PART I
Item 1. Business
OUR COMPANY
General. We are a
fully-integrated and self-managed real estate investment trust (“REIT”) that
focuses on the acquisition, development, ownership, management and leasing of
primarily Class A suburban office properties in the Greater Washington, D.C.
region and other select submarkets. We
also have a core customer expansion strategy built on meeting, through
acquisitions and development, the multi-location requirements of our strategic
tenants. Our strategy is to operate in
select, demographically strong submarkets where we can achieve critical mass,
operating synergies and key competitive advantages, including attracting high
quality tenants and securing acquisition and development opportunities. As of December 31, 2006, our investments in
real estate included the following:
· 170 wholly
owned operating properties in Maryland, Virginia, Colorado, Texas, Pennsylvania
and New Jersey containing 15.1 million rentable square feet that were 92.8%
occupied;
· 16 wholly
owned office properties under construction or development that we estimate will
total approximately 1.8 million square feet upon completion, and two wholly
owned office properties totaling approximately 129,000 square feet that were
under redevelopment;
· wholly owned
land parcels totaling 1,048 acres that were predominantly located near certain
of our operating properties and that we believe are potentially developable
into approximately 8.4 million square feet; and
· partial
ownership interests, primarily through joint ventures, in the following:
· 17 fully
operational properties totaling approximately 727,000 square feet;
· three
properties under construction or development (including one not owned but under
contract) that we estimate will total 324,000 square feet upon completion, and
two properties totaling approximately 611,000 square feet that were mostly
under redevelopment; and
· land parcels
totaling 279 acres that were predominantly located near certain of our
operating properties and potentially developable into approximately 2.4 million
square feet.
We
conduct almost all of our operations through our operating partnership,
Corporate Office Properties, L.P. (the “Operating Partnership”), a Delaware
limited partnership, of which we are the sole general partner. The Operating Partnership owns real estate
both directly and through subsidiaries.
The Operating Partnership also owns 100% of Corporate Office Management,
Inc. (“COMI”) and owns, either directly or through COMI, 100% of the following
entities that provide real estate services (collectively defined as the “Service
Companies”): COPT Property Management Services, LLC (“CPM”), COPT Development
and Construction Services, LLC (“CDC”), Corporate Development Services, LLC (“CDS”)
and COPT Environmental Systems, LLC (“CES”)(formerly named Corporate Cooling
and Controls, LLC). CPM manages most of
our properties and also provides corporate facilities management for select
third parties. CDS and CDC provide
construction and development services primarily to us but also to third
parties. CES provides heating and air
conditioning installation, maintenance, repair and controls services to us and
to third parties.
Interests
in our Operating Partnership are in the form of common and preferred
units. As of December 31, 2006, we owned
approximately 83% of the outstanding common units and approximately 96% of the
outstanding preferred units in our Operating Partnership. The remaining common and preferred units in
our Operating Partnership were owned by third parties, which included certain
of our Trustees.
We
believe that we are organized and have operated in a manner that permits us to
satisfy the requirements for taxation as a REIT under the Internal Revenue Code
of 1986, as amended, and we intend to continue to operate in such a
manner. If we qualify for taxation as a
REIT, we generally will not be subject to Federal income tax on our taxable
income that is distributed to our shareholders.
A REIT is subject to a number of organizational and operational
requirements, including a requirement that it distribute to its shareholders at
least 90% of its annual taxable income (excluding net capital gains).
Our
executive offices are located at 6711 Columbia Gateway Drive, Suite 300,
Columbia, Maryland 21046 and our telephone number is (443) 285-5400.
Corporate
Office Properties Trust’s Internet address is www.copt.com. We make available on our Internet website
free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably
possible after we file such material with the Securities and Exchange
Commission. In addition, we have made
available on our Internet website under the heading “Corporate Governance” the
charters for our Board of Trustees’ Audit Committee, Nominating and
4
Corporate
Governance Committee and Compensation Committee, as well as our Corporate
Governance Guidelines, Code of Business Conduct and Ethics and Code of Ethics
for Financial Officers. We intend to
make available on our website any future amendments or waivers to our Code of
Business Conduct and Ethics and Code of Ethics for Financial Officers within
four business days after any such amendments or waivers. The information on our Internet site is not
part of this report.
The
Securities and Exchange Commission (the “SEC”) maintains an Internet website
that contains reports, proxy and information statements and other information
regarding issuers that file electronically with the SEC. This Internet website can be accessed at
www.sec.gov. The public may also read
and copy paper filings that we have made with the SEC at the SEC’s Public
Reference Room. Information on the
operation of the Public Reference Room may be obtained by calling (800)
SEC-0330.
Significant
2006 Developments
During 2006, we:
· experienced
increased revenues, operating expenses and operating income due primarily to
the addition of properties through acquisition and construction activities;
· finished the period with occupancy for our wholly owned
portfolio of properties at 92.8%;
· acquired six
operating properties totaling 1.0 million square feet, a building to be
redeveloped totaling 74,749 square feet and seven parcels of land that we
believe can support up to 2.3 million developable square feet, for a total of
$169.7 million;
· acquired 500
acres of the 591-acre former Fort Ritchie United States Army Base located in
Cascade, Washington County, Maryland for a value of $5.6 million with an
initial cash outlay of $2.5 million and expect to acquire the remaining 91
acres in 2007. The 591-acre parcel is
anticipated to accommodate a total of 1.7 million square feet of office space and
673 residential units, including approximately 306,000 square feet of existing
office space and 110 existing rentable residential units;
· had seven
newly-constructed properties totaling 866,000 square feet become fully
operational. We also had 68,196 square
feet placed into service in one partially operational property;
· sold seven
operating properties, including three from one of our non-core regions, a newly
constructed property and a parcel of land for a total of $83.0 million,
resulting in recognized gains before minority interest totaling $17.3 million;
· sold 2.0
million common shares to an underwriter at a net price of $41.31 per share, for
net proceeds of $82.4 million;
· sold
3,390,000 Series J Cumulative Redeemable Preferred Shares of beneficial
interest (the “Series J Preferred Shares”) at a price of $25 per share for net
proceeds of $81.9 million;
· redeemed the
Series E Cumulative Redeemable Preferred Shares of beneficial interest and the
Series F Cumulative Redeemable Preferred Shares of beneficial interest for a
redemption price of $25 per share, resulting in a total payment of $64.4
million. We recognized a $3.9 million
decrease to net income available to common shareholders pertaining to the
original issuance costs of these shares;
· issued a
$200.0 million aggregate principal amount of 3.50% Exchangeable Senior Notes
due 2026. The notes are redeemable by us
on or after September 20, 2011. The notes also contain an exchange settlement
feature, which provides that the notes may, under certain circumstances, be
exchangeable for cash (up to the principal amount of the notes) and, with
respect to any excess exchange value, may be exchangeable into (at our option)
cash, our common shares of beneficial interest (“common shares”) or a
combination of cash and common shares at an initial exchange rate of 18.4162
shares per $1,000 principal amount of the notes; and
· borrowed
$146.5 million under a 10-year mortgage payable requiring payments of interest
only at a fixed rate of 5.43%.
Subsequent Events
On January 9 and 10, 2007, we completed a series of
transactions that resulted in the acquisition of 56 operating properties
totaling 2.4 million square feet and land parcels totaling 187 acres. We refer to this transaction as the
Nottingham Acquisition. All of the
acquired properties are located in Maryland, with 36 of the operating
properties, totaling 1.6 million square feet, and land parcels totaling 175
acres, located in White Marsh, Maryland and the remaining properties and land
parcels located in other regions in Northern Baltimore County and the
Baltimore/Washington Corridor. We
believe that the land parcels totaling 187 acres can support at least
2.0 million developable square feet.
We completed the Nottingham acquisition for an aggregate cost of
approximately $363.9 million. We
financed the acquisition by issuing $26.6 million in Series K Preferred Shares
of beneficial interest (the “Series K Preferred Shares”) to the seller, issuing
$154.9 million in common shares to the seller at a deemed value of $49 per
share, using $20.1 million from an escrow funded by proceeds from one of our
property sales and using debt borrowings for the remainder.
5
Corporate Objectives and Strategies
Our primary objectives are to achieve sustainable
long-term growth in results of operations and to maximize long-term shareholder
value. We seek to achieve these
objectives through focusing on the acquisition, development, ownership,
management and leasing of suburban office properties. Important elements of our strategy are set
forth below:
Geographic Focus. We focus our operations in select submarkets
where we believe that we already possess or can achieve the critical mass
necessary to maximize management efficiencies, operating synergies and
competitive advantages through our acquisition, property management and
development programs. The attributes we
look for in selecting submarkets include, among others: (1) proximity to large
demand drivers; (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. When 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. While most
of our properties are located in the Greater Washington, D.C. region, we expect
to pursue selective expansion opportunities outside of that region, typically
to meet the stated or anticipated needs of select strategic tenants.
Office Park Focus. We typically focus on owning and operating
properties located in established suburban corporate office parks. We believe that the suburban office park
environment generally attracts long-term, high-quality tenants seeking to
attract and retain quality work forces, because these parks are typically
situated along major transportation routes with easy access to support
services, amenities and residential communities.
High Quality Tenant Focus. We focus on tenants that are large,
financially sound entities with significant long-term space requirements. To enhance the stability of our cash flow, we
typically structure our leases with terms ranging from three to ten years. We believe that this strategy enables us to
establish long-term relationships with quality tenants and, coupled with our
geographic and submarket focus, enhances our ability to become the landlord of
choice in our targeted markets. Given
the terms of our leases, we monitor the timing of our lease maturities with the
goal being that such timing should not be highly concentrated in any given
one-year or five-year period.
Defense Industry Focus. 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). This industry is particularly interested in a
number of the submarkets where our properties are located and the types of
properties and service that we are able to provide. We also believe that our experience and
existing relationships in the industry position us well to continue and grow on
this focus. We seek to reinforce and expand
our relationships with these current and prospective tenants, while monitoring
our levels of concentration from a business risk perspective.
Acquisition Strategies. We generally pursue the acquisition of
suburban office properties through a three-part acquisition strategy. This strategy includes targeting: (1) entity
acquisitions of significant portfolios along with their management to establish
prominent ownership positions in new neighboring regions and enhance our
management infrastructure; (2) portfolio purchases to enhance our existing
submarket positions as well as enter selective new neighboring regions; and (3)
opportunistic acquisitions of individual properties in our existing
regions. We also pursue acquisition
opportunities for properties that meet the multi-location requirements of our
strategic tenants. We typically seek to
make acquisitions at attractive yields and below replacement cost. We also typically seek to increase cash flow
and enhance the underlying value of each acquisition through repositioning the
properties and capitalizing on existing below market leases and expansion
opportunities.
Property Development Strategies. We balance our acquisition program through
selective development and expansion of suburban office properties as market
conditions and leasing opportunities support favorable risk-adjusted
returns. We pursue development
opportunities principally in response to the needs of existing and prospective
new tenants. We generally develop sites
that are located near our existing properties.
We believe that developing such sites enhances our ability to
effectively meet tenant needs and efficiently provide critical tenant services.
Tenant Services. We seek to capitalize on our geographic focus
and critical mass of properties in our core regions by providing high level,
comprehensive services to our tenants.
We conduct most of our tenant services activities through our subsidiary
service companies. We believe that
providing quality services is an integral part of our goal to achieve
consistently high levels of tenant satisfaction and retention.
Internal Growth Strategies. We aggressively manage our portfolio to
maximize the operating performance of each property through: (1) proactive
property management and leasing; (2) achieving operating efficiencies through
increasing economies of
6
scale
and, where possible, aggregating vendor contracts to achieve volume pricing
discounts; (3) renewing tenant leases and re-tenanting at increased rents where
market conditions permit; and (4) expanding our tenant and real estate service
capabilities. These strategies are
designed to promote tenant satisfaction, resulting in higher tenant retention
and the attraction of new tenants.
Financing Policy
Our financing policy is aimed at maintaining a
flexible capital structure in order to facilitate consistent growth and
performance in the face of differing market conditions in the most
cost-effective way possible. Key
components of our policy are set forth below:
· monitoring
levels of debt relative to our overall capital structure;
· monitoring the
relationship of certain measures of earnings to certain financing cost
requirements; these relationships are known as coverage ratios. One coverage ratio on which our financing
policy focuses is fixed charge coverage ratio (defined as various measures of
results of operations divided by the sum of (1) interest expense on continuing
and discontinued operations; (2) dividends on preferred shares; and (3)
distributions on preferred units in our Operating Partnership not owned by
us). Coverage ratios such as fixed
charge coverage ratio are important to us in evaluating whether our operations
are sufficient to satisfy the cash flow requirements of our debt and equity
holders, including minority interest holders;
· monitoring the
relationship of our total variable-rate debt to our total debt; this is
important to us in limiting the amount of our debt that is subject to future
increases in interest rates;
· monitoring the
timing of our debt maturities to ensure that the maximum maturities of debt in
any year, both including and excluding our primary revolving credit facility,
do not exceed a defined percentage of total debt;
· pursuing
opportunities to reduce financing costs by refinancing existing debt or
redeeming existing preferred equity when we believe market conditions to be
favorable;
· pursuing the
issuance of common and preferred shares when we believe market conditions to be
favorable; and
· using
units in our Operating Partnership as an equity source to finance our investing
activities; this strategy provides prospective property sellers the ability to
defer taxable gains by receiving our partnership units in lieu of cash and
reduces the need for us to access the equity and debt markets.
Debt
For information relating to future maturities of
our debt, you should refer to the section entitled “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” and Note 9 to our
Consolidated Financial Statements and notes thereto, which is located in a
separate section at the end of this report beginning on page F-1.
Industry Segments
We operate in one primary industry: suburban
office real estate. At December 31,
2006, our suburban office real estate operations had nine primary geographical
segments, as set forth below:
· Baltimore/Washington
Corridor (defined as the Maryland counties of Howard and Anne Arundel);
· Northern
Virginia (defined as Fairfax County, Virginia);
· Suburban
Maryland (defined as the Maryland counties of Montgomery, Prince George’s and
Frederick);
· St. Mary’s
& King George Counties (located in Maryland and Virginia, respectively);
· Suburban
Baltimore, Maryland;
· Colorado
Springs, Colorado;
· San Antonio,
Texas;
· Northern/Central
New Jersey (as of December 31, 2006, all of our properties in this segment were
located in Central New Jersey); and
· Greater
Philadelphia, Pennsylvania.
As of December 31, 2006, 124 of our properties
were located in what is widely known as the Greater Washington, D.C. region,
which includes the first four regions set forth above, and 23 were located in
neighboring Suburban Baltimore. The core customer expansion strategy that we
began implementing in 2004 led us into the next two regions set forth above:
San Antonio, Texas and Colorado Springs, Colorado. The last two regions set forth above are
considered non-core to the Company. For
information relating to these geographic segments, you should refer to Note 16
to our Consolidated Financial Statements, which is included in a separate
section at the end of this report beginning on page F-1.
7
Employees
As
of December 31, 2006, we had 313 employees.
We believe that our relations with our employees are good.
Competition
The commercial real estate market is highly
competitive. Numerous commercial
properties compete for tenants with our properties. Some of the properties competing with ours
may be newer or have more desirable locations or the competing properties’
owners may be willing to accept lower rents than are acceptable to us. In addition, the competitive environment for
leasing is affected considerably by a number of factors including, among other
things, changes in economic factors and supply and demand of space. These factors may make it difficult for us to
lease existing vacant space and space associated with future lease expirations
at rental rates that are sufficient to meeting our short-term capital needs.
We also 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 ours. In addition, our competitors may be willing
to accept lower returns on their investments.
If our competitors prevent us from buying properties that we have targeted
for acquisition, we may not be able to meet our property acquisition and development
goals.
Item
1A. Risk Factors
Set
forth below are risks and uncertainties relating to our business and the
ownership of our securities. You should
carefully consider each of the risks and uncertainties below and all of the
information in this Form 10-K and its Exhibits, including our Consolidated
Financial Statements and notes thereto for the year ended December 31, 2006,
which are included in a separate section at the end of this report beginning on
page F-1.
We may suffer adverse consequences as a result of
our reliance on rental revenues for our income. 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.
If our properties do not generate revenue sufficient
to meeting our operating expenses and capital costs, we may have to borrow
additional amounts to cover these costs.
In such circumstances, we would likely have lower profits or possibly
incur losses. We may also find in such
circumstances that we are unable to borrow to cover such costs, in which case
our operations could be adversely affected.
Moreover, there may be less or no cash available for distributions to
our shareholders.
In addition, the competitive environment for leasing
is affected considerably by a number of factors including, among other things,
changes due in economic factors and supply and demand of space. These factors may make it difficult for us to
lease existing vacant space and space associated with future lease expirations
at rental rates that are sufficient to meeting our short-term capital needs.
Adverse developments concerning some of our key
tenants could have a negative impact on our revenue. As of December 31, 2006, 20 tenants accounted
for 56.7% of the total annualized rental revenue of our wholly owned
properties, excluding owner-occupied leasing activity, and five of these
tenants accounted for 34.2% of that total. We computed the annualized rental
revenue by multiplying by 12 the sum of monthly contractual base rents and
estimated monthly expense reimbursements under active leases in our portfolio
of wholly owned properties as of December 31, 2006. We consider annualized rental revenue to be a
useful measure for analyzing revenue sources because, since it is point-in-time
based, it does not contain increases and decreases in revenue associated with
periods in which lease terms were not in effect; historical revenue under GAAP
does contain such fluctuations. We find the measure particularly useful for
leasing, tenant, segment and industry analysis. Information regarding our five
largest tenants is set forth below:
8
|
Tenant
|
|
Annualized
Rental Revenue at
December 31, 2006
|
|
Percentage of
Total Annualized
Rental Revenue of
Wholly Owned Properties
|
|
Number
of Leases
|
|
|
|
|
(in thousands)
|
|
|
|
|
|
|
United States of
America
|
|
$
|
47,584
|
|
16.3
|
%
|
45
|
|
|
Booz Allen
Hamilton, Inc.
|
|
20,145
|
|
6.9
|
%
|
10
|
|
|
Northrop Grumman
Corporation
|
|
12,375
|
|
4.2
|
%
|
15
|
|
|
Computer
Sciences Corporation (1)
|
|
11,076
|
|
3.8
|
%
|
4
|
|
|
AT&T Corporation
|
|
8,693
|
|
3.0
|
%
|
10
|
|
|
|
|
|
|
|
|
|
|
(1) Includes affiliated organizations and agencies
and predecessor companies.
If any of our five largest tenants fail 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, there
would be an adverse effect on our financial performance and ability to make
distributions to our shareholders.
As
of December 31, 2006, the United States defense industry (comprising the United
States Government and defense contractors) accounted for approximately 54.4% of
the total annualized rental revenue of our wholly owned properties. Most of the 16.3% of our total annualized
rental revenue that we derived from leases with agencies of the United States
Government as of December 31, 2006 is included in the 54.4% of our total
annualized revenue from the United States defense industry. We classify the
revenue from our leases into industry groupings based solely on management’s
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.
We have become increasingly reliant on defense
industry tenants in recent years due primarily to: (1) increased activity in
that industry following the events of September 11, 2001; (2) the strong
presence of the industry in a number of our submarkets; and (3) our strategy to
form strategic alliances with certain of our tenants in the industry. The percentage of our total annualized rental
revenue derived from the defense industry could continue to increase. A
reduction in government spending for defense could affect the ability of these
tenants 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. Such occurrences could have an adverse effect on our results of
operations, financial condition, cash flows and ability to make distributions
to our shareholders.
We rely on the ability of our tenants to pay rent
and would be harmed by their inability to do so. Our performance depends on the ability of our
tenants to fulfill their lease obligations by paying their rental payments in a
timely manner. In addition, as noted
above, we rely on a few major tenants for a large percentage of our total rental
revenue. 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 financial performance and ability to make expected
distributions to shareholders.
Most of our properties are geographically
concentrated in the Mid-Atlantic region, particularly in the Greater
Washington, D.C. region and neighboring suburban Baltimore. We may suffer economic harm in the event of a
decline in the real estate market or general economic conditions in those
regions. Most of our
properties are located in the Mid-Atlantic region of the United States and as
of December 31, 2006, our properties located in the Greater Washington, D.C.
region and neighboring Suburban Baltimore accounted for a combined 87.6% of our
total annualized rental revenue from wholly owned properties. Our properties are also typically
concentrated in office parks in which we own most of the properties. Consequently, 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 Greater Washington, D.C. region or
the office parks in which our properties are located could have an adverse
effect on our financial position, results of operations, cash flows and ability
to make expected distributions to our shareholders.
9
We would suffer economic harm if we were unable to
renew our leases on favorable terms. When leases expire for our properties, 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 and
ability to make expected distributions to our shareholders could be adversely
affected if we experience a high volume of tenant departures at the end of
their lease terms. Set forth below are
the percentages of total annualized rental revenue from wholly owned properties
as of December 31, 2006 that are subject to scheduled lease expirations in each
of the next five years:
|
2007
|
|
12.4
|
%
|
|
2008
|
|
9.9
|
%
|
|
2009
|
|
16.0
|
%
|
|
2010
|
|
14.0
|
%
|
|
2011
|
|
8.3
|
%
|
Most
of the leases with our largest tenant, the United States Government, which
account for 16.3% of our total annualized rental revenue in wholly owned
properties at December 31, 2006, 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 it leases 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.
We may not be able to compete successfully with
other entities that operate in our industry. 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 and distributions to our
shareholders.
We may be
unable to successfully execute our plans to acquire existing commercial real
estate properties. We
intend to acquire existing commercial real estate properties to the extent that
suitable acquisitions can be made on advantageous terms. Acquisitions of
commercial properties entail risks, such as the risks that we may not be in a
position or have the opportunity in the future to make suitable property
acquisitions on advantageous terms and that such acquisitions will fail to
perform as expected. Our failure to
successfully execute acquisitions of existing real estate properties could
adversely affect our financial performance and our ability to make
distributions to our shareholders.
We may
suffer economic harm as a result of making unsuccessful acquisitions in new
markets. In 2006, we
completed acquisitions of properties in regions where we did not previously own
properties. Moreover, we expect to continue to pursue
selective acquisitions of properties in new regions. These acquisitions may entail risks in
addition to those we have faced in past acquisitions, such as the risk that we
do not correctly anticipate conditions or trends in a new region, and are
therefore not able to operate the acquired property profitably. If this occurred, it could adversely affect
our financial performance and our ability to make distributions to our
shareholders.
We
may be unable to execute our plans to develop and construct additional
properties. Although the
majority of our investments are in currently leased properties, we also
develop, construct and renovate properties, including some that are not fully
pre-leased. When we develop, construct and renovate properties, we assume the
risk that actual costs will exceed our budgets, that we will experience 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 may suffer economic harm as a result of the
actions of our joint venture partners. We invest in certain entities in which we are
not the exclusive investor or principal decision maker. As of December 31, 2006, we owned 17 fully
operational properties and properties under construction, development,
redevelopment or held for future development through joint ventures. We also continue to pursue new investments in
real estate through joint ventures.
Aside from our inability to unilaterally control
10
the
operations of joint ventures, our investments in joint ventures 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, either of which could have an adverse effect on our financial
condition, results of operations, cash flows and ability to make expected
distributions to our shareholders.
We are subject to possible environmental
liabilities. 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.
Real estate investments are illiquid, and we may
not be able to sell our properties on a timely basis when we determine it is
appropriate to do so.
Real estate investments can be 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 by agreements with the sellers of
the properties 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 seller’s consent. Due to all of these factors, we may be unable
to sell a property at an advantageous time.
We are subject to other possible liabilities that
would adversely affect our financial position and cash flows. Our properties may be subject to other risks
related to current or future laws, including laws benefiting disabled persons,
and state or local laws relating to zoning, construction and other
matters. These laws may require
significant property modifications in the future for which we may not have
budgeted and could result in the levy of fines against us. In addition, 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 a property that is damaged by a fire
or other catastrophic events, including acts of war or terrorism. The occurrence of any of these events could
have an adverse effect on our financial condition, results of operations, cash
flows and ability to make expected distributions to our shareholders.
As a
result of the September 11, 2001 terrorist attacks, we may be subject to
increased costs of insurance and limitations on coverage. Our
portfolio of properties is insured for losses under our property, casualty and
umbrella insurance policies through September 30, 2007. These policies include coverage for acts of
terrorism. Future changes in the
insurance industry’s risk assessment approach and pricing structure 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.
We may suffer adverse effects as a result of the
indebtedness that we carry and the terms and covenants that relate to this
debt. Our strategy is
to operate with slightly higher debt levels than many 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.
The majority of our properties were either collateralized or identified
by us to support repayment on 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. Our organizational documents do
not limit the amount of indebtedness that we may incur. As of December 31, 2006, our total
outstanding debt was $1.5 billion and our debt to total assets (defined as (1)
the sum of mortgage and other loans and exchangeable senior notes divided by
(2) total assets) was 61.9%.
Payments
of principal and interest on our debt may leave us with insufficient cash to
operate our properties or pay distributions to our shareholders required to
maintain our qualification as a REIT. We
are also subject to the risks that:
· we
may not be able to refinance our existing indebtedness or refinance on terms as
favorable as the terms of our existing indebtedness;
11
· certain debt
agreements of our Operating Partnership could restrict the ability of our
Operating Partnership to make cash distributions to us, which could result in
reduced distributions to our shareholders or the need to incur additional debt
to fund these distributions; and
· if
we are unable to pay our debt service on time or are unable to comply with
restrictive financial covenants in certain of our debt, our lenders could
foreclose on our properties securing such debt and in some cases other
properties and assets that we own.
Much
of our debt is cross-collateralized, which means that separate groups of
properties from our portfolio secure each of the underlying loans. More importantly, much of our debt is cross-defaulted,
which means that failure to pay interest or principal on any of our loans will
create a default on certain of our other loans.
Any foreclosure of our properties would result in loss of income and
asset value that would negatively affect our financial condition, results of
operations, cash flows and ability to make expected distributions to our
shareholders. In addition, if we are in
default and the value of the properties securing a loan is less than the loan
balance, the lender may require payment from our other assets.
As of December 31, 2006, 11.7% of our total debt had
variable interest rates, including the effect of interest rate swaps. If short-term interest rates were to rise,
our debt service payments on adjustable rate debt would increase, which would
lower our net income and could decrease our distributions to our
shareholders. We use interest rate swap
agreements from time to time to reduce the impact of changes in interest rates.
Decreases in interest rates would result in increased interest payments due
under interest rate swap agreements in place and could result in the Company
recognizing a loss and remitting a payment to unwind such agreements.
We must refinance our debt in the future. As of December 31, 2006, our scheduled debt
payments over the next five years, including maturities, were as follows:
|
Year
|
|
Amount (1)
|
|
|
|
|
(in thousands)
|
|
|
2007
|
|
$
|
140,950
|
(2)
|
|
2008
|
|
375,208
|
(3)
|
|
2009
|
|
61,791
|
|
|
2010
|
|
73,128
|
|
|
2011
|
|
108,854
|
|
|
|
|
|
|
(1) Represents principal maturities only and therefore excludes premiums and
discounts.
(2) Includes maturities totaling $48.8 million that may be extended for a
one-year period, subject to certain conditions.
(3) Includes
maturities totaling $218.4 million that may be extended for a one-year period,
subject to certain conditions.
Our
operations likely will not generate enough cash flow to repay some or all of
this debt without additional borrowings or new equity financings. If we cannot refinance our debt, extend the
repayment dates, or raise additional equity prior to the date when our debt
matures, we would default on our existing debt, which would have an adverse
effect on our financial position, results of operations, cash flows and ability
to make expected distributions to our shareholders.
We may be unable to continue to make shareholder
distributions at expected levels.
We intend to make regular quarterly cash distributions to our
shareholders. However, distribution
levels depend on a number of factors, some of which are beyond our control.
Our loan agreements contain provisions that could
restrict future distributions. Our
ability to sustain our current distribution level will also be dependent, in
part, on other matters, including:
· continued
property occupancy and timely payment by tenants of rent obligations;
· the amount of
future capital expenditures and expenses relating to our properties;
· the level of
leasing activity and future rental rates;
· the strength of
the commercial real estate market;
· competition;
· the costs of
compliance with environmental and other laws;
· our corporate
overhead levels;
· the amount of
uninsured losses; and
· our
decision to reinvest in operations rather than distribute available cash.
12
In
addition, we can make distributions to the holders of our common shares only
after we make preferential distributions to holders of our preferred shares.
Our ownership limits are important factors. Our Declaration of Trust limits ownership of
our common shares by any single shareholder to 9.8% of the number of the
outstanding common shares or 9.8% of the value of the outstanding common
shares, whichever is more restrictive.
Our Declaration of Trust also limits ownership by any single shareholder
of our common and preferred shares in the aggregate to 9.8% of the aggregate
value of the outstanding common and preferred shares. We call these restrictions the “Ownership
Limit.” Our Declaration of Trust allows our Board of Trustees to exempt
shareholders from the Ownership Limit, and our Board of Trustees previously has
exempted one entity from the Ownership Limit.
Our Declaration of Trust includes other provisions
that may prevent or delay a change of control. Subject to the requirements of the New York Stock
Exchange, our Board of Trustees has the authority, without shareholder
approval, to issue additional securities on terms that could delay or prevent a
change in control. In addition, our
Board of Trustees has the authority to reclassify any of our unissued common
shares into preferred shares. Our Board
of Trustees may issue preferred shares with such preferences, rights, powers
and restrictions as our Board of Trustees may determine, which could also delay
or prevent a change in control.
Our Board of Trustees is divided into three
classes of Trustees, which could delay a change of control. Our Declaration of Trust divides our Board of
Trustees into three classes. The term of
one class of the Trustees expires each year, at which time a successor class is
elected for a term ending at the third succeeding annual meeting of
shareholders. Such staggered terms make
it more difficult for a third party to acquire control of us.
The Maryland business statutes also impose
potential restrictions on a change of control of our company. Various Maryland laws may have the effect of
discouraging offers to acquire us, even if the acquisition would be
advantageous to shareholders.
Resolutions adopted by our Board of Trustees and/or provisions of our
bylaws exempt us from such laws, but our Board of Trustees can alter its
resolutions or change our bylaws at any time to make these provisions
applicable to us.
Our failure to qualify as a REIT would have
adverse tax consequences.
We believe that since 1992 we have qualified for taxation as a REIT for
Federal income tax purposes. We plan to
continue to meet the requirements for taxation as a REIT. Many of these requirements, however, are highly
technical and complex. The determination
that we are a REIT requires an analysis of various factual matters and
circumstances that may not be totally within our control. For example, to
qualify as a REIT, at least 95% of our gross income must come from certain
sources that are itemized in the REIT tax laws.
We are also required to distribute to shareholders at least 90% of our
REIT taxable income (excluding capital gains).
The fact that we hold most of our assets through our Operating
Partnership and its subsidiaries further complicates the application of the
REIT requirements. Even a technical or
inadvertent mistake could jeopardize our REIT status. Furthermore, Congress and the Internal
Revenue Service might make changes to the tax laws and regulations and the
courts might issue new rulings that make it more difficult or impossible for us
to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject
to Federal income tax at regular corporate rates. Also, unless the Internal Revenue Service
granted us relief under certain statutory provisions, we would remain
disqualified as a REIT for four years following the year we first fail to
qualify. If we fail to qualify as a
REIT, we would have to pay significant income taxes and would therefore have
less money available for investments or for distributions to our
shareholders. This would likely have a
significant adverse effect on the value of our securities. In addition, we would no longer be required
to make any distributions to our shareholders.
We have certain distribution requirements that
reduce cash available for other business purposes. As a REIT, we must distribute at least 90% of
our annual 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 we actually receive revenue or pay
expenses and the period during which we report those items for distribution
purposes, we may have to borrow funds to meet the 90% distribution requirement. We may become subject to tax liabilities that
adversely affect our operating cash flow and available cash for distribution to
shareholders.
A number of factors could cause our security
prices to decline. 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:
13
· market
perception of REITs in general and office REITs in particular;
· market
perception of REITs relative to other investment opportunities;
· the level of
institutional investor interest in our company;
· general economic
and business conditions;
· prevailing
interest rates; and
· market
perception of our financial condition, performance, dividends and growth
potential.
Generally, REITs are tax-advantaged relative to C
corporations because they are not subject to corporate-level Federal
income tax on income that they distribute to shareholders. However, Congress
made changes to the tax laws and regulations that could make it less
advantageous for investors to invest in REITs. The Jobs and Growth Tax Relief
Reconciliation Act of 2003, or the 2003 Act, provides that generally for
taxable years beginning after December 31, 2002 and before December 31,
2008, certain dividends received by domestic individual shareholders from
certain C corporations are subject to a reduced rate of tax of up to 15%. Prior
to this Act, such dividends received by domestic individual shareholders were
generally subject to tax at ordinary income rates, which were as high as 38.6%.
In general, the provisions of the Act do not benefit individual shareholders of
REITs and could make an investment in a C corporation that is not a REIT more
attractive than an investment in a REIT. We cannot predict the effects that
this Act may have on the market price for our common or preferred shares.
The average daily trading volume of our common shares
during the year ended December 31, 2006 was approximately 292,000 shares, and
the average trading volume of our publicly-traded preferred shares is
generally insignificant. As a result,
relatively small volumes of transactions could have a pronounced effect on the
market price of such shares.
Our
ability to pay dividends may be limited, and we cannot assure you that we will
be able to pay dividends regularly. Because
we conduct substantially all of our operations through our operating
partnership, our ability to pay dividends on any series of preferred shares
will depend almost entirely on payments and dividends received on our interests
in our operating partnership the payment of which depends in turn on our
ability to operate profitably and generate cash flow from our operations. We cannot guarantee that we will be able to
pay dividends on a regular quarterly basis in the future. Additionally, the terms of some of the debt
to which our operating partnership is a party limit its ability to make some
types of payments and other dividends to us. This in turn limits our ability to
make some types of payments, including payment of dividends on common or
preferred shares, unless we meet certain financial tests or such payments or
dividends are required to maintain our qualification as a REIT. As a result, if
we are unable to meet the applicable financial tests, we may not be able to pay
dividends on our shares in one or more periods.
Furthermore, any new shares of beneficial interest issued will
substantially increase the cash required to continue to pay cash dividends at
current levels. Any common or preferred shares of beneficial interest that may
in the future be issued to finance acquisitions, upon exercise of options or
otherwise, would have a similar effect.
Our
ability to pay dividends is further limited by the requirements of Maryland
law. Our ability to
pay dividends on any series of preferred shares is further limited by the laws
of Maryland. Under applicable Maryland
law, a Maryland REIT may not make a distribution if, after giving effect to the
distribution, the REIT would not be able to pay its debts as the debts become
due in the usual course of business, or the REIT’s total assets would be less
than the sum of its total liabilities plus the amount that would be needed, if
the REIT were dissolved at the time of the distribution, to satisfy the
preferential rights upon dissolution of shareholders whose preferential rights
are superior to those receiving the distribution. Accordingly, we may not make
a distribution on any series of preferred shares if, after giving effect to the
distribution, we would not be able to pay our debts as they become due in the
usual course of business or our total assets would be less than the sum of our
total liabilities plus the amount that would be needed to satisfy the
preferential rights upon dissolution of the holders of shares of any series of
preferred shares then outstanding, if any, with preferences senior to those of
any such series of preferred shares.
We
may incur additional indebtedness, which may harm our financial position and
cash flow and potentially impact our ability to pay dividends on any series of
preferred shares. Our
governing documents do not limit us from incurring additional indebtedness and
other liabilities. As of December 31, 2006, we had $1.5 billion of consolidated
indebtedness outstanding. We may incur additional indebtedness and become more
highly leveraged, which could harm our financial position and potentially limit
our cash available to pay dividends. As a result, we may not have sufficient
funds remaining to satisfy our dividend obligations relating to any series of
preferred shares if we incur additional indebtedness.
We are dependent on external sources of capital
for future growth. As
noted above, because we are a REIT, we must distribute at least 90% of our
annual taxable income to our shareholders.
Due to this requirement, we will not be able to fund our acquisition,
construction and development activities using cash flow from operations. Therefore, our ability to fund these
14
activities
is dependent on our ability to access capital funded by third parties. Such capital could be in the form of new
debt, equity issuances of common shares, preferred shares, common and preferred
units in our Operating Partnership or joint venture funding. Such capital may not be available on
favorable terms or at all. Moreover,
additional debt financing may substantially increase our leverage and subject
us to covenants that restrict management’s flexibility in directing our
operations, and additional equity offerings may result in substantial dilution
of our shareholders’ interests. Our
inability to obtain capital when needed could have a material adverse effect on
our ability to expand our business and fund other cash requirements.
Our business and operations would suffer in
the event of system failures. Despite system redundancy, the implementation of security
measures and the existence of a Disaster Recovery Plan for our internal
information technology systems, our systems are vulnerable to damages from
computer viruses, unauthorized access, energy blackouts, natural disasters,
terrorism, war and telecommunication failures. Any system failure or accident
that causes interruptions in our operations could result in a material
disruption to our business. We may also incur additional costs to remedy
damages caused by such disruptions.
Certain of our officers and Trustees have
potential conflicts of interest. Certain of our officers and members of our
Board of Trustees own partnership units in our Operating Partnership. These individuals may have personal interests
that conflict with the interests of our shareholders. For example, if our Operating Partnership
sells or refinances certain of the properties that these officers or Trustees
contributed to the Operating Partnership, the officers or Trustees could suffer
adverse tax consequences. Their personal
interests could conflict with our interests if such a sale or refinancing would
be advantageous to us. We have certain
policies in place that are designed to minimize conflicts of interest. We cannot, however, assure you that these
policies will be successful in eliminating the influence of such conflicts, and
if they are not successful, decisions could be made that might fail to reflect
fully the interests of all of our shareholders.
We are dependent on our key personnel, and the
loss of any key personnel could have an adverse effect on our operations. We are dependent on the efforts of our
executive officers. The loss of any of
their services could have an adverse effect on our operations. Although certain of our officers have entered
into employment agreements with us, we cannot assure you that they will remain
employed with us.
We may change our policies without shareholder
approval, which could adversely affect our financial condition, results of
operations, market price of our common shares or ability to pay distributions. Our Board of Trustees determines all of our
policies, including our investment, financing and distribution policies. Although our Board of Trustees has no current
plans to do so, it may amend or revise these policies at any time without a
vote of our shareholders. Policy changes
could adversely affect our financial condition, results of operations, the
market price of our securities or distributions.
Compliance with changing regulation of corporate
governance and public disclosure may result in additional expenses, affect our
operations and affect our reputation. Changing laws, regulations
and standards relating to corporate governance and public disclosure, including
the Sarbanes-Oxley Act of 2002 and new SEC regulations and New York Stock
Exchange rules, continue to create uncertainty for public companies. These new
or changed laws, regulations and standards are subject to varying
interpretations in many cases due to their lack of specificity, and as a
result, their application in practice is evolving over time as new guidance is
provided by regulatory and governing bodies, which could result in continuing
uncertainty regarding compliance matters and higher costs necessitated by
ongoing revisions to disclosure and governance practices. We are committed to
maintaining high standards of corporate governance and public disclosure. As a
result, our efforts to comply with evolving laws, regulations and standards
have resulted in, and are likely to continue to result in, increased general
and administrative expenses and a diversion of management time and attention
from revenue-generating activities to compliance activities. In particular, our
efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and
the related regulations regarding our required assessment of our internal
controls over financial reporting and our external auditors’ audit of that
assessment has required the commitment of significant financial and managerial
resources. In addition, it has become more expensive for us to obtain director
and officer liability insurance. We expect these efforts to require the
continued commitment of significant resources. Further, our trustees, Chief
Executive Officer and Chief Financial Officer could face an increased risk of
personal liability in connection with the performance of their duties. As a
result, we may have difficulty attracting and retaining qualified trustees and
executive officers, which could harm our business. If our efforts to comply
with new or changed laws, regulations and standards differ from the activities
intended by regulatory or governing bodies due to ambiguities related to
practice, our reputation may be harmed.
Item
1B. Unresolved Staff Comments
None
15
