Exhibit 99.4

 

CORPORATE OFFICE PROPERTIES TRUST AND SUBSIDIARIES

INDEX TO FINANCIAL STATEMENTS

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Management’s Report of Internal Control Over Financial Reporting	F-2
Report of Independent Registered Public Accounting Firm	F-3
Consolidated Balance Sheets as of December 31, 2008 and 2007	F-4
Consolidated Statements of Operations for the Years Ended December 31, 2008, 2007 and 2006	F-5
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2008, 2007 and 2006	F-6
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006	F-7
Notes to Consolidated Financial Statements	F-8

 

FINANCIAL STATEMENT SCHEDULE

 

Schedule III -Real Estate and Accumulated Depreciation as of December 31, 2008

F-40

 

F-1

 

Management’s Report On Internal Control Over Financial Reporting

 

Management is responsible for establishing and maintaining adequate internal control over financial reporting, and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2008. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and trustees; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management performed an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2008 based upon criteria in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment, management determined that our internal control over financial reporting was effective as of December 31, 2008 based on the criteria in Internal Control-Integrated Framework issued by the COSO.

 

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2008 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

F-2

 

Report of Independent Registered Public Accounting Firm

 

To the Board of Trustees and Shareholders of Corporate Office Properties Trust:

 

In our opinion, the consolidated financial statements listed in the accompanying index 15(a)(1) present fairly, in all material respects, the financial position of Corporate Office Properties Trust and its subsidiaries at December 31, 2008 and December 31, 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Report on Internal Control over Financial Reporting”. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

As discussed in Note 2 to the consolidated financial statements and Note 1 to the financial statement schedule, the Company changed the manner in which it accounts for certain convertible debt instruments, the manner in which it accounts for noncontrolling interests, and the manner in which it computes earnings per share effective January 1, 2009, retrospectively to prior periods.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

 

/s/ PricewaterhouseCoopers LLP
Baltimore, Maryland
February 27, 2009, except with respect to our opinion on the consolidated financial statements and financial statement schedule insofar as it relates to the effects of the retrospective adoption of Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” FASB Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” and EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities,” as to which the date is June 2, 2009.

 

F-3

 

Corporate Office Properties Trust and Subsidiaries

Consolidated Balance Sheets

(Dollars in thousands)

 

		December 31,
		2008			2007
Assets
Properties, net:
Operating properties, net		$	2,283,870		$	2,192,939
Projects under construction or development		494,596			396,909
Property held for sale		—			14,988
Total properties, net		2,778,466			2,604,836
Cash and cash equivalents		6,775			24,638
Restricted cash		13,745			15,121
Accounts receivable, net		13,684			24,831
Deferred rent receivable		64,131			53,631
Intangible assets on real estate acquisitions, net		91,848			108,661
Deferred charges, net		51,801			48,665
Prepaid and other assets		93,789			51,981
Total assets		$	3,114,239		$	2,932,364
Liabilities and equity
Liabilities:
Mortgage and other loans payable		$	1,704,123		$	1,625,842
3.5% Exchangeable Senior Notes		152,628			183,768
Accounts payable and accrued expenses		93,625			75,535
Rents received in advance and security deposits		30,464			31,234
Dividends and distributions payable		25,794			22,441
Deferred revenue associated with acquired operating leases		10,816			11,530
Distributions in excess of investment in unconsolidated real estate joint venture		4,770			4,246
Other liabilities		9,596			8,288
Total liabilities		2,031,816			1,962,884
Commitments and contingencies (Note 18)
Equity:
Corporate Office Properties Trust’s shareholders’ equity:
Preferred Shares of beneficial interest with an aggregate liquidation preference of $216,333 at December 31, 2008 and 2007 (Note 11)		81			81
Common Shares of beneficial interest ($0.01 par value; 75,000,000 shares authorized, shares issued and outstanding of 51,790,442 at December 31, 2008 and 47,366,475 at December 31, 2007)		518			474
Additional paid-in capital		1,112,734			971,459
Cumulative distributions in excess of net income		(162,572		)	(129,599		)
Accumulated other comprehensive loss		(4,749		)	(2,372		)
Total Corporate Office Properties Trust’s shareholders’ equity		946,012			840,043
Noncontrolling interests in subsidiaries:
Common units in the Operating Partnership		117,356			113,469
Preferred units in the Operating Partnership		8,800			8,800
Other consolidated real estate joint ventures		10,255			7,168
Noncontrolling interests in subsidiaries		136,411			129,437
Total equity		1,082,423			969,480
Total liabilities and equity		$	3,114,239		$	2,932,364

 

See accompanying notes to consolidated financial statements.

 

F-4

 

Corporate Office Properties Trust and Subsidiaries

Consolidated Statements of Operations

(Dollars in thousands, except per share data)

 

		For the Years Ended December 31,
		2008			2007			2006
Revenues
Rental revenue		$	336,942		$	314,696		$	253,021
Tenant recoveries and other real estate operations revenue		62,691			51,218			38,423
Construction contract revenues		186,608			37,074			52,182
Other service operations revenues		1,777			4,151			7,902
Total revenues		588,018			407,139			351,528
Expenses
Property operating expenses		141,139			123,258			93,088
Depreciation and other amortization associated with real estate operations		102,720			104,700			76,344
Construction contract expenses		182,111			35,723			49,961
Other service operations expenses		2,031			4,070			7,384
General and administrative expenses		25,329			21,704			18,048
Total operating expenses		453,330			289,455			244,825
Operating income		134,688			117,684			106,703
Interest expense		(86,870		)	(88,638		)	(74,023		)
Interest and other income		2,070			3,030			1,077
Gain on early extinguishment of debt		8,101			—			—
Income from continuing operations before equity in loss of unconsolidated entities and income taxes		57,989			32,076			33,757
Equity in loss of unconsolidated entities		(147		)	(224		)	(92		)
Income tax expense		(201		)	(569		)	(887		)
Income from continuing operations		57,641			31,283			32,778
Discontinued operations		2,571			2,622			22,321
Income before gain on sales of real estate		60,212			33,905			55,099
Gain on sales of real estate, net of income taxes		1,104			2,037			889
Net income		61,316			35,942			55,988
Net income attributable to noncontrolling interests:
Common units in the Operating Partnership		(6,519		)	(3,203		)	(7,097		)
Preferred units in the Operating Partnership		(660		)	(660		)	(660		)
Other		(172		)	122			136
Net income attributable to Corporate Office Properties Trust		53,965			32,201			48,367
Preferred share dividends		(16,102		)	(16,068		)	(15,404		)
Issuance costs associated with redeemed preferred shares		—			—			(3,896		)
Net income attributable to Corporate Office Properties Trust common shareholders		$	37,863		$	16,133		$	29,067
Net income attributable to Corporate Office Properties Trust
Income from continuing operations		$	51,786		$	29,991		$	29,947
Discontinued operations		2,179			2,210			18,420
Net income attributable to Corporate Office Properties Trust		$	53,965		$	32,201		$	48,367
Basic earnings per common share (1)
Income from continuing operations		$	0.73		$	0.29		$	0.25
Discontinued operations		0.04			0.05			0.44
Net income		$	0.77		$	0.34		$	0.69
Diluted earnings per common share (1)
Income from continuing operations		$	0.72		$	0.28		$	0.24
Discontinued operations		0.04			0.05			0.43
Net income		$	0.76		$	0.33		$	0.67
Dividends declared per common share		$	1.4250		$	1.3000		$	1.1800

 

(1) Basic and diluted earnings per common share are calculated based on amounts attributable to common shareholders of Corporate Office Properties Trust.

 

See accompanying notes to consolidated financial statements.

 

F-5

 

Corporate Office Properties Trust and Subsidiaries

Consolidated Statements of Shareholders’ Equity

(Dollars in thousands)

 

		Preferred Shares			Common Shares			Additional Paid-in Capital			Cumulative Distributions in Excess of Net Income			Accumulated Other Comprehensive Loss			Non- controlling Interests			Total
Balance at December 31, 2005 (39,927,316 common shares outstanding)		$	67		$	399		$	650,226		$	(67,697	)	$	(482	)	$	105,210		$	687,723
Conversion of common units to common shares (245,793 shares)		—			3			11,075			—			—			(11,078		)	—
Common shares issued to the public (2,000,000 shares)		—			20			82,413			—			—			—			82,433
Series J Preferred Shares issued to the public (3,390,000 shares)		34			—			81,823			—			—			—			81,857
Series E Preferred Shares redemption		(11		)	—			(28,739		)	—			—			—			(28,750		)
Series F Preferred Shares redemption		(14		)	—			(35,611		)	—			—			—			(35,625		)
3.5% Senior Exchangeable Notes issued to the public								20,844									—			20,844
Issuance of common units in the Operating Partnership in connection with acquisition of properties		—			—			—			—			—			7,497			7,497
Decrease in fair value of derivatives		—			—			—			—			(211		)	(35		)	(246		)
Reversal of unearned restricted common share grants upon adoption of SFAS 123(R)		—			1			1,944			—			—			—			1,945
Exercise of share options (581,932 shares)		—			6			6,761			—			—			—			6,767
Share-based compensation		—			—			3,833			—			—			—			3,833
Adjustments to minority interests resulting from changes in ownership of the Operating Partnership by COPT		—			—			(16,255		)	—			—			16,255			—
Increase in tax benefit from share-based compensation		—			—			562			—			—			—			562
Net income		—			—			—			48,367			—			7,621			55,988
Dividends		—			—			—			(65,071		)	—			—			(65,071		)
Distributions to owners of common and preferred units in the Operating Partnership		—			—			—			—			—			(10,657		)	(10,657		)
Net contributions and distributions to noncontrolling interests in other consolidated real estate joint ventures		—			—			—			—			—			1,195			1,195
Balance at December 31, 2006 (42,897,639 common shares outstanding)		76			429			778,876			(84,401		)	(693		)	116,008			810,295
Conversion of common units to common shares (554,221 shares)		—			6			25,402			—			—			(25,408		)	—
Common shares issued in connection with acquisition of properties, net of transaction costs (3,161,000 shares)		—			32			156,619			—			—			—			156,651
Series K Preferred Shares issued in connection with acquisition of properties, net of transaction costs (531,667 shares)		5			—			26,562			—			—			—			26,567
Issuance of common units in the Operating Partnership in connection with acquisition of properties		—			—			—			—			—			12,125			12,125
Exercise of share options (620,858 shares)		—			6			7,470			—			—			—			7,476
Share-based compensation		—			1			6,642			—			—			—			6,643
Restricted common share redemptions (6,685 shares)		—			—			(351		)	—			—			—			(351		)
Adjustments to minority interests resulting from changes in ownership of Operating Partnership by COPT		—			—			(29,761		)	—			—			29,761			—
Decrease in fair value of derivatives		—			—			—			—			(1,679		)	(284		)	(1,963		)
Net income		—			—			—			32,201			—			3,741			35,942
Dividends		—			—			—			(77,399		)	—			—			(77,399		)
Distributions to owners of common and preferred units in the Operating Partnership		—			—			—			—			—			(11,342		)	(11,342		)
Net contributions and distributions to noncontrolling interests in other consolidated real estate joint ventures		—			—			—			—			—			4,836			4,836
Balance at December 31, 2007 (47,366,475 common shares outstanding)		81			474			971,459			(129,599		)	(2,372		)	129,437			969,480
Conversion of common units to common shares (258,917 shares)		—			3			7,505			—			—			(7,508		)	—
Common shares issued to the public (3,737,500 shares)		—			37			138,886			—			—			—			138,923
Exercise of share options (180,239 shares)		—			2			2,833			—			—			—			2,835
Share-based compensation		—			2			9,034			—			—			—			9,036
Restricted common share redemptions (61,258 shares)		—			—			(1,320		)	—			—			—			(1,320		)
Adjustments to minority interests resulting from changes in ownership of Operating Partnership by COPT		—			—			(16,716		)	—			—			16,716			—
Decrease in fair value of derivatives		—			—			—			—			(2,377		)	(330		)	(2,707		)
Increase in tax benefit from share-based compensation		—			—			1,053			—			—			—			1,053
Net income		—			—			—			53,965			—			7,351			61,316
Dividends		—			—			—			(86,938		)	—			—			(86,938		)
Distributions to owners of common and preferred units in the Operating Partnership		—			—			—			—			—			(12,170		)	(12,170		)
Net contributions and distributions to noncontrolling interests in other consolidated real estate joint ventures		—			—			—			—			—			2,915			2,915
Balance at December 31, 2008 (51,790,442 common shares outstanding)		$	81		$	518		$	1,112,734		$	(162,572	)	$	(4,749	)	$	136,411		$	1,082,423

 

See accompanying notes to consolidated financial statements.

 

F-6

 

Corporate Office Properties Trust and Subsidiaries

Consolidated Statements of Cash Flows

(Dollars in thousands)

 

		For the Years Ended December 31,
		2008			2007			2006
Cash flows from operating activities
Net income		$	61,316		$	35,942		$	55,988
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and other amortization		104,968			107,625			80,074
Amortization of deferred financing costs		3,843			3,583			2,995
Amortization of deferred market rental revenue		(2,064		)	(1,985		)	(1,904		)
Gain on sales of real estate		(4,208		)	(6,979		)	(17,920		)
Other gain on sales		(49		)	(1,033		)	—
Gain on redemption of 3.5% Exchangeable Senior Notes		(8,101		)	—			—
Settlement of previously accreted interest expense		(1,652		)	—			—
Amortization of net discounts on debt		3,873			3,400			541
Share-based compensation		9,036			6,643			3,833
Excess income tax benefits from share-based compensation		(1,053		)	—			(562		)
Other		(856		)	(101		)	534
Changes in operating assets and liabilities:
Increase in deferred rent receivable		(10,594		)	(11,988		)	(10,004		)
Decrease (increase) in accounts receivable		11,128			1,544			(10,844		)
Increase in restricted cash and prepaid and other assets		(15,061		)	(5,040		)	(7,098		)
Increase (decrease) in accounts payable, accrued expenses, and other liabilities		31,136			(3,250		)	13,544
(Decrease) increase in rents received in advance and security deposits		(770		)	10,030			4,181
Net cash provided by operating activities		180,892			138,391			113,358
Cash flows from investing activities
Purchases of and additions to commercial real estate properties		(280,639		)	(353,117		)	(282,306		)
Proceeds from sales of properties		33,412			21,684			46,704
Proceeds from sale of non-real estate investment		91			2,526			—
Mortgage loan receivable funded		(25,251		)	—			—
Proceeds from sale of unconsolidated real estate joint venture		—			—			1,524
Acquisition of partner interests in consolidated joint ventures		(115		)	(1,262		)	(5,250		)
Leasing costs paid		(7,670		)	(12,182		)	(10,480		)
(Increase) decrease in restricted cash associated with investing activities		(842		)	16,018			5,260
Purchases of furniture, fixtures and equipment		(3,581		)	(1,663		)	(8,109		)
Other		(6,227		)	(408		)	(1,384		)
Net cash used in investing activities		(290,822		)	(328,404		)	(254,041		)
Cash flows from financing activities
Proceeds from mortgage and other loans payable		1,080,999			867,842			673,176
Proceeds from 3.5% Exchangeable Senior Notes		—			—			200,000
Repayments of debt
Balloon payments		(988,945		)	(559,467		)	(743,274		)
Scheduled principal amortization		(13,668		)	(19,928		)	(19,316		)
Repurchase of 3.5% Exchangeable Senior Notes		(25,238		)	—			—
Deferred financing costs paid		(6,461		)	(4,171		)	(6,605		)
Net proceeds from issuance of common shares		141,758			7,446			89,202
Net proceeds from issuance of preferred shares		—			—			81,857
Redemption of preferred shares		—			—			(64,375		)
Dividends paid		(83,753		)	(74,277		)	(62,845		)
Distributions paid		(12,002		)	(11,188		)	(10,422		)
Excess income tax benefits from share-based compensation		1,053			—			562
Restricted share redemptions		(1,320		)	(351		)	—
Other		(356		)	822			(138		)
Net cash provided by financing activities		92,067			206,728			137,822
Net (decrease) increase in cash and cash equivalents		(17,863		)	16,715			(2,861		)
Cash and cash equivalents
Beginning of period		24,638			7,923			10,784
End of period		$	6,775		$	24,638		$	7,923

 

See accompanying notes to consolidated financial statements.

 

F-7

 

Corporate Office Properties Trust and Subsidiaries

 

Notes to Consolidated Financial Statements

(Dollars in thousands, except per share data)

 

1.             Organization and Business

 

Corporate Office Properties Trust (“COPT”) and subsidiaries (collectively, the “Company”) is a fully-integrated and self-managed real estate investment trust (“REIT”) that focuses primarily on strategic customer relationships and specialized tenant requirements in the United States Government, defense information technology and data sectors. We acquire, develop, manage and lease properties that are typically concentrated in large office parks primarily located adjacent to government demand drivers and/or in demographically strong markets possessing growth opportunities. As of December 31, 2008, our investments in real estate included the following:

 

·                  238 wholly owned operating properties totaling 18.5 million square feet;

·                  14 wholly owned properties under construction or development that we estimate will total approximately 1.6 million square feet upon completion;

·                  wholly owned land parcels totaling 1,611 acres that we believe are potentially developable into approximately 14.0 million square feet; and

·                  partial ownership interests in a number of other real estate projects in operations, under construction or redevelopment or held for future development.

 

We conduct almost all of our operations through our operating partnership, Corporate Office Properties, L.P. (the “Operating Partnership”), for which we are the managing general partner. The Operating Partnership owns real estate both directly and through subsidiary partnerships and limited liability companies (“LLCs”). A summary of our Operating Partnership’s forms of ownership and the percentage of those ownership forms owned by COPT as of December 31, 2008 and 2007 follows:

 

 

		December 31,
		2008		2007
Common Units		86	%	85	%
Series G Preferred Units		100	%	100	%
Series H Preferred Units		100	%	100	%
Series I Preferred Units		0	%	0	%
Series J Preferred Units		100	%	100	%
Series K Preferred Units		100	%	100	%

 

Three of our trustees controlled, either directly or through ownership by other entities or family members, an additional 12% of the Operating Partnership’s common units.

 

In addition to owning real estate, the Operating Partnership also owns 100% of a number of entities that provide real estate services such as property management, construction and development and heating and air conditioning services primarily for our properties but also for third parties.

 

2.             Summary of Significant Accounting Policies

 

Basis of Presentation

 

The consolidated financial statements include the accounts of COPT, the Operating Partnership, their subsidiaries and other entities in which we have a majority voting interest and control. We also consolidate certain entities when control of such entities can be achieved through means other than voting rights (“variable interest entities” or “VIEs”) if we are deemed to be the primary beneficiary of such entities. We eliminate all significant intercompany balances and transactions in consolidation.

 

We use the equity method of accounting when we own an interest in an entity and can exert significant influence over the entity’s operations but cannot control the entity’s operations. We use the cost method of accounting when we own an interest in an entity and cannot exert significant influence over its operations.

 

Reclassification

 

We reclassified certain amounts from the prior periods to conform to the current period presentation of our Consolidated Financial Statements. As discussed further below, we retrospectively adopted Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”), FASB Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”) and EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” (EITF 03-6-1”).  This resulted in the recording of certain adjustments to amounts previously reported, including changes that affected our previously reported net income attributable to our common shareholders and earnings per common share.

 

We adopted SFAS 160 effective January 1, 2009.  SFAS 160 establishes accounting and reporting standards for noncontrolling interests in subsidiaries and for deconsolidation of subsidiaries.  It requires all entities to report noncontrolling (minority) interests in subsidiaries as equity in the consolidated financial statements.  SFAS 160 also requires that consolidated net income be adjusted to include net income attributable to noncontrolling interests.  In addition, SFAS 160 requires that purchases or sales of equity interests that do not result in a change in control be accounted for as equity transactions.  The presentation and disclosure requirements under SFAS 160 are being applied retrospectively for all periods presented.  SFAS 160 primarily affected how we present noncontrolling interests on our consolidated balance sheets, statements of operations and cash flows but did not otherwise have a material effect on our financial position, results of operations or cash flows.

 

                        We adopted FSP APB 14-1 effective January 1, 2009.  FSP APB 14-1 requires that the initial proceeds from convertible debt instruments that may be settled in cash, including partial cash settlements, be allocated between a liability component and an equity component associated with the embedded conversion option.  This pronouncement’s objective is to require the liability and equity components of convertible debt to be separately accounted for in order to enable interest expense to be recorded at a rate that would reflect the issuer’s conventional debt borrowing rate (previously, interest expense on such debt was recorded based on the contractual rate of interest under the debt).  Under this pronouncement, the liability component is recorded at its fair value, as calculated based on the present value of its cash flows discounted using the issuer’s conventional debt borrowing rate.  The equity component is recorded based on the difference between the debt proceeds and the fair value of the liability.  The difference between the liability’s principal amount and fair value is reported as a debt discount and amortized as interest expense over the debt’s expected life using the effective interest method.  The provisions of FSP APB 14-1 are being applied retrospectively to all periods presented.  FSP APB 14-1 affected the accounting for our 3.5% Exchangeable Senior Notes (the “Exchangeable Notes”), resulting in our retroactive reclassification from debt to equity of $21,309, representing the debt discount, effective upon the origination of the Exchangeable Notes in September 2006.  This debt discount was subsequently amortized.  In addition, we reclassified $465 of the original finance fees incurred in relation to the Exchangeable Notes to equity effective September 2006.  We expect to amortize the remaining unamortized discount as of March 31, 2009 of $9,872 into interest expense through September 2011.  The tables below set forth the changes to our net income and balance sheet for the periods included herein resulting from our adoption of FSP APB 14-1 and SFAS 160:

 

		For the Years Ended December 31,
		2008			2007			2006
Net income as previously reported		$	58,668		$	34,784		$	49,227
Net income attributable to noncontrolling interests related to adoption of SFAS 160		8,147			4,220			7,800
Adjustment to interest expense related to adoption of FSP APB 14-1		(3,224		)	(3,062		)	(1,039		)
Adjustment to gain on early extinguishment of debt related to adoption of FSP APB 14-1		(2,275		)	—			—
Net income, as adjusted		$	61,316		$	35,942		$	55,988

 

Balance Sheet line item		December 31, 2008, as Previously Reported			Adjustments Related to FSP APB 14-1			Adjustments Related to SFAS 160			December 31, 2008, as Adjusted
Properties, net		$	2,776,889		$	1,577		$	—		$	2,778,466
Deferred charges, net		52,006			(205		)	—			51,801
3.5% Exchangeable Senior Notes		162,500			(9,872		)	—			152,628
Minority interest		137,865			(1,454		)	(136,411		)	—
Equity		933,314			12,698			136,411			1,082,423

 

Balance Sheet line item		December 31, 2007, as Previously Reported			Adjustments Related to FSP APB 14-1			Adjustments Related to SFAS 160			December 31, 2007, as Adjusted
Properties, net		$	2,603,939		$	897		$	—		$	2,604,836
Deferred charges, net		49,051			(386		)	—			48,665
3.5% Exchangeable Senior Notes		200,000			(16,232		)	—			183,768
Minority interest		130,095			(658		)	(129,437		)	—
Equity		822,642			17,401			129,437			969,480

 

F-8

 

Use of Estimates in the Preparation of Financial Statements

 

We make estimates and assumptions when preparing financial statements under generally accepted accounting principles (“GAAP”). These estimates and assumptions affect various matters, including:

 

·                  the reported amounts of assets and liabilities in our Consolidated Balance Sheets at the dates of the financial statements;

·                  the disclosure of contingent assets and liabilities at the dates of the financial statements; and

·                  the reported amounts of revenues and expenses in our Consolidated Statements of Operations during the reporting periods.

 

Significant estimates are inherent in the presentation of our financial statements in a number of areas, including the evaluation of the collectability of accounts and notes receivable, the allocation of real estate acquisition costs, the determination of estimated useful lives of assets, the evaluation of impairment of long-lived assets and the level of expense recognized in connection with share-based compensation. Actual results could differ from these and other estimates.

 

Acquisitions of Real Estate

 

We allocate the purchase price of acquired properties to tangible and identified intangible assets based on their relative fair values at the date of acquisition. In making estimates of fair values for purposes of allocating a purchase price, we use a number of sources, including independent appraisals that may be obtained in connection with the acquisition or financing of the respective property and other market data. We allocate the costs of real estate acquisitions to the following components:

 

·                  properties based on a valuation of the acquired property performed with the assumption that the property is vacant upon acquisition (the “if vacant value”). The if-vacant fair value is allocated between land, buildings, tenant improvements and equipment based on our estimates of the relative fair values;

·                  above-market and below-market lease intangible assets or liabilities based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be received pursuant to the in-place leases and (ii) our estimate of fair market lease rates for the corresponding space, measured over a period equal to the remaining non-cancelable term of the lease (including those under bargain renewal options). The capitalized above- and below-market lease values are amortized as adjustments to rental revenue over the remaining terms of the respective leases (including periods under bargain renewal options);

·                  in-place lease value based on our estimates of carrying costs during the expected lease-up periods and costs to execute similar leases. Our estimate of carrying costs includes real estate taxes, insurance and other operating expenses and lost rentals during the expected lease-up periods considering current market conditions. Our estimate of costs to execute similar leases includes leasing commissions, legal and other related costs;

·                  tenant relationship value based on our evaluation of the specific characteristics of each tenant’s lease and our overall relationship with that respective tenant. Characteristics we consider in determining these values include the nature and extent of our existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals, among other factors; and

·                  market concentration premium based on our estimate of the additional amount that we pay for a property over the fair value of assets in connection with our strategy of increasing our presence in regional submarkets.

 

Properties

 

We report properties to be developed or held and used in operations at our depreciated cost, reduced for impairment losses, where appropriate. The amounts reported for our properties include our costs of:

 

·                  acquisitions;

·                  development and construction;

·                  building and land improvements; and

·                  tenant improvements paid by us.

 

We capitalize interest expense, real estate taxes, direct internal labor (including allocable overhead costs) and other costs associated with real estate undergoing construction and development activities to the cost of such activities. The preconstruction stage of development of an operating property (or an expansion of an existing property) includes efforts and related costs to secure land control and zoning, evaluate feasibility and complete other initial tasks which are

 

F-9

 

essential to development. We continue to capitalize these costs while construction and development activities are underway until a property becomes “operational,” which occurs upon the earlier of when leases commence on space or one year after the cessation of major construction activities. When leases commence on portions of a newly-constructed property’s space in the period prior to one year from the cessation of major construction activities, we consider that property to be “partially operational.” When a property is partially operational, we allocate the costs associated with the property between the portion that is operational and the portion under construction. We start depreciating newly-constructed properties as they become operational.

 

We depreciate our assets evenly over their estimated useful lives as follows:

 

·	Buildings and building improvements		10-40 years
·	Land improvements		10-20 years
·	Tenant improvements on operating properties		Related lease terms
·	Equipment and personal property		3-10 years

 

If events or circumstances indicate that a property to be held and used may be impaired, we perform a recoverability analysis based on the estimated undiscounted cash flows to be generated by the property. If the analysis indicates that the carrying value of the property is not recoverable from future cash flows, the property is written down to fair value and an impairment loss is recognized. Fair values are determined based on appraisals and/or estimated future cash flows using appropriate discount and capitalization rates.

 

When we determine that a real estate asset will be held for sale, we discontinue the recording of depreciation expense of the asset and estimate the sales price, net of selling costs; if we then determine that the estimated sales price, net of selling costs, is less than the net book value of the asset, we recognize an impairment loss equal to the difference and reduce the carrying amounts of assets.

 

When we sell an operating property, or determine that an operating property is held for sale, and determine that we have no significant continuing involvement in such property, we classify the results of operations for such property as discontinued operations. Interest expense that is specifically identifiable to properties included in discontinued operations is used in the computation of interest expense attributable to discontinued operations. When properties classified as discontinued operations are included in computations that determine the amount of our borrowing capacity under certain debt instruments (including our Revolving Credit Facility), we allocate a portion of such debt instruments’ interest expense to discontinued operations; we compute this allocation based on the percentage that the related properties represent of all properties included in determining the amount of our borrowing capacity under such debt instruments.

 

We expense property maintenance and repair costs when incurred.

 

Sales of Interests in Real Estate

 

We recognize gains from sales of interests in real estate using the full accrual method, provided that various criteria relating to the terms of sale and any subsequent involvement by us with the real estate sold are met. We recognize gains relating to transactions that do not meet the requirements of the full accrual method of accounting when the full accrual method of accounting criteria are met.

 

Cash and Cash Equivalents

 

Cash and cash equivalents include all cash and liquid investments that mature three months or less from when they are purchased. Cash equivalents are reported at cost, which approximates fair value. We maintain our cash in bank accounts in amounts that may exceed Federally insured limits at times. We have not experienced any losses in these accounts in the past and believe that we are not exposed to significant credit risk because our accounts are deposited with major financial institutions.

 

Accounts Receivable

 

Our accounts receivable are reported net of an allowance for bad debts of $1,455 at December 31, 2008 and $448 at December 31, 2007. We use judgment in estimating the uncollectability of our accounts receivable based primarily upon the payment history and credit status of the entities associated with the individual accounts.

 

F-10

 

Revenue Recognition

 

We recognize minimum rental revenue on a straight-line basis over the non-cancelable term of tenant leases. The non-cancelable term of a lease includes periods when a tenant: (1) may not terminate its lease obligation early; or (2) may terminate its lease obligation early in exchange for a fee or penalty that we consider material enough such that termination would not be probable. We report the amount by which our minimum rental revenue recognized on a straight-line basis under leases exceeds the contractual rent billings associated with such leases as deferred rent receivable on our Consolidated Balance Sheets.

 

We recognize tenant recovery revenue in the same periods in which we incur the related expenses. Tenant recovery revenue includes payments from tenants as reimbursement for property taxes, utilities and other property operating expenses.

 

We recognize fees received for lease terminations as revenue and write off against such revenue any (1) deferred rents receivable and (2) deferred revenue and intangible 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. When a tenant’s lease for space in a property is terminated early but the tenant continues to lease such space under a new or modified lease in the property, the net revenue from the early termination of the lease is generally recognized evenly over the remaining life of the new or modified lease in place on that property.

 

We recognize fees for services provided by us once services are rendered, fees are determinable and collectability is assured. We recognize revenue under construction contracts using the percentage of completion method when the revenue and costs for such contracts can be estimated with reasonable accuracy; when these criteria do not apply to a contract, we recognize revenue on that contract using the completed contract method. Under the percentage of completion method, we recognize a percentage of the total estimated revenue on a contract based on the cost of services provided on the contract as of a point in time relative to the total estimated costs on the contract.

 

Intangible Assets and Deferred Revenue on Real Estate Acquisitions

 

We capitalize intangible assets and deferred revenue on real estate acquisitions as described in the section above entitled “Acquisitions of Real Estate.” We amortize the intangible assets and deferred revenue as follows:

 

·	Above- and below-market leases		Related lease terms
·	In-place lease assets		Related lease terms
·	Tenant relationship value		Estimated period of time that tenant will lease space in property
·	Market concentration premium		40 years

 

We recognize the amortization of acquired above-market and below-market leases as adjustments to rental revenue; we refer to this amortization as amortization of deferred market rental revenue. We recognize the amortization of other intangible assets on real estate acquisitions as amortization expense.

 

Deferred Charges

 

We defer costs that we incur to obtain new tenant leases or extend existing tenant leases. We amortize these costs evenly over the lease terms. When tenant leases are terminated early, we expense any unamortized deferred leasing costs associated with those leases.

 

We also defer costs for long-term financing arrangements and recognize these costs as interest expense over the related loan terms on a straight-line basis, which approximates the amortization that would occur under the effective interest method of amortization. We expense any unamortized loan costs when loans are retired early.

 

When the costs of acquisitions exceed the fair value of tangible and identifiable intangible assets and liabilities, we record goodwill in connection with such acquisitions. We test goodwill annually for impairment and in interim periods if certain events occur indicating that the carrying value of goodwill may be impaired. We recognize an impairment loss when the discounted expected future cash flows associated with the related reporting unit are less than its unamortized cost.

 

Derivatives

 

We are exposed to the effect of interest rate changes in the normal course of business. We use interest rate swap, interest rate cap and forward starting swap agreements in order to attempt to reduce the impact of such interest rate

 

F-11

 

changes. Interest rate differentials that arise under interest rate swap and interest rate cap contracts are recognized in interest expense over the life of the respective contracts. Interest rate differentials that arise under forward starting swaps are recognized in interest expense over the life of the respective loans for which such swaps are obtained. We do not use such derivatives for trading or speculative purposes. We manage counter-party risk by only entering into contracts with major financial institutions based upon their credit ratings and other risk factors.

 

We recognize all derivatives as assets or liabilities in the balance sheet at fair value with the offset to:

 

·                  the accumulated other comprehensive loss component of shareholders’ equity (“AOCL”), net of the share attributable to minority interests, for any derivatives designated as cash flow hedges to the extent such derivatives are deemed effective in hedging risks (risk in the case of our existing derivatives being defined as changes in interest rates);

 

·                  interest expense on our Statements of Operations for any derivatives designated as cash flow hedges to the extent such derivatives are deemed ineffective in hedging risks; or

 

·                  other revenue on our Statements of Operations for any derivatives designated as fair value hedges.

 

We use standard market conventions and techniques such as discounted cash flow analysis, option pricing models, replacement cost and termination cost in computing the fair value of derivatives at each balance sheet date.

 

Noncontrolling Interests

 

As discussed previously, we consolidate the accounts of our Operating Partnership and its subsidiaries into our financial statements. However, we do not own 100% of the Operating Partnership. We also do not own 100% of certain consolidated real estate joint ventures. The amounts reported for noncontrolling interests on our Consolidated Balance Sheets represent the portion of these consolidated entities’ equity that we do not own. The amounts reported for noncontrolling interests on our Consolidated Statements of Operations represent the portion of these consolidated entities’ net income not allocated to us.

 

Common units of the Operating Partnership (“common units”) are substantially similar economically to our common shares of beneficial interest (“common shares”). Common units not owned by us are also exchangeable into our common shares, subject to certain conditions.

 

The Operating Partnership has 352,000 Series I Preferred Units issued to an unrelated party that have a liquidation preference of $25.00 per unit, plus any accrued and unpaid distributions of return thereon (as described below), and may be redeemed for cash by the Operating Partnership at our option any time after September 22, 2019. The owner of these units is entitled to a priority annual cumulative return equal to 7.5% of their liquidation preference through September 22, 2019; the annual cumulative preferred return increases for each subsequent five-year period, subject to certain maximum limits. These units are convertible into common units on the basis of 0.5 common units for each Series I Preferred Unit; the resulting common units would then be exchangeable for common shares in accordance with the terms of the Operating Partnership’s agreement of limited partnership.

 

Earnings Per Share (“EPS”)

 

We present both basic and diluted EPS. We compute basic EPS by dividing net income available to common shareholders allocable to unrestricted common shares under the two-class method by the weighted average number of unrestricted common shares outstanding during the year. Our computation of diluted EPS is similar except that:

 

·                  the denominator is increased to include: (1) the weighted average number of potential additional common shares that would have been outstanding if securities that are convertible into our common shares were converted; and (2) the effect of dilutive potential common shares outstanding during the period attributable to share-based compensation using the treasury stock method; and

 

·                  the numerator is adjusted to add back any convertible preferred dividends and any other changes in income or loss that would result from the assumed conversion into common shares that we added to the denominator.

 

Summaries of the numerator and denominator for purposes of basic and diluted EPS calculations are set forth below (in thousands, except per share data):

 

F-12

 

		For the Years Ended December 31,
		2008			2007			2006
Numerator:
Income from continuing operations		$	57,641		$	31,283		$	32,778
Add: Gain on sales of real estate, net		1,104			2,037			889
Less: Preferred share dividends		(16,102		)	(16,068		)	(15,404		)
Less: Issuance costs associated with redeemed preferred shares		—			—			(3,896		)
Less: Income from continuing operations attributable to noncontrolling interests		(6,959		)	(3,329		)	(3,720		)
Less: Income from continuing operations attributable to restricted shares		(728		)	(517		)	(449		)
Numerator for basic and diluted EPS from continuing operations attributable to COPT common shareholders		34,956			13,406			10,198
Add: Income from discontinued operations		2,571			2,622			22,321
Less: Income from discontinued operations attributable to noncontrolling interests		(392		)	(412		)	(3,901		)
Numerator for basic and diluted EPS on net income attributable to COPT common shareholders		$	37,135		$	15,616		$	28,618
Denominator (all weighted averages):
Denominator for basic EPS (common shares)		48,132			46,527			41,463
Dilutive effect of stock option awards		688			991			1,568
Denominator for diluted EPS		48,820			47,518			43,031
Basic EPS:
Income from continuing operations attributable to COPT common shareholders		$	0.73		$	0.29		$	0.25
Income from discontinued operations attributable to COPT common shareholders		0.04			0.05			0.44
Net income attributable to COPT common shareholders		$	0.77		$	0.34		$	0.69
Diluted EPS:
Income from continuing operations attributable to COPT common shareholders		$	0.72		$	0.28		$	0.24
Income from discontinued operations attributable to COPT common shareholders		0.04			0.05			0.43
Net income attributable to COPT common shareholders		$	0.76		$	0.33		$	0.67

 

Our diluted EPS computations do not include the effects of the following securities since the conversions of such securities would increase diluted EPS for the respective periods:

 

		Weighted Average Shares Excluded from Denominator for the Years Ended December 31,
		2008		2007		2006
Conversion of common units		8,107		8,296		8,511
Conversion of convertible preferred units		176		176		176
Conversion of convertible preferred shares		434		425		N/A
Anti-dilutive share-based compensation awards		1,187		807		618

 

As discussed in Note 9, the Operating Partnership has outstanding 3.50% Exchangeable Senior Notes that are due in 2026. The notes have an exchange settlement feature that 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 or a combination of cash and our common shares at an exchange rate of 18.6947 shares per one thousand dollar principal amount of the notes (exchange rate is as of December 31, 2008 and is equivalent to an exchange price of $53.49 per common share). The Exchangeable Senior Notes did not affect our diluted EPS reported above since the weighted average closing price of our common shares during each of the periods was less than the exchange price per common share applicable for such periods.

 

We adopted FSP EITF 03-6-1 effective January 1, 2009.  FSP EITF 03-6-1 requires that all unvested share-based payment awards that contain nonforfeitable rights to dividends be considered participating securities and therefore shall be included in the computation of EPS pursuant to the two-class method.  The two-class method is an earnings allocation formula that determines EPS for each class of common shares and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings.  FSP EITF 03-6-1 was effective for us beginning January 1, 2009 and interim periods within that year, and the EPS of prior periods was adjusted retrospectively.  Our adoption of FSP EITF 03-6-1 had a decreasing effect on our EPS in the current and in prior periods at a level that was not material.

 

Share-Based Compensation

 

We have historically issued two forms of share-based compensation: options to purchase common shares (“options”) and restricted common shares (“restricted shares”). We account for our share-based compensation in accordance with Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, focusing primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The statement requires us to measure the cost of employee services

 

F-13