Fitch Affirms Corporate Office Properties' IDR at 'BBB-'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed the ratings for Corporate Office Properties Trust (NYSE: OFC) and its operating partnership, Corporate Office Properties, L.P. (collectively COPT, or the company), including the Long-Term Issuer Default Ratings (IDR) at 'BBB-'. A full list of ratings follows at the end of this release.

KEY RATING DRIVERS

Strong Franchise/Defense-Driven Portfolio

COPT generates 77% of net operating income (NOI) from its core defense/IT 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 (e.g. Fort Meade, Northern Virginia), which drives geographic concentration in the Washington, DC and Baltimore region. These strategic locations drive a high degree of tenant investment in the assets and create stickiness, as retention rates have approximated 70% historically.

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 for competitors seeking similar tenants.

Portfolio Realignment Nearly Complete

COPT is close to completing its strategic reallocation plan that commenced in 2011 via the sale of non-core assets which, when combined with follow on equity issuance has improved its portfolio quality and reduced leverage to a level consistent with investment-grade office REITs. The remaining transactions are the approximately $150 million aggregate sale of non-core suburban office properties, the consummation of which Fitch expects will occur during 2H'16 and into early 2017.

Steadying Operating Fundamentals

Fitch expects same store occupancy to remain relatively unchanged, due to dispositions of higher-leased assets offset by good leasing activity. Reductions in defense contractor downsizing, combined with an improving leasing environment, held same-store occupancy roughly flat since the beginning of 2015 at 91.7% as of June 30, 2016. Fundamentals have been improving within the company's portfolio, with the Baltimore/Washington Corridor and Northern Virginia markets, which collectively comprise 51% of total portfolio square feet, having good leasing indicators evidenced by positive GAAP leasing spreads in 2015 and 1H'16.

The company remains well-positioned to capture future demand from cyber security-driven growth, which should offset any weakness in regional markets and potential future downsizing from defense contractors. COPT leased approximately 550,000 square feet of first generation development and redevelopment space in 1H'16, which follows 735,000 in 2015 and 900,000 in 2014.

Informed Demand Mitigates Development Risk

COPT's strong relationship with the U.S. Government provides unique insight into demand trends in its defense-tenant niche that help limit the risk of its development led growth strategy. The company's (re)development pipeline totaled approximately $325 million at June 30, 2016 and the development pipeline was 67% pre-leased to both government agencies and defense contractors supporting these entities. The cost to complete the pipeline is modest at 3.3% of total undepreciated assets and despite potential growth toward 5%, Fitch expects development risk will continue to be mitigated by COPT's unique relationships which provide implicit pre-leasing.

Fitch expects development to be funded primarily with proceeds from asset sales. The company plans on selling primarily non-core suburban office assets.

Metrics Expected to Improve

Fitch expects leverage to center around 6.0x during the rating horizon, primarily due to debt reduction via asset sales. Leverage was 6.8x as of June 30, 2016 (6.6x on an annualized 2Q'16 basis), down slightly from 6.9x as of Dec. 31, 2015 and 2014. Leverage is 0.3x - 0.4x higher when including 50% of preferred stock, per Fitch's hybrids criteria. Projected leverage is good for the 'BBB-' Issuer Default Rating.

Fitch expects fixed-charge coverage will improve into the high 2.0x's, due primarily to lower leverage and recurring operating EBITDA growth via developments. Fixed-charge coverage was 2.3x for the trailing 12 months ended June 30, 2016, up slightly from 2.2x and 2.1x for the years ended Dec. 31, 2015 and 2014, respectively.

Strong Liquidity

COPT has a strong liquidity profile with total sources of liquidity covering total uses of liquidity by 2.4x for the July 1, 2016 - Dec. 31, 2018 period. Liquidity strength is driven by modest debt maturities and 91% availability on the company's unsecured revolving line of credit. Further, the company has an incremental $150 million available on its delayed-draw term loan, which Fitch expects it will utilize in 2H'16.

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.

Low Unencumbered Asset Coverage of Unsecured Debt

The company's unencumbered asset coverage of unsecured debt (using a stressed 9.0% capitalization rate) was 1.8x as of June 30, 2016. Fitch expects this ratio to improve to around 2.0x over the next several years as the company reduces leverage and acquisition and development EBITDA come on line.

Conservative AFFO Payout Ratio

COPT's AFFO payout ratio was 68% for 1H'16 and 74% for 2015, which allows the company to generate approximately $50 million annually of internal liquidity to repay debt and fund development.

PREFERRED STOCK NOTCHING

The two-notch differential between OFC's IDR and its preferred stock rating is consistent with Fitch's criteria for corporate entities with an IDR of 'BBB-'. Based on Fitch's criteria report, 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis,' dated Feb. 29, 2016, the company's preferred stock is deeply subordinated and has loss absorption elements that would likely result in poor recoveries in the event of a corporate default.

STABLE OUTLOOK

The Stable Outlook reflects Fitch's expectation that OFC will sustain leverage around 6.0x through the rating horizon and that the company will have sufficient capacity to address any operating softness via asset sales. Although the company's leverage is low for the rating and could decline below Fitch's 6.0x sensitivity for positive rating momentum, Fitch views the company's access to capital as weaker compared to higher-rated peers.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for COPT include:

--Annual SS NOI growth between 2% - 3% from 2016 - 2018, reflecting positive GAAP leasing spreads, combined with 1.5% contractual rent escalators;

--Annual development spending between $150 - $225 million;

--$125 - 150 million of annual development coming into service at an initial 6.25% yield;

--$350 million of remaining 2016 dispositions; $100 million in 2017 and $50 million in 2018, all at 7.5% cap rates;

--No acquisitions;

--No equity issuance.

RATING SENSITIVITIES

The following factors may have a positive impact on OFC's ratings and/or Outlook:

--Fitch's expectation leverage sustaining below 6.0x (leverage was 6.8x at June 30, 2016, and Fitch expects leverage to sustain around 6.0x during the rating horizon);

--Fitch's expectation of fixed charge coverage sustaining above 2.5x (fixed charge coverage was 2.3x for the trailing twelve months ended June 30, 2016);

--Fitch's expectation of UA/UD maintaining above 2.5x based on a stressed 9% cap rate (UA/UD was 1.8x at June 30, 2016).

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 2.0x;

--Material macroeconomic weakness affecting the defense industry, such that a larger portion of COPT's portfolio would be comprised of traditional suburban office assets.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

Corporate Office Properties Trust

--Long-Term IDR at 'BBB-';

--Preferred Stock at 'BB'.

Corporate Office Properties, L.P.

--Long-Term IDR at 'BBB-';

--Senior unsecured line of credit at 'BBB-';

--Senior unsecured term loans at 'BBB-';

--Senior unsecured notes at 'BBB-'.

The Rating Outlook is Stable.

Additional information is available on www.fitchratings.com.

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:

--Historical and projected recurring operating EBITDA is adjusted to add back non-cash stock-based compensation;

--50% of cumulative perpetual preferred stock is included as debt to calculate certain leverage ratios.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Recovery Ratings and Notching Criteria for Equity REITs (pub. 03 Dec 2015)

https://www.fitchratings.com/site/re/874214

Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 29 Feb 2016)

https://www.fitchratings.com/site/re/878264

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1012654

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012654

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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+1-212-908-9161
Fitch Ratings, Inc.
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or
Secondary Analyst
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Senior Director
+1-212-908-9153
or
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or
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Contacts

Fitch Ratings
Primary Analyst
Steven Marks
Managing Director
+1-212-908-9161
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Stephen Boyd, CFA
Senior Director
+1-212-908-9153
or
Committee Chairperson
David Silverman
Senior Director
+1-212-908-0840
or
Media Relations
Sandro Scenga, +1-212-908-0278
sandro.scenga@fitchratings.com