NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the following credit ratings of Corporate Office Properties Trust (NYSE: OFC) and its operating partnership, Corporate Office Properties, L.P. (collectively COPT, or the company):
Corporate Office Properties Trust
--Issuer Default Rating (IDR) at 'BBB-';
--Preferred Stock at 'BB'.
Corporate Office Properties, L.P.
--IDR at 'BBB-';
--Senior unsecured line of credit at 'BBB-';
--Senior unsecured term loans at 'BBB-';
--Senior unsecured notes at 'BBB-';
--Senior unsecured exchangeable notes at 'BBB-'.
The Rating Outlook is Stable.
KEY RATING DRIVERS
Strong Franchise/Defense-Driven Portfolio
COPT generates 72% of net operating income (NOI) from its strategic tenant niche, which includes properties occupied primarily by government agencies or defense contractors. As a result, COPT's assets are generally located near strategic defense locations (i.e. Fort Meade), which drives geographic concentration in the Washington, DC and Baltimore region. These strategic locations drive strong tenant investment in the assets and create tenant stickiness, as retention rates have averaged 71% since 2007.
Tenant missions also center on R&D and high-tech areas that are critical to national cyber-security in the United States. Together with COPT's long-standing relationships with the federal government and contractors, these strategic locations create meaningful barriers to entry.
Portfolio Realignment Largely Complete
COPT completed its Strategic Reallocation Plan (SRP) commenced in 2011 via the sale of non-core assets (reduced Baltimore County footprint by 2 million square feet), exiting the Colorado Springs market, and improving its balance sheet to levels consistent with an investment grade office REIT. Key remaining transactions include the expected conveyance of a $150 million portfolio (based on outstanding CMBS balances) to the special servicer during 2014 and the redevelopment/expected sale of the company's Blue Bell portfolio. These transactions will further improve financial flexibility and facilitate capital recycling in the company's strategic niche properties.
Improved Credit Profile; Addition by Subtraction
The company sold its 15-asset Colorado Springs portfolio for $133.9 million and conveyed 14 properties to the CMBS special servicer for $146.9 million in December 2013, reflecting the value of in-place debt and accrued interest. These transactions drove leverage lower to 6.5x at Dec. 31, 2013. Fitch anticipates that COPT will convey a separate $150 million portfolio to the special servicer in 2014 following vacancies by Northrop Grumman and CSC in April 2014, which will facilitate further de-levering. Fitch is not concerned about potential franchise risk at this time; however, additional conveyances would be viewed negatively given the potential for weakened access to mortgage debt.
Appropriate Credit Metrics
Leverage declined to 6.5x at Dec. 31, 2013 from 7.0x and 8.7x during the two prior years, respectively. Fitch expects leverage will increase to 6.8x in 2014 before declining to the low-6.0x range over the longer term, driven by low single-digit same-store net operating income (SSNOI) growth and incremental cash flow from development completions. Projected leverage is appropriate for the 'BBB-' IDR. Fitch defines leverage as net debt-to-recurring operating EBITDA.
Fixed charge coverage (FCC) was 2.1x for the trailing 12 months (TTM) ended Dec. 31, 2013, an increase from 1.8x in 2012 and 1.6x in 2011. Fitch expects that FCC will approach 2.5x over the next 12-24 months, driven by recurring operating EBITDA growth and continued access to debt capital at favorable rates. Projected coverage is relatively strong for the rating. Fitch defines FCC as recurring operating EBITDA, less recurring capital expenditures and straight-line rent adjustments, divided by total interest incurred and preferred dividends.
Uneven Operating Fundamentals
Defense contractor downsizing drove same-store occupancy 100 bps lower to 89.8% at Dec. 31, 2013 from 90.8% at June 30, 2013. Fundamentals remain uneven across markets - the Baltimore/Washington Corridor, which makes up 47% of square feet, has seen encouraging leasing indicators evidenced by positive cash leasing spreads in 4Q'13. However, Northern Virginia and Greater Baltimore (collectively 32% of square feet) remain under pressure and have been characterized by cash rent roll down in the high single digits with elevated capex requirements. Favorably though, GAAP leasing spreads continue to be positive across the portfolio and accelerated to 4.6% in 2013. Fitch expects that occupancy will increase marginally in 2014 as contractors finalize real estate rationalization plans.
Informed Demand Mitigates Development Risk
COPT's growth strategy centers on new development given informed demand from the U.S. Government for new space requirements. The pipeline totaled $287 million at Dec. 31, 2013 and was 78% pre-leased to both government agencies and defense contractors supporting these entities. The cost to complete the pipeline is modest at 3% and despite potential growth toward 5%, Fitch expects development risk will continue to be mitigated by COPT's unique relationships that provide implicit pre-leasing. The company remains well-positioned to capture future demand from cyber-driven growth, which should offset weakness in regional markets and potential future downsizing from defense contractors. COPT leased approximately 900,000 square feet of first-generation development and redevelopment space in 2013, which follows a record 1.2 million of square feet in 2012.
Adequate Financial Flexibility
COPT has a strong liquidity profile with total sources of liquidity covering total uses of liquidity by 2.3x for the Jan. 1, 2014 to Dec. 31, 2015 period, strong for the rating.
Fitch defines liquidity coverage as sources of liquidity divided by uses of liquidity. Sources of liquidity include unrestricted cash, availability under the unsecured revolving credit facility, and projected retained cash flow from operating activities after dividends. Uses of liquidity include pro rata debt maturities, expected recurring capital expenditures, and remaining development costs.
Financial flexibility is also supported by improved access to capital (the company issued $600 million of unsecured notes in 2013 at a 4.3% weighted average interest rate) and a growing unencumbered asset pool, which covered net unsecured debt by 2.2x at Dec. 31, 2013 using a stressed 9% capitalization rate.
Conservative AFFO Payout Ratio
COPT's AFFO payout ratio was 70% in 2013, which allows the company to generate approximately $45 million of internal liquidity to fund growth and repay debt. Fitch expects the company to increase the dividend over the next 12-24 months; however, Fitch expects the AFFO ratio will remain below 80%.
The following factors may have a positive impact on COPT's ratings and/or Outlook:
--Fitch's expectation of net debt-to-recurring operating EBITDA sustaining below 6.0x (leverage was 6.5x as of Dec. 31, 2013);
--Fitch's expectation of fixed-charge coverage maintaining above 2.5x (fixed-charge coverage ratio was 2.1x for the TTM ended Dec. 31, 2013);
--Fitch's expectation of unencumbered asset coverage of net unsecured debt (UA/UD) maintaining above 2.5x (coverage was 2.2x as of Dec. 31, 2013).
The following factors may have a negative impact on the company's ratings and/or Outlook:
--Fitch's expectation of leverage sustaining above 7.0x;
--Fitch's expectation of fixed-charge coverage sustaining below 1.8x;
--Fitch's expectation of UA/UD sustaining below 1.8x;
--Material macroeconomic weakness affecting the defense industry, such that a larger portion of COPT's portfolio would consist of standard suburban office assets.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Rating U.S. Equity REITs and REOCs (Sector Credit Factors) (Feb. 26, 2014);
--'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis' (Dec. 23, 2013);
--'Recovery Ratings and Notching Criteria for Equity REITs' (Nov. 19, 2013);
--'Corporate Rating Methodology' (Aug. 5, 2013).
Applicable Criteria and Related Research:
Recovery Ratings and Notching Criteria for Equity REITs
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis
Rating U.S. Equity REITs and REOCs (Sector Credit Factors)