UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2018
OR
For the transition period from____________to____________
Commission file number: 000-55776
RW HOLDINGS NNN REIT, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(855) 742-4862
(Registrant’s telephone number, including area code:)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of October 31, 2018, there were 12,500,779 shares of Class C common stock outstanding and 3,144 shares of Class S common stock outstanding.
September 30, 2018
INDEX
FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and we intend that such forward-looking statements be subject to the safe harbor provisions created thereby. For this purpose, any statements made in this Quarterly Report on Form 10-Q that are not historical or current facts may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, words such as “anticipates,” “believes,” “seeks,” “estimates,” “expects,” “intends,” “continue,” “can,” “may,” “plans,” “potential,” “projects,” “should,” “could,” “will,” “would” or similar expressions and the negatives of those expressions are intended to identify forward-looking statements. Such statements include, but are not limited to, any statements about our plans, strategies, and prospects and are subject to certain risks and uncertainties, as well as known and unknown risks, which could cause actual results to differ materially from those projected or anticipated. Therefore, such statements are not intended to be a guarantee of our performance in future periods.
The forward-looking statements included herein represent our management’s current expectations and assumptions based on information available as of the date of this report. These statements involve numerous known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Readers should carefully review these risks, as well as the additional risks described in other documents we file from time-to-time with the Securities and Exchange Commission. In light of the significant risks and uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by us or any other person that such results will be achieved, and readers are cautioned not to place undue reliance on such forward-looking information, which speak only as of the date of this report.
Moreover, we operate in an evolving environment. New risks and uncertainties emerge from time-to-time and it is not possible for our management to predict all risks and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual future results to be materially different from those expressed or implied by any forward-looking statements. The following are some, but not all, of the assumptions, risks, uncertainties and other factors that could cause our actual results to differ materially from our forward-looking statements:
Our forward-looking statements contained in this Quarterly Report on Form 10-Q should be read in light of the risk factors identified above and the additional risks and uncertainties described in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2017.
Except as required by law, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future. We qualify all of our forward-looking statements by these cautionary statements.
PART I — FINANCIAL INFORMATION
Item 1 – Financial Statements
Condensed Consolidated Balance Sheets
(Unaudited)
See accompanying notes to the condensed consolidated financial statements.
Condensed Consolidated Statements of Operations
Three Months Ended
September 30
Nine Months Ended
Condensed Consolidated Statement of Stockholders' Equity
Nine Months Ended September 30, 2018
Condensed Consolidated Statements of Cash Flows
September 30,
2018
2017
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BUSINESS AND ORGANIZATION
RW Holdings NNN REIT, Inc. (the “Company”) was incorporated on May 14, 2015 as a Maryland corporation. The Company was originally incorporated under the name Rich Uncles Real Estate Investment Trust, Inc., but changed its name on October 19, 2015 to Rich Uncles NNN REIT, Inc. and again on August 14, 2017 to its present name RW Holdings NNN REIT, Inc. The Company has the authority to issue 450,000,000 shares of stock, consisting of 50,000,000 shares of preferred stock, $0.001 par value per share, 300,000,000 shares of Class C common stock, $0.001 par value per share, and 100,000,000 shares of Class S common stock, $0.001 par value per share. The Company was formed to primarily invest, directly or indirectly through investments in real estate owning entities, in single-tenant income-producing corporate properties located in the United States, which are leased to creditworthy tenants under long-term net leases. The Company’s goal is to generate current income for investors and long-term capital appreciation in the value of its properties.
The Company holds its investments in real property through special purpose wholly-owned limited liability companies, which are wholly-owned subsidiaries of Rich Uncles NNN Operating Partnership, LP, a Delaware limited partnership (the “Operating Partnership) or through the Operating Partnership. The Operating Partnership was formed on January 28, 2016. The Company is the sole general partner of, and owns a 99% partnership interest in, the Operating Partnership. Rich Uncles NNN LP, LLC, a Delaware limited liability company formed on May 13, 2016 (“NNN LP”), owns the remaining 1% partnership interest in the Operating Partnership and is the sole limited partner. NNN LP is wholly-owned by the Company.
The Company is externally managed by its advisor, Rich Uncles NNN REIT Operator, LLC (the “Advisor”), a Delaware limited liability company, pursuant to an advisory agreement, as amended (the “Advisory Agreement”). The Advisor is wholly-owned by the Company’s sponsor, BrixInvest, LLC (f/k/a Rich Uncles, LLC, the “Sponsor”), a Delaware limited liability company whose members include Harold Hofer and Ray Wirta, the Company’s Chief Executive Officer and Chairman, respectively. On each of June 24, 2015 and December 31, 2015, the Company issued 10,000 shares of its Class C common stock to the Sponsor for a purchase price of $10.00 per share.
On July 15, 2015, the Company filed a registration statement on Form S-11 with the U.S. Securities and Exchange Commission (the “SEC”) to register an initial public offering of a maximum of 90,000,000 shares of common stock for sale to the public (the “Primary Offering”). The Company also registered a maximum of 10,000,000 shares of common stock pursuant to the Company’s distribution reinvestment plan (the “Registered DRP Offering” and, together with the Primary Offering, the “Registered Offering”). The SEC declared the Company’s registration statement effective on June 1, 2016 and on July 20, 2016, the Company began offering shares of common stock to the public. Pursuant to its securities offering registered with the SEC, the Company sells shares of its “Class C” common stock directly to investors, with a minimum investment in shares of $500. Commencing in August 2017, the Company began selling shares of its Class C common stock only to U.S. persons as defined under Rule 903 promulgated under the Securities Act of 1933, as amended (the “Securities Act”).
On August 11, 2017, the Company began offering up to 100,000,000 shares of its Class S common stock exclusively to non-U.S. Persons as defined under Rule 903 promulgated under the Securities Act pursuant to an exemption from the registration requirements of the Securities Act and in accordance with Regulation S of the Securities Act (the “Class S Offering” and, together with the Registered Offering, the “Offerings”). The Class S common stock has similar features and rights as the Class C common stock, including with respect to voting and liquidation except that the Class S common stock offered in the Class S offering may be sold through brokers or other persons who may be paid upfront and deferred selling commissions and fees.
On January 18, 2018, the Company’s board of directors approved and established an estimated net asset value (“NAV”) per share of the Company’s common stock of $10.05. Effective January 19, 2018, the purchase price per share of the Company’s common stock in the Offerings increased from $10.00 to $10.05.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Through September 30, 2018, the Company had sold 12,920,379 shares of Class C common stock in the Registered Offering, including 737,813 shares of Class C common stock sold under its Registered DRP Offering, for aggregate gross offering proceeds of $129,376,190, and 3,132 shares of Class S common stock in the Class S Offering, including 132 shares of Class S common stock sold under its dividend reinvestment plan applicable to Class S common stock, for aggregate gross offering proceeds of $31,320.
As of September 30, 2018, the Company had invested in (i) 22 operating properties, comprised of: nine retail properties, eight office properties and five industrial properties; (ii) one parcel of land, which currently serves as an easement to one of the Company’s office properties; (iii) one tenant-in-common real estate investment in which the Company has an approximate 72.7% interest; and (iv) one real estate investment in an affiliated REIT in which it has an approximate 4.4% interest.
The Company continues to offer shares of common stock under its Offerings. In some states, the Company is required to renew the registration statement for the Registered Offering annually or file a new registration statement to continue the Registered Offering. The Company may terminate the Registered Offering at any time.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Principles of Consolidation
The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial statements and the rules and regulations of the SEC. Accordingly, they do not contain all information and footnotes required by GAAP for annual financial statements pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. Such unaudited condensed consolidated financial statements and accompanying notes are the representations of the Company’s management, which is responsible for their integrity and objectivity. These unaudited condensed consolidated financial statements should be read in conjunction with the December 31, 2017 audited consolidated financial statements included in the Company’s Form 10-K filed with the SEC on April 3, 2018.
The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which are normal and recurring, necessary to fairly state its financial position, results of operations and cash flows. All significant intercompany balances and transactions are eliminated in consolidation. The December 31, 2017 balance sheet included herein was derived from the audited financial statements but does not include all disclosures or notes required by GAAP for complete financial statements.
Use of Estimates
The preparation of the condensed consolidated financial statements and the accompanying notes thereto in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results may differ from those estimates.
Fair Value Disclosures
The fair value for certain financial instruments is derived using valuation techniques that involve significant management judgment. The price transparency of financial instruments is a key determinant of the degree of judgment involved in determining the fair value of the Company’s financial instruments. Financial instruments for which actively quoted prices or pricing parameters are available and for which markets contain orderly transactions will generally have a higher degree of price transparency than financial instruments for which markets are inactive or consist of non-orderly trades. The Company evaluates several factors when determining if a market is inactive or when market transactions are not orderly. The following is a summary of the methods and assumptions used by management in estimating the fair value of each class of financial instrument for which it is practicable to estimate the fair value:
Cash and cash equivalents, restricted cash, tenant receivables, due from affiliates, purchase and other deposits, prepaid expenses and other assets, accounts payable, accrued and other liabilities and due to affiliates. These balances approximate their fair values due to the short maturities of these items.
Derivative Instruments: The Company’s derivative instruments are presented at fair value in the accompanying condensed consolidated balance sheet. The valuation of these instruments is determined using a proprietary model that utilizes observable inputs. As such, the Company classifies these inputs as Level 2 inputs. The proprietary model uses the contractual terms of the derivatives, including the period to maturity, as well as observable market-based inputs, including interest rate curves and volatility. The fair values of interest rate swaps are estimated using the market standard methodology of netting the discounted fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on an expectation of interest rates (forward curves) derived from observable market interest rate curves. In addition, credit valuation adjustments, which consider the impact of any credit risks to the contracts, are incorporated in the fair values to account for potential nonperformance risk.
Unsecured Credit Facility: The fair value of the Company’s Unsecured Credit Facility (as defined in Note 6) approximates its carrying value as the interest rates and other terms are comparable to those available in the market place for a similar credit facility.
Mortgage notes payable: The fair value of the Company’s mortgage notes payable is estimated using a discounted cash flow analysis based on management’s estimates of current market interest rates for instruments with similar characteristics, including remaining loan term, loan-to-value ratio, type of collateral and other credit enhancements. Additionally, when determining the fair value of liabilities in circumstances in which a quoted price in an active market for an identical liability is not available, the Company measures fair value using (i) a valuation technique that uses the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities or similar liabilities when traded as assets or (ii) another valuation technique that is consistent with the principles of fair value measurement, such as the income approach or the market approach. The Company classifies these inputs as Level 3 inputs.
Restricted Cash
Restricted cash is comprised of funds which are restricted for use as required by certain lenders in conjunction with an acquisition or debt financing and for on-site and tenant improvements.
Pursuant to lease agreements, the Company has obligations to pay for $309,404 and $1,899,485 in site and tenant improvements to be incurred by tenants as of September 30, 2018 and December 31, 2017, respectively, including a 72.7% share of the tenant improvements for the Santa Clara property at both balance sheet dates. At September 30, 2018 and December 31, 2017, the Company had $83,300 and $944,582, respectively, of restricted cash held to fund the improvements.
Other Comprehensive Income (Loss)
For all periods presented, other comprehensive income (loss) is the same as net income (loss).
Per Share Data
Basic earnings per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per share of common stock equals basic earnings per share of common stock as there were no potentially dilutive securities outstanding for the three and nine months ended September 30, 2018 and 2017.
For the three and nine months ended September 30, 2018, the Company has presented net income (loss) per share amounts on the accompanying statements of operations for Class C and S share classes as a combined common share class. Application of the two-class method for allocating income (loss) in accordance with the provisions of Accounting Standards Codification (“ASC”) 260, Earnings per Share, would have resulted in a net income (loss) per share of $0.02 and $(0.01) for Class C shares for the three months ended September 30, 2018 and 2017, respectively, and $(0.03) and $(0.18) for Class S shares for the three months ended September 30, 2018 and 2017, respectively. For the nine months ended September 30, 2018 and 2017, application of the two-class method for allocating income (loss) would have resulted in a net income (loss) per share for Class C shares of $0.00 and $(0.10), respectively, and a net loss per share for Class S shares of $(0.13) and $(0.56), respectively. The Company began offering shares of Class S common stock exclusively to non-U.S. Persons in August 2017. The differences in net income (loss) per share if allocated under this method primarily reflects the lower effective dividends per share for Class S shareholders as a result of the payment of the deferred commission to the Class S distributor of these shares, and also reflects the impact of the timing of the declaration of the dividends relative to the time the shares were outstanding.
Since the Company’s board of directors declared distributions for four months (December 2017 through March 2018) during the three months ended March 31, 2018 in order to transition to a process of declaring dividends prior to the beginning of the month, the dividends declared per common share for the nine months ended September 30, 2018 reflects ten months of dividends rather than nine months of dividends.
Recent Accounting Pronouncements
New Accounting Standards Issued and Adopted
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). ASU 2014-09, as amended, requires an entity to use a five-step model to determine when to recognize revenue from customer contracts in an effort to increase consistency and comparability throughout global capital markets and across industries. ASU 2014-09 supersedes the revenue requirements in Revenue Recognition (Topic 605) and most industry specific guidance throughout the Industry Topics of the Codification. This ASU requires an entity to recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services and also to provide certain additional disclosures. The Company evaluated each of its revenue streams and their related accounting policies under ASU 2014-09. Rental income and tenant reimbursements earned from leasing the Company’s real estate properties are excluded from ASU 2014-09 and will be assessed with the adoption of the lease ASU as discussed below. The Company adopted ASU 2014-09 beginning January 1, 2018. The adoption of ASU 2014-09 did not have a material impact on the Company’s consolidated financial position or consolidated results of operations. However, future real estate sales contracts will qualify as sales to noncustomers. The Company will assess and implement any future recognition of gains or losses on sales of properties according to the provisions of ASU 2014-09.
New Accounting Standards Recently Issued and Not Yet Adopted
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). The amendments in ASU 2016-02 change the existing accounting standards for lease accounting, including requiring lessees to recognize most leases on their balance sheets and making targeted changes to lessor accounting. Under ASU 2016-02, the accounting applied by a lessor is largely unchanged from that applied under Topic 840 leases. The large majority of operating leases shall remain classified as operating leases and lessors should continue to recognize rental income for those leases on a straight-line basis over the lease term. ASU 2016-02 may impact the timing, recognition, presentation and disclosures related to the Company’s tenant reimbursements earned from leasing its real estate properties, although the Company does not expect a significant impact. ASU 2016-02 is effective for the Company beginning January 1, 2019. The Company expects to adopt the practical expedients available for implementation under ASU 2016-02. By adopting the practical expedients, the Company will not be required to reassess (i) whether an expired or existing contract meets the definition of a lease and (ii) the lease classification at the adoption date for expired or existing leases. ASU 2016-02 will also require new disclosures within the notes to its consolidated financial statements. The Company does not expect the adoption of ASU 2016-02 will have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
In July 2018, the FASB issued ASU No. 2018-11, Leases (Topic 842), Targeted Improvements (“ASU No. 2018-11”). ASU 2018-11 provide lessors with a practical expedient, by class of underlying asset, to not separate nonlease components from the associated lease component and, instead to account for those components as a single component if the nonlease components otherwise would be accounted for under the new revenue recognition standard (Topic 606) and if certain conditions are met. Upon adoption of the lease accounting standard under Topic 842, the Company expects to adopt this practical expedient, specifically related to its tenant reimbursements which would otherwise be accounted for under the new revenue recognition standard. The Company believes the two conditions have been met for tenant reimbursements as 1) the timing and pattern of transfer of the nonlease components and associated lease components are the same and 2) the lease component would be classified as an operating lease. In addition, ASU No. 2018-11 provides an additional optional transition method to allow entities to apply the new lease accounting standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings. An entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new lease accounting standard will continue to be reported under the current lease accounting standards of Topic 840. The Company expects to adopt this transition method upon adoption of the lease accounting standard of Topic 842 on January 1, 2019.
In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework -Changes to the Disclosure Requirements for Fair Value Measurement (“ASU No. 2018-13”). ASU No. 2018-13 removes the requirement to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the policy for the timing of transfers between levels and the valuation processes for Level 3 fair value measurements. It also adds a requirement to disclose changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and to disclose the range and weighted average of significant unobservable inputs used to develop recurring and nonrecurring Level 3 fair value measurements. For certain unobservable inputs, entities may disclose other quantitative information in lieu of the weighted average if the other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop the Level 3 fair value measurement. In addition, public entities are required to provide information about the measurement uncertainty of recurring Level 3 fair value measurements from the use of significant unobservable inputs if those inputs reasonably could have been different at the reporting date. ASU 2016-02 is effective for the Company beginning January 1, 2020. Entities are permitted to early adopt either the entire standard or only the provisions that eliminate or modify the requirements. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. The Company is still evaluating the impact of adopting ASU No. 2018-13 on its financial statements.
NOTE 3. CONDENSED CONSOLIDATED BALANCE SHEETS DETAILS
Tenant Receivables, Net
Tenant receivables consisted of the following:
December 31,
Accounts Payable, Accrued and Other Liabilities
Accounts payable, accrued and other liabilities were comprised of the following:
NOTE 4. REAL ESTATE INVESTMENTS
As of September 30, 2018, the Company’s real estate investment portfolio consisted of 22 operating properties in 12 states, consisting of: (i) nine retail, (ii) eight office and (iii) five industrial properties and one parcel of land, which currently serves as an easement to one of the Company’s office properties. The following table provides summary information regarding the Company’s real estate investment portfolio as of September 30, 2018:
Acquisition
Date
Property
Type
Land,
Buildings and
Improvements
Tenant
Origination
and
Absorption
Costs
Accumulated
Depreciation
Amortization
Total
Investment
in Real
Estate
Property,
Net
Current Year Acquisitions
During the nine months ended September 30, 2018, the Company acquired the following properties:
Above-
Market
Lease
Below-
—
The non-cancellable lease terms of the properties acquired during the nine months ended September 30, 2018 are as follows:
The purchase price allocations reflected in the condensed consolidated financial statements are based upon current estimates and assumptions that are subject to change which may impact the fair value of the assets and liabilities above (including real estate investments, other assets and accrued liabilities).
Capitalized acquisition fees paid to the Advisor for properties acquired during the nine months ended September 30, 2018 are as follows:
The Company also paid the Advisor capitalized acquisition fees of $22,238 primarily for the additions to real estate investments.
During the three and nine months ended September 30, 2018, the Company recognized $1,192,671 and $2,121,798, respectively, of total revenue related to these recently-acquired properties.
Operating Leases and Asset Concentration
As of September 30, 2018, the Company’s portfolio’s asset concentration (greater than 10% of total assets) was as follows:
Net Carrying
Value
Percentage of
Total Assets
The Company’s real estate properties are primarily leased to tenants under triple-net leases for which terms and expirations vary. The Company monitors the credit of all tenants to stay abreast of any material changes in credit quality. The Company monitors tenant credit by (1) reviewing the credit ratings of tenants (or their parent companies or lease guarantors) that are rated by national recognized rating agencies; (2) reviewing financial statements and related metrics and information that are publicly available or that are required to be provided pursuant to the lease; (3) monitoring news reports and press releases regarding the tenants (or their parent companies or lease guarantors), and their underlying business and industry; and (4) monitoring the timeliness of rent collections.
As of September 30, 2018, the future minimum contractual rent payments due to the Company under the Company’s non-cancelable operating leases, excluding any renewal periods, are as follows:
Revenue Concentration
The Company’s revenue concentration based on tenants representing greater than 10% of total revenues for the three and nine months ended September 30, 2018 is as follows:
Total Revenue
Intangibles
As of September 30, 2018, the Company’s lease intangibles were as follows:
Tenant Origination
and Absorption
Above-Market
Leases
Below-Market
The amortization of intangible assets over the next five years is expected to be as follows:
Origination and
NOTE 5. INVESTMENTS IN UNCONSOLIDATED ENTITIES
The Company’s investments in unconsolidated entities are as follows:
The Company’s income (loss) from investments in unconsolidated entities is as follows:
The Company’s TIC Interest in the Santa Clara property commenced on September 28, 2017. The Company’s share in income (loss) in the Santa Clara property for three days during the periods presented above was immaterial and was not recorded.
TIC Interest
On September 28, 2017, the Company, through a wholly-owned subsidiary of the Operating Partnership, acquired an approximate 72.7% TIC Interest in the Santa Clara property. The remaining approximate 27.3% of undivided interests in the Santa Clara property are held by Hagg Lane II, LLC (an approximate 23.4% interest) and Hagg Lane III, LLC (an approximate 3.9% interest). The manager of Hagg Lane II, LLC and Hagg Lane III, LLC is a board member of the Sponsor. The Santa Clara property does not qualify as a variable interest entity and consolidation is not required as the Company’s TIC Interest does not control the property. Therefore, the Company accounts for its TIC Interest in the Santa Clara property using the equity method. The Company receives approximately 72.7% of the cash flow distributions and recognizes approximately 72.7% of the results of operations. During the three and nine months ended September 30, 2018, the Company received $36,485 and $353,021 in cash distributions, respectively.
The following is summarized financial information for the Santa Clara property:
REIT I
The Company’s investment in REIT I represented an approximate 4.4% ownership interest as of September 30, 2018 and December 31, 2017, respectively. The Company recorded its share of income (loss) of REIT I based on REIT I’s results of operations for the three and nine months ended September 30, 2018. During the three and nine months ended September 30, 2018, the Company received $68,316 and $204,947 in cash distributions, respectively, related to its investment in REIT I. The following is summarized financial information for REIT I:
NOTE 6. DEBT
Mortgage Notes Payable
As of September 30, 2018 and December 31, 2017, the Company’s mortgage notes payable consisted of the following:
The following were the face value, carrying amount and fair value of the Company’s mortgage notes payable (Level 3 measurement):
Disclosures of the fair values of financial instruments are based on pertinent information available to the Company as of the period end and require a significant amount of judgment. The actual value could be materially different from the Company’s estimate of value.
Unsecured Credit Facility
On February 28, 2018, the Company, together with the Operating Partnership and Rich Uncles NNN LP, LLC (“Borrowers”), entered into a Business Loan Agreement and Promissory Note (the “Unsecured Credit Facility”) with Pacific Mercantile Bank (“Lender”). The Unsecured Credit Facility replaced the $12,000,000 unsecured line of credit with Lender, which expired on January 26, 2018 (the “Former Credit Facility”). The Unsecured Credit Facility is a revolving unsecured line of credit for a maximum principal amount of $9,000,000 and matures on January 26, 2019, unless earlier terminated. Under the terms of the Unsecured Credit Facility, Borrowers pay a variable rate of interest on outstanding amounts equal to one (1) percentage point over an independent index published in The Wall Street Journal based on the highest rate on corporate loans posted by at least 75% of the largest banks (the “Index”). Based upon the Index as of the date of the Unsecured Credit Facility, the interest rate under the Unsecured Credit Facility was 5.50% and is 6.25% as of September 30, 2018.
The Unsecured Credit Facility contains customary representations, warranties and covenants, which are substantially similar to those in the Former Credit Facility. The Company’s ability to borrow under the Unsecured Credit Facility will be subject to its ongoing compliance with various affirmative and negative covenants, including with respect to indebtedness, guaranties, mergers and asset sales, liens, dividends, corporate existence and financial reporting obligations.
The Unsecured Credit Facility also contains customary events of default, including, without limitation, nonpayment of principal, interest, fees or other amounts when due, violation of covenants, breaches of representations or warranties and change of ownership. Upon the occurrence of an event of default, Lender may accelerate the repayment of amounts outstanding under the Unsecured Credit Facility and exercise other remedies subject, in certain instances, to the expiration of an applicable cure period.
The Unsecured Credit Facility is secured by guaranties executed by Raymond E. Wirta, Chairman of the Board of the Company, a trust belonging to Mr. Wirta, Harold C. Hofer, President and Chief Executive Officer of the Company, and a trust belonging to Mr. Hofer, each in the amount of $9,000,000. Such guaranties become effective upon certain triggering events, including an event of default under the Unsecured Credit Facility and the failure by Borrowers to pay one or more subsequent advances within 90 days of disbursement.
As of September 30, 2018, the Unsecured Credit Facility had no outstanding borrowings. On October 31, 2018, the Company borrowed the full $9,000,000 to fund the acquisition of the Bon Secours property in Richmond, Virginia, as more fully described in Note 10. As of December 31, 2017, the Company’s Former Credit Facility had total outstanding borrowings of $12,000,000.
All Debt Agreements
Pursuant to the terms of mortgage notes payable on certain of the Company’s properties and the Unsecured Credit Facility, the Company and/or the Borrowers are subject to certain financial loan covenants. The Company and/or the Borrowers were in compliance with all terms and conditions of the applicable loan agreements as of September 30, 2018.
The following summarizes the future principal repayment of the Company’s mortgage notes payable and Unsecured Credit Facility as of September 30, 2018:
Mortgage Note
Payable
Unsecured
Credit Facility (1)
Interest Expense
The following is a reconciliation of the components of interest expense for the three and nine months ended September 30, 2018 and 2017:
NOTE 7. INTEREST RATE SWAP DERIVATIVES
The primary goal of the Company’s risk management practices related to interest rate risk is to prevent changes in interest rates from adversely impacting the Company’s ability to achieve its investment return objectives. The Company does not enter into derivatives for speculative purposes.
The Company enters into interest rate swaps as a fixed rate payer to mitigate its exposure to rising interest rates on its variable rate mortgage notes payable. The value of interest rate swaps is primarily impacted by interest rates, market expectations about interest rates, and the remaining life of the applicable instrument. In general, increases in interest rates, or anticipated increases in interest rates, will increase the value of the fixed rate payer position and decrease the value of the variable rate payer position. As the remaining life of the interest rate swap decreases, the value of both positions will generally move towards zero.
The Company (or wholly-owned limited liability company subsidiaries) has entered into interest rate swap agreements with amortizing notational amounts relating to four of its mortgage notes payable. The notional amount is an indication of the extent of the Company’s involvement in each instrument at that time, but does not represent exposure to credit, interest rate or market risks.
The following table summarizes the notional amount and other information related to the Company’s interest rate swaps:
The following table sets forth the fair value of the Company’s derivative instruments (Level 2 measurement), as well as their classification in the condensed consolidated balance sheets:
The change in fair value of a derivative instrument that is not designated as a cash flow hedge for financial accounting purposes is recorded as interest expense in the condensed consolidated statements of operations. None of the Company’s derivatives at September 30, 2018 or December 31, 2017 were designated as hedging instruments; therefore, the net unrealized (gains) losses recognized on interest rate swaps of $(185,453) and $(4,627) was recorded as a (decrease) increase in interest expense for the three months ended September 30, 2018 and 2017, respectively, and $(406,023) and $100,006 was recorded as a (decrease) increase in interest expense for the nine months ended September 30, 2018 and 2017, respectively (see Note 6).
NOTE 8. RELATED PARTY TRANSACTIONS
The Company pays the members of its board of directors who are not executive officers for services rendered by issuing shares of Class C common stock to them. The total value of the shares issued was $48,240 and $60,000 for the three months ended September 30, 2018 and 2017, respectively, and $129,645 and $125,000 for the nine months ended September 30, 2018 and 2017, respectively, for which the Company issued 4,800 shares and 6,000 shares of Class C common stock during the three months ended September 30, 2018 and 2017, respectively, and 12,900 shares and 12,500 shares of Class C common stock during the nine months ended September 30, 2018 and 2017, respectively, to the directors in accordance with the terms of its director compensation program.
The Company has entered into an agreement (the “Advisory Agreement”) with the Advisor. This agreement entitles the Advisor to specified fees upon the provision of certain services with regard to the investment of funds in real estate investments, the management of those investments, among other services, and the disposition of investments, as well as entitles the Advisor to reimbursement of organization and offering costs incurred by the Advisor or Sponsor on behalf of the Company, such as expenses related to the Offerings, and certain costs incurred by the Advisor or Sponsor in providing services to the Company. In addition, the Advisor is entitled to certain other fees, including an incentive fee upon achieving certain performance goals, as detailed in the Advisory Agreement. The Sponsor also serves as the sponsor and advisor for REIT I and Brix Student Housing REIT, Inc. During the three and nine months ended September 30, 2018 and 2017, no other business transactions occurred between the Company and REIT I, or Brix Student Housing REIT, Inc., other than as described below or elsewhere herein, and those relating to the Company’s investment in REIT I.
Summarized below are the related party costs incurred by the Company, including those incurred pursuant to the Advisory Agreement, for the three and nine months ended September 30, 2018 and 2017, respectively:
Three
Months
Ended
Nine Months
Nine
Organizational and Offering Expenses
The Company is obligated to reimburse the Sponsor or its affiliates for organizational and offering expenses (as defined in the Advisory Agreement) paid by the Sponsor on behalf of the Company. The Company will reimburse the Sponsor for organizational and offering expenses up to 3.0% of gross offering proceeds. The Sponsor and affiliates will be responsible for any organizational and offering expenses to the extent they exceed 3.0% of gross offering proceeds. As of September 30, 2018, the Sponsor has incurred organizational and offering expenses in excess of 3.0% of the gross offering proceeds received by the Company. To the extent the Company has more gross offering proceeds from future stockholders, the Company will be obligated to reimburse the Sponsor. As the amount of future gross offering proceeds is uncertain, the amount the Company is obligated to reimburse to the Sponsor is uncertain. As of September 30, 2018, the Company has reimbursed the Sponsor $3,879,246 in organizational and offering costs. The Company’s maximum liability for organizational and offering costs through September 30, 2018 was $3,882,226 of which $2,980 was payable as of September 30, 2018 and is included in “Due to affiliates” in the condensed consolidated balance sheet.
Investor Relations Payroll Expense Reimbursement from Sponsor
The Company employs investor personnel that answer inquiries from potential investors regarding the Company and/or its Registered Offering. The payroll expense associated with the investor relations personnel is reimbursed by the Sponsor. The Sponsor considers these payroll costs to be offering expenses. The payroll expense reimbursements from the Sponsor for the three months ended September 30, 2018 and 2017 were $173,464 and $584,230, respectively, and for the nine months ended September 30, 2018 and 2017 were $726,972 and $1,945,160, respectively. The reduction in reimbursements during the 2018 periods corresponds primarily to a reduction in the number of investor relations personnel and related costs.
Acquisition Fees
The Company pays the Advisor a fee in an amount equal to 3.0% of the contract purchase price of the Company’s properties plus additions to real estate investments, as defined, as acquisition fees. The total of all acquisition fees and acquisition expenses shall be reasonable and shall not exceed 6.0% of the contract price of the property. However, a majority of the directors (including a majority of the independent directors) not otherwise interested in the transaction may approve fees in excess of these limits if they determine the transaction to be commercially competitive, fair and reasonable to the Company.
Asset Management Fee
The Company pays the Advisor as compensation for the advisory services rendered to the Company, a monthly fee in an amount equal to 0.1% of the total investment value, as defined (the “Asset Management Fee”), as of the end of the preceding month plus the book value of any properties acquired during the month pro-rated based on the number of days owned. The Asset Management Fee is payable monthly on the last business day of such month. On August 2, 2018, the Conflicts Committee, which is comprised of all of the independent directors of the Company, approved, and on August 3, 2018 the board of directors approved, renewing the Advisory Agreement for an additional year, to August 11, 2019. At the same time, the board of directors also approved amendments to the Advisory Agreement which provide for (i) paying the Asset Management Fee for assets acquired during a month based on the pro-rated number of days following acquisition and (ii) paying the Asset Management Fee on the last business day of the month. The Asset Management Fee, which must be reasonable in the determination of the Company’s independent directors at least annually, may or may not be taken, in whole or in part as to any year, in the sole discretion of the Advisor. All or any portion of the Asset Management Fee not paid as to any fiscal year is deferred without interest and may be paid in such other fiscal year as the Advisor shall determine.
Additionally, to the extent the Advisor elects, in its sole discretion, to defer all or any portion of its monthly Asset Management Fee, the Advisor will be deemed to have waived, not deferred, that portion of its monthly Asset Management Fee that is up to 0.025% of the total investment value of the Company’s assets. The total amount of Asset Management Fees incurred in the three months ended September 30, 2018 and 2017 was $532,355 and $264,927 respectively, of which zero and $42,485, respectively, was waived. The total amount of Asset Management Fees incurred in the nine months ended September 30, 2018 and 2017 was $1,411,585 and $573,081 respectively, of which zero and $119,524, respectively, was waived. Asset Management Fees payable at September 30, 2018 and December 31, 2017 were zero and $567,661, respectively.
Financing Coordination Fee
Other than with respect to any mortgage or other financing related to a property concurrent with its acquisition, if the Advisor or an affiliate provides a substantial amount of the services (as determined by a majority of the Company’s independent directors) in connection with the post-acquisition financing or refinancing of any debt that the Company obtains relative to a property, then the Company pays to the Advisor or such affiliate a financing coordination fee equal to 1.0% of the amount of such financing.
Property Management Fees
If the Advisor or any of its affiliates provides a substantial amount of the property management services (as determined by a majority of the Company’s independent directors) for the Company’s properties, then the Company pays the Advisor or such affiliate a property management fee equal to 1.5% of gross revenues from the properties managed. The Company also reimburses the Advisor and any of its affiliates for property-level expenses that such person pays or incurs on behalf of the Company, including salaries, bonuses and benefits of persons employed by such person, except for the salaries, bonuses and benefits of persons who also serve as one of the Company’s executive officers or as an executive officer of such person. The Advisor or its affiliate may subcontract the performance of its property management duties to third parties and pay all or a portion of its property management fee to the third parties with whom it contracts for these services. The Company currently provides property management services for six of the 22 real estate properties in its portfolio.
Disposition Fees
For substantial assistance in connection with the sale of properties, the Company pays the Advisor or one of its affiliates 3.0% of the contract sales price, as defined, of each property sold; provided, however, that if, in connection with such disposition, commissions are paid to third parties unaffiliated with the Advisor or its affiliates, the disposition fees paid to the Advisor, the Sponsor, their affiliates and unaffiliated third parties may not exceed the lesser of the competitive real estate commission or 6% of the contract sales price. There were no disposition fees incurred during the three and nine months ended September 30, 2018 and 2017.
Subordinated Participation Fees
The Company pays the Advisor or an affiliate a subordinated participation fee calculated as of December 31 of each year and paid (if at all) in the immediately following January. The subordinated participation fee is only due if the Preferred Return, as defined, is achieved and is equal to the sum of (using terms as defined in the Advisory Agreement):
The Company calculated a subordinated participation fee of $315,802 which was accrued as of December 31, 2017 and paid in cash during the first quarter of 2018.
Leasing Commission Fees
If a property or properties of the Company becomes unleased and the Advisor or any of its affiliates provides a substantial amount of the services (as determined by a majority of the Company’s independent directors) in connection with the Company’s leasing of a property or properties to unaffiliated third parties, then the Company pays the Advisor or such affiliate leasing commissions equal to 6.0% of the rents due pursuant to such lease for the first ten years of the lease term; provided, however (i) if the term of the lease is less than ten years, such commission percentage will apply to the full term of the lease; and (ii) any rents due under a renewal of a lease of an existing tenant upon expiration of the initial lease agreement (including any extensions provided for thereunder) shall accrue a commission of 3.0% in lieu of the aforementioned 6.0% commission. There were no leasing commission fees incurred during the three and nine months ended September 30, 2018 and 2017.
Operating Expenses
Under the Company’s charter, total operating expenses of the Company are limited to the greater of 2% of average invested assets or 25% of net income for the four most recently completed fiscal quarters (the “2%/25% Limitation”). If the Company exceeds the 2%/25% Limitation, the Advisor must reimburse the Company the amount by which the aggregate total operating expenses exceeds the limitation, or the Company must obtain a waiver from the Company’s Conflicts Committee. For purposes of determining the 2%/25% Limitation amount, “average invested assets” means the average monthly book value of the Company’s assets invested directly or indirectly in equity interests and loans secured by real estate during the 12-month period before deducting depreciation, reserves for bad debts or other non-cash reserves. “Total operating expenses” means all expenses paid or incurred by the Company, as determined by GAAP, that are in any way related to the Company’s operation including asset management fees, but excluding (a) the expenses of raising capital such as organization and offering expenses, legal, audit, accounting, underwriting, brokerage, listing, registration and other fees, printing and other such expenses and taxes incurred in connection with the issuance, distribution, transfer, listing and registration of shares of the Company’s common stock; (b) interest payments; (c) taxes; (d) non-cash expenditures such as depreciation, amortization and bad debt reserves; (e) reasonable incentive fees based upon increases in NAV per share; (f) acquisition fees and acquisition expenses (including expenses, relating to potential investments that the Company does not close); and (h) disposition fees on the sale of real property and other expenses connected with the acquisition, disposition and ownership of real estate interests or other property (other than disposition fees on the sale of assets other than real property), including the costs of insurance premiums, legal services, maintenance, repair and improvement of real property. The Company is in compliance with the 2/25% Limitation for operating expenses for the four fiscal quarters ended September 30, 2018.
NOTE 9. COMMITMENTS AND CONTINGENCIES
Economic Dependency
The Company depends on its Sponsor and its Advisor for certain services that are essential to the Company, including the sale of the Company’s shares of common stock, the identification, evaluation, negotiation, origination, acquisition and disposition of investments; management of the daily operations of the Company’s investment portfolio; and other general and administrative responsibilities. In the event that these companies are unable to provide the respective services, the Company will be required to obtain such services from other sources.
Environmental
As an owner of real estate, the Company is subject to various environmental laws of federal, state and local governments. Although there can be no assurance, the Company is not aware of any environmental liability that could have a material adverse effect on its financial condition or results of operations. However, changes in applicable environmental laws and regulations, the uses and conditions of properties in the vicinity of the Company’s properties, the activities of its tenants and other environmental conditions of which the Company is unaware with respect to the property could result in future environmental liabilities.
Tenant Improvements
Pursuant to lease agreements, as of September 30, 2018 and December 31, 2017, the Company has obligations to pay for $309,404 and $1,899,485, respectively, in site and tenant improvements to be incurred by tenants, including a 72.7% share of the tenant improvements for the Santa Clara property at both balance sheet dates. At September 30, 2018 and December 31, 2017, the Company had $83,300 and $944,582, respectively, of restricted cash held to fund the improvements.
Redemption of Common Stock
Following the Company’s board of directors’ determination of its NAV and NAV per share on January 18, 2018, the maximum amount that may be repurchased per month is limited to no more than 2% of the Company’s most recently determined aggregate NAV. Repurchases for any calendar quarter will be limited to no more than 5% of its most recently determined aggregate NAV. The foregoing repurchase limitations are based on “net repurchases” during a quarter or month, as applicable. Thus, for any given calendar quarter or month, the maximum amount of repurchases during that quarter or month will be equal to (1) 5% or 2% (as applicable) of the Company’s most recently determined aggregate NAV, plus (2) proceeds from sales of new shares in the Registered Offering and Class S Offering (including purchases pursuant to its Registered DRP Offering) since the beginning of a current calendar quarter or month, less (3) repurchase proceeds paid since the beginning of the current calendar quarter or month.
The Company has the discretion to repurchase fewer shares than have been requested to be repurchased in a particular month or quarter, or to repurchase no shares at all, in the event that it lacks readily available funds to do so due to market conditions beyond the Company’s control, its need to main liquidity for its operations or because the Company determines that investing in real property or other illiquid investments is a better use of its capital than repurchasing its shares. In the event that the Company repurchases some but not all of the shares submitted for repurchase in a given period, shares submitted for repurchase during such period will be repurchased on a pro rata basis. In addition, the Company’s board of directors may amend, suspend or terminate the share repurchase program without stockholder approval upon 30 days’ notice if its directors believe such action is in the Company and its stockholders’ best interests. The Company’s board of directors may also amend, suspend or terminate the share repurchase program due to changes in law or regulation, or if the board of directors becomes aware of undisclosed material information that the Company believes should be publicly disclosed before shares are repurchased.
Legal Matters
From time-to-time, the Company may become party to legal proceedings that arise in the ordinary course of its business. Other than as discussed below, the Company is not a party to any legal proceeding, nor is the Company aware of any pending or threatened litigation that could have a material adverse effect on the Company’s business, operating results, cash flows or financial condition should such litigation be resolved unfavorably.
The SEC is conducting an investigation related to the advertising and sale of securities by the Company in connection with the Registered Offering. The investigation is a non-public fact-finding inquiry. It is neither an allegation of wrongdoing nor a finding that violations of law have occurred. In connection with the investigation, the Company and certain affiliates have received and responded to subpoenas from the SEC requesting documents and other information related to the Company and the Registered Offering. The SEC’s investigation is ongoing. The Company has cooperated and intends to continue to cooperate with the SEC in this matter. The Company is unable to predict the likely outcome of the investigation or determine its potential impact, if any, on the Company.
NOTE 10. SUBSEQUENT EVENTS
The Company evaluates subsequent events up until the date the condensed consolidated financial statements are issued.
Offering Status
Through October 31, 2018, the Company had sold 13,385,609 shares of Class C common stock in the Registered Offering for aggregate gross offering proceeds of $134,051,756, including 791,993 shares of common stock sold under its Registered DRP Offering for aggregate gross offering proceeds of $7,943,572, and 3,144 shares of Class S common stock in the Class S Offering for aggregate gross offering proceeds of $31,445, including 144 shares of Class S common stock sold under its dividend reinvestment plan applicable to Class S common stock for aggregate gross offering proceeds of $1,445.
Distributions
On September 27, 2018, the Company’s board of directors declared distributions based on daily record dates for the period October 1, 2018 through October 31, 2018 at a rate of $0.0018911 per share per day on the outstanding shares of the Company’s Class C and Class S common stock, which the Company will pay on November 26, 2018 which is the first business day following the November 25, 2018 payment date.
On October 29, 2018, the Company’s board of directors declared distributions based on daily record dates for the period November 1, 2018 through November 30, 2018 at a rate of $0.0019542 per share per day on the outstanding shares of the Company’s Class C and Class S common stock, which the Company will pay on December 26, 2018, which is the first business day following the December 25, 2018 payment date.
On October 31, 2018, the Company, through a wholly owned subsidiary of the Operating Partnership, completed the acquisition of a single-story office building with approximately 72,890 square feet located in Richmond, Virginia. This property is 100% leased to Bon Secours Mercy Health, Inc., which recently changed its name from Bon Secours Health System, Inc. after its merger with Mercy Health on September 1, 2018. Bon Secours Mercy Health, Inc. is a nonprofit corporation with 43 hospital locations, a presence in seven states and more than 57,000 employees. The property’s triple-net lease expires on August 31, 2026. The contract purchase price for the property was $10,516,000 which was funded with $1,516,000 in net proceeds from the Company’s Registered Offering and $9,000,000 drawn under the Unsecured Credit Facility. The seller of the property was not affiliated with the Company or its affiliates. The Company paid the Advisor an acquisition fee of $315,480 in connection with this acquisition.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis of our financial condition, results of operations and cash flows together with the condensed consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q and our audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2017 included in our Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on April 3, 2018. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors. See “Forward-Looking Statements” above.
Management’s discussion and analysis of financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). The preparation of these financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a regular basis, we evaluate these estimates. These estimates are based on management’s historical industry experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
Overview
We were formed on May 14, 2015 as a Maryland corporation that elected to be treated as a real estate investment trust, or REIT, beginning with our taxable year ended December 31, 2016 and we intend to continue to operate so as to remain qualified as a REIT for federal income tax purposes thereafter. We intend to invest primarily in single tenant income-producing corporate properties which are leased to creditworthy tenants under long-term net leases. Although we are not limited as to the form our investments may take, our investments in real estate will generally constitute acquiring fee title or interests in entities that own and operate real estate. We will make substantially all acquisitions of our real estate investments directly through Rich Uncles NNN Operating Partnership, LP, a Delaware limited liability company (the “Operating Partnership”), or indirectly through limited liability companies or limited partnerships, including through other REITs, or through investments in joint ventures, partnerships, tenants-in-common, co-tenancies or other co-ownership arrangements with other owners of properties, affiliates of our Advisor (as defined below) or other persons.
We consider our Company to be a perpetual-life investment vehicle because we have no finite date for liquidation and no intention to list our shares of common stock for trading on a national securities exchange or over-the-counter trading market. Although we have registered a fixed number of shares for the Registered Offering (as defined below), we intend to effectively conduct a continuous offering of an unlimited amount of our shares of common stock over an unlimited time period by conducting an uninterrupted series of additional public offerings, subject to regulatory approval of our filings for such additional offerings, and one or more offerings exempt from the registration statement requirements of the Securities Act of 1933, as amended (the “Securities Act”), such as our Class S Offering. This perpetual-life structure is aligned with our overall objective of investing in real estate assets with a long-term view towards making regular cash distributions and generating capital appreciation.
Subject to certain restrictions and limitations, our business is externally managed by our advisor, Rich Uncles NNN REIT Operator, LLC (our “Advisor”), a Delaware limited liability company wholly-owned by our sponsor, BrixInvest, LLC (f/k/a Rich Uncles, LLC, our “Sponsor”), pursuant to the Second Amended and Restated Advisory Agreement between us, our Advisor and our Sponsor (the “Advisory Agreement”). Our Advisor manages our operations and will manage our portfolio of core real estate properties and real estate related assets. Our Advisor also provides asset-management and other administrative services on our behalf. Our Advisor is paid certain fees as set forth in Note 8 to our condensed consolidated financial statements.
We have investor relations personnel, but all related expenses are reimbursed by our Sponsor as part of the organizational and offering services they provide to us to manage our organization and the Registered Offering and to provide administrative investor relations. However, our Sponsor is then entitled to include the reimbursement of such expenses as part of our reimbursement to them of organization and offering costs, but reimbursement shall not exceed an amount equal to 3% of gross offering proceeds.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
On June 24, 2015, our Sponsor purchased 10,000 shares of common stock for $100,000 and became the initial stockholder. Our Sponsor purchased another 10,000 shares of common stock on December 31, 2015 for $100,000. On July 15, 2015, we filed a registration statement on Form S-11 with the SEC to register an initial public offering to offer a maximum of 90,000,000 shares of common stock for sale to the public (the “Primary Offering”). We also registered a maximum of 10,000,000 shares of common stock pursuant to our distribution reinvestment plan (the “Registered DRP Offering” and together with the Primary Offering, the “Registered Offering”). The SEC declared our registration effective on June 1, 2016 and we commenced the sale of our shares to the public on July 20, 2016. Pursuant to our Registered Offering, we do not retain a broker-dealer to offer our shares. Rather, we offer shares of our Class C common stock directly to the public.
On August 11, 2017, we began offering up to 100,000,000 shares of Class S common stock exclusively to non-U.S. Persons as defined under Rule 903 promulgated under the Securities Act pursuant to an exemption from the registration requirements of the Securities Act and in accordance with Regulation S of the Securities Act (the “Class S Offering” and, together with the Registered Offering, the “Offerings”). The Class S common stock has similar features and rights as the Class C common stock, including with respect to voting and liquidation except that the Class S common stock offered in the Class S Offering may be sold through brokers or other persons who may be paid upfront and deferred selling commissions and fees.
On January 18, 2018, our board of directors approved and established an estimated net asset value (“NAV”) per share of our common stock of $10.05. Effective January 19, 2018, the purchase price per share of our common stock in the Offerings increased from $10.00 to $10.05.
We expect to use substantially all of the net proceeds from the Offerings to acquire and manage a portfolio of real estate investments. We intend to invest primarily in single tenant income-producing corporate properties which are leased to creditworthy tenants under long-term net leases. While our focus is on single tenant net leased properties, we plan to diversify our portfolio by geography, investment size and investment risk with the goal of acquiring a portfolio of income-producing real estate investments that provides attractive and stable returns to our stockholders. Although we are not limited as to the form our investments may take, our investments in real estate will generally constitute acquiring fee title or interest in entities that own and operate real estate.
Our investment objectives and policies may be amended or changed at any time by our board of directors. Although we have no plans at this time to change any of our investment objectives, our board of directors may change any and all such investment objectives, including our focus on single tenant properties, if we believe such changes are in the best interest of our stockholders.
Rich Uncles NNN Operator, LLC, our Advisor, will make recommendations on all investments to our board of directors. All proposed real estate investments must be approved by at least a majority of our board of directors.
The Company
We are a publicly registered, non-exchange traded company dedicated to providing stockholders with dependable monthly dividends. We believe we are qualified to operate as a REIT, which requires us to annually distribute at least 90% of our taxable income (excluding net capital gains) in the form of dividends to our stockholders. Our monthly dividends are supported by the cash flow generated from real estate owned under long-term, net lease agreements with local, regional, and national commercial tenants and, to some extent, the waiver or deferral of asset management fees by our Sponsor. See “Distributions” below.
Our primary business consists of acquiring, financing and owning single-tenant retail, office, and industrial real estate leased to creditworthy tenants on long-term leases. We primarily generate revenues by leasing properties to tenants pursuant to net leases. As of September 30, 2018, we owned 22 operating properties in 12 states consisting of retail, office and industrial properties and a parcel of land which serves as an easement to one of our operating properties, a tenant-in-common real estate investment in a property located in Santa Clara, California in which we have an approximate 72.7% interest (“TIC Interest”) and one real estate investment in an affiliated REIT, Rich Uncles Real Estate Investment Trust I (“REIT I”), in which we have an approximate 4.4% interest. The net book value of these investments at September 30, 2018 was $199,047,390.
With respect to our diversified portfolio of 22 operating properties as of September 30, 2018:
Of the 22 operating properties in the portfolio as of September 30, 2018, all 22, or 100%, are single-tenant properties. At September 30, 2018, all 22 properties were leased with a weighted average remaining lease term (excluding rights to extend a lease at the option of the tenant) of approximately 7.7 years.
As of September 30, 2018, we also have an investment in REIT I which represents an approximate 4.4% ownership interest and an approximate 72.7% TIC Interest in a property located in Santa Clara, California. The remaining approximate 27.3% of undivided interest in the Santa Clara property is held by Hagg Lane II, LLC (an approximate 23.4%) and Hagg Lane III, LLC (an approximate 3.9%). The manager of Hagg Lane II, LLC and Hagg Lane III, LLC is a board member of the Sponsor.
On October 31, 2018, we acquired a single-story office building with approximately 72,890 square feet located in Richmond, Virginia. This property is 100% leased to Bon Secours Mercy Health, Inc. The contract purchase price for the property was $10,516,000, which we funded with $1,516,000 in net proceeds from the Registered Offering and $9,000,000 drawn under our unsecured credit facility. See Note 10 to our condensed consolidated financial statements for additional details.
Investment Strategy
Our investment strategy is to acquire single-tenant retail, office, and industrial real estate leased to creditworthy tenants on long-term leases. Our ideal portfolio is comprised of 40% office, 40% industrial, and 20% retail, with greater than 50% of our real estate leased to investment grade tenants as determined by one of the big three credit rating agencies (Standard & Poor’s, Moody’s or Fitch Group). When identifying new properties for investment, we generally focus on acquiring high-quality real estate that tenants consider important to the successful operation of their business. We generally seek to acquire real estate that has the following characteristics:
Our proceeds from shares sold in the Offerings have been, and will continue to be, primarily used for (i) property acquisitions; (ii) capital expenditures; (iii) payment of principal on our outstanding indebtedness; and (iv) payment of fees to our Advisor. Our cash needs for the purchase of real estate properties and other real estate investments will be funded primarily from the sale of our shares of common stock, including those offered for sale through our distribution reinvestment plans, or from debt proceeds.
At September 30, 2018, the outstanding principal balance of our mortgage notes payable was $98,829,220, net of deferred financing costs, and there was no outstanding balance on our unsecured credit facility with Pacific Mercantile Bank. Our unsecured credit facility matures on January 26, 2019 (see Note 6 to our condensed consolidated financial statements). Our approximate 4.4% pro rata share of REIT I’s mortgage notes payable was $2,767,529 at September 30, 2018. Our 72.7% TIC interest in the Santa Clara property’s mortgage note payable was $10,372,537 at September 30, 2018. On October 25, 2018, we borrowed the full $9,000,000 available under our unsecured credit facility to acquire an office building located in Richmond, Virginia as described above. The Company plans to repay the amount drawn under its credit facility with long-term debt within the next few months.
Portfolio Information
Our wholly-owned real estate investments were as follows:
Our approximate 72.7% TIC interest in the Santa Clara property, which approximates 91,740 square feet of office property, is not included in the table above. Also, the above table does not include our approximate 4.4% interest in an affiliated REIT.
Cash Flow Summary
The following table summarizes our cash flow activity for the nine months ended September 30:
Cash Flows from Operating Activities
For the nine months ended September 30, 2018 and 2017, net cash provided by operating activities was $2,555,989 and $2,546,372, respectively. The cash provided by operating activities during the nine months ended September 30, 2018 primarily reflects our net income of $16,145 adjusted for net non-cash charges of $4,535,444 related to depreciation and amortization, amortization of deferred financing costs, distributions from investments in unconsolidated entities, stock compensation expense and amortization of above-market leases, partially offset by deferred rents, unrealized gain on interest rate swap valuation, amortization of below-market leases and income from investment in unconsolidated entities. In addition, the net non-cash charges were partially offset by a net change in operating assets and liabilities of $1,995,600 during the nine months ended September 30, 2018 due to increases in tenant receivables and prepaid expenses and other assets and decreases in accounts payable, accrued and other liabilities and due to affiliates.
The cash provided by operating activities during the nine months ended September 30, 2017 primarily reflects adjustments to our net loss for net non-cash charges of $1,830,338 related to depreciation and amortization, distributions from investments in unconsolidated entities, stock compensation expense, unrealized losses on interest rate swap valuation and amortization of deferred financing costs, partially offset by deferred rents and undistributed income from investment in unconsolidated entity. Cash was also provided by a change in operating assets and liabilities of $1,227,764 during the nine months ended September 30, 2017 due to increases in accounts payable, accrued and other liabilities and due to affiliates, partially offset by increases in tenant receivables and prepaid expenses and other assets.
We expect that our cash flows from operating activities will increase in future periods as a result of anticipated future acquisitions of real estate and the related operating contributions from such investments, as well as from an entire year of operations for the properties that we have acquired since January 1, 2018.
Cash Flows from Investing Activities
Net cash used in investing activities was $53,653,282 for the nine months ended September 30, 2018 and consisted of the following:
Net cash used in investing activities was $75,854,042 for the nine months ended September 30, 2017 and consisted of the following:
Cash Flows from Financing Activities
Net cash provided by financing activities was $52,264,654 for the nine months ended September 30, 2018 and consisted of the following:
Net cash provided by financing activities was $79,220,259 for the nine months ended September 30, 2017 and consisted of the following:
Capital Resources
Generally, our cash requirements for property acquisitions, debt payments, capital expenditures, and other investments will be funded by the Offerings and bank borrowings from financial institutions and mortgage indebtedness on our properties, and to a lesser extent, by internally generated funds. Our cash requirements for operating and interest expenses, repurchases of common stock and dividend distributions will generally be funded by internally generated funds and, to some extent, the waiver or deferral of asset management fees by our Sponsor. Offering proceeds may also be used to fund repurchases of common stock. If available, future sources of capital include proceeds from the Offerings, secured or unsecured borrowings from banks or other lenders and proceeds from the sale of properties, as well as undistributed funds from operations.
Results of Operations
As of September 30, 2018, we owned 22 operating properties and one parcel of land adjacent to one of our operating properties, an approximate 72.7% TIC Interest and one real estate investment in an affiliated REIT in which we have an approximate 4.4% interest. We acquired seven properties from April 1, 2017 to December 31, 2017 and four properties and the parcel of land in the first nine months of 2018. We also acquired our approximate 72.7% TIC Interest in September 2017. We expect that rental income, tenant reimbursements, depreciation and amortization expense, interest expense and asset management fees to affiliates will each increase in future periods as a result of the acquisitions discussed above and our anticipated future acquisitions of real estate investments. Our results of operations for the three and nine months ended September 30, 2018 are not indicative of those expected in future periods as we are continuing to raise capital through the Offerings and acquire additional properties.
Comparison of the Three Months Ended September 30, 2018 to the Three Months Ended September 30, 2017
Rental Income
Rental income for the three months ended September 30, 2018 and 2017 was $3,910,063 and $1,926,722, respectively. The annualized base rental income of the operating properties owned as of September 30, 2018 was $14,520,000. The significant increase quarter-over-quarter primarily reflects rental income from eight operating properties acquired from July 1, 2017 to September 30, 2018. The number of operating properties increased from 14 properties on July 1, 2017 to 22 properties on September 30, 2018.
Tenant Reimbursements
Tenant reimbursements were $815,216 and $389,784 for the three months ended September 30, 2018 and 2017, respectively. Pursuant to most of our lease agreements, tenants are required to pay all or a portion of the property operating expenses. The significant increase quarter-over-quarter was primarily due to the above-mentioned operating properties acquired.
Fees to Affiliates
Fees to affiliates, or asset management fees to affiliate, for the three months ended September 30, 2018 and 2017 were $532,355 and $264,927, respectively, for our investments in operating property. The significant increase quarter-over-quarter was primarily due to the increase in the number of operating properties owned from 14 properties in the third quarter of 2017 to 22 properties in the third quarter of 2018. In addition, the Company also incurred asset management fees to the Advisor of $65,993 and $1,446 related to its TIC Interest in the Santa Clara property during the three months ended September 30, 2018 and 2017, respectively, which amounts are reflected as a reduction of income recognized from investments in unconsolidated entities.
General and Administrative
General and administrative expenses for the three months ended September 30, 2018 and 2017 were $598,578 and $904,818, respectively. The significant decrease quarter-over-quarter was primarily due to a reduction in the number of investor relations personnel and related costs, partially offset by an increase in professional services fees and administrative costs.
Depreciation and Amortization
Depreciation and amortization expense for the three months ended September 30, 2018 and 2017 was $1,861,649 and $921,692, respectively. The purchase price of the acquired properties is allocated to tangible assets, identifiable intangibles and assumed liabilities and depreciated or amortized over their estimated useful lives. The significant increase quarter-over-quarter was primarily due to the increase in the number of operating properties owned from 14 properties during the third quarter of 2017 to 22 properties during the third quarter of 2018.
Interest expense for the three months ended September 30, 2018 and 2017 was $1,070,860 and $541,282, respectively (see Note 6 for the detail of the components of interest expense). The significant increase quarter-over-quarter was primarily due to the increase in the average principal balance of mortgage notes payable from approximately $35,300,000 during the three months ended September 30, 2017 to approximately $94,400,000 during the three months ended September 30, 2018. Average unsecured credit facility borrowings were approximately $8,200,000 during the three months ended September 30, 2017 compared to $0 during the three months ended September 30, 2018.
Property Expenses
Property expenses for the three months ended September 30, 2018 and 2017 were $772,394 and $413,161, respectively. These expenses primarily relate to property taxes and repairs and maintenance expenses. The significant increase quarter-over-quarter was primarily due to the increase in the number of rental properties owned from 14 properties during the third quarter of 2017 to 22 properties during the third quarter of 2018.
Expenses Reimbursed/Fees Waived by Sponsor or Affiliates
Expenses reimbursed/fees waived by Sponsor or affiliates for the three months ended September 30, 2018 and 2017 were $298,645 and $626,715, respectively. For the three months ended September 30, 2018 and 2017, the amounts reimbursed to the Sponsor for investor relations payroll costs were $173,464 and $584,230, respectively. The reduction in reimbursements corresponds primarily to the reduced number of investor relations personnel and related costs as described above under general and administrative expenses.
Other Income
Interest income for the three months ended September 30, 2018 and 2017 was $4,648 and $2,988, respectively.
Income from investments in unconsolidated entities for the three months ended September 30, 2018 and 2017 was $69,863 and $688, respectively. This represents our approximate 4.4% share of the results of operations of REIT I and our approximate 72.7% share of the results of operations of the Santa Clara property for the three months ended September 30, 2018. Investment income for the three months ended September 30, 2017 pertains to REIT I only. Our TIC Interest in the Santa Clara property operations for the three-day period ended September 30, 2017 was not material.
Comparison of the Nine Months Ended September 30, 2018 to the Nine Months Ended September 30, 2017
Rental income for the nine months ended September 30, 2018 and 2017 was $10,490,488 and $3,990,317, respectively. The annualized base rental income of the operating properties owned as of September 30, 2018 was $14,520,000. The significant increase period-over-period primarily reflects rental income from 13 operating properties acquired from January 1, 2017 to September 30, 2018. The number of operating properties increased from nine properties on January 1, 2017 to 22 properties on September 30, 2018.
Tenant reimbursements were $2,076,735 and $915,431 for the nine months ended September 30, 2018 and 2017, respectively. The significant increase period-over-period was primarily due to the above-mentioned operating properties acquired.
Asset Management Fees to Affiliate
Asset management fees to affiliate for the nine months ended September 30, 2018 and 2017 were $1,411,585 and $573,081, respectively. The significant increase period-over-period was primarily due to the increase in the number of operating properties owned from 16 properties during the first nine months of 2017 to 22 properties during the first nine months of 2018. In addition, the Company also incurred asset management fees to the Advisor of $197,978 and $1,446 related to its TIC Interest in the Santa Clara property during the nine months ended September 30, 2018 and 2017, respectively, which amounts are reflected as a reduction of income recognized from investments in unconsolidated entities.
General and administrative expenses for the nine months ended September 30, 2018 and 2017 were $2,047,761 and $2,922,840, respectively. The significant decrease period-over-period was primarily due to the decrease in the number of investor relations personnel and related costs, partially offset by an increase in professional service fees.
Depreciation and amortization expense for the nine months ended September 30, 2018 and 2017 was $4,888,394 and $2,077,970, respectively. The significant increase period-over-period was primarily due to the increase in the number of operating properties owned from 16 properties during the first nine months of 2017 to 22 properties during the first nine months of 2018.
Interest expense for the nine months ended September 30, 2018 and 2017 was $3,364,736 and $1,111,287, respectively. The significant increase period-over-period was primarily due to the increase in the average principal balance of mortgage notes payable from approximately $22,700,000 for the nine months ended September 30, 2017 to approximately $82,900,000 for the nine months ended September 30, 2018. Average unsecured credit facility borrowings were approximately $8,100,000 for the nine months ended September 30, 2017 compared to $5,000,000 for the nine months ended September 30, 2018.
Property expenses for the nine months ended September 30, 2018 and 2017 were $1,966,616 and $968,902, respectively. The significant increase period-over-period was primarily due to the increase in the number of operating properties owned from 16 properties during the first nine months of 2017 to 22 properties during the first nine months of 2018.
Expenses reimbursed/fees waived by Sponsor or affiliates for the nine months ended September 30, 2018 and 2017 were $952,098 and $2,064,684, respectively. For the nine months ended September 30, 2018 and 2017, the amounts reimbursed to the Sponsor for investor relations payroll costs was $726,972 and $1,945,160, respectively. The reduction in reimbursements corresponds to the reduced number of investor relations personnel and related costs as described above under general and administrative expenses. Additional reimbursements were also made for professional fees.
Interest income for the nine months ended September 30, 2018 and 2017 was $12,569 and $3,875, respectively.
Income from investments in unconsolidated entities for the nine months ended September 30, 2018 and 2017 was $163,348 and $168,043, respectively. This represents our approximate 4.4% share of the results of operations of REIT I and our approximate 72.7% share of the results of operations of the Santa Clara property for the nine months ended September 30, 2018. Investment income for the nine months ended September 30, 2017 pertains to REIT I only. Our TIC Interest in the Santa Clara property operations for the three-day period ended September 30, 2017 was not material.
Organizational and Offering Costs
Our organizational and offering costs are paid by our Sponsor on our behalf. Offering costs include all expenses incurred in connection with the Offerings, including investor relations payroll expenses. Other organizational and offering costs include all expenses incurred in connection with our formation, including, but not limited to legal fees, federal and state filing fees, and other costs to incorporate.
During the primary Offerings, we are obligated to reimburse our Sponsor for organizational and offering costs related to the Offerings paid by them on our behalf provided such reimbursement would not exceed 3% of gross offering proceeds raised in the Offerings as of the date of the reimbursement.
As of September 30, 2018, we had not directly incurred any organizational and offering costs related to the Offerings as all such costs had been funded by our Sponsor. As a result, these organizational and offering costs related to the Offerings are not recorded in our financial statements as of September 30, 2018 other than to the extent of 3% of the gross offering proceeds. Through September 30, 2018, our Sponsor had incurred organizational and offering costs on our behalf in connection with our Offerings of $8,156,345. Through September 30, 2018, we had recorded $3,890,026 of organizational and offering costs, of which $2,980 was payable to the Sponsor or affiliates. See Note 8 to our condensed consolidated financial statements for additional information.
During our offering stage, when we may raise capital more quickly than we acquire income producing assets, and from time-to-time during our operational state, we way not pay distributions from operations. In these cases, distributions may be paid in whole or in part from the waiver or deferral of fees otherwise due to our Advisor, if so elected by our Advisor. Historically, the sources of cash used to pay our distributions have been from net rental income received, along with the waiver and deferral of management fees and, to a limited extent, offering proceeds. The leases for certain of our real estate acquisitions may provide for rent abatements. These abatements are an inducement for the tenant to enter into or extend the term of its lease. In connection with the acquisition of some properties, we may be able to negotiate a reduced purchase price for the acquired property in an amount that equals the previously agreed-upon rent abatement. During the period of any rent abatement on properties that we acquire, we may be unable to fully fund our distributions from net rental income received and waivers or deferrals of Advisor asset management fees. In that event, we may expand the sources of cash used to fund our stockholder distributions to include proceeds from the sale of our common stock, but only during the periods, and up to the amounts, of any rent abatements where we are able to negotiate a reduced purchase price.
Distributions declared, distributions paid and cash flows provided by operating activities were as follows:
Our sources of distribution payments were as follows:
Distributions were declared and paid based on daily record dates at rates per share per day as follows:
Going forward, we expect our board of directors to continue to declare cash distributions based on daily record dates and to pay these distributions on a monthly basis, and after our Offerings to continue to declare distributions based on a single record date as of the end of the month, and to pay these distributions on a monthly basis. Cash distributions will be determined by our board of directors based on our financial condition and such other factors as our board of directors deems relevant. We have not established a minimum dividend or distribution level, and our charter does not require that we make dividends or distributions to our stockholders other than as necessary to meet REIT qualification requirements.
Properties
As of September 30, 2018, we owned 22 operating properties encompassing an aggregate of 1,366,603 rentable square feet in 12 states, a parcel of land adjacent to one of the operating properties, one approximate 72.7% TIC Interest and one real estate investment in an affiliated REIT in which we have an approximate 4.4% interest. We have been in the offering state of our life cycle and will continue to acquire assets that adhere to our investment criteria with proceeds from the sale of our shares and financing proceeds. Details about our properties can be found in Note 4 to our condensed consolidated financial statements.
We do not currently have plans to incur any significant costs to renovate, improve or develop the properties, other than as discussed below, and we believe that the properties are adequately insured. We have four tenants with leases that provide for tenant improvement allowances totaling $309,404, including our 72.7% share of the tenant improvement allowance for the Santa Clara property. We expect that the related improvements will be completed during the 2018 calendar year. As of September 30, 2018, there are restricted cash deposits of $83,300 that are available to be used to pay for these improvements. The remainder will be funded from operating cash flow or offering proceeds.
In addition, as of September 30, 2018, we have identified approximately $1,003,000 of roof replacement, exterior painting and sealing and parking lot repairs/restriping that are expected to be completed in 2018 and 2019. Approximately 22% of these improvements are expected to be recoverable from the tenants through their operating expense reimbursements. However, we will have to pay for the improvements and the reimbursements will be billed over an extended period of time. The remaining costs are not recoverable from tenants. These improvements will be funded from operating cash flows or offering proceeds.
Recent Market Conditions
Volatility in global financial markets and changing political environments can cause fluctuations in the performance of the U.S. commercial real estate markets. Possible future declines in rental rates and expectations of future rental concessions, including free rent to renew tenants early, to retain tenants who are up for renewal or to attract new tenants, may result in decreases in cash flows from investment properties. Increases in the cost of financing due to higher interest rates may cause difficulty in refinancing debt obligations prior to maturity at terms as favorable as the terms of existing indebtedness. Market conditions can change quickly, potentially negatively impacting the value of real estate investments. Management continuously reviews our investment and debt financing strategies to optimize our portfolio and the cost of our debt exposure.
Recent financial conditions affecting commercial real estate have been stable, as low treasury rates and increased lending from banks, insurance companies and commercial mortgage backed securities (“CMBS”) conduits have increased lending activity. Nevertheless, the debt market remains sensitive to the macro environment, such as Federal Reserve policy, market sentiment or regulatory factors affecting the banking and CMBS industries. While we expect that financial conditions will remain favorable, if they were to deteriorate, we may experience more stringent lending criteria, which may affect our ability to finance certain property acquisitions or refinance any debt at maturity. Additionally, for properties for which we are able to obtain financing, the interest rates and other terms on such loans may be unacceptable. We expect to manage the current mortgage lending environment by considering alternative lending sources, including securitized debt, fixed rate loans, borrowings on a line of credit, short-term variable rate loans, assumed mortgage loans in connection with property acquisitions, interest rate lock or swap agreements, or any combination of the foregoing.
Commercial real estate fundamentals continue to remain favorable, as a moderate pace of job creation has supported gains in office absorption, retail sales and warehouse distribution. Although commercial property construction activity has increased, it remains near historic lows; as a result, incremental demand growth has helped to reduce vacancy rates and support modest rental growth. Improving fundamentals have resulted in gains in property values. However, future increases in interest rates could have a negative impact on property values.
Election as a REIT
We elected to be taxed as a REIT for federal income tax purposes under the Code beginning with the taxable year ended December 31, 2016. We believe we will continue to qualify as a REIT. To qualify and maintain status as a REIT, we must meet certain requirements relating to our organization, sources of income, nature of assets, distributions of income to our stockholders and recordkeeping. As a REIT, we generally would not be subject to federal income tax on taxable income that we distribute to our stockholders so long as we distribute at least 90% of our annual taxable income (computed without regard to the dividends paid deduction and excluding net capital gains).
If we fail to qualify as a REIT for any reason in a taxable year and applicable relief provisions do not apply, we will be subject to tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates. We will not be able to deduct distributions paid to our stockholders in any year in which we fail to qualify as a REIT. We also will be disqualified for the four taxable years following the year during which qualification is lost, unless we are entitled to relief under specific statutory provisions. Such an event could materially adversely affect our net income and net cash available for distribution to stockholders. However, we believe that we are organized and operate in such a manner as to qualify for treatment as a REIT for federal income tax purposes. No provision for federal income taxes has been made in our condensed consolidated financial statements. We will be subject to certain state and local taxes related to the operations of properties in certain locations. We are subject to certain state and local taxes related to the operations of properties in certain locations, which have been provided for in our condensed consolidated financial statements.
Critical Accounting Policies and Estimates
Our accounting policies have been established to conform with GAAP. The preparation of financial statements in conformity with GAAP requires us to use judgment in the application of accounting policies, including making estimates and assumptions. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied, thus resulting in a different presentation of the financial statements. Additionally, other companies may utilize different estimates that may impact comparability of our results of operations to those of companies in similar businesses. A discussion of the accounting policies that management considers critical in that they involve significant management judgments, assumptions and estimates is included under “Critical Accounting Policies” in Part II, Item 7 of our Annual Report on Form 10-K, filed with the SEC on April 3, 2018. There have been no significant changes to our policies during the nine months ended September 30, 2018.
Commitments and Contingencies
We may be subject to certain commitments and contingencies with regard to certain transactions (see Note 9 to our condensed consolidated financial statements for commitment and contingencies).
Related-Party Transactions and Agreements
We have entered into an Advisory Agreement with our Advisor whereby we have agreed to pay certain fees to, or reimburse certain expenses of, our Advisor or our affiliates, such as acquisition fees and expenses, organization and offering costs, asset management fees, and reimbursement of certain operating costs (see Note 8 to our condensed consolidated financial statements for additional details of the various related-party transactions and agreements).
On August 3, 2018, the Conflicts Committee, which is comprised of our independent directors approved renewing the Advisory Agreement for an additional year, to August 11, 2019. Concurrently, the independent directors also approved amendments to the Advisory Agreement which provide for (i) paying the Asset Management Fee for assets acquired during a month based on the pro-rated number of days following acquisition, and (ii) paying the Asset Management Fee on the last business day of the month.
Subsequent Events
See Note 10 to our condensed consolidated financial statements for events that occurred subsequent to September 30, 2018 through the filing date of this report.
See Note 2 to our condensed consolidated financial statements for recent accounting pronouncements.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that had or are reasonably likely to have a material current or future effect on our financial condition, results of operations, liquidity, or capital resources as of September 30, 2018.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
Not required as we are a Smaller Reporting Company.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our principal executive officer and principal financial officer, have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports we file and submit under the Securities Exchange Act of 1934 is (i) processed, recorded, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including our principal executive officer and our principal financial officer as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.
Changes in Internal Control over Financial Reporting
To further strengthen our internal control over financial reporting, during the third quarter of 2018, we hired our chief accounting officer with extensive experience in accounting and finance in the real estate industry. Other than the hiring of our chief accounting officer, there were no other changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) that occurred during the three months ended September 30, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Limitations on Effectiveness of Controls and Procedures
Our disclosure controls and procedures and internal control over financial reporting are designed to provide reasonable assurance of achieving the desired control objectives. Our management recognizes that any control system, no matter how well designed and operated, is based upon certain judgments and assumptions and cannot provide absolute assurance that our objectives will be met. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs. Similarly, an evaluation of controls cannot provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
The information disclosed under Legal Matters in Note 9 to our condensed consolidated financial statements is incorporated herein by reference.
Item 1A. Risk Factors
There have been no material changes to the risk factors set forth under “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K, as amended, for the year ended December 31, 2017, as filed with the SEC on April 3, 2018.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Unregistered Sales of Equity Securities
During the three months ended September 30, 2018, we issued a total of 4,800 shares of Class C common stock to five members of the board of directors for their services as board members. Such issuance was made in reliance on the exemption from registration under Section 4(a)(2) of the Securities Act.
During the three months ended September 30, 2018, we also issued 100 shares of Class S common stock in the Class S Offering for aggregate gross offering proceeds of $1,003. Such issuances were made pursuant to the dividend reinvestment plan applicable to our Class S common stock in reliance on an exemption from the registration requirements of the Securities Act under and in accordance with Regulation S of the Securities Act.
Use of Proceeds from Sales of Registered Securities
On June 1, 2016, our Registration Statement on Form S-11 (File No. 333-205684) (the “Registration Statement”), covering an initial public offering to offer a maximum of 90,000,000 shares of common stock for sale to the public in the Primary Offering was declared effective under the Securities Act. Pursuant to the Registration Statement, we also registered a maximum of 10,000,000 shares of common stock pursuant to our Registered DRP Offering. The shares of common stock covered by the Registration Statement were renamed and re-designated as Class C shares of common stock pursuant to amendments to our charter that became effective in August 2017.
The Registered Offering commenced on July 20, 2016. We intend to sell the shares of Class C common stock offered in our Primary Offering and pursuant to our Registered DRP Offering until June 1, 2019, unless our board of directors terminates the offering at an earlier date or all shares being offered have been sold, in which case the Registered Offering will be terminated. If all of the shares we are offering have not been sold by June 1, 2019, our board of directors may further extend the offering in accordance with Rule 415 of the Securities Act. Rule 415 of the Securities Act permits us to file a new registration statement on Form S-11 with the SEC, so that we may continuously offer shares of our Class C common stock. If our board of directors determines to extend the offering beyond June 1, 2019, we will notify stockholders by filing a supplement to the prospectus for the Registered Offering with the SEC. We are also required to renew the Registration Statement or file a new registration statement in many states to continue the Registered Offering. We may terminate the Registered Offering at any time. Our board of directors will adjust the price of the Registered Offering shares during the course of the Registered Offering as described in the Registration Statement, as amended.
Through September 30, 2018, we had sold 12,920,379 shares of Class C common stock in the Registered Offering, including 737,813 shares of Class C common stock sold under our Registered DRP Offering, for aggregate gross offering proceeds of $129,376,190.
PART II – OTHER INFORMATION (continued)
Through September 30, 2018, we have paid $3,881,046 to our Sponsor as reimbursement for organizational and offering costs, which reimbursement is subject to the 3% of gross offering proceeds limitation.
From the commencement of the Registered Offering through September 30, 2018, the net offering proceeds to us, after deducting the reimbursable organizational and offering expenses incurred as described above, were approximately $125,289,144, including net offering proceeds from our Registered DRP Offering of $7,400,389. Substantially all of these proceeds, along with proceeds from the Class S Offering and debt financing, were used to make approximately $211,015,000 of investments in real estate properties, including the purchase price of our investments, deposits paid for future acquisitions, acquisition fees and expenses, and costs of leveraging each real estate investment. Of the use of the offering proceeds described in the prior statement, $6,182,521 and $536,150 were used to pay acquisition fees and financing coordination fees to our Advisor, respectively. Our Sponsor was reimbursed for $3,887,046 of organizational and offering costs. See Note 8 of our condensed consolidated financial statements for details about fees paid to affiliates. In addition, through September 30, 2018, $288,370 of proceeds from the Offerings were used to fund stockholder distributions in connection with rent abatements as described above. See Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations —Distributions for a description of the sources that have been used to fund our distributions.
Issuer Redemptions of Equity Securities
The following table summarizes our repurchase activity under our share repurchase program for our Class C common stock for the three months ended September 30, 2018. As of September 30, 2018, we have not repurchased any shares of our Class S common stock.
Item 6. Exhibits
The exhibits listed on the Exhibit Index below are included herewith or incorporated herein by reference.
EXHIBIT INDEX
The following exhibits are included, or incorporated by reference, in this Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018 (and are numbered in accordance with Item 601 of Regulation S-K).
SIGNATURES
Pursuant to the requirements Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: November 13, 2018