FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2004
OR
For the transition period from to
Commission file number 1-13100
HIGHWOODS PROPERTIES, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
3100 Smoketree Court, Suite 600
Raleigh, N.C. 27604
(Address of principal executive offices) (Zip Code)
919-872-4924
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
Name of Each Exchange on
Which Registered
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Exchange Act. Yes ¨ No x
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act. Yes ¨ No x
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ¨ No x
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act). Yes x No ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act). Yes ¨ No x
The aggregate market value of the shares of common stock, par value $0.01 per share, held by non-affiliates (based upon the closing sale price on the New York Stock Exchange) on June 30, 2005 was approximately $1.6 billion. As of November 30, 2005, there were 54,030,309 shares of common stock outstanding.
TABLE OF CONTENTS
Item No.
PART I
1.
1A.
1B.
2.
3.
4.
X.
PART II
5.
Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities
6.
Selected Financial Data
7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
7A.
Quantitative and Qualitative Disclosures About Market Risk
8.
Financial Statements and Supplementary Data
9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
9A.
Controls and Procedures
9B.
Other Information
PART III
10.
Directors and Executive Officers of the Registrant
11.
Executive Compensation
12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
13.
Certain Relationships and Related Transactions
14.
Principal Accountant Fees and Services
PART IV
15.
Exhibits and Financial Statement Schedules
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EXPLANATORY NOTE
This 2004 Annual Report of Highwoods Properties, Inc. is being mailed to stockholders on or about December 29, 2005. Unlike in prior years, this mailing does not include an accompanying proxy statement or proxy card relating to an annual meeting of stockholders. As a result, substantially all of the information that has historically been incorporated by reference from an accompanying proxy statement has been included directly in this Annual Report. This information is set forth in Part II, Item 5, and Part III, Items 9B, 10, 11, 12, 13 and 14 of this Annual Report.
As discussed more fully in “ITEM 9B. OTHER INFORMATION,” we expect that our next annual meeting will be held during May 2006, although the exact date will be determined by our Board of Directors in the future. Prior to that meeting, we will mail to stockholders a proxy statement and form of proxy relating to the meeting together with our 2005 Annual Report.
If you have any questions, please contact us as follows:
Highwoods Properties, Inc.
Investor Relations
3100 Smoketree Court
Suite 600
Raleigh, North Carolina 27604
Phone: (919) 872-4924
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We refer to (1) Highwoods Properties, Inc. as the “Company,” (2) Highwoods Realty Limited Partnership as the “Operating Partnership,” (3) the Company’s common stock as “Common Stock,” (4) the Company’s preferred stock as “Preferred Stock,” (5) the Operating Partnership’s common partnership interests as “Common Units,” (6) the Operating Partnership’s preferred partnership interests as “Preferred Units” and (7) in-service properties (excluding apartment units) to which the Company has title and 100.0% ownership rights as the “Wholly Owned Properties.”
ITEM 1. BUSINESS
General
The Company is a fully-integrated, self-administered and self-managed equity REIT that began operations through a predecessor in 1978. We are one of the largest owners and operators of suburban office, industrial and retail properties in the southeastern and midwestern United States. At December 31, 2004, we:
The Company conducts substantially all of its activities through, and substantially all of its interests in the properties are held directly or indirectly by, the Operating Partnership. The Company is the sole general partner of the Operating Partnership. At December 31, 2004, the Company owned 100.0% of the Preferred Units and 89.8% of the Common Units in the Operating Partnership. Limited partners (including certain officers and directors of the Company) own the remaining Common Units. Each Common Unit is redeemable by the holder for the cash value of one share of Common Stock or, at the Company’s option, one share of Common Stock. The Preferred Units in the Operating Partnership were issued to the Company in connection with the Company’s Preferred Stock offerings that occurred in 1997 and 1998.
The Company was incorporated in Maryland in 1994. The Operating Partnership was formed in North Carolina in 1994. Our executive offices are located at 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604 and our telephone number is (919) 872-4924. We maintain offices in each of our primary markets.
The business of the Company is the acquisition, development and operation of rental real estate properties. The Company operates office, industrial and retail properties and apartment units. There are no material inter-segment transactions. See Note 17 to the Consolidated Financial Statements for a summary of the rental income, net operating income and assets for each reportable segment.
In addition to this Annual Report, we file or furnish quarterly and current reports, proxy statements and other information with the SEC. All documents that we file or furnish with the SEC are made available as soon as reasonably practicable free of charge on our corporate website, which is http://www.highwoods.com. The information on this website is not and should not be considered part of this Annual Report and is not incorporated by reference in this document. This website is only intended to be an inactive textual reference. You may also read and
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copy any document that we file or furnish at the public reference facilities of the SEC at 100 F. Street, N.E., Room 1580, Washington, D.C. 20549. Please call the SEC at (800) 732-0330 for further information about the public reference facilities. These documents also may be accessed through the SEC’s electronic data gathering, analysis and retrieval system (“EDGAR”) via electronic means, including the SEC’s home page on the Internet (http://www.sec.gov). In addition, since some of our securities are listed on the New York Stock Exchange, you can read similar information about us at the offices of the New York Stock Exchange at 20 Broad Street, New York, New York 10005.
Customers
The following table sets forth information concerning the 20 largest customers of our Wholly Owned Properties as of December 31, 2004:
Customer
Federal Government
AT&T (2)
PricewaterhouseCoopers
State of Georgia
T-Mobile USA
Sara Lee
IBM
Northern Telecom
Volvo
US Airways (3)
Lockton Companies
BB&T
CHS Professional Services
ITC Deltacom (4)
Ford Motor Company
IKON
MCI (5)
Hartford Insurance
Aspect Communications
Jacob’s Engineering
Total (6)
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Operating Strategy
Efficient, Customer Service-Oriented Organization. We provide a complete line of real estate services to our customers and third parties. We believe that our in-house development, acquisition, construction management, leasing and property management services allow us to respond to the many demands of our existing and potential customer base. We provide our customers with cost-effective services such as build-to-suit construction and space modification, including tenant improvements and expansions. In addition, the breadth of our capabilities and resources provides us with market information not generally available. We believe that the operating efficiencies achieved through our fully integrated organization also provide a competitive advantage in setting our lease rates and pricing other services.
Capital Recycling Program. Our strategy has been to focus our real estate activities in markets where we believe our extensive local knowledge gives us a competitive advantage over other real estate developers and operators. Through our capital recycling program, we generally seek to:
Our capital recycling activities benefit from our local market presence and knowledge. Our division officers have significant real estate experience in their respective markets. Based on this experience, we believe that we are in a better position to evaluate capital recycling opportunities than many of our competitors. In addition, our relationships with our customers and those tenants at properties for which we conduct third-party fee-based services may lead to development projects when these tenants seek new space.
The following summarizes the changes in square footage in our Wholly Owned Properties during each of the three years ended December 31, 2004:
Office, Industrial and Retail Properties:
Dispositions (includes 225 in 2002 related to the Eastshore transaction)
Contributions to Joint Ventures (includes 205 related to SF-HIW Harborview, LLP in 2002)
Developments Placed In-Service
Redevelopment/Other
Acquisitions (1)
Net Change of In-Service Wholly Owned Properties
In addition, we sold 88 apartment units during 2004.
Conservative and Flexible Balance Sheet. We are committed to maintaining a conservative and flexible balance sheet that allows us to capitalize on favorable development and acquisition opportunities as they arise. Accordingly, we expect to meet our long-term liquidity requirements through a combination of any one or more of:
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Geographic Diversification. We do not believe that our operations are significantly dependent upon any particular geographic market. Today, including our various joint ventures, our portfolio consists primarily of office properties throughout the Southeast and retail and office properties in Kansas City, Missouri, including one significant mixed retail and office property, and office properties in Des Moines, Iowa (joint venture).
Competition
Our properties compete for tenants with similar properties located in our markets primarily on the basis of location, rent, services provided and the design and condition of the facilities. We also compete with other REITs, financial institutions, pension funds, partnerships, individual investors and others when attempting to acquire, develop and operate properties.
Employees
As of December 31, 2004, the Company employed 553 persons.
ITEM 1A. RISK FACTORS
An investment in our equity and debt securities involves various risks. All investors should carefully consider the following risk factors in conjunction with the other information contained in this Annual Report before trading in our securities. If any of these risks actually occur, our business, operating results, prospects and financial condition could be harmed.
Our performance is subject to risks associated with real estate investment. We are a real estate company that derives most of our income from the ownership and operation of our properties. There are a number of factors that may adversely affect the income that our properties generate, including the following:
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Future acquisitions and development properties may fail to perform in accordance with our expectations and may require development and renovation costs exceeding our estimates. In the normal course of business, we typically evaluate potential acquisitions, enter into non-binding letters of intent, and may, at any time, enter into contracts to acquire additional properties. However, changing market conditions, including competition from others, may diminish our opportunities for making attractive acquisitions. Once made, our investments may fail to perform in accordance with our expectations. In addition, the renovation and improvement costs we incur in bringing an acquired property up to market standards may exceed our estimates. Although we anticipate financing future acquisitions and renovations through a combination of advances under the Revolving Loan and other forms of secured or unsecured financing, no assurance can be given that we will have the financial resources to make suitable acquisitions or renovations on favorable terms or at all.
In addition to acquisitions, we periodically consider developing and constructing properties. Risks associated with development and construction activities include:
If new developments are financed through construction loans, there is a risk that, upon completion of construction, permanent financing for newly developed properties will not be available or will be available only on disadvantageous terms. Development activities are also subject to risks relating to our inability to obtain, or delays in obtaining, all necessary zoning, land-use, building, occupancy and other required governmental and utility company authorizations.
Illiquidity of real estate investments and the tax effect of dispositions could significantly impede our ability to sell assets or to respond to favorable or adverse changes in the performance of our properties. Because real estate investments are relatively illiquid, our ability to promptly sell one or more properties in our
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portfolio in response to changing economic, financial and investment conditions is limited. In addition, approximately $1.3 billion of our real assets (undepreciated book value) are encumbered by $822.6 million in mortgage loans as of December 31, 2004 under which we could incur significant prepayment penalties if such loans were paid off in connection with the sale of the underlying real estate assets. Such loans, even if assumed by a buyer rather than being paid off, could reduce the sale proceeds if we decided to sell such assets.
We intend to continue to sell some of our properties in the future. However, we cannot predict whether we will be able to sell any property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. We also cannot predict the length of time needed to find a willing purchaser and to close the sale of a property.
Certain of our properties have low tax bases relative to their fair value, and accordingly, the sale of such assets would generate significant taxable gains unless we sold such properties in a tax-free exchange under Section 1031 of the Internal Revenue Code or another tax-free or tax-deferred transaction. For an exchange to qualify for tax-deferred treatment under Section 1031, the net proceeds from the sale of a property must be held by an escrow agent until applied toward the purchase of real estate qualifying for gain deferral. Given the competition for properties meeting our investment criteria, there could be a delay in reinvesting such proceeds. Any delay in using the reinvestment proceeds to acquire additional income producing assets would reduce our income from operations.
In addition, the sale of certain properties acquired in the J.C. Nichols Company merger in July 1998 would require us to pay corporate-level tax under Section 1374 of the Internal Revenue Code on the built-in gain relating to such properties unless we sold such properties in a tax-free exchange under Section 1031 of the Internal Revenue Code or another tax-free or tax-deferred transaction. This tax will no longer apply after we have owned the assets for ten years or more. As a result, we may be limited or restricted in our ability to sell any of these properties even if management determines that such a sale would otherwise be in the best interests of our stockholders. Although we have no current plans to dispose of any properties in a manner that would require us to pay corporate-level tax under Section 1374, we would consider doing so if our management determines that a sale of a property would be in our best interests based on consideration of a number of factors, including the price being offered for the property, the operating performance of the property, the tax consequences of the sale and other factors and circumstances surrounding the proposed sale.
Because holders of our Common Units, including some of our officers and directors, may suffer adverse tax consequences upon the sale of some of our properties, it is possible that the Company may sometimes make decisions that are not in your best interest. Holders of Common Units may suffer adverse tax consequences upon the Company’s sale of certain properties. Therefore, holders of Common Units, including certain of our officers and directors, may have different objectives than our stockholders regarding the appropriate pricing and timing of a property’s sale. Although we are the sole general partner of the Operating Partnership and have the exclusive authority to sell all of our individual Wholly Owned Properties, officers and directors who hold Common Units may seek to influence us not to sell certain properties even if such sale might be financially advantageous to stockholders or influence us to enter into tax deferred exchanges with the proceeds of such sales when such a reinvestment might not otherwise be in the best interests of the Company.
The success of our joint venture activity depends upon our ability to work effectively with financially sound partners. Instead of owning properties directly, we have in some cases invested, and may continue to invest, as a partner or a co-venturer with one or more third parties. Under certain circumstances, this type of investment may involve risks not otherwise present, including the possibility that a partner or co-venturer might become bankrupt or that a partner or co-venturer might have business interests or goals inconsistent with ours. Also, such a partner or co-venturer may take action contrary to our instructions or requests or contrary to provisions in our joint venture agreements that could harm us, including jeopardizing our qualification as a REIT.
Our insurance coverage on our properties may be inadequate. We carry comprehensive insurance on all of our properties, including insurance for liability, fire and flood. Insurance companies, however, limit coverage against certain types of losses, such as losses due to terrorist acts, named windstorms and toxic mold. Thus, we may not have insurance coverage, or sufficient insurance coverage, against certain types of losses and/or there may be decreases in the limits of insurance available. Should an uninsured loss or a loss in excess of our insured limits occur, we could lose all or a portion of the capital we have invested in a property or properties, as well as the anticipated future revenue from the property or properties. If any of our properties were to experience a catastrophic loss, it could disrupt our operations, delay revenue and result in large expenses to repair or rebuild the property. Such events could adversely affect our ability to pay dividends to our stockholders. Our existing property and casualty insurance policies have been renewed through June 30, 2006.
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Our use of debt to finance our operations could have a material adverse effect on our cash flow and ability to make distributions. We are subject to risks normally associated with debt financing, such as the insufficiency of cash flow to meet required payment obligations, difficulty in complying with financial ratios and other covenants and the inability to refinance existing indebtedness. Increases in interest rates on our variable rate debt would increase our interest expense. If we fail to comply with the financial ratios and other covenants under our Revolving Loan, we would likely not be able to borrow any further amounts under the Revolving Loan, which could adversely affect our ability to fund our operations, and our lenders could accelerate outstanding debt. Unwaived defaults, if any, under our debt instruments could result in an acceleration of some of our outstanding debt. If our debt cannot be paid, refinanced or extended at maturity, in addition to our failure to repay our debt, we may not be able to pay dividends to stockholders at expected levels or at all. Furthermore, if any refinancing is done at higher interest rates, the increased interest expense could adversely affect our cash flow and ability to pay dividends to stockholders. Any such refinancing could also impose tighter financial ratios and other covenants that could restrict our ability to take actions that could otherwise be in our stockholders’ best interest, such as funding new development activity, making opportunistic acquisitions, repurchasing our securities or paying distributions. If we do not meet our mortgage financing obligations, any properties securing such indebtedness could be foreclosed on, which would have a material adverse effect on our cash flow and ability to make distributions.
We may be subject to taxation as a regular corporation if we fail to maintain our REIT status. Our failure to qualify as a REIT would have serious adverse consequences to our stockholders. Many of the requirements for taxation as a REIT are highly technical and complex and depend upon various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, at least 95.0% of our gross income must come from certain sources that are itemized in the REIT tax laws. We are also required to distribute to stockholders at least 90.0% of our REIT taxable income, excluding capital gains. The fact that we hold our assets through the Operating Partnership and its subsidiaries further complicates the application of the REIT requirements. Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, Congress and the IRS might change the tax laws and regulations and the courts might issue new rulings that make it more difficult, or impossible, for us to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income tax at regular corporate rates. Also, unless the IRS granted us relief under certain statutory provisions, we would remain disqualified as a REIT for four years following the year we first failed to qualify. If we failed to qualify as a REIT, we would have to pay significant income taxes and would, therefore, have less cash available for investments or to pay dividends to stockholders. This would likely have a significant adverse effect on the value of our securities. In addition, we would no longer be required to pay dividends to stockholders if we lost our REIT status.
Because provisions contained in Maryland law, our charter and our bylaws may have an anti-takeover effect, investors may be prevented from receiving a “control premium” for their shares. Provisions contained in our charter and bylaws as well as Maryland general corporation law may have anti-takeover effects that delay, defer or prevent a takeover attempt, and thereby prevent stockholders from receiving a “control premium” for their shares. For example, these provisions may defer or prevent tender offers for our Common Stock or purchases of large blocks of our Common Stock, thus limiting the opportunities for our stockholders to receive a premium for their Common Stock over then-prevailing market prices. These provisions include the following:
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SEC investigation. As previously disclosed, the SEC’s Division of Enforcement has issued a confidential formal order of investigation in connection with the Company’s previous restatement of its financial results. Even though we are cooperating fully, we cannot assure you that the SEC’s Division of Enforcement will not take any action that would adversely affect us.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
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ITEM 2. PROPERTIES
Wholly Owned Properties
As of December 31, 2004, we owned 100.0% interests in 444 in-service office, industrial and retail properties, encompassing approximately 33.9 million rentable square feet, and 125 apartment units. The following table sets forth information about our Wholly Owned Properties at December 31, 2004:
Market
Rentable
Square Feet
Occupancy
Raleigh (2)
Atlanta
Tampa
Kansas City
Nashville
Piedmont Triad (4)
Richmond
Memphis
Charlotte
Greenville
Columbia
Orlando
Other
Total (5)
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The following table sets forth information about our Wholly Owned Properties and our development properties as of December 31, 2004 and 2003:
PercentLeased/
Pre-Leased
In-Service:
Office (1)
Industrial
Retail (2)
Total or Weighted Average
Development:
Completed—Not Stabilized (3)
In Process (4)
Retail
Total:
Total or Weighted Average (4) (5)
Development Land
We estimate that we can develop approximately 14 million square feet of office, industrial and retail space on our 1,115 acres of development land that was wholly owned as of December 31, 2004. All of this development land is zoned and available for office, industrial or retail development, substantially all of which has utility infrastructure already in place. We believe that our commercially zoned and unencumbered land in existing business parks gives us a development advantage over other commercial real estate development companies in many of our markets. Any future development, however, is dependent on the demand for office, industrial or retail space in the area, the availability of favorable financing and other factors, and no assurance can be given that any construction will take place on the development land. In addition, if construction is undertaken on the development land, we will be subject to the risks associated with construction activities, including the risks that occupancy rates and rents at a newly completed property may not be sufficient to make the property profitable, construction costs may exceed original estimates and construction and lease-up may not be completed on schedule, resulting in increased debt service expense and construction expense. We may also develop properties other than office, industrial and retail on certain parcels with unrelated joint venture partners. We consider slightly less than half of our development land to be non-core assets as such excess land is not necessary for our foreseeable future development needs. We are actively working to dispose of such non-core development land through sales to other parties or contributions to joint ventures.
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Other Properties
As of December 31, 2004, we owned an interest (50.0% or less) in 66 in-service office and industrial properties, one of which we have a 20.0% joint venture interest, but such property is consolidated as a result of our continuing involvement with the property. The properties encompass approximately 6.9 million rentable square feet and 418 apartment units. These properties exclude approximately 431,000 square feet of properties under development that have not yet achieved stabilization. The following table sets forth information about these properties at December 31, 2004:
Des Moines
Raleigh (4)
Piedmont Triad (5)
Total
As of December 31, 2004, we owned 50.0% interests in two joint ventures that are developing 430,000 rentable square feet of office properties. The following table sets forth information about these properties at December 31, 2004 ($ in thousands):
Property
Plaza Colonnade, LLC
Summit
Pinehurst
Sonoma
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Lease Expirations
The following tables set forth scheduled lease expirations for existing leases at our Wholly Owned Properties (excluding apartment units) as of December 31, 2004. The table includes the effects of any early renewals exercised by tenants as of December 31, 2004.
Office Properties (1):
Lease Expiring
AverageAnnual
Rental RatePer SquareFoot forExpirations
2005 (3)
2006
2007
2008
2009
2010
2011
2012
2013
2014
Thereafter
Industrial Properties:
Percentage ofLeased
Square FootageRepresented byExpiring Leases
2005 (4)
15
Retail Properties:
2005 (2)
Total (3):
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ITEM 3. LEGAL PROCEEDINGS
We are from time to time a party to a variety of legal proceedings, claims and assessments arising in the ordinary course of our business. We regularly assess the liabilities and contingencies in connection with these matters based on the latest information available. For those matters where it is probable that we have incurred or will incur a loss and the loss or range of loss can be reasonably estimated, reserves are recorded in the Consolidated Financial Statements. In other instances, because of the uncertainties related to both the probable outcome and amount or range of loss, a reasonable estimate of liability, if any, cannot be made. Based on the current expected outcome of any such matters, none of these proceedings, claims or assessments is expected to have a material adverse effect on our business, financial condition and results of operations.
Notwithstanding the above, as previously disclosed, the SEC’s Division of Enforcement has issued a confidential formal order of investigation in connection with the Company’s previous restatement of its financial results. Even though we are cooperating fully, we cannot assure you that the SEC’s Division of Enforcement will not take any action that would adversely affect us.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
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ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information with respect to our executive officers:
Name
Position and Background
Edward J. Fritsch
Michael E. Harris
Terry L. Stevens
Gene H. Anderson
Michael F. Beale
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Robert G. Cutlip
Mack D. Pridgen III
W. Brian Reames
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ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
The Common Stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “HIW.” The following table sets forth the quarterly high and low stock prices per share reported on the NYSE for the quarters indicated and the dividends paid per share during such quarter.
Quarter Ended
March 31
June 30
September 30
December 31
On November 30, 2005, the last reported stock price of the Common Stock on the NYSE was $28.83 per share and the Company had 1,567 stockholders of record.
The Company intends to continue to pay quarterly dividends to holders of shares of Common Stock and make distributions to holders of Common Units. Future dividends and distributions will be at the discretion of the Board of Directors and will depend on the actual funds from operations of the Company, its financial condition, capital requirements, the annual dividend requirements under the REIT provisions of the Internal Revenue Code and such other factors as the Board of Directors deems relevant. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources –Stockholder Dividends.”
During 2004, the Company’s Common Stock dividends totaled $1.70 per share, $1.30 of which represented return of capital for income tax purposes. The minimum dividend per share of Common Stock required for the Company to maintain its REIT status (excluding any net capital gains) was $0.00 in 2004 and $0.07 per share in 2003.
The Company did not issue any Common Stock during the fourth quarter of 2004 that was not registered under the Securities Act of 1933 nor did the Company repurchase any Common Stock or Preferred Stock during such period.
The Company has a Dividend Reinvestment and Stock Purchase Plan under which holders of Common Stock may elect to automatically reinvest their dividends in additional shares of Common Stock and may make optional cash payments for additional shares of Common Stock. The administrator of the Dividend Reinvestment and Stock Purchase Plan has been instructed by the Company to purchase Common Stock in the open market for purposes of satisfying the Company’s obligations thereunder. However, the Company may in the future elect to satisfy such obligations by issuing additional shares of Common Stock.
The Company has an Employee Stock Purchase Plan for all active employees. Generally, at the end of each three-month offering period, each participant’s account balance is applied to acquire shares of Common Stock at a cost that is calculated at 85.0% of the lower of the average closing price on the NYSE on the five consecutive days preceding the first day of the quarter or the five days preceding the last day of the quarter. Participants may contribute up to 25.0% of their pay. The Company issued 33,693 shares of Common Stock to employees under the Employee Stock Purchase Plan during 2004.
For information about our equity compensation plans, see “ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.”
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ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data as of December 31, 2004 and 2003 and for each of the three years ended December 31, 2004 is derived from the Company’s audited Consolidated Financial Statements included elsewhere herein. The selected financial data as of December 31, 2002, 2001 and 2000 and for each of the two years ended December 31, 2001 is derived from previously issued financial statements adjusted for matters related to the restatement discussed below.
The Company has restated its results for the four-year period from 2000 to 2003 and the first three quarters of 2004. The restatement resulted from adjustments primarily related to the accounting for lease incentives, depreciation and amortization expense, straight-line ground lease expense on one ground lease, gain recognition on a 2003 land condemnation, accounting for an embedded derivative, land cost allocations, the write-off of undepreciated tenant improvements and commissions, capitalization of interest costs and internal leasing, construction and development costs on development properties, and purchase accounting for acquisitions completed in 1995 to 1998. Refer to Note 19 to the Consolidated Financial Statements for further discussion of the restatement adjustments. The information in the following table should be read in conjunction with the Company’s audited Consolidated Financial Statements and related notes included herein ($ in thousands, except per share data):
Rental and other revenues
Operating expenses:
Rental property and other expenses
Depreciation and amortization
Impairment of assets held for use
General and administrative
Total operating expenses
Interest expense:
Contractual
Amortization of deferred financing costs
Financing obligations
Total interest expense
Other income/expense:
Interest and other income
Settlement of bankruptcy claim
Loss on debt extinguishments
Gain on extinguishment of co-venture obligation
Total other income
Income before disposition of property, co-venture expense, minority interest and equity in earnings of unconsolidated affiliates
Gains on disposition of property, net
Co-venture expense
Minority interest in the Operating Partnership
Equity in earnings of unconsolidated affiliates
Income from continuing operations
Discontinued operations net of minority interest
Net income
Dividends on preferred stock
Excess of preferred stock carrying value over repurchase value
Net income available for common stockholders
Net income per common share – basic:
Income/(loss) from continuing operations
Net income per common share – diluted:
Dividends declared per common share
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Balance Sheet Data:
Total assets
Total mortgages and notes payable
Co-venture obligation
Cumulative redeemable preferred shares
Number of wholly owned in-service properties
Total rentable square feet, in service - Wholly Owned Properties
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
You should read the following discussion and analysis in conjunction with the accompanying Consolidated Financial Statements and related notes contained elsewhere in this Annual Report.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Annual Report may contain forward-looking statements. Such statements include, in particular, statements about our plans, strategies and prospects under this section and under the heading “Business.” You can identify forward-looking statements by our use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue” or other similar words. Although we believe that our plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, we cannot assure you that our plans, intentions or expectations will be achieved. When considering such forward-looking statements, you should keep in mind the following important factors that could cause our actual results to differ materially from those contained in any forward-looking statement:
This list of risks and uncertainties, however, is not intended to be exhaustive. You should also review the other cautionary statements we make in “Business – Risk Factors” set forth elsewhere in this Annual Report.
Given these uncertainties, you should not place undue reliance on forward-looking statements. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect any future events or circumstances or to reflect the occurrence of unanticipated events.
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OVERVIEW
We are a fully integrated, self-administered and self-managed equity REIT that provides leasing, management, development, construction and other customer-related services for our properties and for third parties. As of December 31, 2004, we owned or had an interest in 510 in-service office, industrial and retail properties, encompassing approximately 40.8 million square feet and 543 apartment units. As of that date, we also owned 1,115 acres of development land, which is suitable to develop approximately 14 million rentable square feet of office, industrial and retail space. We are based in Raleigh, North Carolina, and our properties and development land are located in Florida, Georgia, Iowa, Kansas, Maryland, Missouri, North Carolina, South Carolina, Tennessee and Virginia.
As more fully described in Notes 19 and 20 to the Consolidated Financial Statements, the Company has restated its results for the years ended December 31, 2003 and 2002 and for the first three quarters of 2004. The restatement resulted from adjustments primarily related to the accounting for lease incentives, depreciation and amortization expense, straight-line ground lease expense on one ground lease, gain recognition on a 2003 land condemnation, accounting for an embedded derivative, land cost allocations, the write-off of undepreciated tenant improvements and commissions, capitalization of interest costs and internal leasing, construction and development costs on development properties, and purchase accounting for acquisitions completed in 1995 to 1998.
Results of Operations
During 2004, approximately 84% of our rental and other revenue was derived from our office properties. As a result, while we own and operate a limited number of industrial and retail properties, our operating results depend heavily on successfully leasing our office properties. Furthermore, since most of our office properties are located in Florida, Georgia and North Carolina, economic growth in those states is and will continue to be an important determinative factor in predicting our future operating results.
The key components affecting our revenue stream are average occupancy and rental rates. Average occupancy generally increases during times of improving economic growth, as our ability to lease space outpaces vacancies that occur upon the expirations of existing leases, while average occupancy generally declines during times of slower economic growth, when new vacancies tend to outpace our ability to lease space. Asset acquisitions and dispositions also impact our rental revenues and could impact our average occupancy, depending upon the occupancy percentage of the properties that are acquired or sold. A further indicator of the predictability of future revenues is the expected lease expirations of our portfolio. As of September 30, 2005, leases representing 6.0% of our rentable square feet with respect to our Wholly Owned Properties were expiring on or before December 31, 2005, representing approximately 5.0% of our annualized revenue. As a result, in addition to seeking to increase our average occupancy by leasing current vacant space, we also must concentrate our leasing efforts on renewing leases on expiring space. For more information regarding our lease expirations, see “Properties – Lease Expirations.”
Whether or not our rental revenue tracks average occupancy proportionally depends upon whether rents under new leases signed are higher or lower than the rents under the previous leases. During 2004, the average rental rate per square foot on new leases signed in our Wholly Owned Properties was 1.5% lower than the rent under the previous leases (based on straight line rental rates).
At December 31, 2004, the occupancy rate for our Wholly Owned Properties was 85.0%. As of September 30, 2005, the occupancy rate for our Wholly Owned Properties increased to 85.8%.
Our expenses primarily consist of rental property expenses, depreciation and amortization, general and administrative expenses and interest expense. Rental property expenses are expenses associated with our ownership and operation of rental properties and include variable expenses, such as common area maintenance and utilities, and fixed expenses, such as property taxes and insurance. Some of these variable expenses may be lower when our average occupancy declines, while the fixed expenses remain constant regardless of average occupancy. Depreciation and amortization is a non-cash expense associated with the ownership of real property and generally remains relatively consistent each year, unless we buy or sell assets, since we depreciate our properties on a straight-line basis over a fixed life. General and administrative expenses, net of amounts capitalized, consist primarily of management and employee salaries and other personnel costs, corporate overhead and long-term incentive compensation. Interest expense depends upon the amount of our borrowings, the weighted average interest rates on our debt and the amount of interest capitalized on development projects.
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We also record income from our investments in unconsolidated affiliates. We record in “equity in earnings of unconsolidated affiliates” our proportionate share of the unconsolidated joint ventures’ net income or loss. During 2004, income earned from these unconsolidated joint ventures aggregated $7.4 million, which, net of minority interest, represented approximately 16.0% of our total net income.
Additionally, SFAS No. 144 requires us to record net income received from properties sold or held for sale that qualify as discontinued operations under SFAS No. 144 separately as “income from discontinued operations.” As a result, we separately record revenues and expenses from these qualifying properties. During 2004, income, including gains and losses from the sale of properties, from discontinued operations, net of minority interest, accounted for approximately 10.3% of our total net income.
Liquidity and Capital Resources
We incur capital expenditures to lease space to our customers and to maintain the quality of our properties to successfully compete against other properties. Tenant improvements are the costs required to customize the space for the specific needs of the customer. Lease commissions are costs incurred to find the customer for the space. Lease incentives are costs paid to or on behalf of tenants to induce them to enter into leases and which do not relate to customizing the space for the tenant’s specific needs. Building improvements are recurring capital costs not related to a customer to maintain the buildings. As leases expire, we either attempt to relet the space to an existing customer or attract a new customer to occupy the space. Generally, customer renewals require lower leasing capital expenditures than reletting to new customers. However, market conditions such as supply of available space on the market, as well as demand for space, drive not only customer rental rates but also tenant improvement costs. Leasing capital expenditures are amortized over the term of the lease and building improvements are depreciated over the appropriate useful life of the assets acquired. Both are included in depreciation and amortization in results of operations.
Because we are a REIT, we are required under the federal tax laws to distribute at least 90.0% of our REIT taxable income, excluding capital gains, to our stockholders. We generally use rents received from customers to fund our operating expenses, recurring capital expenditures and stockholder dividends. To fund property acquisitions, development activity or building renovations, we incur debt from time to time. As of December 31, 2004, we had $822.6 million of secured debt outstanding and $750.0 million of unsecured debt outstanding. Our debt generally consists of mortgage debt, unsecured debt securities and borrowings under our Revolving Loan. As of November 30, 2005, we had approximately $90.2 million of additional borrowing availability under our Revolving Loan and $6.5 million in available cash and short-term investments.
Our Revolving Loan and the indenture governing our outstanding long-term unsecured debt securities require us to satisfy various operating and financial covenants and performance ratios. As a result, to ensure that we do not violate the provisions of these debt instruments, we may from time to time be limited in undertaking certain activities that may otherwise be in the best interest of our stockholders, such as repurchasing capital stock, acquiring additional assets, increasing the total amount of our debt or increasing stockholder dividends. We review our current and expected operating results, financial condition and planned strategic actions on an ongoing basis for the purpose of monitoring our continued compliance with these covenants and ratios. Any unwaived event of default could result in an acceleration of some or all of our debt, severely restrict our ability to incur additional debt to fund short- and long-term cash needs or result in higher interest expense. See Note 5 to the Consolidated Financial Statements for information regarding certain amendments and waivers relating to covenants under our Revolving Loan.
To generate additional capital to fund our growth and other strategic initiatives and to lessen the ownership risks typically associated with owning 100.0% of a property, we may sell some of our properties or contribute them to joint ventures. When we create a joint venture with a strategic partner, we usually contribute one or more properties that we own and/or vacant land to a newly formed entity in which we retain an interest of 50.0% or less. In exchange for our equal or minority interest in the joint venture, we generally receive cash from the partner and retain some or all of the management income relating to the properties in the joint venture. The joint venture itself will frequently borrow money on its own behalf to finance the acquisition of, and/or leverage the return upon, the properties being acquired by the joint venture or to build or acquire additional buildings. Such borrowings are typically on a non-recourse or limited recourse basis. We generally are not liable for the debts of our joint ventures, except to the extent of our equity investment, unless we have directly guaranteed any of that debt. In most cases, we and/or our strategic partners are required to guarantee customary exceptions to non-recourse liability in non-recourse loans. See Note 15 to the Consolidated Financial Statements for additional information on certain debt guarantees.
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We have historically also sold additional Common Stock or Preferred Stock or issued Common Units to fund additional growth or to reduce our debt, but we have limited those efforts during the past five years because funds generated from our capital recycling program in recent years have provided sufficient funds to satisfy our liquidity needs. In addition, we used funds from our capital recycling program to redeem Preferred Stock in 2005 and repurchase Common Stock in 2003 and 2002. We have also redeemed Common Units for cash in 2002 through 2005.
Management’s Analysis
We believe that funds from operations (“FFO”) and FFO per share are beneficial to management and investors and are important indicators of the performance of any equity REIT. Because FFO and FFO per share calculations exclude such factors as depreciation and amortization of real estate assets and gains or losses from sales of real estate (which can vary among owners of identical assets in similar conditions based on historical cost accounting and useful life estimates), they facilitate comparisons of operating performance between periods and between other REITs. Our management believes that historical cost accounting for real estate assets in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. As a result, management believes that the use of FFO and FFO per share, together with the required GAAP presentations, provide a more complete understanding of our performance relative to competitors and a more informed and appropriate basis on which to make decisions involving operating, financing and investing activities. See “Funds From Operations.”
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Comparison of 2004 to 2003
The following table sets forth information regarding our results of operations for the years ended December 31, 2004 and 2003 ($ in millions):
2004
to 2003$ Change
Discontinued operations:
Income from discontinued operations, net of minority interest
Gain on sale of discontinued operations, net of minority interest
Rental and Other Revenues
The decrease in rental and other revenues from continuing operations was primarily the result of the disposition of certain properties in 2003 and 2004 that were not included in discontinued operations and a decrease of approximately $2.2 million in lease termination fees paid in 2004 from 2003. Partly offsetting these decreases was an increase of approximately $1.2 million in property management fees in 2004 from 2003 due to increased efforts in our third-party management services and the contribution of certain properties to joint ventures in 2004 where we retained the management of the properties and received customary fees.
During the year ended December 31, 2004, 1,037 second generation leases representing 8.2 million square feet of office, industrial and retail space were executed with respect to our Wholly Owned Properties. The average rate per square foot on a GAAP basis over the lease term for these leases was 1.5% lower than the GAAP rent under the previous lease.
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As of the date of this filing, we are beginning to see a modest improvement in employment trends in a few of our markets and an improving economic climate in the Southeast. There has been modest positive absorption of office space in most of our markets during the past year. Also, we expect to deliver approximately 713,000 square feet of office and industrial fully leased new development properties by the end of 2005. Accordingly, we expect our occupancy rate to increase at December 31, 2005 as compared to December 31, 2004.
Operating Expenses
Rental and other operating expenses from continuing operations (real estate taxes, utilities, insurance, repairs and maintenance and other property-related expenses) decreased in 2004 compared to 2003, primarily as a result of the disposition of certain properties in 2003 and 2004 that were not included in discontinued operations. This decrease was offset by general inflationary increases in certain fixed operating expenses, such as salaries, benefits, utility costs and real estate taxes.
Our operating margin, defined as rental and other revenue less rental property and other expenses expressed as a percentage of rental and other revenues, decreased from 64.9% in 2003 to 63.8% in 2004. This decrease in margin was primarily caused by operating expenses increasing from inflationary pressure and other factors at a higher rate than rental revenues, which increased from rising occupancy in 2004, offset by slightly lower average rental rates from rent roll-downs.
We expect rental and other operating expenses to decrease slightly in 2005 due to the disposition of certain properties in 2004 and 2005. This decrease will be partly offset by inflationary increases in certain fixed operating expenses.
The decrease in depreciation and amortization from continuing operations is primarily related to the disposition of certain properties in 2003 and 2004, which were not included in discontinued operations. In addition, the contribution of certain properties to a joint venture in 2004 reduced depreciation and amortization by $1.1 million. We expect depreciation and amortization to decrease slightly in 2005 due to a further net reduction of our Wholly Owned portfolio.
In 2004, an impairment loss of $1.3 million was recognized in connection with an 18,079 rentable square foot office property that was classified as held for use. This asset was later sold in 2005.
The increase in general and administrative expenses in 2004 as compared to 2003 primarily relates to (1) $4.6 million recognized in 2004 in connection with a retirement package for our former chief executive officer, as described in Note 21 to the Consolidated Financial Statements; (2) a $7.8 million increase primarily relating to costs of personnel, consultants and our independent auditors in connection with (a) implementation of Section 404 of the Sarbanes-Oxley Act, (b) evaluation of a strategic transaction in 2004, and (c) the preparation and audit of the Consolidated Financial Statements included herein; and (3) the remaining $3.3 million net increase primarily relates to higher long-term incentive compensation costs, salary, fringe benefit and employee relocation costs.
In 2005, general and administrative expenses are expected to decrease because of the non-recurring nature of costs recorded in 2004 related to the former chief executive officer’s retirement package, the evaluation of a strategic transaction in 2004, and the abnormally high costs associated with the preparation and audit of the Consolidated Financial Statements for the 2004 fiscal year. These decreases will be partly offset by an increase in general and administrative expenses related to inflationary increases in compensation, benefits and other costs expected in 2005.
Interest Expense
The decrease in contractual interest was primarily due to a decrease in average borrowings from $1,821 million in the year ended December 31, 2003 to $1,657 million in the year ended December 31, 2004 and a decrease in average interest rates on outstanding debt from 6.63% in the year ended December 31, 2003 to 6.46% in the year ended December 31, 2004, primarily due to debt refinancings completed in December 2003 and in June 2004.
The decrease in interest expense on financing obligations was primarily a result of the purchase of our partner’s interest in the Orlando City Group properties in MG-HIW, LLC in March 2004 which eliminated the requirement to record financing obligation interest expense with respect to the Orlando City Group properties from March 2, 2004 (See Note 3 to the Consolidated Financial Statements for additional information on real estate sales that are accounted for as financing transactions).
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Total interest expense is expected to decline in 2005 primarily due to the June 2004 refinancing of the $100.0 million of Exercisable Put Option Notes with borrowings on the Revolving Loan which currently has lower floating rate interest and the repayment through December 1, 2005 of $131.6 million of mortgage loans payable, which had interest rates ranging from 5.3% to 9.0%, or a weighted average interest rate of 7.2%. In addition, an increase in capitalized interest due to additional development activity is expected to further decrease net interest expense. These declines will be partly offset by expected increases in average interest rates on our variable rate debt in 2005.
Other Income/Expense
The increase in interest and other income is primarily related to the interest received in 2004 related to a note receivable acquired in connection with the disposition of certain properties in 2003 and higher interest rates earned on cash reserves.
In 2004, we received net proceeds of $14.4 million as a result of the settlement of the bankruptcy of WorldCom (See Note 21 to our Consolidated Financial Statements for further discussion on this settlement).
Loss on debt extinguishments decreased $2.3 million from $14.7 million in 2003 to $12.4 million in 2004. In 2004, a $12.3 million loss was recorded related to the retirement of the Exercisable Put Option Notes described in Note 5 to the Consolidated Financial Statements. In 2003, a $14.7 million loss was recorded related to the retirement of the $125.0 million of MandatOry Par Put Remarketed Securities (“MOPPRS”) described in Note 5 to the Consolidated Financial Statements.
In 2003, we recorded a $16.3 gain on extinguishment of co-venture obligation, which relates to the operations of the MG-HIW, LLC non-Orlando City Group properties which were accounted for as a profit-sharing arrangement until July 2003, at which time we acquired our partner’s interest in the non-Orlando City Group properties.
Gains on Disposition of Property; Co-Venture Expense; Minority Interest; Equity in Earnings of Unconsolidated Affiliates
During 2004, we sold approximately 1.3 million rentable square feet of office, industrial and retail properties and 88 apartment units for gross proceeds of $96.5 million and also sold 213.7 acres of development land for gross proceeds of $35.7 million. The Company also contributed approximately 1.3 million of properties to a joint venture, HIW-KC Orlando LLC, in which we have a 40% interest. During 2003, we sold approximately 3.3 million rentable square feet of office, industrial and retail properties and 122.8 acres of revenue-producing land for $202.9 million and also sold 108.5 acres of non-core development land for gross proceeds of $18.7 million. In addition, we contributed approximately 0.3 million square feet to Highwoods-Markel Associates, LLC, a joint venture in which we have a 50% interest.
Net gains on the dispositions of properties that did not qualify for discontinued operations presentation aggregated $21.6 million in 2004, up from $9.6 million in 2003. The largest gain in 2004 was $15.9 million from the contribution of properties to HIW-KC Orlando. Net gains on the dispositions of properties that are classified as discontinued operations were $2.8 million in 2004, down from $9.8 million in 2003; these amounts are shown net of minority interest. Included in the net $2.8 million for 2004 were $6.3 million of impairment losses.
The decrease in co-venture expense is due to our acquisition of our partner’s interest in the non-Orlando City Group properties in July 2003 and the resultant elimination of recording co-venture expense as of that date. Co-venture expense relates to the operations of the MG-HIW, LLC non-Orlando City Group properties which were accounted for as a profit-sharing arrangement until July 2003.
Minority interest in the continuing operations of the Operating Partnership, after Preferred Unit distributions, increased from $0.0 million in the year ended December 31, 2003 to $0.8 million in the year ended December 31, 2004 due to a corresponding increase in the Operating Partnership’s income from continuing operations.
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The increase in equity in earnings from continuing operations of unconsolidated affiliates was primarily a result of (1) a gain of $1.1 million recognized in 2004 by a certain joint venture related to the disposition of land, of which our portion was $0.5 million; (2) an increase related to the formation of the HIW-KC Orlando, LLC joint venture in 2004, which contributed approximately $1.1 million to equity in earnings from continuing operations of unconsolidated affiliates in 2004; and (3) an increase of $0.9 million related to the addition of three office properties in 2004 to the Highwoods-Markel Associates, LLC joint venture. Partially offsetting these increases was a decrease in average occupancy of buildings owned by certain joint ventures and a land sale by one of our joint ventures in 2003, which resulted in a $0.4 million decrease in equity in earnings from continuing operations of unconsolidated affiliates in 2004 as compared to 2003.
Discontinued Operations
In accordance with SFAS No. 144, we classified net income of $4.3 million and $13.1 million, net of minority interest, as discontinued operations for the years ended December 31, 2004 and 2003, respectively. These amounts pertained to 2.0 million square feet of property, 92 apartment units and 122.8 acres of revenue-producing land sold during 2004 and 2003 and 85,681 square feet of property held for sale at December 31, 2004. These amounts include gain on the sale of these properties, net of impairment charges related to discontinued operations, of $2.8 million and $9.8 million, net of minority interest, in the years ended December 31, 2004 and 2003, respectively.
Net Income
We recorded net income in the year ended December 31, 2004 of $41.6 million, which was a 2.6% decrease from net income of $42.7 million in the year ended December 31, 2003. The decrease was primarily due to the disposition of certain properties in 2004 and 2003 and increases in general and administrative costs as described above. These amounts were offset by lower rental property expenses, depreciation and amortization expense, contractual interest expense, interest expense on financing obligations and co-venture expense and an increase in gains on disposition of property as described above. In 2005, we expect net income to be higher as compared to 2004 due to slightly rising average occupancy and lower operating expenses, depreciation and amortization, general and administrative expenses and interest expense.
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Comparison of 2003 to 2002
The following table sets forth information regarding our restated results of operations for the years ended December 31, 2003 and 2002 ($ in millions):
2003
to 2002
$ Change
The decrease in rental and other revenues from continuing operations was primarily the result of (1) a decrease in average occupancy rates in our Wholly Owned Properties from 86.8% for the year ended December 31, 2002 to 83.7% for the year ended December 31, 2003, and (2) the effect of properties sold in 2003 and 2002 that were not accounted for as discontinued operations. The decrease in average occupancy was primarily a result of the disposition of certain properties, the contribution of certain properties to joint ventures and the bankruptcies of WorldCom and US Airways, which decreased average occupancy rates by 2.8% and rental and other revenues from continuing operations by $15.4 million. Amounts partly offsetting these decreases were: (1) $3.1 million of straight-line rent receivables were written off in 2002 in connection with the bankruptcy of WorldCom; (2) 2.0 million square feet of development properties were placed in-service and, as a result, increased rental and other revenues from continuing operations by $8.6 million in 2003; and (3) rental revenues in 2002 only included a partial year of rental revenues from the Harborview Plaza transaction which occurred in June 2002, increasing 2003 rental revenues by $3.8 million. Recovery income from certain operating expenses decreased in the year ended December 31, 2003 due to lower occupancy.
During the year ended December 31, 2003, 954 second generation leases representing 7.5 million square feet of office, industrial and retail space were executed with respect to our Wholly Owned Properties. The average rate per square foot on a GAAP basis over the lease term for leases executed in the year ended December 31, 2003 was 0.7% lower than the rent paid by previous customers.
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The increase in rental and other operating expenses from continuing operations (real estate taxes, utilities, insurance, repairs and maintenance and other property-related expenses) primarily resulted from general inflationary increases in certain fixed operating expenses, such as compensation, utility costs, real estate taxes and insurance. In addition, we had 2.0 million square feet of development properties placed in service during 2002 that resulted in an increase in rental and other operating expenses from continuing operations. Partly offsetting these increases was a decrease in rental and other operating expenses from continuing operations of properties sold in 2003 and 2002 that were not accounted for as discontinued operations.
Rental and other operating expenses as a percentage of rental and other revenue increased from 32.6% for the year ended December 31, 2002 to 35.1% for the year ended December 31, 2003. The increase was a result of the increases in rental and other operating expenses as described above and a decrease in rental and other revenues, primarily due to lower average occupancy.
The increase in depreciation and amortization from continuing operations in 2003 related to $14.0 million in depreciation from buildings, leasing commissions and tenant improvement expenditures for properties placed in-service during 2002 and $4.5 million from the write-off of deferred leasing costs and tenant improvements for customers who vacated their space prior to lease expiration. Partly offsetting these increases was a decrease in depreciation and amortization from continuing operations of properties sold in 2003 and 2002 that were not accounted for as discontinued operations.
Because there were no properties held for use with indicators of impairment and with a carrying value exceeding the sum of their undiscounted future cash flows, no impairment loss related to properties held for use was recognized during the year ended December 31, 2003. For the year ended December 31, 2002, the impairment loss on properties held for use with a carrying value exceeding the sum of their undiscounted future cash flows was $0.8 million. We also recognized a $9.1 million impairment loss related to one office property, which had a carrying value in excess of the sum of the property’s undiscounted future cash flows, that has been demolished and may be redeveloped into a class A suburban office property in the future.
General and administrative expenses, net of amounts capitalized, decreased $3.4 million for the year ended December 31, 2003 compared to the year ended December 31, 2002. The decrease occurred because 2002 included $3.7 million of stock option expense related to option exercises; there was no corresponding expense in 2003. This decrease was offset by a decrease in 2003 of capitalization of certain general and administrative costs due to the decrease in development and leasing activity, an increase in long-term incentive compensation expense as a result of the issuance of restricted and phantom stock during 2003 and 2002, and higher expenses related to employee compensation from normal salary increases.
Contractual interest expense decreased by $0.7 million in 2003. As a result of decreased development activity in 2003, capitalized interest decreased from $5.5 million for the year ended December 31, 2002 to $1.4 million for the year ended December 31, 2003, resulting in an increase in interest expense from continuing operations in 2003. Offsetting this increase was a decrease in interest caused by a decrease in the average outstanding debt balances from $1,915 million in 2002 to $1,821 million in 2003, and an increase in average interest rates from 6.57% in 2002 to 6.63% in 2003.
Interest expense for the years ended December 31, 2003 and 2002 included $4.4 million and $3.6 million, respectively, of amortization of deferred financing costs.
Interest expense on financing obligations increased by $5.2 million in 2003 (See Note 3 to the Consolidated Financial Statements for additional information on our financing transactions). Of the total $5.2 million increase, $4.6 million occurred because 2002 only included a partial year of interest expense on financing obligations from the Harborview and Eastshore transactions which closed in September 2002 and in November 2002, respectively. The remainder of the increase relates to interest on the MG-HIW Orlando financing transaction.
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The decrease in interest and other income in 2003 is primarily related to the collection of a legal settlement amounting to $1.6 million recorded as other income in the year ended December 31, 2002 related to previously completed mergers and acquisitions.
Loss on debt extinguishments increased $14.3 million from 2002 to 2003 due primarily to the $14.7 million loss recorded in early 2003 related to the MOPPRS debt retirement transaction described in Note 5 to the Consolidated Financial Statements.
In July 2003, we acquired our partner’s interest in the MG-HIW, LLC non-Orlando City Group properties and recognized a $16.3 million gain upon settlement of the $44.5 million co-venture obligation that was recorded on our books. As described in Note 3 to the Consolidated Financial Statements, the non-Orlando City Group properties in MG-HIW, LLC were accounted for as a profit sharing arrangement.
Gains on Disposition of Property; Co-venture Expense; Minority Interest; Equity in Earnings of Unconsolidated Affiliates
During 2003, we sold approximately 3.3 million rentable square feet of office, industrial and retail properties and 122.8 acres of revenue-producing land for $202.9 million and also sold 108.5 acres of non-core development land for gross proceeds of $18.7 million. In addition, we contributed approximately 0.3 million square feet to Highwoods-Markel Associates, LLC, a joint venture in which we have a 50% interest. During 2002, we sold approximately 2.0 million rentable square feet of office and industrial properties for gross proceeds of $213.9 million and also sold 137.7 acres of development land for gross proceeds of $21.3 million.
Net gains on the dispositions of properties that did not qualify for discontinued operations presentation aggregated $9.6 million in 2003, down from $22.8 million in 2002. Net gains on the dispositions of properties that are classified as discontinued operations were $9.8 million in 2003, down from $11.6 million in 2002; these amounts are shown net of minority interest.
Co-venture expense relates to the operations of the MG-HIW, LLC non-Orlando City Group properties accounted for as a profit-sharing arrangement, as more fully described in Note 3 to the Consolidated Financial Statements. The decrease of $3.1 million in co-venture expense in 2003 is largely due to our acquisition of our partner’s interest in the non-Orlando City Group properties in July 2003 and the resultant elimination of recording co-venture expense as of that date.
Minority interest in the continuing operations income of the Operating Partnership, after Preferred Unit distributions, decreased from $3.8 million in 2002 to $0.0 million in 2003 because of a corresponding reduction in the Operating Partnership’s income from continuing operations.
The decrease in equity in earnings from continuing operations of unconsolidated affiliates was primarily a result of lower occupancy in 2003 for certain joint ventures. Partly offsetting this decrease was an increase of $0.5 million in equity in earnings in 2003 related to a charge taken by a joint venture in 2002 related to an early extinguishment of debt loss resulting in a decrease in equity in earnings of $0.3 million in 2002 and an increase in equity in earnings in 2003 of $0.2 million as a result of a gain recognized by a joint venture related to the disposition of land in 2003.
In accordance with SFAS No. 144, we classified net income of $13.1 million and $23.0 million, net of minority interest, as discontinued operations for the years ended December 31, 2003 and 2002, respectively. These amounts related to 3.5 million square feet of property, 92 apartment units and 122.8 acres of revenue-producing land sold during 2004, 2003 and 2002 and 85,681 square feet of property held for sale at December 31, 2004. These amounts include gain on the sale of these properties, net of impairment charges related to discontinued operations, of $9.8 million and $11.6 million, net of minority interest, in 2003 and 2002, respectively.
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We recorded net income in 2003 of $42.7 million, which was a 46.7% decrease from net income of $80.1 million in 2002. This decrease was primarily due to a decrease in rental revenues as a result of lower occupancy and the bankruptcies of WorldCom and US Airways, the effects on continuing and discontinued operations from being a net seller in 2003 and 2002 of operating properties under our capital recycling plan, an increase in interest expense and increased loss on debt extinguishments in 2003. These decreases were offset by the contribution of development properties placed in service during 2003 and by the gain on settlement of the co-venture obligation related to the MG-HIW, LLC non-Orlando properties.
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LIQUIDITY AND CAPITAL RESOURCES
Statement of Cash Flows
As required by GAAP, we report and analyze our cash flows based on operating activities, investing activities and financing activities. The following table sets forth the changes in the Company’s cash flows from 2003 to 2004 ($ in thousands):
Change
Cash Provided by Operating Activities
Cash Provided by Investing Activities
Cash Used in Financing Activities
Total Cash Flows
In calculating cash flow from operating activities, GAAP requires us to add depreciation and amortization, which are non-cash expenses, back to net income. As a result, we have historically generated a significant positive amount of cash from operating activities. From period to period, cash flow from operations depends primarily upon changes in our net income, as discussed more fully above under “Results of Operations,” changes in receivables and payables and net additions or decreases in our overall portfolio, which affect the amount of depreciation and amortization expense.
Cash provided by or used in investing activities generally relates to capitalized costs incurred for leasing and major building improvements and our acquisition, development, disposition and joint venture activity. During periods of significant net acquisition and/or development activity, our cash used in such investing activities will generally exceed cash provided by investing activities, which typically consist of cash received upon the sale of properties. During 2004 and 2003, since our disposition activity has outpaced our investment, development and acquisition activity, we recorded positive cash flow from investing activities in both years.
Cash used in financing activities generally relates to stockholder dividends, distributions on our Common Units, incurrence and repayment of debt and sales, repurchases or redemptions of Common Stock, Common Units and Preferred Stock. As discussed previously, we use a significant amount of our cash to fund stockholder dividends and Common Unit distributions. Whether or not we incur significant new debt during a period depends generally upon the net effect of our acquisition, disposition, development and joint venture activity. We use our Revolving Loan for working capital purposes, which means that during any given period, in order to minimize interest expense associated with balances outstanding under the Revolving Loan, we will likely record significant repayments and borrowings under the Revolving Loan.
The increase of $6.0 million in cash provided by operating activities was primarily a result of the timing of receipt of revenues and payment of expenses, partly offset by lower net income due to the disposition of certain properties under our capital recycling program.
The decrease of $70.7 million in cash provided by investing activities was primarily a result of a decrease in proceeds from dispositions of real estate assets of $71.3 million and our contribution to the Highwoods KC Glenridge, LP joint venture of $9.9 million in 2004. Slightly offsetting this decrease was an increase in distributions of capital from unconsolidated affiliates of $5.9 million, mainly due to the financing of the Highwoods KC Glenridge, LP joint venture and a decrease in additions to real estate assets of $5.1 million, for the year ended December 31, 2004.
Cash used in financing activities decreased $61.6 million from 2003 to 2004. For the year ended December 31, 2004, net repayments on the unsecured Revolving Loan, mortgages and notes payable decreased by $66.4 million, distributions paid on Common Stock and Common Units decreased by $10.2 million and cash paid for the repurchase of Common Stock and Common Units decreased by $17.9 million. Offsetting these effects was a payment on financing obligations of $62.5 million, which is further discussed in Note 3 to the Consolidated Financial Statements, and the effect of payments in 2003 of $26.2 million on our co-venture obligation, which is also discussed in Note 3 to the Consolidated Financial Statements. We recorded payments on debt extinguishments of $12.5 million related to the X-POS refinancing in 2004 and $16.3 million related to the MOPPRS refinancing in 2003, which are both further discussed in Note 5 to the Consolidated Financial Statements.
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In 2005, we have continued our capital recycling program of selectively disposing of non-core land and other assets and using the net proceeds for reduction of outstanding debt and preferred stock balances, investments or other purposes. During the nine months ended September 30, 2005, we have closed on the sale or contribution of 4.4 million square feet of properties and land aggregating $337.1 million in gross sales proceeds. These transactions include most of the properties held for sale at December 31, 2004.
During 2005, we expect to have positive cash flows from operating activities. The net cash flows from investing activities in 2005 are expected to be positive in 2005 based on our level of property dispositions, property acquisitions, development, and capitalized leasing and improvement costs. Positive cash flows from operating and investing activities in 2005 have been or are expected to be used to pay stockholder and unitholder distributions, scheduled debt maturities, principal amortization payments and paydown of debt and redemption of preferred stock.
Capitalization
The following table sets forth our capitalization as of December 31, 2004 and December 31, 2003 (in thousands, except per share amounts):
December 31,
Mortgages and notes payable, at recorded book value
Preferred stock, at redemption value
Common Stock and Common Units outstanding
Per share stock price at period end
Market value of common equity
Total market capitalization with debt
Based on our total market capitalization of approximately $3.7 billion at December 31, 2004 (at the December 31, 2004 per share stock price of $27.70 and assuming the redemption for shares of Common Stock of the 6.1 million Common Units in the Operating Partnership not owned by the Company), our mortgages and notes payable represented 42.8% of our total market capitalization. Mortgages and notes payable at December 31, 2004 was comprised of $822.6 million of secured indebtedness with a weighted average interest rate of 6.9% and $750.0 million of unsecured indebtedness with a weighted average interest rate of 5.9%. As of December 31, 2004, our outstanding mortgages and notes payable were secured by real estate assets with an aggregate undepreciated book value of approximately $1.3 billion.
We do not intend to reserve funds to retire existing secured or unsecured debt upon maturity. For a more complete discussion of our long-term liquidity needs, see “Liquidity and Capital Resources - Current and Future Cash Needs.”
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Contractual Obligations
The following table sets forth a summary regarding our known contractual obligations at December 31, 2004 ($ in thousands):
Fixed Rate Debt:
Unsecured
Notes (1)
Secured:
Mortgage Loans Payable (2)
Total Fixed Rate Debt
Variable Rate Debt:
Unsecured:
Term Loans
Revolving Loan
Construction Loan
Total Variable Rate Debt
Total Mortgages and Notes Payable
Operating Lease Obligations:
Land Leases (3)
Purchase Obligations:
Completion Contracts (3)
Other Long Term Liabilities Reflected on the Balance Sheet:
Capitalized Lease Obligations
Plaza Colonnade Lease Guarantee (3)
Highwoods DLF 97/26 DLF 99/32 LP Lease Guarantee (3)
RRHWoods and Dallas County Partners Lease Guarantee (3)
Capital One Lease Guarantee (4)
Industrial Portfolio Lease Guarantee (4)
SF-HIW Harborview, LP Financing Obligation (5)
Eastshore Financing Obligation (5)
Tax Increment Financing Obligation (6)
DLF Payable (7)
BTI Financing Obligation (8)
KC Orlando, LLC Lease Guarantee (3)
KC Orlando, LLC Accrued Lease Commissions, Tenant Improvements and Building Improvements (3)
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Refinancings in 2004
In 1997, the Operating Partnership sold $100.0 million of Exercisable Put Option Notes due June 15, 2011 (the “Put Option Notes”). The Put Option Notes bore an interest rate of 7.19% from the date of issuance through June 15, 2004. After June 15, 2004, the interest rate to maturity on the Put Option Notes was required to be 6.39% plus the applicable spread determined as of June 10, 2004. In connection with the initial issuance of the Put Option Notes, a counter party was granted an option to purchase the Put Option Notes on June 15, 2004 at 100.0% of the principal amount. The counter party exercised this option and acquired the Put Option Notes on June 15, 2004. On that same date, the Company exercised its option to acquire the Put Option Notes from the counter party for a purchase price equal to the sum of the present value of the remaining scheduled payments of principal and interest (assuming an interest rate of 6.39%) on the Put Option Notes, or $112.3 million. The difference between the $112.3 million and the $100.0 million was charged to loss on extinguishment of debt in the quarter ended June 30, 2004. The Company borrowed funds from its Revolving Loan to make the $112.3 million payment.
In late June 2004, we repaid $51.0 million of borrowings under our Revolving Loan with proceeds from the sale of a 60.0% interest in five office buildings in Orlando, Florida and from the sale of a building at Highwoods Preserve in Tampa, Florida. See Notes 3 and 4 to the Consolidated Financial Statements for further details of these asset sales.
Refinancings in 2005
Through December 1, 2005, we paid off $151.6 million of outstanding loans, excluding any normal debt amortization, which included the following transactions. In early April 2005, we paid off $40.9 million of callable secured mortgage debt; in mid-July 2005, we paid off another $26.0 million of callable secured mortgage debt; and on August 1, 2005, we paid off $47.0 million of secured variable rate mortgage debt that was due January 1, 2006. In September 2005, we paid off our $20.0 million term loan at maturity and three secured loans totaling $3.5 million. In November 2005, we extended the maturity date on our $100.0 million term loan to July 17, 2006 and lowered the interest rate. On December 1, 2005, we paid off $2.1 million of secured variable rate mortgage debt that was due February 2, 2006. In addition, on December 1, 2005, we exercised our option to pay down $9.4 million on our AEGON loan that matures in 2009. We also used some of the proceeds from our disposition activity to redeem, in August 2005, all of our outstanding Series D Preferred Shares and a portion of our outstanding Series B Preferred Shares, aggregating $130.0 million plus accrued dividends. These reductions in outstanding debt and preferred stock balances were made primarily from proceeds from property dispositions that closed in 2005.
Operating and Financial Covenants and Performance Ratios
The terms of the Revolving Loan, the $120.0 million bank term loans and the indenture that governs our outstanding notes require us to comply with certain operating and financial covenants and performance ratios. No circumstance currently exists that would result in an acceleration of any of this outstanding debt. However, depending upon our future operating performance and property and financing transactions, we cannot assure you that no such circumstance would exist in the future.
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If any of our lenders ever accelerated outstanding debt due to an event of default, we would not be able to borrow any further amounts under the Revolving Loan, which would adversely affect our ability to fund our operations. If our debt cannot be paid, refinanced or extended at maturity or upon acceleration, in addition to our failure to repay our debt, we may not be able to make distributions to stockholders at expected levels or at all. Furthermore, if any refinancing is done at higher interest rates, the increased interest expense would adversely affect our cash flows and ability to make distributions to stockholders. Any such refinancing could also impose tighter financial ratios and other covenants that would restrict our ability to take actions that would otherwise be in our stockholders’ best interest, such as funding new development activity, making opportunistic acquisitions, repurchasing our securities or paying distributions.
Our Revolving Loan and the bank term loans have identical ratio and financial covenants. If we fail to satisfy any of the covenants after the expiration of any applicable cure periods, the lenders under our Revolving Loan and our bank term loans could accelerate amounts outstanding thereunder, which aggregated $290.0 million at December 31, 2004. At December 31, 2004 and as of the date of this filing, we were in compliance with these covenants as amended or waived by the lenders as discussed below.
In March 2004, we amended the Revolving Loan and our then outstanding two bank term loans. The changes modified certain definitions used in all three loans to determine amounts that are used to compute financial covenants and also adjusted one of the financial ratio covenants.
In June 2004, we amended the Revolving Loan and our then outstanding two bank term loans. The changes excluded the $12.5 million charge taken related to the refinancing of the Put Option Notes from the calculations used to compute financial covenants.
In August 2004, we further amended the Revolving Loan and our then outstanding two bank term loans. The changes excluded the effects of accounting for three sales transactions as financing or profit sharing arrangements under SFAS No. 66 from the calculations used to compute financial covenants, adjusted one financial covenant and temporarily adjusted a second financial covenant until the earlier of December 31, 2004 or the period when we could record income from the then anticipated settlement of a claim against WorldCom, which occurred in September 2004 (see Note 21 to the Consolidated Financial Statements).
In October 2004, we obtained a waiver from the lenders under the Revolving Loan and our then outstanding two bank term loans for certain covenant violations caused by the effects of the loss on debt extinguishment from the MOPPRS transaction in early 2003.
In June, July, August and September 2005, we obtained waivers from the lenders under the Revolving Loan and our then outstanding two bank loans related to timely reporting to the lenders of annual and quarterly financial statements and to covenant violations that could arise from future redemptions of preferred stock due to the reclassification of the preferred stock from equity to a liability during the period of time from the announcement of the redemption until the redemption is completed.
The aforementioned modifications did not change the economic terms of the loans. In connection with these modifications, we incurred certain loan costs that are capitalized and amortized over the remaining term of the loans.
The Revolving Loan carries an interest rate based upon our senior unsecured credit ratings. As a result, interest currently accrues on borrowings under the Revolving Loan at LIBOR plus 105 basis points. The terms of the Revolving Loan require us to pay an annual base facility fee equal to .25% of the aggregate amount of the Revolving Loan. We currently have a credit rating of BBB- assigned by Standard & Poor’s and Fitch Ratings and Ba1 assigned by Moody’s Investor Service. In January 2005, Moody’s Investor Service confirmed our Ba1 rating with a stable outlook. If Standard and Poor’s or Fitch Ratings were to lower our credit ratings without a corresponding increase by Moody’s, the interest rate on borrowings under the Revolving Loan would be automatically increased by 60 basis points.
In November 2005, we amended our $100.0 million bank term loan to extend the maturity date to July 17, 2006 and reduce the spread over the LIBOR interest rate from 130 basis points to 100 basis points.
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As of the date of this filing, the Operating Partnership has not yet satisfied its requirement under the indenture governing our unsecured notes to file timely SEC reports, but expects to do so as soon as practicable after the filing of our Annual Report. Under the indenture, the notes may be accelerated if the trustee or 25% of the holders provide written notice of a default and such default remains uncured after 60 days. To date, neither the trustee nor any holder has sent us any such default notice. The Operating Partnership is in compliance with all other covenants under the indenture and is current on all payments required thereunder.
Current and Future Cash Needs
Rental revenue, together with construction management, maintenance, leasing and management fees, are our principal source of funds to meet our short-term liquidity requirements, which primarily consist of operating expenses, debt service, stockholder dividends, any guarantee obligations and recurring capital expenditures. In addition, we could incur tenant improvements and lease commissions related to any releasing of vacant space.
We expect to fund our short-term liquidity requirements through a combination of available working capital, cash flows from operations and the following:
Our long-term liquidity needs generally include the funding of existing and future development activity. As of September 30, 2005, we had approximately $128 million of development activity in process, with $54.8 million funded at September 30, 2005 and the remainder expected to be funded in the next 27 months. Our long-term liquidity needs also include the funding of selective asset acquisitions and the retirement of mortgage debt, amounts outstanding under the Revolving Loan and long-term unsecured debt. Our goal is to maintain a conservative and flexible balance sheet. Accordingly, we expect to meet our long-term liquidity needs through a combination of (1) the issuance by the Operating Partnership of additional unsecured debt securities, (2) the issuance of additional equity securities by the Company and the Operating Partnership as well as (3) the sources described above with respect to our short-term liquidity. We expect to use such sources to meet our long-term liquidity requirements either through direct payments or repayments of borrowings under the unsecured Revolving Loan. As mentioned above, we do not intend to reserve funds to retire existing secured or unsecured indebtedness upon maturity. Instead, we will seek to refinance such debt at maturity or retire such debt through the issuance of equity or debt securities.
We anticipate that our available cash and cash equivalents and cash flows from operating activities, with cash available from borrowings and other sources, will be adequate to meet our capital and liquidity needs in both the short and long term. However, if these sources of funds are insufficient or unavailable, our ability to pay dividends to stockholders and satisfy other cash payments may be adversely affected.
Stockholder Dividends
To maintain our qualification as a REIT, we must distribute to stockholders at least 90.0% of our REIT taxable income, excluding capital gains. REIT taxable income, the calculation of which is determined by the federal tax laws, does not necessarily equal net income under GAAP. We generally expect to use our cash flow from operating activities for dividends to stockholders and for payment of recurring capital expenditures. Future dividends will be
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made at the discretion of our Board of Directors. The following factors will affect our cash flows and, accordingly, influence the decisions of the Board of Directors regarding dividends:
Off Balance Sheet Arrangements
We have several off balance sheet joint venture and guarantee arrangements. The joint ventures were formed with unrelated investors to generate additional capital to fund property acquisitions, repay outstanding debt or fund other strategic initiatives and to lessen the ownership risks typically associated with owning 100.0% of a property. When we create a joint venture with a strategic partner, we usually contribute one or more properties that we own to a newly formed entity in which we retain an interest of 50.0% or less. In exchange for an equal or minority interest in the joint venture, we generally receive cash from the partner and frequently retain the management income relating to the properties in the joint venture. For financial reporting purposes, the sales of assets we sold to two of our joint ventures are accounted for as financing and/or profit-sharing arrangements.
As required by GAAP, we use the equity method of accounting for our unconsolidated joint ventures in which we exercise significant influence but do not control the major operating and financial policies of the entity regarding encumbering the entities with debt and the acquisition or disposal of properties. As a result, the assets and liabilities of these joint ventures are not included on our balance sheet and the results of operations of these joint ventures are not included on our income statement, other than as equity in earnings of unconsolidated affiliates. Generally, we are not liable for the debts of our joint ventures, except to the extent of our equity investment, unless we have directly guaranteed any of that debt. In most cases, we and/or our strategic partners are required to guarantee customary limited exceptions to non-recourse liability in non-recourse loans.
As of December 31, 2004, our unconsolidated joint ventures had $826.3 million of total assets and $607.5 million of total liabilities as reflected in their financial statements. At December 31, 2004, our weighted average equity interest based on the total assets of these unconsolidated joint ventures was 40.6%. During 2004, these unconsolidated joint ventures earned $15.7 million of total net income, of which our share, after appropriate purchase accounting and other adjustments, was $7.4 million. For a more detailed discussion of our unconsolidated joint venture activity, see Note 2 to the Consolidated Financial Statements.
As of December 31, 2004, our unconsolidated joint ventures had $578.9 million of outstanding mortgage debt. All of this joint venture debt is non-recourse to us except (1) in the case of customary exceptions pertaining to such matters as misuse of funds, environmental conditions and material misrepresentations and (2) those guarantees and loans described in the following paragraphs. The following table sets forth the scheduled maturities of our share of the outstanding debt of our unconsolidated joint ventures as of December 31, 2004 ($ in thousands):
2005
In connection with the Des Moines joint ventures, we guaranteed certain debt and the maximum potential amount of future payments that we could be required to make under the guarantees is $24.7 million. Of this amount, $8.6 million arose from housing revenue bonds that require credit enhancements in addition to the real estate
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mortgages. The bonds bear a floating interest rate, which at December 31, 2004 averaged 2.00%, and mature in 2015. Guarantees of $9.4 million of debt of the Des Moines joint ventures will expire upon two industrial buildings becoming 93.8% and 95.0% leased or when the related loans mature. As of December 31, 2004, these buildings were 93.2% and 75.0% leased, respectively. The remaining $6.7 million in guarantees of debt of the Des Moines joint ventures relate to loans on four office buildings that were in the lease-up phase at the time the loans were initiated. Each of the loans will mature by May 2008. The average occupancy of the four buildings at December 31, 2004 was 94.0%. If the joint ventures are unable to repay the outstanding balances under the loans that we have guaranteed, we will be required, under the terms of the agreements, to repay the outstanding balances. Recourse provisions exist that enable us to recover some or all of such payments from the joint ventures’ assets and/or the other partners. The joint ventures currently generate sufficient cash flow to cover the debt service required by the loans. As a result, no liability has been recorded on our balance sheet.
In connection with the RRHWoods, LLC joint venture, we renewed our guarantee of $6.2 million to a bank in July 2003; this guarantee expires in August 2006 and may be renewed by us. The bank provides a letter of credit securing industrial revenue bonds, which mature in 2015. We would be required to perform under the guarantee should the joint venture be unable to repay the bonds. We have recourse provisions in order to recover from the joint venture’s assets and the other partner for amounts paid in excess of our proportionate share. The property collateralizing the bonds is 100.0% leased and currently generates sufficient cash flow to cover the debt service required by the bond financing. As a result, no liability has been recorded in our balance sheet.
On December 9, 2004, the Plaza Colonnade, LLC joint venture refinanced its construction loan with a $50.0 million non-recourse permanent loan, thereby releasing us from our former guarantees of a construction loan agreement and a construction completion agreement, which arose from the formation of the joint venture to construct an office building. The $50.0 million mortgage bears a fixed interest rate of 5.72%, requires monthly principal and interest payments and matures on January 31, 2017. We and our joint venture partner have signed a contingent master lease limited to 30,772 square feet for five years. Our maximum exposure under this master lease is $2.1 million. However, the current occupancy level of the building is sufficient to cover all debt service requirements. The likelihood of us paying on the master lease is remote.
On March 30, 2004, the Industrial Development Authority of the City of Kansas City, Missouri issued $18.5 million in non-recourse bonds to finance public improvements made by the Plaza Colonnade, LLC joint venture for the benefit of the Kansas City Missouri Public Library. Since the joint venture leases the land for the office building from the library, the joint venture was obligated to build certain public improvements. The net bond proceeds were $18.1 million and will be used for project and debt service costs. The joint venture has recorded this obligation on its balance sheet. The bonds are ultimately paid by the tax increment financing revenue generated by the building and its tenants.
In the Highwoods DLF 97/26 DLF 99/32, LP joint venture, a single tenant currently leases an entire building under a lease scheduled to expire on June 30, 2008. The tenant also leases space in other buildings owned by us. In conjunction with an overall restructuring of the tenant’s leases with us and with this joint venture, we agreed to certain changes to the lease with the joint venture in September 2003. The modifications included allowing the tenant to vacate the premises on January 1, 2006, and reducing the rent obligation by 50.0% and converting the “net” lease to a “full service” lease with the tenant liable for 50.0% of these costs at that time. In turn, we agreed to compensate the joint venture for any economic losses incurred as a result of these lease modifications. Based on the lease guarantee agreement, in September 2003, we recorded $0.9 million in other liabilities and $0.9 million as a deferred charge in other assets on our Consolidated Balance Sheet. However, should new tenants occupy the vacated space during the two and a half year guarantee period, our liability under the guarantee would diminish. Our maximum potential amount of future payments with regard to this guarantee was $1.1 million as of December 31, 2004. No recourse provisions exist to enable us to recover any amounts paid to the joint venture under this lease guarantee arrangement.
On December 29, 2003, we contributed three in-service office properties encompassing 290,853 rentable square feet at an agreed upon value of $35.6 million to the existing Highwoods-Markel, LLC joint venture. The joint venture’s other partner, Markel Corporation, contributed an additional $3.6 million in cash to maintain its 50.0% ownership interest and the joint venture borrowed and refinanced $40.0 million from a third party lender. We retained our 50.0% ownership interest in the joint venture and received net cash proceeds of $31.9 million. We are the manager and leasing agent for the properties and receive customary management fees and leasing commissions.
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In July 2003, we entered into an option agreement with our partner, Miller Global, to acquire its 50.0% interest in the assets of MG-HIW Metrowest I, LLC and MG-HIW Metrowest II, LLC for $3.2 million. We had previously guaranteed $3.7 million (50.0%) of the $7.4 million construction loan to fund the development of this property, of which $7.3 million was outstanding at December 31, 2003. On March 2, 2004, we exercised our option and acquired our partner’s 50.0% equity interest in the assets of MG-HIW Metrowest I, LLC and MG-HIW Metrowest II, LLC for $3.2 million. The assets in MG-HIW Metrowest I, LLC and MG-HIW Metrowest II, LLC include 87,832 square feet of property and 7.0 acres of development land zoned for the development of 90,000 square feet of office space. The $7.4 million construction loan to fund the development of this property was paid in full by us at closing.
On February 25, 2004, we and Kapital-Consult, a European investment firm, formed Highwoods KC Glenridge, LP, which on February 26, 2004 acquired from a third party Glenridge Point Office Park, consisting of two office buildings aggregating 185,100 square feet located in the Central Perimeter sub-market of Atlanta. At December 31, 2004, the buildings were 89.8% occupied. We contributed $10.0 million to the joint venture in return for a 40.0% equity interest and Kapital-Consult contributed $14.9 million for a 60.0% equity interest in the partnership. The joint venture entered into a $16.5 million ten-year secured loan on the assets. We are the manager and leasing agent for this property and receive customary management fees and leasing commissions. The acquisition also included 2.9 acres of development land.
RRHWOODS, LLC and Dallas County Partners each developed a new office building in Des Moines, Iowa. On June 25, 2004, the joint ventures financed both buildings with a $7.4 million ten-year loan from a lender. As an inducement to make the loan at a 6.3% long-term rate, we and our partner agreed to master lease the vacant space and each guaranteed $0.8 million of the debt with limited recourse. As leasing improves, the guarantee obligations under the loan agreement diminish. As of December 2004, we expensed our share of the master lease payments totaling $0.2 million and recorded $0.6 million in other liabilities and $0.6 million as a deferred charge included in other assets on our Consolidated Balance Sheet with respect to this guarantee. The maximum potential amount of future payments that we could be required to make based on the current leases in place is approximately $3.6 million as of December 31, 2004. The likelihood of us paying on our $0.8 million guarantee is believed to be remote since the master lease payments enable the joint ventures to satisfy the minimum debt coverage ratio and should we be required to pay our portion of the guarantee, we would recover the $0.8 million from other joint venture assets.
On June 28, 2004, Kapital-Consult, a European investment firm, bought an interest in HIW-KC Orlando, LLC, an entity formed by us. HIW-KC Orlando, LLC owns five in-service office properties, encompassing 1.3 million rentable square feet, located in the central business district of Orlando, Florida which were valued under the joint venture agreement at $212.0 million, including amounts related to our guarantees described below, and which were subject to a $136.2 million secured mortgage loan. Our partner contributed $42.1 million in cash and received a 60.0% equity interest in the entity. The joint venture borrowed $143.0 million under a ten-year fixed rate mortgage loan from a third party lender and repaid the original $136.2 million loan. We retained a 40.0% equity interest in the joint venture and received net cash proceeds of $46.6 million, of which $33.0 million was used to pay down our Revolving Loan and $13.6 million was used to pay down additional debt. In connection with this transaction, we agreed to guarantee rent to the joint venture for 3,248 rentable square feet commencing in August 2004 and expiring in April 2011. In connection with this guarantee, as of June 30, 2004, we included $0.6 million in other liabilities and reduced the total amount of gain to be recognized by the same amount. Additionally, we agreed to guarantee re-tenanting costs for approximately 11% of the joint venture’s total square footage. We recorded a $4.1 million contingent liability with respect to such guarantee as of June 30, 2004 and reduced the total amount of gain to be recognized by the same amount. During 2004, we paid $2.4 million in re-tenanting costs related to this guarantee. We believe our estimate related to the re-tenanting costs guarantee is accurate. However, if our assumptions prove to be incorrect, future losses may occur. The contribution was accounted for as a partial sale as defined by SFAS No. 66 and we recognized a $15.9 million gain in June 2004. Since we have an ongoing 40.0% financial interest in the joint venture and since we are engaged by the joint venture to provide management and leasing services for the joint venture, for which we receive customary management fees and leasing commissions, the operations of these properties were not reflected as discontinued operations consistent with SFAS No. 144 and the related gain on sale was included in continuing operations in the second quarter of 2004.
On September 27, 2004, we and an affiliate of Crosland, Inc. formed Weston Lakeside, LLC, in which we have a 50.0% ownership interest. On June 29, 2005, we contributed 22.4 acres of land at an agreed upon value of $3.9 million to this joint venture, and our partner contributed approximately $2.0 million in cash; immediately thereafter, the joint venture distributed approximately $1.9 million to us. Crosland, Inc. will develop, manage and operate this joint venture, which will construct approximately 332 rental residential units at a total estimated cost of
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approximately $32.0 million expected to be completed by the second quarter of 2007. Crosland, Inc. will receive 3.5% of gross revenue of the joint venture in management fees and 4.25% in development fees. The joint venture expects to finance the development with a $28.4 million construction loan that will be guaranteed by Crosland, Inc. We will provide limited development services for the project and will receive a fee equal to 1.0% of the development costs excluding land. We will account for this joint venture using the equity method of accounting.
On December 22, 2004, we and Easlan Investment Group, Inc. formed The Vinings at University Center, LLC. We contributed 7.8 acres of land at an agreed upon value of $1.6 million to the joint venture in December 2004 in return for a 50.0% equity interest and Easlan Investment Group contributed $1.1 million in the form of a non-interest bearing promissory note for a 50.0% equity interest in the entity. Upon formation, the joint venture entered into a $9.7 million secured construction loan to complete the construction of 156 apartment units on the 7.8 acres of land, which is expected to be completed by the fourth quarter of 2005; $392,000 was borrowed on the construction loan at December 31, 2004. Our joint venture partner has guaranteed this construction loan. The Easlan Investment Group, Inc. will be the manager and leasing agent for these apartment units and receive customary management fees and leasing commissions. We will receive development fees throughout the construction project and management fees of 1.0% of gross revenues at the time the apartments are 80.0% occupied. We are currently consolidating this joint venture under the provisions of FIN 46. As such, our balance sheet at December 31, 2004 includes $1.8 million of development in process and a $0.4 million construction note payable.
Financing and Profit-Sharing Arrangements
The following summarizes sale transactions that were or continue to be accounted for as financing and/or profit-sharing arrangements under paragraphs 25 through 29 of SFAS No. 66.
- SF-HIW Harborview, LP
On September 11, 2002, we contributed Harborview Plaza, an office building located in Tampa, Florida, to SF-HIW Harborview Plaza, LP (“Harborview LP”), a newly formed entity, in exchange for a 20.0% limited partnership interest and $35.4 million in cash. The other partner contributed $12.6 million of cash and a new loan was obtained by the partnership for $22.8 million. In connection with this disposition, we entered into a master lease agreement with Harborview LP for five years on the then vacant space in the building (approximately 20% of the building); occupancy was 99.7% at December 31, 2004. We also guaranteed to Harborview LP the payment of tenant improvements and lease commissions of $1.2 million. Our maximum exposure to loss under the master lease agreement was $2.1 million at September 11, 2002 and was $1.1 million at December 31, 2004. Additionally, our partner in Harborview LP was granted the right to put its 80.0% equity interest in Harborview LP to us in exchange for cash at any time during the one-year period commencing on September 11, 2014. The value of the 80.0% equity interest will be determined at the time that such partner elects to exercise its put right, if ever, based upon the then fair market value of Harborview LP’s assets and liabilities, less 3.0%, which amount was intended to cover the normal costs of a sale transaction.
Because of the put option and the master lease agreement, this transaction is accounted for as a financing transaction, as described in Note 1 to the Consolidated Financial Statements. Accordingly, the assets, liabilities and operations related to Harborview Plaza, the property owned by Harborview LP, including any new financing by the partnership, remain on our books. As a result, we have established a financing obligation equal to the net equity contributed by the other partner. At the end of each reporting period, the balance of the financing obligation is adjusted to equal the current fair value, which is $14.8 million at December 31, 2004, but not less than the original financing obligation. This adjustment is amortized prospectively through September 2014. Additionally, the net income from the operations before depreciation of Harborview Plaza allocable to the 80.0% partner is recorded as interest expense on financing obligation. We continue to depreciate the property and record all of the depreciation on our books. Any payments made under the master lease agreement were expensed as incurred ($0.1 million, $0.4 million and $0.3 million was expensed during the years ended December 31, 2004, 2003 and 2002, respectively) and any amounts paid under the tenant improvement and lease commission guarantee are capitalized and amortized to expense over the remaining lease term. At such time as the put option expires or is otherwise terminated, we will record the transaction as a sale and recognize gain on sale.
- Eastshore
On November 26, 2002, we sold three buildings located in Richmond, Virginia (the “Eastshore” transaction) for a total price of $28.5 million in cash, which was paid in full by the buyer at closing. Each of the sold properties is a single tenant building leased on a triple-net basis to Capital One Services, Inc., a subsidiary of Capital One Financial Services, Inc.
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In connection with the sale, we entered into a rental guarantee agreement for each building for the benefit of the buyer to guarantee any shortfalls that may be incurred in the payment of rent and re-tenanting costs for a five-year period from the date of sale (through November 2007). Our maximum exposure to loss under the rental guarantee agreements was $18.7 million at the date of sale and was $12.4 million as of December 31, 2004. No payments were made during 2003 or 2002 in respect of these rent guarantees. However, in June 2004, we began to make monthly payments to the buyer, at an annual rate of $0.1 million, as a result of the existing tenant renewing a lease in one building at a lower rental rate.
These rent guarantees are a form of continuing involvement as discussed in paragraph 28 of SFAS No. 66. Because the guarantees cover the entire space occupied by a single tenant under a triple-net lease arrangement, our guarantees are considered a guaranteed return on the buyer’s investment for an extended period of time. Therefore, the transaction has been accounted for as a financing transaction following the accounting method described in Note 1 to the Consolidated Financial Statements. Accordingly, the assets, liabilities and operations are included in the Consolidated Financial Statements, and a financing obligation of $28.8 million was recorded which represents the amount received from the buyer, adjusted for subsequent activity. The income from the operations of the properties, other than depreciation, is allocated 100.0% to the owner as interest expense on a financing obligation. Payments made under the rent guarantees are charged to expense as incurred. This transaction was recorded as a completed sale transaction in the third quarter of 2005 when the maximum exposure to loss under the guarantees became less than the related gain; deferred gain will be recognized in future periods as the maximum exposure under the guarantees is reduced.
- MG-HIW, LLC
On December 19, 2000, we formed a joint venture with Miller Global, MG-HIW, LLC, pursuant to which we sold or contributed to MG-HIW, LLC 19 in-service office properties in Raleigh, Atlanta, Tampa (the “Non-Orlando City Group”) and Orlando (collectively the “City Groups”), at an agreed upon value of $335.0 million. As part of the formation of MG-HIW, LLC, Miller Global contributed $85.0 million in cash for an 80.0% ownership interest and the joint venture borrowed $238.8 million from a third-party lender. We retained a 20.0% ownership interest and received net cash proceeds of $307.0 million. During 2001, we contributed a 39,000 square foot development project to MG-HIW, LLC in exchange for $5.1 million. The joint venture borrowed an additional $3.7 million under its existing debt agreement with a third party and we retained our 20.0% ownership interest and received net cash proceeds of $4.8 million. The assets of each of the City Groups were legally acquired by four separate LLC’s of which MG-HIW, LLC was the sole member.
The Non-Orlando City Group consisted of 15 properties encompassing 1.3 million square feet and were located in Atlanta, Raleigh and Tampa. Based on the nature and extent of certain rental guarantees made by us with respect to these properties, the transaction did not qualify for sale treatment under SFAS No. 66. The transaction was accounted for as a profit-sharing arrangement, and accordingly, the assets, liabilities and operations of the properties remained on our books and a co-venture obligation was established for the amount of equity contributed by Miller Global related to the Non-Orlando City Group properties. The income from operations of the properties, excluding depreciation, was allocated 80.0% to Miller Global and reported as “co-venture expense” in our Consolidated Financial Statements. We continue to depreciate the properties and record all of the depreciation on our books. In addition to the co-venture expense, we recorded expense of $1.3 million and $0.7 million related to payments made under the rental guarantees for the years ended December 31, 2003 and 2002, respectively. No payments were made under the rental guarantees for the year ended December 31, 2004.
On July 29, 2003, we acquired our partner’s 80.0% equity interest in the Non-Orlando City Group. We paid Miller Global $28.1 million in cash, repaid $41.4 million of debt related to the properties and assumed $64.7 million of debt. We recognized a $16.3 million gain on the settlement of the $43.5 million co-venture obligation recorded on our books.
With respect to the Orlando City Group, which consists of five properties encompassing 1.3 million square feet located in the central business district of Orlando, we assumed obligations to make improvements to the assets as well as master lease obligations and guarantees on certain vacant space. Additionally, we guaranteed a leveraged internal rate of return (“IRR”) of 20.0% on Miller Global’s equity. The contribution of these Orlando properties was
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accounted for as a financing arrangement under SFAS No. 66. Consequently, the assets, liabilities and operations related to the properties remained on our books and a financing obligation was established for the amount of equity contributed by Miller Global related to the Orlando City Group. The income from operations of the properties, excluding depreciation, was allocated 80.0% to Miller Global and reported as interest on financing obligation in our Consolidated Financial Statements. This financing obligation was also adjusted each period by accreting the obligation up to the 20.0% guaranteed internal rate of return by a charge to interest expense, such that the financing obligation equaled at the end of each period the amount due to Miller Global including the 20.0% guaranteed return. We recorded interest expense on the financing obligation of $3.2 million, $11.6 million and $10.1 million, which includes amounts related to this IRR guarantee and payments made under the rental guarantees, for the years ended 2004, 2003 and 2002, respectively. We continued to depreciate the Orlando properties and record all of the depreciation on our books until June 2004 when the assets were contributed to a 40% owned joint venture, HIW-KC Orlando, LLC.
On July 29, 2003, we also entered into an option agreement to acquire Miller Global’s 80.0% interest in the Orlando City Group. On March 2, 2004, we exercised our option and acquired our partner’s 80.0% equity interest in the Orlando City Group. The properties were 86.8% leased as of December 31, 2004 and encumbered by $136.2 million of floating rate debt with interest based on LIBOR plus 200 basis points. At the closing of the transaction, we paid our partner, Miller Global, $62.5 million and a $7.5 million letter of credit delivered to the seller in connection with the original execution of the option agreement was cancelled. Since the initial contribution of these assets was accounted for as a financing arrangement and since the financing obligation was adjusted each period for the IRR guarantee, no gain or loss was recognized upon the extinguishment of the financing obligation. As previously described, we sold a 60.0% interest in these assets in June 2004.
Interest Rate Hedging Activities
To meet in part our long-term liquidity requirements, we borrow funds at a combination of fixed and variable rates. Borrowings under our Revolving Loan and bank term loans bear interest at variable rates. Our long-term debt, which consists of secured and unsecured long-term financings and the unsecured issuance of debt securities, typically bears interest at fixed rates although some loans bear interest at variable rates. In addition, we have assumed fixed rate and variable rate debt in connection with acquiring properties. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, from time to time we may enter into interest rate hedge contracts such as collars, swaps, caps and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not hold or issue these derivative contracts for trading or speculative purposes.
The following table sets forth information regarding our interest rate hedge contract as of December 31, 2004 ($ in thousands):
Type of Hedge
Notional
Amount
Maturity
Date
Fixed
Rate
Fair Market
Value
Interest Rate Swap
The interest rate on all of our variable rate debt is adjusted at one and three month intervals, subject to settlements under these interest rate hedge contracts. We also enter into treasury lock agreements from time to time in order to limit our exposure to an increase in interest rates with respect to future debt offerings. During 2004, only a nominal amount was received from counter parties under interest rate hedge contracts. The interest rate swap that matured on June 1, 2005 was not renewed or extended. We currently have no outstanding interest rate hedge contracts.
As further described below under “- Related Party Transactions,” the Company had an embedded derivative as part of the land purchase arrangement with GAPI, Inc.
Related Party Transactions
We have previously reported that we have had a contract to acquire development land in the Bluegrass Valley office development project from GAPI, Inc., a corporation controlled by Gene H. Anderson, an executive officer and director of the Company. Under the terms of the contract, the development land is to be purchased in phases, and the purchase price for each phase or parcel is settled for in cash and/or Common Units. The price for the various parcels
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is based on an initial value for each parcel, adjusted for an interest factor, currently 6.88% per annum, applied up to the closing date and also for changes in the value of the Common Units. On January 17, 2003, we acquired an additional 23.5 acres of this land from GAPI, Inc. for 85,520 shares of Common Stock and $384,000 in cash for total consideration of $2.3 million. In May 2003, 4.0 acres of the remaining acres not yet acquired by us was taken by the Georgia Department of Transportation to develop a roadway interchange for consideration of $1.8 million. The Department of Transportation took possession and title of the property in June 2003. As part of the terms of the contract between us and GAPI, Inc., we were entitled to and received in 2003 the $1.8 million proceeds from the condemnation. In July 2003, we appealed the condemnation and are currently seeking additional payment from the state; the recognition of any gain has been deferred pending resolution of the appeal process. In April 2005, we acquired for cash an additional 12.1 acres of the Bluegrass Valley land from GAPI, Inc. and also settled for cash the final purchase price with GAPI, Inc. on the 4.0 acres that were taken by the Georgia Department of Transportation, which aggregated approximately $2.7 million, of which $0.7 million was recorded as a payable to GAPI, Inc. on the Company’s financial statements as of December 31, 2004. In August 2005, we acquired 12.7 acres, representing the last parcel of land to be acquired, for cash aggregating $3.2 million. We believe that the purchase price with respect to each land parcel was at or below market value. These transactions were unanimously approved by the full Board of Directors with Mr. Anderson abstaining from the vote. The contract provided that the land parcels could be paid in Common Units or in cash, at the option of the seller. This feature constituted an embedded derivative pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The embedded derivative feature is accounted for separately and adjusted based on changes in the fair value of the Common Units. This resulted in an increase to other income of $1.3 million in 2002, and a decrease to other income of $0.7 and $0.4 million in 2003 and 2004, respectively. In 2005, an additional $0.2 million expense was recorded related to the embedded derivative, which expired upon the closing of the final land transaction in August 2005.
We entered into a series of agreements in January and February 2005, pursuant to which we, through a third party broker, sold on February 28, 2005 and April 15, 2005, three non-core industrial buildings in Winston-Salem, North Carolina to John L. Turner, a director of the Company, and certain of his affiliates in exchange for a gross sales price of approximately $27.0 million, of which $20.3 million was paid in cash and the remainder from the surrender of 256,508 Common Units in the Operating Partnership. We recorded a gain of approximately $4.8 million upon the closing of these sales. We believe that the purchase price paid for these assets by Mr. Turner and his affiliates was equal to their fair market value. The sales were unanimously approved by the full Board of Directors with Mr. Turner not being present to discuss or vote on the matter.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ from our estimates.
The policies and estimates used in the preparation of our Consolidated Financial Statements are described in Note 1 to our Consolidated Financial Statements for the year ended December 31, 2004. However, certain of our significant accounting policies contain an increased level of assumptions used or estimates made in determining their impact on our Consolidated Financial Statements. Management has reviewed our critical accounting policies and estimates with the audit committee of the Company’s Board of Directors and the Company’s independent auditors.
We consider our critical accounting estimates to be those used in the determination of the reported amounts and disclosure related to the following:
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Real Estate and Related Assets
Real estate and related assets are recorded at cost and stated at cost less accumulated depreciation. Renovations, replacements and other expenditures that improve or extend the life of an asset are capitalized and depreciated over their estimated useful lives. Expenditures for ordinary maintenance and repairs are charged to operating expense as incurred. Depreciation is computed using the straight-line method over the estimated useful life of 40 years for buildings and depreciable land infrastructure costs, 15 years for building improvements and five to seven years for furniture, fixtures and equipment. Tenant improvements are amortized over the life of the respective leases using the straight-line method.
Expenditures directly related to the development and construction of real estate assets are included in net real estate assets and are stated at cost in the Consolidated Balance Sheets. Our capitalization policy on development properties is in accordance with SFAS No. 67, “Accounting for Costs and the Initial Rental Operations of Real Estate Properties,” SFAS No. 34, “Capitalization of Interest Costs,” and SFAS No. 58, “Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method.” Development expenditures include pre-construction costs essential to the development of properties, development and construction costs, interest costs, real estate taxes, salaries and related costs and other costs incurred during the period of development. Interest and other carrying costs are capitalized until the building is ready for its intended use. We consider a construction project as substantially completed and held available for occupancy upon the completion of tenant improvements, but no later than one year from cessation of major construction activity. We cease capitalization on the portion substantially completed and occupied or held available for occupancy, and capitalize only those costs associated with the portion under construction.
Expenditures directly related to the leasing of properties are included in deferred leasing costs and are stated at cost in the Consolidated Balance Sheets. We capitalize initial direct costs related to our leasing efforts in accordance with SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” All leasing commissions paid to third parties for new leases or lease renewals are capitalized. Internal leasing costs include primarily compensation, benefits and other costs such as legal fees related to leasing activities that are incurred in connection with successfully securing leases on the properties. Capitalized leasing costs are amortized on a straight-line basis over the estimated lives of the respective leases. Estimated costs related to unsuccessful activities are expensed as incurred. If our assumptions regarding the successful efforts of leasing are incorrect, the resulting adjustments could impact earnings.
Upon the acquisition of real estate, we assess the fair value of acquired tangible assets such as land, buildings and tenant improvements, intangible assets such as above and below market leases, acquired-in place leases and other identified intangible assets and assumed liabilities in accordance with SFAS No. 141, “Business Combinations.” We allocate the purchase price to the acquired assets and assumed liabilities based on their relative fair values. We assess and consider fair value based on estimated cash flow projections that utilize appropriate discount and/or capitalization rates as well as available market information. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant.
Above and below market leases acquired are recorded at their fair value. Fair value is calculated as the present value of the difference between (1) the contractual amounts to be paid pursuant to each in-place lease and (2) management’s estimate of fair market lease rates for each corresponding in-place lease, using a discount rate that reflects the risks associated with the leases acquired and measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market fixed rate renewal options for below-market leases. The capitalized above-market lease values are amortized as a reduction of base rental revenue over the remaining term of the respective leases and the capitalized below-market lease values are amortized as an increase to base rental revenue over the remaining term of the respective leases and any below market option periods. If a tenant vacates its space prior to its contractual expiration date, any unamortized balance is adjusted through rental revenue.
The value of in-place leases is based on our evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, current market conditions and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, depending on local market conditions. In estimating costs to execute similar leases, we consider tenant
47
improvements, leasing commissions and legal and other related expenses. The value of in-place leases is amortized to depreciation and amortization expense over the remaining term of the respective leases. If a tenant vacates its space prior to its contractual expiration date, any unamortized balance of its related intangible asset is expensed.
The value of a tenant relationship is based on our overall relationship with the respective tenant. Factors considered include the tenant’s credit quality and expectations of lease renewals. The value of a tenant relationship is amortized to expense over the initial term and any renewal periods defined in the respective leases. Based on our acquisitions since the adoption of SFAS No. 141 and SFAS No. 142, we have deemed tenant relationships to be immaterial and have not allocated any amounts to this intangible asset.
Real estate and leasehold improvements are classified as long-lived assets held for sale or as long-lived assets to be held for use. Real estate is classified as held for sale when the criteria set forth in SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” are satisfied; this determination requires management to make estimates and assumptions, including assessing the probability that potential sales transactions may or may not occur. Actual results could differ from those assumptions. In accordance with SFAS No. 144, we record assets held for sale at the lower of the carrying amount or estimated fair value. Fair value of assets held for sale is equal to the estimated or contracted sales price with a potential buyer less costs to sell. The impairment loss is the amount by which the carrying amount exceeds the estimated fair value. With respect to assets classified as held for use, if events or changes in circumstances, such as a significant decline in occupancy and change in use, indicate that the carrying value may be impaired, an impairment analysis is performed. Such analysis consists of determining whether the asset’s carrying amount will be recovered from its undiscounted estimated future operating cash flows. These cash flows are estimated based on a number of assumptions that are subject to economic and market uncertainties including, among others, demand for space, competition for tenants, changes in market rental rates and costs to operate each property. If the carrying amount of a held for use asset exceeds the sum of its undiscounted future operating and residual cash flows, an impairment loss is recorded for the difference between estimated fair value of the asset and the net carrying amount. We generally estimate the fair value of assets held for use by using discounted cash flow analysis; in some instances, appraisal information may be available and is used in addition to the discounted cash flow analysis. As the factors used in generating these cash flows are difficult to predict and are subject to future events that may alter our assumptions, the discounted and/or undiscounted future operating and residual cash flows estimated by us in our impairment analyses or those established by appraisal may not be achieved and we may be required to recognize future impairment losses on our properties held for sale and held for use.
Sales of Real Estate
We account for sales of real estate in accordance with SFAS No. 66. For sales transactions meeting the requirements of SFAS No. 66 for full profit recognition, the related assets and liabilities are removed from the balance sheet and the resultant gain or loss is recorded in the period the transaction closes. For sales transactions that do not meet the criteria for full profit recognition, we account for the transactions in accordance with the methods specified in SFAS No. 66. For sales transactions with continuing involvement after the sale, if the continuing involvement with the property is limited by the terms of the sales contract, profit is recognized at the time of sale and is reduced by the maximum exposure to loss related to the nature of the continuing involvement. Sales to entities in which we have an interest are accounted for in accordance with partial sale accounting provisions as set forth in SFAS No. 66.
For sales transactions that do not meet sale criteria as set forth in SFAS No. 66, we evaluate the nature of the continuing involvement, including put and call provisions, if present, and account for the transaction as a financing arrangement, profit-sharing arrangement or other alternate method of accounting rather than as a sale, based on the nature and extent of the continuing involvement. Some transactions may have numerous forms of continuing involvement. In those cases, we determine which method is most appropriate based on the substance of the transaction.
If we have an obligation to repurchase the property at a higher price or at a future indeterminable value (such as fair market value), or we guarantee the return of the buyer’s investment or a return on that investment for an extended period, we account for such transaction as a financing transaction. If we have an option to repurchase the property at a higher price and it is likely we will exercise this option, the transaction is accounted for as a financing transaction. For transactions treated as financings, we record the amounts received from the buyer as a financing obligation and continue to keep the property and related accounts recorded on our books. The results of operations
48
of the property, net of expenses other than depreciation (net operating income), will be reflected as “interest expense” on the financing obligation. If the transaction includes an obligation or option to repurchase the asset at a higher price, additional interest is recorded to accrete the liability to the repurchase price. For options or obligations to repurchase the asset at fair market value at the end of each reporting period, the balance of the liability is adjusted to equal the current fair value to the extent fair value exceeds the original financing obligation. The corresponding debit or credit will be recorded to a related discount account and the revised debt discount is amortized over the expected term until termination of the option or obligation. If it is unlikely such option will be exercised, the transaction is accounted for under the deposit method or profit-sharing method. If we have an obligation or option to repurchase at a lower price, the transaction is accounted for as a leasing arrangement. At such time as these repurchase obligations expire, a sale will be recorded and gain recognized.
If we retain an interest in the buyer and provide certain rent guarantees or other forms of support where the maximum exposure to loss exceeds the gain, we account for such transaction as a profit-sharing arrangement. For transactions treated as profit-sharing arrangements, we record a profit-sharing obligation for the amount of equity contributed by the other partner and continue to keep the property and related accounts recorded on our books. The results of operations of the property, net of expenses other than depreciation (net operating income), will be allocated to the other partner for their percentage interest and reflected as “co-venture expense” in our Consolidated Financial Statements. In future periods, a sale is recorded and profit is recognized when the remaining maximum exposure to loss is reduced below the amount of gain deferred.
Allowance for Doubtful Accounts
Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. Our receivable balance is comprised primarily of rents and operating cost recoveries due from tenants as well as accrued straight-line rents receivable. We regularly evaluate the adequacy of our allowance for doubtful accounts. The evaluation primarily consists of reviewing past due account balances and considering such factors as the credit quality of our tenant, historical trends of the tenant and/or other debtor, current economic conditions and changes in customer payment terms. Additionally, with respect to tenants in bankruptcy, we estimate the expected recovery through bankruptcy claims and increase the allowance for amounts deemed uncollectible. If our assumptions regarding the collectibility of accounts receivable prove incorrect, we could experience write-offs of accounts receivable or accrued straight-line rents receivable in excess of our allowance for doubtful accounts.
Property Operating Expense Recoveries
Property operating cost recoveries from tenants (or cost reimbursements) are determined on a lease-by-lease basis. The most common types of cost reimbursements in our leases are common area maintenance (“CAM”) and real estate taxes, where the tenant pays a share of operating and administrative expenses and real estate taxes, as determined in each lease.
The computation of cost reimbursements from tenants for CAM and real estate taxes is complex and involves numerous judgments, including the interpretation of terms and other tenant lease provisions. Leases are not uniform in dealing with such cost reimbursements and there are many variations in the computations. Many tenants make monthly fixed payments of CAM, real estate taxes and other cost reimbursement items. We record these payments as income each month. We also make adjustments, positive or negative, to cost recovery income to adjust the recorded amounts to our best estimate of the final amounts to be billed and collected with respect to the cost reimbursements. After the end of the calendar year, we compute each tenant’s final cost reimbursements and, after considering amounts paid by the tenant during the year, issue a bill or credit for the appropriate amount to the tenant. The differences between the amounts billed less previously received payments and the accrual adjustment are recorded as increases or decreases to cost recovery income when the final bills are prepared, usually beginning in March and completed by mid-year. The net amounts of any such adjustments have not been material in the years presented.
FUNDS FROMOPERATIONS
We believe that FFO and FFO per share are beneficial to management and investors and are important indicators of the performance of any equity REIT. Because FFO and FFO per share calculations exclude such factors as depreciation and amortization of real estate assets and gains or losses from sales of operating real estate assets (which can vary among owners of identical assets in similar conditions based on historical cost
49
accounting and useful life estimates), they facilitate comparisons of operating performance between periods and between other REITs. Our management believes that historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. As a result, management believes that the use of FFO and FFO per share, together with the required GAAP presentations, provide a more complete understanding of the Company’s performance relative to its competitors and a more informed and appropriate basis on which to make decisions involving operating, financing and investing activities.
FFO and FFO per share as disclosed by other REITs may not be comparable to our calculation of FFO and FFO per share as described below. However, you should be aware that FFO and FFO per share are non-GAAP financial measures and therefore do not represent net income or net income per share as defined by GAAP. Net income and net income per share as defined by GAAP are the most relevant measures in determining our operating performance because FFO and FFO per share include adjustments that investors may deem subjective, such as adding back expenses such as depreciation and amortization. Furthermore, FFO per share does not depict the amount that accrues directly to the stockholders’ benefit. Accordingly, FFO and FFO per share should never be considered as alternatives to net income or net income per share as indicators of our operating performance.
Our calculation of FFO, which we believe is consistent with the calculation of FFO as defined by the National Association of Real Estate Investment Trusts (“NAREIT”) and which appropriately excludes the cost of capital improvements and related capitalized interest, is as follows:
Other REITs may not define FFO in accordance with the current NAREIT definition or may interpret the current NAREIT definition differently than we do.
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FFO and FFO per share for the years ended December 31, 2004, 2003 and 2002 are summarized in the following table ($ in thousands, except per share amounts):
Per Share
Diluted
Funds from operations:
Dividends to preferred shareholders
Net income applicable to common shareholders
Add/(Deduct):
Depreciation and amortization of real estate assets
(Gain) on disposition of depreciable real estate assets
Minority interest from the Operating Partnership in income from operations
Unconsolidated affiliates:
(Gain) on sale
Minority interest from the Operating Partnership in income from discontinued operations
Funds from operations
Dividend payout data:
Dividends paid per common share/common unit
As a % of funds from operations
Weighted average shares outstanding - diluted
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The effects of potential changes in interest rates are discussed below. Our market risk discussion includes “forward-looking statements” and represents an estimate of possible changes in fair value or future earnings that would occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future effects, but only indicators of reasonably possible effects. As a result, actual future results may differ materially from those presented. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” and the Notes to Consolidated Financial Statements for a description of our accounting policies and other information related to these financial instruments.
To meet in part our long-term liquidity requirements, we borrow funds at a combination of fixed and variable rates. Borrowings under our Revolving Loan and bank term loans bear interest at variable rates. Our long-term debt, which consists of secured and unsecured long-term financings and the issuance of unsecured debt securities, typically bears interest at fixed rates although some loans bear interest at variable rates. In addition, we have assumed fixed rate and variable rate debt in connection with acquiring properties. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, from time to time we enter into interest rate hedge contracts such as collars, swaps, caps and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not hold or issue these derivative contracts for trading or speculative purposes.
As of December 31, 2004, we had $1,216 million of fixed rate debt outstanding. The estimated aggregate fair value of this debt at December 31, 2004 was $1,313 million. If interest rates increase by 100 basis points, the aggregate fair market value of our fixed rate debt as of December 31, 2004 would decrease by approximately $59.7 million. If interest rates decrease by 100 basis points, the aggregate fair market value of our fixed rate debt as of December 31, 2004 would increase by approximately $64.7 million.
As of December 31, 2004, we had $356.6 million of variable rate debt outstanding. Of that amount, $336.6 million was not protected by interest rate hedge contracts. If the weighted average interest rate on this variable rate debt is 100 basis points higher or lower, our annual interest expense would be decreased or increased $3.4 million.
For a discussion of our interest rate hedge contract in effect at December 31, 2004, see “Management’s Discussion and Analysis of Financial Conditions and Results of Operations – Liquidity and Capital Resources – Interest Rate Hedging Activities.” If interest rates increase by 100 basis points, the aggregate fair market value of this interest rate hedge contract as of December 31, 2004 would have increased by $0.06 million. If interest rates decrease by 100 basis points, the aggregate fair market value of this interest rate hedge contract as of December 31, 2004 would have decreased by $0.07 million. This interest rate hedge contract matured on June 1, 2005 and was not renewed or extended. We currently have no outstanding interest rate hedge contracts.
At December 31, 2004, we had an embedded derivative as part of a land purchase arrangements, as described under ITEM 7. MANAGEMENT’S DICUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Liquidity and Capital Resources – Related Party Transactions. In 2005, a loss of $0.2 million was recorded on this embedded derivative which expired in August 2005 upon closing of the final land parcel under the arrangement.
In addition, we are exposed to certain losses in the event of nonperformance by the counter parties under any outstanding hedge contracts. We expect the counter parties, which are major financial institutions, to perform fully under any such contracts. However, if any of the counter parties was to default on its obligation under an interest rate hedge contract, we could be required to pay the full rates on our debt, even if such rates were in excess of the rate in the contract.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See page F-1 of the financial report included herein.
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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
ITEM 9A. CONTROLS AND PROCEDURES
GENERAL
The purpose of this section is to discuss the effectiveness of our disclosure controls and procedures and our internal control over financial reporting. The statements in this section represent the conclusions of Edward J. Fritsch, who became our CEO on July 1, 2004, and Terry L. Stevens, who became our CFO on December 1, 2003.
The CEO and CFO evaluations of our disclosure controls and procedures and our internal control over financial reporting include a review of the controls’ objectives and design, the controls’ implementation by us and the effect of the controls on the information generated for use in this Annual Report. We seek to identify data errors, control problems or acts of fraud and confirm that appropriate corrective action, including process improvements, is undertaken. Our disclosure controls and procedures and our internal control over financial reporting are also evaluated on an ongoing basis by or through the following:
Our management, including our CEO and CFO, do not expect that our disclosure controls and procedures and internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of disclosure controls and procedures and internal control over financial reporting must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
MANAGEMENT’S ANNUALREPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is required to establish and maintain internal control over financial reporting designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. As defined in Rule 13a-15(f) under the Exchange Act, internal control over financial reporting includes those policies and procedures that:
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Under the supervision of our CEO and CFO, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2004 based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
A material weakness is a control deficiency, or a combination of control deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As part of our work to assess the effectiveness of internal control over financial reporting, we have identified the following three material weaknesses at December 31, 2004:
The first two material weaknesses described above also affected the accounts of all joint ventures for which we are primarily responsible for the preparation of financial statements, which in turn affected the equity in earnings of unconsolidated affiliates in our Consolidated Financial Statements.
The first two material weaknesses resulted in adjustments to restate our financial statements for the years ended December 31, 2003 and 2002 and the first three quarters of 2004 as more fully described in Notes 19 and 20 to the Consolidated Financial Statements. Adjustments were also recorded in the fourth quarter of 2004.
As a result of the identified material weaknesses, our management has concluded that, as of December 31, 2004, our internal control over financial reporting was not effective. Ernst & Young LLP, our independent registered public accounting firm, has issued their attestation report, which is included below, on management’s assessment of our internal control over financial reporting and the effectiveness of internal control over financial reporting as of December 31, 2004.
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REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Board of Directors and Stockholders of
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, that Highwoods Properties, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of material weaknesses identified in management’s assessment relating to the capitalization of interest and carrying costs during lease-up and internal leasing, development and construction costs, fixed asset and lease incentive accounting and the financial statement close process, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Highwoods Properties, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment:
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The first two material weaknesses described above also affected the accounts of all joint ventures for which the Company is primarily responsible for the preparation of financial statements, which in turn affected the equity in earnings of unconsolidated affiliates in the Company’s Consolidated Financial Statements.
The first two material weaknesses resulted in the Company recording adjustments to restate its financial statements for the years ended December 31, 2003 and 2002 and the first three quarters of 2004 as more fully described in Notes 19 and 20 to the Consolidated Financial Statements. Adjustments were also recorded in the fourth quarter of 2004.
These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 financial statements, and this report does not affect our report dated December 16, 2005 on those financial statements.
In our opinion, management’s assessment that Highwoods Properties, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO control criteria. Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Highwoods Properties, Inc. has not maintained effective internal control over financial reporting as of December 31, 2004, based on the COSO control criteria.
/s/ Ernst & Young LLP
Raleigh, North Carolina
December 16, 2005
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Changes in Internal Control Over Financial Reporting. In our amended 2003 Annual Report, we reported that Ernst & Young LLP had advised our audit committee on October 26, 2004 that they identified the following material weaknesses during their audits of the restated financial statements for 2003, 2002 and 2001: inadequate procedures for appropriately assessing and applying accounting principles to complex transactions; lack of adequate finance and accounting staff to appropriately identify and evaluate accounting for transactions; inadequate procedures to ensure critical information regarding a transaction is known by the persons accounting for such transaction; and lack of application of GAAP to transactions due to perceived immateriality of transactions. As a result of the actions described below, the material weaknesses relating to inadequate procedures to ensure critical information regarding a transaction is known by the persons accounting for such transaction and the lack of application of GAAP to transactions due to perceived immateriality of transactions were each deemed to be remediated and no longer existing as of December 31, 2004. The material weakness relating to a lack of adequate finance and accounting staff to appropriately identify and evaluate accounting for transactions was deemed to have been sufficiently remediated such that it no longer constituted a material weakness as of December 31, 2004. Finally, the material weakness relating to not having adequate procedures for appropriately assessing and applying GAAP to complex transactions was deemed to have been remediated. However, the results of our assessment as of December 31, 2004 indicated that we had ineffective and inadequate procedures relative to fixed asset and lease incentive accounting, the capitalization of interest and carrying costs during lease-up and internal leasing, development and construction costs, and the financial statement close process, as described above in Management’s Annual Report in Internal Control Over Financial Reporting.
Since late 2002, we have added several experienced staff to our Finance and Accounting Departments. These included an Assistant Controller (new position), a Director of Financial Standards and Compliance (new position), a Senior Director of Investor Relations (replacement) and a new Chief Financial Officer (replacement, as the former CFO assumed a new position within the Company). During 2003 and 2004 (including during the fourth quarter of 2004), we improved our internal control over financial reporting by, among other things (i) expanding supervisory activities and monitoring techniques, (ii) increasing and improving the education of personnel on our accounting staff and in our various divisional operating offices, including issue-specific informal mentoring and on-the-job training, (iii) strengthening our procedures designed to ensure that information relating to transactions directly or indirectly involving the Company and its subsidiaries is made known to persons responsible for preparing our financial statements, including implementing a policy to make frequent inquiries of our personnel, requiring all divisional vice presidents, other executive officers and certain members of our accounting staff to execute sub-certifications about the accuracy of the financial records and internal controls and enhancing and formalizing the functioning of our disclosure committee meetings, which include members of senior management and accounting staff, and (iv) preparing and implementing revised checklists to ensure appropriate assessment and application of GAAP to all transactions, particularly complex transactions, such as sales of real estate with continuing involvement that are governed by SFAS No. 66.
Our management is working closely with the audit committee to monitor the ongoing remediation of the material weaknesses in our internal control over financial reporting that existed as of December 31, 2004.
In 2005, we have undertaken the following additional improvements to our internal control over financial reporting. First, we have developed and implemented or are developing remediation plans for the specific material weaknesses described above and for other control deficiencies that were identified but not considered to be material weaknesses. Second, we have begun the process of developing and implementing a Company-wide policy and procedures manual for use by our divisional and accounting staff, intended to ensure consistent and appropriate assessment and application of GAAP. The first phase of this process has focused on the preparation of formal written policies and procedures with respect to accounting for fixed assets and leasing costs. We engaged Grant Thornton LLP this year to assist us with the first phase of this process to develop and implement such policies and procedures. Third, we plan to provide training for our accounting staff and employees in our various divisional operating offices to educate our personnel with respect to the accounting adjustments that have been made to our historical financial statements in this Annual Report and in our amended 2003 Annual Report and to the material weaknesses and other control deficiencies in our internal control over financial reporting that existed as of December 31, 2004. Fourth, we have formed a permanent committee to monitor and oversee the ongoing remediation of all deficiencies identified from time to time in our annual assessment of our internal control over financial reporting. This committee consists of our CFO, COO, corporate controller and representatives from appropriate business functions within the Company. Fifth, we are in the process of hiring a Chief Accounting Officer (new position).
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We believe that the actions taken in 2005, as described above, have resulted in significant improvements to our internal control over financial reporting. However, the time and staff resources involved to complete the restatement of the financial statements for 2002, 2003 and first three quarters of 2004 and to complete this Annual Report have limited our time and ability to remediate all control deficiencies that existed at December 31, 2004. Accordingly, although we have not yet completed our assessment, we expect that one or more of the material weaknesses identified as of December 31, 2004 will not have been sufficiently remediated as of December 31, 2005. Therefore, we currently expect to report in our 2005 Annual Report on Form 10-K that our internal control over financial reporting was not effective as of December 31, 2005.
DISCLOSURE CONTROLS AND PROCEDURES
SEC rules also require us to maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our annual and periodic reports filed with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As defined in Rule 13a-15(e) under the Exchange Act, disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us is accumulated and communicated to our management, including our CEO and CFO, to allow timely decisions regarding required disclosure. Based solely on the material weaknesses described above in Management’s Annual Report on Internal Control Over Financial Reporting, our CEO and CFO do not believe that our disclosure controls and procedures were effective at December 31, 2004.
ITEM 9B. OTHER INFORMATION
New York Stock Exchange rules require that listed companies hold an annual meeting with respect to each fiscal year. We have requested that the Exchange grant us an extension to hold our 2005 annual meeting simultaneously with our 2006 annual meeting. We expect that our next annual meeting will be held during May 2006, although the exact date will be determined by the Board of Directors in the future. To be considered for inclusion in the proxy material for our next annual meeting, the compensation and governance committee has determined that proposals of stockholders to be presented at our next annual meeting must be received by our secretary prior to January 16, 2006. Our bylaws have been amended effective as of the date of this filing to provide that, if a stockholder wishes to present a proposal at the next annual meeting, whether or not the proposal is intended to be included in the proxy material, such stockholder must give advance written notice to our secretary not less than 60 nor more than 90 days prior to May 16, 2006. If a stockholder is permitted to present a proposal at our next annual meeting but the proposal was not included in the proxy material, we believe that our proxy holder would have the discretionary authority granted by the proxy card (and as permitted under SEC rules) to vote on the proposal if the proposal was received after February 14, 2006, which is 45 calendar days prior to the anniversary of the mailing of the 2004 proxy statement.
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ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information regarding our executive officers, see “ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT.” Our Board of Directors currently consists of the following 13 members:
Thomas W. Adler, 65, has been a director since June 1994. Mr. Adler is chairman of PSF Management Co. in Cleveland, Ohio. Mr. Adler formerly served on the board of directors of the National Association of Realtors and the boards of governors of the American Society of Real Estate Counselors and the National Association of Real Estate Investment Trusts and is a past national president of the Society of Industrial and Office Realtors. Mr. Adler is currently active in the Urban Land Institute. Mr. Adler was re-elected by our stockholders in 2002 for a three-year term.
Gene H. Anderson, 60, has been a director and senior vice president since our combination with Anderson Properties, Inc. in February 1997. Mr. Anderson manages our Atlanta regional operations. Mr. Anderson served as president of Anderson Properties, Inc. from 1978 to February 1997. Mr. Anderson was past president of the Georgia chapter of the National Association of Industrial and Office Properties and is a national board member of the National Association of Industrial and Office Properties. Mr. Anderson was re-elected by our stockholders in 2003 for a three-year term.
Kay N. Callison, 62, has been a director since our merger with J.C. Nichols Company in July 1998. Ms. Callison had served as a director of J.C. Nichols Company since 1982. Ms. Callison is active in charitable activities in the Kansas City metropolitan area. Ms. Callison was re-elected by our stockholders in 2002 for a three-year term.
Edward J. Fritsch, 46, has been a director since January 2001. Mr. Fritsch became our chief executive officer on July 1, 2004 and our president in December 2003. Prior to that, Mr. Fritsch was our chief operating officer from January 1998 to July 2004 and was a vice president and secretary from June 1994 to January 1998. Mr. Fritsch joined our predecessor in 1982 and was a partner of that entity at the time of our initial public offering in June 1994. Mr. Fritsch serves on the University of North Carolina’s Board of Visitors, the Board of Trustees of St. Timothy’s Episcopal School and the Board of Directors of the Triangle Chapter of the YMCA. Mr. Fritsch was re-elected by our stockholders in 2004 for a three-year term.
Ronald P. Gibson, 61, has been a director since March 1994. Mr. Gibson was our chief executive officer from March 1994 until his retirement in June 2004. Mr. Gibson also served as our president from March 1994 until December 2003. Mr. Gibson was a founder of our predecessor and served as its managing partner following its formation in 1978. Mr. Gibson is a director of Capital Associated Industries. Mr. Gibson was re-elected by our stockholders in 2003 for a three-year term.
William E. Graham, Jr., 75, has been a director since June 1994. Mr. Graham is a lawyer in private practice with the firm of Hunton & Williams. Before joining Hunton & Williams on January 1, 1994, Mr. Graham was vice chairman of Carolina Power & Light Company and had previously served as its general counsel. Mr. Graham is a former member of the board of directors of Carolina Power & Light Company and former chairman of the Raleigh board of directors of Bank of America Corporation. Mr. Graham served on the board of trustees of BB&T Mutual Funds Group until December 31, 2003. Mr. Graham was re-elected by our stockholders in 2004 for a one-year term.
Lawrence S. Kaplan, 63, has been a director since November 2000. Mr. Kaplan is a certified public accountant and retired in 2000 as a partner from Ernst & Young LLP where he was the national director of that firm’s REIT Advisory Services group. Mr. Kaplan has served on the board of governors of the National Association of Real Estate Investment Trusts and has been actively involved in REIT legislative and regulatory matters for over 20 years. Mr. Kaplan is a director of Endeavor Real Estate Securities, a private REIT, Maguire Properties, Inc., a publicly traded office REIT based in California, and Feldman Mall Properties, Inc., a publicly traded mall REIT based in Arizona. Mr. Kaplan was re-elected by our stockholders in 2004 for a three-year term.
Sherry A. Kellett, 61, has been a director since November 2005. Ms. Kellett is a certified public accountant. Ms. Kellett served as senior executive vice president and controller of BB&T Corporation from 1995 until her retirement
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on August 1, 2003. Ms. Kellett had served as corporate controller of Southern National Corporation from 1991 until 1995 when it merged with BB&T Corporation. Ms. Kellett previously served in several positions at Arthur Andersen & Co. Ms. Kellett is a director of MidCountry Financial Corp., a private financial services holding company based in Macon, GA. Ms. Kellett is a board member of the North Carolina School of the Arts Foundation and has also served on the boards of the Piedmont Kiwanis Club, Senior Services Inc., The Winston-Salem Foundation, the Piedmont Club and the N.C. Center for Character Education. Ms. Kellett was elected by our Board of Directors in November 2005 to fill a vacancy created by an increase in the number of independent directors on the Board. Under Maryland law, a director elected by the board of directors to fill a vacancy serves until the next annual meeting of stockholders and until his or her successor is elected and qualifies.
L. Glenn Orr, Jr., 65, has been a director since February 1995. Mr. Orr has been president and chief executive officer of The Orr Group since 1995. Mr. Orr was chairman of the board of directors, president and chief executive officer of Southern National Corporation from 1990 until its merger with BB&T Corporation in 1995. Mr. Orr previously served as president and chief executive officer of Forsyth Bank and Trust Co., president of Community Bank in Greenville, S.C. and president of the North Carolina Bankers Association. Mr. Orr is a member of the boards of directors of Medical Properties Trust, Inc., The International Group, Inc., Village Tavern, Inc. and Broyhill Management Fund, and he is a trustee of Wake Forest University. Mr. Orr was re-elected by our stockholders in 2004 for a three-year term.
O. Temple Sloan, Jr., 66, is chairman of the Board of Directors, a position he has held since March 1994. Mr. Sloan was a founder of our predecessor. He is chairman and chief executive officer of The International Group, Inc., a distributor of automotive replacement parts. Mr. Sloan is a director of Bank of America Corporation and Lowe’s Companies, Inc. Mr. Sloan was re-elected by our stockholders in 2003 for a three-year term.
Willard H. Smith Jr., 69, has been a director since April 1996. Mr. Smith previously served as a managing director of Merrill Lynch from 1983 to 1995. Mr. Smith is a member of the boards of directors of the Cohen & Steers Family of Funds, Essex Property Trust, Inc., Realty Income Corporation and Crest Net Lease, Inc. Mr. Smith was re-elected by our stockholders in 2002 for a three-year term.
John L. Turner, 59, has been a director since February 1995. Mr. Turner served as vice chairman of the Board of Directors from our merger with Forsyth Partners in February 1995 until the end of 2003, and served as our chief investment officer from February 1995 to December 2001. Mr. Turner co-founded the predecessor of Forsyth Partners in 1975 and served as the chairman of its board of directors and chief executive officer prior to joining us. Mr. Turner is the managing member of Gateway Holdings LLC. Mr. Turner was re-elected by our stockholders in 2002 for a three-year term.
F. William Vandiver, Jr., 63, has been a director since July 2002. Mr. Vandiver served as corporate risk management executive at Bank of America from 1998 until his retirement in 2002. Mr. Vandiver serves as trustee of the Presbyterian Hospital Foundation and is vice chairman of the Queens University of Charlotte board of trustees. He formerly served on the board of directors of the United Way of Central Carolinas, Inc. and the Clemson University Foundation. Mr. Vandiver was re-elected by our stockholders in 2003 for a three-year term.
Independent Directors
At least a majority of our directors and all of the members of the audit committee and the compensation and governance committee must meet the test of “independence” as defined by the New York Stock Exchange. The New York Stock Exchange standards provide that to qualify as an “independent” director, in addition to satisfying certain bright-line criteria, the Board of Directors must affirmatively determine that a director has no material relationship with us (either directly or as a partner, shareholder or officer of an organization that has a relationship with the Company). The Board of Directors has determined that any relationship or arrangement between us and one or more affiliates of a director that does not require disclosure pursuant to Item 404 of SEC Regulation S-K does not, by itself, preclude a determination of independence (except with respect to members of the audit committee). The Board of Directors has determined that each of Messrs. Adler, Graham, Kaplan, Orr, Sloan, Smith and Vandiver and Ms. Callison and Ms. Kellett satisfies the bright-line criteria and that none has a relationship with us that would interfere with such person’s ability to exercise independent judgment as a member of the Board. Therefore, we believe that each of such directors is independent under the New York Stock Exchange rules.
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Committees of the Board of Directors
Audit Commitee. From January 1, 2004 until October 31, 2005, the audit committee consisted of Messrs. Kaplan, Smith and Vandiver and Ms. Callison. Ms. Kellett joined the audit committee on November 1, 2005 after becoming a director. Mr. Kaplan serves as chairman of the audit committee.
The audit committee approves the engagement of independent public accountants, reviews with the independent public accountants the plans and results of the audit engagement, approves professional services provided by the independent public accountants, reviews the independence of the independent public accountants, approves audit and non-audit fees and reviews the adequacy of our internal accounting controls.
The Board of Directors has made the following determinations about the composition of the current and contemplated members of the audit committee:
During 2004, the audit committee held five in-person meetings and 10 conference calls.
The audit committee has adopted a process for stockholders to send communications to the audit committee with concerns or complaints concerning our regulatory compliance, accounting, audit or internal controls issues. Written communications may be addressed to the Chairman of the Audit Committee, Highwoods Properties, Inc., 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604. To view an online version of the audit committee’s charter, please visit the “Investor Relations/Governance Documents” section of our website at www.highwoods.com. This information is also available in print to any stockholder who requests it by writing Investor Relations, Highwoods Properties, Inc., 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604.
Compensation and Governance Committee. Since January 1, 2004, our compensation and governance committee has consisted of Messrs. Graham, Orr and Sloan. Mr. Orr serves as chairman of the compensation and governance committee. The Board of Directors has determined that each of the current and former members of the compensation and governance committee is independent under the rules and regulations of the New York Stock Exchange.
The compensation and governance committee determines compensation for our executive officers and implements our long-term incentive plans, including the Amended and Restated 1994 Stock Option Plan (the “Stock Option Plan”). The committee also makes recommendations concerning board member qualification standards, director nominees, board responsibilities and compensation, board access to management and independent advisors and management succession. On an annual basis, the compensation and governance committee assesses the appropriate skills and characteristics of existing and new board members. This assessment includes consideration as to the members’ independence, diversity, age, skills and experience in the context of the needs of the Board. The same criteria are used by the compensation and governance committee in evaluating nominees for directorship.
During 2004, the compensation and governance committee held four in-person meetings and two conference calls.
In making any nominee recommendations to the Board, the compensation and governance committee will typically consider persons recommended by stockholders so long as the recommendation is submitted to the committee prior to the date which is 120 days before the anniversary of the mailing of the prior year’s proxy statement. However, since our next annual meeting will be held more than 30 days after the anniversary of our last annual meeting on May 18, 2004, the deadline for the submission by stockholders of nominee recommendations for
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the annual meeting expected to be held in May 2006 is January 16, 2006. Any such nominations, together with appropriate biographical information, should be submitted to the Chairman of the Compensation and Governance Committee, Highwoods Properties, Inc., 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604. However, the compensation and governance committee may, in its sole discretion, reject any such recommendation for any reason.
The compensation and governance committee’s charter is available on our website for review at www.highwoods.com in the “Investor Relations/Governance Documents” section. This information is also available in print to any stockholder who requests it by writing Investor Relations, Highwoods Properties, Inc., 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604.
Investment Committee. Since January 1, 2004, our investment committee has consisted of Messrs. Adler, Anderson, Fritsch, Gibson, Sloan and Turner. The investment committee oversees the acquisition, new development, redevelopment and asset disposition process. The investment committee generally meets on call to review new opportunities and to make recommendations to the Board of Directors concerning such opportunities.
Executive Committee. Since January 1, 2004, our executive committee has consisted of Messrs. Adler, Orr, Sloan and Vandiver. In addition, our Chief Executive Officer serves as an ex-officio member of the committee. The executive committee meets on call by the Chairman of the Board of Directors and may exercise all of the powers of the Board of Directors, subject to the limitations imposed by applicable law, the bylaws or the Board of Directors. Our corporate governance guidelines require each of the members of the executive committee (other than the Chief Executive Officer) to be independent under the rules and regulations of the New York Stock Exchange. During 2004, the executive committee held four in-person meetings and ten conference calls.
Meetings of the Board of Directors; Independent Director Executive Sessions
The Board of Directors held five in-person meetings and five conference calls in 2004. At each in-person meeting of the Board of Directors, our independent directors meet in executive session without the presence of any current or former members of management. The Chairman of the Board of Directors (or, in the Chairman’s absence, another independent director designated by the Chairman) has been appointed to preside over such executive sessions. Each of the directors attended at least 75% of the aggregate of the total number of meetings of the Board of Directors and the total number of meetings of all committees of the Board of Directors on which the director served. The Board of Directors encourages its members to attend each annual meeting of stockholders. Three members of the Board of Directors attended our last annual meeting.
Corporate Governance Matters
The Board of Directors, in its role as primary governing body, provides oversight of our affairs and strives to improve and build on the Company’s strong corporate governance practices. To this end, we have adopted corporate governance guidelines and a code of business conduct and ethics applicable to directors, officers and employees. We have also adopted a separate code of ethics for our chief executive officer and our senior financial officers. This information is available in print to any stockholder who requests it by writing Investor Relations, Highwoods Properties, Inc., 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604. We intend to satisfy the disclosure requirement under Item 5.05 (formerly Item 10) of Form 8-K regarding any amendment to, or any waiver from, a provision of these Codes of Ethics by posting such information on our website as identified below. Our website includes our Codes of Ethics, our committee charters and our corporate governance guidelines. The Board of Directors has also established a process for interested parties, including stockholders, to communicate directly with the independent directors. Written communications may be addressed to the Chairman of the Board of Directors, Highwoods Properties, Inc., 3100 Smoketree Court, Suite 600, Raleigh, North Carolina 27604. All of the foregoing information is also available by visiting the “Investor Relations/ Governance Documents” section of our website at www.highwoods.com.
During 2004, we filed unqualified Section 303A certifications with the New York Stock Exchange. We have also filed the CEO and CFO certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 as exhibits to this Annual Report.
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Section 16(a) Beneficial Ownership Reporting Compliance
Each director and executive officer is required to file with the SEC, by a specified date, reports regarding his or her transactions involving Common Stock. To our knowledge, based solely on the information furnished to us and written representations that no other reports were required, all such filing requirements were complied with during 2004, except that: Messrs. Cutlip and Reames were each late in reporting his initial beneficial ownership of our securities upon becoming a section 16 reporting officer; Messrs. Anderson and Harris each reported two Common Stock dispositions late; Messrs. Beale, Cutlip, Fritsch, Gibson and Pridgen each reported one Common Stock disposition late; and Mr. Turner reported one phantom stock disposition late.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information concerning the compensation of each person who served as our Chief Executive Officer and our four other most highly compensated executive officers (the “Named Executive Officers”) for the year ended December 31, 2004:
Summary Compensation Table
Name and
Principal Position
Other Annual
Compensation (2)
Restricted
Stock
Awards (3)
Securities
Underlying
Options (4)
All Other
Compensation (5)
Edward J. FritschPresident and CEO
Ronald P. GibsonCEO (6)
Michael E. HarrisExecutive Vice President and COO
Terry L. StevensVice President and CFO
Mack D. Pridgen, IIIVice President, General Counsel and Secretary
Gene H. AndersonSenior Vice President
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the issuance of phantom stock at a 15% discount, the amount set forth above in 2004 also includes $63,386 in relocation and travel costs related to moving to Raleigh in connection with becoming Executive Vice President and COO on July 1, 2004 and $16,873 of additional perquisites earned during 2004. For Mr. Stevens, the amount set forth above in 2004 includes $47,311 in relocation and travel costs related to moving to Raleigh in connection with becoming Vice President and CFO on December 1, 2003 and $9,417 of additional perquisites earned during 2004.
Restricted Stock Holdings
The total restricted stock holdings and their fair market value based on the per share closing price of $27.70 as of December 31, 2004 are set forth below. The values do not reflect diminution of value attributable to the restrictions applicable to the shares of restricted stock. All of the shares of restricted stock issued on or before December 31, 2004 vest 50% on the third anniversary and 50% on the fifth anniversary of the date of grant. Dividends are paid on all restricted stock, whether or not vested, at the same rate and on the same date as on shares of Common Stock. As part of his retirement package, all shares of Mr. Gibson’s restricted stock vested on June 30, 2004 and, accordingly, are excluded from this table.
Total Shares of
Restricted Stock
Value at
December 31, 2004
Mack D. Pridgen, III
The following table sets forth information with respect to options granted in 2004 to the Named Executive Officers:
Option Grants in 2004
Number of Securities
Underlying Options (1)
Percent of Total
Options Granted
to Employees
in 2004
Exercise
Price
Expiration Date
Grant Date
Present Value (2)
Ronald P. Gibson
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its accuracy at valuing options. All stock option models require a prediction about the future movement of the share price. Except for the 40,000 stock options granted to Mr. Gibson in 2004 with an expiration date of June 7, 2005, the following assumptions were made for purposes of calculating grant date present value: expected time of exercise of 10 years, volatility of 16.0%, risk-free interest of 4.0% and a dividend yield of 6.5%. For the 40,000 stock options granted to Mr. Gibson in 2004 with an expiration date of June 7, 2005, the following assumptions were made for purposes of calculating grant date present value: expected time of exercise of one year, volatility of 16.4%, risk-free interest of 2.0% and a dividend yield of 7.5%. The real value of the options in this table depends upon the actual performance of Common Stock during the applicable period the options are exercisable.
The following table sets forth information with respect to options held by the Named Executive Officers as of December 31, 2004:
2004 Year-End Option Values
Shares Acquired
on Exercise
Realized
Underlying Options at
2004 Year End (1)
Value of Unexercised In the
Money Options at 2004
Year End (2) (3)
Employment and Change-In-Control Contracts
We entered into a three-year employment contract with Mr. Harris on July 1, 2004. The contract is thereafter extended automatically for additional three-year periods unless we give notice to Mr. Harris during the 60-day period ending one year prior to expiration of the contract. Mr. Harris may terminate the contract at any time upon 30 days’ prior written notice to us. The contract provides for a minimum annual base salary at the rate of $305,000 for Mr. Harris, which may be increased by the Board of Directors. His contract includes provisions restricting him from competing with us during employment and, except in certain circumstances, for a one-year period after termination of employment. His employment contract provides for severance payments in the event of termination by us without cause or termination by Mr. Harris for good reason equal to his base salary then in effect for the greater of one year from the date of termination or the remaining term of the contract.
The Company has change in control contracts in effect with each of Messrs. Anderson, Fritsch, Harris, Pridgen and Stevens. The contracts generally provide that, if within 36 months from the date of a change in control (as defined below), the employment of the executive officer is terminated without cause, including a voluntary termination because such executive officer’s responsibilities are changed, salary is reduced or responsibilities are diminished or because of a voluntary termination for any reason in months 13, 14 or 15 following the change of control, such executive officer will be entitled to receive 2.99 times a base amount. An executive’s base amount for these purposes is equal to 12 times the highest monthly salary paid to the executive during the 12-month period ending prior to the change of control plus the greater of (1) the average annual bonus for the preceding three years or
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(2) the last annual bonus paid or payable to the executive. Additionally, the Stock Option Plan and the 1999 Shareholder Value Plan provide for the immediate vesting of all options and benefits upon a change of control. Certain of the executives also receive a lump sum cash payment equal to a stated multiple of the value of all of the executive’s unexercised stock options. The multiple is three times for Mr. Fritsch, two times for Mr. Harris and one time for Messrs. Anderson and Pridgen. The contracts for each of the Named Executive Officers have varying expiration dates, but are automatically extended for one additional year on each of their respective anniversary dates. For purposes of these contracts, “change in control” generally means any of the following events:
Retirement of Former Chief Executive Officer
Mr. Gibson retired as our Chief Executive Officer on June 30, 2004. In connection with his retirement, the Board of Directors approved a retirement package for him that included a lump sum cash payment, accelerated vesting of stock options and restricted stock, extended lives of stock options and continued coverage under our health and life insurance plan for three years at our expense. Under GAAP, the changes to existing stock options and restricted stock give rise to new measurement dates and revised compensation computations. The total cost recognized under GAAP during 2004 for Mr. Gibson’s retirement was $4.6 million, comprised of a $2.2 million cash payment, $0.6 million related to the vesting of stock options, $1.7 million related to the vesting of restricted stock and approximately $100,000 for continued insurance coverage and other benefits.
Compensation and Governance Committee Interlocks and Insider Participation
During 2004, the compensation and governance committee consisted of Messrs. Orr, Graham and Sloan. None of these directors is a current or past employee and each was and is independent under the rules and regulations of the New York Stock Exchange. Mr. Sloan was a founder and former officer of our predecessor prior to our initial public offering in 1994.
Compensation and Governance Committee Report
The committee directs the administration of the Stock Option Plan and other management incentive compensation plans. The committee’s compensation policies are designed to (a) attract and retain key individuals critical to our success, (b) motivate and reward such individuals based on corporate, business unit and individual performance and (c) align executives’ and stockholders’ interests through equity-based incentives. During 2004, the compensation and governance committee met six times and set compensation levels in compliance with the executive compensation program adopted in 1999, which was based upon extensive input from and the recommendation of William M. Mercer, Incorporated, an independent compensation consulting firm.
Compensation for executives is based generally on the following principles:
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A key determinant of overall levels of compensation remains the pay practices of public equity REITs that have revenues comparable to us. This peer group was chosen by our independent compensation and benefit consultants. Overall compensation is intended to be at, above or below competitive levels depending upon our performance relative to our targeted performance and the performance of our peer group.
There are three components to our executive compensation program: base salary; annual bonus; and long-term incentive compensation. The more senior the position, the greater the portion of compensation that varies with performance.
Base Salaries and Annual Bonuses. Executive salaries other than that of the Chief Executive Officer are recommended to the committee by the Chief Executive Officer and are designed to be competitive with the peer group companies described above. Changes in base salaries are based on the peer group’s practices, our performance, the individual’s performance, experience and responsibility and increases in cost of living indices. Base salaries are reviewed for adjustment annually and adjustments, if any, are effective in April. The Chief Executive Officer’s base salary is determined by the committee. No changes were made in 2004 to executive officer base salaries.
Our executive officers participate in an annual bonus program whereby they are eligible for bonuses based on a percentage of their annual base salary as of the prior December. In addition to considering the pay practices of our peer group in determining each executive’s bonus percentage, the committee also considers the executive’s ability to influence our overall performance. Each executive has a target annual incentive bonus percentage that ranges from 30% to 85% of base salary depending on the executive’s position. The executive’s actual incentive bonus for the year is the product of the target annual incentive bonus percentage times a bonus performance “factor,” which can range from zero to 200%. This bonus performance factor depends upon the relationship between how various performance criteria compare with predetermined goals. For an executive who has division responsibilities, goals for certain performance criteria are based on the division’s budget for the year, and goals for other criteria are fixed objectives that are the same for all divisions. For corporate executives, the bonus performance factor is based on the average of the factors achieved by the division executives.
Performance criteria for 2004, which were equally weighted, were the following: average occupancy rates relative to budgeted rates; net operating income relative to budgeted amounts; and average payback on leases (i.e., a metric that compares the investment in a lease to the amount of revenue to be received under the lease) relative to a fixed goal. These criteria provide an objective basis for the committee to determine bonuses for division level and corporate level executive officers. The bonus performance factors for 2004 for division executives ranged from 59% to 134%, and the average bonus performance factor for corporate executives was 88%. Notwithstanding the foregoing criteria, the committee has retained the authority to pay bonuses in its discretion. For 2004, actual incentive bonuses for the Named Executive Officers ranged from 44% to 75% of each officer’s current base salary (not including the effect of any deferral for deemed investment by us in units of phantom stock at a 15% discount as discussed in the next paragraph).
The committee has established a nonqualified deferred compensation plan pursuant to which each executive officer can elect to defer a portion of his base salary and annual bonus for investment in units of phantom stock or in various unrelated mutual funds, based on such officer’s election. At the end of each calendar quarter, any executive officer who defers compensation into phantom stock is credited with units of phantom stock at a 15% discount. Dividends on the phantom units are assumed to be issued in additional units of phantom stock at a 15% discount. If an officer that has elected to defer compensation under this plan leaves our employ voluntarily or for cause within two years after the end of the year in which such officer has deferred compensation for units of phantom stock, at a minimum, the 15% discount and any deemed dividends are forfeited. In July 2005, we modified the plan to preclude any deferrals into phantom stock after December 31, 2005.
Long-Term Incentives. In addition to the annual bonus and as an incentive to retain executive officers, our long-term incentive plan for officers provides for annual grants of stock options and restricted stock under the Stock Option Plan and other awards under the 1999 Shareholder Value Plan. The stock options issued prior to 2005 vest ratably over four years and remain outstanding for 10 years. The value of such options as of the date of grant is calculated using the Black-Scholes option-pricing model. The shares of restricted stock issued prior to 2005 vest 50% after three years and 50% after five years.
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The 1999 Shareholder Value Plan was intended to reward our executive officers when the total shareholder returns measured by increases in the market value of shares of Common Stock plus the dividends on those shares exceeds a comparable index of our peers over a three-year period. A payout for this program, which can be in cash or other consideration, is determined by the percent change in our shareholder return compared to the composite index of our peer group. If our performance is not at least 100% of the peer group index, no payout is made. To the extent performance exceeds the peer group, the payout increases. A new three-year plan cycle begins each year under this program. No payments were earned under this program in 2004.
Section 162(m) of the Internal Revenue Code generally denies a deduction for compensation in excess of $1 million paid to certain executive officers, unless certain performance, disclosure and stockholder approval requirements are met. Option grants and certain other awards under the Stock Option Plan and the 1999 Shareholder Value Plan are intended to qualify as “performance-based” compensation not subject to Section 162(m) deduction limitation. The committee believes that a substantial portion of compensation awarded under our compensation program would be exempted from the $1 million deduction limitation. The committee’s intention is to qualify, to the extent reasonable, a substantial portion of each executive officer’s compensation for deductibility under applicable tax laws.
Chief Executive Officer Compensation. Effective June 30, 2004, Ronald P. Gibson retired from his position as our Chief Executive Officer. Prior to his retirement, his salary and long-term incentive awards were determined by the committee substantially in conformity with the policies described above for all other executive officers. As in 2003, Mr. Gibson’s base salary remained $403,500 in 2004. As of the date of his retirement, Mr. Gibson had earned $206,406 of his base salary in 2004. Because of his retirement, Mr. Gibson did not receive a bonus in 2004 under the annual bonus program. In 2003, Mr. Gibson’s bonus was $240,083. In addition, during 2004, Mr. Gibson was granted long-term incentive compensation consisting of shares of restricted stock valued at $716,222 on the date of grant, which vested upon his retirement on June 30, 2004. This was an increase of $240,093, or 50%, in restricted stock compensation for 2004 as compared to his restricted stock compensation of $476,129 for 2003. Finally, Mr. Gibson received 222,076 stock options during 2004 with 182,076 having an exercise price of $26.15 and 40,000 having an exercise price of $22.44, the fair market value of Common Stock on the respective dates of grant. Mr. Gibson was also eligible to participate in the 1999 Shareholder Value Plan; however, no payouts were made to Mr. Gibson under this plan in 2004.
Effective July 1, 2004, Edward J. Fritsch assumed the responsibilities of Chief Executive Officer upon Mr. Gibson’s retirement. Mr. Fritsch’s salary and long-term incentive awards were determined by the committee substantially in conformity with the policies described above for all other executive officers. Upon becoming Chief Executive Officer, Mr. Fritsch’s annual base salary was set at $403,500. For 2004, Mr. Fritsch earned total base salary of $380,085, which included six months of service as President and Chief Operating Officer. Mr. Fritsch earned a bonus of $302,104 in 2004, which was equal to 75% of his annual base salary as Chief Executive Officer. In addition, during 2004, Mr. Fritsch was granted long-term incentive compensation consisting of shares of restricted stock valued at $485,831 on the date of grant, which vest 50% on the third anniversary and 50% on the fifth anniversary of the date of grant. Finally, Mr. Fritsch received 171,775 stock options during 2004 at an exercise price of $26.15, which was the fair market value of Common Stock on the date of grant. Mr. Fritsch was also eligible to participate in the 1999 Shareholder Value Plan; however, no payouts were made to Mr. Fritsch under this plan in 2004.
The committee believes that the total compensation received by each of Messrs. Gibson and Fritsch during 2004 were reasonable, not excessive and consistent with the pay practices of public equity REITs that have revenues comparable to us.
Compensation Changes in 2005. For 2005, the annual incentive bonus program will operate similarly as in 2004, except that the following four performance criteria will be used for 2005, all of which are weighted equally: average occupancy rates relative to budgeted rates; net operating income relative to budgeted amounts; average payback on leases relative to a fixed goal; and average lease term relative to a fixed goal. These criteria provide an objective basis for the committee to determine bonuses for division level and corporate level executive officers. Notwithstanding the foregoing criteria, the committee has retained the authority to pay bonuses at its discretion.
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Effective for 2005, options that are issued to executive officers under the Stock Option Plan will continue to vest ratably over a four-year period, but the option term will be seven years instead of 10 years. The value of such options as of the date of grant will be calculated using the Black-Scholes option-pricing model. The exercise price per share for such options will be based on the average of the daily closing prices for Common stock over the 10-day period preceding the date of grant, rather than the closing price for Common Stock on the date immediately preceding the date of grant.
We have also prospectively replaced the 1999 Shareholder Value Plan for years beginning in 2005 with a performance-based restricted stock plan under which all or a portion of additional grants of restricted stock will vest if our total shareholder returns exceed the average total returns of a selected group of peer companies over a three-year period. If our performance is not at least 100% of the peer group index, none of the restricted stock will vest at the end of the three-year period. To the extent performance equals or exceeds the peer group, the portion of issued shares that vest can range from 50% to 100%, and for exceptional levels of performance, additional shares can be granted at the end of the three year period up to 100% of the original restricted stock that was issued. These additional shares, if any, would be fully vested when issued. A new three-year plan cycle begins each year under the program. Effective for 2005, shares of time-based restricted stock that are issued to executive officers under the Stock Option Plan will vest one-third on the third anniversary, one-third on the fourth anniversary and one-third on the fifth anniversary of the date of grant.
In addition to time-based restricted stock, a portion of the restricted stock issued to executive officers in 2005 will be subject to Company-wide performance-based criteria. For 2005, the performance-based criteria is based on whether or not we meet or exceed operating goals established under our Strategic Management Plan for the four following areas relative to established goals by the end of 2007: average occupancy rates; long-term debt plus preferred equity as a percentage of total assets; fixed charge coverage ratio; and ratio of dividends to cash available for distribution.
To the extent performance equals or exceeds the threshold performance goals, the portion of issued shares of restricted stock that vest can range from 50% to 100%, and for exceptional levels of performance, additional shares can be granted at the end of the three year period up to 50% of the original restricted shares that were issued. These additional shares, if any, would be fully vested when issued.
Notwithstanding the foregoing criteria, the committee has retained the authority to issue long-term incentive awards at its discretion.
Compensation and Governance Committee
William E. Graham, Jr.
Compensation of Directors
We pay directors who are not our employees fees for their services as directors. During 2004, independent directors received annual compensation of $23,000 plus a fee of $1,250 (plus out-of-pocket expenses) for attendance in person at each meeting of the Board of Directors, $500 for each committee meeting attended, $250 for each telephone meeting of the Board of Directors and between $250 and $400 for each telephone meeting of a committee. In addition, independent directors on the investment committee each received an additional annual retainer of $12,000 and between $500 and $1,000 per day for property visits in 2004 and the chairman of the audit committee received an additional annual retainer of $10,000 and $1,000 per day for non-scheduled audit committee activities.
In addition, each person serving as an independent director on February 3, 2004 received 500 shares of restricted stock under the Stock Option Plan. Mr. Sloan, who serves as Chairman of the Board of Directors, received an additional 750 shares of restricted stock. The restricted stock awards vest 25% on each anniversary of the date of grant. Dividends are paid on all restricted stock awards at the same rate and on the same date as on shares of Common Stock.
Upon becoming a director, each independent director received options to purchase 10,000 shares of Common Stock at an exercise price equal to the fair market value on the date of grant. Independent directors may elect to defer a portion of their retainer and meeting fees for investment in stock options or units of phantom stock under the Stock Option Plan. At the end of each calendar quarter, any director that elects to defer fees in such a manner is credited with units of phantom stock at a 15% discount or with stock options. Dividends on the phantom units are assumed to be issued in additional units of phantom stock at a 15% discount.
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In order to ensure the continued recruitment and retention of qualified board members and reduce the administrative burden of calculating and documenting independent director compensation, the compensation and governance committee has approved certain changes with respect to independent director compensation after conducting an internal review of the director compensation practices of our public REIT competitors. Effective after the regularly scheduled Board meeting on January 25, 2005, independent directors now receive annual compensation of $35,000, but no longer receive additional fees for attendance at meetings or participation in conference calls of the Board of Directors or its committees. Members of the audit, executive and compensation and governance committees now receive additional annual retainers of $5,000 for each committee, except that the chairman of the compensation and governance committee receives $10,000 and the chairman of the audit committee receives $20,000. Independent directors on the investment committee now receive an additional annual retainer of $12,000 and $500 per day for property visits. The annual restricted stock award for each independent director has also been increased by 250 shares to 750 shares. No changes have been made with respect to the eligibility of independent directors to receive awards under the Stock Option Plan, including restricted stock awards, nor with respect to the option for independent directors to defer a portion of their retainer and meeting fees for investment in stock options under the Stock Option Plan. However, directors will no longer be able to defer fees for phantom stock after December 31, 2005.
Officers who are directors are not paid any director fees.
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Stock Price Performance Graph
The following stock price performance graph compares our performance to the S&P 500, the Russell 2000 and the index of equity REITs prepared by National Association of Real Estate Investment Trusts (“NAREIT”). The stock price performance graph assumes an investment of $100 in Common Stock and the two indices on December 31, 1999 and further assumes the reinvestment of all dividends. Equity REITs are defined as those that derive more than 75% of their income from equity investments in real estate assets. The NAREIT equity index includes all tax-qualified REITs listed on the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market System. Stock price performance is not necessarily indicative of future results.
Index
S&P 500
Russell 2000
NAREIT All Equity REIT Index
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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The following table sets forth the beneficial ownership of shares of Common Stock as of December 31, 2004 for each person or group known to us to be holding more than 5% of the Common Stock, each director, each Named Executive Officer and our directors and executive officers as a group. The number of shares shown represents the number of shares of Common Stock the person “beneficially owns,” as determined by the rules of the SEC, including the number of shares that may be issued upon redemption of Common Units.
Name of Beneficial Owner
Number of Shares
Beneficially Owned
Percent of All
Shares (1)
O. Temple Sloan, Jr. (2)
Edward J. Fritsch (3)
Ronald P. Gibson (4)
Michael E. Harris (5)
Gene H. Anderson (6)
Mack D. Pridgen, III (7)
Terry L. Stevens (8)
Thomas W. Adler (9)
Kay N. Callison (10)
William E. Graham, Jr. (11)
Lawrence S. Kaplan (12)
Sherry A. Kellett
L. Glenn Orr, Jr. (13)
Willard H. Smith Jr. (14)
John L. Turner (15)
F. William Vandiver, Jr (16)
AEW Capital Management, L.P. (17)
Cohen & Steers Capital Management, Inc. (18)
Deutsche Bank AG and its affiliates (19)
All executive officers and directors as a group (19 persons)
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The following table provides information as of December 31, 2004 with respect to the shares of Common Stock that may be issued under our existing equity compensation plans:
Plan Category
Number of Securities to
be Issued Upon Exercise
of Outstanding Options
Weighted Average
Exercise Price of
Outstanding Options
Number of Securities Remaining
Available for Future Issuance
Under Equity Compensation Plans
Equity Compensation Plans Approved by Stockholders (1)
Equity Compensation Plans Not Approved by Stockholders (2)
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We have previously reported that we have had a contract to acquire development land in the Bluegrass Valley office development project from GAPI, Inc., a corporation controlled by Gene H. Anderson, an executive officer and director of the Company. Under the terms of the contract, the development land is to be purchased in phases, and the purchase price for each phase or parcel is settled for in cash and/or Common Units. The price for the various parcels is based on an initial value for each parcel, adjusted for an interest factor, currently 6.88% per annum, applied up to the closing date and also for changes in the value of the Common Units. On January 17, 2003, we acquired an additional 23.5 acres of this land from GAPI, Inc. for 85,520 shares of Common Stock and $384,000 in cash for total consideration of $2.3 million. In May 2003, 4.0 acres of the remaining acres not yet acquired by us was taken by the Georgia Department of Transportation to develop a roadway interchange for consideration of $1.8 million. The Department of Transportation took possession and title of the property in June 2003. As part of the terms of the contract between us and GAPI, Inc., we were entitled to and received in 2003 the $1.8 million proceeds from the condemnation. In July 2003, we appealed the condemnation and are currently seeking additional payment from the state; the recognition of any gain has been deferred pending resolution of the appeal process. In April 2005, we acquired for cash an additional 12.1 acres of the Bluegrass Valley land from GAPI, Inc. and also settled for cash the final purchase price with GAPI, Inc. on the 4.0 acres that were taken by the Georgia Department of Transportation, which aggregated approximately $2.7 million. In August 2005, we acquired 12.7 acres, representing the last parcel of land to be acquired, for cash aggregating $3.2 million. We believe that the purchase price with respect to each land parcel was at or below market value. These transactions were unanimously approved by the full Board of Directors with Mr. Anderson abstaining from the vote.
We entered into a series of agreements in January and February 2005, pursuant to which we, through a third party broker, sold on February 28, 2005 and April 15, 2005, three non-core industrial buildings in Winston-Salem,
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North Carolina to Mr. Turner and certain of his affiliates in exchange for a gross sales price of approximately $27.0 million, of which $20.3 million was paid in cash and the remainder from the surrender of 256,508 Common Units. We recorded a gain of approximately $4.8 million upon the closing of these sales. We believe that the purchase price paid for these assets by Mr. Turner and his affiliates was equal to their fair market value. The sales were approved by the Board of Directors with Mr. Turner not being present to discuss or vote on the matter.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Audit Committee Report
Purpose and Function of the Audit Committee. The audit committee oversees the financial reporting process on behalf of the Board of Directors. Management is responsible for our financial statements and the financial reporting process, including implementing and maintaining effective internal control over financial reporting and for the assessment of, and reporting on, the effectiveness of internal control over financial reporting. The independent auditors are responsible for expressing opinions on the conformity of the audited financial statements with U.S. Generally Accepted Accounting Principles, on the effectiveness of our internal control over financial reporting and on management’s assessment of the effectiveness of our internal control over financial reporting.
In fulfilling its oversight responsibilities, the audit committee has reviewed with management and the independent auditors our audited financial statements for the year ended December 31, 2004 and the reports on the effectiveness of internal controls over financial reporting as of December 31, 2004 contained in this Annual Report, including a discussion of the reasonableness of significant judgments and the clarity of disclosures in the financial statements. The audit committee also reviewed and discussed with management and the independent auditors the disclosures made in “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and “ITEM 9A. CONTROLS AND PROCEDURES” included elsewhere in this Annual Report.
In addition, the audit committee received written disclosures from the independent accountants required by Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees), and the audit committee discussed with the independent accountants that firm’s independence from management and us and considered the compatibility of non-audit services with the auditors’ independence.
Recommendations of the Audit Committee. In reliance on the reviews and discussions referred to above, the audit committee recommended to the Board of Directors (and the Board has approved) that the audited financial statements be included in this Annual Report for filing with the SEC.
Audit Committee
Principal Accountant Fees
Aggregate fees for professional services rendered by Ernst & Young LLP for the 2004 and 2003 fiscal years were as follows:
Audit Fees (1)
Audit Related Fees (2)
Tax Fees (3)
All Other Fees (4)
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Pre-Approval Policies
The audit committee has adopted a policy requiring the pre-approval of all fees paid to our independent auditor. All fees paid to our independent auditor for services rendered during 2004 were pre-approved in accordance with the committee’s policies. Before an independent auditor is engaged to render any service, the proposed services must either be specifically pre-approved by the audit committee or such services must fall within a category of services that are pre-approved by the audit committee without specific case-by-case consideration.
The audit committee pre-approved without specific case-by-case consideration the provision by the independent auditor of the following services during or with respect to 2005:
The audit committee pre-approved without specific case-by-case consideration the provision by the independent auditor of the following services during or with respect to the first four months of 2006:
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Any services in excess of these pre-approved amounts, or any services not described above, require the pre-approval of the audit committee chair, with a review by the audit committee at its next scheduled meeting.
The audit committee has determined that the rendering of the non-audit services by Ernst & Young LLP has been compatible with maintaining the auditor’s independence.
The audit committee discussed with our internal and independent auditors the overall scope and plans for their respective audits.
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ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Description
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Raleigh, State of North Carolina, on December 22, 2005.
/s/ EDWARD J. FRITSCH
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacity and on the dates indicated.
Signature
Title
/s/ O. Temple Sloan, Jr.
O. Temple Sloan, Jr.
Chairman of the Board of Directors
/s/ Edward J. Fritsch
President, Chief Executive Officer, and Director
/s/ Gene H. Anderson
Senior Vice President and Director
/s/ Thomas W. Adler
Thomas W. Adler
Director
/s/ Kay N. Callison
Kay N. Callison
/s/ Ronald P. Gibson
/s/ William E. Graham, Jr.
/s/ Lawrence S. Kaplan
Lawrence S. Kaplan
/s/ Sherry A. Kellett
/s/ L. Glenn Orr, Jr.
L. Glenn Orr, Jr.
/s/ Willard H. Smith, Jr.
Willard H. Smith, Jr.
/s/ John L. Turner
John L. Turner
/s/ F. William Vandiver, Jr.
F. William Vandiver, Jr.
/s/ Terry L. Stevens
Vice President and Chief Financial Officer
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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements
Financial Statements:
Consolidated Balance Sheets as of December 31, 2004 and 2003
Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements
Schedule II – Valuation and Qualifying Accounts and Reserves
Schedule III – Real Estate and Accumulated Depreciation
The Consolidated Financial Statements for the years ended December 31, 2002 and 2003 and for the first, second and third quarters of 2004 have been restated, as described in Notes 19 and 20.
All other schedules are omitted because they are not applicable or because the required information is included in the Consolidated Financial Statements or notes thereto.
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON THE CONSOLIDATED FINANCIAL STATEMENTS
The Board of Directors and Stockholders
of Highwoods Properties, Inc.
We have audited the accompanying consolidated balance sheets of Highwoods Properties, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Highwoods Properties, Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Notes 1 and 19 to the consolidated financial statements, the accompanying consolidated balance sheet as of December 31, 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2003 have been restated.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Highwoods Properties, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated December 16, 2005 expressed an unqualified opinion on management’s assessment and an adverse opinion on the effectiveness of internal control over financial reporting.
/S/ ERNST & YOUNG LLP
F-2
Consolidated Balance Sheets
(in thousands, except share and per share data)
Assets:
Real estate assets, at cost:
Land
Buildings and tenant improvements
Development in process
Land held for development
Furniture, fixtures and equipment
Less – accumulated depreciation
Net real estate assets
Property held for sale
Cash and cash equivalents
Restricted cash
Accounts receivable, net of allowance of $1,171 and $1,235, respectively
Notes receivable
Accrued straight-line rents receivable, net of allowance of $1,422 and $0, respectively
Investments in unconsolidated affiliates
Other assets:
Deferred leasing costs
Deferred financing costs
Prepaid expenses and other
Less – accumulated amortization
Other assets, net
Total Assets
Liabilities, Minority Interest in the Operating Partnership and Stockholders’ Equity:
Mortgages and notes payable
Accounts payable, accrued expenses and other liabilities
Total Liabilities
Stockholders’ Equity:
Preferred stock, $.01 par value, 50,000,000 authorized shares;
8 5/8% Series A Cumulative Redeemable Preferred Shares (liquidation preference $1,000 per share), 104,945 shares issued and outstanding at December 31, 2004 and 2003
8% Series B Cumulative Redeemable Preferred Shares (liquidation preference $25 per share), 6,900,000 shares issued and outstanding at December 31, 2004 and 2003
8% Series D Cumulative Redeemable Preferred Shares (liquidation preference $250 per share), 400,000 shares issued and outstanding at December 31, 2004 and 2003
Common stock, $.01 par value, 200,000,000 authorized shares; 53,813,422 and 53,474,403 shares issued and outstanding at December 31, 2004 and 2003, respectively
Additional paid-in capital
Distributions in excess of net earnings
Accumulated other comprehensive loss
Deferred compensation
Total Stockholders’ Equity
Total Liabilities, Minority Interest in the Operating Partnership and Stockholders’ Equity
See accompanying notes to consolidated financial statements.
F-3
Consolidated Statements of Income
(in thousands, except per share amounts)
For the Years Ended December 31, 2004, 2003 and 2002
Other income/(expense):
Gains and impairments on disposition of property, net
Net gains on sale and impairments of discontinued operations, net of minority interest
Net income/(loss) per common share – basic:
Income from discontinued operations
Weighted average common shares outstanding – basic
Net income/(loss) per common share – diluted:
Weighted average common shares outstanding – diluted
F-4
Consolidated Statements of Stockholders’ Equity
($ in thousands)
AccumulatedOtherCompre-hensive
Loss
Distributionsin Excess
of NetEarnings
Balance at December 31, 2001
Restatement adjustments
Restated Balance at December 31, 2001
Issuance of Common Stock
Conversion of Common Units to Common Stock
Common Stock dividends
Preferred Stock dividends
Adjustment to minority interest of unitholders in the Operating Partnership
Issuance of deferred compensation
Amortization of deferred compensation
Repurchase of Common Stock
Other comprehensive income
Net income, as restated
Restated Balance at December 31, 2002
Fair market value of options granted
Restated Balance at December 31, 2003
Balance at December 31, 2004
F-5
Consolidated Statements of Cash Flows
(in thousands)
Operating activities:
Adjustments to reconcile income from continuing operations to net cash provided by operating activities:
Depreciation
Amortization of lease commissions
Amortization of lease incentives
Amortization of accumulated other comprehensive loss
Discontinued operations
Change in financing obligations
Change in co-venture obligation
Distributions of earnings from unconsolidated affiliates
Changes in operating assets and liabilities:
Accounts receivable, net
Prepaid expenses and other assets
Accrued straight-line rents receivable
Net cash provided by operating activities
Investing activities:
Additions to real estate assets and deferred leasing costs
Proceeds from disposition of real estate assets
Repayments from unconsolidated affiliates
Distributions of capital from unconsolidated affiliates
Net repayments in notes receivable
Contributions to unconsolidated affiliates
Other investing activities
Net cash provided by investing activities
Financing activities:
Distributions paid on common stock and common units
Settlement of interest rate swap agreement
Dividends paid on preferred stock
Net proceeds from the sale of common stock
Repurchase of common stock and common units
Borrowings on revolving loans
Repayment of revolving loans
Borrowings on mortgages and notes payable
Repayment of mortgages and notes payable
Borrowings on financing obligations
Payments on financing obligations
Payments on co-venture obligation
Additions to deferred financing costs
Payments on debt extinguishments
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of the year
Cash and cash equivalents at end of the year
F-6
Consolidated Statements of Cash Flows - Continued
Supplemental disclosure of cash flow information:
Cash paid for interest
Supplemental disclosure of non-cash investing and financing activities:
The following table summarizes the net assets acquired/disposed subject to mortgage notes payable and other non-cash transactions:
Accounts receivable
Investment in unconsolidated affiliates
Prepaid and other
Accumulated amortization
Liabilities:
Minority Interest and Stockholders’ Equity:
F-7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004 and 2003
(tabular dollar amounts in thousands, except per share data)
1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
Description of the Company
Highwoods Properties, Inc., together with its consolidated subsidiaries (the “Company”), is a fully-integrated, self-administered and self-managed equity real estate investment trust (“REIT”) that operates in the southeastern and midwestern United States. As of December 31, 2004, the Company’s wholly owned assets included: 444 in-service office, industrial and retail properties; 125 apartment units; 1,115 acres of undeveloped land suitable for future development; and an additional four properties under development.
The Company conducts substantially all of its activities through, and substantially all of its interests in the properties are held directly or indirectly by, Highwoods Realty Limited Partnership (the “Operating Partnership”). The Company is the sole general partner of the Operating Partnership. At December 31, 2004, the Company owned 100.0% of the preferred partnership interests (“Preferred Units”) and 89.8% of the common partnership interests (“Common Units”) in the Operating Partnership. Limited partners (including certain officers and directors of the Company) own the remaining Common Units. Each Common Unit is redeemable for the cash value of one share of the Company’s common stock, $.01 par value (the “Common Stock”), or, at the Company’s option, one share of Common Stock. In 2004, the Company redeemed in cash from limited partners 46,588 Common Units and converted 54,308 Common Units to shares of Common Stock, which increased the percentage of Common Units owned by the Company from 89.5% at December 31, 2003 to 89.8% at December 31, 2004. The three series of Preferred Units in the Operating Partnership as of December 31, 2004 were issued to the Company in connection with the Company’s three preferred stock offerings in 1997 and 1998 (the “Preferred Stock”). The net proceeds raised from each of the three Preferred Stock issuances were contributed by the Company to the Operating Partnership in exchange for the Preferred Units. The terms of each series of Preferred Units generally parallel the terms of the respective Preferred Stock as to dividends, liquidation and redemption rights as more fully described in Note 9.
Basis of Presentation
The Consolidated Financial Statements of the Company include the Operating Partnership, wholly owned subsidiaries and those subsidiaries in which the Company owns a majority voting interest with the ability to control operations of the subsidiaries and where no approval, veto or other important rights have been granted to the minority stockholders. In accordance with Statement of Position 78-9, “Accounting for Investments in Real Estate Ventures,” the Company consolidates partnerships, joint ventures and limited liability companies when the Company controls the major operating and financial policies of the entity through majority ownership or in its capacity as general partner or managing member. The Company does not consolidate entities where the other interest holders have important rights, including the right to approve decisions to encumber the entities with debt and acquire or dispose of properties. In addition, the Company consolidates those entities, if any, where the Company is deemed to be the primary beneficiary in a variable interest entity (as defined by FASB Interpretation No. 46 (revised December 2003) “Consolidation of Variable Interest Entities” (“FIN 46”)). All significant intercompany transactions and accounts have been eliminated.
The Company has elected and expects to continue to qualify as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, the Company generally will not be subject to federal or state income taxes on its net income that it distributes to stockholders. Continued qualification as a REIT depends on the Company’s ability to satisfy the dividend distribution tests, stock ownership requirements and various other qualification tests prescribed in the Code. In June 1994, the Company formed a taxable REIT subsidiary, as permitted under the Code, through which it conducts certain business activities. The taxable REIT subsidiary is subject to federal and state income taxes on its net taxable income and the Company records provisions for such taxes, to the extent required, based on its income recognized for financial statement purposes, including the effects of temporary differences between such income and the amount recognized for tax purposes.
F-8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
1. DESCRIPTION OF BUSINESS ANDSIGNIFICANT ACCOUNTING POLICIES - Continued
Restated and Reclassified Financial Data
As more fully described in Notes 19 and 20, the Company has restated its Consolidated Financial Statements for the years ended December 31, 2003 and 2002 and for the first, second and third quarters of 2004. The restatement resulted from adjustments primarily related to the accounting for lease incentives, depreciation and amortization expense, straight-line ground lease expense on one ground lease, gain recognition on a 2003 land condemnation, land cost allocations, the write-off of undepreciated tenant improvements and commissions, capitalization of interest and internal leasing, construction and development costs on development properties, and purchase accounting for acquisitions completed in 1995 to 1998. The following provides the impact of these restatement adjustments on net income for the years ended December 31, 2004, 2003 and 2002, respectively:
Depreciation and amortization expense
Ground lease straight line rent expense
Gain on land condemnation
Embedded derivatives
Allocation of land costs
Write-off of undepreciated tenant improvements and lease commissions
Property operating cost recovery income accruals
Internal cost capitalization (1)
Interest capitalization (1)
Purchase accounting (1)
Minority interest
Net income per share – diluted
Minority Interest in the Operating Partnership
Minority interest in the accompanying Consolidated Financial Statements relates to the common ownership interests in the Operating Partnership owned by various individuals and entities other than the Company. As of December 31, 2004, the minority interest in the Operating Partnership consisted of 6.1 million Common Units. Minority interest in the net income of the Operating Partnership is computed by applying the weighted average percentage of Common Units not owned by the Company (as a percent of the total number of outstanding Common Units) to the Operating Partnership’s net income after deducting distributions on Preferred Units. The result is the amount of minority interest expense recorded for the period. In addition, when a Common Unitholder redeems a Common Unit for a share of Common Stock or cash, the minority interest is reduced and the Company’s share in the Operating Partnership is increased. At the end of each reporting period, the Company determines the amount that represents the minority unitholders’ share of the net assets (at book value) of the Operating Partnership and compares this amount to the minority interest balance that resulted from transactions during the period involving minority interest. The Company adjusts the minority interest liability to the computed share of net assets with an offsetting adjustment to the Company’s paid in capital.
F-9
Following is the minority interest in the net income of the Operating Partnership:
Amount shown as minority interest in continuing operations
Amount related to income from discontinued operations
Amount related to gain on sale of discontinued operations
Total minority interest in net income of the Operating Partnership
Real estate and related assets are recorded at cost and stated at cost less accumulated depreciation. Renovations, replacements and other expenditures that improve or extend the life of an asset are capitalized and depreciated over their estimated useful lives. Expenditures for ordinary maintenance and repairs are charged to operating expense as incurred. Depreciation is computed using the straight-line method over the estimated useful life of 40 years for buildings and depreciable land infrastructure costs, 15 years for building improvements and five to seven years for furniture, fixtures and equipment. Tenant improvements are amortized over the life of the respective leases, using the straight-line method.
Expenditures directly related to the development and construction of real estate assets are included in net real estate assets and are stated at cost in the Consolidated Balance Sheets. The Company’s capitalization policy on development properties is in accordance with SFAS No. 67, “Accounting for Costs and the Initial Rental Operations of Real Estate Properties,” SFAS No. 34, “Capitalization of Interest Costs,” and SFAS No. 58, “Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method.” Development expenditures include pre-construction costs essential to the development of properties, development and construction costs, interest costs, real estate taxes, salaries and related costs and other costs incurred during the period of development. Interest and other carrying costs are capitalized until the building is ready for its intended use. The Company considers a construction project as substantially completed and held available for occupancy upon the completion of tenant improvements, but no later than one year from cessation of major construction activity. The Company ceases capitalization on the portion substantially completed and occupied or held available for occupancy, and capitalizes only those costs associated with the portion under construction.
Expenditures directly related to the leasing of properties are included in deferred leasing costs and are stated at cost in the Consolidated Balance Sheets. The Company capitalizes initial direct costs related to its leasing efforts in accordance with SFAS No. 91 “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” All leasing commissions paid to third parties for new leases or lease renewals are capitalized. Internal leasing costs include primarily compensation, benefits and other costs such as legal fees related to leasing activities that are incurred in connection with successfully securing leases on the properties. Capitalized leasing costs are amortized on a straight-line basis over the estimated lives of the respective leases. Estimated costs related to unsuccessful activities are expensed as incurred. If the Company’s assumptions regarding the successful efforts of leasing are incorrect, the resulting adjustments could impact earnings.
Upon the acquisition of real estate, the Company assesses the fair value of acquired tangible assets such as land, buildings and tenant improvements, intangible assets such as above and below market leases, acquired-in place leases and other identified intangible assets and assumed liabilities in accordance with SFAS No. 141, “Business Combinations.” The Company allocates the purchase price to the acquired assets and assumed liabilities based on their relative fair values. The Company assesses and considers fair value based on estimated cash flow projections that utilize appropriate discount and/or capitalization rates as well as available market information. The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant.
F-10
The value of in-place leases is based on the Company’s evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, current market conditions and costs to execute similar leases. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, depending on local market conditions. In estimating costs to execute similar leases, the Company considers tenant improvements, leasing commissions and legal and other related expenses. The value of in-place leases is amortized to depreciation and amortization expense over the remaining term of the respective leases. If a tenant vacates its space prior to its contractual expiration date, any unamortized balance of its related intangible asset is expensed.
The value of a tenant relationship is based on the Company’s overall relationship with the respective tenant. Factors considered include the tenant’s credit quality and expectations of lease renewals. The value of a tenant relationship is amortized to expense over the initial term and any renewal periods defined in the respective leases. Based on the Company’s acquisitions since the adoption of SFAS No. 141 and SFAS No. 142, the Company has deemed tenant relationships to be immaterial and has not allocated any amounts to this intangible asset.
Real estate and leasehold improvements are classified as long-lived assets held for sale or as long-lived assets to be held for use. Real estate is classified as held for sale when the criteria set forth in SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” are satisfied; this determination requires management to make estimates and assumptions, including assessing the probability that potential sales transactions may or may not occur. Actual results could differ from those assumptions. In accordance with SFAS No. 144, the Company records assets held for sale at the lower of the carrying amount or estimated fair value. Fair value of assets held for sale is equal to the estimated or contracted sales price with a potential buyer, less costs to sell. The impairment loss is the amount by which the carrying amount exceeds the estimated fair value. With respect to assets classified as held for use, if events or changes in circumstances, such as a significant decline in occupancy and change in use, indicate that the carrying value may be impaired, an impairment analysis is performed. Such analysis consists of determining whether the asset’s carrying amount will be recovered from its undiscounted estimated future operating cash flows. These cash flows are estimated based on a number of assumptions that are subject to economic and market uncertainties including, among others, demand for space, competition for tenants, changes in market rental rates and costs to operate each property. If the carrying amount of a held for use asset exceeds the sum of its undiscounted future operating and residual cash flows, an impairment loss is recorded for the difference between estimated fair value of the asset and the net carrying amount. The Company generally estimates the fair value of assets held for use by using discounted cash flow analysis; in some instances, appraisal information may be available and is used in addition to the discounted cash flow analysis. As the factors used in generating these cash flows are difficult to predict and are subject to future events that may alter the Company’s assumptions, the discounted and/or undiscounted future operating and residual cash flows estimated by the Company in its impairment analyses or those established by appraisal may not be achieved and the Company may be required to recognize future impairment losses on its properties held for sale and held for use.
F-11
The Company accounts for sales of real estate in accordance with SFAS No. 66. For sales transactions meeting the requirements of SFAS No. 66 for full profit recognition, the related assets and liabilities are removed from the balance sheet and the resultant gain or loss is recorded in the period the transaction closes. For sales transactions that do not meet the criteria for full profit recognition, the Company accounts for the transactions in accordance with the methods specified in SFAS No. 66. For sales transactions with continuing involvement after the sale, if the continuing involvement with the property is limited by the terms of the sales contract, profit is recognized at the time of sale and is reduced by the maximum exposure to loss related to the nature of the continuing involvement. Sales to entities in which the Company has an interest are accounted for in accordance with partial sale accounting provisions as set forth in SFAS No. 66.
For sales transactions that do not meet sale criteria as set forth in SFAS No. 66, the Company evaluates the nature of the continuing involvement, including put and call provisions, if present, and accounts for the transaction as a financing arrangement, profit-sharing arrangement or other alternate method of accounting rather than as a sale, based on the nature and extent of the continuing involvement. Some transactions may have numerous forms of continuing involvement. In those cases, the Company determines which method is most appropriate based on the substance of the transaction.
If the Company has an obligation to repurchase the property at a higher price or at a future indeterminable value (such as fair market value), or it guarantees the return of the buyer’s investment or a return on that investment for an extended period, the Company accounts for such transaction as a financing transaction. If the Company has an option to repurchase the property at a higher price and it is likely it will exercise this option, the transaction is accounted for as a financing transaction. For transactions treated as financings, the Company records the amounts received from the buyer as a financing obligation and continues to keep the property and related accounts recorded on its books. The results of operations of the property, net of expenses other than depreciation (net operating income), will be reflected as “interest expense” on the financing obligation. If the transaction includes an obligation or option to repurchase the asset at a higher price, additional interest is recorded to accrete the liability to the repurchase price. For options or obligations to repurchase the asset at fair market value at the end of each reporting period, the balance of the liability is adjusted to equal the current fair value to the extent fair value exceeds the original financing obligation. The corresponding debit or credit will be recorded to a related discount account and the revised debt discount is amortized over the expected term until termination of the option or obligation. If it is unlikely such option will be exercised, the transaction is accounted for under the deposit method or profit-sharing method. If the Company has an obligation or option to repurchase at a lower price, the transaction is accounted for as a leasing arrangement. At such time as these repurchase obligations expire, a sale will be recorded and gain recognized.
If the Company retains an interest in the buyer and provides certain rent guarantees or other forms of support where the maximum exposure to loss exceeds the gain, the Company accounts for such transaction as a profit-sharing arrangement. For transactions treated as profit-sharing arrangements, the Company records a profit-sharing obligation for the amount of equity contributed by the other partner and continues to keep the property and related accounts recorded on its books. The results of operations of the property, net of expenses other than depreciation (net operating income), are allocated to the other partner for their percentage interest and reflected as “co-venture expense” in the Company’s Consolidated Financial Statements. In future periods, a sale is recorded and profit is recognized when the remaining maximum exposure to loss is reduced below the amount of gain deferred.
Lease Incentives
The Company accounts for lease incentive costs, which are payments made to or on behalf of a tenant, as an incentive to sign the lease, in accordance with FASB Technical Bulletin (FTB) 88-1, “Issues Relating to Accounting for Leases.” These costs are capitalized in deferred leasing costs and amortized on a straight-line basis over the respective lease terms as a reduction of rental revenues.
F-12
Properties that are sold or classified as held for sale are classified as discontinued operations in accordance with SFAS No. 144, provided that (1) the operations and cash flows of the property will be eliminated from the ongoing operations of the Company and (2) the Company will not have any significant continuing involvement in the operations of the property after it is sold. If the property is sold to a joint venture in which the Company retains an interest, the property will not be accounted for as a discontinued operation due to the Company’s ongoing interest in the operations through its joint venture interest. If the Company is retained to provide property management, leasing and/or other services for the property owner after the sale, the property will not be accounted for as discontinued operations due to the Company’s ongoing interest in the operations through its providing of such services. The operations of properties classified as held for sale in which the Company could potentially provide future property management, leasing and/or other services are also not classified as discontinued operations. See Note 12 for further discussion.
Investments in Joint Ventures
The Company accounts for its investments in unconsolidated affiliates under the equity method of accounting as the Company exercises significant influence, but does not control the major operating and financial policies of the entity regarding encumbering the entities with debt and the acquisition or disposal of properties. These investments are initially recorded at cost, as investments in unconsolidated affiliates, and are subsequently adjusted for the Company’s share of earnings and cash contributions and distributions. To the extent the Company’s cost basis is different than the basis reflected at the joint venture level, the basis difference is amortized over the life of the related asset and included in the Company’s share of equity in earnings of unconsolidated affiliates.
From time to time, the Company contributes real estate assets to a joint venture in exchange for a combination of cash and an equity interest in the venture. The Company assesses its continuing involvement in the joint venture and accounts for the transaction according to the nature and extent of the involvement. If substantially all the risks and rewards of ownership have transferred, a gain is recognized to the extent of the third party investor’s interest and the Company accounts for its interest in the joint venture under the equity method of accounting as an unconsolidated affiliate as described in the preceding paragraph. However, if substantially all the risks and rewards have not transferred, depending upon the nature and extent of the involvement, the transaction is accounted for as a financing or profit-sharing arrangement or other alternate method of accounting rather than as a sale under paragraph 25 through 29 of SFAS No. 66 and the assets, liabilities and operations of such joint ventures are included on the Company’s Consolidated Financial Statements. See also “Sales of real estate” above.
Additionally, the joint ventures will frequently borrow money on their own behalf to finance the acquisition of, and/or leverage the return upon, the properties being acquired by the joint venture or to build or acquire additional buildings. Such borrowings are typically on a non-recourse or limited recourse basis. The Company generally is not liable for the debts of its joint ventures, except to the extent of the Company’s equity investment, unless the Company has directly guaranteed any of that debt. (See Note 15 for further discussion). In most cases, the Company and/or its joint venture partners are required to guarantee customary limited exceptions to non-recourse liability in non-recourse loans.
F-13
Rental and other revenues from continuing operations consist of the following:
Contractual rents
Straight-line rental income, net
Lease incentive amortization
Property operating cost recovery income
Lease termination fees
Fee income
Other miscellaneous operating income
In accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), rental revenue is recognized on a straight-line basis over the terms of the respective leases. This means that, with respect to a particular lease, actual amounts billed in accordance with the lease during any given period may be higher or lower than the amount of rental revenue recognized for the period. Accrued straight-line rents receivable represents the amount by which straight-line rental revenue exceeds rents currently billed in accordance with lease agreements. Termination fees are recognized as revenue when the following four conditions are met: a fully executed lease termination agreement has been delivered; the tenant has vacated the space; the amount of the fee is determinable; and collectibility of the fee is reasonably assured.
Property operating cost recoveries from tenants (or cost reimbursements) are determined on a lease-by-lease basis. The most common types of cost reimbursements in the Company’s leases are common area maintenance (“CAM”) and real estate taxes, where the tenant pays its pro-rata share of operating and administrative expenses and real estate taxes.
The computation of cost reimbursements from tenants for CAM and real estate taxes is complex and involves numerous judgments, including the interpretation of terms and other tenant lease provisions. Leases are not uniform in dealing with such cost reimbursements and there are many variations in the computation. Many tenants make monthly fixed payments of CAM, real estate taxes and other cost reimbursement items. The Company records these payments as income each month. The Company makes adjustments, positive or negative, to cost recovery income to adjust the recorded amounts to the Company’s best estimate of the final amounts to be billed and collected with respect to the cost reimbursements. After the end of the calendar year, the Company computes each tenant’s final cost reimbursements and, after considering amounts paid by the tenants during the year, issues a bill or credit for the appropriate amount to the tenant. The differences between the amounts billed less previously received payments and the accrual adjustment are recorded as increases or decreases to cost recovery income when the final bills are prepared, usually beginning in March and completed by mid-year. The net amounts of any such adjustments have not been material in any of the years presented.
F-14
Operating Expenses – Rental Property and Other Expenses
Rental property and other operating expenses from continuing operations consist of the following:
Maintenance, cleaning and general building
Utility, insurance and real estate taxes
Division and allocated administrative
Other miscellaneous operating expenses
Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The Company’s receivable balance is comprised primarily of rents and operating cost recoveries due from tenants as well as accrued straight-line rents receivable. The Company regularly evaluates the adequacy of its allowance for doubtful accounts. The evaluation primarily consists of reviewing past due account balances and considering such factors as the credit quality of the tenant, historical trends of the tenant and/or other debtor, current economic conditions and changes in customer payment terms. Additionally, with respect to tenants in bankruptcy, the Company estimates the expected recovery through bankruptcy claims and increases the allowance for amounts deemed uncollectible. If the Company’s assumptions regarding the collectibility of accounts receivable and accrued straight-line rents receivable prove incorrect, the Company could experience write-offs of accounts receivable or accrued straight-line rents receivable in excess of its allowance for doubtful accounts.
Cash Equivalents
The Company considers highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
Restricted Cash
Restricted cash includes security deposits for the Company’s commercial properties and construction-related escrows. In addition, the Company maintains escrow and reserve funds for debt service, real estate taxes and property insurance established pursuant to certain mortgage financing arrangements.
Income Taxes
The Company is a REIT for federal income tax purposes. A corporate REIT is a legal entity that holds real estate assets and, through the payment of dividends to stockholders, is permitted to reduce or avoid the payment of federal and state income taxes at the corporate level. As of December 31, 2004, to maintain qualification as a REIT, the Company was required to distribute to its stockholders at least 90.0% of its REIT taxable income, excluding capital gains.
No provision has been made for federal and state income taxes during the years ended December 31, 2004, 2003 and 2002 because the Company qualified as a REIT, distributed the necessary amount of taxable income and, therefore, incurred no income tax expense during the periods. In addition, no provision has been required for federal and state income taxes with respect to the Company’s taxable REIT subsidiary because it has had no taxable income for financial reporting purposes since its formation. If the Company decided to sell certain properties acquired in prior years, the Company would incur a corporate-level tax under Section 1374 of the Internal Revenue Code on the built-in gain relating to such properties unless such properties were sold in a tax-free exchange under Section 1031 of the Internal Revenue Code or another tax-free or tax-deferred transaction. This situation applies solely to assets acquired in the merger with J.C. Nichols Company in July 1998 and the tax under Section 1374 does not apply after the Company has owned the assets for 10 years or more.
F-15
Concentration of Credit Risk
Management of the Company performs ongoing credit evaluations of its tenants. As of December 31, 2004, the properties (excluding apartment units) to which the Company holds title and has 100.0% ownership rights (the “Wholly Owned Properties”) were leased to 2,546 tenants in 13 geographic locations. The Company’s tenants engage in a wide variety of businesses. No single tenant of the Company’s Wholly Owned Properties currently generates more than 4.0% of the Company’s consolidated revenues. In addition, as described in Note 15, in connection with various real estate sales transactions, the Company has guaranteed to the buyers the rental income during various future periods due from Capital One Services, Inc., a subsidiary of Capital One Financial Services, Inc. The maximum exposure under these guarantees related to Capital One Services, Inc. aggregated $13.8 million at December 31, 2004.
Stock Compensation
The Company generally grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. As described in Note 14, the Company elected to follow Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock options issued through December 31, 2002. During 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” which provides methods of transition to the fair value based method of accounting for stock-based employee compensation. This standard is effective for financial statements issued for fiscal years beginning after December 15, 2002. The Company elected the prospective method as defined by SFAS No. 148 for options issued on or after January 1, 2003.
Awards granted under the Company’s Shareholder Value Plans are accounted for using variable plan accounting. See Note 6 for further discussion.
Restricted Stock Grants
The Company has a long-term incentive plan under which it makes annual grants of restricted shares of Common Stock. The restricted shares generally vest 50.0% three years from the date of grant and the remaining 50.0% five years from date of grant. Restricted shares are recorded at market value on date of grant and amortized to expense over the vesting periods.
Fair Value of Derivative Instruments
In the normal course of business, the Company is exposed to the effect of interest rate changes. The Company limits its exposure by following established risk management policies and procedures, including the use of derivatives. To mitigate its exposure to unexpected changes in interest rates, derivatives are used primarily to hedge against rate movements on the Company’s variable rate debt. The Company is required to recognize all derivatives as either assets or liabilities in its Consolidated Balance Sheets and to measure those instruments at fair value. Changes in fair value will affect either stockholders’ equity or net income depending on whether the derivative instrument qualifies as a hedge for accounting purposes.
To determine the fair value of derivative instruments, the Company uses a variety of methods and assumptions that are based on market conditions and risks existing at each balance sheet date. For the majority of financial instruments, including most derivatives, standard market conventions and techniques such as discounted cash flow analysis, option pricing models, replacement cost and termination cost are used to determine fair value. All methods of assessing fair value result in a general approximation of value, and such value may never actually be realized.
F-16
Earnings Per Share
The Company computes earnings per share in accordance with SFAS No. 128, “Earnings per Share.” Basic earnings per share is computed by dividing net income available for common stockholders by the weighted average number of shares of Common Stock outstanding. Diluted earnings per share is computed by dividing net income available for common stockholders plus minority interest in the operating partnership by the weighted average number of shares of Common Stock plus the dilutive effect of options, warrants and convertible securities outstanding, including Common Units, using the “treasury stock” method. Earnings per share data is required for all periods for which an income statement or summary of earnings is presented, including summaries outside the basic financial statements.
Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Impact of Newly Adopted and Issued Accounting Standards
In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities” (“VIEs”), the primary objective of which is to provide guidance on the identification of entities for which control is achieved through means other than voting rights and to determine when and which business enterprise should consolidate VIEs. This new model applies when either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance the entity’s activities without additional financial support. FIN 46 also requires additional disclosures. According to FIN 46 (revised December 2003), entities shall apply FIN 46 only to special-purpose entities subject to FIN 46 no later than December 31, 2003 and all other entities no later than March 31, 2004. Special-purpose entities are defined as any entity whose activities are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements. Given that the Company has no significant variable interests in special-purpose entities, FIN 46 became effective March 31, 2004. See Note 2 for further discussion of the Company’s variable interest in The Vinings at University Center, LLC.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, with some exceptions, and for hedging relationships designated after June 30, 2003. The guidance was applied prospectively. The provisions of SFAS No. 149 did not have an impact on our financial condition and results of operations. See Note 10 for further discussion of the Company’s derivative instruments.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in certain circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective July 1, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. At its October 29, 2003 meeting, the FASB voted to defer indefinitely SFAS No. 150 as it relates to non-controlling interests in finite-life entities. As of December 31, 2004, the provisions of SFAS No. 150 do not have a material impact on the Company’s financial condition or results of operations.
F-17
In July 2005, the FASB issued Staff Position (FSP) SOP 78-9-1, “Interaction of AICPA Statement of Position 78-9 and EITF Issue No. 04-5”. The EITF reached a consensus on EITF Issue No. 04-5, “Determining Whether a General Partner or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights,” stating that a general partner is presumed to control a limited partnership and should consolidate the limited partnership unless the limited partners possess substantive kick-out rights or the limited partners possess substantive participating rights. This FSP eliminates the concept of “important rights” of SOP 78-9 and replaces it with the concepts of “kick-out rights” and “substantive participating rights” as defined in Issue 04-5. This FSP is effective after June 29, 2005 for general partners of all new partnerships formed and for existing partnerships for which the partnership agreements are modified. For general partners in all other partnerships, the guidance in this FSP is effective no later than January 1, 2006. The Company currently expects to consolidate one of its existing joint ventures upon the adoption of this FSP in January 2006.
In December 2004, the FASB issued SFAS No. 123 (R), “Share-Based Payment,” which revises SFAS No. 123, “Accounting for Stock-Based Compensation” and supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” to require all share-based payments to employees to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123 (R) must be adopted no later than January 1, 2006. On January 1, 2006, the Company plans to adopt the modified prospective method in which compensation cost is based on the requirements of SFAS No. 123 (R) for all share-based payments granted after the effective date and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS 123 (R) that remain unvested on the effective date. Because the Company has used a fair value based method of accounting for stock-based compensation costs for all employee stock compensation awards granted, modified or settled since January 1, 2003 and does not expect to have significant unvested awards from periods prior to January 1, 2003 outstanding at January 1, 2006, the Company does not expect the adoption of SFAS No. 123 (R) to have a material impact on its financial condition and results of operations upon adoption.
In December 2004, the FASB issued Statement of Financial Accounting Standard No. 153, “Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29” (SFAS No. 153). The amendment eliminates the use of the “similar productive assets” concept to account for nonmonetary exchanges at book value with no gain being recognized and requires that nonmonetary exchanges be accounted for at fair value, recognizing any gain or loss, if the transactions meet a commercial-substance criterion and fair value is determinable. The Statement is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of SFAS No. 153 to have a material impact on its financial condition and results of operations upon adoption.
In May 2005, the FASB issued Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections” (SFAS No. 154). The Statement replaces Accounting Principles Board Opinion No. 20, “Accounting Changes” (APB Opinion No. 20) and Statement of Financial Accounting Standard No. 3, “Reporting Accounting Changes in Interim Financial Statements” and changes the requirements for the accounting for and reporting of a change in accounting principle. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The Statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS No. 154 to have a material impact on its financial condition and results of operations upon adoption.
F-18
2. INVESTMENTS IN UNCONSOLIDATEDAND OTHER AFFILIATES
During the past several years, the Company has formed various joint ventures with unrelated investors. The Company has retained minority equity interests ranging from 12.50% to 50.00% in these joint ventures. The Company generally has accounted for its unconsolidated joint ventures using the equity method of accounting. As a result, the assets and liabilities of these joint ventures for which the Company uses the equity method of accounting are not included on the Company’s consolidated balance sheet. One joint venture is accounted for as a financing arrangement pursuant to SFAS No. 66, as described in Note 3, and another joint venture is consolidated pursuant to FIN 46. These two joint ventures are not reflected in the tables below.
Office Property
Location
Board of Trade Investment Company
Dallas County Partners I, LP
Dallas County Partners II, LP
Dallas County Partners III, LP
Fountain Three
RRHWoods, LLC
Kessinger/Hunter, LLC
4600 Madison Associates, LLC
Highwoods DLF 98/29, LP
Atlanta, GA; Charlotte, NC;
Greensboro, NC; Raleigh, NC;
Orlando, FL; Baltimore, MD
Highwoods DLF 97/26 DLF 99/32, LP
Atlanta, GA; Greensboro, NC;
Orlando, FL
Highwoods KC Glenridge Office, LP
Highwoods KC Glenridge Land, LP
HIW-KC Orlando LLC
Concourse Center Associates, LLC
Highwoods-Markel Associates, LLC
Weston Lakeside, LLC
Combined summarized financial information for our unconsolidated joint ventures is as follows:
Balance Sheets:
Real estate, net of accumulated depreciation
Other assets
Liabilities and Partners’ and Shareholders’ Equity:
Mortgage debt (1)
Other liabilities
Partners’ and shareholders’ equity
Total Liabilities and Partners’ and Shareholders’ Equity Assets
The Company’s share of historical partners’ and shareholders’ equity
Net excess of cost of investments over the net book value of underlying net assets (net of accumulated depreciation of $1,615 and $1,360, respectively) (2)
Carrying value of investments in unconsolidated joint ventures
The Company’s share of unconsolidated non-recourse mortgage debt (1)
F-19
2. INVESTMENTS IN UNCONSOLIDATEDAND OTHER AFFILIATES – Continued
The Company generally is not liable for any of this debt, except to the extent of its investment, unless the Company has directly guaranteed any of the debt (see Note 15). In most cases, the Company and/or its strategic partners are required to guarantee customary limited exceptions to non-recourse liability in non-recourse loans.
Income Statements:
Revenues
Expenses:
Interest expense and loan cost amortization
Operating expenses
Total expenses
The Company’s share of:
Depreciation and amortization (real estate related)
The following summarizes the formation and principal activities of the various unconsolidated joint ventures in which the Company has a minority equity interest.
Board of Trade Investment Company; Kessinger/Hunter, LLC; 4600 Madison Associates, LP
In connection with the Company’s merger with J.C. Nichols Company in July 1998, the Company acquired a 49.0% interest in Board of Trade Investment Company, a 30.0% interest in Kessinger/Hunter, LLC and a 12.5% interest in 4600 Madison Associates, L.P. The Company is the property manager for the Board of Trade Investment Company and 4600 Madison Associates, L.P. joint ventures, for which it receives property management fees. In addition, Kessinger/Hunter, LLC provides property management, leasing and brokerage services and provides certain construction related services to certain Wholly Owned Properties of the Company. Kessinger/Hunter, LLC received $3.7 million, $2.7 million and $3.0 million from the Company for these related services in 2004, 2003 and 2002, respectively. During 2002, the Company decreased its ownership interest in Kessinger/Hunter, LLC from 30.0% to 26.5%.
F-20
Des Moines Joint Ventures
Also in connection with the Company’s merger with J.C. Nichols Company in July 1998, the Company succeeded to the interests of J.C. Nichols Company in a strategic alliance with R&R Investors, Ltd. pursuant to which R&R Investors manages and leases certain joint venture properties located in the Des Moines area. As a result of the merger, the Company acquired an ownership interest of 50.0% or more in a series of nine joint ventures with R&R Investors (the “Des Moines Joint Ventures”). Certain of these properties were previously included in the Company’s Consolidated Financial Statements. On June 2, 1999, the Company agreed with R&R Investors to reorganize its respective ownership interests in the Des Moines Joint Ventures such that each would own a 50.0% interest.
Highwoods DLF 98/29, L.P.
On March 15, 1999, the Company closed a transaction with Schweiz-Deutschland-USA Dreilander Beteiligung Objekt DLF 98/29-Walker Fink-KG (“DLF”) pursuant to which the Company sold or contributed certain office properties at an agreed upon value of $142.0 million to a newly created limited partnership (the “DLF I Joint Venture”). DLF contributed $56.0 million for a 77.19% interest in the DLF I Joint Venture and the DLF I Joint Venture borrowed $71.0 million from third-party lenders. The Company retained the remaining 22.81% interest in the DLF I Joint Venture, received net cash proceeds of $124.0 million and is the property manager and leasing agent of the DLF I Joint Venture’s properties. At the formation of this joint venture, the amount DLF contributed in cash to the venture was determined to be in excess of the amount required based on its ownership interest and on the final agreed-upon value of the real estate assets. The Company agreed to repay this amount to DLF over 14 years. The payments of $7.2 million were discounted to net present value of $3.8 million using a discount rate of 9.62% specified in the agreement. Payments of $0.5 million were made in each of the years ended December 31, 2004, 2003 and 2002, of which $0.3 million in each year represented imputed interest expense.
Highwoods DLF 97/26 DLF 99/32, L.P.
On May 9, 2000, the Company closed a transaction with Dreilander-Fonds 97/26 and 99/32 (“DLF II”) pursuant to which the Company contributed five in-service office properties encompassing 570,000 rentable square feet and a 246,000-square-foot development project at an agreed upon value of $110.0 million to a newly created limited partnership (the “DLF II Joint Venture”). DLF II contributed $24.0 million in cash for a 40.0% ownership interest in the DLF II Joint Venture and the DLF II Joint Venture borrowed $50.0 million from a third-party lender. The Company initially retained the remaining 60.0% interest in the DLF II Joint Venture and received net cash proceeds of $73.0 million. During 2001 and 2000, DLF II contributed an additional $10.7 million in cash to the DLF II Joint Venture. As a result, the Company decreased its ownership percentage to 42.93% as of December 31, 2001. The Company is the property manager and leasing agent of the DLF II Joint Venture’s properties and receives customary management and leasing commissions.
Highwoods-Markel Associates, LLC; Concourse Center Associates, LLC
During 1999 and 2001, the Company closed two transactions with Highwoods-Markel Associates, LLC and Concourse Center Associates, LLC pursuant to which the Company sold or contributed certain properties to newly created limited liability companies. Unrelated investors contributed cash for a 50.0% ownership interest in the joint ventures. The Company retained the remaining 50.0% interest, received net cash proceeds and is the property manager and leasing agent of the joint ventures’ properties.
F-21
On December 29, 2003, the Company contributed an additional three in-service office properties encompassing 290,853 rentable square feet at an agreed upon value of $35.6 million to the Highwoods-Markel, LLC joint venture. The joint venture’s other partner, Markel Corporation, contributed an additional $3.6 million in cash to maintain its 50.0% ownership interest and the joint venture borrowed and refinanced $40.0 million from a third party lender. The Company retained its 50.0% ownership interest in the joint venture and received net cash proceeds of $31.9 million. As a result, the Company recognized a $2.7 million gain in accordance with SFAS No. 66, which represents the extent of the Company’s interest sold to outside parties. The Company is the manager and leasing agent for the properties and receives customary management fees and leasing commissions.
MG-HIW Development Joint Ventures
On December 19, 2000, the Company formed or agreed to form four development joint ventures with Denver-based Miller Global Properties, LLC (“Miller Global”) pursuant to which the Company contributed $7.5 million of development land to various newly created limited liability companies and retained a 50.0% ownership interest. Three of these joint ventures have developed a total of three properties that encompass an aggregate of 347,000 rentable square feet and cost $50.4 million in the aggregate. The Company was the developer of these properties. In addition, the Company is the property manager and leasing agent for the properties in all of these joint ventures. The fourth joint venture, MG-HIW Metrowest I, LLC, did not develop a property but holds development land.
On June 26, 2002, the Company acquired Miller Global’s interest in MG-HIW Rocky Point, LLC, which owned Harborview Plaza, a 205,000 rentable square foot office property, to bring its ownership interest in that entity to 100.0%. At that time, the Company consolidated the assets and liabilities and recorded revenues and expenses of that entity on a consolidated basis. (See also Note 3 for SF-HIW Harborview, LP discussion).
As a part of the MG-HIW, LLC acquisition on July 29, 2003 (see Note 3), the Company was assigned Miller Global’s 50.0% equity interest in MG-HIW Peachtree Corners III, LLC, which increased the Company’s ownership interest to 100.0%; the Company consolidated this entity beginning on July 29, 2003. The entity owned a single property encompassing 53,896 square feet. The construction loan, which was made to this joint venture by a wholly owned affiliate of the Company, Highwoods Finance, LLC, had an interest rate of LIBOR plus 200 basis points and was paid in full on July 29, 2003 in connection with the assignment.
On July 29, 2003, the Company entered into an option agreement with its partner, Miller Global, to acquire Miller Global’s 50.0% interest in the assets encompassing 87,832 square feet of property and 7.0 acres of development land (zoned for the development of 90,000 square feet of office space) of MG-HIW Metrowest I, LLC and MG-HIW Metrowest II, LLC for $3.2 million, to bring its ownership interest in these entities to 100.0%.
On March 2, 2004, the Company exercised its option to acquire its partner’s 50.0% equity interest in the assets of MG-HIW Metrowest I, LLC and MG-HIW Metrowest II, LLC for $3.2 million. At that time, the Company consolidated the assets and liabilities and recorded revenues and expenses of that entity on a consolidated basis. A $7.4 million construction loan to fund the development of this property, of which $7.3 million was outstanding at December 31, 2003, was paid in full by the Company at closing.
On June 14, 2002, the Company contributed $1.1 million in cash to Plaza Colonnade, LLC, a limited liability company, for the construction of a 285,000 square foot multi-tenant office property. The Company has retained a 50.0% interest in this joint venture. On February 12, 2003, Plaza Colonnade, LLC signed a $61.3 million construction loan to fund the development of this property. The Company and its joint venture partner each guaranteed 50.0% of the loan. In addition to the construction loan, the partners collectively provided $12.0 million in letters of credit, $6.0 million by the Company and $6.0 million by its partner. In December 2004, the joint venture secured a $50.0 million non-recourse permanent loan and the construction loan was paid off. The related letters of credit were cancelled and the aforementioned guarantee obligations terminated when the construction loan was paid off. (See Note 15 for further discussion).
F-22
Highwoods KC Glenridge, LP
On February 25, 2004, the Company and Kapital-Consult, a European investment firm, formed Highwoods KC Glenridge, LP, which on February 26, 2004 acquired from a third party Glenridge Point Office Park, consisting of two office buildings aggregating 185,100 square feet located in the Central Perimeter sub-market of Atlanta. At December 31, 2004, the buildings were 89.8% occupied. The Company contributed $10.0 million to the joint venture in return for a 40.0% equity interest and Kapital-Consult contributed $14.9 million for a 60.0% equity interest in the partnership. The joint venture entered into a $16.5 million ten-year secured loan on the assets. The Company is the manager and leasing agent for this property and receives customary management fees and leasing commissions. The acquisition also included 2.9 acres of development land.
The Vinings at University Center, LLC
On December 22, 2004, the Company and Easlan Investment Group, Inc. formed The Vinings at University Center, LLC. The Company contributed 7.8 acres of land at an agreed upon value of $1.6 million to the joint venture in December 2004 in return for a 50.0% equity interest and Easlan Investment Group contributed $1.1 million, in the form of a non-interest bearing promissory note, for a 50.0% equity interest in the entity. Upon formation, the joint venture entered into a $9.7 million secured construction loan to complete the construction of 156 apartment units on the 7.8 acres of land, which is expected to be completed by the fourth quarter of 2005; $392,000 was borrowed on the construction loan at December 31, 2004. The Company’s joint venture partner has guaranteed this construction loan. The Easlan Investment Group, Inc. will be the manager and leasing agent for these apartment units and receive customary management fees and leasing commissions. The Company will receive development fees throughout the construction project and management fees of 1.0% of gross revenues at the time the apartments are 80.0% occupied. The Company is currently consolidating this joint venture under the provisions of FIN 46. As such, the Company’s balance sheet at December 31, 2004 includes $1.8 million of development in process and a $0.4 million construction note payable.
HIW-KC Orlando, LLC
See Note 4 for information regarding this joint venture.
On September 27, 2004, the Company and an affiliate of Crosland, Inc. formed Weston Lakeside, LLC, in which the Company has a 50.0% ownership interest. On June 29, 2005, the Company contributed 22.4 acres of land at an agreed upon value of $3.9 million to this joint venture, and its partner contributed approximately $2.0 million in cash; immediately thereafter, the joint venture distributed approximately $1.9 million to the Company and a gain of $1.9 million was recorded. Crosland, Inc. will develop, manage and operate this joint venture, which will construct approximately 332 rental residential units at a total estimated cost of approximately $32.0 million expected to be completed by the second quarter of 2007. Crosland, Inc. will receive 3.5% of gross revenue of the joint venture in management fees and 4.25% in development fees. The Company will provide limited development services for the project and will receive a fee equal to 1.0% of the development costs excluding land. The joint venture expects to finance the development with a $28.4 million construction loan that will be guaranteed by Crosland, Inc. The Company has accounted for this joint venture using the equity method of accounting.
F-23
Development, Leasing and Management Fees
As discussed above, the Company receives development, management and leasing fees for services provided to certain of its joint ventures. These fees are recognized as income to the extent of the other joint venture partner’s interest and are shown in rental and other revenues. They are as follows for 2004, 2003 and 2002:
Development fees
Management and leasing fees
Total fees
3. FINANCINGAND PROFIT-SHARING ARRANGEMENTS
The following summarizes sale transactions that were accounted for as financing and/or profit-sharing arrangements under paragraphs 25 through 29 of SFAS No. 66.
SF-HIW Harborview, LP
On September 11, 2002, the Company contributed Harborview Plaza, an office building located in Tampa, Florida, to SF-HIW Harborview Plaza, LP (“Harborview LP”), a newly formed entity, in exchange for a 20.0% limited partnership interest and $35.4 million in cash. The other partner contributed $12.6 million of cash and a new loan was obtained by the partnership for $22.8 million. In connection with this disposition, the Company entered into a master lease agreement with Harborview LP for five years on the then vacant space in the building (approximately 20% of the building); occupancy was 99.7% at December 31, 2004. The Company also guaranteed to Harborview LP the payment of tenant improvements and lease commissions of $1.2 million. The Company’s maximum exposure to loss under the master lease agreement was $2.1 million at September 11, 2002 and was $1.1 million at December 31, 2004. Additionally, the Company’s partner in Harborview LP was granted the right to put its 80.0% equity interest in Harborview LP to the Company in exchange for cash at any time during the one-year period commencing on September 11, 2014. The value of the 80.0% equity interest will be determined at the time that such partner elects to exercise its put right, if ever, based upon the then fair market value of Harborview LP’s assets and liabilities less 3.0%, which amount was intended to cover the normal costs of a sale transaction.
Because of the put option and the master lease agreement, this transaction is accounted for as a financing transaction as described in Note 1. Accordingly, the assets, liabilities and operations related to Harborview Plaza, the property owned by Harborview LP, including any new financing by the partnership, remain in the financial statements of the Company. As a result, the Company has established a financing obligation equal to the net equity contributed by the other partner. At the end of each reporting period, the balance of the financing obligation is adjusted to equal the current fair value, which is $14.8 million at December 31, 2004, but not less than the original financing obligation. This adjustment is amortized prospectively through September 2014. Additionally, the net income from the operations before depreciation of Harborview Plaza allocable to the 80.0% partner is recorded as interest expense on financing obligation. The Company continues to depreciate the property and record all of the depreciation on its books. Any payments made under the master lease agreement were expensed as incurred ($0.1 million, $0.4 million and $0.3 million was expensed during the years ended December 31, 2004, 2003 and 2002, respectively) and any amounts paid under the tenant improvement and lease commission guarantee are capitalized and amortized to expense over the remaining lease term. At such time as the put option expires or is otherwise terminated, the Company will record the transaction as a sale and recognize gain on sale.
F-24
3. FINANCING ANDPROFIT-SHARING ARRANGEMENTS - Continued
Eastshore
On November 26, 2002, the Company sold three buildings located in Richmond, Virginia (the “Eastshore” transaction) for a total price of $28.5 million in cash, which was paid in full by the buyer at closing. Each of the sold properties is a single tenant building leased on a triple-net basis to Capital One Services, Inc., a subsidiary of Capital One Financial Services, Inc.
In connection with the sale, the Company entered into a rental guarantee agreement for each building for the benefit of the buyer to guarantee any shortfalls that may be incurred in the payment of rent and re-tenanting costs for a five-year period from the date of sale (through November 2007). The Company’s maximum exposure to loss under the rental guarantee agreements was $18.7 million at the date of sale and was $12.4 million as of December 31, 2004. No payments were made by the Company during 2003 and 2002 in respect of these rent guarantees. However, in June 2004, the Company began to make monthly payments to the buyer at an annual rate of $0.1 million as a result of the existing tenant renewing a lease in one building at a lower rental rate.
These rent guarantees are a form of continuing involvement as discussed in paragraph 28 of SFAS No. 66. Because the guarantees cover the entire space occupied by a single tenant under a triple-net lease arrangement, the Company’s guarantees are considered a guaranteed return on the buyer’s investment for an extended period of time. Therefore, the transaction has been accounted for as a financing transaction, following the accounting method described in Note 1. Accordingly, the assets, liabilities and operations are included in these Consolidated Financial Statements, and a financing obligation of $28.8 million is recorded which represents the amount received from the buyer, adjusted for subsequent activity. The income from the operations of the properties, other than depreciation, is allocated 100.0% to the owner as interest expense on financing obligation. Payments made under the rent guarantees are charged to expense as incurred. This transaction was recorded as a completed sale transaction in the third quarter of 2005 when the maximum exposure to loss under the guarantees became less than the related gain; deferred gain will be recognized in future periods as the maximum exposure under the guarantees is reduced.
MG-HIW, LLC
On December 19, 2000, the Company formed a joint venture with Miller Global, MG-HIW, LLC, pursuant to which the Company sold or contributed to MG-HIW, LLC 19 in-service office properties in Raleigh, Atlanta, Tampa (the “Non-Orlando City Group”) and Orlando (collectively the “City Groups”) for an agreed upon value of $335.0 million. As part of the formation of MG-HIW, LLC, Miller Global contributed $85.0 million in cash for an 80.0% ownership interest and the joint venture borrowed $238.8 million from a third-party lender. The Company retained a 20.0% ownership interest and received net cash proceeds of $307.0 million. During 2001, the Company contributed a 39,000 square foot development project to MG-HIW, LLC in exchange for $5.1 million. The joint venture borrowed an additional $3.7 million under its existing debt agreement with a third party and the Company retained its 20.0% ownership interest and received net cash proceeds of $4.8 million. The assets of each of the City Groups were legally acquired by four separate LLC’s for which MG-HIW, LLC was the sole member.
The Non-Orlando City Group consisted of 15 properties encompassing 1.3 million square feet and were located in Atlanta, Raleigh and Tampa. Based on the nature and extent of certain rental guarantees made by the Company with respect to these properties, the transaction did not qualify for sale treatment under SFAS No. 66. The transaction has been accounted for as a profit-sharing arrangement, and accordingly, the assets, liabilities and operations of the properties remain on the books of the Company and a co-venture obligation was established for the amount of equity contributed by Miller Global related to the Non-Orlando City Group properties. The income from operations of the properties, excluding depreciation, was allocated 80.0% to Miller Global (which represents its interest in the joint venture) and reported as “co-venture expense” in these Consolidated Financial Statements. The Company continues to depreciate the properties and record all of the depreciation on its books. In addition to the co-venture expense, the Company recorded expense of $1.3 million and $0.7 million related to payments made under the rental guarantees for the years ended December 31, 2003 and 2002, respectively. No expense was recorded related to payments made under the rental guarantees for the year ended December 31, 2004.
F-25
On July 29, 2003, the Company acquired its partner’s 80.0% equity interest in the Non-Orlando City Group. The Company paid Miller Global $28.1 million, repaid $41.4 million of debt related to the properties and assumed $64.7 million of debt. The Company recognized a $16.3 million gain in 2003 on the settlement of the $43.5 million co-venture obligation recorded on the books of the Company.
With respect to the Orlando City Group, which consists of five properties encompassing 1.3 million square feet located in the central business district of Orlando, the Company assumed obligations to make improvements to the assets as well as master lease obligations and guarantees on certain vacant space. Additionally, the Company guaranteed a leveraged internal rate of return (“IRR”) of 20.0% on Miller Global’s equity. The contribution of these Orlando properties is accounted for as a financing arrangement under SFAS No. 66. Consequently, the assets, liabilities and operations related to the properties remained on the books of the Company and a financing obligation was established for the amount of equity contributed by Miller Global related to the Orlando City Group. The income from operations of the properties, excluding depreciation, is being allocated 80.0% to Miller Global and reported as “interest on financing obligation” in these Consolidated Financial Statements. This financing obligation was also adjusted each period by accreting the obligation up to the 20.0% guaranteed internal rate of return by a charge to interest expense, such that the financing obligation equaled at the end of each period the amount due to Miller Global including the 20.0% guaranteed return. The Company recorded interest expense on the financing obligation of $3.2 million, $11.6 million and $10.1 million, which includes amounts related to this IRR guarantee and payments made under the rental guarantees, for the years ended 2004, 2003 and 2002, respectively. The Company continued to depreciate the Orlando properties and record all of the depreciation in its financial statements until June 2004 when the assets were sold to a 40% owned joint venture, HIW-KC Orlando, LLC.
On July 29, 2003, the Company also entered into an option agreement to acquire Miller Global’s 80.0% interest in the Orlando City Group. On March 2, 2004, the Company exercised its option and acquired its partner’s 80.0% equity interest in the Orlando City Group of MG-HIW, LLC. The properties were 86.8% leased as of December 31, 2004 and were encumbered by $136.2 million of floating rate debt with interest based on LIBOR plus 200 basis points. At the closing of the transaction, the Company paid its partner, Miller Global, $62.5 million and a $7.5 million letter of credit delivered to the seller in connection with the option was cancelled. Since the initial contribution of these assets was accounted for as a financing arrangement and since the financing obligation was adjusted each period for the IRR guarantee, no gain or loss was recognized upon the extinguishment of the financing obligation. In June 2004, the Company contributed these assets to HIW-KC Orlando, LLC for a 40.0% interest.
4. ASSET DISPOSITIONS
Gains and impairments on disposition of properties, net, excluding gains or losses from discontinued operations, consisted of the following:
Gains and impairments on disposition of land, net
Gains on disposition of depreciable properties
Impairments of depreciable properties
Net gains on sale and impairments of discontinued operations, net of minority interest, consisted of the following:
Allocable minority interest
F-26
4. ASSET DISPOSITIONS - Continued
As described in more detail in the following paragraphs, during 2004 the Company sold approximately 1.3 million rentable square feet of office, industrial and retail properties and 88 apartment units for gross proceeds of $96.5 million and also sold 213.7 acres of development land for gross proceeds of $35.7 million. The Company also contributed approximately 1.3 million square feet of buildings and land to joint ventures. The resultant gains and impairments are shown in the preceding table. The larger 2004 transactions are described below.
On June 16, 2004, the Company sold a 177,000 square foot building (the network operations center) located in the Highwoods Preserve Office Park in Tampa, Florida. Highwoods Preserve is a 816,000 square foot office park that WorldCom vacated as of December 31, 2002. Net proceeds from the sale were $18.5 million. The asset had a net book value of $21.8 million. The Company recognized an impairment loss of $3.0 million in discontinued operations in April 2004 when the planned sale met the criteria to be classified as held for sale. In connection with the sale of the network operations center, the buyer also agreed to purchase a 3.3 acre tract of development land located in the office park for $1.4 million, which is subject to the Company securing certain development rights for the land from the local municipality. The net book value of the land is $0.9 million and was classified as held for sale in accordance with SFAS No. 144 in April 2004. This land sale is subject to customary closing conditions and no assurances can be provided that the disposition will occur. The remaining assets in the office park were classified as held for use as of December 31, 2003 and continued to be so classified at December 31, 2004 in accordance with SFAS No. 144.
On June 28, 2004, Kapital-Consult, a European investment firm, bought an interest in HIW-KC Orlando, LLC, an entity formed by the Company. HIW-KC Orlando, LLC owns the Orlando City Group assets which had an agreed upon value under the joint venture agreement of $212.0 million, including amounts related to the Company’s guarantees described below, and which were subject to a $136.2 million secured mortgage loan. Kapital-Consult contributed $42.1 million in cash and received a 60.0% equity interest in the entity. The joint venture borrowed $143.0 million under a ten-year fixed rate mortgage loan from a third party lender and repaid the $136.2 million loan. The Company retained a 40.0% equity interest in the joint venture and received net cash proceeds of $46.6 million, of which $33.0 million was used to pay down the Company’s Revolving Loan and $13.6 million was used to pay down additional debt. In connection with this transaction, the Company agreed to guarantee rent to the joint venture for 3,248 rentable square feet commencing in August 2004 and expiring in April 2011. In connection with this guarantee, as of June 30, 2004, the Company included $0.6 million in other liabilities and reduced the total amount of gain to be recognized by the same amount. Additionally, the Company agreed to guarantee re-tenanting costs for approximately 11% of the joint venture’s total square footage. The Company recorded a $4.1 million liability with respect to such guarantee as of June 30, 2004 and reduced the total amount of gain to be recognized by the same amount. During 2004, the Company paid $2.4 million in re-tenanting costs related to this guarantee. The Company believes its estimate related to the re-tenanting costs guarantee is accurate. However, if its assumptions prove to be incorrect, future losses may occur. The contribution was accounted for as a partial sale as defined by SFAS No. 66 and the Company recognized a $16.3 million gain in June 2004. Since the Company has an ongoing 40.0% financial interest in the joint venture and since the Company is engaged by the joint venture to provide management and leasing services for the joint venture, for which the Company receives customary management fees and leasing commissions, the operations of these properties were not reflected as discontinued operations consistent with SFAS No. 144 and the related gain on sale was included in continuing operations in the second quarter of 2004.
In the fourth quarter of 2004, the Company sold an additional 14 buildings encompassing 514,191 square feet and one 88 unit apartment building for gross proceeds of $37.5 million and recorded an approximate $5.0 million gain on sales in discontinued operations. The Company also sold a 165,000 square foot building located in Orlando, Florida with a net book value of approximately $9.8 million. Gross proceeds from the sale were approximately $6.8 million. The Company had recognized an impairment loss of approximately $3.2 million in the fourth quarter 2004 prior to the closing of the sale.
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During 2004, the Company also contributed 7.8 acres of land to the Vinings at University Center, LLC in which the Company has a 50.0% equity interest. See Note 2 for further discussion of this joint venture.
During 2003, the Company sold approximately 3.3 million rentable square feet of office, industrial and retail properties and 122.8 acres of revenue-producing land for $202.9 million and also sold 108.5 acres of non-core development land for gross proceeds of $18.7 million. In addition, the Company contributed three properties consisting of 290,853 rentable square feet to Highwoods-Markel Associates, LLC in which the Company has a 50.0% equity interest. The resultant gains and impairments are shown in the preceding table.
During 2002, the Company sold approximately 2.0 million rentable square feet of office and industrial properties for gross proceeds of $213.9 million and also sold 137.7 acres of development land for gross proceeds of $21.3 million. The resultant gains and impairments are shown in the preceding table. The Company also sold three buildings in the Eastshore transaction, which was accounted for as a financing arrangement. See Note 3 for further discussion. In September 2002, the Company contributed an office property to SF-HIW Harborview, LP and accounted for the contribution as a financing arrangement. See Note 3 for further discussion. No gains or losses were recorded from these financing arrangements.
From January 1, 2005 through September 30, 2005, the Company sold properties aggregating 4.4 million square feet for total gross sales proceeds of approximately $337.1 million. These dispositions included:
In addition, during the same period, the Company sold 63.1 acres of non-core development land aggregating $13.4 million in gross sales proceeds and contributed 22.4 acres of non-core development land to the newly formed Weston Lakeside, LLC joint venture (discussed further in Note 2) for an additional $1.9 million in cash proceeds and a 50.0% equity interest in the joint venture.
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Proceeds from these asset dispositions in 2005 were used to pay-off debt and redeem preferred stock, as further described in Note 5.
On November 30, 2005, the Company announced that it had executed a contract to sell $143.0 million of non-core properties encompassing 1.9 million square feet of office and industrial properties in Atlanta, Columbia and Tampa. It is expected to close in January 2006; however, completion of this transaction is subject to the absence of any material adverse due diligence findings and satisfaction of other closing conditions.
5. MORTGAGES, NOTES PAYABLEAND FINANCING OBLIGATIONS
The Company’s consolidated mortgages and notes payable consisted of the following at December 31, 2004 and 2003:
Mortgage loans payable:
9.0% mortgage loan due 2005
8.1% mortgage loan due 2005
8.2% mortgage loan due 2007
7.8% mortgage loan due 2009
7.9% mortgage loan due 2009
7.8% mortgage loan due 2010
6.0% mortgage loan due 2013
5.7% mortgage loan due 2013
5.2% to 9.0% mortgage loans due between 2005 and 2017 (1)
Variable rate mortgage loan due 2006
Variable rate mortgage loan due 2007
Variable rate construction loans due 2006 and 2007
Unsecured indebtedness:
7.0% notes due 2006
7.125% notes due 2008
8.125% notes due 2009
Put Option Notes due 2011 (3)
7.5% notes due 2018
Term loan due 2005
Revolving loan due 2006
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5. MORTGAGES, NOTES PAYABLEAND FINANCING OBLIGATIONS – Continued
The following table sets forth the principal payments, including amortization, due on the Company’s mortgages and notes payable as of December 31, 2004:
Unsecured (1):
Notes
Mortgage loans payable (2)
Variable Rate Debt: (3)
Revolving Loan (4)
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5. MORTGAGES, NOTES PAYABLEAND FINANCING OBLIGATIONS - Continued
In March 2004, the Company amended the Revolving Loan and its then outstanding two bank term loans. The changes modified certain definitions used in all three loans to determine amounts that are used to compute financial covenants and also adjusted one of the financial ratio covenants.
In June 2004, the Company further amended the Revolving Loan and its then outstanding two bank term loans. The changes excluded the $12.5 million charge taken related to the refinancing of the Put Option Notes from the calculations used to compute financial covenants.
In August 2004, the Company further amended the Revolving Loan and its then outstanding two bank term loans. The changes excluded the effects of accounting for three sales transactions as financing and/or profit sharing arrangements under SFAS No. 66 from the calculations used to compute financial covenants, adjusted one financial covenant and temporarily adjusted a second financial covenant until the earlier of December 31, 2004 or the period when the Company could record income from the anticipated settlement of a claim against WorldCom, which occurred in September 2004 (see Note 21).
In October 2004, the Company obtained a waiver from the lenders under the Revolving Loan and its then outstanding two bank term loans for certain covenant violations caused by the effects of the loss on debt extinguishment from the MOPPRS transaction in early 2003, as described below.
In June, July, August and September 2005, the Company obtained waivers from the lenders under the Revolving Loan and its then outstanding two bank loans related to timely reporting to the lenders of annual and quarterly financial statements and to covenant violations that could arise from future redemptions of preferred stock due to the reclassification of the preferred stock from equity to a liability during the period of time from the announcement of the redemption until the redemption is completed.
The aforementioned modifications did not change the economic terms of the loans. In connection with these modifications, the Company incurred certain loan costs that are capitalized and amortized to interest expense over the remaining term of the loans.
The Revolving Loan carries an interest rate based upon the Company’s senior unsecured credit ratings. As a result, interest currently accrues on borrowings under the Revolving Loan at an average rate of LIBOR plus 105 basis points. The terms of the Revolving Loan require the Company to pay an annual facility fee equal to .25% of the aggregate amount of the Revolving Loan. The Company currently has a credit rating of BBB- assigned by Standard & Poor’s and Fitch Ratings and Ba1 assigned by Moody’s Investor Service. In January 2005, Moody’s Investor Service confirmed the Company’s Ba1 rating, with a stable outlook. If Standard and Poor’s or Fitch Ratings were to lower the Company’s credit ratings without a corresponding increase by Moody’s, the interest rate on borrowings under the Revolving Loan would be automatically increased by 60 basis points.
In November 2005, the Company amended its $100.0 million bank term loan to extend the maturity date to July 17, 2006 and reduce the spread over the LIBOR interest rate from 130 basis points to 100 basis points.
The terms of the Revolving Loan, the $120.0 million bank loans and the indenture that governs the Company’s outstanding notes require the Company to comply with certain operating and financial covenants and performance ratios. No circumstance currently exists that would result in an acceleration of any of this debt.
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On February 2, 1998, the Company (through the Operating Partnership) sold $125.0 million of MandatOry Par Put Remarketed Securities (“MOPPRS”) which were originally expected to mature on February 1, 2013. The fixed interest rate was 6.835% through January 31, 2003, and would be reset at that date at 5.715% plus a spread as determined under the terms of the MOPPRS. In connection with the original issuance, the Company granted a remarketing option to one of the underwriters for the MOPPRS, the consideration for which was reflected in the premium price of the bonds and aggregated $3.5 million. This consideration was deferred and included in deferred financing cost and was amortized to income over the term of the MOPPRS. The option, if exercised, allowed the option holder to purchase the MOPPRS on January 31, 2003 from the holders for $125.0 million and then resell the MOPPRS in a new offering to new investors at the reset interest rate (5.715% plus the spread). If the option holder did not exercise the option, the Company would be required to repurchase the MOPPRS for $125.0 million plus any accrued interest. The Company also had a one-time right to redeem the MOPPRS from the option holder on January 31, 2003 for $125.0 million plus the then present value of the remarketing option.
On January 28, 2003, the Company, the option holder and an intermediary entered into an agreement under which the option holder agreed to exercise its option to acquire the MOPPRS on January 31, 2003 and the intermediary agreed to acquire the MOPPRS from the option holder for $142.7 million. The intermediary and the Company also agreed to exchange the MOPPRS for new Company debt instruments in the future, subject to certain terms and conditions. The MOPPRS transaction between the option holder and the intermediary occurred on January 31, 2003 and the interest rate on the MOPPRS was reset at 8.975%. On February 4, 2003, a new $142.8 million mortgage loan with a third party, secured by 24 of the Company’s properties, was executed; this loan bears a fixed interest rate of 6.03% and matures in February 2013. The intermediary received the proceeds from the new mortgage loan, and the mortgage loan and the MOPPRS were then exchanged between the Company and the intermediary. The Company then retired the MOPPRS. The retirement of the MOPPRS has been accounted for as an extinguishment. Accordingly, $14.7 million was charged to loss on extinguishment of debt in the quarter ended March 31, 2003.
Total interest capitalized was $1.1 million, $1.4 million and $5.5 million for the years ended December 31, 2004, 2003 and 2002, respectively
Through December 1, 2005, the Company paid off $151.6 million of outstanding loans, excluding any normal debt amortization, which included the following transactions. In early April 2005, the Company paid off $40.9 million of callable secured mortgage debt; in mid-July 2005, the Company paid off another $26.0 million of callable secured mortgage debt; and on August 1, 2005, the Company paid off $47.0 million of secured variable rate mortgage debt that was due January 1, 2006. In September 2005, the Company paid off its $20.0 million term loan at maturity and three secured loans totaling $3.5 million. In November 2005, the Company extended the maturity date on its $100.0 million term loan to July 17, 2006 and lowered the interest rate. On December 1, 2005, the Company paid off $2.1 million of secured variable rate mortgage debt that was due February 2, 2006. In addition, on December 1, 2005, the Company exercised its option to pay down $9.4 million on its AEGON loan that matures in 2009. The Company also used some of the proceeds from its disposition activity to redeem, in August 2005, all of the Company’s outstanding Series D Preferred Shares and a portion of the outstanding Series B Preferred Shares, aggregating $130.0 million plus accrued dividends. These reductions in outstanding debt and preferred stock balances were made primarily from proceeds from property dispositions that closed in 2005.
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Deferred Financing Costs
As of December 31, 2004, the Company had $16.7 million of deferred financing costs, with $6.6 million of accumulated amortization. Deferred financing costs include loan fees, loan closing costs, premium and discounts on bonds, notes payable and debt issuance costs. Amortization of bond premiums and discounts is included in contractual interest expense. All other amortization is shown as amortization of deferred financing costs. The scheduled future amortization of these deferred financings costs will be as follows:
In June 2004, $0.9 million of unamortized deferred financing costs were written off in connection with the early extinguishment of the $136.2 million secured loan related to the MG-HIW Orlando assets sold to a 40.0% owned joint venture with Kapital Consult, as described in Note 4.
Financing Obligations
The Company’s financing obligations consisted of the following at December 31, 2004 and 2003:
SF-HIW Harborview, LP financing obligation (1)
Eastshore financing obligation (1)
MG-HIW, LLC financing obligation (1)
Capitalized ground lease obligation (2)
Tax increment financing obligation (3)
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The following table sets forth the expected payment obligations on financing obligations as of December 31, 2004:
6. EMPLOYEE BENEFIT PLANS
Management Compensation Program
The Company’s officers participate in an annual bonus program whereby they are eligible for bonuses based on a percentage of their annual base salary as of the prior December. Each officer’s target level bonus is determined by competitive analysis and the executive’s ability to influence overall performance of the executive’s business unit and/or of the Company as a whole and, ranges from 30.0% to 85.0% of base salary depending on position in the Company. The executive’s actual incentive bonus for the year is the product of the target annual incentive bonus percentage times a performance ‘factor,’ which can range from zero to 200%. This performance factor depends upon the relationship between how various performance criteria compare with predetermined goals. For an executive who has division responsibilities, goals for certain performance criteria are based on the division’s budget for the year, and goals for other criteria are fixed objectives that are the same for all divisions. For corporate executives, the performance factor is based on the average of the factors achieved by the division executives. Bonuses are accrued and expensed in the year earned and are generally paid in the first quarter of the following year.
Certain other members of management participate in an annual cash incentive bonus program whereby a target level cash bonus is established based upon the job responsibilities of their position. Cash bonus eligibility ranges from 10.0% to 40.0% of annual base salary as of the prior December. The actual cash bonus is determined by the overall performance of the Company and the individual’s performance during each year. These bonuses are also accrued and expensed in the year earned and are generally paid in the first quarter of the following year.
In addition to the annual bonus and as an incentive to retain executive officers, the Company’s long-term incentive plan for officers provides for annual grants of stock options and restricted stock under the Amended and Restated 1994 Stock Option Plan (the “Stock Option Plan”) and other awards under the 1999 Shareholder Value Plan.
The stock options issued prior to 2005 vest ratably over four years and remain outstanding for 10 years. The value of such options as of the date of grant is calculated using the Black-Scholes option-pricing model.
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6. EMPLOYEE BENEFIT PLANS - Continued
The restricted shares issued prior to 2005 generally vest 50.0% three years from the date of grant and the remaining 50.0% five years from date of grant. Such shares are no longer restricted after the vesting date. The restricted share awards are amortized to expense over the explicit service periods, which is the vesting period. Recipients are eligible to receive dividends on restricted stock issued. Restricted stock and annual expense information is as follows:
Restricted shares outstanding at January 1
Number of restricted shares awarded
Restricted shares vested (1)
Restricted shares repurchased upon cancellation or forfeiture
Restricted shares outstanding at December 31
Annual expense (1)
Average grant date market value for all restricted shares outstanding
The 1999 Shareholder Value Plan was intended to reward the executive officers of the Company when the total shareholder returns measured by increases in the market value of Common Stock plus dividends exceeds a comparable index of the Company’s peers over a three-year period. A payout for this program, which can be in cash or other consideration, is determined by the Company’s percentage change in shareholder return compared to the composite index of its peer group. If the Company’s performance is not at least 100% of the peer group, no payout is made. To the extent performance exceeds the peer group, the payout increases. A new three-year plan cycle begins each year under this program. There were no cash payouts under this plan for the years ended December 31, 2004, 2003 or 2002, respectively. This plan is accounted for under variable plan accounting and accordingly, at each period-end, a liability equal to the current computed fair value under the plan for all outstanding plan units, adjusted for the three-year vesting period, is recorded with corresponding charges or credits to compensation expense. Compensation expense recognized under this plan amounted to $0 in 2004, $0 in 2003 and $(846,000) in 2002.
In 1997, the Company adopted the 1997 Performance Award Plan under which 349,990 nonqualified stock options granted to certain executive officers were accompanied by a dividend equivalent right (“DER”). No other options granted by the Company since 1997 have been accompanied by a DER. The plan provided that if the total return on a share of Common Stock exceeded certain thresholds during the five-year vesting period ending in 2002, the exercise price of such options with a DER would be reduced under a formula based on dividends and other distributions made with respect to such a share during the period beginning on the date of grant and ending upon exercise of such stock option. At the end of the five-year vesting period, the total return performance resulted in a reduction in the option exercise price of $6.098 per share. The exercise price per option share was further reduced by $2.964 as of December 31, 2004 as a result of the dividend payments on Common Stock from January 1, 2003 through December 31, 2004. Because of the exercise price reduction feature, the stock options accompanied by a DER were accounted for using variable accounting as provided in FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation.” As a result, the Company recorded compensation expense of $0.06 million, $1.2 million and $0.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. In December 2004, the Company entered into an agreement with the participants to cease the additional reduction in the option exercise price, which fixed the exercise price per share reduction at $9.06. As a result, variable accounting is no longer required as both the number of options and the amount required to exercise is known. As of December 31, 2004, there were 168,948 outstanding options with an accompanying DER.
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The Company has also established a deferred compensation plan pursuant to which various officers can defer a portion of their salary and/or bonus that would otherwise be paid to such officers for investment in units of phantom Company Common Stock or in various, unrelated mutual funds, based on the officers’ elections. The Company records compensation expense for the full amount of compensation deferred by participating officers in each deferral period. At the end of each quarter, any officer who defers compensation into phantom stock that otherwise would have been paid in cash is credited with units of phantom stock at a 15.0% discount. Dividends on the phantom stock are assumed to be issued in additional phantom stock at a 15.0% discount. If the officer leaves employment for any reason (other than death, disability, normal retirement or voluntary termination by the Company) within two years after the end of the year in which such officer has deferred compensation, at a minimum, the 15.0% discount and any deemed dividends are forfeited. Over the two-year vesting period, the Company records additional compensation expense equal to the 15.0% discount, the accrued dividends and any changes in the market value of the Company’s Common Stock from the date of the deferral, which aggregated $0.5 million, $0.7 million and $0.2 million for the years ended December 31, 2004, 2003 and 2002, respectively. In July 2005, the Company modified the plan to preclude any deferrals into phantom stock after December 31, 2005.
For 2005, the annual incentive bonus program will operate similarly as in 2004, except that the following four performance criteria will be used for 2005, all of which are weighted equally: (1) average occupancy rates relative to budgeted rates; (2) net operating income relative to budgeted amounts; (3) average payback on leases relative to a fixed goal; and (4) average lease term relative to a fixed goal. These criteria provide an objective basis for the compensation and governance committee of the Company’s board of directors to determine bonuses for division level and corporate level executive officers. Notwithstanding the foregoing criteria, the compensation and governance committee has retained the authority to pay bonuses at its discretion.
Effective for 2005, options that are issued to executive officers under the Stock Option Plan will continue to vest ratably over a four-year period, but the option term will be seven years instead of 10 years. The value of such options as of the date of grant will be calculated using the Black-Scholes option-pricing model. The exercise price per share for such options will be based on the average of the daily closing prices for the Company’s Common Stock over the 10-day period preceding the date of grant, rather than the closing price for the Company’s Common Stock on the date immediately preceding the date of grant.
Beginning in 2005, the Company has also replaced the 1999 Shareholder Value Plan with a performance-based restricted stock plan under which all or a portion of additional grants of restricted stock will vest if the total return of the Company’s Common Stock exceeds the average total returns of a selected group of peer companies over a three-year period. If the Company’s performance is not at least 100% of the peer group, none of the restricted stock will vest at the end of the three-year period. To the extent performance equals or exceeds the peer group, the portion of issued shares that vest can range from 50.0% to 100.0%, and for exceptional levels of performance, additional shares can be granted at the end of the three-year period up to 100.0% of the original restricted stock that was issued. These additional shares, if any, would be fully vested when issued. A new three-year plan cycle begins each year under the program.
Effective for 2005, shares of time-based restricted stock that are issued to executive officers under the Stock Option Plan will vest one-third on the third anniversary, one-third on the fourth anniversary and one-third on the fifth anniversary of the date of grant.
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In addition to time-based restricted stock, a portion of the restricted stock issued to executive officers in 2005 will be subject to company-wide performance-based criteria. For 2005, the performance-based criteria is based on whether or not the Company meets or exceeds operating goals established under the Company’s Strategic Management Plan for the four following areas relative to established goals by the end of 2007: (1) average occupancy rates; (2) long-term debt plus preferred equity as a percentage of total assets; (3) fixed charge coverage ratio; and (4) ratio of dividends to cash available for distribution. To the extent performance equals or exceeds the threshold performance goals, the portion of issued shares of restricted stock that vest can range from 50.0% to 100.0%, and for exceptional levels of performance, additional shares can be granted at the end of the three-year period up to 50.0% of the original restricted shares that were issued. These additional shares, if any, would be fully vested when issued.
Notwithstanding the foregoing criteria, the compensation and governance committee of the Company’s board of directors has retained the authority to issue long-term incentive awards at its discretion.
Dividends received on restricted stock under all prior and current grants are non-forfeitable by the officer and are paid at the same rate and on the same date as on shares of the Company’s Common Stock on all shares held, whether or not vested.
401(k) Savings Plan
The Company has a 401(k) savings plan covering substantially all employees who meet certain age and employment criteria. The Company contributes amounts for each participant at a rate of 75% of the employee’s contribution (up to 6% of each employee’s salary). During 2004, 2003 and 2002, the Company contributed $1.2 million, $1.0 million and $0.9 million, respectively, to the 401(k) savings plan. Administrative expenses of the plan are paid by the Company.
Employee Stock Purchase Plan
The Company has an Employee Stock Purchase Plan for all active employees under which employees can elect to contribute up to 25.0% of their base compensation. At the end of each three-month offering period, the contributions in each participant’s account balance, which includes accrued dividends, is applied to acquire shares of Common Stock at a cost that is calculated at 85.0% of the lower of the average closing price on the New York Stock Exchange on the five consecutive days preceding the first day of the quarter or the five days preceding the last day of the quarter. During the years ended December 31, 2004, 2003 and 2002, the Company issued 33,693, 50,812 and 47,488 new shares of Common Stock, respectively under the Employee Stock Purchase Plan. The discount on issued shares is expensed by the Company as additional compensation and aggregated $0.2 million, $0.2 million and $0.1 million in 2004, 2003 and 2002, respectively.
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7. RENTAL INCOME
The Company’s real estate assets are leased to tenants under operating leases, substantially all of which expire over the next 10 years. The minimum rental amounts under the leases are generally either subject to scheduled fixed increases or adjustments based on the Consumer Price Index. Generally, the leases also require that the tenants reimburse the Company for increases in certain costs above the base-year costs.
Expected future minimum rents to be received over the next five years and thereafter from tenants for leases in effect at December 31, 2004 for the Company’s Wholly Owned Properties are as follows:
8. RELATEDPARTY TRANSACTIONS
The Company has previously reported that it had a contract to acquire development land in the Bluegrass Valley office development project from GAPI, Inc., a corporation controlled by Gene H. Anderson, an executive officer and director of the Company. Under the terms of the contract, the development land is to be purchased in phases, and the purchase price for each phase or parcel is settled for in cash and/or Common Units. The price for the various parcels is based on an initial value for each parcel, adjusted for an interest factor, currently 6.88% per annum, applied up to the closing date and also for changes in the value of the Common Units. On January 17, 2003, the Company acquired an additional 23.5 acres of this land from GAPI, Inc. for 85,520 shares of Common Stock and $384,000 in cash for total consideration of $2.3 million. In May 2003, 4.0 acres of the remaining acres not yet acquired by the Company was taken by the Georgia Department of Transportation to develop a roadway interchange for consideration of $1.8 million. The Department of Transportation took possession and title of the property in June 2003. As part of the terms of the contract between the Company and GAPI, Inc., the Company was entitled to and received in 2003 the $1.8 million proceeds from the condemnation. In July 2003, the Company appealed the condemnation and is currently seeking additional payment from the state; the recognition of any gain has been deferred pending resolution of the appeal process. In April 2005, the Company acquired for cash an additional 12.1 acres of the Bluegrass Valley land from GAPI, Inc. and also settled for cash the final purchase price with GAPI, Inc. on the 4.0 acres that were taken by the Georgia Department of Transportation, which aggregated approximately $2.7 million, of which $0.7 million was recorded as a payable to GAPI, Inc. on the Company’s financial statements as of December 31, 2004. In August 2005, the Company acquired 12.7 acres, representing the last parcel of land to be acquired, for cash aggregating $3.2 million. The Company believes that the purchase price with respect to each land parcel was at or below market value. These transactions were unanimously approved by the full Board of Directors with Mr. Anderson abstaining from the vote. The contract provided that the land parcels could be paid in Common Units or in cash, at the option of the seller. This feature constituted an embedded derivative pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The embedded derivative feature is accounted for separately and adjusted based on changes in the fair value of the Common Units. This results in an increase to other income of $1.3 million in 2002, and a decrease to other income of $0.7 and $0.4 million in 2003 and 2004, respectively. In 2005, an additional $0.2 million expense was recorded related to the embedded derivative, which expired upon the closing of the final land transaction in August 2005.
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8. RELATED PARTY TRANSACTIONS - Continued
The Company entered into a series of agreements in January and February 2005, pursuant to which the Company, through a third party broker, sold on February 28, 2005 and April 15, 2005, three non-core industrial buildings in Winston-Salem, North Carolina to John L. Turner, a director of the Company, and certain of his affiliates in exchange for a gross sales price of approximately $27.0 million, of which $20.3 million was paid in cash and the remainder from the surrender of 256,508 Common Units in the Operating Partnership. The Company recorded a gain of approximately $4.8 million upon the closing of these sales. The Company believes that the purchase price paid for these assets by Mr. Turner and his affiliates was equal to their fair market value. The sales were unanimously approved by the full Board of Directors with Mr. Turner not being present to discuss or vote on the matter.
9. STOCKHOLDERS’ EQUITY
Common Stock Dividends
Quarterly dividends paid per share of Common Stock aggregated $1.70, $1.86 and $2.34 for the years ended December 31, 2004, 2003 and 2002, respectively.
The following table summarizes the estimated taxability of dividends paid for federal income tax purposes:
Per share:
Ordinary income
Capital gains
Return of capital
The Company’s tax returns have not been examined by the IRS and, therefore, the taxability of dividends is subject to change. As of December 31, 2004, the tax basis of the Company’s assets and liabilities was approximately $2.4 billion and $1.6 billion, respectively.
On January 25, 2005, the Board of Directors declared a cash dividend of $0.425 per share of Common Stock payable on March 4, 2005 to stockholders of record on February 7, 2005. On April 26, 2005, the Board of Directors declared a cash dividend of $0.425 per share of Common Stock payable on June 3, 2005 to stockholders of record on May 17, 2005. On July, 26, 2005, the Board of Directors declared a cash dividend of $0.425 per share of Common Stock payable on September 2, 2005 to stockholders of record on August 8, 2005. On November 15, 2005, the Board of Directors declared a cash dividend of $0.425 per share of Common Stock payable on December 16, 2005 to stockholders of record on November 28, 2005.
Preferred Stock
Below is a tabular presentation of the Company’s Preferred Stock as of December 31, 2004:
Preferred Stock Issuances
Issue
8 5/8% Series A CumulativeRedeemable
8% Series B CumulativeRedeemable
8% Series D CumulativeRedeemable
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9. STOCKHOLDERS’ EQUITY - Continued
The net proceeds raised from each of three Preferred Stock issuances were contributed by the Company to the Operating Partnership in exchange for Preferred Units in the Operating Partnership. The terms of each series of Preferred Units generally parallel the terms of the respective Preferred Stock as to distributions, liquidation and redemption rights. All three series of Preferred Stock are non-voting.
Of the $86.25 dividend paid per Series A Preferred Share in 2004, $64.42 was taxable as ordinary income and $21.83 was taxable as capital gain. Of the $2.00 dividend paid per Series B Preferred Share in 2004, $1.49 was taxable as ordinary income and $0.51 was taxable as capital gain. Of the $20.00 dividend paid per Series D Preferred Share in 2004, $14.94 was taxable as ordinary income and $5.06 was taxable as capital gain.
On August 22, 2005, the Company redeemed all of the outstanding Series D Preferred Shares at a redemption value aggregating $100.0 million plus accrued dividends and a portion of its Series B Preferred Shares at a redemption value aggregating $30.0 million plus accrued dividends. In accordance with EITF Topic D-42, net income allocable to common shareholders in the third quarter of 2005 will be reduced by approximately $4.3 million, or $0.07 per share, representing the amount of original issuance costs related to the redeemed Preferred Stock.
Stockholder Rights Plan
The Company currently has in effect a stockholder rights plan pursuant to which existing stockholders would have the ability to acquire additional Common Stock at a significant discount in the event a person or group attempts to acquire the Company on terms of which the Company’s current board does not approve. These rights are designed to deter a hostile takeover by increasing the takeover cost. As a result, such rights could discourage offers for the Company or make an acquisition of the Company more difficult, even when an acquisition is in the best interest of the Company’s stockholders. The rights plan should not interfere with any merger or other business combination the board of directors approves since the Company may generally terminate the plan at any time at nominal cost.
Dividend Reinvestment Plan
The Company has instituted a Dividend Reinvestment and Stock Purchase Plan under which holders of Common Stock may elect to automatically reinvest their dividends in additional shares of Common Stock and may make optional cash payments for additional shares of Common Stock. The administrator of the Dividend Reinvestment and Stock Purchase Plan has been instructed by the Company to purchase Common Stock in the open market for purposes of satisfying the Company’s obligations thereunder. However, the Company may in the future elect to satisfy such obligations by issuing additional shares of Common Stock.
10. DERIVATIVEFINANCIAL INSTRUMENTS
SFAS No. 133, as amended by SFAS No. 149, requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings or will be recognized in Accumulated Other Comprehensive Loss (“AOCL”) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value is recognized in earnings.
The Company’s interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower overall borrowing costs. To achieve these objectives, from time to time the Company may enter into interest rate hedge contracts such as collars, swaps, caps and treasury lock agreements in order to mitigate its interest rate risk with respect to various debt instruments. The Company does not hold these derivatives for trading or speculative purposes.
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10. DERIVATIVE FINANCIAL INSTRUMENTS - Continued
The interest rate on all of the Company’s variable rate debt is adjusted at one to three month intervals, subject to settlements under these contracts. The Company received only a nominal amount of payments under interest rate hedge contracts in 2004 and 2003. Net payments made to counter parties under interest rate hedge contracts were $0.4 million in 2002 and were recorded as increases to interest expense.
The Company is exposed to certain losses in the event of nonperformance by the counter party under any outstanding hedge contracts. The Company expects the counter parties, which are major financial institutions, to perform fully under any such contracts. However, if any counter party was to default on its obligation under an interest rate hedge contract, the Company could be required to pay the full rates on its debt, even if such rates were in excess of the rate in the contract.
On the date that the Company enters into a derivative contract, the Company designates the derivative as (1) a hedge of the variability of cash flows that are to be received or paid in connection with a recognized liability (a “cash flow” hedge), (2) a hedge of changes in the fair value of an asset or a liability attributable to a particular risk (a “fair value” hedge) or (3) an instrument that is held as a non-hedge derivative. Changes in the fair value of highly effective cash flow hedges, to the extent that the hedges are effective, are recorded in AOCL, until earnings are affected by the hedged transaction (i.e., until periodic settlements of a variable-rate liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivative exceed the variability in the cash flows of the transaction) is recorded in current-period earnings. For derivatives designated as fair value hedges, changes in the fair value of the derivative and the hedged item related to the hedged risk are recognized in current-period earnings. Changes in the fair value of non-hedging instruments are reported in current-period earnings.
The Company formally documents all relationships between hedging instruments and hedged items as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as cash flow hedges to (1) specific assets and liabilities on the balance sheet or (2) forecasted transactions. The Company also assesses and documents, both at the hedging instrument’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows associated with the hedged items. When the Company determines that a derivative is not (or has ceased to be) highly effective as a hedge, the Company discontinues hedge accounting prospectively.
During 2002, the Company entered into and terminated two $24.0 million treasury lock agreements related to an anticipated fixed rate financing with two financial counterparties, which effectively lock the treasury rate at 3.7%. These treasury lock agreements are designated as cashflow hedges and the effective portion of the cumulative loss on the derivative instruments was $1.1 million at December 31, 2004 and is being reported as a component of AOCL in stockholders’ equity with the related offset included in other assets. These costs will be recognized into earnings in the same period or periods during which the hedged transaction affects earnings (as the underlying debt is paid down). The Company expects that the portion of the cumulative loss recorded in AOCL at December 31, 2004 associated with the derivative instruments which will be recognized within the next 12 months will be approximately $0.3 million.
During the year ended December 31, 2003, the Company entered into and subsequently terminated a treasury lock agreement to hedge the change in the fair market value of the MOPPRS and related remarketing option issued by the Operating Partnership. The termination of this treasury lock agreement resulted in a payment of $1.5 million to the Company, which was included as part of the $14.7 million loss on extinguishment recorded in early 2003 (see Note 5).
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In addition, during the year ended December 31, 2003, the Company entered into and subsequently terminated three interest rate swap agreements related to a ten-year fixed rate financing completed on December 1, 2003. These swap agreements were designated as cash flow hedges. The unamortized effective portion of the cumulative gain on these derivative instruments was $3.5 million at December 31, 2004 and is being reported as a component of AOCL in stockholders’ equity with the related offset included in other assets. This deferred gain will be recognized in net income as a reduction of interest expense in the same period or periods during which interest expense on the hedged fixed rate financing affects net income. The Company expects that $0.3 million will be recognized in the next 12 months.
In 2003, the Company also entered into two interest rate swaps related to a floating rate credit facility. The swaps effectively fixed the one-month LIBOR rate on $20.0 million of floating rate debt at 0.99% from August 1, 2003 to January 1, 2004 and at 1.59% from January 2, 2004 until June 1, 2005. These swap agreements are designated as cash flow hedges and the effective portion of the cumulative gain on these derivative instruments was $0.1 million at December 31, 2004 and is being reported as a component of AOCL in stockholders’ equity with the related offset included in other assets. The Company expects that the portion of the cumulative gain recorded in AOCL at December 31, 2004 associated with these derivative instruments, which will be recognized within the next 12 months, will be $0.1 million.
At December 31, 2004, $5.3 million of deferred financing costs from past cash flow hedging instruments is being reported as a component of AOCL in stockholders’ equity. These costs will be recognized as interest expense as the underlying debt is repaid. The Company expects that the portion of the cumulative loss recorded in AOCL at December 31, 2004 associated with these derivative instruments, which will be recognized as interest expense within the next 12 months, will be approximately $0.7 million.
As described in Note 8, the land purchase agreement with GAPI, Inc. included an embedded derivative feature due to the price for the land parcels being determined by the fair value of Common Units, which was accounted for in accordance with SFAS No. 133.
11. OTHER COMPREHENSIVE INCOME
Other comprehensive income represents net income plus the results of certain stockholders’ equity changes not reflected in the Consolidated Statements of Income. The components of other comprehensive income are as follows:
2002
Other comprehensive income:
Realized derivative gains on cashflow hedges
Amortization as interest expense of hedging gains and losses included in other comprehensive income
Total other comprehensive income
Total comprehensive income
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12. DISCONTINUED OPERATIONS ANDTHE IMPAIRMENT OF LONG-LIVED ASSETS
In October 2001, the FASB issued SFAS No. 144, which supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be disposed of” and the accounting and reporting provisions for disposals of a segment of a business as addressed in APB Opinion No. 30. SFAS No. 144 was effective as of January 1, 2002 and extended the reporting requirements of discontinued operations to include those long-lived assets that were classified as held for sale at December 31, 2003 as a result of disposal activities that were initiated subsequent to January 1, 2002, or were sold during 2002 or 2003 as a result of disposal activities that were initiated subsequent to January 1, 2002. The operations and cash flows of qualifying dispositions have been or will be eliminated from the ongoing operations of the Company and the Company will not have any significant continuing involvement in the operations after the disposal transaction.
Per SFAS No. 144, those long-lived assets that were sold during 2002 as a result of disposal activities initiated prior to January 1, 2002 should be accounted for in accordance with SFAS No. 121 and APB Opinion No. 30. During 2002, the Company sold three properties as a result of disposal activities initiated prior to January 1, 2002, and the gains realized on these sales are included in the gains and impairments on disposition of property, net in the Company’s Consolidated Statements of Income.
As part of its business strategy, the Company will from time to time selectively dispose of non-core properties in order to use the net proceeds for investments or other purposes. The table below sets forth the net operating results and net carrying value of those assets classified as discontinued operations in the Company’s Consolidated Financial Statements. These assets classified as discontinued operations comprise 3.5 million square feet of office and industrial property, 92 apartment units and 122.8 acres of revenue-producing land sold during 2002, 2003 and 2004 and 0.09 million square feet of property held for sale at December 31, 2004. These long-lived assets relate to disposal activities that were initiated subsequent to the effective date of SFAS No. 144, or that met certain stipulations prescribed by SFAS No. 144. The operations and cash flows of these assets have been or will be eliminated from the ongoing operations of the Company, and the Company will not have any significant continuing involvement in the operations after the disposal transaction:
Interest expense
Other income
Income before minority interest in the Operating Partnership and net gains on sale and impairment of discontinued operations
Minority interest in discontinued operations
Income from discontinued operations net of minority interest in the Operating Partnership
Net gains on sale and impairment of discontinued operations
Net gains on sale and impairment of discontinued operations, net of minority interest in the Operating Partnership
Total discontinued operations
Carrying value of assets held for sale and assets sold during the year
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12. DISCONTINUED OPERATIONS ANDTHE IMPAIRMENT OF LONG-LIVED ASSETS - Continued
SFAS No. 144 also requires that a long-lived asset classified as held for sale be measured at the lower of the carrying value or fair value less cost to sell. During 2004, the Company determined that five office properties held for sale, which have now been sold, had a carrying value that was greater than fair value less cost to sell; therefore, an impairment loss of $6.3 million, net of minority interest of $0.7 million, was recognized in net gains on sale and impairments of discontinued operations, net of minority interest, in the Consolidated Statement of Income for the year ended December 31, 2004. For 2003, an impairment loss related to one office property whose carrying value was greater than its fair value less cost to sell, which has now been sold, was $0.1 million. This impairment loss is included in net gains on sale and impairments of discontinued operations, net of minority interest, in the Consolidated Statement of Income for the year ended December 31, 2003. For 2002, the impairment loss related to two office properties whose carrying value was greater than their fair value less cost to sell, which have now been sold, was $3.6 million, net of minority interest. This impairment loss is included in net gains on sale and impairments of discontinued operations, net of minority interest of $0.5 million, in the Consolidated Statement of Income for the year ended December 31, 2002. At December 31, 2004, the Company had 248,400 rentable square feet of properties and 31.1 acres of land classified as held for sale. As of November 30, 2005, most of these properties have been sold.
The following table includes the major classes of assets and liabilities of the properties held for sale as of December 31, 2004 and 2003:
Accumulated depreciation
Accrued straight line rents receivable
Tenant security deposits and deferred rents (3)
SFAS No. 144 also requires that if indicators of impairment exist, the carrying value of a long-lived asset classified as held for use be compared to the sum of its estimated undiscounted future cash flows. If the carrying value is greater than the sum of its undiscounted future cash flows, an impairment loss should be recognized for the excess of the carrying amount of the asset over its estimated fair value. During 2004, there were two properties held for use, one of which was later sold in 2004, with indicators of impairment where the carrying value exceeded the sum of undiscounted future cash flows. Accordingly, the Company recognized an impairment loss of $1.6 million, net of minority interest of $0.2 million, of which $0.4 million is related to the property sold in 2004 and is included in income from discontinued operations, net of minority interest, in the Consolidated Statement of Income. The remaining impairment loss is included as impairment of assets held for use. For the year ended December 31, 2003, there was no impairment loss on assets held for use. For the year ended December 31, 2002, the carrying value of one property was greater than the sum of its undiscounted future cash flows and, accordingly, an impairment loss of $0.8 million was recognized. In addition, in 2002, the Company recognized a $9.1 million impairment loss related to one office property that has been demolished and may be redeveloped into a class A suburban office property in the future. The carrying value of this property exceeded the sum of its undiscounted future cash flows. These impairment losses aggregating $9.9 million are included as impairment of assets held for use in the Consolidated Statement of Income for the year ended December 31, 2002.
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13. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share:
Numerator:
Non-convertible preferred stock dividends (1)
Numerator for basic earnings per share – net income available for common stockholders
Add:
Minority interest in continuing operations
Numerator for diluted earnings per share – net income available for common stockholders – after assumed conversions
Denominator:
Denominator for basic earnings per share—weighted-average shares (2)
Employee stock options (1)
Warrants (1)
Operating partnership units
Unvested restricted shares (2)
Denominator for diluted earnings per share – adjusted weighted average shares and assumed conversions
Basic earnings per common share
Diluted earnings per common share
The number of shares of Common Stock reserved for future issuance is as follows:
Outstanding warrants
Outstanding stock options
Possible future issuance under stock option plan
As of December 31, 2004, the Company had 146,186,578 shares of Common Stock authorized to be issued under its charter.
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14. STOCK OPTIONS AND WARRANTS
As of December 31, 2004, 6.0 million shares of the Company’s Common Stock were authorized for issuance under the Amended and Restated 1994 Stock Option Plan. Stock options granted under this plan generally vest over a four or five-year period beginning with the date of grant.
In 1995, the FASB issued SFAS No. 123, which recommends the use of a fair value based method of accounting for an employee stock option whereby compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period (generally the vesting period of the award). However, SFAS No. 123 specifically allows an entity to continue to measure compensation cost under APB Opinion No. 25, so long as pro forma disclosures of net income and earnings per share are made as if SFAS No. 123 had been adopted. Through December 31, 2002, the Company elected to follow APB Opinion No. 25 and related interpretations in accounting for its employee stock options. In 2002 and 2001, 494,329 and 95,443 options were exercised whereby the Company simultaneously repurchased shares from the employees sufficient to pay for the option exercise price and the employees’ withholding taxes. Accordingly, these option exercises were considered to represent new measurement dates and the entire intrinsic value of the options was expensed in accordance with FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Options, An Interpretation of APB Opinion No. 25.” The amounts expensed aggregated $3.7 million during the year ended December 31, 2002. There were no similar option exercises during the years ended December 31, 2004 and 2003.
In December 2002, the FASB issued SFAS No. 148 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. On January 1, 2003, the Company adopted the fair value method of accounting for stock-based compensation provisions of SFAS No. 123. The Company applied the prospective method of accounting and expenses all employee stock options (and similar awards) issued on or after January 1, 2003 over the vesting period based on the fair value of the award on the date of grant. The adoption of this statement did not have a material impact on the Company’s results of operations.
As more fully described in Note 1, SFAS No. 123 (R) will become effective January 1, 2006 and will require recognition of compensation costs for currently unvested options the Company granted before January 1, 2003.
Under SFAS No. 123, the fair value of a stock option is estimated by using an option-pricing model that takes into account as of the grant date the exercise price and expected life of the option, the current price of the underlying stock and its expected volatility, expected dividends on the stock and the risk-free interest rate for the expected term of the option. SFAS No. 123 provides examples of possible pricing models and includes the Black-Scholes pricing model, which the Company used to develop its pro forma disclosures. The Black-Scholes model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable rather than for use in estimating the fair value of employee stock options subject to vesting and transferability restrictions.
Because SFAS No. 123 is applicable only to options granted subsequent to December 31, 1994, only options granted subsequent to that date were valued using the Black-Scholes model. The fair values of the options granted were estimated at the grant dates using the following weighted average assumptions:
Risk free interest rate
Common stock dividend yield
Expected volatility
Average expected option life (years)
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14. STOCK OPTIONS AND WARRANTS- - Continued
Had the compensation cost for the Company’s stock option plans for options issued before January 1, 2003 been determined based on the fair values at the grant dates for awards granted between January 1, 1995 and December 31, 2002 consistent with the provisions of SFAS No. 123, the Company’s net income and net income per share would have decreased to the pro forma amounts indicated below:
Net income available for common stockholders — as reported
Add: Stock option expense included in reported net income
Deduct: Total stock option expense determined under fair value recognition method for all awards
Pro forma net income available for common stockholders
Basic net income per common share - as reported
Basic net income per common share - pro forma
Diluted net income per common share - as reported
Diluted net income per common share - pro forma
The following table summarizes information about stock options outstanding at December 31, 2004, 2003, 2002 and 2001:
Number
of Shares
Exercise Price
Balances at December 31, 2001
Options granted
Options terminated
Options exercised
Balances at December 31, 2002
Balances at December 31, 2003
Balances at December 31, 2004
December 31, 2002
December 31, 2003
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Exercise prices for options outstanding as of December 31, 2004 ranged from $11.63 to $35.00. The weighted average remaining contractual life of those options is 6.1 years. Using the Black-Scholes options valuation model, the weighted average fair values of options granted during 2004, 2003 and 2002 were $1.50, $0.19 and $1.00, respectively, per option.
Warrants
The following table sets forth information regarding warrants outstanding as of December 31, 2004:
Date of Issuance
Number of
February 1995
April 1996
October 1997
December 1997
The warrants granted in February 1995, April 1996 and December 1997 expire 10 years from the respective dates of issuance. All warrants are exercisable from the dates of issuance. The warrants granted in October 1997 do not have an expiration date. All of the February 1995 warrants were exercised by the holder in February 2005, and 120,000 of the April 1996 warrants were exercised by the holder in June and September 2005.
15. COMMITMENTS AND CONTINGENCIES
The Company maintains its cash and cash equivalent investments at financial institutions. The combined account balances at each institution typically exceed FDIC insurance coverage and, as a result, there is a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. Management of the Company believes that the potential risk of loss is remote.
Land Leases
Certain properties in the Company’s wholly owned portfolio are subject to land leases expiring through 2082. Rental payments on these leases are adjusted annually based on either the consumer price index or on a predetermined schedule. Land leases subject to increases under a pre-determined schedule are accounted for under the straight-line method.
For three properties, the Company has the option to purchase the leased land during the lease term at the greater of 85.0% of appraised value or $0.03 million per acre.
The Company’s payment obligations for future minimum payments on operating leases (which include scheduled fixed increases, but exclude increases based on CPI) are as follows:
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15. COMMITMENTS AND CONTINGENCIES - Continued
In addition, the Company has recorded $0.5 million in capitalized lease obligations as of December 31, 2004, which is reflected in other liabilities.
Contracts
The Company has entered into contracts related to tenant improvements and the development of certain properties totaling $58.1 million as of December 31, 2004. The amounts remaining to be paid under these contracts as of December 31, 2004 totaled $27.1 million.
Development Projects
At September 30, 2005, the Company had development projects in process with a total estimated investment at completion of approximately $128 million. At September 30, 2005, $54.8 million was incurred and the remainder expected to be funded in the next 27 months.
Environmental Matters
Substantially all of the Company’s in-service properties have been subjected to Phase I environmental assessments (and, in certain instances, Phase II environmental assessments). Such assessments and/or updates have not revealed, nor is management aware of, any environmental liability that management believes would have a material adverse effect on the accompanying Consolidated Financial Statements.
Joint Ventures
Certain properties owned in joint ventures with unaffiliated parties have buy/sell options that may be exercised to acquire the other partner’s interest by either the Company or its joint venture partner if certain conditions are met as set forth in the respective joint venture agreement.
Guarantees and Other Obligations
The following is a tabular presentation and related discussion of various guarantees and other obligations as of December 31, 2004:
Entity or Transaction
Type of
Guarantee or Other Obligation
Recorded/Deferred
Date Guarantee
Expires
Des Moines Joint Ventures (1),(6)
RRHWoods, LLC (2),(7)
Plaza Colonnade (2),(8)
SF-HIW Harborview, LP (3),(5)
Eastshore (Capital One) (3),(9)
Capital One (3),(10)
Industrial (3),(11)
Highwoods DLF 97/26 DLF 99/32, LP (2),(12)
RRHWoods, LLC and Dallas County Partners (2),(13)
HIW-KC Orlando, LLC (3),(14)
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On March 30, 2004, the Industrial Development Authority of the City of Kansas City, Missouri issued $18.5 million in non-recourse bonds to finance public improvements made by the joint venture for the benefit of the Kansas City Missouri Public Library. Since the joint venture leases the land for the office building from the library, the joint venture was obligated to build certain public improvements. The net bond proceeds were $18.1 million and will be used for project and debt service costs. The joint venture has recorded this obligation on its balance sheet. The bonds are ultimately paid by the tax increment financing revenue generated by the building and its tenants.
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Litigation, Claims and Assessments
The Company is from time to time a party to a variety of legal proceedings, claims and assessments arising in the ordinary course of its business. The Company regularly assesses the liabilities and contingencies in connection with these matters based on the latest information available. For those matters where it is probable that the Company has incurred or will incur a loss and the loss or range of loss can be reasonably estimated, reserves are recorded in the Consolidated Financial Statements. In other instances, because of the uncertainties related to both the probable outcome and amount or range of loss, a reasonable estimate of liability, if any, cannot be made. Based on the current expected outcome of any such matters, none of these proceedings, claims or assessments is expected to have a material adverse effect on the Company’s business, financial condition or results of operations.
Notwithstanding the above, the SEC’s Division of Enforcement has issued a confidential formal order of investigation in connection with the Company’s previous restatement of its financial results. Even though the Company is cooperating fully, it cannot provide any assurances that the SEC’s Division of Enforcement will not take any action that would adversely affect the Company.
16. DISCLOSURE ABOUT FAIR VALUE OF FINANCIALINSTRUMENTS
The following disclosures of estimated fair value were determined by management using available market information and appropriate valuation methodologies. Considerable judgment is used to interpret market data and develop estimated fair values. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize upon disposition of the financial instruments. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair values. The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2004 were as follows:
Fair
Accounts and notes receivable
The fair values of the Company’s fixed rate mortgages and notes payable were estimated using discounted cash flow analysis based on the Company’s estimated incremental borrowing rate at December 31, 2004 for similar types of borrowing arrangements. The carrying amounts of the Company’s variable rate borrowings approximate fair value.
Disclosures about the fair value of financial instruments are based on relevant information available to the Company at December 31, 2004. Although management is not aware of any factors that would have a material effect on the fair value amounts reported herein, such amounts have not been revalued since that date and current estimates of fair value may significantly differ from the amounts presented herein.
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17. SEGMENT INFORMATION
The sole business of the Company is the acquisition, development and operation of rental real estate properties. The Company operates office, industrial and retail properties and apartment units. There are no material inter-segment transactions.
The Company’s chief operating decision maker (“CDM”) assesses and measures operating results based upon property level net operating income. The operating results for the individual assets within each property type have been aggregated since the CDM evaluates operating results and allocates resources on a property-by-property basis within the various property types.
The accounting policies of the segments are the same as those described in Note 1 included herein. Further, all operations are within the United States and, at December 31, 2004, no tenant of the Wholly Owned Properties comprised more than 4.0% of the Company’s consolidated revenues. The following table summarizes the rental income, net operating income and assets for each reportable segment for the years ended December 31, 2004, 2003 and 2002:
Rental and Other Revenues (1):
Office segment
Industrial segment
Retail segment
Apartment segment
Total Rental and Other Revenues
Net Operating Income (1):
Total Net Operating Income
Reconciliation to income before disposition of property, co-venture expense, minority interest and equity in earnings of unconsolidated affiliates:
General and administrative expenses
Loss on debt extinguishment
Total Assets:
Corporate and other
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18. QUARTERLY FINANCIAL DATA (Unaudited)
The following table sets forth quarterly financial information for the Company’s fiscal year ended December 31, 2004 and has been adjusted to reflect the reporting requirements of discontinued operations under SFAS No. 144:
Rental and other revenues (1)
Income/(loss) from discontinued operations
Net (loss attributable to)/income available for common stockholders
Net (loss)/income per share-basic:
(Loss)/income from continuing operations
Net (loss)/income
Net (loss)/income per share-diluted:
Quarterly financial information for the fiscal year ended December 31, 2003 which has been restated and adjusted to reflect the reporting requirements of discontinued operations under SFAS No. 144 appear in Note 20.
19. RESTATED FINANCIAL DATA
The Company has restated its Consolidated Financial Statements for the years ended December 31, 2003 and 2002 and for the first, second and third quarters of 2004. The restatement resulted from adjustments primarily related to accounting for lease incentives, depreciation and amortization expense, straight-line ground lease expense on one ground lease, gain recognition on a 2003 land condemnation, accounting for an embedded derivative, land cost allocations, the write-off of undepreciated tenant improvements and commissions, capitalization of interest and internal leasing, construction and development costs on development properties, and purchase accounting for acquisitions completed in 1995 to 1998. The tables that follow provide a reconciliation between amounts previously reported and the restated amounts in the Consolidated Statements of Income for the years ended December 31, 2004, 2003 and 2002 and in the Consolidated Balance Sheets as of December 31, 2004 and 2003. In addition, some of the adjustments impacted periods prior to 2002 and the net effect of these prior adjustments is a $24.8 million reduction in total Stockholders’ Equity at January 1, 2002. Following is a description of the primary elements of the restatement:
Lease incentives. Lease incentives are payments to tenants for costs such as moving allowances, reimbursement of rent payable to a former landlord and any other payments not associated with the physical space improvements. Pursuant to FASB Technical Bulletin 88-1, such costs should be deferred as an intangible asset and the amortization recorded as a reduction to rental revenue on a straight-line basis. The Company previously classified such costs as tenant improvements and amortized the costs on a straight-line basis over the lease term as part of depreciation and amortization expense. Amortization reclassified in the Consolidated Statements of Income as a reduction of rental income was $1.31 million, $1.02 million and $0.64 million for the years ended December 31, 2004, 2003 and 2002, respectively. This adjustment had no impact on net income.
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19. RESTATED FINANCIAL DATA - Continued
Depreciation and amortization expense. The Company has made adjustments to depreciation and amortization expense related to three matters. First, additional depreciation expense was recorded to commence recording depreciation expense on tenant and building improvement costs at the appropriate times. Under the Company’s prior practices, depreciation commenced in a number of instances several months after the related assets were placed in service. Second, excess depreciation expense was reversed from an isolated error whereby two buildings acquired in 1999 were set up with an incorrect useful life that was shorter than the Company’s policy of 40 years. Third, additional depreciation expense was recorded on purchase price allocated to the investment in the Company’s Kansas City and Des Moines joint ventures that was in excess of the net assets reflected in the joint ventures’ financial statements. These joint ventures were acquired as part of the 1998 JC Nichols merger. Such excess purchase price related to the fair value of the underlying real estate assets as of the acquisition date and should have been amortized over the life of the related real estate; previously, the Company did not depreciate the excess investment amount. These adjustments in the aggregate increased depreciation expense by $1.30 million, $1.53 million and $1.12 million for the years ended December 31, 2004, 2003 and 2002, respectively. These amounts exclude the depreciation expense effects directly related to adjustments to the write-off of undepreciated tenant improvements and lease commissions, purchase accounting, and capitalization of interest and internal costs described below.
Straight-line ground lease expense. Additional straight-line ground lease expense was recorded with respect to one ground lease in accordance with FAS 13, “Accounting for Leases,” which in prior periods had been accounted for based on cash rents paid. The additional ground lease expense amounted to $0.22 million, $0.24 million and $0.25 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Land condemnation gain recognition. An adjustment was made to reverse a gain recorded in the second quarter of 2003. In 2003, the Company received $1.8 million in condemnation proceeds and recognized a $1.04 million gain related to approximately 4.0 acres of land that was taken by the Georgia Department of Transportation to develop a roadway interchange. This land was under contract to be acquired by the Company from GAPI, Inc., a corporation controlled by Gene H. Anderson, an executive officer and director of the Company. The purchase price of the land was not determinable at the time of the condemnation, as described in Note 8, but was finalized and paid for in cash in the second quarter of 2005. In July 2003, the Company appealed the condemnation and is currently seeking additional payment from the state; the recognition of any gain has been deferred pending resolution of the appeal process. In addition, the contract provided that the land parcels could be paid in Common Units or in cash, at the option of the seller. This feature constituted an embedded derivative pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” An adjustment was recorded to account for the embedded derivative feature separately, which is adjusted each period based on changes in the value of Common Units. This resulted in an increase to other income of $1.30 million in 2002, and a decrease to other income of $0.68 and $0.41 million in 2003 and 2004, respectively.
Land cost allocations. Adjustments were made to land costs allocated to specific parcels to reflect the relative fair value of the parcels, as required by GAAP. Previously, such costs allocated to parcels were determined using methods other than relative fair value. The adjustments increased or (decreased) gains on sales of land and buildings for the years ended December 31, 2004, 2003 and 2002 by $(0.01) million, $(2.16) million and $0.43 million, respectively.
Write-off of undepreciated tenant improvements and lease commissions.These adjustments were made primarily to properly record in the correct period the write-off of undepreciated tenant allowances and lease commissions from certain early lease terminations. Such adjustments increased or (decreased) depreciation expense for the years ended December 31, 2004, 2003 and 2002 by $(3.09) million, $1.47 million and $0.89 million, respectively.
F-55
Property operating cost recovery income accruals.Adjustments were made to record accruals for property operating cost recovery income as of December 31, 2003, 2002 and 2001. The increase/(decrease) to rental revenues from these adjustments was $0.11 million, $(0.70) million and $(0.22) million for the years ended December 31, 2004, 2003 and 2002, respectively.
Capitalization of internal costs. Adjustments were recorded to capitalized internal leasing, development and construction costs to conform to the guidance in FAS 91 and FAS 67. Certain costs were previously over-capitalized and other costs were previously under-capitalized. On a net basis, internal costs were over-capitalized by $0.30 million, $0.27 million and $0.47 million for the years ended December 31, 2004, 2003 and 2002, respectively. Depreciation expense was reduced by $0.72 million, $0.78 million and $0.79 million for the years ended December 31, 2004, 2003 and 2002, respectively, related to adjustments to such capitalized assets made during the three years ended December 31, 2004 and in prior periods.
Capitalization of interest and related carrying costs on development property. Adjustments were recorded to correct previous over-capitalization of interest and related carrying costs, which mainly affected periods prior to 2002. These adjustments relate primarily to capitalization during the lease-up period after the building structure was complete (not to exceed one year) and other aspects of the capitalization computations including adjustments to the interest rates used, the amount of qualifying assets, the amount of qualifying carrying costs, and computation methods. Capitalized interest and other carrying costs were decreased for the years ended December 31, 2004, 2003 and 2002 by $0.06 million, $0.05 million and $2.18 million, respectively. Consequently, depreciation expense was reduced and gains on sales of real estate were increased during the years ended December 31, 2004, 2003 and 2002 by $1.92 million, $1.57 million and $1.63 million, respectively.
Purchase accounting related to acquisitions completed from 1995 to 1998. Adjustments were recorded relative to ten acquisitions and mergers completed by the Company from 1995 to 1998. The adjustments relate primarily to record assumed mortgage liabilities at estimated fair value, record the value of property management businesses acquired in two of the purchase transactions and adjust the purchase price allocated to certain assets. The effect of these adjustments on the financial statements for the years ended December 31, 2004, 2003 and 2002 was to decrease interest expense by $0.10 million, $0.26 million and $0.44 million, respectively, increase depreciation expense by $0.10 million, $0.11 million and $0.12 million, respectively, and increase/(decrease) gains on sales of real estate by $(0.63) million, $1.07 million and $(0.76) million, respectively.
F-56
The following condensed Consolidated Balance Sheet and Statement of Income data reconciles previously reported and restated consolidated financial information:
Balance Sheet
Cash, cash equivalents and restricted cash
Accounts, notes and straight-line rents receivable, net
Total Liabilities and Stockholders’ Equity
F-57
Income Statement
Impairment of assets held and used
Settlement on bankruptcy claim
Gain and impairment on disposition of property, net
Income, net of minority interest
Gain on sale, net of minority interest
Net income (1)
F-58
20. RESTATED QUARTERLY FINANCIALDATA (Unaudited)
The Company has set forth selected quarterly financial data for the quarters ended March 31, June 30, and September 30, 2004 and each of the quarters in the year ended December 31, 2003. As discussed in Note 19, the Company restated its results for the years ended December 31, 2003 and 2002. Because certain of the data set forth in the following tables varies from amounts previously reported on the Form 10-Q for the applicable period, the following tables reconcile the previously reported quarterly financial information to the restated quarterly financial information and summarize the reason for the differences:
Other income/expense
Gain on disposition of property, net
Net income per share-basic:
Net income per share-diluted:
F-59
20. RESTATED QUARTERLY FINANCIALDATA (Unaudited) - Continued
F-60
21. OTHER EVENTS
The Company’s former Chief Executive Officer retired on June 30, 2004. In connection with his retirement, the Company’s Board of Directors approved a retirement package for him that included a lump sum cash payment, accelerated vesting of stock options and restricted stock, extended lives of stock options and continued coverage under the Company’s health and life insurance plan for three years at the Company’s expense. Under GAAP, the changes to existing stock options and restricted stock give rise to new measurement dates and revised compensation computations. The total cost recognized under GAAP for the six months ended June 30, 2004 was $4.6 million, comprised of a $2.2 million cash payment, $0.6 million related to the vesting of stock options, $1.7 million related to the vesting of restricted shares and about $0.1 million for continued insurance coverage. Certain components of this retirement package were required to be recognized as of the Board’s approval date, which was in the first quarter, while other components were required to be amortized from that date until his June 30, 2004 retirement date. Accordingly, $3.2 million was expensed in the first quarter of 2004 and the remaining $1.4 million was expensed in the second quarter of 2004.
WorldCom/MCI Settlement
On July 21, 2002, WorldCom filed a voluntary petition with the United States Bankruptcy Court seeking relief under Chapter 11 of the United States Bankruptcy Code. In connection with the bankruptcy filing, WorldCom rejected leases with the Company encompassing 819,653 square feet, including the entire 816,000 square foot Highwoods Preserve office campus in Tampa, Florida. The Company submitted bankruptcy claims against WorldCom aggregating $21.2 million related to these rejected leases and other matters. WorldCom emerged from bankruptcy (now MCI, Inc.) on April 20, 2004. On August 27, 2004, the Company and various MCI subsidiaries and affiliates (the “MCI Entities”) executed a settlement agreement pursuant to which the MCI Entities paid the Company $8.6 million in cash and transferred to it approximately 340,000 shares of new MCI, Inc. stock in September 2004. The Company subsequently sold the stock for net proceeds of approximately $5.8 million, and recorded the full settlement of $14.4 million as Other Income in the third quarter of 2004.
F-61
HIGHWOODS PROPERTIES INC.
SCHEDULE II
(In Thousands)
For the years ended December 31, 2004, 2003 and 2002
A summary of activity for Valuation and Qualifying Accounts and Reserves
Allowance for Bad Debt - Deferred Rent
Allowance for Doubtful Accounts - Accounts Receivable
Allowance for Doubtful Accounts - Notes Receivable
Disposition Reserve
Total Allowances
F-62
SCHEDULE III - REAL ESTATE AND ACCUMULATED DEPRECIATION
12/31/2004
Atlanta, GA
1700 Century Center
1700 Century Circle
1800 Century Boulevard
1825 Century Center (CDC)
1875 Century Boulevard
1900 Century Boulevard
2200 Century Parkway
2400 Century Center
2600 Century Parkway
2635 Century Parkway
2800 Century Parkway
400 North Business Park
50 Glenlake
6348 Northeast Expressway
6438 Northeast Expressway
Bluegrass Valley Land
Bluegrass Lakes I
Bluegrass Place I
Bluegrass Place II
Bluegrass Valley
Century Plaza I
Century Plaza II
Chastain Place I
Chastain Place II
Chastain Place III
Chattahoochee Avenue
Corporate Lakes
Cosmopolitan North
Deerfield I
Deerfield II
Deerfield III
EKA Chemical
Gwinnett Distribution Center
Highwoods Center I at Tradeport
Highwoods Center II at Tradeport
Highwoods Center III at Tradeport
Kennestone Corporate Center
La Vista Business Park
National Archives and Records Administration
Newpoint Place I
Newpoint Place II
Newpoint Place III
Newpoint Place IV
Newpoint Place Land
Norcross I & II
Nortel
Oakbrook I
Oakbrook II
Oakbrook III
Oakbrook IV
Oakbrook V
Oakbrook Summit
Oxford Lake Business Center
Peachtree Corners II
Peachtree Corners III
Peachtree Corners Land
South Park Residential Land
South Park Site Land
Southside Distribution Center
Tradeport I
Tradeport II
Tradeport III
Tradeport IV
Tradeport V
Tradeport Land
Two Point Royal
Baltimore, MD
Sportsman Club Land
F-63
Charlotte, NC
4601 Park Square
First Citizens Building
Mallard Creek I
Mallard Creek III
Mallard Creek IV
Mallard Creek V
Mallard Creek VI
Oakhill Business Park English Oak
Oakhill Business Park Laurel Oak
Oakhill Business Park Live Oak
Oakhill Business Park Scarlet Oak
Oakhill Business Park Twin Oak
Oakhill Business Park Water Oak
Oakhill Business Park Willow Oak
Oakhill Land
Pinebrook
Ridgefield
One Parkway Plaza Building
Two Parkway Plaza Building
Three Parkway Plaza Building
Six Parkway Plaza Building
Seven Parkway Plaza Building
Eight Parkway Plaza Building
Eleven Parkway Plaza
Twelve Parkway Plaza
Fourteen Parkway Plaza Building
University Center
University Center East
University Center - Land
Columbia, SC
Centerpoint I
Centerpoint II
Centerpoint V
Centerpoint VI
Fontaine I
Fontaine II
Fontaine III
Fontaine V
Greenville, SC
385 Building 1
385 Land
770 Pelham Road
Bank of America Plaza
Brookfield Plaza
Brookfield-Jacobs-Sirrine
MetLife @ Brookfield
Patewood Business Center
Patewood I
Patewood II
Patewood III
Patewood IV
Patewood V
Patewood VI
Verizon Wireless
Jacksonville, FL
Belfort Park VI - Land
Belfort Park VII - Land
Kansas City, MO
Country Club Plaza
Alameda Towers
Colonial Shops
Corinth Executive Building
Corinth Office Building
Corinth Shops South
Corinth Square North Shops
Fairway North
Fairway Shops
Fairway West
Residential - Land
Land - Hotel Land - Valencia
Land - JCN Parkway 4502-1
Land - JCN Parkway 4510 & 4518
Land - Lionsgate
Neptune Apartments
Rental Houses
F-64
City
St. Charles Apartments
Wornall Road Apartments
Nichols Building
One Ward Parkway
Park Plaza
Parkway Building
Prairie Village Rest & Bank
Prairie Village Shops
Shannon Valley Shopping Center
Somerset
Two Brush Creek
Valencia Place Office
Memphis, TN
3400 Players Club Parkway
6000 Poplar Ave
6060 Poplar Ave
Atrium I & II
Centrum
Hickory Hill Medical Plaza
International Place II
Shadow Creek I
Shadow Creek II
Southwind Office Center A
Southwind Office Center B
Southwind Office Center C
Southwind Office Center D
The Colonnade
Nashville, TN
3322 West End
3401 West End
5310 Maryland Way
BNA Corporate Center
Century City Plaza I
Cool Springs I
Cool Springs II
Cool Springs Land
Eastpark I, II, & III
Harpeth on the Green II
Harpeth on the Green III
Harpeth on the Green IV
Harpeth on The Green V
Hickory Trace
Highwoods Plaza I
Highwoods Plaza II
Lakeview Ridge I
Lakeview Ridge II
Lakeview Ridge III
Seven Springs I
Seven Springs - Land I
Seven Springs - Land II
SouthPointe
Southwind Land
Sparrow Building
The Ramparts at Brentwood
Westwood South
Winners Circle
Capital Plaza III
In Charge Institute
Interlachen Village
Lake Mary Land
Landmark I
Landmark II
Metrowest Center
Windsor at Metro Center
MetroWest Land
Pine Street I
Pine Street II
Signature Plaza
Sunport Center
Piedmont Triad, NC
101 Stratford
150 Stratford
160 Stratford - Land
F-65
500 Radar Road
502 Radar Road
504 Radar Road
506 Radar Road
531 Northridge Office
531 Northridge Warehouse
6348 Burnt Poplar
6350 Burnt Poplar
7341 West Friendly Avenue
7343 West Friendly Avenue
7345 West Friendly Avenue
7347 West Friendly Avenue
7349 West Friendly Avenue
7351 West Friendly Avenue
7353 West Friendly Avenue
7355 West Friendly Avenue
7906 Industrial Village Road
7908 Industrial Village Road
7910 Industrial Village Road
Airpark East-Building 1
Airpark East-Building 2
Airpark East-Building 3
Airpark East-Building A
Airpark East-Building B
Airpark East-Building C
Airpark East-Building D
Airpark East-Copier Consultants
Airpark East-HewlettPackard
Airpark East-Highland
Airpark East-Inacom Building
Airpark East-Service Center 1
Airpark East-Service Center 2
Airpark East-Service Center 3
Airpark East-Service Center 4
Airpark East-Service Court
Airpark East-Simplex
Airpark East-Warehouse 1
Airpark East-Warehouse 2
Airpark East-Warehouse 3
Airpark East-Warehouse 4
Airpark North - DC1
Airpark North - DC2
Airpark North - DC3
Airpark North - DC4
Airpark South Warehouse 1
Airpark South Warehouse 2
Airpark South Warehouse 3
Airpark South Warehouse 4
Airpark South Warehouse 6
Airpark West 1
Airpark West 2
Airpark West 4
Airpark West 5
Airpark West 6
ALO
Brigham Road - Land
Chesapeake
Chimney Rock A/B
Chimney Rock C
Chimney Rock D
Chimney Rock E
Chimney Rock F
Chimney Rock G
Consolidated Center/ Building I
Consolidated Center/ Building II
Consolidated Center/ Building III
Consolidated Center/ Building IV
Deep River Corporate Center
Enterprise Warehouse I
Forsyth Corporate Center
Highwoods Park Building I
Highwoods Square Land
Jefferson Pilot Land
Madison Park - Building 5620
Madison Park - Building 5630
Madison Park - Building 5635
Madison Park - Building 5640
Madison Park - Building 5650
Madison Park - Building 5655
Madison Park - Building 5660
F-66
Encumberance(10)
Beginning
Madison Parking Deck
Regency One-Piedmont Center
Regency Two-Piedmont Center
Sears Cenfact
The Knollwood-370
The Knollwood-380
The Knollwood -380 Retail
University Commercial Center-Archer 4
University Commercial Center-Landmark 3
University Commercial Center-Service Center 1
University Commercial Center-Service Center 2
University Commercial Center-Service Center 3
University Commercial Center-Warehouse 1
University Commercial Center-Warehouse 2
US Airways
Westpoint Business Park Land
Westpoint Business Park-BMF
Westpoint Business Park-Luwabahnson
Westpoint Business Park-Wp 13
Research Triangle, NC
3600 Glenwood Avenue
3737 Glenwood Avenue
4101 Research Commons
4201 Research Commons
4301 Research Commons
4401 Research Commons
4501 Research Commons
4800 North Park
4900 North Park
5000 North Park
3645 Trust Drive - One North Commerce Center
5200 Greens Dairy-One North Commerce Center
5220 Greens Dairy-One North Commerce Center
Phase I - One North Commerce Center
W Building - One North Commerce Center
801 Corporate Center
Blue Ridge I
Blue Ridge II
BTI
Cape Fear
Catawba
CentreGreen One - Weston
CentreGreen Two - Weston
CentreGreen Three Land - Weston
CentreGreen Four
CentreGreen Five Land - Weston
Concourse
Cottonwood
Creekstone Crossings
Day Tract Residential
Day Tract Land
Dogwood
EPA
GlenLake Land
GlenLake Bldg I
Global Software
Hawthorn
Healthsource
Highwoods Centre-Weston
Highwoods Office Center North Land
Highwoods Office Center South Land
Highwoods Tower One
Highwoods Tower Two
Holiday Inn Reservations Center
Inveresk Land Parcel 2
Inveresk Land Parcel 3
Ironwood
Magnolia
Lake Plaza East
Laurel
Leatherwood
Maplewood
Northpark Land - Wake Forest
Overlook
Pamlico
ParkWest One - Weston
ParkWest Two - Weston
ParkWest Three - Land - Weston
Progress Center Renovation
F-67
Raleigh Corp Center Lot D
Red Oak
Rexwoods Center I
Rexwoods Center II
Rexwoods Center III
Rexwoods Center IV
Rexwoods Center V
Riverbirch
Situs I
Situs II
Situs III
Six Forks Center I
Six Forks Center II
Six Forks Center III
Smoketree Tower
Sycamore
Weston Land
Willow Oak
Other Property
Richmond, VA
4900 Cox Road
Colonade Building
Dominion Place - Pitts Parcel
East Shore I
East Shore II
East Shore III
East Shore IV
Grove Park I
Hamilton Beach
Highwoods Commons
Highwoods Five
Highwoods One
Highwoods Plaza
Highwoods Two
Innslake Center
Liberty Mutual
North Park
North Shore Commons A
North Shore Commons B - Land
North Shore Commons C - Land
North Shore Commons D - Land
One Shockoe Plaza
Pavilion
Sadler & Cox Land
Stony Point F Land
Stony Point I
Stony Point II
Stony Point III
Stony Point IV land
Technology Park 1
Technology Park 2
Vantage Place A
Vantage Place B
Vantage Place C
Vantage Place D
Vantage Pointe
Virginia Mutual
Waterfront Plaza
West Shore I
West Shore II
West Shore III
South Florida
The 1800 Eller Drive Building
Tampa, FL
380 Park Place
Anchor Glass
Atrium
Bay View Office Centre
Bay Vista Gardens
Bay Vista Gardens II
Bayshore
Cypress Center I
Cypress Center III
Cypress Center IV - Land
Cypress Commons
Cypress West
Feathersound Corporate Center II
F-68
Firemans Fund Building
Harborview Plaza
Highwoods Preserve Energy Plant
Highwoods Preserve I
Highwoods Preserve II
Highwoods Preserve IV
Highwoods Preserve V
Highwoods Preserve VI - Land
Highwoods Preserve Land
Horizon
LakePointe I
LakePointe II
Lakeside
Lakeside/Parkside Garage
Northside Square Office
Northside Square Office/Retail
One Harbour Place
Parkside
Pavilion Parking Garage
Registry I
Registry II
Registry Square
Sabal Business Center I
Sabal Business Center II
Sabal Business Center III
Sabal Business Center IV
Sabal Business Center V
Sabal Business Center VI
Sabal Business Center VII
Sabal Industrial Park Land
Sabal Lake Building
Sabal Park Plaza
Sabal Pavilion I
Spectrum
Tower Place
St. Paul Building
Watermark
Westshore Square
(1) These assets are pledged as collateral for a $141,865 first mortgage loan.
(2) These assets are pledged as collateral for an $163,814 first mortgage loan.
(3) These assets are pledged as collateral for a $46,985 first mortgage loan.
(4) These assets are pledged as collateral for a $127,541 first mortgage loan.
(5) These assets are pledged as collateral for a $26,446 first mortgage loan.
(6) These assets are pledged as collateral for a $137,968 first mortgage loan.
(7) These assets are pledged as collateral for a $41,204 first mortgage loan.
(8) These assets are pledged as collateral for a $9,573 first mortgage loan.
(9) These assets are pledged as collateral for a $65,218 first mortgage loan.
(10) Excludes $ 392 of mortgage debt related to property under development at December 31, 2004
F-69
NOTE TO SCHEDULE III
As of December 31, 2004, 2003, and 2002
A summary of activity for Real estate and accumulated depreciation is as follows
Real Estate:
Balance at beginning of year
Additions
Acquisitions, Development and Improvments
Cost of real estate sold and retired
Balance at close of year (a)
Accumulated Depreciaition
Depreciation expense
Real estate sold and retired
Balance at close of year (b)
Total per schedule III
Construction in progress exclusive of land included in schedule III
Reclassification adjustment for discontinued operations
Total real estate assets at cost
Total per Schedule III
Accumulated Depreciation - furniture, fixtures and equipment
Total accumulated depreciation
F-70