Copt Defense Properties Q1 FY2024 Earnings Call

Welcome to the COPT Defense Properties First Quarter 2024 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, Latif. Good afternoon, and welcome to COPT Defense's conference call to discuss first 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. We're off to a positive start in 2024. We reported funds from operations per share of $0.62 for the first quarter, exceeding the midpoint of our guidance by $0.02. There was a 6.1% year-over-year increase in same property cash NOI. This strong performance stems from our high tenant retention, contractual rent increases, revenue growth from vacancies leased last year, strong property operations, and, to a lesser degree, new properties added to the same property pool in January. The 2023 same property pool alone generated 4.8% growth. We completed a total leasing volume of 721,000 square feet, including 551,000 square feet of renewals with a 78% retention rate, 160,000 square feet of new lease activity representing 40% of our annual goal, and 10,000 square feet of development leasing. We allocated $91 million for new investments, which includes two development starts to provide much-needed inventory in our highest occupancy markets, The National Business Park and Redstone Gateway, where we currently have no comparable space available. Our active development pipeline now encompasses approximately 960,000 square feet, with 74% pre-leased and a total cost of $381 million, an increase of nearly $60 million from last quarter. Excluding the three inventory buildings, the pipeline is fully pre-leased. We recently placed 73,000 square feet of development space into service that is 100% leased in Huntsville. In mid-March, we acquired a building in Columbia Gateway totaling 202,000 square feet for $15 million, which I will elaborate on shortly. Our business continues to generate increasing adjusted funds from operations, and our dividend payout ratio remains robust at 57% for the quarter. Reflecting our performance and outlook for sustained growth, our Board of Trustees approved a 3.5% increase in our dividend in February, our second consecutive annual increase, following a 3.6% raise in 2023. We are the sole REIT in our sector to increase the dividend year-to-date, highlighting our confidence in the strength and resilience of our FFO and AFFO growth profile. Looking ahead, we have raised the midpoint of our 2024 FFO per share guidance by $0.03 to $2.54, suggesting a 5% year-over-year increase. In contrast, more than two-thirds of Nareit-defined office REITs are anticipated to experience a decline in FFO per share in 2024. From 2019 to the midpoint of our new 2024 guidance, we expect to achieve 25% FFO per share growth, translating to a 4.6% compound annual growth rate. This is the second highest growth rate among our peers and comparable to the median growth seen in the triple net sector, while outperforming the multi-family segment over the same timeframe. Our distinct strategy has consistently produced unique results. Regarding the global outlook, recent months have seen escalating conflicts involving Iran, its proxies in Israel, and between Russia and Ukraine, with China presenting a growing concern. On March 20, the FY 2024 Defense Appropriations Act was signed, representing a $30 billion or 4% increase from the previous year. This surpasses the 3.3% increase from the approved NDAA submitted in December and is $4 billion above the President's initial budget request. The FY 2024 budget and appropriations are apart from the $95 billion in supplemental funding for Ukraine, Israel, and Taiwan, which received bipartisan backing in both the House and Senate and has been enacted into law. In this increasingly complex global security landscape, we maintain strong confidence that Congress will continue to collaborate across party lines to adequately fund national security needs and support our allies internationally. I will conclude by discussing our recent acquisition. In March, we purchased Franklin Center in Columbia Gateway for $15 million, marking our first acquisition in nine years. Franklin Center is a 202,000 square foot Class A office building located less than a mile from our headquarters, currently 56% leased to a leading defense contractor. Constructed in 2008, this building is the second newest in the park, LEED-Gold certified, and well-appointed. We identified the potential to acquire an asset and significantly enhance its value. Before any technical issues, I want to emphasize the four key criteria used during our acquisition review process. First, the mission. The property must be near a key knowledge-based national defense mission with permanence. Second, the market. It must exhibit fundamentals that attract defense IT tenants aligned with the mission. Third, the property. We seek attributes that foster high tenant retention, such as operational efficiency and significant tenant co-investment in specialized improvements. Lastly, the return. The initial cash yield must meet or exceed our development earnings, and Franklin Center met all these criteria. The strategic rationale is straightforward. This value-add opportunity has significant occupancy potential. We acquired it at a notable discount to replacement costs, enhancing our relationship with a major defense contractor. It further solidifies our position as a leading owner in Columbia Gateway and adds necessary inventory, with our Columbia Gateway portfolio nearly 95% leased aside from this acquisition. We have a solid leasing pipeline for the asset, which shows a leasing activity ratio of 200%, indicating 180,000 square feet of demand for the 90,000 square feet of vacancy we acquired. Overall, our 2.5 million square foot Columbia Gateway portfolio has an activity ratio of 190%, with approximately 445,000 square feet of demand against 235,000 square feet of vacancy. I am highly optimistic about unlocking value in this asset, as roughly 80% of defense IT tenants and the entire Columbia Gateway Park prefer COPT Defense as their landlord. With that, I will hand it over to Britt.

Thank you, Steve. Our business continues to perform well as the federal government and contractors address the global challenges we are facing. The demand for secure space is rising and becoming more urgent. This strong demand has allowed us to improve our leasing conditions by reducing concessions, mainly by lowering or eliminating rent abatements in our defense IT sector. Our leasing activity ratio for available space improved over the quarter to 85% across our total portfolio, even as we leased 160,000 square feet of vacant space and added 90,000 square feet of inventory during the quarter. The activity ratio is even higher in our defense IT segment at 108%, with only 770,000 square feet of available space out of 22 million square feet. Analyzing our markets, the MVP is the strongest part of our portfolio, experiencing ongoing demand from our largest clients, while cyber-related companies are both entering and expanding in the Columbia Gateway submarket. Businesses related to missile defense and support for other missions at Redstone Arsenal are thriving at Redstone Gateway, and we are also seeing heightened interest in R&D testing and lab space. Additionally, with the completion of the fiscal year 2024 budget, we are encouraged to see increased activity in all three of our Navy support locations. In our other segment, we are making leasing advancements in competitive environments, particularly in the 5,000 to 15,000 square foot category. At 2100 L Street in DC, we signed a lease yesterday for 16,000 square feet, bringing that building's occupancy to 92%. We anticipate more positive leasing updates in the coming months. Our overall portfolio occupancy closed the quarter at 93.6%, with our defense IT portfolio at 95.6%. The 60 basis point decline in both figures from the previous quarter was primarily because of the acquisition of Franklin Center, which had 90,000 square feet of vacancy, and the known lease non-renewals discussed last quarter. In terms of vacancy leasing, we executed 160,000 square feet during the quarter and are on track to reach our full-year target of 400,000 square feet. Vacancy leasing as a percentage of available space at year-end was over 14% in our total portfolio and over 18% in our defense IT sector. Half of the leasing volume was in the Fort Meade BW corridor segment, with Columbia Gateway particularly notable at 40,000 square feet, or 25% of the total. To share some key leasing statistics, about 105,000 square feet of vacancy leasing was with defense contractor tenants. Importantly, we recorded almost 50,000 square feet in our other segment, half of which occurred at Pinnacle Towers in Northern Virginia, where we raised the leasing rate by nearly 700 basis points sequentially. Roughly 60,000 square feet, or nearly 40% of the total, was associated with cyber activity. Approximately 70% of our combined vacancy and development leasing came from repeat business with existing clients. Cash rent spreads on the 551,000 square feet of renewals decreased by 2.5%, while GAAP rent spreads increased by 3.7%, driven by annual rent increases of 2.4% and a weighted average lease term of 4.1 years. We offer details on two larger renewals that negatively affected cash rent changes, including a 110,000 square foot lease in our Defense IT segment in Northern Virginia and a 30,000 square foot renewal in our Other segment at 100 Light Street in Baltimore. The Northern Virginia renewal was the largest lease signed in that market this quarter, starting with cash rent in the above-grade space at $40 per square foot, which despite the rent reduction, remains 8% above other agreements in the submarket and all of Northern Virginia. Excluding the effects of these two renewals, cash rent spreads were flat while GAAP rent spreads increased by 8.1%. We expect cash rent spreads to remain flat for the year at the midpoint, with retention in the 75% to 85% range. The 2.5% cash rent decline for the quarter translates to only $450,000 in annual rental revenue, which is just 0.1% of the total and we anticipate recovering this over the year. This impact is insignificant compared to the annualized revenue from vacancy leasing achieved this quarter, approximately $4.8 million. We continue to anticipate retention on our large leases to remain above 95% through year-end 2025. Now moving to development, one key element of our strategy is to maintain some level of inventory in areas where we see strong demand. When we approach full leasing, we initiate a new project to create inventory. The Redstone Arsenal is 98.6% leased and 97.4% occupied across its 2.4 million square foot park. Out of 24 properties, 20 are fully leased, with less than 35,000 square feet currently unleased in the operating portfolio. We're constructing 8100 Rideout Road to develop office inventory at Redstone Gateway. This project is currently 42% pre-leased, with a leasing activity ratio of 135%, as there is demand for 100,000 square feet against 75,000 square feet of vacancy. During the quarter, we also began work on 9700 Advanced Gateway, a high bay R&D and testing facility. This 50,000 square foot project has a total cost of $11 million and is 20% pre-leased to a defense IT firm based in Huntsville. We have a leasing activity ratio of 150%, with demand for 60,000 square feet against 40,000 square feet of vacancy. The National Business Park is 99.1% leased and occupied across its 4.3 million square foot park. Out of 34 properties, 29 are fully leased with only 37,000 square feet available at the end of the quarter. Accordingly, we initiated MVP 400 during the quarter, a 138,000 square foot office project costing $65 million, which has a leasing activity ratio of 150%, with over 200,000 square feet of demand. Our development leasing pipeline, which consists of opportunities we estimate have a 50% or greater chance of winning within two years, currently exceeds 500,000 square feet. We're also monitoring over 1 million square feet of potential future development opportunities, which should ensure we maintain a strong development pipeline in the near to medium term. To conclude, I want to emphasize the growing significance of Columbia Gateway as a hub for cyber defense and IT, thanks to a mix of government clients and a rich concentration of cyber innovators who are expanding their businesses and space needs with us. Four factors contribute to Columbia Gateway's success. First, its location is conveniently commutable, situated halfway between Baltimore and Washington DC, which helps tenants attract young, educated talent from both cities. Second, it is just 7 miles from Fort Meade, home to a major intelligence agency, U.S. Cyber Command, and over 100 federal and military agencies. Third, there is growth in cyber funding, which increased by over $2 billion this year—a more than 40% rise in the past four years—and the Department of Defense has requested another $1 billion increase for 2025. Lastly, our life cycle landlord proposition enables us to attract early and mid-stage defense contractors due to our expertise and ability to scale with them at mission-critical locations. Our variety of product offerings, such as office suites, promotes growth among contractors as they evolve, win contracts, and expand their operations. At quarter-end, Columbia Gateway was 94.8% leased and 92.9% occupied, excluding our Franklin Center acquisition. After setting aside inventory for our high-probability prospects, only 40,000 square feet remain to be leased in the park, with the largest available suite being 9,000 square feet. While we often highlight the strengths of the MVP and Redstone markets, the acquisition of Franklin Center presents an excellent opportunity to showcase our Columbia Gateway portfolio and provides essential inventory to help us fortify our leading market position and fulfill the needs of our Defense/IT clients. I'll now pass it over to Anthony.

Thank you, Britt. We reported first quarter FFO per share as adjusted for comparability of $0.62, which was $0.02 above the midpoint of our guidance. The quarter benefited from lower net operating expenses, primarily due to favorable weather conditions, increased interest income on our cash balances, and slightly lowered net G&A and venture expenses. During the quarter, the Defense/IT portfolio saw an increase of 7.6% in performance. This strong performance was a combination of the 2023 same property pool increasing 4.8% with the Defense/IT portion of that portfolio increasing 6.3%, plus the impact of properties that were added to the 2024 pool. We increased the midpoint of our same property cash NOI guidance by 50 basis points to 6.5%, driven by lower than expected free rent concessions on renewals and better operating margins. Same property occupancy ended the quarter at 93.5%, which is down 30 basis points sequentially from last quarter, but up 90 basis points year-over-year. As previously discussed, the decline was driven primarily by two downsizes, totaling 72,000 square feet. First, a 100,000 square foot contractor downsized to 60,000 square feet, but we're tracking a great opportunity to backfill the majority of that space with a government tenant. Second was the downsize of a law firm in our Other segment. We expect same property occupancy to remain relatively stable throughout the remainder of the year. Our balance sheet continues to be strong and well-positioned to navigate the higher for much longer interest rate environment the market is currently anticipating. 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 quarter, we had over 85% of the capacity on our line of credit available and over $120 million of cash on hand. We currently have no variable rate debt exposure. In February 2023, we entered into interest rate swaps at fixed SOFR at 3.75% for three years on our $125 million term loan and $75 million of the line of credit. The swap rate is over 150 basis points lower than the current one-month term SOFR and has generated significant protection in this prolonged elevated rate environment. Thus far, these swaps have generated over $3 million in interest expense savings. Based on the current SOFR curve, they are expected to remain beneficial through the maturity in 2026. We expect 100% of our debt will be at fixed rates late into 2024, as the equity component of our capital investments will be funded from cash from operations after the dividend and the debt component, from our existing cash balance and subsequently from our line of credit. Turning to our recent acquisition, the initial cash yield on Franklin Center is 11.2%. In 2024, the transaction is roughly $0.05 accretive to FFO per share and $0.10 accretive to AFFO per share. The $15 million acquisition was funded with cash on hand, and there is no impact to leverage. With respect to guidance, we increased 2024 FFO per share guidance by $0.03 at the midpoint, implying 5% growth over 2023's results. The guidance increase is driven by the first quarter's strong performance, the acceleration of commencement dates on some executed leases, and the acquisition of Franklin Center. Additionally, given the higher for longer rate environment, we expect slightly higher interest income on cash balances but are protected against higher variable interest expense because of the previously discussed swaps. Finally, we are establishing second quarter guidance for FFO per share, as adjusted for comparability, in a range of $0.62 to $0.64.

Thank you. I'll close by summarizing our key messages. We're off to a great start in 2024 with first quarter FFO per share $0.02 above the midpoint of guidance. Our Defense/IT segment is 96.8% leased, which is well ahead of our peers. We reported same property cash NOI growth of 6.1% in our total portfolio and 7.6% in our Defense/IT Portfolio. We increased the midpoint of 2024 same property cash NOI growth by 50 basis points to 6.5% at the midpoint. We executed 160,000 square feet of vacancy leasing, which puts us in a good position to achieve our full-year target of 400,000 square feet. Our $381 million of active developments, which are 74% pre-leased, provide a solid trajectory for our external NOI growth over the next few years. We purchased Franklin Center, a modern LEED-Gold certified office building in Columbia Gateway for $15 million at a double-digit initial cash yield. Our liquidity is very strong and we continue to expect to self-fund the equity component of our expected capital investment going forward. We raised our dividend 3.5% in February, which marks our second consecutive annual increase. We increased the midpoint of our 2024 FFO per share guidance by $0.03 to $2.54, which implies 5% year-over-year FFO growth. Finally, looking forward, we continue to expect compound annual FFO per share growth of roughly 4% between 2023 and 2026 based on the midpoint of our initial 2023 guidance. With that, operator, please open up the call for questions.

Thank you, Mr. Budorick. Please stand by. Our first question comes from the line of Michael Griffin of Citi. Your question, please, Michael.

Great. Thanks. Maybe you could give a little more color or context about the Franklin Center acquisition. I mean, are we going to see other assets like this trade in Columbia Gateway? Was this sort of a one-off special to this building? And can you give us any sense on kind of the going in and stabilized cap rate?

We provided the initial cap rate, which is 11.2. Our flip book shows a conservative 12% cash yield after stabilization, which is a better metric than the cap rate. Regarding the acquisition, I don’t see it as reflective of property values in Columbia Gateway. This building was previously acquired as a fully leased asset by a triple net investor. When the current tenant signed the lease several years ago, they didn’t have the ability to effectively compete with our franchise in the area. Their leasing efforts struggled, and they eventually redirected their capital toward more strategic assets. This opened up an excellent opportunity for us to acquire this building, benefiting our shareholders significantly.

Maybe just to follow up on that. With the lease expiring in 2026, would you say the probability is high of the tenant renewing or would you expect that space to be re-leased?

I would say it's exceptionally high they will renew. Remember, we know the tenant, we know the mission they conduct in that building. They have significant tenant co-investment and some very valuable improvements in that building. It would have to be an extraordinary loss of business for that tenant to depart the building.

Got you. That's helpful. And then maybe lastly, just on renewal leasing for the quarter, I saw cash rents declined about 2.5%, mainly driven by one large tenant in Nova. Would you consider that more a one-off or would you expect we could see cash rents decline continuing throughout the year?

I think our comment addresses that. We expect to see overall statistics trend back where we expect them to be in our guidance.

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

Thanks, Michael.

Thank you. Our next question comes from the line of Blaine Heck of Wells Fargo. Please go ahead, Blaine.

Great. Thanks. Good afternoon. There were some audio issues on my side, so I'm sorry if I missed anything related to my questions. But first one, great to see the new investment on both the development and acquisition sides, but just a few questions on that subject. First, can you just talk about the decision to add those two new development projects and what you're seeing that kind of makes you comfortable with the additional speculative leasing just given that overall development leasing was relatively soft this quarter?

Well, development leasing kind of ebbs and flows; it can be lumpy. Several of the prospects for the projects we started and the one we are under construction on in Huntsville. We are awaiting the approval of the NDA to proceed, which just happened in the last couple of weeks. So we expect that leasing activity to pick up through the year on the development side. With regard to the decision to start, at the MVP, we are 99.1% leased and occupied. We have less than 30,000 square feet in the whole park. We expect no space to non-renew in the near term. We have a couple of 100,000 square feet of demand that we're working with tenants on now. It's absolutely a no-brainer and a smart defensive move on our part to create inventory to support the ecosystem that we enjoy supporting Fort Meade. We have every expectation that will be very successful. Similarly, at Redstone Gateway, we have quite a bit of demand developing for High Bay R&D and testing. We decided to build a building with 20% pre-lease to satisfy that demand. We expect to lease up pretty quickly. We think that could be an important additional product type that we might want to develop into going forward.

Great. Thanks, Steve. Just to kind of follow up on that last part. So can you talk specifically about tenant prospects at 8100 Rideout? It's 42% leased. You completed it last year. Operational date is third quarter this year. I guess, just talk about more about your prospects there, whether you think you can have that stabilized by the third quarter? And then just maybe for Anthony, just remind us of your capitalized interest policies, and confirm that you'd stop capitalizing on anything unleased in the third quarter this year?

So I'll deal with the easy part. Our activity ratio is over 100% on the vacancy. Whether we get it completely full by the third quarter, I hate to predict timing. Our industry moves pretty methodically, but we are working with tenants and anticipate some pretty high-value leasing opportunities that will get done this year. We're so confident we're going to fill the building; we're already in advanced planning for the next one we need to build.

And then, Blaine, on capitalized interest, you're correct. We placed the first tenant into service in the first quarter, so capitalized interest on that portion of the building stopped in the first quarter. On any unleased component of the building or unoccupied portion of the building in the third quarter, capitalized interest would stop.

Perfect. Thanks. Last one for me. You guys bumped your expectation for FFO growth here in 2024, but I believe you kept the same expectation for 4% CAGR from '23 to '26 unchanged. Does that imply some growth was pulled forward or maybe just some conservatism with respect to kind of changing that longer-term charge target?

We got to save some news for later, Blaine. No, we put out that benchmark on the '23, '26 almost two years ago. We want to see that fulfilled. Then we'll update our forward thinking, but it doesn't imply a meaningful change to what we think will happen next year.

Great. Thanks, guys.

Thank you. Our next question comes from the line of Camille Bonnel of Bank of America. Your question, please, Camille.

Hi, everyone. I wanted to pick up on some of the drivers of the increasing guidance, particularly the comment of accelerating lease commencement dates. Can you help us understand how much of that was driven by the efforts of your operations team being able to deliver the space ahead of schedule, budget outcomes that Steve highlighted in his opening remarks or just simply, is it the tenants requesting to move in sooner?

It's really the second item that you mentioned. Our team has been able to execute our portion of the required investment in the space sooner than we had anticipated, which allows the tenant to take control of the space and for our leases to commence.

Okay, I'll review the transcript again. The sound is cutting out a bit. But just to follow up, for the last few quarters, your same store NOI has benefited from lower than expected free rent concessions. Would you consider this a trend, and what is driving it when other sectors are experiencing an increase in concessions?

Yeah. This is Britt. It is something that it's obviously a helpful trend that we're seeing and something we're pushing our asset managers and leasing folks to pursue for lower abatement. The demand is incredibly strong, especially for secure space, and that is how tenants are prioritizing what their space needs are. It's actually related to the development leasing a little bit because they're looking at what they need now, and we're seeing high demands for secure space. We feel like we have a very strong position in that regard given that we can provide that kind of space and drive down some of those concessions, particularly free rent. So it is something we're actively pushing.

Could you quantify that in terms of like percent abatement that you're giving per lease term and what that compares to pre-pandemic, for example?

I don't have that offhand, but we can certainly go through our data and get that for you. I mean, I'll say it's definitely something that we've seen, I would say, over the past couple of quarters. It's a trend that we're pushing on, but we can work to quantify that and get that to you.

Thank you. Our next question comes from the line of Tom Catherwood of BTIG. Please go ahead, Tom.

Thank you and good afternoon, everybody. Maybe, Britt, if I'm not mistaken, I think a lot of your activity in the Columbia Gateway market in the last maybe 12 months to 18 months has been small to mid-sized tenants. A lot of overflow coming from NBP. But with this now 90,000 square foot contiguous block of space, does this allow you to target a different set of tenants? Can you be more selective kind of given the activity you already have on the space? What's the kind of leasing strategy as you think of that space?

Yeah. I mean, it's a good question. We are seeing steady increased demand here from cyber tenants. And yes, they are generally smaller in size, but we're also seeing tenants that come in at 5,000 feet and have turned into 70,000 feet because of the cyber hub and the ecosystem that we've created here. So we see that as something that has a very nice trajectory for Columbia Gateway. It's becoming a much more significant cyber/IT hub.

Got it. And then also following up on something else you mentioned in your prepared remarks, Britt, you talked about the defense budget approval benefiting the Navy support portfolio. Can you provide more detail on that comment and maybe what you're seeing in terms of tenant activity in that grouping?

We are observing some fluctuations in the demand for Navy support, but recently we've noticed an increase in contract funding. I cannot specify the exact reasons for this trend, but it aligns with what we're seeing in the defense budget. There is definitely a heightened level of activity and many inquiries regarding the acquisition of additional secure space, which is encouraging to see.

Got it. And then the final question from me, maybe Steve. It's great to see the acquisition of Franklin Center. I know acquisitions can be opportunistic and may be one-off events, but what are you observing regarding potential products coming to market? There has been some discussion about opportunities in the Route 28 South corridor in Northern Virginia, with some buildings potentially aligning with your portfolio. Do you have an idea if there could be other opportunities for COPT in the market this year?

There have been a couple, three opportunities in Northern Virginia. Some of them have been deferred, and a couple resolved where another investor was willing to pay more than we would. I said earlier, we painfully went through our criteria and we're extremely disciplined; if we can't beat our development yield on an acquisition, then we're not going to buy.

Got it. That's it for me. Thanks, everyone.

Thank you. Our next question comes from the line of Ray Zhong of JPMorgan. Please go ahead, Ray.

Hi. Thanks for taking my question. My first question is on Franklin Center. You guys sound like there's no more dollar to be put into the asset itself. It's just a matter of leasing up. Is that the right way to think about that?

Yeah. Generally, yes. The building was very well cared for and it's one of the, like we said, the second newest building in the park. It's really quite prominent. We budget a couple million dollars for some public common area enhancements and improving the initial arrival experience.

Got you. And then the second part of Franklin Center is you guys provided going in cash yield and stabilized cash yield. You mentioned the strong likelihood of renewal for the existing tenant, but there's still some vacancy. Just curious to know whether that stabilized yield you provided is under the assumption of just the current tenant renewing, or assuming it's going to lease up to more like 90% or so? Just trying to think about upside and downside on that yield?

Yeah. There's much more upside than downside. That 12% stabilized cash yield was established to cover absolutely every bad thing that could ever possibly happen concurrently. I think we're going to exceed that target significantly.

Got it. And then any mark to market you can give on that? I noticed on a GAAP basis, I think the rent is a little lower than cash basis. Just curious on the mark to market there?

The value of the mark to market over the remaining lease term was just under $1.5 million. It was about $4 per foot.

Higher than market?

Correct.

Got it. My second question is about the data center. I've noticed there's another expiration later this year. Can you provide any information on the mark to market? I see that the rent is somewhat higher compared to the one that just got renewed. I'm trying to understand the market conditions there.

The negotiations with the tenant are being finalized now. We expect a strong mark to market on that lease despite the fact that its current rent is a bit higher than where our renewal last year ended. So wouldn't want to put a percentage out there right now since we're still in discussions with our tenant.

Thank you. Our next question comes from the line of Peter Abramowitz of Jefferies. Your line is open, Peter.

Hi. Yes. Thank you. Regarding the yield at Franklin Center, Steve, you mentioned that you expect some upside. If we consider reaching around 90% stabilized occupancy from the current 56% occupancy at 11%, can we estimate that the upside could potentially reach the mid to high teens?

Yes.

Got you. That's helpful. Could you touch on the two new projects you're looking to lease at Redstone? What is the depth of pipeline for demand on the build-to-suit side and what do you expect for the rest of the year?

Yes. Our overall development leasing pipeline stands at a little over 0.5 million square feet right now. This includes several possibilities for build suits as well as leasing up what we've started and are currently under construction on.

Got you. Is that something…

I won't tell you who we're working with.

That's all right. We'll wait to hear. Is that something you think could pick up just on the back of some of the strong growth in the defense budget? I would imagine that '23 demand is kind of coming through right now.

Well, it's my belief that all companies are feeling the pressure of the cost of capital right now. Even our customers with good business opportunities and growth are being very prudent about major investment decisions. So I think we get the must-have developments. There’s a wait-and-see on the want-to-haves. I generally believe if the rates improve, our development opportunities will increase from where they are today, but we still see good opportunity to meet our financial objectives in this environment.

Got it. Thank you.

Thank you. Our next question comes from the line of Richard Anderson of Wedbush Securities. Please go ahead, Richard.

I think you said me. Rich Anderson here. It's been somewhat spotty, so if I missed anything, I apologize. You might want to check your Wi-Fi account to ensure it's functioning properly. Just kidding. Franklin Center, does the yield projection take into account a roll down on the existing tenant in '26?

So, Rich, we put out a very conservative future cash yield, which embodies the various risks we could encounter. So, yes, it would absorb a rent roll down. It would absorb more investment in the common area and the structure of the building than we plan to spend. It would also account for higher TIs than we typically would give. It's just a very conservative number in a forward-looking publicly disclosed environment where we never want to overstate our opportunity. As I said to an earlier caller, I expect to beat that target and potentially by a large margin.

Okay. You described the building as very well cared for, but yet still unable to compete with CDP's engine in the vicinity. What would have stopped a tenant from moving over to a very well cared for building in proximity to everything else? It just seems odd to me that if it's a nice building, it looks nice, the pictures look nice, why wouldn't it have been more competitive versus your 97% occupancy vicinity?

It's a hard question for me to answer with specificity, but to kind of ease your concerns, 80% of the defense contractor business in Columbia Gateway is with us. We've been a defense/IT landlord in this market for over 25 years and have strong relationships with most of the tenants in the market. We tend to dominate in this business park.

And I would just add to that. We have an additional 200,000 square feet of demand that we're seeing since we took over. So again that just shows what Steve is saying, which is the relationships that we have draw tenants to our assets here.

One last comment. The prior owner from another part of the country, a different structure and a triple net lease investor, had no particular operating presence on the East Coast. They had to rely on a fee management crowd. Hypothetically, that service component of the business doesn't bring the relationships that we have where we do that primarily directly.

Okay. Made progress on L Street, I think you said fully stabilized now. I know there was some leasing in Baltimore. How are you closing in on some of these 'other asset sales?' Could it be a this year event or is that not a likely outcome at this point?

I don't see it this year, Rich. What transactions that have happened in DC are very opportunistic from the buyer's standpoint. They don't represent cap rates that we would accept with an asset that valuable for the sense of timing. Outside of that, in Tysons Corner in Baltimore, I just don't think you have the depth of capital to make a market on those assets. It's going to take some time.

Okay. And last question from me. You've heard the 4% CAGR through 2026 on FFO. What does that assume on a same store cash NOI growth? I know you're doing 6.5 this year. That's probably not sustainable at that level, I'm guessing. What's the right way to set expectations from an internal growth perspective?

I'm not sure I can answer that question. We haven't really ran maths on it in that way. Do recall, we put that target out several years ago, and we're going to continue to report against that target until we hit it and then consider our new benchmark that we put forward. The intent is to convey our confidence in continuing to produce growth in a challenging financial environment and convey the strength of our business that we continue to prove quarter-in and quarter-out.

Okay. Fair enough. Thanks very much.

Thank you. Our next question comes from the line of Dylan Burzinski of Green Street. Your question please, Dylan?

I actually don't have any more questions. Sorry. Thanks, guys.

Good to talk to you though, Dylan. We'll see you soon.

Thank you. I will now turn the call back to Mr. Budorick for closing remarks.

Well, thank you all for joining our call today and the enriching questions that we got to discuss. We are in our offices all afternoon, so please coordinate through Venkat if you like a follow-up call or talk about something we mentioned in more detail. Thank you.

Thank you for your participation today in the COPT Defense Properties First Quarter 2024 results conference call. This concludes the presentation. You may now disconnect. Good day.