UNITED STATESSECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10–Q
Commission file number 1–9106
Brandywine Realty Trust (Exact name of registrant as specified in its charter)
(610) 325–5600Registrant's telephone number
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 [ ]
A total of 35,226,315 Common Shares of Beneficial Interest, par value $.01 per share, were outstanding as of November 14, 2002.
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BRANDYWINE REALTY TRUST
TABLE OF CONTENTS
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PART I — FINANCIAL INFORMATIONItem 1. — Financial Statements
BRANDYWINE REALTY TRUST CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited and in thousands, except share and per share information)
The accompanying notes are an integral part of these condensed consolidated financial statements.
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BRANDYWINE REALTY TRUST CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited and in thousands, except per share information)
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BRANDYWINE REALTY TRUSTCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited and in thousands)
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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002
1. THE COMPANY
Brandywine Realty Trust (collectively with its subsidiaries, the “Company”) is a self–administered and self–managed real estate investment trust (a “REIT”) active in acquiring, developing, redeveloping, leasing and managing office and industrial properties. As of September 30, 2002, the Company’s portfolio consisted of 290 properties containing an aggregate of approximately 19.9 million net rentable square feet. The Company owns 210 office properties, 27 industrial facilities and one mixed–use property (collectively, the “Properties”) containing an aggregate of approximately 16.0 million net rentable square feet. The Company also performs management and leasing services for 42 properties containing an aggregate of 3.1 million net rentable square feet. In addition, the Company held economic interests in ten real estate ventures (the “Real Estate Ventures”), containing as aggregate of .8 million net rentable square feet, which were formed with third parties to develop commercial properties. As of September 30, 2002, the Company also owned approximately 444 acres of undeveloped land and held options to purchase approximately 63 additional acres. The Properties are located in the office and industrial markets in and surrounding Philadelphia, Pennsylvania, New Jersey and Richmond, Virginia. As of September 30, 2002, the Company had an aggregate investment in the Real Estate Ventures of approximately $15.9 million (net of returns of investment received by Company).
The Company owns its assets and conducts its operations through Brandywine Operating Partnership, L.P. (the “Operating Partnership”). The Company is the sole general partner of the Operating Partnership and, as of September 30, 2002, was entitled to approximately 94.9% of the Operating Partnership’s distributions after distributions by the Operating Partnership to holders of its Series B Preferred Units (defined below). The Operating Partnership owns a 95% interest in Brandywine Realty Services Corporation (the “Management Company”), a taxable REIT subsidiary that, as of September 30, 2002, was performing management and leasing services for the 42 properties owned by third–parties.
Minority interest relates to interests in the Operating Partnership that are not owned by the Company. Income allocated to minority interest in a period is based on the percentage ownership of the Operating Partnership held by third parties throughout the period. Minority interest is comprised of Class A Units of limited partnership interest (“Class A Units”) and Series B Preferred Units of limited partnership interest (“Series B Preferred Units”). The Operating Partnership issued these Units to persons that contributed assets to the Operating Partnership. The Operating Partnership is obligated to redeem each Class A Unit, at the request of the holder, for cash or one Common Share, at the option of the Company. Each Series B Preferred Unit has a stated value of $50.00 and is convertible, at the option of the holder, into Class A Units at a conversion price of $28.00. The conversion price declines to $26.50, if the average trading price of the Common Shares during the 60–day period ending December 31, 2003 is $23.00 or less. The Series B Preferred Units bear a cumulative preferred distribution of 7.25% per annum ($3.625 per unit per annum), subject to an increase in the event quarterly distributions paid to holders of Common Shares exceed $0.51 per share. As of September 30, 2002, 1,787,436 Class A Units and 1,950,000 Series B Preferred Units were outstanding and held by third party investors. Minority interest also includes the 5% interest in the Management Company that is owned by a partnership comprised of two Company executives.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The condensed consolidated financial statements have been prepared by the Company without audit except as to the balance sheet as of December 31, 2001, which has been prepared from audited data, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the included disclosures are adequate to make the information presented not misleading. In the opinion of management, all adjustments (consisting solely of normal recurring matters) necessary to fairly present the financial position of the Company as of September 30, 2002, the results of its operations for the three– and nine–month periods ended September 30, 2002 and 2001, and its cash flows for the nine–month periods ended September 30, 2002 and
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2001 have been included. The results of operations for such interim periods are not necessarily indicative of the results for a full year. For further information, refer to the Company’s consolidated financial statements and footnotes included in the Annual Report on Form 10–K for the year ended December 31, 2001. Certain prior period amounts have been reclassified to conform with the current period presentation.
Use of EstimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Management makes significant estimates regarding the collectibility of the Company’s accounts receivable and regularly evaluates the Company’s long–lived assets for impairment.
Real Estate Investments Real estate investments include capitalized direct internal development costs totaling $.2 million and $.8 million for the three– and nine–month periods ended September 30, 2002 and $1.2 million and $2.4 million for three– and nine–month periods ended September 30, 2001. The Company capitalized interest totaling $.7 million and $2.3 million for the three– and nine–month periods ended September 30, 2002 and $1.3 million and $3.9 million for the three– and nine–month periods ended September 30, 2001 related to property development.
Effective January 1, 2002, the Company changed the estimated useful lives of various buildings from 25 to 40 years. This change resulted in an increase of net income of $4.8 million or $.13 per share and $13.9 million or $.39 per share for the three– and nine–month periods ended September 30, 2002. Management, taking into account industry standards, determined the longer period to be a better estimate of the useful lives of the buildings.
Deferred CostsDeferred costs include internal direct leasing costs totaling $.9 million and $2.6 million for the three– and nine–month periods ended September 30, 2002 and $.7 million and $2.2 million for the three– and nine–month periods ended September 30, 2001. The Company amortizes these costs over the related lease terms.
Accounting for Derivative Instruments and Hedging Activities The Company accounts for its derivative instruments and hedging activities under Statement of Financial Accounting Standards (SFAS) No. 133,Accounting for Derivative Instruments and Hedging Activities, and its corresponding amendments under SFAS No. 138. SFAS 133 requires the Company to measure every derivative instrument (including certain derivative instruments embedded in other contracts) at fair value and record them in the balance sheet as either an asset or liability. For derivatives designated as fair value hedges, the changes in fair value of both the derivative instrument and the hedged item are recorded in earnings. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in other comprehensive income. Changes in fair value of derivative instruments and ineffective portions of hedges are recognized in earnings in the current period. For the nine–month period ended September 30, 2002, the Company was not party to any derivative contract designated as a fair value hedge.
The Company recorded a loss of $2.4 million and $2.6 million in other comprehensive income to recognize the change in value of derivatives accounted for as cash flow hedges during the three– and nine–month periods ended September 30, 2002. The unrealized gains/losses and the transition adjustment recorded in accumulated other comprehensive income will be reclassified into earnings as the underlying hedged items affect earnings, such as when the forecasted interest payments occur. The Company expects that $4.0 million of net losses will be reclassified into earnings over the next twelve months.
The Company formally assesses, both at inception of the hedge and on an on–going basis, whether each derivative is highly–effective in offsetting changes in fair values or cash flows of the hedged item. If management determines that a derivative is not highly–effective as a hedge or if a derivative ceases to be a highly–effective hedge, the Company will discontinue hedge accounting prospectively.
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The Company actively manages its ratio of fixed–to–floating rate debt. To manage its fixed and floating rate debt in a cost–effective manner, the Company, from time to time, enters into interest rate swap agreements, in which it agrees to exchange various combinations of fixed and/or variable interest rates based on agreed upon notional amounts. As of September 30, 2002, the maximum length of time until which the Company is hedging its exposure to the variability in future cash flows is through July 2004. There was no gain or loss reclassified from accumulated other comprehensive loss into earnings during the three&– and nine–month periods ended September 30, 2002 as a result of the discontinuance of a cash flow hedge due to the probability of the original forecasted transaction not occurring.
Change in Accounting for Stock Options In October 1995, the Financial Accounting Standards Board issued SFAS No. 123,Accounting for Stock–Based Compensation. The standard defines a fair value based method of accounting for employee stock compensation plans. Although adoption of this standard’s expense recognitionprovisions is encouraged, it allows a company to continue to account for its employee stock compensation plans under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), but requires additional pro forma disclosure as if the fair value based method had been applied. The Company implemented the expense recognition provisions of SFAS No. 123 in the third quarter of 2002, with retroactive application to employee stock options granted on or after January 1, 2002 only. Options granted in fiscal years prior to 2002 will continue to be accounted for using the intrinsic value method as described in APB 25. The Company issued 100,000 employee stock options during the three–month period ended September 30, 2002 and recorded $17,000 of compensation expense year–to–date as a result of the change in accounting method. The Company already records compensation expense for shares granted under restricted stock plans and, therefore, these shares are not affected by this change. The effects of the implementation of SFAS No. 123 during fiscal year 2002 will not be representative of the effects on reported net income in future years because only the effects of stock option awards granted in 2002 have been considered. The Company believes that this change will more accurately reflect the effect of granting stock options on net income.
If SFAS No. 123 had been adopted as of its effective date (fiscal years that begin after December 15, 1995), additional compensation expense of $.2 million and $.5 million for all options issued after December 1995 would have been included in net income for the three– and nine–month periods ended September 30, 2002 and 2001. The effect on basic and diluted earnings per share would have been minimal.
Accounting for the Impairment or Disposal of Long–Lived Assets Effective January 1, 2002, the Company adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long–Lived Assets,which established a single accounting model for the impairment or disposal of long–lived assets including discontinued operations. This statement requires that the operations related to properties that have been sold orProperties that are intended to be sold be presented as discontinued operations in the statement of operations for all periods presented and Properties intended to be sold are to be designated as “held–for–sale” on the balance sheet. When assets are identified by management as held for sale, the Company discontinues depreciating the assets and estimates the sales price, net of selling costs, of such assets. If, in management’s opinion, the net sales price of the assets which have been identified for sale is less than the net book value of the assets, a valuation allowance is established.
3. ACQUISITIONS AND DISPOSITIONS OF REAL ESTATE INVESTMENTS
2002
During the nine–month period ended September 30, 2002, the Company sold 23 office properties containing an aggregate of 1.4 million net rentable square feet, 20 industrial properties containing an aggregate of .9 million net rentable square feet and two parcels of land containing an aggregate of 12.8 acres for an aggregate of $190.8 million, realizing a net gain of $8.6 million. The Company also purchased seven office properties containing 617,000 net rentable square feet and one parcel of land containing 9.0 acres for an aggregate of $99.1 million. During the three–month period ended September 30, 2002, the Company sold seven office properties containing an aggregate of 288,000 net rentable square feet for an aggregate of $22.7 million. The Company received cash of $19.2 million and a subordinated promissory note of $3.5 million, secured by a pledge of the equity interest of the borrower. As a result, the Company recorded a deferred gain of $2.5 million which is being accounted for under the cost recovery method. The Company also purchased two office properties containing 115,000 net rentable square feet and one land parcel containing 9.0 acres for an aggregate of $17.2 million.
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2001
During the nine–month period ended September 30, 2001, the Company sold one office property containing 30,000 net rentable square feet, eight industrial properties containing an aggregate of 286,000 net rentable square feet and four parcels of land containing 15.8 acres for an aggregate of $21.2 million, realizing a net gain of $1.3 million. During the three–month period ended September 30, 2001, the Company sold six industrial properties containing 245,000 net rentable square feet and three parcels of land containing 13.7 acres for an aggregate of $15.5 million, realizing a net gain of $929,000.
In April 2001, the Company consumated an exchange of properties with Prentiss Properties Acquisition Partners, L.P. (“Prentiss”). The Company acquired from Prentiss 30 properties (29 office and one industrial) containing 1.6 million net rentable square feet and 6.9 acres of developable land for total consideration of $215.2 million. The Company conveyed to Prentiss four office properties located in Northern Virginia that contain an aggregate of 657,000 net rentable square feet, assumed $79.7 million of mortgage debt secured by certain of the Prentiss properties, issued a $7.8 million promissory note, paid $15.9 million in cash at closing and agreed to make additional payments totaling $7.0 million (including $5.4 million of payments discounted at 7.5%) over a three year period subsequent to closing. The Company also contributed to Prentiss its interest in a real estate venture that owns two additional office properties that contain an aggregate of 452,000 net rentable square feet and received a combination of preferred and common units of limited partnership interest in Prentiss having a value of $10.7 million as of the closing. In addition, as part of the Prentiss transaction, in June 2001 the Company purchased a 103,000 square foot building then under construction and six acres of related developable land for $5.7 million, plus $4.2 million on account of additional costs related to development.
Proforma
The properties acquired from Prentiss referenced above were accounted for by the purchase method. The results of operations for each of the acquired properties have been included from the respective purchase dates. All proforma financial information presented within this footnote is unaudited and is not necessarily indicative of the results which actually would have occurred if the exchange of the related properties had been consummated on January 1, 2001, nor does the pro forma information purport to represent the results of operations for future periods.
The following unaudited pro forma financial information for the nine—month period ended September 30, 2001 gives effect to the exchange of properties with Prentiss as if the transaction occurred on January 1, 2001:
4. INVESTMENT IN UNCONSOLIDATED REAL ESTATE VENTURES
As of September 30, 2002, the Company had an aggregate investment of approximately $15.9 million in ten Real Estate Ventures (net of returns of investment received by the Company). The Company formed these ventures with unaffiliated third parties to develop office properties or to acquire land in anticipation of possible development of office properties. Eight of the Real Estate Ventures own eight office buildings that contain an aggregate of approximately .8 million net rentable square feet; one Real Estate Venture developed a hotel property that contains 137 rooms; and one Real Estate Venture holds approximately three acres of land for future development.
During the three–month period ended September 30, 2002, the Company purchased the partnership interests held by third parties in three Real Estate Ventures which owned two office properties containing 222,000 net rentable square feet and one parcel of land containing 1.0 acres for $2.3 million.
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The Company accounts for its non–controlling interests in the Real Estate Ventures using the equity method. Non–controlling ownership interests generally range from 6% to 65%, subject to specified priority allocations in certain of the Real Estate Ventures. The Company’s investments, initially recorded at cost, are subsequently adjusted for the Company’s net equity in the ventures’ income or loss and cash contributions and distributions.
The following is a summary of the financial position of the unconsolidated Real Estate Ventures in which the Company had interests as of September 30, 2002 and December 31, 2001:
The following is a summary of results of operations of the unconsolidated Real Estate Ventures in which the Company had interests as of September 30, 2002 and 2001:
The following is a summary of the financial position as of September 30, 2002 and the results of operations for the nine—month period ended September 30, 2002 for each of the unconsolidated Real Estate Ventures in which the Company had interests as of September 30, 2002 (000’s):
(a) In July 2002, the Company purchased the remaining interests in these Real Estate Ventures for an aggregate of $2.3 million.
As of September 30, 2002, the aggregate maturities of non–recourse debt of Real Estate Ventures payable to third–parties was as follows (000’s):
As of September 30, 2002, the Company had guaranteed repayment of approximately $2.0 million of loans for the Real Estate Ventures. The Company selectively provides completion guaranties on behalf of Real Estate Ventures as part of their development activities.
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5. INDEBTEDNESS
The Company utilizes credit facility borrowings for general business purposes, including the acquisition of properties and the repayment of other debt. The Company maintains a $500 million unsecured credit facility (the “Credit Facility”) that matures in June 2004. Borrowings under the Credit Facility bear interest at LIBOR (LIBOR was 1.82% at September 30, 2002) plus 1.5%, with the spread over LIBOR subject to reductions from .10% to .25% or increases of .25% based on the Company’s leverage. As of September 30, 2002, the Company had $307.0 million of borrowings and $13.3 million of letters of credit outstanding under the Credit Facility, leaving $179.7 million of unused availability.
During the third quarter of 2002, the Company obtained a $100 million term loan. The Company used proceeds of the term loan to repay indebtedness, including indebtedness under its Credit Facility. The term loan is unsecured and matures on July 15, 2005, subject to two extensions of one year each upon payment by the Company of an extension fee and the absence of any defaults at the time of each extension. There are no scheduled principal payments prior to maturity. The term loan bears interest at a spread over the one, two, three or six month LIBOR that varies between 1.05% and 1.90% (1.65% as of September 30, 2002), based on the Company’s leverage ratio.
As of September 30, 2002, the Company had $593.6 million of mortgage notes payable, secured by 110 of the Properties and certain land holdings. Fixed rate mortgages, totaling $532.9 million, require payments of principal and/or interest (or imputed interest) at rates ranging from 6.80% to 9.25% and mature on dates from July 2003 through July 2027. Variable rate mortgages, totaling $60.7 million, require payments of principal and/or interest at rates ranging from LIBOR plus .76% to 1.75% or 75% of prime (prime rate was 4.75% at September 30, 2002) and mature on dates from July 2003 through July 2027. The weighted–average interest rate on the Company’s mortgages was 7.28% for the nine–month period ended September 30, 2002 and 7.43% for the nine–month period ended September 30, 2001.
The Company has entered into interest rate swap and rate cap agreements designated as cash flow hedges that are designed to reduce the impact of interest rate changes on its variable rate debt. At September 30, 2002, the Company had interest rate swap agreements for notional principal amounts aggregating $175 million. The swap agreements effectively fix the LIBOR interest rate on $100 million of Credit Facility borrowings at 4.230% and on $75 million of Credit Facility borrowings at 4.215%, in each case until June 2004. The weighted-average interest rate on borrowings under the Credit Facility, including the effect of cash flow hedges, was 5.47% for the nine-month period ended September 30, 2002 and 6.83% for the nine-month period ended September 30, 2001. The interest rate cap agreement effectively limits the interest rate on a mortgage with a notional value of $28 million at 8.7% until July 2004.
For the three– and nine–month periods ended September 30, 2002 and 2001, the Company paid interest totaling $15.2 million and $46.5 million in 2002 and $21.4 million and $56.9 million in 2001.
6. DISCONTINUED OPERATIONS
For the three– and nine–month periods ended September 30, 2002 and 2001, income from discontinued operations relates to 43 properties containing 2.3 million net rentable square feet that the Company sold during the nine–month period ended September 30, 2002 and two properties containing 127,000 net rentable square feet that the Company has designated as “held–for–sale”. The following table summarizes information for the two properties designated as held–for–sale as of September 30, 2002 (amounts in thousands):
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The following table summarizes revenue and expense information for the above properties sold or held—for—sale:
Discontinued operations have not been segregated in the Condensed Consolidated Statements of Cash Flows.Therefore, amounts for certain captions will not agree with respective data in the Condensed Consolidated Statements of Operations.
7. BENEFICIARIES EQUITY
On September 23, 2002, the Company declared a distribution of $0.44 per Common Share, totaling $15.6 million, which was paid on October 15, 2002 to shareholders of record as of October 4, 2002. The Operating Partnership simultaneously declared a $0.44 per unit cash distribution to holders of Class A Units totaling $.8 million.
On September 23, 2002, the Company and the Operating Partnership, respectively, also declared distributions to holders of Series A Preferred Shares, Series B Preferred Shares and Series B Preferred Units, which are each currently entitled to a cumulative preferential return of 7.25%, 8.75% and 7.25%, respectively. Distributions paid on October 15, 2002 to holders of Series A Preferred Shares, Series B Preferred Shares and Series B Preferred Units totaled $.7 million, $2.3 million and $1.8 million, respectively.
8. COMPREHENSIVE INCOME
Comprehensive income represents net income, plus the results of certain non—shareholders’ equity changes not reflected in the Condensed Consolidated Statements of Operations. The components of comprehensive income are as follows:
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9. SEGMENT INFORMATION
The Company currently manages its portfolio within three segments: (1) Pennsylvania, (2) New Jersey (included New York in prior periods) and (3) Virginia. Corporate is responsible for cash and investment management and certain other general support functions.
Segment information for the three–month periods ended September 30, 2002 and 2001 is as follows (in thousands):
(a) The Company sold all but one of its properties located in New York prior to September 30, 2002.
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Net operating income is defined as total revenue less property operating expenses and real estate taxes. Below is a reconciliation of consolidated net operating income to consolidated income from continuing operations:
10. EARNINGS PER COMMON SHARE
The following table details the number of shares and net income used to calculate basic and diluted earnings per share (in thousands, except per share amounts):
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the financial statements and notes thereto appearing elsewhere herein. This Form 10–Q contains forward–looking statements for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934 and as such may involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from results, performance or achievements expressed or implied by such forward–looking statements. Although the Company believes that the expectations reflected in such forward–looking statements are based upon reasonable assumptions, there can be no assurance that these expectations will be realized. The Company assumes no obligation to update or supplement forward–looking statements that become untrue because of subsequent events. Factors that could cause actual results to differ materially from management’s current expectations include, but are not limited to, changes in general economic conditions, changes in local real estate conditions (including rental rates and competing properties), changes in the economic conditions affecting industries in which the Company's principal tenants compete, the Company’s failure to lease unoccupied space in accordance with the Company’s projections, the failure of the Company to re–lease occupied space upon expiration of leases, the bankruptcy of major tenants, changes in prevailing interest rates, the unavailability of equity and debt financing, unanticipated costs associated with the acquisition and integration of the Company’s acquisitions, costs to complete and lease–up pending developments, the Company’s ability to obtain adequate insurance for terrorist acts, demand for tenant services beyond those traditionally provided by landlords, potential liability under environmental or other laws and the other risks identified in the Company’s Annual Report on Form 10–K for the year ended December 31, 2001.
OVERVIEW
The Company currently manages its portfolio within three segments: (1) Pennsylvania, (2) New Jersey and (3) Virginia. As of September 30, 2002, the Company’s portfolio consisted of 210 office properties, 27 industrial facilities and one mixed–use property that contain an aggregate of approximately 16.0 million net rentable square feet. As of September 30, 2002, the Company held economic interests in ten Real Estate Ventures.
The Company receives income primarily from rental revenue (including tenant reimbursements) from the Properties and, to a lesser extent, from the management of properties owned by third parties and from investments in the Real Estate Ventures.
The Company’s financial performance is dependent upon the demand for office and other commercial space in its markets. Current economic conditions, including recessionary pressures and capital market volatility, have enhanced the challenges facing the Company.
In the current economic climate, the Company continues to seek revenue growth through an increase in occupancy of its portfolio (90.2% at September 30, 2002). However, with a downturn in general leasing activity, owners of commercial real estate, including the Company, are experiencing longer periods in which to lease unoccupied space, and may face higher capital costs and leasing commissions to achieve targeted tenancies.
As the Company seeks to increase revenues, management also focuses on strategies to minimize operating risks, including (i) tenant rollover risk, (ii) tenant credit risk and (iii) development risk.
Tenant Rollover Risk:
The Company is subject to the risk that, upon expiration, leases may not be renewed, the space may not be relet, or the terms of renewal or reletting (including the cost of renovations) may be less favorable than the current lease terms. Leases accounting for approximately 2.5% of the aggregate annualized base rents from the Properties as of September 30, 2002 (representing approximately 2.3% of the net rentable square feet of the Properties) expire without penalty through the end of 2002. In addition, leases accounting for approximately 11.8% of the aggregate annualized base rents from the Properties as of September 30, 2002 (representing approximately 11.2% of the net rentable square feet of the Properties) are scheduled to expire without penalty in 2003. The Company maintains an active dialogue with its tenants in an effort to achieve a high level of lease renewals. The Company’s retention rate for leases that were scheduled to expire in the nine—month period ended September 30, 2002 was 76.1%. If the Company is unable to renew leases for a substantial portion of the space under expiring leases, or to promptly relet this space, at anticipated rental rates, the Company’s cash flow could be adversely impacted.
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Tenant Credit Risk:
In the event of a tenant default, the Company may experience delays in enforcing its rights as a landlord and may incur substantial costs in protecting its investment. Management regularly evaluates its accounts receivable reserve policy in light of its tenant base and general and local economic conditions. To address the risk of tenant delinquencies and non payments, the Company has increased its accounts receivable reserve over the last two years. The accounts receivable reserves were $4.9 million or 14.4% of total receivables (including accrued rent receivable) as of September 30, 2002 compared to $3.2 million or 8.3% of total receivables (including accrued rent receivable) as of September 30, 2001.
Development Risk:
The Company currently has in development or redevelopment three sites aggregating 428,000 square feet. The total cost of these projects is estimated to be $83.7 million of which $72.8 million was incurred as of September 30, 2002. As of September 30, 2002, these projects were approximately 41% leased. While the Company is actively marketing space at these projects to prospective tenants, management cannot provide assurance as to the timing or terms of any leases of such space. As of September 30, 2002, the Company owned approximately 444 acres of undeveloped land and held options to purchase approximately 63 additional acres. Risks associated with development of this land include construction cost overruns and construction delays, insufficient occupancy rates and inability to obtain necessary zoning, land–use, building, occupancy and other required governmental approvals.
RECENT ACTIVITY
The Company sold or disposed of the following properties during the nine–month period ended September 30, 2002:
The Company acquired the following properties during the nine—month period ended September 30, 2002:
During the nine–month period ended September 30, 2002, the Company sold two parcels of land containing an aggregate of 12.8 acres for $725,000 and purchased one parcel of land containing 9.0 acres for $1.5 million. In addition, the Company purchased the partnership interests held by third parties in three Real Estate Ventures which owned two office properties containing 222,000 net rentable square feet and one parcel of land containing 1.0 acres for $2.3 million.
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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Management bases its estimates and assumptions on historical experience and current economic conditions. On an on–going basis, management evaluates its estimates and assumptions including those related to bad debts, capitalization of costs, contingencies and litigation. Actual results may differ from those estimates and assumptions.
The Company’s Annual Report on Form 10–K for the year ended December 31, 2001 contains a discussion of the Company’s critical accounting policies that are influenced by its more significant estimates and assumptions used in preparation of the financial statements. Note 2 to the accompanying financial statements identifies accounting policies implemented by the Company subsequent to December 31, 2001. Management discusses the Company’s critical accounting policies and estimates with the Company’s Audit Committee.
RESULTS OF OPERATIONS
Comparison of the Three Months Ended September 30, 2002 and September 30, 2001
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Comparison of the Nine Months Ended September 30, 2002 and September 30, 2001
Of the 238 Properties owned by the Company as of September 30, 2002, a total of 225 Properties containing an aggregate of 15.0 million net rentable square feet (“Same Store Properties”) were owned for the entire three—month periods ended September 30, 2002 and 2001. The following table sets forth revenue and expense information for these Same Store Properties for the three—month periods ended September 30, 2002 and 2001:
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Revenue increased to $75.8 million and $220.1 million for the three– and nine–month periods ended September 30, 2002 as compared to $70.8 million and $208.0 million for the comparable periods in 2001, primarily due to increased rental rates partially offset by decreased occupancy. The straight–line rent adjustment, which reflects the difference between rents accrued in accordance with generally accepted accounting principles and rents billed, increased revenues by $1.3 million and $4.1 million for the three– and nine–month periods ended September 30, 2002 and $1.5 million and $4.4 million for the comparable periods in 2001. Revenue for Same Store Properties decreased to $66.8 million for the three months ended September 30, 2002 as compared to $68.0 million for the comparable period in 2001. This decrease was the result of decreased occupancy partially offset by increased rental rates in 2002 as compared to 2001. Average occupancy for the Same Store Properties for the three months ended September 30, 2002 decreased to 90.4% from 94.4% for the comparable period in 2001. Other revenue includes lease termination fees, leasing commissions, third–party management fees and interest income. Other revenue decreased to $2.5 million for the three–month period ended September 30, 2002 as compared to $2.6 million for the comparable period in 2001 primarily due to decreased interest income. Other revenue increased to $8.1 million for the nine–month period ended September 30, 2002 as compared to $6.9 million for the comparable period in 2001 primarily due to higher lease termination fees in 2002.
Property operating expenses increased to $19.4 million and $56.4 million for the three– and nine–month periods ended September 30, 2002 as compared to $18.3 million and $54.4 million for the comparable periods in 2001, primarily due to increased insurance costs in 2002 as compared to 2001. Property operating expenses included a provision for doubtful accounts of $0.9 million for the nine–month period ended September 30, 2002 and $543,000 and $1.3 million for the three– and nine–month periods in 2001, respectively, in response to increases in credit risk related to certain tenants and current economic conditions. The Company reduced the bad debt provision by $228,000 during the three–month period ended September 30, 2002. Property operating expenses for the Same Store Properties increased to $20.3 million for the three months ended September 30, 2002 as compared to $20.1 million for the comparable period in 2001 as a result of increased insurance costs in 2002 as compared to 2001.
Real estate taxes increased to $6.8 million and $18.9 million for the three– and nine–month periods ended September 30, 2002 as compared to $6.1 million and $17.4 million for the comparable periods in 2001, primarily due to higher tax rates and property assessments in 2002. Real estate taxes for the Same Store Properties increased to $6.5 million for the three months ended September 30, 2002 as compared to $6.0 million for the comparable period in 2001 as a result of higher tax rates and property assessments.
Interest expense decreased to $16.3 million and $48.2 million for the three– and nine–month periods ended September 30, 2002 as compared to $17.3 million and $50.3 million for the comparable periods in 2001, primarily due to decreased interest rates offset by increased borrowings. Average outstanding debt balances for the nine months ended September 30, 2002 were $1.0 billion as compared to $934.6 million for the comparable period in 2001, primarily due to the assumption of debt related to property acquisitions, net of debt discharged in property dispositions. The Company’s weighted—average interest rate after giving effect to hedging activities on unsecured credit facilities decreased to 5.47% for the nine months ended September 30, 2002 from 6.83% for the comparable period in 2001. The weighted–average interest rate on mortgage notes payable decreased to 7.28% for the nine months ended September 30, 2002 from 7.43% for the comparable period in 2001.
Depreciation decreased to $12.5 million and $39.4 million for the three– and nine–month periods ended September 30, 2002 as compared to $16.4 million and $49.4 million for the comparable periods in 2001. Of this decrease, $4.8 million ($.13 per share) and $13.9 million ($.39 per share) for the three– and nine–month periods ended September 30, 2002 was due to a change made by the Company in the estimated useful lives of buildings from 25 to 40 years. Management determined that the longer period better reflected the useful lives of the buildings. This decrease was offset by the additional depreciation recorded from the increased tenant improvements during 2002. Amortization, related to deferred leasing costs, increased to $1.3 million and $3.9 million for the three– and nine–month periods ended September 30, 2002 as compared to $1.0 million and $2.9 million for the comparable periods in 2001, primarily due to increased leasing activity.
Administrative expenses increased to $4.0 million and $11.8 million for the three– and nine–month periods ended September 30, 2002 as compared to $3.4 million and $11.7 million for the comparable periods in 2001 primarily due to increased professional fees in 2002 as compared to 2001.
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Equity in income of Real Estate Ventures increased to $359,000 for the three–month period ended September 30, 2002 as compared to $235,000 for the comparable period in 2001. Equity in income of Real Estate Ventures decreased to $1.1 million for the nine–month period ended September 30, 2002 as compared to $2.2 million for the comparable period in 2001. The 2001 results include a $785,000 gain on the sale of the Company’s interests in a Real Estate Venture. In addition, the Company acquired the remaining partnership interests in three Real Estate Ventures, and, accordingly, the results attributable to these properties are now consolidated.
Minority interest represents the equity in income attributable to the portion of the Operating Partnership not owned by the Company. Minority interest increased to $2.4 million and $7.0 million for the three– and nine–month periods ended September 30, 2002 as compared to $2.1 million and $6.0 million for the comparable periods in 2001, primarily due to increased results of operations in 2002 as compared to 2001.
During the nine–month period ended September 30, 2002, the Company sold 23 office properties containing an aggregate of 1.4 million net rentable square feet, 20 industrial properties containing an aggregate of .9 million net rentable square feet and one parcel of land containing 10.0 acres for an aggregate of $190.8 million, realizing a net gain of $8.6 million. During the three–month period ended September 30, 2002, the Company sold seven office properties containing an aggregate of 288,000 net rentable square feet for an aggregate of $22.7 million. As a result, the Company recorded a deferred gain of $2.5 million which is being accounted for under the cost recovery method.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows
During the nine–month period ended September 30, 2002, the Company generated $85.2 million in cash flow from operating activities. Other sources of cash flow consisted of: (i) $115.0 million of proceeds from draws on the Credit Facility, (ii) $78.0 million of proceeds from sales of properties, (iii) $13.9 million of proceeds of additional mortgage notes, (iv) $4.1 million of escrowed cash, (v) $1.7 million from repayments of employee loans and (vi) $.8 million of cash distributions from Real Estate Ventures. During the nine–month period ended September 30, 2002, cash out–flows consisted of: (i) $102.3 million of Credit Facility repayments, (ii) $56.4 million of distributions to shareholders, (iii) $46.5 million of mortgage note repayment, (iv) $29.0 million to fund development and capital expenditures, (v) $25.1 million for property acquisitions, (vi) $20.2 million to repurchase Common Shares and minority interest units, (vii) $10.4 million of leasing costs, (viii) $.6 million of debt financing costs and (ix) $.4 million of additional investments in unconsolidated Real Estate Ventures.
Development
The Company currently has in development three sites aggregating 428,000 square feet.The Company treats a property as under development until it reaches 95% occupancy or one year after the completion of shell construction, whichever is earlier. It is anticipated that two projects will come into service during the first quarter of 2003 and one in the third quarter of 2003. The total costs of these projects is estimated to be $83.7 million of which $72.8 million was incurred as of September 30, 2002. As of September 30, 2002, these developments were approximately 41% leased.
Indebtedness and Commitments
As of September 30, 2002, the Company had approximately $1 billion of debt outstanding, consisting of $307 million of borrowings under the Credit Facility, $100 million of unsecured debt and $593.6 million of mortgage notes payable. The mortgage notes payable consists of $532.9 million of fixed rate loans and $60.7 million of variable rate loans. Additionally, the Company has entered into interest rate swap and cap agreements to fix the interest rate on $203.0 million of the Credit Facility and variable rate loans through July 2004. The mortgage loans mature between July 2003 and July 2027. As of September 30, 2002, the Company also had $13.3 million of letters–of–credit outstanding under the Credit Facility and $179.7 million of unused availability under the Credit Facility. For the three– and nine–month periods ended September 30, 2002, the weighted–average interest rate under the Company’s Credit Facility was 5.72% and 5.47%, and the weighted–average interest rate for borrowings under mortgage notes payable was 7.25% and 7.28%.
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The following table outlines the timing of payment requirements related to the Company’s commitments as of September 30, 2002:
The Company intends to refinance its mortgage notes payable as they become due or repay them if they relate to properties being sold. The Company expects to renegotiate its Credit Facility prior to maturity or extend its term.
As of September 30, 2002, the Company had guaranteed repayment of approximately $2.0 million of loans for indebtedness of the Real Estate Ventures.
As of September 30, 2002, the Company’s debt–to–market capitalization ratio was 48.8%. As a general policy, the Company intends, but is not obligated, to adhere to a policy of maintaining a debt–to–market capitalization ratio of no more than 50%.
The Company presently continues to make capital expenditures in the ordinary course of business associated with the maintenance of its Properties.
The Company’s Board of Trustees has previously approved a share repurchase program authorizing the Company to repurchase up to 4,000,000 of its outstanding Common Shares. During 2002, the Company has repurchased 491,000 Common Shares for an aggregate of $11.1 million (an average price of $22.51 per share). The Company may purchase an additional 834,000 Common Shares under this program. No time limit has been placed on the duration of the share repurchase program. In addition, during 2002, the Company repurchased 364,000 Class A Units tendered for redemption for an aggregate of $8.5 million (an average price of $23.44 per unit).
Short– and Long–Term Liquidity
The Company believes that its cash flow from operations is adequate to fund its short–term liquidity requirements. Cash flow from operations is generated primarily from rental revenues and operating expense reimbursements from tenants and management services income from providing services to third parties. The Company intends to use these funds to meet short–term liquidity needs, which are to fund operating expenses, debt service requirements, recurring capital expenditures, tenant allowances, leasing commissions and the minimum distributions required to maintain the Company’s REIT qualification under the Internal Revenue Code.
On September 23, 2002, the Company and the Operating Partnership, respectively, also declared distributions to holders of Series A Preferred Shares, Series B Preferred Shares and Series B Preferred Units, which are each currently entitled to a preferential return of 7.25%, 8.75% and 7.25%, respectively. Distributions paid on October 15, 2002 to holders of Series A Preferred Shares, Series B Preferred Shares and Series B Preferred Units totaled $.7 million, $2.3 million and $.8 million, respectively.
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The Company expects to meet its long–term liquidity requirements, such as for property acquisitions, development, investments in real estate ventures, scheduled debt maturities, major renovations, expansions and other significant capital improvements, through borrowings under its Credit Facility, other long–term secured and unsecured indebtedness, the issuance of equity securities and the proceeds from the disposition of selected assets.
Funds from Operations
Management considers Funds from Operations (“FFO”) as one measure of REIT performance. FFO is calculated as net income (loss) adjusted for depreciation expense attributable to real property, amortization expense attributable to capitalized leasing costs, gains (losses) on sales of real estate investments, extraordinary items and comparable adjustments for real estate ventures accounted for using the equity method. Management believes that FFO is a useful disclosure in the real estate industry; however, the Company’s disclosure may not be comparable to other REITs. FFO should not be considered an alternative to net income as an indication of the Company’s performance or to cash flows as a measure of liquidity.
FFO for the three– and nine–month periods ended September 30, 2002 and 2001 is summarized in the following table (in thousands, except share data):
Inflation
A majority of the Company’s leases provide for separate escalations of real estate taxes and operating expenses either on a triple net basis or over a base amount. The Company believes that inflationary increases in expenses will be significantly offset by expense reimbursement and contractual rent increases.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the exposure to loss resulting from changes in interest rates, commodity prices and equity prices. In pursuing its business plan, the primary market risk to which the Company is exposed is interest rate risk. Changes in the general level of interest rates prevailing in the financial markets may affect the spread between the Company’s yield on invested assets and cost of funds and, in turn, the Company’s ability to make distributions or payments to its shareholders. While the Company has not experienced any significant credit losses, in the event of a significant rising interest rate environment and/or economic downturn, defaults could increase and result in losses to the Company which adversely affect its operating results and liquidity.
There have been no material changes in Quantitative and Qualitative disclosures in 2002. Reference is made to Item 7 included in the Company’s Annual Report on Form 10–K for the year ended December 31, 2001 and the caption “Liquidity and Capital Resources” under Item 2 of this Quarterly Report on Form 10–Q.
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Item 4. Controls and Procedures
(a)Evaluation of Disclosure Controls and Procedures. The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a–14(c) and 15d–14(c)) as of a date within 90 days prior to filing date of this quarterly report (the “Evaluation Date”), have concluded that the Company’s disclosure controls and procedures are effective to ensure that material information relating to the Company and its subsidiaries are made known to them by others, particularly during the period in which this quarterly report was being prepared.
(b)Changes in Internal Controls. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the Evaluation Date, nor any significant deficiencies or material weaknesses in such controls.
Part II. OTHER INFORMATION
Item 5. Other Information
Attached as Exhibit 10.73 is a form of Option Agreement that replaces the Option Agreement attached as Exhibit 10.73 to the Company’s Quarterly Report on Form 10—Q for the quarter ended June 30, 2002.
Item 6. Exhibits and Reports on Form 8–K
(a) Exhibits
(b) Reports on Form 8–K:
During the three months ended September 30, 2002 and through November 14, 2002, the Company filed the following:
(i) Current Report on Form 8–K filed August 27, 2002 (reporting under Items 5 and 7).
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SIGNATURES OF REGISTRANT
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
BRANDYWINE REALTY TRUST (Registrant)
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