UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-K
(Mark One)
For the fiscal year ended December 31, 2004.
OR
For the transition period from to .
Commission file number 0-11290
COMMERCIAL NET LEASE REALTY, INC.
450 South Orange Avenue, Suite 900Orlando, Florida 32801
Registrant’s telephone number, including area code: (407) 265-7348
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to section 12(g) of the Act:None(Title of class)
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 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 X No .
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act): Yes X No .
The aggregate market value of voting common stock held by non-affiliates of the registrant as of June 30, 2004 was $831,086,060.
The aggregate market value of voting common stock held by non-affiliates of the registrant as of February 8, 2005 was $963,531,763.
The number of shares of common stock outstanding as of March 3, 2005 was 52,096,633.
DOCUMENTS INCORPORATED BY REFERENCE:
TABLE OF CONTENTS
PART I
Item 1. Business
The Company
Commercial Net Lease Realty, Inc., a Maryland corporation, is a fully integrated real estate investment trust (“REIT”) formed in 1984. The terms “Registrant” or “Company” refer to Commercial Net Lease Realty, Inc. and its majority owned and controlled subsidiaries. These subsidiaries include the wholly-owned qualified REIT subsidiaries of Commercial Net Lease Realty, Inc., as well as the taxable REIT subsidiary (“TRS”) Commercial Net Lease Realty Services, Inc. and its majority owned and controlled subsidiaries (collectively, “Services”). The Company holds a 98.7 percent, non-controlling interest in Services and is entitled to receive 98.7 percent of the dividends paid by Services. James M. Seneff, Jr., a director of the Company, Kevin B. Habicht, an officer and director of the Company, and Gary M. Ralston, a former officer and director of the Company, collectively own the remaining 1.3 percent interest, which is 100 percent of the voting interest in Services. Effective January 1, 2005, the Company acquired the remaining 1.3 percent voting interest in Services increasing the Company’s ownership in Services to 100 percent.
The Company’s executive offices are located at 450 S. Orange Avenue, Suite 900, Orlando, Florida 32801, and its telephone number is (800) NNN-REIT (666-7348). The Company has an internet website at www.nnnreit.com where the Company’s filings with the Securities and Exchange Commission can be downloaded free of charge.
The Company’s operations are divided into two primary business segments: real estate held for investment, including structured finance investments, and real estate held for sale. The real estate held for investment and structured finance investments (included in mortgages and notes receivable on the balance sheet) are operated through the Company and its wholly owned qualified REIT subsidiaries. The Company, directly and indirectly, through investment interests, acquires, owns, invests in, manages and develops primarily single-tenant retail properties that are generally leased to established tenants under long-term commercial net leases.
Properties
Real Estate Held for Investment
As of December 31, 2004, the Company owned 362 properties (the “Investment Properties”), with an aggregate gross leaseable area of 8,542,000 square feet, that are leased to established tenants, including Academy, Barnes & Noble, Best Buy, Borders, CVS, Eckerd, OfficeMax, The Sports Authority, United Rentals and the United States of America. Approximately 97 percent of the gross leaseable area of the Company’s portfolio of Investment Properties was leased at December 31, 2004.
The Investment Properties are generally leased under net leases pursuant to which the tenant typically will bear responsibility for substantially all property costs and expenses associated with ongoing maintenance and operation. Certain of the Company’s Investment Properties are subject to leases under which the Company retains responsibility for certain costs and expenses associated with the Investment Property. The leases of each of the Company’s Investment Properties require payment of base rent plus, generally, either percentage rent based on the tenant’s gross sales or contractual increases in base rent.
During 2004, one of the Company’s tenants, the United States of America (the “USA”), accounted for more than 10 percent of the Company’s total rental income. As of December 31, 2004, the USA leased three properties. Based on the minimum rental payments required by the leases, we expect that the USA will continue to account for more than 10 percent of the Company’s total rental income in 2005. Any failure of this lessee to make the lease payments when they are due could materially affect the Company’s income.
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Structured Finance Investments
Structured finance agreements are typically loans secured by a pledge of ownership interests in the borrowers (or their subsidiaries) that own the underlying real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans. The Company has entered $50,290,000 structure finance agreements between October 2003 and December 2004. As of December 31, 2004, the structured finance agreements had an outstanding receivable balance of $29,390,000.
Real Estate Held for Sale
The Company’s real estate held for sale is operated through Services, which directly, and indirectly through investment interests, acquires and develops, real estate primarily for the purpose of selling the real estate to purchasers who are looking for replacement like-kind exchange property or to other purchasers with different investment objectives. As of December 31, 2004, Services owned 21 properties that were held for sale (“Inventory Properties”). The portfolio of Inventory Properties consists of properties that have been acquired in the marketplace with the intent to resell and properties that have been, or are currently being, developed by Services. As of December 31, 2004, the portfolio of Inventory Properties consisted of 10 completed inventory properties, seven properties under construction and four land parcels.
Investments in Consolidated Subsidiaries
As of December 31, 2004, the Company had 36 majority or wholly-owned subsidiaries primarily to facilitate the acquisition, development and disposition of certain properties. Some of the subsidiaries were formed to hold an interest in certain of the Company’s unconsolidated affiliates.
Investments in Unconsolidated Affiliates
The Company has entered into five limited liability company (“LLC”) agreements between June 2001 and July 2003, with Orange Avenue Mortgage Investments, Inc. (“OAMI”), formerly known as CNL Commercial Finance, Inc. Each of the LLCs holds an interest in mortgage loans and is 100 percent equity financed. The Company holds a non-voting and non-controlling interest in each of the LLCs ranging from 36.7 to 44.0 percent and accounts for its interests under the equity method of accounting. In 2003, in connection with a loan to OAMI, the Company pledged a portion of its interest in two of the LLCs as partial collateral for the loan.
In May 2002, the Company contributed cash to purchase a combined 25 percent partnership interest in CNL Plaza, Ltd. and CNL Plaza Venture, Ltd. (collectively, “Plaza”), which owns a 346,000 square foot office building and an interest in an adjacent parking garage. Affiliates of James M. Seneff, Jr. and Robert A. Bourne, each a member of the Company’s board of directors, own the remaining partnership interests. The Company accounts for its 25 percent interest in the Plaza under the equity method of accounting. Since November 1999, the Company has leased its office space from Plaza. The Company’s lease expires in October 2014. In addition, the Company has severally guaranteed 41.67% of a $15,500,000 promissory note on behalf of Plaza. The maximum obligation of the Company under this guarantee is $6,458,300 plus interest. Interest accrues at a rate of LIBOR plus 200 basis points per annum on the unpaid principal amount. This guarantee shall continue through the loan maturity, which was extended from the original maturity of November 2004 to May 2005. Plaza intends to refinance the promissory note in 2005.
In 1999, a wholly-owned subsidiary of Services entered into a limited liability membership arrangement, WXI/SMC Real Estate LLC (“WXI”), with Whitehall Street Real Estate Limited Partnership XI. Services’ subsidiary is the sole managing member and holds a 33 1/3 percent interest in WXI. WXI was organized for
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the purpose of owning, developing, redeveloping, operating, leasing and selling a portfolio of real estate. The Company accounts for its interest under the equity method of accounting.
In September 1997, Net Lease Realty III, Inc., a wholly-owned subsidiary of the Company, formed a limited partnership, Net Lease Institutional Realty L.P. (the “Partnership”), with The Northern Trust Company, Trustee of the Retirement Plan for the Chicago Transit Authority Employees (“CTA”) to acquire, own and manage nine properties. Net Lease Realty III, Inc. was the sole general partner with a 20 percent interest in the Partnership and CTA was the sole limited partner with an 80 percent interest in the Partnership. Under the terms of the limited partnership agreement of the Partnership, CTA had the right to convert its 80 percent limited partnership interest into shares of the Company’s common stock. In February 2004, CTA exercised its right to convert and the Company issued 953,551 shares of its common stock to CTA in a private transaction in exchange for CTA’s 80 percent limited partnership interest.
Merger
In December 2001, the Company acquired 100 percent of Captec Net Lease Realty, Inc. (“Captec”), a publicly traded real estate investment trust, which owned 135 freestanding, net lease properties located in 26 states. Captec shareholders had the right to receive $11,839,000 in cash, 4,349,918 newly issued shares of the Company’s common stock and 1,999,974 newly issued shares of the Company’s 9% Series A Preferred Stock. The merger was accounted for under the purchase method of accounting. Under the purchase method of accounting, the merger acquisition price of $124,722,000 was allocated to the assets acquired and liabilities assumed at their fair values. As a result, the Company did not record goodwill.
In January 2002, beneficial owners of shares of Captec stock held of record by Cede & Co. who alleged that they did not vote for the merger (and who alleged that they caused a written demand for appraisal of their Captec shares to be served on Captec), filed in the Chancery Court of the State of Delaware in and for New Castle County a Petition for Appraisal of Stock (“Appraisal Action”). The Appraisal Action alleged that 1,037,946 shares of Captec dissented from the merger and sought to require the Company to pay to all Captec stockholders who demanded appraisal of their shares the fair value of those shares, with interest from the date of the merger. As a result of this action, the plaintiffs were not entitled to receive the Company’s common and Series A Preferred Stock shares as offered in the original merger consideration. Accordingly, the Company reduced the number of common and Series A Preferred Stock shares issued and outstanding by 474,037 and 217,950, respectively, which represents the number of shares that would have been issued to the plaintiffs had they accepted the original merger consideration. In 2003, the Company further reduced the number of common and Series A Preferred Stock shares issued and outstanding by 824 and 379, respectively. In 2004, the Company further reduced the number of common and Series A Preferred Stock shares issued and outstanding by 51 and 56, respectively. As of December 31, 2002, the Company had recorded the value of these shares at the original consideration share price in addition to the cash portion of the original merger consideration as other liabilities totaling $13,278,000. In February 2003, the Company entered into a settlement agreement with the beneficial owners of the 1,037,946 dissenting shares (including the petitioners in the Appraisal Action) which required the Company to pay $15,569,000, which approximated the value of the original merger consideration (which included cash, common stock and Series A Preferred Stock shares) at the time of the litigation settlement plus the dividends that would have been paid if the shares had been issued at the time of the merger. On February 13, 2003, the parties filed a stipulation and order of dismissal and the Court entered the order of dismissal, dismissing the Appraisal Action with prejudice.
Anticipated Merger
In January 2005, the Company entered into an agreement with National Properties Corporation (“NAPE”), which provided that NAPE would merge with and into a subsidiary of the Company. At the time of the merger agreement, NAPE owned 43 properties located in 12 states which were leased to 17 tenants. If the acquisition is consummated, the Company will issue approximately 1,637,000 shares of common stock to holders of NAPE common stock. Total consideration for the merger transaction is estimated to be
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approximately $61,000,000 based on the Company’s closing stock price on the date of the merger agreement. Completion of the merger is subject to customary closing conditions, including the approval of the holders of a majority of the outstanding shares of NAPE common stock. The Company has entered into a shareholders’ agreement with the holders of approximately 53 percent of the outstanding NAPE common stock whereby these holders have agreed to vote in favor of the merger. However, the Company may terminate the merger agreement if a majority of the NAPE shareholders who are not bound by the shareholders’ agreement do not approve the merger. The merger does not require approval by the Company’s shareholders. The Company anticipates that the merger will be completed not later than the second quarter of 2005.
Competition
The Company generally competes with other REITs, commercial developers, real estate limited partnerships and other investors, including but not limited to, insurance companies, pension funds and financial institutions, in the acquisition, leasing, financing, development and disposition of investments in net-leased properties. There are numerous other REITs that own, manage or develop retail properties.
Employees
As of December 31, 2004, the Company employed 74 full-time persons including executive, administrative and field personnel. Reference is made to “Item 10. Directors and Executive Officers of the Registrant” for a listing of the Company’s Executive Officers.
Business Strategies and Policies
The following is a discussion of the Company’s operating strategy and certain of its investment, financing and other policies. These strategies and policies have been determined by the Board of Directors and, in general, may be amended or revised from time to time by the Board of Directors without a vote of the Company’s stockholders.
Operating Strategies
The Company’s strategy is to invest primarily in single-tenant retail properties which typically are located along high traffic commercial corridors near areas of commercial and residential density. Management believes that these types of properties when leased to high-quality tenants primarily pursuant to triple-net leases provide attractive opportunities for a stable current return and the potential for capital appreciation. Triple-net leases typically require the tenant to pay substantially all operating expenses of a property, including, but not limited to, all real estate taxes, assessments and other government charges, insurance, utilities, repairs and maintenance. In management’s view, these types of properties also provide the Company with flexibility in use and tenant selection when the properties are re-let. As of December 31, 2004, the Company owned Investment Properties in 38 states.
In some limited cases, the Company’s investment in properties is in the form of structured finance investments, which are typically loans secured by a pledge of ownership interests in the borrowers (or their subsidiaries) that own the underlying real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans. While not a Company strategy, in the past, the Company also has made opportunistic investments in single-tenant office properties.
With respect to real estate held for investment, the Company holds its properties until it determines that the sale of the properties is advantageous in view of the Company’s investment objectives. In deciding whether to sell properties, the Company will consider factors such as potential capital appreciation, net cash flow, potential use of sale proceeds and federal income tax considerations.
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With respect to real estate held for sale, Services’ strategy is to acquire and develop real estate directly and indirectly, through investment interests, primarily for the purpose of selling the real estate to purchasers who are looking for replacement like-kind exchange property, or to other purchasers with different investment objectives.
The Company’s management team focuses on certain key indicators to evaluate the financial condition and operating performance of the Company. The key indicators for the Company include items such as: the composition of the Company’s portfolio of investment properties and structured finance investments (such as tenant, geographic and industry classification diversification); the occupancy rate of the Company’s portfolio of investment properties; certain financial performance ratios and profitability measures; industry trends and performance compared to that of the Company and returns the Company receives on its invested capital in Services.
Investment in Real Estate or Interests in Real Estate
Management believes that attractive acquisition opportunities for single-tenant retail properties will continue to be available and that the Company is suited to take advantage of these opportunities because of its access to capital markets, ability to underwrite and acquire properties, either for cash or securities, and because of management’s experience in seeking out, identifying and evaluating potential acquisitions.
In evaluating a particular acquisition, management will consider a variety of factors, including (i) the location and accessibility of the property; (ii) the geographic area and demographic characteristics of the community, as well as the local real estate market, including potential for growth; (iii) the size of the property; (iv) the purchase price; (v) the non-financial terms of the proposed acquisition; (vi) the availability of funds or other consideration for the proposed acquisition and the cost thereof; (vii) the “fit” of the property with the Company’s existing portfolio; (viii) the potential for, and current extent of, any environmental problems; (ix) the quality of construction and design and the current physical condition of the property; (x) the financial and other characteristics of the existing tenant, (xi) the tenant’s business plan, operating history and management team, (xii) the tenant’s industry, (xiii) the terms of any existing leases; and (xiv) the potential for capital appreciation. As of December 31, 2004, the Company owned retail Investment Properties located in 38 states and on parcels of land averaging 117,000 square feet upon which are constructed single story buildings averaging 22,000 square feet. However, the Company may, in the future, acquire other types of real estate in other areas of the country as opportunities present themselves. While the Company may diversify in terms of property locations, size and market, the Company does not set any limit on the amount or percentage of Company assets that may be invested in any one property or any one geographic area.
The Company intends to engage in such future investment activities in a manner that is consistent with the maintenance of its status as a REIT for federal income tax purposes and that will not make the Company an investment company under the Investment Company Act of 1940, as amended. Equity investments in acquired properties may be subject to existing mortgage financings and other indebtedness or to new indebtedness which may be incurred in connection with acquiring or refinancing these investments.
Investments in Real Estate Mortgages and Securities of or Interests in Persons Engaged in Real Estate Activities
While the Company’s current portfolio of, and its business objectives primarily emphasize, equity investments in single-tenant retail properties, the Company may invest in (i) a wide variety of retail properties or other property and tenant types; (ii) mortgages, participating or convertible mortgages, deeds of trust and other types of real estate interests or (iii) securities of other REITs, other entities engaged in real estate activities or securities of other issuers, including for the purpose of exercising control over such entities, consistent with its qualification as a REIT. For example, the Company from time to time has made investments in mortgage loans or held mortgages on properties the Company sold and has made structured
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finance investments (as discussed above), which are typically loans secured by a pledge of ownership interests in the borrowers (or their subsidiaries) that own the underlying real estate.
Capital Policies
The Company has authority to offer equity or debt securities in exchange for property and to repurchase or otherwise acquire its common stock or other securities in the open market or otherwise, and may engage in such activities in the future. The Company has not engaged in trading, underwriting or agency distribution or sale of securities of other issues and does not intend to do so.
Policy Changes
Any of the Company’s policies described above may be changed at any time by the Company’s Board of Directors without a vote of the Company’s stockholders.
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Item 2. Properties
Investment Properties
As of December 31, 2004, the Company owned 362 Investment Properties, with an aggregate gross leaseable area of 8,542,000 square feet, located in 38 states, of which 97 percent of the gross leaseable area is leased to established retail and office tenants. Reference is made to the Schedule of Real Estate and Accumulated Depreciation and Amortization filed with this report for a listing of the Investment Properties and their respective carrying costs.
Description of Retail and Office Investment Properties
Retail Investment Properties
Land. The Company’s retail Investment Property sites range from approximately 15,000 to 774,000 (average of 117,000) square feet depending upon building size and local demographic factors. Land costs range from approximately $25,000 to $10,197,000 (average of $1,191,000).
Buildings. The buildings generally are single-story structures constructed from various combinations of stucco, steel, wood, brick and tile. Building sizes range from approximately 1,000 to 135,000 (average of 22,000) square feet. Building costs range from $44,000 to $9,211,000 (average of $1,706,000) for each retail Investment Property, depending upon the size of the building and the site and the area in which the Investment Property is located. Generally, the retail Investment Properties owned by the Company are freestanding, with paved parking areas.
Leases. Although there are variations in the specific terms of the leases, the following is a summarized description of the general structure of the Company’s leases. Generally, the leases of the retail Investment Properties owned by the Company provide for initial terms of 10 to 20 years. As of December 31, 2004, the weighted average remaining lease term was approximately 10 years. The retail Investment Properties are generally leased under net leases pursuant to which the tenant typically will bear responsibility for substantially all property costs and expenses associated with ongoing maintenance and operation, including utilities, property taxes and insurance. In addition, the majority of the Company’s leases provide that the tenant is responsible for roof and structural repairs. The leases of the retail Investment Properties provide for annual base rental payments (payable in monthly installments) ranging from $12,000 to $1,635,000 (average of $272,000). Generally, the leases provide for either percentage rent or contractual increases in annual rent. Leases which provide for contractual increases in annual rent generally have increases which range from one to 10 percent after every one to five years of the lease term. In addition, for those leases which provide for the payment of percentage rent, such rent is generally one to eight percent of the tenants’ annual gross sales for the respective location, less the amount of annual base rent payable in that lease year. As of December 31, 2004, 83 percent of the Company’s annualized base rent was derived from retail Investment Properties. Based on the aggregate annual base rent of the retail Investment Property leases, (i) 55 percent include contractual increases, (ii) eight percent include percentage rent provisions and (iii) 13 percent include both contractual and percentage rent provisions.
Generally, the leases of the retail Investment Properties provide the tenant with one or more multi-year renewal options subject to generally the same terms and conditions as the initial lease. Some of the leases also provide that in the event the Company wishes to sell the Investment Property subject to that lease, the Company first must offer the lessee the right to purchase the Investment Property on the same terms and conditions as any offer which the Company intends to accept for the sale of the Investment Property.
Certain of the Company’s Investment Properties have leases that provide the tenant with a purchase option to acquire the Investment Property from the Company. The purchase price calculations are generally stated in the lease agreement or are based on current market value.
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Office Investment Properties
As of December 31, 2004, the Company’s portfolio of Investment Properties included four office properties with an aggregate gross leaseable area of 687,000 square feet. These office Investment Properties represent 17 percent of the current annual base rent of the entire portfolio of Investment Properties.
In August 2003, the Company acquired two office buildings and a related parking garage in the Washington, D.C. metropolitan area (“DC Office Properties”), for $142,800,000. In addition, the Company has agreed to fund an additional $27,322,000 for building and tenant improvements, and other costs related to the lease. As of December 31, 2004, the Company had funded $23,850,000 of these improvements. The DC Office Properties include two office buildings which have an aggregate of 555,000 rentable square feet and a two-level garage with approximately 1,000 parking spaces. The DC Office Properties are leased substantially to the USA to be used as the headquarters of the Transportation Security Administration. The lease was executed in December 2002 and the USA began occupying space in the buildings in phases beginning in January 2003. The lease will expire in 2014. The USA executed a lease (per which the landlord pays certain property related operating costs), that commenced for a portion of the properties in December 2002. Annual rent for the DC Office Properties is approximately $18,473,000. The USA is responsible for the actual amount of real estate taxes above the base year amount and increases in operating expenses above an expected base year amount, subject to a consumer price index cap. As landlord, the Company is responsible for property insurance.
During 2004, the USA was the Company’s only tenant that accounted for more than 10 percent of the Company’s total rental income. As of December 31, 2004, the USA leased three properties representing 12 percent of the Company’s total assets.
In May 2004, the Company acquired an office building in St. Louis, Missouri for $15,596,000, with 132,000 rentable square feet. The lease was executed in January 2004, with rent commencement in July 2004 and will expire in January 2015. The tenant is responsible for the actual amount of real estate taxes and operating expenses from rent commencement date.
Notes Receivable. Structured finance agreements are typically loans secured by a pledge of ownership interests in the borrowers (or their subsidiaries) that own the underlying real estate. These agreements are typically subordinated to senior loans secured by first mortgages encumbering the underlying real estate. Subordinated positions are generally subject to a higher risk of nonpayment of principal and interest than the more senior loans.
In 2004 and 2003, the Company made structured finance investments of $6,857,000 and $43,433,000, respectively. As of December 31, 2004, the structured finance investments bear a weighted average interest rate of 14.3% per annum, of which 12.5% is payable monthly and the remaining 1.8% accrues and is due at maturity. The principal balance of each structured finance investment is due in full at maturity, which range between November 2006 and November 2007. The structured finance investments are secured by the borrowers’ pledge of their respective membership interests in the certain subsidiaries which own real estate. In December 2004, the Company received $20,900,000 in principal payments and a $418,000 prepayment fee. As of December 31, 2004 and 2003, the outstanding receivable balance of the structured finance investments was $29,390,000 and $43,433,000, respectively.
In January 2005, the Company received $3,935,000 in principal payments; the outstanding receivable balance of the remaining structured finance agreements was $25,455,000 with a weighted average interest rate of 11.8% per annum.
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Inventory Properties
The portfolio of Inventory Properties may consist of properties that have been acquired with the intent to resell and properties that have been, or are currently being, developed by Services. The Company’s Inventory Properties are typically sold to purchasers who are looking for replacement like-kind exchange property or to other purchasers with different investment objectives. As of December 31, 2004, the Company owned 21 Inventory Properties which include 10 completed inventory properties, seven properties under construction and four land parcels. Reference is made to the Schedule of Real Estate and Accumulated Depreciation and Amortization filed with this report for a listing of the Inventory Properties and their respective carrying costs.
Completed Inventory Properties. The completed Inventory Properties held for sale at December 31, 2004 had sites range from approximately 35,000 to 511,000 (average of 129,000) square feet depending upon building size and local demographic factors. Land costs range from approximately $77,000 to $5,454,000 (average of $1,645,000).
The buildings generally are single-story structures ranging in size from approximately 8,000 to 52,000 (average of 16,000) square feet. Building costs range from $309,000 to $8,779,000 (average of $2,226,000) for each Inventory Property, depending upon the size of the building and the site and the area in which the Inventory Property is located.
Under Construction. In connection with the development of seven Inventory Properties by Services, the Company has agreed to fund construction commitments of $26,409,000, of which $12,248,000 has been funded as of December 31, 2004.
Property Environmental Considerations
The Company may acquire a property whose environmental site assessment indicates that a contamination or potential contamination exists, subject to a determination of the level of risk and potential cost of remediation. Investments in real property create a potential for environmental liability on the part of the owner of such property from the presence or discharge of hazardous substances on the property. It is the Company’s policy, as a part of its acquisition due diligence process, generally to obtain a Phase I environmental site assessment for each property, and where warranted, a Phase II environmental site assessment. In such cases, the Company generally requires the seller and/or tenant to (i) remediate the problem prior to the Company’s acquiring the property, (ii) indemnify the Company for environmental liabilities or (iii) agree to other arrangements deemed appropriate by the Company to address environmental conditions at the property. Phase I assessments involve site reconnaissance and review of regulatory files identifying potential areas of concern, whereas Phase II assessments involve some degree of soil and/or groundwater testing. The Company has 12 properties currently under some level of environmental remediation. In general, the seller or the tenant is contractually responsible for the cost of the environmental remediation for each of these properties.
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Item 3. Legal Proceedings
In January 2002, Calapasas Investment Partnership No. 1 Limited Partnership (“Calapasas”), a Captec stockholder, filed a class action complaint against Captec, certain former Captec directors, and the Company (as successor in interest to Captec). In its complaint Calapasas alleged that Captec and certain of its directors violated provisions of the Securities and Exchange Act of 1934 by misrepresenting the value of certain Captec assets on certain of its financial statements in 2000 and 2001. In July 2004, the parties entered into a Stipulation of Settlement which was filed with the court. Pursuant to the Stipulation of Settlement, the total settlement amount paid to the plaintiffs was $225,000, which included payment of attorneys’ fees and costs to plaintiffs’ counsel. In July 2004, a final judgment of dismissal was entered by the court.
In the ordinary course of its business, the Company is a party to various other legal actions which management believes is routine in nature and incidental to the operation of the business of the Company. Management believes that the outcome of the proceedings will not have a material adverse effect upon its operations, financial condition or liquidity.
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Item 4. Submission of Matters to a Vote of Security Holders
None.
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The common stock of the Company currently is traded on the New York Stock Exchange (“NYSE”) under the symbol “NNN.” For each calendar quarter indicated, the following table reflects respective high, low and closing sales prices for the common stock as quoted by the NYSE and the dividends paid per share in each such period.
The following presents the characterizations for tax purposes of such common stock dividends for the years ended December 31:
In February 2005, the Company paid dividends to its stockholders of $16,925,000, or $0.325 per share of common stock.
The Company intends to pay regular quarterly dividends to its stockholders. Future distributions will be declared and paid at the discretion of the board of directors and will depend upon cash generated by operating activities, the Company’s financial condition, capital requirements, annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986 as amended, and such other factors as the board of directors deems relevant.
On February 28, 2005, there were 1,185 stockholders of record of common stock.
Reference is made to the Registrant’s definitive proxy statement to be filed with the Commission pursuant to Regulation 14(a); certain information responsive to this Item is contained in the section thereof captioned “Executive Compensation – Equity Compensation Plan Information,” and the information in such section is incorporated herein by reference.
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Item 6. Selected Financial Data
Historical Financial Highlights(dollars in thousands, except per share data)
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This information contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements generally are characterized by the use of terms such as “believe,” “expect” and “may.” The terms “Registrant” or “Company” refer to Commercial Net Lease Realty, Inc. and its majority owned and controlled subsidiaries. These subsidiaries include the wholly-owned qualified real estate investment trust (“REIT”) subsidiaries of Commercial Net Lease Realty, Inc., as well as the taxable REIT subsidiary (“TRS”) Commercial Net Lease Realty Services, Inc. and its majority owned and controlled subsidiaries (collectively, “Services”).
Although management believes that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, the Company’s actual results could differ materially from those set forth in the forward-looking statements. Certain factors that might cause a difference include the following:
Given these uncertainties, readers are cautioned not to place undue reliance on such statements. Management of the Company currently knows of no trends that will have a material adverse effect on its liquidity, capital resources or results of operations.
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Overview
Commercial Net Lease Realty, Inc., a Maryland corporation, is a fully integrated REIT formed in 1984. All prior period comparable consolidated financial statements have been derived from the audited consolidated financial statements and have been restated to include the consolidated financial information of Services. Effective January 1, 2004, Services is included in the consolidated financial statements due to the Company’s implementation of Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities,” as amended (“FIN 46R”). The Company holds a 98.7 percent, non-controlling interest in Services and is entitled to receive 98.7 percent of the dividends paid by Services. James M. Seneff, Jr., a director of the Company, Kevin B. Habicht, an officer and director of the Company, and Gary M. Ralston, a former officer and director of the Company, collectively own the remaining 1.3 percent interest, which is 100 percent of the voting interest in Services. Effective January 1, 2005, the Company acquired the remaining 1.3 percent voting interest in Services increasing the Company’s ownership in Services to 100 percent.
The Company’s operations are divided into two primary business segments: real estate held for investment, including structured finance investments, and real estate held for sale. The real estate held for investment (the “Investment Properties”) and structured finance investments (included in mortgages and notes receivable on the balance sheet), are operated through Commercial Net Lease Realty, Inc. and its wholly owned qualified REIT subsidiaries. The Company, directly and indirectly, through investment interests, acquires, owns, invests in, manages and develops primarily single-tenant retail properties that are generally leased to established tenants under long-term commercial net leases. As of December 31, 2004, the Company owned 362 Investment Properties, with an aggregate gross leaseable area of 8,542,000 square feet, located in 38 states and leased to established tenants, including Academy, Barnes & Noble, Best Buy, Borders, CVS, Eckerd, OfficeMax, The Sports Authority, United Rentals and the United States of America. In addition to the Investment Properties, as of December 31, 2004, the Company had $29,390,000 in structured finance investments. The real estate held for sale is operated through Services. Services, directly and indirectly, through investment interests, acquires and develops real estate primarily for the purpose of selling the real estate to purchasers who are looking for replacement like-kind exchange property or to other purchasers with different investment objectives. As of December 31, 2004, Services owned 21 properties that were held for sale (“Inventory Properties”).
The Company’s management team focuses on certain key indicators to evaluate the financial condition and operating performance of the Company. The key indicators for the Company include items such as: the composition of the Company’s portfolio of Investment Properties and structured finance investments (such as tenant, geographic and industry classification diversification); the occupancy rate of the Company’s portfolio of Investment Properties; certain financial performance ratios and profitability measures; and industry trends and performance compared to that of the Company; and returns the Company receives on its invested capital in Services.
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Liquidity
General. Historically, the Company’s demand for funds has been primarily for (i) payment of operating expenses and dividends, (ii) property acquisitions, structured finance investments, capital expenditures and development, either directly or through investment interests, (iii) payment of principal and interest on its outstanding indebtedness and (iv) other investments.
Contractual Obligations and Commercial Commitments. The information in the following table summarizes the Company’s contractual obligations and commercial commitments outstanding as of December 31, 2004. The table presents principal cash flows by year-end of the expected maturity for debt obligations and commercial commitments outstanding as of December 31, 2004. As the table incorporates only those exposures that exist as of December 31, 2004, it does not consider those exposures or positions which may arise after that date.
Management anticipates satisfying these obligations with a combination of the Company’s current capital resources, cash on hand, its revolving credit facility and debt or equity financings.
In addition to the contractual obligations outlined in the above table, in connection with its acquisition of two office buildings and a related parking garage located in the Washington, D.C. metropolitan area (“DC Office Properties”) in August 2003, the Company has agreed to fund $27,322,000 for building and tenant improvements, of which $23,850,000 had been funded as of December 31, 2004. The Company anticipates funding the additional costs from borrowings under the Company’s revolving credit facility, which is anticipated to be substantially complete by June 30, 2005.
In connection with the development of seven Inventory Properties by Services, the Company has agreed to fund construction commitments of $26,409,000, of which $12,248,000 has been funded as of December 31, 2004. The Company anticipates funding the additional costs from borrowings under the Company’s revolving credit facility.
The Company has also guaranteed 41.67 percent of a $15,500,000 promissory note on behalf of an unconsolidated affiliate. The maximum obligation to the Company is $6,458,000 plus interest, and the guarantee shall continue through the loan maturity, which was extended from the original maturity of November 2004 to May 2005. In the event the Company is required to perform under this guarantee, the Company would potentially use proceeds from its revolving credit facility.
Many of the Investment Properties are recently constructed and are generally net leased, therefore management anticipates that capital demands to meet obligations with respect to these Properties will be modest for the foreseeable future and can be met with funds from operations and working capital. The leases typically provide that the tenant bears responsibility for substantially all property costs and expenses associated with ongoing maintenance and operation, including utilities, property taxes and
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insurance. In addition, the Company’s leases generally provide that the tenant is responsible for roof and structural repairs. Certain of the Company’s Investment Properties, including the DC Office Properties, are subject to leases under which the Company retains responsibility for certain costs and expenses associated with the Investment Property. Management anticipates the costs associated with the Company’s vacant Investment Properties or those Investment Properties that become vacant will also be met with funds from operations and working capital. The Company may be required to borrow under the Company’s revolving credit facility or use other sources of capital in the event of unforeseen significant capital expenditures.
The lost revenues and increased property expenses resulting from the rejection by any bankrupt tenant of any of their respective leases with the Company could have a material adverse effect on the liquidity and results of operations of the Company if the Company is unable to re-lease the Investment Properties at comparable rental rates and in a timely manner. As of January 31, 2005, the Company owns 10 vacant, unleased Investment Properties, which account for approximately three percent of the total gross leaseable area of the Company’s portfolio of Investment Properties.
Dividends. The Company has made an election to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and related regulations. The Company generally will not be subject to federal income tax on income that it distributes to its stockholders, providing it distributes at least 90 percent of its REIT taxable income and meets certain other requirements for qualifying as a REIT. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income tax on its taxable income at regular corporate rates and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost. Such an event could materially affect the Company’s income and its ability to pay dividends. However, the Company believes that it was organized and operated in such a manner as to qualify for treatment as a REIT for the years ended December 31, 2004, 2003 and 2002, and intends to continue to operate the Company so as to remain qualified as a REIT for federal income tax purposes.
One of the Company’s primary objectives, consistent with its policy of retaining sufficient cash for reserves and working capital purposes and maintaining its status as a REIT, is to distribute a substantial portion of its funds available from operations to its stockholders in the form of dividends. During the years ended December 31, 2004, 2003 and 2002, the Company declared and paid dividends to its common stockholders of $66,272,000, $55,473,000 and $51,178,000 respectively, or $1.29, $1.28 and $1.27 per share, respectively, of common stock.
In February 2005, the Company paid dividends to its common stockholders of $16,925,000, or $0.325 per share of stock.
Holders of the 9% Non-Voting Series A Preferred Stock (the “Series A Preferred Stock”) are entitled to receive, when and as authorized by the board of directors, cumulative preferential cash distributions at the rate of nine percent of the $25.00 liquidation preference per annum (equivalent to a fixed annual amount of $2.25 per share). For the years ended December 31, 2004, 2003 and 2002, the Company declared and
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paid dividends to its Series A Preferred Stock stockholders of $4,008,000, $4,008,000 and $4,010,000, respectively, or $2.25 per share of stock.
In February 2005, the Company declared dividends of $1,002,000 or $0.5625 per share of Series A Preferred Stock, payable in March 2005.
Holders of the 6.70% Non-Voting Series B Preferred Cumulative Convertible Perpetual Preferred Stock (the “Series B Convertible Preferred Stock”), issued during 2003, are entitled to receive, when and as authorized by the board of directors, cumulative preferential cash distributions at the rate of 6.70 percent of the $2,500.00 liquidation preference per annum (equivalent to a fixed annual amount of $167.50 per share). For the years ended December 31, 2004 and 2003, the Company declared and paid dividends to its Series B Convertible Preferred Stock stockholders of $1,675,000 and $502,000, respectively, or $167.50 and $50.25 per share of stock.
In February 2005, the Company declared dividends of $419,000 or $41.875 per share of Series B Convertible Preferred Stock, payable in March 2005.
Property Environmental Considerations. The Company may acquire a property whose environmental site assessment indicates that a contamination or potential contamination exists, subject to a determination of the level of risk and potential cost of remediation. Investments in real property create a potential for environmental liability on the part of the owner of such property from the presence or discharge of hazardous substances on the property. It is the Company’s policy, as a part of its acquisition due diligence process, generally to obtain a Phase I environmental site assessment for each property and, where warranted, a Phase II environmental site assessment. In such cases that the Company intends to acquire real estate where contamination or potential contamination exists, the Company generally requires the seller and/or tenant to (i) remediate the problem prior to the Company’s acquiring the property, (ii) indemnify the Company for environmental liabilities or (iii) agree to other arrangements deemed appropriate by the Company to address environmental conditions at the property. Phase I assessments involve site reconnaissance and review of regulatory files identifying potential areas of concern, whereas Phase II assessments involve some degree of soil and/or groundwater testing. The Company has 12 Investment Properties currently under some level of environmental remediation. In general, the seller or the tenant is contractually responsible for the cost of the environmental remediation for each of these Investment Properties.
Capital Resources
Generally, cash needs for property acquisitions, structured finance investments, capital expenditures, development and other investments have been funded by equity and debt offerings, bank borrowings, the sale of properties and, to a lesser extent, from internally generated funds. Cash needs for other items have been met from operations. Potential future sources of capital include proceeds from the public or private offering of the Company’s debt or equity securities, secured or unsecured borrowings from banks or other lenders, proceeds from the sale of properties, as well as undistributed funds from operations. For the years ended December 31, 2004, 2003, and 2002, the company generated $74,792,000, $48,531,000 and $111,589,000 respectively, of net cash from operating activities. The change in cash provided by operations for the years ended December 31, 2004, 2003 and 2002, is primarily the result of changes in revenues and expenses as discussed in “Results of Operations.” Cash generated from operations could be expected to fluctuate in the future.
Indebtedness. The Company expects to use indebtedness primarily for property acquisitions and development of single-tenant retail and office properties, either directly or through investment interests and structured finance investments.
In May 2003, the Company entered into an amended and restated loan agreement for a $225,000,000 revolving credit facility (the “Credit Facility”) which amended the Company’s existing loan agreement by
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(i) increasing the borrowing capacity to $225,000,000 from $200,000,000, (ii) lowering the interest rates of the tiered rate structure from a maximum of 150 points above LIBOR to a maximum rate of 135 basis points above LIBOR (based upon the debt rating of the Company, the current interest rate is 100 basis points above LIBOR), (iii) requiring the Company to pay a commitment fee based on a tiered rate structure to a maximum of 30 basis points per annum (based upon the debt rating of the Company), (iv) providing for a competitive bid option for up to 50 percent of the facility amount, (v) extending the expiration date to May 9, 2006 and (vi) amending certain of the financial covenants of the Company. The principal balance is due in full upon expiration of the Credit Facility in May 2006, which the Company may request to be extended for an additional 12-month period with the consent of the lender. As of December 31, 2004, $17,900,000 was outstanding and approximately $207,100,000 was available for future borrowings under the Credit Facility, excluding undrawn letters of credit.
In accordance with the terms of the Credit Facility, the Company is required to meet certain restrictive financial covenants, which, among other things, require the Company to maintain certain (i) maximum leverage ratios, (ii) debt service coverage and (iii) cash flow coverage. At December 31, 2004, the Company was in compliance with those covenants. In the event that the Company violates any of the certain restrictive financial covenants, its access to the debt or equity markets may become impaired.
In November 2003, the Company entered into a long-term, fixed rate interest-only loan for $95,000,000. The loan bears interest at a rate of 5.42% per annum with monthly interest payments of $435,000 and the principal balance due in November 2013. Proceeds from the loan were used to pay down outstanding indebtedness of the Company’s Credit Facility. The loan is secured by a first mortgage lien on the DC Office Properties. As of December 31, 2004, the outstanding principal balance was $95,000,000, and the aggregate carrying value of these properties totaled $155,601,000.
In January 1996, the Company entered into a long-term, fixed rate loan for $39,450,000. The loan bears interest at a rate of 7.435% per annum and provides for a ten-year term with monthly principal and interest payments of $330,000 and the balance due in February 2006. The loan is secured by a first mortgage lien on certain of the Company’s Investment Properties. As of December 31, 2004, the outstanding principal balance was $22,466,000, and the aggregate carrying value of these Investment Properties totaled $58,049,000.
In February 2004, the Company increased its ownership in Net Lease Institutional Realty, L.P. to 100 percent (see Capital Resources – Investments in Unconsolidated Affiliates). In October 1997, the partnership entered into a long-term, fixed rated loan for $12,000,000. The loan bears interest at a rate of 7.37% per annum with monthly principal and interest payments of $103,000 and the principal balance due in September 2007. The loan is secured by a first mortgage lien on certain of the partnership’s properties. As of December 31, 2004, the outstanding principal balance was $8,606,000, and the aggregate carrying value of these Investment Properties totaled $28,893,000.
In June 2002, the Company entered into a long-term, fixed rate loan for $21,000,000. The loan bears interest at a rate of 6.9% per annum and provides for a 10-year term, with monthly principal and interest payments of $138,000 and the balance due in July 2012. Proceeds from the loan were used to pay down outstanding indebtedness of the Company’s Credit Facility. The loan is secured by a first mortgage lien on five of the Company’s Investment Properties. As of December 31, 2004, the outstanding principal balance was $20,508,000, and the aggregate carrying value of these Investment Properties totaled $27,111,000.
In February 2004, the Company acquired an Investment Property subject to a mortgage securing a loan for $6,952,000. The loan bears interest at a rate of 6.90% per annum with monthly principal and interest payments of $68,000 and the balance due in January 2016. As of December 31, 2004, the aggregate carrying value of this Investment Property was $12,358,000. The outstanding principal balance as of December 31, 2004, was $6,665,000.
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The Company has acquired four Investment Properties subject to mortgages securing loans in the aggregate original principal balance of $7,214,000 (collectively the “Mortgages”) with the maturities between December 2007 and December 2009. In December 2004, the Company sold one of the properties and the related mortgage was simultaneously paid, which accounted for $2,455,000 of the original principal balance. The remaining Mortgages bear interest at a weighted average rate of 8.45% per annum and have a weighted average remaining maturity of 2.4 years, with an aggregate monthly payment of principal and interest of $60,000. In addition to the Mortgages, the company has letters of credit that also secure two of the loans, which collectively total $2,426,000. As of December 31, 2004, the outstanding principal balances secured by the Mortgages totaled $2,189,000, and the aggregate carrying value of the three Investment Properties and letters of credit totaled $10,751,000.
In July 2002, Services entered into a long-term, fixed rate loan for $2,340,000. The loan bore interest at a rate of 7.42% per annum with monthly principal and interest payments of $18,000 and the principal balance due in July 2012. The loan was secured by a first mortgage lien on one of Services’ properties. In August 2004, the Company disposed of the property, at which time the buyer assumed the loan.
Payments of principal on the mortgage debt and on advances outstanding under the Credit Facility are expected to be met from borrowings under the Credit Facility, proceeds from public or private offerings of the Company’s debt or equity securities, the Company’s secured or unsecured borrowings from banks or other lenders or proceeds from the sale of one or more of its properties.
Debt and Equity Securities. The Company has used, and expects to use in the future, issuances of debt and equity securities primarily to pay down its outstanding indebtedness and to finance investment acquisitions. The Company has maintained investment grade debt ratings from Standard and Poor’s, Moody’s Investor Service and Fitch IBCA on its senior, unsecured debt since 1998. In May 2003, the Company filed a shelf registration statement with the Securities and Exchange Commission, which permits the issuance by the Company of up to $600,000,000 in debt and equity securities; as of December 31, 2004, the Company had $259,167,000 available for issuance under this shelf registration statement.
The Company filed a prospectus supplement to its shelf registration for each issuance of notes outlined in the table below (dollars in thousands).
Each issuance of notes is redeemable at the option of the Company, in whole or in part, at a redemption price equal to the sum of (i) the principal amount of the notes being redeemed plus accrued interest
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thereon through the redemption date and (ii) the make-whole amount, as defined in the respective supplemental indenture notes.
In connection with the debt offerings, the Company incurred debt issuance costs totaling $4,193,000 consisting primarily of underwriting discounts and commissions, legal and accounting fees, rating agency fees and printing expenses. Debt issuance costs have been deferred and are being amortized over the term of the respective notes using the effective interest method.
In accordance with the terms of the indenture, pursuant to which the Company’s notes have been issued, the Company is required to meet certain restrictive financial covenants, which, among other things, require the Company to maintain (i) certain leverage ratios and (ii) certain interest coverage. At December 31, 2004, the Company was in compliance with those covenants. In the event that the Company violates any of the certain restrictive financial covenants, its access to the debt or equity markets may become impaired.
In November 2001, the Company entered into an unsecured $70,000,000 term note (“Term Note”), due November 30, 2004, to finance the acquisition of Captec Net Lease Realty, Inc. (“Captec”) and for the repayment of indebtedness and related expenses in connection therewith. As of December 31, 2003, the Term Note had an outstanding principal balance of $20,000,000. The Term Note bore interest at a rate of 175 basis points above LIBOR. In November 2004, the Company used proceeds from the Credit Facility to repay the obligation of the Term Note.
In December 2001, the Company issued 4,349,918 shares of common stock and 1,999,974 shares of Series A Preferred Stock in connection with the acquisition of Captec (see “Results of Operations – Merger Transactions”). Holders of the Series A Preferred Stock are entitled to receive, when and as authorized by the board of directors, cumulative preferential cash distributions at the rate of nine percent of the $25.00 liquidation preference per annum (equivalent to a fixed annual amount of $2.25 per share). The Series A Preferred Stock ranks senior to the Company’s common stock with respect to distribution rights and rights upon liquidation, dissolution or winding up of the Company. The Company may redeem the Series A Preferred Stock on or after December 31, 2006, in whole or from time to time in part, for cash, at a redemption price of $25.00 per share, plus all accumulated and unpaid distributions.
In 2002, as a result of the appraisal action arising out of the Captec merger (see “Results of Operations – Merger Transactions”), the Company reduced the number of common and Series A Preferred Stock shares issued and outstanding by 474,037 and 217,950, respectively. In 2003, the Company further reduced the number of common and Series A Preferred Stock shares issued and outstanding by 823 and 379, respectively. In 2004, the Company further reduced the number of common and Series A Preferred Stock shares issued and outstanding by 51 and 56, respectively. The reduction in shares represent the number of shares that would have been issued to the plaintiffs had they accepted the original merger consideration. As of December 31, 2002, the Company had recorded the value of these shares at the original consideration share price in addition to the cash portion of the original merger consideration as other liabilities totaling $13,278,000. In 2003, the Company used proceeds from its Credit Facility to fund the settlement of the appraisal action.
In May 2003, the Company filed a shelf registration statement with the Securities and Exchange Commission, which permits the issuance by the Company of up to $600,000,000 in debt and equity securities (which includes approximately $89,637,000 of unissued debt and equity securities under the Company’s previous shelf registration statement).
In July 2003, the Company filed a prospectus supplement to its shelf registration statement and issued 5,600,000 shares of common stock and received gross proceeds of $100,800,000. In connection with this offering, the Company incurred stock issuance costs totaling approximately $5,374,000, consisting primarily of underwriters’ commissions and fees, legal and accounting fees and printing expenses. Net proceeds from the offering were used to fund a portion of the acquisition of the DC Office Properties (see “Results of Operations – Property Analysis – Real Estate Held for Investment”).
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In August 2003, the Company filed a prospectus supplement to its shelf registration statement and issued 10,000 shares of Series B Convertible Preferred Stock and received gross proceeds of $25,000,000. In connection with this offering, the Company incurred stock issuance costs totaling approximately $687,000, consisting primarily of placement fees and legal and accounting fees. The Series B Convertible Preferred Stock is convertible at the option of the holder into 1,293,996 shares of the Company’s common stock on and after the first anniversary from the date on which the shares were issued. Holders of the Series B Convertible Preferred Stock are entitled to receive, when and as authorized by the board of directors, cumulative preferential cash distributions at the rate of 6.70 percent of the $2,500.00 liquidation preference per annum (equivalent to a fixed annual amount of $167.50 per share). The Series B Convertible Preferred Stock ranks pari passu with the Series A Preferred Stock and senior to the Company’s common stock with respect to distribution rights and rights upon liquidation, dissolution or winding up of the Company. The Company may redeem the Series B Convertible Preferred Stock on or after August 13, 2008, in whole or from time to time in part, for cash, at a redemption price of $2,500.00 per share, plus all accumulated and unpaid distributions. Net proceeds from the offering were used to pay down outstanding indebtedness of the Company’s Credit Facility.
In December 2003, the Company filed a prospectus supplement to its shelf registration statement and issued 3,250,000 shares of common stock and received gross proceeds of $56,517,000. In addition, the Company issued an additional 487,500 shares of common stock in connection with the underwriters’ over-allotment option and received gross proceeds of $8,478,000. In connection with these offerings, the Company incurred stock issuance costs totaling approximately $671,000, consisting primarily of underwriters’ commissions and fees, legal and accounting fees and printing expenses. Net proceeds from these offerings were used to pay down outstanding indebtedness of the Company’s Credit Facility.
Financing Lease Obligation. In July 2004, the Company sold five investment properties for approximately $26,041,000 and subsequently leased back the properties under a 10-year financing lease obligation. The Company may repurchase one or more of the properties subject to put and call options included in the financing lease. In accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 66, “Accounting for Sales of Real Estate,” the Company has recognized this as a financing transaction. The 10-year financing lease bears an interest rate of 5.00% annually with monthly interest payments of $109,000 and expires in June 2014 unless either the put or call option is exercised. The Company used the proceeds from two properties to reinvest in other Investment Properties and the remaining proceeds to pay down outstanding indebtedness of the Company’s Credit Facility.
Compensation Plan Equity Issuances. The Company believes that equity-based or equity-related compensation is an important element of overall compensation for the Company. Such compensation advances the interest of the Company by encouraging, and providing for, the acquisition of equity interests in the Company by directors, officers and other key associates, thereby aligning their interests with stockholders and providing them with a substantial motivation to enhance stockholder value.
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Pursuant to the Company’s 2000 Performance Incentive Plan, the Company has granted and issued shares of restricted stock to certain officers and directors of the Company. The following information is a summary of the restricted stock grants for the years ended December 31, 2004, 2003 and 2002:
During 2004 and 2003, the Company cancelled 29,926 and 5,950, respectively, shares of restricted stock.
Investments in Unconsolidated Affiliates. In September 1997, the Company entered into a partnership, Net Lease Institutional Realty, L.P. (the “Partnership”), with the Northern Trust Company, as Trustee of the Retirement Plan for the Chicago Transit Authority Employees (“CTA”). Under the terms of the limited partnership agreement of the Partnership, CTA had the right to convert its 80 percent limited partnership interest into shares of the Company’s common stock. In October 2003, CTA exercised that right, and, based on the terms of and calculation defined in the limited partnership agreement, the Company issued 953,551 shares of common stock to CTA in a private transaction in February 2004 in exchange for CTA’s 80 percent limited partnership interest, increasing the Company’s ownership in the Partnership to 100 percent. Prior to CTA’s exercise, the Company accounted for its 20 percent interest in the Partnership under the equity method of accounting. Net income and losses of the Partnership were allocated to the partners in accordance with their respective percentage interest in the Partnership’s term.
The Company has entered into five limited liability company (“LLC”) agreements (collectively, “CCMH LLCs”) with Orange Avenue Mortgage Investments, Inc. (“OAMI”), formerly known as CNL Commercial Finance, Inc. Each of the LLCs holds an interest in mortgage loans and is 100 percent equity financed. The Company holds a non-voting and non-controlling interest in each of the LLCs and accounts for its investment under the equity method of accounting. The following table summarizes each of the investments as of December 31, 2004:
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In 2003, in connection with a loan to OAMI, the Company pledged a portion of its interest in two of the LLC’s as partial collateral for the loan.
In May 2002, the Company purchased a combined 25 percent partnership interest for $750,000 in CNL Plaza, Ltd. and CNL Plaza Venture, Ltd. (collectively, “Plaza”), which owns a 346,000 square foot office building and an interest in an adjacent parking garage. Affiliates of James M. Seneff, Jr. and Robert A. Bourne, each members of the Company’s board of directors, own the remaining partnership interests. Since November 1999, the Company has leased its office space from Plaza. The Company’s lease expires in October 2014. In addition, the Company has severally guaranteed 41.67 percent of a $15,500,000 promissory note on behalf of Plaza. The maximum obligation of the Company is $6,458,000 plus interest. Interest accrues at a rate of LIBOR plus 200 basis points per annum on the unpaid principal amount. This guarantee shall continue through the loan maturity, which was extended from the original maturity of November 2004 to May 2005. Plaza intends to refinance the promissory note in 2005.
Results of Operations
Critical Accounting Policies and Estimates.
In response to the SEC’s Release Numbers 33-8040, “Cautionary Advice Regarding Disclosure About Critical Accounting Policies,” and 33-8056, “Commission Statement About Analysis of Financial Condition and Results of Operations,” the Company’s management has identified the following critical accounting policies that affect the more significant judgments and estimates used in the preparation of the Company’s consolidated financial statements. The preparation of the Company’s consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments on assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates and judgments. A summary of the Company’s accounting policies and procedures are included in Note 1 of the Company’s consolidated financial statements. Management believes the following critical accounting policies among others affect its more significant judgment of estimates used in the preparation of the Company’s consolidated financial statements.
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Real Estate Held for Investment and Lease Accounting. The Company records the acquisition of real estate at cost, including acquisition and closing costs. The cost of properties developed by the Company includes direct and indirect costs of construction, property taxes, interest and other miscellaneous costs incurred during the development period until the project is substantially complete and available for occupancy.
Real estate is generally leased to tenants on a net lease basis, whereby the tenant is responsible for all operating expenses relating to the property, including property taxes, insurance, maintenance and repairs. The leases are accounted for using either the operating or the direct financing method. Such methods are described below:
Operating method – Leases accounted for using the operating method are recorded at the cost of the real estate. Revenue is recognized as rentals are earned and expenses (including depreciation) are charged to operations as incurred. Buildings are depreciated on the straight-line method over their estimated useful lives (generally 35 to 40 years). Leasehold interests are amortized on the straight-line method over the terms of their respective leases. When scheduled rentals vary during the lease term, income is recognized on a straight-line basis so as to produce a constant periodic rent over the term of the lease. Accrued rental income is the aggregate difference between the scheduled rents which vary during the lease term and the income recognized on a straight-line basis.
Direct financing method – Leases accounted for using the direct financing method are recorded at their net investment (which at the inception of the lease generally represents the cost of the property). Unearned income is deferred and amortized into income over the lease terms so as to produce a constant periodic rate of return on the Company’s net investment in the leases.
The Company periodically assesses its real estate assets for possible impairment when certain events or changes in circumstances indicate that the carrying value of the asset, including any accrued rental income, may not be recoverable. Management considers current market conditions and tenant credit analysis in determining whether the recoverability of the carrying amount of an asset should be assessed. When an assessment is warranted, management determines whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the residual value of the real estate, with the carrying cost of the individual asset. If an impairment is indicated, a loss will be recorded for the amount by which the carrying value of the asset exceeds its fair value.
Intangible Assets. In connection with real estate acquisitions, value is assigned to tangible and other intangible assets. These other intangible assets are computed by valuing the property on an as-if-vacant basis and subtracting from the total acquisition cost the sum of the (i) as-if-vacant value, (ii) contractual to market value rent and (iii) value assigned to in-place leases. Deferred revenue or deferred assets recorded in connection with the contractual to market rent value for acquired properties are amortized into rental revenue over the life of the leases. The value assigned to in-place leases is amortized over the life of the leases.
Real Estate Held for Sale. Services acquires, develops and currently owns properties that it intends to sell. The properties that are classified as held for sale at any given time may consist of properties that have been acquired in the marketplace with the intent to resell the properties that have been, or are currently being, constructed by Services. Services’ records the acquisition of the real estate at cost, including the acquisition and closing costs. The cost of the real estate developed by Services includes direct and indirect costs of construction, interest and other miscellaneous costs incurred during the development period until the project is substantially complete and available for occupancy. The asset is not depreciated. In accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” Services classifies its real estate held for sale as discontinued operations when rental revenues are generated.
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When real estate held for sale is disposed of, the related costs are removed from the accounts and gains and losses from the dispositions are reflected in earnings.
Income Taxes. The Company has made an election to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and related regulations. The Company generally will not be subject to federal income taxes on amounts distributed to stockholders, providing it distributes at least 90 percent of its real estate investment trust taxable income and meets certain other requirements for qualifying as a REIT. For each of the years in the three-year period ended December 31, 2004, the Company believes it has qualified as a REIT. Not withstanding the Company’s qualification for taxation as a real estate investment trust, the Company is subject to certain state taxes on its income and real estate.
Effective January 1, 2001, Commercial Net Lease Realty, Inc. elected for Services to be treated as a TRS pursuant to the provisions of the REIT Modernization Act. As a TRS, Services is able to engage in activities resulting in income that previously would have been disqualified from being eligible REIT income under the federal income tax regulations. As a result, certain activities of the Company which occur within Services are therefore subject to federal and state income taxes. All provisions for federal income taxes in the accompanying consolidated financial statements are attributable to Services.
Income taxes are accounted for under the asset and liability method as required by SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recognized for the temporary differences based on estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Use of Estimates. Additional critical accounting policies of the Company include management’s estimates and assumptions relating to the reporting of assets and liabilities, revenues and expenses and the disclosure of contingent assets and liabilities to prepare the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Additional critical accounting policies include management’s estimates of the useful lives used in calculating depreciation expense relating to the Company’s real estate assets, the recoverability of the carrying value of long-lived assets, the collectibility of receivables from tenants, including accrued rental income, and capitalized overhead relating to development projects. Actual results could differ from those estimates.
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Property Analysis
Property Analysis – Real Estate Held for Investment
General. As of December 31, 2004, the Company owned 362 Investment Properties that are leased to established tenants, including Academy, Barnes & Noble, Best Buy, Borders, CVS, Eckerd, OfficeMax, The Sports Authority, United Rentals and the United States of America. Approximately 97 percent of the gross leaseable area of the Company’s portfolio of Investment Properties was leased at December 31, 2004. The following table summarizes the Company’s portfolio of Investment Properties as of December 31:
The Company regularly evaluates its (i) portfolio of Investment Properties, (ii) financial position, (iii) market opportunities and (iv) strategic objectives and, based on certain factors, may decide to acquire or dispose of a given property or portfolio of properties.
Property Acquisitions. Property acquisitions are typically funded using funds from the Company’s revolving credit facility, proceeds for debt or equity offerings and to a lesser extent, proceeds generated from like-kind exchange transactions. The following table summarizes the Investment Property acquisitions for each of the years ended December 31:
Construction projects:
Tenant improvements Number of Investment Properties
Total dollars invested
In August 2003, the Company acquired the DC Office Properties. Pursuant to the lease agreement, the Company has agreed to fund $27,322,000 for building and tenant improvements, of which $23,850,000 had been funded as of December 31, 2004. The Company anticipates funding the additional costs, which are anticipated to be substantially complete by June 30, 2005, from borrowings under the Company’s Credit Facility. The properties include two office buildings containing an aggregate of 555,000 rentable square feet and a two-level garage with approximately 1,000 parking spaces.
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Property Dispositions. The Company typically uses property sales proceeds to either (i) pay down the outstanding indebtedness of the Company’s Credit Facility or (ii) reinvest in real estate. The following table summarizes the properties held for investment sold by the Company for each of the years ended December 31:
Number of properties
During 2004 and 2003, the Company used the proceeds from the dispositions to pay down the outstanding indebtedness of the Company’s Credit Facility.
During 2002, the Company reinvested the proceeds from three of the investment properties sold to reinvest in additional Investment Properties and the proceeds from the sale of the remaining 16 investment properties to pay down the outstanding indebtedness of the Company’s Credit Facility.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company has classified its investment properties sold during the years ended December 31, 2004, 2003 and 2002, as discontinued operations. In addition, the Company has classified one leasehold interest that expired during the year ended December 31, 2004 as discontinued operations. All investment properties sold subsequent to December 31, 2001, the effective date of SFAS No. 144, have been reclassified to discontinued operations.
Property Analysis – Real Estate Held for Sale
General. The Company’s real estate held for sale is operated through Services, which directly and indirectly, through investment interests, acquires and develops real estate primarily for the purpose of selling the real estate to purchasers who are looking for replacement like-kind exchange property or to other purchasers with different investment objectives. The following summarizes the Company’s real estate held for sale as of December 31:
Number of properties held for sale:
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Property Acquisitions. Inventory Property acquisitions are typically funded using funds from the Company’s credit facility and proceeds from debt or equity offerings.
The following table summarizes the Inventory Property acquisitions for each of the years ended December 31:
Completed construction:
Total dollars invested in real estate held for sale
Property Dispositions. The following table summarizes the number of inventory properties sold and the corresponding gain recognized from the disposition of real estate held for sale included in earnings from continuing and discontinued operations for each of the years ended December 31 (dollars in thousands):
Continuing operations
Discontinued operations:
Minority interest
Total discontinued operations
During the years ended December 31, 2004, 2003 and 2002, the Company used the proceeds from the sale of the inventory properties to pay down the outstanding indebtedness of the Company’s Credit Facility.
Merger Transactions
In December 2001, the Company acquired 100 percent of Captec, a publicly traded real estate investment trust, which owned 135 freestanding, net lease properties located in 26 states. Captec shareholders received $11,839,000 in cash, 4,349,918 newly issued shares of the Company’s common stock and 1,999,974 newly issued Series A Preferred Stock (see “Capital Resources – Debt and Equity Securities”). Under the purchase method of accounting, the acquisition price of $124,722,000 was allocated to the assets acquired and liabilities assumed at their fair values. No goodwill was recorded in connection with the acquisition. The merger was unanimously approved by both the Company’s and Captec’s board of directors and Captec’s shareholders. This transaction increased funds from operations, increased diversification, produced cost savings from opportunities for economies of scale and operating efficiencies and enhanced the Company’s capital markets profile.
In January 2002, beneficial owners of shares of Captec stock held of record by Cede & Co. who alleged that they did not vote for the merger (and who alleged that they caused a written demand for appraisal of their Captec shares to be served on Captec), filed in the Chancery Court of the State of Delaware in and
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for New Castle County a Petition for Appraisal of Stock (“Appraisal Action”). The Appraisal Action alleged that 1,037,946 shares of Captec dissented from the merger and sought to require the Company to pay to all Captec stockholders who demanded appraisal of their shares the fair value of those shares, with interest from the date of the merger. As a result of this action, the plaintiffs were not entitled to receive the Company’s common and Series A Preferred Stock as offered in the original merger consideration. Accordingly, the Company reduced the number of common and Series A Preferred Stock shares issued and outstanding by 474,037 and 217,950, respectively, which represents the number of shares that would have been issued to the plaintiffs had they accepted the original merger consideration. In 2003, the Company further reduced the number of common and Series A Preferred Stock shares issued and outstanding by 823 and 379, respectively. In 2004, the Company further reduced the number of common and Series A Preferred Stock shares issued and outstanding by 51 and 56, respectively. As of December 31, 2002, the Company had recorded the value of these shares at the original consideration share price in addition to the cash portion of the original merger consideration as other liabilities totaling $13,278,000. In February 2003, the Company entered into a settlement agreement with the beneficial owners of the 1,037,946 dissenting shares (including the petitioners in the Appraisal Action) which required the Company to pay $15,569,000 which approximated the value of the original merger consideration (which included cash, common stock and Series A Preferred Stock shares) at the time of the litigation settlement plus the dividends that would have been paid if the shares had been issued at the time of the merger. The Company used proceeds from its Credit Facility to fund the settlement of the legal action. In February 2003, the parties filed a stipulation and order of dismissal and the Court entered the order of dismissal, dismissing the Appraisal Action with prejudice.
In January 2005, the Company entered into an agreement with National Properties Corporation (“NAPE”), which provided that NAPE would merge with and into a subsidiary of the Company. At the time of the merger agreement, NAPE owned 43 properties located in 12 states which were leased to 17 tenants. If the acquisition is consummated, the Company will issue approximately 1,637,000 shares of common stock to holders of NAPE common stock. Total consideration for the merger transaction is estimated to be approximately $61,000,000 based on the Company’s closing stock price on the date of the merger agreement. Completion of the merger is subject to customary closing conditions, including the approval of the holders of a majority of the outstanding shares of NAPE common stock. The Company has entered into a shareholders’ agreement with the holders of approximately 53 percent of the outstanding NAPE common stock whereby these holders have agreed to vote in favor of the merger. However, the Company may terminate the merger agreement if a majority of the NAPE shareholders who are not bound by the shareholders’ agreement do not approve the merger. The merger does not require approval by the Company’s shareholders. The Company anticipates that the merger will be completed not later than the second quarter of 2005.
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Revenue From Operations Analysis
General. During the year ended December 31, 2004, the Company’s rental income increased primarily due to the acquisition of DC Office Properties in August 2003 and other Investment Properties (See “Results of Operations – Property Analysis – Real Estate Held For Investment – Property Acquisitions”) and maintaining an occupancy rate of 97 percent at December 31, 2004 and 2003. The Company anticipates any significant increase in rental income will continue to come primarily from additional property acquisitions.
The following summarizes the Company’s revenues (dollars in thousands):
Revenue From Operations Analysis by Source of Income. The Company has identified two primary business segments, and thus, sources of revenue: (i) earnings from real estate held for investment and (ii) earnings from real estate held for sale. Breaking down revenues into the Company’s two primary operating segments of revenue shows that revenues are historically consistent. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and in assessing performance. The following table summarizes the revenues from continuing operations (dollars in thousands):
The Company evaluates its ability to pay dividends to stockholders by considering the combined effect of income from continuing and discontinued operations.
Comparison of Year Ended December 31, 2004 to Year Ended December 31, 2003. Rental Income increased 19.6 percent for the year ended December 31, 2004, as compared to the year ended December 31, 2003, primarily due to the addition of an aggregate gross leaseable area of 825,000 square feet to the Company’s portfolio resulting from the acquisition of 36 Investment Properties during the year ended December 31, 2004 and the addition of 24 Investment Properties with an aggregate gross leaseable area of 1,453,000 during the year ended December 31, 2003. However, this increase is partially offset by the investment property dispositions during the years ended December 31, 2004 and 2003.
Real estate expense reimbursements from tenants increased 14 percent for the year ended December 31, 2004, as compared to the year ended December 31, 2003, primarily due to the addition of properties that reimburse for expenses, see “Results of Operations – Property Analysis – Real Estate Held for Investment”.
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The gain on disposition of real estate held for sale included in continuing operations, increased 44.8 percent for the year ended December 31, 2004, as compared to the year ended December 31, 2003, primarily due to the increase in gross margin on sales of inventory properties. During the year ended December 31, 2004, the Company disposed of seven inventory properties and recognized a gain of $4,700,000 compared to three inventory properties for a $3,247,000 gain for the year ended December 31, 2003.
Interest and other income from real estate transactions increased 222.9 percent for the year ended December 31, 2004 as compared to the year ended December 31, 2003, primarily due to the interest earned on the $50,290,000 structured finance investments entered into since October 2003. However, this increase was partially offset by a decrease in development fees.
Comparison of Year Ended December 31, 2003 to Year Ended December 31, 2002. Rental Income increased 19.1 percent for the year ended December 31, 2003 due to a three percent increase in the Company’s Investment Property portfolio occupancy rate (97 percent at December 31, 2003 versus 94 percent at December 31, 2002) and the addition of 24 Investment Properties with an aggregate gross leaseable area of 1,453,000 square feet and the completed tenant improvements on nine Investment Properties. However, this increase is partially offset by the investment property dispositions during the years ended December 31, 2003 and 2002.
Real estate expense reimbursements from tenants increased 72.2 percent for the year ended December 31, 2003, as compared to the year ended December 31, 2002, primarily due to the addition of properties and the addition of real estate expenses reimbursed by tenants from the DC Office Properties, see “Property Analysis – Real Estate Held for Investment”.
The gain on disposition of real estate held for sale included in continuing operations, increased 151.6 percent, as compared to the year ended December 31, 2002, primarily due to the increase in gross margin on sales of inventory properties. During the year ended December 31, 2003, the Company disposed of three inventory properties and recognized a gain of $3,247,000 compared to four inventory properties for a $1,290,000 gain for the year ended December 31, 2002.
Interest and other income from real estate transactions increased 34.8 percent for the year ended December 31, 2003, compared to the year ended December 31, 2002. This increase was primarily attributable to (i) the $45,200,000 structured finance investment entered into in October 2003, and (ii) an increase in development fees. However, the increase was partially offset by a decrease in mortgage interest income.
Expense Analysis
General. During 2004 operating expenses increased primarily as a result of the acquisition of additional properties but remained generally proportionate to the Company’s total revenue. The following summarizes the Company’s expenses (dollars in thousands):
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Comparison of Year Ended December 31, 2004 to Year Ended December 31, 2003. In general, operating expenses increased 25.3 percent for the year ended December 31, 2004, over the year ended December 31, 2003, and increased as a percentage of total revenues by 0.1 percent to 43.3 percent.
General and administrative expenses increased 6.0 percent for the year ended December 31, 2004, but decreased as a percentage of total revenues by 3.1 percent to 17.8 percent. General and administrative expenses increased for the year ended December 31, 2004, primarily as a result of increases in expenses related to personnel. In addition, expenses related to professional services provided to the Company increased for the year ended December 31, 2004. For the year ended December 31, 2004, this increase is partially offset by a decrease in state taxes paid by the Company.
Real estate expenses increased 64.5 percent for the year ended December 31, 2004, and increased as a percentage of total revenues by 2.3 percent to 9.4 percent. Real estate expenses for the year ended December 31, 2004, increased primarily due to the August 2003 acquisition of the DC Office Properties. The DC Office Properties lease and the revenues related to such real estate expenses are included in real estate expense reimbursement from tenants. Real estate expenses related to the DC Office Properties were 59.6 and 51.3 percent, respectively, of total real estate expenses for the years ended December 31, 2004 and 2003, respectively. In addition, real estate expenses on vacant properties increased for the year ended December 31, 2004.
Depreciation and amortization expense increased 29.7 percent for the year ended December 31, 2004, and increased 0.5 percent to 13.3 percent of total revenues for the year ended December 31, 2004. The increase in depreciation and amortization expense for the year ended December 31, 2004, is primarily attributable (i) the depreciation on the acquisition of 36 additional Investment Properties and the tenant improvements on four Investment Properties since December 31, 2003, and (ii) the amortization of additional lease costs. The increase is partially offset by a decrease in the amortization of debt costs and the decrease in depreciation resulting from the disposition of 21 and 14 investment properties during each of the years ended December 31, 2004 and 2003, respectively.
During the year ended December 31, 2003, the Company recorded a dissenting shareholders’ settlement expense of $2,413,000 related to the lawsuit that arose as a result of the merger with Captec in December 2001. (See “Results of Operations – Merger Transactions”).
During the year ended December 31, 2004, the Company recorded transition costs of $3,741,000, including severance, accelerated vesting of restricted stock and recruitment costs in connection with the appointment of Craig Macnab as Chief Executive Officer in February 2004, and the resignation of Gary M. Ralston as President and Chief Operating Officer in May 2004.
Comparison of Year Ended December 31, 2003 to Year Ended December 31, 2002. Operating expenses increased 34.9 percent for the year ended December 31, 2003 over the year ended December 31, 2002, and increased as a percentage of total revenues by 3.8 percent to 43.2 percent.
General and administrative expenses increased 32.9 percent for the year ended December 31, 2003, and increased as a percentage of total revenues by 1.5 percent to 20.9 percent. General and administrative expenses increased for the year ended December 31, 2003 primarily as a result of (i) increases in expenses related to personnel costs, (ii) increases in expenses related to professional services provided to the Company, and (iii) increases in state taxes.
Real estate expenses increased 69.4 percent for the year ended December 31, 2003 primarily due to the August 2003 acquisition of the DC Office Properties, increasing as a percentage of total revenues by 1.9 percent to 7.1 percent. The DC Office Properties lease and the revenues related to such real estate expenses are included in real estate expense reimbursements from tenants. Real estate expenses related to the DC Office Properties were 51.3 percent of total real estate expenses for the year ended December 31,
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2003. The increase in real estate expenses was partially offset by an increase in the Company’s occupancy rate to 97 percent at December 31, 2003 from 94 percent at December 31, 2002.
Depreciation and amortization expense increased 21.9 percent for the year ended December 31, 2003, but decreased as a percentage of total revenues by 0.1 percent to 12.8 percent for the year ended December 31, 2003. The increase in depreciation and amortization expense for the year ended December 31, 2003 is primarily attributable to (i) the depreciation on acquisition of and tenant improvements on additional Investment Properties in 2003, (ii) the amortization of loan costs related to the amended Credit Facility and the Term Note, and (iii) the amortization of additional lease costs.
The Company recorded no loss on impairment of real estate during 2003. The Company recorded a provision for loss on impairment of real estate of $1,613,000 and $1,672,000 in continuing operations and discontinued operations, respectively, in the year ended December 31, 2002. The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Generally, the Company makes a provision for impairment loss if estimated future operating cash flows plus estimated disposition proceeds are less than the current book value. Impairment losses are measured as the amount by which the current book value of the asset exceeds the estimated fair value of the asset.
During the year ended December 31, 2003, the Company recorded a dissenting shareholders’ settlement expense of $2,413,000 related to the Appraisal Action that arose as a result of the merger with Captec in December 2001. (See “Results of Operations – Merger Transactions”).
Analysis of Other Expenses and Revenues
General. During the year ended December 31, 2004, interest and other income and interest expense increased with the acquisition of additional properties but remained generally proportionate to the Company’s total revenue and expenses. The following summarizes the Company’s other expenses (revenues) from continuing operations (dollars in thousands):
Comparison of Year Ended December 31, 2004 to Year Ended December 31, 2003. In general, other expenses (revenues) increased 22.5 percent for the year ended December 31, 2004, over the year ended December 31, 2003, but decreased as a percentage of total revenues by 0.4 percent to 22.2 percent.
Interest expense increased 21.3 percent for the year ended December 31, 2004, but decreased as a percentage of total revenues by 0.7 percent to 25.1 percent for the year ended December 31, 2004. The increase in interest expense for the year ended December 31, 2004, was primarily attributable to an increase in the long-term fixed rate average debt outstanding of $475,802,000 as of December 31, 2004, including the addition of the $95,000,000 fixed rate mortgage loan entered into in November 2003. However, the increase in interest expense was partially offset by a lower average debt outstanding of $39,869,000 as of December 31, 2004 on the Company’s short-term variable interest rate debt.
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Comparison of Year Ended December 31, 2003 to Year Ended December 31, 2002. In general, other expenses (revenues) increased 10.0 percent for the year ended December 31, 2003, over the year ended December 31, 2002, but decreased as a percentage of total revenues by 2.7 percent to 22.6 percent.
Interest and other income decreased 14.0 percent for the year ended December 31, 2003, and decreased as a percentage of total revenues by 1.3 percent to 3.2 percent. Interest and other income decreased for the year ended December 31, 2003, primarily as a result of a decrease of interest earned on a note receivable and a related party line of credit.
Interest expense increased 6.3 percent for the year ended December 31, 2003, but decreased as a percentage of total revenues by 4.2 percent to 25.8 percent for the year ended December 31, 2003. The increase in interest expense for the year ended December 31, 2003, was primarily as a result of refinancing a portion of the Company’s Credit Facility and Term Note to long-term fixed rate debt, including the 2012 Notes and the $21,000,000 fixed rate mortgage loan, both entered into in June 2002 and the addition of the $95,000,000 fixed rate mortgage loan entered into in November 2003, as a means to reduce floating interest rate risk. However, the increase in interest expense was partially offset by a decrease in the average interest rates on the Company’s variable interest rate debt.
Unconsolidated Affiliates
For details on each of the Company’s unconsolidated affiliates, see “Capital Resources – Investments in Unconsolidated Affiliates.”
During the years ended December 31, 2004, 2003 and 2002, the Company recognized equity in earnings of unconsolidated affiliates of $4,724,000, $4,341,000 and $1,800,000, respectively. The increase in equity in earnings of unconsolidated affiliates was primarily attributable to the income earned on investments in mortgage loans.
Earnings from Discontinued Operations
The Company has recorded discontinued operations by the defined Company segments: (i) real estate held for investment and (ii) real estate held for sale. As a result, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company classified the revenues and expenses related to its investment properties that were sold and expired leasehold interests subsequent to December 31, 2001, as discontinued operations. The Company also classified the revenues and expenses of its held for sale properties that were sold and generated rental revenues as discontinued operations. In addition, the Company also classified the revenues and expenses related to its 21 Inventory Properties held for sale as of December 31, 2004, as discontinued operations.
During the years ended December 31, 2004, 2003 and 2002, the Company recognized earnings from discontinued operations of (dollars in thousands):
Real estate, held for investment(1)
(1)2004 includes one expired leasehold interest.
The Company occasionally sells investment properties and may reinvest the proceeds of the sales to purchase new properties. The Company evaluates its ability to pay dividends to stockholders by considering the combined effect of income from continuing and discontinued operations.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to interest changes primarily as a result of its variable rate Credit Facility and its long-term, fixed rate debt used to finance the Company’s development and acquisition activities and for general corporate purposes. The Company’s interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs. To achieve its objectives, the Company borrows at both fixed and variable rates on its long-term debt.
The Company entered into a forward starting interest rate swap in February 2004 and terminated the swap effective June 2004 for a swap gain of $4,148,000. The Company had no outstanding derivatives as of December 31, 2004 and 2003.
The information in the table below summarizes the Company’s market risks associated with its debt obligations outstanding as of December 31, 2004 and 2003. The table presents principal cash flows and related interest rates by year of expected maturity for debt obligations outstanding as of December 31, 2004. The variable interest rates shown represent the weighted average rates for the Credit Facility and Term Note at the end of the periods. As the table incorporates only those exposures that exist as of December 31, 2004, it does not consider those exposures or positions which could arise after those dates. Moreover, because firm commitments are not presented in the table below, the information presented therein has limited predictive value. As a result, the Company’s ultimate realized gain or loss with respect to interest rate fluctuations will depend on the exposures that arise during the period, the Company’s hedging strategies at that time and interest rates.
Total
Fair Value:
December 31, 2003
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Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
The Board of Directors and StockholdersCommercial Net Lease Realty, Inc. and Subsidiaries:
We have audited the accompanying consolidated balance sheets of Commercial Net Lease Realty, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules III and IV. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Commercial Net Lease Realty, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Effective January 1, 2004, the Company implemented Financial Accounting Standards Board Interpretation No. 46, revised December 2003, “Consolidation of Variable Interest Entities” (FIN 46R) and has restated all prior period consolidated financial statements to reflect its adoption.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Commercial Net Lease Realty, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 9, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
Orlando, FloridaMarch 9, 2005
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We have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting, that Commercial Net Lease Realty, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Commercial Net Lease Realty, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Commercial Net Lease Realty, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Commercial Net Lease Realty, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Commercial Net Lease Realty, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2004, and the related financial statement schedules III and IV and our report dated March 9, 2005 expressed an unqualified opinion on those consolidated financial statements and the related financial statement schedules III and IV.
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COMMERCIAL NET LEASE REALTY, INC.and SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS(dollars in thousands, except per share data)
Real estate, held for investment:
LIABILITIES AND STOCKHOLDERS’ EQUITY
Line of credit payable
Stockholders’ equity:
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF EARNINGS(dollars in thousands, except per share data)
Revenues:
Operating expenses:
Other expenses (revenues):
Earnings from continuing operations before provision for income taxes, minority interest and equity in earnings of unconsolidated affiliates
Provision for income taxes
Earnings from continuing operations before minority interest and equity in earnings of unconsolidated affiliates
Earnings from continuing operations before equity in earnings of unconsolidated affiliates
Equity in earnings of unconsolidated affiliates
Earnings from continuing operations
Earnings from discontinued operations:
Net earnings
CONSOLIDATED STATEMENTS OF EARNINGS – CONTINUED(dollars in thousands, except per share data)
Net earnings per share of common stock:
Diluted:
Weighted average number of common shares outstanding:
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYYears Ended December 31, 2004, 2003 and 2002(dollars in thousands, except per share data)
Balance at December 21, 2001
Balances at December 31, 2003
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY - CONTINUEDYears Ended December 31, 2004, 2003 and 2002(dollars in thousands, except per share data)
CONSOLIDATED STATEMENTS OF CASH FLOWS(dollars in thousands)
Cash flows from operating activities:
Cash flows from investing activities:
CONSOLIDATED STATEMENTS OF CASH FLOWS – CONTINUED(dollars in thousands)
Cash flows from financing activities:
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
Supplemental disclosure of cash flow information – interest paid, net of amount capitalized
Supplemental disclosure of non-cash investing and financing activities:
CONSOLIDATED QUARTERLY FINANCIAL DATA(unaudited)(dollars in thousands, except for per share data)
Gross revenues
2003
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSYears Ended December 31, 2004, 2003 and 2002
51
accounting to investments in partnerships and joint ventures that are not subject to control by the Company due to the significance of rights held by other parties.
The Company holds a variable interest in, but is not the primary beneficiary of, CNL Plaza Ltd., a variable interest entity. The Company’s maximum exposure to loss as a result of its involvement with CNL Plaza Ltd. as of December 31, 2004, is $6,076,000. As of December 31, 2004, CNL Plaza, Ltd. had total assets and liabilities of $58,913,000 and $62,473,000, respectively.
A wholly-owned subsidiary of Services, CNLRS Equity Ventures, Inc. (“Equity Ventures”), develops real estate through various joint venture development affiliate agreements. Equity Ventures consolidates the joint venture development entities listed in the table below, eliminating significant intercompany balances and transactions and recording a minority interest for its other partners’ ownership percentage. The following table summarizes each of the investments as of December 31, 2004:
Real Estate Held for Investment – The Company records the acquisition of real estate at cost, including acquisition and closing costs. The cost of properties developed by the Company includes direct and indirect costs of construction, property taxes, interest and other miscellaneous costs incurred during the development period until the project is substantially complete and available for occupancy.
Direct financing method – Leases accounted for using the direct financing method are recorded at their net investment (which at the inception of the lease generally represents the
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cost of the property). Unearned income is deferred and amortized into income over the lease terms so as to produce a constant periodic rate of return on the Company’s net investment in the leases.
When real estate is disposed of, the related cost, accumulated depreciation or amortization and any accrued rental income for operating leases and the net investment for direct financing leases are removed from the accounts and gains and losses from the dispositions are reflected in income. Gains from disposition of real estate are generally recognized using the full accrual method in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 66 “Accounting for Real Estate Sales,” provided that various criteria relating to the terms of the sale and any subsequent involvement by the Company with the real estate sold are met. Lease termination fees are recognized when the related leases are cancelled and the Company no longer has a continuing obligation to provide services to the former tenants.
Management reviews its real estate for impairment whenever events or changes in circumstances indicate that the carrying value of the asset, including accrued rental income, may not be recoverable through operations. Management determines whether an impairment in value has occurred by comparing the estimated future cash flows (undiscounted and without interest charges), including the residual value of the real estate, with the carrying cost of the individual asset. If an impairment is indicated, a loss will be recorded for the amount by which the carrying value of the asset exceeds its fair value.
Purchase Accounting for Acquisition of Real Estate – For purchases of real estate that were consummated subsequent to June 30, 2001, the effective date of SFAS No. 141, “Business Combinations,” the fair value of the real estate acquired is allocated to the acquired tangible assets, consisting of land, building and tenant improvements, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, other value of in-place leases and value of tenant relationships, based in each case on their relative fair values.
The fair value of the tangible assets of an acquired property is determined by valuing the property as if it were vacant, and the “as-if-vacant” value is then allocated to land, building and tenant improvements based on the determination of the relative fair values of these assets. Management uses the as-if-vacant fair value of a property provided by a qualified appraiser.
In allocating the fair value of the identified intangible assets and liabilities of an acquired property, above-market and below-market in-place lease values are recorded as other assets based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. The capitalized below-market lease values are amortized as an increase to rental income over the initial term and any fixed rate renewal periods in the respective leases. The Company’s leases do not currently include fixed-rate renewal periods.
The aggregate value of other acquired intangible assets, consisting of in-place leases, is measured by the excess of (i) the purchase price paid for a property after adjusting existing in-place leases to market rental rates over (ii) the estimated fair value of the property as-if-vacant, determined as set forth above. The value of in-place leases exclusive of the value of above-market and below-market in-place leases is amortized to expense over the remaining non-cancelable periods of the respective leases. If a lease were to be terminated prior to its stated expiration, all unamortized amounts relating to that lease would be written off.
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Real Estate Held for Sale – Services acquires, develops and currently owns properties that it intends to sell. The properties that are classified as held for sale at any given time may consist of properties that have been acquired in the marketplace with the intent to resell the properties that have been, or are currently being, constructed by Services. Services’ records the acquisition of the real estate at cost, including the acquisition and closing costs. The cost of the real estate developed by Services includes direct and indirect costs of construction, interest and other miscellaneous costs incurred during the development period until the project is substantially complete and available for occupancy. The asset is not depreciated. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” Services classifies its real estate held for sale as discontinued operations for each property in which rental revenues are generated (see Note 3). When real estate held for sale is disposed of, the related costs are removed from the accounts and gains and losses from the dispositions are reflected in earnings.
Investment in Unconsolidated Affiliates – The Company accounts for each of its investments in unconsolidated affiliates under the equity method of accounting (see Note 4). The Company exercises influence over these unconsolidated affiliates, but does not control them.
Cash and Cash Equivalents – The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents consist of cash and money market accounts. Cash equivalents are stated at cost plus accrued interest, which approximates fair value.
Cash accounts maintained on behalf of the Company in demand deposits at commercial banks and money market funds may exceed federally insured levels; however, the Company has not experienced any losses in such accounts. The Company limits investment of temporary cash investments to financial institutions with high credit standing; therefore, management believes it is not exposed to any significant credit risk on cash and cash equivalents.
Debt Costs – Debt costs incurred in connection with the Company’s $225,000,000 line of credit and mortgages payable have been deferred and are being amortized over the term of the respective loan commitment using the straight-line method which approximates the effective interest method. Debt costs incurred in connection with the term note payable, which matured in November 2004, were amortized over the term using the straight-line method which approximated the effective interest rate. Debt costs incurred in connection with the issuance of the Company’s notes payable have been deferred and are being amortized over the term of the respective debt obligation using the effective interest method.
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Earnings Per Share – Basic net earnings per share is computed by dividing net earnings available to common stockholders by the weighted average number of common shares outstanding during each period. Diluted net earnings per common share is computed by dividing net earnings available to common stockholders for the period by the number of common shares that would have been outstanding assuming the issuance of common shares for all potentially dilutive common shares outstanding during the periods.
The following is a reconciliation of the denominator of the basic net earnings per common share computation to the denominator of the diluted net earnings per common share computation for each of the years ended December 31:
Weighted average number of common shares outstanding
The following represents the number of shares of potentially issuable common stock which were not included in computing diluted earnings per common share because their effects were antidilutive:
Stock-Based Compensation – At December 31, 2004, the Company had one stock-based compensation plan, which is described more fully in Note 19. Prior to 2003, the Company accounted for the plan under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. No stock-based compensation costs are reflected in 2002 net earnings, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock at the date of grant. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” prospectively to all employee and director awards granted, modified, or settled after January 1, 2003. Therefore, the cost related to stock-based employee compensation included in the determination of net earnings for 2004 and 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123.
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The following table illustrates the effect on net earnings available to common stockholders and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period (dollars in thousands, except per share data):
Net earnings available to common stockholders – basic, as reported:
Net earnings available to common stockholders – diluted, as reported:
Earnings available to common stockholders per common share as reported:
Pro forma earnings available to common stockholders per common share:
There were no options granted in 2004. The fair value of each option grant in 2003 and 2002 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: (i) risk free rate of 5.5% for the 2003 grant and 5.4% and 5.5% for the 2002 grants, (ii) expected volatility of 18.0% and 18.0%, respectively, (iii) dividend yields of 9.3% and 9.3%, respectively, and (iv) expected lives of 10 years for each of the 2003 and 2002 grants.
Income Taxes – The Company has made an election to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and related regulations. The Company generally will not be subject to federal income taxes on amounts distributed to stockholders, providing it distributes at least 90 percent of its real estate investment trust taxable income and meets certain other requirements for qualifying as a REIT. For each of the years in the three-year period ended December 31, 2004, the Company believes it has qualified as a REIT. Not withstanding the Company’s qualification for taxation as a real estate investment trust, the Company is subject to certain state taxes on its income and real estate.
Effective January 1, 2001, Commercial Net Lease Realty, Inc. elected for Services to be treated as a TRS pursuant to the provisions of the REIT Modernization Act. As a TRS, Services is able to engage in activities resulting in income that previously would have been disqualified from being eligible REIT income under the federal income tax regulations. As a result, certain activities of the Company which occur within Services are subject to federal and state income taxes (See “Real Estate Held for Sale”). All provisions for federal income taxes in the accompanying consolidated financial statements are attributable to Services.
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contingent rentals and/or scheduled rent increases over the terms of the leases. Generally, the tenant is also required to pay all property taxes and assessments, substantially maintain the interior and exterior of the building and carry property and liability insurance coverage. Certain of the Company’s Investment Properties are subject to leases under which the Company retains responsibility for certain costs and expenses of the property. As of December 31, 2004, the weighted average remaining lease term was approximately 10 years. Generally, the leases of the Investment Properties provide the tenant with one or more multi-year renewal options subject to generally the same terms and conditions as the initial lease.
Accounted for Using the Operating Method – Real estate subject to operating leases consisted of the following as of December 31 (dollars in thousands):
Land and improvements
In August 2003, the Company acquired two office buildings and a related parking garage located in the Washington, D.C. metropolitan area (“DC Office Properties”) for $142,800,000. In addition, pursuant to the lease agreement, the Company has agreed to fund an additional $27,322,000 for building and tenant improvements, of which $23,850,000 had been funded as of December 31, 2004. The Company anticipates the remaining building and improvements to be substantially completed and funded by June 30, 2005.
Some leases provide for scheduled rent increases throughout the lease term. Such amounts are recognized on a straight-line basis over the terms of the leases. For the years ended December 31, 2004, 2003 and 2002, the Company recognized collectively in continuing and discontinued operations, $3,452,000, $6,756,000 and $3,223,000, respectively, of such income. At December 31, 2004 and 2003, the balance of accrued rental income, net of allowances of $1,620,000 and $1,320,000, respectively, was $28,619,000 and $25,322,000, respectively.
The following is a schedule of future minimum lease payments to be received on noncancellable operating leases at December 31, 2004 (dollars in thousands):
Since lease renewal periods are exercisable at the option of the tenant, the above table only presents future minimum lease payments due during the initial lease terms. In addition, this table does not include amounts for potential variable rent increases that are based on the Consumer Price Index (“CPI”) or future contingent rents which may be received on the leases based on a percentage of the tenant’s gross sales.
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Accounted for Using the Direct Financing Method – The following lists the components of net investment in direct financing leases at December 31 (dollars in thousands):
Minimum lease payments to be received
The following is a schedule of future minimum lease payments to be received on direct financing leases at December 31, 2004 (dollars in thousands):
Inventory:
Under construction:
In connection with the development of seven Inventory Properties by Services, the Company has agreed to fund construction commitments of $26,409,000, of which $12,248,000 has been funded as of December 31, 2004.
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The following table summarizes the number of inventory properties sold and the corresponding gain recognized on the disposition of real estate held for sale included in earnings from continuing and discontinued operations for the years ended December 31 (dollars in thousands):
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During the years ended December 31, 2004 and 2003, the Company received $10,562,000 and $4,211,000, respectively, in distributions from the CCMH LLC’s. In 2003, in connection with a loan to OAMI, the Company pledged a portion of its interest in two of the LLC’s as partial collateral for the loan.
The following presents the combined condensed financial information of the CCMH LLCs (dollars in thousands):
Mortgage assets
Total liabilities
Revenues/net earnings
For the years ended December 31, 2004, 2003 and 2002, the Company recognized earnings of $5,042,000, $4,583,000 and $2,445,000, respectively, from the CCMH LLCs.
In May 2002, the Company purchased a combined 25 percent partnership interest in CNL Plaza, Ltd. and CNL Plaza Venture, Ltd. (collectively, “Plaza”) for $750,000. The remaining partnership interests in Plaza are owned by affiliates of James M. Seneff, Jr. and Robert A. Bourne, both members of the Company’s board of directors. Plaza owns a 346,000 square foot office building and an interest in an adjacent parking garage. The Company has severally guaranteed 41.67 percent of a $15,500,000 unsecured promissory note on behalf of Plaza. The maximum obligation of the Company under this guarantee is $6,458,000, plus interest. Interest accrues at a rate of LIBOR plus 200 basis points per annum on the unpaid principal amount. This guarantee shall continue through the loan maturity, which was extended from the original maturity of November 2004 to May 2005. The fair value of the Company’s guarantee is $73,000. During the years ended December 31, 2004, 2003 and 2002 the Company received $446,000, $372,000 and $411,000, respectively, in distributions from Plaza. For the years ended December 31, 2004, 2003 and 2002, the Company recognized a loss from Plaza of $276,000, $306,000 and $159,000, respectively.
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Since November 1999, the Company has leased its office space from Plaza. The Company’s lease expires in October 2014. In addition, other affiliates of James M. Seneff, Jr. also lease office space from Plaza. The Company and other affiliates lease an aggregate of 66 percent of the 346,000 square foot office building. During the years ended December 31, 2004, 2003 and 2002, the Company incurred rental expenses in connection with the lease of $1,018,000, $1,001,000 and $1,222,000, respectively. In May 2000, the Company subleased a portion of its office space to affiliates of James M. Seneff, Jr. During the years ended December 31, 2004, 2003 and 2002, the Company earned $345,000, $338,000 and $270,000, respectively, in rental and accrued rental income from these affiliates.
The following is a schedule of the Company’s future minimum lease payments and the future minimum sublease income from the affiliates related to the office space leased from Plaza at December 31, 2004 (dollars in thousands):
2005
Since lease renewal periods are exercisable at the option of the tenant, the above table only presents future minimum lease payments due during the initial lease terms. The Company has the option to renew its lease with Plaza for three successive five-year periods subject to similar terms and conditions as the initial lease.
In 1999, a wholly-owned subsidiary of the Company entered into a membership arrangement, WXI/SMC Real Estate LLC (“WXI”), with Whitehall Street Real Estate Limited Partnership XI. The Company is the sole managing member and holds a 33 1/3 percent interest in WXI. WXI was organized for the purpose of owning, developing, redeveloping, operating, leasing and selling a portfolio of real estate. The Company accounts for its interest under the equity method of accounting. During the years ended December 31, 2004, 2003, and 2002, the Company recognized a loss of $68,000, 570,000, and $1,438,000, respectively. The Company provides certain management services for WXI on behalf of Services pursuant to WXI’s Limited Liability Company Agreement and Property Management and Development Agreement. WXI paid the Company $14,000, $52,000 and $86,000 in fees during the years ended December 31, 2004, 2003 and 2002, respectively.
The following presents a reconciliation of investments in and receivables from unconsolidated affiliates at December 31 (dollars in thousands):
CCMH LLCs investments
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The following presents a reconciliation of equity in earnings of unconsolidated affiliates for the years ended December 31 (dollars in thousands):
CCMH LLCs
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In November 2003, the Company entered into a long-term, fixed rate interest-only loan for $95,000,000. The loan bears interest at a rate of 5.42% per annum with monthly interest payments of $435,000 and the principal balance due in November 2013. The loan is secured by a first mortgage lien on the DC Office Properties. As of December 31, 2004, the aggregate carrying value of these properties totaled $155,601,000. As of December 31, 2004 and 2003, the outstanding principal balance was $95,000,000.
In February 2004, the Company acquired a property subject to a mortgage securing a loan for $6,952,000. The loan bears interest at a rate of 6.90% per annum with monthly principal and interest payments of $68,000 and the balance due in January 2017. As of December 31, 2004, the aggregate carrying value of the property was $12,358,000. The outstanding principal balance as of December 31, 2004, was $6,665,000.
In December 2004, the Company acquired a property subject to a mortgage securing loan for $408,000. The loan bears interest at a rate of 9.375% per annum with monthly principal and interest payments of $5,000 and the balance due in September 2014. As of December 31, 2004, the aggregate carrying value of this property was $697,000. The outstanding principal balance as of December 31, 2004, was $406,000.
The following is a schedule of the annual maturities of the Company’s mortgages payable (dollars in thousands):
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Ordinary income
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The components of the net income tax asset (liability) consist of the following at December 31 (dollars in thousands):
In assessing the ability to realize a deferred tax asset, management considers whether it is more likely than not that some portion or all of the deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize all of the benefits of these deductible differences that existed as of December 31, 2004.
The income tax (expense) benefit has been allocated to earnings (loss) from continuing operations and to earnings (loss) from discontinued operations for the years ended December 31, 2004, 2003 and 2002. The income tax (expense) benefit consists of the following components for the years ended December 31, 2004, 2003 and 2002 (dollars in thousands):
Net loss from continuing operations of Services before income taxes
Net earnings from discontinued operations of Services before income taxes
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Earnings before gain on disposition of real estate
Gain on disposition of real estate, net of losses on disposition of $544,000, $969,000 and $1,806,000, respectively
Earnings from discontinued operations from real estate held for investment
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Earnings before provision for income taxes and minority interest
Earnings from discontinued operations from real estate held for sale
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
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Item 9A. Controls and Procedures
Process for Assessment and Evaluation of Disclosure Controls and Procedures and Internal Control over Financing Reporting.
The Company carried out an assessment as of December 31, 2004 of the effectiveness of the design and operation of its disclosure controls and procedures and its internal control over financial reporting. This assessment was done under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Rules adopted by the Commission require the Company to present the conclusions of the Chief Executive Officer and Chief Financial Officer about the effectiveness of the Company’s disclosure controls and procedures and the conclusions of the Company’s management about the effectiveness of the Company’s internal control over financial reporting as of the end of the period covered by this annual report.
CEO and CFO Certifications. Included as Exhibits 31.1 and 31.2 to this Annual Report on Form 10-K are forms of “Certification” of the Company’s Chief Executive Officer and Chief Financial Officer. The forms of Certification are required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the Annual Report on Form 10-K that you are currently reading is the information concerning the assessment referred to in the Section 302 certifications and this information should be read in conjunction with the Section 302 certifications for a more complete understanding of the topics presented.
Disclosure Controls and Procedures and Internal Control over Financial Reporting. Disclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act, such as this Annual Report on Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Internal control over financial reporting is a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer, and affected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles (“GAAP”) and includes those policies and procedures that:
Scope of the Assessments. The assessment by the Company’s Chief Executive Officer and Chief Financial Officer of the Company’s disclosure controls and procedures and the assessment by the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the Company’s internal control over financial reporting included a review of procedures and discussions with the Company’s management and others at the Company. In the course of the assessments, the Company
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sought to identify data errors, control problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken.
The Company’s internal control over financial reporting is also assessed on an ongoing basis by personnel in the Company’s Accounting department and by the Company’s internal auditors in connection with their internal audit activities. The overall goals of these various assessment activities are to monitor the Company’s disclosure controls and procedures and the Company’s internal control over financial reporting and to make modifications as necessary. The Company’s intent in this regard is that the disclosure controls and procedures and the internal control over financial reporting will be maintained and updated (including with improvements and corrections) as conditions warrant. Among other matters, management sought in its assessment to determine whether there were any “significant deficiencies” or “material weaknesses” in the Company’s internal control over financial reporting, or whether management had identified any acts of fraud involving personnel who have a significant role in the Company’s internal control over financial reporting. In the Public Company Accounting Oversight Board’s Auditing Standard No. 2, a “significant deficiency” is a “control deficiency,” or a combination of control deficiencies, that adversely affects the ability to initiate, authorize, record, process or report external financial data reliably in accordance with GAAP such that there is more than a remote likelihood that a misstatement of the annual or interim financial statements that is more than inconsequential will not be prevented or detected. A “control deficiency” exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. A “material weakness” is defined in Auditing Standard No. 2 as a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management also sought to deal with other control matters in the assessment, and in each case if a problem was identified, management considered what revision, improvement and/or correction was necessary to be made in accordance with the Company’s on-going procedures. The assessments of the Company’s disclosure controls and procedures and the Company’s internal control over financial reporting is done on a quarterly basis so that the conclusions concerning effectiveness of those controls can be reported in the Company’s Quarterly Reports on Form 10-Q and Annual Report on Form 10-K.
Assessment of Effectiveness of Disclosure Controls and Procedures.
Based upon the assessments, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2004, the Company’s disclosure controls and procedures were effective.
Management’s Report on Internal Control Over Financial Reporting.
Management, including the Company’s Chief Executive Officer and Chief Financial Officer, are responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Management used the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control — Integrated Framework to assess the effectiveness of the Company’s internal control over financial reporting. Based upon the assessments, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2004, the Company’s internal control over financial reporting was effective. The Company’s independent registered public accounting firm has audited the consolidated financial statements in this Annual Report on Form 10-K and have issued an attestation report on management’s assessment of the Company’s internal control over financial reporting and its opinion on the effectiveness of internal control over financial reporting, which appears on page 42 of this Annual Report on Form 10-K.
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Changes in Internal Control Over Financial Reporting.
During the three months ended December 31, 2004, there were no changes in the Company’s internal control over financial reporting that has materially affected, or are reasonably likely to materially affect, the Company’s internal control for financial reporting.
Limitations on the Effectiveness of Controls.
Management, including the Company’s Chief Executive Officer and Chief Financial Officer, do not expect that the Company’s disclosure controls and procedures or the Company’s internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system 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, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of 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’s 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; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
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Item 9B. Other Information.
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PART III
Item 10. Directors and Executive Officers of the Registrant
Reference is made to the Registrant’s definitive proxy statement to be filed with the Commission pursuant to Regulation 14(a); information responsive to this Item is contained in the sections thereof captioned “Proposal I: Election of Directors — Nominees,” “Proposal I: Election of Directors — Executive Officers,” “Proposal I: Election of Directors — Code of Business Conduct” and “Security Ownership,” and the information in such sections is incorporated herein by reference.
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Item 11. Executive Compensation
Reference is made to the Registrant’s definitive proxy statement to be filed with the Commission pursuant to Regulation 14(a); information responsive to this Item is contained in the section thereof captioned “Proposal I: Election of Directors — Compensation of Directors,” “Executive Compensation,” “Compensation Committee Report” and “Performance Graph,” and the information in such sections is incorporated herein by reference.
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Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Reference is made to the Registrant’s definitive proxy statement to be filed with the Commission pursuant to Regulation 14(a); information responsive to this Item is contained in the section thereof captioned “Executive Compensation — Equity Compensation Plan Information,” “Security Ownership,” and the information in such section is incorporated herein by reference.
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Item 13. Certain Relationships and Related Transactions
Reference is made to the Registrant’s definitive proxy statement to be filed with the Commission pursuant to Regulation 14(a); information responsive to this Item is contained in the section thereof captioned “Certain Transactions,” and the information in such section is incorporated herein by reference.
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Item 14. Principal Accounting Fees and Services
Reference is made to the Registrant’s definitive proxy statement to be filed with the Commission pursuant to Regulation 14(a); information responsive to this Item is contained in the section thereof captioned “Audit Committee Report,” and the information in such section is incorporated herein by reference.
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PART IV
Item 15. Exhibits and Financial Statement Schedules
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 14th day of March, 2005.
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Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Each person whose signature appears below hereby constitutes and appoints each of Craig Macnab and Kevin B. Habicht as his attorney-in-fact and agent, with full power of substitution and resubstitution for him in any and all capacities, to sign any or all amendments to this report and to file same, with exhibits thereto and other documents in connection therewith, granting unto such attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary in connection with such matters and hereby ratifying and confirming all that such attorney-in-fact and agent or his substitutes may do or cause to be done by virtue hereof.
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COMMERCIAL NET LEASE REALTY, INC. AND SUBSIDIARIESSCHEDULE III – REAL ESTATE AND ACCUMULATED DEPRECIATION AND AMORTIZATION
See accompanying report of independent registered public accounting firm.
COMMERCIAL NET LEASE REALTY, INC. AND SUBSIDIARIESNOTES TO SCHEDULE III – REAL ESTATE AND ACCUMULATED DEPRECIATION AND AMORTIZATION
COMMERCIAL NET LEASE REALTY, INC. AND SUBSIDIARIESSCHEDULE IV – MORTGAGE LOANS ON REAL ESTATE
(a) The following shows the changes in the carrying amounts of mortgage loans during the years:
(b) Principal and interest is payable at level amounts over the life of the loan.
(c) Interest only payments are due quarterly. Principal is due at maturity.
(d) Interest only payments are due monthly. Principal is due at maturity.
(e) Mortgages held by the Company and its subsidiaries for federal income tax purposes for the years ended December 31, 2004, 2003 and 2002, were $11,527,558, $13,194,972, and $7,064,659, respectively.
(f) Mortgages totaling $17,122,868 and $4,344,460 were accepted in connection with real estate transactions for the years ended December 31, 2003 and 2002, respectively.
(g) The mortgages are affiliates of certain members of the Company’s board of directors.
(h) In January 2005, the mortgagee became current with all delinquent amounts.