COPT Defense Properties (CDP) 2012 Q3 法說會逐字稿

Good morning to you, ladies and gentlemen, and welcome to the Corporate Office Properties Trust third quarter 2012 earnings conference call.

(Operator Instructions) As a reminder, this call is being recorded for replay purposes.

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

Ms. Krewson, please go ahead.

Good morning and welcome to COPT's conference call to discuss the Company's third quarter 2012 results.

With me today are Roger Waesche, President and CEO; Steve Riffee, Executive Vice President and CFO; Steve Budorick, Executive Vice President and COO; and Wayne Lingafelter, Executive Vice President of Development & Construction.

As management discusses GAAP and non-GAAP measures you will find a reconciliation of such measures in the press release issued earlier this morning and under the Investor Relations section of our website.

At the conclusion of management's remarks, the call will be opened up for your questions.

Before turning the call over to management, let me remind you all 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 lease, renew, or re-lease space under favorable terms; regulatory changes; changes in the economy; the successful and timely completion of dispositions, 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.

I would now like to turn the call over to Roger for his formal remarks.

Thank you, Stephanie.

Good morning, everyone.

I'm pleased to report strong progress on the Company's strategic objectives of leasing space, selling non-strategic assets, remaining disciplined with development starts and improving our balance sheet.

Leasing activity has outpaced our expectations this year.

Recall that we began the year tracking 400,000 square feet of demand for first generation space in three of our strategic markets, namely the Fort Meade area, the Fort Belvoir area and Redstone Gateway.

As of mid-October, we had leased a total of 2.3 million square feet of office space, including over 1 million square feet of first generation space, the majority of which is our development pipeline.

Said another way, the 1 million square feet of first generation space we've leased so far in 2012 represents over two times the initial 400,000 square feet of demand we were tracking.

The multiple leases we executed in early October with strategic tenants for three office buildings in Redstone Gateway, our development project in Huntsville, Alabama, represented the culmination of several months of intense competition for and negotiations with government contractors.

These leases, in particular, are proof that critical business decisions can and do get made despite the broader budgetary challenges facing the federal government and the Department of Defense.

On that note, let me take a moment to summarize COPT's understanding as to the likely outcomes surrounding sequestration.

Anecdotal evidence indicates one or a combination of three expectations.

First, that the January 3 deadline specified in the 2011 Budget Control Act will be extended; second, that less severe spending cuts will be implemented; and third, that sequestration cuts will not be implemented at all.

Even as the January 3rd deadline approaches, we have yet to see our defense-related tenants or the DOD begin to take meaningful steps necessary to implement the deep cuts currently outlined by the sequestration.

For example, the federal government and major contractors are, by law, required to give employees 60 days notice of scheduled reductions in force.

Based on the sequestration deadline, this implies thousands of notifications would be issued to workers just before the November elections.

We expect the sequestration deadline to be extended a few months into the spring of 2013 to allow for a more comprehensive compromise to be reached after the election.

We expect the compromise to include reductions to the DOD budget, but do not expect to see significant cuts for several reasons.

First, the global threat to the country are significant and real; second, the US wants to maintain its superpower status; third, money spent on the overseas contingency operations, which largely represent the wars in Iraq and Afghanistan has dropped from $180 billion in fiscal year 2008 to an expected $89 billion in fiscal 2013, which started October 1 and is projected to drop further in the coming years; fourth, the government's basic defense priorities are not shifting and increasingly are focused on cyber security and technology solutions; fifth, the base DOD budget has already leveled off.

Initial spending reductions under the 2011 Budget Control Act included $468 billion of cuts over 10 years that brought the DOD's rate of spending growth below that of inflation.

In fact, defense spending in the fiscal year that just ended decreased 2.9%.

In contrast, the rate of growth on entitlement spending has yet not been curtailed.

For the fiscal year 2012, Social Security and Medicare spending increased 5.9% and 3.2%, respectively, and are both on track to increase by 6% annually.

Said more concisely, defense spending is not the budget buster.

Then how will new spending levels affect our portfolio?

To the extent there are cuts, we anticipate only a modest impact on our business because the government demand drivers, with which our portfolio is aligned are knowledge-based defense installations, not weapons or troops oriented.

Their missions are priority programs, like cyber, that are directly related to national defense, so we expect these agencies' budgets to be largely maintained.

Recall also, we will be the beneficiary of longer term demographic shifts of jobs to our strategic locations as contractors move to be proximate to their government customers.

Turning back to strategic accomplishments, in the third quarter we disposed of 24 buildings that contained 1.5 million square feet for $178 million.

To date, we have sold $394 million of the $562 million of properties and land in the strategic reallocation program, or SRP, and are well ahead of our initial timeline for property dispositions.

Equally important, we reduced the number of leases we have to manage by approximately 30% and removed from our portfolio smaller, older buildings that require disproportionately more capital.

The majority of what is left in the SRP is about $50 million of land for development and the majority of our operating properties in Colorado Springs, the latter of which we anticipate selling in the next 12 months.

We have and will remain disciplined with starting new developments.

As page 24 of the supplemental shows, in the fourth quarter we will start construction on two new Class A office buildings at Redstone Gateway, both of which are 100% preleased.

Having no more inventory available at the National Business Park to accommodate future government demand, we also started construction on NBP 312.

Recall that NBP directly supports Fort Meade, which is the nexus of this country's cyber security efforts.

Last but not least, we continue to make progress on deleveraging our balance sheet.

Since the beginning of 2012, with the net proceeds from asset sales and our Series L Preferred issuance and our October common stock offering, we have reduced our debt by over $350 million and have improved our financial flexibility.

Two things I would like to highlight about our balance sheet before handing the call over to Steve Riffee.

First, our long-term capital strategy is to maintain and ultimately reduce our leverage from the level achieved by paying down debt with the October equity offering.

Second, the recent stock offering does not in any way lessen our sense of urgency about selling non-strategic assets.

We expect it will take more time to completely exit some markets, but we continue to view such asset sales as cost effective sources of capital with which to fund future growth, including near-term development spend and, if they present themselves, strategic acquisitions.

We will also continue to use dispositions in combination with improving cash flow from higher occupancies to further deleverage the balance sheet organically.

With that, let me hand the call over to Steve Riffee.

Steve?

Thanks, Roger, and good morning, everyone.

FFO, as adjusted for comparability, was $0.53 per share for the third quarter.

FFO as defined by NAREIT was $0.52 per diluted share.

Third quarter 2012 FFO per share as adjusted for comparability was $0.03 above the high end of our original third quarter guidance range, owing to lower-than-expected operating expenses and a penny of development fees.

Results were within the increased range we disclosed in a Form 8-K in early October.

Diluted loss per share was $0.39 for the quarter, as compared to earnings per share of $0.03 in the third quarter 2011.

The loss in the third quarter included two significant impairment charges, one related to our Colorado Springs operating properties that were already in the SRP and which we classified as held for sale during the quarter, and the second impairment related to shortening our anticipated holding period on our buildings in the Greater Philadelphia market.

Neither of these one-time losses affected FFO as defined by NAREIT or FFO as adjusted for comparability.

On a GAAP basis, same office NOI grew 2.5% from the third quarter of 2011.

On a cash basis, same office NOI excluding lease termination fees was flat on a sequential quarterly basis and our year-over-year same office cash NOI excluding lease termination fees declined by 2.1% in the third quarter, which was less negative than we had projected.

This decline was caused by a prepayment of rent in the third quarter of 2011.

Excluding the 2011 prepayment and lease termination fees, same office cash NOI increased 3.9%.

Our diluted AFFO payout ratio for the nine months ended September 30, as adjusted, was 54.7% and we expect our AFFO payout ratio for the full year to approach 65%.

Turning to the balance sheet, we made meaningful progress on our objective of deleveraging.

At September 30, the Company had $2.2 billion of debt outstanding and a debt-to-adjusted book ratio of 51.9%.

Debt to gross asset value is a ratio that is calculated according to our bank loan covenants.

At September 30, this ratio was 45.6% or about the same as it was at June 30.

Since we launched the SRP in April 2011, this ratio has improved by approximately 9 percentage points as of September 30, 2012.

Similarly, debt to recurring EBITDA was 9.1 times at March 31, 2011, and improved to 7.6 times as of September 30, 2012.

Subsequent to the quarter-end, we issued 8,625,000 shares of common stock, netting proceeds of $205 million.

We used the proceeds to reduce our indebtedness, and currently have zero drawn on our $800 million line of credit.

This equity raise brought our total debt repayment for 2012 to over $350 million.

Adjusting September 30 ratios to reflect the October stock offering, our pro forma ratios are debt to adjusted book of 48.3%, debt to gross asset value of 41.4%, and debt to recurring EBITDA of 7.2 times.

Now, turning to guidance.

We are narrowing our annual 2012 range for FFO per share as adjusted for comparability to a range of $2.05 to $2.08.

This range implies fourth quarter FFO per diluted share of $0.45 to $0.48.

I'll briefly update the major assumptions behind our guidance.

First is investments.

Our fourth quarter guidance range does not include any asset dispositions or purchases.

Although we have classified the operating properties in Colorado Springs that are in the SRP as held for sale, we anticipate selling them in 2013.

Second, we expect fourth quarter same office cash NOI to be approximately $1.8 million lower than the fourth quarter of 2011.

The year-over-year expected decline is primarily attributable to a one-time prepayment of rent we received from a tenant in the fourth quarter of 2011.

Additionally, due to the fact that 2011's exceptionally mild winter resulted in below average snow removal and utility costs, and that this year, we're budgeting for more normalized costs, the year-over-year results are otherwise flat.

In summary, we exclude the prepayment -- if we exclude the prepayment of rent in the third and fourth quarters of 2011, our 2012 forecast of same office cash NOI would be flat for the fourth quarter, and would increase 4% for the full-year versus 2011.

Third is occupancy.

At the end of the third quarter, the occupancy of our same office pool of assets was 89.3%, and our consolidated operating portfolio was 88.1%.

We expect same office occupancy to increase about 70 basis points in the fourth quarter, but because two unstabilized buildings are rolling off the development pipeline into the operating portfolio during the fourth quarter, we expect consolidated portfolio occupancy to decline 30 basis points.

Fourth, we expect G&A to be between $5 million to $5.5 million and total new business costs to be between $900,000 and $1,250,000.

Fifth, we forecast capitalized interest at $3.1 million for the fourth quarter.

And sixth, we expect straight line rents for the fourth quarter to approximate $3.8 million.

Finally, we will provide our 2013 earnings guidance on a separate conference call in January, the details of which will be provided in a press release later this year.

With that, I will now turn the call over to Steve Budorick.

Thanks, Steve, and good morning, everyone.

I'm going to provide an overview of fundamentals in our markets then discuss specifics on leasing volumes and economics, including average capital commitments.

In aggregate, the fundamentals in our major markets are not materially different than they were at the end of the second quarter as the commercial office markets in Maryland, Washington, DC, and Northern Virginia continue to be challenged by the uncertainty around the 2013 federal budget, the upcoming federal election in November, and the restraint in GSA leasing.

Overall, vacancies remain in the mid to high teens and third quarter absorption was slightly negative in the quarter, varying by market.

In terms of COPT's properties, our consolidated operating portfolio was 88.1% occupied and 89.9% leased at quarter end, up 70 and 60 basis points, respectively, from the end of the second quarter.

Our same office portfolio occupancy of 89.3% at the end of the third quarter was down 30 points sequentially.

Demand for our properties adjacent to government demand drivers has outpaced our initial expectations despite the challenging market conditions, which reaffirms our investment strategy, to concentrate on serving Department of Defense elements that conduct intelligence and cyber activities.

In terms of leasing volume, we leased a total of 612,000 square feet in the third quarter, of which 229,000 square feet related to development or redevelopment projects; 30,000 square feet represented other first generation space lease; 215,000 square feet were renewals; and 138,000 square feet were re-tenanted.

For the nine months ending September 30, we leased 1.9 million square feet of which 614,000 was first generation space, and 1.3 million square feet were related to renewing and re-tenanting activity.

As Roger mentioned, we completed over 2.3 million square feet of leasing so far in 2012, of which a million square feet related to our development pipeline and other first generation space.

These 1 million square feet include 397,000 square feet in the Baltimore Washington Corridor.

As a result of this leasing, NBP 316 and the Riverwood campus are both 100% leased.

We leased another 8,000 square feet in Springfield, Virginia, at Patriot Ridge.

That property is now 46% preleased and continues to get strong interest from prospective tenants attracted to our location's proximity to Fort Belvoir.

In Colorado Springs, this year we've leased 120,000 square feet of new leases through mid October, which increased our percentage leased in that market by 600 basis points to 83%.

Although we are exiting Colorado Springs and have the majority of our buildings there classified as held for sale, the incremental leasing we accomplished should translate into higher values.

In Blue Bell, Pennsylvania, we leased 66,000 square feet so far this year.

Because we've accomplished significant preleasing, we have started redevelopment on 755 Arbor Way, which we also refer to as Hillcrest II.

The supplement shows this property to be 28% preleased, but we also are in advanced negotiations with another large user.

Redeveloping Hillcrest II will substantially complete the initial campus setting we hope to establish at that project.

Lastly, and as detailed in a press release earlier this month, we leased 363,000 square feet at Redstone Gateway.

Strategic tenants have signed leases for 100% of three Class A office buildings there, including 1000 Redstone Gateway, which was shell complete in the first quarter of this year.

While leasing volume has exceeded our expectations, overall leasing statistics have been slightly negatively affected by more aggressive leasing on SRP assets and soft market conditions in Northern Virginia.

For the three months ended September 30, 2012, rents and renewals and re-tenanted leases signed rose 2% on a GAAP basis and declined 8.3% on a cash basis.

For the nine months ended September 30, rents on renewals and re-tenanted leases declined by 1.2% on a GAAP basis and 9.5% on a cash basis.

Recall that in the second quarter we experienced our first decline in GAAP rental rates since late 2009.

That quarter's GAAP rental rate declines were caused by aggressive leasing in SRP properties, short-duration, low TI deals on re-tenanted properties and several larger renewals on which we give high concessions that helps stabilize occupancy.

In the third quarter, we extended some leases prior to their contractual expiration to position assets for sale.

Now I want to put some color around our quarterly renewal statistics and cash roll down numbers.

First, regarding the renewal rate, about 33% of our expirations were negotiated to accommodate growth for those tenants or adjacent tenants.

These were actually positive events.

The renewal rate, after adjusting for these growth actions, is 58%.

Secondly, regarding the cash roll down, two significant transactions skewed the data.

A large early renewal completed to position an SRP asset for sale generated about 17% of the roll down, it also was accompanied by a 33% expansion.

Re-letting of a long-duration vacancy in Northern Virginia resulted in a comparison of a 2001 rent structure to current economics.

Northern Virginia re-tenanting, represented in three deals, generated 70% of the roll down.

Basic renewal activity, excluding re-tenanting and early renewals, actually produced a positive 3.7% increase in cash rents.

Going forward, we expect leasing economics to produce mildly positive GAAP rent increases and less negative cash rent roll downs.

Average capital commitments for the third quarter were high, averaging $16.94 a square foot on renewing and re-tenanted space.

Third quarter leasing did, however, fill some [stubborn] vacancies that I mentioned in Northern Virginia, and I would note that in 2013, our lease rollover is heavily weighted to the Baltimore Washington Corridor, where we have seen far more favorable economics and deals.

Also, on pure renewals, weighted average TIs and leasing commissions in the third quarter were only $8.65, which when amortized over the average lease length of 4.7 years, amounts to about $1.84 a square foot per year.

Average capital commitments for the year stayed in line with our expectations.

Average TIs and leasing commissions for the nine months ended September 30 of $11.60 were comparable to our recent historical average of about $11 per square foot.

Lastly, I'm very pleased to report the execution of our new first new lease at COPT DC-6, which many of you probably still call Power Loft, a high-growth, co-location tenant signed a lease for an initial commitment of 1 megawatt and we believe can expand well beyond that level.

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

Thanks, Steve.

I'll take a few minutes to go over four development projects, starting with the Blue Bell redevelopment in Greater Philadelphia market.

That office park, which we refer to as Arborcrest, has three buildings that are operational.

Woodlands I is a 219,000 square foot building fully leased to a Fortune 100 firm and is the only building in the park not slated for redevelopment.

Lakeside I is a 215,000 square foot building that is 100% leased to three tenants, the largest of which is Unisys.

Hillcrest I is listed on our redevelopment page in the supplement, the 113,000 square foot building is shell complete and 51% leased.

Responding to existing market demand for our project, we are moving forward with the redevelopment of Hillcrest II, a 184,000 square foot building that currently is 28% preleased.

In total, we've now signed leases for approximately 324,000 square feet with high quality tenants whose commitments to our park validate our investment strategy.

Finally, we had the first public presentation of our master plan for the long-term development of the park.

We anticipate this process will take 6 to 12 months to complete.

The objective is to increase the value of the undeveloped land by securing entitlements to allow the campus to ultimately encompass 1,365,000 square feet, including the 730,000 square feet we either have in operations or under redevelopment.

Moving to our strategic projects.

We are in the early stages of pricing out tenant improvement work in our Riverwood buildings in Columbia, Maryland.

The supplement lists two Riverwood Road property addresses that were leased together by the strategic tenant.

Because we completed the shell of the larger building in the fourth quarter of 2011, it will go into service about six months before the second smaller building.

The properties will begin contributing to FFO in the third quarter of 2013.

At the National Business Park, we are on schedule and on budget to complete the shell of our next contractor building, NBP 420, in the second quarter of 2013.

As Roger mentioned in his opening remarks, we continue to be very disciplined with our new development starts.

So once the remaining vacancy at NBP 316 was filled, we decided to commence construction on our next secured building in the NBP campus, NBP 312, which will be a (technical difficulty) square foot office building.

We also are under construction with the final phase of the northern extension of the National Business Parkway, which will be completed next spring.

It will provide connectivity to Route 175 and therefore, improve the access to the northern gate of Fort Meade and the amenity base surrounding the Arundel Mills mall.

Last, but certainly not least, some details on our Redstone Gateway project.

Infrastructure work for phase 1 is essentially complete and can now support up to 1.5 million square feet of office space.

Single story flex building we have under construction will be shell completed next month and we are seeing good prospect activity.

In terms of the three fully leased Class A office buildings we have under construction, RG 1000 is shell complete.

That improvement work starts in November and is scheduled to be completed in March of 2013.

We are scheduled to start construction on RG 1200 next month will be completed in December of 2013.

RG 1100 will start this January and is scheduled for shell completion in the first quarter of 2014.

This activity will establish an appealing front door for the business park and affirms its viability as a desirable location from which contractors can serve the multiple missions in Redstone Arsenal.

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

Thanks, Wayne.

In conclusion, we feel good about how 2012 is shaping up and the results we have achieved, and remain committed to staying focused on fully executing the Company's objectives of leasing space, selling non-strategic assets, remaining disciplined allocators of capital and deleveraging the balance sheet.

With that, operator, please open up the call for questions.

(Operator Instructions) Okay, we have our first question from the line of Sheila McGrath from Evercore Partners.

Please go ahead.

Yes, good morning.

Roger, you mentioned on the leasing of 1 million square feet at your development was well ahead of the 400,000 square feet of demand that you were tracking.

I was wondering if you could tell us what was driving that additional demand.

I think it had to do with pent-up demand for needs of mission providers to various government defense installations and we have been teeing up a lot of deals for an extended period of time and finally the -- we were able to get many of them across the finish line in the quarter, and so I think it was really cleaning up a backlog that had arisen over an extended period of time because of the uncertainty of what's going on in the defense industry and the uncertainty over the future budgets.

But fortunately the missions that we deal with are very strategic and had to move forward, and so people made decisions and allowed their space needs to be taken care of.

Okay, and one last question.

Could you give us your insights post-election?

Do you think that some of the tenants that have been (technical difficulty) more activity at your project?

This is Steve Budorick answering.

Yes, we do expect that.

Exactly how it plays out is tough to predict, but eventually our congressmen and our leadership will address the problem.

We have many, many customers who have made plans to commit additional monies in term to leases that we have, that have [told] those actions until they get by the election.

So I would expect somewhere around March that activity will start breaking loose again.

Okay, thank you.

Thanks for your questions, Sheila.

We have our next question from the line of John Guinee from Stifel.

Please go ahead.

John Guinee here.

First and foremost, congratulations on Redstone Arsenal, well done.

Thank you.

Second, sort of a big picture question, Roger.

As you know, right after 9/11 you saw a lot of rapid take down of space within the defense industry at pretty full rents, whether it's the Department of Defense or the defense contractors.

And what's going on right now is there's a contraction and a rationalization of their space needs, both in terms of square footage and rental rates.

When do you think that actually finishes happening, and the big defense contractors that drive your business say we're done, we've rationalized our space and we've rationalized the pricing?

Well, we have been experiencing for an extended period of time the rationalization of the business, and so we have suffered some contractions over the last several years.

Fortunately, we've been able to backfill most of that space with people who were winners under the new contracting paradigm and are focused on missions that have more importance going forward.

And I do think that that will continue on.

Fortunately, around Fort Meade, the agencies that support Fort Meade are on the leading edge of contracting when it comes to contracting with midsize and small size contractors.

Many of the agencies you have got to go through one of the big four or eight primes that deal with an agency.

Fortunately, at Fort Meade, they really have a leadership structure that allows for contracting to midsize and smaller contractors, and they are the gazelles, they are the groups that are winning a lot of business, and are providing the solutions that the government needs.

So we think that -- although as you suggest, the big primes with some of their legacy weapons programs that will get curtailed or deferred, will shrink somewhat, although we're not that exposed to the legacy weapons systems, we do think that the gazelles will continue to power forward, and then of course we have the force demographic shifts of BRAC coming to Maryland and to Huntsville over an extended period of time.

Great, thank you.

Thank you very much for your question, Mr. Guinee.

We have a next question from the line of George Auerbach from ISI Group.

Please go ahead.

Great, thanks, and good morning.

Roger, just to get back to Sheila's question about pent-up demands and John's question about the BRAC demand.

Can you quantify for us what the demand outlook is from those relocations?

Do you expect to come to your portfolio over the next few years?

I understand that there's going to be winners and losers, but to what extent is the continued move a net beneficiary to your portfolio?

Well, George, first of all, when we step back and try to analyze the demand versus what we expected the demand to be back in 2005 and 2006, realistically, because of efficiencies, we think we're looking at a number that's about 80% of what used to exist, and we think we have realized about one-third of the ultimate moves in the various locations.

That varies a little bit depending on the location, but we still think there's another two-thirds of an 80% number of what the original number was, in terms of growth, job growth to be realized.

And we think that's going to be realized over the next three or plus years as contracts mature and people have certainty and are willing to move to their new locations to support the government customer.

Okay.

I guess the 2012 guidance shows occupancy ticking up on the same store basis by about 70 basis points.

I guess given the outlook today and assuming Congress doesn't do anything crazy, how do you see that occupancy number trending through 2013?

We think we're going to continue to keep chipping away at our vacancy.

There will be set backs in the future, but we think we'll continue to clip along at somewhere in the half to full point over the next year.

Okay, and finally, Roger, given the -- what seems like better demand for the development product, I guess how do you see development starts on an annual basis kind of going forward for the Company?

I don't know that we can for sure put a number on it.

I think it's reasonable to expect that we could get to --- be around 500,000 square feet per year and that's assuming a building a year down in Huntsville, a building or two up at NBP, and a building down in Fort Belvoir.

And then of course, we are pursuing other locations in terms of needs from contractors and the government, but again they're going to be uneven.

I think the message I should leave you with is that I don't think we can put a number every year.

I think the business is going to be a little bit uneven going forward and we'll have fits and starts where we'll have more than 500,000 square feet in the year and then there will be years where we have less than that.

Great, thank you.

Thank you for your questions.

We have a next question from the line of Brendan Maiorana.

Please go ahead.

Thanks.

Good morning.

Question --- it's probably for Steve Budorick.

But the economics on the development pipeline leasing, is that in line with your forecast or are economics getting better or are they a little bit more challenged, which has allowed you to increase that leasing activity?

No, they're generally in line.

In Huntsville, we built one building, very high quality, and the overall yield might be a little less than our target for that market, because of the costs on the first building.

But the second two buildings were right in line, and in NBP we're right in line as well.

So -- and then again, in Fort Belvoir area, we're very pleased with the rates we're achieving in that building.

Okay, that's helpful.

Question for Steve Riffee.

Steve, I think when you had given guidance for Q3, originally there was --- I think operating expenses were likely to be a little bit higher sequentially in the quarter.

Is part of -- and when I look at the guidance for Q4, relative to what you guys did in Q3, it seems like maybe was there -- are there some operating expenses that are getting pushed into Q4 that you originally thought were going to be in Q3?

Well, they're -- some of the savings in Q3 is timing related to the scheduling of maintenance projects that are bleeding over a little heavier in the fourth quarter than we thought.

Some of the ramp-up in the expenses in the fourth quarter relative to the third quarter is we're providing for the possibility of snow and higher utility costs in that month and we had a pretty mild quarter here in the third quarter.

So I guess if I just think about it mathematically, the offering was $0.03 dilutive on a sequential basis; is that right?

Yes.

Okay, so then the additional --

Quarter-to-quarter.

Quarter-to-quarter, right, yes, exactly.

So your $0.53 would be down to $0.50 and you guys are saying it's sort of like $0.47, so there's an additional $0.03 of cost in the fourth quarter?

Correct, well additional --

Okay.

Is the fourth quarter -- I mean do you expect that those costs -- the operating margin is likely to improve as you go into '13 or is the fourth quarter a good run rate in terms of where your margins are likely to be as you look out for a more annualized basis?

No, the fourth quarter is probably a bad one to look at because there is a lot of repair work, major projects that got pushed deep into the year.

I have to say we have had a very busy year, if you think about some of the actions that we took -- that we took earlier in the year, and we've reorganized our teams and refocused them and we got a little behind schedule on those repairs.

The margins should improve as we go into the first quarter.

Sure, okay, that's very helpful.

Last one for me for Steve Riffee again.

We were talking a couple of weeks ago about the balance sheet, the outlook.

Given that you've got Blue Bell now which eventually will be sold, you've got the SRP which is winding up, but you still have some sales to go and this most recent equity offering, if you guys lease up to where you expect to get to, you do the dispositions that you expect and you complete the development pipeline, does that put your leverage metrics where you think they should be from either a debt to gross asset value basis, debt to EBITDA, or do you think there's some additional deleveraging that would need to happen?

We're really happy with the amount of progress we've made from deleveraging if you think about it from the beginning of the SRP, and we made great progress on the equity offering.

I think that the thing that's going to have the biggest impact on leverage in the near term is going to be continuing the SRP asset sale and leasing up our portfolio toward stabilization.

I think that's going to make progress in the near-to-intermediate term.

And then longer term, we may have opportunities to deleverage further, but that's not our immediate focus.

Okay, so as long as things keep on plan with lease up and with the SRP, you guys feel pretty good about it?

Yes.

As Roger said, we want to maintain leverage at the levels that they're at and over time, further improve the leverage ratios on the balance sheet.

Okay, all right.

Great, thank you.

Thank you very much for your questions, Brendan.

We have a next question in the queue from the line of Dave Rodgers from Robert W. Baird.

Please go ahead.

Hey, good morning, guys.

Maybe first question for Roger or if you want to pass it off, but on an apples-to-apples basis, is it getting easier or harder to sell some of the SRP assets just given some of the volatility in the market?

I think it's still relatively easy, because I do think capital is very cheap and I do think a lot of money has been raised to buy, and I think people think that they can spread invest and maybe take a little bit of a residual value risk on the back end, but they feel like they can make enough margin on spread investing, that they're willing to go forward.

So we haven't seen any shortage of capital or capital has not been an impediment to our ability to sell in the past and we don't view that currently as we're talking to people about further sales.

And so pricing on the assets going forward should be fairly similar, at least on a market-by-market basis?

On a market-by-market, I would say that Colorado Springs, the NOI --- the cap rate that we're going to sell is going to be higher than what we've sold up until now.

But, if we were to sell more in this region, we think we can still achieve eight or below on those sales.

Okay, thank you.

Maybe for Steve Budorick.

The leased versus occupied percentage I think implies 330,000, 340,000 square feet of leasing going forward.

Is that timing in the near term or is that protracted at all?

Then I guess as a tie-in to that, 4Q rolls look like they're fairly heavy.

I didn't hear if you said what the year-end occupancy target was, so if you could run through those that would be great.

Well, Dave, fortunately the 4Q rolls are all pretty large tenants that we're very confident are going to extend some of that documentation, may actually not occur until the first quarter of 2013.

But we think we've all ready suffered the majority of our occupancy issues for 2012, and going into 2013, we only have one significant tenant near-term in 2013 that we know is going to roll out that's about 100,000 square feet.

Okay.

Going back to the question on the development yields.

What are you seeing in terms of the construction side of the equation?

Clearly market rents are under pressure, but are you seeing any upward pressure on construction prices that would concern you about maybe the future of development starts and the ability to hold yield?

Dave, it's Wayne.

I would tell you that as we look across the markets, obviously we are active in several right now that we have seen very modest increases in costs.

They're probably ticked up off the bottom that we saw a year or two ago, but nothing that indicates rates of increase that would be a concern to us as we look out at the development pipeline.

Great.

Last question, Steve Riffee.

I don't know if this is something you've given before, but as you go from 4Q this year into first quarter next year, can you talk about what the impact from a GAAP accounting perspective will be for the data center property?

Well, we're not ready to give our guidance yet for 2013.

Clearly we've got some leasing that we just did in this quarter, and that took down the cash NOI to the leasing activity this quarter.

So we'll update you with our 2013 lease assumptions on the January call.

All right, great.

Thanks, guys.

Thank you for your questions.

The next question is from the line of Josh Attie.

Please go ahead.

Thanks, good morning.

I think after the current asset sell program is complete, the portfolio will be about two-thirds core tenants and one-third traditional suburban office and there's a big difference in the fundamental outlook probably for those assets and you also may want to further delever your balance sheet over time.

So I guess in that context, are you considering an additional asset sale program for 2013 or 2014 beyond what might be in the current SRP?

Well, first of all, we have the Arborcrest project up in Blue Bell that as we realize the value creation program that we're currently in the midst of, we think we will sell.

Beyond that, in terms of this region, what we think we'll be doing going forward is just being a regular asset recycler, so we will on an ongoing basis be selling, whatever, $50 million, $100 million a year of assets in order to keep our portfolio young and well located and strategic in nature.

So as we think about 2013 earnings and potential dilution from sales, we shouldn't expect much beyond $170 million or so that's currently in the SRP?

Is that the right way --?

That's correct.

Okay.

Then separate question on the development pipeline.

I know you've mentioned that you're not seeing much change in your returns and in the rental rates you're getting, but is there any elasticity in the rental rates?

I know there's an element of -- that people just aren't signing leases, but if you were to lower your rental rate does that at all induce demand in the pipeline?

As you know, generally it doesn't, meaning you can pick people out of other buildings; you don't create new demand, but the nature of our business with price reduction.

So, yes, we could entice some current tenants out of other buildings because we have a new building at a fair rental rate, but it's -- I don't think we're going to be able to create new demand from reducing our rental rates.

Plus the demand for our new developments is really associated with the demand driver, and people leasing those buildings for very specific reasons and business purposes, and you're really not going to attract somebody with a cheap rate who wouldn't otherwise be associated with that demand driver.

Okay, thank you very much.

Thank you for your questions.

(Operator Instructions) We have a next question in the queue from the line of Michael Knott from Green Street Advisors.

Please go ahead.

Hey, everyone.

Just a question on the investment sales market.

Just curious if there's still sort of a dislocation in the -- especially with contractor tenanted buildings and if you're seeing any more opportunities to acquire buildings like the Virginia property that you've acquired in the recent past?

Well, we aren't giving a big focus on acquisitions right now.

We are softly in the market at all times in order to understand the market and see if there are great opportunities, but I would say that we're not competing in any auctions and we would only buy something if we felt like it was highly strategic and we could take advantage of, as you greatly put, the uncertainty that exists in the Greater Washington region right now.

The building we bought in July we were able to underwrite it differently than other people because we were able to dissect what exactly was going on in the building.

So to the extent that we have knowledge advantage over someone in terms of underwriting, we could make an acquisition, but I don't think we're betting our 2013 business plan on that.

So are investors in general underwriting -- is that underwriting back to normal with respect to defense tenants or is it still somewhat discombobulated a little bit?

Yes, I think you have a standoff between the buyers and the sellers.

The buyers are concerned about where rents are going to go and occupancy, and the sellers are just willing to sit out the selling period until there's more certainty with the election and the ultimate outcome of the budget resolution.

So that dynamic that was there when you bought that building over the summer is still there, but you just aren't seeing any specific opportunities that would fit your overall strategic needs?

That's correct.

Okay.

Thanks.

Thank you for your questions.

We have a next question from the line of Rich Anderson from BMO Capital Markets.

Please go ahead.

Thanks.

Good morning.

Morning.

I just wanted to make sure I understood this correctly.

Did you say that your cash NOI would have been up 3.7% if not for the Northern Virginia and the SRP aggressive leasing influence?

No.

I missed that then.

Can you --?

No, that statistic was the change in cash (technical difficulty) transactions excluding re-tenanting and early renewals --

Okay, cash rents?

Was positive 3.7.

Okay, gotcha.

Thank you.

The remaining $168 million of SRP sales -- being mostly land in Colorado Springs; does that represent an exit of Colorado Springs?

Largely speaking, there are a few assets in Colorado Springs that are tied to a loan that are in a CMBS pool so we're not going to be able to unwind about five of the buildings in Colorado Springs, but the rest of the buildings are unencumbered and we have the ability to sell them into the market.

Okay, so you would be a seller though if not for the CMBS tie up; is that correct?

That's correct.

Okay, an eventual seller at some point down the road out of Colorado Springs?

That's correct.

Okay.

I guess Blue Bell being $100 million or so, eventual sale, and you said $50 million to $100 million on an ongoing basis.

So once you're beyond the bulk of SRP, you have got a dividend payout of 65%, things are starting to feel a little bit better, can you comment at all about dividend policy and what your target dividend payout ratio might be once you're beyond all this noise?

Historically, the Company has had an AFFO payout ratio of around 80% and obviously as we increased the dividend during the 2009/10 period, we outstripped that percentage.

I think the Company's goal would be to be around 75% or a little below going forward.

I think in this environment you want to be -- have financial flexibility and run the Company conservatively.

Okay.

So that's kind of on hold for now as you go through this, but you reunite yourself with maybe a growing dividend model, maybe a year or two out.

Is that a fair way to think about it?

That's right.

We don't feel like we've done a full reset of the Company yet.

We're still in the midst of doing that.

As soon as we do a full reset, then we'll evaluate growing the dividend.

Okay, fair.

Then finally, just so I understand the Huntsville play.

Isn't that more of hard defense cost type of initiatives as opposed to the cyber and defense intelligence that permeates most of your portfolio?

Is that a correct characterization of Huntsville?

Somewhat.

Certainly, it's not as core in cyber as the Fort Meade area, but there is intelligence agency activity on that base.

Also, when you think about Huntsville, you really -- I recommend you pay a visit.

It's a research development --

Waiting for the invite.

What's that?

I'm waiting for the invite.

All right, well I need an [e-mail].

Research, development, testing, and evaluation center for many weapon systems, so it's really knowledge-based and it's a very exciting place to go understand what they're doing there.

And then in the context of a constrained budgetary environment that you could foresee in the next few years, that means that the Army needs to extend the useful life of the weapons systems they have and update the technology and implement that because it's more cost effective than new systems.

And that plays right into the hands of the highly engineering-oriented nature of the people in the Redstone Gateway.

Does the leasing success that you had recently there cause you to think differently about the overall portfolio or is that kind of consistent with what you're trying to do overall with defense intelligence and cyber and all the rest?

I think our goal again is to locate adjacent to defense installations that are on the cutting edge of solving the nation's problems as we go forward.

So those things, as Steve mentioned, that are research and development in nature, high-tech in nature, and cyber in nature, and so Redstone Arsenal happens to have a lot of those elements that are consistent with Fort Meade and Fort Belvoir.

Okay, fair enough.

Thanks for the color.

Thank you for your questions.

(Operator Instructions) We have one more question in the queue from the line of Michael Carroll from RBC Capital Markets.

Please go ahead.

Yes, thank you.

With regard to the recent data center lease, can you quantify or give us a timeframe of the expansion possibilities, and if that is something near-term or not?

Well, it's hard to handicap somebody else's business, but in our conversations with the CEO of the organization, the 1 megawatt ramps up at a minimum over three years.

It looks like their initial deployment will exceed their minimum by almost 50%, and he has represented to us that relatively quickly he thinks he could make a substantially bigger commitment if his business plan materializes the way he is expecting it to.

Is this a government tenant?

It is not.

And then finally, you're still generating, what, 10% cash-on-cash returns from your developments, correct?

That's still your goal?

Well, I think that's a goal.

What we're experiencing right now is high single digits.

We do have some projects that are above 10%, but we have a lot that are below 10% like in the three deals that we just did in Huntsville because again, as Steve and Wayne mentioned, we built a very high-quality building for the first building and we wanted to seed the park and create the ecosystem that would allow us to grow that location going forward.

Okay, great.

Thanks.

Thank you, Michael, for your questions.

Ladies and gentlemen, that's all the time we have for questions today.

I will now turn the call back to Mr. Waesche for closing remarks.

Please go ahead.

Thank you all again for joining us today.

If your question did not get answered on this call, we're in our offices and available to speak with you later.

Thank you very much.

Thank you.

Thank you for your participation today in the Corporate Office Properties Trust third quarter 2012 earnings conference call.

This concludes the presentation.

You may now disconnect.

Have a good day.