Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
(Mark one)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2009
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-14023
(Exact name of registrant as specified in its charter)
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. xYes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). oYes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) o Yes x No
As of July 22, 2009, 58,016,093 of the Company’s Common Shares of Beneficial Interest, $0.01 par value, were issued and outstanding.
TABLE OF CONTENTS
FORM 10-Q
PAGE
PART I: FINANCIAL INFORMATION
Item 1:
Financial Statements:
Consolidated Balance Sheets as of June 30, 2009 and December 31, 2008 (unaudited)
3
Consolidated Statements of Operations for the three and six months ended June 30, 2009 and 2008 (unaudited)
4
Consolidated Statements of Equity for the six months ended June 30, 2009 and 2008 (unaudited)
5
Consolidated Statements of Cash Flows for the six months ended June 30, 2009 and 2008 (unaudited)
6
Notes to Consolidated Financial Statements (unaudited)
7
Item 2:
Management’s Discussion and Analysis of Financial Condition and Results of Operations
24
Item 3:
Quantitative and Qualitative Disclosures About Market Risk
35
Item 4:
Controls and Procedures
36
PART II: OTHER INFORMATION
Legal Proceedings
Item 1A:
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
37
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5:
Other Information
38
Item 6:
Exhibits
SIGNATURES
39
2
ITEM 1. Financial Statements
Corporate Office Properties Trust and Subsidiaries
Consolidated Balance Sheets
(Dollars in thousands)
(unaudited)
June 30,
December 31,
2009
2008
Assets
Properties, net:
Operating properties, net
$
2,340,574
2,283,870
Projects under construction or development
513,562
494,596
Total properties, net
2,854,136
2,778,466
Cash and cash equivalents
11,931
6,775
Restricted cash
17,879
13,745
Accounts receivable, net
13,776
13,684
Deferred rent receivable
67,137
64,131
Intangible assets on real estate acquisitions, net
81,090
91,848
Deferred charges, net
48,812
51,801
Prepaid expenses and other assets
103,914
93,789
Total assets
3,198,675
3,114,239
Liabilities and equity
Liabilities:
Mortgage and other loans payable
1,677,351
1,704,123
3.5% Exchangeable Senior Notes, net
154,362
152,628
Accounts payable and accrued expenses
142,734
93,625
Rents received in advance and security deposits
29,936
30,464
Dividends and distributions payable
27,057
25,794
Deferred revenue associated with acquired operating leases
8,926
10,816
Distributions in excess of investment in unconsolidated real estate joint venture
4,873
4,770
Other liabilities
7,029
9,596
Total liabilities
2,052,268
2,031,816
Commitments and contingencies (Note 15)
Equity:
Corporate Office Properties Trust’s shareholders’ equity:
Preferred Shares of beneficial interest with an aggregate liquidation preference of $216,333 ($0.01 par value; 15,000,000 shares authorized and 8,121,667 issued and outstanding at June 30, 2009 and December 31, 2008)
81
Common Shares of beneficial interest ($0.01 par value; 75,000,000 shares authorized, shares issued and outstanding of 58,016,683 at June 30, 2009 and 51,790,442 at December 31, 2008)
580
518
Additional paid-in capital
1,229,931
1,112,734
Cumulative distributions in excess of net income
(179,698
)
(162,572
Accumulated other comprehensive loss
(1,176
(4,749
Total Corporate Office Properties Trust’s shareholders’ equity
1,049,718
946,012
Noncontrolling interests in subsidiaries:
Common units in the Operating Partnership
76,873
117,356
Preferred units in the Operating Partnership
8,800
Other consolidated real estate joint ventures
11,016
10,255
Noncontrolling interests in subsidiaries
96,689
136,411
Total equity
1,146,407
1,082,423
Total liabilities and equity
See accompanying notes to consolidated financial statements.
Consolidated Statements of Operations
(Dollars in thousands, except per share data)
For the Three Months
For the Six Months
Ended June 30,
Revenues
Rental revenue
88,326
83,154
177,848
164,864
Tenant recoveries and other real estate operations revenue
17,392
14,792
34,714
30,084
Construction contract revenues
102,753
21,899
177,292
32,035
Other service operations revenues
571
525
921
1,003
Total revenues
209,042
120,370
390,775
227,986
Expenses
Property operating expenses
37,162
33,957
76,195
68,499
Depreciation and other amortization associated with real estate operations
28,708
24,955
55,199
49,847
Construction contract expenses
100,647
21,472
173,545
31,377
Other service operations expenses
514
454
939
1,056
General and administrative expenses
5,834
5,934
11,377
11,704
Business development expenses
446
102
1,092
265
Total operating expenses
173,311
86,874
318,347
162,748
Operating income
35,731
33,496
72,428
65,238
Interest expense
(18,678
(21,162
(38,102
(43,077
Interest and other income
1,252
170
2,330
365
Income from continuing operations before equity in loss of unconsolidated entities and income taxes
18,305
12,504
36,656
22,526
Equity in loss of unconsolidated entities
(202
(56
(317
(110
Income tax (expense) benefit
(52
107
(122
(5
Income from continuing operations
18,051
12,555
36,217
22,411
Discontinued operations
—
1,314
2,580
Income before gain on sales of real estate
13,869
24,991
Gain on sales of real estate, net of income taxes
41
1,100
Net income
13,910
26,091
Less net income attributable to noncontrolling interests:
(1,272
(1,461
(3,076
(2,663
(165
(330
Other
25
(25
(222
Net income attributable to Corporate Office Properties Trust
16,639
12,162
32,786
22,876
Preferred share dividends
(4,026
(8,051
Net income attributable to Corporate Office Properties Trust common shareholders
12,613
8,136
24,735
14,825
11,047
20,689
1,115
2,187
Basic earnings per common share (1)
0.22
0.15
0.45
0.26
0.02
0.05
0.17
0.31
Diluted earnings per common share (1)
0.44
0.04
0.30
Dividends declared per common share
0.3725
0.3400
0.7450
0.6800
(1) Basic and diluted earnings per common share are calculated based on amounts attributable to common shareholders of Corporate Office Properties Trust.
Consolidated Statements of Equity
PreferredShares
CommonShares
AdditionalPaid-inCapital
CumulativeDistributions inExcess of NetIncome
AccumulatedOtherComprehensiveLoss
Noncontrolling Interests in Subsidiaries
Total
Balance at December 31, 2008 (51,790,442 common shares outstanding)
Conversion of common units to common shares (2,824,000 shares)
28
61,368
(61,396
Common shares issued to the public (2,990,000 shares)
30
71,795
71,825
Exercise of share options (153,177 shares)
1,855
1,857
Share-based compensation
5,248
5,250
Restricted common share redemptions (71,267 shares)
(1,752
Adjustments to noncontrolling interests resulting from changes in ownership of Operating Partnership by COPT
(21,165
21,165
Increase in fair value of derivatives
3,573
650
4,223
Decrease in tax benefit from share-based compensation
(152
3,431
Dividends
(49,912
Distributions to owners of common and preferred units in the Operating Partnership
(4,308
Net contributions and distributions to noncontrolling interests in other consolidated real estate joint ventures
736
Balance at June 30, 2009 (58,016,683 common shares outstanding)
Balance at December 31, 2007 (47,366,475 common shares outstanding)
474
971,459
(129,599
(2,372
129,437
969,480
Conversion of common units to common shares (15,242 shares)
1
419
(420
Exercise of share options (90,209 shares)
1,346
1,347
4,555
4,556
Restricted common share redemptions (40,892 shares)
(1,304
Decrease in fair value of derivatives
(243
(41
(284
Increase in tax benefit from share-based compensation
1,053
3,215
(40,422
(5,872
2,868
Balance at June 30, 2008 (47,701,812 common shares outstanding)
477
977,528
(147,145
(2,615
129,187
957,513
Consolidated Statements of Cash Flows
For the Six Months EndedJune 30,
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and other amortization
56,311
50,676
Amortization of deferred financing costs
2,033
1,661
Amortization of deferred market rental revenue
(997
(903
Amortization of net debt discounts
1,663
1,936
Gain on sales of real estate
(4,204
Excess income tax shortfall (benefit) from share-based compensation
152
(1,053
(1,946
402
Changes in operating assets and liabilities:
Increase in deferred rent receivable
(3,006
(5,701
(Increase) decrease in accounts receivable
(92
1,379
(Increase) decrease in restricted cash and prepaid expenses and other assets
(4,681
3,380
Increase in accounts payable, accrued expenses and other liabilities
38,055
4,406
(Decrease) increase in rents received in advance and security deposits
(528
1,335
Net cash provided by operating activities
128,431
83,961
Cash flows from investing activities
Purchases of and additions to properties
(101,650
(149,699
Proceeds from sales of properties
65
28,304
Leasing costs paid
(6,282
(2,383
(4,636
(2,504
Net cash used in investing activities
(112,503
(126,282
Cash flows from financing activities
Proceeds from mortgage and other loans payable
314,147
227,932
Repayments of mortgage and other loans payable
(340,848
(149,374
Deferred financing costs paid
(2,250
Net proceeds from issuance of common shares
73,682
1,350
Dividends paid
(47,596
(40,309
Distributions paid
(5,361
(5,878
Excess income tax (shortfall) benefit from share-based compensation
Restricted share redemptions
(2,690
(680
Net cash (used in) provided by financing activities
(10,772
30,540
Net increase (decrease) in cash and cash equivalents
5,156
(11,781
Beginning of period
24,638
End of period
12,857
Notes to Consolidated Financial Statements
Corporate Office Properties Trust (“COPT”) and subsidiaries (collectively, the “Company”, “we” or “us”) is a fully-integrated and self-managed real estate investment trust (“REIT”) that focuses primarily on strategic customer relationships and specialized tenant requirements in the United States Government, defense information technology and data sectors. We acquire, develop, manage and lease properties that are typically concentrated in large office parks primarily located adjacent to government demand drivers and/or in demographically strong markets possessing growth opportunities. As of June 30, 2009, our investments in real estate included the following:
· 243 wholly owned operating properties totaling 18.7 million square feet;
· 16 wholly owned properties under construction or development that we estimate will total approximately 1.8 million square feet upon completion;
· wholly owned land parcels totaling 1,530 acres that we believe are potentially developable into approximately 13.1 million square feet; and
· partial ownership interests in a number of other real estate projects in operation, under development or redevelopment or held for future development.
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 June 30, 2009 follows:
Common Units
92
%
Series G Preferred Units
100
Series H Preferred Units
Series I Preferred Units
0
Series J Preferred Units
Series K Preferred Units
Three of our trustees also controlled, either directly or through ownership by other entities or family members, 7% of the Operating Partnership’s common units at that date.
In addition to owning interests in real estate, the Operating Partnership also owns 100% of a number of entities that provide real estate services such as property management, construction and development and heating and air conditioning services primarily for our properties but also for third parties.
Basis of Presentation
The consolidated financial statements include the accounts of COPT, the Operating Partnership, their subsidiaries and other entities in which we have a majority voting interest and control. We also consolidate certain entities when control of such entities can be achieved through means other than voting rights (“variable interest entities” or “VIEs”) if we are deemed to be the primary beneficiary of such entities. We eliminate all significant intercompany balances and transactions in consolidation. We use the equity method of accounting when we own an interest in an entity and can exert significant influence over the entity’s operations but cannot control the entity’s operations. We use the cost method of accounting when we own an interest in an entity and cannot exert significant influence over its operations.
In preparing the consolidated financial statements, we evaluated subsequent events occurring through July 31, 2009, the date the financial statements were issued.
These interim financial statements should be read together with the financial statements and notes thereto as of and for the year ended December 31, 2008 included in our Current Report on Form 8-K filed on June 2, 2009. The unaudited consolidated financial statements include all adjustments which are necessary, in the opinion of management, to fairly present our financial position and results of operations. All adjustments are of a normal recurring nature. The consolidated financial statements have been prepared using the accounting policies described in the financial statements included in our Current Report on Form 8-K filed on June 2, 2009.
We reclassified certain amounts from the prior periods to conform to the current period presentation of our Consolidated Financial Statements with no effect on previously reported net income or equity.
Recent Accounting Pronouncements Resulting in Adjustments
As discussed further in our Current Report on Form 8-K dated June 2, 2009, we retrospectively adopted Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”), FASB Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”) and EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” (EITF 03-6-1”). This resulted in the recording of certain adjustments to amounts previously reported in our 2008 Annual Report on Form 10-K, including changes that affected our previously reported net income attributable to our common shareholders and earnings per common share. Our Current Report on Form 8-K dated June 2, 2009 updated our 2008 Annual Report on Form 10-K for the effect of these adjustments.
Other Recent Accounting Pronouncements
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167, “Amendments to FASB Interpretation No. 46(R)” (“SFAS 167”), which amends FASB Interpretation No. 46 (revised December 2003) to address the elimination of the concept of a qualifying special purpose entity. SFAS 167 also replaces the quantitative-based risks and rewards calculation for determining which enterprise has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity and the obligation to absorb losses of the entity or the right to receive benefits from the entity. Additionally, SFAS 167 provides more timely and useful information about an enterprise’s involvement with a variable interest entity. SFAS 167 will become effective on January 1, 2010. We are currently evaluating the impact of this standard on our consolidated financial statements.
In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles (as amended)” (“SFAS 168”), which establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied in the preparation of financial statements in conformity with generally accepted accounting principles for nongovernmental entities. SFAS 168 explicitly recognizes rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP for SEC registrants. SFAS 168 became effective on July 1, 2009 and is not expected to have a material effect on our consolidated financial statements.
Fair Value of Financial Instruments
Under Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), fair value is defined as the exit price, or the amount that would be received upon sale of an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. SFAS 157 also establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions about the factors market participants would use in valuing the asset or liability developed based upon the best information available in the circumstances. The hierarchy of these inputs is broken down into three levels: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities; Level 2 inputs include (1) quoted prices for similar assets or liabilities in active markets, (2) quoted prices for identical or similar assets or liabilities in markets that are not active and (3) inputs (other than quoted prices) that are observable for the asset or liability, either directly or indirectly; and Level 3 inputs are unobservable inputs for the asset or liability.
8
Categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
The assets held in connection with our non-qualified elective deferred compensation plan and the corresponding liability to the participants are measured at fair value on a recurring basis on our consolidated balance sheet using quoted market prices. The assets are treated as trading securities for accounting purposes and included in restricted cash on our consolidated balance sheet. The offsetting liability is adjusted to fair value at the end of each accounting period based on the fair value of the plan assets and reported in other liabilities in our consolidated balance sheet. The assets and corresponding liability of our non-qualified elective deferred compensation plan are classified in Level 1 of the fair value hierarchy.
The valuation of our derivatives is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate market data and implied volatilities in such interest rates. While we determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy under SFAS 157, the credit valuation adjustments associated with our derivatives also utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default. However, as of June 30, 2009, we assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our derivatives and determined that these adjustments are not significant. As a result, we determined that our derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.
The table below sets forth our financial assets and liabilities that are accounted for at fair value on a recurring basis as of June 30, 2009:
Quoted Prices in
Active Markets for
Significant Other
Significant
Identical Assets
Observable Inputs
Unobservable Inputs
Description
(Level 1)
(Level 2)
(Level 3)
Assets:
Deferred compensation plan assets (1)
5,520
Interest rate swap contracts (2)
789
6,309
Deferred compensation plan liability (3)
Interest rate swap contracts (3)
1,666
Liabilities
7,186
(1) Included in the line entitled “restricted cash” on our Consolidated Balance Sheet.
(2) Included in the line entitled “prepaid and other assets” on our Consolidated Balance Sheet.
(3) Included in the line entitled “other liabilities” on our Consolidated Balance Sheet.
The carrying values of cash and cash equivalents, restricted cash, accounts receivables, other assets (excluding mortgage loans receivable) and accounts payable and accrued expenses are reasonable estimates of their fair values because of the short maturities of these instruments. We estimated the fair values of our mortgage loans receivable by using discounted cash flow analyses based on an appropriate market rate for a similar type of instrument. We estimated fair values of our debt based on quoted market prices for publicly-traded debt and on the discounted estimated future cash payments to be made for other debt; the discount rates used approximate current market rates for loans, or groups of loans, with similar maturities and credit quality, and the estimated future payments include scheduled principal and interest payments. Fair value estimates are made at a specific point in time, are subjective in nature and involve uncertainties and matters of significant judgment. Settlement of such fair value amounts may not be possible and may not be a prudent management decision.
Mortgage loans receivable are included in the line entitled prepaid and other assets on our consolidated balance sheets. The following table sets forth information pertaining to the fair value of our mortgage loans receivable:
9
June 30, 2009
December 31, 2008
Carrying Amount
31,119
29,380
Estimated Fair Value
30,039
28,951
For additional fair value information, please refer to Note 6 for debt and Note 7 for derivatives.
We compute basic EPS by dividing net income available to common shareholders allocable to unrestricted common shares under the two-class method by the weighted average number of unrestricted 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 into common shares that we added to the denominator.
Summaries of the numerator and denominator for purposes of basic and diluted EPS calculations are set forth below (dollars and shares in thousands, except per share data):
For the Three MonthsEnded June 30,
For the Six MonthsEnded June 30,
Numerator:
Add: Gain on sales of real estate, net
Less: Preferred share dividends
Less: Income from continuing operations attributable to noncontrolling interests
(1,412
(1,549
(3,431
(2,822
Less: Income from continuing operations attributable to restricted shares
(242
(166
(510
(336
Numerator for basic and diluted EPS from continuing operations attributable to COPT common shareholders
12,371
6,855
24,225
12,302
Add: Income from discontinued operations
Less: Income from discontinued operations attributable to noncontrolling interests
(199
(393
Numerator for basic and diluted EPS on net income attributable to COPT common shareholders
7,970
14,489
Denominator (all weighted averages):
Denominator for basic EPS (common shares)
56,637
47,110
54,296
47,055
Dilutive effect of stock option awards
546
790
522
746
Denominator for diluted EPS
57,183
47,900
54,818
47,801
Basic EPS:
Income from continuing operations attributable to COPT common shareholders
Income from discontinued operations attributable to COPT common shareholders
Net income attributable to COPT common shareholders
Diluted EPS:
10
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:
Weighted Average Shares
Conversion of common units
5,483
8,151
6,363
8,153
Conversion of convertible preferred units
176
Conversion of convertible preferred shares
434
Anti-dilutive share-based compensation awards
524
348
641
468
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 each of the periods was less than the exchange price per common share applicable for such periods.
Operating properties consisted of the following:
Land
429,064
423,985
Buildings and improvements
2,293,895
2,202,995
2,722,959
2,626,980
Less: accumulated depreciation
(382,385
(343,110
Projects we had under construction or development consisted of the following:
219,775
220,863
Construction in progress
293,787
273,733
2009 Construction, Development and Redevelopment Activities
During the six months ended June 30, 2009, we had three properties (one each located in the Baltimore/Washington Corridor, Suburban Maryland and Colorado Springs, Colorado (“Colorado Springs”)) totaling 301,000 square feet become fully operational (85,000 of these square feet were placed into service in 2008). We also placed into service 42,000 square feet in two partially operational properties (one each located in Colorado Springs and the Baltimore/Washington Corridor).
As of June 30, 2009, we had construction activities underway on four properties in the Baltimore/Washington Corridor (including one through a consolidated joint venture), three in Colorado Springs, two in San Antonio, Texas (“San Antonio”) and one each in Suburban Baltimore and Suburban Maryland (including one through a consolidated joint venture). We also had development activities underway on four office properties in the Baltimore/Washington Corridor, two in Suburban Baltimore and one in San Antonio. In addition, we had redevelopment underway on one property located in the Baltimore/Washington Corridor owned through a consolidated joint venture.
11
5. Real Estate Joint Ventures
During the six months ended June 30, 2009, 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
Maximum
Date
Nature of
Exposure
Acquired
Ownership
Activity
to Loss (1)
(4,873
)(2)
(4,770
9/29/2005
20
Operates 16 buildings
(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 (see Note 15).
(2) The carrying amount of our investment in this joint venture was lower than our share of the equity in the joint venture by $5,196 at June 30, 2009 and December 31, 2008 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.
The following table sets forth condensed balance sheets for this unconsolidated joint venture:
Properties, net
61,742
62,308
Other assets
7,331
7,530
69,073
69,838
Liabilities (primarily debt)
67,473
67,725
Owners’ equity
1,600
2,113
Total liabilities and owners’ equity
The following table sets forth condensed statements of operations for this unconsolidated joint venture:
2,313
2,413
4,733
4,796
(836
(876
(1,671
(1,701
(980
(1,949
(1,960
Depreciation and amortization expense
(816
(830
(1,627
(1,660
Net loss
(319
(273
(514
(525
12
The table below sets forth information pertaining to our investments in consolidated joint ventures at June 30, 2009:
Pledged
% at
Assets at
6/30/2009
M Square Associates, LLC
6/26/2007
45.0
Developing land parcels (1)
48,944
Arundel Preserve #5, LLC
7/2/2007
50.0
Developing land parcel (2)
29,204
28,475
COPT Opportunity Invest I, LLC
12/20/2005
92.5
Redeveloping one property (3)
28,600
COPT-FD Indian Head, LLC
10/23/2006
75.0
Developing land parcel (4)
6,919
MOR Forbes 2 LLC
12/24/2002
Operates one building (5)
4,653
118,320
(1)
This joint venture is developing land parcels located in College Park, Maryland. We own a 90% interest in Enterprise Campus Developer, LLC, which in turn owns a 50% interest in M Square.
(2)
This joint venture is developing a land parcel located in Hanover, Maryland.
(3)
This joint venture owns a property in the Baltimore/Washington Corridor region.
(4)
This joint venture’s property is located in Charles County, Maryland (located in our “Other” business segment).
(5)
This joint venture’s property is located in Lanham, Maryland (located in the Suburban Maryland region).
Our commitments and contingencies pertaining to our real estate joint ventures are disclosed in Note 15.
Our debt consisted of the following:
Scheduled
Principal
Carrying Value at
Maturity
Amount at
Stated Interest Rates
Dates at
at June 30, 2009
Mortgage and other loans payable:
Revolving Credit Facility
600,000
357,000
392,500
LIBOR + 0.75% to 1.25% (1)
September 30, 2011 (2)
Mortgage and Other Secured Loans
Fixed rate mortgage loans (3)
N/A
932,287
967,617
5.20% - 7.94% (4)
2009 - 2034 (5)
Revolving Construction Facility
225,000
99,161
81,267
LIBOR + 1.60% to 2.00% (6)
May 2, 2011 (2)
Other variable rate secured loans
271,400
221,400
LIBOR + 2.25% to 3.00% (7)
2012-2014 (2)
Other construction loan facilities
23,400
16,753
40,589
LIBOR + 2.75% (8)
2011 (2)
Total mortgage and other secured loans
1,319,601
1,310,873
Note payable
Unsecured seller note
750
5.95%
2016
Total mortgage and other loans payable
3.5% Exchangeable Senior Notes
3.50%
September 2026 (9)
Total debt
1,831,713
1,856,751
The interest rate on the Revolving Credit Facility was 1.11% at June 30, 2009.
Includes loans that may be extended for a one-year period at our option, subject to certain conditions.
Several of the fixed rate mortgages carry interest rates that were above or below market rates upon assumption and therefore were recorded at their fair value based on applicable effective interest rates. The carrying values of these loans reflect unamortized premiums totaling $430 at June 30, 2009 and $501 at December 31, 2008.
The weighted average interest rate on these loans was 5.68% at June 30, 2009.
A loan with a balance of $4,701 at June 30, 2009 that matures in 2034 may be repaid in March 2014, subject to certain conditions.
(6)
The weighted average interest rate on this loan was 2.00% at June 30, 2009.
(7)
The loans in this category at June 30, 2009 are subject to floor interest rates ranging from 4.25% to 5.5%.
(8)
The interest rate on this loan was 3.07% at June 30, 2009.
(9)
As described further in our 2008 Annual Report on Form 10-K, the notes have an exchange settlement feature that provides that they may, under certain circumstances, be exchangeable for cash (up to the principal amount of the notes) and, with respect to any excess exchange value, may be exchangeable into (at our option) cash, our common shares or a combination of cash and our common shares at an exchange rate (subject to adjustment) of 18.8266 shares per one thousand dollar principal amount of the notes (exchange rate is as of June 30, 2009 and is equivalent to an exchange price of $53.12 per common share). The carrying value of these notes included a principal amount of $162,500 and an unamortized discount totaling $8,138 at June 30, 2009 and $9,872 at December 31, 2008. The
13
effective interest rate under the notes, including amortization of the discount, was 5.97%. The table below sets forth interest expense recognized on these notes before deductions for amounts capitalized:
Interest expense at stated interest rate
1,422
1,750
2,844
3,500
Interest expense associated with amortization of discount
874
1,013
1,734
2,011
2,296
2,763
4,578
5,511
We capitalized interest costs of $3,985 in the three months ended June 30, 2009, $4,533 in the three months ended June 30, 2008, $8,484 in the six months ended June 30, 2009 and $9,298 in the six months ended June 30, 2008.
The following table sets forth information pertaining to the fair value of our debt:
Carrying
Estimated
Amount
Fair Value
Fixed-rate debt
1,087,399
998,101
1,120,995
1,010,127
Variable-rate debt
744,314
710,239
735,756
702,092
1,708,340
1,712,219
7. Derivatives
We are exposed to certain risks arising from changes in market conditions. These changes in market conditions may adversely affect our financial performance. We use derivative financial instruments to assist in managing our exposure to these changes in market conditions. Specifically, we enter into derivative financial instruments to manage exposures that arise from business activities that result in the payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Our derivative financial instruments are used to manage differences in the amount, timing, and duration of our known or expected cash payments related to our borrowings.
Our primary objectives in using interest rate derivatives are to add stability to interest expense and to manage exposure to interest rate movements. To accomplish this objective, we primarily use interest rate swaps as part of our interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for our making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. During 2009, these derivatives were used to hedge the variable cash flows associated with both existing and future variable-rate debt. We defer the effective portion of the changes in fair value of the designated cash flow hedges to accumulated other comprehensive loss (“AOCL”) and reclassify such deferrals to interest expense as interest expense is recognized on the hedged forecasted transactions. We recognize directly in interest expense the ineffective portion of the change in fair value of interest rate derivatives. We do not use derivatives for trading or speculative purposes and do not have any derivatives that are not designated as hedges as of June 30, 2009.
As of June 30, 2009, we had four outstanding interest rate derivatives that were designated as cash flow hedges of interest rate risk with an aggregate notional value of $370,000. All four derivative instruments were interest rate swaps. Under one of these interest rate derivatives, we are hedging our exposure to the variability in future cash flows for forecasted transactions over the period ending January 1, 2010. The table below sets forth the fair value of our derivative financial instruments as well as their classification on our Consolidated Balance Sheet as of June 30, 2009:
Derivatives Designated as Hedging
Instruments Under SFAS 133
Balance Sheet Location
Interest Rate Swaps
Prepaid and other assets
(1,666
14
The table below presents the effect of our interest rate swaps on our Consolidated Statements of Operations and comprehensive income for the three and six months ended June 30, 2009:
For the Three
For the Six
Months Ended
Amount of gain recognized in AOCL (effective portion)
1,658
277
Amount of loss reclassified from AOCL into interest expense (effective portion)
(1,647
(3,946
Amount of gain (loss) recognized in interest expense (ineffective portion and amount excluded from effectiveness testing)
51
(228
Over the next 12 months, we estimate that approximately $3,304 will be reclassified from AOCL as an increase to interest expense.
We have agreements with each of our derivative counterparties that contain provisions under which if we default or are capable of being declared in default on any of our indebtedness, we could also be declared in default on our derivative obligations.
We have agreements with our derivative counterparties that incorporate the loan covenant provisions of our indebtedness with a lender affiliate of the derivative counterparties. Failure to comply with the loan covenant provisions would result in our being in default on any derivative instrument obligations covered by the agreements.
As of June 30, 2009, the fair value of derivatives in a liability position related to these agreements was $1,307, excluding the effects of accrued interest. As of June 30, 2009, we had not posted any collateral related to these agreements. We are not in default with any of these provisions. If we breached any of these provisions, we would be required to settle our obligations under the agreements at their termination value of $1,682.
Common Shares
In April 2009, we issued 2.99 million common shares in an underwritten public offering made in conjunction with our inclusion in the S&P MidCap 400 Index effective April 1, 2009. The shares were issued at a public offering price of $24.35 per share for net proceeds of $72,078 after underwriting discounts but before offering expenses.
During the six months ended June 30, 2009, we converted 2,824,000 common units in our Operating Partnership into common shares on the basis of one common share for each common unit.
See Note 12 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 accumulated other comprehensive loss component of shareholders’ equity:
Beginning balance
Amount of gain (loss) recognized in AOCL (effective portion)
(1,450
Amount of loss reclassified from AOCL to income
3,946
1,166
Adjustment to AOCL attributable to noncontrolling interests
(650
Ending balance
15
The table below sets forth total comprehensive income and total comprehensive income attributable to COPT:
1,230
1,647
838
Total comprehensive income
21,356
15,978
40,440
25,807
Net income attributable to noncontrolling interests
(1,748
(3,215
Other comprehensive income attributable to noncontrolling interests
(300
(315
(416
44
Total comprehensive income attributable to COPT
19,644
13,915
36,593
22,636
The following table summarizes our dividends and distributions when either the payable dates or record dates occurred during the six months ended June 30, 2009:
Record Date
Payable Date
Dividend/Distribution PerShare/Unit
Series G Preferred Shares:
Fourth Quarter 2008
January 15, 2009
0.5000
First Quarter 2009
March 31, 2009
April 15, 2009
Second Quarter 2009
July 15, 2009
Series H Preferred Shares:
0.4688
Series J Preferred Shares:
0.4766
Series K Preferred Shares:
0.7000
Common Shares:
Series I Preferred Units:
Common Units:
16
For the Six Months Ended June 30,
Supplemental schedule of non-cash investing and financing activities:
Increase in accrued capital improvements, leasing, and acquisition costs
11,971
2,176
Consolidation of real estate joint venture:
Real estate assets
14,208
(10,859
Noncontrolling interests
(3,349
Net adjustment
Proceeds from sale of property invested in restricted cash
5,103
Increase (decrease) in fair value of derivatives applied to AOCL and noncontrolling interests
4,225
Dividends/distribution payable
22,548
17
11. Information by Business Segment
As of June 30, 2009, 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 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 and investments in unconsolidated entities. 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 GeorgeCounties
San Antonio
Central NewJersey
IntersegmentElimination
Three Months Ended June 30, 2009
49,531
19,211
13,793
5,803
5,179
2,507
3,478
3,547
601
2,998
(930
105,718
17,494
7,510
5,818
1,718
2,030
792
963
47
864
(75
NOI
32,037
11,701
7,975
4,085
3,149
2,506
2,686
2,584
554
2,134
(855
68,556
Additions to properties, net
15,642
2,299
5,592
12,870
13,102
2,098
178
11,998
1,075
(7
64,856
Three Months Ended June 30, 2008
46,426
18,927
13,502
4,691
4,907
3,134
1,999
586
2,256
98,031
15,686
7,255
5,691
1,738
1,587
40
747
443
1,062
33,968
30,740
11,672
7,811
2,953
3,320
2,466
2,387
1,556
548
1,194
(584
64,063
40,092
803
4,309
41,510
1,238
384
674
18,738
22
968
(29
108,709
Six Months Ended June 30, 2009
99,123
41,570
27,621
10,681
10,216
5,013
6,888
6,492
1,222
5,597
(1,861
212,562
36,136
15,372
12,520
3,031
4,089
99
1,664
1,800
83
(265
62,987
26,198
15,101
7,650
6,127
4,914
5,224
4,692
1,139
3,931
(1,596
136,367
34,987
2,368
8,903
18,067
17,759
4,411
19,377
8,616
(14
115,010
Segment assets at June 30, 2009
1,277,271
455,539
436,220
268,667
167,227
97,618
94,398
116,590
20,768
265,372
(995
Six Months Ended June 30, 2008
92,003
37,931
27,412
8,863
9,491
5,012
6,294
3,907
1,338
4,833
(1,781
195,303
31,901
14,239
12,014
3,251
104
1,489
876
247
1,813
(557
68,697
60,102
23,692
15,398
5,543
6,240
4,908
4,805
1,091
3,020
(1,224
126,606
54,281
1,729
7,737
53,531
22,096
612
1,236
18,248
43
2,275
161,759
Segment assets at June 30, 2008
1,248,815
469,146
438,548
235,765
139,787
95,123
94,798
84,359
22,155
183,862
(984
3,011,374
18
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 14)
(85
(355
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 14)
(11
(198
Total property operating expenses
As previously discussed, we own 100% of a number of entities that provide real estate services such as property management, construction and development and heating and air conditioning services primarily for our properties but also for third parties. The revenues and costs associated with these services include 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 such revenues and expenses to evaluate the performance of our service operations since we view such service operations to be an ancillary component of our overall operations that we expect to continue to be a small contributor to our operating income relative to our real estate operations. The table below sets forth the computation of our income from service operations:
(100,647
(21,472
(173,545
(31,377
(454
(939
(1,056
Income from service operations
2,163
498
3,729
605
19
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
Income tax expense
Other adjustments:
(28,708
(24,955
(55,199
(49,847
(5,834
(5,934
(11,377
(11,704
(446
(102
(1,092
Interest expense on continuing operations
Net operating income from discontinued operations
(74
(157
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 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 revenues, other service operations revenues, construction contract expenses, other service operations expenses, equity in loss of unconsolidated entities, general and administrative expenses, business development expenses, interest and other income and income taxes because these items represent general corporate items not attributable to segments.
12. Share-Based Compensation
During the six months ended June 30, 2009, we granted 40,000 options to purchase common shares (“options”) to members of our Board of Trustees with an exercise price of $29.98 per share. These options vest on the first anniversary of the grant date provided that the Trustees remain in their positions. These option grants 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 assumptions we used in that model are set forth below:
Fair value of grants on grant date
9.62
Risk-free interest rate
2.08
Expected life (in years)
5.31
Expected volatility
47.60
Expected annual dividend yield
3.73
During the six months ended June 30, 2009, 153,177 options to purchase common shares were exercised. The weighted average exercise price of these options was $12.12 per share, and the total intrinsic value of the options exercised was $2,785.
During the six months ended June 30, 2009, certain employees were granted a total of 332,060 restricted shares with a weighted average grant date fair value of $25.05 per share; these shares are subject to forfeiture restrictions that lapse in equal increments annually over periods of three to five years, beginning on or about the first anniversary of the grant date, provided that the employees remain employed
by us. During the six months ended June 30, 2009, forfeiture restrictions lapsed on 207,855 common shares previously issued to employees; these shares had a weighted average grant date fair value of $35.85 per share, and the total fair value of the shares on the vesting dates was $5,146.
We realized a windfall tax shortfall of $152 in the six months ended June 30, 2009 and windfall tax benefit of $1,053 in the six months ended June 30, 2008 on options exercised and vesting restricted shares in connection with employees of our subsidiaries that are subject to income tax.
We own a taxable REIT subsidiary (“TRS”) that is subject to Federal and state income taxes. Our TRS’ provision for income tax consisted of the following:
Deferred
Federal
(46
53
(100
(303
State
(10
(22
(71
61
(374
Current
34
(171
(38
(209
Total income tax (expense) benefit
(583
Reported on line entitled income tax (expense) benefit
Reported on line entitled gain on sale of real estate, net
(578
Items in our TRS contributing to temporary differences that lead to deferred taxes include depreciation and amortization, share-based compensation, certain accrued compensation and compensation paid in the form of contributions to a deferred nonqualified compensation plan.
Our TRS’ combined Federal and state effective tax rate was 39% for the three and six months ended June 30, 2009 and 2008.
Income from discontinued operations primarily includes revenues and expenses associated with the following:
· 429 Ridge Road property located in the Central New Jersey region that was sold on January 31, 2008;
· 47 Commerce Drive property located in the Central New Jersey region that was sold on April 1, 2008; and
· 7253 Ambassador Road property located in the Suburban Baltimore region that was sold on June 2, 2008.
21
The table below sets forth the components of income from discontinued operations:
June 30, 2008
Revenue from real estate operations
85
355
Expenses from real estate operations:
198
Depreciation and amortization
52
Expenses from real estate operations
301
Income from discontinued operations before gain on sales of real estate
64
54
1,250
2,526
Income from discontinued operations
In the normal course of business, we are involved in legal actions arising from our ownership and administration of properties. We establish reserves for specific legal proceedings when we determine that the likelihood of an unfavorable outcome is probable and the amount of loss can be reasonably estimated. Management does not anticipate that any liabilities that may result from such proceedings will have a materially adverse effect on our financial position, operations or liquidity. Our assessment of the potential outcomes of these matters involves significant judgment and is subject to change based on future developments.
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.
Joint Ventures
In connection with our 2005 contribution of properties to an unconsolidated partnership in which we hold a limited partnership interest, we entered into standard nonrecourse loan guarantees (environmental indemnifications and guarantees against fraud and misrepresentation, including springing guarantees of partnership debt in the event of a voluntary bankruptcy of the partnership). The maximum amount we could be required to pay under the guarantees is approximately $67 million. So long as we continue to be the property manager for the properties, 20% of any amounts paid under the guarantees are recoverable from an affiliate of the general partner pursuant to an indemnity agreement. In the event that we no longer manage the properties, the percentage recoverable under the indemnity agreement is increased to 80%. Management estimates that the aggregate fair value of the guarantees is not material and would not exceed the amounts included in distributions in excess of investment in unconsolidated real estate joint venture reported on the consolidated balance sheets.
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, our joint venture partner would contribute land into newly-formed entities and we would make additional cash capital contributions into such entities to fund development and construction activities for which financing is not obtained. We owned a 50% interest in one such joint venture as of June 30, 2009.
We may be required 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 deem it appropriate to make even larger investments in these joint ventures.
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. 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.
23
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a specialty office real estate investment trust (“REIT”) that focuses primarily on strategic customer relationships and specialized tenant requirements in the United States Government, defense information technology and data sectors. We acquire, develop, manage and lease properties that are typically concentrated in large office parks primarily located adjacent to government demand drivers and/or in demographically strong markets possessing growth opportunities. As of June 30, 2009, our investments in real estate included the following:
During the six months ended June 30, 2009, we:
· experienced significant growth in our revenues from real estate operations in total by amounts that exceeded the growth in our property operating expenses compared to the six months ended June 30, 2008. This increase is attributable to both the growth of our portfolio from property additions and the performance of properties that were owned and 100% operational since January 1, 2008;
· finished the period with occupancy of our wholly owned portfolio of properties at 92.3%;
· placed into service an aggregate of 258,000 square feet in newly constructed space located in five properties; and
· issued 2.99 million common shares in an underwritten public offering made in conjunction with our inclusion in the S&P MidCap 400 Index effective April 1, 2009. The shares were issued at a public offering price of $24.35 per share for net proceeds of $72.1 million after underwriting discounts but before offering expenses.
As discussed in greater detail in our 2008 Annual Report Form 10-K, the United States and world economies are in the midst of a significant recession that has had devastating effects on the capital markets, reducing stock prices and limiting credit availability. We believe that for much of the office real estate sector, since the core operations tend to be structured as long-term leases and since revenue streams generally remain in place until leases expire or tenants fail to satisfy lease terms, the effect of the changes in the overall economy on our operations has not been fully felt to date. As a result, we do not believe that the economic downturn has significantly affected the operations of our real estate properties yet but do expect the effects to become increasingly evident over the remainder of 2009 and 2010, and perhaps beyond. We continue to see signs of increased competition for tenants and downward pressure on rental rates in most of our regions, which we expect, along with an anticipated increased tendency by certain tenants to reduce costs through job cuts and associated space reductions, could adversely affect our occupancy and renewal rates. In addition, we may also experience higher bad debt expense should tenants be unable to pay their rents. However, we believe that our future real estate operations may be affected to a lesser degree than many of our peers for the following reasons:
· our expectation of continued strength in demand from our customers in the United States Government, defense information technology and data sectors; and
· our high concentration of large, high-quality tenants with a relatively small concentration of revenue from the financial services sector.
In this section, we discuss our financial condition and results of operations as of and for the three and six months ended June 30, 2009. 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 and six months ended June 30, 2009 compared to the same periods in 2008;
· our cash flows;
· how we expect to generate cash for short and long-term capital needs;
· our commitments and contingencies at June 30, 2009; and
· the computation of our Funds from Operations.
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.
Results of Operations
Occupancy and Leasing
The table below sets forth leasing information pertaining to our portfolio of wholly owned operating properties:
Occupancy rates
92.3
93.2
Baltimore/Washington Corridor
93.0
93.4
Northern Virginia
94.7
97.4
Suburban Baltimore
82.1
83.1
Colorado Springs
94.3
Suburban Maryland
92.8
97.7
St. Mary’s and King George Counties
97.5
95.2
Greater Philadelphia
100.0
Central New Jersey
99.3
Average contractual annual rental rate per square foot at period end (1)
23.12
22.40
(1) Includes estimated expense reimbursements.
We renewed 74.3% of the square footage scheduled to expire in the six months ended June 30, 2009 (including the effects of early renewals and leases terminated less than one year prior to the scheduled lease expiration date).
As discussed in greater detail in our 2008 Annual Report Form 10-K, we expect that the effects of the global downturn in the economy on our real estate operations will make our leasing activities increasingly challenging during the remainder of 2009, 2010 and perhaps beyond. As a result, we expect that we may find it increasingly difficult to maintain high levels of occupancy and tenant retention. We believe that the immediacy of our exposure to the increased challenges in the leasing environment is lessened to a certain extent by the generally long-term nature of our leases and our operating strategy of monitoring concentrations of lease expirations occurring in any one year. Our weighted average lease term for wholly owned properties at June 30, 2009 was approximately five years, and no more than 15% of our annualized rental revenues at June 30, 2009 were scheduled to expire in any one calendar year between 2010 and 2013 (8.5% of our annualized rental revenues at June 30, 2009 were scheduled to expire during the six months ended December 31, 2009).
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. Most of the leases with our largest tenant, the United States Government, provide for consecutive one-year terms or provide for early termination rights; all of the leasing statistics set forth above assume that the United States Government will remain in the space that they lease through the end of the respective arrangements, without ending consecutive one-year leases prematurely or exercising early termination rights. We report the statistics in this manner since we manage our leasing activities using these assumptions and believe them to be probable.
26
The table below sets forth occupancy information pertaining to operating properties in which we have a partial ownership interest:
Occupancy Rates at
Geographic Region
Interest
Greater Harrisburg (1)
20.0
86.2
89.4
Suburban Maryland (2)
(2
65.6
94.8
Baltimore/Washington Corridor (3)
(1) Includes 16 properties totaling 672,000 square feet.
(2) Includes two properties totaling with 172,000 operational square feet at June 30, 2009 (we had a 50% ownership interest in 56,000 square feet and a 45% ownership interest in 116,000 square feet). Includes two properties totaling 97,000 operational square feet at December 31, 2008 (we had a 50% interest in 56,000 square feet and a 45% interest in 41,000 square feet).
(3) Includes one property with 9,000 operational square feet at June 30, 2009.
Revenues from real estate operations and property operating expenses
We typically view our changes in revenues from real estate operations and property operating expenses as being comprised of the following 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;” and
· 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 tables included in this section set forth the components of our changes in revenues from real estate operations and property operating expenses (dollars in thousands). The tables, and the discussion that follows, include results and information pertaining to properties included in continuing operations.
Changes From the Three Months Ended June 30, 2008 to 2009
PropertyAdditions
Same-Office Properties
Dollar
Percentage
Change (1)
Change
Change (2)
Revenues from real estate operations
2,717
2,469
3.0
5,172
833
1,629
11.6
138
2,600
3,550
4,098
4.3
124
7,772
1,162
1,906
5.9
137
3,205
Number of operating properties included in component category
228
246
(1) Includes 13 newly-constructed properties and one redeveloped property placed into service and four acquired 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.
27
The increase in rental revenue for the Same-Office Properties for the three month periods included the following:
· an increase of $2.0 million attributable primarily to changes in occupancy and rental rates between the two periods; and
· an increase of $514,000 in net revenue from the early termination of leases.
Tenant recoveries and other revenue for the Same-Office Properties for the three month periods increased due primarily to the increase in property operating expenses described below. While we have some lease structures under which tenants pay for 100% of properties’ operating expenses, our most prevalent lease structure is for tenants to pay for a portion of property operating expenses to the extent that such expenses exceed amounts established in their respective leases that are based on historical expense levels. As a result, while there is an inherent direct relationship between our tenant recoveries and property operating expenses, this relationship does not result in a dollar for dollar increase in tenant recoveries as property operating expenses increase.
The increase in the Same-Office Properties’ property operating expenses for the three month periods included the following:
· an increase of $812,000 in electric utilities expense, which included the effects of: (1) increased usage at certain properties due to increased occupancy at such properties; and (2) rate increases; and
· an increase of $477,000 in bad debt expense due to additional reserves on tenant receivables.
Changes From the Six Months Ended June 30, 2008 to 2009
6,133
6,872
(21
12,984
1,430
3,282
11.5
(82
4,630
7,563
10,154
5.4
(103
17,614
2,452
4,957
7.6
287
7,696
223
(1) Includes 17 newly-constructed properties and two redeveloped properties placed into service and four acquired properties.
The increase in rental revenue for the Same-Office Properties for the six month periods included the following:
· an increase of $3.5 million in net revenue from the early termination of leases, most of which was due to the early termination of one lease at a property in Northern Virginia; and
· an increase of $3.3 million attributable primarily to changes in occupancy and rental rates between the two periods.
Tenant recoveries and other revenue for the Same-Office Properties for the six month periods increased due primarily to the increase in property operating expenses described below.
The increase in Same-Office Properties’ property operating expenses for the six month periods included the following:
· an increase of $1.6 million in electric utilities expense due primarily to the reasons discussed above for the variance in the three month periods;
· an increase of $1.0 million in bad debt expense due to additional reserves on tenant receivables;
· an increase of $892,000 in snow removal due primarily to increased snow and ice in most of our regions; and
· an increase of $499,000 in cleaning services and related supplies due in large part to increased contract rates and increased occupancy at certain properties.
Construction contract revenues and expenses
Construction contract revenues and expenses consist primarily of subcontracted costs that are reimbursed to us by the customer along with a construction management fee. As a result, the operating margins from these operations are small relative to the revenue. We use the net of these revenues and expenses to evaluate performance. The increase in the net of these revenues and expenses for the three and six month periods was due primarily to a high volume of construction activity in the current periods in connection with one large construction contract.
Our interest expense included in continuing operations decreased by $2.5 million for the three month periods and $5.0 million for the six month periods due primarily to a decrease in the weighted average interest rates of our debt from 5.1% to 4.7% for the three month periods and 5.3% to 4.8% for the six month periods. The events in the economy have contributed towards significant reductions in interest rates on our variable rate debt. We expect interest expense in the second half of 2009 to increase somewhat from the first half of 2009 as we repay a certain amount of our variable rate debt using proceeds from newly obtained fixed rate debt bearing higher interest rates.
Our interest and other income increased $1.1 million for the three month periods and $2.0 million for the six month periods due primarily to interest income earned in the current periods associated with a mortgage loan receivable which we funded in August 2008.
Income from discontinued operations, net of income taxes
Discontinued operations represents income from properties sold in 2008, and is comprised primarily of gain from the sales of such properties occurring during the three and six month periods ended June 30, 2008. We had no discontinued operations in the six months ended June 30, 2009.
Gain on sales of real estate was recognized on the sale of six office condominiums located in Northern Virginia during the six months ended June 30, 2008. No similar sales occurred in the six months ended June 30, 2009.
Liquidity and Capital Resources
Our primary cash requirements are for operating expenses, debt service, development of new properties, improvements to existing properties and acquisitions. While we may experience increasing challenges discussed elsewhere herein and in our 2008 Annual Report on Form 10-K due to the current economic environment, we believe that our liquidity and capital resources are adequate for our near-term and longer-term requirements. 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
29
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 (defined below) or forgo borrowing under construction loan credit facilities to fund development activities.
We rely primarily on fixed-rate, non-recourse mortgage loans from banks and institutional lenders to finance most of our operating properties. We have also made use of the public equity and debt markets to meet our capital needs, principally to repay or refinance corporate and property secured debt and to provide funds for property development and acquisition costs. We have an unsecured revolving credit facility (the “Revolving Credit Facility”) with a group of lenders that provides for borrowings of up to $600.0 million, $243.0 million of which was available at June 30, 2009; this facility is available through September 2011 and may be extended by one year at our option, subject to certain conditions. In addition, we have a Revolving Construction Facility, which provides for borrowings of up to $225.0 million, $125.8 million of which was available at June 30, 2009 to fund future construction costs; this facility is available until May 2011 and may be extended by one year at our option, subject to certain conditions. Selective dispositions of operating and other properties may also provide capital resources for the remainder of 2009 and in future years. We are continually evaluating sources of capital and believe that there are satisfactory sources available for meeting our capital requirements without necessitating property sales.
We believe that we have sufficient capacity under our Revolving Credit Facility to satisfy our debt maturities occurring through 2010. We also believe that we have sufficient capacity under our Revolving Construction Facility to fund the construction of properties that were under construction at June 30, 2009, as well as projects expected to be started during the remainder of 2009. During the six months ended June 30, 2009, we closed on a $50.0 million secured loan with a five-year term and a $23.4 million construction loan with a two-year term and the right to extend for an additional year, subject to certain conditions. In addition, we closed on a $90.0 million secured loan with a five-year term in July 2009. We expect to pursue a certain amount of additional new medium or long-term debt during the remainder of 2009; if we are successful in obtaining this debt, we expect to use the proceeds to pay down our Revolving Credit Facility to create additional borrowing capacity to enable us to fund future investment opportunities.
In our discussions of liquidity and capital resources herein and in our Current Report on Form 8-K filed on June 2, 2009, we describe certain of the risks and uncertainties relating to our business. Additional risks are described in Item 1A of our 2008 Annual Report on Form 10-K.
Operating Activities
Our cash flow from operations increased $44.5 million, or 53.0%, when comparing the six months ended June 30, 2009 and 2008; this increase is attributable in large part to: (1) the timing of cash flow associated with third-party construction projects in the current period; and (2) the additional cash flow from operations generated by our property additions. We expect to continue to use cash flow provided by operations to meet our short-term capital needs, including all property operating expenses, general and administrative expenses, interest expense, scheduled principal amortization on debt, dividends to our shareholders, distributions to our noncontrolling 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 Six Months Ended June 30, 2009
We had three newly-constructed properties totaling 301,000 square feet (one each located in the Baltimore/Washington Corridor, Suburban Maryland and Colorado Springs) become fully operational during the six months ended June 30, 2009 (85,000 of these square feet were placed into service in 2008). These properties were 80% leased or committed as of June 30, 2009. Costs incurred on these properties through June 30, 2009 totaled $59.4 million, of which $5.2 million was incurred during the six months ended June 30, 2009.
As of June 30, 2009, we had construction activities underway on 11 office properties totaling 1.3 million square feet that were 24% leased, or considered committed to lease (including two properties
owned through joint ventures). Costs incurred on these properties through June 30, 2009 totaled approximately $187.5 million, of which approximately $57.5 million was incurred during the six months ended June 30, 2009. We estimate that remaining costs to be incurred through 2011 will total approximately $99.6 million upon completion of these properties. We expect to fund these costs using primarily borrowings from our Revolving Construction Facility and Revolving Credit Facility.
As of June 30, 2009, we had development activities underway on seven office properties estimated to total 739,000 square feet. Costs incurred on these properties through June 30, 2009 totaled $19.4 million, of which $8.2 million was incurred during the six months ended June 30, 2009. We estimate the remaining costs to be incurred will total approximately $148.7 million; we expect to incur these costs through 2012. We expect to fund most of these costs using primarily borrowings from our Revolving Construction Facility.
We had redevelopment activities underway on two properties at June 30, 2009 for which we estimate remaining costs to be incurred of approximately $45 million. We expect to fund most of the costs for these redevelopment projects using borrowings from our Revolving Credit Facility.
The table below sets forth the major components of our additions to the line entitled “Total Properties, net” on our Consolidated Balance Sheet for the six months ended June 30, 2009 (in thousands):
Construction, development and redevelopment
91,885
Acquisitions
11,255
Tenant improvements on operating properties
8,002
Capital improvements on operating properties
3,868
(1) Tenant improvement costs incurred on newly-constructed properties are classified in this table as construction, development and redevelopment.
As discussed above, during the six months ended June 30, 2009, we closed on a $50.0 million secured loan with a five-year term and a $23.4 million construction loan with a two-year term and the right to extend for an additional year, subject to certain conditions; most of the proceeds from these borrowings were used to repay debt maturities and pay down our Revolving Credit Facility.
In April 2009, we issued 2.99 million common shares in an underwritten public offering made in conjunction with our inclusion in the S&P MidCap 400 Index effective April 1, 2009. The shares were issued at a public offering price of $24.35 per share for net proceeds of $72.1 million after underwriting discounts but before offering expenses. The net proceeds were used to pay down our Revolving Credit Facility and for general corporate purposes.
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 June 30, 2009, 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 decreased $13.8 million when comparing the six months ended June 30, 2009 and 2008 due primarily to the net effect of a $48.0 million decrease in property additions and a $28.2 million decrease in proceeds from sales of properties. Our cash flow provided by financing activities decreased $41.3 million when comparing the six months ended June 30, 2009 and 2008 due primarily to an increase in debt repayments (net of proceeds from new debt) during the current period, offset in part by $72.3 million in additional proceeds from common share issuances due to our underwritten public offering in April 2009.
31
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 Current Report on Form 8-K filed on June 2, 2009.
Funds From Operations
Funds from operations (“FFO”) is defined as net income computed using GAAP, excluding gains (or losses) from sales of operating properties, plus real estate-related depreciation and amortization. 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 for real 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.
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 FFO available to common share and common unit holders (“Basic FFO”) is FFO adjusted to subtract (1) preferred share dividends, (2) income attributable to noncontrolling interests through ownership of preferred units in the Operating Partnership or interests in other consolidated entities not owned by us, (3) depreciation and amortization allocable to noncontrolling interests in other consolidated entities and (4) Basic FFO allocable to restricted shares. With these adjustments, Basic FFO represents FFO available to
32
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 FFO available to common share and common unit holders (“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 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 that 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.
Our Basic FFO, Diluted FFO and Diluted FFO per share for the three month and six month periods ended June 30, 2009 and 2008 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):
33
Add: Real estate-related depreciation and amortization
49,899
Add: Depreciation and amortization on unconsolidated real estate entities
161
163
321
327
Less: Gain on sales of operating properties, net of income taxes
(1,250
(2,630
Funds from operations (“FFO”)
46,920
37,778
91,737
73,687
Less: Noncontrolling interests-preferred units in the Operating Partnership
Less: Noncontrolling interests-other consolidated entities
Less: Depreciation and amortization allocable to noncontrolling interests in other consolidated entities
(107
(160
(124
Less: basic and diluted FFO allocable to restricted shares
(450
(308
(582
Funds from Operations - basic and diluted (“Basic and Diluted FFO”)
42,197
33,082
82,268
64,378
Weighted average common shares
Conversion of weighted average common units
Weighted average common shares/units - Basic FFO
62,120
55,261
60,659
55,208
Dilutive effect of share-based compensation awards
Weighted average common shares/units - Diluted FFO
62,666
56,051
61,181
55,954
Diluted FFO per common share
0.67
0.59
1.34
1.15
Numerator for diluted EPS
Add: Income allocable to noncontrolling interests-common units in the Operating Partnership
1,272
1,461
3,076
2,663
Add: Depreciation and amortization of unconsolidated real estate entities
Add: Numerator for diluted EPS allocable to restricted shares
242
166
510
336
Less: Basic and diluted FFO allocable to restricted shares
Diluted FFO
Weighted average common units
Denominator for Diluted FFO per share
Our computation of FFO and the other measures described above changed as a result of our adoption on January 1, 2009 of SFAS 160, FSP APB 14-1 and FSP EITF 03-6-1, all of which were applied respectively to prior periods. We discuss SFAS 160, FSP APB 14-1 and FSP EITF 03-6-1 in Note 2 to our consolidated financial statements.
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 capital 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 June 30, 2009, 90.7% of our fixed-rate debt was scheduled to mature after 2010. As of June 30, 2009, 25.9% of our total debt had variable interest rates, including the effect of interest rate swaps, and the percentage of variable-rate debt, including the effect of interest rate swaps, relative to total assets was 14.8%.
The following table sets forth as of June 30, 2009 our long-term debt obligations and weighted average interest rates for fixed rate debt by expected maturity date (dollars in thousands):
For the Periods Ending December 31,
2010
2011 (1)
2012
2013
Thereafter
Long term debt:
Fixed rate (2)
28,134
74,033
272,314
42,200
137,718
540,708
1,095,107
Weighted average interest rate
6.92
5.98
4.30
6.32
5.57
5.58
5.35
Variable rate
254
526
473,478
222,005
649
47,402
(1) Includes amounts outstanding at June 30, 2009 of $357.0 million under our Revolving Credit Facility and $99.2 million under our Revolving Construction Facility that may be extended for a one-year period, subject to certain conditions.
(2) Represents principal maturities only and therefore excludes net discounts of $7.7 million.
The fair market value of our debt was $1.71 billion at June 30, 2009. If interest rates on our fixed-rate debt had been 1% lower, the fair value of this debt would have increased by $55.9 million at June 30, 2009.
The following table sets forth information pertaining to interest rate swap contracts in place as of June 30, 2009, and their respective fair values (dollars in thousands):
Fair Value at
Notional
One-Month
Effective
Expiration
LIBOR base
50,000
4.3300
10/23/2007
10/23/2009
(623
100,000
2.5100
11/3/2008
12/31/2009
(1,043
120,000
1.7600
1/2/2009
5/1/2012
359
1.9750
1/1/2010
430
(877
Based on our variable-rate debt balances, including the effect of interest rate swaps, our interest expense would have increased by $1.8 million in the six months ended June 30, 2009 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 June 30, 2009. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of June 30, 2009 were 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
We are not aware of any material developments during the most recent fiscal quarter regarding the litigation described in our 2008 Annual Report on Form 10-K. 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
There have been no material changes to the risk factors included in our 2008 Annual Report on Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(a) During the three months ended June 30, 2009, 514,000 of the Operating Partnership’s common units were exchanged for 514,000 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) Not applicable
(c) Not applicable
Item 3. Defaults Upon Senior Securities
(a) Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
On May 14, 2009, we held our annual meeting of shareholders. At the annual meeting, the shareholders voted on the election of nine trustees, each for a one-year term and the ratification of the appointment of PricewaterhouseCoopers LLP as our independent registered public accounting firm for the current fiscal year. The voting results at the annual meeting were as follows:
Proposal 1:
Votes
Name of Nominee
Received
Withheld
Jay H. Shidler
42,796,369
6,539,840
Clay W. Hamlin, III
42,928,522
6,407,687
Thomas F. Brady
43,193,451
6,142,758
Robert L. Denton
42,935,129
6,401,080
Douglas M. Firstenberg
43,192,103
6,144,106
Randall M. Griffin
43,060,816
6,275,393
Steven D. Kesler
43,060,098
6,276,111
Kenneth S. Sweet, Jr.
42,886,674
6,449,535
Kenneth D. Wethe
43,059,608
6,276,601
Proposal 2:
Votes Cast
Broker
For
Against
Abstain
Non-votes
Ratification of the Appointment of PricewaterhouseCoopers LLP as Our Independent Registered Public Accounting Firm for the Current Fiscal Year
49,066,362
158,545
111,301
Item 5. Other Information
Not applicable
(a) Exhibits:
EXHIBITNO.
DESCRIPTION
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.)
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CORPORATE OFFICE PROPERTIES TRUST
Date: July 31, 2009
By:
/s/ Randall M. Griffin
President and Chief Executive Officer
/s/ Stephen E. Riffee
Stephen E. Riffee
Executive Vice President and Chief Financial Officer