Welcome to the 3:40 P.M. Tuesday session at Citi's 2023 Global Property CEO Conference. I'm Michael Griffin with Citi Research, and we're pleased to have with us Corporate Office Properties Trust and CEO, Steve Budorick. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those in the room or the webcast, you can sign on to liveqa.com and enter code GPC23 to submit any questions if you do not want to raise your hand. Steve, we'll turn it over to you to introduce COPT and any members of management with you here today, provide any opening remarks, and then we'll get into Q&A.
With me is Venkat, Kommineni, and Neni. Help me out. Kommineni.
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Vice President of IR, Anthony Mifsud. We have very easy names in this company. Our CFO. I'm Steve Budorick, CEO. Thank you. Briefly, and for anyone new to our story, Corporate Office Properties Trust, or COPT, is a specialized office REIT, deeply concentrated in assets to support the national defense activity of the United States government. The vast majority of our 194 properties are located adjacent to or are occupied by priority defense missions, generally involving knowledge-based defense activities. The missions we support include intelligence and surveillance, cybersecurity and network activities, naval sea and air technology development, missile attack and defense systems, Army aviation and systems procurement, drone aviation technology development, weapon lethality, law enforcement and terrorism, explosive technology, and cloud computing. Our property locations are not typical for an office company.
They're adjacent to United States defense installations in Maryland, Virginia, Alabama, and Texas. Our defense tenants must work in their office due to the security requirements. 85% of our portfolio contains high security operations. We have 8 U.S. government-secured campuses that total over 4 million sq ft that are Anti-terrorism Force Protected and fully SCIFed, which is secured compartmentalized information facilities. We also have 1 million sq ft of U.S. government high security leases that are not in Anti-terrorism Force Protected buildings, but they're access controlled. We have 15 data center campuses with 5 million sq ft that are fenced with limited access. We have over 9 million sq ft of leases that contain SCIF facilities in our more routine office buildings and great locations. During the COVID-19 shutdowns, we operated every building every day. Our defense assets never dropped below 50% utilization.
Within months of the pandemic arrival, our defense locations were operating at normal occupancy levels. We completed vacancy and development leasing throughout the shutdown period, and most importantly, we collected 99 and a half % of rent as billed during that period of time. Today, 91% of our annualized rental revenue, or ARR, is derived from the defense IT locations. Our pre-lease developments will increase that to 93% or more in the coming years. The U.S. government is our largest tenant. We have over 85 separate leases and over 60 different properties totaling 5.1 million sq ft, and that produces over 35% of our annualized rental revenue. Our defense contractor tenants lease 13 million sq ft. This includes over 3 million sq ft of cyber defense contractor tenants.
Defense contractors contribute 47% of our ARR, and 15 defense contractors are in our top 20 tenants. Our non-defense locations provide 9% of our ARR. This really consists of five assets that we call regional office assets, three located in the Baltimore waterfront, one in Tysons Corner, and one in Washington CBD. Our tenants in these assets have excellent credit postures as well. Our growth strategy relies on low risk development, and we are a very active developer of specialized properties for our tenants. Over the past 11 years, we've completed 12 million sq ft of development leasing, averaging over 1 million sq ft per year. We're currently developing 1.5 million sq ft, that is 89% pre-lease. That includes 10 projects in three states and four development locations.
When completed, these low risk projects, along with those completed in 2022, will add $66 million to future cash NOI on an annual basis. That will be driving roughly 4% compound FFO growth between 2023 and 2026. Looking backward, between 2012 and 2017, we completed a strategic asset recycling plan. We sold 11 million sq ft of legacy non-defense assets. We created 8 million sq ft of new developments. We reduced our leverage and became investment grade rated. The price for that reform was flat FFO from 2012 to 2018. Commencing in 2019, we entered the growth phase we had envisioned. Since 2018, FFO per share has grown at 4.4% compounded. In 2023, we expect to deliver 1% FFO growth.
This modest growth was diminished by two factors: the elevated interest rate environment and a $190 million Blackstone joint venture we executed early in January rather than at the end of the year, which, by the way, completely funds the equity component of our expected development spend in 2023. We have five main points we'd like investors to leave with related to our outlook. We continue to expect FFO per share growth will increase on a compound basis of roughly 4% between 2023 and 2026, despite the rise in interest rate environment. We expect AFFO per share will exceed FFO per share growth during that period. We anticipate self-funding our equity requirements for development investments from this point onward on a leverage neutral basis.
We recently announced a 3.6% increase to our dividend, our first in over a decade, which indicates the high level of confidence we have in our business. Finally, the outlook for defense spending remains strong. This defense budget has increased roughly $100 billion, or nearly 15% over the past 12 months. In summary, we're a specialized office REIT. We're not correlated with the broader economy. Our assets have strategic features and locations. There's little, if not, no risk from work from home. There's strong demand for our new development and vacancy leasing. Our defense concentration offers durable recession-resistant performance, market-leading retention rates, very low capital costs from leasing and reliable growth for at least the next 4 years.
With that, we consider ourselves a great value at today's pricing, trading at roughly 10 times 2023 FFO. We have a 4.5% dividend yield, we're trading at a 21% discount to NAV. With that, I'll open up for questions.
Thanks, Steve. We're starting off each one of these sessions with the same question. I think you touched on some of it in your prepared remarks. What are the top three reasons investors should buy COPT stock today?
The top 3 reasons are reliable, durable, predictable growth. I thought I just gave those 3 reasons, but I'll give them again. We're a very defensive stock in that not only is our customers in defense, but our business is sound, financed by the basically the defense activity in the United States and aligned with priority missions that will be funded in good times and bad.
Maybe just starting with that strong correlation with defense spending you've talked about and highlighted over the years. You pointed out, call it 4% expected CAGR over the coming years. You know, is there maybe a worry, just given that we're in a divided Congress this year, that a worry about a recession? Could this impact, you know, funding needs for the tenants that you serve? Do you see this having any impact on your portfolio?
I don't have great concern about any impairment to the budget, the defense budget, for 2 reasons. First of all, in the last 12 months, those budgets have increased by $100 billion. Even if they were to freeze at that level, that is very strong funding to operate our business in. Secondly, even going back to the election in 2016, in the fiscal year 2017 NDAA, we've had strong bipartisan support to increase defense spending each and every year, and that bipartisan support exists currently today. The defense spending increases were initiated by the Republican Party. Over the last 2 years, the Democratic Party has controlled both chambers of the House, and they have pushed forward higher funding amounts than the president requested.
Lastly, big picture, we spend about 2.5% of our GDP on defense. China spends 7%. It's not a sustainable relationship, and our congresspeople are recognizing that outstanding other deficit issues, our defense spending needs to be maintained.
One could argue if, for say, we go back to the Reagan administration, where defense spending was about 5%-7% of GDP, the underlying spend there continues to benefit your business. I'm not saying that's happening overnight by any chance, but the strong correlation there that you talked about.
Correct.
Great. let's just talk on leasing for a bit. You know, you started off the year pretty strong, particularly on the development side. You know, how are you thinking about the cadence of leasing velocity throughout the year, you know, both in terms of development and the vacancy leasing fronts?
With regard to vacancy, we've guided to about 400,000 sq ft, which is half of what we delivered last year. The principal reason for that is we don't have inventory left to lease. Our core portfolio is 95.3% leased, and our defense portfolio is 96.7% leased. Within that 400,000, there's about 50,000 that we expect to do in our regional office portfolio, and that should occur ratably over the 4 quarters. We expect to get about 100,000 signed in the first quarter. With regard to development leasing, 3 build suits that we announced in January. 2 data center shell build suits for our large cloud computing company and 1 new defense contractor headquarters at the Redstone Arsenal. We guided the 700,000 sq ft for the year.
It's really conservative from a timing standpoint. We expect an opportunity to do one more data center build suit this year. Should that be delayed because of delivery of timing issues that affect the cadence of that development, we can still make our 700,000 sq ft with what we expect to do in the defense sector.
We had a question come in from Live Q&A here, just on the regional portfolio assets, specifically for Baltimore. I know there's probably been some softer demand for that traditional office relative to your core, you know, defense IT tenant base. I mean, any thoughts, I might have missed this, just around, you know, what the expectation for these properties are and any sense of, you know, maybe a buyer pool disposing of them at some point? Anything you can enlighten there would be helpful.
We have no affirmative plan to sell those assets other than 2100 L Street. That's trophy asset in downtown D.C. We're basically 1 lease away from stabilizing the asset. We have reasonable expectation we might get that lease this year. If that were the case, we believe that market has potential liquidity to get a good value on a sale. The other 4 assets, we don't believe the financing market would support a sale of at this point in time. Long term, over the 7 years that I've been CEO, the 11 years I've been with the company, we've taken our defense concentration from roughly 50%. 7 years ago, it was 25% or 75%. We're down to 9%. We are on a trajectory, we expect to continue to improve the relationship with defense, the regional office.
Great. Maybe getting back to tenant retention. I think you're expecting about 80% or so for 2023, which seems to be slightly above recent trends. What is driving this greater retention rate and, how do you expect to capitalize on this?
How do we expect to what?
Capitalize on this.
What's driving it is a heavy concentration of lease maturities in our defense IT assets. One of the compelling advantage of these assets is they are closely aligned to critical missions. The tenants need to be proximate to the missions to serve them, and our tenants are heavily co-invested in their space. For the next 24 months, we have roughly 5 million sq ft that's gonna roll. Half of that is represented by 21 leases over 50,000 sq ft. 19 of those leases are either US government data center shells or defense contractor buildings. Those 19 leases we expect to release at 99%. We have 2 regional office leases that also have maturities.
We know we're gonna get back 50,000 sq ft because it's the end of a restacking of a 15-year renewal we did in 2021, and we have about a 60% handicap on another non-defense tenant. That's half of our role. In total, that's gonna be over 95%. The other half is equally compelling statistics. We expect to do very well.
Maybe just on your tenant base from a leasing perspective, from your development net and vacancy leasing execution expectations for this year. Is there anything that tenants, you know, might be asking for that they might not have been, call it six to twelve months ago? Or any commentary around that would be helpful.
Within the defense business, we've got a very stable supply and demand environment. Tenants don't have undue leverage upon us. The one issue that they are seeking routinely is access to SCIF space, which is very scarce and hard to come by, and that's good for us because it drives vacancy leasing and buildings that don't currently have it. Within the regional office portfolio, we have to admit, the demand is less urgent, more patient, and tenants are working through thoughtfully what their long-term needs for office are. We're expecting a lower cadence of progress, but we do expect to make progress.
Just on the SCIF comment for the uninitiated, you know, how cumbersome a process is it to, you know, develop those for tenants to get in those? I seem to recall something that there needs to be some government official on-site at all times when those things are being built, maybe just talk about the process as it goes on.
They're kind of the catch twenty-two of the intelligence community. To win a contract, you need to have SCIF. Can't get a SCIF unless you have a contract. To have a SCIF, first of all, it has to be authorized or sponsored by one of the IC community members. They have to approve the construction. During construction, the work has to be supervised by independent third parties that are employed by the government security teams. I like to joke that it looks like a Chicago streets and sanitation job. For every one person working there's three watching. When completed. And these SCIFs have advanced features, so they have barriers within the well, so they can't be penetrated. They have foil to prevent eavesdropping or any electronic monitoring. They have doors that are equivalent to a safe.
Some of them have to have the windows blocked out. It takes really 2 years to build and certify a SCIF. Once that SCIF is certified, if it's ever breached, it's of no value, and it has to be dismantled. The SCIF is a very important element of our long-term north of 70% retention experience.
Is, is foreign investment allowed in SCIFs? I imagine there must be some national security concerns if, you know, some foreign entity were looking to invest in that, but maybe any regulatory things like that.
Defense contractors could not operate secure missions in assets owned by a foreign entity or the government, for that matter.
Great. That's helpful. Maybe just switching over to the development pipeline. You touched on the proceeds from the data center shell joint venture you had to lock up your funding needs for this year. Just how are you thinking about development on a go-forward basis as a growth opportunity, given that, you know, we've seen rising impact costs, impact yield, or any color around that would be helpful?
We fell a little short of our goal last year due to a timing issue. We've guided the 700,000 sq ft for this year. We could very well exceed that pretty significantly. Over the last decade, our average development leasing has been about 1.1 million sq ft. We expect overall, call it 700,000-900,000 sq ft on a go-forward basis. More importantly than that, it's the spend. It'll be at least $250 million-$300 million looking forward, and that's kind of the spend ratio that we've had.
Just on additional growth opportunities, you talked about your markets not really being as we think of as traditional office markets, you know, whether it's NBP, the data center shell business, Redstone down in Huntsville, you know, maybe Lackland. Where do you see the greatest opportunity, or are there opportunity sets kind of within each of those areas?
Well, there's really 4 areas over longer term. We have a high security campus in Northern Virginia we don't identify the location of, but we have substantial capacity to expand that campus and a customer who desires the full completion of it. Redstone Arsenal has been our fastest producing, Redstone Gateway, development over the last 5 years. Over the last 6 years, we've done about 2 million square feet of new development on that campus, and we have 3.4 million square feet of additional development capacity. That'll be a big player. At The National Business Park, we've done over the last 3 years, 1 each, larger 100% pre-leased assets for defense contractors. The park is now 98% leased. We have 1 parcel of space over 20,000 square feet, and that's over 4.5 million square foot park.
We expect to start a development this year for inventory, and we have reasonable expectation we'll have additional build suits in the next 24 months. In the data center shell segment, we signed two leases on land we owned this year. We expect to sign one this year on our remaining parcel, and we are actively working with that customer to identify additional sites to provide inventory.
Then just on Redstone, specifically, the development opportunities that you talk about, they're both inside, in front of and behind the fence, right? Is there any difference in developing either, you know, in front of or on a military installation?
Well, in terms of tenancy, it's going to be a U.S. government user inside the fence. Defense contractors will be outside the fence. We currently have about 500,000 sq ft developed out of what we initially expected to be a 1 million sq ft campus inside the fence. We're actively working with our partner, the United States Army, to provide some additional capacity for demand that we expect to arrive in the next several years. Outside the fence, we have roughly 3 million sq ft of capacity on land, costs are a little cheaper outside the fence because they're not Anti-terrorism Force Protection protected, but the stickiness of the tenants of the mission is the same.
To that end, you know, what's, what makes Huntsville so attractive? I mean, I think it's a market that maybe not a lot of people think about, but I know that the GDP there per capita is well above kind of the rest of Alabama. You've got a large number of PhDs. I mean, they call it Rocket City for a reason. Just, you know, the growth opportunities set there, and I don't know if there's been any update on the Space Command moving there.
Many layers to that question, so I'll start from the top. Indeed, Redstone Arsenal is where the US Space program was initiated and developed, and it continues to have a co-adjacency of US Army and NASA. It's an important technology center. For instance, the Space Launch System, which is a future rocket for deep space exploration, those engines are being engineered and tested on the Redstone Arsenal. There's a heavy space component. The Army Materiel Command was BRAC to that location in 2011. AMC is the procurement arm for the US Army. Anything a soldier ever needs is procured out of that. It's also a center of excellence of research, development, test, and evaluation. We've co-located a significant number of scientists with companies that produce weapons in an environment where they can evaluate and test them and then bring them to procurement.
Space exploration, missile defense, missile lethality, advanced research across the board, plus the future, we expect that the new combatant command called Space Command, which will take all the activities of Air Force, Army, Navy that pertain to space defense or offensive actions, will be stood up on that base, and that could be an opportunity for us to develop further. It has the highest concentration of command generals in the world outside of Washington, D.C., Capital Region. That's not a war zone.
We had a question come in from Live Q&A. Are your properties operated under pure triple net lease basis? Is there any extra CapEx needed for the company to spend given the unique nature of your tenants? Could your properties easily be repositioned to serve non-defense IT tenants?
Many layers. All right, we'll take them one at a time. What was the first layer?
Um-
Yeah, all right.
Triple net.
About 55% of our leases are triple net. Everything with the U.S. government is triple net, and everything in our data center shell segment is triple net. Defense contractor leases tend to have a base year with an expense stop. Any increases in expenses over a base year is a direct pass-through. There's layer 1. Give me layer 2.
Layer two is there any extra CapEx needed for the company to spend, given the unique nature of your tenants?
Upfront, a U.S. government facility is more expensive to build for a couple reasons. It has hardening and curtain wall to protect from blast. It has a more durable metal structure to avoid progressive collapse from a satchel explosive, and it consumes more land because it requires further setback from vehicles. They're, call it, maybe 10% more expensive to develop. We get return on cost, so it's not an issue.
And then the last-
Compared to our defense contractor buildings, our tenants heavily co-invest because we'll give a market tenant improvement. They need to build their SCIF environment. SCIF costs currently are about $200 a sq ft. If we're giving them $50-$60 on a 10-year lease, they're heavily co-invested. Other than that, their capital is the typical life cycle capital you'd have on a four to five story asset.
The last part, thank you, whoever submitted this. This is making my job a lot easier. How easily can your properties be repositioned to serve non-defense IT tenants?
The ones in the secure environment that the U.S. government leases, first of all, they'll never not be renewed. They're priority assets. That'd be difficult because you can't put a regular tenant inside a secure fence. The rest of those assets can be converted to ordinary tenant occupancy. Because of our locations and the priority missions we support, it's unlikely we'd ever have that need.
Right. I don't think Citi will be setting up an office at NVP or Redstone anytime soon.
We wouldn't lease it to Citi.
Maybe just one on the data center shell business. Are there any worries about increased power costs and how that might affect the data center shells business?
I think the cost of the power is somewhat inconsequential to the margin of the customer that provides the cloud computing. It's more availability of power and the ability to continue to expand their capacity.
Then, we're asking one ESG related question in each of these roundtable sessions. Steve, can you highlight important ESG initiatives that COPT is undertaking?
First I want to throw a plug out there. We've produced 8 consecutive sustainability reports, and for 8 years we've been awarded a green star by GRESB. We are a serious manager of our sustainability program. This year, we're trying to advance our TCFD disclosure to enrich the specificity of the scenarios to the upside and downside temperature swings and what that would mean to our company to improve our risk disclosure.
I think we have a question over here.
Just a follow-up on the data centers. How does the distribution limitations impact your outlook and your thoughts about data center development?
It certainly slowed the pace at which we've been able to deliver them. The two we executed this January, we have targeted a delivery date for early 2025. Normally, we would have banged those out in 8 to 12 months. Currently, the customer expects the power to be available in 2025. It is making it difficult to identify future land sites and have the assurance that you'll be able to get the critical power. We believe the runway will be there, but the cadence will be slower.
Are there places in the surrounding areas that don't have the same distribution?
There are other counties that have far more available power.
That makes sense.
Just the customer doesn't want to go there.
Yeah. Yeah. Okay.
The network interconnectivity in Prince William and Loudoun County is really what makes it the most important data center market in the world.
I've got my three rapid fire questions to end the session.
You've got to-
What is the best real estate decision today: buy, sell, develop, redevelop, or pause?
For our company, it's always develop.
Same store growth expectations for the defense IT office landlord sector. I guess you for 2024.
2%-4%.
Will there be more, fewer, or same number of defense IT contractor office landlords a year from now?
It will be the same.
Great. Thank you so much.