COPT Defense Properties ($CDP)

Okay. Folks, thanks for joining us for our last session for the day. My name is Mark Streeter. And in addition to being the high-grade and high-yield transportation analyst, which is most of the -- which is I've been wearing, I think, for the last 2 days, I get to put on my REIT hat because I'm also our REIT credit analyst and very pleased to, in partnership with my colleague who's on the road, Tony Paolone, who covers COPT Defense Properties. Very pleased to have with us Stephen Budorick, President and Chief Executive Officer, joined by Venkat and Britt on his team. So Steve, thanks for joining us, making it all the way down from the home office or the corporate office and the home office. I guess you have a long commute home tonight, but we were just talking about not that far, but -- it's a little bit of track.

It's 20 miles, 25 miles.

25 miles. So just sort of thinking about maybe because there's some folks here in the room that might not know a lot about the story. Hopefully, the folks on the webcast is probably a little bit more familiar. But maybe sort of just talk a little bit about your focus, and then we'll jump into some questions on how -- especially how events over the recent weeks are sort of impacting your business. But maybe just sort of lay the groundwork with the basics before we jump in.

Okay. So COPT Defense Properties. We're a specialized real estate investment trust or REIT, and we're deeply concentrated in mission-critical assets to support national defense activity in the United States. The vast majority of our 207 properties are located adjacent to or occupied by priority defense missions, generally involving knowledge-based defense activities. The missions we support include intelligence surveillance and reconnaissance, cybersecurity and network activities, naval, sea and air technology development, missile attack and defense systems, drone aviation technology development, cloud computing, among others. Our property locations are not typical for an office company. They are approximate to United States defense installations that have permanence in Maryland, Virginia, Alabama and Texas. Our properties are improved for top secret mission work. 80% of our portfolio contains high security operations. That includes 9 U.S. government secured campuses, representing over 4 million square feet that are built to anti-terrorism force protection standards and developed with SCIF improvements. We have another 1 million square feet with the U.S. government in non-full building properties or leases, 6 million square feet of defense contractor leases with SCIF, and we have 15 cloud computing campuses representing over 6 million square feet. So how is that for intro.

That's great. That's great. So first off, occupancy right now in the portfolio because certainly, there's a lot of struggling office REITs. And I think that's probably the best sort of testament to your resiliency when I cover certainly on the office side, some companies that have fallen below 80%. Where are you now? And where have you been sort of at the lows?

So right now, we're 94.5% occupied. We are 95.5% leased overall and 96.5% leased in our defense assets. Our lows, when I first joined the company and we were more of a diversified REIT with a suburban office presence, our low was probably about 87%. We spent 7 years repositioning the company to be a pure defense play. During that period of time, we sold 11 million square feet of property and replaced it with high-value new developments in the defense space. And since then, we've never been below 93%.

Yes. I mean it's amazing testament to, especially with a low now increasingly mid-BBB credit rating, some of your peers in the pure office space, if we ever want to call them peers, obviously, like I said, dipped below 80%, right? So it's -- maybe you can talk a little bit about sort of your lease structure versus a typical sort of government lease, how are they different?

So the leases that we do with the United States government are with the missions that we support. They're not GSA structured leases. So there are a couple of differences that we're able to achieve. On the one hand, we get annual escalators on our rent. It's on a flat rent structure. On the other hand, we've learned to be very accommodating to our government customers by basically doing 1-year leases. When we sign a lease with the U.S. government for a new building, it will be a 1-year lease with 9 automatic renewals or 14 automatic renewals. And we have the confidence to accept that structure, one, because we don't have property level debt, we don't have to deal with lenders. But secondly, we know that the government will co-invest in those buildings as much money as we do. And not just an improvement, the whole structure. And so with that confidence, we accept that structure because it allows them to score 1 year's rent at a time instead of scoring all the rent of the lease in 1 year.

And what has your retention rate been running with your government tenants direct rather than separating that from sort of adjacency tenants?

Government approximates 100%. In 34 years of leasing to the U.S. government, we've never had a full building non-renew.

An amazing statistic. Can we talk...

I'd like to point out, we have a building. Show me any other one in the country that's been leased every square foot, every day for 34 years.

Yes. It's amazing. So maybe can you talk a little bit about -- it's funny, we were talking about moats around the airline businesses at this conference earlier today, as you can think about like loyalty for the big airlines, et cetera. Maybe talk about the moats around your building. Why can't someone else buy land next to one of your campuses and sort of throw a building up? Maybe I'm sort of thinking about like you have cables underground, right, that tie into critical facilities and so forth. So maybe just sort of describe how high your barrier to entry is.

So I'll give you what we call our 4 pillars of strength. One is we have a 30-plus year track record with defense contractors in the U.S. government. The second is in those 34 years, we've developed a specialized workforce. 45% of our employees carry the highest credentials available to a contractor to support top secret.

Including yourself, right?

I'm not supposed to tell -- you're not supposed to ask.

I thought that was public knowledge.

It is now. Also, we've committed to this business early. We have advantaged land positions in our operating excellence, our top 15 tenants average 6 leases in 4 or 5 locations or more. So we're tightly aligned with the industry, and we know how to support it.

So you made a big bet on Huntsville and the Redstone Arsenal a number of years ago, right? Maybe you can talk about why, how has that played out? What's the growth opportunity there outside of sort of your original core D.C. properties?

Yes. So in 2010, we entered into a joint venture relationship with a local developer that had won an enhanced use lease. We created a structure that gives them a preferred return, all the incremental capital we invested in it was baron land. We invested in infrastructure to create a business park. And in 2011, we built our first building on spec. We had 0 pre-leasing. And -- it took us about 6 months to convert that to a lease with Boeing, and it was actually a 3-building lease. So we did 2 build-to-suits. That represented about 360,000 square feet. Today, that park is over 2.5 million square feet. It's virtually 100% leased or about to be leased. We're actively developing 150,000 square foot inventory building that we have great demand for, and we have significant runway with about 3 million to 3.5 million square feet of additional development capacity.

So there's a lot of talk even before the hostilities in Iran about the Golden Dome. So how does that something -- for those that don't understand the real estate business, don't understand your company, they read a lot about Trump's focus on a Golden Dome initiative. How does that impact your business?

Well, Golden Dome or the current activities?

Well, the Golden Dome first.

Well, I'm going to do it back.

Okay, do it backwards.

The current activities personifies to America what it's like to live in a world where you can be under threat of multiple missiles inbound in the places where you live. And that's a threat that our President has identified as untolerable for this country. So Golden Dome envisions the kind of anti-missile defenses that Israel had to deploy with their Iron Dome distributed eventually across the entire United States of America. And it's aspirational in many respects. It's going to use a lot of the great technology you can now see on TV, but it also aspires to bring some of that technology into space with space-based interceptors and eventually weaponry to deter. So that activity is really centered around the Redstone Arsenal, where the Missile Defense Agency and the Defense Intelligence Agency for space are centered and as a matter of fact, NASA and other space-oriented functions. So we anticipate it's going to be a big growth opportunity for our development outside the base. We've already signed one -- remember, it just got funded in July. We've already signed one lease with defense contractors specifically.

What was the funding for it on that.

It was in the One Big Beautiful Bill Act. It was $175 billion.

Dedicated just to Golden Dome.

To Golden Dome. And if you think about that, it's roughly 20% of the prior year defense budget for one program over a 3- to 4-year period. The down payment that's in FY 2026 budget is $25 billion.

Interesting. And it sounds like a great opportunity. So can you talk about at your heart, you're a developer, right? So you have a land bank. So when you think about how much inventory to have in land and that pace of building -- knowing now we can call it spec or whatever or inventory building, but knowing that the government is likely going to be on the back end, how are you managing? How size is that land? How big is that land bank? How much are you doing annually in terms of trying to turn that raw inventory into new leasing?

So I think in total, we've got development capacity for around 8 million square feet additional property, and that's centered around priority defense locations like Huntsville, Alabama and I would say, Fort Meade, Maryland. We don't force production. We've just built it into our cost structure. We've achieved a point in time where we can self-fund $250 million to $300 million a year in new development without any external equity or capital source on a leverage-neutral basis. We acquired this land to defend our franchise and to support our customers. And so we develop to known demand.

So speaking on the development side, you were early on in the data center shell business with Amazon Web Services, right? So...

I can neither confirm nor deny our tenant.

Okay. So -- but that's who it is. But okay, we're going to pretend, we don't know.

I repeat. I neither confirmed nor denied.

So how much of your NOI comes from data centers? How has the shell business worked out? We can't admit that you have data center shells, right? So maybe you could just talk about sort of the data center contribution. And I want to dig into as those leases come due, how are rents rolling over? Maybe just whatever you can tell us about that side of the business.

Sure. So in total, we've developed about 4.6 million square feet of data center shells for a very impressive customer. They were all pre-leased build-to-suits on a negotiated yield basis. One of the prices we had to pay to get ourselves to a point where we are able to self-fund our development is we entered into joint ventures with quite a few of those with Blackstone ultimately as our joint venture partner. So we still own 10% of, let's say, 2/3 of that. So currently, our data center shell exposure is really only about 8%. We have several that we've just completed the development of. And as rents kick in, it will get up to 10% or 11%. But it's not as great. In a perfect world, I'd kept every one of them because as the leases have matured, the net rents have increased by a minimum of 100% and as high as about 130%.

And how much of those -- what's the cadence of -- I know it's a smaller part of the portfolio, but how much is rolling over this year, next year? What's that churn?

I think it's like 2 to 3 a year.

Okay. So all right. Interesting. So is there any concern about the Department of Defense sort of taking its eyes off the ball of leasing space because they're so distracted with a war? Does it impact the day-to-day? I mean we've got a government shutdown that we're dealing with partially. There's noise at the airports with TSA, et cetera. Does any of this noise either with the war or the government funding impact your ability to do sort of your regular way relationship with all the government agencies that you work with?

No, it doesn't. First of all, during the shutdown, we do get paid rent. Government regulations require the contracts to get paid. So it's never been an issue. The war fighting part of our customer base is not who we negotiate with for leasing space or renewing leases. So it really has no material effect. It's more headline risk. And I'd like to say when the headlines hit, it's a great opportunity to get an entry point in our stock because we usually trade off a few dollars and you can make a quick gain pretty quickly.

Yes. It's right? So that kind of brings me to one of the points I want to mention is just when we look at the catalysts for the stock, right, you hate to like boil it down to like war is good for you or conflict is good for you and so forth. But I mean, if we try to separate what's going on with Iran and the Middle East and maybe -- I mean, we had Venezuela, we have potentially Cuba coming and so forth. How do you think about sort of the catalyst for the stock outside of the conflicts and what you think could propel the stock higher?

So I really don't believe the conflicts are the catalysts that drive our stock price or our company. When the conflict occurs, the missions we support, the technology that's been developed, they apply that to the situation. The leases we have are with a variety of groups that are heavily engaged in executing that. But that's not really what drives our stock. We're not selling missiles or weapons. We're providing facilities for knowledge-based defense installations long term. I think a great catalyst for our stock is peace through strength. The recognition that the United States government has underinvested in defense that at least before this most recent conflict, we've run the risk that we no longer have uncontested dominance in every theater of war and that peace through strength demands that we invest to make sure that we have the most lethal fighting force in the world.

So we talked a little bit about Golden Dome, but specifically on Space Command, are there different drivers there or opportunities for you there?

Yes. So Space Command is one of the 11 combatant commands, which are formed to integrate the activities of Army, Navy, Air Force, Space Force, Coast Guard into a single command structure for a theater. So current events, Central Command is executing oversight on all activities that involve the current conflict. Space Command is going to concentrate all the capabilities of the armed services for space activities. It had been stood up temporarily in Colorado Springs. When Space Force was created, Space Command was structured Under the first Trump administration, they went through a process to pick the best location where it would be, should be. They came up with Huntsville, Alabama, Redstone Gateway or Redstone Arsenal. That was challenged and re-adjudicated twice in all 3 competitions. Redstone Arsenal won the competition. The prior President used the executive order to freeze it in Colorado Springs. The current President has overruled that order, allowed the Air Force to make its own decision, and it was once again selected for Redstone Arsenal. And so it will be moving in these next 3 years to the Redstone Arsenal. The opportunity for us initially is we have a high confidence we're going to provide an initial building to accept the early relocations because we can develop much quicker than the government can. There could potentially be opportunity to house the command itself beyond that, but we don't have clarity into that at this point in time. But ultimately, as the command relocates, the defense contractor community that supports that command is roughly 800,000 to 1.2 million square feet of future demand that's going to want to be co-located with the command in Alabama. So we think over the next 2 to 4 years, there'll be a really nice runway of growth for us in our Redstone Gateway.

Right. That's helpful. When -- if we take a step back, if you look at your total rental income, total NOI pie chart, how much right now is direct government leases versus government contractors versus something outside of that ecosystem, if we were to split it in those 3 ways.

So roughly 35%, 36% U.S. government, 55% defense contractors, 10% nondefense.

And we know on the government direct related, that's where the retention is highest, right? I mean with the government contractors or the nondefense related, how different are the characteristics of those -- of tenant retention rollover in those 2 subsets?

So government -- just throw government and defense contractors in, they're very comparable. Over the last 10 years, we've averaged 80% retention, and that includes part of the portfolio that was nondefense. Our government tends to approximate one defense contractors, any given year, there's some flux as contractors win or lose business and make adjustments. I'd like to point out if we measured our renewal statistics as binary events, do we keep them or lose them. We'd be at almost with defense contractors. But they have to manage their portfolio to the current business needs.

So you sort of mentioned that you can self-fund the development without raising equity capital. Can you just update us on where leverage is versus your target? Let's start there.

So our target is approximately 6x debt to EBITDA. We finished the year at 5.9x debt to EBITDA. Our credit rating and our benchmark of peers would suggest we could get up to 6.4 or 6.5x debt to EBITDA. And we like to manage to a lower level. So we have embedded capacity to accept excess opportunity in the future. So in a year where our development opportunity set were to exceed the $250 million to $300 million, we have that capacity to go out and grab those developments, complete them. They will, of course, be pre-leased. The predominant portion of our development is pre-leased development. When that income comes online, it will naturally return to the 6.0 debt to EBITDA.

So when I'm sure you do your own benchmarking. I'm sure your finance team has done this with you going in to see the rating agencies. When you compare 6x leverage on your portfolio, which is mid-90s leased and so forth or occupied and show the stability of that cash flow, I mean, you have some, what I would call more of the commodity office peers or even if we call it premium workspaces and so forth. The bottom line is we can look at the volatility of that cash flow. And there, the leverage is often higher, much higher than your leverage and the credit rating is often a notch or 2 higher. Now you've made some progress with the rating agencies recently. Maybe you could talk about that. And why do they still apply sort of a penalty to you? I mean, are they so fixated on size?

No, it's actually worse than that. First of all, shameless plug. We just got upgraded by Moody's to Baa2 from Baa3. So we're very...

That was a layup for you. I was leading you to that.

All right. Did I slam it like Jordan? Yes, got it. The argument for delaying or not upgrading through both of the major rating agencies is highly theoretical. They say we have a very tight concentration of customers and a very tight concentration of assets. Now I would flip it and say, that's why we should be higher rated. We have the best credit tenants in the country in the best locations where demand has proven to be high in any cycle you want to refer to, but they kind of get that backwards. And so my smart ask comment is, would we be a better risk if we had law firms across the country? I don't think we would. We have the United States government and defense contractors -- and by the way, defense contractors have to be in good financial standing to do business with the United States government.

So what do you really think drove Moody's? What changed in their mind? Was it just a recognition of the stability of your cash flow and occupancy in light of what's happened with the broader office peer set?

They've always recognized the argument. But on several occasions, they'd say, well, let's see how you do in this environment. So when COVID hit, they said, let's see what happens through COVID. Well, we sail through COVID without any problem. And then it was higher interest rates, it was higher inflation and our durability, our 7-year track record of FFO growth, high occupancy, we've really demonstrated to them that we are far more resilient than their theoretical arguments might suggest.

How should investors that might be new to your story think about which party is in control in Washington, D.C. We have the midterm elections coming up. I think the expectation is that the Republicans won't hold everything and that the pendulum will shift a little bit to the left. Is there -- you've obviously done all the tracking between the correlation between the elections and DoD budget and so forth. What are some of the misconceptions regarding that? Is it something anyone should be worried about if that political pendulum does shift come November?

So the misconception is that throughout all parts of government, we have a disagreement between the parties. But in defense, we have very strong alignment. So over the last 3 presidential terms, it's a question of is it good or great. But in each -- through each one of those presidencies, there is a common recognition in the House Armed Services, Senate Committee and the Senate Armed Services Committee that we need to invest in defense to keep America strong. So we've -- since sequestration, we have a graph, if you look at our reference material, defense budget has increased every year.

Yes. By an average of what? I think you know the status.

Probably 7%.

Yes, 7%, pretty good CAGR when that's driving your business. I want to give our audience here in the room a chance to ask any questions. Anyone have one? Please. Mic is coming.

Can you talk about -- there's a lot of energy as evidenced by this conference and just what's going on in the world around new entrants into the defense space. Can you talk about the kind of interactions you're having with some of those new entrants and the kind of services or opportunities you can deliver to them with your business?

So you're talking about the new start-up companies.

New start-up companies who might not be familiar with this world and maybe say, "Oh, let's SCIF...

So one, some of them have developed technology in other parts of the country. and need now that they've proven it out to relocate to be near the commands they're going to support. So to that point, Golden Dome, 3 or 4 start-up technology companies are looking at leasing in our business park right now because they'll be adjacent to the Golden Dome command structure. Another area of great demand that we've enjoyed is cybersecurity because we have significant holdings outside Fort Meade, where U.S. Cyber Command is out. And we've been able to attract the good idea start-up company put them into the space that they can't afford, support them as they grow their business, relocate them to other buildings and support them as they get the contract that allows them to have SCIF with our deep experience in constructing SCIF and guide them through the process and help get them up to speed. We have a concept that we call life cycle landlord. We're constantly looking for that small guy who's breaking out, and we tell them, I want to be your landlord when you need a full building.

One more in the room. Yilma Abebe.

Can you talk about the 35% of your business that's direct to government. Why would the government choose to lease and then own real estate outright?

Well, the fact of the matter is the government never has enough money for the facilities that they require. The missions we support generally are funded out of the DoD. And there's a line item in the DoD budget called MILCON or Military Construction. For them to get a facility that they own, they have to compete with all the missions worldwide in the DoD from Okinawa to Europe to get that priority funding to build the building, and there's just never enough money. We are -- we don't get all of their business, but I'd like to say we fill the gaps. When there's not enough money for the missions we support, then they can move forward to lease space, and we've been a go-to source of that leasing for over 30 years. By the way, we can also build the anti-terrorism force protected building in half the time for half the money that it takes the U.S. government. So we're also a speed-to-market kind of solution as well.

Last question for me, Steve, is there any opportunity to recreate what you did in Huntsville in another market? Is there like a list of -- does the government say, "Hey, not they're going to just tell you, but that we'd like to work with you on -- here's a new area of the country that we think we might be building up a bigger presence.

We have several active dialogues where we've identified parts of the DoD that need the same kind of help we've given to the missions we support. But I will never tell you where they are, and I will never tell you when we expect them to occur.

I don't expect you to tell me where they are, but I am curious if you think that if we look 5 or 10 years from now, will your geographic footprint look different?

I think 5 years from now, we should be able to add at least 1, if not 2 more locations.

Okay. Interesting. All right. I think we'll end it on that with a minute to spare. So Stephen, thank you very much. Thanks to Britt and Venkat for coming. We appreciate you joining us at the Industrials Conference for a different twist on some of the opportunities in the defense-related industry. So good to have you.

Thank you for having us. Appreciate it.

Thank you.