Hello, everyone. My name is Camille Bonnel. I am the office REIT analyst on the U.S., Bank of America research team, and I'm also joined here by my colleague, Dan Jin. And our next roundtable session is with Corporate Office Properties Trust, but known soon to be renamed and rebranded. So-
Right.
I'm joined by Steve Budorick, President and CEO of the company. If you could start with a brief introduction, company overview, and then we'll get into Q&A.
Sure. I think you can all hear me? So Corporate Office Properties Trust, we're a specialized REIT, deeply concentrated in mission-critical assets that support national defense activity of the United States government. Effective on September 15th, which is Friday, we're changing our name to COPT Defense Properties, to better reflect our portfolio composition and our investment strategy. The vast majority of our 194 properties are located proximate to, or in some cases, containing priority defense missions, generally involving knowledge-based defense activities. Missions we support include intelligence and surveillance, cybersecurity and network activities, naval, sea, air technology, missile attack and missile defense systems, army aviation and enhancements, drone aviation technology development, weapon lethality, law enforcement, terrorism, explosive device technology, and cloud computing. Our property locations are not typical for an office company. They're proximate to United States defense installations, and they're located in Maryland, Virginia, Alabama, and Texas.
Our defense tenants must work in their office due to the security requirements of the missions that they conduct. Breaking our portfolio down, 85% of our portfolio contains some level of high security operations. We have 8 U.S. Government campuses, totaling 4 million sq ft, that are Anti-Terrorism Force Protection and have SCIF, which is Sensitive Compartmented Information Facilities. We have over 1 million sq ft of other high security leases with the U.S. Government that are not contained in campuses. Our defense contractor tenants total about 9 million sq ft of their leases contain SCIF, and we have 15 data center campuses that are fenced with limited access, totaling 5 million sq ft. So today, 90% of our annualized rental revenue is derived from our defense IT properties.
Our pre-lease developments will increase that to 93% or more in the coming years as we complete the construction and deliver those assets. Our defense IT segment is 96.8% leased, and that's the highest lease rate we've had since we started reporting the segment back in 2015. Our three largest concentrations of defense installations include the National Business Park, adjacent to Fort Meade, Maryland, the Redstone Arsenal or Gateway, adjacent to the Redstone Arsenal in Huntsville, Alabama, and our privately owned secure campus, adjacent to the Lackland Air Force Base in San Antonio. Collectively, those three locations are 98.8% leased, and they account for 45% of our aggregate annualized rental revenue. Adding our fully leased data center shell portfolio, that adds, we have 12.5 million sq ft.
That's 99.3% leased in aggregate and accounts for 50% of our annualized, annualized rental revenue. The U.S. government is our largest tenant. We have 108 separate leases in over 65 different properties, totaling 5.3 million sq ft and producing 36% of our annual revenue. Our defense contractor tenants, in total, lease 14 million sq ft, and this includes over 2 million sq ft of cyber defense contractors that we've accumulated over the last 8 years. In total, defense contractors contribute 48% of our annual rental revenue. 15 of our top 20 tenants are defense contractors. Our non-defense locations provide about 10% of our ARR, and this consists today of only 5 regional office assets, and they're located in, on the Baltimore waterfront, in downtown Washington, D.C., in the CBD, and then Tysons Corner.
And by the way, our tenants in these assets have excellent credit profiles as well. Our strategy is simple and straightforward. We allocate capital to durable demand locations, primarily at defense demand mission locations. Our playbook is simple. We execute low risk, highly leased developments. We maintain a strong investment-grade balance sheet. Development is key to our external growth. Commencing in 2023, the equity component of our development spend will be funded by cash from operations after the dividend, and the debt component will be funded from our line of credit. And in this case, cash from our recent debt offering that we completed last weekend. Over time, as we build up the balance on our line of credit, we replenish that capacity with longer-term financing. We're an active developer, but we're an active developer of specialized properties for our tenants.
We currently are developing 1.5 million sq ft. It's 92% leased. It represents nine projects in three states and three separate development locations. Over the past 11 years, we've completed 12.5--12 million sq ft of development leasing, averaging over 1 million sq ft per year. And during that period of time, we've developed 88 separate properties. When completed, these low-risk projects, along with those completed in 2022, will add as much as $66 million of future cash NOI on an annual basis, and that's driving the roughly 4% compound annual FFO growth we expect to achieve between 2023 and 2026. Our competitive platform is multifaceted. We have an operating platform with experienced, credentialed workforce.
Fully 1/3 of our employees are cleared at the highest level to operate facilities that conduct the most secretive missions of the United States government. Secondly, is our development expertise in providing secure, specialized space, including SCIF and Anti-Terrorism Force Protection. We have a 30-year track record of executing development and operations for the U.S. government, and that accrues well to our shareholders. And lastly, we have advanced land positions already on our balance sheet, approximate to mission-critical, knowledge-based defense installations. So in summary, we're a specialized REIT. We're not correlated to the broader economy, which is why we embarked on a rebrand from Corporate Office Properties Trust, a name that we've enjoyed for 25 years, but we've evolved our investment strategy, so we've changed our name to COPT Defense Properties. Our assets have strategic features and locations. There's little risk from work from home.
There's strong demand for new development and vacancy. Our new name better reflects our strategy from both an investment standpoint and our portfolio composition. Our defense concentration offers durable, recession-resistant performance, market-leading retention rates averaging 76% over the last five years, which translates to very low capital costs from leasing and reliable growth for at least the next four years. And today, we're a great value at $25.14, which is 10.5x our 2023 FFO. We're generating a 4.5% dividend yield, and we're trading at a 19% discount to NAV. With that, back to you, Camille.
Great. I think you've clearly outlined the reasoning and motivation behind the rebranding strategy. Just to confirm, will this result in any change in your marketing and outreach to clients?
No. What we hope it will do is make it easier for the generalist investor to understand the difference between our strategy and that of a generic office company. The REIT community is very familiar with our company and our strategy, but our prior name was somewhat misleading relative to our investment strategy and our portfolio composition. So after 25 successful years as Corporate Office Properties Trust, we've simplified it for investors. We look forward to our next 25 years as COPT Defense Properties.
Okay. And of course, if anyone from the audience has any questions, feel free to jump in at any time. But maybe starting with the demand drivers for the company, because when we look to the 2024 presidential election, what does this mean for the defense industry?
So the best-kept secret in Washington is there is a bipartisan issue, and it is defense spending, and it may be the only bipartisan issue in Congress today. Since the fiscal year 2016 defense budget got passed, we've had various parties control the House and Senate Armed Services Committees, but the votes have been staggeringly unanimous in terms of supporting increased defense spending, recognizing the capacity and capability challenges that China represents, as well as our obligations to NATO and the current threat of the Russian activities. So with regard to this pending election, I don't think there's a lot of outcome that could influence the strong future that we project. Both parties support increased defense spending.
I think where there will be differences in policy, that will largely be focused on what decisions we make supporting Ukraine in the future, and that really has no influence on the business that we invest in.
Are there any other demand drivers that you see your portfolio benefiting from?
Well, we have quite a few now. In terms of new locations, there are some missions that we keep our eye on in locations in the future, for possible locations in the future. We have yet to see the confidence that the sustained spending and contractor demand would occur, and we're very comfortable operating in the locations that we have.
Are there any locations that you can specifically-
No, I would definitely not. There are companies that would act on that.
Okay. And just, I guess, this comes up in our discussion every time, you know, the government seems to be debating a shutdown, the risks around that. I guess, as you think about your portfolio, what is the impact on rent collection for DoD tenants, if we were to go in under that scenario?
There is no impact on our business or any of our tenants' business. First of all, the components of the government that we serve are priority missions. They will continue to operate even in a shutdown environment. The congressional rules, contracting rules require that our rents get paid, and they require that the defense contractor contracts get paid in a shutdown or otherwise. It tends to represent some headline noise and questions, but it has no impact on our business.
Even if the new contracts, leasing activity?
So to that extent, to the extent a contractor is waiting for the next funding from the next budget, and they believe they've won that contract, until that budget were to get funded, that new mission could not proceed. There have been years where we're awaiting a government approval of a budget to execute a lease that we're anticipating. We have no such circumstance this year.
If you look at your... You mentioned your occupancies for the Defense Force is highest since it started breaking out in 2015. If you look at that net absorption, any way to attribute how much of that net absorption has been from new, new contracts [audio distortion] just market share?
So, over the last 24 months... Remember, last year, in 2012, we set a record for vacancy leasing. It was almost universally in our defense IT segment. And year to date, we're on track to lease more than half of what we did last year with diminished inventory. Much of that demand is new contract wins, requiring new SCIF facilities to expand programs with existing tenants that we already have. So I think quite a bit of it has come from increased defense spending. Although that's not any information that a tenant typically discloses, observation says this is all growth.
What's the outlook on defense spending? The fact that these contractors are still mandated to pay you if there were to shut down, what are potential headwinds for your business? How do you think about the risks going forward?
Well, this might be a little bit of a smart guy answer, but as we look towards the leasing success we've had at the National Business Park, we have 4.5 million sq ft that's operating and under construction, and we're 99.5% leased, and the biggest vacant space we have is under 8,000 sq ft. We've been able to redirect some of the demand in the normal part to our adjacent, our nearest adjacent park, Columbia Gateway. And our activity ratio on Columbia Gateway is 150%, which means we have 50% more demand than we have inventory available to lease. So my concern looking forward, particularly in Maryland, is as we secure these additional leases in Columbia Gateway, that we have no inventory to lease.
So we're planning to start an inventory building, which other companies might call a speculative office building. But a building that we need to build at the National Business Park to create inventory to continue to capture demand. So that's one of the biggest headwinds I see, is that as we fill our properties, we need more inventory to lease.
Quick question. You had a joint venture with Blackstone earlier this year in the data centers, which, if I understand, funded your development pipeline. Is that correct?
We have done several with Blackstone, the most recent this year that you're referring to.
20... What was the, what was the first one?
I'm getting old.
Yeah, 2017.
Any other plans for private capital or joint ventures?
No, actually, one of the things we've been messaging this year is with our visibility into FFO growth, our rate of FFO growth is actually gonna be higher than our FFO growth. And that with the two joint ventures that we completed, one at the end of last year and one in January of this year, we see that we'll be able to fund our expected development investment, the equity component from cash flow after dividend, and then accumulating the debt component on our line or currently the cash we've just raised until such time as new EBITDA comes online. So on a debt neutral basis, we'll be able to self-fund our development using only our line of credit.
So the proceeds of the senior note offering that just closed, I think last week, you're saying that's just to really manage the terms maturity schedule?
Actually, think of it as pre-funding a future debt need. So as we modeled our business, by fourth quarter of next year, we anticipated we would need to raise or to term out some debt to replenish the capacity on our line of credit. Recognizing the great opportunity with this financing vehicle, we reached ahead 12-14 months, raised that money in advance, which allows us to substantially pay off our line of credit, retaining just a small component to cover some hedges, put cash in the bank, and have the capacity to continue to develop with both the cash, the equity component, and the debt component through 2026, when our next bond matures.
We do have questions later on your views on interest rate environment, and I guess that, to some degree, talks to how you're thinking about the balance sheet. On the point about approaching the spec development, I guess, walk us through what are some key considerations for you, to start something in today's market in terms of returns, yields?
So we've historically targeted 8% cash yield on development costs as a threshold value to proceed with defense contractor and government assets. Our data center development, we build to a slightly more competitive yield, but we still create immense value. Those have not changed materially. Over the last 18 months, we've elevated 25-50 basis points, our target for development yields, respecting the cost of capital changes in the market that we've experienced. But we're still on that low, mid-8% cash yield on development. Remember that our leases are all structured with escalators, and they tend to be 10 to 12-year leases on development. So our GAAP yields are substantially higher.
Are you agnostic on the opportunity, whether it be a data center shell or a SCIF, or is it more like whatever?
So with regard to development, we are very happy to do both. With regard to the assets that we will hold long term, we never have, and we never will consider joint venturing a U.S. government asset or our prime defense contractor assets. They represent a franchise holding an advantage that we don't share.
Okay.
We've only joint ventured data center shells.
In that case, for the data center exposure, where would you be comfortable taking it?
In terms of, So I would be comfortable if we could accumulate 20% of our revenue, in the data center shell or, or, or better. We've had discussions with our board. They're comfortable to the 20% level. We're currently below 8% with the joint venture activity we've had, so we have significant capacity to run. But the nature of those assets is very comparable to our U.S. government assets. The tenant is significantly co-invested. It's an absolute vital asset to their core business. There's scarcity in terms of replacement, and it's difficult to relocate an operating business out of that asset. So the expected full occupancy of those is very, very long term, and they're just a tremendous asset to hold in a REIT.
Do you think the market annual escalator is a pure sign of the cycle today?
For which segment or which customer?
Your data center shelves, just generic.
2012? 2012?
Where was that, say, in 2019?
2012?
Surprised you're not getting any more pricing power? Not just given the supply and demand imbalance, or is it all being made up in the starting rate?
I think we're capturing plenty of value on our starting rate. And we, we've got a long-term relationship with this single customer. We did our first build suit for them, and we signed it in 2012. We delivered in 2013. And we work in harmony to shape a deal to fit their needs as well as ours, and create tremendous value for our shareholders.
What do you think the starting rate is now versus 2019?
On a percentage basis, probably 130%. Oh, 19, you said.
Yeah, 2019.
Probably 75%.
Okay.
I thought you were talking about 2012.
Wow!
Can we shift gears to the leasing demand you're seeing? How has that trended into the third quarter?
Very strong. So, as we sit here today, our annual goal is 400,000 sq ft, with diminished availability because of our record leasing last year. We've executed 60% of our target. We have 3% of our target is designated as advanced negotiations, where we're working to finalize the lease. We have another 20% of that target in negotiations for leases. So the sum of those three is 110%. And beyond that, we have almost a half million sq ft of other prospects. So demand is strong. We have every confidence we're gonna hit our annual goal.
Okay. Going back to locations like where missions are being located, the U.S. Space Command recently decided not to relocate, so-
No, they didn't decide that.
Oh, sorry.
President Biden decided that.
Yes.
Let's be clear.
Is there any impact to your leasing pipeline from that?
So, yes. We, in turn, we call our development pipeline, and on the second quarter call, I represented that was 1 million sq ft. Today, I would represent it's about 700,000 sq ft. There are about 300,000 sq ft of development opportunities that would have supported that, had it been selected for Alabama. So yes, our opportunity to grow our development is somewhat diminished by the decision. My belief is, the decision is still not final, because I don't believe Congress will fund any capital improvements or expansion of the temporary facilities they're in, because of the way it was overruled from a triple adjudicated process. And I think the question might be up for reconsideration after a presidential election.
If we look at your expiration profile through 2024, it seems very elevated. If you could talk about your retention expectations and what's driving your improved outlook for 2023.
So, between now and the end of 2025. Let's just go through 2025, the next 10 quarters. We have 7.1 million sq ft that is maturing. 3.9 million of that 7.1, or 55%, are leases over 55,000 sq ft. Our projected renewal on the large leases is over 95%. It's heavily represented by a couple of data center fully leased assets, a significant amount of U.S. government leasing, and several single building leases with priority defense contractor missions. So our confidence level is extremely high on retention. If you just applied our historical 70%-75% retention on the balance, we would be our five-year historical of 76%. We believe that our retention numbers are gonna be extremely strong through the end of 2025.
You did update guidance in the second quarter around retention. So what was driving that change? Are you seeing any differences in decision making?
No. It's just our tenants are... We tend to guide conservatively, and now that we have much more clarity for this year, we expect extremely strong retention through the end of the year.
Maybe touching on the regional office, any updates there, how operations and disposal strategy is going?
So one of the advantages of changing our name, it's in our defined investment strategy, is we're going to reclassify our what had been a segment of regional office into other. So we'll no longer have a segment regional office. Those five assets, we view them as future recycling opportunities. We have a full intention of recycling out of all of them, but we will be patient and wait for the right market opportunities to preserve shareholder value and then simplify our story.
Mm-hmm. Are you currently in the market for removing assets?
No, we're not. With the current debt environment, it just won't support office leasing currently, and that could be 12-18 months away.
Mm-hmm. We have seen some smaller deals, smaller office buildings trade in a few months, but still, I guess, not enough confidence to go out there yet.
Not yet.
Okay. I think we have time for a few more questions before rapid fire, in case anyone from the audience-
Uh-oh, rapid fire.
[audio distortion] ...your underwriting to many data centers is more competitive. Can you talk about how much more competitive?
So most recent deals have been at 6.5%-6.75%. The most recent joint venture that we did priced at a 5.48%, and the development profit on that joint venture was north of 40%.
Just around the dividend, your business has come a long way in transforming the portfolio, but given all the market uncertainty and the questions around access to capital, can you speak to why the board felt it was the right time?
So the company cut its dividend in 2012 and held it constant for a decade. The reason we did that is concurrently in 2013, we embarked on a long-term plan to reshape our portfolio to what it is today. For seven years, that our strategy translated to a more densification or a transformation of our portfolio. For the last five years, it's translated into FFO growth. With the heavy amount of pre-leasing we have in both the properties we just delivered and the properties that we're developing, we have clear sight into roughly 4% FFO growth through 2026, and our AFFO growth actually exceeds our FFO growth.
Our board recognized that we'd hit a threshold where we can internally fund the equity component of our expected development spend, and increase the dividend to shareholders, which they increased by 3.6% in February. With that confidence in mind, the board makes decisions to increase the dividend. I can't speak for the future expectation, but our trend suggests in the future, we will have to increase our dividend for both tax reasons and other reasons.
Can you comment on how often the board intends to revisit or?
I'm certain they'll revisit annually. I can't tell you what they will elect to do. I'm one of ten.
Thank you. I think we only have time left for the rapid-fire questions, so shoot it over. First, on the Fed, do you believe that the Fed is done hiking?
No.
Yes or no? Okay. Do you expect the Fed to cut rates in 2024? Yes or no.
I don't.
That's definitely a contrarian view. Second, do you believe real estate transactions will meaningfully pick up by, A, the fourth quarter of 2023, B, first half of 2024, or C, second half of 2024?
Purchase and sales transactions?
Yeah.
End of 2024.
Okay. And third, are you using AI today to help you run your business?
No, we are not. We forbid AI to be run on our system.
Okay.
You forbid AI?
Forbid it.
Why?
We have no particular need for it. If you participate in AI broadly, then you're exposing the data on your network to other networks. We run a very private business. We have no need for it. Represents more risk than upside. Not a big fan.
Maybe the answer to the second part of this question is obvious, but do you plan to ramp up on spending on AI initiatives?
No, I plan to ramp up on development to support AI initiatives, but not within our business.
Got it. Thank you for your time, Steve, and thank you, everyone, for joining.
Thank you.