COPT Defense Properties (CDP) Earnings Call Transcript

Welcome to the COPT Defense Properties Second Quarter 2026 Results Conference Call. As a reminder, today's call is being recorded. At this time, I will turn the call over to Vince Kommineni COPT Defense's Vice President of Investor Relations. Mr. Kommineni please go ahead.

Thank you, Atif. Good afternoon, and welcome to COPT Defense's conference call to discuss second quarter 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. The company delivered a strong first half of the year in all aspects of our financial and operating performance and the defense economy we serve continues to be strong and benefits from increasing investment. For the second quarter, FFO per share was $0.71, which was $0.02 above the midpoint of guidance. represents a 4.4% increase year-over-year and in the 24th consecutive quarter of year-over-year FFO per share growth for the company. Same-property cash NOI increased 7.4% year-over-year, and we generated 6.4% growth in the first half of the year. This is favorably impacted by the timing of lease and rent commencements. We expect growth will moderate slightly in the back half of the year, which has been reflected in our annual guidance. Anthony will provide more detail. We executed 139,000 square feet of vacancy leasing in the quarter and 231,000 square feet during the first half of the year. This amounts to nearly 60% of our full year target and represents 20% of the unleased space we had at the beginning of the year. We invested $43 million to acquire 17 acres of land and a ground lease in the Westfield submarket in Chantilly, Virginia, and a GAAP yield of roughly 7.5% with some additional future upside. Turning to guidance. Based on our strong performance year-to-date and our outlook for the second half of the year, we increased the midpoint of 2026 guidance for 4 metrics. FFO per share increased by $0.02 to $2.78 per share. This implies 2.2% growth over 2025's results and is $0.03 above our initial guidance. This revised midpoint is even more impressive when you account for the $0.12 of higher financing costs year-over-year in our guidance based on $0.08 of incremental net interest expense from our bond refinancing and $0.04 of dilution from our exchangeable notes, resulting from our strong stock performance. Same-property cash NOI growth increased by 100 basis points to 4%, which is 150 basis points above our initial guidance. Cash rent spreads on renewals increased by 100 basis points to 3%, and our capital commitment to new investments increased by $45 million to $335 million. Additionally, our vacancy leasing target increased by nearly 20% from 400,000 to 475,000 square feet. Moving now to the defense budget. In April, the White House submitted the FY 2027 Defense base budget request, which requested a 30% increase year-over-year to $1.1 trillion and amounts to a nearly 50% increase over the last 5 years. Last week, Congress made progress on the legislation and the House passed the National Defense Authorization Act, or NDAA, which matched the President's base budget request of $1.1 trillion. Reconciliation funding is expected to provide additional upside to FY 2027 spending, and the estimates range between $73 billion at the low end based on the reconciliation framework passed by the house, all the way to the $350 billion at the high end, which was the President's request. The NDAA calls for meaningful increases in funding in the priority missions that our portfolio supports, including the $16 billion or 14% increase for Intelligence, a $4 billion or 25% increase for DoD cyber funding and an additional $18 billion for Golden Dome. While the ultimate outcome is still being determined in Congress, our business has really driven off the base budget of $1.1 trillion, which is expected to be the new run rate for transpending. Mike Rogers, Chairman of the House Armed Services Committee was recently quoted stating that $1 trillion base budgets are going to be the new normal. Regarding our growth opportunities, things are getting even more exciting at Redstone Gateway in Huntsville. In the third quarter, we will start 2 new development projects totaling 240,000 square feet because we have no contractor space left to lease. Our 2.4 million square-foot operating portfolio is 99.6% leased. And the only remaining availability is spoken for. Following the execution of this last 10,000 square foot lease, all 24 buildings will be 100% leased. In our active developments for defense contractors, 7,700 Advanced Gateway is fully leased and 8,500 Advanced Gateway, our current inventory development is 41% leased. We expect final lease for 75,000 square feet this week, and we're negotiating a lease for the remaining 15,000 square feet, which we expect to sign next month. Beyond these deals in progress, we have another 415,000 square feet of demand from contractors for mission space related to golden dumb and missile defense activities. Given our strong success in the quarter, and the depth of demand we're seeing, we're commencing development on 2 inventory buildings, consisting of RG 6,300, 180,000 square foot building with 30,000 square foot floor plates, which will deliver in early 2028 and RG 2200, a 60,000 square foot building with 20,000 square foot floor plates, which will deliver in late 2027. These buildings will provide vital inventory to begin to meet the space and timing requirements of the current demand. Looking back in 2011, we commenced our first development in Redstone Gateway, a 120,000 square foot building in order to create the initial inventory to see the park. We leased that building to a defense contractor shortly thereafter, and it has been 100% leased ever since. Over the past 15 years, we developed 2.4 million square feet that will be 100% leased in the coming weeks. Upon completion of the 3 projects under active development, the park will be 2.8 million square feet, making Redstone Gateway our second largest market condenstration. And following completion of the 2 plant starts, the park will exceed 3 million square feet. For context, it took 21 years for the National Business Park to reach 3 million square feet after commencing development in 1990 anticipating only our current planned activity -- we'll achieve that milestone at Redstone Gateway in 16 years or 5 years earlier than the national business park. Given the strength of the demand we're seeing in the market, we look forward to updating this projection in the next 24 months. And with that, I'll turn the call over to Britt.

Thank you, Steve. Before I walk through our operating performance during the quarter, I'd like to share 3 key highlights. First, we are outperforming on vacancy leasing driven by demand in our Fort Meade BW corridor subsegment, materializing most significantly in Columbia Gateway. Second, we continue to deliver sector-leading tenant retention. We averaged 84% in the first half of the year and 79% over the past decade. This provides a material capital advantage over traditional office landlords and is the foundation for our unique ability to self-fund the equity required for external growth. And third, the government's massive investments in the missions that we support is providing not only current opportunities, but also long-term external growth potential. We finished the quarter with continued strength in both our lease and occupancy rates. Our total portfolio was 95.6% leased and 94.1% occupied while our Defense/IT portfolio was 96.4% leased and 95.1% occupied. 2 data points, which demonstrate the strength of the demand we're seeing in our markets and our ability to to convert that demand into lease executions are: first, our Northern Virginia portfolio ended the quarter at 95.2% leased, which is the highest lease rate in the subsegment in over a decade and compares very favorably to the overall Northern Virginia market occupancy rate of about 78%. Second, our Columbia Gateway portfolio has seen significant momentum in terms of vacancy leasing over the past few years. In 2023, we executed 50,000 square feet, which increased to nearly 100,000 square feet in 2024 and surpassed 160,000 square feet last year. In 2026 to date, we've executed 110,000 square feet. And with the additional activity in the pipeline, we are confident this will be the strongest year for vacancy leasing in Columbia Gateway in over 5 years. There were 2 temporary events in the quarter, which caused total occupancy to decline by 30 basis points in aggregate, both of which will reverse next quarter. First, we placed NBP 400 and nearly 150,000 square foot building into service as vacant space. However, the building is fully leased to a leading defense contractor and the lease will commence in the third quarter. This delivery resulted in a 60 basis point decrease in occupancy in Q2 that will reverse in Q3. Second, all of firm tenant relocated within 100 Light Street in Baltimore and downsized modestly. However, they continue to occupy their old space in the quarter, and this resulted in a temporary 30 basis point increase in both total and same property occupancy and an almost 400 basis point increase in the occupancy rate of the other portfolio. The net impact of these 2 temporary events will be a 30 basis point increase in total occupancy in the third quarter. We executed 139,000 square feet of vacancy leasing during the second quarter, nearly 70% of which was with existing tenants further demonstrating the strength of our franchise and our deep relationships within the defense industry. Year-to-date, we have signed 290,000 square feet of vacancy leasing, which amounts to roughly 25% of the unleased space in our total portfolio at the beginning of the year and equates to over 70% of our initial full year target of 400,000 square feet. We have approximately 125,000 square feet of prospects in advanced negotiations, which we define as over 90% likely to execute. Taken together, we have over 415,000 square feet of leases either executed or in advanced negotiations. This achievement and the continued strength of our demand gives us the confidence to raise our target to 475,000 square feet for the year. Our leasing activity ratio was 69% which equates to 770,000 square feet of prospects on 1.1 million square feet of availability. Turning to renewal leasing. We executed nearly 350,000 square feet in the quarter with tenant retention of 68%, cash rent spreads down 20 basis points and GAAP rent spreads up 4.4%. We continue to leverage the strength of demand for our Defense/IT portfolio by minimizing concessions on renewal leasing. Year-to-date, our renewal concessions are down nearly 30% compared to 2025. Our relatively lower retention rate this quarter was driven by 2 strategic nonrenewals in the Fort BW quarter. These nonrenewals occurred following strategic expansions of 2 tenants into new properties to accommodate the growth required for them to execute their priority missions. Net of these 2 deals, retention would have been 12 percentage points higher. Notably, we backfilled 1 of the nonres immediately at a significant increase in rent and the other provides the necessary growth capacity for a third tenant in our portfolio. These anomalies occur when you have the strong tenant relationships that we have and our commitment to accommodate tenant growth in our highly occupied portfolio. Our full year outlook for tenant retention is unchanged at 80% to 85%. Our outlook for retention over the next several years continues to remain strong. Looking back, as shown on Page 18 of our foot book, in the second quarter of 2024, we disclosed our view on the renewal of large leases. Those in excess of 50,000 square feet over the next 10 quarters through year-end 2026. At the time, we had 32 large leases totaling 4 million square feet set to expire. Since then, we have renewed 24 of those leases and achieved a 97% retention rate on this 3 million square feet. The remaining 8 leases in that pool are all full building leases to the U.S. government, which total nearly 1 million square feet. We expect to retain 100% of that lease space with lease executions expected in 2027. When these 8 leases renew, our retention on their 4 million square foot pool will be nearly 98%, which compares favorably with our initial projection of over 95%. On Page 19 of our foot book, we expanded this disclosure to include our view of large lease expirations for the next 10 quarters through year-end 2028. In this window, we have 39 large leases expiring, totaling 4.1 million square feet which account for nearly 60% of our total expiring annualized rental revenue during the period. We expect approximately 90% retention on this population. Roughly 70% of this large lease pool by square footage and 66% by annualized rental revenue is government and data center shell tenants for which we expect 100% retention. This pool includes 2 leases in our Other segment, which equates to roughly 5% or 160,000 square feet of the total area, on which we expect approximately 50% retention. Looking back, since we provided -- started providing large lease retention disclosure 4 years ago, we have renewed 5 million square feet of large leases at a 98% retention rate. And importantly, over those 4 years, we have retained 100% of the tenants in our portfolio with only 4 modest downsizes that total less than 120,000 square feet. We continue to provide this disclosure to reinforce the fact that our portfolio is not exposed to material nonrenewals, which would impact occupancy, cash flow and NOI. Moving on to development. Our active pipeline now totals nearly 900,000 square feet that is 73% pre-leased and amounts to nearly $450 million in capital commitment. 4 of the 6 projects are 100% pre-leased. In Huntsville, 8,500 advanced gateway is 41% leased, and we are currently negotiating 2 leases that will bring this building to 100% leased this quarter. For 10 Gas Road is our inventory building for the government, which is inside defense. We are in active discussions with multiple government agencies related to missile defense and space activity, and we expect lease action for that building sometime in 2027. As Steve discussed, we will commence development of RG 6300 and RG 2200 later this summer, which totals $91 million in capital commitments. Our development leasing pipeline, which we define as opportunities we consider 50% likely to win or better within 2 years or less, currently stands at nearly 1.2 million square feet, a 20% increase since last quarter. Beyond that, we're tracking an additional 900,000 square feet of potential development opportunities, a nearly 60% increase since last quarter. Combined, the pipeline increased over 500,000 square feet over the last quarter and this acceleration further reinforces our confidence in achieving external growth in the coming years. With that, I'll hand it over to Anthony.

Thank you, Britt. We reported second quarter FFO per share of $0.71 and which was $0.02 above the midpoint of guidance and represents a 4.4% increase year-over-year. The quarter benefited primarily from effective operating expense and property management, which resulted in lower net operating expenses, as well as higher net development fees. Same property cash NOI for the quarter increased 7.4% year-over-year driven by cash rent commencement on developments and acquisitions placed into service in prior years, cash rent increases on virtually all the leases in our portfolio, along with the benefits from the commencement of a large portion of the over 0.5 million square feet of vacancy leasing executed last year. Same-property occupancy ended the quarter at 94.5%, which is up 30 basis points from last quarter due to the temporary occupancy bump at 100 Light Street that Britt mentioned. We continue to expect same-property occupancy will end the year at roughly 94%. With respect to guidance, we increased the midpoint for the following 4 key metrics regarding FFO per share, our assumed full year share count reflects roughly $0.04 of dilution from our exchangeable notes, the impact of which has doubled in each of the past 2 quarters. We will gladly manage through the impact of this dilution since it is a result of our 38% stock price appreciation year-to-date. And despite this impact, we increased the midpoint of full year FFO per share guidance by $0.02 and to $2.78. Our forecast for FFO has increased by $8 million since we established initial 2026 guidance, which is driven by $5 million of outperformance during the first half of the year and $3 million from the net impact from the acquisition of Mission Ridge, additional interest income and the expected settlement agreement with a nondefense tenant to regain control of much needed inventory in Columbia Gateway. We increased the midpoint of same-property cash NOI growth by 100 basis points to 4%. This reflects the strong performance during the first half of the year and our expectation that growth will moderate in the back half of the year due to several known move-outs and contractions along with nonrecurring real estate tax refunds received in the back half of 2025, primarily in the third quarter. We increased the midpoint of the cash change in cash rents on renewals by 100 basis points to 3%, which is positively impacted by several early renewals we expect to sign later this year. Finally, we increased the target of capital committed to new investment guidance by $40 million to $330 million -- $5 million, which reflects the impact of an additional start at Redstone Gateway. We are establishing FFO per share guidance for the third and fourth quarter at a range of $0.68 to $0.70. With that, I'll turn the call back to Steve.

Thank you. Summarizing the key themes of our call today. We outperformed our FFO objectives and raised our annual guidance, outpacing the incremental dilution resulting from our sector-leading 38% increase in share price year-to-date. And we raised our guidance on 3 other metrics. Our tenant retention remains rock solid, providing the strong foundation to support continued growth in investment spending and FFO per share achievement. We continue to have the capacity to fund the equity component of roughly $300 million of investment on a leverage-neutral basis annually. We are committing another $91 million to new development and Redstone Gateway to begin to address the accelerating demand from space and missile programs, our country is prioritizing. We continue to enjoy strong market fundamentals throughout our portfolio, supported by record increases in defense-based budget spending and growth in the priority missions we serve. We're benefiting from advancements in missile defense, cyber activities, quotum computing, military space activities and intelligence programs. And this mission is durable and growing. National fund spending has entered the year of $1 trillion base budgets -- to support the creation and development of advanced technology weapons programs and thereby creating current and growing opportunities throughout our markets. We look forward to sharing our third quarter progress in October. And with that, operator, please open the call for questions.

Thank you, Mr. Budorick. [Operator Instructions]. Our first question comes from the line of Seth Bergey of Citi.

I guess just the first 1 on the increase in the base budget. And it sounds like based off your commentary that the 20% increase is kind of a structural step-up just given the expectation for it to be kind of $1 trillion moving forward. Does that kind of change the way you think about the amount of capital you would look to deploy in future developments going forward? .

No, not really. We've positioned the company very well to deploy capital on a low-risk basis where we see incremental opportunities. And to the extent this new elevated trillion level generates more activity, we're prepared and we've got a strong balance sheet to support increasing our investment on the same low-risk basis, we've been running the company for the last 10 years. .

And then just any changes on kind of your expectations for development yields? And then just given kind of the year-to-date even in the stock price, has that changed the way you think about funding development with free cash flow versus potentially assuming equity of ATM.

Well, let me take the first 1 first. We continue to achieve initial cash yields of roughly 8.5% on our new development target that we elevated from 8% a few years back, we've been able to hold that. And I don't see that target changing. With regard to funding, then we have no interest or intention of funding with new equity issuance, and we're very satisfied to continue to fund with free cash flow. We've worked very hard for several years to get us in a position where we can grow this company without going to the market. and we intend to keep it there.

Our next question comes from the line of Manus Ebbecke of Evercore.

Just curious, in addition to the 2 new starts that you have earmarked for Huntsville in Q3. If you kind of go through your portfolio and look at the different regions you're in, like where could you see additional starts kind of coming up next or like which are kind of like the next markets on the list where you think like it's also getting really tight in supply versus like the strong demand that you're seeing? .

Yes. Well, Manus, this is Britt. First, I do want to hit on Huntsville because, I mean, we are taking a longer view on development there just generally beyond even these 2 and investing in some predevelopment dollars for the next 4 buildings beyond these 2 and even the next -- looking at where we're going to cite the next 8 buildings beyond that. I mean I think there's -- the demand in Huntsville is tangible. So -- but in addition to Huntsville, looking around the port meat market is still showing signs of strong demand, and there's a few areas that we have at National Business Park and then also down around College Park that we like that we like a lot for potential future development starts as well. .

Yes. And if I can add to that Manus, as we're starting 2 buildings, and our comments carefully said to begin to address the accelerating demand -- we believe there's pretty strong potential to either add additional inventory or sign pre-leases beyond this initial 2-building commitment we are making in the quarter. .

Okay. Makes sense. And then maybe a quick follow-up. I know you always are actively talking to your tenants and contractors in the areas that you guys are in. just curious if there's any updated takes or kind of like a story you can share on like Golden Dome that you've been hearing over the last few months. and how that could potentially kind of like incrementally healthy even in the future? Obviously, we understand that the positive impact of these 2 big programs have to you overall?

Well, I would say over the -- if you're looking at the near-term pipeline of that or higher probability pipeline of 1.2 million square feet, I would say 83% of that higher probability pipeline is in Huntsville and 50% of that is Golden Dome related. So it is something that is steadily growing down there. .

Our next question from the line of Blaine Heck.

Steve and Britt, not to beat a dead horse here, but it does sound like activity is picking up rapidly in Huntsville and not to overlook the increased guidance. But -- do you think there's potential upside to the incremental $45 million of development starts in Huntsville in the second half of this year? I guess -- are those 2 starts truly speculative? Or do you have negotiations or even letters of intent on those buildings that such that you could actually start more on a spec basis this year? Or should we expect that ramp to be more in '27 and beyond? .

Well, there's a lot of activity. Timing is tough to predict. I would not like to overpromise on this call that Mark can occur during the year. I can tell you, we don't have any pre-leases on those buildings. -- we consider them inventory because we're working with tenants on specific space requirements. And we picked those 2 sizes of buildings for a reason to match the floor plates with the kind of demand we're seeing. So we certainly anticipate activity behind these 2. We have every confidence we get these leases quickly. Whether it happens this year or next we'll leave that future calls.

All right. Probably fair. Second question, I know it was a very recent acquisition, but I wanted to ask whether there was any update on the ground lease in Chantilly or any progress made towards potentially taking control of the assets there? .

So we have made no progress in taking control of the assets. The facts are that the owner of the property had a mortgage that matured. It's not been repaid. The mortgage has been transferred through a special servicer. I believe they are working to refinance it. And that's all we really know. We know long term, we'd love to have those properties in our portfolio, really a perfect fit, both with tenant -- tenant presence, the nature of the construction of the development in the location. And we believe sometime we'll be in a position to acquire those buildings. .

Our next question comes from the line of Anthony Paolone of JPMorgan.

Great. I'm struck by just how how much Golden Dome has had an impact on your leasing. And so just wondering, with midterms coming up, if that changes sort of power in the House and Senate -- does it have any implications on that? Or do you think it has any implications on momentum anywhere else in the portfolio? .

Well, let's just -- I got to regroup a little bit. Before this president got elected, we repeatedly said the 1 issue in the U.S. government that is bipartisan, is increased defense spending. Under the prior President, the pattern was that the President did have strong interest in investing in defense. So the White House requests were relatively flat. And the House and the Senate addressed the needs of the defense department by increasing those budgets in a bipartisan way. . So I truly believe irrespective of the outcome of the midterm that bipartisan recognition of the need to have the strongest military on the face of the earth and to invest in the new technologies that have the potential to change that balance will exist. And so we're not hearing the midterm change -- and we know that irrespective of what happens in the House and Senate, we do have a President who's very motivated to see increases in defense spending. So I think it will still be a favorable environment.

Okay. And then just a follow-up. Obviously, a lot of participants at this point and liquidity in the data center industry broadly I know you guys have the Des Moines land. But just as you think about your positioning there and what you've done in the past, like do you -- do you think you still have an opportunity there in the future? Do you see yourselves getting more active in that space? Or has it just become too crowded? .