SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2005
Commission file number: 001-13100
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 Number)
3100 Smoketree Court, Suite 600, Raleigh, N.C.
(Address of principal executive office)
27604
(Zip Code)
(919) 872-4924
(Registrant’s telephone number, including area code)
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 whether the Registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of ‘accelerated filer’ and ‘large accelerated filer’ in Rule 12b-2 of the Securities Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
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 Company had 54,136,934 shares of common stock outstanding as of April 30, 2006.
QUARTERLY REPORT FOR THE PERIOD ENDED JUNE 30, 2005
TABLE OF CONTENTS
PART I
Item 1.
Item 2.
Item 3.
Item 4.
PART II
Item 6.
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
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.”
The information furnished in the accompanying Condensed Consolidated Financial Statements reflect all adjustments (consisting of normal recurring accruals) that are, in our opinion, necessary for a fair presentation of the aforementioned financial statements for the interim period.
The aforementioned financial statements should be read in conjunction with the notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Risk Factors included herein and in our 2004 Annual Report on Form 10-K.
2
Condensed Consolidated Balance Sheets
(Unaudited and $ in thousands, except per share amounts)
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
Real estate and other assets, net of accumulated depreciation, held for sale
Cash and cash equivalents
Restricted cash
Accounts receivable, net
Notes receivable
Accrued straight-line rents receivable, net
Investments in unconsolidated affiliates
Deferred financing and leasing costs, net
Prepaid expenses and other
Total Assets
Mortgages and notes payable
Accounts payable, accrued expenses and other liabilities
Financing obligations
Total Liabilities
Minority interest in the Operating Partnership
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 June 30, 2005 and December 31, 2004
8% Series B Cumulative Redeemable Preferred Shares (liquidation preference $25 per share), 6,900,000 shares issued and outstanding at June 30, 2005 and December 31, 2004
8% Series D Cumulative Redeemable Preferred Shares (liquidation preference $250 per share), 400,000 shares issued and outstanding at June 30, 2005 and December 31, 2004
Common stock, $.01 par value, 200,000,000 authorized shares; 54,037,013 shares issued and outstanding at June 30, 2005 and 53,813,422 at December 31, 2004, 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 condensed consolidated financial statements.
3
Consolidated Statements of Income
(Unaudited and in thousands, except per share amounts)
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
Other income:
Interest and other income
Loss on debt extinguishment
Income/(loss) before disposition of property, minority interest and equity in earnings of unconsolidated affiliates
Gains on disposition of property, net
Equity in earnings of unconsolidated affiliates
Income from continuing operations
Discontinued operations:
Income from discontinued operations, net of minority interest
Gains/(losses) on sales and impairments of discontinued operations, net of minority interest, including gain from related party transactions of $952 and $4,816 in the three and six months ended June 30, 2005, respectively
Net income
Dividends on preferred stock
Net income available for/(loss attributable to) common stockholders
Net income/(loss) per common share—basic:
Income/(loss) from continuing operations
Income from discontinued operations
Net income/(loss)
Weighted average common shares outstanding—basic
Net income/(loss) per common share—diluted:
Weighted average common shares outstanding—diluted
Dividends declared per common share
4
Consolidated Statement of Stockholders’ Equity
For the Six Months Ended June 30, 2005
(Unaudited and in thousands, except share amounts)
AccumulatedOtherCompre-hensive
Loss
Distributionsin Excess
of NetEarnings
Balance at December 31, 2004
Issuance of Common Stock, net
Common Stock Dividends
Preferred Stock Dividends
Adjustment to minority interest of unitholders in the Operating Partnership
Issuance of Restricted Stock, net
Fair market value of options granted
Amortization of equity- based compensation
Other comprehensive income
Balance at June 30, 2005
5
Condensed Consolidated Statements of Cash Flows
(Unaudited and in thousands)
Operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of lease incentives
Amortization of equity-based compensation
Amortization of accumulated other comprehensive loss
Loss on debt extinguishments
(Gains) and impairments on disposition of property, net
Change in financing obligations
Distributions of earnings from unconsolidated affiliates
Changes in operating assets and liabilities
Net cash provided by operating activities
Investing activities:
Additions to real estate assets and deferred leasing costs
Proceeds from disposition of real estate assets
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
Dividends paid on preferred stock
Net proceeds from the sale of common stock
Repurchase of common units
Borrowings on revolving loan
Repayment of revolving loan
Borrowings on mortgages and notes payable
Repayment of mortgages and notes payable
Payments on financing obligations
Additions to deferred financing costs
Payments on debt extinguishments
Net cash used in financing activities
Net increase/(decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of the period
Cash and cash equivalents at end of the period
Supplemental disclosure of cash flow information:
Cash paid for interest, net of amounts capitalized
6
Condensed Consolidated Statements of Cash Flows - Continued
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:
Assets:
Deferred leasing costs, net
Prepaid and other
Liabilities:
Financing obligation
Minority Interest and Stockholders’ Equity
7
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(tabular dollar amounts in thousands, except per share data)
(Unaudited)
1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
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 June 30, 2005, the Company’s wholly owned assets included: 424 in-service office, industrial and retail properties; 156 apartment units; 1,011 acres of undeveloped land suitable for future development; and an additional eight 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 June 30, 2005, the Company owned 100.0% of the preferred partnership interests (“Preferred Units”) and 90.4% 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. During the six months ended June 30, 2005, the Company redeemed in cash or property from limited partners 433,467 Common Units, which increased the percentage of Common Units owned by the Company to 90.4% at June 30, 2005 from 89.8% at December 31, 2004. Preferred Units in the Operating Partnership were issued to the Company in connection with the Company’s preferred stock offerings in 1997 and 1998 (the “Preferred Stock”). The net proceeds raised from each of the 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.
Basis of Presentation
The Condensed Consolidated Financial Statements of the Company are prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). The presentation in the Condensed Consolidated Statement of Cash Flows of operating cash flows for the six months ended June 30, 2004 have been revised by beginning with net income, rather than income from continuing operations. As more fully described in Note 9, as required by SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS No. 144”), the Condensed Consolidated Balance Sheet at December 31, 2004 and the Consolidated Statement of Income for the three and six months ended June 30, 2004 were revised from previously reported amounts to reflect in real estate and other assets held for sale and in discontinued operations the assets and operations for those properties sold or held for sale in the first six months of 2005 which qualified for discontinued operations.
The Condensed Consolidated Financial Statements 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(R)”)). All significant intercompany transactions and accounts have been eliminated.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
1. DESCRIPTION OF BUSINESS ANDBASIS OF PRESENTATION - Continued
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.
The accompanying unaudited financial information, in the opinion of management, contains all adjustments (including normal recurring accruals) necessary for a fair presentation of the Company’s financial position, results of operations and cash flows. The Company has condensed or omitted certain notes and other information from the interim financial statements presented in this Quarterly Report on Form 10-Q. These financial statements should be read in conjunction with the Company’s 2004 Annual Report on Form 10-K.
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.
Minority Interest in the Operating Partnership
Minority interest in the accompanying Condensed 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 June 30, 2005, the minority interest in the Operating Partnership consisted of approximately 5.7 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 during the period (as a percent of the total number of outstanding Common Units) to the Operating Partnership’s net income/(loss) after deducting distributions on Preferred Units. The result is the amount of minority interest expense or income 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.
Following is the minority interest in the net income of the Operating Partnership:
Six Months
Ended June 30,
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
9
Stock-Based Compensation
In accordance with Statement of Financial Accounting Standards No. 148, “Accounting for Stock-based Compensation – Transition and Disclosure” (“SFAS No. 148”), the Company expenses all stock options issued on or after January 1, 2003 over the vesting period based upon the fair value of the award on the date of grant. The unamortized value of option grants since January 1, 2003 aggregated $2.0 million at June 30, 2005. See below for the amounts that would have been deducted from net income if the Company had elected to expense the fair value of all stock option awards that had vested rather than only those awards issued subsequent to January 1, 2003:
Net income available for/(loss) attributable to 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 (loss)/income attributable to common stockholders
Basic net income/(loss) per common share - as reported
Basic net income/(loss) per common share - pro forma
Diluted net income/(loss) per common share - as reported
Diluted net income/(loss) per common share - pro forma
Impact of Newly Adopted and Issued Accounting Standards
In March 2005, the FASB issued FASB Interpretation No. 47 (“FIN 47”) “Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS No. 143” which clarifies that a liability for the performance of asset retirement activities should be recorded if the obligation to perform such activities is unconditional, whether or not the timing or method of settlement of the obligation may be conditional on a future event. FIN 47 is effective no later than the end of 2005. The Company implemented FIN 47 in the fourth quarter of 2005, and the application of FIN 47 did not have a material effect on the Company’s financial condition or results of operations.
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, Highwoods-Markel Associates, LLC, upon the adoption of this FSP in January 2006; the Company expects to treat this as a change of accounting principle as permitted by the FSP. The change is not expected to have any effect on the Company’s net income. The Consolidated Balance Sheet is expected to be impacted by including approximately $50 million of real estate assets, net of accumulated depreciation, and other assets, approximately $40 million in mortgages and notes payable and other liabilities, with the remaining effects to investments in unconsolidated affiliates and to minority interest.
10
Impact of Newly Adopted and Issued Accounting Standards - Continued
In December 2004, the FASB issued SFAS No. 123 (R), “Share-Based Payment,” which revises SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes 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 will apply SFAS No. 153 to any applicable transactions occurring on or after January 1, 2006.
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 any accounting changes and corrections of errors made on or after January 1, 2006.
2. INVESTMENTS IN UNCONSOLIDATED ANDOTHER 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 Statement of Financial Accounting Standards (“SFAS”) No. 66, as described in Note 3 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K, and another joint venture is consolidated pursuant to FIN 46(R). These two joint ventures are not reflected in the tables below.
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2. INVESTMENTS IN UNCONSOLIDATEDAND OTHER AFFILIATES - Continued
Investments in unconsolidated affiliates as of June 30, 2005 and combined summarized financial information for our unconsolidated joint ventures for the three and six months ended June 30, 2005 and 2004 are as follows:
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
Plaza Colonnade, 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
Income Statements:
Revenues
Expenses:
Interest expense and loan cost amortization
Operating expenses
Total expenses
The Company’s share of:
Net income (1)
Depreciation and amortization (real estate related)
12
On September 27, 2004, the Company and an affiliate of Crosland, Inc. (“Crosland”) 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 Crosland contributed approximately $2.0 million in cash; immediately thereafter, the joint venture distributed approximately $1.9 million to the Company and a gain of $0.5 million was recorded. Crosland will develop, manage and operate this joint venture, which is now constructing approximately 332 rental residential units at a total estimated cost of approximately $33 million expected to be completed by the second quarter of 2007. Crosland, Inc. will receive 3.25% of all project costs other than land as a development fee and 3.5% of gross revenue of the joint venture in management fees. The Company is providing certain development services for the project and will receive a fee equal to 1.0% of all project costs excluding land. The joint venture is financing the development with a $28.4 million construction loan that is guaranteed by Crosland, Inc. The Company has accounted for this joint venture using the equity method of accounting.
On December 22, 2004, the Company and Easlan Investment Group, Inc. (“Easlan”) 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 contributed $1.1 million, in the form of non-interest bearing promissory notes, 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. Easlan has guaranteed this construction loan, and at December 31, 2005, $7.7 million had been borrowed on the loan. The construction of the apartments was completed in the first quarter of 2006. Easlan is the manager and leasing agent for these apartment units and receives customary management fees and leasing commissions. The Company has received development fees throughout the construction project and will receive 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(R) because Easlan has no at-risk equity and accordingly the Company absorbs the majority of the joint venture’s expected losses. Accordingly, the Company’s balance sheet at June 30, 2005 includes $2.8 million of development in process and a $1.3 million construction note payable.
For additional information regarding our investments in unconsolidated and other affiliates, see Note 2 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K.
3. FINANCING ARRANGEMENTS
For information regarding sale transactions that were accounted for as financing arrangements at June 30, 2005 under paragraphs 25 through 29 of SFAS No. 66, see Note 5 herein and Note 3 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K.
4. ASSET DISPOSITIONS
During 2005 and the first quarter of 2006, the Company’s dispositions consisted of the following:
FirstQuarter2006
Operating properties (square feet in thousands)
Land held for development (acres)
Gross sale proceeds on operating properties
Gross sale proceeds on development land
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4. ASSET DISPOSITIONS - Continued
Included among the dispositions of operating properties during 2005 were the following larger transactions, all of which except the Eastshore transaction were recorded as discontinued operations. In the first quarter, the Company sold an office building in Raleigh, North Carolina to an owner/user for gross proceeds of approximately $27.3 million. In the first and second quarters, the Company sold industrial buildings in Winston-Salem, North Carolina for gross proceeds of approximately $27.0 million, as more fully described in Note 6 herein. In the second quarter, the Company sold two vacant buildings in Highwoods Preserve, Tampa, Florida to an owner/user for gross proceeds of approximately $24.5 million. In the third quarter, the Company sold all of its operating properties and certain vacant land in Charlotte, North Carolina and certain operating properties in Tampa, Florida in a single transaction for gross proceeds of approximately $228 million. In connection with this sale, the Company closed its division office in Charlotte and incurred employee severance costs of approximately $0.6 million, which were charged to general and administrative expenses during the second and third quarters. In the third quarter, the Company also recognized as a completed sale a transaction involving three office buildings in Richmond, Virginia that were sold in 2002 (“Eastshore”); this transaction had been accounted for as a financing due to a significant guarantee of rent under leases in the sold properties that was made by the Company when the sale occurred in 2002, as more fully described in Note 3 to the Consolidated Financial Statements in the 2004 Annual Report on Form 10K. This transaction was recorded as a completed sale transaction in July 2005 when the maximum exposure to loss under the guarantees became less than the related deferred gain; accordingly, $1.7 million in gain was recognized in the third and fourth quarters of 2005 and additional gain will be recognized in 2006 and 2007 as the maximum exposure under the guarantees is reduced. Payments made under rent guarantees after July 2005 are recorded as a reduction of the deferred gain.
In the first quarter of 2006, the Company sold office and industrial properties in Atlanta, Georgia, Columbia, South Carolina and Tampa, Florida in a single transaction for gross proceeds of approximately $141 million. This transaction was classified as held for sale and an impairment loss of $7.7 million was recorded in the fourth quarter of 2005. The properties subject to this sale were recorded as discontinued operations in fourth quarter 2005.
Gains, losses and impairments on disposition of properties, net, from dispositions not classified as discontinued operations, consisted of the following:
Gains on disposition of land, net
Impairments on land
Gains on disposition of depreciable properties, net
Total
Net gains on sale and impairments of discontinued operations, net of minority interest, consisted of the following:
Impairments on disposition of depreciable properties
Allocable minority interest
See Note 9 for information on discontinued operations and impairment of long-lived assets.
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5. MORTGAGES, NOTES PAYABLE ANDFINANCING OBLIGATIONS
The Company’s consolidated mortgages and notes payable consisted of the following at June 30, 2005 and December 31, 2004:
Secured mortgage loans
Unsecured loans
As of June 30, 2005, the Company’s outstanding mortgages and notes payable were secured by real estate assets with an aggregate undepreciated book value of approximately $1.4 billion.
Refinancings and Preferred Stock Redemptions in 2005 and 2006
During 2005 and the first quarter of 2006, the Company paid off $196.2 million of outstanding loans, excluding any normal debt amortization, which included $176.2 million of secured debt with a weighted average interest rate of 6.9% and $20.0 million of unsecured floating rate debt with an interest rate of 4.9%. Included in the $176.2 million was $89.8 million of floating rate secured debt. The Company incurred $0.5 million loss on debt extinguishments in 2005 in connection with these loan pay-downs. Approximately $350 million of real estate assets (based on undepreciated cost basis) became unencumbered after paying off the secured debt. The Company also used some of the proceeds from its disposition activity to redeem, in August 2005 and February 2006, all of the Company’s outstanding Series D Preferred Shares and 3.2 million of its outstanding Series B Preferred Shares, aggregating $180.0 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 and 2006 described in Note 4. In connection with the redemption of preferred stock, the excess of the redemption cost over the net carrying amount of the redeemed shares was recorded as a reduction to net income available for common shareholders. These reductions amounted to $4.3 million and $1.7 million for the third quarter of 2005 and first quarter of 2006, respectively.
On May 1, 2006, the Company obtained a new $350.0 million, three-year unsecured revolving credit facility from Bank of America, N.A. The Company used $273.0 million of proceeds from the new revolving credit facility, together with available cash, to pay off the remaining outstanding balance of $178.0 million under its previous revolving credit facility and a $100.0 million bank term loan, both of which have now been terminated. Loss on debt extinguishments of approximately $0.5 million will be recorded in second quarter 2006. The Company and Bank of America plan to syndicate the new revolving credit facility later in 2006.
The new revolving credit facility is initially scheduled to mature on May 1, 2009. The Company has an option to extend the maturity date by one additional year assuming no default exists and, at any time prior to May 1, 2008, may request increases in the borrowing availability under the credit facility by up to an additional $100.0 million. The increases in borrowing availability are subject to approval by the lender(s). The interest rate has been reduced from LIBOR plus 105 basis points to LIBOR plus 80 basis points and the annual base facility fee has been reduced from 25 basis points to 20 basis points.
In May, July, August and September 2005 and February 2006, the Company obtained waivers from the lenders under its previous $250.0 million unsecured revolving credit facility and its previous bank term 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 over the remaining term of the loans.
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5. MORTGAGES, NOTES PAYABLE ANDFINANCING OBLIGATIONS - Continued
Financing Obligations
The Company’s financing obligations consisted of the following at June 30, 2005 and December 31, 2004:
SF-HIW Harborview, LP financing obligation
Eastshore financing obligation (1)
Capitalized ground lease obligation (2)
Tax increment financing obligation (3)
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6. RELATED PARTY 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 was purchased in phases, and the purchase price for each phase or parcel was settled in cash and/or Common Units. The price for the various parcels was based on an initial value for each parcel, adjusted for an interest factor, 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 March 31, 2005. In August 2005, the Company acquired 12.7 acres, representing the last parcel of land to be acquired, for cash of $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 was accounted for separately and adjusted based on changes in the fair value of the Common Units. This resulted in a decrease to other income of $0.2 million in the first six months of 2005 and an increase of $0.4 million in the first six months of 2004. In the remainder of 2005, $0.02 million in expense was recorded related to the embedded derivative, which expired upon the closing of the final land transaction in August 2005.
On February 28, 2005 and April 15, 2005, the Company sold through a third party broker three non-core industrial buildings in Winston-Salem, North Carolina to John L. Turner and certain of his affiliates 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. The Company recorded a gain of approximately $4.8 million upon the closing of these sales. Mr. Turner, who was a director at the time of these transactions, retired from the Board of Directors effective December 31, 2005. 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.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The interest rate on all of the Company’s variable rate debt is adjusted at one to three month intervals, subject to settlements under any outstanding interest rate hedge contracts. The Company received net payments from counter parties under interest rate hedge contracts totaling $0.1 million in the six months ended June 30, 2005 which was recorded as a decrease to interest expense.
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7. DERIVATIVE FINANCIAL INSTRUMENTS - Continued
The AOCL balance at June 30, 2005 and December 31, 2004 was $2.6 million and $2.8 million, respectively, and consisted of deferred gains and losses from past cash flow hedging instruments which are being recognized as interest expense over the terms of the related debt (see Note 8). The Company expects that the portion of the cumulative loss recorded in AOCL at June 30, 2005 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 6, 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.
8. OTHER COMPREHENSIVE INCOME
Other comprehensive income represents net income plus the changes in certain amounts deferred in accumulated other comprehensive income/(loss) related to hedging activities not reflected in the Consolidated Statements of Income. The components of other comprehensive income are as follows:
Other comprehensive income:
Unrealized derivative gains/(losses) on cash flow hedges
Amortization of hedging gains and losses included in other comprehensive income
Total other comprehensive income
Total comprehensive income
9. DISCONTINUED OPERATIONS AND THEIMPAIRMENT OF LONG-LIVED ASSETS
As part of its business strategy, the Company will from time to time selectively dispose of non-core properties and 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. These assets classified as discontinued operations comprise 3.1 million square feet of office and industrial properties and 88 apartment units sold during 2004 and the first six months of 2005 and 2.5 million square feet of property held for sale at June 30, 2005. 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 of these assets have been reclassified from the ongoing operations of the Company to discontinued operations, and the Company will not have any significant continuing involvement in the operations after the disposal transactions:
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9. DISCONTINUED OPERATIONS AND THEIMPAIRMENT OF LONG-LIVED ASSETS - Continued
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/(losses) on sale and impairment of discontinued operations
Net gains/(losses) on sale and impairment of discontinued operations, net of minority interest in the Operating Partnership
Total discontinued operations
The carrying net book value of property classified as discontinued operations that were held for sale at June 30, 2005 or were sold during the six months ended June 30, 2005 aggregated approximately $278.2 million.
Certain other assets were sold during 2004 that did not meet the criteria of SFAS No. 144 to be classified as discontinued operations due to the Company’s ongoing management and/or leasing services on behalf of the new owners.
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 the six months ended June 30, 2005, the Company determined that 2 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 related to assets sold of $0.7 million was recognized in the Consolidated Statements of Income for the six months ended June 30, 2005. During the six months ended June 30, 2004, the Company recorded impairment losses of $3.1 million related to three properties sold.
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. One land parcel had indicators of impairment where the carrying value exceeded the sum of estimated undiscounted future cash flows. Therefore, an impairment loss of $2.6 million was recorded in the quarter ended March 31, 2005 and a further impairment of $0.60 million was recorded in the quarter ended June 30, 2005. There were no similar impairments on assets held for use during the six months ended June 30, 2004.
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The following table includes the major classes of assets and (liabilities) of the properties classified as held for sale as of June 30, 2005 and December 31, 2004:
Accumulated depreciation
Accrued straight-line rents receivable
Total assets
Tenant security deposits, accrued real estate taxes and accrued costs
10. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share:
Three Months
Non-convertible preferred stock dividends
Income/(loss) from continuing operations available for (loss attributable to) common stockholders
Income/(loss) from discontinued operations
Denominator for basic earnings per share – weighted average shares
Basic earnings per common share
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10. EARNINGS PER SHARE - Continued
Minority interest in continuing operations
Income (loss) from continuing operations available for (loss attributable to) common stockholders
Income (loss) from discontinued operations
Net income (loss) for diluted earnings/(loss) per share:
Add:
Employee stock options
Common Units
Unvested restricted stock
Denominator for diluted earnings per share – adjusted weighted average shares and assumed conversions
Diluted earnings per common share
Income (loss) from continuing operations
Net income (loss)
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11. COMMITMENTS AND CONTINGENCIES
Concentration of Credit Risk
The Company maintains its cash and cash equivalent investments and its restricted cash 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.
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 (CPI) or on a pre-determined 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.
As of June 30, 2005, the Company’s payment obligations for future minimum payments on operating leases (which include scheduled fixed increases, but exclude increases based on CPI) were as follows:
Remainder of 2005
2006
2007
2008
2009
Thereafter
Capital Expenditures
The Company incurs capital expenditures to lease space to its customers, maintain the quality of its existing properties and build new properties. Capital expenditures include tenant improvements, building improvements, new building completion costs and land infrastructure costs. Tenant improvements are the costs required to customize space for the specific needs of first-generation and second-generation customers. Building improvements are recurring capital costs not related to a specific customer to maintain existing buildings. New building completion costs are expenses for the construction of new buildings. Land infrastructure costs are expenses to prepare development land for future development activity that is not specifically related to a single building. Excluding recurring capital expenditures for leasing costs and tenant improvements and for normal building improvements, the Company’s expected future capital expenditures for started and/or committed new development projects as of May 15, 2006 were approximately $200 million, which includes several projects started or committed after December 31, 2005. A significant portion of these future expenditures are currently subject to binding contractual arrangements.
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 Condensed Consolidated Financial Statements.
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11. COMMITMENTS AND CONTINGENCIES - Continued
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 June 30, 2005:
Entity or Transaction
Type of Guarantee or Other Obligation
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)
Industrial Environmental (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. Cash proceeds from tax increment financing revenue generated by the building and its tenants are expected to be sufficient in the future to pay the required debt service on the bonds.
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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.
12. 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.
All operations are within the United States and, at June 30, 2005, no tenant of the Wholly Owned Properties comprised more than 4.1% of the Company’s consolidated revenues.
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12. SEGMENT INFORMATION - Continued
The following table summarizes the rental income, net operating income and assets for each reportable segment for the three and six months ended June 30, 2005 and 2004:
Office segment
Industrial segment
Retail segment
Apartment segment
Total Rental and Other Revenues
Total Net Operating Income
Reconciliation to (loss)/income before disposition of property, minority interest and equity in earnings of unconsolidated affiliates:
General and administrative expense
Corporate and other
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ITEM 2. 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 Condensed Consolidated Financial Statements and related notes contained elsewhere in this Quarterly Report.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Quarterly Report may contain forward-looking statements. Such statements include, in particular, statements about our plans, strategies and prospects under this section. 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 in our 2004 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.
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 June 30, 2005, we owned or had an interest in 490 in-service office, industrial and retail properties, encompassing approximately 38.8 million square feet and 541 apartment units. As of that date, we also owned 1,011 acres of development land, approximately 510 acres of which are considered core holdings. 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. Additional information about us can be found on our website atwww.highwoods.com. Information on our website is not part of this Quarterly Report.
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Results of Operations
Approximately 83% of our rental and other revenue in 2005 was derived from our office properties. As a result, while we own and operate a limited number of industrial, retail and apartment properties, our operating results depend heavily on successfully leasing our office properties. Furthermore, since approximately 60% 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. Accordingly, most of the analysis and comments below focus on our office properties.
The key components affecting our rental revenue stream are dispositions, acquisitions, new developments placed in service, 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, dispositions and new developments placed in service directly impact our rental revenues and could impact our average occupancy, depending upon the occupancy percentage of the properties that are acquired, sold or placed in service. A further indicator of the predictability of future revenues is the expected lease expirations of our portfolio. 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. 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.
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 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.
We record in “equity in earnings of unconsolidated affiliates” our proportionate share of net income or loss, adjusted for purchase accounting effects, of our unconsolidated joint ventures.
Additionally, Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” 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. As also required by SFAS No. 144, prior period results are reclassified to reflect the operations for such properties in discontinued operations.
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.
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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 and proceeds from the sale of non-core development land to fund our operating expenses, recurring capital expenditures and stockholder dividends. To fund property acquisitions, development activity or building renovations, we may sell other assets and may incur debt from time to time. Our debt generally consists of mortgage debt, unsecured debt securities and borrowings under our revolving credit facility.
Our revolving credit facility 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.
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.
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 since 1998 because funds generated from our capital recycling program in recent years have provided sufficient funds to satisfy our liquidity needs. In addition, we have recently used funds from our capital recycling program to redeem Common Units and Preferred Stock for cash.
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In accordance with SFAS No. 144 and as described in Note 9 to the Condensed Consolidated Financial Statements, we reclassified the operations and/or gain/(loss) from disposal of certain properties to discontinued operations for all periods presented if the operations and cash flows have been or will be eliminated from our ongoing operations and we will not have any significant continuing involvement in the operations after the disposal transaction and the properties were either sold during 2004 and the first six months of 2005 or were held for sale at June 30, 2005. Accordingly, any properties sold during 2004 and the first six months of 2005 that did not meet certain conditions as stipulated by SFAS No. 144 were not reclassified to discontinued operations.
Three Months Ended June 30, 2005
The following table sets forth information regarding our unaudited results of operations for the three months ended June 30, 2005 and 2004 (in millions):
$ Change
% of
Change
Net gains on sale of discontinued operations, net of minority interest
Dividends on preferred shares
Rental and Other Revenues
Rental and other revenues from continuing operations increased by $0.2 million in the second quarter of 2005. This was primarily the result of the disposition of certain properties in 2004 that were not included in discontinued operations, which negatively impacted rental and other revenues. Offsetting this decrease was an increase in lease termination fees of approximately $2.0 million in 2005.
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Operating Expenses
The decrease 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 the disposition of certain properties in 2004 and 2005 that were not included in discontinued operations, which reduced rental operating expenses, partially offset by general inflationary increases, particularly salaries, benefits, utility costs, real estate taxes and insurance and the fact that certain fixed operating expenses do not vary with net changes in our occupancy percentages, such as real estate taxes, insurance and utility rate changes.
One land parcel had indicators of impairment where the carrying value exceeded the sum of estimated undiscounted future cash flows. Therefore, an impairment loss of $2.6 million was recorded in the quarter ended March 31, 2005 and a further impairment of $0.6 million was recorded in the quarter ended June 30, 2005. There were no similar impairments on assets held for use during the six months ended June 30, 2004.
The decrease in general and administrative expenses primarily relates to severance costs related to the retirement of our former CEO in 2004 and increased costs of personnel and consultants in connection with implementing the Sarbanes-Oxley Act and the restatement of the Company’s financial statements in 2004, partially offset by higher long-term incentive compensation costs and higher salary, fringe benefit and employee relocation costs in the second quarter of 2005.
Interest Expense
The decrease in contractual interest was primarily due to a decrease in average borrowings from $1,716 million in the three months ended June 30, 2004 to $1,552 million in the three months ended June 30, 2005, partially offset by an increase in weighted average interest rates on outstanding debt from 6.4% in the three months ended June 30, 2004 to 6.6% in the three months ended June 30, 2005. In addition, capitalized interest was approximately $0.7 million higher in the three months ended June 30, 2005 than in the three months ended June 30, 2004 due to increased development activity and higher average construction and development costs.
Other Income
Loss on debt extinguishments was $12.5 million in the second quarter of 2004, which represented a loss recorded related to the retirement of the $100.0 million principal amount of Exercisable Put Option Notes.
Gains on Disposition of Property; Equity in Earnings of Unconsolidated Affiliates
Net gains on dispositions of properties not classified as discontinued operations were $1.4 million in the three months ended June 30, 2005 compared to $15.2 million for the three months ended June 30, 2004. Gains are dependent on the specific assets sold, their historical cost basis and other factors, and can vary significantly from period to period. The significant gain in the second quarter of 2004 primarily related to the $16.3 million gain recorded from the contribution of properties to the HIW-KC Orlando, LLC joint venture as further described in Note 4 to the Consolidated Financial Statements in the 2004 Annual Report.
The increase in equity in earnings from continuing operations of unconsolidated affiliates was primarily a result of the formation of the HIW-KC Orlando, LLC joint venture in late June 2004, which contributed approximately $0.6 million higher equity in earnings from continuing operations of unconsolidated affiliates in the second quarter of 2005 compared to the second quarter of 2004.
Discontinued Operations
In accordance with SFAS No. 144, we classified net income of $2.5 million and net loss of $0.3 million, net of minority interest, as discontinued operations for the three months ended June 30, 2005 and 2004, respectively. These amounts relate to 3.1 million square feet of office and industrial properties and 88 apartment units sold during 2004 and the first six months of 2005 and 2.5 million square feet of property held for sale at June 30, 2005. These amounts include gain/(loss) on the sale of these properties of $0.5 million and $(2.8) million, net of minority interest, in the three months ended June 30, 2005 and 2004, respectively.
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We recorded $7.7 million in Preferred Stock dividends in each of the three months ended June 30, 2005 and 2004.
Net Income
We recorded net income in the three months ended June 30, 2005 of $11.4 million, compared to $6.5 million in the three months ended June 30, 2004, resulting from the various factors described above.
Six Months Ended June 30, 2005
The following table sets forth information regarding our results of operations for the six months ended June 30, 2005 and 2004 (in millions):
Other income/expense:
Gain on sale of discontinued operations, net of minority interest
The decrease in rental and other revenues from continuing operations was primarily the result of the disposition of certain properties in 2004 that were not included in discontinued operations, which negatively impacted rental and other revenues, partially offset by $4.3 million higher lease termination fees in 2005.
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The decrease 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 the disposition of certain properties in 2004 that were not included in discontinued operations, which reduced rental operating expenses, partially offset by general inflationary increases, particularly salaries, benefits, utility costs, real estate taxes and insurance and the fact that certain fixed operating expenses do not vary with net changes in our occupancy percentages, such as real estate taxes, insurance and utility rate changes.
Depreciation and amortization from continuing operations increased in the first six months of 2005 compared to the first six months of 2004 primarily from normal increases from tenant improvements and deferred leasing costs placed in service subsequent to June 30, 2004, from a building placed in service in September 2004, and from adjustments to write off unamortized balances of tenant improvements and deferred leasing costs for early lease terminations, partly offset by the effect from the contribution of properties in 2004 to the HIW-KC Orlando joint venture, as discussed above.
One land parcel had indicators of impairment where the carrying value exceeded the sum of estimated undiscounted future cash flows. Therefore, an impairment loss of $3.2 million was recorded in the first six months of 2005. There were no similar impairments on assets held for use during the six months ended June 30, 2004.
The decrease in general and administrative expenses primarily relates to severance costs incurred in the first six months of 2004 related to the former CEO’s retirement in 2004 and increased costs of personnel and consultants in connection with implementing the Sarbanes-Oxley Act and the restatement of our financial statements in 2004, partially offset by higher long-term incentive compensation costs and higher salary, fringe benefit and employee relocation costs in the first six months of 2005.
The decrease in contractual interest was primarily due to a decrease in average borrowings from $1,726 million in the six months ended June 30, 2004 to $1,558 million in the six months ended June 30, 2005, partially offset by an increase in weighted average interest rates on outstanding debt from 6.4% in the six months ended June 30, 2004 to 6.6% in the six months ended June 30, 2005. In addition, capitalized interest in the first six months of 2005 was approximately $0.8 million higher compared to the first six months of 2004 due to increased development activity and higher average construction and development costs.
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 interest on the $62.5 million financing obligation (see Note 3 to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K for additional information on real estate sales that are accounted for as financing transactions).
Loss on debt extinguishments was $12.5 million in the first six months of 2004, which represented a loss recorded in June 2004 related to the retirement of the Exercisable Put Option Notes.
Gains on Disposition of Property; Minority Interest; Equity in Earnings of Unconsolidated Affiliates
Net gains on dispositions of properties not classified as discontinued operations were $1.8 million in the six months ended June 30, 2005 compared to $16.1 million for the six months ended June 30, 2004. Gains are dependent on the specific assets sold, their historical cost basis and other factors, and can vary significantly from period to period. The significant net gain in the six months ended June 30, 2004 primarily related to the $16.3 million gain recorded from the contribution of properties to the HIW-KC Orlando, LLC joint venture as further described in Note 4 to the Consolidated Financial Statements in the 2004 Annual Report.
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Minority interest income in the continuing operations of the Operating Partnership, after Preferred Unit distributions, was $0.1 million for the six months ended June 30, 2005 and $0.9 million for the six months ended June 30, 2004. The decrease in the first six months of 2005 was due to a corresponding reduction in the Operating Partnership’s loss from continuing operations after Preferred Unit distributions.
The increase in equity in earnings from continuing operations of unconsolidated affiliates was primarily a result of the formation of the HIW-KC Orlando, LLC joint venture in late June 2004, which contributed approximately $1.3 million higher equity in earnings from continuing operations of unconsolidated affiliates in the first six months of 2005 compared to the first six months of 2004. In addition, the Plaza Colonnade, LLC joint venture, which was placed in service in the fourth quarter of 2004, contributed approximately $0.3 million to equity in earnings in the first six months of 2005. In addition, certain non-recurring expenses in the Dallas County Partners joint venture occurred in the first six months of 2004, which contributed approximately $0.2 million of equity losses for 2004.
In accordance with SFAS No. 144, we classified net income of $19.0 million and $5.9 million, net of minority interest, as discontinued operations for the six months ended June 30, 2005 and 2004, respectively. These amounts relate to 3.1 million square feet of office and industrial properties and 88 apartment units sold during 2004 and the first six months of 2005 and 2.5 million square feet of property held for sale at June 30, 2005. These amounts include gain on the sale of these properties of $14.7 million and $0.6 million, net of minority interest, in the six months ended June 30, 2005 and 2004, respectively.
We recorded net income in the six months ended June 30, 2005 of $32.6 million, compared to $12.6 million in the six months ended June 30, 2004, resulting from the various factors described above.
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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 our cash flows in the first six months of 2004 as compared to the first six months of 2005 (in thousands):
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 consists of cash received upon the sale of properties and distributions of capital from our joint ventures.
Cash used in financing activities generally relates to stockholder dividends, distributions on 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 credit facility for working capital purposes, which means that during any given period, in order to minimize interest expense associated with balances outstanding under our revolving credit facility, we will likely record significant repayments and borrowings under our revolving credit facility.
The increase of $5.1 million in cash provided by operating activities was primarily a result of $7.7 million higher cash flows from operations in the first six months of 2005 compared to the first six months of 2004, partially offset by $2.6 million increased use of cash from net changes in operating assets and liabilities in the first six months of 2005 compared to the first six months of 2004.
The decrease of $10.3 million in cash provided by investing activities was primarily a result of the increase of $30.0 million in additions to real estate assets and deferred leasing costs and a decrease of $6.3 million in distributions received from unconsolidated affiliates. Partly offsetting these decreases was an increase of $14.5 million in proceeds from dispositions of real estate assets and a decrease of $10.0 million in contributions made to unconsolidated affiliates during the six months ended June 30, 2005 as compared to the same period in 2004.
The reduction of $34.8 million in cash used in financing activities relates primarily to $26.5 million less net reductions in debt and financing obligations in the first six months of 2005 compared to the first six months of 2004, $12.3 million more in cash paid in connection with debt extinguishments in the first six months of 2004 compared to the first six months of 2005, offset by $4.8 million more in cash paid for redemption of Common Units in the first six months of 2005 compared to the first six months of 2004.
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In 2005, we continued our capital recycling program of selectively disposing of non-core properties in order to use the net proceeds for investments or other purposes. At June 30, 2005, we had 2.5 million square feet of properties, 88 apartment units and 39.6 acres of land classified as held for sale pursuant to SFAS No. 144 with a carrying value of $219.9 million.
Capitalization
The following table sets forth our capitalization as of June 30, 2005 and December 31, 2004 (in thousands, except per share amounts):
Mortgages and notes payable, at recorded book value
Preferred Stock, at liquidation value
Common Stock and Common Units outstanding
Per share stock price at period end
Market value of Common Stock and Common Units
Total market capitalization with debt
Based on our total market capitalization of approximately $3.8 billion at June 30, 2005 (at the June 30, 2005 per share stock price of $29.76 and assuming the redemption for shares of Common Stock of the 5.7 million Common Units in the Operating Partnership not owned by the Company), our mortgages and notes payable represented approximately 42.0% of our total market capitalization.
Mortgages and notes payable at June 30, 2005 was comprised of $814.2 million of secured indebtedness with a weighted average interest rate of 6.8% and $765.0 million of unsecured indebtedness with a weighted average interest rate of 6.2%. As of June 30, 2005, our outstanding mortgages and notes payable were secured by real estate assets with an aggregate undepreciated book value of approximately $1.4 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.”
Contractual Obligations
See our 2004 Annual Report on Form 10-K for a table setting forth a summary regarding our known contractual obligations at December 31, 2004. The financing obligation of $28.8 million as of December 31, 2004 relating to the Eastshore transaction was eliminated as of September 30, 2005 because the 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.
Refinancings and Preferred Stock Redemptions in 2005 and First Quarter of 2006
During 2005 and the first quarter of 2006, we paid off $196.2 million of outstanding loans, excluding any normal debt amortization, which included $176.2 million of secured debt with a weighted average interest rate of 6.9% and $20.0 million of unsecured floating rate debt with an interest rate of 4.9%. Included in the $176.2 million was $89.8 million of floating rate secured debt. Approximately $350 million of real estate assets (based on undepreciated cost basis) became unencumbered after paying off the secured debt. We also used some of the proceeds from our disposition activity to redeem, in August 2005 and February 2006, all of our outstanding Series D Preferred Shares and 3.2 million of our outstanding Series B Preferred Shares, aggregating $180.0 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 and 2006. In connection with the redemption of Preferred Stock, the excess of the redemption cost over the net carrying amount of the redeemed shares was recorded as a reduction to net income available for common shareholders. These reductions amounted to $4.3 million and $1.7 million for the third quarter of 2005 and first quarter of 2006, respectively.
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Unsecured Indebtedness
On May 1, 2006, we obtained a new $350.0 million, three-year unsecured revolving credit facility from Bank of America, N.A. We used $273.0 million of proceeds from the new revolving credit facility, together with available cash, to pay off the remaining outstanding balance of $178.0 million under our previous revolving credit facility and the $100.0 million bank term loan, both of which have now been terminated. In connection with these payoffs, we expect to write off approximately $0.5 million in unamortized deferred financing costs in the second quarter of 2006 as a loss on debt extinguishment. We and Bank of America plan to syndicate the new revolving credit facility later in 2006.
Our new revolving credit facility is initially scheduled to mature on May 1, 2009. We have an option to extend the maturity date by one additional year assuming no default exists and, at any time prior to May 1, 2008, may request increases in the borrowing availability under the credit facility by up to an additional $100.0 million. The increases in borrowing availability are subject to approval by the lender(s). The interest rate has been reduced from LIBOR plus 105 basis points to LIBOR plus 80 basis points and the annual base facility fee has been reduced from 25 basis points to 20 basis points.
Like our previous revolving credit facility, the new revolving credit facility requires us to comply with customary operating covenants and various financial and operating ratios. We believe the required financial and operating ratios under the new revolving credit facility are less stringent and more appropriately reflect our current and future business prospects than the requirements under our previous revolving credit facility. We expect to be in compliance with these provisions of our new revolving credit facility for the foreseeable future. However, depending upon our future operating performance and property and financing transactions and general economic conditions, we cannot assure you that no circumstance will arise in the future that would render us unable to comply with any of these covenants or result in an increase in the borrowing costs under this facility.
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 our revolving credit facility, 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.
In May, July, August and September 2005 and February 2006, we obtained waivers from the lenders under our previous revolving credit facility and our previous bank term 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 terms of the loans. In November 2005, we amended the $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. These loans were paid off in May 2006 in connection with the closing of our new revolving credit facility, as discussed above.
As of the date of this filing, the Operating Partnership has not yet satisfied its requirement under the indenture governing the outstanding notes to file timely SEC reports, but expects to do so as soon as practicable. 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. If the Operating Partnership failed to file its delinquent SEC reports prior to expiration of the 60-day cure period after receipt of any such default notice, the lender under our revolving credit facility would also have the ability to accelerate amounts outstanding under the revolving credit facility. 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.
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Current and Future Cash Needs
Rental revenue, together with construction management, maintenance, leasing and management fees, is 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 capital expenditures to lease space to our customers, maintain the quality of our existing properties and build new properties. Capital expenditures include tenant improvements, building improvements, new building completion costs and land infrastructure costs. Tenant improvements are the costs required to customize space for the specific needs of first-generation and second-generation customers. Building improvements are recurring capital costs not related to a specific customer to maintain existing buildings. New building completion costs are expenses for the construction of new buildings. Land infrastructure costs are expenses to prepare development land for future development activity that is not specifically related to a single building. Excluding recurring capital expenditures for leasing costs and tenant improvements and for normal building improvements, our expected future capital expenditures for started and/or committed new development projects as of May 15, 2006 are approximately $200 million. A significant portion of these future expenditures are currently subject to binding contractual arrangements.
Additionally, $110.0 million of 7.0% unsecured notes will mature in December 2006 and approximately $63 million of 8.2% secured debt will mature in February 2007. We expect to repay both borrowings with proceeds from pending or future disposition activity and the issuance of additional unsecured debt. We also have a significant pool of unencumbered assets that could serve as collateral for additional secured debt. Although we expect to repay or refinance all of this outstanding debt on or prior to their respective maturity dates, no assurances can be given that we will be able to do so on favorable terms or at all.
Our long-term liquidity needs also include the funding of development commitments, selective asset acquisitions and the retirement of mortgage debt, amounts outstanding under our revolving credit facility 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, (3) borrowings under other secured construction loans that we may enter into, as well as (4) 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 our revolving credit facility. 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 or from proceeds from sales of properties.
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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 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 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, certain assets we sold have been accounted for as financing arrangements.
As of June 30, 2005, our unconsolidated joint ventures had $820.8 million of total assets and $604.2 million of total liabilities as reflected in their financial statements. At June 30, 2005, our weighted average equity interest based on the total assets of these unconsolidated joint ventures was 40.7%. During the six months ended June 30, 2005, these unconsolidated joint ventures earned $9.3 million of total net income of which our share, after appropriate purchase accounting and other adjustments, was $4.9 million. For additional information about our unconsolidated joint venture activity, see Note 2 to the Condensed Consolidated Financial Statements.
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As of June 30, 2005, our unconsolidated joint ventures had $574.9 million of outstanding mortgage debt. All of this joint venture debt is non-recourse to us except (1) in the case of customary exceptions pertaining to such matters as misuse of funds, environmental conditions and material misrepresentations and (2) those guarantees and loans described in the following paragraphs. The following table sets forth the scheduled maturities of our share of the outstanding debt of our unconsolidated joint ventures as of June 30, 2005 ($ in thousands):
For information regarding our off-balance sheet arrangements as of December 31, 2004, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Off Balance Sheet Arrangements” in our 2004 Annual Report on Form 10-K.
Financing Arrangements
For information regarding sales transactions that were accounted for as financing arrangements at December 31, 2004, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financing and Profit-Sharing Arrangements” in our 2004 Annual Report on Form 10-K.
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 credit facility 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 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 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 the second quarter of 2005, $0.07 million 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,” we had an embedded derivative as part of the land purchase arrangement with GAPI, Inc. that expired in August 2005 upon closing of the final land parcel under the arrangement.
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Related Party Transactions
We have previously reported that we 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 was purchased in phases, and the purchase price for each phase or parcel was settled in cash and/or Common Units. The price for the various parcels was based on an initial value for each parcel, adjusted for an interest factor, 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 our financial statements as of March 31, 2005. In August 2005, we acquired 12.7 acres, representing the last parcel of land to be acquired, for cash of $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 was accounted for separately and adjusted based on changes in the fair value of the Common Units. This resulted in a decrease to other income of $0.2 million in the first six months of 2005 and an increase to other income of $0.4 million in the first six months of 2004. In the remainder of 2005, $0.02 million in expense was recorded related to the embedded derivative, which expired upon the closing of the final land transaction in August 2005.
On February 28, 2005 and April 15, 2005, we sold through a third party broker three non-core industrial buildings in Winston-Salem, North Carolina to John L. Turner and certain of his affiliates 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. Mr. Turner, who was a director at the time of these transactions, retired from the Board of Directors effective December 31, 2005. 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
There were no changes to the critical accounting policies and estimates made by management in the six months ended June 30, 2005. For a detailed description of our critical accounting estimates, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates” in our 2004 Annual Report on Form 10-K.
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FUNDS FROM OPERATIONS
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 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 our performance relative to our 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 three and six months ended June 30, 2005 and 2004 are summarized in the following table ($ in thousands, except per share amounts):
Dividends to preferred shareholders
Net income applicable to/(loss attributable to) common shareholders
Add/(Deduct):
Depreciation and amortization of real estate assets
(Gain)/loss on disposition of depreciable real estate assets
Minority interest from the Operating Partnership in income/(loss) from operations
Unconsolidated affiliates:
(Gain)/loss on sale
Minority interest from the Operating Partnership in income from discontinued operations
Funds from operations
Dividends paid per common share/ common unit
As a percentage of funds from operations
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ITEM 3. 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 Condensed 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 credit facility 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. We had no interest rate hedge contracts in effect at June 30, 2005.
As of June 30, 2005, we had approximately $1,190 million of fixed rate debt outstanding. The estimated aggregate fair market value of this debt at June 30, 2005 was approximately $1,294 million. If interest rates increase by 100 basis points, the aggregate fair market value of our fixed rate debt as of June 30, 2005 would decrease by approximately $55.9 million. If interest rates decrease by 100 basis points, the aggregate fair market value of our fixed rate debt as of June 30, 2005 would increase by approximately $60.6 million.
As of June 30, 2005, we had approximately $389 million of variable rate debt outstanding. If the weighted average interest rate on this variable rate debt is 100 basis points higher or lower during the 12 months ended June 30, 2006, our interest expense would be increased or decreased approximately $3.9 million.
At June 30, 2005, we had an embedded derivative as part of a land purchase arrangement, as described under “Management’s Discussion And Analysis Of Financial Condition And Results Of Operations – Liquidity And Capital Resources – Related Party Transactions.” This embedded derivative expired in August 2005 upon closing of the final land parcel under the arrangement.
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ITEM 4. CONTROLS AND PROCEDURES
GENERAL
The purpose of this section is to discuss the effectiveness of our disclosure controls and procedures and recent changes in our internal control over financial reporting. The statements in this section represent the conclusions of Edward J. Fritsch, our President and Chief Executive Officer, and Terry L. Stevens, our Vice President and Chief Financial Officer.
The CEO and CFO evaluations of our controls and procedures 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 Quarterly 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 controls and procedures are also evaluated on an ongoing basis by or through the following:
Our management, including our CEO and CFO, do not expect that our controls and procedures 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 controls and procedures 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.
CHANGES IN INTERNAL CONTROL OVERFINANCIAL 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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As reported in Item 9A of our 2004 Annual Report on Form 10-K, our management reported that the Company’s internal control over financial reporting was not effective as of December 31, 2004 due to material weaknesses that existed as of such date in: (1) our accounting processes for capitalizing interest and carrying costs during lease-up and internal leasing, development and construction costs; (2) our fixed asset and lease incentive accounting processes; and (3) our financial statement close process. The first two material weaknesses could also affect the equity in earnings of unconsolidated affiliates in our Consolidated Financial Statements for those joint ventures for which we are primarily responsible for the preparation of their financial statements.
In Item 9A of our 2005 Annual Report on Form 10-K, our management will report that the Company’s internal control over financial reporting was not effective as of December 31, 2005 due to material weaknesses that existed as of such date in: (1) our real estate asset and lease incentive accounting processes, which in turn could affect the equity in earnings of unconsolidated affiliates in our Consolidated Financial Statements for those joint ventures for which we are primarily responsible for the preparation of their financial statements; and (2) our journal entry approval and financial statement close processes.
To mitigate or remediate specified material weaknesses reported in our 2004 Annual Report, during 2005, we formed a permanent committee to monitor and oversee the ongoing remediation of all deficiencies identified in our annual assessment of our internal control over financial reporting. This committee consists of our CFO, COO and representatives from appropriate business and accounting functions within the Company. Second, we designed, implemented and tested new and enhanced accounting processes for capitalizing interest and carrying costs during lease-up and internal leasing, development and construction costs. As a result, the material weakness reported in our 2004 Annual Report relating to capitalizing interest and carrying costs during lease-up and internal leasing, development and construction costs no longer existed as of December 31, 2005. Third, we designed, implemented and tested new and enhanced fixed asset and lease incentive accounting processes to reasonably assure the timely start of depreciation on certain building improvements, the effectiveness of fixed asset account reconciliations, the proper allocation of costs to land parcels, the proper classification and depreciation of depreciable infrastructure costs and the proper depreciation of newly constructed buildings during the lease-up phase. While these changes have remediated various aspects of our real estate asset accounting during 2005, we still had material weaknesses with respect to our real estate asset and lease incentive accounting processes as of December 31, 2005.
During the second quarter of 2006, to remediate our material weakness regarding the use of and dependence upon manually prepared spreadsheets in accumulating and consolidating restatement adjustments recorded in connection with our historical financial statements, we began to record in our general ledger and fixed asset accounting systems all of the restatement adjustments related to our amended 2003 Annual Report and our 2004 Annual Report on Form 10-K, which should reduce the likelihood of errors in our future consolidated financial statements by lessening our reliance upon such manually prepared spreadsheets in the financial statement close process. We expect to complete this project before December 31, 2006.
We also plan to undertake the following overall activities to improve our internal control over financial reporting. First, we are developing and implementing a Company-wide policy and procedures manual for use by our divisional and accounting staff, intended to reasonably assure 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 building and tenant improvements. Second, 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 were made to the historical financial statements in our 2004 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 and as of December 31, 2005. Third, we plan to implement improvements to our journal entry review and approval processes and to limit the ability of users to record and delete journal entries in our general ledger system which should reduce the likelihood of potential errors in future financial statements. Fourth, we plan to implement revised approval procedures over signing of
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construction contracts and change orders to provide reasonable assurance that such matters are approved by management at appropriate levels in the Company. Fifth, we engaged a search firm to assist us with the process of hiring a Chief Accounting Officer (new position).
We have developed and implemented or are in the process of developing and implementing remediation plans for the material weaknesses described above. Our management is working closely with the audit committee to monitor the ongoing remediation of these material weaknesses.
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, our CEO and CFO do not believe that our disclosure controls and procedures were effective at the end of the quarterly period covered by this Quarterly Report.
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PART II - OTHER INFORMATION
ITEM 6. EXHIBITS
Description
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/S/ EDWARD J. FRITSCH
/S/ TERRY L. STEVENS
Date: June 2, 2006
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