Fitch Ratings has assigned a 'BBB-' rating to the senior unsecured exchangeable notes to be issued by Corporate Office Properties, L.P (COPT; BBB-/Stable).

Fitch expects the proceeds to be used to repay unsecured debt.

Key Rating Drivers

Defense Niche Reduces Volatility: COPT generates approximately 90% of annualized rental revenues 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, D.C. and Baltimore region. These strategic locations drive a high degree of tenant investment in the assets and create stickiness; retention rates have historically been around 75%, with the company forecasting similar levels going forward.

Tenant directives also focus on R&D and high-tech areas that are critical to national cyber security in the U.S. Together with COPT's long-standing relationships with the federal government and contractors, these strategic locations create entry barriers for competitors seeking similar tenants.

Resilient Portfolio: The majority of Corporate Office Properties Trust's (OFC) tenants operate in the defense/IT sectors, making them unable to work from home (WFH) because of the sensitive nature of the work they perform. This work continued unabated through the pandemic because government and contractor tenants are considered essential businesses in every state in which they operate.

Approximately 85% of OFC's portfolio house tenants whose highly secure, mission-critical work cannot be performed remotely, including 65% of space that is either located in secure government campuses that OFC leased to them or have required secured compartmented information facility environments, and another 20% have other very high security protocols, which does not permit these tenants to conduct this WFH or unsecured locations. The inability for tenants to perform their job functions remotely should provide protection against the growing sentiment for an increased WFH environment that is likely to otherwise lessen demand for office space going forward.

Stable Fundamentals: Fitch expects COPT to operate with mid-single-digit same store NOI growth near term, which is driven by a couple of non-renewals in its regional office portfolio and to then exhibit positive low single-digit growth through the remainder of the forecast period, supported by similar growth in U.S. defense spending as has been seen historically. COPT's portfolio is well positioned to benefit from above average spending growth in key defense/IT initiatives, such as intelligence, surveillance, reconnaissance, missile defense, navy force and cybersecurity.

The company's outsized exposure to higher growth defense IT projects allowed the company to grow its defense revenues by 3% per annum through the five-year U.S. defense industry downturn between 2011 and 2015.

Preleasing Balances Development Risk: Fitch expects pre-leasing will continue to mitigate development risk, owing to COPT's strong relationships with key U.S. government and private sector defense tenants. The company has been able to maintain consistently high levels of development leasing levels. The pipeline has been almost entirely pre-leased to both government agencies and defense contractors supporting these entities.

COPT's total development pipeline has grown above historical averages as a share of total assets. However, COPT's strong relationship with the U.S. government provides unique insight into demand trends in its defense-tenant niche that helps limit the risk of its developmental growth strategy.

Sound Credit Protection Metrics: Fitch expects COPT's leverage (net debt-to-recurring operating EBITDA) to sustain at around low 6x over the forecast horizon, primarily through incremental EBITDA from development and by funding new investments on a generally leverage-neutral basis, mainly through proceeds from data shell dispositions and debt issuance. Fitch expects fixed-charge coverage will sustain around the 4.0x range over the Rating Outlook horizon, due primarily to recurring operating EBITDA growth via developments and generally consistent leverage.

Mostly Unencumbered Portfolio: The company's unencumbered asset coverage of unsecured debt was modestly below the 2.0x at Fitch's last review. Positively, unencumbered properties generate approximately 96% of the company's NOI, and development deliveries should strengthen COPT's unencumbered portfolio asset quality and coverage.

Conservative AFFO Payout Ratio: COPT's AFFO payout ratio was 65% for 2021 and 64% and 71% in 2020 and 2019, respectively.

Derivation Summary

COPT's defense/IT office strategy provides a defensible niche that should limit rental income risk relative to similarly rated peer, Hudson Pacific Properties (BBB-/Negative) due to above-average tenant credit quality and retention rates based on the high level of tenant investment in building security and infrastructure. However, it also results in high exposure to secondary and tertiary markets in aligning its portfolio with key defense initiative locations in comparison to office peers, such as SL Green (BB+/Negative) and Vornado Realty Trust (BB+/Stable), whose portfolios are concentrated within gateway markets.

COPT's markets generally have less robust non-defense related office using demand and weaker access to institutional equity and secured mortgage debt capital. The company's financial policies are appropriate to moderately strong for the 'BBB' category for a REIT with the company's portfolio quality. COPT is an established unsecured borrower with demonstrated public bond issuance.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer Include:

U.S. defense spending grows at a low single-digit rate through the forecast period;

SSNOI low single digit growth through the remainder of the forecast period, which reflects slightly improving occupancy thereafter, modest negative re-leasing spreads on renewals in 2022-2023 and 2% annual lease escalations;

Development spend totals approximately $300 million per annum through the forecast period. No acquisitions are projected;

No equity issuance during the forecast period, and dispositions of approximately $200 million in 2023.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Fitch's expectation of net debt to recurring operating EBITDA sustaining below 6.0x;

Fitch's expectation of UA/UD maintaining above 2.5x based on a stressed 9% cap rate;

Fitch's expectation of REIT Fixed Charge Coverage (FCC) sustaining above 3.0x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Fitch's expectation of net debt to recurring operating EBITDA sustaining above 7.0x;

Fitch's expectation of FCC sustaining below 2.0x;

Fitch's expectation of UA/UD sustaining below 2.0x.

Liquidity and Debt Structure

Healthy Liquidity Position: The company has an adequate liquidity profile with total sources of liquidity covering total uses of liquidity by 1.5x through Dec. 31, 2023. Fitch expects COPT maintain ample availability under its $600 million revolver, as well as adequate cash on hand, healthy retained cash flow after capex, with dividends in the $125 million per year range underpinning the company's liquidity position.

COPT's 2023 maturities are only the outstanding balances on the revolving credit facility ($171 million at June 30, 2023). However, the credit facility has two six-month extension options at the company's discretion. Fitch's liquidity analysis included approximately $260 million of unfunded development costs during the projection period.

Issuer Profile

Corporate Office Properties Trust (NYSE: OFC) is an office REIT that owns, manages, develops and acquires office and data center properties in key strategic locations that support the U.S. government and its contractors, most of whom are engaged in national security, defense and information technology related activities servicing priority missions (Defense/IT Locations).

Date of Relevant Committee

27 September 2022

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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