where our relationships take us 2004 ANNUAL REPORT CORPORATE OFFICE PROPERTIES Corporate Office Properties Trust (COPT) is a fully integrated, self- managed real estate investment trust (REIT) that focuses on the ownership, management, leasing, acquisition and development of suburban office properties primarily in select Mid-Atlantic submarkets. The Company is among the largest owners of suburban office properties in the Greater Washington, DC region. As of March 15, 2005, the Company owned 145 office properties totaling 12 million rentable square feet. The Company has implemented a core customer expansion strategy that is built around meeting, through acquisitions and development, the multi-location requirements of the Company’s existing strategic tenants. The Company’s property management services team provides comprehensive property and asset management to company owned properties and select third party clients. The Company’s development and construction services team provides a wide range of development and construction management services for company owned properties, as well as land planning, design/build services, consulting and merchant development to select third party clients. FINANCIAL HIGHLIGHTS Dollars in thousands, except per share data OPERATING DATA 2000 2001 2002 2003 2004 Revenues from Real Estate Operations $105,142 $121,663 $ 150,335 $ 174,423 $ 214,573 Diluted Funds from Operations 37,351 43,001 52,854 61,268 76,248 Total Assets 794,837 994,896 1,138,721 1,332,076 1,732,026 Total Equity Market Capitalization 352,773 493,768 591,963 1,017,832 1,510,254 PER SHARE DATA Funds from Operations $ 1.16 $ 1.28 $ 1.44 $ 1.56 $ Common Dividends 0.78 0.82 0.86 0.91 1.74 0.98 PROPERTY PORTFOLIO Number of Properties Owned 83 98 110 119 145 Rentable Square Feet Owned (in 000’s) 6,473 7,801 8,942 10,033 11,978 TOTAL SHAREHOLDER RETURN(1) zzzzzzz Corporate Office Properties Trust zzzzzzz Morgan Stanley REIT Index zzzzzzz DOW zzzzzzz S&P 500 zzzzzzz NASDAQ 427% 450% 400% 350% 300% 250% 200% 150% 100% 50% 0 -50% 1 YEAR 2 YEARS 3 YEARS 4 YEARS 5 YEARS (1) Based on total returns including the closing prices as of December 31 each year and the reinvestment of dividends on the ex-dividend date for the calendar years 2000–2004, as compiled by the National Association of Real Estate Investment Trusts. NASDAQ data does not include reinvestment of dividends. No.1 in the office REIT industry Over the last five years, we have achieved a 427% total shareholder return—the highest in the office REIT industry and fourth highest among all equity REITs. Our strong performance is based on forging long-term relationships with our tenants. With strategically located properties, we have the resources to meet our tenants’ expansion requirements— leading to growth and strong performance over the long term. (left to right) Randall M. Griffin Clay W. Hamlin, III Dear Shareholders: Two years ago, we anticipated that both 2003 and 2004 would be a difficult economic environment— and we were right. We also believed that we were positioned to continue achieving profitable growth— which we have. We are pleased to report that for 2004, the Company increased FFO by 11.5% on a diluted per share basis and achieved a 45.2% total return for our shareholders. By year-end 2004, through acquisition and development, our portfolio increased to 145 buildings and 12 million square feet, a substantial increase from two years ago, when we owned 110 buildings and 8.9 million square feet. Operating Results Our strong market position and customer service focus produced great operating results. For 2004, we renewed over 947,000 square feet, resulting in a 71% renewal rate on expiring leases. Unlike many of our peer office REITs that experienced declining rents, we achieved a 5.3% increase in base rent on leases renewed during the year. In addition to the lease renewals, we re-tenanted 747,000 square feet, both contributing to our 94.0% occupancy level at year- end, up from 91.2% at year-end 2003. We have grown our portfolio while still maintaining the excellent level of customer service our tenants have come to expect. Our rating from the independent national CEL & Associates, Inc. survey of tenants for the National Commercial Real Estate Customer Service Award for Excellence increased from third place in 2003 to tied for first place in 2004 in Category I, the largest office owner category. We also increased our number of “A” list buildings from 11 buildings in 2000 to 74 buildings for 2004. This is a major accom- plishment for our Company and our entire team, as we work every day to “exceed expectations.” Much of 2004 was spent diligently working through the Sarbanes-Oxley 404 compliance process. We are happy to report that we have no material weak- nesses in our financial reporting processes. Through the 404 process, we have, however, found several new ways to improve our efficiency and record keep- ing that will help us as we continue to grow. Value Creation We thought our development activity would acceler- ate to meet tenant demand, and it has. During 2004, we placed in service over 300,000 square feet that was 90.0% leased. We built new buildings for some of our largest tenants—The Titan Corporation (157,000 square feet) and The Aerospace Corporation (88,000 square feet). At the end of 2004, over 900,000 square feet was under construction, which was 50.4% pre- leased, and another 500,000 square feet was in our development pipeline. This equates to $257 million in new buildings that will come on line over the next two years. Our diligent work on our land control has continued as we executed on our plan to acquire enough land to support our development over the next ten years. At the end of 2004, we had 218 acres that can support 2 3.6 million square feet of new space. Our goal is to double our development capacity through control of additional land parcels by the end of 2005. disposing of some non-strategic properties, where value has been fully created. Our 2004 acquisition efforts more than doubled our goal, acquiring $264 million in properties, comprising 1.6 million square feet, that were 92% occupied at the time of acquisition. We entered a new submarket in Northern Virginia—Tysons Corner—by acquiring 440,000 square feet located in two office towers. This purchase diversified our tenant base and added Wachovia Bank as our 9th largest tenant. We anticipate following our strategy of creating a toehold, followed by additional buying and/or building to increase our position in this market. Our purchase of portfolios in St. Mary’s County, Maryland, and in Dahlgren, Virginia, exemplifies our strategy of locating next to key demand drivers. In both locations, we purchased buildings that are leased to existing tenants in our portfolio. These acquisitions also added new defense contractors to our list of high credit tenants, such as BAE Systems. In both locations, several of the tenants need additional space and we control developable land to fulfill that demand. Capital Markets During 2004, we thoughtfully managed our balance sheet. We took a significant step in converting our $150 million secured Revolving line to a $300 million unsecured Revolver. In the process, nine new banks were added. The new Revolver has provided us with greater efficiency and the flexibility to move faster on acquisitions and to more easily fund initial development costs for our new projects. We continued to focus on our floating rate debt and fixed $115 million at 5.5% for seven years. We also redeemed our 10% Series B preferred shares. These steps, and others, improved our fixed charge coverage ratio. Our issuance of $115.7 million in new common equity was utilized to redeem the Series B preferred shares, repay a $26 million loan with an above market interest rate and fund the Tysons Corner acquisition. Our institutional shareholder base has expanded, adding a number of pension funds this year. Long-Term Growth For 2005, we face the challenges of continuing to uncover acquisitions, leasing our existing buildings and our new developments, controlling our expenses and finding creative ways to add value to our prop- erties and operations. We also have set a goal of As anticipated, the revenue generated from the intel- ligence and defense sectors has continued to grow. By the end of 2004, these tenants contributed 47% of our total annualized rental revenue versus 26% at the end of 2001. In looking toward the future, we see more opportu- nities to expand these key tenant relationships. The Company is poised to initiate its core customer expansion strategy built around meeting, through acquisition and development, the multi-location requirements of the Company’s existing strategic tenants and obtaining a critical mass of these key tenants, usually built around government demand drivers. By executing on our tenant driven focus, we will continue to meet their needs while at the same time generating earnings growth for our shareholders. Conclusion At our February 2005 Board meeting, Clay Hamlin, our CEO, announced his retirement effective April 1, 2005. Mr. Hamlin has presided over the growth of the Company since its inception in 1997. He will be moving from the CEO position to Vice Chairman of the Board of Trustees and has executed a three year agreement to provide strategic services to the Company. Rand Griffin will assume the position of President and CEO, effective April 1, 2005, and has also been named a Trustee. We wish to thank Betsy Cohen, who has announced she will not stand for reelection after serving for five years on our Board of Trustees. We thank Betsy for sharing her time, experience and insightful perspec- tives. We will miss her seasoned judgment, counsel and real estate knowledge. We thank our Board of Trustees who guide us, our employees who execute with the utmost dedication and professionalism, and our shareholders, who support our efforts to maximize shareholder value. We look forward to an active and rewarding 2005. Sincerely, Randall M. Griffin President and Chief Operating Officer Clay W. Hamlin, III Chief Executive Officer 3 FUNDS FROM OPERATIONS Per diluted share $1.74 $1.56 $1.44 $1.28 $1.16 2000 2001 2002 2003 2004 Strong relationships lead to great financial performance. financial performance from strong relationships, new opportunities emerge Relationships Strong relationships are at the core of our business. And look where our relationships are taking us. Our relationships take us to new submarkets. Our relationships help us expand in our existing markets. They allow us to win repeat business and to grow along with our tenants. Service Strong relationships result from great customer service. We have a number of philosophies that help drive excellent cus- tomer service. For example, DWYSYWD-AW—“do what you say you will do—and when.” Our word is our commitment and we act with a sense of urgency. We strive every day to provide a level of customer service for our tenants that will ensure repeat business from all our customers. Another philosophy is—exceed expectations by paying attention to the details— again dealing with our tenants in a manner that addresses their needs, every day. Development Strong relationships lead us to greater development opportunities. We are developing new buildings to help our tenants grow. During 2004, we completed 300,000 square feet in three buildings, providing the space for three of our tenants—The Aerospace Corporation, The Titan Corporation and Northrop Grumman Corporation—to grow their business. We continue to plan for our tenants’ growing space needs, and now have close to 1 million square feet under construction, that is significantly pre-leased. Acquisitions Strong relationships lead to acquisition opportunities. During 2004, we purchased $264 million in properties, more than doubling our goal for the year. Most of these properties were located around a key government demand driver. And the properties are leased by many of our existing tenants that know us from other locations in our portfolio. Financial Performance Strong relationships lead to great financial performance. Our financial results for 2004 resulted in our Company being among the top performing office REITs. These results included: increasing our FFO per diluted share by 11.5%; increasing our quarterly dividend by 8.5%; renewing 71% of our expiring leases; and increasing our portfolio occupancy to 94% at year-end. The high retention rate and the improvement in occupancy are due largely to the strong markets in which we operate, to the strong tenants that occupy our buildings and to our great relationships with those strong tenants. 4 We add value to each tenant relationship through our expertise and creative spirit. service We have the land to meet the demand. development We are focused on building long-term relationships with large, growing tenants. relationships We have the financial resources to expand our reach. acquisitions 5 Relationships— we’re focused on building long-term relationships with large, growing tenants We have grown our relationships with our top 20 tenants (listed at left) significantly over the past several years. These tenants now represent 59% of our annual revenue. We now have 30 leases with the U.S. Government, comprising 13% of our revenue. Our total revenue from our government and defense contractor tenants now totals 47% of our annualized rental revenue. We have multiple leases with our largest tenants in numerous locations, with the average lease size over 50,000 square feet for our top 20 tenants. As we develop and acquire properties and expand our reach, we continue to add leases with our largest tenants in multiple locations. Now we connect the dots—our tenants realize that they already know us and are pleased to find that we are their landlord at a new location and that they have a trusted relationship that already exists. Many of our tenants started with a small lease and have expanded over the last several years. For example, in 1996 we signed our first lease with Booz Allen Hamilton for 31,217 square feet. Today, we have eleven leases with Booz Allen Hamilton for a total of over 500,000 square feet, making them our second largest tenant. We also have six or more leases with each of our top seven tenants. As these tenants continue to grow, we are there to meet their needs. We solve their problems by designing new buildings to meet their unique requirements, planning interior fit up, offering a consistent simplified lease process and meeting critical deadlines and budgets. Our responsiveness, along with our consistent ability to execute in a professional, yet user-friendly manner, has led to the repeat business that fuels our growth. Our core markets are not defined by geographic boundaries but rather by our ability to achieve a critical mass of our key tenants in locations that are built around demand drivers. If our strategic tenants need to expand in specific locations to service their customers, we are prepared to follow in order to continue to fulfill our tenants’ needs. Top 20 Tenants United States of America Booz Allen Hamilton, Inc. Computer Sciences Corporation AT&T Corporation The Titan Corporation General Dynamics Corporation Northrop Grumman Corporation Unisys Wachovia Bank The Aerospace Corporation The Boeing Company Ciena Corporation VeriSign, Inc. Commonwealth of Pennsylvania PricewaterhouseCoopers LLP Magellan Health Services, Inc. Johns Hopkins University Merck & Co., Inc. Carefirst, Inc. and Subsidiaries BAE Systems 6 6 4 2 7 5 3 1 11 14 15 13 8 9 12 17 10 16 47% of revenues from the Government/defense sector Key: The National Business Park 1 2 3 4 5 6 7 131 132 133 134 135 140 141 8 9 10 11 12 13 14 191 201 211 220 221 304 318 15 16 17 Phase II One National Business Park To Fort Meade/NSA Under Construction: 306 322 Government Services team (left to right) Stanley A. Link, George J. Marcin, Jeffrey L. Marquina, S. Judson Williams 7 Service— we add value to each tenant relationship through our expertise and creative spirit Our top 20 tenant list includes many large credit worthy companies, along with our largest tenant, the U.S. Government. In order to better serve our largest tenant, we have formed a team of specialists—our Government Services team—that is trained to meet the special needs of this tenant. This team is capable of dealing with specific building requirements, leasing issues and property management issues above and beyond those found in typical office buildings. By organizing a specialized team, we are able to better serve this tenant and to expand upon this relationship. A second example of our commitment to service is our relationship with The Titan Corporation. Titan started out with a single lease for 4,800 square feet in our portfolio. As Titan grew and expanded its work- force over the past several years, we have provided additional space. We recently completed and leased to Titan a new 157,000 square foot building at The National Business Park. In doing so, we worked closely with Titan to design a building that would meet its unique requirements. One of the reasons we are able to meet the needs of our tenants, such as Titan, is that we provide a one-stop shop for our tenants. By having the in-house expertise to develop, coordinate design, lease and manage our buildings, we are able to anticipate, plan and execute to meet our tenants’ changing space requirements. Our commitment to service is best reflected in the feedback provided by our tenants. Each year we participate in the independent national CEL & Associates, Inc. survey that measures tenant satisfaction with their building and landlord. For the fifth year in a row, we have improved our results. For 2004, we were tied for first place, receiving the National Commercial Real Estate Customer Service Award for Excellence for Category I—companies owning 100 buildings or more, the largest owner category. In addition, we had 74 buildings that were ranked “A” buildings, an improvement from 11 buildings in 2000, our first year. OUR LEASING HISTORY WITH THE TITAN CORPORATION 220 National Business Park leased 4,800 sq. ft. leasing 30,393 sq. ft. at 12/31/01 leasing 88,675 sq. ft. at 12/31/03 leasing 245,345 sq. ft. at 12/31/04 1999 2001 2002 2003 2004 leasing 54,905 sq. ft. at 12/31/02 1344 Ashton Road 8 201 National Business Park 220 National Business Park We ranked 1st in the National Commercial Real Estate Customer Service Award for Excellence survey by CEL & Associates, Inc. Titan team (left to right) Max T. Ryan, S. Judson Williams, Karen M. Singer, Carl M. Nelson, Peter Ward (President and General Manager of Titan’s National Intelligence Solutions Group), Josephina A. Fogell, Brad E. Friedman Washington Dulles Airport Park Center One, Two and Three Ridgeview Washington Technology Park I, II and III Development— we have the land to meet the demand Greens I, II and III We have acquired land in key locations, within our core markets, to position the Company for growth over the next ten years. We typically buy land in office parks where we have a large ownership position. Buying land adjacent to our existing buildings allows us to develop new space for existing tenants to best meet their growth requirements. Over the past year we have added to our supply of land and now own 218 acres that can support 3.6 million square feet. We expect to increase our position this year with land that can support another 4.5 million square feet of office space, thereby increasing our development capacity to over 8 million square feet. We believe this is sufficient development capacity to allow us to continue building for our tenants over the next ten years. During 2004, we completed and placed into service three buildings totaling 300,000 square feet that are 90% leased. The development activities have acceler- ated significantly. Based on tenant demand we have over 900,000 square feet under construction and over 500,000 square feet in our development pipeline. As evidence of continuing tenant demand, 39% of the construction space is already pre-leased to some of our largest tenants such as Booz Allen Hamilton and Northrop Grumman Corporation. We have worked closely with our tenants in the design phase to meet new anti-terrorism force protection (ATFP) require- ments as well as to meet the requirement for “Green” buildings—buildings that are environmentally friendly. Over the next two years, as we bring this space on line, the income generated by these new buildings will add significantly to our earnings. We expect the demand for space to continue both at The National Business Park that is 100% occupied and at Westfields Corporate Center (pictured left) where our buildings are 99% occupied as of year-end. We are also positioned to build space for our tenants on our land in the Columbia Gateway Business Park where our buildings are 95% occupied. Westfields Corporate Center 11 Acquisitions— we have the financial resources to expand our reach During 2004, we accomplished a number of key objectives. First, we more than doubled our acquisition goal, buying over $264 million of properties totaling 1.6 million square feet that were 92% occupied at acquisition. We were able to buy at attractive yields, despite the competitive acquisition market, by assuming above market debt or creatively structuring for seller tax related issues. Second, we entered a new submarket in Northern Virginia—Tysons Corner— with a $113 million acquisition of two office towers totaling 440,000 square feet. We were able to purchase this property, known as Pinnacle Towers, due to our relationship with the seller. Our ability to creatively structure a deal to solve the seller’s complex tax issues, as well as our proven ability to move quickly and execute on the transaction, resulted in our becoming the successful bidder. Through this acquisition, we were able to add Wachovia Bank as our 9th largest tenant. We are well positioned to expand our presence in this submarket through additional acquisition opportunities and development. Third, we were able to enter another new submarket at two locations adjacent to key government installations. We purchased eleven buildings near the Patuxent River Naval Air Station in St. Mary’s County, Maryland. Located within these buildings are many of the defense contractors that are existing tenants in our other business parks. In addition, we have developed new relationships with tenants such as Sikorsky Aircraft Corporation, BAE Systems and BearingPoint, Inc. Through our purchase of six buildings adjacent to the Dahlgren Naval Warfare Center in Dahlgren, Virginia, we were able again to expand relationships with some of our existing tenants. The proximity of the St. Mary’s County and Dahlgren properties allows us to provide the high level of service to which our tenants are accustomed from a single regional office located in St. Mary’s County. Finally, we are now positioned to expand our reach in other core markets where our existing tenants have expressed a need to expand and want to utilize our expertise and quality customer service. Due Diligence team (left to right) Joni L. Magill, Kristen M. Waterfield, Catherine M. Ward, Jonathan M. Carpenter, Ivy Barton Wagner, Elisa M. Wolf Acquisition team (left to right) John T. Hermann, Stephanie L. Shack, Cathleen A. Stramella, James K. Davis, Jr., Cathleen M. Smith, Zarae C. Pitts $264 million in acquisitions for 2004 400 Professional Drive 129,030 square feet Gaithersburg, MD St. Mary’s County 11 Buildings 560,106 square feet Lexington Park, MD 10150 York Road 176,689 square feet Hunt Valley, MD Pinnacle Towers 2 Buildings 440,102 square feet Tysons Corner, VA 14280 Park Meadow Drive 114,126 square feet Chantilly, VA Dahlgren Technology Center 6 Buildings 204,605 square feet Dahlgren, VA Pinnacle Towers Acquired September 2004 440,102 square feet 13 Continue to look for opportunities to meet tenant demand either by acquiring or developing in select locations sought after by our tenants. 2005 Future Franchise value— we have dominant positions in growing markets When looking at our Company, we believe the whole is greater than the sum of its parts. We have worked hard to differentiate ourselves as a real estate growth company as opposed to a collector of office buildings. What creates franchise value? We believe a number of factors. The first is an emphasis on nurturing tenant relationships. We focus on large credit worthy tenants. We anticipate the needs of those tenants and solve their problems through our unique skill sets and credentials. We execute quickly. We are able to respond to our tenants’ changing requests. With our position in desired locations, we are able to move tenants around—increasing or decreasing their space as needed. Along with great execution, we provide an excellent level of cus- tomer service, as reflected in the independent national CEL & Associates, Inc. survey results. The second element is locating in select markets. We have been focused on specific markets in the Greater Washington, DC region, one of the strongest office markets in the country. We buy and build properties that are located around key demand drivers. We locate in areas of job growth. Third, we selectively buy buildings, again focusing on strong demand drivers. But, we are careful to assess the long-term viability of a market and the potential for us to grow our position to a size that makes economic sense for us. We also develop new buildings, working with our tenants to design buildings that will meet their needs. We build in select locations adjacent to government demand drivers and based on demand from our tenants. We use our unique skill sets to determine how best to meet the needs of our largest tenants. The strong tenant relationships we have developed over the past ten years, the commitment to excellent service, the expertise to build new office space that meets tenants’ specific design needs, the ability to buy properties accretively, and to grow the Company within strong markets combine to create our unique franchise value. TOTAL SQUARE FOOTAGE In millions 12.0 10.0 8.9 7.8 6.5 6.1 5.0 1998 1999 2000 2001 2002 2003 2004 14 Entrance into the Northern Virginia market with the acquisition of Washington Technology Park. The Company has expanded its ownership in this market from 470,000 square feet to over two million square feet as of December 31, 2004. 2001 Northern Virginia Acquired buildings in a new submarket for the Company and showcased its ability to acquire properties strategically located near government demand drivers—in this case, the Patuxent River Naval Air Station and the Dahlgren Naval Surface Warfare Center. 1998 marked the Company’s entrance into the B/W Corridor through ownership in office parks such as Airport Square, Columbia Gateway Business Park and The National Business Park. The Company has grown in each park since that time. 2004 St. Mary’s County King George County 1998 Baltimore/Washington Corridor 15 The Senior Management Team (left to right) John T. Hermann, Director, Asset Management and Leasing, Susan M. Sheridan, Vice President, Financial Services, Mary Ellen Fowler, Vice President, Finance and Investor Relations, Thomas J. Holly, Director, Corporate and Tax Reporting, Jacob H. Baugher, III, Vice President and Controller, Karen M. Singer, Vice President, General Counsel and Secretary, Roger A. Waesche, Jr., Executive Vice President and Chief Financial Officer, Derrick Boegner, Vice President, Asset Management and Leasing, S. Judson Williams, Senior Vice President, Asset Management and Leasing, Catherine M. Ward, Senior Vice President, Asset Management and Leasing, James K. Davis, Jr., Vice President, Investments, Peg Ohrt, Vice President, Human Resources The Property Management Team (left to right) Bruce H. Lewin, General Manager, Cathleen M. Stramella, Director, Operations, Douglas Mentlik, Manager, Controls Division, Jeffrey L. Marquina, Regional Director, Keith Queen, Senior Property Manager, Caryn A. Newman, Senior Property Manager, P. Gregory Gardes, Senior Property Manager, Sandra A. Haertig, Regional Director, Ann E. Pippin, Senior Property Manager, Gregory B. White, Senior Property Manager The Development and Construction Team (left to right) George J. Marcin, Director, Interior Construction and Renovation, Stanley A. Link, Senior Vice President, Government and Construction Services, Peter Z. Garver, Director, Development Services, Connie S. Epperlein, Director, Interior Programming and Design, Dwight S. Taylor, President, Corporate Development Services, Carl M. Nelson, Director, Construction Services 2004 Financial Review 18 Property Information 22 Selected Financial Data 24 Management’s Discussion and Analysis of Financial Condition and Results of Operations 49 Consolidated Balance Sheets 50 Consolidated Statements of Operations 51 Consolidated Statements of Shareholders’ Equity 52 Consolidated Statements of Cash Flows 53 Notes to Consolidated Financial Statements 78 Management’s Report on Internal Control over Financial Reporting 79 Report of Independent Registered Public Accounting Firm 80 Market for Registrant’s Common Equity and Related Shareholder Matters Property Information Property Location Year Built Rentable or Renovated Square Feet Operating Properties Baltimore/Washington Corridor 2730 Hercules Road 7200 Riverwood Drive 2720 Technology Drive 2500 Riva Road 2711 Technology Drive 9140 Route 108 7000 Columbia Gateway Drive 6731 Columbia Gateway Drive 140 National Business Parkway 132 National Business Parkway 2721 Technology Drive 2701 Technology Drive 1306 Concourse Drive 6940 Columbia Gateway Drive 6950 Columbia Gateway Drive 870-880 Elkridge Landing Road 1304 Concourse Drive 900 Elkridge Landing Road 1199 Winterson Road 920 Elkridge Landing Road 134 National Business Parkway 133 National Business Parkway 141 National Business Parkway 135 National Business Parkway 1302 Concourse Drive 7067 Columbia Gateway Drive 6750 Alexander Bell Drive 6700 Alexander Bell Drive 7467 Ridge Road 7240 Parkway Drive 881 Elkridge Landing Road 1099 Winterson Road 131 National Business Parkway 1190 Winterson Road 849 International Drive 911 Elkridge Landing Road 1201 Winterson Road 999 Corporate Boulevard 6740 Alexander Bell Drive 7318 Parkway Drive 7320 Parkway Drive 891 Elkridge Landing Road 930 International Drive 800 International Drive 901 Elkridge Landing Road 900 International Drive Annapolis Junction, MD Columbia, MD Annapolis Junction, MD Annapolis, MD Annapolis Junction, MD Columbia, MD Columbia, MD Columbia, MD Annapolis Junction, MD Annapolis Junction, MD Annapolis Junction, MD Annapolis Junction, MD Linthicum, MD Columbia, MD Columbia, MD Linthicum, MD Linthicum, MD Linthicum, MD Linthicum, MD Linthicum, MD Annapolis Junction, MD Annapolis Junction, MD Annapolis Junction, MD Annapolis Junction, MD Linthicum, MD Columbia, MD Columbia, MD Columbia, MD Hanover, MD Hanover, MD Linthicum, MD Linthicum, MD Annapolis Junction, MD Linthicum, MD Linthicum, MD Linthicum, MD Linthicum, MD Linthicum, MD Columbia, MD Hanover, MD Hanover, MD Linthicum, MD Linthicum, MD Linthicum, MD Linthicum, MD Linthicum, MD 1990 1986 2004 2000 2002 1985 1999 2002 2003 2000 2000 2001 1990 1999 1998 1981 2002 1982 1988 1982 1999 1997 1990 1998 1996 2001 2001 1988 1990 1985 1986 1988 1990 1987 1988 1985 1985 2000 1992 1984 1983 1984 1986 1988 1984 1986 240,336 160,000 156,730 155,000 152,000 150,000 145,806 123,885 119,904 118,456 118,093 117,450 114,046 108,847 107,778 105,151 102,964 97,261 96,636 96,566 93,482 88,666 87,318 86,863 84,505 82,953 78,460 74,852 74,326 73,960 73,572 71,076 69,039 69,024 68,865 68,296 67,903 67,456 61,957 59,204 58,453 57,857 57,409 57,379 57,294 57,140 18 CORPORATE OFFICE PROPERTIES TRUST Property 8671 Robert Fulton Drive 921 Elkridge Landing Road 939 Elkridge Landing Road 938 Elkridge Landing Road 6716 Alexander Bell Drive 940 Elkridge Landing Road 8661 Robert Fulton Drive 1340 Ashton Road 9140 Guilford Road 7321 Parkway Drive 7065 Columbia Gateway Drive 1334 Ashton Road 7063 Columbia Gateway Drive 9160 Guilford Road 6760 Alexander Bell Drive 6708 Alexander Bell Drive 1331 Ashton Road 7061 Columbia Gateway Drive 6724 Alexander Bell Drive 1350 Dorsey Road 9150 Guilford Road 1344 Ashton Road 1341 Ashton Road 9130 Guilford Road 1343 Ashton Road 114 National Business Parkway 1348 Ashton Road Total Baltimore/Washington Corridor Location Columbia, MD Linthicum, MD Linthicum, MD Linthicum, MD Columbia, MD Linthicum, MD Columbia, MD Hanover, MD Columbia, MD Hanover, MD Columbia, MD Hanover, MD Columbia, MD Columbia, MD Columbia, MD Columbia, MD Hanover, MD Columbia, MD Columbia, MD Hanover, MD Columbia, MD Hanover, MD Hanover, MD Columbia, MD Hanover, MD Annapolis Junction, MD Hanover, MD 15000 Conference Center Drive 13200 Woodland Park Drive 1751 Pinnacle Drive 1753 Pinnacle Drive 15059 Conference Center Drive 15049 Conference Center Drive 14900 Conference Center Drive 14280 Park Meadow Drive 13454 Sunrise Valley Road 4851 Stonecroft Boulevard 14850 Conference Center Drive 14840 Conference Center Drive 13450 Sunrise Valley Road Total Northern Virginia 753 Jolly Road 785 Jolly Road 760 Jolly Road 751 Jolly Road Total Greater Philadelphia Chantilly, VA Herndon, VA McLean, VA McLean, VA Chantilly, VA Chantilly, VA Chantilly, VA Chantilly, VA Herndon, VA Chantilly, VA Chantilly, VA Chantilly, VA Herndon, VA Blue Bell, PA Blue Bell, PA Blue Bell, PA Blue Bell, PA Year Built Rentable or Renovated Square Feet 2002 1983 1983 1984 1990 1984 2002 1989 1983 1984 2000 1989 2000 1984 1991 1988 1989 2000 2001 1989 1984 1989 1989 1984 1989 2002 1988 1989 2002 1989/1995 1976/2004 2000 1997 1999 1999 1998 2004 2000 2000 1998 1992 1996 1994 1991 56,350 54,175 53,031 52,988 52,002 51,704 49,500 46,400 41,704 39,822 38,560 37,565 36,936 36,528 36,309 35,040 29,936 29,604 28,420 19,992 17,655 17,061 15,841 13,700 9,962 9,717 3,108 5,347,828 470,406 404,665 258,465 181,637 145,192 145,053 127,572 114,126 113,093 88,094 69,711 69,710 53,728 2,241,452 419,472 219,065 208,854 112,958 960,349 CORPORATE OFFICE PROPERTIES TRUST 19 Northern Virginia Greater Philadelphia Northern/Central New Jersey Property Location Year Built Rentable or Renovated Square Feet 431 Ridge Road 695 Route 46 429 Ridge Road 710 Route 46 4301 Route 1 68 Culver Road 104 Interchange Plaza 101 Interchange Plaza 47 Commerce 437 Ridge Road 7 Centre Drive 8 Centre Drive 2 Centre Drive Total Northern/Central New Jersey Dayton, NJ Fairfield, NJ Dayton, NJ Fairfield, NJ Monmouth Junction, NJ Dayton, NJ Cranbury, NJ Cranbury, NJ Cranbury, NJ Dayton, NJ Monroe Township, NJ Monroe Township, NJ Monroe Township, NJ St. Mary’s & King George Counties 22309 Exploration Drive 16480 Commerce Drive 46579 Expedition Drive 22289 Exploration Drive 44425 Pecan Court 22299 Exploration Drive 44408 Pecan Court 23535 Cottonwood Parkway 22300 Exploration Drive 16541 Commerce Drive 16539 Commerce Drive 44417 Pecan Court 16442 Commerce Drive 44414 Pecan Court 44420 Pecan Court 16501 Commerce Drive 16543 Commerce Drive Total St. Mary’s & King George Counties Lexington Park, MD Dahlgren, VA Lexington Park, MD Lexington Park, MD California, MD Lexington Park, MD California, MD California, MD Lexington Park, MD King George, VA King George, VA California, MD Dahlgren, VA California, MD California, MD Dahlgren, VA Dahlgren, VA 2605 Interstate Drive 6345 Flank Drive 6340 Flank Drive 2601 Market Place 5035 Ritter Road 6400 Flank Drive 6360 Flank Drive 6385 Flank Drive 6380 Flank Drive 5070 Ritter Road, Building A 6405 Flank Drive 5070 Ritter Road, Building B 95 Shannon Road 75 Shannon Road 6375 Flank Drive 85 Shannon Road Total Greater Harrisburg Harrisburg, PA Harrisburg, PA Harrisburg, PA Harrisburg, PA Mechanicsburg, PA Harrisburg, PA Harrisburg, PA Harrisburg, PA Harrisburg, PA Mechanicsburg, PA Harrisburg, PA Mechanicsburg, PA Harrisburg, PA Harrisburg, PA Harrisburg, PA Harrisburg, PA Greater Harrisburg 20 CORPORATE OFFICE PROPERTIES TRUST 1998 1990 1996 1985 1986 2000 1990 1985 1998 1996 1986 1989 1989 1984/1997 2000 2002 2000 1997 1998 1986 1984 1997 1996 1990 1989 2002 1986 1989 2002 2002 1990 1989 1988 1989 1988 1992 1988 1995 1991 1989 1991 1989 1999 1999 2000 1999 170,000 157,394 142,385 101,263 61,433 57,280 47,677 43,621 41,398 30,000 19,468 16,199 16,132 904,250 98,860 70,728 61,156 60,811 59,055 58,509 50,532 46,656 44,830 36,053 32,076 29,053 25,518 25,444 25,200 22,860 17,370 764,711 79,456 69,443 68,200 65,411 56,556 52,439 46,500 32,921 32,668 32,309 32,000 28,347 21,976 20,887 19,783 12,863 671,759 Suburban Maryland Other Property Location Year Built Rentable or Renovated Square Feet 11800 Tech Road 400 Professional Drive 14502 Greenview Drive 14504 Greenview Drive 4230 Forbes Boulevard Total Suburban Maryland 10150 York Road 9690 Deereco Road 375 West Padonia Road 1615 and 1629 Thames Street Total Other Silver Spring, MD Gaithersburg, MD Laurel, MD Laurel, MD Lanham, MD Hunt Valley, MD Timonium, MD Timonium, MD Baltimore, MD 1989 2000 1988 1985 2003 1985 1988 1986 1989 235,954 129,030 72,392 69,334 55,867 562,577 176,689 134,096 110,328 104,214 525,327 Total Operating Properties Portfolio 11,978,253 Properties under Development(1) 15010 Conference Center Drive Chantilly, VA 304 Carina Road (304 NBP) Annapolis Junction, MD 306 Carina Road (306 NBP) Annapolis Junction, MD 302 Carina Road (302 NBP) Annapolis Junction, MD 318 Carina Road (318 NBP) Annapolis Junction, MD 322 Carina Road (322 NBP) Annapolis Junction, MD 320 Carina Road (320 NBP) Annapolis Junction, MD 6711 Columbia Gateway Drive Columbia, MD 2691 Technology Drive (191 NBP) Annapolis Junction, MD 8621 Robert Fulton Drive Columbia, MD 46591 Expedition Drive Lexington Park, MD Total Properties Under Development Other Portfolio Information Percentage Occupied as of December 31, 2004 by Region: Baltimore/Washington Corridor Northern Virginia Greater Philadelphia Northern/Central New Jersey St. Mary’s & King George Counties Greater Harrisburg Suburban Maryland Other Total Portfolio (1) Estimated square footage upon completion. 213,091 162,498 160,000 160,000 125,847 125,847 125,760 125,000 103,683 82,000 60,000 1,443,726 96% 94% 100% 91% 97% 85% 79% 91% 94% CORPORATE OFFICE PROPERTIES TRUST 21 Selected Financial Data The following table sets forth summary financial data as of and for each of the years ended December 31, 2000 through 2004. The table illustrates the significant growth our Company experienced over the periods reported. Most of this growth, particularly pertaining to revenues, operating income and total assets, was attributable to our addition of properties through acquisition and development activities. We financed most of the acquisition and development activities by incurring debt and issuing preferred and common equity, as indicated by the growth in our interest expense, preferred share dividends and weighted aver- age common shares outstanding. The growth in our general and administrative expenses reflects, in large part, the growth in management resources required to support the increased size of our portfolio. Since this information is only a summary, you should refer to our Consolidated Financial Statements and notes thereto and the section of this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information. (Dollar and share information in thousands, except ratios and per share data) 2004 2003 2002 2001 2000 Revenues Revenues from real estate operations Construction contract and other service operations revenues(1) Total revenues Expenses Property operating Depreciation and other amortization associated with real estate operations Construction contract and other service operations expenses(1) General and administrative expenses Total operating expenses Operating income Interest expense Amortization of deferred financing costs Income from continuing operations before (loss) gain on sales of real estate, equity in loss of unconsolidated entities, income taxes and minority interests (Loss) gain on sales of real estate, excluding discontinued operations(2) Equity in loss of unconsolidated entities Income tax (expense) benefit(1) Income from continuing operations before minority interests Minority interests in income from continuing operations(1) Income from continuing operations Income from discontinued operations, net of minority interests(3) Cumulative effect of accounting change, net of minority interests(4) Net income Preferred share dividends Repurchase of preferred units in excess of recorded book value(5) Issuance costs associated with redeemed preferred shares(6) Net income available to common shareholders Basic earnings per common share Income before discontinued operations and cumulative effect of accounting change Net income available to common shareholders Diluted earnings per common share Income before discontinued operations and cumulative effect of accounting change Net income available to common shareholders Weighted average common shares outstanding—basic Weighted average common shares outstanding—diluted $214,573 28,903 243,476 $174,423 31,740 206,163 $150,335 4,677 155,012 $121,663 4,901 126,564 $105,142 — 105,142 63,053 51,699 43,929 35,413 30,162 51,904 37,122 30,859 20,405 16,513 26,996 10,938 152,891 90,585 (44,263) (2,431) 30,933 7,893 127,647 78,516 (41,079) (2,767) 4,981 6,697 86,466 68,546 (39,065) (2,501) 5,391 5,289 66,498 60,066 (32,297) (2,031) — 4,867 51,542 53,600 (29,786) (1,535) 43,891 34,670 26,980 25,738 22,279 (150) (88) (795) 42,858 (5,826) 37,032 — — 37,032 (16,329) — (1,813) $ 18,890 472 (98) 169 35,213 (6,759) 28,454 2,423 — 30,877 (12,003) (11,224) — $ 7,650 2,564 (402) 347 29,489 (7,461) 22,028 1,273 — 23,301 (10,134) — — $ 13,167 1,618 (84) 409 27,681 (8,555) 19,126 970 (174) 19,922 (6,857) — — $ 13,065 107 (310) — 22,076 (7,976) 14,100 1,034 — 15,134 (3,802) — — $ 11,332 $ $ $ $ 0.57 0.57 0.54 0.54 33,173 34,982 $ $ $ $ 0.20 0.29 0.19 0.27 26,659 28,021 $ $ $ $ 0.53 0.59 0.51 0.56 22,472 24,547 $ $ $ $ 0.61 0.65 0.60 0.63 20,099 21,623 $ $ $ $ 0.55 0.60 0.54 0.59 18,818 19,213 22 CORPORATE OFFICE PROPERTIES TRUST Balance Sheet Data (as of period end): Investment in real estate Total assets 2004 2003 2002 2001 2000 $1,544,501 $1,189,258 $1,042,955 $ 923,700 $751,587 $1,732,026 $1,332,076 $1,138,721 $ 994,896 $794,837 Mortgage and other loans payable $1,022,688 $ 738,698 $ 705,056 $ 573,327 $474,349 Total liabilities Minority interests Shareholders’ equity Other Financial Data (for the year ended): Cash flows provided by (used in): Operating activities Investing activities Financing activities Numerator for diluted EPS Diluted funds from operations(7) Diluted funds from operations per share(7) Cash dividends declared per common share Property Data (as of period end): Number of properties owned(8) Total rentable square feet owned (in thousands)(8) $1,111,224 $ 801,899 $ 749,338 $ 626,193 $495,549 $ 98,878 $ 79,796 $ 100,886 $ 104,782 $105,560 $ 521,924 $ 450,381 $ 288,497 $ 263,921 $193,728 $ 84,494 $ 67,783 $ 62,242 $ 50,875 $ 35,026 $ (263,792) $ (172,949) $ (128,571) $(155,741) $ (73,256) $ 183,638 $ 108,656 $ $ $ $ 18,911 76,248 1.74 0.98 145 11,978 $ $ $ $ 7,650 61,268 1.56 0.91 119 10,033 $ $ $ $ $ 65,680 13,711 52,854 1.44 0.86 110 8,942 $ 106,525 $ 40,835 $ 13,573 $ 11,332 $ 43,001 $ 37,351 $ $ 1.28 0.82 $ $ 1.16 0.78 98 7,801 83 6,473 (1) Certain prior period amounts have been reclassified to conform with the current presentation. These reclassifications did not affect con- solidated net income or shareholders’ equity. (2) Reflects (loss) gain from sales of properties and unconsolidated real estate joint ventures not associated with discontinued operations. (3) Reflects income derived from one operating real estate property that we sold in 2003 (see Note 18 to our Consolidated Financial Statements). (4) Reflects loss recognized upon our adoption of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities.” (5) Reflects a decrease to net income available to common shareholders representing the excess of the repurchase price of the Series C Preferred Units in our Operating Partnership over the sum of the recorded book value of the units and the accrued and unpaid return to the unitholder. (6) Reflects a decrease to net income available to common shareholders pertaining to the original issuance costs of the Series B Preferred Shares of beneficial interest that was recognized upon redemption of the shares. (7) For definitions of diluted funds from operations per share and diluted funds from operations, and reconciliations of these measures to their comparable measures under generally accepted accounting principles, you should refer to the section entitled “Funds from Operations” within the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” (8) Amounts reported for December 31, 2004 include two properties totaling 213,261 rentable square feet held through two joint ventures. Amounts reported for December 31, 2003 include one property totaling 157,394 rentable square feet held through a joint venture. Amounts reported for December 31, 2001 include two properties totaling 135,428 rentable square feet held through two joint ventures. CORPORATE OFFICE PROPERTIES TRUST 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW The attributes we look for in selecting submarkets include, Corporate Office Properties Trust (“COPT”) and subsidiaries among others, (1) proximity to large demand drivers, (2) strong (collectively, the “Company”) is a real estate investment trust, demographics, (3) attractiveness to high quality tenants, or REIT, that focuses on the ownership, management, leas- including our existing tenants, (4) potential for growth and sta- ing, acquisition and development of suburban office proper- bility in economic down cycles and (5) future acquisition and ties. We typically focus our operations geographically in select development opportunities. Once we select a submarket, our submarkets that are attractive to our tenant base and in which strategy generally involves establishing an initial presence by we can establish a critical mass of square footage. At acquiring properties in that submarket and then increasing December 31, 2004, all of our properties were located in the our ownership through future acquisitions and development Mid-Atlantic region of the United States, although in accor- until we own a significant portion of the rental space in that dance with our strategy of focusing on submarkets that are submarket of the same class as our properties. Due to this attractive to our tenants, we may seek to expand our opera- strategy, we own much of the same-class office space in a tions outside of that region. We conduct our real estate own- number of the submarkets in which we own properties. As of ership activity through our operating partnership, Corporate December 31, 2004, our primary submarkets were located in Office Properties, L.P. (the “Operating Partnership”), for which (1) the Baltimore/Washington Corridor (defined as the we are the sole general partner. The Operating Partnership Maryland counties of Howard and Anne Arundel), (2) Northern owns real estate both directly and through subsidiary part- Virginia (defined as Fairfax County, Virginia), (3) Northern nerships and limited liability companies. The Operating Central New Jersey, (4) St. Mary’s & King George Counties Partnership also owns an entity through which we provide real (located in Maryland and Virginia, respectively), (5) Greater estate-related services that include (1) property management, Philadelphia, Pennsylvania, (6) Greater Harrisburg, Pennsylvania (2) construction and development management and (3) heat- and (7) Suburban Maryland (defined as the Maryland counties ing and air conditioning services and controls. The number of Montgomery and Prince George’s). of operating properties in our portfolio totaled 145 as of Achieving optimal performance from our properties is crucial December 31, 2004, 119 as of December 31, 2003 and 110 as to our Company. We evaluate the performance of our proper- of December 31, 2002. Our growth in number of operating ties by focusing on changes in revenues from real estate oper- properties over that timeframe was achieved primarily ations and property operating expenses. However, since we through our acquisition and development of properties. experienced significant growth in revenues from real estate REITs were created by the United States Congress in order operations and property operating expenses between 2002 and to provide large numbers of investors with the ability to make 2004, our growth in number of properties makes such revenue investments into entities that own large scale commercial real and expense growth misleading. Therefore, we evaluate the estate. One of the unique aspects of a REIT is that the entity changes in revenues from real estate operations and property typically does not pay corporate income tax, provided that the operating expenses attributable to property additions and prop- entity distributes 100% of its REIT taxable income to its share- erty sales separately from the changes attributable to properties holders and meets a number of other strict requirements of the that were owned and operational throughout any two periods Internal Revenue Code of 1986, as amended (it is noteworthy being compared (these concepts are discussed further in the that REITs are required to distribute only 90% of REIT taxable section entitled “Results of Operations”). In addition to evalu- income to maintain their tax status as a REIT, although any dif- ating changes in the main components of revenues from these ferential between the 90% and 100% would be taxable). Most of property groupings ((1) rental revenues and (2) tenant recoveries our revenues come from rents and property operating expense and other revenues), we consider the portion of any change reimbursements earned from tenants leasing space in our prop- in rental revenue from these properties that is attributable to erties. Most of our expenses take the form of (1) property oper- (a) straight-line rental revenue adjustments and (b) amortization ating costs, such as real estate taxes, utilities and repairs and of origination value of leases on acquired properties; these maintenance, (2) financing costs, such as interest and loan costs revenue adjustments, which are discussed and defined in and (3) depreciation and amortization associated with our greater detail in Note 3 to the Consolidated Financial operating properties. We also have revenues and expenses Statements, are important to us in evaluating changes in total associated with our service operations, although since the rental revenue because such adjustments are not indicative operating margins from these operations are small relative to of the cash revenue stream from those properties. the revenue and since the gross revenue and costs often bear In order to maximize the revenue potential of our proper- little relationship to the level of activity, we use the net of such ties, we try to maintain high levels of occupancy; as a result, revenues and expenses to evaluate their performance. we consider occupancy rates to be an important measure of 24 CORPORATE OFFICE PROPERTIES TRUST the productivity of our properties. One way that we attempt available for other uses; however, it is noteworthy that we have to maximize occupancy rates is by renewing a high percentage historically paid dividends in excess of our REIT taxable income of our existing tenants; accordingly, tenant renewal rates are (see Note 17 to our Consolidated Financial Statements for fur- important to us in monitoring our leasing activities and tenant ther discussion of income taxes). relationships. In managing the effect of our leasing activities on We historically have financed our long-term capital needs, our financial position and future operating performance sta- including property acquisition and development activities, bility, we also monitor the timing of our lease maturities with through a combination of the following: the intent that the timing of such maturities not be highly con- • borrowings under our primary revolving credit facility (the centrated in a given one-year or five-year period. “Revolving Credit Facility”); We focus on tenants that are large, financially sound enti- • borrowings from new loans; ties with significant long-term space requirements. A number • issuances of common shares of beneficial interest (“common of our tenants lease a significant portion or all of the space in shares”), preferred shares of beneficial interest (“preferred individual properties, and in some cases these tenants lease shares”) and common units and/or preferred units in our space in a number of our properties. We also pursue select Operating Partnership; acquisition opportunities involving properties in which certain • contributions from outside investors into real estate joint of our existing tenants either lease or wish to lease space. ventures; Through this strategy, our goal is to become a preferred land- • proceeds from sales of real estate; and lord for such tenants. As a result of this strategy, a significant • any available residual cash flow from operations after appli- portion of our revenues come from a highly concentrated cation to the items described in the previous paragraph. number of tenants. Since we rely on a relatively small number One aspect of how we manage our financing policy of tenants for such a large portion of our revenues, we closely involves monitoring the relationship of certain measures of monitor the concentration levels we have with our tenants, earnings to certain financing cost requirements; these rela- particularly our 20 largest tenants. In addition, as we discuss tionships are known as coverage ratios. One coverage ratio below, a high concentration of our revenues is generated from on which our financing policy focuses is fixed charge cover- tenants in the United States intelligence and defense industry age ratio (defined as various measures of results of operations (comprised of the United States Government and intelligence divided by the sum of (a) interest expense on continuing and and defense contractors); we monitor this level of concentration discontinued operations, (b) dividends on preferred shares from a business risk perspective. and (c) distributions on preferred units in our Operating Cash provided from operations is our primary source of cash Partnership not owned by us). Coverage ratios such as fixed for funding dividends and distributions, debt service on our charge coverage ratio are important to us in evaluating loans and other working capital requirements. A good place whether our operations are sufficient to satisfy the cash flow to start in evaluating our cash flow provided by operations is requirements of our loans and equity holders, including minor- the line entitled “net cash provided by operating activities” on ity interest holders. Another aspect to our financing policy our Statements of Cash Flows. We also believe that the amount involves monitoring the relationship of our total variable-rate that we incur on our operating properties for tenant and capi- debt to our total assets; this is important to us in limiting the tal improvements and leasing costs are particularly useful in amount of our debt that is subject to future increases in inter- evaluating our cash flow from operations since these costs are est rates. We also closely monitor the timing of our debt matu- required to operate our properties; we provide this information rities to ensure that the maximum maturities of debt in any in the section entitled “Investing and Financing Activities During year, both including and excluding our Revolving Credit the Year Ended December 31, 2004.” Since we are a REIT and Facility, do not exceed a defined percentage of total assets. therefore distribute 100% of our REIT taxable income in order to avoid paying income taxes, our dividends and distributions paid are also useful in determining how much cash we have CORPORATE OFFICE PROPERTIES TRUST 25 During 2004, we: You should refer to our Consolidated Financial Statements • experienced increased revenues, operating expenses and and Selected Financial Data table as you read this section. operating income due primarily to the addition of properties This section contains “forward-looking” statements, as through acquisition and construction activities; defined in the Private Securities Litigation Reform Act of 1995, • experienced increased revenue from Same-Office that are based on our current expectations, estimates and pro- Properties of $6.0 million, or 4%, and increased operating jections about future events and financial trends affecting the expenses from those properties of $3.8 million, or 8%; financial condition and operations of our business. Forward- • finished the year with occupancy for our portfolio of prop- looking statements can be identified by the use of words such erties at 94.0%; as “may,” “will,” “should,” “expect,” “estimate” or other com- • renewed 71.4% of the square footage under leases expiring parable terminology. Forward-looking statements are inherently during the year; subject to risks and uncertainties, many of which we cannot pre- • acquired 22 office properties and seven land parcels for dict with accuracy and some of which we might not even antic- $284.3 million; 50.3% of these acquisition costs represented ipate. Although we believe that the expectations, estimates and properties located in Northern Virginia and 17 of these projections reflected in such forward-looking statements are office properties represented our initial entry into the St. based on reasonable assumptions at the time made, we can Mary’s and King George Counties region; give no assurance that these expectations, estimates and pro- • placed into service three newly-constructed buildings total- jections will be achieved. Future events and actual results may ing 300,691 square feet that were 90.3% leased at differ materially from those discussed in the forward-looking December 31, 2004; statements. Important factors that may affect these expecta- • sold 5,033,600 common shares in registered underwrit- tions, estimates and projections include, but are not limited to: ten public offerings for net proceeds of approximately • our ability to borrow on favorable terms; $115.4 million; • general economic and business conditions, which will, • redeemed our Series B Preferred Shares of beneficial inter- among other things, affect office property demand and est (the “Series B Preferred Shares”) for a redemption price rents, tenant creditworthiness, interest rates and financ- of $31.3 million; and ing availability; • obtained a new $300.0 million Revolving Credit Facility • adverse changes in the real estate markets, including, among which replaced our previous facility. other things, increased competition with other companies; In this section, we discuss our results of operations for 2004 • risks of real estate acquisition and development activities, and 2003 and our financial condition at December 31, 2004. including, among other things, risks that development proj- This section includes discussions on, among other things: ects may not be completed on schedule, that tenants may • our results of operations and why various components of not take occupancy or pay rent or that development or oper- our Consolidated Statements of Operations changed from ating costs may be greater than anticipated; 2003 to 2004 and from 2002 to 2003; • risks of investing through joint venture structures, including • how we raised cash for acquisitions and other capital risks that our joint venture partners may not fulfill their finan- expenditures during 2004; • our cash flows during 2004; cial obligations as investors or may take actions that are inconsistent with our objectives; • how we expect to generate cash for short and long-term • governmental actions and initiatives; and capital needs; • environmental requirements. • our off-balance sheet arrangements in place that are rea- We undertake no obligation to update or supplement sonably likely to affect our financial condition, results of forward-looking statements. operations and liquidity; • our commitments and contingencies; • our accounting policies that require our most difficult, sub- jective or complex judgments and materially affect our reported operating performance or financial condition; and • the computation of our Funds from Operations for 2000 through 2004. 26 CORPORATE OFFICE PROPERTIES TRUST Operating Data Variance Analysis (Dollars in thousands, except per share data) Revenues Rental revenue Tenant recoveries and other real estate operations revenue Construction contract revenues Other service operations revenues Total revenues Expenses Property operating Depreciation and other amortization associated with real estate operations Construction contract expenses Other service operations expenses General and administrative expense Total operating expenses Operating income Interest expense Amortization of deferred financing costs (Loss) gain on sales of real estate, For the Years Ended December 31, For the Years Ended December 31, 2004 2003 Variance Change 2003 2002 Variance Change % % $192,353 $153,048 $39,305 26% $153,048 $134,421 $ 18,627 14% 22,220 25,018 3,885 243,476 21,375 28,865 2,875 206,163 845 (3,847) 1,010 37,313 4% (13%) 35% 18% 21,375 28,865 2,875 206,163 15,914 826 3,851 155,012 5,461 28,039 (976) 51,151 34% 3395% (25%) 33% 63,053 51,699 11,354 22% 51,699 43,929 7,770 18% 51,904 23,733 3,263 37,122 27,483 3,450 14,782 (3,750) (187) 40% (14%) (5%) 37,122 27,483 3,450 10,938 152,891 90,585 (44,263) 7,893 127,647 78,516 (41,079) 3,045 25,244 12,069 (3,184) 39% 20% 15% 8% 7,893 127,647 78,516 (41,079) 30,859 789 4,192 6,697 86,466 68,546 (39,065) 6,263 26,694 (742) 20% 3383% (18%) 1,196 41,181 9,970 (2,014) 18% 48% 15% 5% (2,431) (2,767) 336 (12%) (2,767) (2,501) (266) 11% excluding discontinued operations (150) 472 (622) N/A 472 2,564 (2,092) (82%) Equity in loss of unconsolidated entities Income tax (expense) benefit Income from continuing operations before minority interests Minority interests in income from continuing operations Income from discontinued operations, net Net income Preferred share dividends Repurchase of preferred units (88) (795) (98) 169 10 (964) (10%) N/A (98) 169 (402) 347 304 (178) (76%) (51%) 42,858 35,213 7,645 22% 35,213 29,489 5,724 19% (5,826) (6,759) 933 (14%) (6,759) (7,461) 702 (9%) — 37,032 (16,329) 2,423 30,877 (12,003) (2,423) 6,155 (4,326) (100%) 20% 36% 2,423 30,877 (12,003) 1,273 23,301 (10,134) 1,150 7,576 (1,869) 90% 33% 18% in excess of recorded book value — (11,224) 11,224 (100%) (11,224) — (11,224) N/A Issuance costs associated with redeemed preferred shares Net income available (1,813) — (1,813) N/A — — — N/A to common shareholders $ 18,890 $ 7,650 $11,240 147% $ 7,650 $ 13,167 $ (5,517) (42%) Basic earnings per common share Income before discontinued operations Net income available to common shareholders Diluted earnings per common share Income before discontinued operations Net income available to common shareholders $ $ $ $ 0.57 0.57 0.54 0.54 $ $ $ $ 0.20 $ 0.37 185% $ 0.20 0.29 $ 0.28 97% $ 0.29 0.19 $ 0.35 184% $ 0.19 0.27 $ 0.27 100% $ 0.27 $ $ $ $ 0.53 $ (0.33) (62%) 0.59 $ (0.30) (51%) 0.51 $ (0.32) (63%) 0.56 $ (0.29) (52%) CORPORATE OFFICE PROPERTIES TRUST 27 RESULTS OF OPERATIONS As we discussed above, we observed increased leasing While reviewing this section, you should refer to the “Operating activity in many of our submarkets in 2004. However, since Data Variance Analysis” table set forth on the preceding page, rental conditions in many of our regions continue to be affected as it reflects the computation of many of the variances by the economic downturn, we expect that the operating described in this section. You should also refer to the section performance of our properties may be adversely affected as entitled “Liquidity and Capital Resources” for certain factors we attempt to lease vacant space and renew leases that are that could negatively affect various aspects of our operations. scheduled to expire. Our exposure over the next year is reduced Occupancy and Leasing somewhat by the fact that only 9.8% of our annualized rental revenues from leases in place as of December 31, 2004 were Over the last three years, the United States economy suffered from leases scheduled to expire by the end of 2005. Looking from an economic slowdown that we believe had an adverse longer term, the weighted average lease term for leases in place effect on the office real estate leasing market. Occupancy rates as of December 31, 2004 was 4.9 years and 61.2% of our annu- declined in most parts of the country, placing downward pres- alized rental revenues on leases in place as of December 31, sure on rental rates and increasing the competitive environ- 2004 were from leases scheduled to expire by the end of 2009, ment for attracting tenants. We believe that the national trend with no more than 17% scheduled to expire in any one calen- was felt in each of our geographic regions, contributing dar year between 2005 and 2009. towards decreased occupancy in our portfolio of properties Annualized rental revenue is a measure that we use to eval- from 96.1% on December 31, 2001, to 93.0% on December 31, uate the source of our rental revenue as of a point in time. It is 2002 to 91.2% on December 31, 2003. We also experienced computed by multiplying by 12 the sum of monthly contractual downward pressure on rental rates and increased competi- base rents and estimated monthly expense reimbursements tion for tenants in our properties. In calendar year 2004, leas- under active leases in our portfolio of properties as of a point ing activity in many of our regions increased and occupancy in time. Portfolio annualized rental revenue is annualized rental improved throughout the year. We expect the increased leas- revenue for our entire portfolio of properties as of a point in ing activity trend in these regions to continue into 2005, which time, including both consolidated properties and properties we expect will improve occupancy levels in those regions and owned through unconsolidated real estate joint ventures. We in our properties. The table below sets forth certain occupancy consider annualized rental revenue to be a useful measure for and leasing information: analyzing revenue sources because, since it is point-in-time December 31, based, it does not contain increases and decreases in revenue 2004 2003 2002 associated with periods in which lease terms were not in effect; Occupancy for historical revenue under generally accepted accounting prin- portfolio of properties 94.0% 91.2% 93.0% ciples (“GAAP”) does contain such fluctuations. We find the Average contractual annual measure particularly useful for leasing, tenant, segment and rental rate per square foot(1) $20.32 $20.06 $18.87 industry analysis. (1) Includes estimated expense reimbursements. Most of the leases with our largest tenant, the United States Government, provide for consecutive one-year terms or provide for early termination rights; all of the leasing sta- We were able to renew 71.4% of the square footage under tistics set forth above assume that the United States leases expiring in 2004 and 75.7% of the square footage under Government will remain in the space that they lease through leases expiring in 2003. The December 31, 2004 occupancy the end of the respective arrangements, without ending con- and leasing information reflected in the table above includes secutive one-year leases prematurely or exercising early ter- the effects of properties acquired during 2004; these properties mination rights. We report the statistics in this manner since were 92.4% occupied as of December 31, 2004. We believe we manage our leasing activities using these same assump- that our leasing activities in many of the submarkets in which tions and believe these assumptions to be probable. Please our properties are located have benefited from the expansion refer to the section entitled “Liquidity and Capital Resources” of the United States intelligence and defense industry since where we further discuss our leases with the United States such submarkets are particularly attractive to that industry. Government and the underlying risks. 28 CORPORATE OFFICE PROPERTIES TRUST Geographic Concentration of Property Operations Concentration of Leases with Certain Tenants During 2003 and 2004, our operating property acquisitions We experienced changes in our tenant base during 2004 due included nine buildings in Northern Virginia, 17 in St. Mary’s to acquisitions and leasing activity. The following schedule and King George counties (located in Maryland and Virginia, lists our 20 largest tenants based on percentage of portfolio respectively), one each in the Baltimore/Washington Corridor annualized rental revenue: and Suburban Maryland regions and one in Northern Baltimore County. We also placed into operations two build- ings in the Baltimore/Washington Corridor and one building each in the Northern Virginia and Suburban Maryland regions. The table below sets forth the changes in the regional alloca- tion of our portfolio annualized rental revenue occurring pri- Tenant marily as a result of these acquisition and development United States of America activities and changes in leasing activity: Booz Allen Hamilton, Inc. % of Portfolio Annualized Rental Revenue as of December 31, Computer Sciences Corporation(1) AT&T Corporation(1) Titan Corporation(1) Region 2004 2003 2002 General Dynamics Corporation Baltimore/Washington Corridor Northern Virginia Northern/Central New Jersey St. Mary’s and King George counties Greater Philadelphia Harrisburg, Pennsylvania Suburban Maryland Other Northrop Grumman Corporation 48.7% 22.9% 53.6% 19.8% 54.4% 11.3% Unisys(2) Wachovia Bank 7.7% 9.5% 11.5% The Boeing Company(1) The Aerospace Corporation 4.6% 4.5% 3.8% 3.8% 4.0% N/A 5.7% 5.1% 2.9% 3.4% N/A 6.5% 6.2% 6.1% 4.0% Ciena Corporation VeriSign, Inc. Commonwealth of Pennsylvania(1) PricewaterhouseCoopers LLP Magellan Health Services, Inc. Johns Hopkins University(1) 100.0% 100.0% 100.0% Merck & Co., Inc.(2) Carefirst, Inc. and Subsidiaries(1) We expect that we will continue to focus much of our 2005 BAE Systems acquisition and development activities in the Northern Virginia USinternetworking, Inc. and Baltimore/Washington Corridor regions. We also expect Comcast Corporation in 2005 that we will have an increased focus on acquisition and Omniplex World Services development opportunities outside of our existing regions, Subtotal of 20 largest tenants typically to meet the anticipated needs of our existing and All remaining tenants future tenants. Total Percentage of Portfolio Annualized Rental Revenue for 20 Largest Tenants as of December 31, 2004 13.1% 2003 14.8% 5.4% 5.2% 4.2% 3.9% 3.7% 3.6% 3.4% 2.3% 2.2% 1.8% 1.4% 1.4% 1.3% 1.3% 1.1% 1.1% 1.0% 1.0% 1.0% N/A N/A N/A 2.6% 6.3% 5.2% 1.3% 3.3% 2.5% 4.4% N/A 1.9% 2.1% 2.2% 5.1% 1.5% N/A 1.8% 1.3% 1.3% 1.2% N/A 1.1% 1.0% 0.9% 59.4% 40.6% 100.0% 61.8% 38.2% 100.0% (1) Includes affiliated organizations and agencies. (2) Unisys subleases space to Merck & Co., Inc.; revenue from this subleased space is classified as Merck & Co., Inc. revenue. As noted above, most of the leases with the United States Government provide for a series of one-year terms or provide for early termination rights. The government may terminate its leases if, among other reasons, the United States Congress fails to provide funding. CORPORATE OFFICE PROPERTIES TRUST 29 Industry Concentration of Tenants in the space leased from us is focused on providing service to The percentage of our portfolio annualized rental revenue the United States Government’s defense department, we clas- derived from the United States intelligence and defense sify the revenue we earn from the lease as United States intel- industry increased each of the last three years. One reason ligence and defense industry revenue. We do not use for this increase is the expansion of the industry in the independent sources such as Standard Industrial Classification Baltimore/Washington Corridor and Northern Virginia and, in codes for classifying our revenue into industry groupings and particular, in our submarkets since the events of September 11, if we did, the resulting groupings would be materially different. 2001. Another reason for the increase is that certain of the prop- erties we acquired in each of the last three years have leases Revenues from Real Estate Operations with the United States Government and intelligence and and Property Operating Expenses defense contractors. The table below sets forth the percentage We typically view our changes in revenues from real estate of our annualized rental revenue derived from that industry and, operations and property operating expenses as being com- by doing so, demonstrates our increasing concentration: prised of three main components: % of Annualized Rental Revenue from United States Intelligence and Defense Industry as of December 31, 2004 46.8% 63.4% 50.3% 2003 39.9% 57.4% 45.5% 2002 37.6% 45.4% 81.8% • Changes attributable to the operations of properties owned and 100% operational throughout the two years being compared. We define these as changes from “Same- Office Properties.” For example, when comparing 2003 and 2004, Same-Office Properties would be properties owned and 100% operational from January 1, 2003 through December 31, 2004. For further discussion of the concept of “operational,” you should refer to the section of Note 3 of the Consolidated Financial Statements entitled “Commercial Real Estate Properties.” • Changes attributable to operating properties acquired dur- Total Portfolio Baltimore/Washington Corridor Northern Virginia St. Mary’s and King George Counties 90.6% N/A N/A ing the two years being compared and newly-constructed properties that were placed into service and not 100% We classify the revenue from our leases into industry group- operational throughout the two years being compared. ings based solely on our knowledge of the tenants’ opera- We define these as changes from “Property Additions.” tions in leased space. Occasionally, classifications require • Changes attributable to properties sold during the two subjective and complex judgments. For example, we have a years being compared that are not reported as discon- tenant that is considered by many to be in the computer tinued operations. We define these as changes from industry; however, since the nature of that tenant’s operations “Sold Properties.” 30 CORPORATE OFFICE PROPERTIES TRUST The tables below sets forth the components of our changes in revenues from real estate operations and property operating expenses (dollars in thousands): Property Additions Dollar Change(1) Dollar Change Changes from 2003 to 2004 Same-Office Properties Sold Properties Percentage Dollar Change Change(2) Change(3) Other Dollar Total Dollar Change Revenues from real estate operations Rental revenue Tenant recoveries and other real estate operations revenue Total Property operating expenses Straight-line rental revenue adjustments $34,400 $ 5,994 1,402 $35,802 $ 8,867 26 $ 6,020 $ 3,806 4% 0% 4% 8% $(623) $(466) $39,305 (89) $(712) $(320) (494) $(960) $(999) 845 $40,150 $11,354 included in rental revenue $ 5,633 $(1,882) N/A $ (12) $ (1) $ 3,738 Amortization of origination value of leases on acquired properties included in rental revenue $ (1,131) $ 245 N/A $ — $ — $ (886) Number of operating properties included in component category 35 109 N/A 1 N/A 145 (1) (2) (3) Includes 29 acquired properties and six newly-constructed properties. Includes sold operating properties that are not reported as discontinued operations. Includes, among other things, the effects of amounts eliminated in consolidation. Certain amounts eliminated in consolidation are attrib- utable to the Property Additions and Same-Office Properties. Changes from 2002 to 2003 Property Additions Dollar Change(1) Same-Office Properties Dollar Change Percentage Dollar Change Sold Properties Other Dollar Change(2) Change Total Dollar Change Revenues from real estate operations Rental revenue Tenant recoveries and other real estate operations revenue Total Property operating expenses Straight-line rental revenue adjustments $22,614 $ (873) (1%) $(3,114) $ — $18,627 3,229 $25,843 $ 6,811 2,389 $1,516 $2,427 17% 1% 6% (168) $(3,282) $(1,312) 11 $ 11 $(156) 5,461 $24,088 $ 7,770 included in rental revenue $ 1,141 $1,217 N/A $ (64) $ — $ 2,294 Amortization of origination value of leases on acquired properties included in rental revenue $ (306) $ (219) N/A $ — $ — $ (525) Number of operating properties included in component category 25 93 N/A 2 N/A 120 (1) (2) Includes 17 acquired properties and eight newly-constructed properties. Includes sold operating properties that are not reported as discontinued operations. As the tables above indicate, our total increase in revenues from real estate operations and property operating expenses was attributable primarily to the Property Additions. However, the total revenues from the Property Additions were offset some- what by property vacancies and the slow lease-up of newly-constructed buildings, conditions that we believe were attributable to the economic slowdown. The increase in rental revenue of the Property Additions from 2003 to 2004 includes $5.3 million that was attributable to net revenue from the early termination of leases; most of this increase was attributable to one lease termina- tion transaction. To explain further the concept of net revenue from the early termination of leases, when tenants terminate their CORPORATE OFFICE PROPERTIES TRUST 31 lease obligations prior to the end of the agreed lease terms, • increase of $661,000, or 54.8%, in general administrative they typically pay fees to break these obligations. We recog- costs allocable to property operations due primarily to an nize such fees as revenue and write off against such revenue increase in asset management and legal staffing over the any (1) deferred rents receivable and (2) deferred revenue and prior period; deferred assets that are amortizable into rental revenue asso- • increase of $574,000, or 5.9%, in real estate taxes due pri- ciated with the leases; the resulting net amount is the net reve- marily to an increase in the assessed value of many of our nue from the early termination of the leases (see the section properties. This increasing trend was present across all of entitled “Revenue Recognition” in Note 3 to our Consolidated our regions. While we continue to monitor the reasonable- Financial Statements). ness of the increase in the assessed value of our proper- Rental revenue reported herein included net revenue from ties in determining whether appeals are necessary, we the early termination of leases of $9.9 million for 2004, $4.7 mil- expect that this increasing trend will continue. We also lion for 2003 and $6.2 million for 2002. While early lease termi- expect that the rates used by state and local municipali- nations are not unusual and can be unpredictable, we believe ties to assess real estate taxes on our properties may that the revenue we recognized from such terminations in 2004 increase in the future in response to budgetary shortfalls was higher than we can expect to recognize in future years. in those municipalities; The increase in rental revenue from the Same-Office • increase of $410,000, or 17.7%, in heating and air condi- Properties from 2003 to 2004 was attributable primarily to an tioning repairs and maintenance, most of which was attrib- increase in occupancy and rental rates between the two peri- utable to a project undertaken at one of our buildings; a ods, including $2.8 million relating to one property. tenant in this building was reimbursing us for these costs The decrease in rental revenue from the Same-Office through its tenant recovery billings; Properties from 2002 to 2003 included the following: • decrease of $1.2 million, or 49.2%, in snow removal due to • decrease of $2.3 million in net revenue from the early higher snowfall in the prior period; and termination of leases; and • decrease of $424,000, or 85.4%, in expense associated with • increase of $965,000 in connection with three properties doubtful or uncollectible receivables. Most of this decrease that experienced significant changes in occupancy was attributable to a large expense associated with two between the two periods. tenants in the prior period coupled with much lower Tenant recoveries and other revenue from the Same-Office expense in the current period. Properties increased from 2002 to 2003 due primarily to the The increase in the Same-Office Properties’ property oper- increase in property operating expenses described below. ating expenses from 2002 to 2003 included the following: The increase in the Same-Office Properties’ property oper- • increase of $1.6 million, or 260.2%, in snow removal due to ating expenses from 2003 to 2004 included the following: higher snowfall in 2003; • increase of $1.7 million, or 42.1%, in property labor costs due • increase of $345,000, or 4.6%, in real estate taxes due primarily to an increase in billable rates of repair and main- primarily to an increase in the assessed value of many of tenance employees as well as higher than normal hours dur- our properties; ing the earlier portion of 2004 for projects undertaken at • increase of $305,000, or 6.0%, in cleaning expenses; certain properties; $609,000 of this increase was attributable • increase of $304,000, or 16.7%, in heating and air condi- to a building that was staffed with employees throughout tioning repairs and maintenance due primarily to additional 2004 but not staffed for most of 2003. Since the increase repair projects undertaken in 2003; and in billable rates of repairs and maintenance employees • decrease of $858,000 in gas and electric utility expenses contributed to additional profit in our service operations associated with three properties that were occupied by prior to eliminations recorded in consolidation, a significant a single tenant; that tenant assumed responsibility for portion of the increase in our property labor costs was elim- direct payment of such utility expenses in the latter por- inated in consolidation; tion of 2002. • increase of $819,000, or 12.8%, in cleaning expenses due primarily to cleaning costs required in the current period at properties that had increased occupancy over the prior period; 32 CORPORATE OFFICE PROPERTIES TRUST Construction Contract and Other Service Revenues and Expenses Changes from 2003 to 2004 Changes from 2002 to 2003 Construction Other Service Contract Dollar Change Operations Dollar Change $(3,847) (3,750) $ (97) $1,010 (187) $1,197 Total Dollar Change $(2,837) (3,937) $ 1,100 Construction Other Service Contract Dollar Change Operations Dollar Change $28,039 26,694 $ 1,345 $(976) (742) $(234) Total Dollar Change $27,063 25,952 $ 1,111 Service operations Revenues Expenses Income from service operations The increase in income from other service operations from 2003 to 2004 can be attributed primarily to a $662,000 increase in income from the heating and air conditioning services and controls division. The improvement in income from the heat- ing and air conditioning services and controls division was attributable primarily to increased time and materials billing activity from its service contract and controls product lines. Much of this activity was attributable to several large contracts; once these contracts are complete, additional contracts will need to be obtained to continue to maintain the activity level. As a result, there is a high level of uncertainty over whether the improvement in income from the division is a trend that will continue. The increase in income from construction contracts from 2002 to 2003 reflects the significant increase in volume of serv- ices and the change in profit margins associated with certain of these contracts. The division’s $1.4 million gross profit included $1.0 million earned from three contracts, including $676,000 from one contract; it is also noteworthy that a signifi- cant portion of the gross profit, including the most profitable contract, was earned from one customer. • an increase of $641,000 in consulting expense which included, among other things, our Sarbanes-Oxley Section 404 prepa- ration and increased external audit fees relating thereto; • an increase of $175,000 for marketing and investor rela- tions activity due to an increase in such activity; and • an increase of $121,000 in trustees’ and officers’ insurance costs due to additional coverage and higher rates. General and administrative expenses increased $1.2 mil- lion, or 18%, from 2002 to 2003, which included an increase of $709,000 associated with common share awards to employees due primarily to more of these awards vesting in 2003. Interest Expense and Amortization of Deferred Financing Costs Our interest expense and amortization of deferred financing costs increased 6.5% from 2003 to 2004 due primarily to an 18% increase in our average outstanding debt balance result- ing from our 2003 and 2004 acquisition and development activities, offset by the effects of (1) an increase in the amount of interest capitalized to construction and development projects due to increased construction and pre-construction activity and (2) a decrease in our weighted average interest rates from Depreciation and Amortization 5.9% to 5.7%. Our interest expense and amortization of Of the $14.8 million increase in our depreciation and other deferred financing costs increased 5.5% from 2002 to 2003 amortization expense from 2003 to 2004, $13.4 million was due primarily to a 15% increase in our average outstanding attributable to the Property Additions, which included $3.2 mil- debt balance resulting from our 2002 and 2003 acquisition and lion recorded in connection with one lease termination trans- development activities, offset by a decrease in our weighted action. Of the $6.3 million increase in our depreciation and average interest rates from 6.5% to 5.9%. Interest rates avail- other amortization expense from 2002 to 2003, $6.2 million was able from lenders on fixed and variable-rate loans decreased attributable to the Property Additions. from 2002 through early 2004. The decreasing interest rate environment contributed to the decrease in our weighted General and Administrative Expenses average interest rates by reducing the amount of interest General and administrative expenses increased $3.0 million, expense we paid on variable-rate debt and enabling us to refi- or 39%, from 2003 to 2004. This increase included the following: nance certain variable and fixed-rate debt with lower interest • an increase of $1.7 million in compensation expense due rate fixed-rate debt. primarily to additional employee positions, increased As of December 31, 2004, 72.2% of our mortgage and expenses associated with share based compensation and other loans payable balance carried fixed interest rates and increased salaries for existing employees; 94.9% of our fixed-rate loans were scheduled to mature after CORPORATE OFFICE PROPERTIES TRUST 33 2005; for a more comprehensive presentation of our fixed-rate common units in the Operating Partnership each time we loan maturities, please refer to the section entitled issue preferred shares and common shares; “Quantitative and Qualitative Disclosures About Market Risk.” • the exchange of common units for our common shares by certain minority interest holders of common units; (Loss) Gain on Sales of Real Estate, • our repurchase of the Series C Preferred Units from third Excluding Sales Classified as Discontinued Operations parties in June 2003 (as discussed in the section below enti- In 2004, we recognized a $245,000 decrease to a gain recog- tled “Adjustments to Net Income to Arrive at Net Income nized on a prior-year disposition of an investment in a real Available to Common Shareholders”); estate joint venture as a result in a change in the settlement • the conversion of the Series D Preferred Shares of benefi- negotiated between our joint venture partner and us. In 2003, cial interest (the “Series D Preferred Shares”)(as discussed we recognized a $376,000 gain on the sale of two land parcels. in Note 11 to the Consolidated Financial Statements); In 2002, we recognized a $1.2 million gain on the disposition • our redemption of the Series B Preferred Shares in July of investments in two real estate joint ventures and a $1.4 mil- 2004 (as discussed in Note 11 to the Consolidated Financial lion gain on three land parcel sales. Gain on sales of real estate Statements); and for all three years presented also includes amortized gain from • our issuance of the Series I Preferred Units to a third party a building sale that occurred in 2002. in September 2004 (as discussed in Note 3 to the We generally do not acquire properties with the intent of Consolidated Financial Statements). selling them. We generally attempt to sell a property when we Our income allocated to minority interest holders of pre- believe that most of the earnings growth potential in that prop- ferred units decreased due to our repurchase of the Series C erty has been realized or determine that the property no longer Preferred Units, offset slightly by the issuance of the Series I fits within our strategic plans due to its type and/or location. Preferred Units. Our changes in income allocated to minority Since our real estate sales activity is driven by transactions unre- interest holders of common units included the following: lated to our core operations, our gain on sales of real estate is • decrease attributable to our increasing ownership of com- subject to material fluctuation from period to period. mon units and preferred units; and Minority Interests Interests in our Operating Partnership are in the form of pre- • increase due to an increase in the Operating Partnership’s income from continuing operations before minority interests. ferred and common units. The line entitled “minority interests Income from Discontinued Operations in income from continuing operations” on our Consolidated Income from discontinued operations is composed entirely of Statements of Operations includes primarily income before one operating office property that we sold in March 2003. minority interests and discontinued operations allocated to Income from discontinued operations increased from 2002 to preferred and common units not owned by us; for the amount 2003 because 2003 included a $3.0 million gain before minor- of this line attributable to preferred units versus common units, ity interests from the sale of the property. See Note 18 to the you should refer to our Consolidated Statements of Consolidated Financial Statements for a summary of income Operations. Income is allocated to minority interest preferred from discontinued operations. unitholders equal to the priority return from the Operating Partnership to which they are entitled. Income is allocated to Adjustments to Net Income to Arrive minority interest common unitholders based on the income at Net Income Available to Common Shareholders earned by the Operating Partnership after allocation to pre- We completed the sale of two series of preferred shares in ferred unitholders multiplied by the percentage of the com- 2003. On February 11, 2004, the holder of our Series D mon units in the Operating Partnership owned by those Preferred Shares exercised its right to cause us to convert the common unitholders. shares into 1,196,800 common shares. Preferred share divi- As of December 31, 2004, we owned 95% of the outstand- dends increased due to the dividend requirements of the two ing preferred units and approximately 80% of the outstand- new series of preferred shares issued in 2003. This increase ing common units. Changes in the percentage of the was offset somewhat by the decrease caused by the redemp- Operating Partnership owned by minority interests during the tion of the Series B Preferred Shares and conversion of the last three years included the following: Series D Preferred Shares in 2004. • the issuance of additional units to us as we issued new pre- During 2004, we recognized a $1.8 million decrease to net ferred shares and common shares during 2002 through income available to common shareholders pertaining to the 2004 due to the fact that we receive preferred units and original issuance costs incurred on the Series B Preferred 34 CORPORATE OFFICE PROPERTIES TRUST Shares. We redeemed these shares in July 2004 for a redemp- requirements. When we determine that the amount of cash tion price of $31.3 million. and cash equivalents on hand is more than we need to meet During 2003, we recognized an $11.2 million decrease to such requirements, we may pay down our Revolving Credit net income available to common shareholders, representing Facility or forgo borrowing under construction loan credit the excess of the repurchase price of the Series C Preferred facilities to fund development activities. Units in the Operating Partnership over the sum of the recorded book value of the units and the accrued and unpaid Operating Activities return to the unitholder; prior to this repurchase, these units We generate most of our cash from the operations of our prop- were convertible, subject to certain restrictions, into 2,420,672 erties. A review of our Statements of Operations indicates that common units in the Operating Partnership. These units were over the last three years, 29% to 30% of our revenues from real repurchased by the Operating Partnership for $36.1 million estate operations (defined as the sum of (1) rental revenue and (including $477,000 for accrued and unpaid distributions), or (2) tenant recoveries and other real estate operations revenue) $14.90 per common share on an as-converted basis. were used for property operating expenses. Most of the amount by which our revenues from real estate operations Diluted Earnings Per Common Share exceeded property operating expenses was cash flow; we Diluted earnings per common share on net income available applied most of this cash flow towards interest expense, sched- to common shareholders increased from 2003 to 2004 due pri- uled principal amortization on mortgage loans, dividends to marily to the $11.2 million decrease to net income available our shareholders, distributions to minority interest holders of to common shareholders in 2003 representing the excess of preferred and common units in the Operating Partnership, the repurchase price of the Series C Preferred Units over the capital improvements and leasing costs for our operating sum of the recorded book value of the units and the accrued properties and general and administrative expenses. and unpaid return to the unitholder. This increase was offset Our cash flow from operations determined in accordance somewhat by the issuance costs associated with the redeemed with GAAP increased $16.7 million, or 25%, from 2003 to 2004; Series B Preferred Shares and the increased common shares this increase is attributable primarily to the additional cash outstanding due to common share issuances in 2003 and 2004. flow from operations generated by our newly-acquired and Diluted earnings per common share decreased from 2002 to newly-constructed properties. We expect to continue to use 2003 due primarily to the decrease to net income available to cash flow provided by operations to meet our short-term capi- common shareholders resulting from the repurchase of the tal needs, including all property operating expenses, general Series C Preferred Units, offset by the net effect of the other and administrative expenses, interest expense, scheduled items discussed above. principal amortization of mortgage loans, dividend and distri- butions and capital improvements and leasing costs. We do LIQUIDITY AND CAPITAL RESOURCES not anticipate borrowing to meet these requirements. Factors In our discussion of liquidity and capital resources set forth that could negatively affect our ability to generate cash flow below, we describe certain of the risks and uncertainties relat- from operations in the future include the following: ing to our business; however, they may not be the only ones • We earn revenue from renting our properties. Our oper- that we face. Cash and Cash Equivalents ating costs do not necessarily fluctuate in relation to changes in our rental revenue. This means that our costs will not necessarily decline and may increase even if our Our cash and cash equivalents balance as of December 31, revenues decline. 2004 totaled $13.8 million, an increase of 46% from the bal- • For new tenants or upon lease expiration for existing ten- ance as of December 31, 2003. The balance of cash and cash ants, we generally must make improvements and pay other equivalents that we carried as of the end of the eight cal- tenant-related costs for which we may not receive endar quarters during the two years ended December 31, increased rents. We also make building-related capital 2004 ranged from $6.3 million to $13.8 million and averaged improvements for which tenants may not reimburse us. $10.0 million. The cash and cash equivalents balances that • When leases for our properties expire, our tenants may not we carry as of a point in time can vary significantly due in renew or may renew on terms less favorable to us than the part to the inherent variability of the cash needs of our terms of their original leases. If a tenant leaves, we can acquisition and development activities. We maintain suffi- expect to experience a vacancy for some period of time as cient cash and cash equivalents to meet our operating cash well as higher tenant improvement and leasing costs than if requirements and short term investing and financing cash a tenant renews. As a result, our financial performance CORPORATE OFFICE PROPERTIES TRUST 35 could be adversely affected if we experience a high vol- located could have an adverse effect on our financial posi- ume of tenant departures at the end of their lease terms. tion, results of operations and cash flows. • As discussed earlier, we are dependent on a highly concen- • As noted above in the section entitled “Results of trated number of tenants for a large percentage of our reve- Operations,” we believe that the economic slowdown in nue. Most of the leases of one of these tenants, the United the United States over the last three years adversely States Government, provide for a series of one-year terms affected occupancy rates in the Mid-Atlantic region and or provide for early termination rights. Our cash flow from our properties and, in turn, led to downward pressure on operations would be adversely affected if our larger ten- rental rates. Lower occupancy rates and the resulting ants failed to make rental payments to us, or if the United increased competition for tenants in our operating regions States Government elects to terminate several of its leases placed downward pressure on rental rates in most of these and the space cannot be re-leased on satisfactory terms. regions, a trend that we believe may affect us further as we • As discussed earlier, a high concentration of our revenues attempt to lease vacant space and renew leases scheduled comes from tenants in the United States defense industry. to expire on occupied space. As a result, we may have dif- A reduction in government spending for defense could ficulty leasing both existing vacant space and space asso- affect the ability of our tenants in the defense industry to ciated with future lease expirations at rental rates that are fulfill lease obligations or decrease the likelihood that these sufficient to meet our short term capital needs, which could tenants will renew their leases. In the case of the United negatively affect our financial position, results of opera- States Government, a reduction in government spending tions and cash flows. could result in the early termination of leases. • The commercial real estate market is highly competitive. • Our performance depends on the ability of our tenants to We compete for the purchase of commercial property with fulfill their lease obligations by paying their rental payments many entities, including other publicly traded commercial in a timely manner. In addition, as noted above, we rely on REITs. Many of our competitors have substantially greater a relatively small number of tenants for a large percentage financial resources than we do. If our competitors prevent of our revenue from real estate operations. If one of our major us from buying properties that we target for acquisition, tenants, or a number of our smaller tenants, were to experi- we may not be able to meet our property acquisition and ence financial difficulties, including bankruptcy, insolvency development goals. Moreover, numerous commercial or general downturn of business, there could be an adverse properties compete for tenants with our properties. Some effect on our results of operations and financial condition. of the properties competing with ours may have newer or • We provide construction management services for third- more desirable locations or the competing properties’ party clients. When providing these services, we usually owners may be willing to accept lower rates than are pay for the costs of construction and subsequently bill our acceptable to us. Competition for property acquisitions, clients for the costs of construction plus a construction or for tenants in properties that we own, could have an management fee. When we provide construction manage- adverse effect on our financial performance. ment services, the costs of construction can amount to mil- • If short-term interest rates were to increase, the interest lions of dollars. If any of our clients for construction payments on our variable-rate debt would increase, management services fail to reimburse us for costs incurred although this increase may be reduced to the extent that under a significant construction management contract, it we had interest rate swap and cap agreements outstand- could have an adverse effect on our results of operations ing. If longer-term interest rates were to increase, we may and financial condition. not be able to refinance our existing indebtedness on terms • Since all of our properties are currently located in the Mid- as favorable as the terms of our existing indebtedness and Atlantic region of the United States and are also typically we would pay more for interest expense on new indebted- concentrated in office parks in which we own most of the ness that we incur for future operating property additions. properties, we do not have a broad geographic distribu- • Our portfolio of properties is insured for losses under our tion of our properties. While we may in the future pursue property, casualty and umbrella insurance policies through selective acquisitions outside of the Mid-Atlantic region, September 2005. These policies include coverage for acts we expect to continue to have a geographic concentration of terrorism. Although we believe that we adequately insure in that region. As a result, a decline in the real estate mar- our properties, we are subject to the risk that our insurance ket or general economic conditions in the Mid-Atlantic may not cover all of the costs to restore properties damaged region, the Baltimore/Washington Corridor, Northern by a fire or other catastrophic event. In addition, due largely Virginia or the office parks in which our properties are to the terrorist attacks on September 11, 2001, the insurance 36 CORPORATE OFFICE PROPERTIES TRUST industry changed its risk assessment approach and cost in connection with our adoption of FIN 46(R), which is structure. Continuing changes in the insurance industry may described below (in thousands): increase the cost of insuring our properties and decrease the scope of insurance coverage, either of which could Acquisitions(1) adversely affect our financial position and operating results. Construction and development • As a REIT, we must distribute at least 90% of our annual Tenant improvements on operating properties(2) REIT taxable income (excluding capital gains), which lim- Capital improvements on operating properties $260,023 93,401 14,067 10,349 $377,840 its the amount of cash we have available for other busi- ness purposes, including amounts to fund our growth. Also, it is possible that because of the differences between the time that we actually receive revenue or pay expenses and the period we report those items for distribution pur- poses, we may have to borrow funds on a short-term basis to meet the 90% distribution requirement. We may become subject to tax liabilities that adversely affect our operating cash flow. Investing and Financing Activities During the Year Ended December 31, 2004 During 2004, we acquired 22 office properties totaling 1.6 mil- lion square feet and seven parcels of land for $284.3 million. These acquisitions were financed using the following: • $160.3 million from borrowings of new and assumed mort- gage loans; • $104.3 million in borrowings from our Revolving Credit Facility; • $8.8 million from preferred units in the Operating Partnership issued; • $4.0 million from common share sale proceeds; and • cash reserves for the balance. During 2004, we placed into service three newly-constructed buildings totaling 300,691 square feet. These buildings were 90.3% leased at December 31, 2004. Costs incurred on these properties through December 31, 2004 totaled $54.9 million, $32.3 million of which was incurred in 2004. We financed the (1) Excludes intangible assets and deferred revenues recorded in connection with acquisitions. (2) Tenant improvement costs incurred on newly-constructed proper- ties are classified in this table as construction and development. Our investment in unconsolidated real estate joint ven- tures decreased $4.1 million due to our consolidation as of March 31, 2004 of Gateway 70 LLC, MOR Forbes 2 LLC and MOR Montpelier 3 LLC in conjunction with our adoption of Financial Accounting Standards Board’s Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46(R)”) for those joint venture investments. For additional information regarding our investments in unconsolidated real estate joint ventures, refer to the section below entitled “Off-Balance Sheet Arrangements” and Note 5 to our Consolidated Financial Statements. On March 10, 2004, we obtained a new Revolving Credit Facility with a number of lenders led by Wachovia Bank, National Association. We used proceeds from our initial bor- rowing under this facility to (1) repay the $27.8 million balance that was outstanding under our since-terminated Revolving Credit Facility with Bankers Trust Company and (2) refinance $95.2 million in other mortgage loans. During 2004, we borrowed $307.7 million under mortgages and other loans, excluding our Revolving Credit Facility; the proceeds from these borrowings were used as follows: 2004 costs using $8.9 million in borrowings under construc- • $160.3 million to finance acquisitions; tion loan facilities and most of the balance using borrowings • $64.0 million to pay down our Revolving Credit Facility; under our Revolving Credit Facility. • $43.5 million to refinance existing debt; At December 31, 2004, we had construction activities • $28.9 million to finance construction activities; and underway on seven office properties totaling 907,119 square • the balance to fund cash reserves. feet that were 36.5% pre-leased. Costs incurred on these prop- On April 23, 2004, we sold 2,750,000 common shares in a erties through December 31, 2004 totaled $67.8 million, of registered underwritten public offering at a net price of $21.243 which $48.5 million were incurred in 2004. We have construction per share. We contributed the net proceeds totaling $58.2 mil- loan facilities in place totaling $63.0 million to finance the con- lion to our Operating Partnership in exchange for 2,750,000 struction of three of these properties; borrowings under these common units. We initially used the proceeds to pay down our facilities totaled $23.3 million at December 31, 2004. The Revolving Credit Facility. We re-borrowed most of the amount remaining costs were funded using borrowings from our by which the Revolving Credit Facility was paid down to (1) pre- Revolving Credit Facility and cash reserves. pay a $26.0 million mortgage in June 2004 and (2) redeem for The table below sets forth the major components of our $31.3 million our Series B Preferred Shares in July 2004. 2004 additions to investment in real estate, excluding addi- On September 28, 2004, we sold 2,283,600 common shares tions related to the consolidation of real estate joint ventures in a registered underwritten public offering at a net price of CORPORATE OFFICE PROPERTIES TRUST 37 $25.10 per share. We contributed the net proceeds totaling • $60.5 million decrease in common and preferred share $57.2 million to our Operating Partnership in exchange for issuances completed; 2,283,600 common units. The proceeds were used to pay • $35.6 million in cash used to repurchase the Series C down our Revolving Credit Facility. Preferred Units in the Operating Partnership in 2003; this occurred as a result of a specific transaction that will not Analysis of Cash Flow Associated recur on an ongoing basis; with Investing and Financing Activities • $31.3 million in cash used to redeem the Series B Preferred Our net cash flow used in investing activities increased Shares in 2004. We may use cash in the future to redeem $90.8 million from 2003 to 2004. This increase was due primarily outstanding series of preferred shares once they become to the following: redeemable. None of our preferred shares are redeemable • $55.1 million increase in purchases of and additions to com- before July 2006; and mercial real estate; this increase is due primarily to an • $12.1 million increase in dividends and distributions paid increase in property acquisitions. Our ability to locate and due to (1) the increase of common and preferred shares complete acquisitions is dependent on numerous variables outstanding following share issuances in the last nine and, as a result, is inherently subject to significant fluctua- months of 2003 and the first nine months of 2004, net of tion from period to period. While we expect to continue the decrease in preferred shares outstanding relating to the to acquire properties in the future, we are unable to pre- redemption of the Series B Preferred Shares and the conver- dict whether the increasing acquisition volume is a trend sion of the Series D Preferred Shares and (2) an increased that will continue; and dividend rate on common shares and common units. • $40.2 million decrease in proceeds from sales of properties. We generally do not acquire properties with the intent of Off-Balance Sheet Arrangements selling them. We generally attempt to sell a property when Some of our real estate investments are owned through joint we believe that most of the earnings growth potential in ventures. We use joint ventures from time to time for reasons that property has been realized, or determine that the that include the following: (1) they can provide a facility to property no longer fits within our strategic plans due to its access new markets and investment opportunities while type and/or location. Since our real estate sales activity is enabling us to benefit from the expertise of our partners, (2) driven by transactions unrelated to our core operations, they are an alternative source for raising capital to put towards our proceeds from sales of properties are subject to mate- acquisition or development activities and (3) they can reduce rial fluctuation from period to period and, therefore, we our exposure to risks associated with a property and its activ- do not believe that the change described above is neces- ities. Each of our real estate joint ventures has a two-member sarily indicative of a trend. management committee that is responsible for making major Our cash flow provided by financing activities increased decisions (as defined in the joint venture agreement), and we $75.0 million from 2003 to 2004. This increase included control one of the management committee positions in each the following: case. All of our real estate joint venture investments owned • $302.9 million increase in proceeds from mortgage and during 2004 can be classified into one of the three categories other loans payable; this increase is due primarily to the described below: following: • Externally-managed construction joint ventures (the • borrowings under our new Revolving Credit Facility that “Externally-Managed JVs”). These joint ventures construct were used to fund our loan refinancings and repayment buildings to either be sold to third parties or purchased by of the since terminated Revolving Credit Facility with us. Our partners in all of these joint ventures are controlled Bankers Trust Company and property acquisitions; and by a company that owns, manages, leases and develops • borrowing under a $115.0 million loan with Teachers properties in the Baltimore/Washington Corridor; that com- Insurance and Annuity Association of America (“TIAA”) pany also serves as the project manager for all of these that was used primarily to pay down the Revolving joint ventures. During 2004, we were invested in three of Credit Facility and refinance other existing debt. these joint ventures; we accounted for these investments • $150.5 million increase in repayments of mortgage and using the equity method of accounting until March 31, other loans payable; this increase is attributable primarily to 2004, at which point we began to use the consolidation the additional repayments of existing loans using borrow- method of accounting in connection with our adoption of ings under our new Revolving Credit Facility and the new FIN 46(R)(see Note 2 to the Consolidated Financial loan with TIAA described above; Statements). These joint ventures enable us to make use 38 CORPORATE OFFICE PROPERTIES TRUST of the expertise of our partner; the use of the joint venture venture and we served as the project manager. The pri- structures provides further leverage to us both from a mary purpose behind the use of the joint venture was to financing and risk perspective. We generally guarantee the enable us to leverage most of the equity requirements and repayment of construction loans for these projects in reduce the construction and development risk to us. We amounts proportional to our ownership percentage. In served as the sole guarantor for repayment of the construc- addition, we are obligated to acquire our partners’ mem- tion loan for the project. We also earned construction, bership interest in each of the joint ventures if defined property management and guaranty fees from the joint events were to occur. The amount we would be required venture. The Internally-Managed JV in which we invested to pay for those membership interests is computed based during 2004 had provisions making us solely responsible on the amount that the owners of those interests would for funding defined additional investments in the joint ven- receive under the joint venture agreements in the event ture to the extent that costs to complete construction that office properties owned by the respective joint ven- exceed amounts funded by member investments previ- tures were sold for a capitalized fair value (as defined in ously made and the existing construction loan, although the agreements) on a defined date. We estimate the no such additional investments were ultimately required. aggregate amount we would need to pay for our partners’ • Operating joint ventures to which we contribute an office membership interests in these joint ventures to be $2.1 mil- property to partially dispose of our interest (the lion; however, since the determination of this amount is “Disposition JV”). During 2004, we owned one investment dependent on the operations of the office properties and in a Disposition JV to which we previously contributed an none of these properties are both completed and occu- office property in exchange for cash and a 20% interest in pied, this estimate is preliminary and could be materially the joint venture. This Disposition JV enabled us to dis- different from the actual obligation. pose of most of our investment in a property that we • Construction joint ventures managed by us (the “Internally- believe realized most of its earnings growth potential. We Managed JV”). During 2004, we had one investment in an manage the joint venture’s property operations and any Internally-Managed JV until we acquired for $4.9 million required construction projects and earn fees for these serv- the interest of our joint venture partner on September 10, ices. Our joint venture partner has preference in receiving 2004. We accounted for this investment using the financ- distributions of cash flows for a defined return; once our ing method of accounting until March 31, 2004, at which partner receives its defined return, we are entitled to point we began to use the consolidation method of receive distributions for a defined return and, once we accounting in connection with our adoption of FIN 46(R) receive that return, remaining distributions of cash flows (see Note 2 to the Consolidated Financial Statements). are allocated based on percentages defined in the joint Our partner in the project owned a majority of the joint venture agreement. CORPORATE OFFICE PROPERTIES TRUST 39 The table below sets forth certain additional information regarding these categories of real estate joint ventures for the period of time that such joint ventures were not consolidated (in thousands): Category of Real Estate Joint Venture Externally-Managed JVs Disposition JV Internally-Managed JVs Investment Balances at 12/31/04 $ — 1,201 — $1,201 Net Cash Outflow to Category in 2004 $(515) (146) — $(661) Loss from Category in 2004 $(88) — — $(88) Fees Earned from Category in 2004(1) Balance of Debt Unilaterally Fund Obligation to Guaranteed by Us at 12/31/2004(2) Additional Project Costs (if necessary)(3) $ — 183 36 $219 $— — — $— $ — 420 — $420 (1) Fees earned by us for construction, asset management and property management services provided to joint ventures. (2) Excludes debt guaranteed by us for an externally-managed JV that is accounted for using the consolidation method of accounting. (3) Amounts reported in this column represent additional investments we could be required to fund on a unilateral basis. We are also required to unilaterally fund leasing commissions incurred, if any, above a market rate specified in the joint venture agreement for the Disposition JV. We and our partners are also required to fund proportionally (based on our ownership percentage) additional amounts when needed by the Externally-Managed JVs and Disposition JV. Since the additional fundings described in this footnote are uncertain in dollar amount and we do not expect that they will be necessary, they are not included in the table. You should refer to Notes 5 and 19 for additional informa- Analysis of Indebtedness tion pertaining to our investments in unconsolidated real The timing and nature (fixed-rate versus variable-rate) of the estate joint ventures. scheduled maturities on our debt are discussed in the section On April 26, 2004, we sold for $9.6 million a land parcel in entitled “Quantitative and Qualitative Disclosures about Columbia, Maryland and a land parcel in Linthicum, Maryland. Market Risk.” We issued to the buyer a $5.6 million mortgage loan bearing We often use our Revolving Credit Facility initially to interest at 5.5% and a maturity date of July 2005; the balance finance much of our investing and financing activities. We then of the acquisition was in the form of cash from the buyer. Upon pay down our Revolving Credit Facility using proceeds from completion of the sale, we entered into an agreement with long-term borrowings collateralized by our properties as the buyer to lease the land parcels for an aggregate monthly attractive financing conditions arise and equity issuances as payment of $10,000 from July 1, 2004 until April 30, 2005, at attractive equity market conditions arise. Our Revolving Credit which time the rent reduces to $1,000 per month until 2079. Facility from the beginning of the periods reported herein until The buyer in this transaction had an option to contribute the March 10, 2004 was with Bankers Trust Company. However, on two land parcels into our Operating Partnership between March 10, 2004, we obtained a new Revolving Credit Facility January 1, 2005 and February 28, 2005 in exchange for extin- with a group of lenders headed by Wachovia Bank, National guishment of the $5.6 million mortgage loan with us and Association. The maximum principal under the new Revolving $4.0 million in common units in our Operating Partnership; Credit Facility with Wachovia Bank, National Association is the buyer in the transaction exercised its option in February $300.0 million, with amounts available generally being com- 2005 and, as a result, the debt from us will be extinguished puted based on 60% of the unencumbered asset pool value. and it will receive 154,440 common units in the Operating Based on assets encumbered, the full $300.0 million was avail- Partnership in March 2005. We accounted for this transac- able as of March 15, 2005, $63.4 million of which was unused. tion using the financing method of accounting; as a result, Certain of our mortgage loans require that we comply with the transaction was not recorded as a sale and the $4.0 mil- a number of restrictive financial covenants, including leverage lion in net proceeds received from the buyer is included in ratio, adjusted consolidated net worth, minimum property other liabilities on our consolidated balance sheet as of interest coverage, minimum property hedged interest cover- December 31, 2004. age, minimum consolidated interest coverage, minimum fixed We had no other material off-balance sheet arrangements charge coverage, minimum debt service coverage, maximum during 2004. consolidated unhedged floating rate debt and maximum con- solidated total indebtedness. As of December 31, 2004, we were in compliance with these financial covenants. 40 CORPORATE OFFICE PROPERTIES TRUST Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2004 (in thousands): Contractual obligations(1)(2) Mortgage loans payable(3) Acquisitions of properties(4) New construction and development contracts and obligations(5)(6) Third-party construction and development contracts(6)(7) Capital expenditures for operating properties(6)(8) Operating leases(9) Capital lease obligations(9) Other purchase obligations(9) For the Years Ended December 31, 2005 2006 to 2007 2008 to 2009 Thereafter Total $ 60,026 $428,139 $215,772 $317,182 $1,021,119 9,816 2,000 54,711 56,723 10,523 1,006 18 687 — — — 897 — 1,045 — — — — 191 — 835 4,000 15,816 — — — 837 — 1,822 54,711 56,723 10,523 2,931 18 4,389 Total contractual cash obligations $193,510 $432,081 $216,798 $323,841 $1,166,230 (1) The contractual obligations set forth in this table generally exclude individual contracts that had a value of less than $20 thousand. Also excluded are contracts associated with the operations of our properties that may be terminated with notice of one month or less, which is the arrangement that applies to most of our property operations contracts. (2) Not included in this section are amounts contingently payable by us to acquire the membership interests of certain real estate joint ven- ture partners. See the section entitled “Off Balance Sheet Arrangements” for further discussion of such amounts. (3) Represents principal maturities only and therefore excludes net premiums of $1.6 million. Our loan maturities in 2005 include $41.5 mil- lion that we expect to refinance; the balance of the 2005 maturities represents scheduled principal amortization payments that we expect to pay using cash flow from operations. (4) Represents contractual obligations at December 31, 2004 to purchase a land parcel in Linthicum, Maryland and a leasehold interest in a property located in Washington County, Maryland. We expect to acquire these properties in 2005 using borrowings under the Revolving Credit Facility. A $4.0 million final payment of the acquisition cost of the leasehold interest included in the “Thereafter” column could be reduced by a range of $750,000 to the full $4.0 million; the amount of such decrease will be determined based on defined levels of job creation resulting from the future development of the property taking place. (5) Represents contractual obligations pertaining to new construction and development activities. We expect to finance these costs primarily using proceeds from our Revolving Credit Facility and construction loans. (6) Because of the long-term nature of certain construction and development contracts, some of these costs will be incurred beyond 2005. (7) Represents contractual obligations pertaining to projects for which we are acting as construction manager on behalf of unrelated parties who are our clients. We expect to be reimbursed in full for these costs by our clients. (8) Represents contractual obligations pertaining to capital expenditures for our operating properties. We expect to finance all of these costs using cash flow from operations. (9) We expect to pay these items using cash flow from operations. CORPORATE OFFICE PROPERTIES TRUST 41 Investing and Financing Activity Subsequent to December 31, 2004 of our common and preferred shares. As is the case with any publicly-traded securities, certain factors outside of On January 27, 2005, we purchased a 19-acre land parcel our control could influence the value of our common and located in Chantilly, Virginia adjacent to a property that we preferred shares. These conditions include, but are not lim- already own. The purchase price of $7.1 million was financed ited to (1) market perception of REITs in general and office using borrowings from our Revolving Credit Facility. REITs in particular, (2) market perception of REITs relative Other Future Cash Requirements for Investing and Financing Activities to other investment opportunities, (3) the level of institu- tional investor interest in our company, (4) general eco- nomic and business conditions, (5) prevailing interest rates As previously discussed, as of December 31, 2004, we had and (6) market perception of our financial condition, per- construction activities underway on seven office properties formance, dividends and growth potential. totaling 907,119 square feet that were 36.5% pre-leased. We • We may from time to time pursue selective acquisitions estimate remaining costs to be incurred will total approxi- outside of the Mid-Atlantic region, expanding into regions mately $89.8 million upon completion of these properties, where we do not currently have properties. These acquisi- most of which we expect to incur in 2005. We have $39.7 mil- tions may entail risks in addition to those we have faced in lion remaining to be borrowed under a $63.0 million construc- past acquisitions, such as the risk that we do not correctly tion loan facility for three of the properties; we expect to fund anticipate conditions or trends in a new region, and are most of the remaining costs for these activities using proceeds therefore not able to operate the acquired property prof- from new construction loan facilities. itably. If this occurred, it could adversely affect our finan- As of December 31, 2004, we had pre-construction activi- cial performance and our ability to make distributions to ties underway on four office properties estimated to total our shareholders. 536,607 square feet. We estimate that costs for these proper- • When we develop and construct properties, we assume ties will total approximately $99.2 million. As of December 31, the risk that actual costs will exceed our budgets, that we 2004, costs incurred on these properties totaled $18.9 million will experience construction or development delays and and the balance is expected to be incurred in 2005 and 2006. that projected leasing will not occur, any of which could We expect to fund most of these costs using borrowings from adversely affect our financial performance and our ability new construction loan facilities. to make distributions to our shareholders. In addition, we During 2005 and beyond, we expect to complete other generally do not obtain construction financing commit- acquisitions of properties and commence construction and ments until the development stage of a project is com- development activities in addition to the ones previously plete and construction is about to commence. We may find described. We expect to finance these activities as we have in that we are unable to obtain financing needed to continue the past, using mostly a combination of borrowings from new with the construction activities for such projects. loans, borrowings under our Revolving Credit Facility and addi- • We invest in certain entities in which we are not the exclu- tional equity issuances of common and/or preferred shares. sive investor or principal decision maker. Aside from our Factors that could negatively affect our ability to finance inability to unilaterally control the operations of these joint our long-term financing and investing needs in the future ventures, our investments entail the additional risks that include the following: (1) the other parties to these investments may not fulfill • Our strategy is to operate with slightly higher debt levels their financial obligations as investors, in which case we than many other REITs. However, these higher debt levels may need to fund such parties’ share of additional capital could make it difficult to obtain additional financing when requirements and (2) the other parties to these investments required and could also make us more vulnerable to an may take actions that are inconsistent with our objectives. economic downturn. Most of our properties have been • Real estate investments can be difficult to sell and convert mortgaged to collateralize indebtedness. In addition, we to cash quickly, especially if market conditions are rely on borrowings to fund some or all of the costs of new depressed. Such illiquidity will tend to limit our ability to property acquisitions, construction and development activ- vary our portfolio of properties promptly in response to ities and other items. changes in economic or other conditions. Moreover, under • We may not be able to refinance our existing indebtedness. certain circumstances, the Internal Revenue Code imposes • Much of our ability to raise capital through the issuance of certain penalties on a REIT that sells property held for less preferred shares, common shares or securities that are con- than four years. In addition, for certain of our properties vertible into our common shares is dependent on the value that we acquired by issuing units in our Operating 42 CORPORATE OFFICE PROPERTIES TRUST Partnership, we are restricted by agreements with the sellers Statements. The following section is a summary of certain of the properties for a certain period of time from entering aspects of those accounting policies involving estimates and into transactions (such as the sale or refinancing of the assumptions that (1) require our most difficult, subjective or acquired property) that will result in a taxable gain to the complex judgments in accounting for highly uncertain matters sellers without the sellers’ consent. Due to all of these factors, or matters that are susceptible to change and (2) materially we may be unable to sell a property at an advantageous affect our reported operating performance or financial con- time to fund our long-term capital needs. dition. It is possible that the use of different reasonable esti- • We are subject to various federal, state and local environ- mates or assumptions in making these judgments could result mental laws. These laws can impose liability on property in materially different amounts being reported in our owners or operators for the costs of removal or remedia- Consolidated Financial Statements. While reviewing this sec- tion of hazardous substances released on a property, even tion, you should refer to Note 3 to our Consolidated Financial if the property owner was not responsible for the release Statements, including terms defined therein. of the hazardous substances. Costs resulting from environ- • When we acquire real estate properties, we allocate the mental liability could be substantial. The presence of haz- acquisition to numerous components. Most of the terms ardous substances on our properties may also adversely in this bullet section are defined in the section of Note 3 affect occupancy and our ability to sell or borrow against to the Consolidated Financial Statements entitled those properties. In addition to the costs of government “Acquisitions of Real Estate.” Our process for determin- claims under environmental laws, private plaintiffs may ing the allocation to these components is very complex bring claims for personal injury or other reasons. and requires many estimates and assumptions. Included Additionally, various laws impose liability for the costs of among these estimates and assumptions are the following: removal or remediation of hazardous substances at the dis- (1) determination of market rental rate, (2) estimates of leas- posal or treatment facility. Anyone who arranges for the ing and tenant improvement costs associated with the disposal or treatment of hazardous substances at such a remaining term of acquired leases for deemed cost avoid- facility is potentially liable under such laws. These laws ance, (3) leasing assumptions used in determining the as-if often impose liability on an entity even if the facility was vacant value and lease-up value, including the rental rates, not owned or operated by the entity. period of time that it will take to lease vacant space and estimated tenant improvement and leasing costs, (4) esti- Management Change Subsequent to December 31, 2004 mate of the property’s future value in determining the as-if On February 24, 2005, the following events took place: vacant value, (5) estimate of value attributable to market • Clay W. Hamlin, III, our Chief Executive Officer, retired concentration premiums and tenant relationship values effective April 1, 2005. Mr. Hamlin will remain on the Board and (6) allocation of the as-if vacant value between land of Trustees, of which he was appointed Vice Chairman and building. A change in any of the above key assump- effective April 1, 2005. He will also enter into a three-year tions, most of which are extremely subjective, can materi- consulting agreement with us effective April 1, 2005 to ally change not only the presentation of acquired assist with acquisitions and strategic initiatives; and properties in our Consolidated Financial Statements but • Randall M. Griffin, our current President and Chief also reported results of operations. The allocation to dif- Operating Officer, was appointed to the position of ferent components affects the following: President and Chief Executive Officer effective April 1, 2005. • Amount of the acquisition costs allocated among dif- Mr. Griffin was also elected as a Class I Trustee of our Board ferent categories of assets and liabilities on our bal- of Trustees effective February 24, 2005. The terms of our ance sheet, the amount of costs assigned to individual Class I Trustees will expire upon the election of their suc- properties in multiple property acquisitions and the cessors at our next annual shareholder meeting, to be held amount of costs assigned to individual tenants at the on May 19, 2005 (the “2005 Annual Meeting”). Mr. Griffin time of acquisition; was nominated to stand for re-election at that time. • Where the amortization of the components appears CRITICAL ACCOUNTING POLICIES AND ESTIMATES the lease to market value component are amortized Our Consolidated Financial Statements are prepared in accor- into rental revenue, whereas allocations to most of the dance with GAAP, which require us to make certain estimates other components (the one exception being the land and assumptions. A summary of our significant accounting component of the as-if vacant value) are amortized into policies is provided in Note 3 to our Consolidated Financial depreciation and amortization expense. As a REIT, this over time in our statements of operations. Allocations to CORPORATE OFFICE PROPERTIES TRUST 43 is important to us since much of the investment com- regarding the entity’s future operating performance, finan- munity evaluates our operating performance using non- cial condition, future valuation and other variables that may GAAP measures such as funds from operations, the affect the partners’ share of cash flow from the entity over computation of which includes rental revenue but does time; we also need to estimate the probability of different not include depreciation and amortization expense; scenarios taking place over time and project the effect that • Timing over which the items are recognized as revenue each of those scenarios would have on variables affecting or expense in our statements of operations. For exam- the partners’ cash flow. The conclusion reached as a result ple, for allocations to the as-if vacant value, the land por- of this process affects whether or not we use the consolida- tion is not depreciated and the building portion is tion method in accounting for our investment or either the depreciated over a longer period of time than the other equity or financing method of accounting. Whether or not components (generally 40 years). Allocations to lease to we consolidate an investment can materially affect our market value, deemed cost avoidance, lease-up value Consolidated Financial Statements. and tenant relationship value are amortized over signif- icantly shorter timeframes, and if individual tenants’ FUNDS FROM OPERATIONS leases are terminated early, any unamortized amounts Funds from operations (“FFO”) is defined as net income com- remaining associated with those tenants are generally puted using GAAP, excluding gains (or losses) from sales of expensed upon termination. These differences in tim- real estate, plus real estate-related depreciation and amorti- ing can materially affect our reported results of opera- zation and after adjustments for unconsolidated partnerships tions. In addition, we establish lives for lease-up value and joint ventures. Gains from sales of newly-developed prop- and tenant relationship value based on our estimates of erties less accumulated depreciation, if any, required under how long we expect the respective tenants to remain in GAAP are included in FFO on the basis that development the properties; establishing these lives requires estimates services are the primary revenue generating activity; we and assumptions that are very subjective. believe that inclusion of these development gains is in accor- • When events or circumstances indicate that a property may dance with the National Association of Real Estate Investment be impaired, we perform an undiscounted cash flow analy- Trusts (“NAREIT”) definition of FFO, although others may sis. We consider an asset to be impaired when its undis- interpret the definition differently. Additionally, the repur- counted expected future cash flows are less than its chase of the Series C Preferred Units in the Operating depreciated cost. If such impairment is present, an impair- Partnership for an amount in excess of their recorded book ment loss is recognized based on the excess of the carry- value was a transaction not contemplated in the NAREIT def- ing amount of the asset over its fair value. We compute a inition of FFO; we believe that the exclusion of such an real estate asset’s undiscounted expected future cash flows amount from FFO is appropriate. and fair value using certain estimates and assumptions. As Accounting for real estate assets using historical cost a result, these estimates and assumptions impact whether accounting under GAAP assumes that the value of real an impairment is deemed to have occurred and the estate assets diminishes predictably over time. NAREIT amount of impairment loss that we recognize. stated in its April 2002 White Paper on Funds from • We use four different accounting methods to report our Operations that “since real estate asset values have histor- investments in entities: the consolidation method, the ically risen or fallen with market conditions, many industry equity method, the cost method and the financing method investors have considered presentations of operating results (see Note 2 to our Consolidated Financial Statements). We for real estate companies that use historical cost account- use the cost method when we own an interest in an entity ing to be insufficient by themselves.” As a result, the con- and cannot exert significant influence over the entity’s oper- cept of FFO was created by NAREIT for the REIT industry ations. When the cost method does not apply, we evalu- to “address this problem.” We agree with the concept of ate whether or not we can exert significant influence over FFO and believe that FFO is useful to management and the entity’s operations but cannot control the entity’s oper- investors as a supplemental measure of operating perform- ations; when considering that, we need to determine ance because, by excluding gains and losses related to sales whether a situation exists in which the entity is controlled of previously depreciated operating real estate properties by its owners (either us or our joint venture partners) with- and excluding real estate-related depreciation and amorti- out such owners owning most of the outstanding voting zation, FFO can help one compare our operating perform- rights in the entity. In performing this evaluation, we typ- ance between periods. In addition, since most equity REITs ically need to make subjective estimates and judgments provide FFO information to the investment community, we 44 CORPORATE OFFICE PROPERTIES TRUST believe that FFO is useful to investors as a supplemental Diluted FFO per share does not assume conversion of securi- measure for comparing our results to those of other equity ties that are convertible into common shares if the conversion REITs. We believe that net income is the most directly com- of those securities would increase Diluted FFO per share in a parable GAAP measure to FFO. given period. We believe that Diluted FFO per share is use- Since FFO excludes certain items includable in net income, ful to investors because it provides investors with a further reliance on the measure has limitations; management com- context for evaluating our FFO results in the same manner pensates for these limitations by using the measure simply as that investors use earnings per share (“EPS”) in evaluating net a supplemental measure that is weighed in the balance with income available to common shareholders. In addition, since other GAAP and non-GAAP measures. FFO is not necessarily most equity REITs provide Diluted FFO per share information an indication of our cash flow available to fund cash needs. to the investment community, we believe Diluted FFO per Additionally, it should not be used as an alternative to net share is a useful supplemental measure for comparing us to income when evaluating our financial performance or to cash other equity REITs. We believe that diluted EPS is the most flow from operating, investing and financing activities when directly comparable GAAP measure to Diluted FFO per share. evaluating our liquidity or ability to make cash distributions Diluted FFO per share has most of the same limitations as or pay debt service. The FFO we present may not be compa- Diluted FFO (described below); management compensates rable to the FFO presented by other REITs since they may for these limitations in essentially the same manner as interpret the current NAREIT definition of FFO differently or described below for Diluted FFO. they may not use the current NAREIT definition of FFO. Diluted funds from operations (“Diluted FFO”) is Basic FFO Basic funds from operations (“Basic FFO”) is FFO adjusted adjusted to add back any convertible preferred share divi- to (1) subtract preferred share dividends and (2) add back dends and any other changes in Basic FFO that would result GAAP net income allocated to common units in the from the assumed conversion of securities that are convertible Operating Partnership not owned by us. With these adjust- or exchangeable into common shares. However, the compu- ments, Basic FFO represents FFO available to common share- tation of Diluted FFO does not assume conversion of securi- holders and common unitholders. Common units in the ties that are convertible into common shares if the conversion Operating Partnership are substantially similar to our com- of those securities would increase Diluted FFO per share in a mon shares; common units in the Operating Partnership are given period. We believe that Diluted FFO is useful to also exchangeable into common shares, subject to certain investors because it is the numerator used to compute Diluted conditions. We believe that Basic FFO is useful to investors FFO per share. In addition, since most equity REITs provide due to the close correlation of common units to common Diluted FFO information to the investment community, we shares. We believe that net income is the most directly com- believe Diluted FFO is a useful supplemental measure for parable GAAP measure to Basic FFO. Basic FFO has essen- comparing us to other equity REITs. We believe that the tially the same limitations as FFO; management compensates numerator for diluted EPS is the most directly comparable for these limitations in essentially the same manner as GAAP measure to Diluted FFO. Since Diluted FFO excludes described above for FFO. certain items includable in the numerator to diluted EPS, Diluted funds from operations per share (“Diluted FFO per reliance on the measure has limitations; management com- share”) is (1) Basic FFO adjusted to add back any convertible pensates for these limitations by using the measure simply as preferred share dividends and any other changes in Basic FFO a supplemental measure that is weighed in the balance with that would result from the assumed conversion of securities other GAAP and non-GAAP measures. Diluted FFO is not nec- that are convertible or exchangeable into common shares essarily an indication of our cash flow available to fund cash divided by (2) the sum of the (a) weighted average common needs. Additionally, it should not be used as an alternative shares outstanding during a period, (b) weighted average to net income when evaluating our financial performance or common units outstanding during a period and (c) weighted to cash flow from operating, investing and financing activities average number of potential additional common shares that when evaluating our liquidity or ability to make cash distribu- would have been outstanding during a period if other secu- tions or pay debt service. The Diluted FFO that we present rities that are convertible or exchangeable into common shares may not be comparable to the Diluted FFO presented by were converted or exchanged. However, the computation of other REITs. CORPORATE OFFICE PROPERTIES TRUST 45 Our FFO, Basic FFO, Diluted FFO per share and Diluted FFO for 2000 through 2004 and reconciliations of (1) net income to FFO, (2) the numerator for diluted EPS to diluted FFO and (3) the denominator for diluted EPS to the denominator for diluted FFO per share are set forth in the following table (dollars and shares in thousands, except per share data): (Dollars and shares in thousands, except per share data) 2004 2003 2002 2001 2000 Net income $ 37,032 $ 30,877 $ 23,301 $19,922 $15,134 Add: Real estate-related depreciation and amortization 51,371 36,681 30,832 20,558 16,887 For the Years Ended December 31, Add: Depreciation and amortization on unconsolidated real estate entities Less: Depreciation and amortization allocable to minority interests in other consolidated entities Less: Gain on sales of real estate, excluding development and redevelopment portion(1) Less: Issuance costs associated with redeemed preferred shares Add: Cumulative effect of accounting change FFO Add: Minority interests-common units in the Operating Partnership Less: Preferred share dividends Basic FFO Add: Preferred unit distributions Add: Convertible preferred share dividends Add: Restricted common share dividends Expense associated with dilutive options 106 (86) 295 — 165 — 144 — — — (95) (2,897) (268) (416) (107) (1,813) — — — — — — 263 — — 86,515 64,956 54,030 40,471 31,914 5,659 (16,329) 75,845 — 21 382 — 6,712 5,800 (12,003) (10,134) 59,665 1,049 544 — 10 49,696 2,287 544 283 44 6,592 (6,857) 40,206 2,287 508 — — 6,322 (3,802) 34,434 2,240 677 — — Diluted FFO $ 76,248 $ 61,268 $ 52,854 $43,001 $37,351 Weighted average common shares Conversion of weighted average common units Weighted average common shares/units—basic FFO Assumed conversion of weighted average convertible preferred units Assumed conversion of share options Assumed conversion of weighted average convertible preferred shares Assumed conversion of common unit warrants Restricted common shares 33,173 8,726 41,899 — 1,675 134 — 221 26,659 8,932 35,591 1,101 1,405 22,472 9,282 31,754 2,421 936 20,099 9,437 29,536 2,421 406 1,197 1,197 1,118 — — — 326 — — 18,818 9,652 28,470 2,371 164 918 231 — Weighted average common shares/units—diluted FFO 43,929 39,294 36,634 33,481 32,154 Diluted FFO per share $ 1.74 $ 1.56 $ 1.44 $ 1.28 $ 1.16 46 CORPORATE OFFICE PROPERTIES TRUST (Dollars and shares in thousands, except per share data) 2004 2003 2002 2001 2000 For the Years Ended December 31, Numerator for diluted EPS Add: Minority interests-common units in the Operating Partnership Add: Real estate-related depreciation and amortization Add: Depreciation and amortization on unconsolidated real estate entities Less: Depreciation and amortization allocable to minority interests in other consolidated entities Less: Gain on sales of real estate, excluding development and redevelopment portion(1) Add: Convertible preferred share dividends Add: Preferred unit distributions Add: Expense associated with dilutive options Add: Restricted common share dividends Add: Repurchase of Series C Preferred Units in excess of recorded book value Add: Cumulative effect of accounting change Diluted FFO Denominator for diluted EPS Weighted average common units Assumed conversion of weighted average convertible preferred shares Assumed conversion of weighted average convertible preferred units Restricted common shares Additional dilutive options $18,911 $ 7,650 $13,711 $13,573 $11,332 5,659 51,371 6,712 36,681 5,800 30,832 6,592 20,558 6,322 16,887 106 (86) 295 — (95) (2,897) — — — 382 — — 544 1,049 10 — 11,224 — 165 — (268) — 2,287 44 283 — — 144 — (416) — 2,287 — — — 263 — — (107) 677 2,240 — — — — $76,248 $61,268 $52,854 $43,001 $37,351 34,982 8,726 28,021 8,932 24,547 9,282 21,623 9,437 19,213 9,652 — 1,197 — — 918 — 221 — 1,101 2,421 2,421 2,371 — 43 326 58 — — — — Denominator for Diluted FFO per share 43,929 39,294 36,634 33,481 32,154 (1) Gains from the sale of real estate that are attributable to sales of non-operating properties are included in FFO. Gains from newly- developed or re-developed properties less accumulated depreciation, if any, required under GAAP are also included in FFO on the basis that development services are the primary revenue generating activity; we believe that inclusion of these development gains is in compliance with the NAREIT definition of FFO, although others may interpret the definition differently. CORPORATE OFFICE PROPERTIES TRUST 47 INFLATION QUANTITATIVE AND QUALITATIVE DISCLOSURES Our operations were not significantly affected by inflation ABOUT MARKET RISK during the periods presented in this report due primarily to We are exposed to certain market risks, the most predomi- the relatively low inflation rates in our markets. Most of our nant of which is change in interest rates. Increases in interest tenants are obligated to pay their share of a building’s oper- rates can result in increased interest expense under our ating expenses to the extent such expenses exceed amounts Revolving Credit Facility and our other mortgage loans established in their leases, based on historical expense lev- payable carrying variable interest rate terms. Increases in inter- els. In addition, some of our tenants are obligated to pay their est rates can also result in increased interest expense when full share of a building’s operating expenses. These arrange- our loans payable carrying fixed interest rate terms mature ments somewhat reduce our exposure to increases in such and need to be refinanced. Our debt strategy favors long- costs resulting from inflation. term, fixed-rate, secured debt over variable-rate debt to min- Our costs associated with constructing buildings and com- imize the risk of short-term increases in interest rates. As of pleting renovation and tenant improvement work increased December 31, 2004, 72.2% of our mortgage and other loans due to higher cost of materials. We expect to recover a portion payable balance carried fixed interest rates and 94.9% of our of these costs through higher tenant rents and reimburse- fixed-rate loans were scheduled to mature after 2005. As of ments for tenant improvements. The additional costs that we December 31, 2004, the percentage of variable-rate loans rel- do not recover increase depreciation expense as projects are ative to total assets was 16.4%. completed and placed into service. The following table sets forth our long-term debt obligations, principal cash flows by scheduled maturity and weighted average interest rates at December 31, 2004 (dollars in thousands): 2005 2006 2007(1) 2008 2009 Thereafter Total For the Years Ended December 31, Long term debt: Fixed rate(2) Average interest rate Variable rate Average interest rate $37,418 6.26% $22,608 4.13% $78,904 6.58% $ — $ 87,803 $155,003 6.63% 6.76% $261,432 $ — 3.67% — — $60,769 6.16% $ — — $317,182 $737,079 $ 5.71% — — 6.14% $284,040 4.00% (1) Includes maturities totaling $261.4 million that may be extended for a one-year period, subject to certain conditions. (2) Represents principal maturities only and therefore excludes net premiums of $1.6 million. The fair market value of our mortgage and other loans payable was $1.04 billion at December 31, 2004 and $771.4 million at December 31, 2003. The following table sets forth information pertaining to our derivative contract in place as of December 31, 2004 and its fair value: Nature of Derivative Notional Amount (in millions) Interest rate swap $50.0 One-Month LIBOR base 2.308% Effective Date 1/2/03 Expiration Date 1/3/05 Fair value on December 31, 2004 (in thousands) $— Based on our variable-rate debt balances, our interest expense would have increased by $2.0 million in 2004 and $1.4 mil- lion in 2003 if short-term interest rates were 1% higher. Interest expense in 2004 was more sensitive to a change in interest rates than 2003 due to a higher average variable-rate debt balance in 2004. RECENT ACCOUNTING PRONOUNCEMENTS For disclosure regarding recent accounting pronouncements and the anticipated impact they will have on our operations, you should refer to Note 3 to our Consolidated Financial Statements. 48 CORPORATE OFFICE PROPERTIES TRUST Consolidated Balance Sheets (Dollars in thousands) Assets Investment in real estate: Operating properties, net Projects under construction or development Total commercial real estate properties, net Investments in and advances to unconsolidated real estate joint ventures Investment in real estate, net Cash and cash equivalents Restricted cash Accounts receivable, net Investments in and advances to other unconsolidated entities Deferred rent receivable Intangible assets on real estate acquisitions, net Deferred charges, net Prepaid and other assets Furniture, fixtures and equipment, net Total assets Liabilities and shareholders’ equity Liabilities: Mortgage and other loans payable Accounts payable and accrued expenses Rents received in advance and security deposits Dividends and distributions payable Deferred revenue associated with acquired operating leases Fair value of derivatives Other liabilities Total liabilities Minority interests: Common units in the Operating Partnership Preferred units in the Operating Partnership Other consolidated real estate joint ventures Total minority interests Commitments and contingencies (Note 19) Shareholders’ equity: Preferred Shares of beneficial interest ($0.01 par value; 15,000,000 shares authorized) (Note 11) Common Shares of beneficial interest ($0.01 par value; 75,000,000 shares authorized, shares issued of 36,842,108 at December 31, 2004 and 29,397,267 at December 31, 2003) Additional paid-in capital Cumulative distributions in excess of net income Value of unearned restricted common share grants Accumulated other comprehensive loss Total shareholders’ equity Total liabilities and shareholders’ equity See accompanying notes to consolidated financial statements. December 31, 2004 2003 $1,407,148 $1,116,847 136,152 1,543,300 1,201 67,149 1,183,996 5,262 1,544,501 1,189,258 13,821 12,617 16,771 1,621 26,282 67,560 27,642 18,646 2,565 9,481 11,030 13,047 1,621 17,903 55,692 17,723 14,311 2,010 $1,732,026 $1,332,076 $1,022,688 $ 738,698 46,307 12,781 14,713 7,247 — 7,488 23,126 10,112 12,098 9,630 467 7,768 1,111,224 801,899 88,355 8,800 1,723 98,878 67 368 578,228 (51,358) (5,381) — 521,924 79,796 — — 79,796 85 294 492,886 (38,483) (4,107) (294) 450,381 $1,732,026 $1,332,076 CORPORATE OFFICE PROPERTIES TRUST 49 Consolidated Statements of Operations (Dollars in thousands, except per share data) Revenues Rental revenue Tenant recoveries and other real estate operations revenue Construction contract revenues Other service operations revenues Total revenues Expenses Property operating Depreciation and other amortization associated with real estate operations Construction contract expenses Other service operations expenses General and administrative expenses Total operating expenses Operating income Interest expense Amortization of deferred financing costs For the Years Ended December 31, 2004 2003 2002 $192,353 $153,048 $134,421 22,220 25,018 3,885 21,375 28,865 2,875 15,914 826 3,851 243,476 206,163 155,012 63,053 51,904 23,733 3,263 10,938 152,891 90,585 (44,263) (2,431) 51,699 37,122 27,483 3,450 7,893 127,647 78,516 (41,079) (2,767) 43,929 30,859 789 4,192 6,697 86,466 68,546 (39,065) (2,501) 26,980 2,564 (402) 347 Income from continuing operations before (loss) gain on sales of real estate, equity in loss of unconsolidated entities, income taxes and minority interests 43,891 34,670 (Loss) gain on sales of real estate, excluding discontinued operations Equity in loss of unconsolidated entities Income tax (expense) benefit (150) (88) (795) 472 (98) 169 Income from continuing operations before minority interests 42,858 35,213 29,489 Minority interests in income from continuing operations Common units in the Operating Partnership Preferred units in the Operating Partnership Other consolidated entities Income from continuing operations Income from discontinued operations, net of minority interests Net income Preferred share dividends Repurchase of preferred units in excess of recorded book value Issuance costs associated with redeemed preferred shares (5,659) (179) 12 37,032 — 37,032 (16,329) — (1,813) (5,710) (1,049) — 28,454 2,423 30,877 (12,003) (11,224) — (5,233) (2,287) 59 22,028 1,273 23,301 (10,134) — — Net income available to common shareholders $ 18,890 $ 7,650 $ 13,167 Basic earnings per common share Income before discontinued operations Discontinued operations Net income available to common shareholders Diluted earnings per common share Income before discontinued operations Discontinued operations Net income available to common shareholders See accompanying notes to consolidated financial statements. $ $ $ $ 0.57 — 0.57 0.54 — 0.54 $ $ $ $ 0.20 0.09 0.29 0.19 0.08 0.27 $ $ $ $ 0.53 0.06 0.59 0.51 0.05 0.56 50 CORPORATE OFFICE PROPERTIES TRUST Consolidated Statements of Shareholders’ Equity Cumulative Distributions Unearned Value of Accumulated Other (Dollars in thousands) Balance at December 31, 2001 Preferred Common Shares Shares Additional Paid-in Capital in Excess of Net Income Restricted Compre- hensive Common Loss Share Grants Total (20,648,101 common shares outstanding) $ 43 $206 $283,949 $(14,502) $(3,275) $(2,500) $263,921 Conversion of common units to common shares (617,510 shares) Common shares issued to the public (2,084,828 shares) Increase in fair value of derivatives Value of earned restricted share grants Exercise of share options (255,692 shares) Net expense reversal associated with share options Adjustments to minority interests resulting from changes in ownership of Operating Partnership by COPT Net income Dividends Balance at December 31, 2002 (23,606,132 common shares outstanding) Conversion of common units to common shares (119,533 shares) Common shares issued to the public (5,290,000 shares) Series G Cumulative Redeemable Preferred Shares issued to the public (2,200,000 shares) Series H Cumulative Redeemable Preferred Shares issued to the public (2,000,000 shares) Series C Preferred Unit redemption Increase in fair value of derivatives Restricted common share grants issued (119,324 shares) Value of earned restricted share grants Exercise of share options (262,278 shares) Expense associated with share options Adjustments to minority interests resulting from changes in ownership of Operating Partnership by COPT Net income Dividends Balance at December 31, 2003 (29,397,267 common shares outstanding) Conversion of common units to common shares (326,108 shares) Common shares issued — — — — — — — — — 43 — — 22 20 — — — — — — — — — 85 — to the public (5,033,600 shares) — — Common shares issued to employees (4,000 shares) (13) Series B Preferred Share redemption (5) Series D Preferred Share conversion Increase in fair value of derivatives — Restricted common share grants issued (99,935 shares) — — Value of earned restricted share grants — Exercise of share options (784,398 shares) Expense associated with share options — Adjustments to minority interests resulting from changes in ownership of Operating Partnership by COPT — Permanent tax benefit on share-based compensation — — Net income Dividends — Balance at December 31, 2004 6 21 — — 3 — — — — 8,617 23,391 — 325 2,125 (64) — — — — — — (5,970) — — — 23,301 (29,866) — — — 536 — — — — — — 8,623 — 2,151 — — — 23,412 2,151 861 2,128 (64) — — — (5,970) 23,301 (29,866) 236 312,373 (21,067) (2,739) (349) 288,497 1 53 — — — — 1 — 3 — — — — 2,065 79,205 53,153 48,312 — — 1,750 185 2,465 75 — — — — (11,224) — — — — — — — — — — — (1,751) 383 — — (6,697) — — — 30,877 (37,069) — — — — — — — — 55 — — — — — — — 2,066 79,258 53,175 48,332 (11,224) 55 — 568 2,468 75 (6,697) 30,877 (37,069) 294 492,886 (38,483) (4,107) (294) 450,381 3 50 — — 12 — 1 — 8 — — — — — 8,038 115,184 91 (31,238) (7) — 2,270 388 7,502 519 — — — — — — — — — — (19,360) 1,955 — — — — 37,032 (49,907) — — — — — — (2,271) 997 — — — — — — — — — — — 294 — — — — — — — — 8,041 115,234 91 (31,251) — 294 — 1,385 7,510 519 (19,360) 1,955 37,032 (49,907) (36,842,108 common shares outstanding) $ 67 $368 $578,228 $(51,358) $(5,381) $ — $ 521,924 See accompanying notes to consolidated financial statements. CORPORATE OFFICE PROPERTIES TRUST 51 Consolidated Statements of Cash Flows (Dollars in thousands) Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Minority interests Depreciation and other amortization Amortization of deferred financing costs Amortization of value of acquired operating leases to rental revenue Equity in loss of unconsolidated entities Loss (gain) on sales of real estate, including amounts in discontinued operations Changes in operating assets and liabilities: Increase in deferred rent receivable Increase in accounts receivable, restricted cash and prepaid and other assets Increase in accounts payable, accrued expenses, rents received in advance and security deposits Other Net cash provided by operating activities Cash flows from investing activities For the Years Ended December 31, 2004 2003 2002 $ 37,032 $ 30,877 $ 23,301 5,826 51,904 2,431 (931) 88 150 7,761 37,141 2,799 (1,817) 98 (3,467) (8,372) (11,438) (4,670) (11,144) 5,850 1,954 84,494 9,278 927 67,783 8,028 31,340 2,501 (2,342) 402 (2,564) (2,327) (1,904) 4,721 1,086 62,242 Purchases of and additions to commercial real estate properties (251,982) (196,888) (133,553) Proceeds from sales of properties Investments in and advances to unconsolidated real estate joint ventures Leasing costs paid (Increase) decrease in advances to certain real estate joint ventures Proceeds from sales of unconsolidated real estate joint ventures Other Net cash used in investing activities Cash flows from financing activities Proceeds from mortgage and other loans payable Repayments of mortgage and other loans payable Deferred financing costs paid Increase (decrease) in other liabilities associated with financing activities Acquisition of partner interest in consolidated joint venture Net proceeds from issuance of common shares Net proceeds from issuance of preferred shares Repurchase of preferred units Redemption of preferred shares Dividends paid Distributions paid Other Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents Beginning of year End of year See accompanying notes to consolidated financial statements. — (146) (11,024) (515) — (125) 40,204 (7,062) (2,861) (2,520) — (3,822) 7,509 2,089 (5,974) 2,583 2,283 (3,508) (263,792) (172,949) (128,571) 573,879 270,956 306,317 (421,621) (271,146) (210,628) (3,436) 4,000 (4,928) 122,744 — — (31,251) (47,551) (8,435) 237 183,638 4,340 (1,681) 4,000 — 81,726 101,507 (35,591) — (34,719) (9,210) 2,814 108,656 3,490 (2,397) (11,336) — 25,541 — — — (28,997) (10,265) (2,555) 65,680 (649) 9,481 $ 13,821 $ 5,991 9,481 6,640 5,991 $ 52 CORPORATE OFFICE PROPERTIES TRUST Notes to Consolidated Financial Statements (Dollars in thousands, except per share data) 1. ORGANIZATION 2. BASIS OF PRESENTATION Corporate Office Properties Trust (“COPT”) and subsidiaries We use four different accounting methods to report our invest- (collectively, the “Company”) is a fully-integrated and self- ments in entities: the consolidation method, the equity method, managed real estate investment trust (“REIT”). We focus on the the cost method and the financing method. ownership, management, leasing, acquisition and development of suburban office properties. We typically focus our operations Consolidation Method geographically in select submarkets that are attractive to our We generally use the consolidation method when we own tenant base and in which we believe we can establish a critical most of the outstanding voting interests in an entity and can mass of square footage. At December 31, 2004, all of our prop- control its operations. Under the consolidation method of erties were located in the Mid-Atlantic region of the United accounting, the accounts of the entity being consolidated are States, although in accordance with our strategy of focusing on combined with our accounts. We eliminate balances and trans- submarkets that are attractive to our tenants, we may seek to actions between companies when we consolidate these expand our operations outside of that region. COPT is quali- accounts. For all of the periods presented, our Consolidated fied as a REIT as defined in the Internal Revenue Code of 1986 Financial Statements include the accounts of: and is the successor to a corporation organized in 1988. As of • COPT; December 31, 2004, our portfolio included 145 office proper- • the Operating Partnership and its subsidiary partnerships ties, including two properties owned through joint ventures. and LLCs; We conduct almost all of our operations through our operat- • the Service Companies; and ing partnership, Corporate Office Properties, L.P. (the “Operating • Corporate Office Properties Holdings, Inc. (of which we Partnership”), for which we are the managing general partner. own 100%). The Operating Partnership owns real estate both directly and Our approach to determining when the use of the consoli- through subsidiary partnerships and limited liability companies dation method is appropriate recently changed with our (“LLCs”). A summary of our Operating Partnership’s forms of adoption of Financial Accounting Standards Board (“FASB”) ownership and the percentage of those ownership forms owned Interpretation No. 46(R), “Consolidation of Variable Interest by COPT follows: Entities” (“FIN 46(R)”). FIN 46(R) provides guidance in identi- December 31, fying situations in which an entity is controlled by its owners Common Units Series B Preferred Units Series D Preferred Units Series E Preferred Units Series F Preferred Units Series G Preferred Units Series H Preferred Units Series I Preferred Units 2004 80% N/A N/A 100% 100% 100% 100% 0% 2003 without such owners owning most of the outstanding voting 75% rights in the entity; it defines the entity in such situations as a 100% 100% 100% 100% 100% 100% variable interest entity (“VIE”). FIN 46(R) then provides guid- ance in determining when an owner of a VIE should use the consolidation method in accounting for its investment in the VIE. We adopted FIN 46(R) immediately for all VIEs created subsequent to January 31, 2003 and effective March 31, 2004 for VIEs created prior to February 1, 2003. In connection with N/A our adoption of FIN 46(R), we began to use the consolidation method of accounting effective March 31, 2004 for our invest- The Operating Partnership also owns 100% of Corporate ments in the following joint ventures: MOR Forbes 2 LLC, Office Management, Inc. (“COMI”) (together with its sub- Gateway 70 LLC and MOR Montpelier 3 LLC, which were pre- sidiaries defined as the “Service Companies”). COMI’s con- viously accounted for using the equity method of accounting, solidated subsidiaries are set forth below: and NBP 220, LLC, which was previously accounted for using Entity Name Corporate Realty Type of Service Business the financing method of accounting (see below for a discus- Real Estate sion of the equity and financing methods). The effect of con- Management, LLC (“CRM”) Management solidating these joint ventures on our Consolidated Balance Corporate Development Construction Services, LLC (“CDS”) and Development Corporate Cooling Heating and and Controls, LLC (“CC&C”) Air Conditioning COMI owns 100% of these entities. Most of the services that CRM and CDS provide are for us. CORPORATE OFFICE PROPERTIES TRUST 53 Sheet upon our adoption of FIN 46(R) on March 31, 2004 is • the cash received from a joint venture in connection with set forth below. Operating properties Projects under construction or development Investments in and advances $ 2,176 17,959 our land contribution is reported as other liabilities on our Consolidated Balance Sheets. The liability is accreted towards the pre-determined purchase price over the life of our option to acquire our partner’s interest in the joint to unconsolidated real estate joint ventures (3,957) venture. We also report interest expense in connection with Restricted cash Accounts receivable, net Deferred rent receivable Deferred charges, net Prepaid and other assets 10 145 7 1,026 (3,263) the accretion of the liability; • as construction of a building on the land parcel is com- pleted and operations of the building commence, we report 100% of the revenues and expenses associated with the property on our Consolidated Statements of Mortgage and other loans payable (10,171) Operations; and Accounts payable and accrued expenses (2,737) • construction costs and debt activity for the real estate proj- Rents received in advance and security deposits Other liabilities Minority interests—other (347) 4,650 ect relating to periods after the land contribution are not reported by us. At the time we exercise the option to acquire our partner’s consolidated real estate joint ventures (5,498) joint venture interest, we begin consolidating the accounts of $ — the entity with our accounts. As discussed above, FIN 46(R) affects our determination of when to use the financing method Equity Method of accounting. We generally use the equity method of accounting when we own an interest in an entity and can exert significant influence 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES over the entity’s operations but cannot control the entity’s Use of Estimates in the operations. Under the equity method, we report: Preparation of Financial Statements • our ownership interest in the entity’s capital as an invest- We make estimates and assumptions when preparing finan- ment on our Consolidated Balance Sheets; and cial statements under generally accepted accounting princi- • our percentage share of the earnings or losses from the ples (“GAAP”). These estimates and assumptions affect entity in our Consolidated Statements of Operations. various matters, including: As discussed above, FIN 46(R) affects our determination of • the reported amounts of assets and liabilities in our when to use the equity method of accounting. Consolidated Balance Sheets at the dates of the finan- cial statements; Cost Method • the disclosure of contingent assets and liabilities at the We use the cost method of accounting when we own an inter- dates of the financial statements; and est in an entity and cannot exert significant influence over the • the reported amounts of revenues and expenses in our entity’s operations. Under the cost method, we report: Consolidated Statements of Operations during the report- • the cost of our investment in the entity as an investment ing periods. on our Consolidated Balance Sheets; and These estimates involve judgments with respect to, among • distributions to us of the entity’s earnings in our Consolidated other things, future economic factors that are difficult to pre- Statements of Operations. dict and are often beyond management’s control. As a result, actual amounts could differ from these estimates. Financing Method We use the financing method of accounting for certain real Acquisitions of Real Estate estate joint ventures. We use this method when we contribute We allocate the costs of real estate acquisitions to the follow- a parcel of land into a real estate joint venture and have an ing components: option to acquire our partner’s joint venture interest for a pre- • Real estate based on a valuation of the acquired property determined purchase price. Details of the financing method performed with the assumption that the property is vacant of accounting are described below: upon acquisition (the “as-if vacant value”). We then allo- • the costs associated with a land parcel at the time of its con- cate the real estate value derived using this approach tribution into a joint venture are reported as commercial between land and building and improvements using our real estate properties on our Consolidated Balance Sheets; estimates and assumptions; 54 CORPORATE OFFICE PROPERTIES TRUST • In-place operating leases to the extent that the present Commercial Real Estate Properties value of future rents under the contractual lease terms are We report commercial real estate properties at our depreci- above or below the present value of market rents at the ated cost. The amounts reported for our commercial real time of acquisition (the “lease to market value”). For exam- estate properties include our costs of: ple, if we acquire a property and the leases in place for that • acquisitions; property carry rents below the market rent for such leases • development and construction; at the time of acquisition, we classify the amount equal to • building and land improvements; and the difference between (1) the present value of the future • tenant improvements paid by us. rental revenue under the lease using market rent assump- We capitalize interest expense, real estate taxes, direct inter- tions and (2) the present value of future rental revenue nal labor (including allocable overhead costs) and other costs under the terms of the lease as deferred revenue. associated with real estate undergoing construction and develop- Conversely, if the leases in place for that property carry ment activities to the cost of such activities. We continue to cap- rents above the market rent, we classify the difference as italize these costs while construction and development activities an intangible asset. Deferred revenue or deferred assets are underway until a building becomes “operational,” which is recorded in connection with in-place operating leases of the earlier of when leases commence on space or one year from acquired properties are amortized into rental revenue over the cessation of major construction activities. When leases com- the lives of the leases. mence on portions of a newly-constructed building’s space in the • Existing tenants in a property (the “lease-up value”). This period prior to one year from the construction completion date, amount represents the value associated with acquiring a we consider that building to be “partially operational.” When a built-in revenue stream on a leased building. It is computed building is partially operational, we allocate the costs associated as the difference between the present value of the prop- with the building between the portion that is operational and erty’s (1) revenues less operating expenses as if the prop- the portion under construction. We start depreciating newly- erty was vacant upon acquisition and (2) revenues less constructed properties when they become operational. operating expenses as if the property was acquired with We depreciate our assets evenly over their estimated use- leases in place at market rents. ful lives as follows: • Deemed cost avoidance of acquiring in-place operating • Buildings and building improvements leases (“deemed cost avoidance”). For example, when a • Land improvements 10–40 years 10–20 years new lease is entered into, the lessor typically incurs a num- • Tenant improvements Related lease terms ber of origination costs in connection with the leases; such on operating properties costs include tenant improvements and leasing costs. • Equipment and personal property 3–10 years When a property is acquired with in-place leases, the orig- When events or circumstances indicate that a property may ination costs for such leases were already incurred by the be impaired, we perform an undiscounted cash flow analysis. prior owner. Therefore, to recognize the value of these We consider an asset to be impaired when its undiscounted costs in recording a property acquisition, we assign value expected future cash flows are less than its depreciated cost. to the tenant improvements and leasing costs associated When we determine that an asset is impaired, we utilize meth- with the remaining term of in-place operating leases. ods similar to those used by independent appraisers in esti- • Market concentration premium equal to the additional mating the fair value of the asset; this process requires us to amount that we pay for a property over the fair value of make certain estimates and assumptions. We then recognize assets in connection with our strategy of increasing our an impairment loss based on the excess of the carrying presence in regional submarkets (the “market concentra- amount of the asset over its fair value. We have not recog- tion premium”). nized impairment losses on our real estate assets to date. • Tenant relationship value equal to the additional amount When we determine that a real estate asset is held for sale, that we pay for a property in connection with the presence we discontinue the recording of depreciation expense of the of a particular tenant in that property (the “tenant relation- asset and estimate the sales price, net of selling costs; if we ship value”). then determine that the estimated sales price, net of selling For acquisitions of real estate prior to July 1, 2001, we allo- costs, is less than the net book value of the asset, we recog- cated the costs of such acquisitions between land and build- nize an impairment loss equal to the difference and reduce ing and improvements. We allocated the components of the carrying amount of the asset. these acquisitions using relative fair values using our esti- We expense property maintenance and repair costs mates and assumptions. when incurred. CORPORATE OFFICE PROPERTIES TRUST 55 Cash and Cash Equivalents contracts call for services to be provided over a period of time Cash and cash equivalents include all cash and liquid invest- exceeding six months and the revenue and costs for such con- ments that mature three months or less from when they are tracts can be estimated with reasonable accuracy; when these purchased. Cash equivalents are reported at cost, which criteria do not apply to a contract, we recognize revenue on that approximates fair value. We maintain our cash in bank accounts contract once the services under the contract are complete. in amounts that may exceed federally insured limits at times. Under the percentage of completion method, we recognize a We have not experienced any losses in these accounts in the percentage of the total estimated revenue on a contract based past and believe we are not exposed to significant credit risk. on the cost of services provided on the contract as of a point in time relative to the total estimated costs on the contract. Accounts Receivable Our accounts receivable are reported net of an allowance for Major Tenants bad debts of $490 at December 31, 2004 and $548 at The following table summarizes the respective percentages December 31, 2003. of our rental revenue earned from our individual tenants that accounted for at least 5% of our rental revenue and our five Revenue Recognition largest tenants (in aggregate): We recognize rental revenue evenly over the terms of tenant leases. When our leases provide for contractual rent increases, which is most often the case, we average the non-cancelable rental revenues over the lease terms to evenly recognize such United States Government revenues; we refer to the adjustments resulting from this process AT&T Local Services(1) as straight-line rental revenue adjustments. We consider rental Computer Sciences Corporation revenue under a lease to be non-cancelable when a tenant Booz Allen Hamilton, Inc. (1) may not terminate its lease obligation early or (2) may ter- Unisys minate its lease obligation early in exchange for a fee or Five largest tenants For the Years Ended December 31, 2004 11% 6% 6% 5% N/A 33% 2003 10% 6% 6% N/A 5% 31% 2002 10% 6% N/A N/A 6% 28% penalty that we consider material enough such that termina- tion would not be probable. We report these straight-line rental revenue adjustments recognized in advance of payments (1) Includes affiliated organizations and agencies. received as deferred rent receivable on our Consolidated Geographical Concentration Balance Sheets. We report prepaid tenant rents as rents All of our operations are geographically concentrated in the received in advance on our Consolidated Balance Sheets. Mid-Atlantic region of the United States. Our properties in the When tenants terminate their lease obligations prior to the Baltimore/Washington Corridor accounted for 49% of our total end of their agreed lease terms, they typically pay fees to can- revenue from real estate operations in 2004, 55% in 2003 and cel these obligations. We recognize such fees as revenue and 56% in 2002. write off against such revenue any (1) deferred rents receivable and (2) deferred revenue and intangible assets that are amor- tizable into rental revenue associated with the leases; the result- Intangible Assets and Deferred Revenue on Real Estate Acquisitions ing net amount is the net revenue from the early termination We capitalize intangible assets and deferred revenue on real of the leases. When a tenant’s lease in a property is terminated estate acquisitions as described in the section above entitled early but the tenant continues to lease space under a new or “Acquisitions of Real Estate.” We amortize the intangible modified lease in the property, the net revenue from the early assets and deferred revenue as follows: termination of the lease is recognized evenly over the remain- • Lease to market value Related lease terms ing life of the new or modified lease in place on that property. • Lease-up value Estimated period of time We recognize tenant recovery revenue in the same periods in which we incur the related expenses. Tenant recovery revenue that tenant will lease space in property includes payments from tenants as reimbursement for property • Deemed cost avoidance Related lease terms taxes, insurance and other property operating expenses. • Market concentration We recognize fees for services provided by us once serv- premium 40 years ices are rendered, fees are determinable and collectibility • Tenant relationship value Estimated period of time assured. We generally recognize revenue under construction contracts using the percentage of completion method when the that tenant will lease space in property 56 CORPORATE OFFICE PROPERTIES TRUST We recognize the amortization of lease to market value cash flow hedges to the extent such derivatives are deemed assets and deferred revenues as adjustments to rental reve- effective in hedging risks (risk in the case of our existing nue reported in our Consolidated Statements of Operations; derivatives being defined as changes in interest rates); we refer to this amortization as amortization of origination • interest expense on our Statements of Operations for any value of leases on acquired properties. We recognize the derivatives designated as cash flow hedges to the extent amortization of other intangible assets on real estate acquisi- such derivatives are deemed ineffective in hedging risks; or tions as additional depreciation and amortization expense on • other revenue on our Statements of Operations for any our Consolidated Statements of Operations. derivatives designated as fair value hedges. Deferred Charges We use standard market conventions and techniques such as discounted cash flow analysis, option pricing models, We defer costs that we incur to obtain new tenant leases or replacement cost and termination cost in computing the fair extend existing tenant leases. We amortize these costs evenly value of derivatives at each balance sheet date. over the lease terms. When tenant leases are terminated early, we expense any unamortized deferred leasing costs associ- Minority Interests ated with those leases. As discussed previously, we consolidate the accounts of our We also defer costs for long-term financing arrangements Operating Partnership and its subsidiaries into our financial and amortize these costs over the related loan terms on a statements. However, we do not own 100% of the Operating straight-line basis, which approximates the amortization that Partnership. We also do not own 100% of certain consolidated would occur under the effective interest method of amortiza- real estate joint ventures. The amounts reported for minority tion. We expense any unamortized loan costs when loans are interests on our Consolidated Balance Sheets represent the retired early. portion of these consolidated entities’ equity that we do not When the costs of acquisitions exceed the fair value of own. The amounts reported for minority interests on our tangible and identifiable intangible assets and liabilities, Consolidated Statements of Operations represent the portion we record goodwill in connection with such acquisitions. of these consolidated entities’ net income not allocated to us. We test goodwill annually for impairment and in interim Common units of the Operating Partnership (“common periods if certain events occur indicating that the carrying units”) are substantially similar economically to our common value of goodwill may be impaired. We recognize an shares of beneficial interest (“common shares”). Common impairment loss when the discounted expected future cash units not owned by us are also exchangeable into our com- flows associated with the related reporting unit are less than mon shares, subject to certain conditions. its unamortized cost. Derivatives For 2002 and a portion of 2003, the Operating Partnership had 1,016,662 Series C Preferred Units outstanding that we did not own. These units were convertible, subject to certain We are exposed to the effect of interest rate changes in the conditions, into common units on the basis of 2.381 common normal course of business. We use interest rate swap and units for each Series C Preferred Unit. These units were repur- interest rate cap agreements to reduce the impact of such chased by the Operating Partnership on June 16, 2003 for interest rate changes. Interest rate differentials that arise $36,068 (including $477 for accrued and unpaid distributions), under these contracts are recognized in interest expense over or $14.90 per common share on an as-converted basis. As a the life of the respective contracts. We do not use such deriv- result of the repurchase, we recognized an $11,224 reduction atives for trading or speculative purposes. We manage to net income available to common shareholders associated counter-party risk by only entering into contracts with major with the excess of the repurchase price over the sum of the financial institutions based upon their credit ratings and other recorded book value of the units and the accrued and unpaid risk factors. return to the unitholder. We recognize all derivatives as assets or liabilities in the On September 23, 2004, we issued 352,000 Series I balance sheet at fair value with the offset to: Preferred Units in the Operating Partnership to an unrelated • the accumulated other comprehensive loss component of party in connection with our acquisition of two properties in shareholders’ equity (“AOCL”), net of the share attributa- Northern Virginia. These units have a liquidation preference ble to minority interests, for any derivatives designated as of $25.00 per unit, plus any accrued and unpaid distributions CORPORATE OFFICE PROPERTIES TRUST 57 of return thereon (as described below), and may be redeemed Earnings Per Share (“EPS”) for cash by the Operating Partnership at our option any time We present both basic and diluted EPS. We compute basic after September 22, 2019. The owner of these units is entitled EPS by dividing net income available to common sharehold- to a priority annual cumulative return equal to 7.5% of their ers by the weighted average number of common shares out- liquidation preference through September 22, 2019; the annual standing during the year. Our computation of diluted EPS is cumulative preferred return increases for each subsequent similar except that: five-year period, subject to certain maximum limits. These • the denominator is increased to include the weighted aver- units are convertible into common units on the basis of 0.5 age number of potential additional common shares that common units for each Series I Preferred Unit; the resulting would have been outstanding if securities that are convert- common units would then be exchangeable for common ible into our common shares were converted; and shares in accordance with the terms of the Operating • the numerator is adjusted to add back any convertible pre- Partnership’s agreement of limited partnership. ferred dividends and any other changes in income or loss that would result from the assumed conversion into com- mon shares. Our computation of diluted EPS does not assume conversion of securities into our common shares if conversion of those secu- rities would increase our diluted EPS in a given year. A summary of the numerator and denominator for purposes of basic and diluted EPS calculations is set forth below (dollars and shares in thousands, except per share data): For the Years Ended December 31, 2004 2003 2002 Numerator: Numerator for basic EPS on net income available to common shareholders $18,890 $ 7,650 $13,167 Subtract: Income from discontinued operations, net Numerator for basic EPS before discontinued operations Add: Series D Preferred Share dividends Numerator for diluted EPS before discontinued operations Add: Income from discontinued operations, net — 18,890 21 18,911 — (2,423) 5,227 — 5,227 2,423 (1,273) 11,894 544 12,438 1,273 Numerator for diluted EPS on net income available to common shareholders $18,911 $ 7,650 $13,711 Denominator (all weighted averages): Denominator for basic EPS (common shares) Assumed conversion of share options Assumed conversion of Series D Preferred Shares Denominator for diluted EPS Basic EPS: Income before discontinued operations Income from discontinued operations Net income available to common shareholders Diluted EPS: Income before discontinued operations Income from discontinued operations Net income available to common shareholders 33,173 1,675 134 34,982 $ 0.57 — $ 0.57 $ 0.54 — $ 0.54 26,659 1,362 — 28,021 $ 0.20 0.09 $ 0.29 $ 0.19 0.08 $ 0.27 22,472 878 1,197 24,547 $ 0.53 0.06 $ 0.59 $ 0.51 0.05 $ 0.56 58 CORPORATE OFFICE PROPERTIES TRUST Our diluted EPS computations do not include the effects of the following securities since the conversions of such securi- ties would increase diluted EPS for the respective periods: Conversion of weighted average common units Restricted common shares Conversion of share options Conversion of weighted average preferred units Conversion of weighted average preferred shares Weighted Average Shares in Denominator For the Years Ended December 31, 2004 8,726 221 5 48 — 2003 8,932 166 47 1,101 1,197 2002 9,282 326 62 2,421 — Stock-Based Compensation We grant common shares subject to forfeiture restrictions We and the Service Companies recognize expense from share to certain employees (see Note 11). We recognize compen- options issued to employees using the intrinsic value method. sation expense for such grants over the service periods to As a result, we do not record compensation expense for share which the grants relate. We compute compensation expense option grants except as set forth below: for common share grants based on the value of such grants, as • When the exercise price of a share option grant is less than determined by the value of our common shares on the appli- the market price of our common shares on the option grant cable measurement date, as defined below: date, we recognize compensation expense equal to the • When forfeiture restrictions on grants only require the difference between the exercise price and the grant-date recipient to remain employed by us over defined periods market price; this compensation expense is recognized of time for such restrictions to lapse, the measurement date over the service period to which the options relate. is the date the shares are granted. • In 1999, we reduced the exercise price of 360,500 share • When forfeiture restrictions on grants require (1) that the options from $9.25 to $8.00. We recognize compensation recipient remain employed by us over defined periods of expense on the share price appreciation and future vest- time and (2) that the Company meet certain performance cri- ing associated with the re-priced share options. As of teria for such restrictions to lapse, the measurement date is December 31, 2004, 4,250 of these share options were out- the date that the performance criteria are deemed to be met. standing. In July 2002, we paid $694 to employees to Expenses from stock-based compensation are included in redeem 105,300 of the re-priced share options. The our Consolidated Statements of Operations as follows: expense we recognized in 2002 relating to the cash redemption was substantially offset by the reversal of pre- viously recorded compensation expense on the share For the Years Ended December 31, 2004 2003 2002 options resulting from share price appreciation. Increase in general and • We recognize compensation expense on share options administrative expenses $1,579 $1,020 $411 granted to employees of CRM and CC&C prior to January 1, Increase in losses 2001 equal to the difference between the exercise price of from service operations 552 374 136 such share options and the market price of our common shares on January 1, 2001, to the extent such amount relates to service periods remaining after January 1, 2001. CORPORATE OFFICE PROPERTIES TRUST 59 The following table summarizes our operating results as if we elected to account for our stock-based compensation under the fair value provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”: Net income, as reported For the Years Ended December 31, 2004 $37,032 2003 $30,877 2002 $23,301 Add: Stock-based compensation expense, net of related tax effects and minority interests, included in the determination of net income 1,824 Less: Stock-based compensation expense determined under the fair value based method, net of related tax effects and minority interests Net income, pro forma Basic EPS on net income available to common shareholders, as reported Basic EPS on net income available to common shareholders, pro forma Diluted EPS on net income available to common shareholders, as reported Diluted EPS on net income available to common shareholders, pro forma (1,500) $37,356 $ 0.57 $ 0.58 $ 0.54 $ 0.55 917 (835) $30,959 $ 0.29 $ 0.29 $ 0.27 $ 0.28 341 (847) $22,795 $ 0.59 $ 0.56 $ 0.56 $ 0.54 The stock-based compensation expense under the fair value after July 1, 2005 for the portion of outstanding awards for method, as reported in the above table, was computed using which the requisite service has not yet been rendered, based the Black-Scholes option-pricing model; the weighted average on the fair value of those awards on the date of grant. We are assumptions we used in that model are set forth below: reviewing the provisions of SFAS 123(R) and assessing the For the Years Ended December 31, impact it will have on us upon adoption. 2004 2003 2002 Fair Value of Financial Instruments Risk-free interest rate 3.15% 3.05% 4.09% Our financial instruments include primarily notes receiv- Expected life-years Expected volatility 4.21 5.87 3.68 able, mortgage and other loans payable and interest rate 22.89% 23.97% 24.46% derivatives. The fair values of notes receivable were not Expected dividend yield 7.60% 7.80% 7.90% materially different from their carrying or contract values at In December 2004, the FASB issued Statement of Financial and 10 for fair value of mortgage and other loans payable December 31, 2004 and 2003. You should refer to Notes 9 Accounting Standards No. 123(R), “Share-Based Payment” and derivative information. (“SFAS 123(R)”). The statement establishes standards for the accounting for transactions in which an entity exchanges its Reclassification equity instruments for goods or services, focusing primarily We reclassified certain amounts from the prior periods to on accounting for transactions in which an entity obtains conform to the current period presentation of our employee services in share-based payment transactions. The Consolidated Financial Statements. These reclassifications statement will require us to measure the cost of employee did not affect previously reported consolidated net income services received in exchange for an award of equity instru- or shareholders’ equity. ments based generally on the fair value of the award on the grant date; such cost will be recognized over the period dur- Recent Accounting Pronouncements ing which an employee is required to provide service in See the section in Note 2 entitled “Consolidation Method” exchange for the award (generally the vesting period). No for disclosure pertaining to FIN 46(R). compensation cost is recognized for equity instruments See the section above entitled “Stock-Based Compensation” for which employees do not render the requisite service. for disclosure pertaining to SFAS 123(R). SFAS 123(R) will be effective for us in June 2005 and will apply In December 2004, the FASB issued Statement of Financial to all awards granted after July 1, 2005 and to awards modi- Accounting Standards No. 153, “Exchanges of Nonmonetary fied, repurchased or cancelled after that date. The statement Assets, an amendment of APB Opinion No. 29” (“SFAS 153”). will also require that we recognize compensation cost on or The Accounting Principles Board’s Opinion No. 29, 60 CORPORATE OFFICE PROPERTIES TRUST “Accounting for Nonmonetary Transactions” (“APB 29”) is 4. COMMERCIAL REAL ESTATE PROPERTIES based on the principle that exchanges of nonmonetary assets Operating properties consisted of the following: should be measured based on the fair value of the assets exchanged. However, the guidance in APB 29 included certain exceptions to that principle. SFAS 153 amends APB 29 to elim- Land December 31, 2004 2003 $ 268,327 $ 216,703 inate the exception for nonmonetary exchanges of similar pro- Buildings and improvements 1,280,537 1,003,214 ductive assets and replaces it with a general exception for 1,548,864 1,219,917 exchanges of nonmonetary assets that do not have commercial Less: accumulated depreciation (141,716) (103,070) substance. Under SFAS 153, a nonmonetary exchange has commercial substance if the future cash flows of the entity are $1,407,148 $1,116,847 expected to change significantly as a result of the exchange. Projects we had under construction or development con- SFAS 153 will be effective for us for nonmonetary asset sisted of the following: exchanges occurring after December 31, 2005. We are review- ing the provisions of SFAS 153 and assessing the impact it will have on us upon adoption. Land Construction in progress December 31, 2004 $ 74,190 61,962 $136,152 2003 $53,356 13,793 $67,149 2004 Acquisitions We acquired the following office properties in 2004: Project Name Location 400 Professional Drive Gaithersburg, MD Date of Acquisition 3/5/2004 Wildewood and Exploration/ St. Mary’s County, MD 3/24/2004, 5/5/2004 Expedition Office Parks 10150 York Road Pinnacle Towers Corporate Pointe III Dahlgren Properties Hunt Valley, MD Tysons Corner, VA Chantilly, VA Dahlgren, VA & 11/9/2004 4/15/2004 9/23/2004 9/29/2004 12/21/2004 & 12/28/2004 Number of Total Rentable Buildings Square Feet 1 11 1 2 1 6 129,030 560,106 176,689 440,102 114,126 204,605 Initial Cost $ 23,196 66,274 15,393 106,452 22,903 27,230 1,624,658 $261,448 The table below sets forth the allocation of the acquisition costs of these properties: 400 Wildewood and Professional Exploration/ Expedition Drive $ 3,673 17,400 $11,599 49,644 10150 York Road $ 2,700 11,730 Pinnacle Towers $ 18,566 76,820 Corporate Dahlgren Properties Pointe III $ 3,511 15,503 $ 4,888 20,401 Total $ 44,937 191,498 2,154 23,227 5,159 66,402 1,357 15,787 11,066 106,452 3,889 22,903 2,115 27,404 25,740 262,175 Land Building and improvements Intangible assets on real estate acquisitions Total assets Deferred revenue associated with acquired operating leases (31) (128) (394) — — (174) (727) Total acquisition cost $23,196 $66,274 $15,393 $106,452 $22,903 $27,230 $261,448 CORPORATE OFFICE PROPERTIES TRUST 61 We also acquired the following during 2004: located in Lanham, Maryland and a new building located in • a parcel of land located in St. Mary’s County, Maryland Chantilly, Virginia. for $1,905 on March 24, 2004 in connection with our acqui- As of December 31, 2004, we had construction underway sition of the Wildewood and Exploration/Expedition on five new buildings in the Baltimore/Washington Corridor, Office Parks; one in Chantilly, Virginia and one in St. Mary’s County, Maryland. • two adjacent parcels of land located in Chantilly, Virginia We also had development underway in three new buildings in for $4,011 on April 14, 2004. An operating building of ours Annapolis Junction, Maryland and one in Columbia, Maryland. is located on one of these parcels and a project we have under construction is located on the other parcel; 2004 Dispositions • a 5.3 acre panel of land located in Herndon, Virginia that On April 26, 2004, we sold a land parcel in Columbia, Maryland is adjacent to one of our office properties for $9,614 on and a land parcel in Linthicum, Maryland for $9,600. We issued April 29, 2004; to the buyer a $5,600 mortgage loan bearing interest at 5.5% • a property located in Blue Bell, Pennsylvania that is adja- and a maturity date of July 2005; the balance of the acquisition cent to an office park we own for $401 on July 15, 2004; was in the form of cash from the buyer. Upon completion of the • a 14.0 acre parcel of land located in Columbia, Maryland sale, we entered into an agreement with the buyer to lease the for $6,386 on September 20, 2004; and land parcels for an aggregate monthly payment of $10 begin- • an 18.8 acre parcel of land located in South Brunswick, New ning July 1, 2004 until April 30, 2005, at which time the rent Jersey that is adjacent to an office park we own for $512 reduces to $1 per month until 2079. The buyer in this transac- on September 29, 2004 from a seller in which certain of our tion had an option to contribute the two land parcels into our Trustees and officers own partnership interests. The terms Operating Partnership between January 1, 2005 and February 28, of the land acquisition were determined as a result of arm’s- 2005 in exchange for extinguishment of the $5,600 mortgage length negotiations and were approved by the Audit and loan with us and $4,000 in common units in our Operating Investment Committees of our Board of Trustees. In man- Partnership; the buyer in the transaction exercised its option in agement’s opinion, the resulting terms reflected fair value February 2005 and, as a result, the debt from us will be extin- for the property based on management’s knowledge and guished and it will receive 154,440 common units in the experience in the real estate market. Operating Partnership in March 2005. We accounted for this transaction using the financing method of accounting; as a result, 2004 Construction/Development the transaction was not recorded as a sale and the $4,000 in net During 2004, we fully placed into service a new building proceeds received from the buyer is included in other liabilities located in Annapolis Junction, Maryland, a new building on our Consolidated Balance Sheet as of December 31, 2004. 2003 Acquisitions We acquired the following office properties in 2003: Project Name 2500 Riva Road 13200 Woodland Park Drive Dulles Tech Ridgeview Location Annapolis, MD Herndon, VA Herndon, VA Chantilly, VA Date of Acquisition 4/4/2003 6/2/2003 7/25/2003 7/25/2003 Number of Total Rentable Buildings Square Feet 1 1 2 3 155,000 404,665 166,821 266,993 993,479 Initial Cost $ 18,038 71,449 27,036 48,538 $165,061 The table below sets forth the allocation of the acquisition costs of these properties: Land Building and improvements Intangible assets on real estate acquisitions Total acquisition cost 2500 Riva Road 13200 Woodland Dulles Tech Park Drive Ridgeview Total $ 2,791 12,145 3,102 $18,038 $10,428 49,475 11,546 $71,449 $ 4,310 17,777 4,949 $27,036 $ 6,622 31,427 10,489 $48,538 $ 24,151 110,824 30,086 $165,061 62 CORPORATE OFFICE PROPERTIES TRUST During 2003, we acquired a 108-acre land parcel from an 2003 Dispositions affiliate of Constellation Real Estate, Inc. (“Constellation”). The On January 31, 2003, we contributed a developed land par- land parcel is located adjacent to an office park that we own cel into a real estate joint venture called NBP 220, LLC in Annapolis Junction, Maryland. We completed the acquisi- (“NBP 220”) and subsequently received a $4,000 distribution. tion in two phases for a total cost of $30,094, of which $25,668 Upon completion of this transaction, we owned a 20% inter- was financed by seller-provided mortgage loans bearing inter- est in NBP 220. Since we had the option to acquire our joint est at 3%. Since we considered the interest rate on these loans venture partner’s interest, we accounted for the transaction to be below the market rate for similar loans, we discounted under the financing method of accounting (see Note 2). On the recorded amounts for the acquisition and mortgage loans September 10, 2004, we acquired the membership interest of by $2,075. Under an agreement that was terminated on March 5, our joint venture partner in NBP 220 for $4,928. 2002, Constellation nominated two members for election to On March 14, 2003, we contributed a 157,394 square foot our Board of Trustees; these members still served on our Board office building located in Fairfield, New Jersey into a real of Trustees as of December 31, 2003. The terms of the land estate joint venture called Route 46 Partners, LLC in exchange parcel acquisition were determined as a result of arm’s-length for $19,960 in cash and a 20% interest in the joint venture. Our negotiations. In our opinion, the resulting terms reflected fair joint venture partner has preference in receiving distributions value for the property based on management’s knowledge and of cash flows for a defined return; once our partner receives experience in the real estate market. its defined return, we are entitled to receive distributions for a On November 14, 2003, we acquired from Constellation defined return and, once we receive that return, remaining another parcel of land adjacent to the office park discussed distributions of cash flows are allocated based on percent- above in Annapolis Junction, Maryland for $1,658. ages defined in the joint venture agreement. We did not rec- In December 2003, we acquired three office properties and ognize a gain on this sale due to our continuing investment a land parcel through the purchase of our joint venture part- in the property through the joint venture. See Notes 5 and 19 ners’ interests in two of our real estate joint ventures. These for further disclosures related to this joint venture. acquisitions are discussed in Note 5. On March 31, 2003, we sold an office property totaling 181,768 square feet and two adjacent land parcels located in 2003 Construction/Development Oxon Hill, Maryland, for a total sale price of $21,288. We rec- During 2003, a 123,743 square foot building that was partially ognized a total gain of $3,371 on this sale. operational at the beginning of the year became fully opera- tional. This building is located in Columbia, Maryland. 5. INVESTMENTS IN AND ADVANCES TO UNCONSOLIDATED REAL ESTATE JOINT VENTURES Our investments in and advances to unconsolidated real estate joint ventures accounted for using the equity method of account- ing included the following: Balance at December 31, 2004 2003 Date Acquired Ownership Nature of Activity Total Maximum Assets at Exposure to Loss(1) 12/31/04 Route 46 Partners, LLC $1,201 $1,055 3/14/03 20% Operating building(2) $23,003 $1,621 Gateway 70 LLC MOR Forbes 2 LLC MOR Montpelier 3 LLC — — — 3,017 4/5/01 See Below Developing land parcel(3) 735 455 12/24/02 See Below Operating building(4) 2/21/02 See Below Developing land parcel(5) $1,201 $5,262 N/A N/A N/A N/A N/A N/A $23,003 $1,621 (1) Derived from the sum of our investment balance, loan guarantees (based on maximum loan balance) and maximum additional unilat- eral capital contributions and loans required from us. Not reported above are additional amounts that we and our partners are required to fund when needed by these joint ventures; these funding requirements are proportional to our ownership percentage. (2) This joint venture’s property is located in Fairfield, New Jersey. (3) This joint venture’s property is located in Columbia, Maryland. (4) This joint venture’s property is located in Lanham, Maryland. (5) This joint venture’s property is located in Laurel, Maryland. CORPORATE OFFICE PROPERTIES TRUST 63 A two-member management committee is responsible for making major decisions (as defined in the joint venture agreement) for each of these joint ventures, and we control one of the management committee positions in each case. We have additional commitments pertaining to our real estate joint ventures that are disclosed in Note 19. As discussed in Note 2, we adopted FIN 46(R) effective March 31, 2004 for VIEs created prior to February 1, 2003. Upon this adoption, we began using the consolidation method of accounting for the following joint ventures that had previously been accounted for using either the equity or financing methods of accounting: NBP 220, LLC MOR Forbes 2 LLC Gateway 70 LLC MOR Montpelier 3 LLC Date Acquired 1/31/03 12/24/02 4/5/01 2/21/02 Ownership % at 12/31/04 100% 50% 80% 50% Nature of Activity Operating building(1) Operating building(2) Developing land parcel(3) Developing land parcel(4) Total Assets at 12/31/04 $34,826 4,637 4,510 947 Collateralized Assets at 12/31/04 $33,101 4,154 — — $44,920 $37,255 (1) This joint venture’s property is located in Annapolis Junction, Maryland. Our ownership was 20% until we acquired the remaining inter- est on September 10, 2004. The building was placed into service in September 2004. (2) This joint venture’s property is located in Lanham, Maryland. The recently constructed building became 100% operational in August 2004. (3) This joint venture’s property is located in Columbia, Maryland. (4) This joint venture’s property is located in Laurel, Maryland. During 2003, we acquired our joint venture partners’ inter- The following table sets forth a condensed combined ests in NBP 140, LLC and Gateway 67, LLC (90% and 20%, statement of operations for our one unconsolidated real estate respectively) for $6.2 million. Prior to these acquisitions, we joint venture for the year ended December 31, 2004: accounted for our investments in these joint ventures using the Revenues equity method of accounting. Upon completion of these acqui- Property operating expenses sitions, these two entities, which own a total of three office Interest expense properties totaling 225,754 square feet and a parcel of land Depreciation and amortization expense that is contiguous to two of these properties, became consoli- Net income $ 3,054 (1,461) (847) (514) $ 232 dated subsidiaries. Our commitments and contingencies pertaining to our real estate joint ventures are disclosed in Note 19. The following table sets forth a condensed balance sheet for our one uncon- solidated real estate joint venture: December 31, 2004 2003 Commercial real estate property $21,567 $30,594 Other assets Total assets Liabilities Owners’ equity 1,436 $23,003 $14,727 8,276 1,981 $32,575 $18,687 13,888 Total liabilities and owners’ equity $23,003 $32,575 64 CORPORATE OFFICE PROPERTIES TRUST 6. INVESTMENTS IN AND ADVANCES TO OTHER UNCONSOLIDATED ENTITIES Our investments in and advances to other unconsolidated entities included the following: TractManager, Inc.(1) Balance at December 31, 2004 $1,621 2003 $1,621 Date Acquired Ownership % at 12/31/04 Investment Accounting Method Various 2000 5% Cost (1) TractManager, Inc. developed an Internet-based contract imaging and management system which it sells to real estate owners and healthcare providers. 7. INTANGIBLE ASSETS ON REAL ESTATE ACQUISITIONS 8. DEFERRED CHARGES Intangible assets on real estate acquisitions consisted of Deferred charges consisted of the following: the following: Lease-up value Lease to market value Lease cost portion of deemed cost avoidance Market concentration premium Subtotal Accumulated amortization Intangible assets on real December 31, 2004 2003 Deferred leasing costs $ 65,638 $46,613 Deferred financing costs 9,595 7,819 Goodwill Deferred other 8,700 1,333 85,266 (17,706) 5,294 1,333 Accumulated amortization 61,059 Deferred charges, net (5,367) estate acquisitions, net $ 67,560 $55,692 December 31, 2004 2003 $ 33,302 $ 20,712 16,996 13,263 1,853 155 1,880 155 52,306 36,010 (24,664) (18,287) $ 27,642 $ 17,723 CORPORATE OFFICE PROPERTIES TRUST 65 9. MORTGAGE AND OTHER LOANS PAYABLE Mortgage and other loans payable consisted of the following: Maximum Amount Available at December 31, 2004 Carrying Value at December 31, 2004 2003 Stated Interest Rates Scheduled Maturity Dates at December 31, 2004 Credit Facilities Wachovia Bank, N.A. Revolving Credit Facility $300,000 $ 203,600 $ — LIBOR + 1.25% to 1.55%(1) March 2007(2) Wachovia Bank, N.A. Line of Credit Bankers Trust Revolving Credit Facility Mortgage Loans N/A N/A — — $300,000 203,600 18,900 LIBOR + 1.90% 12,775 31,675 LIBOR + 1.75% N/A N/A Fixed rate mortgage loans(3) N/A 737,380 547,174 0.00%–9.48%(4) 2005–2025(5) Variable rate construction loan facilities Other variable rate mortgage loans Total variable rate mortgage loans Note Payable Unsecured seller note Total mortgages and other loans payable $ 77,832 35,316 29,247 LIBOR + 1.55% to 2.20% 2005–2007(2) N/A 45,124 129,236 LIBOR + 1.20% to 2.00% 2005–2007(2) 817,820 705,657 N/A 1,268 1,366 5.95% May 2007 $1,022,688 $738,698 (1) The LIBOR interest rate in effect on our LIBOR-based variable rate loans ranged from 2.36% to 2.42% at December 31, 2004 and from 1.12% to 1.17% at December 31, 2003. (2) At December 31, 2004, a total of $261.4 million in loans scheduled to mature in 2007 that are included in these lines may be extended for a one-year period, subject to certain conditions. (3) Several of the fixed rate mortgages carry interest rates that were above or below market rates upon assumption and therefore are recorded at their fair value based on applicable effective interest rates. The carrying values of these loans reflect a net premium totaling $1,569. (4) The weighted average interest rate on these loans was 6.15% at December 31, 2004 and 6.25% at December 31, 2003. (5) A loan with a balance of $11.0 million at December 31, 2004 that matures in 2025 is subject to a call date of October 2010. We have guaranteed the repayment of $334.6 million of the mortgage and other loans set forth above as of December 31, 2004. In the case of each of our mortgage and construction loans, we have pledged certain of our real estate assets as collat- eral. As of December 31, 2004, substantially all of our real estate properties were collateralized on loan obligations. Certain of our mortgage loans require that we comply with a number of restrictive financial covenants, including adjusted consoli- dated net worth, minimum property interest coverage, minimum property hedged interest coverage, minimum consolidated interest coverage, maximum consolidated unhedged floating rate debt and maximum consolidated total indebtedness. As of December 31, 2004, we were in compliance with these financial covenants. 66 CORPORATE OFFICE PROPERTIES TRUST Our mortgage loans mature on the following schedule Weighted average borrowings under our secured revolv- (excluding extension options): ing credit facility with Wachovia Bank, National Association 2005 2006 2007 2008 2009 Thereafter Total $ 60,026 totaled $142,043 in 2004. The weighted average interest rate 78,904 349,235 155,003 60,769 317,182 on this credit facility totaled 3.13% in 2004. Weighted average borrowings under our secured revolving credit facility with Bankers Trust Company totaled $3,607 in 2004 and $88,636 in 2003. The weighted average interest rate on this credit facility totaled 3.01% in 2004 and 3.06% in 2003. $1,021,119(1) The amount available under our secured revolving credit (1) Represents principal maturities only and therefore excludes net premiums of $1,569. We estimate that the fair value of our mortgage and other facility with Wachovia Bank, National Association is generally computed based on 60% of the appraised value of properties pledged as collateral for this loan. As of December 31, 2004, the maximum amount available under this line of credit totaled loans was $1,037,100 at December 31, 2004 and $771,367 at $300,000, of which $96,400 was unused. December 31, 2003. 10. DERIVATIVES We capitalized interest costs of $5,112 in 2004, $2,846 in 2003 and $3,091 in 2002. The following table sets forth our derivative contracts and their respective fair values: Nature of Derivative Interest rate swap Interest rate swap Total Notional Amount One-Month LIBOR base in (millions) $50.0 50.0 2.308% 1.520% Effective Date 1/2/2003 1/7/2003 Expiration Date 1/3/2005 1/2/2004 Fair Value at December 31, 2004 $— — $— 2003 $(467) — $(467) We have designated each of these derivatives as cash flow hedges. All of these derivatives are hedging the risk of changes in interest rates on certain of our one-month LIBOR-based variable rate borrowings. At December 31, 2004, our outstanding inter- est rate swap was considered a highly effective cash flow hedge under SFAS 133. The table below sets forth our accounting application of changes in derivative fair values: Increase (decrease) in fair value applied to AOCL(1) and minority interests Increase (decrease) in fair value recognized as gain(2) For the Years Ended December 31, 2004 $390 77 2003 $104 (77) 2002 $3,285 2 (1) AOCL is defined in Note 3. (2) Represents hedge ineffectiveness and is included in interest expense on our Consolidated Statements of Operations. CORPORATE OFFICE PROPERTIES TRUST 67 11. SHAREHOLDERS’ EQUITY Preferred Shares Preferred shares of beneficial interest (“preferred shares”) consisted of the following: 1,725,000 designated as Series B Cumulative Redeemable Preferred Shares of beneficial interest (no shares issued and outstanding at December 31, 2004 and 1,250,000 shares issued and outstanding with an aggregate liquidation preference of $31,250 at December 31, 2003) $— $13 544,000 designated as Series D Cumulative Convertible Redeemable Preferred Shares of beneficial interest (no shares issued and outstanding at December 31, 2004 and 544,000 shares issued and outstanding with an aggregate liquidation December 31, 2004 2003 preference of $13,600 at December 31, 2003) 1,265,000 designated as Series E Cumulative Redeemable Preferred Shares of beneficial interest (1,150,000 shares issued with an aggregate liquidation preference of $28,750 at December 31, 2004 and 2003) 1,425,000 designated as Series F Cumulative Redeemable Preferred Shares of beneficial interest (1,425,000 shares issued with an aggregate liquidation preference of $35,625 at December 31, 2004 and 2003) 2,200,000 designated as Series G Cumulative Redeemable Preferred Shares of beneficial interest (2,200,000 shares issued with an aggregate liquidation preference of $55,000 at December 31, 2004 and 2003) 2,000,000 designated as Series H Cumulative Redeemable Preferred Shares of beneficial interest (2,000,000 shares issued with an aggregate liquidation preference of $50,000 at December 31, 2004 and 2003) Total preferred shares — 11 14 22 20 $67 5 11 14 22 20 $85 Set forth below is a summary of additional information pertaining to our preferred shares of beneficial interest: Series of Preferred Share of Beneficial Interest Series B(2) Series D(3) Series E Series F Series G Series H # of Shares Issued 1,250,000 544,000 1,150,000 1,425,000 2,200,000 2,000,000 Month of Issuance July 1999 January 2001 April 2001 September 2001 August 2003 December 2003 Annual Dividend Yield(1) 10.000% 4.000% 10.250% 9.875% 8.000% 7.500% Annual Dividend Per Share $2.50000 1.00000 2.56250 2.46875 2.00000 1.87500 Earliest Redemption Date N/A N/A 7/15/06 10/15/06 8/11/08 12/18/08 (1) Yield computed based on $25 per share redemption price. (2) This series was redeemed in July 2004. (3) This series was converted in February 2004. 68 CORPORATE OFFICE PROPERTIES TRUST All of the classes of preferred shares set forth in the table common shares on the basis of one common share for each above are nonvoting and redeemable for cash at $25.00 per common unit in the amount of 326,108 in 2004, 119,533 in share at our option on or after the earliest redemption date. 2003 and 617,510 in 2002. Holders of these shares are entitled to cumulative dividends, We issued common shares to certain employees totaling payable quarterly (as and if declared by the Board of Trustees). 99,935 in 2004 and 119,324 in 2003. All of these share issuances In the case of each series of preferred shares, there is a series are subject to forfeiture restrictions that lapse annually of preferred units in the Operating Partnership owned by us throughout their respective terms as the employees remain that carries substantially the same terms. employed by us. Forfeiture restrictions lapsed on common On August 11, 2003, we completed the sale of 2,200,000 shares issued to employees in the amount of 113,478 in 2004, Series G Preferred Shares of beneficial interest (the “Series G 49,073 in 2003 and 72,659 in 2002. Preferred Shares”) at a price of $25.00 per share for net pro- Over the three years ended December 31, 2004, we issued ceeds of $53,175. We contributed the net proceeds to our common shares in connection with the exercise of share options Operating Partnership in exchange for 2,200,000 Series G totaling 784,398 in 2004, 262,278 in 2003 and 255,692 in 2002. Preferred Units. The Series G Preferred Units carry terms that The table below sets forth activity in the AOCL component are substantially the same as the Series G Preferred Shares. of shareholders’ equity: On December 18, 2003, we completed the sale of 2,000,000 Series H Preferred Shares of beneficial interest (the “Series H Preferred Shares”) at a price of $25.00 per share for net proceeds of $48,332. We contributed the net proceeds to Beginning balance our Operating Partnership in exchange for 2,000,000 Series H Unrealized gain on interest rate For the Years Ended December 31, 2004 2003 2002 $(294) $(349) $(2,500) Preferred Units. The Series H Preferred Units carry terms that swaps, net of minority interests 294 55 2,151 are substantially the same as the Series H Preferred Shares. Ending balance $ — $(294) $ (349) On February 11, 2004, the holder of the Series D Preferred Shares exercised its right to cause us to convert the shares The table below sets forth our comprehensive income: into common shares on the basis of 2.2 common shares for each Series D Preferred Share, resulting in the issuance of 1,196,800 common shares. On July 15, 2004, we redeemed the Series B Preferred Net income Shares for a redemption price of $31,250. At the completion of Unrealized gain on interest rate For the Years Ended December 31, 2004 2003 2002 $37,032 $30,877 $23,301 this transaction, we recognized a $1,813 decrease to net swaps, net of minority interests 294 55 2,151 income available to common shareholders pertaining to the Total comprehensive income $37,326 $30,932 $25,452 original issuance costs we incurred on the shares. 12. SHARE OPTIONS Common Shares In 1993, we adopted a share option plan for our Trustees under On May 27, 2003, we sold 5,290,000 common shares in an which we have 75,000 common shares reserved for issuance. underwritten public offering at a net price of $15.03 per share. These options expire ten years after the date of grant and are We contributed the net proceeds from the sale to our all exercisable. Operating Partnership in exchange for 5,290,000 common units. In March 1998, we adopted a long-term incentive plan for On April 23, 2004, we sold 2,750,000 common shares in an our Trustees and employees. This plan provides for the award underwritten public offering at a net price of $21.243 per share. of share options, common shares subject to forfeiture restric- We contributed the net proceeds totaling approximately tions and dividend equivalents. We are authorized to issue $58,200 to our Operating Partnership in exchange for awards under the plan amounting to no more than 13% of the 2,750,000 common units. total of (1) our common shares outstanding plus (2) the num- On September 28, 2004, we sold 2,283,600 common shares ber of shares that would be outstanding upon redemption of in an underwritten public offering at a net price of $25.10 per all units of the Operating Partnership or other securities that share. We contributed the net proceeds totaling approxi- are convertible into our common shares. Trustee options under mately $57,200 to our Operating Partnership in exchange for this plan become exercisable beginning on the first anniversary 2,283,600 common units. of their grant. The vesting periods for employees’ options Over the three years ended December 31, 2004, com- under this plan range from immediately to five years. Options mon units in our Operating Partnership were converted into expire ten years after the date of grant. CORPORATE OFFICE PROPERTIES TRUST 69 The following table summarizes share option transactions under the plans described above: Outstanding at December 31, 2001 Granted—2002 Forfeited—2002 Exercised—2002 Outstanding at December 31, 2002 Granted—2003 Forfeited—2003 Exercised—2003 Outstanding at December 31, 2003 Granted—2004 Forfeited—2004 Exercised—2004 Outstanding at December 31, 2004 Available for future grant at December 31, 2004 Exercisable at December 31, 2002 Exercisable at December 31, 2003 Exercisable at December 31, 2004 Shares 2,899,583 856,303 (194,651) (255,692) 3,305,543 174,740 (15,979) (262,278) 3,202,026 290,450 (20,994) (784,398) 2,687,084 1,067,861 1,768,919 1,986,464 1,617,080 Range of Exercise Price Per Share $ 5.25–$12.25 $10.58–$14.30 $ 7.63–$11.87 $ 5.25–$10.58 $ 5.25–$14.30 $13.47–$18.08 $ 7.63–$13.69 $ 7.63–$14.30 $ 5.25–$14.30 $15.93–$28.69 $ 8.63–$25.05 $ 5.63–$17.25 $ 5.38–$28.69 $ 5.25–$14.30 (1) (2) Weighted Average Exercise Price Per Share $ 8.79 $12.18 $ 8.99 $ 8.32 $ 9.69 $15.53 $11.52 $ 9.39 $10.03 $22.30 $17.81 $ 9.57 $11.43 $ 9.37 $ 9.64 $10.26 (1) 432,183 of these options had an exercise price ranging from $5.25 to $7.99, 1,089,165 had an exercise price ranging from $8.00 to $10.99 and 465,116 had an exercise price ranging from $11.00 to $14.30. (2) 312,650 of these options had an exercise price ranging from $5.38 to $7.99, 704,238 had an exercise price ranging from $8.00 to $10.99 and 600,192 had an exercise price ranging from $11.00 to $18.08. The weighted average remaining contractual life of the options at December 31, 2004 was approximately 6 years. A summary of the weighted average grant-date fair value per option granted is as follows: Weighted average grant-date fair value Weighted average grant-date fair value-exercise price equals market price on grant-date Weighted average grant-date fair value-exercise price exceeds market price on grant-date Weighted average grant-date fair value-exercise price less than market price on grant-date For the Years Ended December 31, 2003 $1.34 $1.30 $1.16 $1.62 2004 $2.18 $2.15 $1.65 $2.24 2002 $1.13 $1.11 $1.01 $1.41 13. RELATED PARTY TRANSACTIONS The table below sets forth revenues earned and costs incurred in our transactions with related parties: Rental revenue earned from Constellation Interest income earned from unconsolidated real estate joint venture Other fee revenue earned from unconsolidated real estate joint ventures For the Years Ended December 31, 2002 2003 2004 $ — $ — $ 56 $ — $ — $126 $219 $351 $158 During the reporting periods, we acquired properties from Constellation. We also acquired a land parcel from a seller in which certain of our Trustees and officers own partnership interests. Both of these transactions are described in Note 4. Baltimore Gas and Electric Company (“BGE”), an affiliate of Constellation, provided utility services to most of our proper- ties in the Baltimore/Washington Corridor during each of the last three years. 14. OPERATING LEASES We lease our properties to tenants under operating leases with various expiration dates extending to the year 2018. Gross min- imum future rentals on noncancelable leases at December 31, 2004 were as follows: For the Years Ended December 31, 2005 2006 2007 2008 2009 Thereafter Total $ 201,441 180,096 156,117 131,887 106,330 322,448 $1,098,319 We consider a lease to be noncancelable when a tenant (1) may not terminate its lease obligation early or (2) may ter- minate its lease obligation early in exchange for a fee or penalty that we consider material enough such that termina- tion would be highly unlikely. 70 CORPORATE OFFICE PROPERTIES TRUST 15. SUPPLEMENTAL INFORMATION TO STATEMENTS OF CASH FLOWS Interest paid, net of capitalized interest Supplemental schedule of non-cash investing and financing activities: Consolidation of real estate joint ventures in connection with adoption of FIN 46(R): Operating properties Projects under construction or development Investments in and advances to unconsolidated real estate joint ventures Restricted cash Accounts receivable, net Deferred rent receivable Deferred charges, net Prepaid and other assets Mortgage and other loans payable Accounts payable and accrued expenses Rents received in advance and security deposits Other liabilities Minority interests—other consolidated real estate joint ventures Net adjustment Purchase/adjustment of commercial real estate properties by acquiring joint venture partner interests: Operating properties Investments in and advances to unconsolidated real estate joint ventures Accounts receivable, net Deferred rent receivable Deferred costs Prepaid and other assets Mortgage and other loans payable Accounts payable and accrued expenses Rents received in advance and security deposits Other liabilities Cash from purchase Debt assumed in connection with acquisitions Notes receivable assumed upon sales of real estate Investment in real estate joint venture obtained with disposition of property Increase (decrease) in accrued capital improvements and leasing costs Increase in other accruals associated with investment activities Amortization of discounts and premiums on mortgage loan to commercial real estate properties Accretion of other liability to commercial real estate properties Increase (decrease) in fair value of derivatives applied to AOCL and minority interests Issuance of preferred units in the Operating Partnership in connection with acquisition of real estate Adjustments to minority interests resulting from changes in ownership of Operating Partnership by COPT Dividends/distribution payable Decrease in minority interests and increase in shareholders’ equity in connection with the conversion of common units into common shares Conversion of preferred shares adjusted to common shares and paid in capital Issuance of restricted shares For the Years Ended December 31, 2004 2003 2002 $ 43,717 $ 39,898 $38,866 $ 2,176 $ 17,959 (3,957) 10 145 7 1,026 (3,263) (10,171) (2,737) (347) 4,650 (5,498) — $ — — — — — — — — — — — — — — $ — — — — — — — — — — — — — $ — (83) $ 25,400 $ — $ $ $ 83 — — — — — — — — — $120,817 $ $ — — $ 17,234 $ $ $ $ — 925 147 390 $ 8,800 — — — — — — — — — $ — $36,040 $ 2,326 $ — $ (1,408) $ — $ — $ — $ 3,285 (10,634) 152 134 1,902 68 (16,470) (370) (120) (62) — $ $ 16,917 $ — $ 2,300 $ 4,670 351 445 503 (104) $ $ $ $ $ — $ — $ 19,360 $ 14,713 $ 6,697 $ 12,098 $ 5,970 $ 9,794 $ 8,041 $ 2,066 $ $ 12 2,271 $ $ — — $ 8,623 $ — $ — CORPORATE OFFICE PROPERTIES TRUST 71 16. INFORMATION BY BUSINESS SEGMENT We have seven primary office property segments: Baltimore/Washington Corridor, Northern Virginia, Greater Philadelphia, St. Mary’s and King George Counties, Northern/Central New Jersey, Suburban Maryland and Greater Harrisburg. The table below reports segment financial information. The reportable segments include, when applicable, properties clas- sified as discontinued operations because these properties are included in the measure of profit reviewed by management. Our segment entitled “Other” includes assets and operations not specifically associated with the other defined segments, including elimination entries required in consolidation. We measure the performance of our segments based on total revenues less property operating expenses, a measure we define as net operating income (“NOI”). We believe that NOI is an impor- tant supplemental measure of operating performance for a REIT’s operating real estate because it provides a measure of the core operations that is unaffected by depreciation, amortization, financing and general and administrative expenses; this meas- ure is particularly useful in our opinion in evaluating the performance of geographic segments, same-office property groupings and individual properties. Baltimore/ Washington Northern Virginia Corridor & King George Philadelphia Counties Greater Central New Jersey St. Mary’s Northern/ Suburban Greater Maryland Harrisburg Other Total Year Ended December 31, 2004 Revenues $105,945 $ 48,701 $ 10,025 $ 5,483 $ 18,793 $ 8,924 $ 8,855 $ 7,847 $ 214,573 Property operating expenses NOI Commercial real estate 33,246 14,323 165 1,327 5,362 3,378 2,874 2,378 63,053 $ 72,699 $ 34,378 $ 9,860 $ 4,156 $ 13,431 $ 5,546 $ 5,981 $ 5,469 $ 151,520 property expenditures $110,313 $148,400 $ 1,176 $90,214 $ 2,063 $27,460 $ 509 $ 17,815 $ 397,950 Segment assets at December 31, 2004 $773,602 $421,434 $101,042 $96,413 $ 85,110 $70,152 $68,126 $116,147 $1,732,026 Year Ended December 31, 2003 Revenues $ 95,796 $ 30,398 $ 10,025 $ — $ 15,643 $ 6,722 $ 9,897 $ 6,852 $ 175,333 Property operating expenses NOI Commercial real estate 29,289 9,186 134 — 5,579 2,674 2,707 2,489 52,058 $ 66,507 $ 21,212 $ 9,891 $ — $ 10,064 $ 4,048 $ 7,190 $ 4,363 $ 123,275 property expenditures $ 85,175 $125,188 $ 663 $ — $ 675 $ 1,015 $ 502 $ 1,519 $ 214,737 Segment assets at December 31, 2003 $683,030 $263,524 $102,219 $ — $ 84,435 $42,228 $69,376 $ 87,264 $1,332,076 Year Ended December 31, 2002 Revenues $ 86,830 $ 14,250 $ 10,025 $ — $ 18,991 $ 7,994 $ 9,553 $ 6,661 $ 154,304 Property operating expenses NOI Commercial real estate 24,723 5,463 151 — 6,925 3,193 2,562 2,270 45,287 $ 62,107 $ 8,787 $ 9,874 $ — $ 12,066 $ 4,801 $ 6,991 $ 4,391 $ 109,017 property expenditures $ 80,863 $ 46,977 $ 563 $ — $ 1,095 $24,669 $ 956 $ 932 $ 156,055 Segment assets at December 31, 2002 $598,561 $115,243 $103,686 $ — $106,928 $59,738 $70,431 $ 84,134 $1,138,721 72 CORPORATE OFFICE PROPERTIES TRUST The following table reconciles our segment revenues and property operating expenses to total revenues and operating expenses as reported on our Consolidated Statements of Operations: Segment revenues Construction contract revenues Other service operations revenues Less: revenues from discontinued real estate operations Total revenues Segment property operating expenses Less: property expenses from discontinued real estate operations For the Years Ended December 31, 2004 2003 2002 $214,573 $175,333 $154,304 25,018 3,885 — $243,476 $ 63,053 — 28,865 2,875 (910) $206,163 $ 52,058 (359) 826 3,851 (3,969) $155,012 $ 45,287 (1,358) Total property operating expenses $ 63,053 $ 51,699 $ 43,929 The following table reconciles our NOI for reportable segments to income from continuing operations as reported on our Consolidated Statements of Operations: NOI for reportable segments Construction contract revenues Other service operations revenues (Loss) gain on sales of real estate, excluding discontinued operations Equity in loss of unconsolidated entities Income tax (expense) benefit Less: Depreciation and other amortization associated with real estate operations Construction contract expenses Other service operations expenses General and administrative expenses Interest expense Amortization of deferred financing costs Minority interests NOI from discontinued operations Income from continuing operations For the Years Ended December 31, 2004 2003 2002 $151,520 $123,275 $109,017 25,018 3,885 (150) (88) (795) (51,904) (23,733) (3,263) (10,938) (44,263) (2,431) (5,826) — 28,865 2,875 472 (98) 169 (37,122) (27,483) (3,450) (7,893) (41,079) (2,767) (6,759) (551) 826 3,851 2,564 (402) 347 (30,859) (789) (4,192) (6,697) (39,065) (2,501) (7,461) (2,611) $ 37,032 $ 28,454 $ 22,028 We did not allocate (loss) gain on sales of real estate, interest expense, amortization of deferred financing costs and depreciation and other amortization to segments since they are not included in the measure of segment profit reviewed by management. We also did not allocate construction contract revenues, other service operations revenues, construction con- tract expenses, other service operations expenses, equity in loss of unconsolidated real estate joint ventures, general and administrative expense, income taxes and minority interests because these items represent general corporate items not attributable to segments. CORPORATE OFFICE PROPERTIES TRUST 73 17. INCOME TAXES Corporate Office Properties Trust elected to be treated as a REIT under Sections 856 through 860 of the Internal Revenue Code. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we distribute at least 90% of our adjusted taxable income to our shareholders. As a REIT, we generally will not be subject to Federal income tax if we distribute at least 100% of our REIT taxable income to our shareholders and satisfy certain other requirements (see discussion below). If we fail to qualify as a REIT in any tax year, we will be subject to Federal income tax on our taxable income at regular corporate rates and may not be able to qualify as a REIT for four subsequent tax years. The differences between taxable income reported on our income tax return (estimated 2004 and actual 2003 and 2002) and net income as reported on our Consolidated Statements of Operations are set forth below (unaudited): Net income Adjustments: Rental revenue recognition Compensation expense recognition Operating expense recognition Gain on sales of properties Interest income Losses from service operations Income tax expense (benefit) Income (loss) from cost method investments Depreciation and amortization Earnings from unconsolidated real estate joint ventures Minority interests, gross Other Taxable income For the Years Ended December 31, 2004 (Estimated) $ 37,032 2003 2002 $30,877 $23,301 (5,936) (10,268) (57) 150 — (1,971) 795 — 11,818 65 6,149 (67) (4,297) (1,194) (214) (1,531) — 458 (169) 116 1,232 (87) 1,787 103 (62) (171) 51 (731) 25 867 (347) (701) (252) (960) 389 26 $ 37,710 $27,081 $21,435 For Federal income tax purposes, dividends to sharehold- COMI is subject to Federal and state income taxes. COMI ers may be characterized as ordinary income, capital gains or had income (losses) before income taxes under GAAP of return of capital. The characterization of dividends declared $1,971 in 2004, ($458) in 2003 and ($910) in 2002. COMI rec- on our common shares during each of the last three years was ognized an income tax (expense) benefit on such income and losses of ($795) in 2004, $169 in 2003 and $347 in 2002. COMI’s provision for income tax consisted of the following: For the Years Ended December 31, 2003 2002 2004 Current Federal State Deferred Federal State Total $ — — — (654) (141) (795) $(795) $ — — — 139 30 169 $169 $182 39 221 104 22 126 $347 as follows: Ordinary income Return of capital Long term capital gain For the Years Ended December 31, 2003 68.6% 27.6% 3.8% 2004 67.4% 32.6% 0.0% 2002 59.5% 31.2% 9.3% The dividends declared on our preferred shares during each of the last three years were all characterized as ordinary income. We distributed all of our REIT taxable income in 2002, 2003 and 2004 and, as a result, did not incur Federal income tax in those years on such income. 74 CORPORATE OFFICE PROPERTIES TRUST A reconciliation of COMI’s Federal statutory rate of 35% to 19. COMMITMENTS AND CONTINGENCIES the effective tax rate for income tax reported on our In the normal course of business, we are involved in legal actions Statements of Operations is set forth below: arising from our ownership and administration of properties. For the Years Ended December 31, 2003 2002 2004 Income taxes at U.S. statutory rate State and local, net 35.0% 35.0% 35.0% of U.S. Federal tax benefit Other Effective tax rate 4.6% 0.7% 40.3% 4.2% (2.6%) 36.6% 4.4% (1.5%) 37.9% Items contributing to temporary differences that lead to deferred taxes include net operating losses that are not deductible until future periods, depreciation and amortiza- tion, certain accrued compensation and compensation paid in the form of contributions to a deferred nonqualified com- pensation plan. We are subject to certain state and local income and fran- chise taxes. The expense associated with these state and local taxes is included in general and administrative expense on our Consolidated Statements of Operations. We did not sep- arately state these amounts on our Consolidated Statements of Operations because they are insignificant. Management does not anticipate that any liabilities that may result will have a materially adverse effect on our financial posi- tion, operations or liquidity. We are subject to various Federal, state and local environmental regulations related to our prop- erty ownership and operation. We have performed environ- mental assessments of our properties, the results of which have not revealed any environmental liability that we believe would have a materially adverse effect on our financial position, oper- ations or liquidity. Acquisitions As of December 31, 2004, we were under contract to acquire a land parcel in Linthicum, Maryland for $841. As of December 31, 2004, we were also under contract to acquire a leasehold interest in a property in Washington County, Maryland for $9,000, subject to potential future reduc- tions ranging from $750 to $4,000; the amount of such decrease will be determined based on defined levels of job creation resulting from the future development of the prop- erty taking place. Upon completion of this acquisition, we will be obligated to incur $7,500 in development and construc- tion costs for the land parcel over approximately five years. 18. DISCONTINUED OPERATIONS Income from discontinued operations includes revenues and Joint Ventures expenses associated with an operating property located in Oxon We may be required to make additional unilateral capital con- Hill, Maryland which was sold in March 2003. The table below sets tributions to Route 46 Partners, LLC of up to $320 to fund our forth the components of income from discontinued operations: partners’ preferred return. We may also be required to fund For the Years Ended December 31, leasing commissions associated with leasing space in this joint venture’s building to the extent such commissions exceed a defined amount; we do not expect that any such funding, if 2003 2002 required, will be material to us. In addition, we agreed to uni- Revenue from real estate operations $ 910 $3,969 laterally loan the joint venture an additional $100 in the event Expenses from real estate operations: that funds are needed by the entity. Property operating expenses Depreciation and amortization Interest expense Expenses from real estate operations 359 19 100 478 1,358 We may need to make our share of additional investments 481 291 in our real estate joint ventures (generally based on our per- centage ownership) in the event that additional funds are 2,130 needed. In the event that the other members of these joint Earnings from real estate operations ventures do not pay their share of investments when addi- before gain on sale of real estate and minority interests Gain on sale of real estate Income from discontinued tional funds are needed, we may then need to make even 432 2,995 1,839 larger investments in these joint ventures. — In the three consolidated real estate joint ventures that we owned as of December 31, 2004, we would be obligated to operations before minority interests 3,427 1,839 acquire the other members’ interest in each of the joint ven- Minority interests in discontinued operations Income from discontinued tures (20% in the case of one and 50% each in the case of two) (1,004) (566) if defined events were to occur. The amount we would need to pay for those membership interests is computed based on operations, net of minority interests $ 2,423 $1,273 the amount that the owners of those interests would receive CORPORATE OFFICE PROPERTIES TRUST 75 under the joint venture agreements in the event that office Land Leases properties owned by the respective joint ventures were sold We are obligated under leases for two parcels of land, both for a capitalized fair value (as defined in the agreements) on of which are being held for future development (see the sec- a defined date. We estimate the aggregate amount we would tion above entitled “2004 Dispositions”). These leases pro- need to pay for our partners’ membership interests in these vide for monthly rent through April 2079. Future minimum joint ventures to be $2,067; however, since the determination annual rental payments due under the terms of these leases of this amount is dependent on the operations of the office as of December 31, 2004 follow: properties and none of the properties are both completed and occupied, this estimate is preliminary and could be mate- rially different from the actual obligation. Office Leases We are obligated under five operating leases for office space. 2005 2006 2007 2008 2009 Future minimum rental payments due under the terms of these Thereafter leases as of December 31, 2004 follow: $ 48 12 12 12 12 832 $928 2005 2006 2007 2008 2009 $ 616 Other Operating Leases 355 We are obligated under various leases for vehicles and office 71 62 11 $1,115 equipment. Future minimum annual rental payments due under the terms of these leases as of December 31, 2004 follow: 2005 2006 2007 2008 2009 Thereafter $342 275 173 85 9 5 $889 20. QUARTERLY DATA (UNAUDITED) Revenues Operating income Income from continuing operations Net income Preferred share dividends Issuance costs associated with redeemed preferred shares For the Year Ended December 31, 2004 First Quarter $56,623 $22,029 $ 8,993 $ 8,993 (4,456) — Second Quarter $59,962 $21,112 $ 8,843 $ 8,843 (4,435) — Third Quarter $60,563 $22,888 $ 9,750 $ 9,750 (3,784) (1,813) Fourth Quarter $66,328 $24,556 $ 9,446 $ 9,446 (3,654) — Net income available to common shareholders $ 4,537 $ 4,408 $ 4,153 $ 5,792 Basic earnings per share: Income before discontinued operations Net income available to common shareholders Diluted earnings per share: Income before discontinued operations Net income available to common shareholders $ 0.15 $ 0.15 $ 0.14 $ 0.14 $ 0.13 $ 0.13 $ 0.13 $ 0.13 $ 0.12 $ 0.12 $ 0.12 $ 0.12 $ 0.16 $ 0.16 $ 0.15 $ 0.15 76 CORPORATE OFFICE PROPERTIES TRUST Revenues Operating income Income from continuing operations Net income Preferred share dividends Repurchase of preferred units in excess of recorded book value For the Year Ended December 31, 2003 First Quarter $45,987 $17,791 $ 5,552 $ 7,987 (2,533) — Second Quarter $ 43,069 $ 18,701 $ 6,261 $ 6,238 (2,534) (11,224) Third Quarter $65,251 $21,716 $ 8,571 $ 8,582 (3,157) — Fourth Quarter $51,856 $20,308 $ 8,070 $ 8,070 (3,779) — Net income (loss) available to common shareholders $ 5,454 $ (7,520) $ 5,425 $ 4,291 Basic earnings per share: Income (loss) before discontinued operations Net income (loss) available to common shareholders Diluted earnings per share: Income (loss) before discontinued operations Net income (loss) available to common shareholders $ 0.13 $ 0.23 $ 0.12 $ 0.22 $ (0.29) $ (0.30) $ (0.29) $ (0.30) $ 0.19 $ 0.19 $ 0.18 $ 0.18 $ 0.15 $ 0.15 $ 0.14 $ 0.14 21. PRO FORMA FINANCIAL INFORMATION (UNAUDITED) We accounted for our 2003 and 2004 acquisitions using the purchase method of accounting. We included the results of operations for the acquisitions in our Consolidated Statements Pro forma total revenues of Operations from their respective purchase dates through Pro forma net income December 31, 2004. Pro forma net income available For the Years Ended December 31, 2004 2003 (unaudited) (unaudited) $260,852 $ 38,366 $245,604 $ 32,244 We prepared our pro forma condensed consolidated finan- to common shareholders $ 20,224 $ 9,017 cial information presented below as if all of our 2003 and 2004 Pro forma earnings per common acquisitions and dispositions of operating properties had share on net income available occurred at the beginning of the respective periods. The pro to common shareholders forma financial information is unaudited and is not necessar- ily indicative of the results that actually would have occurred if Basic Diluted these acquisitions and dispositions had occurred at the begin- $ $ 0.61 0.58 $ $ 0.31 0.30 ning of the respective periods, nor does it purport to indicate 22. SUBSEQUENT EVENTS our results of operations for future periods. On January 27, 2005, we purchased a 19-acre land parcel located in Chantilly, Virginia for a purchase price of $7,100. CORPORATE OFFICE PROPERTIES TRUST 77 Management’s Report on Internal Control over Financial Reporting Management is responsible for establishing and maintain- Management performed an assessment of the effective- ing adequate internal control over financial reporting, and ness of our internal control over financial reporting as of for performing an assessment of the effectiveness of inter- December 31, 2004 based upon criteria in Internal Control— nal control over financial reporting as of December 31, 2004. Integrated Framework issued by the Committee of Sponsoring Internal control over financial reporting is a process designed Organizations of the Treadway Commission (“COSO”). Based to provide reasonable assurance regarding the reliability of on our assessment, management determined that our inter- financial reporting and the preparation of financial state- nal control over financial reporting was effective as of ments for external purposes in accordance with generally December 31, 2004 based on the criteria in Internal Control— accepted accounting principles. Our internal control over Integrated Framework issued by the COSO. financial reporting includes those policies and procedures Our management’s assessment of the effectiveness of our that (i) pertain to the maintenance of records that, in reason- internal control over financial reporting as of December 31, able detail, accurately and fairly reflect the transactions and 2004 has been audited by PricewaterhouseCoopers LLP, an dispositions of our assets; (ii) provide reasonable assurance independent registered public accounting firm, as stated in that transactions are recorded as necessary to permit prepa- their report which appears herein. ration of financial statements in accordance with generally accepted accounting principles, and that our receipts and Dated: March 16, 2005 expenditures are being made only in accordance with author- izations of our management and trustees; and (iii) provide reasonable assurance regarding prevention or timely detec- tion of unauthorized acquisition, use or disposition of our Clay W. Hamlin, III assets that could have a material effect on the financial state- Chief Executive Officer ments. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstate- ments. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may Randall M. Griffin become inadequate because of changes in conditions, or President and Chief Operating Officer that the degree of compliance with the policies or proce- dures may deteriorate. Roger A. Waesche, Jr. Executive Vice President and Chief Financial Officer 78 CORPORATE OFFICE PROPERTIES TRUST Report of Independent Registered Public Accounting Firm To the Board of Trustees and Shareholders of Corporate Office Properties Trust: We have completed an integrated audit of Corporate Office Properties Trust’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated Financial Statements In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, share- holders’ equity and cash flows present fairly, in all material respects, the financial position of Corporate Office Properties Trust and its subsidiaries (the “Company”) at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the stan- dards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and per- form the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluat- ing the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for the consolidation of variable interest entities as of March 31, 2004. Internal Control over Financial Reporting Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting that the Company main- tained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is respon- sible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of inter- nal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal con- trol over financial reporting includes obtaining an understand- ing of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and perform- ing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reason- able basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regard- ing the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those poli- cies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the com- pany; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial state- ments in accordance with generally accepted accounting prin- ciples, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detec- tion of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inad- equate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. PricewaterhouseCoopers LLP Baltimore, Maryland March 16, 2005 CORPORATE OFFICE PROPERTIES TRUST 79 Market for Registrant’s Common Equity and Related Shareholder Matters Our common shares trade on the New York Stock Exchange The number of holders of record of our shares was 382 as (“NYSE”) under the symbol “OFC.” The table below shows of December 31, 2004. This number does not include share- the range of the high and low sale prices for our common holders whose shares are held of record by a brokerage house shares as reported on the NYSE, as well as the quarterly com- or clearing agency, but does include any such brokerage mon share dividends per share declared. house or clearing agency as one record holder. Price Range 2003 First Quarter Second Quarter Third Quarter Fourth Quarter Low $13.50 14.75 16.79 18.51 High $15.07 16.96 19.35 22.40 Price Range 2004 First Quarter Second Quarter Third Quarter Fourth Quarter Low $20.28 19.00 24.09 25.70 High $25.05 25.10 26.91 29.37 Dividends Per Share $0.220 $0.220 $0.235 $0.235 Dividends Per Share $0.235 $0.235 $0.255 $0.255 We will pay future dividends at the discretion of our Board of Trustees. Our ability to pay cash dividends in the future will be dependent upon (i) the income and cash flow generated from our operations, (ii) cash generated or used by our financ- ing and investing activities and (iii) the annual distribution requirements under the REIT provisions of the Code described above and such other factors as the Board of Trustees deems relevant. Our ability to make cash dividends will also be limited by the terms of our Operating Partnership Agreement and our financing arrangements as well as limi- tations imposed by state law and the agreements governing any future indebtedness. 80 CORPORATE OFFICE PROPERTIES TRUST Corporate Information TRUSTEES Jay H. Shidler Managing Partner, The Shidler Group; Chairman of the Board, Corporate Office Properties Trust Clay W. Hamlin, III Chief Executive Officer, Corporate Office Properties Trust Thomas F. Brady Executive Vice President, Corporate Strategy and Retail Competitive Supply, Constellation Energy Group Robert L. Denton Managing Partner, The Shidler Group Steven D. Kesler Formerly President and Chief Executive Officer, Constellation Investments, Inc. Kenneth S. Sweet, Jr. Principal, GS Capital, L.P. Kenneth D. Wethe Principal, Wethe & Associates Betsy Z. Cohen (not pictured), Chief Executive Officer and Trustee, RAIT Investment Trust; Chief Executive Officer, The Bancorp, Inc. Randall M. Griffin (not pictured), President and Chief Operating Officer, added to the Board of Trustees as of February 24, 2005. EXECUTIVE OFFICERS Clay W. Hamlin, III Chief Executive Officer Randall M. Griffin President and Chief Operating Officer Roger A. Waesche, Jr. Executive Vice President and Chief Financial Officer Karen M. Singer Vice President, General Counsel and Secretary SERVICE COMPANY EXECUTIVE OFFICER Dwight S. Taylor President, Corporate Development Services EXECUTIVE OFFICES Corporate Office Properties Trust 8815 Centre Park Drive, Suite 400 Columbia, Maryland 21045 Telephone: (410) 730-9092 Facsimile: (410) 740-1174 Pennsylvania Office Corporate Office Properties Trust 40 Morris Avenue, Suite 220 Bryn Mawr, Pennsylvania 19010 LEGAL COUNSEL Morgan, Lewis & Bockius 1701 Market Street Philadelphia, Pennsylvania 19103 REGISTRAR AND TRANSFER AGENT Shareholders with questions concerning stock certificates, account information, dividend payments or stock transfers should contact our transfer agent: Wells Fargo Bank, N.A. 161 North Concord Exchange South St. Paul, Minnesota 55075 Toll-free: (800) 468-9716 www.wellsfargo.com/com/shareowner_services INDEPENDENT AUDITORS PricewaterhouseCoopers LLP 250 West Pratt Street, Suite 2100 Baltimore, Maryland 21201 DIVIDEND REINVESTMENT PLAN Registered shareholders may reinvest dividends through the Company’s dividend reinvestment plan. For more information, please contact Wells Fargo Shareowner Services at (800) 468-9716. ANNUAL MEETING The annual meeting of shareholders will be held at 9:30 a.m. on Thursday, May 19, 2005, at The World Trade Center Baltimore, 401 East Pratt Street, Baltimore, Maryland 21202. INVESTOR RELATIONS For help with questions about the Company, or for additional corporate information, please contact: Mary Ellen Fowler Vice President, Finance and Investor Relations Corporate Office Properties Trust 8815 Centre Park Drive, Suite 400 Columbia, Maryland 21045 Telephone: (410) 992-7324 Facsimile: (410) 740-1174 Email: ir@copt.com m o c . e v i t a e r c i c f . w w w D M , a d s e h t e B . c n I i s n o i t a c n u m m o C l a i c n a n F i : n g i s e D 5 0 0 2 t s u r T s e i t r e p o r P e c i f f O e t a r o p r o C © SHAREHOLDER INFORMATION As of March 15, 2005, the Company had 36,999,383 outstanding common shares owned by approximately 390 shareholders of record. This does not include the number of persons whose shares are held in nominee or “street name” accounts through brokers or clearing agencies. COMMON AND PREFERRED SHARES The common and preferred shares of Corporate Office Properties Trust are traded on the New York Stock Exchange. Common shares are traded under the symbol OFC, and preferred shares are traded under the symbols OFC —PrE, PrF, PrG and PrH. WEB SITE For additional information on the Company, visit our web site at www.copt.com. FORWARD-LOOKING INFORMATION This report contains forward-looking information based upon the Company’s current best judgment and expectations. Actual results could vary from those pre- sented herein. The risks and uncertainties associated with the forward-looking information include the strength of the commercial office real estate market in which the Company operates, competitive market conditions, general economic growth, interest rates and capital market conditions. For further information, please refer to the Company’s filings with the Securities and Exchange Commission. CORPORATE OFFICE PROPERTIES 8815 Centre Park Drive, Suite 400 Columbia, MD 21045 410.730.9092 www.copt.com