COPT Defense Properties:
A Unique Specialty Real Estate Franchise Supporting National Defense
COPT Defense Properties (COPT Defense) (NYSE: CDP) is an equity REIT whose 21.3 million square foot portfolio of office and data center properties was 97% leased on September 30, 2023. Classified by Nareit as an “office REIT,” COPT Defense’s specialized capability to provide real estate solutions to the U.S. Government and its defense contractors, most of whom are engaged in national security, defense, and information technology (IT) related activities (collectively referred to as the “Defense/IT Portfolio”) is unique in the REIT industry and makes COPT Defense more of a specialty REIT.
The Defense/IT Portfolio is adjacent to defense installations that execute high-tech and knowledge-based defense missions encompassing intelligence, surveillance and reconnaissance (ISR), research and development (R&D), missile defense, Naval weapons and systems development, space exploration and defense, and cybersecurity. Accordingly, COPT Defense’s business is not correlated with the broader economy or traditional office fundamentals, and the company strongly outperformed other office REITs during the COVID-19 pandemic shutdowns. In fact, the company grew its compound annual FFO (funds from operations) per share, as adjusted for comparability, by 5.1% from 2019 to 2022.
For 2023, COPT Defense expects to grow FFO per share, as adjusted for comparability, by another 2%, despite the rapid rise in interest rates. This track record of reliable growth through tumultuous economic events, combined with its secure, annualized dividend yield of ~4.7%, makes COPT Defense an attractive investment opportunity. Moreover, management believes the company is on track to generate roughly 4% compound FFO per share growth from 2023 to 2026. Underpinning this expectation are the following points:
- Healthy defense spending environment in the United States continues to drive strong demand for COPT Defense’s locations. The Defense/IT Portfolio, which accounts for ~90% of annualized rental revenue, is 97% leased, which is the highest level since the segment was disclosed in 2015. Through the third quarter of 2023, the company completed 2.2 million square feet of total leasing, with a tenant retention rate of 82.5%, which is ahead of the 5-year average of 76%, and well ahead of other office REITs. Because demand for COPT Defense locations is not correlated to the macroeconomic environment or general office fundamentals, COPT Defense is on track to achieve its development leasing objective of 700,000 square feet in 2023.
- COPT Defense owns and controls over 650 acres of land in its Defense/IT Properties, which limits competing supply and can accommodate over 8 million square feet of future mission growth.
- On September 30, 2023, 1.0 million square feet of specialized office and data centers were under construction, all of which are at Defense/IT locations; 90% of that space is pre-leased and will support growth in the coming quarters.
- An investment grade-rated balance sheet supports future growth through development and ensures dividend safety. COPT Defense’s market capitalization is $5.2 billion, composed of $2.8 billion in equity capitalization and $2.4 billion in total debt. The debt portfolio is primarily composed of long-term unsecured senior notes with attractive interest rates, and maturities that occur in 2026, 2028, 2029, 2031 and 2033. The company has no refinancing exposure until 2026.
Advisor Access spoke with Stephen E. Budorick, CEO of COPT Defense Properties.
Advisor Access: In September, Corporate Office Properties Trust announced a name change to COPT Defense Properties and a ticker change to CDP from OFC. Why did the company rebrand?
Stephen Budorick: We rebranded to better inform investors of our capital allocation strategy and portfolio quality, and to provide investors with a loud reminder that we completed the transformation of our portfolio back in 2018. Our strategy is to allocate capital to durable demand locations proximate to, or sometimes containing, key U.S. Government (USG) defense installations and missions.
Our property locations are not typical for an office company, as the vast majority of our 194 properties are proximate to these defense installations in Maryland, Virginia, Alabama and Texas. 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 Enhancements, Drone Aviation Technology Development, Weapon Lethality, Law Enforcement and Terrorism Explosive Technology, and Cloud Computing.
We embarked on a portfolio transformation in 2011 and sold out of commodity suburban office product and deepened our concentration in our Defense/IT Portfolio, by selling over 10 million square feet, developing over 11 million square feet, and acquiring only 1.5 million square feet.
Today, roughly 90% of our rental revenue is derived from our Defense/IT Portfolio, compared to 60% in 2011. Additionally, 70% of our portfolio has been developed by us. These modern, efficient buildings were developed for the missions we serve and are located in the best Defense/IT locations.
The key point is COPT Defense Properties is not the old Corporate Office Properties Trust and that’s why we changed the name: to provide clarity to investors. This is a different company and we have created a unique REIT platform that is outperforming peers.
AA: COPT Defense announced strong Q3 2023 results. What are some of the highlights?
SB: We delivered strong results in Q3 2023 and expect to deliver FFO per share growth of 2% in 2023, which is 1% higher than our initial expectations, and well ahead of peers which largely expect FFO per share to decline given the headwinds facing traditional office.
We are on track to meet both our vacancy and development leasing targets. Our Defense/IT Portfolio is 97% leased, which is the highest level since we began disclosing the segment in 2015, and represents a 70 basis point year-over-year increase. We expect full year same property Cash NOI (net operating income) will increase 6% year over year, which is the highest level in over a decade.
We forecast tenant retention in the 80–85% range in 2023, which is above our 5-year historical average of 76%, and expect to renew 95% of our large leases (over 50,000 square feet) scheduled to expire through year-end 2025, which provides a high level of earnings visibility in the near and medium term.
Our balance sheet is well positioned to navigate the volatility in the capital markets environment. We have no significant debt maturities until March 2026. We have no variable rate debt exposure and forecast 100% of our debt will be at fixed rates late into 2024.
We raised $345 million in Exchangeable notes in September 2023 at 5.25%, which is 200 basis points below where we could have priced unsecured debt. The proceeds from this offering, in conjunction with our free cash flow, provide us the necessary capital to fund our expected development investment through late 2026.
Given the strength of our operating portfolio and our highly leased development pipeline, 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.
AA: Defense makes up most of the leasing in your buildings. What measures do you take to buffer the cyclicality of defense spending?
SB: Over the past 20 years, I would describe defense spending as more secular than cyclical. Between FY 2001 and the FY 2024E Budget request, defense spending has increased by nearly 3x, growing from roughly $300 billion to $825 billion, which equates to a compound annual growth rate of 4.4%.
Defense spending can be thought of in terms of three phases over the two decades. Phase I is the post 9/11 period. Defense spending ramped up significantly in the decade following the 9/11 terrorist attacks, more than doubling from roughly $300 billion to $670 billion between FY 2001 and FY 2011, at a compound annual growth rate of 8%.
Phase II occurred after the Budget Reform and Control Act of 2011 (August 2011). The Budget Control Act sought to reduce government spending by roughly $1 trillion over the following decade, and triggered sequestration in 2013. The impact of these actions was a near 20% decline in defense spending between FY 2011 and FY 2015, falling from roughly $670 billion to $550 billion.
Phase III is the current period of Bipartisan Support. Commencing in FY 2016, defense spending has increased approximately 50% from roughly $550 billion in FY 2015 to $825 billion in the FY 2024 request, which equates to a compound annual growth rate of 4.5%. Since 2015, there has been strong bipartisan support for defense spending, in both the House of Representatives and Senate. The global threat environment to our national security and that of our allies continues to escalate, virtually assuring continued strong investments in defense. As we’ve watched the tragic events unfold recently, it provides a stark reminder of the importance of having a strong Defense Posture, and the significance of Intelligence and Surveillance, to the security of our country.
AA: How has the work-from-home trend affected the specialized type of office workers in your buildings? Are they less able to work from home given the type of work they do?
SB: 85% of our portfolio contains high security operations, which includes SCIF (Sensitive Compartmented Information Facility), ATFP (Anti-Terrorism Force Protection), and secured campuses with visitor access control. The mission-critical work our tenants conduct must be performed in a secure working space, which protects us from work-from-home trends. If you take work home in the industries we serve, you get arrested. It is called espionage.
During the COVID period, we experienced high utilization and operated every building every day. Utilization was roughly 50% in our Defense/IT Portfolio from March to Summer 2020. By October 2020, we were back to 100% utilization in our Defense/IT Portfolio, and have remained at that level since, given the mission work our tenants support.
Our industry leading retention is partly attributable to these security requirements as secure work is generally performed in a SCIF. A SCIF is hard to procure, very expensive to construct, and requires significant tenant co-investment in our assets, which makes tenants unable or unlikely to relocate.
AA: How is COPT Defense positioned for long-term growth and value creation?
SB: Our playbook to accomplish our strategy is to execute low-risk highly leased development, while maintaining a strong, investment grade rated balance sheet. Internal growth is achieved by continued uplift in occupancy, high tenant retention, low capex on renewal leasing, and contractual rent escalators.
Development is the key to our external growth. We are an active developer of specialized properties for our tenants and are currently developing 1 million square feet that is 90% leased, with a total estimated cost of nearly $340 million, consisting of six projects located in Maryland, Northern Virginia, and Huntsville, Alabama.
Year to date, we have placed roughly 470,000 square feet into service that is 96% leased, and we expect to place another 380,000 square feet into service in 4Q23 that is 100% leased. When completed, these low-risk projects, along with those completed in 2022, will add over $60 million of future Cash NOI on an annual basis, ignoring any future development starts.
Over the next three years, we expect annual development investment in the range of $250 to $275 million, which will further contribute to Cash NOI and FFO growth in the medium term.
We have a high level of earnings visibility driven by these factors, which will drive roughly 4% FFO growth on a compound annual basis from 2023 to 2026.
AA: Is there anything else you would like investors to know about COPT Defense?
SB: I’d like to quickly recap the major points for investing in CDP shares.
First, we have a unique specialty real estate franchise supporting national defense. The missions our buildings support—including Signals and Human Intelligence, Missile Defense, Space Activities, Law Enforcement, and Cyber Security—are driven by national and global security needs.
Second and very importantly, these missions are supported by strong and growing defense budgets, and our portfolio operations are not correlated with traditional office fundamentals, or the broader economic cycle. National security work cannot be performed outside of secure office facilities, and our tenants’ employees generally cannot work from home.
Third, following six years of strategic portfolio realignment and refinement, COPT Defense entered a period of FFO growth in 2018. Between 2019 and 2022, we delivered 5.1% compound annual FFO per share growth. Our 1.0 million square foot, 90% pre-leased active development pipeline for our unique tenant base, in addition to development deliveries in 2022 and 2023 YTD, drives the roughly 4% growth we expect to achieve from 2023 to 2026.
Fourth and finally, we outperformed our REIT sector during the pandemic shutdowns, and continue to outperform in the current period of economic uncertainty and what appears to be a “higher for longer” interest rate environment. Despite our outperformance, proven resilience and the strength of our outlook, our current stock price represents a compelling value and entry point for new investors.
AA: Thank you for your insights.
Stephen E. Budorick is President and Chief Executive Officer of COPT Defense Properties. Mr. Budorick was elected Trustee in May 2016 and was COPT Defense’s Executive Vice President and Chief Operating Officer from September 2011 through May 2016.
Prior to joining COPT, Mr. Budorick served as Executive Vice President of asset management at Callahan Capital Partners, LLC since 2006. Before his tenure at Callahan Capital Partners, he was Executive Vice President in charge of Trizec Properties, Inc.’s Central Region from 1997–2006, and Executive Vice President in charge of third-party management and leasing at Miglin Beitler Management Company from 1991–1997. Mr. Budorick also worked in asset management at LaSalle Partners, Inc. from 1988–1991 and in facilities management and planning at American Hospital Association from 1983–1988.
Mr. Budorick earned a B.S. in Industrial Engineering from the University of Illinois and an MBA in Finance from the University of Chicago in 1982 and 1988, respectively. He was elected a member of the Nareit Advisory Board of Governors in November 2017 and serves on the Board of Directors of the Greater Baltimore Committee and the United Way of Central Maryland.
“We think the company’s positioning in the path of defense/IT demand, development pipeline, and balance sheet are all positives – standing in contrast to the trends and situation at many office REITs.”
—Anthony Paolone, CFA, J.P.Morgan
October 26, 2023
“We see continued upside as higher defense spending drives demand for mission critical real estate in COPT’s core markets.”
—Thomas Catherwood, BTIG
October 26, 2023
“As highlighted at its recent investor day, CDP continues to benefit from its core defense/IT-focused tenant base, which has helped drive leasing momentum and elevated retention rates.”
—Michael A. Griffin, CFA, Citi Research
October 26, 2023
“CDP reported another solid earnings result for 3Q23 and continues to demonstrate the value of its niche defense/IT office platform in suburban clusters near key government installations. With 90% of its business either with the US government or contractors working on mission critical national security programs, CDP’s physical assets play a key role in the underlying business of its tenants.”
—Richard Anderson, Wedbush
October 30, 2023
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