UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, DC 20549
(Mark one)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2007
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-14023
Maryland
23-2947217
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
6711 Columbia Gateway Drive, Suite 300, Columbia MD
21046
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: (443) 285-5400
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes oNo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) oYes x No
On April 27, 2007, 47,069,523 shares of the Company’s Common Shares of Beneficial Interest, $0.01 par value, were issued.
TABLE OF CONTENTS
FORM 10-Q
PAGE
PART I: FINANCIAL INFORMATION
Item 1:
Financial Statements:
Consolidated Balance Sheets as of March 31, 2007 and December 31, 2006 (unaudited)
3
Consolidated Statements of Operations for the three months ended March 31, 2007 and 2006 (unaudited)
4
Consolidated Statements of Cash Flows for the three months ended March 31, 2007 and 2006 (unaudited)
5
Notes to Consolidated Financial Statements
6
Item 2:
Management’s Discussion and Analysis of Financial Condition and Results of Operations
23
Item 3:
Quantitative and Qualitative Disclosures About Market Risk
38
Item 4:
Controls and Procedures
39
PART II: OTHER INFORMATION
Legal Proceedings
Item 1A:
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
40
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5:
Other Information
Item 6:
Exhibits
SIGNATURES
42
2
ITEM 1. Financial Statements
Corporate Office Properties Trust and SubsidiariesConsolidated Balance Sheets(Dollars in thousands)(unaudited)
March 31,
December 31,
2007
2006
Assets
Investment in real estate:
Operating properties, net
$
2,080,310
1,812,883
Property held for sale, net
14,573
—
Projects under construction or development
379,294
298,427
Total commercial real estate properties, net
2,474,177
2,111,310
Cash and cash equivalents
22,003
7,923
Restricted cash
19,030
52,856
Accounts receivable, net
24,478
26,367
Deferred rent receivable
44,294
41,643
Intangible assets on real estate acquisitions, net
131,934
87,325
Deferred charges, net
45,496
43,710
Prepaid and other assets
53,311
48,467
Total assets
2,814,723
2,419,601
Liabilities and shareholders’ equity
Liabilities:
Mortgage and other loans payable
1,515,183
1,298,537
3.5% Exchangeable Senior Notes
200,000
Accounts payable and accrued expenses
61,131
68,190
Rents received in advance and security deposits
25,127
20,237
Dividends and distributions payable
20,687
19,164
Deferred revenue associated with acquired operating leases
14,607
11,120
Distributions in excess of investment in unconsolidated real estate joint venture
3,797
3,614
Fair value of derivatives
556
308
Other liabilities
8,395
7,941
Total liabilities
1,849,483
1,629,111
Minority interests:
Common units in the Operating Partnership
118,614
104,934
Preferred units in the Operating Partnership
8,800
Other consolidated real estate joint ventures
2,408
2,453
Total minority interests
129,822
116,187
Commitments and contingencies (Note 20)
Shareholders’ equity:
Preferred Shares of beneficial interest ($0.01 par value; shares authorized of
15,000,000, issued and outstanding of 8,121,667 at March 31, 2007
and 7,590,000 at December 31, 2006 (Note 13)
81
76
Common Shares of beneficial interest ($0.01 par value;
75,000,000 shares authorized, shares issued and outstanding of
46,879,852 at March 31, 2007 and 42,897,639 at December 31, 2006
469
429
Additional paid-in capital
932,287
758,032
Cumulative distributions in excess of net income
(96,516
)
(83,541
Accumulated other comprehensive loss
(903
(693
Total shareholders’ equity
835,418
674,303
Total liabilities and shareholders’ equity
See accompanying notes to consolidated financial statements.
Corporate Office Properties Trust and SubsidiariesConsolidated Statements of Operations(Dollars in thousands, except per share data)(unaudited)
For the Three Months Ended March 31,
Revenues
Rental revenue
75,882
60,562
Tenant recoveries and other
real estate operations revenue
13,793
8,660
Construction contract revenues
8,691
14,544
Other service operations revenues
1,386
1,765
Total revenues
99,752
85,531
Expenses
Property operating expenses
31,748
21,061
Depreciation and other amortization
associated with real estate operations
26,569
18,672
Construction contract expenses
8,483
14,026
Other service operations expenses
1,405
1,678
General and administrative expenses
4,614
3,963
Total operating expenses
72,819
59,400
Operating income
26,933
26,131
Interest expense
(19,876
(17,029
Amortization of deferred financing costs
(884
(556
Income from continuing operations before equity in loss of unconsolidated entities, income taxes and minority interests
6,173
8,546
Equity in loss of unconsolidated entities
(94
(23
Income tax expense
(105
(215
Income from continuing operations before minority interests
5,974
8,308
Minority interests in income from continuing operations
(308
(826
(165
Other consolidated entities
47
33
Income from continuing operations
5,548
7,350
(Loss) income from discontinued operations, net of minority interests
(1
2,477
Income before gain on sales of real estate
5,547
9,827
Gain on sales of real estate, net
110
Net income
9,937
Preferred share dividends
(3,993
(3,654
Net income available to common shareholders
1,554
6,283
Basic earnings per common share
0.03
0.10
Discontinued operations
0.06
0.16
Diluted earnings per common share
0.09
0.15
Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Cash Flows
(Dollars in thousands)
(unaudited)
For the Three Months
Ended March 31,
Cash flows from operating activities
Adjustments to reconcile net income to net cash
provided by operating activities:
Minority interests
426
1,538
26,626
19,337
884
559
Amortization of deferred market rental revenue
(511
94
Gain on sales of real estate
(2,571
Share-based compensation
1,340
642
Excess income tax benefits from share-based compensation
(865
(258
Changes in operating assets and liabilities:
Increase in deferred rent receivable
(2,651
(2,198
Decrease (increase) in accounts receivable
1,889
(1,123
Decrease in restricted cash and prepaid and other assets
1,349
5,152
Decrease in accounts payable, accrued expenses and other liabilities
(4,005
(2,637
Increase in rents received in advance and security deposits
4,890
1,620
Other
(25
(79
Net cash provided by operating activities
34,988
29,386
Cash flows from investing activities
Purchases of and additions to commercial real estate properties
(187,966
(38,267
Proceeds from sales of properties
28,217
Investments in and advances to unconsolidated entities
(190
Acquisition of partner interests in consolidated joint ventures
(3,016
Distributions from unconsolidated entities
89
113
Leasing costs paid
(4,059
(1,984
Decrease in restricted cash associated with investing activities
13,858
218
(5,951
(175
Net cash used in investing activities
(184,029
(15,084
Cash flows from financing activities
Proceeds from mortgage and other loans payable
188,090
47,905
Repayments of mortgage and other loans payable
(10,380
(36,559
Deferred financing costs paid
(507
(49
Distributions paid to partners in consolidated joint ventures
(787
Net proceeds from issuance of common shares
5,120
1,581
Dividends paid
(16,931
(14,721
Distributions paid
(2,787
(2,553
865
258
(349
8
Net cash provided by (used in) financing activities
163,121
(4,917
Net increase in cash and cash equivalents
14,080
9,385
Beginning of period
10,784
End of period
20,169
Notes to Consolidated Financial Statements(Dollars in thousands, except per share data)
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 also have a core customer expansion strategy that is built on meeting, through acquisitions and development, the multi-location requirements of our strategic tenants. As of March 31, 2007, our investments in real estate included the following:
· 226 wholly owned operating properties in our portfolio totaling 17.4 million square feet;
· 17 wholly owned properties under construction or development that we estimate will total approximately 1.9 million square feet upon completion and two wholly owned office properties totaling approximately 129,000 square feet that were under redevelopment;
· wholly owned land parcels totaling 1,254 acres that we believe are potentially developable into approximately 10.3 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”), for which we are the managing 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 March 31, 2007 follows:
Common Units
84%
Series G Preferred Units
100%
Series H Preferred Units
Series I Preferred Units
0%
Series J Preferred Units
Series K Preferred Units
(issued on January 9, 2007)
Two of our trustees also controlled, either directly or through ownership by other entities or family members, 13% 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 owns, either directly or through COMI, 100% of the consolidated subsidiaries that are set forth below (collectively defined as the “Service Companies”):
Entity Name
Type of Service Business
COPT Property Management Services, LLC (“CPM”)
Real Estate Management
COPT Development & Construction Services, LLC (“CDC”)
Construction and Development
Corporate Development Services, LLC (“CDS”)
COPT Environmental Systems, LLC (“CES”)
Heating and Air Conditioning
Most of the services that CPM provides are for us. CDC, CDS and CES provide services to us and to third parties.
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 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 2006 Annual Report on Form 10-K. 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.
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 of beneficial interest (“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 changes in income or loss that would result from the assumed conversion of securities into common shares that were added to the denominator.
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):
Numerator:
Add: Gain on sales of real estate, net
Less: Preferred share dividends
Numerator for basic and diluted EPS from continuing operations
1,555
3,806
(Loss) income from discontinued operations, net
Numerator for basic and diluted EPS on net income available
to common shareholders
Denominator (all weighted averages):
Denominator for basic EPS (common shares)
45,678
39,668
Dilutive effect of share-based compensation awards
1,465
1,842
Denominator for diluted EPS
47,143
41,510
Basic EPS:
Income from discontinued operations
Diluted EPS:
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:
7
Weighted Average Shares inDenominatorFor the Three Months EndedMarch 31,
Conversion of weighted average common units
8,411
8,520
Conversion of weighted average convertible preferred units
176
Conversion of weighted average convertible preferred shares
395
The 3.5% Exchangeable Senior Notes did not affect our diluted EPS reported above since the weighted average closing price of our common shares during the period over which the notes were outstanding was less than $54.30.
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. Our adoption of FIN 48 did not 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 February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of SFAS 159 on our consolidated financial position and results of operations.
Operating properties consisted of the following:
Land
409,859
343,098
Buildings and improvements
1,904,154
1,689,359
2,314,013
2,032,457
Less: accumulated depreciation
(233,703
(219,574
At March 31, 2007, 429 Ridge Road, an office property located in Dayton, New Jersey that we were under contract to sell for $17,000, was classified as held for sale (Dayton, New Jersey is located in the Northern/Central New Jersey Region). We expect to complete the sale of this property by January 2008. The components associated with 429 Ridge Road as of March 31, 2007 included the following:
2,932
14,588
17,520
(2,947
Projects we had under construction or development consisted of the following:
193,715
153,436
Construction in progress
185,579
144,991
2007 Acquisitions
On January 9 and 10, 2007, we completed a series of transactions that resulted in the acquisition of 56 operating properties totaling approximately 2.4 million square feet and land parcels totaling 187 acres. We refer to these transactions collectively as the Nottingham Acquisition. All of the acquired properties are located in Maryland, with 36 of the operating properties, totaling 1.6 million square feet, and land parcels totaling 175 acres, located in White Marsh, Maryland (located in the Suburban Baltimore region) and the remaining properties and land parcels located in other regions in Northern Baltimore County and the Baltimore/Washington Corridor. We believe that the land parcels can support at least 2.0 million developable square feet. We completed the Nottingham Acquisition for an aggregate cost of $366,830. The table below sets forth the allocation of the acquisition costs of the Nottingham Acquisition:
Land, operating properties
69,322
Land, construction or development
37,789
Building and improvements
211,194
Intangible assets on real estate acquisitions
53,214
371,519
(4,689
Total acquisition cost
366,830
Intangible assets recorded in connection with the Nottingham Acquisition include the following:
Weighted
Average
Amortization
Cost
Period (inYears)
Tenant relationship value
25,778
Lease-up value
19,425
Lease cost portion of deemed cost avoidance
4,206
Lease to market value
3,805
2007 Construction and Development Activities
As of March 31, 2007, we had construction underway on four new buildings in the Baltimore/Washington Corridor (including one partially operational property owned through a 50% joint venture), two in Colorado Springs, Colorado and one each in Suburban Baltimore, Southwest Virginia and Chesterfield, Virginia. We also had development activities underway on five new buildings located in the Baltimore/Washington Corridor (including one owned through a joint venture), two in Suburban Baltimore, two in Suburban Maryland and one each
9
in King George County, Virginia and Colorado Springs, Colorado (we owned a 50% undivided interest in the Colorado Springs property until April 6, 2007, when we purchased the remaining 50%). In addition, we had redevelopment underway on two wholly owned existing buildings (one is located in the Baltimore/Washington Corridor and the other in Colorado Springs, Colorado) and two buildings owned by a joint venture (one is located in Northern Virginia and the other in the Baltimore/Washington Corridor).
6. Real Estate Joint Ventures
During the three months ended March 31, 2007, we had an investment in one unconsolidated real estate joint venture accounted for using the equity method of accounting. Information pertaining to this joint venture investment is set forth below.
Investment Balance at
Total
Maximum
Date
Owner-
Nature of
Assets at
Exposure
Acquired
ship
Activity
3/31/2007
to Loss (1)
Harrisburg Corporate
Gateway Partners, L.P.
$(3,797)(2
$(3,614)(2
9/29/2005
20%
Operates 16 buildings(3
$75,190
(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, which we would be required to make if certain contingent events occur.
(2) The carrying amount of our investment in this joint venture was lower than our share of the equity in the joint venture by $4,860 at March 31, 2007 and $5,072 at December 31, 2006 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 remains the same.
(3) This joint venture’s properties are located in Greater Harrisburg, Pennsylvania.
The following table sets forth condensed balance sheets for Harrisburg Corporate Gateway Partners, L.P.:
Commercial real estate property
72,199
72,688
Other assets
2,991
3,207
75,190
75,895
Liabilities
68,149
67,350
Owners’ equity
7,041
8,545
Total liabilities and owners’ equity
The following table sets forth a combined condensed statement of operations for Harrisburg Corporate Gateway Partners, L.P. for the three months ended March 31, 2007:
2,444
(960
(1,138
Depreciation and amortization expense
(867
Net loss
(521
10
Our investments in consolidated real estate joint ventures included the following:
Ownership
Collateralized
% at
COPT Opportunity Invest I, LLC
12/20/2005
92.5%
Redeveloping two properties (1)
44,919
Commons Office 6-B, LLC
2/10/2006
50.0%
Developing land parcel (2)
7,466
7,430
MOR Forbes 2 LLC
12/24/2002
Operates one building (3)
4,074
3,697
COPT-FD Indian Head, LLC
10/23/2006
75.0%
Developing land parcel (4)
3,003
59,462
11,127
(1) This joint venture owns one property in the Northern Virginia region and one in the Baltimore/Washington Corridor region.
(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).
(4) This joint venture’s property is located in Charles County, Maryland (located in our “other” business segment).
Our commitments and contingencies pertaining to our real estate joint ventures are disclosed in Note 20.
Intangible assets on real estate acquisitions consisted of the following:
March 31, 2007
December 31, 2006
Gross Carrying
Accumulated
Net Carrying
Amount
125,144
43,900
81,244
105,719
38,279
67,440
35,149
2,691
32,458
9,371
1,178
8,193
Lease cost portion of deemed
cost avoidance
17,086
6,591
10,495
12,880
5,819
7,061
14,428
7,869
6,559
10,623
7,178
3,445
Market concentration premium
1,333
155
147
1,186
193,140
61,206
139,926
52,601
Amortization of the intangible asset categories set forth above totaled $8,628 in the three months ended March 31, 2007 and $5,017 in the three months ended March 31, 2006. The approximate weighted average amortization periods of the categories set forth below follow: lease-up value: nine years; tenant relationship value: eight years; lease cost portion of deemed cost avoidance: six years; lease to market value: five years; and market concentration premium: 35 years. The approximate weighted average amortization period for all of the categories combined is nine years. Estimated amortization expense associated with the intangible asset categories set forth above for the nine months ended December 31, 2007 is $20.1 million, for 2008 is $21.8 million, for 2009 is $19.1 million, for 2010 is $14.8 million, for 2011 is $11.9 million and for 2012 is $9.6 million.
Deferred charges consisted of the following:
Deferred leasing costs
55,716
52,263
Deferred financing costs
28,837
28,275
Goodwill
1,853
Deferred other
86,561
82,546
Accumulated amortization
(41,065
(38,836
11
Our accounts receivable are reported net of an allowance for bad debts of $286 at March 31, 2007 and $252 at December 31, 2006.
Prepaid and other assets consisted of the following:
Construction contract costs incurred in excess of billings
19,194
18,324
Furniture, fixtures and equipment
10,587
Prepaid expenses
7,714
9,059
15,816
10,589
Our debt consisted of the following:
Principal Amount
Carrying Value at
ScheduledMaturity
Under Debt at
Stated Interest Rates at
Dates at
Mortgage and other loans payable:
Revolving Credit Facility
Wachovia Bank, N.A. Revolving Credit Facility
500,000
264,000
185,000
LIBOR + 1.15% to 1.55%
March 2008 (1)
Mortgage Loans
Fixed rate mortgage loans (2)
N/A
1,048,913
1,020,619
5.20% — 9.48% (3)
2007 — 2034 (4)
Variable rate construction loan facilities
122,447
76,324
56,079
LIBOR + 1.40% to 2.20%
2007 — 2008 (5)
Other variable rate mortgage loans
123,615
34,500
LIBOR + 1.20% to 1.50%
2007 (6)
Total mortgage loans
1,248,852
1,111,198
Note payable
Unsecured seller notes
2,331
2,339
0% — 5.95%
2007-2008
Total mortgage and other loans payable
3.50%
September 2026(7)
Total debt
1,715,183
1,498,537
(1) The Revolving Credit Facility may be extended for a one-year period, subject to certain conditions.
(2) Several of the fixed rate mortgages carry interest rates that were above or below market rates upon assumption and therefore are recorded at their fair value based on applicable effective interest rates. The carrying values of these loans reflect net premiums totaling $839 at March 31, 2007 and $210 at December 31, 2006.
(3) The weighted average interest rate on these loans was 6.05% at March 31, 2007.
(4) A loan with a balance of $4,874 at March 31, 2007 that matures in 2034 may be repaid in March 2014, subject to certain conditions.
(5) At March 31, 2007, $53,505 in loans scheduled to mature in 2008 may be extended for a one-year period, subject to certain conditions.
(6) At March 31, 2007, a $34,500 loan scheduled to mature in 2007 may be extended for a one-year period, subject to certain conditions.
(7) Refer to our 2006 Annual Report on Form 10-K for descriptions of provisions for early redemption and repurchase of these notes.
We capitalized interest costs of $4,132 in the three months ended March 31, 2007 and $3,130 in three months ended March 31, 2006.
12
The following table sets forth our derivative contracts at March 31, 2007 and their respective fair values:
Fair Value at
Notional
One-Month
Effective
Expiration
Nature of Derivative
LIBOR base
Interest rate swap
50,000
5.0360
%
3/28/2006
3/30/2009
(174
(42
25,000
5.2320
5/1/2006
5/1/2009
(191
(133
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:
For the Three Months EndedMarch 31,
(Decrease) increase in fair value applied to accumulated
other comprehensive loss and minority interests
(248
Preferred Shares
Preferred shares of beneficial interest (“preferred shares”) consisted of the following:
2,200,000 designated as Series G Cumulative Redeemable Preferred Shares of beneficial interest (2,200,000 shares issued with an aggregate liquidation preference of $55,000)
22
2,000,000 designated as Series H Cumulative Redeemable Preferred Shares of beneficial interest (2,000,000 shares issued with an aggregate liquidation preference of $50,000)
20
3,390,000 designated as Series J Cumulative Redeemable Preferred Shares of beneficial interest (3,390,000 shares issued with an aggregate liquidation preference of $84,750)
34
531,667 designated as Series K Cumulative Redeemable Convertible Preferred Shares of beneficial interest (531,667 shares issued with an aggregate liquidation preference of $26,583)
Total preferred shares
We issued the Series K Cumulative Redeemable Convertible Preferred Shares of beneficial interest (the “Series K Preferred Shares”) in the Nottingham Acquisition at a value of, and liquidation preference equal to, $50 per share. The Series K Preferred Shares are nonvoting, redeemable for cash at $50 per share at our option on or after January 9, 2017, and are convertible, subject to certain conditions, into common shares on the basis of 0.8163 common shares for each preferred share, in accordance with the terms of the Articles Supplementary describing the Series K Preferred Shares. Holders of the Series K Preferred Shares are entitled to cumulative dividends, payable quarterly (as and if declared by our Board of Trustees). Dividends accrue from the date of issue at the annual rate of $2.80 per share, which is equal to 5.6% of the $50 per share liquidation preference.
13
Common Shares
In connection with the Nottingham Acquisition in January 2007, we issued 3,161,000 common shares at a value of $49.57 per share.
During the three months ended March 31, 2007, we converted 221,350 common units in our Operating Partnership into common shares on the basis of one common share for each common unit.
See Note 17 for disclosure of common share activity pertaining to our share-based compensation plans.
Accumulated Other Comprehensive Loss
The table below sets forth activity in the AOCL component of shareholders’ equity:
For the Three MonthsEnded March 31,
Beginning balance
(482
Unrealized (loss) gain on derivatives, net of minority interests
(223
90
Realized loss on derivatives, net of minority interests
Ending balance
(380
The table below sets forth our comprehensive income:
Total comprehensive income
5,337
10,039
14
The following table summarizes our dividends and distributions when either the payable dates or record dates occurred during the three months ended March 31, 2007:
Dividend/
Distribution Per
Total Dividend/
Record Date
Payable Date
Share/Unit
Distribution
Series G Preferred Shares:
Fourth Quarter 2006
December 29, 2006
January 17, 2007
0.5000
1,100
First Quarter 2007
March 30, 2007
April 17, 2007
Series H Preferred Shares:
0.4688
938
Series J Preferred Shares:
0.4766
1,616
Series K Preferred Shares:
0.7466
397
Common Shares:
0.3100
13,292
14,529
Series I Preferred Units:
165
Common Units:
2,622
2,554
For the Three Months Ended
Supplemental schedule of non-cash investing and financing activities:
Debt assumed in connection with acquisition of properties
38,848
(Decrease) increase in accrued capital improvements and leasing costs
(2,600
6,307
Amortization of discounts and premiums on mortgage loans to
commercial real estate properties
255
45
(Decrease) increase in fair value of derivatives applied to AOCL and minority interests
Issuance of common shares in connection with acquisition of properties
156,691
Issuance of preferred shares in connection with acquisition of properties
26,583
Restricted cash used in connection with acquisition of properties
20,122
Adjustments to minority interests resulting from changes in ownership
of Operating Partnership by COPT
26,511
778
Dividends/distribution payable
16,878
Decrease in minority interests and increase in shareholders’ equity in
connection with the conversion of common units into common shares
10,563
1,945
15
As of March 31, 2007, we had nine primary office property segments: Baltimore/Washington Corridor; Northern Virginia; Suburban Baltimore; Colorado Springs, Suburban Maryland; Greater Philadelphia; St. Mary’s and King George Counties; San Antonio; and Northern/Central New Jersey.
The table below reports segment financial information. Our segment entitled “Other” includes assets and operations not specifically associated with the other defined segments, including corporate assets, investments in unconsolidated entities and elimination entries required in consolidation. We measure the performance of our segments based on total revenues less property operating expenses, a measure we define as net operating income (“NOI”). We believe that NOI is an important supplemental measure of operating performance for a REIT’s operating real estate because it provides a measure of the core operations that is unaffected by depreciation, amortization, financing and general and administrative expenses; this measure is particularly useful in our opinion in evaluating the performance of geographic segments, same-office property groupings and individual properties.
Baltimore/WashingtonCorridor
NorthernVirginia
SuburbanBaltimore
ColoradoSprings
SuburbanMaryland
GreaterPhiladelphia
St. Mary’s &King George Counties
San Antonio
Northern/Central New Jersey
Three Months Ended March 31, 2007
43,837
17,172
13,081
3,595
3,967
2,506
3,098
1,781
1,786
(428
90,395
14,526
6,328
5,771
1,280
1,663
771
359
697
596
32,024
NOI
29,311
10,844
7,310
2,315
2,304
2,473
2,327
1,422
1,089
(1,024
58,371
Additions to commercial real estate properties
77,115
10,852
261,734
3,803
496
232
69
(34
254
25,421
379,942
Segment assets at March 31, 2007
1,153,457
480,989
462,330
137,948
117,496
97,306
96,884
57,250
44,486
166,577
Three Months Ended March 31, 2006
34,393
15,573
7,357
1,289
3,553
2,505
2,988
1,810
2,893
(182
72,179
10,369
5,490
2,840
491
1,317
691
333
985
(489
22,067
24,024
10,083
4,517
798
2,236
2,465
2,297
1,477
1,908
307
50,112
31,563
3,123
871
5,833
404
338
311
7,702
587
(268
50,464
Segment assets at March 31, 2006
925,067
462,441
187,732
69,086
114,873
99,029
98,818
51,570
58,203
76,056
2,142,875
16
The following table reconciles our segment revenues to total revenues as reported on our Consolidated Statements of Operations:
Segment revenues
Less: Revenues from discontinued real estate operations (Note 19)
(720
(2,957
The following table reconciles our segment property operating expenses to property operating expenses as reported on our Consolidated Statements of Operations:
Segment property operating expenses
Less: Property operating expenses from discontinued real estate operations (Note 19)
(276
(1,006
Total property operating expenses
The following table reconciles our NOI for reportable segments to income from continuing operations as reported on our Consolidated Statements of Operations:
NOI for reportable segments
Less:
Depreciation and other amortization associated with real estate operations
(26,569
(18,672
(8,483
(14,026
(1,405
(1,678
(4,614
(3,963
Interest expense on continuing operations
Minority interests in continuing operations
(426
(958
NOI from discontinued operations
(444
(1,951
The accounting policies of the segments are the same as those previously disclosed for Corporate Office Properties Trust and subsidiaries, where applicable. We did not allocate interest expense, amortization of deferred financing costs and depreciation and other amortization to segments since they are not included in the measure of segment profit reviewed by management. We also did not allocate construction contract
17
revenues, other service operations revenues, construction contract expenses, other service operations expenses, equity in loss of unconsolidated entities, general and administrative expense, income taxes and minority interests because these items represent general corporate items not attributable to segments.
During the three months ended March 31, 2007, we granted to employees 226,660 options to purchase common shares with a weighted average exercise price of $49.25 per share. All of these options vest in equal increments annually over a three-year period beginning on the first anniversary of the grant date provided that the employees remain employed by us, and they expire ten years after the grant date. We computed share-based compensation expense for these options under the fair value method using the Black-Scholes option-pricing model; the weighted average assumptions we used in that model are set forth below:
Weighted average fair value per share option granted during the period
9.85
Risk-free interest rate
4.61
%(1)
Expected life (in years)
6.25
Expected volatility
21.51
%(2)
Expected annual dividend yield
3.27
%(3)
(1) Ranged from 4.53% to 4.91%.
(2) Ranged from 21.41% to 21.75%.
(3) Ranged from 3.21% to 3.35%.
During the three months ended March 31, 2007, 469,918 options to purchase common shares were exercised. The weighted average exercise price of these options was $10.92 per share, and the total intrinsic value of options exercised was $19,642.
During the three months ended March 31, 2007, certain employees were granted 128,776 restricted shares with a weighted average grant date fair value of $50.57 per share. All of these shares are subject to forfeiture restrictions that lapse in equal increments annually over a three-year period beginning on the first anniversary of the grant date provided that the employees remain employed by us. During the three months ended March 31, 2007, forfeiture restrictions lapsed on 126,619 common shares previously issued to employees. These shares had a weighted average grant date fair value of $21.97 per share, and the total fair value of the shares on the vesting date was $6,514.
Expenses from share-based compensation are reflected in our Consolidated Statements of Operations as follows:
For the
Three Months Ended
Increase in general and administrative expenses
879
Increase in construction contract and other service operations expenses
354
144
Share-based compensation expense
1,233
613
Income taxes
(35
(17
(193
(109
Net share-based compensation expense
1,005
487
18
COMI’s provision for income tax expense consisted of the following:
Deferred
Federal
86
State
19
105
215
Items contributing to temporary differences that lead to deferred taxes include net operating losses that are not deductible until future periods, depreciation and amortization, certain accrued compensation and compensation paid in the form of contributions to a deferred nonqualified compensation plan.
COMI’s combined Federal and state effective tax rate was 39% for the three months ended March 31, 2007 and 2006.
Income from discontinued operations includes revenues and expenses associated with the following:
·
the two Lakeview at the Greens properties that were sold on February 6, 2006;
the 68 Culver Road property that was sold on March 8, 2006;
the 710 Route 46 property that was sold on July 26, 2006;
the 230 Schilling Circle property that was sold on August 9, 2006;
the 7 Centre Drive property that was sold on August 30, 2006;
the Brown’s Wharf property that was sold on September 28, 2006; and
the 429 Ridge Road property which, as of March 31, 2007, we were under contract to sell, and was classified as held for sale.
The table below sets forth the components of income from discontinued operations:
Revenue from real estate operations
720
2,957
Expenses from real estate operations:
276
1,006
Depreciation and amortization
57
665
388
686
Expenses from real estate operations
721
2,360
Income from discontinued operations before gain on sales of real estate and minority interests
597
2,435
Minority interests in discontinued operations
(555
Income from discontinued operations, net of minority interests
In the normal course of business, we are involved in legal actions arising from our ownership and administration of properties. Management does not anticipate that any liabilities that may result will have a materially adverse effect on our financial position, operations or liquidity. We are subject to various Federal, state and local environmental regulations related to our property ownership and operation. We have performed environmental assessments of our properties, the results of which have not revealed any environmental liability that we believe would have a materially adverse effect on our financial position, operations or liquidity.
Acquisitions
As of March 31, 2007, we were under contract to acquire the following properties:
· a parcel of land in Aberdeen, Maryland for $10,000, of which we paid a deposit of $100 in 2006; and
· the remaining 91 acres of land not yet acquired as part of the acquisition of the former Fort Ritchie United States Army base located in Cascade, Washington County, Maryland; we expect to make the following additional future cash payments to the seller for (1) the acquisition of the remaining 91 acres and (2) portions of the contract price on which payment was deferred by the contract: $1,310 in 2007, $1,000 in 2008 and $155 in 2009. We could incur an additional cash obligation to the seller after that of up to $4,000; this $4,000 cash obligation is subject to reduction by an amount ranging between $750 and $4,000, with the amount of such reduction to be determined based on defined levels of (1) job creation resulting from the future development of the property and (2) future real estate taxes generated by the property. Following completion of this acquisition, we will be obligated to incur $7,500 in development and construction costs for the property.
Joint Ventures
As part of our obligations under the partnership agreement of Harrisburg Corporate Gateway Partners, LP, we may be required to make unilateral payments to fund rent shortfalls on behalf of a tenant that was in bankruptcy at the time the partnership was formed. Our total unilateral commitment under this guaranty is approximately $153; the tenant’s account was current as of March 31, 2007. We also agreed to indemnify the partnership’s lender for 80% of any losses under standard nonrecourse loan guarantees (environmental indemnifications and guarantees against fraud and misrepresentation) during the period of time in which we manage the partnership’s properties; we do not expect to incur any losses under these loan guarantees.
We are party to a contribution agreement that formed a joint venture relationship with a limited partnership to develop up to 1.8 million square feet of office space on 63 acres of land located in Hanover, Maryland. Under the contribution agreement, we agreed to fund up to $2,200 in pre-construction costs associated with the property. As we and the joint venture partner agree to proceed with the construction of buildings in the future, we would make additional cash capital contributions into newly-formed entities and our joint venture partner would contribute land into such entities. We will have a 50% interest in this joint venture relationship.
We may need to make our pro rata share of additional investments in our real estate joint ventures (generally based on our percentage ownership) in the event that additional funds are needed. In the event that the other members of these joint ventures do not pay their share of investments when additional funds are needed, we may then need to make even larger investments in these joint ventures.
In two of the consolidated joint ventures that we owned as of March 31, 2007, we would be obligated to acquire the other members’ 50% interests in the joint ventures if defined events were to occur. The amounts we would need to pay for those membership interests are computed based on the amounts that the owners of the interests would receive under the joint venture agreements in the event that office properties owned by the joint ventures were sold for a capitalized fair value (as defined in the agreements) on a defined date. We estimate the aggregate amount we would need to pay for the other members’ membership
interests in these joint ventures to be $2,383; however, since the determination of this amount is dependent on the operations of the office properties, which are not both completed and sufficiently occupied, this estimate is preliminary and could be materially different from the actual obligation.
Ground Lease
On April 4, 2006, we entered into a 62-year ground lease agreement on a six-acre land parcel on which we expect to construct a 110,000 square foot property. We paid $550 to the lessor upon lease execution and expect to pay an additional amount of approximately $1,898 in rent under the lease in 2007. No other rental payments are required over the life of the lease, although we are responsible for expenses associated with the property. We will recognize the total lease payments incurred under the lease evenly over the term of the lease
Office Space Operating Leases
We are obligated as lessee under five operating leases for office space. Future minimum rental payments due under the terms of these leases as of March 31, 2007 follow:
Nine months ended December 31, 2007
212
2008
261
2009
2010
135
2011
841
Other Operating Leases
We are obligated under various leases for vehicles and office equipment. Future minimum rental payments due under the terms of these leases as of March 31, 2007 follow:
493
317
142
21
1,399
Environmental Indemnity Agreement
We agreed to provide certain environmental indemnifications in connection with a lease of three properties in our New Jersey region. The prior owner of the properties, a Fortune 100 company that is responsible for groundwater contamination at such properties, previously agreed to indemnify us for (1) direct losses incurred in connection with the contamination and (2) its failure to perform remediation activities required by the State of New Jersey, up to the point that the state declares the remediation to be complete. Under the lease agreement, we agreed to the following:
· to indemnify the tenant against losses covered under the prior owner’s indemnity agreement if the prior owner fails to indemnify the tenant for such losses. This indemnification is capped at $5,000 in perpetuity after the State of New Jersey declares the remediation to be complete;
· to indemnify the tenant for consequential damages (e.g., business interruption) at one of the buildings in perpetuity and another of the buildings for 15 years after the tenant’s acquisition of the property from us, if such acquisition occurs. This indemnification is capped at $12,500; and
· to pay 50% of additional costs related to construction and environmental regulatory activities incurred by the tenant as a result of the indemnified environmental condition of the properties. This indemnification is capped at $300 annually and $1,500 in the aggregate.
We have insurance coverage in place that we believe will indemnify us, at least in part, for losses incurred as a result of this agreement.
21. Pro Forma Financial Information (Unaudited)
We accounted for our acquisitions using the purchase method of accounting. We included the results of operations on our acquisitions in our Consolidated Statements of Operations from their respective purchase dates through March 31, 2007.
We prepared our pro forma condensed consolidated financial information presented below as if the Nottingham Acquisition had occurred at the beginning of the respective periods. The pro forma financial information is unaudited and is not necessarily indicative of the results that actually would have occurred if this acquisition had occurred at the beginning of the respective periods, nor does it purport to indicate our results of operations for future periods.
Pro forma total revenues
100,571
93,804
Pro forma net income
5,809
8,046
Pro forma net income available to common shareholders
1,783
4,020
Pro forma earnings per common share on net income available to common shareholders
Basic
0.04
Diluted
At March 31, 2007, we owned a 50% undivided interest in a 132 acre parcel of land that we believe can support future development of 1.75 million square feet of office space in Colorado Springs, Colorado. On April 6, 2007, we acquired the remaining 50% interest for approximately $14.0 million. We issued 262,165 common units in our Operating Partnership valued at $47.68 per unit in connection with this transaction.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a REIT that focuses on the acquisition, development, ownership, management and leasing of primarily Class A suburban office properties in select, demographically strong submarkets where we can achieve critical mass, operating synergies and key competitive advantages, including attracting high quality tenants and securing acquisition and development opportunities. We also have a core customer expansion strategy that is built on meeting, through acquisitions and development, the multi-location requirements of our strategic tenants. As of March 31, 2007, our investments in real estate included the following:
During the three months ended March 31, 2007, we:
· experienced increased revenues, operating expenses and operating income due primarily to the addition of properties through acquisition and construction activities since January 1, 2006;
· finished the period with occupancy of our wholly owned portfolio of properties at 93.0%;
· completed, on January 9 and 10, 2007, a series of transactions that resulted in the acquisition of 56 operating properties totaling approximately 2.4 million square feet and land parcels totaling 187 acres. We refer to these transactions collectively as the Nottingham Acquisition. All of the acquired properties are located in Maryland, with 36 of the operating properties, totaling 1.6 million square feet, and land parcels totaling 175 acres, located in White Marsh, Maryland (located in the Suburban Baltimore region) and the remaining properties and land parcels located in other regions in Northern Baltimore County and the Baltimore/Washington Corridor. We believe that the land parcels can support at least 2.0 million developable square feet. We completed the Nottingham Acquisition for an aggregate cost of $366.8 million. We financed the acquisition by issuing $26.6 million in Series K Cumulative Redeemable Convertible Preferred Shares of beneficial interest (the “Series K Preferred Shares”) to the seller, issuing $156.7 million in common shares of beneficial interest (“common shares”) to the seller at a value of $49.57 per share, using $20.1 million from an escrow funded by proceeds from one of our property sales and using debt borrowings for the remainder.
In this section, we discuss our financial condition and results of operations as of and for the three months ended March 31, 2007. This section includes discussions on, among other things:
· our results of operations and why various components of our Consolidated Statements of Operations changed for the three months ended March 31, 2007 compared to the same period in 2006;
· how we raised cash for acquisitions and other capital expenditures during the three months ended March 31, 2007;
· our cash flows;
· how we expect to generate cash for short and long-term capital needs;
· our commitments and contingencies; and
· the computation of our Funds from Operations for the three months ended March 31, 2007 and 2006.
You should refer to our Consolidated Financial Statements as you read this section.
This section contains “forward-looking” statements, as defined in the Private Securities Litigation Reform Act of 1995, that are based on our current expectations, estimates and projections about future
events and financial trends affecting the financial condition and operations of our business. Forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “estimate” or other comparable terminology. Forward-looking statements are inherently subject to risks and uncertainties, many of which we cannot predict with accuracy and some of which we might not even anticipate. Although we believe that the expectations, estimates and projections reflected in such forward-looking statements are based on reasonable assumptions at the time made, we can give no assurance that these expectations, estimates and projections will be achieved. Future events and actual results may differ materially from those discussed in the forward-looking statements. Important factors that may affect these expectations, estimates and projections include, but are not limited to:
· our ability to borrow on favorable terms;
· general economic and business conditions, which will, among other things, affect office property demand and rents, tenant creditworthiness, interest rates and financing availability;
· adverse changes in the real estate markets, including, among other things, increased competition with other companies;
· risks of real estate acquisition and development activities, including, among other things, risks that development projects may not be completed on schedule, that tenants may not take occupancy or pay rent or that development and operating costs may be greater than anticipated;
· risks of investing through joint venture structures, including risks that our joint venture partners may not fulfill their financial obligations as investors or may take actions that are inconsistent with our objectives;
· our ability to satisfy and operate effectively under federal income tax rules relating to real estate investment trusts and partnerships;
· governmental actions and initiatives; and
· environmental requirements.
We undertake no obligation to update or supplement forward-looking statements.
24
Corporate Office Properties Trust and SubsidiariesOperating Data Variance Analysis
(Dollars for this table are in thousands, except per share data)
Variance
% Change
15,320
25.3
Tenant recoveries and other real estate operations revenue
5,133
59.3
(5,853
(40.2
%)
(379
(21.5
14,221
16.6
10,687
50.7
7,897
42.3
(5,543
(39.5
(273
(16.3
General and administrative expense
651
16.4
13,419
22.6
802
3.1
Interest expense and amortization of deferred financing costs
(20,760
(17,585
(3,175
18.1
(71
308.7
(51.2
(2,334
(28.1
532
(55.5
(1,802
(24.5
(2,478
(100.0
(110
(4,390
(44.2
(339
9.3
(4,729
(75.3
(0.07
(70.0
(0.13
(81.3
(0.06
(66.7
(0.12
(80.0
25
Results of Operations
While reviewing this section, you should refer to the “Operating Data Variance Analysis” table set forth on the preceding page, as it reflects the computation of the variances described in this section.
Geographic Concentration of Property Operations
The table below sets forth the changes in the regional allocation of our annualized rental revenue from December 31, 2006 to March 31, 2007. These changes occurred primarily as a result of the Nottingham Acquisition:
Percentage of Annualized
Rental Revenue of
Wholly Owned Properties as of
Region
Baltimore/Washington Corridor
46.6
51.2
Northern Virginia
20.2
20.5
Suburban Baltimore
15.1
7.5
Suburban Maryland
4.3
4.1
Colorado Springs, Colorado
3.9
4.2
St. Mary’s and King George Counties
3.6
Greater Philadelphia
3.2
3.7
San Antonio, Texas
2.1
2.4
1.0
2.2
100.0
Annualized rental revenue is a measure that we use to evaluate the source of our rental revenue as of a point in time. It is computed by multiplying by 12 the sum of monthly contractual base rents and estimated monthly expense reimbursements under active leases as of a point in time. We consider annualized rental revenue to be a useful measure for analyzing revenue sources because, since it is point-in-time based, it does not contain increases and decreases in revenue associated with periods in which lease terms were not in effect; historical revenue under GAAP does contain such fluctuations. We find the measure particularly useful for leasing, tenant, segment and industry analysis.
Since most of the operating properties included in the Nottingham Acquisition were located in the Suburban Baltimore region, the percentage of annualized revenue derived from wholly owned properties in that region increased to approximately twice what it was prior to the acquisition.
Concentration of Leases With Certain Tenants
We experienced changes in our tenant base during the three months ended March 31, 2007 due primarily to the Nottingham Acquisition, but also due to development and leasing activity. The following table lists our 20 largest tenants in our portfolio of wholly owned properties based on percentage of annualized rental revenue:
26
Percentage of Annualized Rental
Revenue of Wholly Owned Properties
for 20 Largest Tenants as of
Tenant
March 31,2007
December 31,2006
United States Government
14.4
16.3
Booz Allen Hamilton, Inc.
6.2
6.9
Northrop Grumman Corporation
5.4
Computer Sciences Corporation(1)
3.4
3.8
L-3 Communications Holdings, Inc.(1)
2.6
3.0
Unisys Corporation(2)
General Dynamics Corporation
Wachovia Corporation
2.0
The Aerospace Corporation
1.9
AT&T Corporation(1)
1.7
Comcast Corporation
1.5
The Boeing Company(1)
1.2
1.4
Ciena Corporation
1.1
Science Applications International Corporation
Lockheed Martin Corporation
0.9
Magellan Health Services, Inc.
BAE Systems PLC
0.8
Merck & Co., Inc.(2)
Johns Hopkins University(1)
0.7
Wyle Laboratories, Inc.
Harris Corporation
EDO Corporation
Subtotal of 20 largest tenants
51.9
56.7
All remaining tenants
48.1
43.3
(1) Includes affiliated organizations and agencies and predecessor companies.
(2) Unisys Corporation subleases space to Merck and Co., Inc.; revenue from this subleased space is classified as Merck & Co., Inc. revenue.
Industry Concentration of Tenants
The percentage of total annualized rental revenue in our wholly owned properties derived from the United States defense industry decreased during the three months ended March 31, 2007 due primarily to the Nottingham Acquisition, since the properties included in that transaction had an insignificant number of tenants in that industry. The table below sets forth the percentage of annualized rental revenue in our portfolio of wholly owned properties derived from that industry:
27
Rental Revenue of Wholly
Owned Properties from Defense
Industry Tenants as of
Total Portfolio
48.3
54.4
64.4
66.7
49.4
54.5
6.7
9.8
11.2
13.3
Colorado Springs
37.1
39.4
89.8
Occupancy and Leasing
The table below sets forth leasing information pertaining to our portfolio of wholly owned operating properties:
Occupancy rates
93.0
92.8
94.1
95.1
99.4
90.9
85.2
81.1
94.8
83.2
92.1
68.7
97.2
Average contractual annual rental rate per square foot at period end (1)
20.92
20.90
(1) Includes estimated expense reimbursements.
The total occupancy rate of our wholly owned properties was negatively affected by the operating properties included in the Nottingham Acquisition, which were 86.1% occupied at March 31, 2007. We also had a decrease in occupancy in our New Jersey region that was attributable to a lease termination at our 429 Ridge Road property located in Dayton, New Jersey (we are under contract to sell our 429 Ridge Road property and expect to complete such sale by January 2008). However, we had a net positive increase in occupancy in our other properties that offset the decreasing effects of the Nottingham Acquisition and the 429 Ridge Road property; this positive increase was largely attributable to lease commencements for space in our Northern Virginia and Suburban Maryland regions.
We renewed 72.1% of the square footage scheduled to expire in the three months ended March 31, 2007 (including the effect of early renewals and excluding the effect of early lease terminations).
28
The table below sets forth occupancy information pertaining to properties in which we have a partial ownership interest:
Occupancy Rates at
Geographic Region
Interest
50.0
47.9
92.5
Greater Harrisburg
20.0
91.2
(1) Excludes the effect of 62,000 unoccupied square feet undergoing redevelopment at period end.
Revenues from real estate operations and property operating expenses
We view our changes in revenues from real estate operations and property operating expenses as being comprised of the following main components:
· Changes attributable to the operations of properties owned and 100% operational throughout the two periods being compared. We define these as changes from “Same-Office Properties.” For example, when comparing the three months ended March 31, 2006 and 2007, Same-Office Properties would be properties owned and 100% operational from January 1, 2006 through March 31, 2007.
· Changes attributable to operating properties acquired during the two periods being compared and newly-constructed properties that were placed into service and not 100% operational throughout the two periods being compared. We define these as changes from “Property Additions.”
The table below sets forth the components of our changes in revenues from real estate operations and property operating expenses (dollars in thousands):
Changes From the Three Months Ended March 31, 2006 to 2007
PropertyAdditions
Same-Office Properties
Dollar
Percentage
Change(1)
Change
Change(2)
Revenues from real estate operations
13,684
1,869
(233
2,688
2,427
29.1
16,372
4,296
6.3
20,453
5,722
3,900
18.5
1,065
Straight-line rental revenue adjustments included in rental revenue
1,218
(592
629
120
(76
44
Number of operating properties included in component category
70
157
227
(1) Includes 63 acquired properties and seven newly-constructed properties.
(2) Includes, among other things, the effects of amounts eliminated in consolidation. Certain amounts eliminated in consolidation are attributable to the Property Additions and Same-Office Properties.
The analysis set forth in this section pertains to properties included in continuing operations.
As the table above indicates, our total increase in revenues from real estate operations and property operating expenses was attributable primarily to the Property Additions.
29
With regard to changes in the Same-Office Properties’ revenues from real estate operations:
· the increase in revenues from real estate operations for the Same-Office Properties included the following:
· an increase of $1.4 million, or 2.3%, in rental revenue from the Same-Office Properties attributable primarily to changes in rental rates and occupancy between the two periods; and
· an increase of $492,000, or 99.3%, in net revenue from the early termination of leases. To explain further the term net revenue from the early termination of leases, when tenants terminate their lease obligations prior to the end of the agreed lease terms, they typically pay fees to break these obligations. We recognize such fees as revenue and write off against such revenue any (1) deferred rents receivable and (2) deferred revenue and deferred assets that are amortizable into rental revenue associated with the leases; the resulting net amount is the net revenue from the early termination of the leases.
· tenant recoveries and other revenue from the Same-Office Properties increased due primarily to the increase in property operating expenses described below.
The increase in operating expenses for the Same-Office Properties included the following:
· an increase of $1.3 million, or 28.1%, in utilities due primarily to (1) rate increases that we believe are the result of (a) increased oil prices and (b) energy deregulation in Maryland and (2) our assumption of responsibility for payment of utilities at certain properties due to changes in occupancy and lease structure;
· an increase of $1.2 million, or 165.1%, in snow removal due to increased snow and ice in our regions;
· an increase of $452,000, or 11.2%, in real estate taxes reflecting primarily an increase in the assessed value of many of our properties; and
· an increase of $292,000, or 32.1% in heating and air conditioning repairs and maintenance due to an increase in general repair activity and the commencement of new service contracts at certain properties.
Construction contract and other service revenues and expenses
The table below sets forth changes in our construction contract and other service revenues and expenses (dollars in thousands):
Changes Between the Three Month Periods
Ended March 31, 2007 and 2006
Construction
Other Service
Contract Dollar
Operations Dollar
Total Dollar
Service operations
(6,232
(5,816
Income from service operations
(310
(106
(416
The gross revenues and costs associated with these services generally bear little relationship to the level of activity from these operations since a substantial portion of the costs are subcontracted costs that are reimbursed to us by the customer at no mark up. As a result, the operating margins from these operations are small relative to the revenue. We use the net of service operations revenues and expenses to evaluate performance. We believe that the changes in net amounts reflected above were not significant.
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Our increase in depreciation and other amortization expense was due primarily to a $9.0 million increase attributable to the Property Additions, of which $6.3 million was attributable to the Nottingham Acquisition. Compared to other acquisitions that we have completed in recent years, a considerably larger portion of the value of the operating properties included in the Nottingham Acquisition was allocated to assets with lives that are based on the lives of the underlying leases; due to that fact and the fact that a large number of the leases in these properties have lives of four years or less, much of the depreciation and amortization associated with these properties will be front-loaded to the four years following the completion of the acquisition. This will result in increased depreciation and amortization expense over the initial four years following the acquisition.
The change in depreciation and other amortization expense also included a $1.1 million, or 6.3%, decrease attributable to the Same Office Properties due to unamortized costs expensed in the prior period in connection with lease terminations.
The increase in general and administrative expenses included the following:
· a $921,000, or 27.4%, increase in compensation expense due in large part to the increased number of employees in response to the continued growth of the Company, increased salaries and bonuses for existing employees and increased expense associated with share-based compensation due to an increase in the award values being amortized into expense;
· a $298,000 increase in the write off of costs incurred on acquisition opportunities that we ultimately decided not to pursue; and
· an $823,000, or 73.4%, decrease attributable to increased allocation of corporate overhead primarily to our service companies. The increased allocation of corporate overhead to our service companies was attributable primarily to our increased general and administrative expenses and the increase in the number of employees in our service companies in response to the continued growth of the Company.
The increase in interest expense and amortization of deferred financing costs included in continuing operations was due primarily to a 23.7% increase in our average outstanding debt balance, resulting primarily from our acquisition and construction activities, offset in part by the effects of: (1) a $1.0 million, or 32.0%, increase in interest capitalized to construction and development projects due to increased construction and development activity; and (2) a decrease in our weighted average interest rates from 6.1% to 5.8%.
Interests in our Operating Partnership are in the form of preferred and common units. The line entitled “minority interests in income from continuing operations” includes primarily income before continuing operations allocated to preferred and common units not owned by us; for the amount of this line attributable to preferred units versus common units, you should refer to our Consolidated Statements of Operations. Income is allocated to minority interest preferred unitholders in an amount equal to the priority return from the Operating Partnership to which they are entitled. Income is allocated to minority interest common unitholders based on the income earned by the Operating Partnership after allocation to preferred unitholders multiplied by the percentage of the common units in the Operating Partnership owned by those common unitholders.
As of March 31, 2007, we owned 96% of the outstanding preferred units and 84% of the outstanding common units. The percentage of the Operating Partnership owned by minority interests decreased in the aggregate due primarily to the effect of the following transactions:
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· the issuance of additional units to us as we issued new preferred shares and common shares due to the fact that we receive preferred units and common units in the Operating Partnership each time we issue preferred shares and common shares;
· the exchange of common units for our common shares by certain minority interest holders of common units;
· our issuance of common units to third parties totaling 181,097 in 2006;
· the redemption by us of the Series E and Series F Preferred Shares in 2006.
The decrease in income allocated to minority interest holders of common units included in income from continuing operations was attributable primarily to the following:
· a decrease in the Operating Partnership’s income from continuing operations before minority interests due in large part to the changes described above; and
· a decrease attributable to our increasing ownership of common units (from 82% at December 31, 2005 to 84% at March 31, 2007).
Our income from discontinued operations decreased due primarily to the sale of three properties in the prior period from which we recognized gain of $2.4 million before allocation to minority interests.
Diluted earnings per common share on net income available to common shareholders decreased due to the following:
· decreases in net income available to common shareholders, attributable primarily to the reasons set forth above; and
· a larger number of common shares outstanding due to share issuances since January 1, 2006.
Liquidity and Capital Resources
Our cash and cash equivalents balance totaled $22.0 million as of March 31, 2007, a 177.7% increase from the balance at December 31, 2006. The cash and cash equivalents balances that we carry as of a point in time can vary significantly due in part to the inherent variability of the cash needs of our acquisition and development activities. We maintain sufficient cash and cash equivalents to meet our operating cash requirements and short term investing and financing cash requirements. When we determine that the amount of cash and cash equivalents on hand is more than we need to meet such requirements, we may pay down our Revolving Credit Facility or forgo borrowing under construction loan credit facilities to fund construction activities.
Operating Activities
We generated most of our cash from the operations of our properties. Most of the amount by which our revenues from real estate operations exceeded property operating expenses was cash flow; we applied most of this cash flow towards interest expense, scheduled principal amortization on debt, dividends to our shareholders, distributions to minority interest holders of preferred and common units in the Operating Partnership, capital improvements and leasing costs for our operating properties and general and administrative expenses.
Our cash flow from operations determined in accordance with GAAP increased $5.6 million, or 19.1%, when comparing the three months ended March 31, 2007 and 2006; this increase is attributable primarily to the additional cash flow from operations generated by our newly-acquired and newly-constructed properties. We expect to continue to use cash flow provided by operations to meet our short-term capital
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needs, including all property operating expenses, general and administrative expenses, interest expense, scheduled principal amortization on debt, dividends to our shareholders, distributions to our minority interest holders of preferred and common units in the Operating Partnership and capital improvements and leasing costs. We do not anticipate borrowing to meet these requirements.
Investing and Financing Activities During the Three Months Ended March 31, 2007
As discussed above, we completed the Nottingham Acquisition on January 9 and 10, 2007. The acquired properties included 56 operating properties totaling approximately 2.4 million square feet and land parcels totaling 187 acres that we believe can support at least 2.0 million developable square feet. We completed the Nottingham Acquisition for an aggregate cost of $366.8 million, which was financed using the following:
· the issuance of 3,161,000 common shares to the seller at a value of $156.7 million, or $49.57 per share;
· the issuance of 531,667 Series K Preferred Shares to the seller at a value of $26.6 million, or $50.00 per share;
· $89.1 million in borrowings under a variable-rate loan bearing interest at LIBOR plus 1.15 to 1.55% depending on our leverage levels;
· borrowings assumed under fixed-rate mortgage loans with an aggregate fair value of $38.6 million;
· $33.7 million in borrowings under our Revolving Credit Facility;
· $20.1 million in cash from a previous property sale that was released from escrow; and
· a $2.0 million deposit previously paid.
We issued the Series K Preferred Shares in the Nottingham Acquisition at a value, and liquidation preference equal to, $50 per share. The Series K Preferred Shares are nonvoting, redeemable for cash at $50 per share at our option on or after January 9, 2017, and are convertible, subject to certain conditions, into common shares on the basis of 0.8163 common shares for each preferred share, in accordance with the terms of the Articles Supplementary describing the Series K Preferred Shares. Holders of the Series K Preferred Shares are entitled to cumulative dividends, payable quarterly (as and if declared by our Board of Trustees). Dividends accrue from the date of issue at the annual rate of $2.80 per share, which is equal to 5.6% of the $50 per share liquidation preference.
At March 31, 2007, we had construction activities underway on nine office properties totaling 935,000 square feet that were 71.9% pre-leased, including 68,196 square feet already placed in service in a partially operational property. One of these properties is owned through a consolidated joint venture in which we have a 50% interest. Costs incurred on these properties through March 31, 2007 totaled approximately $139.5 million, of which approximately $29.8 million was incurred in the three months ended March 31, 2007. We have construction loan facilities in place totaling $117.7 million to finance the construction of five of these properties; borrowings under these facilities totaled $72.6 million at March 31, 2007, $20.2 of which was borrowed in the three months ended March 31, 2007. The remaining costs incurred in the three months ended March 31, 2007 were funded using primarily borrowings from our Revolving Credit Facility and cash reserves.
The table below sets forth the major components of our additions to the line entitled “Total Commercial Real Estate Properties” on our Consolidated Balance Sheet for the three months ended March 31, 2007 (in thousands):
320,867
Construction and development
47,108
Capital improvements on operating properties
6,164
Tenant improvements on operating properties
5,803
(1)
(1) Tenant improvement costs incurred on newly-constructed properties are classified in this table as construction and development.
Certain of our mortgage loans require that we comply with a number of restrictive financial covenants, including leverage ratio, minimum net worth, minimum fixed charge coverage, minimum debt service and maximum secured indebtedness. As of March 31, 2007, we were in compliance with these financial covenants.
Analysis of Cash Flow Associated with Investing and Financing Activities
Our net cash flow used in investing activities increased $168.9 million when comparing the three months ended March 31, 2007 and 2006. This increase was due primarily to the following:
· a $149.7 million, or 391%, increase in purchases of and additions to commercial real estate due primarily to the completion of the Nottingham Acquisition;
· a $28.2 million decrease in proceeds from sales of properties; and
· a $13.6 million decrease in restricted cash associated with investing activities due primarily to the release of funds held in escrow relating to a property sale completed in 2006.
Our cash flow provided by financing activities increased $168.0 million due primarily to a a $140.2 million, or 293%, increase in proceeds from mortgage and other loans payable driven mostly by the financing needs of the Nottingham Acquisition.
Off-Balance Sheet Arrangements
We had no significant changes in our off-balance sheet arrangements from those described in the section entitled “Off-Balance Sheet Arrangements” in our 2006 Annual Report on Form 10-K.
Investing and Financing Activities Subsequent to March 31, 2007
Other Future Cash Requirements for Investing and Financing Activities
As of March 31, 2007, we were under contract to acquire the following:
· a parcel of land in Aberdeen, Maryland for $10.0 million, of which we paid a deposit of $100,000 in 2006; and
· the remaining 91 acres of land not yet acquired as part of the acquisition of the former Fort Ritchie United States Army base located in Cascade, Washington County, Maryland; we expect to make the following additional future cash payments to the seller for (1) the acquisition of the remaining 91 acres and (2) portions of the contract price on which payment was deferred by the contract: $1.3 million in 2007, $1.0 million in 2008 and $155,000 in 2009. We could incur an additional cash obligation to the seller after that of up to $4.0 million; this $4.0 million cash obligation is subject to reduction by an amount ranging between $750,000 and $4.0 million, with the amount of such reduction to be determined based on defined levels of (1) job creation resulting from the future development of the property and (2) future real estate taxes generated by the property.
We expect to fund these acquisitions and development costs using borrowings under our Revolving Credit Facility.
As previously discussed, as of March 31, 2007, we had construction activities underway on nine office properties totaling 935,000 square feet that were 71.9% pre-leased (one of these properties is owned
through a consolidated joint venture in which we have a 50% interest). We estimate remaining costs to be incurred will total approximately $72.5 million upon completion of these properties; we expect to incur these costs primarily in 2007 and 2008. We have $45.1 million remaining to be borrowed under construction loan facilities totaling $117.7 million for five of these properties. We expect to fund the remaining portion of these costs using borrowings from new construction loan facilities and our Revolving Credit Facility.
As of March 31, 2007, we had development activities underway on 11 new office properties estimated to total 1.3 million square feet (we owned a 50% interest in two of these properties as of March 31, 2007). We estimate that costs for these properties will total approximately $260.0 million. As of March 31, 2007, costs incurred on these properties totaled $30.9 million and the balance is expected to be incurred from 2007 through 2009. We expect to fund most of these costs using borrowings from new construction loan facilities.
As of March 31, 2007, we had redevelopment activities underway on four properties totaling 740,000 square feet (two of these properties are owned through a consolidated joint venture in which we own a 92.5% interest). We estimate that the remaining costs of the redevelopment activities will total approximately $44.1 million. We expect to fund most of these costs using borrowings under new construction loan facilities.
During the remainder of 2007 and beyond, we expect to complete other acquisitions of properties and commence construction and development activities in addition to the ones previously described. We expect to finance these activities as we have in the past, using mostly a combination of borrowings from new debt, borrowings under our Revolving Credit Facility, proceeds from sales of existing properties and additional equity issuances of common and/or preferred shares or units.
The maximum principal amount on our Revolving Credit Facility is $500.0 million, with a right to further increase the maximum principal amount in the future to $600.0 million, subject to certain conditions. The borrowing capacity under this Revolving Credit Facility is generally computed based on 65% of the value of assets identified by us to support repayment of the loan. As of April 30, 2007, the borrowing capacity under the Revolving Credit Facility was $500.0 million, of which $202.0 million was available.
Funds From Operations
Funds from operations (“FFO”) is defined as net income computed using GAAP, excluding gains (or losses) from sales of real estate, plus real estate-related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Gains from sales of newly-developed properties less accumulated depreciation, if any, required under GAAP are included in FFO on the basis that development services are the primary revenue generating activity; we believe that inclusion of these development gains is in accordance with the National Association of Real Estate Investment Trusts (“NAREIT”) definition of FFO, although others may interpret the definition differently.
Accounting for real estate assets using historical cost accounting under GAAP assumes that the value of real estate assets diminishes predictably over time. NAREIT stated in its April 2002 White Paper on Funds from Operations that “since real estate asset values have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results forreal estate companies that use historical cost accounting to be insufficient by themselves.” As a result, the concept of FFO was created by NAREIT for the REIT industry to “address this problem.” We agree with the concept of FFO and believe that FFO is useful to management and investors as a supplemental measure of operating performance because, by excluding gains and losses related to sales of previously depreciated operating real estate properties and excluding real estate-related depreciation and amortization, FFO can help one compare our operating performance between periods. In addition, since most equity REITs provide FFO information to the investment community, we believe that FFO is useful to investors as a supplemental measure for comparing our results to those of other equity REITs. We believe that net income is the most directly comparable GAAP measure to FFO.
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Since FFO excludes certain items includable in net income, reliance on the measure has limitations; management compensates for these limitations by using the measure simply as a supplemental measure that is weighed in the balance with other GAAP and non GAAP measures. FFO is not necessarily an indication of our cash flow available to fund cash needs. Additionally, it should not be used as an alternative to net income when evaluating our financial performance or to cash flow from operating, investing and financing activities when evaluating our liquidity or ability to make cash distributions or pay debt service. The FFO we present may not be comparable to the FFO presented by other REITs since they may interpret the current NAREIT definition of FFO differently or they may not use the current NAREIT definition of FFO.
Basic funds from operations (“Basic FFO”) is FFO adjusted to (1) subtract preferred share dividends and (2) add back GAAP net income allocated to common units in the Operating Partnership not owned by us. With these adjustments, Basic FFO represents FFO available to common shareholders and common unitholders. Common units in the Operating Partnership are substantially similar to our common shares and are exchangeable into common shares, subject to certain conditions. We believe that Basic FFO is useful to investors due to the close correlation of common units to common shares. We believe that net income is the most directly comparable GAAP measure to Basic FFO. Basic FFO has essentially the same limitations as FFO; management compensates for these limitations in essentially the same manner as described above for FFO.
Diluted funds from operations (“Diluted FFO”) is Basic FFO adjusted to add back any changes in Basic FFO that would result from the assumed conversion of securities that are convertible or exchangeable into common shares. However, the computation of Diluted FFO does not assume conversion of securities other than common units in the Operating Partnership that are convertible into common shares if the conversion of those securities would increase Diluted FFO per share in a given period. We believe that Diluted FFO is useful to investors because it is the numerator used to compute Diluted FFO per share, discussed below. In addition, since most equity REITs provide Diluted FFO information to the investment community, we believe Diluted FFO is a useful supplemental measure for comparing us to other equity REITs. We believe that the numerator for diluted EPS is the most directly comparable GAAP measure to Diluted FFO. Since Diluted FFO excludes certain items includable in the numerator to diluted EPS, reliance on the measure has limitations; management compensates for these limitations by using the measure simply as a supplemental measure that is weighed in the balance with other GAAP and non-GAAP measures. Diluted FFO is not necessarily an indication of our cash flow available to fund cash needs. Additionally, it should not be used as an alternative to net income when evaluating our financial performance or to cash flow from operating, investing and financing activities when evaluating our liquidity or ability to make cash distributions or pay debt service. The Diluted FFO that we present may not be comparable to the Diluted FFO presented by other REITs.
Diluted funds from operations per share (“Diluted FFO per share”) is (1) Diluted FFO divided by (2) the sum of the (a) weighted average common shares outstanding during a period, (b) weighted average common units outstanding during a period and (c) weighted average number of potential additional common shares that would have been outstanding during a period if other securities that are convertible or exchangeable into common shares were converted or exchanged. However, the computation of Diluted FFO per share does not assume conversion of securities other than common units in the Operating Partnership that are convertible into common shares if the conversion of those securities would increase Diluted FFO per share in a given period. We believe that Diluted FFO per share is useful to investors because it provides investors with a further context for evaluating our FFO results in the same manner that investors use earnings per share (“EPS”) in evaluating net income available to common shareholders. In addition, since most equity REITs provide Diluted FFO per share information to the investment community, we believe Diluted FFO per share is a useful supplemental measure for comparing us to other equity REITs. We believe that diluted EPS is the most directly comparable GAAP measure to Diluted FFO per share. Diluted FFO per share has most of the same limitations as Diluted FFO (described above); management compensates for these limitations in essentially the same manner as described above for Diluted FFO.
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Our Basic FFO, Diluted FFO and Diluted FFO per share for the three months ended March 31, 2007 and 2006 and reconciliations of (1) net income to FFO, (2) the numerator for diluted EPS to diluted FFO and (3) the denominator for diluted EPS to the denominator for diluted FFO per share are set forth in the following table (dollars and shares in thousands, except per share data):
Add: Real estate-related depreciation and amortization
26,300
19,068
Add: Depreciation and amortization on unconsolidated real estate entities
168
85
Less: Depreciation and amortization allocable to minority interests in other consolidated entities
(33
Less: Gain on sales of real estate, excluding development portion (1)
(2,459
Funds from operations (“FFO”)
31,973
26,598
Add: Minority interests-common units in the Operating Partnership
1,406
Funds from Operations - basic and diluted (“Basic and Diluted FFO”)
28,288
24,350
Weighted average common shares
Weighted average common shares/units - Basic FFO
54,089
48,188
Weighted average common shares/units - Diluted FFO
55,554
50,030
Diluted FFO per common share
0.51
0.49
Numerator for diluted EPS
Diluted FFO
Weighted average common units
Denominator for Diluted FFO per share
(1) Gains from the sale of real estate that are attributable to sales of non-operating properties are included in FFO. Gains from newly-developed or re-developed properties less accumulated depreciation, if any, required under GAAP are also included in FFO on the basis that development services are the primary revenue generating activity; we believe that inclusion of these development gains is in compliance with the NAREIT definition of FFO, although others may interpret the definition differently.
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Inflation
Most of our tenants are obligated to pay their share of a building’s operating expenses to the extent such expenses exceed amounts established in their leases, based on historical expense levels. Some of our tenants are obligated to pay their full share of a building’s operating expenses. These arrangements somewhat reduce our exposure to increases in such costs resulting from inflation. In addition, since our average lease life is approximately five years, we generally expect to be able to compensate for increased operating expenses through increased rental rates upon lease renewal or expiration.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to certain market risks, the most predominant of which is change in interest rates. Increases in interest rates can result in increased interest expense under our Revolving Credit Facility and our other debt carrying variable interest rate terms. Increases in interest rates can also result in increased interest expense when our debt carrying fixed interest rate terms mature and need to be refinanced. Our debt strategy favors long-term, fixed-rate, secured debt over variable-rate debt to minimize the risk of short-term increases in interest rates. As of March 31, 2007, 77.9% of our fixed-rate debt was scheduled to mature after 2008. As of March 31, 2007, 21.2% of our total debt had variable interest rates, including the effect of interest rate swaps. As of March 31, 2007, the percentage of variable-rate debt, including the effect of interest rate swaps, relative to total assets was 12.9%.
The following table sets forth our long-term debt obligations by scheduled maturity and weighted average interest rates at March 31, 2007 (dollars in thousands):
For the Periods Ended December 31,
2007(2)
2008(3)
Thereafter
Long term debt:
Fixed rate (1)
74,215
157,660
62,745
74,141
109,930
771,714
1,250,405
Average interest rate
5.58
5.42
5.25
5.17
5.09
4.31
4.81
Variable rate
146,435
317,504
463,939
6.31
6.66
(1) Represents scheduled principal maturities only and therefore excludes a net premium of $839,000.
(2) Our loan maturities in 2007 include $49.0 million that may be extended until 2008, subject to certain conditions, and $159.2 million under various loans that we expect to either refinance or repay using borrowings under our Revolving Credit Facility; the balance of the 2007 maturities represent primarily scheduled principal amortization payments that we expect to pay using cash flow from operations.
(3) Our loan maturities in 2008 include $317.5 million that may be extended until 2009, subject to certain conditions
The fair market value of our debt was $1.72 billion at March 31, 2007. If interest rates on our fixed-rate debt had been 1% lower, the fair value of this debt would have increased by $49.2 million at March 31, 2007.
The following table sets forth information pertaining to our derivative contracts in place as of March 31, 2007, and their respective fair values (dollars in thousands):
$50,000
$(174
Based on our variable-rate debt balances, our interest expense would have increased by $705,000 in the three months ended March 31, 2007 if short-term interest rates were 1% higher.
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2007. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of March 31, 2007 are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
(b) Change in Internal Control over Financial Reporting
No change in our internal control over financial reporting occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II
Item 1. Legal Proceedings
Jim Lemon and Robin Biser, as plaintiffs, initiated a suit on May 12, 2005, in The United States District Court for the District of Columbia (Case No. 1:05CV00949), against The Secretary of the United States Army, PenMar Development Corporation (“PMDC”) and the Company, as defendants, in connection with the then pending acquisition by the Company of the former army base known as Fort Ritchie located in Cascade, Maryland. The case was dismissed by the United States District Court on September 28, 2006, due to the plaintiffs’ lack of standing. The plaintiffs have filed an appeal in the case in the United States Court of Appeals for the District of Columbia Circuit and that appeal is pending. The plaintiffs were unsuccessful in their request for an emergency injunction pending appeal. The Company acquired from PMDC fee simple title to 500 acres of the 591 acres comprising Fort Ritchie on October 5, 2006.
We are not currently involved in any other material litigation nor, to our knowledge, is any material litigation currently threatened against the Company (other than routine litigation arising in the ordinary course of business, substantially all of which is expected to be covered by liability insurance).
Item 1A. Risk Factors
Not applicable
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(a)
During the three months ended March 31, 2007, 221,350 of the Operating Partnership’s common units were exchanged for 221,350 common shares in accordance with the Operating Partnership’s Second Amended and Restated Limited Partnership Agreement, as amended. The issuance of these common shares was effected in reliance upon the exemption from registration under Section 4(2) of the Securities Act of 1933, as amended.
(b)
(c)
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits
Exhibits:
EXHIBITNO.
DESCRIPTION
10.1
Amended and Restated 1998 Long Term Incentive Plan (filed with the Company’s Current Report on Form 8-K dated April 3, 2007 and incorporated herein by reference
10.2
Twenty-Third Amendment to Second Amended and Restated Limited Partnership Agreement of Corporate Office Properties, L.P., dated April 6, 2007 (filed with the Company’s Current Report on Form 8-K dated April 12, 2007 and incorporated herein by reference).
31.1
Certification of the Chief Executive Officer of Corporate Office Properties Trust required by Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended (filed herewith).
31.2
Certification of the Chief Financial Officer of Corporate Office Properties Trust required by Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended (filed herewith).
32.1
Certification of the Chief Executive Officer of Corporate Office Properties Trust required by Rule 13a-14(b) under the Securities Exchange Act of 1934, as amended. (This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liability of that section. Further, this exhibit shall not be deemed to be incorporated by reference into any filing under the Securities
Exchange Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.) (Furnished herewith.)
32.2
Certification of the Chief Financial Officer of Corporate Office Properties Trust required by Rule 13a-14(b) under the Securities Exchange Act of 1934, as amended. (This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liability of that section. Further, this exhibit shall not be deemed to be incorporated by reference into any filing under the Securities Exchange Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.) (Furnished herewith.)
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Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CORPORATE OFFICE PROPERTIESTRUST
Date: May 10, 2007
By:
/s/ RANDALL M. GRIFFIN
Randall M. Griffin
President and Chief Executive Officer
/s/ STEPHEN E. RIFFEE
Stephen E. Riffee
Executive Vice President and ChiefFinancial Officer