MISSION WEST PROPERTIES INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying condensed consolidated financial statements and notes thereto under Part I, Item 1 of this Report and our audited consolidated financial statements and notes thereto contained in our Annual Report on Form 10-K as of and for the year endedDecember 31, 2011 . The results for the three and nine months endedSeptember 30, 2012 , are not necessarily indicative of the results to be expected for the entire fiscal year endingDecember 31, 2012 .
Forward-Looking Information
This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and are including this statement for purposes of complying with these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions, including statements regarding distributions and dividends that may be made to our stockholders and the timing and amounts thereof, the potential sale of assets, the anticipated timing of the closing of the Asset Sale, and any statements of assumptions underlying any of the foregoing. Additionally, all disclosures under Part I, Item 3 constitute forward-looking statements. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have a material adverse effect on our operations and future prospects or would cause actual results in the future to differ materially from any of our forward-looking statements include, but are not limited to, the following:
· the current turmoil in the credit markets could limit the demands for R&D
space and affect the overall availability and cost of credit,
· economic conditions generally and the real estate market specifically,
· the occupancy rates of the properties,
· rental rates on new and renewed leases,
· legislative or regulatory provisions (including changes to laws governing the
taxation of REITs),
· availability of capital,
· interest rates, · competition,
· supply of and demand for R&D, office and industrial properties in our current
and proposed market areas,
· tenant defaults and bankruptcies,
· lease term expirations and renewals,
· changes in general accounting principles, policies and guidelines applicable
to REITs, and
· ability to timely refinance maturing debt obligations and the terms of any
such refinancing. These risks and uncertainties, together with the other risks described under Part I, Item 1A - "Risk Factors" of our 2011 Annual Report on Form 10-K and from time to time in our other reports and documents filed with theSecurities and Exchange Commission ("SEC"), should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
Overview
We acquire, market, lease, and manage R&D/office properties, primarily located in theSilicon Valley portion of theSan Francisco Bay Area . As ofSeptember 30, 2012 , we owned and managed 101 properties totaling approximately 7.6 million rentable square feet through six limited partnerships, or operating partnerships, for which we are the sole general partner. This class of property is designed for research and development and office uses and, in some cases, includes space for light manufacturing operations with loading docks. We believe that we have one of the largest portfolios of R&D/office properties in theSilicon Valley . As ofSeptember 30, 2012 , two tenants individually leased in excess of 300,000 rentable square feet from us: Microsoft Corporation and Apple, Inc. The Microsoft lease expires inAugust 2014 with two separate options to extend the lease for two successive additional periods of five years commencing on the expiration of the initial lease term upon the same terms and conditions of the initial lease term except that base rent for each option shall be determined at 95% of the fair market rent for the option term with annual increases in base rent. We have five leases with Apple for multiple properties: two leases expiring in 2014, one lease expiring in 2018, and two leases expiring in 2022. The two leases that expire in 2022 have annual termination rights with 12 months advance written notice afterMay 1, 2019 andJuly 31, 2019 . These leases have a range of one to three separate options to extend the lease for successive additional periods of three to five years commencing on the expiration of the initial lease term upon the same terms and conditions of the initial lease term except that base rent for each option shall be determined at 95% of the fair market rent for the option term with annual increases in base rent.
For federal income tax purposes, we have operated as a self-managed, self-administered and fully integrated real estate investment trust ("REIT") since the beginning of fiscal 1999.
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Our acquisition, growth and operating strategy incorporates the following elements:
· capitalizing on opportunistic acquisitions from third parties of high-quality
R&D/office properties that provide attractive initial yields and significant
potential for growth in cash-flow;
· focusing on general purpose, single-tenant Silicon Valley R&D/office
properties for information technology companies in order to maintain low
operating costs, reduce tenant turnover and capitalize on our relationships
with these companies and our extensive knowledge of their real estate needs;
and
· maintaining prudent financial management principles that emphasize current
cash flow while building long-term value, the acquisition of pre-leased
properties to reduce development and leasing risks and the maintenance of
sufficient liquidity to acquire and finance properties on desirable terms.
Company Sale Status Operating Partnership Recapitalization OnNovember 2, 2012 , we entered into anAsset Alignment and Limited Partnership Conversion Agreement (the "Alignment and Conversion Agreement") withMission West Properties, L.P. ,Mission West Properties, L.P. I,Mission West Properties, L.P. II,Mission West Properties, L.P. III,Mission West Properties, L.P. IV andMission West Properties , L.P. V (each, anOperating Partnership , and collectively, the "Operating Partnerships"), and a majority in interest of the limited partners (the "Limited Partners") of the Operating Partnerships. Also onNovember 2, 2012 , we entered into a Partnership Separation Agreement (the "Separation Agreement") with the Operating Partnerships and a majority in interest of the Limited Partners. The Alignment and Conversion Agreement and the Separation Agreement are collectively referred to as the "Recapitalization Agreements." Prior to consummating the transactions contemplated by the Recapitalization Agreements, we will remain the general partner of each of the Operating Partnerships and members of theBerg Group will continue to hold a majority of the limited partnership interests in the Operating Partnerships. The "Berg Group " consists ofCarl E. Berg , our Chief Executive Officer and Chairman of the Board, Clyde J. Berg, Kara Ann Berg,Berg & Berg Enterprises, Inc. ,Berg & Berg Enterprises, LLC , 1981Kara Ann Berg Trust ,West Coast Venture Capital, Inc. , theCarl and Mary Ann Berg Charitable Remainder Trust , the Clyde J. Berg 2011Charitable Remainder Trust and the Kara Ann Berg 2011Charitable Remainder Trust . Pursuant to the Recapitalization Agreements, certain of the real estate assets held by the Operating Partnerships will be sold among the Operating Partnerships. In addition, certain Limited Partners may elect to convert their interests in the Operating Partnerships (the "O.P. Units") into cash, shares of our common stock, a combination thereof, or promissory notes. Upon completion of these sales and conversions, we will withdraw as the general partner of each of the Operating Partnerships and with respect to any limited partnership interests we hold. In addition, certain Operating Partnerships will retain their remaining assets and liabilities with an approximate net value of$525 million and the non-converting Limited Partners will retain an ownership interest in those Operating Partnerships, of which theBerg Group will hold a majority in interest. The transactions contemplated by the Recapitalization Agreements are referred to as the "OP Recapitalization." Asset Sale OnNovember 2, 2012 , we entered into an Agreement of Purchase and Sale and Escrow Instructions (the "Sale Agreement") withM West Holdings, L.P. , aDelaware limited partnership (the "Buyer") sponsored by Divco West andTPG Real Estate , pursuant to which we have agreed to sell a significant portion of our assets (the "Asset Sale") to the Buyer. The assets to be sold to the Buyer include property to be transferred to us from our Operating Partnerships as part of the Recapitalization. On the closing of the Asset Sale, the Buyer will pay to us approximately$400 million in cash and assume debt and other obligations totaling approximately$398 million . If the Asset Sale and the OP Recapitalization are approved and adopted by our stockholders and satisfaction and/or waiver of the conditions to closing occurs, the closing of the Asset Sale is expected to take place byDecember 27, 2012 . Completion of the Asset Sale is contingent upon the consummation of the OP Recapitalization.
Liquidation
Following completion of the OP Recapitalization and the Asset Sale, we will have transferred or disposed of substantially all of our assets and intend to liquidate (the "Liquidation") after satisfying outstanding debts and obligations, applicable taxes and related transaction costs. We currently estimate these transactions will result in a distribution to stockholders (and any holders of O.P. Units that elect to redeem their O.P. Units for common stock) in the range of$9.20 to $9.28 per share in cash, although the amount ultimately distributed to stockholders may be below this range. The estimated distribution amount includes the sales proceeds, after liabilities and expenses, and the final 2012 dividend in accordance with statutory REIT distribution requirements. The OP Recapitalization, the Asset Sale and the Liquidation are referred to herein as the "Transactions."
Following the Liquidation, our common stock will cease to be listed on the
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Current Economic Environment
All of our properties are located in theNorthern California area known as theSilicon Valley , which generally consists of portions ofSanta Clara County ,Southwestern Alameda County ,Southeastern San Mateo County andEastern Santa Cruz County . Historically, the Silicon Valley R&D property market has fluctuated with the local economy.The Silicon Valley economy and business activity slowed markedly from 2001 through 2006 and grew slowly until the second half of 2008. SinceSeptember 2008 , the impact of the worldwide recession has adversely affected the local economy, but less so than other regions ofCalifornia . Data suggests that theSilicon Valley economy in particular has improved this year. While this is generally beneficial, we do not expect a significant positive effect on our leasing activities. According to a recent report byCassidy Turley Real Estate (the "CT Report"), which we consider to be a useful publicly available source of relevant market data, the vacancy rate forSilicon Valley R&D property was approximately 15.8% in late 2011 and 14.5% at the end of the third quarter of 2012. Total direct vacant R&D square footage in theSilicon Valley at the end of the third quarter of 2012 amounted to approximately 22.3 million square feet and sublet vacant was approximately 2.2 million square feet. According to the CT Report, total positive net absorption (which is the computation of gross square footage leased less gross new square footage vacated for the period presented) in 2011 amounted to approximately 4.0 million square feet, and in the first nine months of 2012 there was total positive net absorption of approximately 1.0 million square feet. Also according to the CT Report, the average asking market rent per square foot for R&D space at the end of the third quarter of 2012 was$1.28 per month compared with$1.15 per month in late 2011. The Silicon Valley R&D property market is characterized by a substantial number of submarkets, with rent and vacancy rates varying by submarket and location within each submarket. Individual properties within any particular submarket presently may be leased above or below the current average asking market rental rates within that submarket and the region as a whole. Notwithstanding the improving local economic conditions, due to the substantial overhang of vacant R&D properties throughout theSilicon Valley , we believe that we are unlikely to see a sustainable recovery in the leasing market for our properties prior to 2013. Our occupancy rate atSeptember 30, 2012 , was 70.6% compared with 66.7% atSeptember 30, 2011 . Most of the occupancy improvement was attributable to vacant property dispositions and vacant properties classified as assets held for sale which were not included in the vacancy statistic. We believe that our occupancy rate could decline if key tenants seek the protection of bankruptcy laws, consolidate operations or discontinue operations. In addition, excluding approximately 71,000 rentable square feet of properties subject to a month-to-month lease, leases with respect to approximately 41,000 rentable square feet are scheduled to expire during the remainder of 2012 and approximately 377,000 rentable square feet are scheduled to expire in 2013. The properties subject to these leases may take anywhere from 24 to 40 months or longer to re-lease. If we fail to re-lease a substantial portion of this square footage, our operating results and cash flows are likely to be affected adversely. We believe that the average 2012 renewal rental rates for our properties will be approximately equal to, greater than, or perhaps, below current market rents, but we cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current quoted market rates. At this time, we estimate that none of the rentable square feet scheduled to expire in the remainder of 2012 and 56% of the rentable square feet scheduled to expire in 2013 will be renewed, however, we cannot give any assurances that we will renew the expiring leases at that rate. In the third quarter 2012, we signed three lease renewals for approximately 108,000 rentable square feet with a weighted average effective rent of$1.16 per square foot for a renewal period of two to four years. No tenant improvement costs and leasing commissions were related to these leases. We did not renew approximately 37,000 rentable square feet due to one expired lease in the third quarter 2012. One current tenant also needed less space and gave up approximately 11,000 rentable square feet. The weighted average expired rent for these newly available spaces was approximately$0.87 per square foot. Despite our strategic focus on single tenant properties and leases, in order to meet market conditions, we have been, and expect to continue leasing less than the entire premises of some of our R&D properties to a single tenant from time to time. Leasing our R&D properties, which generally have been built for single tenant occupancy, to multiple tenants can increase our leasing costs and operating expenses and reduce the profitability of our leasing activities. If we are unable to lease a significant portion of any vacant space or space subject to expiring leases; if we experience significant tenant defaults as a result of the current economic downturn; if we are not able to lease space at or above current market rates; if we restructure existing leases and lower existing rents in order to retain tenants for an extended term; or if we increase our lease costs and operating expenses substantially to accommodate multiple tenants in our R&D properties, our results of operations and cash flows will be affected adversely. Furthermore, in this event it is probable that our board of directors will reduce the quarterly dividend on the outstanding common stock and the O.P. units. Our operating results and ability to pay dividends at current levels remain subject to a number of material risks, as indicated under the caption "Forward-Looking Information" above and in the section entitled "Risk Factors" in our most recent annual report on Form 10-K. -13- --------------------------------------------------------------------------------
Critical Accounting Policies and Estimates
We prepare the condensed consolidated financial statements in conformity with accounting principles generally accepted inthe United States of America ("GAAP"), which requires us to make certain estimates, judgments and assumptions that affect the reported amounts in the accompanying condensed consolidated financial statements, disclosure of contingent assets and liabilities and related footnotes. Accounting and disclosure decisions with respect to material transactions that are subject to significant management judgments or estimates include impairment of long lived assets, deferred rent reserves, and allocation of purchase price relating to property acquisitions and the related depreciable lives assigned. Actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are defined as those that require management to make estimates, judgments and assumptions, giving due consideration to materiality, in certain circumstances that affect amounts reported in the condensed consolidated financial statements, and potentially result in materially different results under different conditions and assumptions. We based these estimates and assumptions on historical experience and evaluate them on an on-going basis to help ensure they remain reasonable under current conditions. Actual results could differ from those estimates. During the nine months endedSeptember 30, 2012 , there were no significant changes to the critical accounting policies and estimates discussed in the Company's 2011 annual report on Form 10-K.
Results of Operations
Comparison of the three and nine months ended
As ofSeptember 30, 2012 , through our controlling interests in the operating partnerships, we owned 101 properties totaling approximately 7.6 million rentable square feet compared with 112 properties totaling approximately 8.1 million rentable square feet owned by us as ofSeptember 30, 2011 .
Comparison of rental income from real estate for the three and nine months ended
Three Months Ended September 30, % Change by 2012 2011 $ Change Property Group (dollars in thousands) Same Property (1) $ 20,266 $ 20,696 $ (430 ) (2.1 %) 2011 Acquisitions 205 194 11 5.7 % 2012 Acquisitions - - - - Total $ 20,471 $ 20,890 $ (419 ) (2.0 %) Nine Months Ended September 30, % Change by Property 2012 2011 $ Change Group (dollars in thousands) Same Property (1) $ 59,879 $ 62,773 $ (2,894 ) (4.6 %) 2011 Acquisitions 679 194 485 250.0 % 2012 Acquisitions - - - - Total $ 60,558 $ 62,967 $ (2,409 ) (3.8 %)
(1) "Same Property" is defined as properties owned by us prior to 2011 that we
still owned as of
"same property" as of
Rental Income from Real Estate Operations For the quarter endedSeptember 30, 2012 , rental income from real estate decreased by approximately($0.4) million , or (2.0%), from$20.9 million for the three months endedSeptember 30, 2011 , to$20.5 million for the three months endedSeptember 30, 2012 . The decrease resulted primarily from leases that expired and did not renew sinceSeptember 30, 2011 . Our occupancy rate atSeptember 30, 2012 , was approximately 70.6%, compared with 66.7% atSeptember 30, 2011 . Most of the occupancy improvement was attributable to vacant property dispositions and vacant properties classified as assets held for sale which were not included in the vacancy statistic. Other Income Other income of approximately$0.7 million for the three months endedSeptember 30, 2012 , included approximately$0.3 million from management fees,$0.2 million from security deposit forfeitures and$0.2 million from miscellaneous income. Other income of approximately$0.5 million for the three months endedSeptember 30, 2011 , included approximately$0.3 million from management fees and$0.2 million from miscellaneous income. For the nine months endedSeptember 30, 2012 , other income of approximately$1.3 million included approximately$0.8 million from management fees,$0.2 million from security deposit forfeitures and$0.3 million from miscellaneous income. For the nine months endedSeptember 30, 2011 , other income of approximately$1.9 million included approximately$0.7 million from an incentive to lessee adjustment,$0.8 million from management fees and$0.4 million from miscellaneous income. -14- -------------------------------------------------------------------------------- Operating Expenses and Tenant Reimbursements Property operating expenses, maintenance and real estate taxes for the three months endedSeptember 30, 2012 , decreased by approximately($0.5) million , or (8.2%), to$5.3 million from$5.8 million for the three months endedSeptember 30, 2011 . This decrease was due in part to a decrease in roofing repairs and utility expenses. Tenant reimbursements decreased by approximately($0.2) million , or (5.2%), from$4.2 million for the three months endedSeptember 30, 2011 , to$4.0 million for the three months endedSeptember 30, 2012 . The level of tenant reimbursements is affected by vacancies because certain recurring expenses such as property insurance, real estate taxes, and other fixed operating expenses are not recoverable from vacant properties. For the nine months endedSeptember 30, 2012 , property operating, maintenance and property taxes decreased by approximately($0.7) million , or (4.4%), from$16.8 million for the nine months endedSeptember 30, 2011 , to$16.1 million for the nine months endedSeptember 30, 2012 , primarily due to higher property tax refunds in 2012. Tenant reimbursements decreased by approximately($2.0) million , or (15.6%), from$13.0 million for the nine months endedSeptember 30, 2011 , to$11.0 million for the nine months endedSeptember 30, 2012 , primarily due to refunds to tenants relating to annual common area charges reconciliation in 2012. General and administrative expenses increased by approximately$0.4 million , or 74.6%, from$0.5 million to$0.9 million for the three months endedSeptember 30, 2011 and 2012, respectively. For the nine months endedSeptember 30, 2011 and 2012, general and administrative expenses increased by approximately$0.9 million , or 57.9%, from$1.5 million to$2.4 million , respectively. For both periods, the increase in general and administrative expenses was primarily a result of expenses related to the evaluation of strategic alternatives for the possible sale of the Company. Real estate depreciation and amortization expense remained relatively flat at approximately$5.9 million for each of the three months endedSeptember 30, 2011 and 2012. Real estate depreciation and amortization expense increased by approximately$1.1 million , or 6.6%, from$16.7 million to$17.8 million for the nine months endedSeptember 30, 2011 and 2012, respectively. Equity in Earnings from Unconsolidated Joint Venture As ofSeptember 30, 2012 , we held an investment in one R&D building totaling approximately 155,500 rentable square feet through an unconsolidated joint venture, TBI-MWP, in which we acquired a 50% interest from theBerg Group inJanuary 2003 . We have a non-controlling limited partnership interest in this joint venture, which we account for using the equity method of accounting. For the three months endedSeptember 30, 2012 , we recorded equity in earnings from the unconsolidated joint venture of approximately$0.04 million compared with$0.01 million for the same period in 2011. For the nine-month periods endedSeptember 30, 2012 and 2011, equity in earnings from the unconsolidated joint venture was approximately$0.21 million and$0.03 million , respectively. The occupancy rate for the property owned by this joint venture atSeptember 30, 2012 and 2011, was 100%. Interest Income Interest income for each of the three months endedSeptember 30, 2012 and 2011, was approximately$0.05 million . Interest income for the nine months endedSeptember 30, 2012 and 2011, was approximately$0.20 million and$0.18 million , respectively. Interest Expense Interest expense decreased by approximately($0.6) million , or (10.6%), from$5.3 million for the three months endedSeptember 30, 2011 , to$4.7 million for the three months endedSeptember 30, 2012 . Interest expense (related parties) decreased by approximately($0.06) million , or (30.9%), from$0.19 million for the three months endedSeptember 30, 2011 , to$0.13 million for the three months endedSeptember 30, 2012 . Interest expense decreased by approximately($1.3) million , or (8.4%), from$15.8 million for the nine months endedSeptember 30, 2011 , to$14.5 million for the nine months endedSeptember 30, 2012 . Interest expense (related parties) decreased by approximately, or (11.9%), from $0.5 million for the nine months endedSeptember 30, 2011 , to$0.4 million for the nine months endedSeptember 30, 2012 . Total debt outstanding, including debt due related parties, decreased by approximately($27.8) million , or (7.8%), from$354.1 million as ofSeptember 30, 2011 , to$326.3 million as ofSeptember 30, 2012 , because of recurring scheduled debt payments. Income (Loss) from Discontinued Operations In accordance with the provisions of the Property, Plant, and Equipment Topic of the FASB ASC 360, as of and for the period endedSeptember 30, 2012 , two vacant R&D properties were classified as assets held for sale and discontinued operations because they will be sold within one year. Also in the third quarter of 2012, we sold three vacant R&D properties and classified them as discontinued operations. The income (loss) attributable to discontinued operations primarily from the gains on sale from these properties for the three months endedSeptember 30, 2012 and 2011, was approximately$5.1 million and($0.7) million , respectively. The total income (loss) attributable to discontinued operations primarily from the gains on sale from these properties and properties sold earlier in the year , for the nine months endedSeptember 30, 2012 and 2011, was approximately$18.4 million and($2.0) million , respectively. -15- -------------------------------------------------------------------------------- Net Income Available to Common Stockholders and Net Income Attributable to Noncontrolling Interests Net income available to common stockholders increased by approximately$1.0 million , or 55.7%, from$1.9 million for the three months endedSeptember 30, 2011 , to$2.9 million for the three months endedSeptember 30, 2012 . Net income attributable to noncontrolling interests increased by approximately$5.0 million , or 90.4%, from$5.6 million for the three months endedSeptember 30, 2011 , to$10.6 million for the three months endedSeptember 30, 2012 . For the nine months endedSeptember 30, 2012 and 2011, net income available to common stockholders was approximately$8.5 million and$6.2 million , respectively, and net income attributable to noncontrolling interests was approximately$31.9 million and$18.6 million , respectively. The amount of net income attributable to noncontrolling interests has been calculated by multiplying the net income of the operating partnerships (on a stand-alone basis) by the respective noncontrolling interests ownership percentage. Noncontrolling interests represent the ownership interest of all limited partners in the operating partnerships taken as a whole, which was approximately 78% and 79% as ofSeptember 30, 2012 and 2011, respectively. The increase in net income attributable to noncontrolling interests in the first three and nine months of 2012 occurred solely as a result of the increases in our net income for the periods.
Changes in Financial Condition
The most significant changes in our financial condition during the nine months endedSeptember 30, 2012 , resulted from R&D property transactions. We acquired three vacant R&D buildings consisting of approximately 202,500 rentable square feet and approximately 19 acres of raw land located in theSilicon Valley for approximately$28.2 million . We disposed of 13 vacant R&D buildings consisting of approximately 647,000 rentable square feet for approximately$82.2 million . Total stockholders' equity, net, decreased by approximately($1.5) million fromDecember 31, 2011 . We obtained additional capital from the issuance of 82,000 shares of our common stock for the exchange of O.P. units, which increased additional paid-in capital by approximately$0.8 million . Distributions to common stockholders in excess of accumulated earnings increased during the most recent quarter by approximately($2.3) million .
Liquidity and Capital Resources
In 2012, we anticipate operating cash flows from our operating property portfolio to decrease compared with 2011 because we continue to experience weak demand for our R&D properties in certain areas of theSilicon Valley . If we are unable to lease a significant portion of the approximately 41,000 rentable square feet scheduled to expire during the remainder of 2012, 377,000 rentable square feet scheduled to expire in 2013 or an equivalent amount of our currently available space of approximately 2.2 million rentable square feet, our operating cash flows after year 2012 may be affected adversely. We are also subject to risks of decreased occupancy through tenant defaults and bankruptcies and potential reduction in rental rates upon renewal of properties that could result in reduced cash flow from operations instead. Cash proceeds from lease terminations are non-recurring. To maintain or increase cash flows in the future we must lease our vacant properties and renew upcoming expiring leases. Our principal sources of liquidity for distributions to stockholders and O.P. unit holders (noncontrolling interests), debt service, leasing costs, capital expenditures and tenant improvements are to come from net cash flow provided by operations, borrowings from our credit facility, borrowings from related parties, and other sources of financing, as required. We expect these sources of liquidity to be adequate to meet projected distributions to stockholders and other presently anticipated liquidity requirements for the remainder of 2012 and all of 2013. However, there can be no assurance that these sources of liquidity will continue to be available. The unavailability of capital could adversely affect our ability to pay cash dividends to our shareholders. We expect to meet our long-term liquidity requirements for the funding of property development, property acquisitions and other material non-recurring capital improvements through cash, long-term secured and unsecured indebtedness, and the issuance of additional equity securities.
As of
Distributions
OnOctober 4, 2012 , we paid dividends of$0.13 per share of common stock to all common stockholders of record as ofSeptember 28, 2012 . On the same date, the operating partnerships paid a distribution of$0.13 per O.P. unit to all holders of O.P. units. The aggregate dividends and distributions amounted to approximately$13.7 million . Distributions are declared at the discretion of our Board of Directors and are subject to actual cash available for distribution, our financial condition, capital requirements and such other factors, as our Board of Directors deems relevant.
Debt
AtSeptember 30, 2012 , we had total indebtedness of approximately$326.3 million , including$319.6 million of fixed rate mortgage debt and$6.7 million debt under theBerg Group mortgage note (related parties), as detailed in the table below. The Northwestern, Allianz,Hartford and HBC loans contain certain financial loan and reporting covenants as defined in the loan agreements. As ofSeptember 30, 2012 , we were in compliance with these loan covenants. -16- --------------------------------------------------------------------------------
The following table and notes set forth information regarding debt outstanding as of
Debt Description Collateral Properties Balance Maturity Date Interest Rate (dollars in thousands) Line of Credit: Heritage Bank of 1600 Memorex Drive, Sept 2013 (1) Commerce Santa Clara, CA 1688 Richard Drive, Santa Clara, CA 1700 Richard Drive, Santa Clara, CA - Mortgage Note Payable 5300 & 5350 Hellyer $6,672 Jun 2013 7.65% (related parties) (2) : Avenue, San Jose, CA Mortgage Notes Payable (2): Hartford Life Insurance 5981 Optical Court, Oct 2018 6.21% Company San Jose, CA Hartford Life and 5500 Hellyer Avenue, Accident Insurance San Jose, CA Company 5550 Hellyer Avenue, Hartford Life and San Jose, CA Annuity Insurance 4050 Starboard Drive, Company Fremont, CA (collectively known as 45738 Northport Loop, the "Hartford Loan I") Fremont, CA (3) 233 South Hillview Drive, Milpitas, CA 10300 Bubb Road, Cupertino, CA 1230 E. Arques, Sunnyvale, CA 1250-1280 E. Arques, Sunnyvale, CA 1212 Bordeaux Lane, Sunnyvale, CA 2904 Orchard Parkway, San Jose, CA 3236 Scott Blvd, Santa Clara, CA 6311 San Ignacio Avenue, San Jose, CA 6321-6325 San Ignacio Avenue, San Jose, CA 6331 San Ignacio Avenue, San Jose, CA 6341-6351 San Ignacio Avenue, San Jose, CA 3540-3580 Bassett Street, Santa Clara, CA 102,120 Hartford Life Insurance 5830-5870 Hellyer Sept 2030 6.05% Company Avenue, San Jose, CA Hartford Life and 5750 Hellyer Avenue, Accident Insurance San Jose, CA Company 255 Caspian Drive, (collectively known as Sunnyvale, CA the "Hartford Loan II") 5970 Optical Court, (4) San Jose, CA 3301 Olcott Street, Santa Clara, CA 37,810 Northwestern Mutual 1750 Automation Feb 2013 5.64% Life Insurance Company Parkway, San Jose, CA (5) 1756 Automation Parkway, San Jose, CA 1762 Automation Parkway, San Jose, CA 6320 San Ignacio Avenue, San Jose, CA 6540-6541 Via Del Oro, San Jose, CA 6385-6387 San Ignacio Avenue, San Jose, CA 20605-20705 Valley Green Drive, Cupertino, CA 2001 Walsh Avenue, Santa Clara, CA 2220 Central Expressway, Santa Clara, CA 2300 Central Expressway, Santa Clara, CA 2330 Central Expressway, Santa Clara, CA 65,635 Allianz Life Insurance 5900 Optical Court, 19,510 Aug 2025 5.56% Company (Allianz Loan San Jose, CA I) (6) Allianz Life Insurance 5325-5345 Hellyer Aug 2025 5.22% Company (Allianz Loan Avenue, San Jose, CA II) (6) 1768 Automation Parkway, San Jose, CA 2880 Scott Boulevard, Santa Clara, CA 2890 Scott Boulevard, Santa Clara, CA 2800 Scott Boulevard, Santa Clara, CA 10450-10460 Bubb Road, Cupertino, CA 6800-6810 Santa Teresa Blvd., San Jose, CA 6850 Santa Teresa Blvd., San Jose, CA 4750 Patrick Henry Drive, Santa Clara, CA 94,590 319,665 TOTAL $326,337
(1) The interest rate on the revolving line of credit is the greater of LIBOR
plus 1.75% or 4.00% per annum. The interest rate for the HBC line of credit
at
this loan aggregated approximately
over the loan period. The HBC line of credit contains certain financial loan
and reporting covenants as defined in the loan agreement, including minimum
tangible net worth and debt service coverage ratio. As ofSeptember 30, 2012 , we were in compliance with these loan covenants.
(2) Mortgage notes payable and mortgage note payable (related parties) generally
require monthly installments of principal and interest ranging from
approximately
2030. The weighted average interest rate of the mortgage notes payable and
mortgage note payable (related parties) was 5.78% at
(3) The
interest. Costs and fees incurred with obtaining this loan aggregated
approximately
period. The
in the loan agreement. As of
these loan covenants.
(4) The
interest. Costs and fees incurred with obtaining this loan aggregated
approximately
The
loan agreement. As of
loan covenants.
(5) The Northwestern loan is payable in monthly installments of approximately
interest. Costs and fees incurred with obtaining this loan aggregated
approximately
The Northwestern loan contains certain customary covenants as defined in the
loan agreement. As of
loan covenants. -17-
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(6) The Allianz loans are payable in monthly aggregate installments of
approximately
amortization) and interest. Costs and fees incurred with obtaining these
loans aggregated approximately
over the loan periods. The Allianz loans contain certain customary covenants
as defined in the loan agreements. As ofSeptember 30, 2012 , we were in compliance with these loan covenants. AtSeptember 30, 2012 , our debt to total market capitalization ratio, which is computed as our total debt outstanding divided by the sum of total debt outstanding plus the market value of common stock (based upon the closing price of$8.70 per share onSeptember 28, 2012 ) on a fully diluted basis, including the conversion of all O.P. units into common stock, was approximately 26.2%. OnSeptember 28, 2012 , the last trading day in the quarter, total market capitalization, including total debt outstanding, was approximately$1.25 billion . AtSeptember 30, 2012 , the outstanding balance remaining under certain notes that we owed to the operating partnerships was approximately$2.8 million . The due date of these notes has been extended toSeptember 30, 2013 . The principal amount of these notes, along with the interest expense, which is interest income to the operating partnerships, is eliminated in consolidation and is not included in the corresponding line items within the condensed consolidated financial statements. However, the interest income earned by the operating partnerships, which is interest expense to us, in connection with this debt, is included in the calculation of noncontrolling interests as reported on the condensed consolidated statement of operations, thereby reducing our net income by this same amount. At present, our only means for repayment of this debt is through distributions that we receive from the operating partnerships that are in excess of the amount of dividends to be paid to our stockholders or by raising additional equity capital.
Historical Cash Flows
Comparison of the nine months ended
Net cash provided by operating activities for the nine months endedSeptember 30, 2012 , was approximately$41.4 million compared with$56.3 million for the same period in 2011. Cash flow decreased primarily because in 2011 we received approximately$10.9 million fromM&M Real Estate Control & Restructuring, LLC , a variable interest entity, as the final release of restricted cash from ourAugust 2007 lease assignment and assumption transaction with this variable interest entity. Additionally, in 2012, cash flow attributable to base rent declined compared to 2011. Net cash provided by (used in) investing activities was approximately$52.6 million</money> and ($5.5) million for the nine months endedSeptember 30, 2012 and 2011, respectively. Cash provided by investing activities during the nine months endedSeptember 30, 2012 , related to proceeds from the sales of real estate of approximately$61.8 million , offset with the acquisitions of three R&D buildings and 19 acres of raw land from theBerg Group for approximately$28.2 million . We received cash of approximately$63.4 million and a note receivable in the amount of approximately$18.8 million for the properties we sold. As ofSeptember 30, 2012 , approximately$3.0 million of the note receivable has been repaid. The three R&D buildings and 19 acres of raw land were acquired by offsetting theBerg Group's $16.7 million obligation to the Company towards the purchase price and issuing an unsecured short-term note payable for approximately$11.5 million . As ofSeptember 30, 2012 , the note payable had been fully repaid. Cash used in investing activities during the nine months endedSeptember 30, 2011 , related to the transfer of approximately$6.8 million from restricted cash held in escrow into our operating checking account, offset with the acquisition of an R&D property for approximately$10.8 million and$1.8 million in real estate improvements. The R&D property was acquired by paying$2.0 million in cash and issuing an unsecured short-term note payable for approximately$8.8 million . As ofSeptember 30, 2011 , approximately$8.5 million have been repaid towards the note payable. Net cash used in financing activities was approximately$67.1 million for the nine months endedSeptember 30, 2012 , compared with approximately$54.4 million for the nine months endedSeptember 30, 2011 . During the first nine months of 2012, we financed approximately$26.3 million in short-term debt from theBerg Group , paid approximately$3.3 million towards our line of credit, paid approximately$38.3 million towards outstanding debt, paid approximately$40.9 million of distributions to noncontrolling interests and paid approximately$10.9 million of dividends to common stockholders. During the same period in 2011, we financed approximately$8.6 million in short-term debt from theBerg Group , received approximately$11.6 million from our line of credit, paid approximately$30.6 million towards outstanding debt, paid approximately$34.8 million of distributions to noncontrolling interests and paid approximately$9.2 million of dividends to common stockholders. -18- --------------------------------------------------------------------------------
Funds From Operations ("FFO")
FFO is a non-GAAP financial measurement used by real estate investment trusts to measure and compare operating performance. As defined by theNational Association of Real Estate Investment Trusts , FFO represents net income (loss), computed in accordance with GAAP, plus non-recurring events other than "extraordinary items" under GAAP, excluding gains and losses from sales of depreciable operating properties, plus real estate related depreciation and amortization, excluding amortization of deferred financing costs and depreciation of non-real estate assets, and after adjustments for joint ventures and unconsolidated partnerships. FFO does include impairment losses for properties held for sale and held for use. Management considers FFO to be an appropriate supplemental measure of our operating and financial performance because when compared year over year, it reflects the impact to operations from trends in occupancy rates, rental rates, operating costs, general and administrative expenses and interest costs, providing a perspective not immediately apparent from net income. In addition, management believes that FFO provides useful information about our financial performance when compared with other REITs because FFO is generally recognized as the industry standard for reporting the operations of REITs. In addition to the disclosure of operating earnings per share, we will continue to use FFO as a measure of our performance. FFO should neither be considered as an alternative for net income as a measure of profitability nor is it comparable to cash flows provided by operating activities determined in accordance with GAAP, nor is FFO necessarily indicative of funds available to meet our cash needs, including the need to make cash distributions to satisfy REIT requirements. For example, FFO is not adjusted for payments of debt principal required under our debt service obligations. Our definition of FFO also assumes conversion at the beginning of the period of all convertible securities, including noncontrolling interests represented by O.P. units that might be exchanged for common stock. FFO does not represent the amount available for management's discretionary use; as such funds may be needed for capital replacement or expansion, debt service obligations or other commitments and uncertainties. Furthermore, FFO is not comparable to similarly entitled items reported by other REITs that do not define FFO exactly as we do.
FFO for the three and nine months ended
Three Months Ended September 30, Nine Months Ended September 30, 2012 2011 2012 2011 (dollars in thousands) (dollars in thousands) Net income $ 13,506 $ 7,436 $ 40,468 $ 24,741 Add: Depreciation and amortization (1) 6,375 6,784 19,405 19,639
Less:
Noncontrolling interests in joint ventures (86 ) (100 ) (267 ) (311 ) Gain on sale of real estate (5,191 ) - (18,699 ) - FFO $ 14,604 $ 14,120 $ 40,907 $ 44,069
(1) Includes depreciation and amortization of real estate from discontinued
operations totaling approximately
30, 2011, and approximately
2011. Includes our portion of depreciation and amortization of real estate
and leasing commissions from our unconsolidated joint venture totaling
approximately
2011 and
Also includes our amortization of leasing commissions of approximately
and
respectively, and
2012 and 2011, respectively. Amortization of leasing commissions is included
in the property operating and maintenance line item in the condensed consolidated statements of operations.
Dividend and Distribution Policy
Our board of directors determines the amount and timing of dividends and distributions to our stockholders and O.P. unit holders. The board of directors will consider many factors prior to making any dividends and distributions, including the following:
· the amount of cash available for dividends and distributions;
· our ability to refinance maturing debt obligations;
· our financial condition;
· whether to reinvest funds rather than to distribute such funds;
· our committed and projected capital expenditures;
· the amount of cash required for new property acquisitions, including
acquisitions under existing agreements with the
· the amount of our annual debt service requirements;
· prospects of tenant renewals and re-leases of properties subject to expiring
leases;
· cash required for re-leasing activities;
· the annual dividend and distribution requirements under the REIT provisions of
the federal income tax laws; and
· such other factors as the board of directors deems relevant.
We cannot assure you that we will be able to meet or maintain our cash dividend and distribution objectives.
-19-
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
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