COPT Defense Properties Quarterly report pursuant to Section 13 or 15(d)

Quarterly report pursuant to Section 13 or 15(d)

Leases

Leases

3 Months Ended

Mar. 31, 2019

Lessor arrangements

We lease real estate properties, comprised primarily of office properties and data center shells, to third parties. As of March 31, 2019, these leases, which may encompass all, or a portion of, a property, had remaining lease terms spanning from one month to 15 years and averaging approximately five years. These leases usually include options under which the tenant may renew its lease based on market rates at the time of renewal, which are then typically subject to further negotiation. These leases occasionally provide the tenant with an option to terminate its lease early usually for a defined termination fee. While a significant portion of our portfolio is leased to the United States Government, and the majority of those leases consist of a series of one-year renewal options, or provide for early termination rights, we have concluded that exercise of existing renewal options, or continuation of such leases without exercising early termination rights, is reasonably assured for virtually all of these leases.

Most of our lease revenue is from fixed contractual payments defined under the lease that, in most cases, escalate annually over the term of the lease. Our lease revenue also includes variable lease payments predominantly for tenant reimbursements of property operating expenses and lease termination fees. Property operating expense reimbursement structures vary, with some tenants responsible for all of a property’s expenses, while others are responsible for their share of a property’s expense only to the extent such expenses exceed amounts defined in the lease (which are derived from the property’s historical expense levels). Lease termination fees in most cases result from a tenant’s exercise of an existing right under a lease, and are usually equal to a defined percentage of the remaining rents due under the lease and/or the remaining unamortized lease origination costs (including tenant improvements and lease commissions).

The table below sets forth our allocation of lease revenue recognized between fixed contractual payments and variable lease payments (in thousands):



Lease revenue	For the Three Months Ended March 31, 2019
Fixed contractual payments	$	105,335
Variable lease payments	25,568
	$	130,903

Fixed contractual payments due under our property leases were as follows (in thousands):



Year Ending December 31,	March 31, 2019		December 31, 2018
2019 (1)	$	305,864	$	400,617
2020	347,477		337,646
2021	293,546		280,369
2022	258,502		246,329
2023	206,833		194,888
Thereafter	562,614		523,932
	$	1,974,836	$	1,983,781

(1) As of March 31, 2019, represents the nine months ending December 31, 2019.

Lessee arrangements

We lease from third parties land underlying properties that we are operating or developing. These ground leases have long durations with remaining terms ranging from 30 years (excluding extension options) to 97 years. As of March 31, 2019, our balance sheet included $68.1 million in right-of-use assets associated with ground leases that included:


•	$37.8 million for land on which we are developing an office property in Washington, DC through our Stevens Investors, LLC joint venture, virtually all of the rent on which was previously paid. This lease has a 97-year remaining lease term, and we possess a bargain purchase option that we expect to exercise in 2020;


•	$10.4 million for land underlying office properties in Washington, DC under two leases with remaining terms of approximately 80 years;


•	$6.5 million for land underlying a parking garage in Baltimore, Maryland under a lease with a remaining term of 30 years and an option to renew for an additional 49 years that was included in the lease term used in determining the asset balance;


•	$6.7 million for land in a research park in College Park, Maryland under four leases through our M Square Associates, LLC joint venture all of the rent on which was previously paid. These leases had remaining terms ranging from 64 to 75 years;


•	$4.3 million for land in a business park in Huntsville, Alabama under nine leases through our LW Redstone Company, LLC joint venture, with remaining terms ranging from 44 to 50 years and options to renew for an additional 25 years that were not included in the lease term used in determining the asset balance; and


•	$2.3 million for other land in our Fort Meade/BW Corridor sub-segment under two leases with remaining terms of approximately 49 years all of the rent on which was previously paid.

As of March 31, 2019, our balance sheet also included right-of-use lease assets totaling $1.2 million in connection with vehicles and office equipment that we lease from third parties.

In determining operating right-of-use assets and lease liabilities for our existing operating leases upon our adoption of the new lease guidance discussed further in Note 2, as well as for new operating leases in the current period, we were required to estimate an appropriate incremental borrowing rate on a fully-collateralized basis for the terms of the leases. Since the terms under our ground leases are significantly longer than the terms of borrowings available to us on a fully-collateralized basis, our estimate of this rate required significant judgment, and considered factors such as interest rates available to us on a fully-collateralized basis for shorter-termed debt and U.S. Treasury rates.

Our right-of-use assets consisted of the following (in thousands):



Leases	Balance Sheet Location	March 31, 2019
Right-of-use assets
Operating leases - Property	Property - operating right-of-use assets	$	27,569
Finance leases
Property	Property - finance right-of-use assets	40,488
Vehicles and office equipment	Prepaid expenses and other assets, net	1,197
Total finance lease right-of-use assets		41,685

Total right-of-use assets		$	69,254

Lease liabilities consisted of the following (in thousands):



Leases	Balance Sheet Location	March 31, 2019
Lease liabilities
Operating leases - Property	Property - operating lease liabilities	$	16,619
Finance leases	Other liabilities	1,275

Total lease liabilities		$	17,894

The table below sets forth the weighted average lease terms and discount rates of our leases as of March 31, 2019:



Weighted average remaining lease term
Operating leases	70 years
Finance leases	2 years
Weighted average discount rate
Operating leases	7.35	%
Finance leases	3.10	%

The table below presents our total lease cost (in thousands):



Lease cost	Statement of Operations Location	For the Three Months Ended March 31, 2019
Operating lease cost
Property leases	Property operating expense	$	413
Vehicles and office equipment	General, administrative and leasing expense	17
Finance lease cost
Amortization of vehicles and office equipment right-of-use assets	General, administrative and leasing expense	113
Interest on lease liabilities	Interest expense	4
		$	547

The table below presents the effect of lease payments on our consolidated statement of cash flows (in thousands):



Supplemental cash flow information	For the Three Months Ended March 31, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows for operating leases	$	228
Operating cash flows for financing leases	$	4
Financing cash flows for financing leases	$	52

Payments on leases as of March 31, 2019 were due as follows (in thousands):



Year Ending December 31,	Operating leases			Finance leases			Total
2019 (1)	$	830		$	179		$	1,009
2020	1,128			862			1,990
2021	1,111			202			1,313
2022	1,129			64			1,193
2023	1,135			—			1,135
Thereafter	99,185			—			99,185
Total lease payments	104,518			1,307			105,825
Less: Amount representing interest	(87,899		)	(32		)	(87,931		)
Lease liability	$	16,619		$	1,275		$	17,894

(1) Represents the nine months ending December 31, 2019.

Future minimum rental payments on leases as of December 31, 2018 were due as follows (in thousands):



Year Ending December 31,	Operating leases		Finance leases			Total
2019	$	1,101	$	219		$	1,320
2020	1,110		844			1,954
2021	1,094		184			1,278
2022	1,115		49			1,164
2023	1,119		—			1,119
Thereafter	83,373		—			83,373
Total lease payments	$	88,912	1,296			90,208
Less: Amount representing interest	N/A		(24		)	(24		)
Total	N/A		$	1,272		$	90,184