UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
Commission file number 0-20047
Corporate Office Properties Trust (Exact name of registrant as specified in its charter)
Registrant's telephone number, including area code: (410) 730-9092
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.
ýYes o No
On November 7, 2002, 23,762,552 of the Company's Common Shares of Beneficial Interest, $0.01 par value, were issued.
TABLE OF CONTENTS FORM 10-Q
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Corporate Office Properties Trust and SubsidiariesConsolidated Balance Sheets(Dollars in thousands)
See accompanying notes to financial statements.
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Corporate Office Properties Trust and Subsidiaries Consolidated Statements of Operations (Dollars in thousands, except per share data) (unaudited)
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Corporate Office Properties Trust and Subsidiaries Consolidated Statements of Cash Flows (Dollars in thousands) (unaudited)
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Corporate Office Properties Trust and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands, except per share data) (unaudited)
1. Organization
Corporate Office Properties Trust ("COPT") and subsidiaries (collectively, the "Company") is a fully- integrated and self-managed real estate investment trust ("REIT"). We focus principally on the ownership, management, leasing, acquisition and development of suburban office properties located in select submarkets in the Mid-Atlantic region of the United States. COPT is qualified as a REIT as defined in the Internal Revenue Code and is the successor to a corporation organized in 1988. As of September 30, 2002, our portfolio included 111 office properties, including one owned through a joint venture.
We conduct almost all of our operations principally through our operating partnership, Corporate Office Properties, L.P. (the "Operating Partnership"), for which we are the managing general partner. The Operating Partnership owns real estate both directly and through subsidiary partnerships and limited liability companies ("LLCs"). The Operating Partnership also owns Corporate Office Management, Inc. ("COMI") (together with its subsidiaries defined as the "Service Companies"). A summary of our Operating Partnership's classes of securities and the percentage of the outstanding units of each class owned by COPT as of September 30, 2002 follows:
2. Basis of Presentation
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and disclosures required by accounting principles generally accepted in the United States for complete consolidated financial statements are not included herein. These interim financial statements should be read together with the financial statements and notes thereto included in our 2001 Annual Report on Form 10-K. The interim financial statements on the previous pages reflect all adjustments that we believe are necessary for the fair presentation of our financial position and results of operations for the interim periods presented. These adjustments are of a normal recurring nature. The results of operations for such interim periods are not necessarily indicative of the results for a full year.
We use three different accounting methods to report our investments in entities: the consolidation method, the equity method and the cost method.
Consolidation Method
We use the consolidation method when we own most of the outstanding voting interests in an entity and can control its operations. This means the accounts of the entity are combined with our accounts. We eliminate balances and transactions between companies when we consolidate these accounts. Our consolidated financial statements include the accounts of:
Equity Method
We use the equity method of accounting when we own an interest in an entity and can exert significant influence over the entity's operations but cannot control the entity's operations. Under the equity method, we report:
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Cost Method
We use the cost method of accounting when we own an interest in an entity and cannot exert significant influence over the entity's operations. Under the cost method, we report:
Reclassification
We reclassified certain amounts from the prior period to conform to the current period presentation of our consolidated financial statements. These reclassifications did not affect consolidated net income or shareholders' equity.
3. Summary of Significant Accounting Policies
Use of Estimates in the Preparation of Financial Statements
We make estimates and assumptions when preparing financial statements under generally accepted accounting principles. These estimates and assumptions affect various matters, including:
These estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict and are often beyond management's control. As a result, actual amounts could differ from these estimates.
Minority Interests
As discussed previously, we consolidate the accounts of our Operating Partnership and its subsidiaries into our financial statements. However, we do not own 100% of the Operating Partnership. Our Operating Partnership also did not own 11% of one of its subsidiary partnerships until September 11, 2002, when it acquired that remaining interest for $124 from Clay W. Hamlin, III, our Chief Executive Officer. In addition, COMI did not own 20% of one of its subsidiaries, Martin G. Knott and Associates, LLC, until May 31, 2002, when it acquired that remaining interest. The amounts reported for minority interests on our Consolidated Balance Sheets represent the portion of these consolidated entities' equity that we do not own. The amounts reported for minority interests on our Consolidated Statements of Operations represent the portion of these consolidated entities' net income not allocated to us.
Earnings Per Share
We present both basic and diluted earnings per Common Share ("EPS"). We compute basic EPS by dividing income available to common shareholders by the weighted-average number of Common Shares of beneficial interest ("Common Shares") outstanding during the period. Our computation of diluted EPS is similar except that:
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Our computation of diluted EPS does not assume conversion of securities into our Common Shares if conversion of those securities would increase our diluted EPS in a given period. A summary of the numerator and denominator for purposes of basic and diluted EPS calculations is as follows (in thousands, except per share data):
Our diluted EPS computation only assumes the conversion of share options and Series D Cumulative Convertible Redeemable Preferred Shares of beneficial interest (the "Series D Preferred Shares") because conversions of Preferred Units, Series A Convertible Preferred Shares of beneficial interest (the "Series A Preferred Shares") and Common Units and vesting of restricted Common Shares would increase diluted EPS in the periods presented.
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Recent Accounting Pronouncements
On July 1, 2001 and January 1, 2002, we adopted Statement of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS 141"), and No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), respectively. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. The provisions of SFAS 142 require that (1) amortization of goodwill, including goodwill recorded in past business combinations, be discontinued upon adoption of this standard and (2) goodwill be tested annually for impairment and in interim periods if certain events occur indicating that the carrying value of goodwill may be impaired. After completing an evaluation of our unamortized goodwill under the provisions of SFAS 142, we concluded that our carrying value of goodwill was not impaired as of January 1, 2002 and September 30, 2002. The following table summarizes our goodwill amortization and operating results as if goodwill amortization did not occur in the 2001 periods reported herein.
Diluted EPS on net income available to Common Shareholders reported on our Consolidated Statements of Operations would not have changed if goodwill amortization did not occur in the 2001 periods reported herein.
On January 1, 2002, we adopted Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). SFAS 144 provides new guidance on recognition of impairment losses on long-lived assets to be held and used and broadens the definition of what constitutes a discontinued operation and how the results of discontinued operations are to be measured. Our adoption of this standard did not impact our Consolidated Balance Sheets or Statements of Operations.
In April 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS No. 145"). SFAS 145 generally eliminates the requirement that gains and losses from the retirement of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. SFAS 145 also eliminates previously existing inconsistencies between the accounting for sale-leaseback transactions and certain lease modifications that have economic effects similar to that of sale-leaseback transactions. SFAS 145 is effective for us on January 1, 2003, although certain aspects of the standard are effective for transactions occurring after May 15, 2002. Upon adoption, SFAS 145 requires that gains or losses from retirement of debt reported as an extraordinary item in prior periods presented be reclassified. We expect the only impact of our
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adoption on January 1, 2003 will be the reclassification of all prior period losses on early retirement of debt from the line on the Consolidated Statements of Operations entitled "extraordinary item" to the line entitled "amortization of deferred financing costs." These reclassifications will not result in changes to net income available to Common Shareholders or basic and diluted EPS on net income available to Common Shareholders. The following table summarizes our losses from early retirement of debt and change to the line entitled "income before extraordinary item and cumulative effect of accounting change" as if such reclassifications were made for the periods reported herein.
4. Commercial Real Estate Properties
Operating properties consist of the following:
Projects under construction or development consist of the following:
Acquisitions
We acquired the following office properties during the nine months ended September 30, 2002:
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We also acquired the following during the nine months ended September 30, 2002:
2002 Construction/Development
During the nine months ended September 30, 2002, we completed the construction of four office buildings totaling 382,131 square feet. The buildings are located in the Baltimore/Washington Corridor.
As of September 30, 2002, we are also nearing completion on the construction of two new buildings.
2002 Dispositions
We sold the following properties during the nine months ended September 30, 2002:
The terms of the land parcel sales to Mr. Hamlin's cousins described above were determined as a result of arms-length negotiations. In management's opinion, the resulting sales prices reflect fair value for the properties based on management's knowledge of and experience in the respective real estate markets.
Accounting for Certain Real Estate Joint Ventures
Prior to 2002, we contributed parcels of land into two real estate joint ventures. In exchange for the contributions of land, we received joint venture interests and $9,600 in cash. Each of these joint ventures constructed office buildings on the land parcels. Each of the joint ventures' operating agreements provided us with the option to acquire the joint venture partners' interests for a pre-determined purchase price over a limited period of time. In February 2002, we acquired the joint venture partner's interest in one of these joint ventures for the pre-determined purchase price of $5,448. In June 2002, we acquired the joint venture partner's interest in the other joint venture for the
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pre-determined purchase price of $6,361. For periods prior to acquiring the joint venture partners' interests, we accounted for our interests in these joint ventures as follows:
Upon completion of these acquisitions, we began consolidating the accounts of the entities with our accounts.
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5. Investments in and Advances to Unconsolidated Real Estate Joint Ventures
On February 21, 2002, we acquired the remaining 20% interest in MOR Montpelier LLC not previously owned by us and simultaneously sold the 43,785 square foot building owned by that entity, realizing a gain of $349.
On February 21, 2002, we also acquired a 50% interest in MOR Montpelier 3 LLC, an entity developing a parcel of land located in Columbia, Maryland.
Our investments in and advances to unconsolidated real estate joint ventures are accounted for using the equity method of accounting and include the following:
We have additional commitments pertaining to our real estate joint ventures that are disclosed in Note 15.
The following table sets forth condensed combined balance sheet information for these unconsolidated real estate joint ventures:
6. Accounts Receivable
Our accounts receivable are reported net of an allowance for bad debts of $782 at September 30, 2002 and $723 at December 31, 2001.
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7. Investments in and Advances to Other Unconsolidated Entities
Our investments in and advances to other unconsolidated entities include the following:
8. Deferred Charges
Deferred charges consist of the following:
9. Derivatives
The following table sets forth derivative contracts we had in place and their respective fair market values ("FMV"):
We designated each of these derivatives as cash flow hedges. At September 30, 2002, the interest rate swap is effective. During the nine months ended September 30, 2002, we decreased the negative balance in the accumulated other comprehensive loss component of shareholders' equity ("AOCL") and increased minority interests in total by $2,738 to recognize the increase in the fair value of the interest rate swap during that period. Over time, the unrealized loss held in AOCL and minority interests associated with our interest rate swap will be reclassified to earnings. Within the next three months, we expect to reclassify to earnings an estimated $1.0 million of the balances held in AOCL and minority interests.
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On November 6, 2002 we entered into an interest rate swap agreement with SunTrust Bank that fixes the one-month LIBOR base rate at 2.31% on a notional amount of $50,000. This swap agreement will be effective on January 2, 2003 and carry a two-year term.
10. Shareholders' Equity
On March 5, 2002, we participated in an offering of 10,961,000 Common Shares to the public at a price of $12.04 per share; Constellation was the owner of 8,876,172 of these shares and 2,084,828 of these shares were newly issued by us. With the completion of this transaction, Constellation, which had been our largest Common shareholder, no longer owned any of our shares. We contributed the net proceeds from the sale of the newly-issued shares to our Operating Partnership in exchange for 2,084,828 Common Units.
Also on March 5, 2002, Constellation converted its one remaining Series A Preferred Share into 1.8748 Common Shares. As holder of the Series A Preferred Share, Constellation had the right to nominate two members for election to our Board of Trustees; with the conversion of its Series A Preferred Share into Common Shares, Constellation no longer has that right. Constellation sold one of these Common Shares and we redeemed the fractional share.
On December 16, 1999, we issued 471,875 Common Shares subject to forfeiture restrictions to certain officers; we issued an additional 12,500 Common Shares to an officer in 2000 that were subject to the same restrictions. The forfeiture restrictions of specified percentages of these shares originally were scheduled to lapse annually through 2004 provided that the officers remain employed by us; in September 2002, the forfeiture restriction lapsing schedule for most of these shares was lengthened to allow for the restrictions to lapse through 2005 and 2006, again provided that the officers remain employed by us. These shares may not be sold, transferred or encumbered while the forfeiture restrictions are in place. Forfeiture restrictions lapsed on 72,659 of these shares in 2002.
During the nine months ended September 30, 2002, 617,510 Common Units in our Operating Partnership were converted into Common Shares on the basis of one Common Share for each Common Unit.
We issued 232,798 Common Shares in connection with the exercise of share options during the nine months ended September 30, 2002.
A summary of the activity in the accumulated other comprehensive loss component of shareholders' equity for the nine months ended September 30, 2002 follows:
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The components of comprehensive income for the three and nine months ended September 30, 2002 and 2001 follow:
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11. Dividends and Distributions
The following summarizes our dividends and distributions for the nine months ended September 30, 2002:
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12. Supplemental Information to Consolidated Statements of Cash Flows
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13. Information by Business Segment
We have six office property segments: Baltimore/Washington Corridor, Greater Philadelphia, Northern/Central New Jersey, Greater Harrisburg, Northern Virginia and Suburban Washington, D.C.
The table below reports segment financial information. Our segment entitled "Other" includes other assets and operations not specifically associated with the other defined segments (including deferred goodwill and other intangible deferred costs). We measure the performance of our segments based on total revenues less property operating expenses. Accordingly, we do not report other expenses by segment in the table below.
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The following table reconciles our earnings from operations for reportable segments to income before income taxes, extraordinary item and cumulative effect of accounting change as reported in our Consolidated Statements of Operations.
We did not allocate interest expense, amortization of deferred financing costs and depreciation and other amortization to segments since they are not included in the measure of segment profit reviewed by management. We also did not allocate equity in income of unconsolidated real estate joint ventures, earnings (losses) from service operations, general and administrative expense and minority interests since these items represent general corporate expenses not attributable to segments.
14. Income Taxes
COMI's provision for income tax benefit consists of the following:
Items contributing to temporary differences that lead to deferred taxes include depreciation and amortization, certain accrued compensation, compensation made in the form of contributions to a deferred nonqualified compensation plan and expenses associated with share options.
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COMI's combined Federal and state effective tax rate for the nine months ended September 30, 2002 and 2001 was approximately 40%.
15. Commitments and Contingencies
In the normal course of business, we are involved in legal actions arising from our ownership and administration of properties. Management does not anticipate that any liabilities that may result will have a materially adverse effect on our financial position, operations or liquidity. We are subject to various Federal, state and local environmental regulations related to our property ownership and operation. We have performed environmental assessments of all of our properties, the results of which have not revealed any environmental liability that we believe would have a materially adverse effect on our financial position, operations or liquidity.
At September 30, 2002, we have $6,700 in secured letters of credit with Bankers Trust Company for the purpose of further securing one of our mortgage loans payable with Teachers Insurance and Annuity Association of America.
Joint Ventures
In the event that costs to complete construction of a building owned by one of our joint ventures exceed amounts funded by existing credit facilities and member investments previously made, we will be responsible for making additional investments in this joint venture of up to $4,000.
We may need to make our share of additional investments in our real estate joint ventures (generally based on our percentage ownership) in the event that additional funds are needed. In the event that the other members of these joint ventures do not pay their share of investments when additional funds are needed, we may then need to make even larger investments in these joint ventures.
As of September 30, 2002, we served as guarantor for the repayment of mortgage loans totaling $7,979 for certain of our unconsolidated real estate joint ventures.
In four of our five joint ventures, we would be obligated to acquire the membership interests of those joint ventures not owned by us (20% in the case of three and 50% in the case of one) in the event that all of the following were to occur:
The amount we would need to pay for those membership interests is computed based on the amount that the owners of those interests would receive under the joint venture agreements in the event that the buildings were sold for a capitalized fair value (as defined in the agreements) on a defined date. At September 30, 2002, one of the buildings in these joint ventures had exceeded 85% occupancy for one month.
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Office Leases
We are obligated under five operating leases for office space. The monthly rent under one of these leases is subject to an annual increase based on the Consumer Price Index. Future minimum annual rental payments due under the terms of these leases are as follows:
Land Leases
We are obligated under leases for two parcels of land; we have a building located on one of these parcels and the other parcel is being developed. These leases provide for monthly rent on one parcel through March 2098 and the other through September 2099. Future minimum annual rental payments due under the terms of these leases are as follows:
We have the option to acquire these land parcels from January 2, 2004 through January 2, 2007 for a total price of $4,000; this purchase price is subject to future escalation based on a multiple of operating revenues derived from the properties.
16. Pro Forma Financial Information
We accounted for our 2001 and 2002 acquisitions using the purchase method of accounting. We included the results of operations for the acquisitions in our Consolidated Statements of Operations from their respective purchase dates through September 30, 2002.
We prepared the pro forma condensed consolidated financial information presented below as if all of our 2001 and 2002 acquisitions and dispositions of operating properties had occurred on January 1, 2001. The pro forma financial information is unaudited and is not necessarily indicative of the results
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that actually would have occurred if these acquisitions and dispositions had occurred on January 1, 2001, nor does it intend to represent our results of operations for future periods.
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
In this section, we discuss our financial condition and results of operations for the three and nine months ended September 30, 2002. This section includes discussions on, among other things:
You should refer to our consolidated financial statements and the operating data variance analysis table set forth below as you read this section.
This section contains "forward-looking" statements, as defined in the Private Securities Litigation Reform Act of 1995, that are based on our current expectations, estimates and projections about future events and financial trends affecting the financial condition of our business. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. These statements are not guarantees of future performance, events or results and involve potential risks and uncertainties. Accordingly, actual results may differ materially from those addressed in the forward-looking statements. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise.
Important factors that may affect these expectations, estimates or projections include, but are not limited to: our ability to borrow on favorable terms; general economic and business conditions, which will, among other things, affect office property demand and rents, tenant creditworthiness, interest rates and financing availability; adverse changes in the real estate markets including, among other things, increased competition with other companies; risks of real estate acquisition and development; governmental actions and initiatives and environmental requirements.
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Corporate Office Properties Trust Operating Data Variance Analysis (Dollars for this table are in thousands, except per share data)
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Results of Operations
The economic slowdown in the United States has impacted our 2002 operations primarily by decreasing occupancy in certain of our properties, which in turn has led to decreased revenues in those properties. While we ended each of the quarters in 2001 with an average occupancy rate of 97%, our average occupany rate at the end of the three quarters in 2002 was 94%. Lower occupancy rates and the resulting increased competition for tenants in our operating segments are also placing downwards pressure on rental rates in most of these segments, which will impact us further as we lease vacant space and renew leases scheduled to expire on occupied space. Our exposure to continued pressure on occupancy and rental rates in the short term is reduced somewhat by the fact that as of September 30, 2002, leases on only 14% of our occupied square feet were scheduled to expire before 2004. We have deferred certain discretionary capital improvement and repair and maintenance projects on our operating properties as a means of offsetting a portion of the decrease in revenues.
The United States defense industry (comprised of the United States Department of Defense and defense contractors) continues to expand in our Baltimore/Washington Corridor segment; the industry's expansion has helped us maintain high occupancy levels in that segment, despite an otherwise softening leasing environment. Due to our increased leasing to tenants in the defense industry, that industry represents approximately 36% of our total annualized rental revenue at September 30, 2002; we expect the percentage of our total annualized rental revenue derived from the defense industry to continue to increase. While much of the annualized rental revenue derived from the defense industry is from leases carrying terms of longer than three years, a downturn of business in that industry could have a materially adverse effect on our ability to continue to maintain occupancy levels in our Baltimore/Washington Corridor segment as leases expire, which in turn could impact our financial performance.
Comparison of the three months ended September 30, 2002 and 2001
Our revenue from real estate operations increased $5.9 million or 18%, substantially all of which was attributable to rental revenue. Included in this change are the following:
Our expenses from real estate operations increased $7.0 million or 29% due to the effects of the increases in property operating expenses, interest expense and amortization of deferred financing costs and depreciation and other amortization described below.
Our property operating expenses increased $2.7 million or 28%. Included in this change are the following:
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Our interest expense and amortization of deferred financing costs increased $2.4 million or 27% due primarily to a 32% increase in our average outstanding debt balance resulting from our 2001 and 2002 acquisitions and construction activity, offset by a decrease in our weighted-average interest rates from 7.1% to 6.5%. Our depreciation and other amortization expense increased $1.9 million or 36%, $1.6 million of which is attributable to 21 properties acquired and five newly-constructed properties placed in service since June 30, 2001.
Our general and administrative expense decreased $532,000 or 39%. The decrease is primarily attributable to the following equity compensation items:
The decreases in general and administrative expense described above were offset by a $145,000 increase in employee bonus expense.
Income before minority interests, income taxes, extraordinary item and cumulative effect of accounting change increased $765,000 or 10% due to a $796,000 increase in gain from sales of real estate due to no such sales occurring in the prior period, offset slightly by the other factors described above. The amounts reported for minority interests on our Consolidated Statements of Operations represent primarily the portion of the Operating Partnership's net income not allocated to us. Our income allocation to minority interests before giving effect to income tax, extraordinary item and cumulative effect of accounting change decreased $267,000 or 12%; this decrease is primarily attributable to the increase in our ownership of the Operating Partnership.
Our net income available to Common Shareholders increased $237,000 or 7% reflecting the factors discussed above, offset by a $703,000 increase in Preferred Share dividends resulting from our issuance of a new series of preferred shares in September 2001. Basic and diluted earnings per Common Share decreased 6% due to the impact of additional Common Shares outstanding in the current period exceeding the increase in net income available to Common Shareholders.
Comparison of the nine months ended September 30, 2002 and 2001
Our revenue from real estate operations increased $18.6 million or 20%, substantially all of which was attributable to rental revenue. Included in this change are the following:
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Our expenses from real estate operations increased $15.9 million or 24% due to the effects of the increases in property operating expenses, interest expense and amortization of deferred financing costs and depreciation and other amortization described below.
Our property operating expenses increased $6.2 million or 23%. Included in this change are the following:
Our interest expense and amortization of deferred financing costs increased $4.3 million or 17% due primarily to a 27% increase in our average outstanding debt balance resulting from our 2001 and 2002 acquisition and construction activity, offset by a decrease in our weighted-average interest rates from 7.4% to 6.5%. Our depreciation and other amortization expense increased $5.4 million or 36%, $4.3 million of which is attributable to 23 properties acquired and eight newly-constructed properties placed in service during 2001 and 2002.
Our general and administrative expense increased $803,000 or 19%, $675,000 of which is attributable to additional employee bonus expense, including additional discretionary bonuses awarded to officers in the current period that were associated with performance in the prior year.
Income before minority interests, income taxes, extraordinary item and cumulative effect of accounting change increased $2.4 million or 12% primarily as a result of the above factors, along with a $146,000 increase in gain from sales of real estate. Our income allocation to minority interests before giving effect to income tax, extraordinary item and cumulative effect of accounting change decreased $785,000 or 11%; this decrease is primarily attributable to the increase in our ownership of the Operating Partnership.
Our net income available to Common Shareholders increased $36,000 reflecting the factors discussed above, combined with the net effect of the following:
Basic and diluted earnings per Common Share decreased due to additional Common Shares outstanding in the current period.
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Liquidity and Capital Resources
Cash provided from operations is our primary source of liquidity to fund dividends and distributions, pay debt service and fund working capital requirements. We expect to continue to use cash provided by operations to meet our short-term capital needs, including all property expenses, general and administrative expenses, debt service, dividend and distribution requirements and recurring capital improvements and leasing commissions. We do not anticipate borrowing to meet these requirements. Factors that could negatively affect our ability to generate cash from operations in the future are discussed in our 2001 Annual Report on Form 10-K.
We historically have financed our long-term capital needs, including property acquisitions and construction activity, through a combination of the following:
We often use our Revolving Credit Facility to initially finance much of our investing and financing activities. We then pay down our Revolving Credit Facility using proceeds from long-term borrowings collateralized by our properties as attractive financing conditions arise and equity issuances as attractive equity market conditions arise. Amounts available under the Revolving Credit Facility are generally computed based on 65% of the appraised value of properties pledged as collateral. As of November 7, 2002, the maximum amount available under our Revolving Credit Facility is $150.0 million, of which $18.5 million is unused.
We own real estate through joint ventures when suitable equity partners are available at attractive terms. We use joint ventures primarily for properties undergoing construction or development and, upon completion of construction and development activities, the properties are acquired by us or sold to third parties. The primary business purpose behind the use of such joint ventures is to leverage our equity funding of such projects and reduce the risk of construction and development activities; another purpose in some of these joint ventures is to make use of the expertise of our joint venture partner in managing the entity's activities. In some of these joint ventures, the joint venture partner acts as project manager during construction and development activities and property manager once the building becomes operational; in other cases, we serve the role of project manager and property manager. All of our joint ventures have a two-member management committee responsible for making all major decisions, and we control one of the two positions in all of these joint ventures. The joint venture partners in four of our five real estate joint ventures in place at September 30, 2002 are controlled by an entity that owns, manages, leases and develops properties primarily in the Baltimore/Washington Corridor and acts as project manager for these joint ventures. The joint venture partner in our other real estate joint venture is also controlled by an entity that owns, manages and leases properties; we act as project manager for this joint venture. See Notes 5 and 15 to our consolidated financial statements for additional information pertaining to our real estate joint venture investments.
Factors that could negatively affect our ability to finance our long-term capital needs in the future are discussed in our 2001 Annual Report on Form 10-K.
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Mortgage and other loans payable at September 30, 2002 consist of the following (dollars in thousands):
We have guaranteed the repayment of $254.2 million of the mortgage and other loans payable set forth above.
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The following table summarizes our material contractual cash obligations and other commitments at September 30, 2002 (in thousands):
In addition to the contractual obligations set forth above, we also had the following commitments at September 30, 2002:
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We had no other material contractual obligations as of September 30, 2002 besides the items discussed above and tenant improvements and leasing costs in the ordinary course of business.
In October 2002, we became committed to obtain mortgage loans from Allstate Life Insurance Company and its affiliates totaling $49.0 million. These loans will carry an interest rate of 5.6% over a 10-year term. We expect to use the proceeds from these loans to repay other mortgage loans.
Investing and financing activities for the nine months ended September 30, 2002
During the nine months ended September 30, 2002, we acquired nine office buildings totaling 839,364 square feet for $107.3 million, two parcels of land for $7.4 million and a leasehold interest carrying a right to purchase an additional parcel of land for $466,000. These acquisitions were financed using the following:
During the nine months ended September 30, 2002, we completed the construction of four office buildings totaling 382,131 square feet (excluding one building completed by a joint venture). Costs incurred on these buildings through September 30, 2002 total $60.1 million. These costs were funded in part using $36.3 million in proceeds from three construction loan facilities, $27.1 million of which was repaid in 2002 using proceeds from a new loan. We also used $9.6 million in contributions from joint venture partners prior to our acquisition of the joint venture partners' interests in 2002 for $11.8 million; the acquisition of the joint venture partners' interests was funded using proceeds from a new loan and borrowings on our Revolving Credit Facility. The balance of the costs was funded primarily using proceeds from our Revolving Credit Facility and cash reserves.
As of September 30, 2002, we had construction activities underway on two buildings totaling 152,163 square feet that were 60% operational and 67% pre-leased (excluding the construction activities of two joint ventures). Estimated costs upon completion for these projects total approximately $28.9 million. Costs incurred on these buildings through September 30, 2002 total $25.2 million. We have a construction loan facility in place totaling $15.8 million to finance the construction of one of these projects; borrowings under this facility total $11.5 million at September 30, 2002. We also used borrowings from our Revolving Credit Facility and cash reserves funded in part by debt refinancings.
During the nine months ended September 30, 2002, we acquired the remaining 20% interest not previously owned by us in one of our unconsolidated real estate joint ventures, MOR Montpelier LLC, and simultaneously sold the 43,785 square foot building owned by that entity for net proceeds of $1.1 million. We also acquired a 50% interest in MOR Montpelier 3 LLC, an entity developing a parcel of land located in Columbia, Maryland. Our investments in unconsolidated real estate joint ventures decreased by $2.4 million during the nine months ended September 30, 2002 due primarily to a reimbursement to us of advances we had previously made to NBP 140, LLC, offset partially by the net effect of the transactions described above.
During the nine months ended September 30, 2002, we sold an office building and three land parcels for $10.6 million, providing $2.3 million in mortgage loans to the purchasers. The net proceeds from these sales after transaction costs and the loans provided by us to the purchasers totaled $7.5 million; these proceeds were used as follows:
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During the nine months ended September 30, 2002, we borrowed $168.0 million under mortgages and other loans payable other than our Revolving Credit Facility, the proceeds of which were used as follows:
On March 5, 2002, we participated in an offering of 10,961,000 Common Shares to the public at a price of $12.04 per share; Constellation was the owner of 8,876,172 of these shares and 2,084,828 of these shares were newly issued by us. With the completion of this transaction, Constellation, which had been our largest shareholder, no longer owned any of our shares. We contributed the net proceeds from the sale of the newly-issued shares to our Operating Partnership in exchange for 2,084,828 Common Units. The Operating Partnership used most of the proceeds to pay down our Revolving Credit Facility.
Investing and financing activities subsequent to September 30, 2002
On November 6, 2002 we entered into an interest rate swap agreement with SunTrust Bank that fixes the one-month LIBOR base rate at 2.31% on a notional amount of $50.0 million. This swap agreement will be effective on January 2, 2003 and carry a two-year term.
Statement of cash flows
We generated net cash flow from operating activities of $41.8 million for the nine months ended September 30, 2002, an increase of $7.0 million from the nine months ended September 30, 2001. Our increase in cash flow from operating activities is due primarily to income generated from our newly-acquired and newly-constructed properties. Our net cash flow used in investing activities for the nine months ended September 30, 2002 increased $39.8 million from the nine months ended September 30, 2001 due primarily to additional cash outlays of $62.4 million in connection with purchases of and additions to commercial real estate properties, offset by a $16.8 million decrease in investments and advances to unconsolidated real estate joint ventures and a $4.8 million increase in proceeds from sales of real estate. Our increase in net cash flow provided by financing activities for the nine months ended September 30, 2002 of $30.9 million from the nine months ended September 30, 2001 includes a $72.5 million decrease in repayments of mortgage and other loans payable and a $26.7 million increase in proceeds from mortgage and other loans payable, offset by a $47.9 million decrease in proceeds from the issuance of equity instruments and a $12.8 million decrease in cash flow associated with other liabilities.
Funds From Operations
We consider Funds from Operations ("FFO") to be meaningful to investors as a measure of the financial performance of an equity REIT when considered with the financial data presented under generally accepted accounting principles ("GAAP"). Under the National Association of Real Estate Investment Trusts' ("NAREIT") definition, FFO means net income (loss) computed using GAAP, excluding gains (or losses) from debt restructuring and sales of real estate, plus real estate-related depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures, although we have included gains from the sales of properties to the extent such gains related to sales of non-operating properties and development services provided on operating properties. FFO adjusted for the conversion of dilutive securities adjusts FFO assuming conversion of securities that are convertible into our Common Shares when such conversion does not increase our diluted FFO per share in a given
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period. The FFO we present may not be comparable to the FFO of other REITs since they may interpret the current NAREIT definition of FFO differently or they may not use the current NAREIT definition of FFO. FFO is not the same as cash generated from operating activities or net income determined in accordance with GAAP. FFO is not necessarily an indication of our cash flow available to fund cash needs. Additionally, it should not be used as an alternative to net income when evaluating our financial performance or to cash flow from operating, investing and financing activities when evaluating our liquidity or ability to make cash distributions or pay debt service. Our FFO for the three and nine months ended September 30, 2002 and 2001 are summarized in the following table:
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Inflation
We have not been significantly impacted by inflation during the periods presented in this report due mostly to the relatively low inflation rates in our markets. Most of our tenants are obligated to pay their share of a building's operating expenses to the extent such expenses exceed amounts established in their leases, based on historical expense levels. In addition, some of our tenants are obligated to pay their share of all of a building's operating expenses. These arrangements reduce our exposure to increases in such costs resulting from inflation.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to certain market risks, the most predominant of which is change in interest rates. Increases in interest rates can result in increased interest expense under our Revolving Credit Facility and our other mortgage loans payable carrying variable interest rate terms. Increases in interest rates can also result in increased interest expense when our loans payable carrying fixed interest rate terms mature and need to be refinanced. Our debt strategy favors long-term, fixed-rate, secured debt over variable-rate debt to minimize the risk of short-term increases in interest rates. As of September 30, 2002, 61.1% of our mortgage and other loans payable balance carried fixed interest rates. We also use interest rate swap and interest rate cap agreements to reduce the impact of interest rate changes.
The following table sets forth our long-term debt obligations, principal cash flows by scheduled maturity and weighted average interest rates at September 30, 2002 (dollars in thousands):
The fair market value of our mortgage and other loans payable was $749.0 million at September 30, 2002.
The following table sets forth information pertaining to our one derivative contract in place as of September 30, 2002:
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Based on our variable-rate debt balances, our interest expense would have increased by $1.1 million during the nine months ended September 30, 2002 if interest rates were 1% higher.
Item 4. Controls and Procedures
Clay W. Hamlin, III, our Chief Executive Officer, and Roger A. Waesche, Jr., our Chief Financial Officer, completed an evaluation of the effectiveness of the Company's disclosure controls and procedures within a 90 day period prior to the filing date of this Form 10-Q. They concluded, based on this review, that the Company's disclosure controls and procedures are effective in providing reasonable assurance that information required to be disclosed by the Company in reports that it files under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in the Commission's rules and procedures. There were no significant changes to the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
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PART II
Item 1. Legal Proceedings
Not applicable
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
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Item 6. Exhibits and Reports on Form 8-K
Report dated July 24, 2002 containing Item 7 and Item 9 disclosures that were filed in connection with our release of earnings on July 24, 2002. We also through this filing made available certain additional information pertaining to our properties and operations as of and for the period ended June 30, 2002.
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SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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Certifications
I, Clay W. Hamlin, III, certify that:
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I, Roger A. Waesche, Jr., certify that:
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