Exhibit 13.1

 

Selected Financial Data

 

The following table sets forth summary financial data as of and for each of the years ended December 31, 1999 through 2003.  The table illustrates the significant growth our Company experienced over the periods reported.  Most of this growth, particularly pertaining to revenues and earnings from real estate operations and total assets, was attributable to our addition of properties through acquisition and development activities.  We financed most of the acquisition and development activities by incurring debt and issuing preferred and common equity, as indicated by the growth in our interest expense, preferred share dividends and weighted average common shares outstanding.  The growth in our general and administrative expenses reflects the growth in management resources required to support the increased size of our portfolio.  Since this information is only a summary, you should refer to our Consolidated Financial Statements and notes thereto and the section of this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information.

 

Corporate Office Properties Trust and Subsidiaries

(Dollar and share information in thousands, except ratios and per share data)

 

		2003			2002			2001			2000			1999
Real Estate Operations:
Revenues
Rental revenue (1)		$	153,048		$	134,421		$	107,166		$	89,946		$	66,747
Tenant recoveries and other revenue		21,375			15,914			14,497			15,196			10,733
Revenue from real estate operations		174,423			150,335			121,663			105,142			77,480
Expenses
Property operating		51,699			43,929			35,413			30,162			21,187
Interest		41,079			39,065			32,297			29,786			21,190
Amortization of deferred financing costs (1)		2,767			2,501			2,031			1,535			1,878
Depreciation and other amortization (1)		37,122			30,859			20,405			16,513			11,646
Expenses from real estate operations		132,667			116,354			90,146			77,996			55,901
Earnings from real estate operations before equity in (loss) income of unconsolidated real estate joint ventures		41,756			33,981			31,517			27,146			21,579
Equity in (loss) income of unconsolidated real estate joint ventures		(98		)	169			208			—			—
Earnings from real estate operations		41,658			34,150			31,725			27,146			21,579
Income (losses) from service operations		807			(875		)	(782		)	(310		)	198
General and administrative expenses		(7,893		)	(6,697		)	(5,289		)	(4,867		)	(3,204		)
Income before gain on sales of real estate, minority interests, income taxes, discontinued operations and cumulative effect of accounting change		34,572			26,578			25,654			21,969			18,573
Gain on sales of real estate (2)		472			2,564			1,618			107			1,140
Income before minority interests, income taxes, discontinued operations and cumulative effect of accounting change		35,044			29,142			27,272			22,076			19,713
Minority interests		(6,714		)	(7,356		)	(8,415		)	(7,976		)	(5,747		)
Income before income taxes, discontinued operations and cumulative effect of accounting change		28,330			21,786			18,857			14,100			13,966
Income tax benefit, net of minority interests		124			242			269			—			—
Income from discontinued operations, net of minority interests (3)		2,423			1,273			970			1,034			1,117
Cumulative effect of accounting change, net of minority interests (4)		—			—			(174		)	—			—
Net income		30,877			23,301			19,922			15,134			15,083
Preferred share dividends		(12,003		)	(10,134		)	(6,857		)	(3,802		)	(2,854		)
Repurchase of preferred units in excess of recorded book value (5)		(11,224		)	—			—			—			—
Net income available to common shareholders		$	7,650		$	13,167		$	13,065		$	11,332		$	12,229
Basic earnings per common share
Income before discontinued operations and cumulative effect of accounting change		$	0.20		$	0.53		$	0.61		$	0.55		$	0.71
Net income available to common shareholders		$	0.29		$	0.59		$	0.65		$	0.60		$	0.72
Diluted earnings per common share
Income before discontinued operations and cumulative effect of accounting change		$	0.19		$	0.51		$	0.60		$	0.54		$	0.64
Net income available to common shareholders		$	0.27		$	0.56		$	0.63		$	0.59		$	0.66
Weighted average common shares outstanding – basic		26,659			22,472			20,099			18,818			16,955
Weighted average common shares outstanding – diluted		28,021			24,547			21,623			19,213			22,574

 

 

		2003			2002			2001			2000			1999
Balance Sheet Data (as of period end):
Investment in real estate (1)		$	1,189,258		$	1,042,955		$	923,700		$	751,587		$	696,489
Total assets (1)		$	1,332,076		$	1,138,721		$	994,896		$	794,837		$	721,034
Mortgage and other loans payable		$	738,698		$	705,056		$	573,327		$	474,349		$	399,627
Total liabilities (1)		$	801,899		$	749,338		$	626,193		$	495,549		$	416,298
Minority interests		$	79,796		$	100,886		$	104,782		$	105,560		$	112,635
Shareholders’ equity		$	450,381		$	288,497		$	263,921		$	193,728		$	192,101
Other Financial Data (for the year ended):
Cash flows provided by (used in):
Operating activities		$	67,783		$	62,242		$	50,875		$	35,026		$	32,296
Investing activities		$	(172,949	)	$	(128,571	)	$	(155,741	)	$	(73,256	)	$	(125,836	)
Financing activities		$	108,656		$	65,680		$	106,525		$	40,835		$	93,567
Numerator for diluted EPS		$	7,650		$	13,711		$	13,573		$	11,332		$	14,788
Basic funds from operations (6)		$	59,665		$	49,696		$	40,206		$	34,434		$	26,525
Diluted funds from operations (6)		$	61,268		$	52,854		$	43,001		$	37,351		$	30,498
Diluted funds from operations per share (6)		$	1.56		$	1.44		$	1.28		$	1.16		$	1.04
Cash dividends declared per common share		$	0.91		$	0.86		$	0.82		$	0.78		$	0.74
Ratio of earnings to combined fixed charges and preferred share dividends		1.11			1.25			1.26			1.30			1.42
Property Data (as of period end):
Number of properties owned (7)		119			110			98			83			79
Total rentable square feet owned (in thousands) (7)		10,033			8,942			7,801			6,473			6,076

 

(1)   Certain prior period amounts have been reclassified to conform with the current presentation.  These reclassifications did not affect consolidated net income or shareholders’ equity.  You should refer to the section in Note 3 to our Consolidated Financial Statements entitled “Acquisitions of Real Estate” for a description of our reclassification in connection with our accounting under Statement of Financial Accounting Standards No. 141, “Business Combinations.”  You should also refer to the section in Note 3 to our Consolidated Financial Statements entitled “Recent Accounting Pronouncements” for a description of our reclassification of losses on early retirement of debt in connection with our adoption of Statement of Financial Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections” on January 1, 2003.

(2)   Reflects gain from sales of properties and unconsolidated real estate joint ventures not associated with discontinued operations.

(3)   Reflects income derived from one operating real estate property that we sold in 2003 (see Note 18 to our Consolidated Financial Statements).

(4)   Reflects loss recognized upon our adoption of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (discussed in Note 10 to our Consolidated Financial Statements).

(5)   Reflects a decrease to net income available to common shareholders representing the excess of the repurchase price of the Series C Preferred Units in our Operating Partnership over the sum of the recorded book value of the units and the accrued and unpaid return to the unitholder.

(6)   For definitions of basic funds from operations, diluted funds from operations per share, diluted funds from operations and reconciliations of these measures to their comparable measures under generally accepted accounting principles, you should refer to the section entitled “Funds from Operations” within the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

(7)   Amounts reported for December 31, 2003 include one property totaling 157,394 rentable square feet held through a joint venture.  Amounts reported for December 31, 2001 include two properties totaling 135,428 rentable square feet held through two joint ventures.

 

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

Corporate Office Properties Trust (“COPT”) and subsidiaries (collectively, the “Company”) is a real estate investment trust, or REIT, that focuses on the ownership, management, leasing, acquisition and development of suburban office properties located in select submarkets in the Mid-Atlantic region of the United States.  We conduct our real estate ownership activity through our operating partnership, Corporate Office Properties, L.P. (the “Operating Partnership”), for which we are the sole general partner.  The Operating Partnership owns real estate both directly and through subsidiary partnerships and limited liability companies.  The Operating Partnership also owns an entity through which we provide real estate-related services that include (1) property management, (2) construction and development management and (3) heating and air conditioning services and controls.  The number of operating properties in our portfolio totaled 119 as of December 31, 2003, 110 as of December 31, 2002 and 98 as of December 31, 2001.  Our growth in number of operating properties over that timeframe was achieved primarily through our acquisition and development of properties.

 

REITs were created by the United States Congress to provide large numbers of investors with the ability to invest in real estate and receive income from such investments that would be free from income tax on REIT taxable income at the entity level, provided that the entity distributes 100% of its REIT taxable income and meets a number of other strict requirements (it is noteworthy that REITs are required to distribute only 90% of REIT taxable income to maintain their tax status as a REIT, although any differential between the 90% and 100% would be taxable).   Most of our revenues come from rents and property operating expense reimbursements earned from tenants leasing space in our properties.  Most of our expenses take the form of (1) property operating costs, such as real estate taxes, utilities and repairs and maintenance, (2) financing costs, such as interest and loan costs and (3) depreciation and amortization of our operating properties and tenant lease costs.

 

The attributes we look for in selecting submarkets include, among others, (1) proximity to large markets, (2) strong demographics, (3) attractiveness to high quality tenants, including our existing tenants, (4) potential for growth and stability in economic down cycles and (5) future acquisition and development opportunities.  Once we select a submarket, our strategy generally involves establishing an initial presence by acquiring properties in that submarket and then increasing our ownership through future acquisitions and development until we own a significant portion of the rental space in that submarket of the same class as our properties.  Due to this strategy, we own most or all of the same class office space in a number of the submarkets in which we own properties.  As of December 31, 2003, most of our submarkets were located in (1) the Baltimore/Washington Corridor (defined as the Maryland counties of Howard and Anne Arundel), (2) Northern Virginia (defined as Fairfax County, Virginia), (3) Northern Central New Jersey, (4) Greater Philadelphia, Pennsylvania, (5) Greater Harrisburg, Pennsylvania and (6) Suburban Maryland (defined as the Maryland counties of Montgomery and Prince George’s).

 

Achieving optimal performance from our properties is crucial to our Company.  We evaluate the performance of our properties by focusing on changes in revenues and property operating expenses.  While we experienced significant growth in revenues from real estate operations and property operating expenses between 2001 and 2003, our growth in number of properties makes such revenue and expense growth misleading.  Therefore, we evaluate the changes in revenues and property operating expenses attributable to property additions and property sales separately from the changes attributable to properties that were owned and operational throughout any two periods being compared (these concepts are discussed further in the section entitled “Results of Operations”).  In addition to evaluating changes in the main components of revenues from these property groupings ((1) rental revenues and (2) tenant recoveries and other revenues), we consider the portion of any change in rental revenue from these properties that is attributable to (a) straight-line rental revenue adjustments and (b) amortization of origination value of leases on acquired properties; these revenue adjustments, which are discussed and defined in greater detail in Note 3 to the Consolidated Financial Statements, are important to us in evaluating changes in total rental revenue because such adjustments are not indicative of the cash revenue stream from those properties.

 

In order to maximize the revenue potential of our properties, we try to maintain high levels of occupancy; as a result, we consider occupancy rates to be an important measure of the productivity of our properties.  One way that we attempt to maximize occupancy rates is by renewing a high percentage of our existing tenants; accordingly, tenant renewal rates are important to us in monitoring our leasing activities and tenant relationships.  In managing the effect of our leasing activities on our financial position and future operating performance stability, we also monitor the timing of our lease maturities with the goal being that such timing not be highly concentrated in a given one-year or five-year period.

 

 

We focus on tenants that are large, financially sound entities with significant long-term space requirements.  A number of these tenants lease a significant portion or all of the space in individual properties, and in some cases these tenants lease all of the space in a number of our properties.  Through this strategy, our goal is to become a preferred landlord for such tenants.  A result of this strategy is that most of our revenues come from a highly concentrated number of tenants.  Since we rely on a relatively small number of tenants for such a large portion of our revenues, we closely monitor the concentration levels we have with our tenants, particularly our 20 largest tenants.  In addition, as we discuss below, a high concentration of our revenues is generated from tenants in the United States defense industry (comprised of the United States Government and defense contractors); we monitor this level of concentration from a business risk perspective.

 

Cash provided from operations is our primary source of cash for funding dividends and distributions, debt service on our loans and other working capital requirements.  A good place to start in evaluating our cash flow provided by operations is the line entitled “net cash provided by operating activities” on our Statements of Cash Flows.  We also believe that the amount that we incur on our operating properties for tenant and capital improvements and leasing costs are particularly useful in evaluating our cash flow from operations since these costs are required to operate our properties; we provide this information in the section entitled “Funds from Operations.”  Since we are a REIT and therefore distribute 100% of our REIT taxable income in order to avoid paying income taxes, our dividends and distributions paid are also useful in determining how much cash we have available for other uses; however, it is noteworthy that we have historically paid dividends in excess of our REIT taxable income (see Note 17 to our Consolidated Financial Statements for further discussion of income taxes).

 

We historically have financed our long-term capital needs, including property acquisition and development activities, through a combination of the following:

 

•      borrowings under our primary revolving credit facility (the “Revolving Credit Facility”);

•      borrowings from new loans;

•      issuances of common shares of beneficial interest (“common shares”), preferred shares of beneficial interest (“preferred shares”) and common units and/or preferred units in our Operating Partnership;

•      contributions from outside investors into real estate joint ventures;

•      proceeds from sales of real estate; and

•      any available residual cash flow from operations after application to the items described in the previous paragraph.

 

One aspect of how we manage our financing policy involves monitoring the relationship of certain measures of earnings to certain financing cost requirements; these relationships are known as coverage ratios.  The coverage ratios on which our financing policy focuses are debt service coverage ratio (defined as various measures of results of operations divided by the sum of (1) interest expense on continuing and discontinued operations and (2) scheduled principal amortization on mortgage loans for continuing and discontinued operations) and fixed charge coverage ratio (defined as various measures of results of operations divided by the sum of (a) interest expense on continuing and discontinued operations, (b) dividends on preferred shares and (c) distributions on preferred units in our Operating Partnership not owned by us).  These coverage ratios are important to us in evaluating whether our operations are sufficient to satisfy the cash flow requirements of our loans and equity holders, including minority interest holders.  Another aspect to our financing policy involves monitoring the relationship of our total variable-rate debt to our total assets; this is important to us in limiting the amount of our debt that is subject to future increases in interest rates.  We also closely monitor the timing of our debt maturities to ensure that the maximum maturities of debt in any year, both including and excluding our Revolving Credit Facility, do not exceed a defined percentage of total assets.

 

In this section, we discuss our financial condition and results of operations for 2003 and 2002.  This section includes discussions on, among other things:

 

•      our results of operations and why various components of our Consolidated Statements of Operations changed from 2002 to 2003 and from 2001 to 2002;

•      how we raised cash for acquisitions and other capital expenditures during 2003;

•      our cash flows;

•      how we expect to generate cash for short and long-term capital needs;

•      our off-balance sheet arrangements in place that are reasonably likely to affect our financial condition, results of operations and liquidity;

•      our commitments and contingencies;

 

 

•      our accounting policies that require our most difficult, subjective or complex judgments and materially affect our reported operating performance or financial condition; and

•      the computation of our Funds from Operations for 2003, 2002 and 2001.

 

You should refer to our Consolidated Financial Statements and Selected Financial Data table as you read this section.

 

This section contains “forward-looking” statements, as defined in the Private Securities Litigation Reform Act of 1995, that are based on our current expectations, estimates and projections about future events and financial trends affecting the financial condition and operations of our business.  Forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “estimate” or other comparable terminology.  Forward-looking statements are inherently subject to risks and uncertainties, many of which we cannot predict with accuracy and some of which we might not even anticipate.  Although we believe that the expectations, estimates and projections reflected in such forward-looking statements are based on reasonable assumptions at the time made, we can give no assurance that these expectations, estimates and projections will be achieved.  Future events and actual results may differ materially from those discussed in the forward-looking statements.  Important factors that may affect these expectations, estimates and projections include, but are not limited to:

 

•      our ability to borrow on favorable terms;

•      general economic and business conditions, which will, among other things, affect office property demand and rents, tenant creditworthiness, interest rates and financing availability;

•      adverse changes in the real estate markets, including, among other things, increased competition with other companies;

•      risks of real estate acquisition and development activities;

•      risks of investing through joint venture structures, including risks that our joint venture partners may not fulfill their financial obligations as investors or may take actions that are inconsistent with our objectives;

•      governmental actions and initiatives; and

•      environmental requirements.

 

We undertake no obligation to update or supplement forward-looking statements.

 

 

Corporate Office Properties Trust

Operating Data Variance Analysis

 

(Dollars for this table are in thousands, except per share data)

 

		For the Years Ended December 31,											For the Years Ended December 31,
		2003			2002			Variance			% Change		2002			2001			Variance			% Change
Real Estate Operations:
Revenues
Rental revenue		$	153,048		$	134,421		$	18,627		14	%	$	134,421		$	107,166		$	27,255		25	%
Tenant recoveries and other revenue		21,375			15,914			5,461			34	%	15,914			14,497			1,417			10	%
Revenues from real estate operations		174,423			150,335			24,088			16	%	150,335			121,663			28,672			24	%
Expenses
Property operating		51,699			43,929			7,770			18	%	43,929			35,413			8,516			24	%
Interest and amortization of deferred financing costs		43,846			41,566			2,280			5	%	41,566			34,328			7,238			21	%
Depreciation and other amortization		37,122			30,859			6,263			20	%	30,859			20,405			10,454			51	%
Expenses from real estate operations		132,667			116,354			16,313			14	%	116,354			90,146			26,208			29	%
Earnings from real estate operations before equity in (loss) income of unconsolidated real estate joint ventures		41,756			33,981			7,775			23	%	33,981			31,517			2,464			8	%
Equity in (loss) income of unconsolidated real estate joint ventures		(98		)	169			(267		)	N/A		169			208			(39		)	(19	)%
Earnings from real estate operations		41,658			34,150			7,508			22	%	34,150			31,725			2,425			8	%
Income (losses) from service operations		807			(875		)	1,682			N/A		(875		)	(782		)	(93		)	12	%
General and administrative expenses		(7,893		)	(6,697		)	(1,196		)	18	%	(6,697		)	(5,289		)	(1,408		)	27	%
Gain on sales of real estate		472			2,564			(2,092		)	(82	)%	2,564			1,618			946			58	%
Income before minority interests, income taxes, discontinued operations and cumulative effect of accounting change		35,044			29,142			5,902			20	%	29,142			27,272			1,870			7	%
Minority interests		(6,714		)	(7,356		)	642			(9	)%	(7,356		)	(8,415		)	1,059			(13	)%
Income tax benefit, net		124			242			(118		)	(49	)%	242			269			(27		)	(10	)%
Income from discontinued operations, net		2,423			1,273			1,150			90	%	1,273			970			303			31	%
Cumulative effect of accounting change, net		—			—			—			N/A		—			(174		)	174			(100	)%
Net income		30,877			23,301			7,576			33	%	23,301			19,922			3,379			17	%
Preferred share dividends		(12,003		)	(10,134		)	(1,869		)	18	%	(10,134		)	(6,857		)	(3,277		)	48	%
Repurchase of preferred units in excess of recorded book value		(11,224		)	—			(11,224		)	N/A		—			—			—			N/A
Net income available to common shareholders		$	7,650		$	13,167		$	(5,517	)	(42	)%	$	13,167		$	13,065		$	102		1	%
Basic earnings per common share
Income before discontinued operations and cumulative effect of accounting change		$	0.20		$	0.53		$	(0.33	)	(62	)%	$	0.53		$	0.61		$	(0.08	)	(13	)%
Net income available to common shareholders		$	0.29		$	0.59		$	(0.30	)	(51	)%	$	0.59		$	0.65		$	(0.06	)	(9	)%
Diluted earnings per common share
Income before discontinued operations and cumulative effect of of accounting change		$	0.19		$	0.51		$	(0.32	)	(63	)%	$	0.51		$	0.60		$	(0.09	)	(15	)%
Net income available to common shareholders		$	0.27		$	0.56		$	(0.29	)	(52	)%	$	0.56		$	0.63		$	(0.07	)	(11	)%

 

 

Results of Operations

 

While reviewing this section, you should refer to the “Operating Data Variance Analysis” table set forth on the preceding page, as it reflects the computation of many of the variances described in this section.  You should also refer to the section entitled “Liquidity and Capital Resources” for certain factors that could negatively affect various aspects of our operations.

 

Occupancy and leasing

 

Over the last two to three years, the United States economy suffered from an economic slowdown that we believe had an adverse affect on the office real estate leasing market.  Occupancy rates declined in most parts of the country, placing downward pressure on rental rates and increasing the competitive environment for attracting tenants.  We believe that the national trend was felt in each of our geographic regions, contributing towards decreased occupancy in our portfolio of properties from 96.1% on December 31, 2001, to 93.0% on December 31, 2002, to 91.2% on December 31, 2003.  We also experienced downward pressure on rental rates and increased competition for tenants in our properties, although we believe that our portfolio generally fared better than both the national office market and the office markets in the regions where our properties are located.  We believe that the primary reasons our occupancy rates did not fall further include the following:

 

•      Occupancy rates in the Baltimore/Washington Corridor and Northern Virginia office markets, our two largest, fared better than the national office average.  We believe that the expansion of the United States defense industry brought about by increased activity in that sector following the events of September 11, 2001 contributed towards these markets’ occupancy rates being stronger than the national average;

•      The submarkets in which our properties are located are particularly attractive to the United States defense industry, which helped us maintain higher occupancy than the regional averages in the Baltimore/Washington Corridor and Northern Virginia;

•      Only 24.5% of our annualized rental revenues (defined below) on leases in place at December 31, 2001 were from leases expiring in 2002 and 2003 and the weighted average remaining term for leases in place at that time was 4.6 years; and

•      We were able to renew 75.7% of the square footage under leases expiring in 2003 and 66.2% of the square footage under leases expiring in 2002.

 

Annualized rental revenue is a measure that we use to evaluate the source of our rental revenue as of a point in time.  It is computed by multiplying by 12 the sum of monthly contractual base rents and estimated monthly expense reimbursements under active leases in our portfolio of properties as of a point in time.  Portfolio annualized rental revenue is annualized rental revenue for our entire portfolio of properties as of a point in time, including both consolidated properties and properties owned through unconsolidated real estate joint ventures.  We consider annualized rental revenue to be a useful measure for analyzing revenue sources because, since it is point-in-time based, it does not contain increases and decreases in revenue associated with periods in which lease terms were not in effect; historical revenue under generally accepted accounting principles (“GAAP”) does contain such fluctuations.  We find the measure particularly useful for leasing, tenant, segment and industry analysis.

 

Since rental conditions in many of our regions continue to be affected by the economic downturn, we expect that the operating performance of our properties may be adversely affected as we attempt to lease vacant space and renew leases that are scheduled to expire.  However, our exposure over the next year is reduced somewhat by the fact that only 9.0% of our annualized rental revenues from leases in place as of December 31, 2003 were from leases scheduled to expire by the end of 2004, and we were beginning to see signs of improvement in leasing trends in many of our submarkets by the end of 2003.  Looking longer term, the weighted average lease term for leases in place as of December 31, 2003 was 4.9 years and 59.5% of our annualized rental revenues on leases in place as of December 31, 2003 were from leases scheduled to expire by the end of 2008, with no more than 15.0% scheduled to expire in any one calendar year between 2004 and 2008.

 

Most of the leases with our largest tenant, the United States Government, provide for consecutive one-year terms or provide for early termination rights; all of the leasing statistics set forth above assume that the United States Government will remain in the space that they lease through the end of the respective arrangements, without ending consecutive one-year leases prematurely or exercising early termination rights.  We reported the statistics in this manner since we manage our leasing activities using these same assumptions and believe these assumptions to be probable.  Please refer to the section entitled “Liquidity and Capital Resources” where we further discuss our leases with the United States Government and the underlying risks.

 

 

Geographic concentration of property operations

 

During 2002 and 2003, we acquired eight operating properties in Northern Virginia, seven in the Baltimore/Washington Corridor and one in Suburban Maryland.  We placed six properties into operations in the Baltimore/Washington Corridor (including one that was considered partially operational in 2002, as defined in Note 3 to our Consolidated Financial Statements).  We also added three additional properties in the Baltimore/Washington Corridor in 2003 when we acquired the interests of our joint venture partners in joint ventures that were previously not consolidated into our financial statements.  The table below sets forth the changes in the regional allocation of our portfolio annualized rental revenue resulting primarily as a result of these acquisition and development activities and changes in leasing activity:

 

		% of Portfolio Annualized Rental Revenue as of December 31,
Region		2003		2002		2001
Baltimore/Washington Corridor		53.6	%	54.4	%	55.8	%
Northern Virginia		19.8	%	11.3	%	7.2	%
Northern/Central New Jersey		9.5	%	11.5	%	13.5	%
Greater Philadelphia		5.7	%	6.5	%	7.3	%
Harrisburg, Pennsylvania		5.1	%	6.2	%	6.9	%
Other		3.4	%	4.0	%	4.7	%
Suburban Maryland		2.9	%	6.1	%	4.6	%
		100.0	%	100.0	%	100.0	%

 

We expect that we will continue to focus most of our acquisition and development activities in the Northern Virginia, Baltimore/Washington Corridor and Suburban Maryland regions in 2004.  In addition, we became contractually obligated in February 2004 to acquire 10 office properties in St. Mary’s County, Maryland; this acquisition represents our initial entry into that region, which is approximately 40 miles south of Washington, D.C.

 

Concentration of leases with certain tenants

 

The percentage of our portfolio annualized rental revenue from leases in place with the United States Government continued to increase in 2003.  We also experienced changes in our tenant base during 2003 due primarily to acquisitions and leasing activity.  The following schedule lists our 20 largest tenants based on percentage of portfolio annualized rental revenue:

 

 

		Percentage of Portfolio Annualized Rental Revenue for 20 Largest Tenants as of December 31,
Tenant		2003		2002
United States of America		14.8	%	14.2	%
Computer Sciences Corporation (1)		6.3	%	2.9	%
AT&T Corporation (1)		5.2	%	6.0	%
VeriSign, Inc.		5.1	%	N/A
Unisys (2)		4.4	%	5.0	%
General Dynamics Government Corporation		3.3	%	2.8	%
Booz Allen Hamilton		2.6	%	2.6	%
Northrop Grumman Corporation		2.5	%	2.2	%
Ciena Corporation		2.2	%	2.5	%
The Boeing Company (1)		2.1	%	1.4	%
The Aerospace Corporation		1.9	%	2.3	%
Magellan Health Services, Inc.		1.8	%	2.1	%
Commonwealth of Pennsylvania (1)		1.5	%	1.8	%
Merck & Co., Inc. (2)		1.3	%	1.5	%
Johns Hopkins University (1)		1.3	%	1.2	%
Titan Corporation (1)		1.3	%	N/A
Carefirst, Inc. and Subsidiaries (1)		1.2	%	1.4	%
USinternetworking, Inc.		1.1	%	N/A
Comcast Corporation		1.0	%	1.1	%
Omniplex World Services		0.9	%	N/A
Dyncorp Information Systems, LLC		N/A		3.5	%
Ameritrade Holding Corporation		N/A		1.0	%
Sun Microsystems, Inc.		N/A		1.0	%
Lockheed Martin Corporation		N/A		0.9	%
Subtotal of 20 largest tenants		61.8	%	57.4	%
All remaining tenants		38.2	%	42.6	%
Total		100.0	%	100.0	%

 

(1) Includes affiliated organizations and agencies.

(2) Unisys subleases space to Merck and Co., Inc; revenue from this subleased space is classified as Merck & Co., Inc. revenue.

 

Most of the leases with the United States Government provide for a series of one-year terms or provide for early termination rights.  The government may terminate its leases if, among other reasons, the United States Congress fails to provide funding.

 

Industry concentration of tenants

 

The percentage of our portfolio annualized rental revenue derived from the United States defense industry increased from 2001 to 2002 and again from 2002 to 2003.  One reason for this increase is the expansion of the industry in the Baltimore/Washington Corridor and Northern Virginia and, in particular, in our submarkets since the events of September 11, 2001.  Another reason for the increase is that certain of the properties we acquired in each of the last three years have leases with the United States Government and defense contractors.  The table below sets forth the percentage of our annualized rental revenue derived from that industry and, by doing so, demonstrates our increasing concentration:

 

		% of Annualized Rental Revenue as of December 31,
		2003		2002		2001
Total Portfolio		39.9	%	37.6	%	25.7	%
Baltimore/Washington Corridor		57.4	%	45.4	%	32.3	%
Northern Virginia		45.5	%	81.8	%	66.4	%

 

 

We expect the percentage of our portfolio annualized rental revenue derived from the United States defense industry will continue to increase in 2004.

 

We classify the revenue from our leases into industry groupings based solely on our knowledge of the tenants’ operations in leased space. Occasionally, classifications require subjective and complex judgments. For example, we have a tenant that is considered by many to be in the computer industry; however, since the nature of that tenant’s operations in the space leased from us is focused on providing service to the United States Government’s defense department, we classify the revenue we earn from the lease as United States defense industry revenue. We do not use independent sources such as Standard Industrial Classification codes for classifying our revenue into industry groupings and if we did, the resulting groupings would be materially different.

 

Revenues from real estate operations and property operating expenses

 

We typically view our changes in revenues from real estate operations and property operating expenses as being comprised of three main components:

 

•      Changes attributable to the operations of properties owned and 100% operational throughout the two years being compared.  We define these as changes from “Same-Office Properties.”  For example, when comparing 2002 and 2003, Same-Office Properties would be properties owned and 100% operational from January 1, 2002 through December 31, 2003.  For further discussion of the concept of “operational,” you should refer to the section entitled “Critical Accounting Policies and Estimates.”

•      Changes attributable to operating properties acquired during the two years being compared and newly-constructed properties that were placed into service and not 100% operational throughout the two years being compared.  We define these as changes from “Property Additions.”

•      Changes attributable to properties sold during the two years being compared.  We define these as changes from “Sold Properties.”

 

The tables below sets forth the components of our changes in revenues from real estate operations and property operating expenses (dollars in thousands):

 

		Changes from 2002 to 2003
		Property Additions			Same-Office Properties					Sold Properties			Other			Total
		Dollar Change (1)			Dollar Change			Percentage Change		Dollar Change (2)			Dollar Change			Dollar Change
Revenues from real estate operations
Rental revenue		$	22,614		$	(873	)	(1	)%	$	(3,114	)	$	—		$	18,627
Tenant recoveries and other revenue		3,229			2,389			17	%	(168		)	11			5,461
Total		$	25,843		$	1,516		1	%	$	(3,282	)	$	11		$	24,088
Property operating expenses		$	6,811		$	2,427		6	%	$	(1,312	)	$	(156	)	$	7,770
Straight-line rental revenue adjustments included in rental revenue		$	1,141		$	1,217		N/A		$	(64	)	$	—		$	2,294
Amortization of origination value of leases on acquired properties included in rental revenue		$	(306	)	$	(219	)	N/A		$	—		$	—		$	(525	)
Number of operating properties included in component category		25			93			N/A		2			N/A			120

 

(1) Includes 17 acquired properties and 8 newly-constructed properties.

(2) This includes sold operating properties that are not reported as discontinued operations.

 

 

		Changes from 2001 to 2002
		Property Additions			Same-Office Properties					Sold Properties			Other			Total
		Dollar Change (1)			Dollar Change			Percentage Change		Dollar Change (2)			Dollar Change			Dollar Change
Revenues from real estate operations
Rental revenue		$	27,235		$	1,268		1	%	$	(1,248	)	$	—		$	27,255
Tenant recoveries and other revenue		4,746			(884		)	(8	)%	(86		)	(2,359		)	1,417
Total		$	31,981		$	384		0	%	$	(1,334	)	$	(2,359	)	$	28,672
Property operating expenses		$	10,203		$	(1,457	)	(5	)%	$	(402	)	$	172		$	8,516
Straight-line rental revenue adjustments included in rental revenue		$	922		$	(1,564	)	N/A		$	(147	)	$	—		$	(789	)
Amortization of origination value of leases on acquired properties included in rental revenue		$	2,341		$	1		N/A		$	—		$	—		$	2,342
Number of operating properties included in component category		31			78			N/A		2			N/A			111

 

(1) Includes 23 acquired properties and 8 newly-constructed properties.

(2) This includes sold operating properties that are not reported as discontinued operations.

 

As the tables above indicate, our total increase in revenues from real estate operations and property operating expenses was attributable primarily to the Property Additions.  However, the total revenues from the Property Additions were adversely affected by property vacancies and the slow lease-up of newly-constructed buildings, conditions that we believe were attributable to the economic slowdown.  It is also noteworthy that our Property Additions incurred $398,000 in snow removal expenses in 2003, a year in which snowfall was greater than usual.

 

The decrease in rental revenue from the Same-Office Properties from 2002 to 2003 includes the following:

 

•      decrease of $2.3 million in net revenue from the early termination of leases.  To explain further, when tenants terminate their lease obligations prior to the end of the agreed lease terms, they typically pay fees to break these obligations.  We recognize such fees as revenue and write off against such revenue any (1) deferred rents receivable and (2) deferred revenue and deferred assets that are amortizable into rental revenue associated with the leases; the resulting net amount is the net revenue from the early termination of the leases (see the section entitled “Revenue Recognition” in Note 3 to our Consolidated Financial Statements); and

•      increase of $965,000 in connection with three properties that experienced significant changes in occupancy between the two periods.

 

The increase in rental revenue from the Same-Office Properties from 2001 to 2002 includes a $2.3 million increase in net revenue from the early termination of leases.  The $2.3 million increase includes $2.4 million in net revenue earned from one lease termination in December 2002.  The fact that our rental revenue from the Same-Office Properties would have decreased had it not been for the net revenue from early termination of leases was due mostly to decreased occupancy in these properties; the average month-end occupancy levels in these properties decreased from 96.6% in 2001 to 93.6% in 2002.  We attribute the decrease in occupancy to the economic slowdown in the United States, which we believe adversely affected business conditions and office occupancy rates in most of our regions.

 

Tenant recoveries and other revenue from the Same-Office Properties increased from 2002 to 2003 due primarily to the increase in property operating expenses described below.  The decrease in tenant recoveries and other revenue from the Same-Office Properties from 2001 to 2002 was due primarily to the decrease in occupancy and the decrease in property operating expenses described below.

 

The increase in the Same-Office Properties’ property operating expenses from 2002 to 2003 included the following:

 

•      increase of $1.6 million, or 260.2%, in snow removal due to higher snowfall in 2003;

•      increase of $345,000, or 4.6%, in real estate taxes due primarily to an increase in the assessed value of many of our properties;

•      increase of $305,000, or 6.0%, in cleaning expenses;

 

 

•      increase of $304,000, or 16.7%, in heating and air conditioning repairs and maintenance due primarily to additional repair projects undertaken in 2003; and

•      decrease of $858,000 in gas and electric utility expenses associated with three properties that were occupied by a single tenant; that tenant assumed responsibility for direct payment of such utility expenses in the latter portion of 2002.

 

The decrease in the Same-Office Properties’ property operating expenses from 2001 to 2002 included the following:

 

•      decrease of $601,000, or 74%, in expense associated with doubtful or uncollectible receivables, $518,000 of which was attributable to one tenant that declared bankruptcy in 2001;

•      decrease of $582,000, or 30%, in exterior repair and grounds maintenance due primarily to fewer special projects undertaken and the discontinuance of certain services in the spring and summer months due to drought conditions;

•      decrease of $477,000, or 7%, in utilities, most of which was attributable to certain tenants assuming responsibility for property utility payments;

•      decrease of $260,000, or 6%, in cleaning expenses;

•      increase of $270,000, or 38%, in property administrative costs due to increased general and administrative costs associated with employees engaged in property operating activities; and

•      increase of $261,000, or 5%, in real estate taxes due primarily to an increase in the assessed value of many of our properties.

 

We expect that the cost of utility services for our properties may increase within the next year as a result of energy de-regulation expected to take place in Maryland during mid-2004.  In addition, we expect that real estate taxes assessed by state and local municipalities on our properties may increase in the future in response to budgetary shortfalls in those municipalities.  Should these increases in expenses occur, we expect that we will be able to recover a significant portion of the expense increases through increased tenant recovery revenue in the short term and increased rental revenue in the long term.

 

The $2.4 million decrease from 2001 to 2002 in tenant recoveries and other revenue from other sources is attributable primarily to a $2.5 million decrease in fees earned for certain real estate consulting services provided in 2001 that we generally no longer provide.

 

Interest expense and amortization of deferred financing costs

 

Our interest expense and amortization of deferred financing costs increased 5.5% from 2002 to 2003 due primarily to a 15% increase in our average outstanding debt balance resulting from our 2002 and 2003 acquisition and development activities, offset by a decrease in our weighted average interest rates from 6.5% to 5.9%.  Our interest expense and amortization of deferred financing costs increased 21% from 2001 to 2002 due primarily to a 29% increase in our average outstanding debt balance resulting from our 2001 and 2002 acquisition and development activities, offset by a decrease in our weighted average interest rates from 7.6% to 6.5%.  Interest rates available from lenders on fixed and variable-rate loans decreased throughout these periods.  The decreasing interest rate environment contributed to the decrease in our weighted average interest rates by reducing the amount of interest expense we paid on variable-rate debt and enabling us to refinance certain variable and fixed-rate debt with lower interest rate fixed-rate debt.

 

As of December 31, 2003, 74.3% of our mortgage and other loans payable balance carried fixed interest rates and 92.5% of our fixed-rate loans were scheduled to mature after 2004; for a more comprehensive presentation of our fixed-rate loan maturities, please refer to the section entitled “Quantitative and Qualitative Disclosures About Market Risk.”  As of December 31, 2003, we also had one interest rate swap that expires after 2004 that fixes the one-month LIBOR base rate on a notional amount of $50.0 million, or 6.8% of our mortgage and other loans payable.  As of December 31, 2003, the percentage of variable-rate loans (computed with the variable loan dollar amount being reduced by the $50.0 million interest rate swap expiring after 2004) relative to total assets was 10.5%; this percentage was lower than it has been in prior periods due primarily to variable-rate debt pay downs and reduced variable-rate borrowing needs resulting from cash provided from preferred shares that we sold in the latter portion of 2003.

 

Depreciation and amortization

 

Of the $6.3 million increase in our depreciation and other amortization expense from 2002 to 2003, $6.2 million was attributable to the Property Additions.  Of the $10.5 million increase in our depreciation and other amortization expense from 2001 to 2002, $8.8 million was attributable to the Property Additions.

 

We adopted Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS 141”) for our acquisitions of real estate occurring after June 30, 2001 (see the section entitled “Critical Accounting Policies and

 

 

Estimates” and Note 3 to our Consolidated Financial Statements for further discussion).  One effect that SFAS 141 has on our results of operations is that an allocated portion of new acquisitions of properties are depreciated or amortized over significantly shorter periods of time than our acquisitions occurring prior to our adoption of SFAS 141; this effect results in higher depreciation and amortization expense in the initial years following these new acquisitions.

 

Income (loss) from service operations

 

After incurring losses of $875,000 in 2002 and $782,000 in 2001, our service operations generated income of $807,000 in 2003.  This improvement can be attributed primarily to $1.4 million in gross profit earned from construction management contracts in 2003, which was substantially more than gross profit earned from such contracts in 2002 of $37,000 and 2001 of $89,000.  While the construction services division had a significant increase in volume of services provided in 2003 relative to prior years, most notable is the change in profit margins associated with certain of these contracts.  Of the $1.4 million gross profit referred to above, $1.0 million of this profit was earned from three contracts, including $676,000 from one contract; it is also noteworthy that a significant portion of the gross profit, including the most profitable contract, was earned from one customer.  For the construction management division to continue to achieve gross profit at levels approaching its 2003 gross profit, it will need to continue to attract new contracts with similar profit margins; while the division intends to continue to pursue such contracts, we believe that there is inherent uncertainty over whether their pursuit will be successful.

 

Our heating and air conditioning services and controls division incurred losses of $591,000 in 2003 and $207,000 in 2002, after earning income of $82,000 in 2001.  The increased losses are due primarily to decreased revenue from service contracts and decreased margins on installation contracts; we believe that these decreases are attributable primarily to the economic slowdown in the Baltimore/Washington region that this service division serves.  We believe that due to the slowdown, owners of real estate deferred capital improvement and repair projects and, as a result, the region’s competition for contracts increased and margins decreased.  While we believe that the heating and air conditioning services and controls division is well staffed and well managed to recover from this downward trend, there is inherent uncertainty on whether it will be successful in doing so.

 

General and administrative expenses

 

General and administrative expenses increased $1.2 million, or 18% from 2002 to 2003, which includes an increase of $709,000 associated with common share awards to employees due primarily to more of these awards vesting in 2003.  General and administrative expenses increased $1.4 million, or 27% from 2001 to 2002, of which $1.0 million was attributable to additional employee bonus expense, including additional discretionary bonuses awarded to officers in 2002 that were associated with performance in 2001.

 

Gain on sales of real estate, excluding sales classified as discontinued operations

 

In 2003, we recognized a $376,000 gain on the sale of two land parcels.  In 2002, we recognized a $1.2 million gain on the disposition of investments in two real estate joint ventures and a $1.4 million gain on three land parcel sales.  Gain on sales of real estate for 2002 and 2003 also includes amortized gain from a building sale that occurred in 2002 (see Note 4 to the Consolidated Financial Statements for further description of this sale).  In 2001, we recognized a $1.6 million gain on the sale of an office property.

 

We generally do not acquire properties with the intent of selling them.  We generally sell properties when we believe that most of the earnings growth potential in such properties has been realized or determine that a property no longer fits within the Company’s strategic plans due to its type and/or location.  Since our real estate sales activity is driven by transactions unrelated to our core operations, our gain on sales of real estate is subject to material fluctuation from period to period.

 

Minority interests

 

Interests in our Operating Partnership are in the form of preferred and common units.  The line entitled “minority interests” on our Consolidated Statements of Operations includes primarily income before minority interests, income taxes, discontinued operations and cumulative effect of accounting change allocated to preferred and common units not owned by us; for the amount of this line attributable to preferred units versus common units, you should refer to our Consolidated Statements of Operations.  Income is allocated to minority interest preferred unitholders equal to the priority return from the Operating Partnership to which they are entitled.  Income is allocated to minority interest common unitholders based on the income earned by the Operating Partnership after allocation to preferred unitholders multiplied by the percentage of the common units in the Operating Partnership owned by those common unitholders.

 

 

As of December 31, 2003, we owned 100% of the outstanding preferred units and approximately 75% of the outstanding common units.  The percentage of the Operating Partnership owned by minority interests decreased each of the last three years due primarily to the following:

 

•      the Operating Partnership issued very few new common units and no new preferred units to third parties;

•      since we receive preferred units and common units in the Operating Partnership each time we issue preferred shares and common shares, additional units were issued to us as we issued new shares in each of the last three years;

•      certain minority interest holders of common units exchanged their common units for our common shares; and

•      we owned all of the preferred units in the Operating Partnership during the last three years except for the Series C Preferred Units, which were owned by third parties until the Operating Partnership repurchased the units in June 2003 (see discussion below).

 

Our income allocated to minority interest holders of preferred units decreased from 2002 to 2003 due to the repurchase of the Series C Preferred Units.  Our changes in income allocated to minority interest holders of common units included the following:

 

•      decrease attributable to our increasing ownership of common units and preferred units each year; and

•      increase due to yearly increases in the Operating Partnership’s income before minority interests, income taxes, discontinued operations and cumulative effect of accounting change.

 

Income from discontinued operations

 

Income from discontinued operations is composed entirely of one operating office property that we sold in March 2003.  Income from discontinued operations increased from 2002 to 2003 because 2003 includes a $3.0 million gain before minority interests from the sale of the property.  See Note 18 to the Consolidated Financial Statements for a summary of income from discontinued operations.

 

Adjustments to net income to arrive at net income available to common shareholders

 

We completed the sale of two series of preferred shares in 2003 and three series of preferred shares in 2001.  Preferred share dividends increased from 2002 to 2003 due to the dividend requirements of the two new series of preferred shares issued in 2003.  Preferred share dividends increased from 2001 to 2002 due to 2002 containing a full year of the dividend requirements of the three new series of preferred shares issued during 2001.  We expect preferred share dividends to increase in 2004 over 2003 due to 2004 containing a full year of the dividend requirements of the two new series of preferred shares issued in 2003.

 

During 2003, we recognized an $11.2 million decrease to net income available to common shareholders, representing the excess of the repurchase price of the Series C Preferred Units in the Operating Partnership over the sum of the recorded book value of the units and the accrued and unpaid return to the unitholder; prior to this repurchase, these units were convertible, subject to certain restrictions, into 2,420,672 common units in the Operating Partnership.  These units were repurchased by the Operating Partnership for $36.1 million (including $477,000 for accrued and unpaid distributions), or $14.90 per common share on an as-converted basis.  Since this decrease to net income available to common shareholders occurred as a direct result of a specific transaction, we expect it to be nonrecurring.

 

Our Series B Preferred Shares may be redeemed as early as July 15, 2004.  If these shares were redeemed, we would recognize a $1.8 million decrease to net income available to common shareholders pertaining to the original issuance costs we incurred on the shares.

 

Diluted earnings per common share

 

Diluted earnings per common share decreased from 2002 to 2003 due primarily to the decrease to net income available to common shareholders resulting from the repurchase of the Series C Preferred Units, offset by the net effect of the other items discussed above.  Diluted earnings per common share decreased from 2001 to 2002 due to the effect of the additional common shares and common share equivalents outstanding in 2002 exceeding our growth in net income available to common shareholders.

 

Liquidity and Capital Resources

 

In our discussion of liquidity and capital resources set forth below, we describe certain of the risks and uncertainties relating to our business; however, they are not the only ones that we face.

 

 

Cash and cash equivalents

 

Our cash and cash equivalents balance as of December 31, 2003 totaled $9.5 million, an increase of 58% from the balance as of December 31, 2002.  The balance of cash and cash equivalents that we carried as of the end of the eight calendar quarters during the two years ended December 31, 2003 ranged from $4.3 million to $13.3 million and averaged $7.5 million.  The cash and cash equivalents balances that we carry as of a point in time can vary significantly due in part to the inherent variability of the cash needs of our development activities.  We maintain sufficient cash and cash equivalents to meet our operating cash requirements and short term investing and financing cash requirements.  When we determine that the amount of cash and cash equivalents on hand is more than we need to meet such requirements, we may pay down our Revolving Credit Facility or forgo borrowing under construction loan credit facilities to fund development activities.

 

Operating activities

 

We generate most of our cash from the operations of our properties.  A review of our Statements of Operations indicates that over the last three years, 29% to 30% of our revenues from real estate operations were used for property operating expenses.  Most of the amount by which our revenues from real estate operations exceeded property operating expenses was cash flow; we applied most of this cash flow towards interest expense, scheduled principal amortization on mortgage loans, dividends to our shareholders, distributions to minority interest holders of preferred and common units in the Operating Partnership, capital improvements and leasing costs for our operating properties and general and administrative expenses.

 

Our cash flow from operations determined in accordance with GAAP increased $5.5 million or 8.9% from 2002 to 2003; this increase is attributable primarily to the additional cash flow from operations generated by our newly-acquired and newly-constructed properties.  The change in our cash flow from operations from 2002 to 2003 included a $9.4 million increase in accounts receivable due primarily to significant billings to tenants in December 2003 for leasehold improvements completed and paid for by us in space that they rent from us; we consider this increase to be associated primarily with the significance of the improvements for which we billed and the timing of such billings and not a change in trend for the amount of receivables we expect to carry in the future.  The change in our cash flow from operations from 2002 to 2003 also included a $6.1 million increase in accounts payable and accrued expenses due primarily to the following: (1) increased payables associated with construction services performed for third parties brought about by an increase in construction services activity and the timing of our payments; (2) increased interest expense payable due to a change in the timing of our monthly debt service payment process; and (3) increased accrual associated with common shares issued to employees that vest in January 2004 due primarily to more shares vesting for 2003 than for 2002.

 

We expect to continue to use cash flow provided by operations to meet our short-term capital needs, including all property operating expenses, general and administrative expenses, debt service, dividend and distributions and capital improvements and leasing costs.  We do not anticipate borrowing to meet these requirements.  Factors that could negatively affect our ability to generate cash flow from operations in the future include the following:

 

•      We earn revenue from renting our properties.  Our operating costs do not necessarily fluctuate in relation to changes in our rental revenue.  This means that our costs will not necessarily decline and may increase even if our revenues decline.

•      For new tenants or upon lease expiration for existing tenants, we generally must make improvements and pay other tenant-related costs for which we may not receive increased rents.  We also make building-related capital improvements for which tenants may not reimburse us.

•      When leases for our properties expire, our tenants may not renew or may renew on terms less favorable to us than the terms of their original leases.  If a tenant leaves, we can expect to experience a vacancy for some period of time as well as higher capital costs than if a tenant renews. As a result, our financial performance could be adversely affected if we experience a high volume of tenant departures at the end of their lease terms.

•      As discussed earlier, we are dependent on a highly concentrated number of tenants for a large percentage of our revenue.  Most of the leases of one of these tenants, the United States Government, provide for a series of one-year terms or provide for early termination rights.  Our cash flow from operations would be adversely affected if our larger tenants failed to make rental payments to us, or if the United States Government elects to terminate several of its leases and the space cannot be re-leased on satisfactory terms.

•      As discussed earlier, a high concentration of our revenues comes from tenants in the United States defense industry. A reduction in government spending for defense could affect the ability of our tenants in the defense industry to fulfill lease obligations or decrease the likelihood that these tenants will renew their leases. In the case of the United States Government, a reduction in government spending could result in the early termination of leases.

•      Our performance depends on the ability of our tenants to fulfill their lease obligations by paying their rental payments in a timely manner.  We believe that the recent economic slowdown in the United States has, and could continue to, adversely affect a number of our

 

 

tenants.  In addition, as noted above, we rely on a relatively small number of tenants for a large percentage of our revenue from real estate operations.  If one of our major tenants, or a number of our smaller tenants, were to experience financial difficulties, including bankruptcy, insolvency or general downturn of business, there could be an adverse effect on our results of operations and financial condition.

•      We provide construction management services for third-party clients.  When providing these services, we usually pay for the costs of construction and subsequently bill our clients for the costs of construction plus a construction management fee.  When we provide construction management services, the costs of construction can amount to millions of dollars.  If any of our clients for construction management services fail to reimburse us for costs incurred under a significant construction management contract, it could have an adverse effect on our results of operations and financial condition.

•      Since all of our properties are located in the Mid-Atlantic region of the United States and are also typically concentrated in office parks in which we own most of the properties, we do not have a broad geographic distribution of our properties. As a result, a decline in the real estate market or general economic conditions in the Mid-Atlantic region, the Baltimore/Washington Corridor, Northern Virginia or the office parks in which our properties are located could have an adverse effect on our financial position, results of operations and cash flows.

•      As noted above in the section entitled “Results of Operations,” we believe that the recent economic slowdown in the United States has adversely affected occupancy rates in the Mid-Atlantic region and our properties and, in turn, led to downward pressure on rental rates. Lower occupancy rates and the resulting increased competition for tenants in our operating regions placed downward pressure on rental rates in most of these regions, a trend that we believe will affect us further as we attempt to lease vacant space and renew leases scheduled to expire on occupied space. If occupancy rates in our regions do not improve or further decline, we may have difficulty leasing both existing vacant space and space associated with future lease expirations at rental rates that are sufficient to meet our short term capital needs, which could adversely affect our financial position, results of operations and cash flows.

•      The commercial real estate market is highly competitive.  We compete for the purchase of commercial property with many entities, including other publicly traded commercial REITs.  Many of our competitors have substantially greater financial resources than we do.  If our competitors prevent us from buying properties that we target for acquisition, we may not be able to meet our property acquisition and development goals.  Moreover, numerous commercial properties compete for tenants with our properties.  Some of the properties competing with ours may have newer or more desirable locations or the competing properties’ owners may be willing to accept lower rates than are acceptable to us.  Competition for property acquisitions, or for tenants in properties that we own, could have an adverse effect on our financial performance.

•      If short-term interest rates were to increase, the interest payments on our variable-rate debt would increase, although this increase may be reduced to the extent that we had interest rate swap and cap agreements outstanding.  If longer-term interest rates were to increase, we may not be able to refinance our existing indebtedness on terms as favorable as the terms of our existing indebtedness and we would pay more for interest expense on new indebtedness that we incur for future operating property additions.

•      Our portfolio of properties is insured for losses under our property, casualty and umbrella insurance policies through September 2004.  These policies include coverage for acts of terrorism.  Although we believe that we adequately insure our properties, we are subject to the risk that our insurance may not cover all of the costs to restore properties damaged by a fire or other catastrophic event.  In addition, due largely to the terrorist attacks on September 11, 2001, the insurance industry has changed its risk assessment approach and cost structure.  Continuing changes in the insurance industry may increase the cost of insuring our properties and decrease the scope of insurance coverage, either of which could adversely affect our financial position and operating results.

•      As a REIT, we must distribute at least 90% of our annual REIT taxable income (excluding capital gains), which limits the amount of cash we have available for other business purposes, including amounts to fund our growth.  Also, it is possible that because of the differences between the time that we actually receive revenue or pay expenses and the period we report those items for distribution purposes, we may have to borrow funds on a short-term basis to meet the 90% distribution requirement.  We may become subject to tax liabilities that adversely affect our operating cash flow.

 

Investing and financing activities during the year ended December 31, 2003

 

During 2003, we acquired seven office properties totaling 993,479 square feet for $165.1 million and two parcels of land for $31.8 million.  These acquisitions were financed using the following:

 

•              $83.8 million from borrowings under new mortgage loans;

•              $63.9 million in proceeds from the sale of common shares in an underwritten public offering;

•              $33.1 million in borrowings from our Revolving Credit Facility;

•              $9.9 million in funds escrowed from previous property sales; and

•              cash reserves for the balance.

 

During 2003, we acquired our joint venture partners’ interests in NBP 140, LLC and Gateway 67, LLC (90% and 20%, respectively) for $6.2 million and assumed $16.5 million in mortgage loans.  Prior to these acquisitions, we

 

 

accounted for our investments in these joint ventures using the equity method of accounting (see Note 2 to the Consolidated Financial Statements).  Upon completion of these acquisitions, these two entities, which own a total of three office properties totaling 225,754 square feet and a parcel of land that is contiguous to two of these properties, became consolidated subsidiaries.

 

During 2003, an office property totaling 123,743 square feet that was partially operational and 63% pre-leased at December 31, 2002 became 100% operational.  Costs incurred on this project through December 31, 2003 totaled $22.0 million, of which $373,000 was incurred in 2003.  We have a construction loan facility in place totaling $14.0 million to finance the construction of this project; borrowings under this facility totaled $12.8 million at December 31, 2003.  We also used borrowings from our Revolving Credit Facility and cash reserves funded by a portion of our debt refinancing proceeds.

 

During 2003, we had construction activities underway on two office properties totaling 244,824 square feet that were 100% pre-leased.  Costs incurred on these properties through December 31, 2003 totaled $18.0 million, of which $13.9 million was incurred in 2003.  We have a construction loan facility in place totaling $20.0 million to finance the construction of one of these properties; borrowings under this facility totaled $3.3 million at December 31, 2003.  The remaining costs were funded using borrowings from our Revolving Credit Facility and cash reserves.

 

The table below sets forth the major components of our real estate property additions for 2003 and 2002 (in thousands):

 

		For the Years Ended December 31,
		2003			2002
Acquisitions (1)		$	197,300		$	116,087
Property additions upon acquisition of joint venture partner interests (1)(2)		25,546			29,067
Construction and development		10,681			15,555
Tenant improvements on operating properties (3)		8,588			4,213
Capital improvements on operating properties		4,415			3,264
		$	246,530		$	168,186

 

(1)   Includes intangible assets and deferred revenues recorded in connection with acquisitions.

(2)   We acquired the ownership interests of partners in two real estate joint ventures for $6,208 in 2003; prior to these acquisitions, we were accounting for our investments in these joint ventures using the equity method of accounting. We also acquired the ownership interests of partners in two real estate joint ventures for $11,809 in 2002; prior to these acquisitions, we were accounting for our investments in these joint ventures using the financing method of accounting (see Note 2 to the Consolidated Financial Statements).

(3)   Tenant improvement costs incurred on newly-constructed properties are classified in this table as construction and development.

 

During 2003, we sold an office property and two land parcels for a total of $21.3 million.  We also contributed a 157,394 square foot office property into a joint venture called Route 46 Partners, LLC in exchange for $20.0 million in cash and a 20% interest in the joint venture.  The net proceeds from these transactions after transaction costs totaled $40.2 million; these proceeds were used as follows:

 

•      $29.4 million to pay down our Revolving Credit Facility;

•      $7.5 million to fund a cash escrow that was subsequently applied towards an acquisition; and

•      $3.3 million to fund cash reserves.

 

Our investments in unconsolidated real estate joint ventures decreased $2.7 million during 2003; this decrease included primarily the following:

 

•      $4.4 million decrease due to the purchase of our joint venture partners’ interests in NBP 140, LLC and Gateway 67, LLC described above, after which those entities became consolidated subsidiaries of ours; and

•      $1.1 million increase due to the investment in Route 46 Partners, LLC brought about by our contribution of an office property into the joint venture described above.

 

For additional information regarding our investments in unconsolidated real estate joint ventures, you may refer to the section below entitled “Off-Balance Sheet Arrangements” and Note 5 to our Consolidated Financial Statements.

 

 

During 2003, we borrowed $191.2 million under mortgages and other loans, excluding our Revolving Credit Facility; the proceeds from these borrowings were used as follows:

 

•      $83.8 million to finance acquisitions;

•      $45.0 million to refinance existing debt;

•      $36.1 million for the repurchase of the Series C Preferred Units of our Operating Partnership described below;

•      $18.4 million to pay down our Revolving Credit Facility;

•      $1.2 million to finance construction activities; and

•      the balance to fund cash reserves.

 

On May 27, 2003, we sold 5,290,000 common shares in an underwritten public offering at a price of $15.03 per share for net proceeds of $79.4 million.  We contributed the net proceeds from the sale to our Operating Partnership in exchange for 5,290,000 common units.  The Operating Partnership, in turn, used $63.9 million of the proceeds to fund a property acquisition and the balance to pay down our Revolving Credit Facility.

 

On June 16, 2003, we redeemed all of the 1,016,662 Series C Preferred Units in our Operating Partnership for $36.1 million using proceeds from a newly acquired $40.0 million mortgage loan.  As a result of the repurchase, we recognized an $11.2 million reduction to net income available to common shareholders associated with the excess of the repurchase price over the sum of the recorded book value of the units and the accrued and unpaid return to the unitholder.

 

On August 11, 2003, we completed the sale of 2,200,000 Series G Preferred Shares at a price of $25.00 per share for net proceeds of $53.2 million.  These shares are nonvoting and redeemable for cash at $25.00 per share at our option on or after August 11, 2008.  Holders of these shares are entitled to cumulative dividends, payable quarterly (as and if declared by the Board of Trustees).  Dividends accrue from the date of issue at the annual rate of $2.00 per share, which is equal to 8% of the $25.00 per share redemption price.  We contributed the net proceeds from the sale to our Operating Partnership in exchange for 2,200,000 Series G Preferred Units.  The Series G Preferred Units carry terms that are substantially the same as the Series G Preferred Shares.  The Operating Partnership used most of the net proceeds to pay down our Revolving Credit Facility.

 

On December 18, 2003, we completed the sale of 2,000,000 Series H Preferred Shares at a price of $25.00 per share for net proceeds of $48.3 million.  These shares are nonvoting and redeemable for cash at $25.00 per share at our option on or after December 18, 2008.  Holders of these shares are entitled to cumulative dividends, payable quarterly (as and if declared by the Board of Trustees).  Dividends accrue from the date of issue at the annual rate of $1.875 per share, which is equal to 7.5% of the $25.00 per share redemption price.  We contributed the net proceeds from the sale to our Operating Partnership in exchange for 2,000,000 Series H Preferred Units.  The Series H Preferred Units carry terms that are substantially the same as the Series H Preferred Shares.  The Operating Partnership used most of the net proceeds to pay down our Revolving Credit Facility.

 

Analysis of cash flow associated with investing and financing activities

 

Our net cash flow used in investing activities increased $44.4 million from 2002 to 2003.  This increase was due primarily to the following:

 

•      $63.3 million increase in purchases of and additions to commercial real estate; this increase is due to the dollar amount of property acquisitions completed in 2003 exceeding that of 2002.  Our ability to locate and complete acquisitions is dependent on numerous variables and, as a result, is inherently subject to significant fluctuation from year to year; while we expect to continue to acquire properties in the future, we are unable to predict whether the increasing acquisition volume from 2002 to 2003 is a trend that will continue; and

•      $32.7 million increase in proceeds from sales of properties; this increase resulted from the dollar amount of transactions completed in 2003 exceeding that of 2002.  As discussed earlier, we generally do not acquire properties with the intent of selling them.  We generally sell properties when we believe that most of the earnings growth potential in such properties has been realized or determine that a property no longer fits within the Company’s strategic plans due to its type and/or location.  Since our real estate sales activity is driven by transactions unrelated to our core operations, our proceeds from sales of properties is subject to material fluctuation from period to period and, therefore, we do not believe that the change from 2002 to 2003 is necessarily indicative of a trend.

 

Our cash flow provided by financing activities increased $43.0 million from 2002 to 2003.  This increase included the following:

 

 

•      $157.7 million increase in proceeds from the sale of preferred and common shares; most of this increase is attributable to the dollar amount of public offerings completed during 2003 exceeding that of 2002.  We were able to complete these sales due to an attractive equity market for our shares in 2003.  While we expect to complete additional preferred and common share offerings in the future, our desire and ability to do so will be dependent on both (1) our need for funds from such offerings for our investing and financing activities and (2) the attractiveness of the equity markets at the time the funds are needed;

•      $60.5 million increase in repayments of mortgage and other loans payable; this increase is attributable primarily to (1) additional repayments made using the increased proceeds from both the sale of preferred and common shares and sales of properties in 2003, offset by (2) additional repayments that occurred in 2002 compared to 2003 due to additional loan refinancings completed in 2002 in response largely to the decreasing interest rate environment;

•      $35.4 million decrease in proceeds from mortgage and other loans payable; this decrease is due primarily to fewer loan refinancings taking place in 2003 than in 2002 and a reduced need for additional borrowings in 2003 due to the sales of preferred and common shares; and

•      $35.6 million in cash used to repurchase the Series C Preferred Units in the Operating Partnership; this occurred as a result of a specific transaction that will not reoccur on an ongoing basis.  We may use cash in the future to redeem outstanding series of preferred shares once they become redeemable; if this were to occur, we would expect to finance the cost of such a redemption using proceeds from the sale of common or preferred shares.

 

As discussed above, the increase in repayments of mortgages and other loans payable and decrease in proceeds from mortgages was influenced in part by the availability of proceeds from the sale of common and preferred shares; we were able to complete these sales due to an attractive equity market for our shares in 2003.  These changes do not necessarily indicate a continuing trend since equity markets for our shares may not always be as attractive.  In less attractive equity market conditions, it is likely that we will finance a larger portion of our investing and financing activities using debt.

 

Off-Balance Sheet arrangements

 

Some of our real estate investments are owned through joint ventures.  Reasons that we use joint ventures from time to time include the following: (1) they can provide a facility to access new markets and investment opportunities while enabling us to benefit from the expertise of our partners; (2) they are an alternative source for raising capital to put towards acquisition or development activities; and (3) they can reduce our exposure to risks associated with a property and its activities.  Each of our real estate joint ventures has a two-member management committee that is responsible for making major decisions (as defined in the joint venture agreement), and we control one of the management committee positions in each case.  All of our real estate joint venture investments owned during 2003 can be classified into one of the three categories described below:

 

•      Externally-managed construction joint ventures (the “Externally-Managed JVs”).  These joint ventures construct buildings to either be sold to third-parties or purchased by us.  Our partners in all of these joint ventures are controlled by a company that owns, manages, leases and develops properties in the Baltimore/Washington Corridor; that company also serves as the project manager for all of these joint ventures.  During 2003, we were invested in four of these joint ventures, three of which were remaining at December 31, 2003; all of these investments were accounted for using the equity method of accounting (see Note 2 to the Consolidated Financial Statements).  These joint ventures enable us to make use of the expertise of our partner and, in the case of certain projects, provide us with access to build-for-sale real estate opportunities not within our normal focus; the use of the joint venture structures provides further leverage to us both from a financing and risk perspective.  We generally guarantee the repayment of construction loans for these projects in amounts proportional to our ownership percentage.  In addition, we are obligated to acquire our partners’ membership interest in each of the joint ventures in the event that all of the following occur:

 

(1)   an 18-month period passes from the date of completion of the shell of the final building to be constructed by the joint venture;

(2)   at the end of the 18-month period, the aggregate leasable square footage of the joint venture’s buildings is 90% leased and occupied by tenants who are not in default under their leases; and

(3)   six months pass from the end of the 18-month period and either the buildings have not been sold or we have not acquired our partners’ interests.

 

The amount we would need to pay for our partners’ membership interest is computed based on the amount that the partners would receive under the respective joint venture agreements in the event that the buildings were sold for a capitalized fair value (as defined in the agreements) on a defined date.  As of December 31, 2003, none of the three remaining Externally-Managed JVs had completed the shell construction on their final buildings.  We estimate the aggregate amount we would need to pay for our partners’ membership interests in these joint ventures to be $1.3 million; however, since the determination of this amount is dependent on the operations of the properties and none

 

 

of these properties are both completed and occupied, this estimate is preliminary and could be materially different from the actual obligation.

•      Construction joint ventures managed by us (the “Internally-Managed JVs”).  During 2003, we were invested in two of these joint ventures, one of which was remaining at December 31, 2003; one of these ventures was accounted for using the financing method of accounting and one using the equity method of accounting (see Note 2 to the Consolidated Financial Statements).  Our partners in these projects typically own a majority of the joint ventures, and we serve as the project manager.  The primary purpose behind the use of joint venture structures for these projects is to enable us to leverage most of the equity requirements and reduce our risk in construction and development projects.  We serve as the sole guarantor for repayment of construction loans for these projects.  We also earn construction, property management and guaranty fees from these joint ventures.  The Internally-Managed JVs in which we invested during 2003 both contained provisions making us solely responsible for funding defined additional investments in the joint venture to the extent that costs to complete construction exceed amounts funded by member investments previously made and existing construction loans.  These projects also both contained provisions giving us the option to purchase our partners’ joint venture interests for pre-determined purchase prices over limited periods of time; however, if we do not elect to exercise this purchase option in a project, our partner can take control of the joint venture’s management committee by appointing an additional representative to the committee.  We acquired our partner’s interest in one of these joint ventures on December 31, 2003 for a purchase price of $5.4 million.  Our partners can typically gain control of the management committees of these joint ventures if the respective projects fail to attain certain defined performance criteria, such as construction completion and tenant occupancy target dates, although if this were to occur in a project, we would have the option to acquire the partners’ interests for pre-determined purchase prices.  Our partner in the one Internally-Managed JV remaining at December 31, 2003 can gain control of the joint venture’s management committee if construction of the building is not completed by January 2005, although if that were to occur, we would have the option of acquiring our partner’s interest for $4.9 million; we could also be required to purchase our partner’s interest in this joint venture for a minimum purchase price of $4.9 million in the event that the joint venture defaults on its obligations as landlord or does not meet certain construction completion timeframes.  The earliest date that we can exercise our option to acquire our partner’s joint venture interest in the one Internally-Managed JV remaining as of December 31, 2003 is September 1, 2004, on which date the purchase price would be $4.9 million.

•      Operating joint ventures to which we contribute an office property to partially dispose of our interest (the “Disposition JV”). During 2003, we contributed an office property into a Disposition JV in exchange for cash and a 20% interest in the joint venture.  This Disposition JV enabled us to dispose of most of our investment in a property that we believe realized most of its earnings growth potential.  We manage the joint venture’s property operations and any required construction projects and earn fees for these services.  Our joint venture partner has preference in receiving distributions of cash flows for a defined return; once our partner receives its defined return, we are entitled to receive distributions for a defined return and, once we receive that return, remaining distributions of cash flows are allocated based on percentages defined in the joint venture agreement.

 

The table below sets forth certain additional information regarding these categories of real estate joint ventures (in thousands):

 

Category of Real Estate Joint Venture		Investment Balances at 12/31/03			Net Cash Flow to Category in 2003			Income from Category in 2003			Fees Earned from Category in 2003 (1)			Balance of Debt Guaranteed by Us at 12/31/2003			Obligation to Unilaterally Fund Additional Project Costs (if necessary)(2)
Externally-Managed JVs		$	4,207		$	(1,349	)	$	(217	)	$	—		$	3,360		$	—
Internally-Managed JVs (3)		—			(4,230		)	—			251			3,299			4,500
Disposition JV		1,055			(933		)	123			100			—			320
		$	5,262		$	(6,512	)	$	(94	)	$	351		$	6,659		$	4,820

 

(1)   Fees earned by us for construction, asset management and property management services provided to joint ventures.

(2)   Amounts reported in this column represent additional investments we could be required to fund on a unilateral basis.  We are also required to unilaterally fund leasing commissions incurred, if any, above a market rate specified in the joint venture agreement for the Disposition JV.  We and our partners are also required to fund proportionally (based on our ownership percentage) additional amounts when needed by the Externally-Managed JVs and Disposition JV.  In addition, we are required to fund 50% of additional amounts needed by the Internally-Managed JVs.  Since the additional fundings described in this footnote are uncertain in dollar amount and we do not expect that they will be necessary, they are not included in the table.

(3)   The one remaining Internally-Managed JV as of December 31, 2003 was accounted for using the financing method of accounting.  As a result, we reported a zero investment balance in that JV (see section entitled “Financing Method” in Note 2 to our Consolidated Financial Statements).

 

 

The net cash flow to Externally-Managed JVs during the year includes $857,000 paid to acquire our partner’s interest in one joint venture during 2003.  The net cash flow to Internally-Managed JVs includes $5.4 million paid to acquire our partner’s interest in one joint venture.

 

You should refer to Notes 5 and 19 for additional information pertaining to our investments in unconsolidated real estate joint ventures.

 

We had no other material off-balance sheet arrangements during 2003.

 

Analysis of indebtedness

 

As we discussed earlier, two non-GAAP measures that we use in managing our financing policy are debt service coverage ratio and fixed charge coverage ratio; both of these measures are defined in the section entitled “Overview.”  We believe that debt service coverage ratio is a useful measure in evaluating the relationship of our earnings to the total cash flow requirements of our loans associated with operating properties.  We believe that fixed charge coverage ratio is a useful measure in evaluating the relationship of our earnings to the cash flow requirements of (1) interest expense on loans associated with our operating properties and (2) dividends to our preferred equity holders.  The table below reconciles the denominators for debt service coverage ratio and fixed charge coverage ratio to interest expense, the most directly comparable GAAP measure, for the year ended December 31, 2003 (in thousands):

 

Interest expense from continuing operations		$	41,079
Interest expense from discontinued operations		100
Scheduled principal amortization on mortgage and other loans		9,221
Denominator for debt service coverage ratio		50,400
Less: scheduled principal amortization on mortgage and other loans		(9,221		)
Preferred share dividends		12,003
Preferred unit distributions		1,049
Denominator for fixed charge coverage ratio		$	54,231

 

One non-GAAP measure of earnings that is useful in evaluating our debt service coverage and fixed charge coverage is earnings before interest, income taxes, depreciation and amortization (“EBITDA”).  EBITDA is net income adjusted for the effects of interest expense, depreciation and amortization, income taxes, gain on sales of real estate (excluding sales of non-operating properties and development services provided on operating properties) and minority interests.  We believe that EBITDA is an important measure of performance for a REIT because it provides a further tool to evaluate our ability to incur and service debt and to fund dividends and other cash needs.  We believe that net income is the most directly comparable GAAP measure to EBITDA.  The table below sets forth our computation of EBITDA for the year ended December 31, 2003 (in thousands):

 

Net income		$	30,877
Interest expense from continuing operations		41,079
Interest expense from discontinued operations		100
Amortization of deferred financing costs		2,767
Income tax benefit, gross		(169		)
Depreciation of furniture, fixtures and equipment		460
Real estate-related depreciation and amortization		36,681
Gain on sale of depreciated real estate properties, excluding development portion		(2,897		)
Minority interests		7,761
EBITDA		$	116,659

 

The timing and nature (fixed-rate versus variable-rate) of the scheduled maturities on our debt are discussed in the section entitled “Quantitative and Qualitative Disclosures about Market Risk.”

 

We often use our Revolving Credit Facility initially to finance much of our investing and financing activities.  We then pay down our Revolving Credit Facility using proceeds from long-term borrowings collateralized by our properties as attractive financing conditions arise and equity issuances as attractive equity market conditions arise.  Our primary

 

 

Revolving Credit Facility throughout the periods reported herein was with Bankers Trust Company.  Amounts available under this Revolving Credit Facility are generally computed based on 65% of the appraised value of properties pledged as collateral.  As of March 5, 2004, the maximum amount available under our Revolving Credit Facility was $122.9 million, of which $95.1 million was unused.

 

We expect to obtain a new Revolving Credit Facility with Wachovia Bank, National Association in March 2004; we expect to use this facility as our primary revolving credit facility to replace the facility with Bankers Trust Company.  The facility is expected to have a maximum principal of $300.0 million, a three-year term (with an additional one-year extension available) and a variable interest rate based on the 30-day LIBOR rate plus 1.25% to 1.55% (as determined by our leverage levels at different points in time).  We also expect the facility to have a fee of 0.125% to 0.25% on the amount of the credit facility that is unused.

 

We have a secured revolving credit facility with Wachovia Bank, National Association for a maximum principal amount of $25.0 million.  As of March 5, 2004, $6.1 million was unused, although such amount is not available for borrowing until additional properties are pledged as collateral.  We expect to repay and eliminate this loan using proceeds from our Revolving Credit Facility in March 2004.

 

Certain of our mortgage loans require that we comply with a number of restrictive financial covenants, including leverage ratio, adjusted consolidated net worth, minimum property interest coverage, minimum property hedged interest coverage, minimum consolidated interest coverage, minimum fixed charge coverage, minimum debt service coverage, maximum consolidated unhedged floating rate debt and maximum consolidated total indebtedness.  As of December 31, 2003, we were in compliance with these financial covenants.

 

Contractual obligations

 

The following table summarizes our contractual obligations as of December 31, 2003 (in thousands):

 

 

		For the Years Ended December 31,
		2004			2005 to 2006			2007 to 2008			Thereafter			Total
Contractual obligations (1)
Mortgage loans payable (2)		$	176,904		$	162,466		$	220,281		$	179,047		$	738,698
New construction and development contracts (3)		13,688			—			—			—			13,688
Third-party construction and development contracts (4)		21,310			—			—			—			21,310
Capital expenditures for operating properties (5)		5,204			—			—			—			5,204
Operating leases (6)		1,235			1,896			790			31,711			35,632
Capital lease obligations (6)		33			18			—			—			51
Other purchase obligations (6)		711			1,018			896			2,234			4,859
Total contractual cash obligations		$	219,085		$	165,398		$	221,967		$	212,992		$	819,442
Other commitments (7)
Guarantees of joint venture loans (8)		$	3,360		$	3,299		$	—		$	—		$	6,659

 

(1)   The contractual obligations set forth in this table generally exclude individual contracts that had a value of less than $20 thousand. Also excluded are contracts associated with the operations of our properties that may be terminated with notice of one month or less, which is the arrangement that applies to most of our property operations contracts.

(2)   Our loan maturities in 2004 include $107.5 million that we expect to refinance using proceeds from the new Revolving Credit Facility with Wachovia Bank, $25.8 million that we expect to refinance using proceeds from other financings or equity offerings and $27.2 million for which we expect to obtain extensions for a minimum of one year.  The remaining $16.4 million represents scheduled principal amortization payments that we expect to pay using cash flow from operations.

(3)   Represents contractual obligations pertaining to new construction and development activities.  We expect to finance these costs using primarily proceeds from our Revolving Credit Facility and construction loans.

(4)   Represents contractual obligations pertaining to projects for which we are acting as construction manager on behalf of unrelated parties who are our clients.  We expect to be reimbursed in full for these costs by our clients.

(5)   Represents contractual obligations pertaining to capital expenditures for our operating properties.  We expect to finance all of these costs using cash flow from operations.

(6)   We expect to pay these items using cash flow from operations.

(7)   Not included in this section are amounts contingently payable by us to acquire the membership interests of certain real estate joint venture partners.  See the section entitled “Off-Balance Sheet Arrangements” for further discussion of such amounts.

(8)   We do not expect to be required to fulfill our obligation as guarantor of joint venture loans.

 

Investing and financing activity subsequent to December 31, 2003

 

On March 5, 2004, we acquired for $22.4 million a 129,000 square foot office property located in Gaithersburg, Maryland, which is in Montgomery County.  This acquisition was financed using $16.8 million in mortgage loans assumed from the seller and the balance with proceeds from our Revolving Credit Facility.

 

Other future cash requirements for investing and financing activities

 

Subsequent to December 31, 2003, we entered into a contract to acquire 10 office properties totaling approximately 535,000 square feet for $65.2 million.  These buildings are located in St. Mary’s County, Maryland.  We expect that these acquisitions will be completed by April 2004 using borrowings under our Revolving Credit Facility.

 

As previously discussed, we had construction activities underway on two office properties totaling 244,824 square feet that were 100% pre-leased as of December 31, 2003.  We estimate remaining costs to be incurred will total approximately $22.8 million upon completion of these properties, most of which we expect to incur in 2004.  We have $16.7 million remaining to be borrowed under a $20.0 million construction loan facility for one of the properties; we expect to fund the remaining costs for these activities using primarily borrowings from our Revolving Credit Facility.

 

As of December 31, 2003, we had development activities underway on a new office property estimated to total 104,000 square feet.  We estimate that costs for this property will total approximately $18.0 million, which is expected to be incurred in 2004 and 2005.  We expect to fund approximately $12.0 million of these costs using borrowings from a new construction loan and $6.0 million using borrowings from our Revolving Credit Facility.

 

 

We estimate that we will incur additional tenant improvement, leasing and construction completion costs of $3.1 million during 2004 for three newly-constructed buildings that are 100% operational.  We expect to use remaining balances available under two construction loan facilities to finance these costs.

 

We intend to develop two of the new parcels of land acquired during 2003 and construct multiple office properties on the land.  We expect that the land will require approximately $2.0 million in development-related costs over the next two years prior to commencement of construction activities on the buildings; we expect to fund these costs using a combination of cash flow from operations and proceeds from our Revolving Credit Facility.  When construction of the buildings is ready to commence, we expect to obtain construction loans to finance the construction activities.  In addition, as construction of the buildings commences, we will need to pay down the portions of the existing loans on the property that are attributable to the land where the construction is taking place (the total loan balance at December 31, 2003 was $25.7 million, excluding discounts recorded on the loans); we expect to fund these loan pay downs primarily using proceeds from our Revolving Credit Facility.  While the timing of development and construction activities is dependent on the demand for office space in the real estate market, we expect to commence construction in 2004 on two office properties on this land parcel that will total approximately $48.4 million upon completion; we expect to fund approximately $33.9 million of these costs with borrowings from new construction loans and the balance using proceeds from our Revolving Credit Facility.

 

During 2004 and beyond, we expect to complete other acquisitions of properties and commence construction and development activities in addition to the ones previously described.  We expect to finance these activities as we have in the past, using mostly a combination of additional equity issuances of common and/or preferred shares, borrowings from new loans and borrowings under our Revolving Credit Facility.

 

Factors that could negatively affect our ability to finance our long-term financing and investing needs in the future include the following:

 

•      Our strategy is to operate with slightly higher debt levels than most other REITs.  However, these higher debt levels could make it difficult to obtain additional financing when required and could also make us more vulnerable to an economic downturn.  Most of our properties have been mortgaged to collateralize indebtedness.  In addition, we rely on borrowings to fund some or all of the costs of new property acquisitions, construction and development activities and other items.

•      We may not be able to refinance our existing indebtedness.

•      Much of our ability to raise capital through the issuance of preferred shares, common shares or securities that are convertible into our common shares is dependent on the value of our common and preferred shares.  As is the case with any publicly-traded securities, certain factors outside of our control could influence the value of our common and preferred shares. These conditions include, but are not limited to (1) market perception of REITs in general and office REITs in particular; (2) market perception of REITs relative to other investment opportunities; (3) the level of institutional investor interest in our company; (4) general economic and business conditions; (5) prevailing interest rates; and (6) market perception of our financial condition, performance, dividends and growth potential.

•      When we develop and construct properties, we assume the risk that actual costs will exceed our budgets, that we will experience construction or development delays and that projected leasing will not occur, any of which could adversely affect our financial performance and our ability to make distributions to our shareholders. In addition, we generally do not obtain construction financing commitments until the development stage of a project is complete and construction is about to commence.  We may find that we are unable to obtain financing needed to continue with the construction activities for such projects.

•      We invest in certain entities in which we are not the exclusive investor or principal decision maker.  Aside from our inability to unilaterally control the operations of these joint ventures, our investments entail the additional risks that (1) the other parties to these investments may not fulfill their financial obligations as investors, in which case we may need to fund such parties’ share of additional capital requirements and (2) the other parties to these investments may take actions that are inconsistent with our objectives.

•      Equity real estate investments such as our properties are relatively difficult to sell and convert to cash quickly, especially if market conditions are depressed.  Such illiquidity will tend to limit our ability to vary our portfolio of properties promptly in response to changes in economic or other conditions.  Moreover, under certain circumstances, the Internal Revenue Code imposes certain penalties on a REIT that sells property held for less than four years.  In addition, for certain of our properties that we acquired by issuing units in our Operating Partnership, we are restricted for a certain period of time from entering into transactions (such as the sale or refinancing of the acquired property) that will result in a taxable gain to the sellers without the sellers’ consent.  Due to all of these factors, we may be unable to sell a property at an advantageous time to fund our long-term capital needs.

•      We are subject to various federal, state and local environmental laws.  These laws can impose liability on property owners or operators for the costs of removal or remediation of hazardous substances released on a property, even if the property owner was not responsible for the release of the hazardous substances. Costs resulting from

 

 

environmental liability could be substantial.  The presence of hazardous substances on our properties may also adversely affect occupancy and our ability to sell or borrow against those properties.  In addition to the costs of government claims under environmental laws, private plaintiffs may bring claims for personal injury or other reasons.  Additionally, various laws impose liability for the costs of removal or remediation of hazardous substances at the disposal or treatment facility.  Anyone who arranges for the disposal or treatment of hazardous substances at such a facility is potentially liable under such laws.  These laws often impose liability on an entity even if the facility was not owned or operated by the entity.

 

Critical Accounting Policies and Estimates

 

Our Consolidated Financial Statements are prepared in accordance with GAAP, which require us to make certain estimates and assumptions. A summary of our significant accounting policies is provided in Note 3 to our Consolidated Financial Statements.  The following section is a summary of certain aspects of those accounting policies involving estimates and assumptions that (1) require our most difficult, subjective or complex judgments in accounting for highly uncertain matters or matters that are susceptible to change and (2) materially affect our reported operating performance or financial condition.  It is possible that the use of different reasonable estimates or assumptions in making these judgments could result in materially different amounts being reported in our Consolidated Financial Statements.  While reviewing this section, you should refer to Note 3 to our Consolidated Financial Statements, including terms defined therein.

 

•      When we acquire real estate properties, we allocate the acquisition to numerous components.  Most of the terms in this bullet section are defined in the section of Note 3 to the Consolidated Financial Statements entitled “Acquisitions of Real Estate.”  Our process for determining the allocation to these components is very complex and requires many estimates and assumptions.  Included among these estimates and assumptions are the following: (1) determination of market rental rate; (2) estimates of leasing and tenant improvement costs associated with the remaining term of acquired leases for deemed cost avoidance; (3) leasing assumptions used in determining the as-if vacant value and tenant value, including the rental rates, period of time which it will take to lease vacant space and estimated tenant improvement costs and estimated leasing costs; (4) estimate of the property’s future value in determining the as-if vacant value; (5) estimate of value attributable to market concentration premiums and tenant relationship values; and (6) allocation of the as-if vacant value between land and building.  A change in any of the above key assumptions, most of which are extremely subjective, can materially change not only the presentation of acquired properties in our Consolidated Financial Statements but also reported results of operations.  The allocation to different components affects the following:

•      Amount of the acquisition costs allocated between different categories of assets and liabilities on our balance sheet, the amount of costs assigned to individual properties in multiple property acquisitions and the amount of costs assigned to individual tenants at the time of acquisition;

•      Where the amortization of the components appear over time in our statements of operations.  Allocations to the lease to market value component are amortized into rental revenue, whereas allocations to most of the other components (the one exception being the land component of the as-if vacant value) are amortized into depreciation and amortization expense.  As a REIT, this is important to us since much of the investment community evaluates our operating performance using non-GAAP measures such as funds from operations, the computation of which includes rental revenue but does not include depreciation and amortization expense;

•      Timing over which the items are recognized as revenue or expense in our statements of operations.  For example, for allocations to the as-if vacant value, the land portion is not depreciated and the building portion is depreciated over a longer period of time than the other components (generally 40 years).  Allocations to lease to market value, deemed cost avoidance, tenant value and tenant relationship value are amortized over significantly shorter timeframes, and if individual tenants’ leases are terminated early, any unamortized amounts remaining associated with those tenants are generally expensed upon termination.  These differences in timing can materially affect our reported results of operations.  In addition, we establish lives for tenant value and tenant relationship value based on our estimates of how long we expect the respective tenants to remain in the properties; establishing these lives requires estimates and assumptions that are very subjective.

•      When we construct or develop a property, we capitalize all costs associated with that property.  Such costs include not only direct construction costs but also interest, real estate taxes and other costs associated with owning the property.  We continue to capitalize these costs while construction and development activities are underway until a building becomes “operational.”  A building becomes operational the earlier of when leases commence on its space or one year from the completion of major construction activities on the building (the “construction completion date”).  Our determination of the date construction and development activities are underway and the construction completion date occasionally requires judgments and estimates, which affect how much in costs associated with these properties are capitalized or expensed.  Since depreciation expense begins to be recorded when a building is operational, these judgments and estimates also affect depreciation expense.

•      We recognize an impairment loss on a real estate asset if the asset’s undiscounted expected future cash flows are less than its depreciated cost.  We compute a real estate asset’s undiscounted expected future cash flows using

 

 

certain estimates and assumptions.  As a result, these estimates and assumptions impact the amount of impairment loss that we recognize.

•      We use four different accounting methods to report our investments in entities: the consolidation method, the equity method, the cost method and the financing method (see Note 2 to our Consolidated Financial Statements).  We use the cost method when we own an interest in an entity and cannot exert significant influence over the entity’s operations.  When the cost method does not apply, we evaluate whether or not we can exert significant influence over the entity’s operations but cannot control the entity’s operations; when considering that, we need to determine whether a situation exists in which the entity is controlled by its owners (either us or our joint venture partners) without such owners owning most of the outstanding voting rights in the entity.  In performing this evaluation, we typically need to make subjective estimates and judgments regarding the entity’s future operating performance, financial condition, future valuation and other variables that may affect the partners’ share of cash flow from the entity over time; we also need to estimate the probability of different scenarios taking place over time and project the effect that each of those scenarios would have on variables affecting the partners’ cash flow.  The conclusion reached as a result of this process affects whether or not we use the consolidation method in accounting for our investment or either the equity or financing method of accounting.  Whether or not we consolidate an investment can materially affect our Consolidated Financial Statements.

 

Funds From Operations

 

Funds from operations (“FFO”) is defined as net income computed using GAAP, excluding gains (or losses) from sales of real estate, plus real estate-related depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures.  Gains from sales of newly-developed properties less accumulated depreciation, if any, required under GAAP are included in FFO on the basis that development services are the primary revenue generating activity; we believe that inclusion of these development gains is in accordance with the National Association of Real Estate Investment Trusts (“NAREIT”) definition of FFO, although others may interpret the definition differently.  Additionally, the repurchase of the Series C Preferred Units in the Operating Partnership for an amount in excess of their recorded book value was a transaction not contemplated in the NAREIT definition of FFO; we believe that the exclusion of such an amount from FFO is appropriate.

 

Accounting for real estate assets using historical cost accounting under GAAP assumes that the value of real estate assets diminishes predictably over time.  NAREIT stated in its April 2002 White Paper on Funds from Operations that “since real estate asset values have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves.”  As a result, the concept of FFO was created by NAREIT for the REIT industry to “address this problem.”  We agree with the concept of FFO and believe that FFO is useful to investors as a supplemental measure of operating performance.  In addition, since most equity REITs provide FFO information to the investment community, we believe that FFO is useful to investors as a supplemental measure for comparing our results to those of other equity REITs, although the FFO we present may not be comparable to the FFO presented by other REITs since they may interpret the current NAREIT definition of FFO differently or they may not use the current NAREIT definition of FFO.  We believe that net income is the most directly comparable GAAP measure to FFO.

 

Basic funds from operations (“Basic FFO”) is FFO adjusted to (1) subtract preferred share dividends and (2) add back GAAP net income allocated to common units in the Operating Partnership not owned by us.  With these adjustments, Basic FFO represents FFO available to common shareholders and common unitholders.  Common units in the Operating Partnership are substantially similar to our common shares; common units in the Operating Partnership are also exchangeable into common shares, subject to certain conditions.  We believe that Basic FFO is useful to investors due to the close correlation of common units to common shares.  We believe that net income is the most directly comparable GAAP measure to Basic FFO.

 

Diluted funds from operations per share (“Diluted FFO per share”) is (1) Basic FFO adjusted to add back any convertible preferred share dividends and any other changes in Basic FFO that would result from the assumed conversion of securities that are convertible or exchangeable into common shares divided by (2) the sum of the (a) weighted average common shares outstanding during a period, (b) weighted average common units outstanding during a period and (c) weighted average number of potential additional common shares that would have been outstanding during a period if other securities that are convertible or exchangeable into common shares were converted or exchanged.  However, the computation of Diluted FFO per share does not assume conversion of securities that are convertible into common shares if the conversion of those securities would increase Diluted FFO per share in a given period.  We believe that Diluted FFO per share is useful to investors because it provides investors with a further context for evaluating our FFO results in the same manner that investors use earnings per share (“EPS”) in evaluating net income available to common shareholders.  In addition, since most equity REITs provide Diluted FFO per share information to the investment community, we believe Diluted FFO per share is a useful supplemental measure for comparing us to

 

 

other equity REITs.  We believe that diluted EPS is the most directly comparable GAAP measure to Diluted FFO per share.

 

Diluted funds from operations (“Diluted FFO”) is Basic FFO adjusted to add back any convertible preferred share dividends and any other changes in Basic FFO that would result from the assumed conversion of securities that are convertible or exchangeable into common shares.  However, the computation of Diluted FFO does not assume conversion of securities that are convertible into common shares if the conversion of those securities would increase Diluted FFO per share in a given period.  We believe that Diluted FFO is useful to investors because it is the numerator used to compute Diluted FFO per share.  In addition, since most equity REITs provide Diluted FFO information to the investment community, we believe Diluted FFO is a useful supplemental measure for comparing us to other equity REITs.  We believe that the numerator for diluted earnings per share is the most directly comparable GAAP measure to Diluted FFO.

 

Our Basic FFO, Diluted FFO per share and Diluted FFO for the years ended December 31, 1999 through 2003 and reconciliations of (1) net income to FFO, (2) the numerator for diluted earnings per share to diluted FFO and (3) the denominator for diluted earnings per share to the denominator for diluted FFO per share are set forth in the following table: