Corporate Office Property Trust: A Good Offense Is Owning 'Defense'

NEW YORK ( TheStreet) -- Stability, consistency and growth. These are three traits investors look for when determining where and how to invest their capital.

These are the same three traits that attract investors to real estate investment trusts.

The question is which REIT sector will best achieve cash-flow stability, tenant consistency and growth of cash flow and dividends.

One REIT area that investors have overlooked is the office sector.

The office sector currently has 18 REITs with a combined market capitalization of $50 billion dollars and a dividend yield of 3.50%.

The year-to-date return for the sector has been 7.53%, which about average across sectors. But this is better performance than the more popular apartment, self-storage and health care sectors.

These factors suggest that investors should consider this sector for future returns and performance.

The office sector is improving, according to Karen Nickerson a senior credit officer with Moody's Investors Service:

"Signs are encouraging for the office sector, but risks remain. The U.S. labor market is improving, corporate profits are strong and balance sheets are stable. Office vacancy in the fourth quarter 2011 declined 50 basis points to 16% year-over-year, according to a fourth-quarter report by CBRE Econometric Advisors. However, Europe's debt situation remains unsettled and U.S. fiscal policy remains uncertain. In light of these unknowns, we expect the office market recovery to remain tentative."

While the sector begins to rebuild and grow, a good offensive strategy might be owning defense -- defense-related office properties, that is.

As the only global hyperpower, the U.S. spends more on defense than any other country (by a multiple).

Unlike many sectors of the office market that will begin to fully recover when the employment situation gains steam and strength, office REITs that focus on the government and defense-related industries should recover quicker and show greater stability.

A prime example of one of these REITs is Corporate Office Properties Trust ( OFC).

It focuses on providing office and data-center space for the government and for defense contractors in the information technology industry.


One of the first things a REIT investor looks for is dividend stability. COPT produced a stable dividend through the recession but slashed its dividend 30% beginning in 2012, from 41 cents to 28 cents.

This is always a sign that something is going on within the REIT. In Corporate Office Property Trust's case it is due to a portfolio restructuring.

In April 2011, management and the Board announced a strategic reallocation plan that called for the disposition of $512 million in operating properties and $50 million in land.

Warren Buffett believes in picking an industry in which you know much more than the average investor. He calls that industry your circle of competence. His partner Charlie Munger once said that the simple way to get success in life is to play on the field that we are the best at, otherwise we would get beaten up pretty fast.

Corporate Office Property Trust has come to the same conclusion and is reorganizing its portfolio to operate within its circle of competence.

Tenant Diversity

As 60% of Corporate Office Property Trust's annualized rents are derived from office properties occupied primarily by government agencies and defense IT contractors, its tenant roster is somewhat concentrated.

It includes Northrop Grumman ( NOC), Computer Sciences ( CSC), Wells Fargo ( WFC), Boeing ( BA) and Booz Allen Hamilton ( BAH). In fact, 36 of the 50 largest Defense Contractors, or 72%, already are COPT tenants:


Like most office REITs, Corporate Office Properties Trust's occupancy has been hard hit and slow to recover.

On the most recent earnings call, Steve Budorick, the company's chief operating officer, said uncertainty about the 2012 and 2013 federal budgets has affected the commercial office market in and around Washington, D.C. He added that overall vacancies hover in the 15% to 16% range.

The company's CEO, Roger Waesche, said the company was "thinking in terms of 92% to 93%" for its target occupancy, adding it would take until 2013 and early 2014 to see occupancy stabilize in that range.

Geographic Diversity

As Corporate Office Properties Trust is government focused, 83% of its square footage is located in the Baltimore Washington area:

Although normally this would be too concentrated, the company is located where their preferred client is located. When focusing on the government and defense industries, it is reasonable to expect a focused geographic concentration.


Corporate Office Properties Trust has a significant development pipeline that is absorbing its cash and partly accounts for the dividend cut.

Due to market conditions, however, much of that development has been curtailed and the company has an active development pipeline of seven buildings, which represents approximately $80 million in future capital commitments.

Construction projects are 31% leased, and the company is talking to strategic customers for another 45% of the rentable area that has been constructed.

Debt Data and Metrics

Corporate Office Properties Trust is currently overleveraged. It is really that simple. The company has realized this and has the stated goal of increasing balance sheet flexibility (i.e., reducing debt) in order to continue its expansion in a more conservative manner.

The REIT has brought down its percentage of secured debt, which is a positive as more properties are unencumbered and available to stakeholders.

Unfortunately, at the same time, the company has increased its debt-to-capitalization ratio to approximately 55%, which is high for a company this size.

Debt-to-EBITDA (at 8.8) and debt-to-gross properties (74%) are also high and need to be brought down for the company to proceed in a financially prudent manner and for investors to get more comfortable with the company.

Fortunately, the company's upcoming debt maturities are somewhat low and afford the company with the time necessary to delever.

Bottom Line: Corporate Office Properties Trust has some work to do in order to create a sustainable business model.

The company has refocused on its circle of competency, which should help improve metrics across the board, and it has the breathing room to make it happen.

The business model is solid and the company has some strategic advantages within its sector: It's one of the only REITs with a meaningful number of "credentialed" employees, strong relationships with defense departments and contractors and a strong penetration into "intelligence" aspects of national defense.

This bodes well for longer-term growth and stability. Unfortunately, it will take some time for all the pieces to fall into place, making the equity a longer-term investment.

The newest preferred stock (OFC-L), however, is attractive relative to peers and due to the call protection has value relative to the REIT's previous preferred stock.

Research conducted by Rubicon Associates. Mr. Michael M. Terry, CFA is the Founder/Principal of Rubicon Associates LLC and has nearly 20 years of experience in the investment management industry focused on the analysis, investment and management of fixed income and preferred stock portfolios.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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