Concentration on U.S. Defense Industry Tenants Insulates this Office REIT from Pandemic Trends

Corporate Office Properties Trust (COPT) (NYSE: OFC) is an equity REIT whose portfolio of office and data center properties, totaling 21 million square feet, was 95% leased as of March 31, 2021. Classified by Nareit as an “office REIT,” COPT’s focus on providing real estate solutions to the U.S. government and its contractors, most of whom are engaged in national security, defense, and information technology-related activities (COPT’s Defense/IT Locations), is unique in the REIT industry.

These Defense/IT Locations are adjacent to defense installations that execute high-tech and research-oriented defense missions encompassing intelligence, surveillance, and reconnaissance (ISR), research and development (R&D) for unmanned drones, missile defense, space, 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. In fact, the company exceeded its elevated guidance in 2020 and grew its FFO (funds from operations) per share, as adjusted for comparability, by 4.4% relative to 2019 results.

Based on a strong first quarter, COPT has already increased its outlook for 2021 and expects to grow FFO per share, adjusted for comparability, by 3–6% this year. When combined with COPT’s secure, annualized dividend yield of 4%, COPT’s growth outlook implies a 7–10% total return for shareholders. Moreover, management believes the company is on track to generate 3–5% FFO per share growth for a sustained time period. Underpinning this expectation is the healthy defense spending environment in the United States, which continues to drive strong demand for COPT’s locations.

  • In 2020 the company completed 1 million square feet of development leasing and had record tenant retention of 81%. Because demand for COPT locations is not correlated to the economy or general office fundamentals, COPT is on track to complete at least another 1 million square feet of development leasing in 2021.
  • COPT owns and controls over 800 acres of land at its Defense/IT Locations, which limits competing supply and can accommodate over 10 million square feet of future mission growth.
  • As of March 31, 2021, 1.5 million square feet of specialized office and data centers were under construction; 85% of that space is pre-leased and should support impressive growth in the coming quarters.
  • An investment grade-rated balance sheet supports future growth through development and ensures dividend safety.
  • The company was minimally affected by pandemic-related restrictions, shutdowns, or tenant credit issues, exceeded its elevated guidance in 2020, and already increased its original guidance expectations for 2021.
  • COPT recently announced its 93rd consecutive dividend, a remarkable return on investment.

Advisor Access spoke with Corporate Office Properties’ President and CEO, Steve Budorick, about the REIT’s business model and growth strategy.

Advisor Access: Your business model is built on accommodating a specific real estate sector. Please tell us about COPT’s focus.

Steve Budorick: COPT’s business model focuses on owning properties and developable land (Defense/IT Locations) near key defense installations whose missions have been, and continue to be, U.S. Department of Defense (DOD) spending priorities, such as intelligence, surveillance and reconnaissance (ISR), missile defense R&D, space, cybersecurity, and cloud computing.

Our unique portfolio and operating expertise have distinct competitive advantages in the REIT space. We are the “go-to” landlord 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 mission-critical defense installations, we also have the credentialed personnel required to collaborate with the U.S. government and defense customers in their secure spaces.

Our defense customers do not lease their space through the General Services Administration (GSA). Rather, our defense customers have very specific location requirements for executing their missions, and procure their real estate solutions using non-GSA agencies. Due to the specialized security requirements in the defense industry, our defense customers heavily co-invest in the space they lease from us, and in some instances have more invested in our properties than we do.

These two factors—the need to be at our locations to execute their missions, and heavily co-investing in their leased spaces—create very high barriers-to-exit and have translated into our decades-long track record of extremely high renewal rates. In fact, our 81% renewal rate in 2020 matched our 20-year record for tenant retention. This year we expect to renew 70–75% of expiring leases, which would be consistent with our 20-year average of 72%.

The reason high renewal rates are important to any landlord is that avoiding the downtime and the capital expenditures required to re-tenant translates directly into higher cash flow growth and steady internal growth. At COPT, for example, not only do we retain 70% or more of expiring leases annually, we also only spend around $2 per square foot of leasing capital to retain tenants. In contrast, a typical office landlord renews only about 50–65% of expiring leases and spends a multiple of what we do. Our stable operations support solid same-property growth, typically averaging between 2–3% each year, which, when combined with our external growth from low-risk development activity, supports our expectation to produce 3–5% FFO per share growth for the next several years.

In terms of external growth, we pursue low-risk development opportunities at our Defense/IT Locations. At these locations, demand is driven by defense spending and mission growth, which advance irrespective of election outcomes or the broader economic environment. One of the only bipartisan issues in Washington, D.C., is national security, which continues to be well funded and supported by 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 complete at least another 1 million square feet of development leasing in 2021.

Our development activity is low risk because we pursue fully or highly pre-leased opportunities. Last year we placed a record 1.8 million fully leased square feet of developed properties into service, and expect to place nearly 800,000 square feet into service this year. Since 2012, we have placed 8.4 million square feet into service, which on average was 96% leased. Our ability to place large volumes of stabilized development projects in service generates highly visible, low-risk cash flows that maintain our strong balance sheet, support our dividend, and typically contribute 1–2% of the 3–5% FFO per share growth we expect to generate annually.

AA: You recently announced your 93rd consecutive dividend, extending a remarkable record—even during a pandemic. What aspects of the COPT strategy enable you to sustain this run?

SB: One of the main reasons investors buy shares of any REIT is for dividend income. We manage our operations to ensure the safety of our dividend, regardless of the economic, social, political, or capital market trends that may occur.

In addition to generating 88% of our revenues from Defense/IT Locations, where demand for facilities remains solid regardless of the broader economy, 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 1.7 million square feet of highly leased developments is responsibly funded, and our dividend is well covered. To this end, our 2021 plan forecasts a dividend-to-AFFO payout of 65–70%.

AA: You also recently published your 2020 ESG Report, in which you outlined the firm’s environmental, social, and governance practices. Can you provide the highlights?

SB: We have been committed to sustainable development standards since 2003, and have earned a green star rating from the Global Real Estate Sustainability Benchmark every year since 2015, when we began participating in their assessment program.

In addition to highlighting our record leasing achievements in 2019, our 2020 Corporate Sustainability Report introduces our environmental goals for 2025: to reduce energy use and scope 1 and scope 2 greenhouse gas (GHG) emissions by 5%; to hold water use steady at 2019 levels; and to develop a corporate water management program by 2022. We changed waste management providers during 2019, and are establishing a new baseline and related goals in 2021.

AA: How has a year of sheltering in place, or some version thereof, affected COPT? What adaptations have you made, whether at a particular site or company-wide?

SB: We were one of the few REITs, and absolutely one of the only office REITs, that was not materially impacted by the pandemic shutdowns and related restrictions. Operationally, none of our office and data center properties were subject to pandemic shutdowns and, because the vast majority of our buildings either are part of secure campuses, contain high security SCIF environments, or operate pursuant to high security standards, the preponderance of our tenants required employees to work on our properties, allowing only a small proportion to work from home. The defense missions executed at our locations absolutely cannot be performed remotely.  

Throughout the pandemic, our rent collection rates were largely unaffected, and between April and December last year, we collected 99.9% of gross rents, meaning rents before adjusting for rent relief. Additionally, and in strong contrast to other office REITs, we not only maintained our 2020 guidance (while the majority of office REITs withdrew theirs), we also increased our full-year forecast—and then exceeded that elevated guidance for the year.

Our strategy of concentrating assets around the U.S. government demand drivers we support was designed to create a portfolio that generates highly durable and growing cash flows for shareholders, regardless of the broader economic environment. The shutdowns and economic challenges brought about by the pandemic clearly showed the resiliency of our franchise.

AA: What changes do you anticipate as we move out of pandemic mode? Do you foresee specific opportunities as we enter what’s expected to be a robust recovery?       

SB: We already are off to a strong start in 2021, and have no plans to implement major changes to our proven strategy of generating highly resilient, low-risk growth. We consistently outperformed on many metrics throughout 2020—bottom-line results and our stock price, to name two—and have already increased our original guidance for 2021. On our 1Q/21 results call, we increased the midpoint of our full-year guidance for FFO per share, as adjusted for comparability, by $0.03, to a new range of $2.19–2.25. Our company’s expected 3.3–6.1% growth over 2020’s elevated results compares very favorably to the 1.7% average decline in FFO per share investors expect from other office REITs this year.

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 franchise supporting national defense. The missions our buildings support—signals and human intelligence, missile defense, space exploration, law enforcement, and cyber activity—are driven by national and global security needs.

Second, and very importantly, these missions are driven by defense budgets, are not correlated with traditional office fundamentals, and absolutely cannot be performed from remote locations.

Third, we have a decade-long track record of executing over a million square feet of development projects for our unique tenant base each year, the cash flows from which assure the 3–6% percent growth we expect to achieve in 2021, and should drive similar growth thereafter.

Fourth, and finally, despite our proven resilience and the strength of our outlook, our current stock price represents a compelling value. Based on the May 28 closing price of $27.60, our stock was trading 12% below the Street’s average NAV (net asset value) estimate of $31.50 per share. Our dividend represents a 4% cash yield that is supported by a conservative 65–70% AFFO payout ratio and our investment grade balance sheet.

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, and was COPT’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, starting in 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 Co. from 1991–1997. Mr. Budorick also worked in asset management at LaSalle Partners Inc. from 1988–1991, and in facilities management and planning at the American Hospital Association from 1983–1988. Mr. Budorick earned a BS 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.

 Analyst Commentary

“OFC is well positioned in this environment to deliver per-share growth from a position of relative strength given its unique focus on the federal government and cloud tenants.”

—Chris Lucas, Capital One Securities 
April 29, 2021

“COPT’s strategic focus on defense, IT, cyber, and data continues to result in strong leasing demand, nearly 100% rent collection, and spares the company from much of the uncertainty surrounding future office demand—and higher capex—that engulfs much of the rest of the office REIT market. Office is hard. Nothing comes easy. But we like the relative positioning of Corporate Office.”

—William A. Crow, Raymond James 
April 29, 2021

“The company remains almost completely unaffected by the pandemic, as most tenants are high-credit defense contractors and do not have the option to work from home. OFC continues to collect nearly 100% of rent due, tenant retention is near record highs and development leasing is strong.”

—Michael Lewis, Truist Securities 
May 15, 2021


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