COPT: Concentration of Leases to U.S. Government and Defense Industry Tenants Insulates this Office REIT from Economic Downturn
Corporate Office Properties Trust (COPT) (NYSE: OFC) is an equity REIT whose 21.9 million square foot portfolio of office and data center properties was 95% leased on September 30, 2022. Classified by NAREIT as an “office REIT,” COPT’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 COPT’s “Defense/IT Locations”) is unique in the REIT industry and makes COPT more of a specialty REIT.
These Defense/IT Locations are 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’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 4.4% from 2018 to 2021.
For 2022, COPT expects to grow FFO per share, as adjusted for comparability, by another 2.6%, diminished by a strategic asset sale completed in the year. This track record of reliable growth through tumultuous economic events, combined with its secure, annualized dividend yield of just over 4%, makes COPT an attractive investment opportunity. Moreover, management believes the company is on track to generate 4% or more 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’s locations. Through the third quarter of 2022, the company completed 2.3 million square feet of total leasing and had the highest quarterly volume of vacancy leasing in the last twelve years with 351,000 square feet. COPT’s third quarter 2022 tenant retention of 92% was the highest in 21 years. Because demand for COPT locations is not correlated to the macroeconomic environment or general office fundamentals, COPT is on track to achieve its development leasing objective of 700,000 square feet in 2022.
- COPT owns and controls approximately 700 acres of land at its Defense/IT Locations, which limits competing supply and can accommodate over 7 million square feet of future mission growth.
- On September 30, 2022, 1.9 million square feet of specialized office and data centers are under construction, all of which are at Defense/IT locations; 91% 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’s market capitalization is $5.2 billion, composed of $3 billion in equity capitalization, and $2.2 billion in total debt. Their debt portfolio is primarily composed of long-term unsecured senior notes with attractive interest rates, and maturities that occur in 2026, 2029, 2031 and 2033. The company has no refinancing exposure until 2026.
Advisor Access spoke with Corporate Office Properties’ President and CEO Steve Budorick about the REIT’s business model and growth strategy.
Advisor Access: Corporate Office Properties Trust has a unique niche in the real estate investment trust (REIT) sector. Would you tell us about it?
Steve Budorick: COPT’s business model focuses on owning properties and developable land (Defense/IT Locations) near key United States defense installations whose missions have been and continue to be Department of Defense spending priorities such as Intelligence, Surveillance and Reconnaissance, Missile Defense, R&D, Space, Cybersecurity and Cloud Computing. Over 90% of our rental revenue comes from properties in Defense/IT locations. Our largest tenant is the United States Government, generating 37% of annualized rental revenue. The next 53% of annual rental revenue is generated from the Defense Contractor Industry, conducting work to support the priority missions of our United States Government tenants in proximate or adjacent properties we own.
Our unique portfolio of assets, specialized development and operating expertise offer distinct competitive advantages in the REIT space. We are the dominant landlord, public or private, for secured, specialized space, including sensitive compartmented information facilities (SCIF), anti-terrorism force protection (ATFP) and other secure facility requirements. In addition to owning concentrations of properties and entitled land adjacent to these mission-critical defense installations, we also have the credentialed personnel required to develop and operate properties occupied by these U.S. Government missions and their defense contractors.
Our U.S. Government customers possess their own procurement authority from Congress and are exempt from the regulations and activities of the General Services Administration (GSA). Their authorities recognize the importance of their specific needs to address national security challenges and established information security protocols. Our defense tenants, both government and defense contractors, require specialized security improvements that compel them to make significant co-investment in the design and function of their leased space. In many instances, our tenants have invested more capital improving our properties than we have invested to construct them. Moreover, the government regulates the creation of these specialized conditions, often requiring years to obtain approvals and complete construction, creating a scarcity of real estate supply meeting those requirements and severely limiting competition.
These three factors—the need to be proximate to the missions we support, the significant tenant co-investment in the leased space, and the scarcity of competing supply—create very high barriers-to-exit and have translated into our decades-long track record of extremely high renewal rates. Our 10-year retention average is 75%, and our 24-year retention average is 72.6%. Our 92% retention rate in the third quarter of 2022 was our highest achievement level in 21 years. This year we expect to renew approximately 75% of expiring leases.
AA: How has COPT positioned itself for long-term growth and value creation?
SB: Our Defense investments are concentrated in five regional segments, each containing fully operational assets and land to support further development. Our core growth strategy relies on low-risk development opportunities at our Defense/IT Locations, where demand is driven by defense spending and mission growth that advance irrespective of election outcomes or the broader economic environment. One of the only bi-partisan issues in Congress today is support for and growth of national security capabilities. The Defense budget continues to be well funded and broadly supported in both chambers of Congress. We have completed an average of 1.1 million square feet of development leasing annually since 2011 and are on-track to achieve our development leasing objective of 700,000 square feet in 2022.
Our development activity is low risk because we achieve fully or highly pre-leased developments. Last year we placed 766,000 fully leased square feet of developments into service and expect to place approximately 1.2 million square feet into service this year. Our ability to place large volumes of stabilized development projects into service each year generates highly visible, low-risk cash flow growth that creates asset value, maintains our strong balance sheet, funds our attractive dividend, and contributes to FFO per share growth.
AA: COPT recently announced its 100th consecutive quarterly dividend. What is behind this remarkable streak?
SB: One of the main reasons investors buy shares of any REIT is for dividend income. We manage our company to ensure the safety of our dividend, regardless of what economic, social, political or capital market trends may occur. Our current dividend is extremely well covered, representing less than 70% of our adjusted funds from operation. We operate with very conservative levels of debt and have been investment grade rated by all three major rating agencies since 2013. Operating with conservative leverage ensures the growth from our pipeline of 1.9 million square feet of highly leased developments is responsibly funded, and our dividend is well-covered.
AA: What changes in leasing trends are you seeing in this post-pandemic period and how are you addressing them?
SB: Over the past two years we have seen a very strong and growing level of demand from our Defense/IT tenants. Our vacancy leasing accomplished through the end of September 2022 totaled 628,000 square feet, exceeding our leasing goal for the full year. Even after the leasing success executed through the first nine months of the year, we continue to have strong demand for space, with a leasing pipeline totaling almost 90% of our available space.
Within the leasing volume executed through September 30th, 140,000 square feet was current tenant expansions and over 125,000 square feet of new leasing to the U.S. Government. The demand from tenants at these locations is driven by new and expanding mission requirements.
AA: COPT recently published its 2022 Corporate Sustainability Report. What are some of its highlights?
SB: We have been committed to sustainable development standards since 2003 and have earned a green star rating from GRESB (the Global Real Estate Sustainability Benchmark) every year since 2015 when we began participating in their survey. In addition to highlighting our record leasing achievements in 2021, our 2022 Corporate Sustainability Report announces the completion of our first climate-related risk assessment aligned with the Task Force for Climate-Related Financial Disclosures (TCFD) framework, features our enhanced alignment with 13 of the 17 United Nations Sustainable Development Goals (UN SDGs), discusses our disclosure of our first publicly available Environmental Policy Statement and Human Rights Policy, codifying our commitment to these principles, and highlights our environmental goals for 2025, namely: to reduce energy use and scope 1 and scope 2 greenhouse gas (GHG) emissions by 5%, to hold water use steady at 2021 levels, to develop a corporate water management program and enhance our waste management practices.
AA: Is there anything else you’d like readers to know?
SB: I’d like to quickly recap the major points for investing in OFC 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 the secure office facilities, and our tenants’ employees generally cannot work from home.
Third, following six years of strategic portfolio realignment and refinement, COPT entered a period of FFO growth in 2018, delivering 4.4% compound annual FFO per share growth through 2021. Our 1.9 million square foot, 91% pre-leased active development pipeline for our unique tenant base assures the 4% or more 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 stress. 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, Steve.
Stephen E. Budorick is President and Chief Executive Officer of Corporate Office Properties Trust (COPT). Mr. Budorick was elected Trustee in May 2016. Mr. Budorick was COPT’s Executive Vice President and Chief Operating Officer from September 2011 through May 2016. Prior to joining COPT, Steve 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. Steve 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. Steve 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 are maintaining our Overweight rating and $34 price target after updating estimates to reflect 3Q flow through and our updated interest rate forecast.”
—Chris Lucas, Capital One Securities Inc.
Nov. 1, 2022
“COPT benefits from a tenant base that 1) is benefiting from increases to the DoD base budget; and 2) faces strict limitations to work-from-home options for tenants; and 3) has resulted in a unique relationship with COPT that severely limits development risks.”
—William A. Crow, Raymond James
November 1, 2022
“The highest tenant retention in 21 years (92%) contributed to 857K sf of leasing in the quarter, which also included 351K sf of new leasing (the company’s highest new leasing activity in 12 years).”
—Michael Lewis, Truist Securities
October 27, 2022
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