COPT Defense Properties (NYSE:CDP) Q4 2023 Earnings Call Transcript

COPT Defense Properties (NYSE:CDP) Q4 2023 Earnings Call Transcript February 9, 2024

COPT Defense Properties isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Welcome to the COPT Defense Properties Fourth Quarter and Full Year 2023 Results Conference Call. As a reminder, today's call is being recorded. At this time, I will turn the call over to Venkat Kommineni, COPT Defense's Vice President of Investor Relations. Mr. Kommineni, please go ahead.

Venkat Kommineni: Thank you, Abigail. Good afternoon and welcome to COPT Defense's conference call to discuss fourth quarter and full-year results. With me today are Steve Budorick, President and CEO; Britt Snider, Executive Vice President and COO; and Anthony Mifsud, Executive Vice President and CFO. Reconciliations of GAAP and non-GAAP financial measures that management discusses are available on our website in the results, press release, and presentation and in our supplemental information package. As a reminder, forward-looking statements made during today's call are subject to risks and uncertainties which are discussed in our SEC filings. Actual events and results can differ materially from these forward-looking statements, and the company does not undertake a duty to update them. Steve?

Steve Budorick: Good afternoon, and thank you for joining us. Our strategy, concentrating investments in assets that support priority U.S. National Defense Missions once again in 2023 generated exceptionally strong results driven by strong vacancy and new development leasing, superior tenant retention, a highly pre-leased development pipeline, and significant value creation from delivering fully leased new properties, all of which is supported by our prudent balance sheet management. Since 2019, we've generated compound annual FFO per share growth of 4.5% due to these attributes. Our total portfolio is 95.3% leased. Our Defense/IT portfolio is an even higher 97.2%, which is over 800 basis points higher than the traditional office REIT average and is on par with the industrial, apartment, and retail sectors.

A security guard patrolling a defense facility, protecting critical technologies.

We've been able to grow our occupancy up to strength in defense spending in missions supported at our Defense/IT locations, and have not been impacted by trends plaguing conventional office products. We placed nearly $1.4 billion of Defense/IT developments into service since 2019, totaling 4.5 million square feet that were 99% leased at the end of 2023. On an annualized run rate basis, these developments, net of the properties we've joint ventured, generated over $80 million of contractual cash NOI, which is roughly a 30% increase to the 2019 cash NOI level, driving both FFO and NAV per share growth. We've also strengthened our balance sheet with our refinancing activities in 2020 and 2021, and then again with our exchangeable note offering in September.

So, to sum this up, our business was strong in 2019 and has only strengthened over the past four years. Our portfolio rental rates and occupancy are well above 2019's level. We've expanded our relationships with top defense contractors in the country. We continue to demonstrate the ability to place highly leased development into service at strong initial cash yields, and we've defended and enhanced our balance sheet, all of which serves to create further shareholder value. In 2023 simply put, we had another great year. We delivered strong results, with FFO per share increasing 2.5% over last year's results, exceeding our expectations by roughly 1.5 percentage points. Full-year same property cash NOI increased 5.7%, which is the highest level since we started reporting the full-year metric back in 2008.

We completed 2.9 million square feet of total leasing volume, which consisted of 1.7 million square feet renewal leasing with an 80% retention rate, 747,000 square feet of development leasing exceeding our annual goal, and 452,000 square feet of vacancy leasing again exceeding our annual goal. Rent spreads on renewals increased 1.5% on a cash basis and 9.3% on a GAAP basis, achieving the highest levels since 2008. We placed $275 million of development projects into service that were 98% leased at year end, totaling roughly 850,000 square feet all in our Defense/IT portfolio. We committed $280 million of capital to new development starts which are 100% pre-leased, totaling 690,000 square feet all in our Defense/IT portfolio. Our active development pipeline has total cost of roughly $325 million, is 91% pre-leased, and totals roughly 820,000 square feet.

We also raised our dividend in 2023 for the first time in over a decade. We are one of only two REITs in our sector to have raised a dividend during the year, and we maintain a rock-solid AFFO payout ratio which has been at or below 70% for the past five years. Turning to the worldview, the global threats to national security of the United States continue to escalate with increased conflict in both the physical and cyber domains. The war in Ukraine and the aggressive posture of Russia poses a significant risk of escalation throughout Eastern Europe. Combat activities in Ukraine are revealing capability strengths and weaknesses in weapons systems and introducing new innovative applications that pose opportunities for and threats to our defense systems.

The terrorist attack in Israel demonstrated the need for increased intelligence in the Middle East. The Israeli combat response in Gaza triggered escalated terrorists and militia attacks on U.S. troops deployed in the region and is now advanced to U.S. combat responses. Similarly, Houthi rebels, actions are threatening international trade routes through the Red Sea and the Suez Canal, triggering combat responses from both the United States and the United Kingdom. And meanwhile, China continues to posture an intent to invade Taiwan and North Korea has amplified its missile testing activity and its aggressive rhetoric. All of these situations demand elevated intelligence, surveillance, reconnaissance, and technology advancements. Moreover, the Center for Strategic and International Studies published a report which revealed that cyberattacks in the United States remained elevated in 2023 with 118 major cyber events, more than double the number of attacks that occurred just six years ago.

Clearly, the threat environment to our national defense continues to escalate, suggesting U.S. defense spending has and must remain elevated to maintain parity and elevate deterrence in the physical, cyber, and intelligence domains. Over the past three fiscal years, the U.S. defense budget increased by roughly $100 billion or 15%. Since we typically experience a 12 to 18-month lag between defense budget funding and contractor demand, we expect this budget growth will continue to support strong tenant demand into 2025. Congress passed the fiscal year 2024 National Defense Authorization Act in December, which calls for a further 3.3% growth year-over-year in line with expectations and is now awaiting appropriation. Clearly, in this threat environment, funding for priority missions tied to national security must continue.

Turning to guidance, we established 2024 FFO per share guidance of $2.51 at the midpoint, which implies 3.7% year-over-year growth. In contrast, two-thirds of the NAREIT-defined office REITs are expected to see FFO per share decline in 2024. The execution of our differentiated strategy has and will continue to produce differentiated results. Now I'd like to turn it over to our new Chief Operating Officer, Britt Snider, who joined the company in December. Britt is a highly experienced leader with nearly 20 years of real estate experience, spanning asset management, development, and investment banking. We welcome Britt to the team, and we are glad to have him join us.

Britt Snider: Thank you so much, Steve. And first I want to thank Steve, Anthony, and the entire Board of Trustees for their support in allowing me to take on this role of the Chief Operating Officer. It's an honor to join the company, given the 30-year history of supporting this country's national security mission. I'm very excited to work with such a talented and accomplished team. Our portfolio is extremely healthy and we continue to see robust demand in our Defense/IT markets, driven by sustained strength in defense spending, fueling high renewals and mission expansions. Our portfolio continues to outperform with our total portfolio at 94.2% occupied. Our Defense/IT portfolio, which represents 91% of our total square footage is 96.2% occupied with particular strength in the National Business Park and Redstone Gateway.

This strong demand is evidenced by the outperformance in vacancy leasing executed in 2023, along with our leasing activity ratio which provides visibility into current demand on our unleased space. Our overall portfolio leasing activity ratio, which is defined as square feet of demand divided by available square feet to lease, remains very strong at 75% with a total prospect pipeline of 880,000 square feet, the ratio is an even higher 89% in our Defense/IT portfolio as we only have roughly 600,000 square feet of inventory available out of nearly 22 million square feet. Demand is especially strong in our Fort Meade/BW Corridor segment with a prospect ratio of over 110%. Yes, this means we actually have more prospects than we have space to lease.

And you'll recall we set our vacancy leasing target at 400,000 square feet for 2023, because we had so little space to lease. We actually exceeded that target by executing 452,000 square feet of vacancy leasing with a weighted average lease term of over eight years. For our Defense/IT portfolio, we increased the lease rate in all but one of our subsegments compared to year-end 2022. Now I'd like to share some key leasing stats. We signed 60 deals at an average lease size of 7,500 square feet. Nearly 100,000 square feet or 23% of the vacancy leasing was with the DoD. Over 200,000 square feet vacancy leasing was with defense contractor tenants. Of these amounts, roughly 175,000 square feet, almost 40% of the total was tied to cyber activity. An important fact surrounding the strength of our tenant relationships is that 75% of combined vacancy and development leasing was repeat business with existing tenants.

We executed over 90,000 square feet in our other segment in 2023 which exceeded our internal goal of 50,000 square feet. Of that 90,000 square feet, we signed 35,000 square feet across our three Baltimore properties and signed a 40,000 square foot lease with a law firm at 2100 L Street in DC, which is now 83.5% leased and the team is tracking some additional demand at 2100 L Street and we hope to share some more good news soon on that asset. We completed 2.9 million square feet total leasing volume, which included 1.7 million square feet renewals for the year. Our overall retention rate was 80% with our Defense/IT portfolio even higher at 86%. And just to note, four U.S. government renewals that were delayed into 2024 by the continuing resolution which had they completed, would have resulted in an 83.4% overall retention rate with the Defense/IT portfolio at 88.5%, and we do expect those four renewals will be completed in the coming months.

Cash rent spreads on renewal leasing were up 1.5%, while GAAP rent spreads were up 9.3%, driven by annual rent increases of 2.6%, with a weighted average lease term of 4.8 years. Measuring the starting cash rent of the tenant's expiring lease to the starting cash rent of the renewal lease, the compound annual growth rate achieved on these leases was 3.2% for the year. On Page 17 of our flipbook, we provide our large lease disclosure which details our view of renewals, defined as 50,000 square feet through 2025. Looking backward, over the last six quarters, we've renewed 17 large leases totaling 1.7 million square feet with a retention rate of 97%, including 15 full premises renewals and two renewals with only modest downsizes. And now looking forward, over the next eight quarters, we have 6.2 million square feet of leases expiring, which includes 3.3 million square feet large leases.

Large leases account for nearly 60% of total annualized rental revenue expiring in the next two years. Of those large leases, nearly 75% are full building leases to the U.S. Government and recall in our 30-year history, we've had 100% renewal rate on full building government leases. We expect a retention rate of over 95% on the 2024 and 2025 large leases and we remain highly confident, our overall tenant retention will remain strong in the near and medium term. Now, turning to development, one key aspect of our development strategy is to always maintain some level of inventory at locations where we see strong demand and when nearing fully leased, we'll commence a new project to create inventory. The National Business Park is 99.4% leased and 99.3% occupied across that 4.3 million square foot park.

30 of the 34 buildings are 100% leased, with only 25,000 square feet unleased space at year end. Accordingly, we commenced development of MVP 400 in the first quarter of 2024 to add approximately 140,000 square feet of capacity. Similarly, Redstone Gateway is 98.7% leased and 97.5% occupied across that 2.3 million square foot park. 19 of the 22 properties are 100% leased, with less than 30,000 square feet of unleased space at year-end in the operating portfolio. Accordingly, we are in the planning phase of RG 8500 to add approximately 150,000 square feet office capacity, and we're planning RG 9700 a 50,000 square-foot high bay building to meet increasing demand for that particular product type. Our active developments total roughly $325 million in investment are 91% preleased and total, 117,000 square feet.

During 2023, we executed 747,000 square feet of development leasing, which was towards the high end of guidance and includes three data center shell leases totaling 643,000 square feet and over 100,000 square feet at Redstone Gateway. Our development leasing pipeline, which we define as opportunities we consider 50% likely or better to win within two years or less, currently stands at 500,000 square feet due to the leasing success in the fourth quarter, and beyond that, we're tracking over 1 million square feet potential future development opportunities which should allow us to maintain a solid development pipeline in the near and medium term. Before I conclude my remarks, I wanted to note that last month Steve and I, along with Senior Leadership in our Asset Management and Operations Groups, attended the ribbon cutting of our 300 secured gateway development located in the secure campus of Redstone Gateway, which is 100% leased to the Huntsville Center of the U.S. Army Corps of Engineers.

We commenced development of the $67 million project in the third quarter of 2021 and delivered the building to the Army Corps in the third quarter of 2023. The 206,000 square-foot state-of-the-art facility will serve as a prototype for future Army Corps locations and is an example of the value-add solutions we provide to the U.S. Government. Colonel Sebastien Joly, Commander of the U.S. Army Engineering and Support Center in Huntsville stated, and I quote, this facility allows us to consolidate 16 different leases into one, finally, all colocated and meeting all force protection requirements and safety requirements for the very first time, end of quote. We are very grateful and honored to be able to support the vital missions conducted out of the Redstone Arsenal and all of our strategic defense holdings that contribute to our collective national security.

With that, I'll turn it over to Anthony.

Anthony Mifsud: Thank you, Britt. We reported 2023 FFO per share as adjusted for comparability of $2.42, which was $0.04 above the midpoint of our original guidance. The year benefited from early lease commencements on several operating and development leases, favorable renewal outcomes, lower net operating expenses, primarily seasonal and utility costs, and higher net development fees. We reported fourth-quarter FFO per share as adjusted for comparability of $0.62, which was $0.01 above the midpoint of our guidance. The quarter benefited from higher development fees and slightly lower net operating expenses. In 2023, we reported same property cash NOI growth of 5.7%. The increase is driven primarily by rent commencement of vacancy leasing executed in 2022, embedded escalations in virtually all of our leases, lower-than-expected free rent concessions, and rent commencement on development leases placed into service in 2021.

Same property occupancy ended the year at 93.4% which is flat sequentially from last quarter and up 140 basis points year-over-year, driven largely by the following segments. The Fort Meade/BW Corridor increased 370 basis points year-over-year to 96.2%. 60% of the increase was due to lease commencements at the National Business Park, primarily by the government; Redstone Gateway increased 940 basis points year-over-year to 97.4%, as Lockheed Martin took occupancy of over 120,000 square feet at 1200 Redstone Gateway. Our balance sheet is well-positioned to navigate the current stress in the capital markets. We have no significant debt maturities until March 2026. Our unencumbered portfolio represents 95% of total NOI from real estate operations.

At the end of the year, we had over 85% of the capacity on our line of credit available and over $165 million of cash on hand. We currently have no variable rate debt exposure. In February 2023, we entered into interest rate swaps that fixed SOFR at 3.75% for three years on our $125 million term loan and $75 million of the line of credit. The swap rate is over 150 basis points lower than the current one-month term SOFR and provides significant protection in this prolonged elevated rate environment. We expect 100% of our debt will be at fixed rates late into 2024, as we look to fund the equity component of our development, investment from cash from operations after the dividend and fund the debt component from our existing cash balance and subsequently, from our line of credit.

With respect to guidance, we are establishing 2024 FFO per share at a range of $2.47 to $2.55 implying 3.7% growth over 2023's results. At the midpoint of this guide -- the midpoint of this guidance takes into account the following positive contributions; $0.25 from increases in GAAP NOI, including $0.09 from cash NOI from developments placed into service. This is partially offset by $0.11 from higher interest expense based on higher projected debt balance and a slight decline in capitalized interest, and $0.05 primarily from lower development fees, higher G&A, and other GAAP adjustments. Same property cash NOI guidance is projected to increase 6% at the midpoint. Of note, more than half of the growth comes from the strength of our portfolio operations.

If we were to keep the 2023 pool intact, we forecast roughly 3.5% same property cash NOI growth driven by average portfolio rent escalations of 2.5% and lease commencements, primarily at our Fort Meade/BW Corridor and Redstone Gateway segments. The remaining 2.5% of same property NOI growth is due to cash commencements on development leases placed into service in 2022, which are now part of the 2024 same property pool. We expect same property occupancy to end the year between 93% to 94%. We do expect occupancy to dip in the first quarter, driven by several non-renewals with 30,000 square feet occurring in the other segment, and then remain relatively stable throughout the remainder of the year. Similar to last year, we are targeting 400,000 square feet of vacancy leasing, which we consider an aggressive goal since we are so highly leased.

We expect tenant retention in the 75% to 85% range. Cash rent spreads on renewals to be flat at the midpoint, with average escalations of roughly 2.5%. We expect to commit $200 million to $240 million of investment capital for the full year and expect our development spend on active and future projects will range from $240 million to $280 million. We plan to place three projects totaling nearly $150 million into service, which are 81% leased and total 400,000 square feet. We've historically framed development in terms of leased square feet. However, beginning in 2024, we will instead guide to committed capital to investment as we feel this is a more suitable disclosure when evaluating the future NOI contributions from our invested capital. The cost to construct a Defense/IT property has increased approximately 25% when comparing the three-year average of our starts between 2017 and 2019, to those commenced between 2021 and 2023, driven by inflation in both material and labor costs.

Importantly, we earned both our return and NOI on invested capital, not square feet. Despite the increases in costs, we have been able to increase our initial cash yield on developments on Defense/IT projects modestly to approximately 8.25%. Since we have leased all of the land we owned for data center shell developments, we assume no additional capital is committed to shells in 2024. As illustrated on Slide 10 of our Flipbook, the $200 million to $240 million of expected investment in 2024 into Defense/IT office projects is the second-highest annual level since 2019. In closing, the building blocks of our guidance illustrate why we are well positioned to continue to generate increasing NOI, FFO, and cash from operations, which we expect to allocate towards accretive investment opportunities.

With that, I'll turn the call back to Steve.

Steve Budorick: Thank you. I'll close by summarizing our key messages. We delivered another strong year in 2023 with FFO per share $0.04 above our original guidance. Our Defense/IT segment is 97.2% leased, the highest rate achieved since we started reporting the segment in 2015. Full-year same property cash NOI increased 5.7%, which is the highest level since we started reporting the full-year metric in 2008. We exceeded our vacancy leasing target by executing 452,000 square feet. Our $325 million active developments which are 91% preleased provide a solid trajectory for NOI growth over the next few years. Our liquidity is very strong and we continue to expect to self-fund the equity component of our expected development investment going forward.

We established 2024 FFO per share guidance of $2.51 at the midpoint, which implies 3.7% year-over-year growth. Between 2019 and 2023, we generated compound annual FFO per share growth of 4.5%. Looking forward, we continue to expect compound annual FFO per share growth of roughly 4% between 2023 and 2026 from the midpoint of our original 2023 guidance. In a time where global threats are increasing, data security and facility security are becoming more important every day, fueling demand for specialized real estate solutions. We are uniquely positioned to capture that demand and we expect our strong performance to continue. Operator, please open the call for questions.

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