Good afternoon, and welcome to our Global Real Estate Conference roundtable session with COPT Defense, your new name. I have joining me with today, President and CEO, Steve Budorick. My name is Camille Bonnel, and I'm the Office REIT Analyst here at Bank of America. Just for the benefit of the group, it would be great if we can start with a high-level overview of the company, and then we'll go into Q&A.
Okay. Well, thank you, Camille. COPT Defense Properties is a specialized REIT, deeply concentrated in mission-critical assets that support national defense activity of the United States government. The vast majority of our 201 properties are located adjacent to or occupied by priority defense missions, generally involving knowledge-based activities. Some of the missions we support are intelligence and surveillance, cybersecurity and network activity, naval sea and air technology development, missile attack and defense systems, army aviation and enhancements, and cloud computing. Our property locations are not typical for an office company. They're proximate to United States defense installations in Maryland, Virginia, Alabama, and Texas. Our properties are approved for top-secret mission work. 80% of our portfolio contains high-security operations. We have eight U.S. government-secured campuses totaling 4 million sq ft that are anti-terrorism force protected and contain SCIF, which is Sensitive Compartmented Information Facilities.
Beyond that 4 million sq ft, we have another 1 million sq ft of US government high-security leases that are SCIFed and access-controlled. We own 12 cloud computing campuses, totaling six million sq ft, that are fenced with limited access, and we have 6 million sq ft of defense contractor leases that contain SCIF. Additionally, a notable difference is defense tenants must work in their office due to security requirements, and today, 90% of our annualized rental revenue, or ARR, is derived from our defense IT properties. Notably, our defense IT segment is 96.7% leased. Our three largest defense concentrations include those properties around Fort Meade, Maryland, Redstone Arsenal in Huntsville, Alabama, and the Lackland Air Force Base campus in San Antonio.
If we add to that our fully leased data center shell portfolio, we have over 18 million sq ft that is 98% occupied in aggregate and accounts for nearly 75% of our ARR. The U.S. government is our largest tenant by revenue. They have 96 separate leases in 70 different properties, totaling 5.5 million sq ft and producing 36% of our annualized rental revenue. Our defense contractor tenants lease over 14 million sq ft. This includes roughly 2.5 million sq ft of defense cyber contractors, and 16 of our top 20 of our top tenants are defense contractors. Our non-defense locations provide about 10% of our ARR, and this really consists of 5 assets located in the Baltimore waterfront, Tysons Corner, and Washington, D.C.
Our tenants in these assets have excellent credit postures, but we do plan to recycle these assets as markets support reasonable sale values. Our strategy is simple: We allocate capital to durable demand locations adjacent to priority defense installations. The playbook is straightforward. We execute low risk, highly pre-leased development, redevelopment, or in some cases, repositioning, and we maintain a strong investment-grade balance sheet. Development is and has been our primary external growth activity. Over the past decade, we've delivered over $2.5 billion of successful developments, averaging over $250 million a year. Currently developing six projects with a total cost of $380 million, that are 74% pre-lease and represent 960,000 sq ft.
When completed, these low-risk development projects, along with those that we completed in 2023, will add an additional $37 million of future contractual cash NOI on an annual basis. And then, NOI contribution will be driving at least 4% compound FFO growth between 2023 and 2026. Our sources of capital to fund our external growth, currently, our equity component, we're funding through cash from operations after payment of our dividend, and our debt component for the next two years, initially, will be from cash on hand. We have about $100 million in cash, and then subsequently on our line of credit. Long- term, as our line of credit reaches capacity, we term that out with unsecured notes. Our competitive advantage is really four pillars. And I held up five fingers.
Our operating platform fully. A third of our employees are experienced and credentialed to operate in high-secure facilities. Our development expertise, we've developed millions of square feet of advanced properties, including SCIF, anti-terrorism force protected data center, and mission-specific critical facilities. We have over 30-year track record serving the highest secure functions of the US government, and of course, we have advantage land positions adjacent to critical knowledge-based defense installations. So in summary, we're a specialized REIT. We're not correlated with the broader economy. Our assets have strategic features and locations. There is little or no risk from work- from- home, and there's strong demand for new development and vacancy. There's four points we'd like investors to leave with today is, one, our leasing activity is very strong.
We will beat our 400,000 sq ft of vacancy leasing that we projected for the year. Two, we've achieved self-funding of our development pipeline at a rate of approximately $250 million a year of incremental investment. Three, we will meet or beat our FFO growth target of 4% compounded between 2023 and 2026, irrespective of what interest rates do. And fourth, defense outlook, defense spending outlook is incredibly strong. It's compounded at 4.6% over the last nine years. It's compounded at 6% over the last three years, and yet today, as a percentage of GDP, represents only 2.9% versus the country's long-term average of 4%- 4.5% in the post-Vietnam era. And by the way, it's up $100 billion over the last two years.
With that, I'll turn it back to you.
Steve, you've highlighted how the asset base has transformed, but not only that, a year ago, you did undergo a brand refresh. I was wondering if you could talk a little bit about that. How has this been received by your customers and investors?
Sure. Well, first, let me give you the background. We have been Corporate Office Properties Trust. Our tenants know us as COPT, and so we recognize we have immense brand value in the acronym COPT, so we wanted to keep that, so our tenants knew who we were. But as we've morphed the company, we're really a defense property company, so we became COPT Defense Properties. The reception's been incredible, both... Well, in three ways. Our employees love it, our investors greatly appreciate the clarity in the name, and the analysts have been very complimentary as well. So it's been, it's been really well received.
Thank you for that, and just given we had the debate last night and-
Kamala promised higher defense spending. I wrote it down.
So you think she's the winner?
No, but I just... It's the first time I heard her say it.
That was my question. What are the key policies that are on your radar?
Our world is really it's the defense spending pace and commitment by whatever leadership would enter that White House. We've handicapped our opportunity set of from good to great, and good being we'll continue the measured pace of increases, 3.5%-4.5% on average each year, or potentially much higher, depending on what the outcome of the election was.
Just on that side, around the contract awards, do you see any pickup heading into or slowdown with deals being done?
No, really, our deal pace tends to be timed with the expiration of the spending authority under an appropriation. So for instance, we came back from Labor Day, and we've got awarded two government leases because they have to get that money committed by the end of the month, and there could be potentially some other activity that follows it. Heading into election, the next defense appropriation probably won't occur until next year, but that's just a timing issue, not an ultimate outcome issue.
So is that being pushed out from when it normally would?
It's legally supposed to be done by September 30th. In my thirteen years with the company, it's happened one time. And generally, it's completed after a continuing resolution. In the last election, they continued. They passed a continuing resolution to get it to December, and then another one to get it. Ultimately, it got appropriated in May. But, they'll push it beyond the election to clear the deck, and then with the new president coming in, I would expect whichever wins will want to weigh in on that budget. So I would expect it somewhere in the March timeframe.
And so for the benefit of those who haven't followed the company through prior election cycles, during that time, did you see a difference in your ability to sign leases?
Not at all. The bulk of our activity is defense contractor. Their cycle is not directly related to a particular appropriation. When new programs are funded by an appropriation, we don't see the demand through the contractor side, usually for 12-18 months till after those awards, because they're formulated into specific performance contracts. Those are competed, ... winners are typically selected, often contested, adjudicated, and then ultimately finalized. So that lag tends to even out the pace of leasing, and government leasing tends to be in the June through September timeframe as they reach the end of their fiscal year.
Got it. Can you touch on the demand and leasing pipeline you're seeing into September?
Yeah. So we were real pleased to share at today's conference meetings that since our earnings call, our leasing activity pipeline strengthened by 15%. Overall, we have prospects for 110% of the vacancy we have. Within our Defense IT segment, it's 112%, but that's a 15% increase in just call it five or six weeks. Moreover, in the last week, I've mentioned two government awards, where we've also been advised of a couple of other lease wins. So year- to- date, we're at 330,000 sq ft of vacancy leasing against a goal of 400, and we have about 145,000 sq ft in what we call advanced negotiations, where we're trading paper, and we expect to close it.
We're looking at a likely outcome, closer to 500,000 sq ft for the year, if not more, which would be 25% outperformance.
Wow! And then, on the development side, are you seeing a similar pickup?
Uh-
What does that encompass?
One of those leases I mentioned, award from the U.S. government, is 40,000 sq ft for our RG 8100, which leaves us about 30,000 sq ft of vacancy. We have some good prospects. We've been advising the street since May, that we'll be really fourth quarter-oriented towards our development leasing achievements, and we're right on track.
And then, on potential defense agency relocations, it's, it seems to come and go. I was just wondering if there's any that are being discussed in your markets or that you're, you have an eye on?
There's much anticipation on the ultimate final home of Space Command. The Space Command location was initially established by the Air Force, while President Trump was still president, and he approved that command being located at the Redstone Arsenal. It went through a very formal process. Subsequent to the election, that decision was contested by individuals in the Senate. It was re-adjudicated and redetermined to go to Redstone Arsenal. It was again contested, it was again adjudicated, and for a third time, selected Redstone Arsenal. President Biden, a little over a year ago, signed an executive order, overturning the three levels of assessment of the best place and kept it in Colorado Springs.
This election, if Donald Trump were to win, I would expect that executive order to be overturned, and the ultimate decision of the Air Force be respected, and it would be put back in Redstone Arsenal. That would be a net positive for us, we believe.
But your same store this year is, it's a multi-high kind of,
Pretty close.
Yeah. Is there a giveback next year? The expense, some of this expense rate, does that take, what else is going on?
Well, so the expense component, tell me what the weather's gonna be, and I'll answer that question. There's, you know, a little over $1 million in savings from expenses. Some of it is from free rent burning off and developments that were placed in service and are now in the same store.
Yeah.
There's a timing component on a tax contestation that we won that'll have an ongoing effect, but smaller-
Right
... 'cause the trip occurred this year, and some of it's just good, solid growth. A big component has been less free rent in our renewal negotiations, which
Yeah
... I would expect to continue, given our markets.
Okay. So but you do anticipate generally higher growth with than you achieved historically and,
A little, a little stronger than normal. Yeah. Great question.
Thank you.
Is there anything on an OpEx side that you can drive further efficiencies?
I wouldn't count on that. The seasonal expenses are our biggest swing. Being in the Mid-Atlantic, we can get pounded with many small snow events, and those are very expensive because of the nature of our portfolio. We can have mild winters and generate favorable variances. So much of our... About half of our portfolio is net leased, so it doesn't flow through.
To sustain this level of same-store NOI growth, do you need to keep up that development program, or are there other ways?
Well, some will come from increased occupancy as we continue to drive our leasing as we have this year, to higher levels. And then, our run rate's probably 3.5%-4% to 3%-3.5%. And then, as we deliver new developments, and they become same store, there's usually an uplift from there.
Can we go back to retention? I think you had-
We love retention.
You had put an update around the leasing costs and benefits you have from your high retention. Could you just walk us through that?
Sure. Well, first of all, the reason we, we like to emphasize that, our markets are very stable over a long period of time because we're associated with defense installations. So they tend to have better growth in our leases, and our markets don't dip nor soar. They're very steady. So from time to time, investors will say: "How come your mark-to-markets are relatively flat on retention?" That's because those leases have been growing at a compound rate and will continue when we renew them. We like to counter the argument and demonstrate that the AFFO efficiency of retention is far more powerful than mark to market on a portfolio that has industry average of 40% retention.
For instance, this year, we've elevated our guidance to from 80%-85% of retention, and it just has a massive impact on cash flow because your tenant improvements are significantly lower. You don't suffer downtime. You don't have to issue incentive levels of free rent, and it's just a far more efficient cash-generating structure.
Question from the audience?
The Navy support being below kind, is there something specific there?
No, we had one defense contractor at Maritime Plaza, near the end of the year, give us back a reasonably big chunk of space. We just leased a big chunk of that space to the U.S. Navy to bring some SCIF facilities to the building, and we actually have some emerging opportunities that are going to be pretty good for this quarter or early next quarter. So just call it a seasonal dip. Believe it'll come back.
Okay. And then, just the, the 10% other, which is your non-defense stuff. What, what's the world like in that 10%?
So we really don't see an opportunity to sell debt in the current environment. There's very little debt for office investment. If to the extent a borrower could get a debt commitment, it's going to be a pretty high interest rate. The investor's going to look for a spread from their interest costs to their cap rate-
Yeah.
and that means low proceeds. We have no need for the capital.
Yeah.
We are in a great position to continue to add value by leasing up what vacancy we have.
Yeah.
- and wait for the right market.
Is there any dynamic change from the debt side? Is it leasing picking up at all or is it-
We stabilized 2100 L, which we're thrilled with. We're at 92% lease.
Okay.
We've got a very long weighted average lease term, so we can be patient and wait for great value on that. And we're happy to report we've got more demand in our downtown Baltimore assets than we have in over a year. We just got awarded one smaller lease, 20,000 sq ft. Competing for a couple other larger ones that could be meaningful. So, we're pretty focused on putting some hay in the barn there.
Okay. Yeah. What changed out there that kind of spurred this demand?
You know, it really is, it's the state of Maryland. State of Maryland is it had an owned campus on the fringe of downtown Baltimore that's just obsolete and dilapidated. The prior governor, Larry Hogan, made a decision not to rebuild and to take that those uses, break them up, and put them into the commercial inventory. So that's absorbing quite a bit of space and creating an opportunity for the few landlords that are well capitalized, like we are, to fund tenant improvements and lease up some buildings.
Can you talk about Franklin Center, the recent acquisition you did?
Yeah. Love to talk about Franklin Center. So for those of you that aren't familiar, we were able to buy 200,000 sq ft, Class A building, LEED Gold certified, completed in 2008, 55% leased on a going-in cash yield of 11.2%. We spent $70 a square feet for an asset. Its replacement cost would be closer to $400. The opportunity really arises from an out-of-state landlord trying to compete in our backyard with our defense franchise. And although we don't own 100% of Columbia Gateway, we own about a little over half. We capture over 80% of the defense contractor work because our relationships, our expertise, and just our overall franchise dominates. And so that owner of real estate had other uses for capital, and they were leaving the market.
We were able to pick up that asset and overlay our franchise, and so whereas it's been 45% vacant for over five years. We have demand at almost 2.5x the amount of vacancy we bought, so we have 90,000 sq ft to lease. We've got about 240,000 sq ft of prospects. We anticipate as we get into the fourth quarter, we'll have some real positive news, and ultimately, this can be a great asset for us and a nice return for our investors.
Was it just connections that you have, contacts in the industry? Did you just market it better? How did you go from 45% vacant to more demand than-
It's our franchise. So the defense tenants know that we can accommodate their needs, we can operate the building appropriately, we can support them in constructing their SCIF. We like to point out that when a contractor is awarded the opportunity to build SCIF, there are twenty-five critical steps that they have to do. We can do 20 of them. So we bring a value proposition that landlords that aren't deeply experienced as we are. We bring a service level that they can't compete with. And then lastly, there's a thirty-year relationship of trust. We've. Our typical tenant is in three different markets and at least four leases or lease concentrations. That's tough for somebody who's not in this business, especially that landlord who is really more triple net, relying on third-party services to compete with.
But when Paul signs the leases, then we'll be a little worse, or Britt, sorry. Paul.
Are there more opportunities like that, or is that a one-off?
There are a couple of things that we're looking at, nothing I'd talk about.
Okay. But there's not like-
But, you know, we have an earnings call coming up, so you might want to listen to that.
But you don't see more landlords that are, you know, not necessarily, local or, or that connected? Like Columbia Gateway, the part that you don't own, the ownership structure of that other than outsiders?
It's pretty heavily concentrated with one private owner that we have a great relationship with.
Okay.
We work in harmony on community and development issues, but.
Yeah
... we tend to win the defense deals, and-
Okay
... he doesn't, but-
So it's not like there's a bunch of, like, third party, you know, out-of-state people that are gonna just like-
Not in that market, but there are some other opportunities we have our eyes on-
Okay
... that are similar. We have an earnings call at the end of October.
Do you guys compete with, I guess, the National Landing market and JBG Smith? Because I know they've been talking about that as SCIF space, and-
They have a bit, not like what we have in our portfolio. Their space tends to be more headquarters of defense contractors and the forward-facing marketing groups that deal with the Pentagon. Historically, Crystal City, what they call National Landing now, that's where those concentrations were. Before the last BRAC, there were some very heavy demand drivers there. Army Materiel Command, which procures everything, a U.S. soldier in the army uses or relies upon, used to be there, and it's got BRAC'ed to the Redstone Arsenal. Similarly, Defense Information Systems Administration, which is the networks of the DoD, used to be in the landing. It got BRAC'ed to Fort Meade. So, we've noticed a couple of publicly traded companies using our language to talk about their defense tenants, but the difference is, our leases are mission work, and they're not overhead.
We've been very disciplined for going on nine years that we only want the mission work. We don't want accounting departments. I don't want marketing. We want the heavy SCIF environment.
Steve, with the investment opportunities on the horizon, your development program, I was just wondering where you see the portfolio in five years' time. Will you have a larger data center exposure, more weighted in, you know, certain geographies?
It's tough to give you the outcome. I project continued opportunity to develop at the pace we have, $250 million call it, plus or minus a year. Certainly, there's gonna be increased growth in Redstone Arsenal, the National Business Park. We expect our data center shell portfolio to continue to grow. I remind investors that we have now achieved self-funding on our development, so we no longer have to look to that portfolio as a recycle candidate with joint ventures to fund development. So I think its share will increase. The exact percentages, I wouldn't wanna, I wouldn't want to guess and be wrong about.
But if you think about the capital markets and access to financing, maybe picking up a bit or improving, I guess at what point would you consider using or raising capital to start funding your development?
As soon as those five assets that we don't want to own anymore are marketable. But we're not going to recycle capital in our very strong defense IT franchise, because that's the strength of the company. It's delivering exceptional performance. It's delivered great performance through the COVID crisis, through the interest rate checks, and through, you know, the highest inflationary period we've had since, you know, the end of the '70s, early '80s. That's the strength of our REIT, and we're going to keep it.
Okay. So there's no kind of spread that you're, you're thinking of, like, development spread versus whatever cost of capital you can-
No, to the extent our opportunities exceed our ability to fund from cash flow, if we weren't able to recycle capital with the five assets I've referred to, we hypothetically could joint venture some of our data center shells, but our base plan is to fund internally, and in the future, recycle some of those five assets.
Okay. Is there anything that's come up over your discussions today that we haven't covered?
No, we just talked a lot about our leasing pickup, up 15%, and the fact that we're going to handily beat our annual goal of 400,000 sq ft. Other than that, it's very positive meetings today.
Great to hear. Well, we just have three rapid-fire questions for you-
I love these.
Before we wrap up, so just to begin, with the Fed expected to cut, if you, you agree with that, when do you expect transactions will pick up in the?
Capital?
Investment transactions.
Yeah. In our call it regional office markets, I still think you're 15 months out, if not 18.
All right, you'll have to do the math there, Andrew. And then how would you characterize the demand for space today? Improving, steady, or weakening?
Improving.
Around AI spend next year?
Holy cow!
Do you think it's-
$800 million or more?
We're just more interested to know if you're planning to increase-
Oh, in our world?
Yes.
No, we're not investing in AI per se. We'd like to develop for AI. But I don't think we're planning on AI as an investment for our business now.
Do you benefit from the AI growth in-
Ultimately, I have confidence we will. Right now, it's a developing technology. Someday it'll become a reliable technology, and there's no doubt in my mind that technology will be applied to defense and intelligence challenges. When and where, I'm not gonna hazard a guess. Incrementally, I think our data center shell development will... Our opportunity set could be influenced by opportunities driven by AI.
It's still very early.
Yeah.
Okay. Well, thank you, everyone.
Thank you.