UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10 - Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period _________ to __________. Commission File Number: 0-32615 Franklin Street Properties Corp. (Exact name of registrant as specified in its charter) Maryland 04-3578653 (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) 401 Edgewater Place, Suite 200 Wakefield, MA 01880-6210 (Address of principal executive offices) Registrant's telephone number: (781) 557-1300 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 ninety days. YES |X| NO |_| Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended. YES |X| NO |_| The number of shares of common stock outstanding as of July 27, 2004 was 49,630,338.
Franklin Street Properties Corp. Form 10-Q Quarterly Report June 30, 2004 Table of Contents Part I. Financial Information Page ---- Item 1. Financial Statements Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003...................................... 3 Consolidated Statements of Income for the three and six months ended June 30, 2004 and 2003................ 4 Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003.................... 5 Notes to Consolidated Financial Statements............. 6-15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................... 16-27 Item 3. Quantitative and Qualitative Disclosures about Market Risk................................................... 27 Item 4. Controls and Procedures................................ 28 Part II. Other Information Item 1. Legal Proceedings...................................... 29 Item 2. Changes in Securities and Use of Proceeds.............. 29 Item 3. Defaults upon Senior Securities........................ 29 Item 4. Submission of Matters to a Vote of Security Holders.... 29 Item 5. Other Information...................................... 29 Item 6. Exhibits and Reports on Form 8-K....................... 29 Signatures ....................................................... 30
PART I - FINANCIAL INFORMATION Item 1. Financial Statements Franklin Street Properties Corp. Consolidated Balance Sheets (Unaudited) <TABLE> <CAPTION> June 30, December 31, (in thousands, except shares and par value amounts) 2004 2003 ================================================================================================================= <S> <C> <C> Assets: Real estate investments, at cost: Land $ 71,236 $ 71,236 Buildings and improvements 403,768 $403,243 Fixtures and equipment 894 889 - ----------------------------------------------------------------------------------------------------------------- 475,898 475,368 Less accumulated depreciation 31,390 25,836 - ----------------------------------------------------------------------------------------------------------------- Real estate investments, net 444,508 449,532 Acquired real estate leases, net of accumulated amortization of $2,605 and $1,539 6,898 7,964 Assets held for syndication -- 4,117 Cash and cash equivalents 59,000 58,793 Restricted cash 1,028 982 Tenant rent receivables, less allowance for doubtful accounts of $150 and $155, respectively 630 881 Straight-line rent receivables, less allowance for doubtful accounts of $360 and $360, respectively 4,941 4,087 Prepaid expenses 1,007 806 Investment in non-consolidated REITs 4,301 -- Office computers and furniture, net of accumulated depreciation of $529 and $473, respectively 431 398 Deferred leasing commissions, net of accumulated amortization of $725 and $586, respectively 1,082 969 - ----------------------------------------------------------------------------------------------------------------- Total assets $ 523,826 $528,529 ================================================================================================================= Liabilities and Stockholders' Equity: Liabilities: Bank note payable $ -- $ 4,117 Accounts payable and accrued expenses 7,982 5,030 Accrued compensation 1,817 1,545 Tenant security deposits 1,028 982 - ----------------------------------------------------------------------------------------------------------------- Total liabilities 10,827 11,674 - ----------------------------------------------------------------------------------------------------------------- Commitments and Contingencies Stockholders' Equity: Preferred Stock, $.0001 par value, 20,000,000 shares authorized, none issued or outstanding -- -- Common Stock, $.0001 par value, 180,000,000 shares authorized, 49,630,338 issued and outstanding 5 5 Additional paid-in capital 512,813 512,797 Retained earnings (distributions in excess of earnings) (225) 3,647 Accumulated undistributed net realized gain on sale of properties 406 406 - ----------------------------------------------------------------------------------------------------------------- Total Stockholders' Equity 512,999 516,855 - ----------------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $ 523,826 $528,529 ================================================================================================================= </TABLE> See accompanying notes to consolidated financial statements. 3
Franklin Street Properties Corp. Consolidated Statements of Income (Unaudited) <TABLE> <CAPTION> For the For the Three Months Ended Six Months Ended June 30, June 30, ------------------------------------------------- (in thousands, except shares and per share amounts) 2004 2003 2004 2003 ============================================================================================================================= <S> <C> <C> <C> <C> Revenue: Rental $17,022 $ 9,440 $35,067 $14,839 Syndication fees 5,407 2,174 8,448 5,407 Transaction fees 5,193 2,222 8,742 5,437 Sponsored REIT income 709 517 2,334 901 Other 348 289 742 606 - ----------------------------------------------------------------------------------------------------------------------------- Total Revenue 28,679 14,642 55,333 27,190 - ----------------------------------------------------------------------------------------------------------------------------- Expenses: Real estate operating expenses 3,472 2,152 6,771 3,585 Real estate taxes and insurance 2,247 1,207 4,567 1,904 Depreciation and amortization 3,497 1,431 6,697 2,261 Sponsored REIT expenses 635 350 1,678 641 Selling, general and administrative 1,606 1,334 3,132 2,732 Commissions 2,767 1,090 4,287 2,706 Shares issued as compensation -- -- 162 -- Interest 253 207 517 538 - ----------------------------------------------------------------------------------------------------------------------------- Total expenses 14,477 7,771 27,811 14,367 - ----------------------------------------------------------------------------------------------------------------------------- Income before interest income and taxes on income 14,202 6,871 27,522 12,823 Interest income 122 59 349 108 - ----------------------------------------------------------------------------------------------------------------------------- Income before taxes on income 14,324 6,930 27,871 12,931 Taxes on income 648 196 976 425 - ----------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 13,676 6,734 26,895 12,506 Income from discontinued operations -- 49 -- 144 Gain on sale of properties, less applicable income tax -- -- -- 1,421 - ----------------------------------------------------------------------------------------------------------------------------- Net income $13,676 $ 6,783 $26,895 $14,071 ============================================================================================================================= Weighted average number of shares outstanding, basic and diluted 49,630 32,964 49,627 28,797 ============================================================================================================================= Net income per share, basic and diluted, attributable to: Continuing operations $ 0.28 $ 0.20 $ 0.54 $ 0.43 Discontinued operations -- -- -- 0.01 Gain on sale of properties, less applicable income tax -- -- -- 0.05 - ----------------------------------------------------------------------------------------------------------------------------- Net income per share, basic and diluted $ 0.28 $ 0.20 $ 0.54 $ 0.49 ============================================================================================================================= </TABLE> See accompanying notes to consolidated financial statements. 4
Franklin Street Properties Corp. Consolidated Statements of Cash Flows (Unaudited) <TABLE> <CAPTION> For the Six Months Ended June 30, ------------------------ (in thousands) 2004 2003 ==================================================================================================================================== <S> <C> <C> Cash flows from operating activities: Net Income $ 26,895 $ 14,071 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization expense 6,697 2,438 Amortization of above market lease 118 -- Gain on sale of real estate assets -- (1,421) Equity in earnings from non-consolidated REITs (112) -- Distributions from non-consolidated REITs 59 -- Shares issued as compensation 162 -- Changes in operating assets and liabilities: Restricted cash (46) 17 Tenant rent receivables, net 251 (35) Straight-line rents, net (854) 240 Prepaid expenses and other assets, net (201) 338 Accounts payable and accrued expenses 2,952 304 Accrued compensation 272 (17) Tenant security deposits 46 (553) Payment of deferred leasing commissions (252) (149) - ----------------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used for) operating activities 35,987 15,233 - ----------------------------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Cash acquired through issuance of common stock in merger transaction -- 23,524 Purchase of real estate assets, office computers and furniture, capitalized merger costs (619) (1,708) Investment in non-consolidated REITs (4,248) -- Change in deposits on real estate assets -- 841 Sale of assets held for syndication 4,117 -- Proceeds received on sales of real estate assets -- 6,228 - ----------------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used for) investing activities (750) 28,885 - ----------------------------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Distibutions to stockholders (30,767) (15,271) Proceeds from (payments to) bank note payable, net (4,117) 38,122 Purchase of treasury stock (146) -- - ----------------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used for) financing activities (35,030) 22,851 - ----------------------------------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 207 66,969 Cash and cash equivalents, beginning of period 58,793 22,316 - ----------------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents, end of period $ 59,000 $ 89,285 =================================================================================================================================== Supplemental disclosure of cash flow information: Cash paid for: Interest $ 517 $ 538 Income taxes 1,020 585 Non-cash investing and financing activities: Dividends declared but not paid -- 5,172 Assets acquired through issuance of common stock in merger transaction, net -- 297,648 </TABLE> See accompanying notes to consolidated financial statements. 5
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 1. Organization, Properties, Basis of Presentation, and Recent Accounting Pronouncements Organization Franklin Street Properties Corp. (together with its subsidiaries, "FSP Corp." or the "Company", known as Franklin Street Partners Limited Partnership, or the "Partnership", prior to January 1, 2002) was formed as a Massachusetts limited partnership on February 4, 1997. In December 2001, the limited partners of the Partnership approved the conversion of the Partnership from a partnership into a corporation (the "Conversion"). The Conversion was effective January 1, 2002, and was accomplished as a tax-free reorganization by merging the Partnership with and into a wholly owned subsidiary, Franklin Street Properties Corp., with the subsidiary as the surviving entity. In 2002, the Company elected to be taxed as a real estate investment trust ("REIT"). As part of the Conversion, all of the Partnership's outstanding units were converted on a one-for-one basis into 24,586,249 shares of common stock of the Company. The Conversion was accounted for as a reorganization of affiliated entities, with assets and liabilities recorded at their historical costs. On May 30, 2003, the shareholders of the Company approved the Company's acquisition by merger of 13 REITs (the "Target REITs"). The mergers were effective June 1, 2003 and, as a result, the Company issued 25,000,091 shares in a tax-free exchange for all the outstanding preferred shares of the Target REITs. The mergers were accounted for as a purchase and the acquired assets and liabilities were recorded at their fair value. The Company operates in two business segments: real estate operations and investment banking/investment services. As part of the Company's real estate operations segment, FSP Property Management LLC, a wholly owned subsidiary of the Company, provides asset management and property management services for our properties and for the Sponsored REITs. As part of the Company's investment banking/investment services segment, FSP Investments LLC, a wholly owned subsidiary of the Company, provides real estate investment and broker/dealer services. FSP Investments' services include: (i) the organization of REIT entities (the "Sponsored REITs"), which are syndicated through private placements; (ii) the acquisition of real estate on behalf of the Sponsored REITs; and (iii) the sale of preferred stock in Sponsored REITs. As of June 30, 2004, the Company has a non-controlling interest in twelve Sponsored REITs. Properties The following table summarizes the Company's investment in real estate assets, excluding assets held for syndication: As of June 30, 2004 2003 --------- --------- Residential real estate Number of properties 4 5 Number of apartments 837 996 Commercial real estate Number of properties 24 24 Square feet 3,049,357 3,049,357 6
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 1. Organization, Properties, Basis of Presentation and Recent Accounting Pronouncements (continued) Basis of Presentation The unaudited consolidated financial statements of the Company include all the accounts of the Company and its wholly and majority owned subsidiaries. All significant intercompany balances and transactions have been eliminated. These financial statements should be read in conjunction with the Company's financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for its fiscal year ended December 31, 2003. The accompanying interim financial statements are unaudited; however, the financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in conjunction with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting solely of normal recurring matters) necessary for a fair presentation of the financial statements for these interim periods have been included. Certain prior-year balances have been reclassified in order to conform to the current-year presentation. Recent Accounting Standards In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities. In December 2003, the FASB revised FIN 46 with certain modifications and clarifications. The objective of this interpretation is to provide guidance on how to identify a variable interest entity ("VIE") and determine when the assets, liabilities, non-controlling interests, and results of operations of a VIE need to be included in a company's consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Application of this guidance was effective for all enterprises with VIEs created after January 31, 2003. In December 2003, FASB issued a revised FIN 46 which provided for the deferral of the effective date of the interpretation to January 1, 2004, for VIEs created prior to January 31, 2003. The adoption of FIN 46 had no effect on our financial statements. 2. Investment Banking/Investment Services Activity During the six months ended June 30, 2004, the Company sold on a best efforts basis, through private placements, the preferred stock in the following Sponsored REITs: <TABLE> <CAPTION> Date Syndication Gross Proceeds Sponsored REIT Property Location Completed (in thousands) --------------------------------------------------------------------------------------------------- <S> <C> <C> <C> FSP Blue Lagoon Drive Corp. Miami, FL January 30, 2004(1) $ 3,925 FSP Eldridge Green Corp. Houston, TX March 25, 2004 45,250 FSP Highland Place I Corp. Englewood, CO May 13, 2004 21,000 FSP Satellite Place Corp. Duluth, GA June 21, 2004 27,700 FSP 1441 Main Street Corp. Columbia, SC July 26, 2004 34,350(2) --------- Total $ 132,225 ========= </TABLE> 1. The syndication of the Blue Lagoon Drive Corp. commenced in the fourth quarter of 2003. 2. The syndication of FSP 1441 Main Street Corp. was not complete at June 30, 2004. This represents the gross proceeds syndicated as of June 30, 2004. An additional $2,650,000 was syndicated in July 2004. Of the $132,225,000 gross proceeds from the sale of preferred stock in Sponsored REITs, approximately $49,175,000 was syndicated in the three months ended March 31, 2004 and $83,050,000 was syndicated in the three months ended June 30, 2004. 7
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 2. Investment Banking/Investment Services Activity (continued) The Company has in the past acquired by merger entities similar to the Sponsored REITs. The Company's business model includes the potential acquisition by merger in the future of Sponsored REITs. However, the Company has no legal or any other enforceable obligation to acquire or to offer to acquire any Sponsored REIT. In addition, any offer (and the related terms and conditions) that might be made in the future to acquire any Sponsored REIT would require the approval of the boards of directors of the Company and the Sponsored REIT, the approval of the shareholders of the Sponsored REIT, and any such acquisition may also require the approval of the shareholders of the Company. 3. Related Party Transactions and Investments in Non-consolidated Entities The Company typically purchases and retains a non-controlling common stock ownership interest in Sponsored REITs that it has organized. These ownership interests have virtually no economic benefit or risk. In January 2004 the Company also purchased 49.25 preferred shares or 8.22% of FSP Blue Lagoon Drive Corp. for $4,248,000 ($4,925,000 less non-recorded commissions of $394,000 and loan fees of $283,000). At June 30, 2004, December 31, 2003 and June 30, 2003, the Company had ownership interests in twelve, eight and five Sponsored REITs, respectively. Summarized financial information for the Sponsored REITs is as follows: June 30, December 31, (unaudited) 2004 2003 --------- ----------- (in thousands) Balance Sheet Data: ------------------- Real estate, net $ 376,473 $ 257,700 Other assets 46,045 53,646 Total liabilities (6,783) (18,129) ---------------------------- Shareholders' equity $ 415,735 $ 293,217 ============================ <TABLE> <CAPTION> For the For the Three Months Ended Six Months Ended June 30, June 30, 2004 2003 2004 2003 ---------------------------------------------- (in thousands) <S> <C> <C> <C> <C> Operating Data: --------------- Rental revenue $ 13,548 $ 6,052 $ 26,554 $ 10,857 Other revenue 124 38 244 76 Operating and maintenance expenses (4,359) (2,141) (8,212) (3,662) Depreciation and amortization (3,195) (1,504) (6,245) (2,267) Interest expense and commitment fees (4,918) (3,591) (8,250) (5,597) ---------------------------------------------- Net income (loss) $ 1,200 $(1,146) $ 4,091 $ (593) ============================================== </TABLE> The Company's proportionate share of revenue and expenses prior to completion of the syndication from these Sponsored REITs is shown in the following table: For the For the Three Months Ended Six Months Ended June 30, June 30, 2004 2003 2004 2003 ---------------------------------------------- (in thousands) Revenue $ 709 $ 517 $ 2,334 $ 901 Expenses (635) (350) (1,678) (641) ---------------------------------------------- Net income $ 74 $ 167 $ 656 $ 260 ============================================== 8
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 3. Related Party Transactions and Investments in Non-consolidated Entities (continued) The Company also recognized $112,000 for the six months ended June 30, 2004, which was the Company's equity in earnings resulting from its interest in preferred stock of FSP Blue Lagoon Drive Corp. and is included in "Other" revenue in the Consolidated Statements of Income. The Company provided syndication and real estate acquisition advisory services for the Sponsored REITs in 2004 and 2003. For the three months ended June 30, 2004 and 2003, respectively, syndication fees were approximately $5.4 million and $2.2 million, and transaction fees were approximately $5.1 million and $2.2 million. For the six months ended June 30, 2004 and 2003, respectively, syndication fees were approximately $8.4 million and $5.4 million, and transaction fees were approximately $8.7 million and $5.4 million. Asset management fees charged by the Company to the Sponsored REITs and reported as revenue by the Company amounted to approximately $140,000 and $149,000 for the three months ended June 30, 2004 and 2003, respectively, and $255,000 and $298,000 for the six months ended June 30, 2004 and 2003, respectively, and is included in "Other" revenue in the Consolidated Statements of Income. Asset management fees range from 1% to 5% of collected rents and the applicable contracts are cancelable with 30 days' notice. 4. Bank Note Payable The Company has a revolving line of credit agreement (the "Loan Agreement") with a group of banks providing for borrowings at the Company's election of up to $125,000,000. Borrowings under the Loan Agreement bear interest at either the bank's base rate or a variable LIBOR rate, as defined. The balance outstanding was $0 and $4,117,000 as of June 30, 2004 and December 31, 2003, respectively. The Loan Agreement includes restrictions on property liens and requires compliance with various financial covenants. Financial covenants include the maintenance of at least $1,500,000 in operating cash accounts, a minimum tangible net worth and compliance with various debt and operating income ratios, as defined in the Loan Agreement. The Company was in compliance with the Loan Agreement's financial covenants as of June 30, 2004. The Loan Agreement matures on August 18, 2005. 5. Net Income Per Share Basic net income per share is computed by dividing net income by the weighted average number of Company shares outstanding during the period. Diluted net income per share reflects the potential dilution that could occur if securities or other contracts to issue shares were exercised or converted into shares. There were no potential dilutive shares outstanding at or during the periods ended June 30, 2004 and 2003. 6. Business Segments The Company operates in two business segments: real estate operations (including real estate leasing, interim acquisition financing and asset/property management) and investment banking/investment services (including real estate acquisition and broker/dealer services). The Company has identified these segments because this discrete information is the basis upon which management makes decisions regarding resource allocation and performance assessment. The accounting policies of the reportable segments are the same as those described in the "Significant Accounting Policies" set forth in Note 2 to the Company's audited financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. The Company's segments are located in the United States of America. 9
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 6. Business Segments (continued) The Company evaluates the performance of its reportable segments based on Cash Available for Distribution ("CAD") as management believes that CAD represents the most accurate measure of the reportable segment's activity and is the basis for distributions paid to equity holders. The Company defines CAD as: net income as computed in accordance with accounting principles generally accepted in the United States of America ("GAAP"); plus certain non-cash items included in the computation of net income (depreciation and amortization, gain or loss on the sale of real estate, equity in earnings from non-consolidated REITs net of cash received, certain non-cash compensation expenses and straight-line rent adjustments); plus the net proceeds from the sale of land; less capital expenditures and payments for deferred leasing commissions, plus proceeds from (payments to) cash reserves established at the acquisition date of the property. Depreciation and amortization, gain or loss on the sale of real estate, equity in earnings from non-consolidated REITs net of cash received, non-cash compensation and straight-line rents are an adjustment to CAD, as these are non-cash items included in net income. Capital expenditures, payments of deferred leasing commissions and the proceeds from (payments to) the funded reserve are an adjustment to CAD, as they represent cash items not reflected in net income. The funded reserve represents funds that the Company has set aside in anticipation of future capital needs. These reserves are typically used for the payment of capital expenditures, deferred leasing commissions and certain tenant allowances; however, there are no legal restrictions on their use and they may be used for any Company purpose. CAD should not be considered as an alternative to net income (determined in accordance with GAAP), as an indicator of the Company's financial performance, nor as an alternative to cash flows from operating activities (determined in accordance with GAAP), nor as a measure of the Company's liquidity, nor is it necessarily indicative of sufficient cash flow to fund all of the Company's needs. Other real estate companies may define CAD in a different manner. It is at the Company's discretion to retain a portion of CAD for operational needs. We believe that in order to facilitate a clear understanding of the results of the Company, CAD should be examined in connection with net income and cash flows from operating, investing and financing activities in the consolidated financial statements. 10
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 6. Business Segments (continued) Cash Available for Distribution by business segment is as follows (in thousands): <TABLE> <CAPTION> Investment Banking/ Rental Operations Investment Services Totals ----------------- ------------------- ------ <S> <C> <C> <C> Three Months Ended March 31, 2003 Net Income $ 6,986 $ 302 $ 7,288 Depreciation and amortization 901 30 931 Straight line rent 432 -- 432 Gain on sale of property (1,421) -- (1,421) Capital expenditures (183) -- (183) Payment of deferred leasing costs (53) -- (53) Proceeds from funded reserve 191 -- 191 -------- -------- -------- Cash Available for Distribution $ 6,853 $ 332 $ 7,185 ======== ======== ======== Three Months Ended June 30, 2003 Net Income $ 6,474 $ 309 $ 6,783 Depreciation and amortization 1,530 (23) 1,507 Straight line rent 208 -- 208 Capital expenditures and capitalized merger costs (1,525) -- (1,525) Payment of deferred leasing costs (94) -- (94) Proceeds from funded reserve 615 -- 615 -------- -------- -------- Cash Available for Distribution $ 7,208 $ 286 $ 7,494 ======== ======== ======== Six Months Ended June 30, 2003 Net Income 13,460 611 14,071 Depreciation and amortization 2,431 7 2,438 Straight line rent 640 -- 640 Gain on sale of property (1,421) -- (1,421) Capital expenditures and capitalized merger costs (1,708) -- (1,708) Payment of deferred leasing costs (147) -- (147) Proceeds from funded reserve 806 -- 806 -------- -------- -------- Cash Available for Distribution $ 14,061 $ 618 $ 14,679 ======== ======== ======== </TABLE> 11
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 6. Business Segments (continued) Cash Available for Distribution by business segment is as follows (in thousands): <TABLE> <CAPTION> Investment Banking/ Rental Operations Investment Services Totals ----------------- ------------------- ------ <S> <C> <C> <C> Three Months Ended March 31, 2004 Net Income $ 12,739 $ 480 $ 13,219 Depreciation and amortization 3,235 24 3,259 Straight line rent revenue (340) -- (340) Non-cash compensation expense -- 162 162 Capital expenditures (100) (17) (117) Payment of deferred leasing costs (151) -- (151) Equity in earnings from non-consolidated REITs, net of cash received (44) -- (44) Proceeds from funded reserves 251 -- 251 -------- -------- -------- Cash Available for Distribution $ 15,590 $ 649 $ 16,239 ======== ======== ======== Three Months Ended June 30, 2004 Net Income $ 12,780 $ 896 $ 13,676 Depreciation and amortization 3,501 55 3,556 Straight line rent revenue (514) -- (514) Capital expenditures (430) (72) (502) Payment of deferred leasing costs (101) -- (101) Payments to (proceeds from) funded reserve 531 -- 531 Equity in earnings from non-consolidated REITs, net of cash received (9) -- (9) -------- -------- -------- Cash Available for Distribution $ 15,758 $ 879 $ 16,637 ======== ======== ======== Six Months Ended June 30, 2004 Net Income $ 25,519 $ 1,376 $ 26,895 Depreciation and amortization 6,736 79 6,815 Straight line rent revenue (854) -- (854) Capital expenditures (530) (89) (619) Payment of deferred leasing costs (252) -- (252) Payments to (proceeds from) funded reserve 782 -- 782 Non-cash compensation -- 162 162 Equity in earnings from non-consolidated REITs, net of cash received (53) -- (53) -------- -------- -------- Cash Available for Distribution $ 31,348 $ 1,528 $ 32,876 ======== ======== ======== </TABLE> 12
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 6. Business Segments (continued) The following table is a summary of other financial information by business segment (in thousands): <TABLE> <CAPTION> Investment Banking/ Rental Operations Investment Services Totals ----------------- ------------------- ------ <S> <C> <C> <C> Three Months Ended June 30, 2004: Revenue $ 22,857 $ 5,822 $ 28,679 Interest Income 117 5 122 Interest Expense 253 -- 253 Capital Expenditures 430 72 502 Total assets at June 30, 2004 $518,313 $ 5,513 $523,826 Three Months Ended June 30, 2003: Revenue $ 12,107 $ 2,535 $ 14,642 Interest Income 40 19 59 Interest Expense 207 -- 207 Income from discontinued operations 49 -- 49 Capital Expenditures 1,525 -- 1,525 Total assets at June 30, 2003 $565,261 $ 6,083 $571,344 Six Months Ended June 30, 2004: Revenue $ 45,749 $ 9,584 $ 55,333 Interest Income 328 21 349 Interest Expense -- -- 517 Capital Expenditures 530 89 619 Total assets at June 30, 2004 $518,313 $ 5,513 $523,826 Six Months Ended June 30, 2003: Revenue $ 21,248 $ 5,942 $ 27,190 Interest Income 68 40 108 Interest Expense 538 -- 538 Income from discontinued operations 144 -- 144 Capital Expenditures 1,708 -- 1,708 Total assets at June 30, 2003 $565,261 $ 6,083 $571,344 </TABLE> 13
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 7. Cash Dividends The Company declared and paid dividends as follows (in thousands, except per share amounts): Dividends Per Total Quarter Paid Share Dividends ---------------------- ------------- --------- First Quarter of 2004 $0.31 $ 15,382 Second Quarter of 2004 0.31 15,385 -------- $ 30,767 ======== 8. Income Taxes The Company has elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"). As a REIT, the Company generally is entitled to a tax deduction for dividends paid to its shareholders, thereby effectively subjecting the distributed net income of the Company to taxation at the shareholder level only. The Company must comply with a variety of restrictions to maintain its status as a REIT. These restrictions include the type of income it can earn, the type of assets it can hold, the number of shareholders it can have and the concentration of their ownership, and the amount of the Company's income that must be distributed annually. One such restriction is that the Company generally cannot own more than 10% of the voting power or value of the securities of any one issuer unless the issuer is itself a REIT or a "taxable REIT subsidiary" ("TRS"). The Company's ownership of securities in all TRSs generally cannot exceed 20% of the value of all of the Company's assets and, when considered together with other non-real estate assets, cannot exceed 25% of the value of all of the Company's assets. Effective January 1, 2001, FSP Investments has elected to be treated as a TRS. As a result, FSP Investments operates as a taxable corporation under the Code and has accounted for income taxes in accordance with the provisions of Statement of Financial Accounting Standard ("SFAS") No. 109, Accounting for Income Taxes. Taxes are provided when FSP Investments has net profits for both financial statement and income tax purposes. Income taxes are recorded based on the future tax effects of the difference between the tax and financial reporting bases of the Company's assets and liabilities. In estimating future tax consequences, potential future events are considered except for potential changes in income tax law or in rates. The income tax expense reflected in the consolidated statement of income relates only to FSP Investments. The expense differs from the amounts computed by applying the Federal statutory rate of 35% to income before income taxes as follows: <TABLE> <CAPTION> For the For the Six Months Six Months Ended Ended (in thousands) June 30, 2004 June 30, 2003 ------------- ------------- <S> <C> <C> Federal income tax expense at statutory rate $ 823 $ 362 Increase in taxes resulting from: State income taxes, net of federal impact 145 63 Other 8 -- ------------- ------------- $ 976 $ 425 ============= ============= </TABLE> No deferred income taxes were provided as there were no material temporary differences between the financial reporting basis and the tax basis of FSP Investments. 14
Franklin Street Properties Corp. Notes to Consolidated Financial Statements (Unaudited) 9. Merger Transactions On June 1, 2003, the Company issued approximately 25 million shares of common stock, $0.0001 par value per share in exchange for all of the outstanding preferred stock of 13 Sponsored REITs it acquired by merger. The results of operations for each of the Sponsored REITs have been included in the Company's consolidated financial statements since that date. The merger transactions were structured as exchanges of shares and no cash was involved. The aggregate purchase price was approximately $321 million. On the acquisition date, for each Sponsored REIT, the increase between the appraised value of the property and the historical cost of the property was allocated to real estate investments and leases, including lease origination costs. Lease origination costs represent the value associated with acquiring an in-place lease (i.e. the market cost to execute a similar lease, including leasing commission, legal, vacancy, and other related costs). The value assigned to buildings approximates their replacement cost; the value assigned to land approximates its appraised value; and the value assigned to leases approximates their fair value. Other assets and liabilities are recorded at their historical costs, which approximates fair value. Pro forma operating results for the Company and the 13 Sponsored REITs the Company acquired during 2003 are shown in the following table. The results assume that the mergers occurred and the shares of the Company's stock were issued on January 1, 2003 and are not necessarily indicative of what the Company's actual financial position or results of operations would have been for the period indicated, nor do they purport to represent the results of operations for any future period. For the Six Months Ended June 30, 2003 ---------------- Revenues $ 46,418 Expenses (25,271) Interest income 224 Taxes on income (425) --------- Net income from continuing operations 20,946 Income from discontinued operations 1,432 --------- Net income $ 22,378 ========= Weighted average shares outstanding 49,630 ========= Net income per share $ 0.45 ========= 10. Subsequent Events The Company declared a dividend of $0.31 per share on July 30, 2004 to shareholders of record as of July 30, 2004. 15
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report and in our Annual Report on Form 10-K for the year ended December 31, 2003. Historical results and percentage relationships set forth in the Consolidated Statements of Income contained in the financial statements, including trends which might appear, should not be taken as necessarily indicative of future operations. This discussion may also contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. For purposes of these Acts, any statement that is not a statement of historical fact may be deemed a forward-looking statement. The forward-looking statements found in this Quarterly Report on Form 10-Q are based on current judgments and current knowledge of management, which are subject to certain risks, trends and uncertainties that could cause actual results to differ materially from those indicated in such forward-looking statements. Accordingly, readers are cautioned not to place undue reliance on forward-looking statements. Investors are cautioned that our forward-looking statements involve risks and uncertainty, including without limitation, changes in economic conditions in the markets in which we own properties, expectations with respect to individual properties owned by us, changes in the demand by investors for investment in Sponsored REITs, risks of a lessening of demand for the types of real estate owned by us, changes in government regulations, and expenditures that cannot be anticipated such as utility rate and usage increases, unanticipated repairs, additional staffing, insurance increases and real estate tax valuation reassessments. See the factors set forth below under the caption, "Certain Factors That May Affect Future Results". Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We will not update any of the forward-looking statements after the date this quarterly report is filed to conform them to actual results or to changes in our expectations that occur after such date, other than as required by law. Overview FSP Corp. operates in two business segments: real estate operations and investment banking/investment services. The real estate operations segment involves real estate rental operations, leasing, interim acquisition financing and asset/property management services. The investment banking/investment services segment involves the provision of real estate investment and broker/dealer services that include the organization of Sponsored REITs, the acquisition of real estate on behalf of Sponsored REITs and the syndication of Sponsored REITs through sale of preferred stock in private placements. The main factor that affects our real estate operations is the broad economic market conditions in the United States. These market conditions affect the occupancy levels and the rent levels on both a national and local level. We have no influence on the national market conditions. We look to acquire quality properties in good locations in order to lessen the impact of downturns in the market and to take advantage of upturns when they occur. Our investment banking/investment services customers are primarily institutions and high net-worth individuals. To the extent that the broad capital markets affect these investors our business is also affected. These investors have many investment choices. We must continually search for real estate at a price and at a competitive risk/reward rate of return that meets our customer's risk/reward profile for providing a stream of income and as a long-term hedge against inflation. Critical Accounting Policies We have certain critical accounting policies that are subject to judgments and estimates by our management and uncertainties of outcome that affect the application of these policies. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances. On an on-going basis, we evaluate our estimates. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. The accounting policies that we believe are most critical to the understanding of our financial position and results of operations, and that require significant management estimates and judgments, are discussed in Item 7, Management's Discussion and Analysis of Financial Conditions and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2003. 16
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Critical Accounting Policies (continued) Critical accounting policies are those that have the most impact on the reporting of our financial condition and results of operations and those requiring significant judgments and estimates. We believe that our judgments and assessments are consistently applied and produce financial information that fairly presents our results of operations. No changes to our critical accounting policies have occurred since our Annual Report on Form 10-K for the year ended December 31, 2003 except with respect to our accounting policy regarding "Ownership of stock in a Sponsored REIT" as described below. This policy was previously reported on our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2004. Ownership of Stock in a Sponsored REIT We typically purchase and retain a common stock ownership in a Sponsored REIT following syndication, and earn an ongoing asset and/or property management fee. Accordingly, transaction fee revenue and our share of the operations of these Sponsored REITs are not classified as discontinued operations due to our continuing involvement. Our investment in non-consolidated REITs represents our investment in the common and preferred stock in Sponsored REITs. We account for these investments using the equity method of accounting as we exercise significant influence over, but do not control, these entities. Under the equity method of accounting we record our percentage share of net earnings from these investments and our investment balance of these entities is subsequently adjusted. Equity in the losses of these entities is not recognized to the extent that the investment balance would become negative. Dividends are recognized as income after the investment balance is reduced to zero. Under the equity method, accounting policy judgments made by the Sponsored REITs could have a material affect on our net income. Also, if we determine that there is an other than temporary decline in the fair value of any of these investments, its investment balance would be written down to fair value and the amount of the write down would be included in our earnings. In evaluating the fair value of these investments, we have considered, among other things, the financial condition and near term prospects of the investment, earnings trends, asset quality, asset valuation models, and the financial condition and prospects for its industry. Incorrect assumptions may incorrectly report the carrying value of the asset and incorrectly report revenue. Trends and Uncertainties Real Estate Operations The portfolio remained 90% leased at the end of the second quarter. No major leases expired during the quarter, and no new large leases were signed. Our three Houston area apartments continue to face weakened demand for apartment units. No major improvement in rents or occupancy is expected in the next quarter, although an increase in mortgage interest rates could help to increase the supply of renters versus homebuyers. During the second quarter of 2004, we continued to see an increase in leasing activity in the office sector with a slight improvement in occupancy and absorption rates in some of our markets, but we cannot predict if this leasing activity will lead to an increase in occupancy in our buildings, which markets will improve first, or if there will be an increase in rental rates. Some of our current office vacancy is a result of large corporations shedding excess space that they acquired as a result of a merger or acquisition, and we expect to see that trend continue in the next quarter. If we cannot lease the space given back by those tenants before their leases expire, then our occupancy rates could decrease. We expect the competition for office tenants that we experienced in the first half of the year to continue in the third quarter of 2004 and to cause leasing commissions, tenant improvements, and rent concessions to remain high. Our utility costs have increased, and we expect our utility costs to follow the national trends. While many of our leases allow us to pass the increase in utility costs on to the tenants, not all of our leases allow us to do so. We also have to pay for the costs if the space becomes vacant. In contrast to utility costs, we may realize a reduction in real estate taxes at many of our buildings if the abatements of real estate tax assessments that we have received as a result of appeals are not offset by increases in tax rates by the local municipalities. 17
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) The following table summarizes property wholly owned by us as of the dates indicated: June 30, ---------------------------- 2004 2003 Residential: Number of properties 4 5 Number of apartment units 837 996 Commercial: Number of properties 24 24 Square footage 3,049,357 3,049,357 Investment Banking/Investment Services Unlike our real estate operations business, which provides a rental revenue stream which is ongoing and recurring in nature, our investment banking/investment services business is transactional in nature. Both the number of Sponsored REIT syndications completed and the amount of equity raised in 2003 were below our expectations. Syndication business in the first half of 2004 was also slightly below already reduced expectations. Future business in this area is unpredictable. Our property acquisition executives continue to be concerned about high valuation levels for prime commercial investment real estate in 2004. It appears that a combination of factors, including relatively low interest rates, a recovering general economy and increased capital allocation to real estate assets, is increasing prices on many properties we would have an interest in acquiring. This general price increase is causing capitalization rates to fall and prices per square foot to rise. Specifically, our acquisition executives fear that we will not be able to purchase enough property during the second half of 2004 at a price acceptable under our investment criteria to grow our overall investment banking/investment services business for the full year. In the first half of 2004 investment demand by our client base exceeded our ability to acquire acceptable properties. If this situation continues into the second half of the year, lower revenues from this business could reduce the cash available for distribution to stockholders as dividends. However, the same capital market forces that are causing higher real estate prices and difficulties in achieving property acquisition goals are also presenting some appealing opportunities for the dispositions of certain of our assets. Although our general intention is to hold our properties for long-term appreciation, if opportunities present themselves that are sufficiently attractive, we may take advantage of the current market environment in 2004 and sell certain selected real estate assets. The sale of these assets could generate cash gains available for distribution to shareholders as dividends. We continue to rely solely on our in-house investment executives to access interested investors who have capital they can afford to place in an illiquid position for an indefinite period of time (i.e., invest in a Sponsored REIT). While we continue to expand our in-house sales force, uncertainties always exist as to whether we are capable, either through our existing client base or through new clients, of raising the amount of capital invested in Sponsored REITs to achieve future performance objectives. 18
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations The following table shows variance in dollars for the three and six months ended June 30, 2004 and 2003: <TABLE> <CAPTION> Variance Variance For the three For the six (in thousands) months ended months ended June 30, June 30, 2004 and 2003 2004 and 2003 ------------- ------------- <S> <C> <C> Revenue Rental operations Rental income $ 7,582 $ 20,228 Transaction income 2,918 2,705 Sponsored REIT income 192 1,433 Other 59 136 -------- -------- Total rental operations 10,751 24,502 -------- -------- Investment banking/investment services Syndication fees 3,233 3,041 Transaction fees 53 600 -------- -------- Total investment banking/investment services revenue 3,286 3,641 -------- -------- Total revenue 14,037 28,143 -------- -------- Expenses Rental operations Rental operating expenses 1,320 3,186 Real estate taxes and insurance 1,040 2,663 Depreciation and amortization 1,988 4,364 Sponsored REIT expense 285 1,037 Selling, general and administrative (207) (92) Interest Expense 46 (21) -------- -------- Total rental operations 4,472 11,137 -------- -------- Investment banking/investment services Selling, general and administrative 479 492 Commission expense 1,677 1,581 Depreciation and amortization 78 72 Shares issued as compensation -- 162 -------- -------- Total investment banking/investment services 2,234 2,307 -------- -------- Total expenses 6,706 13,444 -------- -------- Income before interest income and taxes on income 7,331 14,699 Interest income 63 241 Taxes on income 452 551 -------- -------- Income from continuing operations 6,942 14,389 Income from discontinued operations (49) (144) Gain on sale of real estate from discontinued operations -- (1,421) -------- -------- Net income $ 6,893 $ 12,824 ======== ======== </TABLE> 19
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Comparison of the three months ended June 30, 2004 to the three months ended June 30, 2003: We completed the syndication of two Sponsored REITs and substantially completed the syndication of a third Sponsored REIT in the three months ended June 30, 2004. The aggregate proceeds from the syndication of these three Sponsored REITs was $83.0 million, an increase of $50.6 million compared to the gross proceeds of $32.4 million in the comparable period in 2003 from the partial syndication of one Sponsored REIT. On June 1, 2003 we completed the acquisition by merger of 13 Sponsored REITs. This merger more than doubled the size of our real estate operations. The results of operations for these 13 properties are included in our operating results for three months in 2004 compared to one month in 2003. We operated 28 properties for the three-month period ended June 30, 2004, and 15 properties for two months, and 28 properties for one month, in the comparable period of 2003. Increases in rental revenues and expenses for the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 are primarily a result of this merger. The results of operations for the two properties that were sold in 2003 have been classified as discontinued operations. Revenue Total revenues increased $14.0 million, or 96%, to $28.7 million for the three months ended June 30, 2004, as compared to $14.6 million for the comparable period in 2003. Income from rental operations was $22.9 million for the three months ended June 30, 2004, an increase of $10.7 million, or 89%, compared to the three months ended June 30, 2003. The increase is attributable to: o An increase in rental revenue $7.6 million of which $7.4 million relates to the 13 properties acquired by the Company in June 2003; o An increase in transaction fees of $2.9 million as a result of increased syndication activity; and o Sponsored REIT income of $0.2 million as a result of increased syndication activity. Investment banking/investment services revenue was $5.8 million for the three months ended June 30, 2004, an increase of $3.3 million, or 130%, compared to the three months ended June 30, 2003. The increase is attributable to the increase in syndication activity. Expenses Total expenses were $14.4 million for the three months ended June 30, 2004, an increase of $6.7 million, or 86%, compared to the three months ended June 30, 2003. Expenses for rental operations were $10.2 million for the three months ended June 30, 2004, a net increase of $4.5 million, or 78%, compared to the three months ended June 30, 2003. The increase is attributable to: o Rental operation expenses aggregating $4.5 million for the 13 properties acquired by the Company in June, 2003; o An increase of $0.3 million of Sponsored REIT expenses as a result of increased syndication activity o These expenses were offset by a decrease in selling, general and administrative expenses of $0.2 million relating to certain professional fees incurred in 2003 but did not occur in 2004. Expenses for investment banking services were $4.3 million for the three months ended June 30, 2004, an increase of $2.2 million, or 109%, compared to the three months ended June 30, 2003. The increase is attributable to: o An increase of $1.7 million of commission expenses relating to increased syndication activity; o An increase of $0.5 million in selling, general and administrative expenses of which $0.2 million relates to an investor relations consulting project; and $0.3 million relates to a general increase in overhead costs resulting from increased personnel and occupancy costs; Interest income for the three month period ended June 30, 2004 was consistent with the comparable period of 2003. Taxes on income increased $0.5 million as a result of increased syndication activity. The tax rate was consistent with the comparable period of 2003. 20
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Comparison of the six months ended June 30, 2004 to the six months ended June 30, 2003: We completed the syndication of four Sponsored REITs and substantially completed the syndication of a fifth Sponsored REIT in the six months ended June 30, 2004. The total proceeds from the syndication of these five Sponsored REITs was $132.2 million, an increase of $46.9 million compared to total gross proceeds of $85.3 million in the comparable period in 2003 from the syndication of two Sponsored REITs. The results of operations for the 13 properties acquired in 2003 are included in our operating results for six months in 2004 compared to one month in 2003. We operated 28 properties for the six-month period ended June 30, 2004, and 15 properties for five months, and 28 properties for one month, in the comparable period of 2003. Increases in rental revenues and expenses in the six months ended June 30, 2004 are primarily a result of this merger. The results of operations for the two properties that were sold in 2003 have been classified as discontinued operations. Revenue Total revenue increased $28.1 million, or 103%, to $55.3 million for the six months ended June 30, 2004, as compared to $27.2 million for the comparable period in 2003. Revenue from rental operations was $45.7 million for the six months ended June 30, 2004, an increase of $24.5 million, or 115%, compared to the six months ended June 30, 2003. The increase is attributable to: o An increase in rental revenue of $20.2 million, of which $19.9 million relates to the 13 properties acquired by the Company in June 2003. This includes a lease termination fee of approximately $1.2 million paid by a tenant; o An increase in transaction income of $2.7 million and sponsored REIT income of $1.4 million, both as a result of our increased syndication activity in 2004; and o An increase in other revenue of $0.1 million primarily representing our proportionate share of income from FSP Blue Lagoon Drive Corp. in which we acquired an interest in preferred stock in January 2003. Investment banking/investment services revenue was $9.6 million for the six months ended June 30, 2004; an increase of $3.6 million, or 61%, compared to the six months ended June 30, 2003. The increase is attributable to the increase in gross syndication proceeds as discussed above. Expenses Total expenses were $27.8 million for the six months ended June 30, 2004, an increase of $13.4 million, or 94%, compared to the six months ended June 30, 2003. Expenses for rental operations were $20.6 million for the six months ended June 30, 2004, a net increase of $11.1 million, or 118%, compared to the six months ended June 30, 2003. The increase is attributable to: o Rental operation expenses aggregating $10.3 million for the 13 properties acquired by the Company in June, 2003; and o An increase of $1.0 million of Sponsored REIT expenses as a result of increased syndication activity. Expenses for investment banking services were $7.2 million for the six months ended June 30, 2004, an increase of $2.3 million, or 46%, compared to the six months ended June 30, 2003. The increase is attributable to: o An increase of $1.6 million in commissions and broker expenses as a result of increased syndication activity; o An increase of $0.1 million in office rents and occupancy expenses as a result of increasing office space in the third quarter of 2003; o An increase of $0.2 million relating to a investor relations consulting project; o Expenses of $0.2 million as a result of the issuance of shares as compensation in 2004. No shares were issued in 2003; and o An aggregate net increase of $0.2 million in other selling, general and administrative expenses. Interest income for the six-month period ended June 30, 2004 was consistent with the comparable period of 2003. Taxes on income increased $0.6 million as a result of increased syndication activity. The tax rate was consistent with the comparable period of 2003. 21
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources Cash and cash equivalents were $59.0 million and $58.8 million at June 30, 2004 and December 31, 2003, respectively. This increase of $0.2 million is attributable to $36.0 million provided by operating activities; $0.8 million used for investing activities; and $35.0 million used for financing activities. Operating Activities The cash provided by the Company's operating activities of $36.0 million is primarily attributable to net income of $26.9 million plus the add-back of $6.9 million from non-cash activity, principally consisting of depreciation and amortization, plus a $2.4 million net change in operating assets and liabilities, less payments for deferred leasing costs of $0.3 million. Investing Activities The Company's cash used for investing activities of $0.8 million is attributable to $4.1 million in proceeds from the sale of assets held for syndication offset by $0.6 million used for the purchase of real estate assets, office computers and furniture, and a $4.2 million investment in non-consolidated REIT. Financing Activities The Company's cash used for financing activities of $35.0 million is attributable to $4.1 million in payments on our line of credit, and $30.8 million of distributions to the Company's shareholders as dividends. Sources and Uses of Funds Our principal demands for liquidity are cash for operations, dividends to equity holders, debt repayments and expenses associated with indebtedness. As of June 30, 2004 we had approximately $10.8 million in liabilities. The Company has no permanent, long-term debt. In the near term, liquidity is generated from funds from ongoing real estate operations and transaction fees and commissions received in connection with the sale of shares in new Sponsored REITs. Contingencies We are subject to various legal proceedings and claims that arise in the ordinary course of its business. Although occasional adverse decisions (or settlements) may occur, we believe that the final disposition of such matters will not have a material adverse effect on our financial position or results of operations. Assets Held For Syndication In July 2004 we completed the syndication of FSP 1441 Main Street Corp. Related Party Transactions In the three months ended June 30, 2004, we completed the syndication of two Sponsored REITs and substantially completed the syndication of a third Sponsored REIT. The Company did not enter into any other significant transactions with related parties during the quarter ended June 30, 2004. For a discussion of transactions between the Company and related parties during 2003, see "Related Party Transactions" under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - of the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Economic Conditions We generally pay the ordinary annual operating expenses of our properties from the rental revenue generated by the properties. For the six months ended June 30, 2004, the rental income exceeded the expenses for each individual property, with the exception of Blue Ravine. The single tenant lease at the Blue Ravine property located in Folsom, California, expired June 30, 2003; there is no new lease, and we expect that the property will not produce revenue to cover its expenses in the third quarter. In addition to rental income we maintain cash reserves that may be used to fund unusual expenses or major capital improvements. The cash reserves included in cash and cash equivalents, which as of June 30, 2004 were approximately $15.7 million, are in excess of the known needs for extraordinary expenses or capital improvements for the real properties currently owned by us within the next year. There are no external restrictions on these reserves, and they may be used for any business purpose. Although there is no guarantee that we will be able to obtain the funds necessary for our future growth, we anticipate generating funds from continuing real estate operations and from fees and commissions from the sale of shares in newly formed Sponsored REITs. We believe that we have adequate funds to cover unusual expenses and capital improvements, in addition to normal operating expenses. Our ability to maintain or increase our level of dividends to stockholders, however, depends in part upon the level of interest on the part of investors in purchasing shares of Sponsored REITs and the level of rental income from our real properties. 22
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS The following important factors, among others, could cause actual results to differ materially from those indicated by forward-looking statements made in this Quarterly Report on Form 10-Q and presented elsewhere by management from time to time. If we are not able to collect sufficient rents from each of our owned real properties, we may suffer significant operating losses. A substantial portion of our revenues are generated by the rental income of our real properties. If our properties do not provide us with a steady rental income, our revenues will decrease and may cause us to incur operating losses in the future. We face risks in continuing to attract investors for Sponsored REITs. Our investment banking/investment services business continues to depend upon its ability to attract purchasers of equity interests in Sponsored REITs. Our success in this area will depend on the propensity and ability of investors who have previously invested in Sponsored REITs to continue to invest in future Sponsored REITs and on our ability to expand the investor pool for the Sponsored REITs by identifying new potential investors. Moreover, our investment banking/investment services business may be affected to the extent existing Sponsored REITs incur losses or have operating results that fail to meet investors' expectations. If we are unable to fully syndicate a Sponsored REIT, we may be required to keep a balance outstanding on our line of credit or use our cash balance to repay our line of credit, which may reduce cash available for distribution to our stockholders. We typically draw on our line of credit to make an interim mortgage loan to a Sponsored REIT, so that it can acquire real property prior to the consummation of the offering of its equity interests; this interim loan is secured by a first mortgage of the real property acquired by the Sponsored REIT. Once the offering has been completed, the Sponsored REIT repays the loan out of the offering proceeds. If we are unable to fully syndicate a Sponsored REIT, the Sponsored REIT could be unable to fully repay the loan, and we would have to satisfy our obligation under our line of credit through other means. If we are required to use cash for this purpose, we would have less cash available for distribution to our stockholders. We may not be able to find properties that meet our criteria for purchase. Growth in our investment banking/investment services business is dependent on the ability of our acquisition executives to find properties for sale which meet our investment criteria. To the extent they fail to find such properties, we will be unable to syndicate offerings of Sponsored REITs to investors, and this segment of our business could have lower revenue, which would reduce the cash available for distribution to our stockholders. We are dependent on key personnel. We depend on the efforts of George Carter, our Chief Executive Officer, and our other executive officers. If they were to resign, our operations could be adversely affected. We do not have employment agreements with Mr. Carter or any other of our executive officers. Our level of dividends may fluctuate. Because our investment banking/investment services business is transactional in nature and real estate occupancy levels and rental rates can fluctuate, there is no predictable recurring level of revenue from such activities. As a result of this, the amount of cash available for distribution may fluctuate, which may result in us not being able to maintain or grow dividend levels in the future. The real properties held by us may significantly decrease in value. As of June 30, 2004, we owned 28 properties. Some or all of these properties may decline in value. To the extent our real properties decline in value, our stockholders could lose some or all the value of their investments. 23
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) New acquisitions may fail to perform as expected. We may acquire new properties, whether by cash purchase, by acquisition of Sponsored REITs or by investment in a Sponsored REIT. Newly acquired properties may fail to perform as expected, in which case our results of operations could be adversely affected. We face risks in owning and operating real property. An investment in us is subject to the risks incident to the ownership and operation of real estate-related assets. These risks include the fact that real estate investments are generally illiquid, which may impact our ability to vary our portfolio in response to changes in economic and other conditions, as well as the risks normally associated with: o changes in general and local economic conditions; o the supply or demand for particular types of properties in particular markets; o changes in market rental rates; o the impact of environmental protection laws; and o changes in tax, real estate and zoning laws. Certain significant costs, such as real estate taxes, utilities, insurance and maintenance costs, generally are not reduced even when a property's rental income is reduced. In addition, environmental and tax laws, interest rate levels, the availability of financing and other factors may affect real estate values and property income. Furthermore, the supply of commercial and multi-family residential space fluctuates with market conditions. We face risks from tenant defaults or bankruptcies. If any of our tenants defaults on its lease, we may experience delays in enforcing our rights as a landlord and may incur substantial costs in protecting our investment. In addition, at any time, a tenant of one of our properties may seek the protection of bankruptcy laws, which could result in the rejection and termination of such tenant's lease and thereby cause a reduction in cash available for distribution to our stockholders. We may encounter significant delays in reletting vacant space, resulting in losses of income. When leases expire, we will incur expenses and may not be able to re-lease the space on the same terms. Certain leases provide tenants the right to terminate early if they pay a fee. If we are unable to re-lease space promptly, if the terms are significantly less favorable than anticipated or if the costs are higher, we may have to reduce distributions to our stockholders. We face risks from geographic concentration. The properties in our portfolio, by aggregate square footage, are distributed geographically as follows: Southwest - 26%, Northeast - 31%, Midwest - 19%, West - - 16% and Southeast 8%. However, within certain of those segments, we hold a larger concentration of our properties in Houston, Texas - 18% and Washington, DC - 13%. We are likely to face risks to the extent that any of these areas in which we hold a larger concentration of our properties suffer deteriorating economic conditions. We compete with national, regional and local real estate operators and developers, which could adversely affect our cash flow. Competition exists in every market in which our properties are located and in every market in which our properties will be located. We compete with, among others, national, regional and numerous local real estate operators and developers. Such competition may adversely affect the percentage of leased space and the rental revenues of our properties, which could adversely affect our cash flow from operations and our ability to make expected distributions to our stockholders. Some of our competitors may have more resources than we do or other competitive advantages. Competition may be accelerated by any increase in availability of funds for investment in real estate. For example, decreases in interest rates tend to increase the availability of funds and therefore can increase competition. To the extent that our properties continue to operate profitably, this will likely stimulate new development of competing properties. The extent to which we are affected by competition will depend in significant part on local market conditions. 24
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) There is limited potential for an increase in leased space gains in our properties. We anticipate that future increases in revenue from our properties will be primarily the result of scheduled rental rate increases or rental rate increases as leases expire. Properties with higher rates of vacancy are generally located in soft economic markets so that it may be difficult to realize increases in revenue when vacant space is re-leased. We are subject to possible liability relating to environmental matters, and we cannot assure you that we have identified all possible liabilities. Under various federal, state and local laws, ordinances and regulations, an owner or operator of real property may become liable for the costs of removal or remediation of certain hazardous substances released on or in its property. Such laws may impose liability without regard to whether the owner or operator knew of, or caused, the release of such hazardous substances. The presence of hazardous substances on a property may adversely affect the owner's ability to sell such property or to borrow using such property as collateral, and it may cause the owner of the property to incur substantial remediation costs. In addition to claims for cleanup costs, the presence of hazardous substances on a property could result in the owner incurring substantial liabilities as a result of a claim by a private party for personal injury or a claim by an adjacent property owner for property damage. In addition, we cannot assure you that: o future laws, ordinances or regulations will not impose any material environmental liability; o the current environmental conditions of our properties will not be affected by the condition of properties in the vicinity of such properties (such as the presence of leaking underground storage tanks) or by third parties unrelated to us; o tenants will not violate their leases by introducing hazardous or toxic substances into our properties that could expose us to liability under federal or state environmental laws; or o environmental conditions, such as the growth of bacteria and toxic mold in heating and ventilation systems or on walls, will not occur at our properties and pose a threat to human health. We are subject to compliance with the Americans With Disabilities Act and fire and safety regulations which could require us to make significant capital expenditures. All of our properties are required to comply with the Americans With Disabilities Act (ADA), and the regulations, rules and orders that may be issued thereunder. The ADA has separate compliance requirements for "public accommodations" and "commercial facilities," but generally requires that buildings be made accessible to persons with disabilities. Compliance with ADA requirements might require, among other things, removal of access barriers and noncompliance could result in the imposition of fines by the U.S. government, or an award of damages to private litigants. In addition, we are required to operate our properties in compliance with fire and safety regulations, building codes and other land use regulations, as they may be adopted by governmental agencies and bodies and become applicable to our properties. Compliance with such requirements may require us to make substantial capital expenditures, which expenditures would reduce cash otherwise available for distribution to its stockholders. There are significant conditions to our obligation to redeem shares of our common stock, and any such redemption will result in the stockholders tendering shares receiving less than their fair market value. Under our redemption plan, we are only obligated to use our best efforts to redeem shares of our common stock from stockholders wishing to have them redeemed. There are significant conditions to our obligation to redeem shares of our common stock including: o we cannot be insolvent or be rendered insolvent by the redemption; o the redemption cannot impair our capital or operations; o the redemption cannot contravene any provision of federal or state securities laws; o the redemption cannot result in our failing to qualify as a REIT; and o our management must determine that the redemption is in our best interests. Any redemption effected by us under this plan would result in those stockholders tendering shares of our common stock receiving 90% of the fair market value of such shares, as determined by our board of directors in its sole and absolute discretion, and not their full fair market value. 25
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) We may lose capital investment or anticipated profits if an uninsured event occurs. We carry or our tenants carry comprehensive liability, fire and extended coverage with respect to each of our properties, with policy specification and insured limits customarily carried for similar properties. There are, however, certain types of losses, such as from wars, pollution or earthquakes, that may be either uninsurable or not economically insurable (although the properties located in California all have earthquake insurance). Should an uninsured material loss occur, we could lose both capital invested in the property and anticipated profits. Contingent or unknown liabilities acquired in mergers or similar transactions could require us to make substantial payments. The properties which we acquired in mergers were acquired subject to liabilities and without any recourse with respect to liabilities, whether known or unknown. As a result, if liabilities were asserted against us based upon any of these properties, we might have to pay substantial sums to settle them, which could adversely affect our results of operations and financial condition and our cash flow and ability to make distributions to our stockholders. Unknown liabilities with respect to properties acquired might include: o liabilities for clean-up or remediation of environmental conditions; o claims of tenants, vendors or other persons dealing with the former owners of the properties; and o liabilities incurred in the ordinary course of business. We would incur adverse tax consequences if we failed to qualify as a REIT. If in any taxable year we do not qualify as a real estate investment trust, we would be taxed as a corporation and distributions to our stockholders would not be deductible by us in computing our taxable income. In addition, if we were to fail to qualify as a real estate investment trust, we could be disqualified from treatment as a real estate investment trust in the year in which such failure occurred and for the next four taxable years and, consequently, we would be taxed as a corporation during such years. Failure to qualify for even one taxable year could result in a significant reduction of our cash available for distribution to stockholders or could require us to incur indebtedness or liquidate investments in order to generate sufficient funds to pay the resulting federal income tax liabilities. In addition, timing differences between the receipt of income and payment of expenses and the inclusion and deduction of such amounts in arriving at taxable income could make it necessary for us to borrow in order to make certain distributions to our stockholders in satisfaction of the 90% distribution requirement applicable to real estate investment trusts. The provisions of the Internal Revenue Code governing the taxation of real estate investment trusts are very technical and complex, and although we expect that we will be organized and will operate in a manner that will enable us to meet such requirements, no assurance can be given that we will always succeed in doing so. In addition, you should note that if one or more of the REITs we acquired in June 2003 did not qualify as a real estate investment trust immediately prior to the consummation of the mergers, we would be disqualified as a REIT as a result of the mergers. As a result of our acquisition of 13 REITs, we may no longer qualify as a REIT. As a result of our acquisition of 13 REITs by merger in June 2003, we might no longer qualify as a real estate investment trust under Section 856 of the Internal Revenue Code of 1986, as amended. We could lose our ability to so qualify for a variety of reasons relating to the nature of the assets acquired from the acquired REITs, the identity of the shareholders of the acquired REITs who became our shareholders, or the failure of one or more of the acquired REITs to have previously qualified as a real estate investment trust. Provisions in our organizational documents may prevent changes in control. Our Articles of Incorporation and Bylaws contain provisions, described below, which may have the effect of discouraging a third party from making an acquisition proposal for us and may thereby inhibit a change of control under circumstances that could otherwise give the holders of our common stock the opportunity to realize a premium over the then-prevailing market prices. 26
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Ownership Limits. In order for us to maintain our qualification as a real estate investment trust, the holders of our common stock may be limited to owning, either directly or under applicable attribution rules of the Internal Revenue Code, no more than 9.8% of the lesser of the value or the number of equity shares of us, and no holder of common stock may acquire or transfer shares that would result in our shares of common stock being beneficially owned by fewer than 100 persons. Such ownership limit may have the effect of preventing an acquisition of control of us without the approval of our board of directors. Moreover, we will have the right to redeem any shares of common stock that are acquired or transferred in violation of these provisions at the market price, which is determined by our board of directors. In addition, our Articles of Incorporation give our board of directors the right to refuse to give effect to the acquisition or transfer of shares by a stockholder in violation of these provisions. Staggered Board. Our board of directors is divided into three classes. The terms of these classes will expire in 2005, 2006 and 2007, respectively. Directors of each class are elected for a three-year term upon the expiration of the initial term of each class. The staggered terms for directors may affect our stockholders' ability to effect a change in control even if a change in control were in the stockholders' best interests. Preferred Stock. Our Articles of Incorporation authorize our board of directors to issue up to 20,000,000 shares of preferred stock, par value $.0001 per share, and to establish the preferences and rights of any such shares issued. The issuance of preferred stock could have the effect of delaying or preventing a change in control even if a change in control were in our stockholders' best interest. Increase of Authorized Stock. Our board of directors, without any vote or consent of the stockholders, may increase the number of authorized shares of any class or series of stock or the aggregate number of authorized shares we have authority to issue. The ability to increase the number of authorized shares and issue such shares could have the effect of delaying or preventing a change in control even if a change in control were in our stockholders' best interest. Amendment of Bylaws. Our board of directors has the sole power to amend our Bylaws. This power could have the effect of delaying or preventing a change in control even if a change in control were in our stockholders' best interests. Stockholder Meetings. Our Bylaws require advance notice for stockholder proposals to be considered at annual meetings of stockholders and for stockholder nominations for election of directors at special meetings of stockholders. Our Bylaws also provide that stockholders entitled to cast more than 50% of all the votes entitled to be cast at a meeting must join in a request by stockholders to call a special meeting of stockholders. These provisions could have the effect of delaying or preventing a change in control even if a change in control were in the best interests of our stockholders. Supermajority Votes Required. Our Articles of Incorporation require the affirmative vote of the holders of no less than 80% of the shares of capital stock outstanding and entitled to vote in order (i) to amend the provisions of our Articles of Incorporation relating to the classification of directors, removal of directors, limitation of liability of officers and directors or indemnification of officers and directors or (ii) to amend our Articles of Incorporation to impose cumulative voting in the election of directors. These provisions could have the effect of delaying or preventing a change in control even if a change in control were in our stockholders' best interest. There is no public trading market for our securities. There is no public trading market for our common stock, and we cannot assure you that any market will develop or that, if such a market develops, there will be any liquidity in such a market for our common stock. We have announced our intention to file an application for the listing of our stock on the American Stock Exchange. However, there is no assurance that we will file such application, or in the event that we do, that the American Stock Exchange will accept it. Item 3. Quantitative and Qualitative Disclosures about Market Risk We were not a party to any derivative financial instruments at or during the three months ended June 30, 2004. We borrow from time to time on our line of credit. These borrowings bear interest at a variable rate. As of June 30, 2004, $0 was outstanding under this line of credit. We have used the funds from our line of credit for the purpose of making interim mortgage loans to Sponsored REITs. These mortgage loans bear interest at the same variable rate payable by us under our line of credit. Therefore, we believe that we have mitigated our interest rate risk with respect to our borrowings. 27
Item 4. Controls and Procedures. Our management, with the participation of FSP Corp.'s President and Chief Executive Officer and FSP Corp.'s Vice President and Chief Operating Officer (equivalent of Chief Financial Officer), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(d) under the Exchange Act) as of June 30, 2004. Based on this evaluation, FSP Corp.'s President and Chief Executive Officer and FSP Corp.'s Vice President and Chief Operating Officer (equivalent of Chief Financial Officer) concluded that, as of June 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to FSP Corp.'s President and Chief Executive Officer and FSP Corp.'s Vice President and Chief Operating Officer (equivalent of Chief Financial Officer) by others within these entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. No change to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 28
PART II - OTHER INFORMATION Item 1. Legal Proceedings: Not applicable. Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities: Not applicable. Item 3. Defaults Upon Senior Securities: Not applicable. Item 4. Submission of Matters to a Vote of Security Holders: On May 7, 2004, the Registrant held its 2004 Annual Meeting of Stockholders (the "2004 Annual Meeting"). The 2004 Annual Meeting was called for the following purposes: (1) to elect two Class II directors to serve until the 2007 annual meeting and (2) to transact such other business as may properly come before the meeting or any adjournment thereof. The following table sets forth the names of the directors elected at the 2004 Annual Meeting for new three-year terms and the number of votes cast for and withheld for each director: Withheld Directors For Authority to Vote --------- --- ----------------- Dennis J. McGillicudy 34,700,635.37 75,376.77 Janet P. Notopoulos 34,753,638.14 22,374.00 The names of each of the other directors whose terms of office continued after the 2004 Annual Meeting are as follows: George J. Carter, Barry Silverstein, Barbara J. Fournier and Richard R. Norris. Item 5. Other Information: Not applicable. Item 6. Exhibits and Reports on Form 8-K: (a) Exhibits: 31.1 Certification of the President and Chief Executive Officer of the Registrant pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Vice President, Chief Operating Officer (equivalent of Chief Financial Officer), Treasurer and Secretary of the Registrant pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the President and Chief Executive Officer of the Registrant pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of the Vice President, Chief Operating Officer (equivalent of Chief Financial Officer), Treasurer and Secretary of the Registrant pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: On May 7, 2004 the Registrant filed a current report on Item 9 of Form 8-K dated May 7, 2004 to report that George J. Carter, President, Chief Executive Officer, and a member of the Board of Directors of the Registrant, intended to inform the stockholders of the Registrant at the Annual Meeting of Stockholders that the Registrant's Board of Directors had authorized management to pursue a listing on the American Stock Exchange. On June 1, 2004 the Registrant filed a current report on Item 5 of Form 8-K dated June 1, 2004 to report that John Burke had been elected as a member of the Board of Directors of the Registrant and appointed as chairperson of the Audit Committee of the Board of Directors. 29
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Franklin Street Properties Corp. <TABLE> <CAPTION> Date Signature Title <S> <C> <C> July 30, 2004 /s/ George J. Carter Chief Executive Officer and ------------------ Director (Principal Executive Officer) George J. Carter July 30, 2004 /s/ Lloyd S. Dow Senior Vice President and Controller ----------------- (Principal Accounting Officer) Lloyd S. Dow </TABLE> 30