COPT Defense Properties - 10-Q quarterly report FY

PART I: FINANCIAL INFORMATION

ITEM 1. Financial Statements

Corporate Office Properties Trust and Subsidiaries
Consolidated Balance Sheets
(Dollars in thousands)
(unaudited)

See accompanying notes to consolidated financial statements.

3

Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Operations
(Dollars in thousands, except per share data)
(unaudited)

See accompanying notes to consolidated financial statements.

4

Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Cash Flows
(Dollars in thousands)
(unaudited)

See accompanying notes to consolidated financial statements.

5

Corporate Office Properties Trust and Subsidiaries

Notes to Consolidated Financial Statements
(Dollars in thousands, except per share data)
(unaudited)

1.             Organization

Corporate Office Properties Trust (“COPT”) and subsidiaries (collectively, the “Company”) is a fully-integrated and self-managed real estate investment trust (“REIT”) that focuses on the acquisition, development, ownership, management and leasing of primarily Class A suburban office properties in the Greater Washington, D.C. region and other select submarkets.  We have implemented a core customer expansion strategy that is built on meeting, through acquisitions and development, the multi-location requirements of our strategic tenants.  As of September 30, 2006, our investments in real estate included the following:

·                  168 wholly owned operating properties totaling 14.6 million square feet;

·                  17 wholly owned properties under construction or development that we estimate will total approximately 2.1 million square feet upon completion and two wholly owned office properties totaling approximately 115,000 square feet that were under redevelopment;

·                  wholly owned land parcels totaling 555 acres that we believe are potentially developable into approximately 6.9 million square feet; and

·                  partial ownership interests in a number of other real estate projects in operations or under development or redevelopment.

We conduct almost all of our operations through our operating partnership, Corporate Office Properties, L.P. (the “Operating Partnership”), of which we are the general partner.  The Operating Partnership owns real estate both directly and through subsidiary partnerships and limited liability companies (“LLCs”).  A summary of our Operating Partnership’s forms of ownership and the percentage of those securities owned by COPT as of September 30, 2006 follows:

Two of our trustees controlled, either directly or through ownership by other entities or family members, an additional 14% of the Operating Partnership’s common units.

In addition to owning interests in real estate, the Operating Partnership also owns 100% of Corporate Office Management, Inc. (“COMI”) and, either directly or through COMI, 100% of the consolidated subsidiaries that are set forth below (collectively defined as the “Service Companies”):

Most of the services that CPM provides are for us.  CDC, CDS and CC&C provide services to us and to third parties.

2.                                      Basis of Presentation

The accompanying unaudited interim Consolidated Financial Statements have been prepared in accordance with the rules and regulations for reporting on Form 10-Q.  Accordingly, certain information and disclosures

6

required by accounting principles generally accepted in the United States for complete Consolidated Financial Statements are not included herein.  These interim financial statements should be read together with the financial statements and notes thereto included in our Current Report on Form 8-K filed on August 31, 2006.  The interim financial statements on the previous pages reflect all adjustments that we believe are necessary for the fair statement of our financial position and results of operations for the interim periods presented.  These adjustments are of a normal recurring nature.  The results of operations for such interim periods are not necessarily indicative of the results for a full year.

3.             Earnings Per Share (“EPS”)

 We present both basic and diluted EPS.  We compute basic EPS by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period.  Our computation of diluted EPS is similar except that:

·                  the denominator is increased to include: (1) the weighted average number of potential additional common shares that would have been outstanding if securities that are convertible into our common shares were converted; and (2) the effect of dilutive potential common shares outstanding during the period attributable to share-based compensation using the treasury stock method; and

·                  the numerator is adjusted to add back any convertible preferred dividends and any other changes in income or loss that would result from the assumed conversion into common shares.

Our computation of diluted EPS does not assume conversion of securities into our common shares if conversion of those securities would increase our diluted EPS in a given period.  A summary of the numerator and denominator for purposes of basic and diluted EPS calculations is set forth below (dollars and shares in thousands, except per share data):

7

Our diluted EPS computations do not include the effects of the following securities since the conversions of such securities would increase diluted EPS for the respective periods: 

4.             Recent Accounting Pronouncements

See Note 5 for disclosure associated with our implementation of recent accounting pronouncements relating to our accounting for share-based compensation.

In June 2005, the Financial Accounting Standards Board (“FASB”) ratified the consensus reached by the Emerging Issues Task Force (“EITF”) regarding EITF 04-05, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.”  The conclusion provided a framework for addressing the question of when a general partner, as defined in EITF 04-05, should consolidate a limited partnership.  Under the consensus, a general partner is presumed to control a limited partnership (or similar entity) and should consolidate that entity unless the limited partners possess kick-out rights or other substantive participating rights as described in EITF 96-16, “Investor’s Accounting for an Investee When the Investor has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights.”  This EITF was initially effective for all new limited partnerships formed and for existing limited partnerships for which the partnership agreements were modified after June 29, 2005, and, as of January 1, 2006, for existing limited partnership agreements.  The EITF did not impact us in 2005.  The adoption of this EITF in 2006 for existing limited partnership agreements did not have a material effect on our financial position, results of operations or cash flows.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109,” (“FIN 48”).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.”  FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  We do not expect that the implementation of FIN 48 will have a material effect on our financial position, results of operations or cash flows.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”).   SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements.  The Statement does not require any new fair value measurements but does apply under other accounting pronouncements that require or permit fair value measurements.  The changes to current practice resulting from the Statement relate to the definition of fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with earlier application encouraged.  We do not expect that the adoption of this Statement will have a material effect on our financial position, results of operations or cash flows.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”), which addresses diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet.  There have historically been two widely recognized methods for quantifying the effects of financial statement errors: the “roll-over” method and the “iron curtain” method.  The roll-over method focuses primarily on the impact of a misstatement on the income statement, including the reversing effect of prior year misstatements, but its use can lead to the accumulation of misstatements on the balance sheet.  Conversely, the iron-curtain method focuses primarily on the effect of correcting the period end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement.  SAB 108 establishes an approach that requires quantification of financial statement errors based on the effects of the

8

error on each of the company’s financial statements and the related financial statement disclosures.  This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron-curtain and the roll-over methods.  SAB 108 is effective for financial statements for fiscal years ending after November 15, 2006.  We do not expect that SAB 108 will have a material effect on our consolidated financial position or results of operations.

5.             Share-Based Compensation

Share-based Compensation Plans

In 1993, we adopted a share option plan for our Trustees under which we have 75,000 common shares reserved for issuance.  These options expire ten years after the date of grant and are all exercisable.  Shares for this plan are issued under a registration statement on Form S-8 that became effective upon filing with the Securities and Exchange Commission.  As of September 30, 2006, there were no awards available for future grant under this plan.

In March 1998, we adopted a long-term incentive plan for our Trustees and employees.  This plan provides for the award of options to acquire our common shares (“share options”), common shares subject to forfeiture restrictions (“restricted shares”) and dividend equivalents.  We are authorized to issue awards under the plan amounting to no more than 13% of the total of (1) our common shares outstanding plus (2) the number of shares that would be outstanding upon redemption of all units of the Operating Partnership or other securities that are convertible into our common shares.  Trustee options under this plan become exercisable beginning on the first anniversary of their grant.  The vesting periods for employees’ options under this plan range from immediately to five years, although they generally are three years.  Options expire ten years after the date of grant.  Restricted shares generally vest annually in the following increments: 16% upon the first anniversary following the date of grant, 18% upon the second anniversary, 20% upon the third anniversary, 22% upon the fourth anniversary and 24% upon the fifth anniversary.  Shares for this plan are issued under a registration statement on Form S-8 that became effective upon filing with the Securities and Exchange Commission.  As of September 30, 2006, we had 743,683 awards available for future grant under this plan.

The following table summarizes share option transactions under the plans described above for the nine months
ended September 30, 2006:

The total intrinsic value of options exercised during the nine months ended September 30, 2006 was $18,916.

We received $6,265 in proceeds from the exercise of share options during the nine months ended September 30, 2006.

9

The following table summarizes restricted share transactions under the plans described above for the nine months ended September 30, 2006:

The total fair value of restricted shares vested during the nine months ended September 30, 2006 was $5,319.

We did not realize a windfall tax benefit for the 2006 periods on options exercised and restricted shares vested by employees of our subsidiaries that are subject to income tax due to the existence of a net operating loss carryforward on such subsidiaries.

Adoption of Statement of Financial Accounting Standards No. 123(R)

We have historically issued two forms of share-based compensation: share options and restricted shares.  Prior to January 1, 2006, when we adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), our general method for accounting for these forms of share-based compensation was as follows:

·                  Share options: These awards were accounted for using the intrinsic value method.  Under this method, we recorded compensation expense only when the exercise price of a grant was less than the market price of our common shares on the option grant date; when this occurred, we recognized compensation expense equal to the difference between the exercise price and the grant-date market price over the service period to which the options related.

·                  Restricted shares: We computed compensation expense for restricted share grants based on the value of such grants, as determined by the value of our common shares on the applicable measurement date (generally the date of grant).  We recognized compensation expense for such grants over the service periods to which the grants related based on the vesting schedules for such grants.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R).  The statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, focusing primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions.  The statement requires us to measure the cost of employee services received in exchange for an award of equity instruments based generally on the fair value of the award on the grant date; such cost should then be recognized over the period during which the employee is required to provide service in exchange for the award (generally the vesting period).  No compensation cost is recognized for equity instruments for which employees do not render the requisite service.  In 2005, the FASB also issued several FASB Staff Positions that clarify certain aspects of SFAS 123(R).  SFAS 123(R) became effective for us on January 1, 2006, applying to all awards granted after January 1, 2006 and to awards modified, repurchased or cancelled after that date.  We used the modified prospective application approach to adoption provided for under SFAS 123(R); under this approach, we recognized compensation cost on or after January 1, 2006 for the portion of outstanding awards for which the requisite service was not yet rendered, based on the fair value of those awards on the date of grant.

The primary effect of our adoption of SFAS 123(R) on our Consolidated Financial Statements is that beginning January 1, 2006 we are: (1) incurring higher expense associated with share options issued to employees relative to what we would have recognized under the intrinsic value method; (2) recognizing expenses associated with restricted common shares over the life of the grant using a straight line basis methodology over the service period; and (3) reporting the benefits of tax deductions in excess of recognized compensation costs as cash flow from financing activities (such benefits were previously reported as operating cash flows).

10

Prior to our adoption of SFAS 123(R), we provided disclosures in our financial statements for periods prior to 2006 that summarized what our operating results would have been if we had elected to account for our share-based compensation under the fair value provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).  In computing the amounts that appeared in these disclosures, we accounted for forfeitures as they occurred.  SFAS 123(R) requires that share-based compensation be computed based on awards that are ultimately expected to vest.  As a result, future forfeitures of awards are to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  SFAS 123(R) also requires that companies make a one-time cumulative effect adjustment upon adoption of the standard to record the effect that estimated future forfeitures of outstanding awards would have on expenses previously recognized in the companies’ financial statements; we did not record such a cumulative effect adjustment since we determined that the effect of pre-vesting forfeitures on our recorded expense has historically been negligible.  The amounts included in our Consolidated Statements of Operations for share-based compensation in the three and nine months ended September 30, 2006 reflected an estimate of pre-vesting forfeitures of approximately 5%.

In the disclosures that we provided in our financial statements for periods prior to 2006 that summarized what our operating results would have been if we had elected to account for our share-based compensation under the fair value provisions of SFAS 123, we did not capitalize costs associated with share-based compensation.  Effective upon our adoption of SFAS 123(R), we began capitalizing costs associated with share-based compensation.

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.”  We elected to adopt the alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to SFAS 123(R).  The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of
SFAS 123(R).

We compute the fair value of share options under SFAS 123(R) using the Black-Scholes option-pricing model; the weighted average assumptions we used in that model for share options issued during the nine months ended September 30, 2006 are set forth below:

(1)             Ranged from 4.35% to 5.31%.

The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.  The expected option life is based on our historical experience of employee exercise behavior.  Expected volatility is based on historical volatility of our common shares.  Expected dividend yield is based on the average historical dividend yield on our common shares over a period of time ending on the grant date of the options.

The table below sets forth information relating to expenses from share-based compensation included in our Consolidated Statements of Operations for the three and nine months ended September 30, 2006:

11

We also capitalized share-based compensation costs of approximately $52 in the three months ended September 30, 2006 and $137 in the nine months ended September 30, 2006.

As of September 30, 2006, there was $1,492 of unrecognized compensation cost related to nonvested options that is expected to be recognized over a weighted average period of approximately two years.  As of September 30, 2006, there was $9,273 of unrecognized compensation cost related to unvested restricted shares that is expected to be recognized over a weighted average period of approximately three years.

Disclosure for Periods Prior to 2006, Including Pro Forma Financial Information Under SFAS 123

Expenses from share-based compensation reflected in our Consolidated Statements of Operations for the three and nine months ended September 30, 2005 were as follows:

The following table summarizes our operating results for the three and nine months ended September 30, 2005 as if we elected to account for our share-based compensation under the fair value provisions of SFAS 123 in that period:

12

The share-based compensation expense under the fair value method, as reported in the above table, was computed using the Black-Scholes option-pricing model.

6.             Commercial Real Estate Properties

Operating properties consisted of the following:

Projects we had under construction or pre-construction consisted of the following:

13

2006 Acquisitions

We acquired the following office properties during the nine months ended September 30, 2006:

(1)             Located in the Baltimore/Washington Corridor.

The table below sets forth the allocation of the acquisition costs of the properties described above:

Intangible assets recorded in connection with these acquisitions included the following:

During the nine months ended September 30, 2006, we also acquired the following:

·                  a property located in Colorado Springs, Colorado containing a 60,000 square foot building that will be redeveloped and a four-acre parcel of land that we believe can support approximately 30,000 developable square feet for $2,602 on January 19, 2006;

·                  a 31-acre parcel of land located in San Antonio, Texas that we believe can support up to 375,000 developable square feet for $7,430 on January 20, 2006;

·                  a six-acre parcel of land located in Hanover, Maryland that we believe can support up to 60,000 developable square feet for $2,141 on February 28, 2006 (Hanover, Maryland is located in the Baltimore/Washington Corridor);

·                  a 20-acre parcel of land located in Colorado Springs, Colorado that we believe can support up to 300,000 developable square feet for $1,060 on April 21, 2006;

·                  a 13-acre parcel of land located in Colorado Springs, Colorado that we believe can support up to 150,000 developable square feet for $2,263 on May 19, 2006;

14

·                  a 178-acre parcel of land located in Annapolis Junction, Maryland, located adjacent to the National Business Park, that we believe can support up to 1.25 million developable square feet for $26,833 on June 29, 2006 (Annapolis Junction, Maryland is located in the Baltimore/Washington Corridor);

·                  a five-acre parcel of land located in Columbia, Maryland that we believe can support up to 120,000 developable square feet for $3,361 on June 29, 2006; and

·                  a 28-acre parcel of land located in Chesterfield, Virginia on September 15, 2006 that was acquired under the terms of a lease for a 193,000 square foot building that we are constructing on the property (Chesterfield, Virginia, which is located in Greater Richmond, Virginia, is included in our “other” business segment).  The fair value of the land and closing costs associated with the title transfer totaled $1,303.

We also acquired a 50% interest in a consolidated joint venture called Commons Office 6-B, LLC that owns a land parcel located in Hanover, Maryland for $1,830 on February 10, 2006.  The joint venture is constructing an office property totaling approximately 44,000 square feet on the land parcel.

2006 Construction and Pre-Construction Activities

During 2006, we fully placed into service two properties totaling 212,000 (one located in the Baltimore/Washington Corridor and one in Colorado Springs, Colorado) and placed into service a portion of two properties totaling 179,000 square feet (both located in the Baltimore/Washington Corridor).

As of September 30, 2006, we had construction underway on six new buildings in the Baltimore/Washington Corridor (including the one 50% joint venture discussed above), one in Northern Virginia, one in St. Mary’s County, Maryland, one in Suburban Baltimore and one in Chesterfield, Virginia.  We also had pre-construction activities underway on four new buildings located in the Baltimore/Washington Corridor (including one through a 50% joint venture, the formation of which was pending at September 30, 2006), one in Suburban Maryland, one in King George County, Virginia, two in Colorado Springs, Colorado and one in Suburban Baltimore.  In addition, we had redevelopment underway on two wholly owned existing buildings (one is located in the Baltimore/Washington Corridor and one in Colorado Springs, Colorado) and two buildings owned by a joint venture (one is located in Northern Virginia and one in the Baltimore/Washington Corridor).

2006 Dispositions

We sold the following operating properties during the nine months ended September 30, 2006:

(1)             Located in the Suburban Maryland region.

(2)             Located in the Suburban Baltimore region.

During the nine months ended September 30, 2006, we also sold the following:

·                  a newly constructed property in Columbia, Maryland for $2,530 on January 17, 2006.  We recognized a gain of $111 on this sale; and

·                  a two-acre parcel of land located in Linthicum Heights, Maryland for $900 on September 7, 2006.  We recognized a gain of $165 on this sale.

7.                                      Real Estate Joint Ventures

Our investments in and advances to unconsolidated real estate joint ventures accounted for using the equity method of accounting included the following:

15

(1)             Derived from the sum of our investment balance and maximum additional unilateral capital contributions or loans required from us.  Not reported above are additional amounts that we and our partner are required to fund when needed by this joint venture; these funding requirements are proportional to our respective ownership percentages.  Also not reported above are additional unilateral contributions or loans from us, the amounts of which are uncertain, that would be due if certain contingent events occurred.

(2)             The carrying amount of our investment in this joint venture was lower than our share of the equity in the joint venture by $5,195 at September 30, 2006 and $5,204 at December 31, 2005 due to our deferral of gain on the contribution by us of real estate into the joint venture upon its formation.  A difference will continue to exist to the extent the nature of our continuing involvement in the joint venture does not change.

(3)             This joint venture’s properties are located in Greater Harrisburg, Pennsylvania.

(4)             As discussed further below, we sold the property owned by this joint venture on July 26, 2006, after which the joint venture was dissolved.  The carrying amount of our investment in this joint venture was lower than our share of the equity in the joint venture by $1,370 at December 31, 2005 due to our deferral of gain on the contribution by us of real estate into the joint venture upon its formation.

(5)          This joint venture’s property was located in Fairfield, New Jersey.

On July 26, 2006, Rt. 46 Partners sold its property for $27,000.  After the sale, the joint venture was dissolved.  We recognized a gain of $563 on the disposition of our joint venture interest.

The following table sets forth condensed balance sheets for our unconsolidated real estate joint ventures:

The following table sets forth combined condensed statements of operations for the three and nine months ended September 30, 2006 for the two unconsolidated joint ventures we owned during the nine months ended September 30, 2006:

The table above includes net income from Rt. 46 Partners of $3,272 for the three month period and $3,501 for the nine month period.  Our joint venture partner in Route 46 Partners had preference in receiving distributions of cash flows for a defined return.  We were not entitled to receive distributions for a defined return until our partner received its defined return.  We did not recognize income from our investment in Route 46 Partners in the three and nine months ended September 30, 2006 and 2005 until the dissolution of the entity since the income earned by

16

the entity in those periods did not exceed our partner’s defined return until that point in time.  Upon dissolution of the entity, we recognized income from our investment of $60, excluding the $563 gain on disposition of the joint venture interest discussed above.

Our investments in consolidated real estate joint ventures included the following:

(1)             This joint venture owns one property in Northern Virginia and one in the Baltimore/Washington Corridor.

(2)             This joint venture’s property is located in Hanover, Maryland (located in the Baltimore/Washington Corridor region).

(3)             This joint venture’s property is located in Lanham, Maryland (located in the Suburban Maryland region).

On January 17, 2006 we acquired our partner’s remaining 50% interest in MOR Montpelier 3 LLC, an entity that recently completed the construction of an office property, for $1,186.  We then sold the property to a third party for $2,530, as discussed in Note 6.

Our commitments and contingencies pertaining to our real estate joint ventures are disclosed in Note 20.

8.             Intangible Assets on Real Estate Acquisitions

Intangible assets on real estate acquisitions consisted of the following:

Amortization of the intangible asset categories set forth above totaled approximately $15.9 million in the nine months ended September 30, 2006 and $10.2 million in the nine months ended September 30, 2005.  The approximate weighted average amortization periods of the categories set forth above follow: lease up value: 6 years; lease cost portion of deemed cost avoidance: 4 years; lease to market value: 3 years; tenant relationship value: 5 years; and market concentration premium: 36 years.  The approximate weighted average amortization period for all of the categories combined above is 5 years.  Estimated amortization expense associated with the intangible asset categories set forth above for the three months ended December 31, 2006 is $4.3 million, for 2007 is $15.1 million, 2008 is $13.4 million, 2009 is $11.5 million, 2010 is $8.5 million and 2011 is $6.7 million.

17

9.             Deferred Charges

Deferred charges consisted of the following:

10.          Accounts Receivable

Our accounts receivable are reported net of an allowance for bad debts of $253 at September 30, 2006 and $421 at December 31, 2005.

11.          Prepaid and Other Assets

Prepaid and other assets consisted of the following:

12.          Derivatives

The following table sets forth our derivative contracts at September 30, 2006 and their respective fair values:

We designated these derivatives as cash flow hedges.  These contracts hedge the risk of changes in interest rates on certain of our one-month LIBOR-based variable rate borrowings until their respective maturities.

The table below sets forth our accounting application of changes in derivative fair values:

18

The activity reported in the table above for the three and nine months ended September 30, 2005 represents changes in the fair value of a forward starting swap into which we entered to lock in the 10-year LIBOR swap rate in contemplation of our obtaining a long-term, fixed rate financing later in 2005.  We obtained this long-term financing in October 2005 and cash settled the swap at that time for a payment to the swap party of $603.

13.          Loans Payable

Mortgage and other loans payable consisted of the following: