us to be affected by DOGE. It's really not an impact.

And maybe to that end, just sticking on the political side of things. Is there a worry if a budget can't get reached in a week or so and the government shuts down or there are changes to kind of weapon shipments for foreign conflicts going on, could that have a knock-on effect for your business and your tenants' demand for space?

So let me take one at a time. Shutdowns are always headline, but they're not material to our business. The federal contract laws require that our rent get paid even if the government shuts down. Employees typically nonessential employees are furloughed, but they're always paid when they come back irrespectively because of the missions we serve, our buildings are never affected because they are essential components of the DoD, you can't send those people home. In the last shutdown, the only material impact we saw were the lines of Redstone Arsenal got longer because they had fewer guards to clear the people coming through. So shutdowns are really not an issue. What was the second half?

Just around we obviously heard the news that the Trump administration is planning on halting weapon shipments to Ukraine and...

Great. So divisions we serve are high priority and their knowledge base, intelligence, surveillance, reconnaissance, research and development test and evaluation, ground missile defense. We don't really support arms manufacturing, arms sales directly to other components. We are knowledge based. So no, it's not a concern. We didn't benefit from Ukraine, and we certainly won't get hurt if Ukraine stops. Similarly, during the Gulf War, all that extra money to fight -- to do the war fighting was called overseas contingency operations. We didn't benefit from that component of the budget and it didn't impact us when it ceased.

So as it stands, I think the U.S. currently spends about 4% of GDP on defense versus at the height of the cold war, it was closer to 8%. So as you kind of mentioned about the geopolitical conflicts that are going on in today's world, would you expect that defense spending to continue to increase? And should COPT's businesses and tenants ultimately benefit from that?

So my expectation is the probability of an increase this year followed by modest increases exceeds that of a cut. I can say there are members of the House and Senate Armed Services Committees with very strong opinions that we are underspending to the point you made and that we should be investing 5% of GDP into the defense budget.

Maybe just going back to the leasing pipeline and demand you're seeing there. Obviously, a number of your main markets, NBP, Redstone, et cetera, et cetera, very highly leased. For at least your private sector tenants, I realize the renewals and leasing for government tenants is a little bit different. But have you noticed an ability to either push on rents or flex concessions just given kind of the favorable supply backdrop and the highly occupied nature of your portfolio?

So we did last year in a pretty meaningful way, not so much on fixed rates. We have a lease structure that has embedded growth every year. And at the maturity of those leases often, we've increased our rents to the structure to a level that's pretty close to parity with where a market lease should be. If you measure our rents in our portfolio versus the market rent in the areas they're at, we're typically at a 15% premium. And so it's tough to -- and we have a policy of not sticking it to our tenants. They've invested heavily in our office buildings, and we don't want to abuse that trust that they've given us. But where that manifests itself is in lower concessions and higher effective rents. And a big part of our outperformance in same office NOI last year was from reductions in concessions, specifically free rent.

Have you noticed that tenants are willing to commit to longer leases? Obviously, I think in the vacancy leasing, the term is typically longer than renewals. But just given the space constraints, do they want to lock in their space needs for longer? Or are wallets still around the same as they have been?

The structure is pretty consistent over the many years I've been doing it. New leases will get typically a 10-year, sometimes longer with defense contractors. Renewals tend to approximate 5-year leases. There's really been no change in that dynamic.

You highlight a number of large government leases, I think, over 50,000 square feet in your investor deck that you're expecting, I think, 98% retention on. Why is this the case? Does the government come to you early and say, we need this space requirement, so you're able to kind of get it out of the potential expiration pool. Why is there such demand for that space?

Well, first of all, let me just make a fine point about the statistic. Our leases over 50,000 square feet for the next 2 years, we expect to renew above 95%. In that is a significant component of U.S. government leases, and we're contemplating 100% retention on the government leases. The reason we project that is often we are operating the buildings we're embedded in the operation. We understand the mission criticality of that function. And we also have real knowledge of how much money the U.S. government has invested to create the systems that they rely on those buildings, which often or typically exceeds our investment in the entire building. In our 32-year history of leasing to the DoD components of the U.S. government, we have never gotten a full building not renewed.

Appreciate that, Steve. Maybe we'll switch over to external growth opportunities. You did a number of deals last year. You acquired a property in Franklin Center and Columbia Gateway, one in San Antonio, announced a number of development potential with the data center land bank in Iowa. Starting with the acquisitions first and maybe Franklin Center, you recently announced that 50,000 or so square foot lease on that vacant space. How did that building come to be in COPT's portfolio? It really makes sense for you. It's right in your backyard. Why was that such an attractive investment opportunity?

Well, so summary, it was acquired by a triple net lease company years ago, and it was fully leased. The full building tenant downsized by roughly half. They, the prior owner, had to compete with our franchise in our backyard for defense tenants, and they were unable to defeat us. And so for 7 years, they were trying to lease it, but they are unsuccessful. They got to the point where they needed to exit. We had liquidity. We got a phenomenal price on the asset. When you add that asset to our franchise and our relationships, we immediately were able to generate a strong pipeline of activity. We just signed 48,000 square foot lease with a top 5 defense contractor who's going to invest significantly in the building. It will be 90% SCIF improved, and it's related to U.S. cyber activity of the Navy.

How hard is it to build or develop SCIF space? Obviously, it's very niche to CDP, but is this something your average merchant developer can go out and do? Or the specificities just give you that competitive moat and advantage?

Well, first of all, there's knowledge and understanding of how to build the SCIF. The second component is you have to have the right credentials to build the SCIF. And so one of our advantages is 1/3 of our employees carry the highest security clearance the government affords a contractor. And we've literally developed millions of square feet of SCIF, and we believe we're the largest private owner of SCIF in the country. So it's very hard. Contractors can provide those services, but they come at a cost and your average landlord has no understanding of how to execute that. So some of our really advanced defense contractors will bring that process in-house and do it themselves. But others rely on us, and we can guide them through the steps to get a SCIF constructed then properly accredited and commissioned, and that has always been a core strength of the company.

And I think earlier this year, you announced 2 new development starts. Obviously, the development pipeline very highly pre-leased. I think one at NBP and one down in Redstone in Alabama. But maybe just talk to the demand that you're seeing on the development leasing side, when we could see these things stabilize and fully leased up just given what seems like there's a lot of demand for this product.

So we just started a building at Redstone Gateway. It will be 150,000 square feet. We're doing that because what little remaining space we have in our active development or recently completed portfolio is not near enough to meet the kind of demand we're seeing in the market. So we need to stay ahead. We call that building an inventory building. We're building it to meet demand that we see because we have no inventory. There are decisions that we expect to be made. And one of those is that would relocate Space Command from its current temporary site to the Redstone Arsenal. When that gets announced or if or when, but we're pretty confident it will. We expect a pretty strong demand from contractors hoping to do business with the command to want to move to Huntsville and co-locate. We do not want to be caught short. At the National Business Park, when we started NBP 400, which is about 140,000 square feet, we had 4.3 million square feet that was 99.4% leased, and our biggest vacant space was 7,000 feet. Our demand is so strong that any contractor expansion would -- we would not be able to accommodate. So we started that inventory building. We have very strong demand anticipated primarily U.S. government. We don't expect those lease actions to emerge until probably July or later. Some recent discussions we have suggest that could be advanced. But I have every confidence -- I'm actually starting to get concerned that we don't have enough under construction relative to the demand that I suspect is going to come.

We had a question come here from live QA. What makes Huntsville such a dynamic market? And why does it fit well into your portfolio?

So Huntsville is maybe one of the best kept secrets in America. It's called Rocket City. That's where NASA, Wernher von Braun and his team of German scientists started the Army Space program, which became NASA. And it continues to have a major presence of NASA on that arsenal. Co-located with it are a bunch of deeply technical missions. It's the most diversely funded U.S. Military installation in the country, including missiles and space activity, space intelligence activity, all things Army aviation are managed out of that facility. The Army Materiel Command, which procures every item the soldier would ever need in the U.S. Army from food to the most high-tech weapons is located on the base. There's advanced research, development, test and evaluation capabilities on that facility. It's home to the FBI National Counterterrorism Center, where any explosive use in the terrorist device that the U.S. can get their hands on and sent there to be reengineered and reverse engineered and fingerprinted back to try to identify who created the bottom and find the bad guys. So it's a very advanced center of excellence for a variety of high-tech defense installations. That's why it fits in our portfolio. We have enhanced use lease on the base. Part of it is behind the secure fence. Part of it has got public access. We have 2.5 million square feet that's highly leased, 96%, 97% with 100% either U.S. government or defense contractors.

Turning next to the data center shell business. Obviously, this has been a growth engine of the development pipeline for some time. You have a big presence in Northern Virginia, but recently announced an expansion opportunity into Iowa. I guess another kind of off the beaten path market. Why is Iowa a good place to develop data centers?

So Iowa, Des Moines, Iowa, in particular, sounds offbeat in the context of most conversations about the country's locations, but it's actually the fifth biggest hyperscale market in the country. So we identified Iowa as a place with very affordable land very supportive local and state government of data center development, great access to power. And we presented our concept to our development client, and they are pretty excited about pursuing this development. So we purchased enough land to support 3.3 million square feet of new development, which will approximate somewhere between $1.1 billion and $1.2 billion of investment, 15 separate data center shell assets that will each be pre-leased and give us about a 7-year runway to expand that program.

And how might that land acquisition that you talked about compare to a similar comparable trade if you were to try to buy land like that in Northern Virginia?

So we spent $32 million on 366 acres. If we were to buy land at that scale in Northern Virginia, it would have cost us $1.2 billion.

Are there any worries about kind of AI or the DeepSeek model potentially impacting demand for those data center shells?

So the customer that we build for chooses to be anonymous. They are a major factor in cloud computing. And since we started a relationship with them in 2012, we have developed assets to support their continuous growth over the past 14 years. This campus will be a cloud computing campus, part of a very profitable existing business. So we're not really concerned about AI. So soon.

We still got 5 minutes.

Correct. 5 minutes.

Next one. Just touching on the regional office portfolio a bit. I mean it feels like, obviously, it's a noncore part of the story, but sentiment does seem to be improving in the traditional office sector. I know your portfolio is mainly concentrated in Baltimore, and I believe you have one property in Downtown D.C. But have you started seeing any buyer pool or interest in those properties? Obviously, you don't have to be a forced seller, but is there going to be a time in the future when it does make sense to sell those?

So even as we speak, there's more interest in investment in trophy assets in Downtown D.C. where we have a real gem. And that's true, the cap rate is going to approximate or generate the value we've created currently, but it's improved, and we've had some inbound inquiries in D.C. In Tysons Corner, we're working through some value creation options and leasing that asset up further. I don't see a market for that currently, but I don't think it's far away. Downtown Baltimore is going to require bank or CMBS lending for office investment. And I just don't think the capital is there to support an efficient sale. So we're going to be very patient. We're going to wait these out. We've predetermined we will sell them all the last vestiges of a more diverse company. But we're going to do it when we can extract solid shareholder value.

We had another question come in on a recent transaction. For the San Antonio property that you acquired, can you expand on that a little bit? Why did it make sense to be part of CDP's portfolio?

So the -- first of all, we -- the tenant for the building is our customer. We had awareness of their need for a satellite facility. We worked over the marketplace, identified some alternatives, presenting them with some solutions. We got some favorable feedback about that property. We executed a purchase and sale agreement. We closed on the building, and we're able to lease it in 3 business days, 100%.

Are there any markets you're not currently in that you could be looking to potentially expand? Obviously, the military has a big presence across the country. So are there any things you're kind of keeping an eye on that we could see you expand in, in subsequent years?

There are several that we keep an eye on. I'm not going to share what they are. Somebody front run me do them. But I don't really expect that to happen in the near term.

Well, if there's no other questions from everyone, I've got my rapid fires to end the session. What is your expectation for net effective rent growth for the office sector overall, so not CDP specifically in 2026?

'26. So I would suggest '25 is likely to be negative. '26 could be 3% to -- 3%.

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

Same.

Great. Thank you so much.

Thanks.