Welcome to the COPT Defense Properties' Third Quarter 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.

Thank you, Abigail. Good afternoon, and welcome to Comp Defense's conference call to discuss third quarter results. With me today are Steve Budorick, President and CEO; 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?

Good afternoon, and thank you for joining us. Our investment strategy and differentiation continue to generate strong operating results, and support the positive outlook we have for our business for the coming years. On September 15, the company adopted a new name, Cap Defense properties, a new ticker CDP and a new logo, which combines some important symbols of our core customers. The Shield shape is a symbol of military strength in defense activities. The flag identifies the United States of America, which is not only the country we serve, but our number one tenant. The Eagle is a symbol of the U.S. Army. The Star, the symbol of the U.S. Navy and the Lightning Bolt, a symbol of both the U.S. Air Force and U.S. Cyber Command. 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. Over the past 12 years, we sold over 10 million square feet. We acquired only 1.5 million square feet. We developed over 11 million square feet. And today, 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 Cap defense properties is not the old corporate office property stress, and that's why we changed the name. To provide clarity to investors. This is a different company, and we've created a unique REIT platform that is outperforming peers. Turning to highlights from the quarter. We delivered strong results with FFO per share at the midpoint of our guidance. Our Defense/IT portfolio is 97% leased which is the highest level since we began disclosing the segment in 2015 and…

Thank you, Steve. We reported third quarter FFO per share as adjusted for comparability of $0.60, which was at the midpoint of our guidance. The quarter benefited from an uptick in occupancy and revenue recognition from developments placed into service, partially offset by higher interest expense. We have generated excellent growth in same-property cash NOI with results that continue to surpass our initial expectations. Driven by the year-to-date outperformance and our forecast for the remainder of the year, we are increasing the midpoint of our same-property cash NOI guidance by another 100 basis points to 6%. This represents a 300 basis point increase in the midpoint for same-property cash NOI growth from our initial guidance established at the beginning of the year. This increase is driven primarily by a reduction in free rent concessions and lower-than-expected net operating expenses. Same-property occupancy ended the quarter at 93.4% and which is up 60 basis points sequentially from last quarter and up 120 basis points year-over-year, driven largely by the following lease commencements. 70,000 square feet by Lockheed Martin at 1,200 Redstone Gateway, after taking occupancy of 52,000 square feet in the second quarter and 90,000 square feet in our Fort Meade BW corridor sub segment. We lowered the midpoint of our same-property year-end occupancy guidance by 25 basis points to 93.5%. The decline is driven by lease commencements that will slip into 2024. For context, the 25 basis point reduction in same property year-end occupancy only amounts to a 50,000 square foot timing change. During the quarter, we also successfully issued debt in the public markets. Last month, we issued $345 million of exchangeable notes maturing in 2028 with a coupon of 5.25%. The rationale for the deal is simple. First and foremost, this eliminates the execution and pricing risk in a…

Thank you. I typically close out the call by summarizing our key messages for the quarter. However, this quarter, I'd like to end by reminding investors of 10 key differentiators of our business, our strategy and our portfolio relative to peers that we reviewed at our recent Investor Day. One, our underlying economy is national defense and the missions we align with are high-priority knowledge-based national defense missions. Two, these mission locations have permanence, and therefore, our building locations are irreplaceable. Three, we have advantaged land positions to develop which provides a clear path for future growth. Four, our tenant relationships are built on decades of trust as our top 15 tenants have, on average, 14 leases and are located in three to four of our markets. Five, the mission work must be performed in secure working space, which protects us from work-from-home trends. SCIF facilities are hard to procure and very expensive to construct, requiring significant tenant co-investment in our assets, which makes tenants unable or unlikely to relocate supporting our industry-leading retention rates. Sixth, the funds contracting is a very profitable business and financial distress is a major risk indicator for vulnerability to espionage. For this reason, we have extremely strong tenant credit quality. And seven, our low-risk development pipeline drives reliable external growth. Over the last seven years, we've allocated capital to over 7 million square feet of highly pre-leased defense IT projects. Eight, our deeply experienced employees who carry high security credentials have a 30-year track record of both constructing and operating secured facilities, including full government campuses, SCIFs, in antiterrorism first protected properties. Nine, our balance sheet is very strong, and we are prepositioned to fund incremental development through 2026 and with no need for further debt or equity capital and no near-term debt maturities. And finally, 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 over the past several weeks, 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. Operator, please open up the call for questions.

Thank you, Mr. Budorick. [Operator Instructions] Our first question comes from Camille Bonnel with Bank of America. Your line is open.

Hello. There's been a lot of changes in the government, and we're heading into an election year. Just wondering if you still have confidence on the outlook for the DoD's funding plans on 2024. And is there anything you foresee that could change there?

Well, that's a bit of a coin toss right now. There has been a pretty can last three weeks in the house. What I can tell you is both the House and Senate and services committees recommended roughly a 3% increase in defense. I think the worst-case scenario would be in an environment where they go to a continuing resolution and reduced defense by approximately 1%. But remember, this reduction would be vastly different than the sequestrations that occurred years ago because it is not mandated ratably across the DoD and the DoD can prioritize where those cuts go. And as I said in my 10 key points. The missions we support our high-priority knowledge-based missions that will be well funded.

Appreciate that color. Can you talk next to the returns you're underwriting on the new development you've started this quarter? Has there been any significant change in hurdles compared to projects started 12 months ago?

So we've pushed up our targeted cash yield. I believe the targeted cash yield on that development is 8.25.

Got it. And last one for me. Can you talk to some of the third-party broker assumptions made that drove the impairment adjustments on your regional assets or now called the other bucket?

So I'll describe the process. We engaged two sets of investment sales teams asked them to give us pricing on all those assets. In a spot market viewpoint, what would they sell for today? We amalgamated the data, and we apply that to the assets individually and result in that $250 million mark-to-market.

I guess just trying to understand if the underwriting is conservative enough? Or could we see more adjustments down the road?

No. We wanted to make sure that we take a very realistic and kind of -- fore view of value. So we -- there's no sugar coating in those numbers.

Got it. Thank you for taking my questions.

Thank you.

One moment for our next question. Our next question comes from Nick Joseph with Citi. Your line is open.

Thanks. Maybe just following up on your first comments regarding the defense budget and what's happening in kind of Congress. You had mentioned negotiating with defense contractors for space right now. Are they more impacted by the uncertainty there relative to a more traditional DoD?

Not the current negotiations that we're engaged in by any means. I don't know what impact in the future might occur because of this budget, but all the deals that we're working on now, there's been no discussion but any concern about passage of budget.

Thanks. And then just on the other bucket at this point. So you walked through the write-down. What are you looking for in terms of actually putting those assets on market or actually executing on a sale? Is it stability of interest rates? Is it something else as you talk to those brokers, when do you actually think you will look to move away from them?

Really, each asset has kind of a different story. I'll just deal with the one we have our eye on to monetize first, 2100, we'd like to get stabilized above 85% from a lease standpoint. Similarly, under light needs a bunch of leasing. Some of the other assets are more stabilized. But I think most importantly, outside of D.C., it's the functioning of a healthy debt market for office investors which will require some better pricing that's available today to engage into a procurement

Thank you very much.

One moment for our next question. Our next question comes from Blaine Heck with Wells Fargo. Your line is open.

Thanks. Good afternoon. Steve, how do you feel about pricing power in general? I mean, you guys increased your expectations slightly for rent spreads last quarter, but you're still kind of hovering around flat. Are there any indications that you guys can continue to see improvement there? Or should we expect those kind of rent spreads to remain pretty range bound?

I'd expect them to remain reasonably range-bound. Remember, our quarter-to-quarter statistics can be somewhat misleading depending on how long the terms of the expiring leases work, with our compound growth embedded in our lease structures. When we get longer leases that have moved to a reset point, it's not uncommon for them to have grown above the current market. And that reduces the mark-to-market that we get. That's why we always remind you of what's the compound growth from start rent to start rent in the bucket of leases we complete in the quarter. Because our growth manifests itself in the structure and not on the mark-to-market.

Right. That's helpful. I guess following up on that, can you just talk about what kind of annual rent increases or escalators you guys are putting into leases on newly signed deals and how that kind of compares with historical averages? And then maybe remind us what the average escalator is in your portfolio?

So currently, we're seeking escalators in the 3% range, where typically we would have been at 2.5%. I would say the weight average embedded. This is entirely a guess is somewhere around 2.7%.

Yeah. And Blaine, that's consistent with what we accomplished in the third quarter, the escalators on the renewal leases were 2.7%.

Great. That's helpful. And then maybe sticking with you, Anthony, just on guidance. The increase in same-store guidance was certainly a positive, but didn't flow through to an increase on FFO. So just wondering if that's a timing issue or whether that same-store improvement was kind of offset by higher interest expense or something else?

It was really the -- what was creating the incremental cash. So we have had success renewing space within our portfolio with limited free rent concessions compared to what we had forecasted. So that results in increases in cash NOI from a GAAP basis, it's a pretty minor increase because the GAAP rent would have been included in our forecast. And with respect to interest expense, because we've essentially are fully fixed right now. There's really no interest rate exposure for the balance of the year that would have offset that. So it's mostly coming from the strength of the leasing activity we've had.

Got it. That's helpful. Thanks, guys.

One moment for next question. Our next question comes from Tom Catherwood with BTIG. Your line is open.

Thank you. Good afternoon, everybody. Steve, following up on one of your responses to DoD budget. You've highlighted this 14.7% increase in the budget since 2021. But when we get kind of under the hood on that, are there also reallocations amongst that budget giving more proceeds to priority missions that your clusters are serving? And -- you have -- if that's the case, do you have a sense maybe if the whole budget is up 14.7%, do you have a sense of how much the missions that your properties are serving? How much are they up? Is it more than that? Is it flat with that? Or is that not something you track?

So it's hard to get into that level of detail because the Green Book don't tend to provide it. The 1 that is called out is cyber and cyber is, I believe, up like 15% year-over-year. It's compounded at an extremely strong rate for the last decade. In the Fort Meade area, a lot of our leasing demand is tied cyber. The other comment that you didn't ask, but I'll point out, it takes roughly 18 months after those increases to manifest itself in contractor demand. So from that 14% increase, we still think we have quite a bit of runway in demand notwithstanding what happens to this budget.

Got it. I appreciate that. And then at the Investor Day, you guys had done a deep dive on SCIF in the costs and what it takes to certify them from a tenant's perspective, who typically manages that skiff build-out process? Are they going out and hiring the designer and consultants and contractor, similar to like they do for a regular office fit-out.

So it depends on the tenant. I think what you'll find is a few of the larger national platforms will handle that themselves with their own consultants. For instance, in the building now turn with us, which was 560 NBP. That particular tenant is managing that SCIF development themselves with their parties more common with the small- and medium-sized contractors. They come to us because of our expertise and capability of managing them through that process, in getting them online as quickly as you can. So it's kind of split, but it's not -- it's not pure either way. A few will do it themselves.

Understood. Understood. And last one for me. Over on 2100 L Street. Any updates on tenant activity or kind of near-term leasing expectations?

Well, I'm reluctant to be too assertive at this particular topic. We thought we were close to a deal in August that ended up being a no deal, which is pretty disappointing. We do have activity as a percent of vacancy, our activity ratio is 58%. We've got one large prospect we're working with. We've got a couple of preliminaries behind that, but that market continues to move in a very slow and deliberate way.

Got it. Thanks for answers.

One moment for our next question. Our next question comes from Richard Anderson with Wedbush Securities. Your line is open.

Hey, thanks. Good afternoon. So on the new basis on the other assets, $311 million. What would that imply if you were to sell it the entirety of it today in terms of a cap rate sort of trying to get a sense of the sort of potential dilution from a transaction, understand you're not doing at this moment, but I just want to sort of triangulate that a little bit.

So Rich, if you take the annualized quarterly cash NOI from those properties and deduct the land component, the Canton land that's part of that $311 million. The cap rate is about 8.8%.

Okay. Were any of the people that helped you in the valuation interested themselves?

No, there are service firms ---

You're interested in selling them when we're ready, but we weren't interested in buying.

I think Wedbush would look great on top of one of those buildings. We have sites available in several spots.

Yeah. Well, all those corporate office signs need to be dusted off maybe. So the other question I have is you talked about I would call spec development at MVP and Redstone. Understood, you want to be ready for demand. How large of a percentage of spec development are you comfortable having in its entirety within the development portfolio? And would there be any more outside of MVP in Redstone that you'd be willing to take that type of strategy?

Well, I'll answer the last component first. No, outside of NBP and Redstone, we'd be highly reliant start spec building at both Redstone and NBP, we see the demand. And for us to capture, we need to get going. So we have more than 100% of the capacity of NBP 400 looking for Space Solutions now, roughly third of the building, we're actually negotiating lease terms on and there are multiple tenants. So we're extremely confident that they'll be released. And frankly, we're working on what's our next alternative as we get this one rolling, we want to make sure we can deliver another one as well.

And specifically for NBP, ---

Our goal is, one at a time and NBP and Redstone to be the evolving or emerging demand we see. If we didn't see the demand, we wouldn't start the building. And we don't use the words back we use inventory because we have nothing left to lease.

Fair enough. And this might be in the range of a silly question, but I'll ask it anyway. NBP has been around for a while now. So you're building further and further away from the hub of activity. I mean does that become an issue where just proximity is less appealing to people? Or are you just nowhere near that type of stress in terms of the development.

That's really never an issue. Because the advantages of being at the NBP, are ubiquitous, the comps run throughout the entirety of the park. The shuttle services run through the entirety of the park. And the ability to work in harmony with competitors or partners on contracts is not impaired by the short distance between NBP South and North. So it's really never been a factor.

And then last, Anthony, for you, I understand with the debt raise and having yourself covered through 2026, no need for outside capital. Does that mean dispositions? Or is it all just cash flow generation to cover the difference between what you raised and what you have to spend over the next three years? Or could there be a meaningful asset sale component to that financing activity over the next few years? Thanks.

No. It's all -- our base plan is built on sources that are the debt that we have raised and now have in the bank and the equity component of the development investment is funded from cash from operations after our dividend. If we have the opportunity to take advantage of developments that are in excess of that amount, then we would look to different ways to capitalize that. But our base plan of $250 million to $275 million of development each year is effectively fully funded right now.

Okay. Awesome. Thanks, very much.

One moment for our next question. Our next question comes from Dylan Burzinski with Green Street. Your line is open.

Thanks for taking the question. Just on development leasing. You guys mentioned you're still likely to hit the 700,000 square foot mark for this year. But as we look out towards '24 and '25, I guess, -- what do you guys have baked into your estimates? Should we expect you guys to remain in that 700,000 square foot range or slightly lower? Or just how should we be thinking about that?

Well, I think about it more as dollars than square feet. And Anthony gave the range of $250 million to $275 million each year. One of the facts that you have to recognize as developments roughly 30% more expensive today than it was two and half years ago. And it's the money we invest that we generate the growth off of, not the square footage. So I don't want to give any guidance looking forward. But we do have 1.25 million square feet of projects that we have actively had discussions with customers on that we currently do not believe are 50% likely to win in two years or less. So we're pretty confident we'll have some substantial square footage numbers guide to.

Thanks. That's all I had.

Thank you. [Operator Instructions] One moment for our next question. Our next question comes from Jay Poskitt with Evercore ISI. Your line is open.

Hi, thanks for taking my question. I was wondering if you could just provide a little bit of color on the breakdown of the development leasing pipeline. Are they more focused on new needs, expansions, renewals? Any color there would be great.

So most of them, I would say, are new business opportunities with defense contractors. In the current pipeline, there's about 31% of the square footage that we said is roughly 700,000 square feet, it's associated with the datacenter shell. The other 69% are defense contractors in a variety of locations in our park. And with regard to the 1.25 million square feet beyond that, it's only about 15% datacenter shell, 85% defense contract are pretty broad-based in three or more of our locations both the defense contractor and the U.S. government.

That's helpful. Thank you. And then just on the datacenter point there, can you just talk about your appetite for potentially going to new markets? I know Northern Virginia has a power constraint. So just curious your thoughts on potentially developing in a non, let's call it, core market for data centers?

Well, we'd be happy to follow our core customer to a new market, provided it was a established datacenter market with a strong expectation of long-term value. If it were a secondary tertiary market that is not well established, I don't think we put our capital into that.

Sounds good. Thank you.

All right. Thank you.

This concludes the question-and-answer session. I will now turn the call back to Mr. Budorick for closing remarks.

So first, welcome back, Rich. It's good to have you on the call, and thank you all for joining the call today. We're in our offices, so please coordinate through Venkat, if you'd like a follow-up.

Thank you for your participation today in the COPT Defense Properties third quarter 2023 results conference call. This concludes the presentation. You may now disconnect. Good day.