Highwoods Properties - 10-Q quarterly report FY

We refer to Highwoods Properties, Inc. as the “Company,” Highwoods Realty Limited Partnership as the “Operating Partnership,” the Company’s common stock as “Common Stock,” the Company’s preferred stock as “Preferred Stock,” the Operating Partnership’s common partnership interests as “Common Units,” the Operating Partnership’s preferred partnership interests as “Preferred Units” and in-service properties (excluding rental residential units) to which the Company and/or the Operating Partnership have title and 100.0% ownership rights as the “Wholly Owned Properties.” The partnership agreement provides that the Operating Partnership will assume and pay when due, or reimburse the Company for payment of, all costs and expenses relating to the ownership and operations of, or for the benefit of, the Operating Partnership. The partnership agreement further provides that all expenses of the Company are deemed to be incurred for the benefit of the Operating Partnership.

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. The Company conducts virtually all of its activities through Highwoods Realty Limited Partnership (the “Operating Partnership”). As of September 30, 2009, the Company and/or the Operating Partnership wholly owned: 309 in-service office, industrial and retail properties; 96 rental residential units; 580 acres of undeveloped land suitable for future development, of which 490 acres are considered core holdings; an additional four office and industrial properties under development; and 54 for-sale residential condominiums.

The Company is the sole general partner of the Operating Partnership. As of September 30, 2009, the Company owned all of the preferred partnership interests (“Preferred Units”) and 70.7 million, or 94.7%, of the common partnership interests (“Common Units”) in the Operating Partnership. Limited partners (including certain officers and directors of the Company) own the remaining 4.0 million Common Units. Generally, the Operating Partnership is required to redeem each Common Unit at the request of the holder thereof for cash equal to the value of one share of the Company’s Common Stock, $.01 par value (the “Common Stock”), based on the average of the market price for the 10 trading days immediately preceding the notice date of such redemption, provided that the Company at its option may elect to acquire any such Common Units presented for redemption for cash or one share of Common Stock. The Common Units owned by the Company are not redeemable. During the nine months ended September 30, 2009, the Company redeemed 101,935 Common Units for a like number of shares of Common Stock.

On June 1, 2009, the Company issued in a public offering approximately 7.0 million shares of Common Stock for net proceeds of $144.1 million. As required by the terms of the partnership agreement of the Operating Partnership, the net proceeds from the offering were contributed to the Operating Partnership in exchange for additional Common Units. The net impact of the offering and the redemptions discussed above was to increase the percentage of Common Units owned by the Company from 94.0% as of December 31, 2008 to 94.7% as of September 30, 2009. On June 1, 2009, we used a portion of the net proceeds of the offering to retire the remaining $107.2 million principal amount of a secured loan. The remaining net proceeds from the offering were used to reduce the amount of borrowings outstanding under our revolving credit facility.

Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). As more fully described in Notes 3 and 10, the Consolidated Balance Sheet at December 31, 2008 was revised from previously reported amounts to reflect in real estate and other assets, net, held for sale those properties held for sale at September 30, 2009. The Consolidated Statements of Income for the three and nine months ended September 30, 2008 were also revised from previously reported amounts to reflect in discontinued operations the operations for those properties sold or held for sale during 2008 and the first nine months of 2009 which qualified for discontinued operations presentation.

Beginning in the first quarter of 2009, we were required to present noncontrolling interests, defined as the portion of equity in a subsidiary not attributable directly or indirectly to the parent, as a separate component of equity in the Consolidated Balance Sheets subject to existing requirements for the classification and measurement of redeemable securities. Additionally, we were required to modify the presentation of net income by attributing earnings and other comprehensive income to controlling and noncontrolling interests. These accounting changes are required to be retroactively applied for all periods presented. Below are the steps we have taken as a result of retroactively applying these changes to previously reported amounts:

Beginning in the first quarter of 2009, we were required to include our total number of restricted common shares outstanding in the calculation of weighted average common shares outstanding, basic and diluted, for all periods presented. As a result, for the three months ended September 30, 2008, weighted average common shares outstanding, basic and diluted, are 501,468 and 290,963 shares higher than previously reported, respectively. For the nine months ended September 30, 2008, weighted average common shares outstanding, basic and diluted, are 506,102 and 311,366 shares higher than previously reported, respectively. Basic earnings per common share for the three months ended September 30, 2008 is unchanged from the amount previously reported and, for the nine months ended September 30, 2008, is $0.01 lower than previously reported. Diluted earnings per common share for the three and nine months ended September 30, 2008 is unchanged from amounts previously reported.

The Consolidated Financial Statements include the Operating Partnership, wholly owned subsidiaries and those subsidiaries in which we have the controlling interest and where no substantive participating rights or substantive kick out rights have been granted to the noncontrolling interests. All significant intercompany transactions and accounts have been eliminated.

The unaudited interim consolidated financial statements and accompanying unaudited consolidated financial information, in the opinion of management, contain all adjustments (including normal recurring accruals) necessary for a fair presentation of our financial position, results of operations and cash flows. We have omitted certain notes and other information from the interim consolidated financial statements presented in this Quarterly Report on Form 10-Q as permitted by SEC rules and regulations. These consolidated financial statements should be read in conjunction with our 2008 Annual Report on Form 10-K.

The preparation of consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

We have elected and expect to continue to qualify as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended. A corporate REIT is a legal entity that holds real estate assets and, through the payment of dividends to stockholders, is generally permitted to reduce or avoid the payment of federal and state income taxes. To maintain qualification as a REIT, we are required to pay dividends to our stockholders equal to at least 90.0% of our annual REIT taxable income, excluding capital gains. In addition, although capital gains are not required to be distributed to maintain REIT status, capital gains, if any, are subject to federal and state income tax unless such gains are distributed to stockholders. Under temporary IRS regulations, for 2009, distributions can be paid partially using a REIT’s freely tradable stock so long as stockholders have the option of receiving at least 10% of the total distribution in cash.

Beginning in the first quarter of 2009, we have modified the measurement and presentation of noncontrolling interests for all periods presented, as described previously.

Noncontrolling interests in the Operating Partnership in the accompanying Consolidated Financial Statements relates to the ownership of Common Units in the Operating Partnership by various individuals and entities other than the Company. Net income attributable to noncontrolling interests in the Operating Partnership is computed by applying the weighted average percentage of Common Units not owned by the Company during the period (as a percent of the total number of outstanding Common Units) to the Operating Partnership’s net income for the period after deducting distributions on Preferred Units. When a noncontrolling unitholder redeems a Common Unit for a share of Common Stock or cash, the noncontrolling interests in the Operating Partnership are reduced and the Company’s share in the Operating Partnership is increased by the fair value of each redeemed security. The following table sets forth noncontrolling interests in the Operating Partnership:

The following table sets forth net income available for common stockholders and transfers from noncontrolling interests in the Operating Partnership:

Noncontrolling interests in consolidated affiliates relates to our respective joint venture partners’ 50.0% interest in Highwoods-Markel Associates, LLC (“Markel”) and estimated 18% economic interest in Plaza Residential, LLC (“Plaza Residential”). Each of our joint venture partners is an unrelated third party. We consolidate Markel since we are the general partner and control the major operating and financial policies of the joint venture. We consolidate Plaza Residential since we own the majority interest in and control the joint venture.

Beginning in the first quarter of 2010, we will be required to perform an ongoing assessment to determine whether each entity in which we have an equity interest is a variable interest entity that should be consolidated if qualitative factors indicate we have the controlling interest. We are currently evaluating the impact this requirement may have on our financial position, results of operations and disclosures.

We have equity interests ranging from 10.0% to 50.0% in various joint ventures with unrelated third parties. We account for our unconsolidated joint ventures using the equity method of accounting. As a result, the assets and liabilities of these joint ventures for which we use the equity method of accounting are not included in our Consolidated Balance Sheets.

The combined, summarized income statements for our unconsolidated joint ventures were as follows:

During the third quarter of 2009, we and an unrelated third party formed a joint venture in which we have a 10.0% ownership interest. In the third quarter of 2009, this joint venture purchased land for $3.4 million to be used for future development.

We have a 22.81% interest in a joint venture with Schweiz-Deutschland-USA Dreilander Beteiligung Objekt DLF 98/29-Walker Fink-KG. In the second quarter of 2009, this joint venture sold one property for gross proceeds of $14.8 million and recorded a gain of $3.4 million. We recorded $0.8 million as our proportionate share of this gain through equity in earnings of unconsolidated affiliates in the second quarter of 2009.

We have a 42.93% interest in a joint venture with Dreilander-Fonds 97/26 and 99/32. In the third quarter of 2009, this joint venture sold one property for gross proceeds of $7.1 million and recorded an impairment charge of $0.5 million. We recorded $0.2 million as our proportionate share of this impairment charge through equity in earnings of unconsolidated affiliates in the third quarter of 2009.

We are required to measure long-lived assets classified as held for sale at the lower of the carrying value or fair value less cost to sell. In the third quarter of 2009, we classified four properties as held for sale and recorded an impairment loss of $0.4 million on two of those properties.

In the second quarter of 2009, we sold three non-core community retail centers aggregating 413,000 square feet in the Kansas City metropolitan area for gross proceeds of $62.1 million. A gain of $20.9 million was recorded in the second quarter of 2009.

Development in process as of September 30, 2009 consisted primarily of two office properties aggregating 258,000 rentable square feet and 75 acres of vacant land undergoing infrastructure improvements. The aggregate cost, including leasing commissions, of the two office properties currently is expected to be $64.1 million when fully leased and completed, of which $62.6 million had been incurred as of September 30, 2009. The weighted average pre-leasing, based on projected development costs, of these development properties was approximately 62% as of September 30, 2009.

Additionally, we currently have one office property and one industrial property recently completed, but not yet stabilized, aggregating 353,000 square feet. We define “stabilized” as 95% occupied or one year from substantial completion, whichever comes first. The aggregate cost, including leasing commissions, of these properties currently is expected to be $40.0 million when fully leased, of which $34.5 million had been incurred as of September 30, 2009. The dollar weighted average pre-leasing of these properties was approximately 62% as of September 30, 2009. The components of these properties are included in land, building and tenant improvements and deferred financing and leasing costs in our Consolidated Balance Sheet as of September 30, 2009.

We own a majority interest in Plaza Residential, LLC, a joint venture which was formed to develop and sell 139 for-sale residential condominiums constructed above an office tower developed by us in Raleigh, NC. For-sale residential condominiums in our Consolidated Balance Sheets include our completed, but unsold, condominium inventory as of September 30, 2009 and December 31, 2008. We initially record receipt of deposits as a component of Accounts Payable, Accrued Expenses, and Other Liabilities in our Consolidated Balance Sheets as required by the deposit method. For those units sold, we account for the resulting sales proceeds using the deposit method. For the three and nine months ended September 30, 2009, we sold seven and 20 condominiums for net sales proceeds of $2.7 million and $7.9 million, respectively, and recorded gains of $0.2 million and $0.8 million, respectively. For the three and nine months ended September 30, 2008, there were no corresponding sales or gains. Net sales proceeds include forfeitures of earnest money deposits of $0.1 million and $0.6 million for the three and nine months ended September 30, 2009, respectively. We record forfeitures of earnest money deposits as income when entitled to claim the forfeited deposit upon legal default. Our estimate of our partner’s economic ownership, which is impacted by a contractually-based promoted return, decreased from 25% as of December 31, 2008 to 18% as of September 30, 2009.

As of September 30, 2009 and December 31, 2008, we had deferred financing costs of $12.5 million and $14.7 million, respectively, with related accumulated amortization of $4.5 million and $7.8 million, respectively. As of September 30, 2009 and December 31, 2008, we had deferred leasing costs of $109.7 million and $110.5 million, respectively, with related accumulated amortization of $47.4 million and $44.6 million, respectively. Aggregate amortization expense (included in depreciation and amortization and amortization of deferred financing costs) for these intangibles for the three months ended September 30, 2009 and 2008 was $4.4 million and $4.5 million, respectively, and for the nine months ended September 30, 2009 and 2008 was $13.6 million and $13.5 million, respectively.

The estimated aggregate amortization expense for each of the next five succeeding fiscal years is as follows:

Our consolidated mortgages and notes payable consisted of the following:

As of September 30, 2009, our secured mortgage loans were secured by real estate assets with an aggregate undepreciated book value of $1.2 billion.

Our $70.0 million secured construction facility is initially scheduled to mature on December 20, 2010. Assuming no defaults have occurred, we have options to extend the maturity date for two successive one-year periods. The interest rate is LIBOR plus 85 basis points. Our secured construction facility had $28.3 million of availability as of September 30, 2009 and October 26, 2009.

In January 2009, we paid off at maturity $50.0 million of 8.125% unsecured notes using borrowings under our revolving credit facility.

In March 2009, we obtained a $20.0 million, three-year unsecured term loan with a bank lender. The interest rate is LIBOR plus 250 basis points, subject to a minimum total interest rate of 3.9%.

In June 2009, we retired the remaining $107.2 million principal amount of a secured loan using a portion of the net proceeds of our Common Stock offering on June 1, 2009. We incurred no prepayment penalties.

In August 2009, we obtained a $115.0 million, six and a half-year secured loan that bears interest at 6.875% and a $47.3 million, seven-year secured loan that bears interest at 7.5%.

During the second quarter of 2009, we repurchased $3.2 million principal amount of 2017 bonds for a purchase price of 79% of par value.

During the third quarter of 2009, we repurchased $5.0 million principal amount of 2017 bonds for a purchase price of 86% of par value.

Our revolving credit facility, variable rate term loans and the indenture that governs the Operating Partnership’s outstanding notes require us to comply with customary operating covenants and various financial and operating ratios. We and the Operating Partnership are each currently in compliance with all such requirements.

During the nine months ended September 30, 2009, we granted under our Amended and Restated 1994 Stock Option Plan 394,044 stock options at an exercise price equal to the closing market price of a share of our common stock on the date of grant. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, which resulted in a weighted-average grant date fair value per share of $1.80. During the nine months ended September 30, 2009, we also granted 128,384 shares of time-based restricted stock and 99,910 shares of total return-based restricted stock with weighted-average grant date fair values per share of $19.33 and $10.13, respectively. We recorded stock-based compensation expense of $1.6 million and $1.3 million during the three months ended September 30, 2009 and 2008, respectively. We recorded stock-based compensation expense of $5.2 million and $5.3 million during the nine months ended September 30, 2009 and 2008, respectively. As of September 30, 2009, there was $9.3 million of total unrecognized stock-based compensation costs, which will be recognized over a weighted average remaining contractual term of 1.5 years.

To meet, in part, our liquidity requirements, we borrow funds at a combination of fixed and variable rates. Borrowings under our revolving credit facility, construction facility 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. 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. The interest rate on all of our variable rate debt is generally adjusted at one or 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.

In prior periods, we entered into certain interest rate hedging arrangements which were designated and are being accounted for as cash flow hedges. The effective portion of these arrangements, representing deferred interest expense, was $1.0 million as of September 30, 2009 and is included in Accumulated Other Comprehensive Loss (“AOCL”). This deferred expense will be recognized as an addition to interest expense in the same periods during which interest expense on the hedged financings affects net income. We expect approximately $0.1 million will be recognized as a decrease to interest expense within the next 12 months.

In January 2008, we entered into two floating-to-fixed interest rate swaps for a one-year period with respect to an aggregate of $50.0 million of borrowings outstanding under our revolving credit facility or other floating rate debt. These swaps fixed the underlying LIBOR rate upon which interest on such borrowings is based at 3.26% for $30.0 million of borrowings and 3.24% for $20.0 million of borrowings. These swaps were designated and accounted for as cash flow hedges and matured in January 2009.

In April 2008, we entered into a floating-to-fixed interest rate swap for a two-year period with respect to an aggregate of $50.0 million of borrowings outstanding under our term loan or other floating rate debt. The swap fixes the underlying LIBOR rate upon which interest on such borrowings is based at 2.52%. The counterparty under this swap is Bank of America, N.A. The swap was designated and is being accounted for as a cash flow hedge. The effective portion of the swap representing deferred interest expense was $0.6 million as of September 30, 2009 and is included in AOCL. We expect all of the balance to be recognized as an increase to interest expense within the next seven months. See Note 9 for Fair Value Measurements disclosure.

In October 2008, we entered into a floating-to-fixed interest rate swap for a one-year period with respect to an aggregate of $25.0 million of borrowings outstanding under our term loan or other floating rate debt. The swap fixes the underlying LIBOR rate upon which interest on such borrowings is based at 2.35%. The counterparty under this swap is PNC Bank, N.A. The swap was designated and is being accounted for as a cash flow hedge. The effective portion of the swap representing deferred interest expense was $39,000 as of September 30, 2009 and is included in AOCL. We expect all of the balance to be recognized as an increase to interest expense within the next month. See Note 9 for Fair Value Measurements disclosure.

Other comprehensive income/(loss) represents net income plus the changes in certain amounts deferred in accumulated other comprehensive income/(loss) related to hedging and other activities not reflected in the Consolidated Statements of Income. The components of other comprehensive income/(loss) are as follows:

The following summarizes the three levels of inputs that we use to measure fair value, as well as the assets, mezzanine noncontrolling interests and liabilities that we recognize at fair value using those levels of inputs.

Level 1.  Quoted prices in active markets for identical assets or liabilities.

Our Level 1 assets are comprised of investments in marketable securities which we use to pay benefits under our deferred compensation plan. Our Level 1 noncontrolling interests in the Operating Partnership are comprised of Common Units in the Operating Partnership not owned by the Company. Our Level 1 liabilities are our obligations to pay certain deferred compensation plan benefits whereby participants have designated investment options (primarily mutual funds) to serve as the basis for measurement of the notional value of their accounts.

Level 2. Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities.

Our Level 2 liabilities are interest rate swaps whose fair value is determined using a pricing model based upon observable market inputs.

Level 3. Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Our Level 3 asset is our tax increment financing bond issued by a municipal authority in connection with our construction of a public parking facility that is not routinely traded but whose fair value is determined using an estimate of projected redemption value based on quoted bid/ask prices for similar unrated municipal bonds. This available for-sale security is carried at estimated fair value in prepaid and other assets with unrealized gains or losses reported in accumulated other comprehensive loss. The estimated fair value as of September 30, 2009 was $2.2 million below the outstanding principal due on the bond. We currently intend to hold this bond, which amortizes to maturity in 2020, and do not believe that we will be required to sell this bond before recovery. Payment of the principal and interest for the bond is guaranteed by us and, therefore, we have recorded no credit losses related to the bond’s impairment. Our Level 3 liability is our SF-HIW Harborview Plaza, LP financing obligation that is not traded but whose fair value is determined using an estimate of discounted cash flows dependent on future leasing assumptions for the property.

The following tables set forth the assets and liabilities that we measured at fair value on a recurring basis by level within the fair value hierarchy.

The following table sets forth our Level 3 asset and liability.

The following estimated fair values 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 we 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 our financial instruments were as follows:

The fair values of our mortgages and notes payable and financing obligations were estimated using discounted cash flow analyses based on estimated market rates on similar borrowing arrangements at September 30, 2009 and December 31, 2008, respectively. The carrying amounts of our cash and cash equivalents, accounts and notes receivable equal or approximate fair value.

Disclosures about the fair value of financial instruments are based on relevant information available to us at September 30, 2009. 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.

As part of our business strategy, we from time to time selectively dispose of non-core properties and use the net proceeds for investments, for repayment of debt and/or retirement of Preferred Stock, or other purposes. The table below sets forth the net operating results of those assets classified as discontinued operations in our Consolidated Financial Statements. These assets classified as discontinued operations comprise 1.2 million square feet of office and retail properties and 13 rental residential units sold during 2008 and the nine months ended September 30, 2009. The operations of these assets have been reclassified from our ongoing operations to discontinued operations, and we will not have any significant continuing involvement in the operations after the disposal transactions:

The following table includes the major classes of assets and liabilities of the properties classified as held for sale:

Beginning in the first quarter of 2009, we have modified our calculation of weighted average common shares, basic and diluted, to include our total number of restricted common shares outstanding, as described in Note 1.

The following table sets forth the computation of basic and diluted earnings per common share:

Our principal business is the acquisition, development and operation of rental real estate properties. We evaluate our business by product type and by geographic locations. Each product type has different customers and economic characteristics as to rental rates and terms, cost per square foot of buildings, the purposes for which customers use the space, the degree of maintenance and customer support required and customer dependency on different economic drivers, among others. The operating results by geographic grouping are also regularly reviewed by our chief operating decision maker for assessing performance and other purposes. There are no material inter-segment transactions.

The accounting policies of the segments are the same as those described in Note 1 included herein. All operations are within the United States and, as of September 30, 2009, no customer of the Wholly Owned Properties comprised more than 8.9% of our consolidated revenues.

The following table summarizes the rental income and other revenues and net operating income, defined as rental and other revenues less rental property and other expenses, for each reportable segment: