FORM 10-QSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
For the quarterly period ended SEPTEMBER 30, 2002
OR
Commission File Number: 1-12252
EQUITY RESIDENTIAL (Exact name of registrant as specified in its charter)
(312) 474-1300 (Registrant's telephone number, including area code)
http://www.equityapartments.com (Registrant's web site)
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 ý No o
The number of Common Shares of Beneficial Interest, $0.01 par value, outstanding on October 31, 2002 was 270,855,698.
EQUITY RESIDENTIAL CONSOLIDATED BALANCE SHEETS (Amounts in thousands except for share amounts) (Unaudited)
See accompanying notes
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EQUITY RESIDENTIAL CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands except per share data) (Unaudited)
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EQUITY RESIDENTIAL CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) (Unaudited)
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EQUITY RESIDENTIAL NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. Business
Equity Residential ("EQR"), formed in March 1993, is a fully integrated real estate company engaged in the acquisition, ownership, management and operation of multifamily properties. The Company has elected to be taxed as a real estate investment trust ("REIT").
EQR is the general partner of, and as of September 30, 2002 owned an approximate 92.4% ownership interest in, ERP Operating Limited Partnership (the "Operating Partnership"). The Company conducts substantially all of its business and owns substantially all of its assets through the Operating Partnership. The Operating Partnership is, in turn, directly or indirectly, a partner, member or shareholder of numerous partnerships, limited liability companies and corporations which have been established primarily to own fee simple title to multifamily properties or to conduct property management activities and other businesses related to the ownership and operation of multifamily residential real estate. References to the "Company" include EQR, the Operating Partnership and each of the partnerships, limited liability companies and corporations controlled by the Operating Partnership or EQR.
As of September 30, 2002, the Company owned or had interests in a portfolio of 1,059 multifamily properties containing 227,426 apartment units located in 36 states consisting of the following:
2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) and certain reclassifications considered necessary for a fair presentation have been included. Certain reclassifications have been made to the prior period financial statements in order to conform to the current year presentation. Operating results for the nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002.
The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.
For further information, including definition of capitalized terms not defined herein, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2001.
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Other
In June 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS No. 141 requires companies to account for all business combinations using the purchase method of accounting. SFAS No. 141 is effective for fiscal years beginning after December 15, 2001. The Company adopted the standard effective January 1, 2002.
In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires companies to eliminate the amortization of goodwill in favor of a periodic impairment based approach. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. The Company adopted the standard effective January 1, 2002. See Note 16 for further discussion.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145, among other items, rescinds the automatic classification of costs incurred on debt extinguishment as extraordinary charges. Instead, gains and losses from debt extinguishment should only be classified as extraordinary if they meet the "unusual and infrequently occurring" criteria outlined in APB No. 30. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. The Company will adopt the standard effective January 1, 2003, but does not expect it to have a material impact on its financial condition and results of operations.
3. Shareholders' Equity and Minority Interests
The following table presents the changes in the Company's issued and outstanding Common Shares for the nine months ended September 30, 2002:
The equity positions of various individuals and entities that contributed their properties to the Operating Partnership in exchange for a partnership interest are collectively referred to as the "Minority Interests—Operating Partnership". The Minority Interests—Operating Partnership held 22,537,901 units of limited partnership interest ("OP Units") representing a 7.6% interest in the Operating Partnership at September 30, 2002. Assuming conversion of all OP Units into Common Shares, total Common Shares outstanding at September 30, 2002 would have been 298,387,904. Subject to applicable securities law restrictions, the Minority Interests—Operating Partnership may exchange their OP Units for EQR Common Shares on a one-for-one basis.
Net proceeds from the Company's Common Share and Preferred Share offerings are contributed by the Company to the Operating Partnership. In return for those contributions, EQR receives a number of OP Units in the Operating Partnership equal to the number of Common Shares it has issued in the equity offering (or in the case of a preferred equity offering, a number of preference units in the Operating Partnership equal in number and having the same terms as the Preferred Shares issued in the equity offering).
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The Company's declaration of trust authorizes the Company to issue up to 100,000,000 preferred shares of beneficial interest, $0.01 par value per share (the "Preferred Shares"), with specific rights, preferences and other attributes as the Board of Trustees may determine, which may include preferences, powers and rights that are senior to the rights of holders of the Company's Common Shares.
The following table presents the Company's issued and outstanding Preferred Shares as of September 30, 2002 and December 31, 2001:
The liquidation value of the Preference Interests and the Junior Preference Units (see below) are included as separate components of Minority Interests in the consolidated balance sheets and the distributions incurred are included in preferred distributions in the consolidated statements of operations.
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The following table presents the issued and outstanding Preference Interests as of September 30, 2002 and December 31, 2001:
The following table presents the Operating Partnership's issued and outstanding Junior Convertible Preference Units (the "Junior Preference Units") as of September 30, 2002 and December 31, 2001:
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4. Real Estate Acquisitions
During the nine months ended September 30, 2002, the Company acquired the entire equity interest in the ten properties listed below from unaffiliated parties, and one additional unit at an existing property, for a total purchase price of $245.4 million.
5. Real Estate Dispositions
During the nine months ended September 30, 2002, the Company disposed of the thirty-five properties listed below to unaffiliated parties. The Company recognized a net gain on sales of discontinued operations of approximately $61.2 million and a net loss on sales of unconsolidated entities of approximately $0.6 million.
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6. Commitments to Acquire/Dispose of Real Estate
As of September 30, 2002, the Company had entered into separate agreements to acquire two multifamily properties containing 581 units from unaffiliated parties. The Company expects a combined
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purchase price of approximately $44.5 million, including the assumption of mortgage indebtedness of approximately $18.4 million.
As of September 30, 2002, in addition to the properties that were subsequently disposed of as discussed in Note 18, the Company had entered into separate agreements to dispose of seventeen multifamily properties containing 3,338 units to unaffiliated parties. The Company expects a combined disposition price of approximately $148.9 million.
The closings of these pending transactions are subject to certain contingencies and conditions; therefore, there can be no assurance that these transactions will be consummated or that the final terms thereof will not differ in material respects from those summarized in the preceding paragraphs.
7. Investments in Unconsolidated Entities
The Company has entered into various agreements with third party companies. The following table summarizes the Company's investments in unconsolidated entities as of September 30, 2002 (amounts in thousands except for project and unit amounts):
Investments in unconsolidated entities include the Unconsolidated Properties as well as various development properties under construction or pending construction. The Company does not consolidate these entities as it does not have sole control of major decisions (such as sale and/or financing/refinancing). The Company's common equity ownership interests in these entities range from 4.5% to 57.0% at September 30, 2002.
These investments are accounted for utilizing the equity method of accounting. Under the equity method of accounting, the net equity investment of the Company is reflected on the consolidated balance
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sheets and after the project is completed, the consolidated statements of operations include the Company's share of net income or loss from the unconsolidated entity. Prior to the project being completed, the Company capitalizes interest on its equity contribution in accordance with the provisions of SFAS No. 58, Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method. During the nine months ended September 30, 2002 and 2001, the Company capitalized $12.5 million and $14.4 million, respectively, in interest cost related to its unconsolidated development projects (which reduced interest expense incurred in the consolidated statements of operations).
The Company generally contributes between 25% and 35% of the project cost of the unconsolidated projects under development, with the remaining cost financed through third-party construction mortgages.
8. Deposits—Restricted
As of September 30, 2002, deposits-restricted totaled $168.1 million and primarily included the following:
9. Mortgage Notes Payable
As of September 30, 2002, the Company had outstanding mortgage indebtedness of approximately $3.1 billion.
During the nine months ended September 30, 2002, the Company:
As of September 30, 2002, scheduled maturities for the Company's outstanding mortgage indebtedness were at various dates through October 1, 2033. The interest rate range on the Company's mortgage debt was 1.55% to 12.465% at September 30, 2002. During the nine months ended September 30, 2002, the weighted average interest rate was 6.37%.
10. Notes
As of September 30, 2002, the Company had outstanding unsecured notes of approximately $2.4 billion.
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As of September 30, 2002, scheduled maturities for the Company's outstanding notes are at various dates through 2029. The interest rate range on the Company's notes was 4.75% to 7.75% at September 30, 2002. During the nine months ended September 30, 2002, the weighted average interest rate was 6.47%.
11. Line of Credit
On May 30, 2002, the Company obtained a new three-year $700.0 million unsecured revolving credit facility maturing May 29, 2005. The new line of credit replaced the Company's $700.0 million unsecured revolving credit facility that was scheduled to expire in August 2002. The prior existing revolving credit facility was terminated upon the closing of the new facility. Advances under the new credit facility bear interest at variable rates based upon LIBOR at various interest periods, plus a spread dependent upon the Operating Partnership's credit rating, or based upon bids received from the lending group. As of September 30, 2002, $35.0 million was outstanding and $83.3 million was restricted (dedicated to support letters of credit and not available for borrowing) on the line of credit. During the nine months ended September 30, 2002, the weighted average interest rate on borrowings under the former and new lines of credit was 2.49%.
12. Derivative Instruments and Hedging Activities
The following table summarizes the Company's consolidated derivative instruments and hedging activities at September 30, 2002 (amounts are in thousands):
At September 30, 2002, certain unconsolidated development partnerships in which the Company invested had entered into swaps to hedge the interest rate risk exposure on unconsolidated floating rate construction mortgage loans. The Company has recorded its proportionate share of these hedges on its consolidated balance sheets. These swaps have been designated as cash flow hedges with a current aggregate notional amount of $427.7 million (notional amounts range from $166.5 million to $552.4 million over the terms of the swaps) at interest rates ranging from 2.25% to 6.94% maturing at various dates ranging from 2003 to 2005 with a net liability fair value of $15.0 million. During the nine months ended September 30, 2002, the Company recognized an unrealized loss of $0.8 million due to ineffectiveness of certain of these unconsolidated development derivatives (included in income (loss) from investments in unconsolidated entities).
On September 30, 2002, the net derivative instruments were reported at their fair value as other liabilities of approximately $9.0 million and as a reduction to investments in unconsolidated entities of approximately $15.0 million. As of September 30, 2002, there were approximately $44.2 million in deferred losses, net, included in accumulated other comprehensive loss. Based on the estimated fair values of the net derivative instruments at September 30, 2002, the Company may recognize an estimated $19.3 million of
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accumulated other comprehensive loss as additional interest expense during the twelve months ending September 30, 2003, of which $8.0 million is related to the unconsolidated development partnerships.
13. Calculation of Net Income Per Weighted Average Common Share
The following tables set forth the computation of net income per share—basic and net income per share—diluted:
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Convertible preferred shares/units that could be converted into 15,461,855 and 15,322,607 weighted average Common Shares for the nine months ended September 30, 2002 and 2001, respectively, and 15,095,576 and 15,626,902 weighted average Common Shares for the quarters ended September 30, 2002 and 2001, respectively, were outstanding but were not included in the computation of diluted earnings per share because the effects would be anti-dilutive.
On October 11, 2001, the Company effected a two-for-one split of its Common Shares and OP Units to shareholders and unitholders of record as of September 21, 2001. All per share and OP Unit data and numbers of Common Shares and OP Units have been retroactively adjusted to reflect the Common Share and OP Unit split.
14. Discontinued Operations
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which is effective for fiscal years beginning after December 15, 2001. The Company adopted the standard effective January 1, 2002, which did not have a material effect on the Company's financial condition and results of operations.
Under the provisions of SFAS No. 144, for long-lived assets to be held and used, the Company first determines whether any indicators of impairment exist. If indicators exist, the Company compares the expected future undiscounted cash flows for the long-lived asset against the carrying amount of that asset. If the sum of the estimated undiscounted cash flows is less than the carrying amount of the asset, an impairment loss would be recorded for the difference between the estimated fair value and the carrying amount of the asset.
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For long-lived assets to be disposed of, an impairment loss is recognized when the estimated fair value of the asset, less the estimated cost to sell, is less than the carrying amount of the asset measured at the time that the Company has determined it will sell the asset. Long-lived assets held for disposition are reported at the lower of their carrying amounts or their estimated fair values, less their costs to sell.
Goodwill and investments in unconsolidated entities accounted for under the equity method of accounting are specifically excluded from the scope of SFAS No. 144.
On January 11, 2002, the Company disposed of its furniture rental business for $30.0 million and received net proceeds of $28.7 million. No gain/loss on sale was recognized as the net book value at the sale date after giving effect to a previously recorded impairment loss approximated the sales price.
The components of discontinued operations for the nine months and quarters ended September 30, 2002 and 2001, respectively, are outlined below and include the results of operations through the date of each respective sale for the nine months and quarter ended September 30, 2002, and a full nine months and quarter of operations for the nine months and quarter ended September 30, 2001, for the following:
15. Commitments and Contingencies
The Company, as an owner of real estate, is subject to various environmental laws of Federal and local governments. Compliance by the Company with existing laws has not had a material adverse effect on the Company's financial condition and results of operations. However, the Company cannot predict the impact of new or changed laws or regulations on its current properties or on properties that it may acquire in the future.
The Company does not believe there is any litigation threatened against the Company other than routine litigation arising out of the ordinary course of business, some of which is expected to be covered by liability insurance, none of which is expected to have a material adverse effect on the consolidated financial statements of the Company.
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In regards to the funding of properties in the development stage and the agreements with multifamily residential real estate developers, the Company funded a net total of $65.1 million during the nine months ended September 30, 2002. In connection with one development agreement, the Company has an obligation to fund up to an additional $9.5 million to guarantee third party construction financing. As of September 30, 2002, the Company has 17 projects in various stages of development (includes two consolidated projects) with estimated completion dates ranging through March 31, 2004.
For one development agreement, the Company's partner has the right, at any time following completion of a project, to stipulate a value for such project and offer to sell its interest in the project to the Company based on such value. If the Company chooses not to purchase the interest, it must agree to a sale of the project to an unrelated third party at such value. The Company's partner must exercise this right as to all projects within five years after the receipt of the final certificate of occupancy on the last developed property.
Under a second development agreement, the Company's partner has the right, at any time following completion of a project, to require the Company to purchase the partners' interest in that project at a mutually agreeable price. If the Company and the partner are unable to agree on a price, both parties will obtain appraisals. If the appraised values vary by more than 10%, both the Company and its partner will agree on a third appraiser to determine which original appraisal is closest to its determination of value. The Company may elect at that time not to purchase the property and instead, authorize its partner to sell the project at or above the agreed-upon value to an unrelated third party. Five years following the receipt of the final certificate of occupancy on the last developed property, any projects remaining unsold must be purchased by the Company at the agreed-upon price.
The Company provided a credit enhancement with respect to certain tax-exempt bonds issued to finance certain public improvements at a multifamily development project. As of September 30, 2002, this enhancement was still in effect at a commitment amount of $12.7 million.
16. Asset Impairment
For the nine months ended September 30, 2002 and 2001, the Company recorded approximately $0.9 million and $8.0 million, respectively, of asset impairment charges related to its technology investments. These charges were the result of review of the existing investments reflected on the consolidated balance sheet. These impairment losses are reflected on the statement of operations in total expenses and include the write-down of assets classified as other assets and investments in unconsolidated entities.
For the nine months ended September 30, 2002, the Company recorded approximately $17.1 million of asset impairment charges related to its corporate housing business. Following the guidance in SFAS No. 142, these charges were the result of the Company's decision to reduce the carrying value of its corporate housing business to $30.0 million, given the continued weakness in the economy and management's expectations for near-term performance. This impairment loss is reflected on the consolidated statements of operations as impairment on corporate housing business and on the consolidated balance sheets as a reduction in goodwill, net.
As of September 30, 2001, the Company recorded $60.0 million of asset impairment charges related to its furniture rental business. These charges were the result of a review of the existing intangible and tangible assets reflected on the consolidated balance sheet as of September 30, 2001. The Company reviewed the current net book value taking into consideration existing business and economic conditions as well as projected cash flows. The impairment loss is reflected on the income statement in discontinued operations, net, and includes the write-down of the following assets: a) goodwill of approximately $26.0 million; b) rental furniture, net of approximately $28.6 million; c) property and equipment, net of approximately $4.5 million; and d) other assets of approximately $0.9 million.
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17. Reportable Segments
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by senior management. Senior management decides how resources are allocated and assesses performance on a monthly basis.
The Company's primary business is owning, managing, and operating multifamily residential properties, which includes the generation of rental and other related income through the leasing of apartment units to residents. Senior management evaluates the performance of each of our apartment communities on an individual basis, however, each of our apartment communities has similar economic characteristics, residents, and products and services so they have been aggregated into one reportable segment. The Company's rental real estate segment comprised approximately 98.8% and 97.9% of total revenues for the nine months ended September 30, 2002 and 2001, respectively, and approximately 99.0% and 98.5% of total revenues for the quarters ended September 30, 2002 and 2001, respectively. The Company's rental real estate segment comprised approximately 99.7% and 99.4% of total assets at September 30, 2002 and December 31, 2001, respectively.
The primary financial measure for the Company's rental real estate segment is net operating income ("NOI"), which represents rental income less: 1) property and maintenance expense; 2) real estate taxes and insurance expense; and 3) property management expense (all as reflected in the accompanying statements of operations). Current year NOI is compared to prior year NOI and current year budgeted NOI as a measure of financial performance. NOI from our rental real estate totaled approximately $905.1 million and $916.2 million for the nine months ended September 30, 2002 and 2001, respectively, and approximately $297.5 million and $312.6 million for the quarters ended September 30, 2002 and 2001, respectively.
During the acquisition, development and/or disposition of real estate, the NOI return on total capitalized costs is the primary measure of financial performance the Company considers.
The Company's fee and asset management activity is immaterial and does not meet the threshold requirements of a reportable segment as provided for in SFAS No. 131.
18. Subsequent Events/Other
During the nine months ended September 30, 2002, the Company entered into an agreement with the U.S. Army with an initial cash investment of $10.0 million and assumed management of 3,637 multifamily units at Fort Lewis, Washington.
Subsequent to September 30, 2002 and through November 4, 2002, the Company:
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
For further information including definitions for capitalized terms not defined herein, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2001.
Forward-looking statements in this report are intended to be made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words "believes", "expects" and "anticipates" and other similar expressions that are predictions of or indicate future events and trends and which do not relate solely to historical matters identify forward-looking statements. Such forward-looking statements are subject to risks and uncertainties, which could cause actual results, performance, or achievements of the Company to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Factors that might cause such differences include, but are not limited to, the following:
Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to publicly release any revisions to these forward-looking statements, which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Forward-looking statements and related uncertainties are also included in Note 6 to the Notes to Consolidated Financial Statements in this report.
Results of Operations
The following table summarizes the number of properties and related units for the year-to-date periods presented:
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The Company's acquisition and disposition activity has impacted overall results of operations for the nine months and quarters ended September 30, 2002 and 2001. Significant changes in revenues and expenses have resulted primarily from the consolidation of previously Unconsolidated Properties in July 2001, the disposition of the furniture rental business on January 11, 2002, reduced rental income through increased concessions or reduced apartment rents at selected properties as well as the properties acquired and developments completed in 2001 and 2002, which have been partially offset by the properties disposed in 2001 and 2002. Significant changes in expenses have also resulted from changes in insurance costs, general and administrative costs, impairment charges and variable interest rates. This impact is discussed in greater detail in the following paragraphs.
Properties that the Company owned for all of both the nine month periods ended September 30, 2002 and September 30, 2001 (the "Nine-Month 2002 Same Store Properties"), which represented 191,940 units, and properties that the Company owned for all of both the quarters ended September 30, 2002 and September 30, 2001 (the "Third Quarter 2002 Same Store Properties"), which represented 197,852 units, also impacted the Company's results of operations. Both the Nine-Month 2002 Same Store Properties and Third Quarter 2002 Same Store Properties are discussed in the following paragraphs.
Comparison of the nine months ended September 30, 2002 to the nine months ended September 30, 2001
For the nine months ended September 30, 2002, income before allocation to Minority Interests, income (loss) from investments in unconsolidated entities, net gain (loss) on sales of unconsolidated entities, discontinued operations, extraordinary items and cumulative effect of change in accounting principle decreased by approximately $46.5 million when compared to the nine months ended September 30, 2001.
Revenues from the Nine-Month 2002 Same Store Properties decreased primarily as a result of lower overall physical occupancy, increased concessions and lower rental rates charged new residents. Property operating expenses from the Nine-Month 2002 Same Store Properties, which include property and maintenance, real estate taxes and insurance and an allocation of property management expenses, remained relatively stable with increases in real estate taxes and insurance costs offset by a decrease in utility costs. The following tables provide comparative revenue, expense, net operating income ("NOI") and weighted average occupancy for the Nine-Month 2002 Same Store Properties:
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September 30, 2002 Year-to-Date "Same Store" Results
$ in Millions—191,940 "Same Store" Units
"Same Store" Occupancy Statistics
For properties that the Company acquired prior to January 1, 2001 and expects to continue to own through December 31, 2002, the Company anticipates the following operating assumptions for the year ending December 31, 2002:
2002 "Same Store" Operating Assumptions
For properties that the Company acquired prior to January 1, 2002 and expects to continue to own through December 31, 2003, the Company anticipates the following operating assumptions for the year ending December 31, 2003:
2003 "Same Store" Operating Assumptions
These 2002 and 2003 operating assumptions are based on current expectations and are forward-looking.
Rental income from properties other than Nine-Month 2002 Same Store Properties increased by approximately $10.4 million primarily as a result of revenue from properties the Company acquired in 2001 and 2002 and additional Partially Owned Properties that the Company consolidated in 2001.
Interest and other income decreased by approximately $6.1 million, primarily as a result of lower balances available for investment and related interest rates being earned on the Company's short-term
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investment accounts along with lower balances on deposit in tax-deferred exchange accounts.
Interest income—investment in mortgage notes decreased by $8.8 million as a result of the Company consolidating previously Unconsolidated Properties in July 2001. No additional interest income will be recognized on such mortgage notes in future years as the Company now consolidates the results related to these previously Unconsolidated Properties.
Property management expenses include off-site expenses associated with the self-management of the Company's properties. These expenses decreased by approximately $0.5 million or 0.1%. This decrease is primarily attributable to lower expected levels of employee bonus and profit sharing payments for 2002.
Fee and asset management revenues, net of fee and asset management expenses, increased by $1.1 million as a result of the Company managing an additional 3,637 units at Fort Lewis, Washington starting in April 2002. As of September 30, 2002 and 2001, the Company managed 20,142 units and 15,948 units, respectively, for third parties and unconsolidated entities.
The Company recorded impairment charges in 2002 on its corporate housing business and its technology investments of approximately $17.1 million and $0.9 million, respectively. See Note 16 in the Notes to Consolidated Financial Statements for further discussion.
Interest expense, including amortization of deferred financing costs, decreased approximately $11.9 million primarily due to lower variable interest rates. During the nine months ended September 30, 2002, the Company capitalized interest costs of approximately $19.4 million as compared to $21.0 million for the nine months ended September 30, 2001. This capitalization of interest primarily related to investments in unconsolidated entities engaged in development activities. The effective interest cost on all of the Company's indebtedness for the nine months ended September 30, 2002 was 6.60% as compared to 7.00% for the nine months ended September 30, 2001.
General and administrative expenses, which include corporate operating expenses, increased approximately $9.4 million between the nine months under comparison. This increase was primarily due to higher state income taxes in Michigan and New Jersey, income taxes incurred at one of the Company's taxable REIT subsidiaries which has an ownership interest in properties that in prior periods were classified as Unconsolidated Properties, retirement plan expenses for certain key executives, restricted shares/awards granted to key employees and additional compensation charges and costs associated with the Company's new President.
Income (loss) from investments in unconsolidated entities decreased approximately $3.6 million between the periods under comparison. This decrease is primarily the result of increased equity losses and unrealized losses on derivative instruments.
Net gain on sales of discontinued operations decreased approximately $38.6 million between the periods under comparison. This decrease is primarily the result of approximately 3,200 fewer number of units sold during the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001 (includes approximately 3,000 units sold into a joint venture in February 2001).
Comparison of the quarter ended September 30, 2002 to the quarter ended September 30, 2001
For the quarter ended September 30, 2002, income before allocation to Minority Interests, income (loss) from investments in unconsolidated entities, net gain (loss) on sales of unconsolidated entities, discontinued operations, extraordinary items and cumulative effect of change in accounting principle decreased by approximately $34.3 million when compared to the quarter ended September 30, 2001.
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Revenues from the Third Quarter 2002 Same Store Properties decreased primarily as a result of lower rental rates charged new residents, increased concessions and lower overall physical occupancy. Property operating expenses from the Third Quarter 2002 Same Store Properties, which include property and maintenance, real estate taxes and insurance and an allocation of property management expenses, increased $3.5 million or 2.0% primarily as a result of increases in real estate taxes, insurance costs and payroll overtime. The following tables provide comparative revenue, expense, NOI and weighted average occupancy for the Third Quarter 2002 Same Store Properties:
Third Quarter 2002 "Same Store" Results
$ in Millions—197,852 "Same Store" Units
Rental income from properties other than Third Quarter 2002 Same Store Properties increased by approximately $1.8 million primarily as a result of revenue from properties the Company acquired in the third and fourth quarters of 2001 and during the nine months ended September 30, 2002.
Interest and other income decreased by approximately $3.9 million, primarily as a result of lower balances available for investment and related rates being earned on the Company's short-term investment accounts along with lower balances on deposit in tax-deferred exchange accounts.
Property management expenses include off-site expenses associated with the self-management of the Company's properties. These expenses decreased by approximately $2.2 million or 11.1%. This decrease is primarily attributable to lower expected levels of employee bonus and profit sharing payments for 2002.
Fee and asset management revenues, net of fee and asset management expenses, increased by $1.2 million as a result of the Company managing an additional 3,637 units at Fort Lewis starting in April 2002. As of September 30, 2002 and 2001, the Company managed 20,142 units and 15,948 units, respectively, for third parties and unconsolidated entities.
The Company recorded impairment charges in 2002 on its corporate housing business and its technology investments of approximately $17.1 million and $0.3 million, respectively. See Note 16 in the Notes to Consolidated Financial Statements for further discussion.
Interest expense, including amortization of deferred financing costs, decreased approximately $5.2 million primarily due to lower variable interest rates. During the quarter ended September 30, 2002, the Company capitalized interest costs of approximately $7.1 million as compared to $8.2 million for the quarter ended September 30, 2001. This capitalization of interest primarily related to investments in unconsolidated
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entities engaged in development activities. The effective interest cost on all of the Company's indebtedness for the quarter ended September 30, 2002 was 6.52% as compared to 6.82% for the quarter ended September 30, 2001.
General and administrative expenses, which include corporate operating expenses, increased approximately $1.1 million between the quarters under comparison. This increase was primarily due to retirement plan expenses for certain key executives, higher state income taxes, restricted shares/awards granted to key employees and additional compensation charges and costs associated with the Company's new President.
Income (loss) from investments in unconsolidated entities decreased approximately $2.9 million between the periods under comparison. This decrease is primarily the result of increased equity losses and unrealized losses on derivative instruments.
Net gain (loss) on sales of unconsolidated entities decreased approximately $5.9 million between the periods under comparison. This decrease is the loss associated with the sale in the third quarter of 2002 of one property held in one of our development entities.
Net gain on sales of discontinued operations decreased approximately $20.8 million between the periods under comparison. This decrease is primarily the result of certain properties sold during the quarter ended September 30, 2001 having a lower net carrying value at sale, which resulted in higher recognition of gain for financial reporting purposes.
Liquidity and Capital Resources
As of January 1, 2002, the Company had approximately $51.6 million of cash and cash equivalents and $505.0 million available under its line of credit, of which $59.0 million was restricted (not available for borrowings). After taking into effect the various transactions discussed in the following paragraphs and the net cash provided by operating activities, the Company's cash and cash equivalents balance at September 30, 2002 was approximately $21.8 million and the amount available on the Company's line of credit was $665.0 million, of which $83.3 million was restricted (not available for borrowings).
Part of the Company's acquisition and development funding strategy and the funding of the Company's investment in various unconsolidated entities is to utilize its line of credit and to subsequently repay the line of credit from the disposition of properties, retained cash flows or the issuance of additional equity or debt securities. Continuing to utilize this strategy during the nine months ended September 30, 2002, the Company:
All of these proceeds were utilized to either:
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The Company's total debt summary and debt maturity schedule, as of September 30, 2002, are as follows:
Debt Summary as of September 30, 2002
Debt Maturity Schedule as of September 30, 2002
The Company's "Consolidated Debt-to-Total Market Capitalization Ratio" as of September 30, 2002 is presented in the following table. The Company calculates the equity component of its market capitalization as
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the sum of (i) the total outstanding Common Shares and assumed conversion of all OP Units at the equivalent market value of the closing price of the Company's Common Shares on the New York Stock Exchange; (ii) the "Common Share Equivalent" of all convertible preferred shares and preference interests/units; and (iii) the liquidation value of all perpetual preferred shares and preference interests outstanding.
Capitalization as of September 30, 2002
Convertible Preferred Shares, Preference Interests and Junior Preference Unitsas of September 30, 2002
The Company's policy is to maintain a ratio of consolidated debt-to-total market capitalization of less than 50%.
From October 1, 2002 through November 4, 2002, the Company:
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The Company may repurchase up to an additional $85.0 million of its Common Shares pusuant to the common share buy back program authorized by its Board of Trustees. In addition, during the fourth quarter of 2002, the Company anticipates closing on an unsecured note offering of up to $250 million.
Investments in Unconsolidated Entities
In connection with one development agreement, the Company has an obligation to fund up to an additional $9.5 million to guarantee third party construction financing. As of September 30, 2002, the Company has 15 projects under development with estimated completion dates ranging through March 31, 2004.
Capitalization of Fixed Assets and Improvements to Real Estate:
Our policy with respect to capital expenditures is generally to capitalize expenditures that improve the value of the property or extend the useful life of the component asset of the property. We track improvements to real estate in two major categories and several subcategories:
We capitalize approximately $260 to $270 per unit annually for inside the unit replacements. All replacements are depreciated over a five-year estimated useful life. We expense as incurred all maintenance and turnover costs such as cleaning, interior painting of individual units and the repair of any replacement item noted above.
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We capitalize approximately $340 to $370 per unit annually for outside the unit building improvements. All building improvements are depreciated over a five to ten-year estimated useful life. We expense as incurred all recurring expenditures that do not improve the value of the asset or extend its useful life.
For the nine months ended September 30, 2002, our actual improvements to real estate totaled approximately $110.3 million. This includes the following detail (amounts in thousands except for unit and per unit amounts):
Capitalized Improvements to Real Estate For the Nine Months Ended September 30, 2002
We anticipate capitalizing an average of approximately $600 to $640 per unit annually for inside and outside the unit capital improvements to our real estate. Total improvements to real estate for the remainder of 2002 are estimated to be $22.0 million.
During the nine months ended September 30, 2002, the Company's total non-real estate capital additions, such as computer software, computer equipment, and furniture and fixtures and leasehold improvements to the Company's property management offices and its corporate offices, was approximately $5.6 million. Total additions to non-real estate property for the remainder of 2002 are estimated at $1.2 million.
Improvements to real estate and additions to non-real estate property for both 2002 and 2001 were funded from net cash provided by operating activities.
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Minority Interests as of September 30, 2002 decreased by $14.7 million when compared to December 31, 2001. The primary factors that impacted this account in the Company's consolidated statements of operations and balance sheets during the nine months were:
Total distributions paid in October 2002 amounted to $145.2 million (excluding distributions on Partially Owned Properties), which included certain distributions declared during the quarter ended September 30, 2002.
The Company expects to meet its short-term liquidity requirements, including capital expenditures related to maintaining its existing properties and certain scheduled unsecured note and mortgage note repayments, generally through its working capital, net cash provided by operating activities and borrowings under its line of credit. The Company considers its cash provided by operating activities to be adequate to meet operating requirements and payments of distributions. The Company also expects to meet its long-term liquidity requirements, such as scheduled unsecured note and mortgage debt maturities, property acquisitions, financing of construction and development activities and capital improvements through the issuance of unsecured notes and equity securities, including additional OP Units, and proceeds received from the disposition of certain properties. In addition, the Company has certain unencumbered properties available to secure additional mortgage borrowings in the event that the public capital markets are unavailable to the Company or the cost of alternative sources of capital to the Company is too high. The fair value of these unencumbered properties are in excess of the required value the Company must maintain in order to comply with covenants under its unsecured notes and line of credit.
On May 30, 2002 the Company obtained a new three-year $700.0 million unsecured revolving credit facility. The new line of credit replaces the Company's $700.0 million unsecured revolving credit facility that was scheduled to expire in August 2002. The prior existing revolving credit facility terminated upon the closing of the new facility. This new facility matures in May 2005 and will be used to fund property acquisitions, costs for certain properties under development and short term liquidity requirements. As of November 7, 2002, $285.0 million was outstanding under this new facility.
The Company provided a credit enhancement with respect to certain tax-exempt bonds issued to finance certain public improvements at a multifamily development project. As of November 4, 2002, this enhancement was still in effect at a commitment amount of $12.7 million.
Critical Accounting Policies and Estimates
The Company's significant accounting policies are described in Note 2 in the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2001. These policies were followed in preparing the unaudited condensed consolidated financial statements for the nine months ended September 30, 2002.
The Company has identified six significant accounting policies as critical accounting policies. These critical accounting policies are those that have the most impact on the reporting of our financial condition and those requiring significant judgments and estimates. With respect to these critical accounting policies, management believes that the application of judgments and assessments is consistently applied and produces
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financial information that fairly presents the results of operations for all periods presented. The six critical accounting policies are:
Impairment of Long-Lived Assets, Including Goodwill
The Company periodically evaluates its long-lived assets, including its investments in real estate and goodwill, for impairment indicators. The judgments regarding the existence of impairment indicators are based on factors such as operational performance, market conditions and legal factors. Future events could occur which would cause the Company to conclude that impairment indicators exist and an impairment loss is warranted.
Depreciation of Investment in Real Estate
The Company depreciates the building component of its investment in real estate over a 30-year estimated useful life, building improvements over a 5-year to 10-year estimated useful life and both the furniture, fixtures and equipment and replacements components over a 5-year estimated useful life, all of which are judgmental determinations.
Fair Value of Financial Instruments, Including Derivative Instruments
The valuation of financial instruments under SFAS No. 107 and SFAS No. 133 requires the Company to make estimates and judgments that affect the fair value of the instruments. The Company, where possible, bases the fair values of its financial instruments, including its derivative instruments, on listed market prices and third party quotes. Where these are not available, the Company bases its estimates on other factors relevant to the financial instruments.
Stock Option Compensation
The Company has chosen to account for its stock option compensation in accordance with APB No. 25, which results in no compensation expense for options issued with an exercise price equal to or exceeding market value of the Company's Common Shares on the date of grant. The Company will elect to expense its stock option compensation in accordance with SFAS No. 123 effective January 1, 2003 which will result in compensation expense being recorded based on the fair value of the stock option compensation issued.
Cost Capitalization
See the Capitalization of Fixed Assets and Improvements to Real Estate section for discussion of the Company's policy with respect to capitalization vs. expensing of fixed asset/repair and maintenance costs. The Company expenses as incurred all payroll costs of employees working directly at our properties, except that during the initial lease-up phase on a development project, an allocated portion of payroll costs is capitalized based upon the occupancy of the project until stabilized occupancy is achieved. Stabilized occupancy is always deemed to have occurred no later than one year from cessation of major development activities.
The Company capitalizes interest, real estate taxes and insurance related to its development projects. The Company also capitalizes payroll and associated costs for those individuals directly responsible for and who spend all of their time on development activities. The incremental payroll and associated costs are capitalized to the projects under development based upon the effort directly identifiable with such projects. These costs are reflected on the balance sheet as either construction in progress or a separate component of investments in unconsolidated entities. The Company ceases the capitalization of such costs as the property becomes substantially complete and ready for its intended use. In addition, the Company capitalizes the payroll and associated costs of employees directly responsible for and who spend all of their time on major capital projects. These costs are reflected on the balance sheet as an increase to building. The Company follows the guidance in SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, and uses its professional judgment in determining whether such costs meet the criteria for capitalization or must be expensed as incurred.
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Revenue Recognition
Rental income attributable to leases is recorded when due from residents and is recognized monthly as it is earned, which is not materially different than on a straight-line basis. Interest income is recorded on an accrual basis. Leases entered into between a resident and a property for the rental of an apartment unit are generally year-to-year, renewable upon consent of both parties on a year-to-year or month-to-month basis.
The Company adopted the provisions of Staff Accounting Bulletin ("SAB") No. 101, Revenue Recognition, effective October 1, 2000. SAB No. 101 provides guidance on the recognition, presentation and disclosure of revenue in financial statements.
Adjusted Net Income
For the nine months ended September 30 2002, Adjusted Net Income ("ANI") available to Common Shares and OP Units decreased $16.0 million as compared to the nine months ended September 30, 2001.
For the quarter ended September 30, 2002, ANI available to Common Shares and OP Units decreased $11.7 million as compared to the quarter ended September 30, 2001.
The following is a reconciliation of net income available to Common Shares to ANI available to Common Shares and OP Units for the nine months and quarters ended September 30, 2002 and 2001:
Adjusted Net Income (Amounts in thousands)(Unaudited)
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The Company believes that ANI is helpful to investors as a supplemental measure of the operating performance of a real estate company because, along with cash flows from operating activities, financing activities and investing activities, it provides investors an understanding of the ability of the Company to incur and service debt and to make capital expenditures. ANI in and of itself does not represent cash generated from operating activities in accordance with GAAP and therefore should not be considered an alternative to net income as an indication of the Company's performance or to net cash flows from operating activities as determined by GAAP as a measure of liquidity and is not necessarily indicative of cash available to fund cash needs. The Company's calculation of ANI may differ from the methodology for calculating ANI utilized by other real estate companies and may differ, for example, due to variations among the Company's and other real estate companies' accounting policies for replacement type items and, accordingly, may not be comparable to such other real estate companies.
Funds From Operations
For the nine months ended September 30, 2002, Funds From Operations ("FFO") available to Common Shares and OP Units decreased $25.0 million as compared to the nine months ended September 30, 2001.
For the quarter ended September 30, 2002, FFO available to Common Shares and OP Units decreased $20.7 million as compared to the quarter ended September 30, 2001.
The following is a reconciliation of net income available to Common Shares to FFO available to Common Shares and OP Units for the nine months and quarters ended September 30, 2002 and 2001:
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Funds from Operations (Amounts in thousands)(Unaudited)
The Company believes that FFO is helpful to investors as a supplemental measure of the operating performance of a real estate company because, along with cash flows from operating activities, financing activities and investing activities, it provides investors an understanding of the ability of the Company to incur and service debt and to make capital expenditures. FFO in and of itself does not represent cash generated from operating activities in accordance with GAAP and therefore should not be considered an alternative to net income as an indication of the Company's performance or to net cash flows from operating activities as determined by GAAP as a measure of liquidity and is not necessarily indicative of cash available to fund cash needs. The Company's calculation of FFO may differ from the methodology for calculating FFO utilized by other real estate companies and may differ, for example, due to variations among the Company's and other real estate companies' accounting policies for replacement type items and, accordingly, may not be comparable to such other real estate companies.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company's market risk has not changed materially from the amounts and information reported in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, to the Company's Form 10-K for the year ended December 31, 2001. See also Note 12 to the Notes to Consolidated Financial Statements for additional discussion on the Company's derivative instruments and hedging activities.
Item 4. Disclosure Controls and Procedures
Within 90 days prior to the filing date of this quarterly report on Form 10-Q, the Company carried out an evaluation, under the supervision and with the participation of the Company's management including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and
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procedures are effective in timely alerting them to material information related to the Company. There have been no significant changes to the internal controls of the Company or in other factors that could significantly affect the internal controls subsequent to the completion of this evalution.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
There have been no new or significant developments related to the legal proceedings that were discussed in Part I, Item III of the Company's Form 10-K for the year ended December 31, 2001.
Item 6. Exhibits and Reports on Form 8-K
A report on Form 8-K dated August 13, 2002 containing the Chief Executive Officer and Chief Financial Officer sworn statements pursuant to the SEC's Order No. 4-460 issued June 27, 2002 and their respective certifications pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf by the undersigned thereunto duly authorized.
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CERTIFICATIONS
I, Douglas Crocker II, principal executive officer of Equity Residential, certify that:
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I, David J. Neithercut, principal financial officer of Equity Residential, certify that:
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