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.

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?

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. 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…

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…

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%…

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.

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

Hi everyone. Steve, can you remind us how the 3.3 National Defense budget that passed in December compares to the initial projections? And then, is there anything on the horizon, either from elections or potential major agency relocations, that you're closely watching this year?

Sure. So, with regard to the budget increase, it's exactly where it was expected to be in the 3% to 3.5% range. To recall, the last three years, that budget ramped up $100 billion. So 3.3 is a big number on an extra $100 billion and a lot of money to fund defense priorities. With regard to the election, it'll be a fascinating outcome, I just want to remind everybody that since 2016, after the restorative increase to the defense budget we have had going on seven years of solid bipartisan support for increases in defense spending. And it's the one part of our government that operates in a strongly cooperative bipartisan way. And I expect irrespective of this outcome of this election, that support will continue.

And in terms of major agency relocations, are there any that you've been hearing about tracking in your markets?

The only one that comes up from time to time is, the prolonged discussions about the relocation of the FBI out of their headquarters building in downtown DC to a more protected location that would either be in Virginia or Maryland. That's kind of gone quiet in the world of current events over the last six months, and I think it's so heavily disputed, it'll be years off before it's finalized.

That's helpful. And all the disclosure you've provided has been very helpful in understanding the building blocks that support your three-year CAGR of 4%, just given the high expected retention levels, could you comment on how that outlook is on an AFFO basis?

Well, Anthony, I'll flip it to you.

From an AFFO standpoint, as I think, we've talked about on some recent calls, we had some elevated leasing capital in 2023 -- 2022 and 2023 and the third and fourth-quarter are back to sort of back to our regular levels. So, we expect AFFO over that three-year period to grow slightly more than what we've been talking about with respect to FFO, because of the capital -- the relative capital that we have to invest in renewal and new leasing compared to some of our peers.

Okay, great. And welcome, Britt. Just lastly, could you provide some color on the known move-outs that were highlighted in the press release last night? What are some reasons your tenants are not renewing and how much are tenants downsizing? Thank you.

Yes, absolutely. It's something we're seeing, I guess, outside of the Defense/IT world, and primarily in our non-Defense/IT tenants and with law firms, for example, one of them was a law firm that is consolidating and there's some strategic consolidations of a few smaller IT Defense related contractors, but that is definitely the exception. Most of them are growing.

Camille, we routinely get some non-renewal from small and mid-sized contractors due to the M&A activity. So they tend to innovate, create a new concept or product they can sell. They grow to a certain level, and then they typically sell to one of the larger contractors. Sometimes that results in some contraction as they get consolidated into bigger tenants.

And one other -- this is Britt, one other thing I'll note is that when we do have non-Defense and IT tenants leaving our Defense/IT portfolio, they're typically backfilled with Defense/IT with incredibly strong credit and strong businesses. So, we actually see that as a positive.

Thank you.

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

Great, thanks. Good afternoon. Steve, how do you feel about pricing power in general, you guys achieved 1.5% rent spreads in 2023, but you're guiding to flat for 2024. I'm just wondering, how much of that is conservatism and a return to more historical averages versus maybe something in the market telling you, it could be a little tougher to push rents this year, or even specific leases or extension options that might keep that metric lower this year.

So, one thing that affects that overall metric is the mix of leases and where they're at. We did significant amount of leasing over the last year in the BW quarter, where pricing power is strong as anywhere. We expect some good traction in Northern Virginia, which is a little more competitive. And then generally, you'll notice we guide pretty conservatively because we never want to over-promise. So I'd say, a little bit mix and probably 50% - 60% just conservative viewpoint in our guidance.

Got it, really helpful. Can you talk about the 500,000 square feet development leasing pipeline you have at this point, and how much of that is in advanced stages or close to becoming executed deals? Just trying to get a feel for kind of the cadence of commencements in '24. And then also, how much is NBP versus Huntsville?

So I think it's two to one Huntsville to NBP, roughly. Commencements, I think you'll see June through November with peak volume of execution. As Britt mentioned, we have another million plus square feet of projects that we're entertaining with customers. But as I pointed out on prior calls, in this world of an elevated cost of capital, it really affects the decision-making of all companies, even defense contractors. And what we see is they're being very methodical to make the business cases for the facilities they need. So, the pace of progress is a little slow, but the visibility is very clear. We're very excited about what we can get done this year.

Hi, Blaine, just to clarify and make sure that you understand the distinction. The 500,000 square feet that Britt mentioned is new leasing activity that we're looking at that has the possibility of being executed in 2024. In terms of commencements, the vast majority of that leasing is already executed, and the commencements that we expect in 2024 are the development projects that are under construction right now and significantly well leased.

Right. Okay, I think we're on the same page there. Okay, helpful color. And then Steve, appreciate your comments on having defense support no matter what happens in the election, but have you seen any pause in leasing activity in past election years? Just as your tenants kind of take some time to figure out the ultimate implications of either kind of more of the same or a new president in office?

You know, we really didn't see that in either of the prior two elections. Our demand was pretty solid throughout. So, no, the business case for leasing and development is driven by defense needs and funding that's usually already occurred beforehand. And with the mission-critical nature of the tenants we support, it's really not tied to changes in philosophy on the edges with the President position.

Great. Thank you.

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

Great, thanks. Maybe going back to the defense spending bit for a second. Steve, you noted the passage of the NDAA in December, but I think the Defense Department is still running on a continuing resolution. I'd just be curious to your thoughts on if these continuing resolutions continue to be the case and whether or not that would impact kind of demand or space needs for some of your tenants.

Yes, well, let me phrase it this way. In the 12 years that I've worked at this company, in only one year did we not have a continuing resolution. The continuing resolution is really the norm, and the issue is, does it get wrapped up early or does it become protracted. The longest protracted continuing resolution was in 2017, which extended to about May 25, primarily because the new President wanted to top-up the defense spending and slow down the passage. I would think by March we should be -- Congress would get around to the point where they're going to appropriate the funds, but it could go longer. Ultimately, it doesn't affect the outcomes that are going to come our way. It will cram a lot of activity in the second half of the year, so it could manifest itself in some lower progress in the first and second quarter, which we'll catch up for.

Got you. That's helpful. And then maybe just on the development pipeline and future opportunities. You talked about the current pipeline being highly pre-leased. Seems like demand is really outstripping supply in some of your key markets. Is there any appetite to start to execute on future development opportunities, or are construction costs still prohibitive to make that happen?

Well, Britt pointed out that we just kicked off, call it a not pre-leased or spec building at the MBP, and that'll deliver about 138,000 square feet early next year because we need the inventory. We're about 40% leased on an inventory building in Redstone Gateway RG 8100, got very clear visibility into the full lease-up of that asset. So we're actually moving dirt and preparing to kick off RG 8500, which would be 150,000 square foot building to create inventory, and then we've had increased demand for a high bay product at Redstone Gateway. So, we're going to kick off a 50,000 square-foot high bay support facility for some of our existing tenants, also this quarter. So, when we have demand and a lack of inventory, we will build to the demand.

Great. That's it for me. Thanks for the time.

Thanks, Michael.

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

Thank you and good afternoon everybody. Steve, I know there's no acquisition in guidance, but you've talked in the past about maintaining liquidity for potential investment opportunities. Are you seeing any early movement in the transaction markets and kind of, given your focus on specific submarkets and tenants, what criteria would you be keying on if you were to pursue a deal?

So that's a great question. To pursue a deal, it has to be an asset with current or expected occupancy that serves the missions that we typically serve, geographically would have to be very closely located to the assets we own currently, and then the return that we'd have to get on that asset would have to be competitive with our development yields. And so that creates pretty small set of opportunities. We're always diligent to look at opportunities that come up, but we haven't found many that meet that criteria.

Gotcha. Appreciate that. And then maybe sticking with your commentary about the inventory building at NBP, given that the park is 99.4% leased and that inventory building doesn't deliver with 18 months - 24 months, whatever it may be, what are tenants doing when they need expansion space? And is that demand having any impact on your other Howard County business parks?

We've been able to push quite a bit of demand that would have otherwise gone to the MBP into our portfolio in Columbia and Gateway. And we've got a prospect ratio that's about 160% for our vacancy in that park. So it's very positive for us long term because we're adding quite a bit of skiff facilities in Columbia Gateway that typically would have favored the MBP.

Got it. And then last one for me, Britt, first off, congratulations on your first call. And second off, you had mentioned a handful of lease renewals that were delayed because of the continuing resolution. How does the mechanics of that work? Did the leases expire and the tenants are now month to month or is there still term left on the lease? How does that kind of all come together?

Yes, no, it just gets put into, if it approaches expiration, then it just goes into holdover. But I mean we feel great. Like I said about those leases, it's going to happen in 2024, just some things are out of our control, but, yes, they would stay in the space. Obviously, we have no intention of moving them out or asking them to move, they're long-term partners of ours.

To be clear, we use a different term, it's standstill not holdover. Holdover implies that we could put penalties on them and kind of jack up rent; there's just provisions in the lease that allow them to keep paying what they were paying. We true up when they get a lease.

And that's perfect. See, that was what I was worried about, was that there would be some sort of a roll-down if they were on a holdover lease. So it would be just no change in the rent while you're coming through the continuing resolution.

Yes, standstill. Correct.

Got it. All right. That's it for me. Thanks, everybody.

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

Thanks. Good afternoon. So on Slide 17, what about the other 2.9 million square feet that isn't 50,000 square feet or greater, what's the status of those situations?

If you look at our overall guidance, it's impossible for me to go lease-by-lease. It's very comparable. Maybe, there'll be some non-renewal, but we're getting to a midpoint of 80 and we're very confident we're going to deliver that.

Okay. You mentioned the statistic 89% demand to space available in your Defense/IT segment, I guess that's a good number. I think you'd like it to be above 100%. Is there a line of sight into how that number might change over the passage of time based on what you're seeing today? And am I asking for too much for it to be over 100%?

Yes, over 100% is pretty rare. We actually have a graph. We track that statistic and anything over 70% is pretty strong; 60% is not unusual in a submarket. But remember that spot demand for your inventory. So, it changes with every ebb and flow of a deal. But 70 and up is very strong. Over 100 is great and we are over 100 in the BW corridor, which includes Columbia Gateway.

Right. 6% same-store NOI growth for this coming year at the midpoint, a little bit less than 4% FFO growth. Anthony said, maybe a little bit more AFFO growth, but still, the common theory is if you get X internal growth, you should get X plus Y at the bottom line, it's not the case here with you. Actually, your FFO growth is actually lower. Is that just a condition of the fact that you're a big-time developer and you'll never kind of really see 6% equal 8% FFO growth or 4% equal 6% FFO growth? I'm just curious if that's just sort of a function of the way CDP operates.

No, I think it's the function of no one, none of us are immune from the changes in interest rates and the full-year impact of the exchangeable note offering that we did in September of last year is in 2024's math. And that 5.25% is higher than the debt portfolio interest rate that we had prior to that transaction. So, some of that, both internal and external growth -- EBITDA growth is being absorbed by an increase in interest expense.

I guess I would have thought that interest rates last year versus this year, almost a wash, if not an opportunity. But I hear your point, you have more stuff to deal with. So interest expense goes up. But in theory, you should see what I described, right? If holding all else constant, that shouldn't be any reason why you shouldn't get more FFO growth than you get same-store growth. Is that a fair statement?

Yes. All capital costs being equal, that's a fair statement.

Okay, last question...

When interest rates come down, there's some pretty interesting growth that could come back, stay tuned.

And then the last question is, I'm just thinking you mentioned cyber and how important it is to your business. I wonder about AI these days and whether that is being weaponized, certainly it is. Is that like a demand driver for cyber demand as well? And how do you see AI impacting your business, either positively or negatively, whether it's a demand or a competitive threat to CDP? I'm just riffing a little bit, but I'm curious if you have any thoughts on that.

Well, the answer is you got to be highly speculative. So, if we understand the speculative, eventually the AI technology is going to reach some level of competency where it will have to be evaluated for use in the DoD environment. And I don't think we've seen -- we have no evidence that we've seen any increased activity and contracts related to AI as of current. So could be potentially upside, but it's a little early to tell.

Okay, fair enough. Thanks very much.

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

Good afternoon, guys. Thanks for taking the question. I guess just going back to some of the comments on cash release and spread guidance, being potentially conservative in '24, but I guess just as we think about the business over the next five years, given portfolio occupancy is at historically high levels, and given your comments on being able to push higher yields on costs and new Defense and IT developments, I guess at what point does that give you guys the ability to continue to push rents in the operating portfolio. I mean, is the zero -- call it the flat mark to market, sort of a low baseline as we think about the business over the next five years?

Well, I do recall, one of the interesting dynamics of our business is, we have embedded growth in our leases and that's why we give you the compound annual growth rate from the original lease to the renewal lease because we capture growth in all of our leases and the mark-to-market is really on the renewal is -- we a little below the market growth in rent or we are a little above. And the zero guidance says the internal growth, we expect is about what the market has grown and if we beat it, we were able to push up a little higher or not. But it's not a measure of no growth, it's a measure of deviation of the mark-to-market growth from the embedded growth.

Right. So I guess the question really is like over the next few years you continue to expect that market rent growth will keep pace with called the 2.5% annual escalators. Is that fair to say then?

Yes. And remember, the 2.5% escalators generate a higher growth than 2.5% because 2.5% on a gross rent with an expense stop, which allows us to pass through increases of expenses. So the average of 2.5% on the gross rents produces 3.2% to 3.45% compound growth over the term, depending on the length.

Great. Appreciate the comment, Steve. Thanks.

[Operator Instructions] Our next question comes from Steve Sakwa with Evercore ISI. Your line is open.

Great, thanks. Good afternoon. Steve, I think in your prepared remarks you guys talked about the lease-up of 2100 L Street, which I know is kind of in the non-core, non-Defense/IT bucket. Where does that sit in terms of potential disposition candidates in '24?

That'll be market-dependent. So Britt alluded to some more news that could be positive in the leasing front. And I think if we're able to achieve what he alluded to, the occupancy will be positioned well for a disposition. And then it's a question of what does the capital market look like to bring that asset to market? Currently, our belief is there's very little demand for investment in even a trophy asset like this. There's a lot of uncertainty around interest rates and what the Fed's going to do. The cuts that were expected have been delayed. I think that's all creates a difficult backdrop for investors to move ahead. But I will say we will maintain a very nimble position, and when the market supports an efficient sale, we intend to sell it.

Great. And then on the data center shells, you basically said you've got no land, I think, and no starts penciled in. Just how are you thinking about that business at this point with kind of the major customer you have? Are you looking for additional sites outside of the northern Virginia kind of core market that you had or that whole business is on hold? And how do you think about the retention of that business long term if it doesn't grow from here?

So we are working actively to find additional opportunities to develop. Our market is further impaired by a lack of clarity of power availability. And so until there's clarity on power, and then from that demand, we just have to be an observer of the conditions, looking for opportunities and moving forward when conditions will allow us to do a lease.

Well, maybe ask a little differently. Are you kind of locked into the one submarket or one area where you develop with them, or could that sort of expand geographically within the broader Virginia market?

I think it could expand. I can't tell you that. We're actively working on expansion. We haven't yet seen the demand spill into the Collar counties that have more affordable land and quite a bit of it, primarily because the power is still the constraint on the market.

Great. That's it for me. Thanks.

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

Thank you all for joining the call today and the great questions. We're in our offices, so please coordinate through Venkat, if you'd like a follow-up call. Thank you.

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