ProArtWork/E+ via Getty Images Introduction I’ve often been hesitant to write about REITs as I’m of the view that many will suffer in a higher rate environment. With office REITs in particular, there’s pain in the sector. And for good reason. High interest rates, high levels of leverage, the shift to work-from-home, and urbanization trends have all been factors that have led to investors selling office REITs. However, there’s opportunity for investors willing to dig deeper. In this article, I’ll discuss COPT Defense Properties (NYSE:CDP), a REIT that’s classified as office, but is significantly more resilient due to its tenant mix, ability to increase rents, balance sheet, and growth drivers. I’ll also discuss the company’s recent results and why I believe that the current valuation isn’t as expensive at first glance relative to its peer group. Company Overview COPT Defense Properties is a real estate investment trust (REIT) that owns a portfolio of properties, all of which cater to defense and IT tenants. Many of its tenants include large, recognizable companies including General Dynamics (GD), Boeing (BA), Booz Allen Hamilton (BAH) and Lockheed Martin (LMT). COPT also has the United States Government as its largest tenant, representing 95 out of the 210 leases. Almost of the companies properties are located within Virginia, Maryland, Washington DC, and Alabama. Attractive Tenant Profile Despite being classified as an ‘office REIT’, I find COPT to exhibit significant differentiating factors that make them different to your typical office REIT. Unlike the rest of the office real estate, having defense tenants provides comfort as it has relatively more market resilience, providing stable cash flows. This includes the stability gained from having large tenants (who don’t have the agility to move spaces quickly and often enter into long-term leases) and being located in very specific areas. It’s not uncommon for several defense companies to locate in one designated location. For example, in National Business Park in Maryland, COPT has all of the defense companies I mentioned earlier on leases at this property, plus several well-known companies including IBM (IBM), Accenture (ACN), and Oracle (ORCL). Tenants at National Business Park (Loopnet) Another way COPT differentiates itself is that its properties s leased to defense and IT tenants typically require robust security measures and specialized infrastructure, such as data centers and secure communication facilities. COPT’s ability to meet these stringent requirements through its properties further differentiates it from traditional office REITs, which generally do not need to invest in such specialized infrastructure. The company’s track record of meeting these demands also signifies to its tenants that its capable of meeting their demands. This creates a barrier to entry for potential competition, as evidenced by the fact that a third of COPT’s employees have some sort of credential required in order to perform their job. As such, the company enjoys very high retention rates above 80%, with an average of 75% over the last ten years. Long-term Tailwinds One of the biggest drivers for growth in the defense industry is government defense spending. When looking at the Department of Defense’s budget, the trend over the most recent four years highlights an accelerated growth rate, growing at 19.4% over the period. While my first impression was that some of this might have been attributable to partisan politics, the most recent National Defense Authorization Act for the 2024 full year passed with bipartisan support in March 2024 will increase 4% over 2023. As a percentage of U.S. GDP, defense accounts for 3.1%. Investor Presentation The long-term growth in defense spending is important for COPT. Back to COPT’s National Business Park in Maryland, this was a property that had just 4 buildings totaling 485k square feet in 1997 to over 3.8 million square feet today. Located just outside one of the main entryways to Fort Meade, a hub for information, intelligence and cyber activity, COPT has been developing NBP to become a high quality, state-of-the-art park that’s designed around its tenants, including the U.S. Government and those companies serving the country’s Defense/IT missions on Fort Meade. These tenants want to be located here because it provides the proximity and access to 120 federal agencies and commands on post, including U.S. Cyber Command, Defense Information Systems Agency and several others. This example highlights how COPT directly benefits from increased defense spending. National Business Park Growth (Loopnet) Recent Results When looking at the most recent results for COPT, the company reported FFO per share of $0.62, which was very good considering it exceeded the high-end of the guidance range set out at the end of Q4’23. Historically, COPT has had a track record of meeting or exceeding guidance in sixteen out of the last seventeen quarters. With respect to NOI, property cash NOI increased 6.1% which is consistent with the mid-single digit rent increases the company is able to achieve year in and year out. On leases, COPT had 721,000 square feet of total leasing; 160,000 square feet of vacancy leasing with a weighted average lease term of 8.2 years. Interestingly, the active development pipeline now sits at 960,000 square feet, most of which (74%) is actually pre-leased, something you don’t often see from your traditional office properties. Leased with a total cost of about $381 million, this was a $60 million increase from Q4’23. Total retention rate came in at 78% with the Defense/IT Portfolio retention rate clocking in at 83%. Investor Presentation Overall, this was a great quarter for COPT. Based on Q1 results, the company looks like it will be on track to reach its annual goal of between 75% to 85% retention rate. With NOI growth of 6.1%, the company is just below the midpoint the 2024 guidance range and the accelerated growth looks to be achievable. Guidance (Investor Presentation) One of the things that excites me the most for COPT the fact that this quarter, the company put $91 million of capital to work in new investments. This consisted of two development projects with an estimated cost of $76 million and acquired a property for $15 million (202,000 square foot building in Columbia Gateway, a market it already has a sizable presence in). The two development projects will be at National Business Park and Redstone Gateway, two of the highest occupancy markets COPT serves, where they “literally have no comparable space left to lease”, according to CEO Stephen Budorick. Investing in these development starts should add more inventory in these markets and, in my view, are likely to be leased quickly with new tenants because of the high demand. So the risk-reward for such investments makes it a near-no brainer for COPT. Guidance for capital to new investments was around $220 million for 2024 so with Q1 completed, the company is nearly halfway on its goal. Financials During the quarter, management increased guidance for FFO per share growth by 3 cents to $2.54. Compared to most office REITs that are expected to see FFO per share decline this year, COPT is expecting FFO to increase 5% on a year over year basis. This is a direct result of the company’s differentiated approach to its tenant base, which has proven considerably more resilient during the office downturn. From 2019 to implied 2024 guidance, FFO growth on a per share basis will equate to a 4.6% CAGR. COPT’s balance sheet is also in a good position. As an investment grade REIT with a BBB profile by S&P, the company does not appear to be over-levered, unlike other REITs which are facing the challenge of operating in a higher interest rate environment. At the end of the most recent quarter, COPT had $2.42 billion of debt, most of which is attributable to their unsecured senior notes which have laddered maturities between 2026 and 2033, the most recent of which was financed at 5.25% which is in line with other BBB REIT peers. 10Q With cash on the books of $123.1 million and EBITDA of $346.1 million for FY’23, the company has a Net Debt to EBITDA ratio of 6.6x. While that may seem high on an absolute basis, keep in mind that the tenant quality is above average and that the leverage below what’s typical for an office REIT. With interest expense of $77.7 million in 2023, the interest coverage ratio is about 4.5x, so COPT generates adequate cash flow to meet its interest obligations. Valuation and Wrap Up Valuing COPT can be a bit tricky. For one thing, there are no publicly traded defense and IT REITs. When we compare COPT to peers like Boston Properties (BXP), Cousins Properties (CUZ), Easterly Government Properties (DEA), and SL Green (SLG), the company trades at over a 2-turn premium to the median multiple of the group coming at 10.1x P/FFO compared to the median of 7.7x. In addition to this, the company trades at 1.9x tangible book value compared to the peer group median of 0.9x. Overall, I’d say the company’s premium is well deserved considering the higher quality tenants, high renewal rates, and steady growth, even during a tough market. Author, based on data from S&P Capital IQ As for the risks to the investment thesis, the main one would be that renewal rates don’t stay above 75%. In 2025, the company has a sizable number of leases that are up for renewal, about 23% of rental revenues expiring. For the reasons discussed earlier, like the special services that COPT provides in addition to the attractive locations of the properties, I think it’s likely that these leases are renewed. Nevertheless, investors should still monitor renewal rates as a key indicator to evaluate performance of the REIT. Lease Expirations (Supplemental Information Package) In conclusion, COPT isn’t your average office REIT. Its portfolio properties are higher quality because of its focus on defense and IT tenants which exhibit characteristics that make rental revenues more defensible and faster growing, even during weaker economic periods. While the company does trade at a premium to peers at 10.1x P/FFO, I believe the valuation is justified given the above-average growth in rental revenues and FFO on a per share basis. With lower levels of leverage and less cyclicality built into the REIT, the 4.9% dividend (46.2% payout on FFO) seems to be well covered by free cash flow generation, particularly with a balance sheet with sufficient liquidity and adequate leverage. Overall, COPT should make for a great addition to a well-diversified portfolio looking for safe and reliable dividends. As such, I rate the shares as a ‘buy’.
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