COPT Defense Properties (CDP) Earnings Call Transcript & Summary

[Audio Gap] and COPT, Steve. This session is for Citi clients only and disclosures have been made available to corporate access desk. [Operator Instructions] Steve, we'll turn it over to you to introduce your company and team, provide any opening remarks and tell the audience the top reasons and investors should buy your stock today, and then we can jump into Q&A. Yes. And just tap the mic to turn it on. Tap the mic to turn it on, the green -- yes. Here you go.

Yes, we are good. To my left is Anthony Mifsud. He's our Chief Financial Officer. To my right, Brett Snyder, our Chief Operating Officer; and I'm Stephen Budorick, CEO. So thank you, Seth. COPT Defense Properties is a specialized REIT, deeply concentrated in mission critical assets to support national defense activity of the United States government. The vast majority of our 207 properties are located adjacent to or in some cases, occupied by priority defense missions generally involving knowledge-based defense activities. The missions we support are intelligence, surveillance and reconnaissance, cybersecurity and network activities. They will see an air technology development, missile tech and defense systems, general aviation technology development, cloud computing and others. Our property locations are not typical for an office company. They're approximate to the United States defense installations that have permanence in Maryland, Virginia, Alabama and Texas. Our properties are approved for top secret mission work. 80% of our Defense/IT portfolio contains high security operations. That includes 9 U.S. government secured campuses, representing over 4 million square feet. Those campuses are antiterrorism force protection constructed and include SCIF, which is secured compartmentalized information facility improvements. We have another 1 million square feet of U.S. government high-security leases outside of campuses that are CCIF and access control. We have 6 million square feet with defense contractor leases that contain CCIF. And we own 15 cloud computing campuses with over 6 million square feet that are fenced and have limited access. Additionally, an important distinction as these defense tenants must work in their offices due to the security requirements. They're executing classified missions, which must be performed in a secure space. If you take your work home, you go to jail. It's called espionage. Today, over 90% of our annualized rental revenue, or ARR, is derived from our Defense/IT properties. Our pre-leased developments will increase that figure in the coming years. Our Defense/IT segment was 96.5% leased at year-end, which is well above peer averages. The U.S. government is our largest tenant by revenue. We have 99 separate leases at 70 different properties, totaling 5.7 million square feet and producing 35% of our ARR. Our defense contractor tenants lease over 15 million square feet, which includes 3 million square feet of cyber defense contractor tenants. Defense contractors contributed 52% of our annualized rental revenue and 16 of our top 20 tenants are defense contractors. Nondefense locations provide just 10% of our ARR. And this consists of 5 regional office assets located in the Baltimore Waterfront, Tysons Corner and Washington, D.C. in the CBD area. Our tenants in these assets have excellent credit pass-throughs as well, and we plan to recycle these assets as markets support a reasonable sale value. Our strategy is very straightforward. We allocate capital to durable demand locations that are adjacent to priority defense installation emissions. Our playbook is also straightforward. We execute low-risk, highly pre-leased development, redevelopment and in some cases, repositioning. We maintain a strong investment-grade balance sheet. Our competitive advantage really falls into 4 pillars. One is our operating platform. We have a unique platform where we're deeply experienced and we have credentials, over 35% of our company is credentialed to work in and create high security environments. We have deep development expertise, including secured compartmentalized information facilities, antiterrorism force protection, data center and mission-critical facilities. We have a 30-plus year track record of providing space and then operating that space for the U.S. government in some of the most highly secure missions of our country. And we have advantaged land positions proximate to these mission-critical knowledge-based defense installations. So in summary, we're a specialized REITs, not really correlated with the broader economy. Our assets have strategic features and locations. There's little risk of work from home, and there's strong demand for new development and vacancy leasing. So with that, I'll turn it back to you.

Great. Maybe just starting with some of the leasing activity. The defense budget exceeds $950 billion. Historically, there's been a 12- to kind of 18-month lag between the appropriations and leasing activity. Just some of the kind of administration's urgency behind Golden Dome, shorten not time line? Or is that still kind of the right time line we should be thinking about from that impact?

So in the broader budget, I'd say the time line would hold 12 to 18 months for the time funding that's created until we see the demand for our portfolio. And the reason for that is money tends to be allocated to a program, and the program has to be defined, competed, awarded to a contractor and then they can lease space. Golden Dome, on the other hand, is very different. It's a fast-track program. The notional initial value of the program is $175 billion. And the intent is to have the Golden Dome functional by 2028. To put that in context, $135 billion is like 20% of 1 year's defense contract for 1 program. The $25 billion that was allocated to fiscal year '26 is the fast track down payment and the general who commands the program has been given uniquely strong authority to commit money quickly. And so we have -- even though that program just got funded in July, on July 4, we've already signed 1 lease for about 32,000 square feet with a contractor specifically related to Golden Dome. And our development that is active at the Redstone Arsenal, we have about a 400% demand to supply relationship, and almost all of that has driven over Golden Dome. So it's pretty exciting. It's early, but we think, through this year, there'll be quite a bit of leasing driven off of that, which is much quicker than normal.

And then maybe following up on that. For the 400,000 square feet of prospects at 8,500 Advanced Gateway, how much of that is tied to hard-funded Golden Dome mandates versus contractors just positioning kind of ahead of awards in anticipation of funding?

So right now, and at that about 50-50. Many contractors have received an award, very few have received funding yet, but they've been given what's called an IDIQ, indefinite delivery, indefinite quantity contract vehicle that allows the money to flow through a specific program quickly. Some of them have real work objectives that they are pursuing. And the one lease we signed has work objective, the 2 there were pretty advanced negotiations clearly have a work objective in mind. There are others that are handicapping the market for more of a long-term play, So about 50-50.

Great. And then with Space Command moving to Huntsville, are you seeing any preemptive leasing from contractors or is the market waiting for that kind of formally happen? And can you remind us just kind of the process and not moving to Huntsville?

So the Space Command is a relocation from Colorado Springs to the Redstone Arsenal. The command itself is going through its planning process. We believe we'll be the beneficiary of 1 build-to-suit lease for the command, if not more in the future. The contractor tail is defined by the government is about 2 jobs for every 1 job that will move. But that command or that contractor tail is supporting the active command. So you won't see that relocation occur until the command starts to phase its occupancy into the Redstone Arsenal, which is probably 24 months away, 18 to 24 for the first elements relocate.

And then you kind of have talked about on the development side, just not really starting kind of the next red zone building until the 8500 Advanced Gateway hits around that 60% kind of lease threshold. Just given the urgency of Golden Dome, would you kind of consider accelerating some of that development activity just in anticipation of that demand, or how do you think about that?

Yes. Just to be clear, that's actually committing to putting investment in the ground is what you're referring to. We've already preplanned 3 different sized buildings, and we are permit ready on all 3 of those. So we've taken quite a bit of the development time line and shorten that measurably. And as we see the demand for 8500 start to commit, we don't necessarily need signed leases. But when we see that demand filling that building, we will start the next one. We have 3 alternative kind of structures that we can build depending what demand looks like.

Maybe just kind of turning attention to kind of the expiration schedule for 2026. Can you just kind of update us on the delayed renewals from 2025 that got pushed from the government shutdown and and kind of walk us through how the rest of the year's expirations are shaping up?

Yes. So we've got about 2.8 million square feet that expires this year. The vast majority of that is U.S. government leases. The specific delays that you're referring to is about 1 million square feet located in one of -- in our Texas location that was because of approval processes just flipped into this year. Our large lease projection for a 30-month period as we'll renew 95% of our large leases are better. And this year, on our overall retention, we expect it to be -- we guided to 80%, and we like to be in our guidance.

And then just on some of the expirations, can you remind us how that works? Is there incremental TIs that kind of go into the space upon renewal or most renewals kind of adds as renewals?

So yes, routinely, we do give some TI and renewals. But I think if you do a good comprehensive look at our tenant improvement allowances relative to other companies in our segment, they're a fraction of theirs. So typically about $3 a square foot a year on a renewal would be a healthy renewal tenant improvement.

And then with some of the kind of the geopolitical changes with Venezuela and more recently, Iran, kind of how does that change the way that the way you think about the government's need for space?

So the missions we support, those 2 particular situations or deployment of weapon systems and troops, Certainly, the missions we support, support those and some of them develop those systems. But our business is not one that's going to flex up with the activity in Iran per se. That's more consumption of established weapon systems and deployment of troops a hotspot in the United States. This is more knowledge-based defense activities. Certainly, many of the activities we support are clearly supporting that, but it's not going to be an inflection point for our business. Our business is more long term and methodical.

Maybe switching some capital allocation topics. With your blended kind of development yield at 8.5% and where the hyperscale shelves kind of trade at like a 6% to 7% yield, does that kind of require you to have the office kind of above 9% to kind of maintain that blended yield or -- and that's where you're kind of underwriting hurdles for development spend?

So we're very comfortable with our office. Our defense IT generally at 8.5% or north. Sometimes, we exceed that 8.5% threshold, but that's our target. Certainly, the work we've done in data center shelves, we can be a little more aggressive on the rate because of the deep spread between value and cost. That's been a very profitable development realm for us, we'd welcome more, but the 2 are kind of related.

And then just you've kind of discussed kind of self-funding the equity that you need for development. Just -- does the renewals and potential kind of TIs, does that require you to hit the ATM? Or can you fully fund your anticipated development spend with free cash flow?

Yes. Since really 2023, we've been in a position to fund $275 million to $300 million a year on a leverage-neutral basis because of the free cash flow we generate after our capital use for the portfolio and payment of our dividend. And we don't see that changing. We've projected out through our 5-year forecast. We're solidly able to self-fund.

And then...

And, by the way, raised our dividend this year in the last 3.

Yes. With the pipeline kind of 86% pre-leased and there have been some stabilization with construction costs, would you start to kind of do any development that's more SPAC development? Or are you primarily sticking towards built a suite or kind of waiting until you hit certain kind of leasing thresholds to start new development activity?

So we primarily build-to-suit for our tenants, but in a couple of our locations in particular, we need to have inventory. So we just announced the full building lease for a building that we started at the National Business Park. When we started that building, we were 99.7% leased, and our largest vacant space was 7,000 square feet. To defend our franchise in that development, we need to have inventory to support growth. So we built a 140,000 square foot building, which we just leased. Similarly in Redstone Arsenal, we have 2 vacant suites and 2.5 million square feet, one's 10,000 feet, one's 25,000 feet. They are both actively -- we're negotiating leases for both of those at this time. So we started RG 8500, 150,000 square foot building. So we have inventory available. And so we don't call it spec, we call it inventory development when we're so heavily leased. We just have to have space to work with. And we anticipate shortly proceeding with the next building in Redstone Gateway.

And then with what being able to kind of develop that 8.5% yields with the credit primarily being the U.S. government or kind of contractors that work closely with the U.S. government, how is the competitive landscape for those development projects, especially just kind of given the backdrop of an increasing defense spending budget? Who do you compete against? How do you win kind of those mandates?

So to the extent that we have competition, it's really market to market, and I have to walk you through the portfolio. But generally, when we're developing, we're not really competing. We've got such a deep relationship with the contractors in the U.S. government. And remember, I talked about the 4 legs of our stool. We have advantaged land positions. And so there are companies that could develop in Huntsville, but they can't develop into the ecosystem of contractors we've built on our development, and they can't develop on the front door to the Redstone Arsenal with immediate access and interface with their government customer. And then in some of our locations, we have connectivity that they could not possibly compete with, which is a distinct advantage of having access to priority networks. So we tend to negotiate those build-to-suits with the long-term relationships we have with the contractors and rarely are we head to head with another developer.

And then you mentioned kind of the noncore buildings in DC and Baltimore and elsewhere. Can you just walk through maybe the timing and pricing expectations for those? And what kind of pricing expectations would you have before you're looking to sell those?

Well, I'm never going to talk about pricing. I appreciate your question. But let's just put it this way. Timing will be dependent on the financial markets. So -- and the interest rates that are available to investors to invest in real estate. Currently, for office, private user office borrowing, and they're pretty high interest rates. Anybody who wants to buy those buildings is going to look for a return spread above the cost of their debt. And those are cap rates we're not willing to sell it. 4 of those 5 buildings are very stable. And in particular, the 1 in D.C. is an absolute trophy. We've got 12 years of walk on that Class AA development, and we'll be patient to let the capital markets pick back up.

Is there any sense of -- are those kind of assets being marketed? And is there any kind of sense of increased interest that would suggest that it's more near term? Or is it more of kind of a long-term play at this point?

So we're not actively marketing any of them because we don't see the financial backdrop that we're looking for. And we're constantly working those assets to create value. So we'll just be very patient.

And then you recently kind of raised the dividend 4.9%, which is kind of above, I think, what your guidance implies for FFO growth. How do you kind of view the dividend and capital return? Or are you expecting kind of an acceleration in FFO growth kind of beyond where you're at now?

Well, to be clear, the Board makes decisions on our dividend. But our raises are tied to our projection of taxable income growth. So you can kind of put 2 and 2 together from there.

One of the questions we've kind of been asking all the companies is on AI. Obviously, your product is very specialized. But just for -- how do you use AI at the company? What AI tools do you use, is the first part of the question? And then how do you determine whether or not to develop something either internally or to use a third-party application?

So from an AI standpoint, we're very conservative. We do not -- we would not, do not and will not allow any AI application inside of our network. We just won't take the risk. We have a couple of uses through our economy and the reporting group, where they are procuring data from AI located somewhere else to simplify their world. But we're not by design a leader in AI applications inside our company.

And then how do you think AI changes? Obviously, your space is very specialized to support government missions. How do you think AI changes the way government kind of use space? Does it change anything at all from your perspective?

I think there's a lot of room for the government to get a boost out of AI, but I think about the IRS and administrative functions, I don't see it in the DoD in the near term.

And then maybe flipping to kind of the data center business that you guys have. Obviously, AI has been a driver for development in that sector. Has it changed kind of any views on how much you would like to kind of do there? You have the Iowa site. Can you give us an update there? And then just how you think overall about kind of the data center platform that you have?

So let me just address Iowa, and then I'll bridge back. That was a long-term investment, a very modest amount of money we're able to control significant anchorage in a market that an existing customer finds attractive. It will probably take us 4 years to get the power to develop there. So it's more of a long-term investment play. We put a very mass amount of money into that land, $32 million. And the entirety of that development will be build-to-suit for an existing customer when we get to the point where we can develop. With respect to AI, we have not done any AI data center development that we know of. We've developed on a build-to-suit basis only for a large cloud computing and government contractor.

And then would you kind of -- as you think about deploying capital, would you look to do kind of any additional land sites or additional data center development? Or how often do you kind of look at your land bank and see if there is a higher and better use for any land you have if it's possible to develop data centers?

So with the client in hand, we'd be willing to go to other markets and develop -- acquire land and develop. The challenge right now nationally is there's not enough power. It's just not available and almost any market. And I don't see us making any incremental land investment until there's access to power. And then with regard to redeploying our current land bank, I don't see us using that for AI data centers.

Okay. Speaking of kind of the land bank, you have I think at National Business Park around 1.5 million square feet of future development. How are you thinking about kind of the scoping like a dollar amount of that future development? And kind of time line at which that could be developed?

So the 1.5 million square feet you're referring to, I think, is the NBP.

Yes.

We've held land in inventory supporting the missions for me for the 15 years I've been with the company. And we'll continue to hold that land because it's very valuable not only to our company and our shareholders international security generally to have the capacity to provide the support to the missions that we support. And so we don't have a time line. We've built it into our cost structure. The land is valuable. And we just announced the development that will go there on that land that's important to our country, and that's kind of the way we view it. We have significantly more development capacity in Huntsville. We've developed a 2.5 million square feet. We -- the land we control, we have 3.5 million square feet of incremental capacity, surface park generally, and we're very happy to just hold that position for the long term and develop into the mission growth.

I guess as you think about kind of the demand drivers and the increased government spending, what would kind of drive you to accelerate some of that development of the land bank to the near term? Is there just not enough demand from tenants or leasing activity yet to warrant kind of shovels in the ground? Or just can you talk a little bit more about that?

Yes. I think I can already have. So we -- at the National Business Park, we built the building to create inventory. We have that lease that actually is going to give us a little more room because some of that occupancy will move out of existing buildings we have. But when we get to a point where the accommodating the growth in mission is limited, then we'll deploy capital and build another building. And that's why I think that pace is much quicker. You could expect with what I think is going to happen over the next 2 years, maybe 2 buildings a year just to keep the inventory up.

Great. And then maybe just kind of moving into our rapid fire within the last minute here. What will that effective rent growth be for the office sector overall in 2027, not your specific company?

Nationally?

Nationally.

Minus 2%.

Minus 2%. And then will the office sector have more or fewer of the same number of pump companies a year from now?

Fewer.

Great. Thank you so much.

Great. Thank you.