COPT Defense Properties (CDP) 2011 Q3 法說會逐字稿

Welcome to the Corporate Office Properties Trust Third Quarter 2011 Earnings conference call.

As a reminder today's call is being recorded.

At this time, I will turn the call over to Stephanie Krewson, the Company's Vice President of Investor Relations.

Ms.

Krewson, please go ahead.

Thank you, Latasha.

Good morning and welcome to COPT's Third Quarter 2011 Earnings conference call.

With me today are Rand Griffin, COPT's CEO, Roger Waesche, our President and future CEO, Steve Riffee, our Executive Vice President and CFO, Steve Budorick, our new Executive VP and COO, and Wayne Lingafelter, Executive VP of Development and Construction.

As management reviews our financial results, they will refer to our quarterly supplemental information package and associated press release, both of which can be found on the Investor Relations section of our web site at www.copt.com.

Within the supplemental package you will find a reconciliation of GAAP measures to non-GAAP financial measures referenced throughout this call.

Also under the Investor Relations section of our web site you will find a reconciliation of our 2011 fourth quarter guidance.

At the conclusion of this discussion the call will be opened up for your questions.

Before turning the call over to management, let me remind you that certain statements made during this call regarding anticipated operating results and future events are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Although such statements and projections are based upon what we believe to be reasonable assumptions, actual results may differ from those projected.

Factors that could cause actual results to differ materially include without limitation the ability to renew and re-lease space under favorable terms, regulatory changes, changes in the economy, the successful and timely completion of acquisitions and development projects, changes in interest rates, and other risks associated with the commercial real estate business as detailed in our filings with the SEC.

With that, I'll turn the call over to Rand.

Thank you, Stephanie, and good morning, everyone.

Weak economic growth in the US, including the possibility of a double-dip recession, along with concerns over financial markets and federal gridlock continued to present significant leasing challenges for the office sector in the third quarter.

Even so, COPT's operations modestly outperformed our expectations, which had anticipated such an environment.

Our FFO per share of $0.52 after adjustments was $0.01 above the high end of our revised third quarter guidance range.

Even before adjustments, our FFO per share of $0.49 was $0.01 above the low end of that range.

Unadjusted third quarter results were driven by lower-than-anticipated operating expenses partially offset by a $0.025 loss on the early extinguishment of debt.

The remainder of my comments focus on the status of defense spending and how we expect the current environment to impact demand for COPT's space.

Congress failed to pass a fiscal year 2012 budget by September 30, so the country is once again operating in a continuing resolution environment.

What this means for COPT is that government agencies can renew and expand existing leases, but they cannot execute new leases until fiscal year 2012 appropriations bills are passed.

As expected, we saw an increase in government tenant activity before the fiscal year-end.

In the third quarter COPT signed 147,000 square feet of new government leases at NBP and other locations and also executed contracts for meaningful government fit-outs in multiple COPT buildings.

Even though we are in another continuing resolution, the completion of government agency relocations associated with the 2005 BRAC has spurred new contractor demand.

Contractors who need to move to be proximate to the new government locations and who have existing, affirmed contracts are in some cases now looking for space.

COPT currently is in various stages of discussions for about 400,000 square feet of new leases with defense contractors at multiple locations.

Overall, however, the threat of budgetary cuts, especially as they may relate to the Department of Defense or DoD continue to weigh upon the collective psychology in our markets.

The feedback we hear from government agencies is that they are anticipating budget cuts beginning in 2013.

The specter of those cuts is making most government and defense contractors more cautious about spending money.

When it comes to office space procurement, they continue to be very conscious of maximizing their use of existing facilities and actually receiving contract awards before expanding or signing up for new space.

These concerns are heightened by the looming deadline for the congressional super-committee.

As most of you know, the super-committee must come to agreement by November 23 on $1.2 trillion of budgetary cuts over ten years.

And then the Congress has to pass that agreement by December 23 to avoid triggering the automatic cuts mandated by the 2011 Budget Control Act.

It's important to keep perspective on a couple of things.

First is timing -- whether the super-committee budget comes to agreement or not, any cuts would not occur until the 2013 budget.

And secondly, future congresses can nullify these cuts or modify them as they see fit.

Now the obvious question is what effect could such cuts have on COPT's existing portfolio?

Assuming the mast draconian scenario that the super-committee does not come to agreement on a deficit reduction package and that the automatic $1.2 trillion of cuts is triggered, then the impact to the DoD's base budget would be a reduction of about 10% or $55 billion per year that would have a declining impact over the nine-year period.

Next you have to ask what is likely to be cut.

All of our sources indicate that service force structure and legacy weapons programs, not cyber and higher-technology missions would face cuts.

In fact, Moody's Investor Service in their ongoing analysis of large defense contractors anticipates that various weapons systems could face cuts.

In the same report, Moody's stated that cyber security and unmanned aviation programs were likely to see budget increases as they were better aligned with the nature of future threats facing the US.

As we've stated before and as many of you know, COPT's franchise is built around serving the specialized requirements of office tenants in the government and defense IT industries and that the four major BRAC locations where we are developing are knowledge base defense installations, not legacy weapon bases.

The government agencies at our locations are fulfilling missions in cyber security and other higher-tech areas that are critical to national security.

So what we initially expect out of the super-committee process is a spike in tenant anxiety and uncertainty, then getting back to business in an environment that is not dissimilar to what has persisted for the last several years.

In short, the real issue for COPT continues to be the lack of a federal budget.

To allow more time to assess the progress of our Strategic Reallocation Plans, asset sales that Roger will discuss momentarily, and for potential clarification regarding the 2012 federal budget, we believe it is prudent to let as many variables beyond our control become resolved in the next few months before giving 2012 guidance.

We therefore will be hosting a conference call in early January to go over our 2012 outlook and guidance.

One positive for COPT that could result from the prospect of DoD budget cuts is that funds from military construction or MILCON most likely will be cut dramatically.

If this does occur, COPT could benefit from increased leasing by government agencies, which otherwise would've built their own facilities to meet their mission requirements.

One last item to highlight is our executive transition.

As many of you know from our mid September press release, Roger has been elected CEO and appointed to the Board of Trustees effective April 1, 2012.

I will retire as CEO at the end of March 2012 and look forward to continue serving our shareholders as a trustee on our Board.

And with that I'll now turn the call over to Roger for his remarks.

Thanks Rand.

Although we're not providing 2012 guidance on this call, we can still clarify our strategic objectives going forward.

In order of importance our priorities are to aggressively lease space in order to drive occupancy, accelerate noncore asset sales, continue to strengthen our balance sheet, and develop properties where specific tenant demand exists.

Although acquisitions are not a current priority, we will continue to evaluate high-quality, stabilized assets that are in line with the Company's super-core strategy.

During the third quarter, we did acquire one property, 310 Bridge Street, a Class A, stabilized office building in Cummings Research Park in Huntsville, Alabama for $33.4 million.

The building is 100% leased to Computer Sciences Corporation, which based on annualized revenues in place at September 30 is COPT's fourth-largest tenant.

310 Bridge Street is the best office building in the Redstone Arsenal market and represents the kind of asset into which we may redeploy proceeds from asset sales as we upgrade our portfolio through our Strategic Reallocation Plan.

That being said, we do not intend to make additional acquisitions in Huntsville.

Instead we will build our market presence there through new development, which brings me to asset sales.

Since launching our Strategic Reallocation Plan in late April, we've sold eight buildings aggregating about $25 million.

As Page 22 of our supplement details, most of these asset sales were in our suburban Baltimore portfolio and were 86% occupied at closing.

These sales equate to 1.2% of square footage, 0.7% of revenues, but importantly 6% of our tenants.

We have $42 million of additional sales under contract, which should close by year-end, putting us on track to exceed our $55 million dispositions goal for 2011.

Additionally we are evaluating offers on or are in various stages of marketing for another $160 million of asset sales, several which could close later this year or in the first quarter of 2012.

Our goal is to accelerate our original disposition time frame so that the entire $260 million of assets targeted in what we're now referring to as phase one of the Strategic Reallocation Plan are completed earlier than year-end '13.

Also we're in the process of identifying a second phase of dispositions, which will likely equal or exceed the dollar value of assets in phase one of that plan.

Strategically we intend to use proceeds from asset sales to fund development costs and to de-lever our balance sheet.

This will provide the Company with ample liquidity.

Wayne is going to highlight the progress in the development pipeline, but first let me lay out a change to COPT's strategy as it relates to future development starts.

When you review the summary of pre-construction projects schedule on Page 26 of the third quarter supplement and compare it to last quarter's list of what was under development, you'll notice there are fewer projects listed.

We are delaying pre-construction activities except for those locations where current demand from contractors is tangible and very quantifiable.

Accordingly our primary locations for 2012 starts as of now are the National Business Park, Patriot Ridge, and Redstone Gateway in Huntsville.

You'll notice that the three projects listed under pre-construction are also characterized as being leasing contingent starts.

Quite simply, we will not commence construction on new projects if the leasing prospects are not there.

Our commitment to closely match new supply with current demand is also why we no longer list completion or operational dates on our pre-construction pipeline.

We are not giving up on other locations and still believe BRAC-related contractor demand is coming to our other strategic business parks, but the continued lack of visibility as to when has caused us to refine our appetite even for the COPT brand of speculative development.

As a result, we are taking a very deliberate pause on new construction in certain locations to allow demand to catch up with existing supply.

Should a build-to-suit or a major requirement come into any of our markets, we are very well-positioned to compete because we have fully-entitled land, approved building designs, and infrastructure in place to rapidly deliver buildings to the market.

The future projects listed on Page 26 are those that are entitled and where we are able to begin construction immediately to meet any surges in demand.

In summary, we remain committed to developing specialized office buildings that serve the security requirements of our government and defense IT tenants.

Development has been and will continue to be a differentiating feature of COPT's long-term growth profile.

However, until the economy and/or Washington, DC provide a more certain operating environment for tenants who will then be more inclined to lease space, we believe the best decision for our shareholders is to moderate development in the near-term.

At this point in the call, I would normally walk through our operating and leasing results for the quarter.

However, I'm happy to introduce Steve Budorick, our new COO.

Steve joins us from Callahan Capital Partners and has decades of experience in office real estate with well-respected firms including LaSalle Partners and Trizec Properties.

The COPT family welcomes Steve and he will now walk you through the details.

Steve?

Thanks Roger.

I'm happy to be part of the COPT team and welcome the opportunity to meet each of you listening to the call in the coming months.

At quarter-end COPT's wholly-owned portfolio of 246 buildings encompassed 20 million square feet.

Our occupancy increased 70 basis points in the third quarter to 88% from 87.3% at June 30, 2011.

The percentage leased, which is a leading indicator, increased by 40 basis points in the third quarter to 89.8% from 89.4% at the end of the second quarter 2011.

We leased approximate 880,000 square feet during the third quarter.

That combined with 2.2 million square feet of leases in the first half of the year brings year-to-date total leasing to 3.1 million square feet and keeps COPT on pace to reach our 2011 leasing goal of 4 million square feet.

Of the space leased in the quarter, 576,000 square feet were renewals, of which 311,000 square feet related to 2011 expirations and 265,000 square feet related primarily to 2012 lease expirations.

We re-tenanted 78,000 square feet.

We executed 111,000 square feet of leases in development or redevelopment projects.

And we also signed leases for 114,000 square feet of vacant first-generation space.

During the third quarter, we signed 147,000 square feet of new leases with the government, of which 78,000 was in new developments and 69,000 was for existing space.

We are also in active lease negotiations with contractor prospects for about 170,000 square feet of our development pipeline and we have another 250,000 square feet of active tenant proposals.

Our pricing and rental rates and leasing costs continues to improve and provide evidence that we are rebounding albeit slowly off the bottom.

Year to date our average renewal rate of 77% demonstrates the stability of our existing tenant base.

For third quarter we have a renewal rate of 82% and an average capital cost of $5.39 a square foot.

Rents on renewals increased 9.8% on a straight-line basis and decreased 2.3% on a cash basis.

Total rent for renewed and re-tenanted space increased 9.3% on a straight-line basis and decreased 2.1% on a cash basis.

For all renewed and re-tenanted space in the third quarter the average capital cost was $7.76 per square foot versus $13.21 in the second quarter.

Another positive trend is that we continue to see fewer renewal transactions accompanied by downsizing.

For the third quarter, only three tenants out of 34 renewal transactions downsized their space requirements.

We continue to believe same-office occupancy bottomed in the first quarter of this year.

For the fourth quarter we have about 190,000 square feet of known move-outs, which will be more than offset by 364,000 square feet of space that's leased and will become occupied before year-end.

Accordingly we project that same-office occupancy will improve modestly in the fourth quarter.

Now I'll turn things over to Steve Riffee to discuss those and other specifics.

Steve?

Thanks Steve.

For the third quarter of 2011, we reported FFO available to common shareholders of $44.4 million or $0.52 per diluted share.

This result excludes a loss on the early extinguishment of debt in the quarter and the acquisition costs primarily associated with buying 310 Bridge Street.

Including these charges, our FFO per diluted share was $0.49.

For the third quarter of 2011, net income attributable to common shareholders was $2.5 million and diluted earnings per share was $0.03 compared to net earnings attributable to common shareholders of $4.8 million or $0.08 per share for the third quarter of 2010.

Our diluted FFO payout ratio for the nine months ended September 30, 2011 as adjusted was 78.4% and our diluted AFFO payout ratio excluding capital expenditures invested at properties that are part of our disposition plan was 90.3%.

As of September 30, our same-office portfolio consisted of 187 properties representing 78.4% of the consolidated portfolio square footage and excluded all properties we intend to dispose of as phase one of the Strategic Reallocation Plan.

Same-office cash NOI excluding termination fees increased by $2.9 million or 4.8% from the second quarter of 2011 and was flat compared to the third quarter of 2010.

Same-office occupancy averaged 89.8% in the third quarter versus 89.6% in the second quarter of 2010, an increase of 20 basis points.

Turning to the balance sheet, at September 30 the Company had $2.4 billion of debt outstanding at a weighted average cost of 4.7%.

70% of our debt was at fixed interest rates.

For the quarter, our adjusted EBITDA to interest expense coverage ratio was 3.0 times and our adjusted EBITDA to fixed charge coverage ratio was 2.6 times.

Our debt to adjusted EBITDA ratio adjusted for construction in progress was 7.0 times at quarter-end.

During the third quarter, we entered into a syndicated credit agreement with our bank group that provides for a new $1 billion unsecured line of credit that matures on September 1, 2014 and may be extended by one year.

The credit facility replaced the Company's existing $800 million line of credit, which was due to mature September 30, 2011, and the $225 million construction facility, which was due to mature May 2012.

On the same day COPT also entered into a $400 million unsecured term loan agreement with our bank group that has a four-year initial term and a one-year extension option.

The Company had very strong support from an expanded bank group with over $1.7 billion of commitments for these transactions.

The Company used proceeds from these transactions to repurchase the $162.5 million of its outstanding 3.5% exchangeable senior notes that were put back to the Company by investors and to repay $275 million of mortgage debt, $221 million of which was scheduled to mature within a year.

In the quarter the loss from the early extinguishments consisted of a $1.7 million write-off of deferred financing costs and a $350,000 prepayment penalty on an unassumable loan associated with a property that was sold during the quarter.

Importantly, COPT has only $53 million of debt maturing in the fourth quarter of 2012 and $141 million of debt maturing in 2013.

And going forward we intend to take advantage of low long-term interest rates and extend our debt maturity ladder.

Now regarding earnings guidance as Rand mentioned, we will host a conference call on January 12 at 11.00 a.m.

to give our outlook and guidance for 2012.

Today we are prepared to provide guidance for next quarter.

For the fourth quarter, we expect FFO per diluted share of $0.54 to $0.57.

The major updated assumptions behind our fourth quarter guidance are as follows.

First, for the same-office portfolio, end of third quarter occupancy improved 10 basis points sequentially from the second quarter and should modestly improve in the fourth quarter to end the year 10 to 20 basis points higher.

We project a tenant retention rate of 65% to 70% for the fourth quarter.

Second, our prior guidance anticipated $750,000 in lease termination fees for the third quarter.

As shown on Page 3 of the supplement, we recognized approximately $100,000 of lease termination income in the third quarter and only $445,000 through the first three quarters.

We are lowering our expected quarterly run rate for lease termination fees beginning with the fourth quarter to $250,000.

Third, our guidance assumes no acquisitions.

And fourth, in addition to the $25 million of assets already sold to date, our guidance assumes we will sell an additional $30 million to $50 million of assets in the fourth quarter.

Finally is other income.

Year-to-date we recognized $4 million or $0.055 per diluted share of gains on land sales and our investment in KEYW.

For the fourth quarter we expect other income from gains on land transactions to be up to $750,000.

And we are not forecasting any gain or loss on our investment in KEYW in the fourth quarter.

A quick reminder from the July call related to our investment in KEYW, because Rand resigned from KEYW's Board on July 1, in the third quarter we stopped accounting for our 2.6 million shares of KEYW under the equity method and instead began marking the investment to market.

On September 30, KEYW's share price closed at $7.11 whereas our basis in our shares was $7.45.

That $0.34 loss per share in KEYW plus a $200,000 reduction in the value of the 50,000 KEYW warrants we hold resulted in our booking an unrealized noncash loss of $1.1 million or $0.014 per diluted share in the third quarter of 2011.

We do not plan to forecast any gain or loss on our KEYW investment.

However, we will provide an update each quarter of how many shares we own, what our basis in those shares is, and what realized or unrealized gain or loss we incur each quarter for as long as we hold that investment.

For projection purposes investors should not include it in our future FFO estimates.

And with that, I will now turn the call over Wayne.

Thanks Steve.

My comments will focus on updates to projects under construction, redevelopment, and pre-construction, which are summarized on Pages 25 and 26 of the supplement.

During the third quarter we did not start construction on any new office buildings, nor did we place any newly-constructed buildings fully into service as part of our operating portfolio.

But as anticipated, our leasing in the under-construction portfolio did improve moderately during the quarter.

We signed leases with the government for 63% of 316 NBP and expect to deliver that space to them next year.

We also achieved incremental leasing at 430 NBP, which is now 61% leased to contractors.

And we have a lease out for signature for another 11% of the building.

We also have active leasing interest in the other properties under construction in this park.

Although we have not shown any pre-leasing at 7770 Backlick Road at Patriot Ridge, we are under negotiations with contractors for significant portions of that building.

We hope to update you on this progress on the next earnings call, if not sooner.

In our redevelopment properties, during the third quarter we leased 25% of Hillcrest One in Blue Bell, Pennsylvania, which has been renamed 751 Arbor Way.

Occupancy is slated for January of next year, roughly one month after the building is delivered to the market.

We have taken four projects off our pre-construction list from last quarter, which is on Page 26, and moved them to future status.

One project, 200 Sentry Gateway in San Antonio, Texas was dropped from this -- with this realignment in reporting.

As Roger discussed, we do not intend to resume pre-construction activities beyond the three projects until demand improves and the existing space in these markets is absorbed.

The three potential construction starts for 2012 are in our strongest development markets, but we are in negotiations with tenants for space already under construction and therefore may need to begin building additional supply to keep pace with demand.

These projects are the National Business Park, Patriot Ridge, and Redstone Gateway in Huntsville.

With that I'll turn the call back to Roger.

Thanks Wayne.

In summary, the message we hope you've all heard today is that although the broader economy and our friends in Washington, DC continue to make daily operations challenging for us and other landlords, COPT's operating results continue to show gradual improvement.

Our priorities are simple and clear -- lease space, sell noncore assets, continue to strengthen our balance sheet, and develop properties where a specific tenant demand exists.

With that, Operator, please open up the call now for questions.

Thank you, Mr.

Waesche.

(Operator Instructions).

And your first question comes from the line of Craig Mailman with KeyBanc Capital Markets.

Please proceed.

Hi.

Good morning, guys.

Roger, maybe can you just provide a little bit of detail?

As it stands now, you guys have the $260 million for phase one potentially going to another $260 million or above for phase two, but you're also kind of ratcheting back development expectations.

I know it may be hard, but could you maybe give us a sense of what portion of the phase one proceeds are going to be reinvested versus used to de-leverage and then maybe what your thoughts are on the phase two proceeds?

Sure.

In terms of phase one, so we have yet to sell about $235 million.

And looking at our existing under construction and under redevelopment pipeline, we have with some other investments we're doing in some land improvements we have approximately $200 million yet to spend.

So the phase one will largely cover the portfolio of projects that are where we are on the construction at this point.

The phase two proceeds would be largely dedicated to initial starts to the extent that they happen as a result of build-to-suits or specific tenant demand and also to de-leverage our balance sheet.

And it's possible if we find a really strategic acquisition, we could participate in that.

That's helpful.

Have you guys refined maybe what your leverage targets are now?

We are -- Craig, this is Steve.

We are at this point comfortable operating at the level that we're at in the near term, but have a long-term leverage goal of getting to 50% or below the way we traditionally look at the gross assets.

Okay.

Then just Steve also, now that you guys kind of collapsed the construction facility into the revolver, what type of pickup should we think about for capitalized interest as you guys continue to build out?

I would say considering the general direction of building out what we have and being a little more cautious on starts that you could expect capitalized interest -- we're not giving the '12 guidance, but I'd say $4.5 million to $5 million for '12 and we'll give you an update when we -- in January for the balance of 2012.

But is it safe to assume like a 300-basis point spread going forward on incremental capital spend?

No, I think you should look at basically our average borrowing rate that you would project.

And we'll give you more color on that going forward.

Times the projected spend is the way you should look at it.

Great.

Thanks guys.

Thank you, Craig.

Your next question comes from the line of Jamie Feldman with Bank of America.

Please proceed.

Thank you.

I know you guys gave your views on kind of how the environment looks in terms of the government, but can you give us a sense of what your clients are saying and maybe how their views have evolved or maybe their lack of patience has evolved and how they're thinking about the world as you head into 2012?

Well, I think frankly everyone's very frustrated with the lack of activity on the part of the government.

I mean, it's in a gridlock and I think that's going to show in terms of the -- both the midterm elections and in the national election.

And so I think we're -- collectively what our tenants are telling us and those that are in the dialogue and throughout the country really, not just in the DC area, is really that they're being cautious and it's the -- it's really primarily the uncertainty caused by the lack of government decision-making that is causing a lot of the cautiousness.

I mean, they see businesses doing well.

In the defense side it's the uncertainty as I said in my remarks, Jamie.

But by and large they're also still getting business and if they could just make decisions and get done with it, they do expect to still come out of it fairly well.

There are some weapons programs that clearly are headed for deferments or cuts, but beyond that they do think that the -- particularly the national security part, they're actually seeing increases and fairly robust activity.

So I think it's a mixed message.

And we certainly are seeing that around the country.

I think clearly the whole European, one day it's up, things look positive today, and then there'll be other details that come out and it's negative.

And that's weighing on the cautiousness.

A lot of CFOs are sitting there saying we know the local -- and I hear this every day from our tenants, you know, the local people are out of space.

They need more space desperately.

They're hiring people a lot.

They're hiring and they don't have a place to put them.

And yet the CFOs are sitting on the requirements until they get clarity on the financial markets and on the election.

So I just think we're into another tough year from that perspective.

Okay.

And then can you also talk for a little bit more about the appetite for your assets?

I know you want to ramp up the program.

I'm just curious what kind of dollars are out there and then what kind of financing they're able to get.

The assets that we have for sale are largely targeted for private buyers.

Some are institutional, but I would say the larger percentage of the initial assets are targeted for private buyers.

So far we've dealt with investors who are well-heeled and have access to bank debt given the size of the transactions we've done and so they've been able to execute.

But we also have some transactions targeted for institutions who are all cash buyers.

And so far financing or access to money has not been an impediment to us selling assets.

Okay.

And then do you -- yes, you look at Duke's sales announced late last week, I mean, is there something along those lines that you guys would be interested in doing?

I'd say the assets that we're trying to sell are largely disparate assets that don't connect to each other and wouldn't largely be sold to individual investors.

We do have certain portfolios of assets that we could put together that might target a big, larger institutional sale.

And that's something we are looking at.

Okay, thank you.

Thank you, Jamie.

Your next question comes from the line of Brendan Maiorana.

Please proceed.

Thanks.

Just to follow up, have you guys updated the cap rate expectation on the dispositions?

I think it was 8% rough target when you had initially laid out the plan in April.

Right.

So what we've sold so far ended up blending to about 8.5%.

I still think that 8% or maybe a tad over is a good number because we do have some assets that we'll sell below an 8%, but we do have some that are going to sell above an 8%, so I think 8%, in that range, is still a pretty good number.

Okay, that's helpful.

And then when I look at the projects that I think are coming online over the next 12 or 15 months, there's about $200 million of them and they're about 36% leased according to your detailed schedule in the back of the supplemental.

What level of leased rate or occupancy do those projects need to get to when they become call it cash flow neutral on an NOI basis so that they can be neutral to next year's earnings as opposed to a drag when you stop the capitalization?

Well, we are capitalizing interest at approximately a 5% interest rate.

And if you took a 10% asset yield on average for what we're putting in place, but then you've got some operating costs to absorb, so we probably need to be in the high sixties to sort of -- percentage leased to break even.

But as you guys think about, you know, as you're dialing back a little bit on new development starts and you think about everything that's coming online next year, do you think that what you have moving online is going to be additive to your run rate?

Or do you think that from an initial FFO perspective that it might be a little bit of a drag.

I think it will be somewhat additive.

I do agree with you that we run the risk next year of having to carry some assets.

We're already sort of doing that out in Colorado Springs, some assets that we put into service that aren't leased.

But I -- knowing them -- the -- what has been leased so far, we've got just a little under 200,000 square feet of leasing that's not yet occupied.

And the leasing that Steve Budorick mentioned that we're closing in on, I think between those two and some other activity that we feel pretty good about that we won't have a drag situation.

The question is how positive will it be in 2012, but much more positive in 2013.

Yes, okay, that's very helpful.

And then in terms of Power Loft, is that -- other than the 17% that's online today, the capitalization that's now with the remainder and given that you guys acquired that about a year ago, does that one come off of protection as you go into 2012?

Well, it -- to -- as you think about Power Loft, what we bought about a year ago was a shell and a construction project.

So we finished building out the infrastructure to actually establish it as a leasable location sometime this summer.

And typically it takes 18 to 24 months to lease up that project from the point that there's infrastructure that exists.

We at the end of December will have delivered the MEP to have available 9 megawatts of power.

We have leasing.

And we will not build out any more of the infrastructure until leasing progresses.

So we will stop spending capital until you see further leasing progress.

We have had more activity once we finished some of the base infrastructure.

We've seen RFPs that we're working on, but we haven't had any leases to announce.

So I think you'll see us spend us spend less on Power Loft capital for the first good bit of 2012.

And as we -- as leasing progresses, we'll give you projections of additional build-out.

Okay.

And sorry, Steve, just to clarify, so the 9 megawatts is built out kind of now and then you have a -- you have 12 months from now to lease that out before it runs off capitalization protection?

That's correct.

Okay, great.

Thank you.

Thank you.

Your next question comes from the line of Sheila McGrath with KBW.

Please proceed.

Sheila McGrath with KBW, please proceed.

Go ahead to the next one.

Your next question comes from the line of Dave Rodgers with RBC.

Please proceed.

Hey, good morning.

Thanks.

Rand, a quick question -- I thought per your prior understanding was that cyber budget was somewhat siphoned of the remainder of the DoD budget and perhaps not at risk at all.

You didn't really present it that way, so is that at all at risk in this current cut?

Or is the commitments from the cyber component of the budget really just a function of the overall government?

Can you clarify that for me?

So a good question, Dave.

Our understanding is that the cyber component is protected and in fact all readings that we've done and input is that it actually is expected to increase.

Those are the indications.

So we think that's very good for us in the long term and that that, of course, is headquartered at Fort Meade and they have requirements.

They're going to have some difficulty getting MILCON money and so there's a potential of some of that demand really in effect having to siphon off some space to their neighbor.

And that should create some additional demand for us as it shifts over into National Business Park.

So I guess it's not really an approval problem there, just an actual funding problem that you're waiting to clear?

Right.

Exactly.

Okay.

And then Steve, I guess going back to the capitalization, I guess I wanted to be clear, is -- are you changing or have you changed your capitalization policies with respect to the various bucket?

Or is it simply a function of how much capital is -- or how many projects are in each component of that budget let's say?

We have not changed our capitalization policy.

It's just the level of capital spend for the various projects that's changing.

Okay, great.

Thank you.

Thank you, Dave.

Your next question comes from the line of Erin Aslakson.

Please proceed.

Oh, hey.

Roger, congratulations.

John Guinee here.

Thank you.

Rand, we're going to miss you.

When's your last call?

The next call.

I will finish out the fourth quarter call (multiple speakers).

Wow, okay, all right, just a few sort of housekeeping questions, which I know you would anticipate, $240 a square foot in Huntsville, Alabama to buy a very good building still seems very, very rich, perhaps the highest price ever paid in the State of Alabama.

Can you kind of elaborate on that, Roger, a little bit on why that makes sense?

Sure.

Well, first of all, it is the number one building in Huntsville, both in terms of its physical features and its location.

It's located adjacent or as part of a lifestyle center, 500,000 square feet, and it's really in the midst of a great amenities situation.

It also happens to be one mile from the main gate to Redstone Arsenal.

And so we think that building, both because of its proximity to Redstone and its rich amenity base and its high quality remain leased for a long period of time.

We would agree that $240 a square foot is a big number, but it's, you know, what you pay has to do with your relationship to how you think it will stay leased and at what kind of rental rates.

And we think that given the tenant in that building and our relationship that that building will stay leased for a long time at rates that will allow us to get a return, a good return.

Okay.

Then any [skiff] build-out in the space or anything unusual in that regard?

There is, yes.

Okay.

Second question, on Page 24, you've got 2,200 acres of land, 20 million square feet of development rights, and you can just eyeball some of this and realize that a lot of it's just never going to be built, 194 acres in Colorado Springs, 400-plus acres in Huntsville, et cetera.

Do you have any plans to dispose of any of this land in the near or medium term?

John, it's Rand.

Never is a long time.

So things go through cycles as you know from your previous background and sometimes you look at it and say that there are out lots and other alternative uses that are currently readily available to be sold in the marketplace.

And so part of our program is to accelerate those, including the opportunity to in some of our markets do the sales to apartment builders, hotels, retail, and so on like that.

So that is part of the program.

Some of those properties are immediately available for sale.

Others need a little bit of work for positioning them for entitlements or for, you know, breaking the lots up.

So we're very active in that.

We do expect as we give '12 guidance for there to be some aspects of that in the '12 and '13.

And the other parts of it is really a function of as development -- when the offices continues to do well and accelerate as we expect, then we'll continue to take that ground down.

Okay.

And then the last question I think building a little bit on Power Loft, has there been any leases signed at Power Loft since you acquired it I guess about 15 months ago?

And is that possibly on the block for sale, Roger, in phase two in of the disposition program?

I don't know that we've thought that through yet, John.

We have not signed any leases since we acquired the property.

And we are targeting tenants that tie to our niche of government and defense for that particular location.

And I think we'll wait and see how core strategic that asset is to the Company a year and a half from now.

Okay.

Thank you very much.

Thanks John.

Your next question comes from the line of Michael Knott.

Please proceed.

Yes, I have a kind of a little string of development questions here.

I'll just kind of piece it all out there and then we can talk about it.

Just curious how tough the decision was to take a more cautious stance on development and kind of what all that you've thought about in regards to making that decision and then also does that shift have anything to do with the pending change in leadership?

I don't think it had to do with the pending change in leadership.

I think we stepped back and said look, the Company has a huge value creation portfolio.

We've got 1.1 million square feet under construction.

We've got 300,000 square feet under redevelopment.

We've got Power Loft.

We've got some of our existing portfolio that's turned value-add because of the downturn in the economy.

And then we've got this great future BRAC opportunity where we're entitled to go forward on many of opportunities.

If you look at our total value-add portfolio relative to the Company's asset total, it's about 20%.

And so we said that's enough.

We need now to go back and do backing and filling.

We need to make sure that what we've started, all of the toys that we've bought and built over the last couple of years, we need to make sure that they're working.

And so that's where the Company's emphasis.

Now as we said, both in Wayne's section and mine, we're positioned to build additional buildings, but we've got to see measurable demand in order to do that.

I think what the Company needs to do in the short run is to de-risk a little bit.

I think we can create a lot of value by de-risking the story and not adding any more non-earning assets to our portfolio at this point.

Okay, that sounds like a good strategy.

And just to clarify what you said, are you no longer doing any spec development anywhere even at the three core locations?

Or do you just need some pre-leasing on some of your projects?

I just want to make sure I understood what you said.

I think what it is is that we are placing a more onerous underwriting standard on ourself related to leasing and pre-leasing when it comes to development.

But as an example of that, if you progress as we expect with some of the fairly strong leasing that's at Patriot Ridge, you'll have that decision.

If that building is at 14 months to build the next building, then you're sitting there with a velocity that finishes that building up in the middle of next year, then you have that kind of decision to make.

And you have to look out as to others in the marketplace leasing up and what's the expected demand and make those kinds of decisions.

So what we've tried to do, Michael, is really just look at where we see that projection of volume and make those calls accordingly.

And interestingly, in this cycle, at this time in these cycles, what you do start to see and there's some of those discussions underway is a design/build stepping forward where full building users that are consolidating or that are looking at their particular growth accelerating, they don't have a lot of options and they start stepping forward for design/builds.

And so we're very well-positioned for that and would expect that that may take some of the place of some of these other projects that are really there and we're just waiting on that, so.

Okay.

And then sorry to -- not to belabor the point, but are you guys leaving yourselves some flexibility to start projects completely spec?

Or are you going to require some level of pre-leasing on every project that you start from here?

Well, obviously some of our tenants require us to create inventory for them to lease.

And so -- but it will be done with very strong knowledge that there's a tenant for a building [before] we start another building.

Okay.

And then just a question on the sales program, if I heard your numbers right, it sounds like -- and based on what you disclosed in writing, it sounds like you have about $20 million done, sounds like there's another $40 million under contract, and then you're evaluating or have offers on another $160 million?

So if I add those three source -- and with that batch being potentially done by first quarter of '12 if I heard that right, so that total would be about $225 million.

And if that's all right, why would it take another five quarters for the last call it $30 million if you said through the year-end '13?

No, I think what we said is that we had moved that 2013 goal up to 2012.

We didn't say that it would all be done in the first quarter, but there is an internal goal to try to have those assets sold during calendar 2013.

Okay, so phase one you expect to have completed at -- by year-end '12 now, the first $260 million?

That's correct.

Okay.

And then phase two would be kind of another two years from 2013, through the end of 2014 perhaps?

Well, I think we'd like to spend a little more time to think about the assets and the timeline and probably talk about that in January.

Okay, fair enough.

Thanks a lot.

Thanks Michael.

(Operator Instructions).

Your next question comes from the line of Steve Benyik.

Please proceed.

Thanks very much and good morning.

You guys have spoken pretty positively of three of the four BRAC locations that you have.

Just hoping you could provide a little color on North Gate Business Park, Aberdeen Proving Ground, and just what you think it's going to take there to just see a more sustained improvement in leasing velocity?

Well, I think that's been a disappointment to date, not just for us, but for any of the other developers that are in the marketplace, Steve.

And I think it really relates to the 140 firms that are in Fort Monmouth that have been doing business with C4ISR.

Only a small percentage of those have moved.

And we're just now for the first time starting to see signs that those tenants, a lot of whom who are on month-to-month leasing up in Fort Monmouth start to now come out with RFPs in the marketplace to look for space.

So that's an early indicator.

We'll have to see if those in fact get formalized.

But now that C4ISR is in and completely moved and starting to award contracts that have been authorized, we would expect that as part of those awards those future tenants would need to be relocated into the marketplace.

And so even though it's been frustrating for all of us and has been under our expectations, I think the next six months or so will start to give us a much better indication of that activity.

I guess when you look at the hierarchy of all of your other markets, would that market still come in fourth place following the first three BRAC locations?

Or are there other markets where you're a bit more positive even though they're not sort of BRAC-related?

Well, I think the -- we still stand by the numbers and it's been out in the papers a lot and the base commander and the general have discussed it.

I mean, the numbers expected for the defense contractors as they complete the move is still in that 2.5 million to 3.2 million square feet in total.

And that would take care of our entire development and take care of the onsite, the gate development, and leave a little for others in the marketplace.

I think the difficulty has been over what period of time.

And we're all kind of just waiting to see how that unfolds.

And that square footage directly related to the BRAC, for example, is pretty comparable to the numbers we're expecting to see in Huntsville and a little bit more actually than the numbers that we expect to see at Patriot Ridge.

The difference is at Patriot there are just not as many alternatives.

They're moving very rapidly on space requirements there.

They under-built -- even though it's at 2.4 million square feet they under-built the requirements for National Geospatial, both for space and parking.

And so that has a little bit different dynamics.

And then the dynamics down in Huntsville at our Redstone Gateway project, in addition to the BRAC relocation, there's a fair amount of pent-up demand, particularly for AT/FP secured space behind the gate that we expect to be able to capture as our project gets velocity there.

Okay, that's helpful.

I guess turning to the dividend, I think you had mentioned getting down to an AFFO payout of close to 90%.

I just want to better understand.

Was that completing all -- after completing all of the phase one sales?

And then also sort of where do you guys expect to be at year-end if you hit the midpoint of the asset sale guidance for the fourth quarter?

I think we'll likely -- I think the asset sales are going to be timed in the second half of the quarter and not have a significant effect on the fourth quarter in terms of cash flow.

I would say that our expected payout ratio for the full year will be halfway between the 90% and the 100% that we've been talking about before.

Okay.

And then just lastly I was wondering are there any additional capital raises, construction loans, anything of that variety in the 2011 guidance?

And then lastly just whether the rate on the new unsecured credit facility and the term loan have been disclosed, sort of how those came in relative to your expectations?

With regard to construction facilities, we're still working and may put in place a construction facility for the Redstone project in Alabama.

The term -- we worked for quite some time on our bank group and our term loan and we thought we did some very good financing and favorable and we had very strong interest and expanded the bank group partners.

So that -- I would say that turned out to where we expected it to be.

He asked for the pricing.

The pricing.

We're currently borrowing 200 basis points over LIBOR on our bank line and 190 basis points over LIBOR on our term loan.

Okay.

Thanks very much.

Thank you.

Your next question comes from the line of Christopher Lucas.

Please proceed.

Good afternoon, everyone.

Hey Chris.

Rand, Roger, I just want to talk on the BRAC-related activity.

I guess if you could just maybe comment on the non-defense, non-BRAC-related leasing environment and how -- if there's any difference between what the tenants are saying and telling you now relative to the other contractor demand drivers?

So what's -- is there any difference right now in the environment between the two?

I think they both have their own sets of issues.

In the case of the BRAC-related tenants, they're dealing with where the future of government -- the budget is going and what their individual impact will be relative to the programs that they are involved with with the government.

With respect to the 40% of our business that is tied to commercial tenants, whether it be education, healthcare, financial services, et cetera, I would say that that part of the business is stable.

It's not improving significantly, but it's not as bad as it was back in 2008 or 2009.

But it's going to be a slow grind in that part of our portfolio to continue to bring occupancy up.

Okay.

And then just on the development return expectations are you adjusting those at all?

Or are you guiding us towards the lower end of your traditional range at this point?

Or should we be thinking about lower returns on developments at this point?

The returns may be a little lower, but it's not significant.

We may elect to take volume over price in a couple of places, which could have an impact.

But I think our key locations we'll still get pretty high margins.

And then just a point of clarification, on the Power Loft build-out, the 9 megawatts, does that include the 3 that was sort of in place at the time of acquisition?

That's correct.

Okay.

And then the last question, just so, again, so I'm clear on the disposition program, essentially what I'm hearing from you is is that the program is going to be somewhat accelerated compared to what was maybe originally announced and that there is plans for additional sales, but those -- the timing and the composition and the scale of those is to be determined?

That's correct.

Okay, great.

Thanks a lot, guys.

Thanks Chris.

Your next question comes from the line of Craig Mailman with KeyBanc Capital Markets.

Please proceed.

Hey, it's Jordan Sadler here with Craig.

Just following up on the dividend a little bit, Roger, I'm just curious.

I mean, this activity, it appears the de-leveraging, the accelerated sales, reduced acquisitions, the softness in the core decreased development, I mean, this will obviously put pressure on the run rate.

Is the dividend sacrosanct?

It's not sacrosanct.

I think in a perfect world we would like to grow back into it.

For the nine years prior to 2010, we had a AFFO payout ratio in the mid 80s.

Last year we were in the 90s.

We would -- our goal of the Company to try to grow our earnings back to make the dividend payout ratio in the low to mid-80s.

So that's the target.

But we will see what happens in 2012 and adjust accordingly.

Right.

I mean, and if it were to take three years to grow back into it, would that be sort of acceptable or that just remains to be seen.

I really don't have a strong answer for that now.

It's obviously we'd have to sit down and go through the three-year outlook with the Board and get their views on that.

Fair enough.

Thank you guys.

Thanks Jordan.

And your next question comes from the line of Erin Aslakson.

Please proceed.

Just a quick follow-up, John Guinee here again.

I was at a business event here about a month ago where Billy Barroll [in your shop] was on a panel, did a great job, and they had a gentleman from DISA, Defense Information Agency, which is moving from Skyline, the Vornado asset, over to Fort Meade.

And he went to great length to talk about the employees at DISA and how because of flex time and remote commuting really only had to be at Fort Meade for three out of every ten days.

And that ended up resulting in a lot of retention.

Is that the same issue that's going on with the defense contractors and the slowness to locate in relatively remote locations like Aberdeen or National Business Park?

I don't think so.

I think, John, that DISA when they first announced the relocation, they were quite shocked when they did the survey that as much as 60% of their employees did not intend to relocate.

And so they went out and had a very specific program to try to accommodate that.

And, of course, DISA is also responsible for the entire network service for the entire government, so they pride themselves on trying to help create the solutions.

When they then turned around for the contractors, they have said very clearly we have a contract with you.

We expect you to be nearby and adjacent to service our requirements.

They did say that they would give a little bit more time and recognition of the lease costs that they had that they're asking their contractors to give up.

And so they worked that out to be by '14 those contractors have to move.

Similar situation, probably more critical even in C4ISR whereas they award those contracts, a lot of those have the requirement where they have to be on base within ten minutes of the notification.

And you can't do that from Fort Monmouth, New Jersey.

So we do expect that once those contracts are awarded that the relocations will occur.

So it's really more just the time frame of those agencies getting in, getting settled, starting to do the awards, and then that will trigger the relocations of the contractors.

Yes.

And then last question, I think probably, Steve, you might know the answer to this.

What are your coupons on your preferreds?

All of your preferreds are callable now.

I'm sure a few of them are above 7% or 8%.

And is that a way to sell assets without incurring dilution?

We definitely have some 8%s and some in the high 7%s that we continue to evaluate as we think about allocating capital and have at this point not decided to call those, but it is one of the things that we are always evaluating, John.

All right, thank you.

Thanks John.

I will now turn the call back to Mr.

Griffin for closing remarks.

Thank you for joining us today on a fairly lengthy call.

And if we didn't get a chance to get to your questions or we didn't get them answered on this call, we are all in the office today and available to speak with you later.

And, again, our next call will be on January 12 when we will then give 2012 guidance.

So thank you very much.

Have a good day.

Thank you for your participation in the Corporate Office Properties Trust Third Quarter 2011 Earnings conference call.

This concludes the presentation.

You may all now disconnect.

Good day.