COPT DEFENSE PROPERTIES quarterly report, Q2 FY2014

Business context and reporting period

Corporate Office Properties Trust (COPT), a REIT, conducts nearly all operations through Corporate Office Properties, L.P. (COPLP). The companies focus on office and data-center properties serving U.S. government agencies and defense contractors, particularly in the Greater Washington, DC/Baltimore region. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2014; comparisons are with the corresponding 2013 periods. Unless noted, figures below are consolidated and in U.S. dollars.

• At quarter-end, the portfolio included 180 operating office properties totaling 16.9 million square feet, 12 properties under construction, committed construction or redevelopment, and a partially operational wholesale data center.
• Portfolio occupancy was 89.3% at June 30, versus 89.1% at December 31, 2013. Same-office occupancy was 90.8%, versus 90.6%.

Financial performance and position

Real-estate NOI was $72.1 million in Q2, down from $80.6 million, and $147.3 million for the first half, down from $158.6 million. For the first half, same-office NOI declined $1.6 million; newly placed-in-service properties added $6.2 million, while dispositions and properties expected to be conveyed reduced NOI. The filing does not provide a single consolidated operating-margin measure.

• Operating cash flow was $103.0 million for the first half, compared with $61.5 million. Investing cash outflow was $140.0 million, versus $115.3 million; financing cash inflow was $58.9 million, versus $52.4 million.
• Cash and cash equivalents were $76.2 million at June 30, up from $54.4 million at year-end. Total assets were $3.71 billion.
• Debt, net, increased to $2.10 billion from $1.93 billion at year-end. The reported debt fair value was approximately $2.10 billion. The $800 million revolving facility had no balance outstanding; $785.2 million was available. An additional $180 million was available under term loan facilities, subject to conditions and lender approval.
• Common dividends declared were $0.275 per share in Q2 and $0.55 for the first half, unchanged from 2013. The company redeemed $50 million of 7.5% Series H preferred shares in June.

Material changes, outlook, and risks

• Revenue and costs: First-half revenue rose $23.7 million, including higher construction and service revenue. Operating income nevertheless fell $19.4 million, reflecting higher property operating costs, depreciation and service expenses. A revision to the useful life of a property removed from service for redevelopment added $12.9 million of depreciation in the first half. Severe winter weather also increased Mid-Atlantic property recoveries and operating costs.
• Debt refinancing: In May, COPLP issued $300 million of 3.700% senior notes due 2021, receiving approximately $297.3 million before other offering expenses. Proceeds were used for debt repayment, the preferred-share redemption and general corporate purposes. The prior-year comparison included substantial losses on early debt extinguishment, making the change in net income an imperfect indicator of underlying operating performance.
• Significant loan default: A subsidiary defaulted in April on a $150 million nonrecourse mortgage secured by two Northern Virginia properties. The lender accelerated maturity to July 2014 after quarter-end. Management expected to convey the properties to the lender to extinguish the loan. Their estimated fair value was below the loan balance; cash flows from the properties had belonged to the lender from April 1. These properties are excluded from reported portfolio occupancy statistics.
• Development and leasing: Three newly constructed properties totaling 457,000 square feet were placed in service in the first half and were 91% leased at June 30. The company completed 1.1 million square feet of leasing and renewed 68.8% of lease expirations, excluding a property removed from service for redevelopment. The data center had 9.0 megawatts operating, 6.3 megawatts leased, and a planned 18-megawatt critical load upon completion.
• Spending and management outlook: Management expected to spend more than $174 million on construction and development and approximately $22 million on operating-property improvements during the remainder of 2014. It stated that available liquidity and resources were adequate for near- and longer-term needs without requiring property sales. No numerical earnings or FFO guidance is provided in the supplied filing text.
• Key risks and contingencies: Management identified government budget cuts or shutdowns, changes in defense-related demand, interest rates and financing access, development and leasing execution, property values, joint-venture risks, REIT qualification and environmental requirements. The company reported compliance with debt covenants at June 30. Disclosed obligations include tax-incremental-financing shortfall exposure, capped environmental indemnities and construction commitments. Management did not expect routine legal proceedings to materially affect financial position, operations or liquidity; no material litigation was reported.

Important facts for investors to verify

1. Subsequent developments and final resolution of the $150 million nonrecourse mortgage default, including whether the property conveyance extinguished the loan without further material obligations.
2. Actual leasing, occupancy, rent collection and asset values, especially for government- and defense-exposed markets and the properties under construction or redevelopment.
3. Debt maturities, refinancing capacity, covenant headroom and the effect of interest-rate changes; first-half debt increased while the company continued substantial development spending.
4. Whether expected 2014 construction and property-improvement spending is completed on budget and funded as planned.
5. The sustainability of operating cash flow, NOI and distributions. Reported FFO and adjusted FFO are non-GAAP measures and should be considered alongside GAAP results and cash flows.