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Corporate Office Properties Trust (NYSE:OFC)

Q3 2011 Earnings Conference Call

October 27, 2011 11:00 AM ET

Executives

Stephanie Krewson – VP, IR

Rand Griffin – CEO

Roger Waesche – President

Steve Budorick – EVP and COO

Steve Riffee – EVP and CFO

Wayne Lingafelter – President, COPT Development & Construction Services

Analysts

Craig Mailman – KeyBanc Capital Markets

Jamie Feldman – Bank of America

Brendan Maiorana – Wells Fargo Securities

Dave Rodgers – RBC

John Guinee – Stifel Nicolaus & Company

Michael Knott – Green Street Advisors

Steve Benyik – Jeffries & Company

Christopher Lucas – Robert W. Baird & Company

Jordan Sadler – KeyBanc Capital Markets

Operator

Welcome to the Corporate Office Properties Trust Third Quarter 2011 Earnings Conference Call. As a reminder, today's call is being recorded. At this time, I will turn the call over to Stephanie Krewson, the company’s Vice President of Investor Relations. Ms. Krewson, please go ahead.

Stephanie Krewson

Thank, you Natasha. Good morning and welcome to COPT third quarter 2011 earnings conference call. With me today are Rand Griffin, COPT’s CEO; Roger Waesche, our President and future CEO; Steve Riffee, our Executive VP and CFO; Steve Budorick, our new Executive VP and COO; and Wayne Lingafelter, Executive VP of Development and Construction.

As management reviews our financial results, they will refer to our quarterly supplemental information package and associated press release, both of which can be found on the Investor Relations section of our Website at www.copt.com.

Within the supplemental package, you will find a reconciliation of GAAP measures to non-GAAP financial measures referenced throughout this call. Also under the Investor Relations section of our Website, you will find a reconciliation of our 2011 fourth quarter guidance. At the conclusion of this discussion, the call will be opened up for your questions.

Before turning the call over to management, let me remind you that certain statements made during this call regarding anticipated operating results and future events are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although such statements and projections are based upon what we believe to be reasonable assumptions, actual results may differ from those projected.

Factors that could cause actual results to differ materially, include, without limitation, the ability to renew and release space under favorable terms, regulatory changes, changes in the economy, the successful and timely completion of acquisitions and development projects, changes in interest rates and other risks associated with the commercial real estate business, as detailed in our filings with the SEC.

With that, I will turn the call over to Rand.

Rand Griffin

Thank you, Stephanie. Good morning everyone. Weak economic growth in the U.S. including the possibility of a double-dip recession along with concerns over financial markets and federal grid law continued to present significant leasing challenges for the Office sector in the third quarter.

Even so COPT’s operations modestly outperformed our expectations, which had anticipated such an environment. Our FFO per share of $0.52 after adjustments was $0.01 above the high end of our revised third quarter guidance range. Even before adjustments, our FFO per share of $0.49 was $0.01 above the low end of that range.

Unadjusted third quarter results were driven by lower-than-anticipated operating expenses partially offset by a (inaudible) loss on the early extinguishment of debt. The remainder of my comments focus on the status of defense spending and how we expect the current environment to impact demand for COPT space. Congress failed to pass the fiscal year 2012 budget by September 30th. So, the country is once again operating in a continuing resolution environment.

What this means for COPT is that government agencies can renew and expand existing leases, but they cannot execute new leases until fiscal year 2012 appropriations bills are passed. As expected, we saw an increase in government tenant activity before the fiscal year-end.

In the third quarter, COPT signed 147,000 square feet of new government leases at NBP and other locations and also executed contracts for meaningful government bid-outs in multiple COPT buildings. Even though we are in another continuing resolution, the completion of government agency relocations associated with the 2005 BRAC has spurred new contractor demand. Contractors who need to move to be proximate to the new government locations and who have existing affirmed contracts are in some cases now looking for space.

COPT currently is in various stages of discussions for about 400,000 square feet of new leases with defense contractors at multiple locations. Overall, however, the threat of budgetary cuts especially as they may relate to the Department of Defense or DoD continue to weigh upon the collective psychology in our markets. The feedback we hear from government agencies is that they are anticipating budget cuts beginning in 2013. The specter of those cuts is making most government and defense contractors more cautious about spending money.

When it comes to office space procurement, they continue to be very conscious of maximizing the use of existing facilities and actually receiving contract awards before expanding or signing up for new space. These concerns are heightened by the looming deadline for the Congressional Super Committee. As most of you know, the Super Committee must come to an agreement by November 23rd on $1.2 trillion of budgetary cuts over 10 years, and then the Congress has to pass that agreement by December 23rd to avoid triggering the automatic cuts mandated by the 2011 Budget Control Act.

It’s important to keep perspective on a couple of things. First is timing. Whether the Super Committee budget comes to agreement or not, any cuts would not occur until the 2013 budget. And secondly, future Congresses can nullify these cuts or modify them as they see fit. Now, the obvious question is what effect could such cuts have on COPT’s existing portfolio. Assuming the mast draconian scenario that the Super Committee does not come to agreement on a deficit reduction package and that the automatic $1.2 trillion of cuts is triggered, then the impact to the DoD’s base budget would be a reduction of about 10% or $55 billion per year that would have a declining impact over the nine-year period.

Next, you have to ask, what is likely to be cut. All of our sources indicate that service for structure and legacy weapons programs, not cyber and higher technology missions would face cuts. In fact, Moody’s investor services in their ongoing analysis of large defense contractors anticipate that various weapons systems could face cuts. In the same report, Moody’s stated that cyber security and unmanned aviation programs were likely to see budget increases as they were better aligned with the nature of future threats facing the U.S.

As we have stated before and as many of you know, COPT’s franchise is built around serving specialized requirements of Office tenants in the government and defense IT industries and that the four major BRAC locations where we are developing are knowledge base defense installations, not legacy weapon bases. The government agencies that our locations are fulfilling missions in cyber security and other higher tech areas that are critical to national security.

But what we initially expect out of the Super Committee process is a spike in tenant anxiety and uncertainty, then getting back to business in an environment that is not dissimilar to what has persisted for the last several years. In short, the real issue for COPT continues to be the lack of a federal budget. To allow more time to assess the progress of our strategic reallocation plans assets sales that Roger will discuss momentarily and for potential clarification regarding the 2012 federal budget, we believe it is prudent to let as many variables beyond our control become resolved in the next few months before giving 2012 guidance.

We therefore will be hosting a conference call in early January to go over our 2012 outlook and guidance. One positive for COPT that could result from the prospect of DoD budget cuts is that funds from military construction or MILCON most likely will be cut dramatically. If this does occur, COPT could benefit from increased leasing by government agencies which otherwise would have built their own facilities to meet their mission requirements.

One last item to highlight is our executive transition. As many of you know from our mid-September press release, Roger has been elected CEO and appointed to the Board of Trustees effective April 1st, 2012. I will retire as CEO at the end of March 2012 and look forward to continue serving our shareholders as a Trustee on our Board. And with that, I will now turn the call over to Roger for his remarks.

Roger Waesche

Thanks, Rand. Although we are not providing 2012 guidance on this call, we can still clarify our strategic objectives going forward. In order of importance, our priorities are

to aggressively lease space in order to drive occupancy; accelerate non-core asset sales; continue to strengthen our balance sheet; and develop properties where specific tenant demand exists.

Although acquisitions are not a current priority, we will continue to evaluate high quality stabilized assets that are in line with the company’s Super Four strategy. During the third quarter, we did acquire one property, 310 Bridge Street, a Class A, stabilized office building in Cummings Research Park in Huntsville, Alabama for $33.4 million. The building is 100% leased to Computer Sciences Corporation, which based on annualized revenues in place at September 30th is COPT’s fourth largest tenant. 310 Bridge Street is the best office building in the Redstone Arsenal market and represent the kind of asset into which we may redeploy proceeds from asset sales as we upgrade our portfolio through our strategic reallocation plan.

That being said, we do not intend to make additional acquisitions in Huntsville, instead we will build our market presence there through new development; which brings me to asset sales. Since launching our strategic reallocation plan in late April, we have sold eight buildings, aggregating about $25 million. As page 22 of our supplement details, most of these asset sales were in our suburban Baltimore portfolio and were 86% occupied at closing. These sales equate to 1.2% of square footage, 0.7% of revenues, but importantly, the 6% of our tenants.

We have $42 million of additional sales under contract which should close by year-end, putting us on track to exceed our $55 million dispositions goal for 2011. Additionally, we are evaluating offers on or are in various stages of marketing for another $160 million of asset sales, several which could close later this year or in the first quarter of 2012. Our goal is to accelerate our original disposition time frame, so that the entire $260 million of assets targeted in what we are now referring to as Phase I of the strategic reallocation plan or completed earlier than year-end '13.

Also, we are in the process of identifying a second phase of dispositions which will likely equal or exceed the dollar value of assets in Phase I of that plan. Strategically, we intend to use proceeds from asset sales to fund development costs and to delever our balance sheet. This will provide the company with ample liquidity. Wayne is going to highlight the progress in the development pipeline, but first let me lay out a change to COPT’s strategy as it relates to future development starts.

When you review the summary of pre-construction project schedule on page 26 of the third quarter supplement, and compare it to last quarter’s list of what was under development, you will notice there are fewer projects listed. We are delaying pre-construction activities except for those locations where current demand from contractors is tangible and very quantifiable. Accordingly, our primary locations for 2012 starts as of now are the National Business Park, Patriot Ridge and Redstone Gateway in Huntsville.

You will notice that the three projects listed under pre-construction are also characterized as being leasing contention starts. Quite simply, we will not commence construction on new projects if the leasing prospects are not there. Our commitment to closely match new supply with current demand is also why we no longer list completion or operational dates in our pre-construction pipeline.

We are not giving up on other locations and still believe BRAC-related contractor demand is coming to our other strategic business parks, but the continued lack of visibility as to when has cost us to refine our appetite even for the COPT brand speculative development. As a result, we are taking a very deliberate pause on new construction in certain locations to allow demand to catch up with existing supply.

Should a builder suit or a major requirement come into any of our markets, we are very well positioned to compete, because we have fully-entitled land, approved building designs and infrastructure in place to rapidly delever buildings to the market.

The future projects listed on page 26 are those that are entitled and where we are able to begin construction immediately to meet any surges in demand. In summary, we remain committed to developing specialized office buildings that serve the security requirements of our government and defense IT tenants. Development has been and will continue to be a differentiating feature of COPT’s long-term growth profile. However, until the economy and/or Washington D.C. provide a more certain operating environment for tenants who will then be more inclined to lease space, we believe the best decision for our shareholders is to moderate development in the near term.

At this point in the call, I would normally walk through our operating and leasing results for the quarter; however, I am happy to introduce Steve Budorick, our new COO. Steve joins us from Callahan Capital Partners and has decades of experience in office real estate with well-respected firms, including LaSalle Partners and Trizec Properties. The COPT family welcomes Steve and he will now walk you through the details. Steve?

Steve Budorick

Thanks Roger. I am happy to be part of the COPT team and welcome the opportunity to meet each of you listening to the call in the coming months. At quarter-end, COPT’s wholly-owned portfolio of 246 buildings encompass 20 million square feet. Our occupancy increased 70 basis points in the third quarter to 88% from 87.3% at June 30th, 2011. The percentage leased which is leading indicator increased by 40 basis points in the third quarter to 89.8% from 89.4% at the end of the second quarter of 2011. We leased approximately 880,000 square feet during the third quarter. That combined with 2.2 million square feet of leases in the first half of the year brings year-to-date total leasing to 3.1 million square feet and keeps COPT on pace to reach our 2011 leasing goal of 4 million square feet.

Of the space leased in the quarter, 576,000 square feet were renewals, of which 311,000 square feet related to 2011 exploration and 265,000 square feet related primarily to 2012 lease exploration. We re-tenanted 78,000 square feet. We executed 111,000 square feet of leases in development or redevelopment projects, and we also signed leases for 114,000 square feet of vacant first generation space. During the third quarter, we signed 147,000 square feet of new leases with the government, of which 78,000 was for new developments and 69,000 was for existing space.

We are also in active lease negotiations with contractor prospects for about 170,000 square feet of our development pipeline, and we have another 250,000 square feet of active tenant proposals. Our pricing and rental rate and leasing costs continues to improve and provide evidence that we are rebounding, albeit slowly off the bottom. Year-to-date, our average renewal rate of 77% demonstrates the stability of our existing tenant base. For third quarter, we have renewal rate of 82% and an average capital cost of $5.39 per square foot.

Rents on renewals increased 9.8% on a straight line basis and decreased 2.3% on a cash basis. Total rent for renewed and re-tenanted space increased 9.3% on a straight line basis and decreased 2.1% on a cash basis. For all renewed and re-tenanted space in the third quarter, the average capital cost was $7.76 per square foot versus $13.21 in the second quarter.

Another financial trend is that we continue to see fewer renewal transactions accompanied by downsizing. Through the third quarter, only three tenants out of 34 renewal transactions downsized their space requirements. We continue to believe same office occupancy bottomed in the first quarter of this year. For the fourth quarter, we have about 190,000 square feet of known move-outs, which will be more than offset by 364,000 square feet of space at lease and will become occupied before year-end.

Accordingly, we project that same office occupancy will improve modestly in the fourth quarter. Now, I will turn things over to Steve Riffee to discuss those and other specifics. Steve?

Steve Riffee

Thanks, Steve. For the third quarter of 2011, we reported FFO available to common shareholders of $44.4 million or $0.52 per diluted share. This result excludes a loss on the early extinguishment of debt in the quarter and the acquisition costs primarily associated with buying 310 Bridge Street. Including these charges, our FFP per diluted share was $0.49. For the third quarter of 2011, net income attributable to common share holders was $2.5 million and diluted earnings per share was $0.03 compared to net earnings attributable to common shareholders of $4.8 million or $0.08 per share for the third quarter of 2010.

Our diluted FFO payout ratio for the nine months ended September 30th, 2011 as adjusted was 78.4%, and our diluted AFFO payout ratio excluding capital expenditures invested at properties that are part of our disposition plan was 90.3%. As of September 30th, our same office portfolio consisted of 187 properties, representing 78.4% of the consolidated portfolio square footage and excluded all properties we intend to dispose of at Phase I of the strategic reallocation plan. Same office cash NOI excluding termination fees increased by $2.9 million or 4.8% from the second quarter of 2011 and was flat compared to third quarter of 2010. Same office occupancy averaged 89.8% in the third quarter versus 89.6% in the second quarter of 2011, an increase of 20 basis points. Turning to the balance sheet at September 30th, the company had $2.4 billion of debt outstanding at a weighted average cost of 4.7%, 70% of our debt was fixed interest rate.

For the quarter, our adjusted EBITDA to interest expense coverage ratio was 3.0 times and our adjusted EBITDA to fixed charge coverage ratio was 2.6 times. Our debt to adjusted EBITDA ratio adjusted for construction and progress was 7.0 times at quarter-end. During the third quarter, we entered into a syndicated credit agreement with our bank group that provides for a new $1 billion unsecured line of credit that matures on September 1st, 2014 and may be extended by one year.

The credit facility replaced the company’s existing $800 million line of credit, which was due to mature September 30th, 2011 and a $225 million construction facility, which was due to mature May 2012. On the same day, COPT also entered into a $400 million unsecured term loan agreement with our bank group that has a four-year initial term and a one-year extension option. The company had very strong support from an expanded bank group, with over $1.7 billion of commitment for these transactions.

The company used proceeds from these transactions to purchase the $162.5 million of its outstanding, 3.5% exchangeable senior notes that were put back to the company by investors and to repay $275 million of mortgage debt, $221 million of which was scheduled to mature within a year. In the quarter, the loss in the early extinguishments consisted of a $1.7 million write-off of deferred financing costs and a $350,000 prepayment penalty on an unassumable loan associated with a property that was sold during the quarter.

Importantly, COPT has only $53 million of debt maturing in the fourth quarter of 2012, and $141 million of debt maturing in 2013. Going forward, we intend to take advantage of low long-term interest rates and extend our debt maturity ladder. Now, regarding earnings guidance as Rand mentioned, we will host a conference call on January 12th, at 11 AM to give our outlook and guidance for 2012. Today, we are prepared to provide guidance for next quarter.

For the fourth quarter, we expect FFO per diluted share of $0.54 to $0.57. The major update of assumptions behind our fourth quarter guidance are as follows

first, for the same office portfolio, end of third quarter occupancy improved 10 basis points sequentially from the second quarter and should modestly improve in the fourth quarter to end the year 10 to 20 basis points higher. We project a tenant retention rate of 55% to 70% for the fourth quarter.

Second, our prior guidance anticipated $750,000 in lease termination fees for the third quarter. As shown on page 3 of the supplement, we recognized approximately $100,000 of lease termination income in the third quarter and only $445,000 through the first three quarters. We are lowering our expected quarterly run rate for lease termination fees, beginning with the fourth quarter to $250,000. Third, our guidance assumes no acquisitions and fourth, in addition to the $25 million of assets already sold to date, our guidance assumes we will sell an additional $30 million to $50 million of assets in the fourth quarter.

Finally is other income. Year-to-date, we recognized $4 million or $0.055 per diluted share of gains on land sales and our investment in KEYW. For the fourth quarter, we expect other income from gains on land transactions to be up to $750,000, and we are not forecasting any gain or loss on our investment in KEYW in the fourth quarter. A quick reminder from the July call related to our investment in KEYW. Because Rand resigned from KEYW’s board on July 1st, in the third quarter, we stopped accounting for our 2.6 million shares of KEYW under the equity method and instead began marking the investment to market.

On September 30th, KEYW share price closed at $7.11 whereas our basis in our shares were $7.45. At $0.34 loss per share in KEYW, plus a $200,000 reduction in the value of the 50,000 KEYW warrants we hold resulted in our booking an unrealized non-cash loss of $1.1 million or $0.014 per diluted share in the third quarter of 2011.

We do not plan to forecast any gain or loss on our KEYW investment; however, we will provide an update each quarter of how many shares we own, what our basis in those shares is, and what realized or unrealized gain or loss we incur each quarter for as long as we hold that investment. For projection purposes, investors should not include it in our future FFO estimates. And with that, I will now turn the call over to Wayne.

Wayne Lingafelter

Thanks Steve. My comments will focus on updates to projects under construction, redevelopment and pre-construction which are summarized on pages 25 and 26 of the supplement. During the third quarter, we did not start construction on any new office buildings, nor did we place any newly constructed buildings fully into service as part of our operating portfolio. But as anticipated, our leasing in the under construction portfolio did improve moderately during the quarter.

We signed leases with the government for 63% of 316 NBP and expect to deliver that space to them next year. We also achieved incremental leasing at 430 NBP, which is now 61% leased to contractors and we have a lease out for signature for another 11% of the building. We also have active leasing interest in the other properties under construction in this park.

Although we have not shown any pre-leasing at 7770 Backlick Road at Patriot Ridge, we are under negotiations with contractors for significant portions of that building. We hope to update you on this progress on the next earnings call if not sooner.

In our redevelopment properties, during the third quarter, we leased 25% of Hillcrest One in Blue Bell, Pennsylvania, which has been renamed 751 Arbor Way. Occupancy is slated for January of next year, roughly one month after the building is delivered to the market. We have taken four projects off of our pre-construction list from last quarter, which is on page 26 and moved them to future status. One project, 200 Sentry Gateway in San Antonio, Texas was dropped from this, with this realignment in reporting. As Roger discussed, we do not intend to resume pre-construction activities beyond the three projects until demand improves and existing space in these markets is absorbed.

The three potential construction starts for 2012 are in our strongest development markets. And we are in negotiations with tenants for space already under construction and therefore may need to begin building additional supply to keep pace with demand. These projects are the National Business Park, Patriot Ridge, and Redstone Gateway in Huntsville. With that, I will turn the call back to Roger.

Roger Waesche

Thanks Wayne. In summary, the message we hope you have all heard today is that although the broader economy and our friends in Washington D.C. continue to make daily operations challenging for us and other landlords, COPT’s operating results continue to show gradual improvement. Our priorities are simple and clear, lease space, sell non-core assets, continue to strengthen our balance sheet and develop properties where specific tenant demand exists.

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

Question-and-Answer Session

Operator

Thank you, Mr. Waesche. (Operator instructions) And your first question comes from the line of Craig Mailman with KeyBanc Capital Markets. Please proceed.

Craig Mailman – KeyBanc Capital Markets

Hi, good morning guys. Roger, maybe can you just provide a little bit detail as it stands now, you guys have the 260 for Phase I potentially going to another 260 or above for Phase II, but you are also kind of ratcheting back development expectations. I know it may be hard, but could you maybe give us a sense of what portion of the Phase I proceeds are going to be reinvested versus to deleverage and then maybe what your thoughts are on Phase II proceeds?

Roger Waesche

Sure. In terms of Phase I, we have yet to sell about $235 million, and looking at our existing under construction and under re-development pipeline, we have some other investments we are doing in some land improvements. We have approximately $200 million yet to spend. So, the Phase I will largely cover the portfolio of projects that are where we are on the construction at this point.

The Phase II proceeds would be largely dedicated to initial starts to the extent that they happen as a result of build-to-suits for specific tenant demand and also to deleverage our balance sheet and it’s possible if we find a really strategic acquisition we need to participate in that.

Craig Mailman – KeyBanc Capital Markets

That’s helpful. Have you guys refined maybe what your leverage targets are now?

Steve Riffee

Craig, this is Steve. We are at this point comfortable operating at the level that we are at in the near term, but have a long-term leverage goal of getting to 50% or below the way we traditionally look at, at the gross assets.

Craig Mailman – KeyBanc Capital Markets

And then just, Steve, also, now that you guys kind of collapsed the construction facility into the revolver, what type of pickup should we think about for capitalized interest that you guys continue to build out?

Steve Riffee

I would say considering the general direction of building out what we have and being a little more cautious on starts that you could expect capitalized interest, we are not giving the ’12 guidance, but I would say 4.5 million to 5 million for ’12 and we will give you an update in January for the balance of 2012.

Craig Mailman – KeyBanc Capital Markets

But is it safe to assume like a 300 basis points spread going forward on incremental capital spend?

Steve Riffee

No, I think you should look at basically our average borrowing rate that you would project and we will give you more color on that going forward. Times the projected spend is the way you should look at it.

Craig Mailman – KeyBanc Capital Markets

Great, thanks guys.

Steve Riffee

Thank you, Craig.

Operator

Your next question comes from the line of Jamie Feldman with Bank of America. Please proceed.

Jamie Feldman – Bank of America

Thank you. I know you guys gave your views on kind of how the environment looks in terms of the government, but can you give us a sense of what your clients are saying, and maybe how their views have evolved, maybe their lack of patience have evolved and how they are thinking about the world as we head into 2012?

Roger Waesche

I think frankly, everyone is very frustrated with the lack of activity on the part of the government. I mean, it’s in a gridlock and I think that’s going to show in terms of both the mid-term elections and then the national elections. And so, I think we are collectively, what our tenants are telling us and those that are in the dialog throughout the country really not just in the D.C. areas really that they are being cautious and it’s really primarily the uncertainty caused by the lack of government decision-making that is causing a lot of the cautiousness. I mean, they see business as doing well. In the defense side, it’s the uncertainty as I said in my remarks, Jamie, but by and large, they are also still getting business and they could just make decisions and get done with it, they do expect to still come out of it fairly well. There are some weapons programs clearly are headed for deferments or cuts, but beyond that, they do think that particularly with the national security part, they actually have seen increases and fairly robust activity.

So, I think it’s a mixed message and you certainly are seeing that around the country. I think clearly the whole European, one day it’s up, things are positive today and then there will be other details that come out and it’s negative and that’s weighing on the cautiousness. A lot of CFOs are sitting and saying, we know the local – and I hear this everyday from our tenants, the local people are out of space, they need more space desperately. They are hiring people a lot, they are hiring and they don’t have place to put them and you have to see if those are sitting on the requirement until they get clarity on the financial markets and on the elections.

So, I just think we are into another tough year from that perspective.

Jamie Feldman – Bank of America

Okay. And then, can you also talk a little bit more about the appetite for your assets? I know you want to ramp up the program. I am just curious what kind of buyers are out there, and then, what kind of financing you are able to get?

Steve Riffee

The assets that we have for sale are largely targeted for private buyers. Some are institutional, but I would say the larger percentage of the initial assets are targeted for private buyers. But so far we have dealt with investors who are well-heeled and have access to bank debt, given the size of the transactions we have done. And so, they have been able to execute, but we also have some transactions targeted for institutions who are all cash buyers and so far, financing, access to money has not been an impediment to us selling assets.

Jamie Feldman – Bank of America

Okay. And then you look at Duke’s sale and also that’s weak, I mean, is there something along those lines that you guys would be interested in doing?

Steve Riffee

I would say the assets that we are trying to sell are largely disparate assets that don’t connect to each other and largely be sold to individual investors. We do have certain portfolios of assets that we could put together that might target a big, larger institutional sale, and that’s something we are looking at.

Jamie Feldman – Bank of America

Okay. Thank you.

Roger Waesche

Thank you, Jamie.

Operator

Your next question comes from the line of Brendan Maiorana. Please proceed.

Brendan Maiorana – Wells Fargo Securities

Thanks. Just a follow-up, have you guys updated the cap rate expectation on the dispositions? I think it was 8% rough target when you initially laid out the plan in April.

Steve Riffee

Right. So, what we have sold so far ended up blending to that 8.5%. I still think that 8% or maybe a tad over is a good number, because we do have some assets that will sell below 8%, but we do have some that are going to sell above 8%. So, I think 8% in that range is still a pretty good number.

Brendan Maiorana – Wells Fargo Securities

Okay. That’s helpful. And then, when I look at the projects that I think are coming online over the next 12 or 15 months, there was about 200 million of them and they are about 36% leased according to your detailed schedule in the back of the supplemental. What level of lease rate or occupancy did those projects need to get to when they become, call it cash flow neutral on an NOI basis, so that they can be neutral to next year’s earnings as opposed to a drag when you stop the capitalization?

Steve Riffee

We are capitalizing interest at approximately a 5% interest rate and if you took a 10% asset yield on average for what we are putting in place, but then you have got some operating costs to absorb, then we probably need to be in the high 60s to sort of percentage lease to breakeven.

Brendan Maiorana – Wells Fargo Securities

As you guys think about, as you are dialing back a little bit on new development starts and you think about everything that’s coming online next year, do you think that what you have moving online is going to be additive to your run rate or do you think that from an initial FFO perspective that it might be a little bit of a drag?

Steve Riffee

I think it will be somewhat additive. I do agree with you that we run the risk next year of having to carry some assets. We are already sort of doing that out in Colorado Springs some assets that we put into service that aren’t leased. But knowing what has been leased so far, we have got just a little under $200,000 square feet of leasing that’s not yet occupied, and the leasing that Steve Budorick mentioned that we are closing in on, I think between those two and some other activity that we feel pretty good about that we won’t have a drag situation, the question is how positive will it be in 2012, but much more positive in 2013.

Brendan Maiorana – Wells Fargo Securities

Okay. That’s very helpful. And then, in terms of Power Loft, is that – other than the 17% that’s online today, what’s the capitalization that’s now with the remainder and given that you guys acquired that about a year ago, does that one come off of protection as you go into 2012?

Steve Riffee

As you think about Power Loft, what we bought about a year ago was a shell in the construction project. So, we finished building out the infrastructure to actually establish it as a leasable location sometime this summer and typically it takes 18 to 24 months to lease up that project from the point that there is infrastructure that exists. At the end of December, we will have delivered the MEP to have available 9 megawatts of power. We have leasing and we will not build out anymore of the infrastructure until leasing progresses. So, we will stop spending capital until you see further leasing progress.

We have had more activity once we finish them with a base infrastructure. We have seen RFPs that we are working on, but we haven’t had any leases to announce. So, I think you will see us spend less on Power Loft capital for the first good bit of 2012, and then as leasing progresses, we will give you projections of additional build-out.

Brendan Maiorana – Wells Fargo Securities

Okay. And sorry, Steve, to clarify, so the 9 megawatts that’s built out kind of now and then you have 12 months from now to lease that out before it runs off capitalization reduction?

Steve Riffee

That’s correct.

Brendan Maiorana – Wells Fargo Securities

Okay. Great. Thank you.

Roger Waesche

Thank you.

Operator

Your next question comes from the line of Sheila McGrath with KBW. Please proceed.

Roger Waesche

Go ahead to the next one.

Operator

Next question comes from the line of Dave Rodgers with RBC. Please proceed.

Dave Rodgers – RBC

Hi, good morning, thanks. Rand, quick question, I thought from your prior understanding was that cyber budget was somewhat siphoned off for the remainder of the DoD budget and perhaps not at risk at all. You didn’t really present it that way. So, is that at all at risk in this current cut or is the commitments from the cyber component of the budget really just a function of the overall government? Can you clarify that for me?

Rand Griffin

Good question, Dave. Our understanding is cyber component is protected and in fact all readings that we have done and input that is actually is expected to increase, those are indications. So, we think that’s very good for us in the long term and that of course is headquartered at Fort Meade and they have requirements. They are going to have some difficulty getting MILCON money and so there is a potential of some of that demand really in effect having to siphon off some space to their neighbor and that should create some additional demand for us as it shifts over into National Business Park.

Dave Rodgers – RBC

So, I guess it’s not only an approval problem there, just an actual funding problem that you are waiting to clear?

Rand Griffin

Exactly.

Dave Rodgers – RBC

Okay. And then, Steve, I guess going back to the capitalization, I guess wanted to be clear is, are you changing or have you changed your capitalization policies with respect to the various bucket, or is it simply a function of how much capital or how many projects are in each component of that budget, let’s say?

Steve Riffee

We have not changed on capitalization policy. It’s just the level of capital spent for the various projects that’s changing.

Dave Rodgers – RBC

Okay. Great. Thank you.

Rand Griffin

Thank you.

Operator

The next question comes from the line of Aaron Alaskanson [ph]. Please proceed.

John Guinee – Stifel Nicolaus & Company

Hi, Roger, congratulations, John Guinee here.

Rand Griffin

Thank you.

John Guinee – Stifel Nicolaus & Company

Rand, we are going to miss you, when is your last call?

Rand Griffin

The next call, we will finish out the fourth quarter call.

John Guinee – Stifel Nicolaus & Company

Okay, all right. Just a few sort of housekeeping questions, which I know you would anticipate. $240 a square foot in Huntsville, Alabama to buy a very good building still seems very, very rich, perhaps the highest price ever paid in the state of Alabama. Can you kind of elaborate on that Roger a little bit on why that makes sense?

Roger Waesche

Sure. First of all, it is the Number 1 building in Huntsville, both in terms of its physical features and its location. It’s located adjacent or is part of a lifestyle center 500,000 square feet, and it’s really in the midst of a great amenity situation. It also happens to be one mile from the main gate to Redstone Arsenal. And so, we think that building because of its proximity to Redstone and its rich amenity base and its high quality will remain leased for a long period of time. We would agree that $240 a square foot is a big number, but what you pay has to do with your relationship to how you think it will stay leased and what kind of rental rates. And we think that given the tenant in that building and our relationship that, that building will stay leased for a long time at rates that will allow us to get a good return.

John Guinee – Stifel Nicolaus & Company

Okay. Then any skip build-out in the space or anything unusual in that regard?

Roger Waesche

There is, yes.

John Guinee – Stifel Nicolaus & Company

Okay. Second question, on page 24, you have got 2,200 acres of land, 20 million square feet of development right, and you can just eyeball some of this and realize that a lot of it is just never going to be built, 194 acres in Colorado Springs, 400 plus acres in Huntsville etcetera, do you have any plans to dispose any of this land in the near or medium term?

Rand Griffin

John, it’s Rand. Never is a long time. So, things go through cycles as you know from your previous background and sometimes you look at it and say that there are out lots and other alternative uses that are currently readily available to be sold in the marketplace. And so, part of our program is to accelerate those, including the opportunity to in some of our markets to the sales to apartment builders, hotels, retail and something like that. And so that is part of the program. Some of those properties are immediately available for sale, others need a little bit of work for positioning them for entitlements or for breaking the lots up. So, we are very active in that. We do expect as we give ’12 guidance for there to be some aspects of that in the ’12 and ’13.

And the other parts of it is really a function of development. And the offices continues to do well and accelerate as we expect and we will continue to take that ground down.

John Guinee – Stifel Nicolaus & Company

And then, the last question I think of building a little bit on Power Loft, has there been any leases signed at Power Loft since you acquired it, I guess about 15 months ago? And is that possibly on the block for sale, Roger, in Phase II of the disposition program?

Roger Waesche

I don’t know that we have thought that through yet, John. We have not signed any leases since we acquired the property, and we are targeting tenants that tie to our niche of government and defense for that particular location. And I think we will wait and see how core strategic that asset is to the company a year-and-a-half from now.

John Guinee – Stifel Nicolaus & Company

Okay. Thank you very much.

Rand Griffin

Thanks John.

Operator

Your next question comes from the line of Michael Knott. Please proceed.

Michael Knott – Green Street Advisors

As I have kind of a little string of development questions here, I will just kind of piece it all out there and we can talk about it. Just curious how tough the decision was to take a more cautious stance on development and kind of what all that you thought about in regards to making that decision. And then also, does that shift have anything to do with the pending change in leadership?

Steve Riffee

I don’t think it had to do with the pending change in leadership. I think we step back and said, look, the company has a huge value creation portfolio. We have got 1.1 million square feet under construction, we have got 300,000 square feet re-development, we have got Power Loft, we have got some of our existing portfolio that’s turned value add because of the downturn in the economy, and then, we have got this great future back opportunity where we are entitled to go forward on many of opportunities. If we look at our total value add portfolio relative to the company’s asset total, it’s about 20%, and so we said that’s enough. We need now to go back and do backing and filling. We need to make sure that what we have started all the toys that we have bought and built over the last couple of years, we need to make sure that they are working, and so, that’s where the company’s emphasis now.

As we said, both in Wayne’s section and mine, we are positioned to build additional buildings, but we have got to see measurable demand in order to do that. I think what the company needs to do in the short run is to de-risk a little bit, I think we can create a lot of value by de-risking the story and not adding any more non-earning assets to our portfolio at this point.

Michael Knott – Green Street Advisors

Okay. Sounds like a good strategy. And just to clarify what you said, are you no longer doing any spec development anywhere even at the three core locations or do you just need some free leasing on some of your projects? Just want to make sure I understood what you said.

Steve Riffee

I think what it is, is that we are placing a more onerous underwriting standard on ourselves related to leasing and pre-leasing when it comes to development.

Rand Griffin

There is an example of that. If you progress as we expect with some of the fairly strong leasing that’s at Patriot Ridge, you will have that decision. If that building at 14 months to build the next building, and you are sitting there with a velocity that finishes that building up in the middle of next year, then you have that kind of decision to make. And you have to look out as to others in the marketplace leasing up and what’s expected demand and make those kinds of decision. So, what we have tried to do, Michael, is really just look at where we see that projection of volume and make those calls accordingly.

And interestingly in this cycle, at this time in these cycles, what you do start to see and there is some of those discussions underway as design builds stepping forward where full building users that are consolidating or that are looking at their particular growth accelerating, they don’t have a lot of options and they start stepping forward for design build. And so, we are very well positioned for that and would expect that, that may take some of the place of some of these other projects that are really there, we are just waiting on that, so.

Michael Knott – Green Street Advisors

Okay. Sorry to not to belabor the point, but are you guys leaving yourself some flexibility to start projects completely spec or you are going to require some level of pre-leasing on every project that you start from here?

Steve Riffee

Obviously some of our tenants require us to create inventory for them to lease, and so, but it will be done with very strong knowledge that there is a tenant for a building before we start another building.

Michael Knott – Green Street Advisors

Okay. And then, just a question on sales program, if I heard your numbers right, it sounds like and based on what you disclosed in writing, it sounds like you have about $20 million done, it sounds like there is another $40 million under contract, and then you are evaluating you have offers on another $160 million. If I add those three source, and with that batch being potentially done by first quarter of ’12 if I heard that right, so that total would be about $225 million. And if that’s all right, why would it take another five quarters for the last, call it 30, if you said through the year-end ’13?

Steve Riffee

I think what we have said is that we have moved that 2013 goal up to 2012. We didn’t say that it would all be done in the first quarter, but there is an internal goal, we will try to have those assets sold during calendar 2012.

Michael Knott – Green Street Advisors

Okay. So Phase I, you expect to have completed by year-end ’12 now, the first $260 million?

Steve Riffee

That’s correct.

Michael Knott – Green Street Advisors

Okay. And then, Phase II would be kind of another two years from 2013, through the end of 2014, perhaps?

Steve Riffee

I think we would like to spend a little more time to think about the assets and the time line and probably talk about that in January.

Michael Knott – Green Street Advisors

Okay. Fair enough. Thanks a lot.

Rand Griffin

Thanks, Michael.

Operator

(Operator instructions) Your next question comes from the line of Steve Benyik. Please proceed.

Steve Benyik – Jeffries & Company

Thanks very much and good morning. You guys have spoken pretty positively of three of the four BRAC locations that you have, just hoping you could provide a little color on North Gate Business Park, Aberdeen Proving Ground, and just what you think it’s going to take there to just see a more sustained improvement in leasing velocity?

Roger Waesche

I think that’s been a disappointment to date not just for us, but for any of the other developers that are in marketplace, Steve. And I think it really relates to the 140 firms that are in Fort Monmouth that have been doing business with C4ISR, only a small percentage of those have moved and we are just now for the first time starting to see signs that those tenants, a lot of whom are on month-to-month leasing up in Fort Monmouth start to now come out with RFPs in the marketplace to look for space. So, that’s an early indicator. We will have to see if those in fact get formalized, but now that C4ISR is in and completely moved and starting to award contracts that have been authorized, we would expect that as part of those awards, those future tenants would need to be relocated into the marketplace.

And so, even though it has been frustrating for all of us and it’s been under our expectations, I think the next six months or so, will start to give us a much better indication of that activity.

Steve Benyik – Jeffries & Company

I guess when you look at the hierarchy of all of your other markets, would that market still come in fourth place following the first three BRAC locations, or are there other markets where you are a bit more positive even though they are not sort of BRAC-related?

Roger Waesche

I think we still stand by the numbers and it’s been out in papers a lot, and Base Commander and the General have discussed it. I mean, the numbers expected for the defense contractors as they complete the move is still in that 2.5 million to 3.2 million square feet in total. And that would take care of our entire development and take care of the onsite, the gate development and leave a little for others in the marketplace.

I think the difficulty has been over what period of time, and we are all kind of just waiting to see how that unfolds. And that square footage directly related to the BRAC for example is pretty comparable to the numbers we are expecting to see in Huntsville and little bit more actually than the numbers that we expect to see at Patriot Ridge. The difference is that Patriot, there are just not as many alternatives, they are moving very rapidly on space requirements there. They under built, even though it’s at 2.4 million square feet, they under built the requirements for National Geospatial, both for space and parking. And so, that has a little bit different dynamics, and then the dynamics down in Huntsville at our Redstone Gateway project, in addition to the BRAC relocation, there is a fair amount of pent-up demand particularly for AT/FP secured space behind the gate that we expect to be able to capture as our project gets velocity there.

Steve Benyik – Jeffries & Company

Okay. That’s helpful. I guess just trying to the dividend, I think you had mentioned getting down to an AFFO payout of close to 90%. I just want to better understand, was that completing all, after completing all of the Phase I sales, and then also, sort of where do you guys expect to be at year-end if you hit the midpoint of the asset sale guidance for the fourth quarter?

Roger Waesche

I think the asset sales are going to be timed in the second half of the quarter, and not have a significant effect on the fourth quarter in terms of cash flow. I would say that our expected payout ratio for the full year would be halfway between the 90% and 100% that we have been talking about before.

Steve Benyik – Jeffries & Company

Okay. And then, just lastly, I was wondering are there any additional capital raises, construction loans, anything of that variety in the 2011 guidance, and then, lastly whether the rate on the new unsecured credit facility and the term loan have been disclosed, sort of how those came in relative to expectations?

Roger Waesche

With regard to construction facilities, we are still working and may put in place a construction facility for the Redstone project in Alabama. The term, we worked for quite some time on our bank group in our term loan, and we thought we did some very good financing favorable and we have very strong interest and expanded the bank group numbers. So, I would say that turned out to where we expected it to be. The pricing, we are currently borrowing 200 basis points over LIBOR on our bank line and 190 basis points over LIBOR on our term loan.

Steve Benyik – Jeffries & Company

Okay. Thanks very much.

Rand Griffin

Thank you.

Operator

Your next question comes from the line of Christopher Lucas. Please proceed.

Christopher Lucas – Robert W. Baird & Company

Good afternoon, everyone.

Rand Griffin

Hi, Chris.

Christopher Lucas – Robert W. Baird & Company

Rand, Roger, I guess a lot of talk on the BRAC-related activity. I guess if you could just maybe comment on the non-defense, non-BRAC related leasing environment and how or is there any difference between what the tenants are saying and telling you now relative to the other contractor demand driver? So, is there any difference right now in the environment between the two?

Roger Waesche

I think they both have their own sets of issues. In case of the BRAC-related tenants, they are dealing with where the future of government, of budget is going and what their individual impact would be relative to the programs that they are involved with, with the government. With respect to the 40% of our business that is tied to commercial tenants, whether it be education, healthcare, financial services, etcetera, I would say that, that part of the business is stable, it’s not improving significantly, but it’s not as bad as it was back in 2008 or 2009, but it’s going to be a slow grind in that part of our portfolio to continue to bring occupancy up.

Christopher Lucas – Robert W. Baird & Company

Okay. And then just on the development return expectations, are you adjusting those at all or are you guiding us towards the lower end of your traditional range at this point or should we be thinking about lower returns on developments at this point?

Roger Waesche

The returns may be a little lower, but it’s not significant. We may elect to take volume over price in a couple of places, which could have an impact, but I think our key locations will still get pretty high margins.

Christopher Lucas – Robert W. Baird & Company

And then, just a point of clarification, on the Power Loft build-out to 9 megawatts, does that include the three that was sort of in place at the time of acquisition?

Roger Waesche

That’s correct.

Christopher Lucas – Robert W. Baird & Company

Okay. And then, the last question, just so again so I am clear on it. Disposition program, essentially what I am hearing from you is that the program is going to be somewhat accelerated compared to what was maybe originally announced, and that there is plans for additional sales, but those, the timing and the composition and the scale of those is to be determined.

Roger Waesche

That’s correct.

Christopher Lucas – Robert W. Baird & Company

Okay. Great, thanks a lot guys.

Rand Griffin

Thanks Chris.

Operator

Your next question comes from the line of Craig Mailman with KeyBanc Capital Markets. Please proceed.

Jordan Sadler – KeyBanc Capital Markets

Hi, it’s Jordan Sadler here with Craig. Just following up on the dividend a little bit, Roger, I am just curious, this activity, it appears that the de-leveraging, the accelerated sales, reduced acquisitions, the softness in the core, decreased development, I mean, this will obviously put pressure on the run rate. Is the dividend sacrosanct?

Roger Waesche

It’s not sacrosanct. I think in a perfect world, we would like to grow back into it for the nine years. Prior to 2010, we had an AFFO payout ratio in the mid-80s, last year we were in the 90s. We would go over the company that try to grow our earnings back to make the dividend payout ratio in the mid-80s. So, that’s the target, but we will see what happens in 2012 and adjust accordingly.

Jordan Sadler – KeyBanc Capital Markets

And if it were to take three years to grow back into it, would that be sort of acceptable or that just remains to be seen?

Roger Waesche

I really don’t have a strong answer for that now. It’s obviously, we have to sit down and go through the three-year outlook with the Board and get their views on that.

Jordan Sadler – KeyBanc Capital Markets

Fair enough. Thank you guys.

Rand Griffin

Thanks Jordan.

Operator

And your next question comes from the Aaron Alaskanson [ph]. Please proceed.

John Guinee – Stifel Nicolaus & Company

Just a quick follow-up. John Guinee here again. I was at a business event here about a month ago where Billy Barroll in your shop was on a panel, did a great job. And they had a gentleman from DISA, Defense Information Agency, which is moving from Skyline, the Vornado asset, over to Fort Meade. And he went to great length to talk about the employees at DISA and how because of flex timer and remote commuting, really only had to be at Fort Meade for three out of every 10 days.

And that ended up result in a lot of retention. Is that the same issue that’s going on with the defense contractors and the slowness to locate in relatively remote locations like Aberdeen or National Business Park?

Roger Waesche

I don’t think so. I think, John, that DISA, when they first announced the relocation, they were quite shocked when they did the survey that as much as 60% of their employees did not intend to relocate and so they went out and had a very specific program to try to accommodate that and of course, DISA is also responsible for the entire network service, for the entire government. So, they pride themselves on trying to help create the solutions. When they then turn around for the contractors, they have said very clearly, we have a contract with you, we expect you to be nearby and adjacent to service our requirements. They did say that they would give a little bit more time and recognition of the lease costs, but they are asking their contractors to give up and so they worked that out to be by ’14, those contractors have to move.

Similar situation, probably more critical even in C4ISR, whereas they award those contracts a lot of those have the requirement where they have to be on pace within 10 minutes of the notification and you can’t do that from Fort Monmouth, New Jersey. So, we do expect that once those contracts are awarded that the relocations will occur.

So, it’s really more just the timeframe of those agencies getting in, getting settled starting to do the awards, and then that will trigger the relocations of the contractors.

John Guinee – Stifel Nicolaus & Company

And then, last question, I think probably, Steve, you might know the answer to this. What are your coupons on your preferreds? All of your preferreds are callable now, I am sure a few of them are above 7 or 8, and is that a way to sell assets without incurring dilution?

Roger Waesche

We definitely have some 8% and some in the high 7s that we continue to evaluate as we think about allocating capital and have at this point not decided to call those, but it is one of the things that we are always evaluating, John.

John Guinee – Stifel Nicolaus & Company

All right, thank you.

Rand Griffin

Thanks John.

Operator

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

Rand Griffin

Thank you for joining us today on a fairly lengthy call. And if we didn’t get a chance to get to your questions or we didn’t get them answered on this call, we are all in the office today and available to speak with you later, and again our next call will be in January 12th and we will then give 2012 guidance. So, thank you very much. Have a good day.

Operator

Thank you for your participation in the Corporate Office Properties Trust third quarter 2011 earnings conference call. This concludes the presentation. You may all now disconnect. Good day.

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