UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934.
For the quarterly period ended June 30, 2004.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934.
For the transition period from to .
Commission File Number 001-11290
COMMERCIAL NET LEASE REALTY, INC.
450 South Orange Avenue, Orlando, Florida 32801(Address of principal executive offices, including zip code)
(407) 265-7348(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ].
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ].
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.
51,852,663 shares of Common Stock, $0.01 par value, outstanding as of July 30, 2004.
CONTENTS
COMMERCIAL NET LEASE REALTY, INC.and SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
See accompanying notes to condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
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CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS — CONTINUED(dollars in thousands, except per share data)
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS — CONTINUED(dollars in thousands)
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — CONTINUEDSix Months Ended June 30, 2004 and 2003
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(1) Includes the effects of intersegment eliminations.
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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 term “Company” includes, unless otherwise noted, 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 the 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: the ability of the Company to qualify as a real estate investment trust for federal income tax purposes; the ability of tenants to make payments under their respective leases, including our reliance on certain major tenants and the ability of the Company to re-lease properties that are currently vacant or that become vacant; the ability of the Company to locate suitable tenants for its properties; changes in real estate market conditions; changes in general economic conditions; the ability of the Company to repay debt financing obligations; the ability of the Company to refinance amounts outstanding under its credit facilities at maturity on terms favorable to the Company; continued availability of proceeds from the Company’s debt or equity capital; the availability of other debt and equity financing alternatives; market conditions affecting the Company’s equity capital; ability to sell properties at an attractive return; changes in interest rates under the Company’s current credit facilities and under any additional variable rate debt arrangements that the Company may enter into in the future; the ability of the Company to be in compliance with certain debt covenants; the inherent risks associated with owning real estate (including: local real estate market conditions, governing laws and regulations and illiquidity of real estate investments); the ability of the Company to integrate office and industrial properties into existing operations that historically have been primarily focused on retail properties; the loss of any member of the Company’s management team; the ability of the Company to successfully implement its selective acquisition strategy or fully realize the anticipated benefits of renovation or development projects; the ability of the Company to integrate acquired properties and operations into existing operations; and recent changes in tax legislation provide favorable treatment for dividends for regular companies, but not generally dividends from real estate investment trusts. 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.
Overview
Commercial Net Lease Realty, Inc., a Maryland corporation, is a fully integrated REIT formed in 1984. Amounts as of December 31, 2003, included in the condensed consolidated financial statements, have been derived from the audited consolidated financial statements as of that date and have been restated to include the consolidated financial information of Services. Services is included in the consolidated financial statements due to the implementation of Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities,” as amended.
The Company’s operations are divided into two primary business segments: real estate held for investment and real estate held for sale. The real estate held for investment (the “Investment Properties”), is operated through Commercial Net Lease Realty, Inc. and its wholly owned qualified REIT subsidiaries (collectively, “NNN”). NNN directly, and indirectly through investment interests, acquires, owns, invests in, manages and develops primarily single-tenant retail and office properties that are generally leased to established tenants under long-term commercial net leases. As of June 30, 2004, NNN owned 346 Investment Properties, located in 38 states and leased to established tenants, including Academy, Barnes & Noble, Bed Bath & Beyond, Best Buy, Borders, Eckerd, Jared Jewelers, OfficeMax, The Sports Authority and the United States of America. The real estate held for sale is operated through Services. Services, directly and indirectly through investment interests, acquires and develops real estate primarily
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Overview – continued:
for the purpose of selling the real estate to purchasers who are looking for replacement like-kind exchange property (“Section 1031”) 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 NNN include such items as: the composition of NNN’s portfolio of Investment Properties (such as tenant, geographic and industry classification diversification); the occupancy rate of NNN’s portfolio of Investment Properties; certain financial ratios; and industry trends and performance compared to that of the Company. The key indicators for Services include such items as: certain profitability measures; transaction pipeline measures; and returns NNN receives on its invested capital in Services.
Liquidity
General. Historically, the Company’s demand for funds has been primarily for (i) payment of operating expenses and dividends, (ii) property acquisitions, 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 June 30, 2004. The table presents principal cash flows by year-end of the expected maturity for debt obligations and commercial commitments outstanding as of June 30, 2004. As the table incorporates only those exposures that exist as of June 30, 2004, it does not consider those exposures or positions which arise after that date.
In connection with its acquisition of two office buildings and a related parking garage located in Arlington, Virginia (the Washington, D.C. metropolitan area) in August 2003, the Company has agreed to fund $27,244,000 for building, tenant improvements and other costs related to the lease, of which $19,893,000 had been funded as of June 30, 2004, These costs will be capitalized to building and improvements upon completion which is anticipated to be substantially complete by December 31, 2004. The Company anticipates funding the additional costs from borrowings under the Company’s revolving credit facility. For a description of the acquisition, see “Results of Operations – Property Analysis” below.
In connection with the development of nine properties by Services, the Company has agreed to fund construction commitments of $51,267,000, of which $34,509,000 has been funded as of June 30, 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
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Liquidity — continued:
guarantee shall continue through the loan maturity in November 2004. In the event the Company is required to perform under this guarantee, the Company anticipates it would 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 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 two office buildings acquired during 2003, 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 June 30, 2004, the Company owns 13 vacant, unleased Investment Properties, which account for 3.4 percent of the total gross leasable area of the Company’s portfolio of Investment Properties. Additionally, 1.5 percent of the total gross leasable area of the Company’s portfolio of Investment Properties is leased to two tenants, which have each filed a voluntary petition for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. As a result, each of the tenants has the right to reject or affirm its leases with the Company.
Dividends. NNN had 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. NNN 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 NNN 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.
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 six months ended June 30, 2004 and 2003, the Company declared and paid dividends to its common stockholders of $32,530,000 and $25,884,000 respectively, or $0.64 per share of common stock. In July 2004, the Company declared dividends to its common shareholders of $16,852,000 or $0.325 per share of common stock, payable in August 2004.
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 six months ended June 30, 2004 and 2003, the Company declared and paid dividends to its Series A Preferred Stock stockholders of $2,004,000 and $2,003,000, respectively, or $1.125 per share of stock.
Holders of the 6.70% Non-Voting Series B Preferred Cumulative Convertible Perpetual Preferred Stock (the “Series B Convertible Preferred Stock”) are entitled to receive, when and as authorized by the board
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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 six months ended June 30, 2004, the Company declared and paid dividends to its Series B Convertible Preferred Stock stockholders of $838,000 or $83.75 per share of stock.
Capital Resources
Generally, cash needs for property acquisitions, 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.
Indebtedness. In February 2004, the Company acquired a property subject to a mortgage securing 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 June 30, 2004, the aggregate carrying value of the property was $12,569,000. The outstanding principal balance as of June 30, 2004, was $6,839,000.
Debt. In June 2004, the Company filed a prospectus supplement to its $600,000,000 shelf registration statement and issued $150,000,000 of 6.25% notes due June 2014 (the “2014 Notes”). The 2014 Notes are senior, unsecured obligations of the Company and are subordinated to all secured indebtedness of the Company. The 2014 Notes were sold at a discount for an aggregate purchase price of $149,560,000 with interest payable semi-annually commencing on December 15, 2004. The discount of $440,000 is being amortized to interest expense over the term of the debt obligation using the effective interest method. In connection with the debt offering, the Company entered into a forward starting interest rate swap agreement which fixed a swap rate of 4.61% on a notional amount of $94,000,000. Upon issuance of the 2014 Notes, the Company terminated the forward starting interest rate swap agreement resulting in a gain of $4,148,000. The gain has been deferred and is being amortized as an adjustment to interest expense over the term of the 2014 Notes using the effective interest method. The effective interest rate of the 2014 Notes, including the effects of the discount and swap gain, is 5.91%. The 2014 Notes are 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 2014 Notes being redeemed plus accrued interest thereon through the redemption date and (ii) the Make-Whole Amount, as defined in the Supplemental Indenture No. 5 dated June 18, 2004 for the 2014 Notes. The terms of the indenture include financial covenants which provide for the maintenance of certain financial ratios.
In connection with the debt, the Company incurred debt issuance costs totaling $1,275,000 consisting primarily of underwriting discounts and commissions, legal and accounting fees and rating agency fees. Debt issuance costs have been deferred and are being amortized over the term of the 2014 Notes using the effective interest method.
The Company used the proceeds of the 2014 Notes to pay down outstanding indebtedness of the Company’s credit facility, including amounts incurred by the Company to repay the outstanding principal on the 8.125% $100,000,000 notes that were due in June 2004.
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. During the six months ended June 30, 2004, the Company issued 185,211 shares of restricted stock to certain officers and key associates of the Company.
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Results of Operations — continued:
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 various issuances of restricted stock:
Investments in Unconsolidated Affiliates. In September 1997, the Company entered into a partnership arrangement, 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”). The Partnership owns and leases nine properties to eight tenants under long-term commercial net leases. Net income and losses of the Partnership are to be allocated to the partners in accordance with their respective percentage interest in the Partnership.
In October 2003, under the terms of the Agreement, CTA exercised its right to convert its 80 percent limited partnership interest into shares of the Company’s common stock, and in February 2004, the Company issued 953,551 shares of common stock to CTA in a private transaction in exchange for CTA’s 80 percent limited partnership interest, increasing the Company’s direct or indirect ownership to 100 percent of the Partnership.
The Company recorded $116,000 in distributions from the Partnership during the six months ended June 30, 2003. For the six months ended June 30, 2004 and 2003, the Company recognized earnings of $26,000 and $66,000, respectively. The Company recognized $140,000 during the quarter ended June 30, 2003. The Company managed the Partnership and pursuant to a management agreement, the Partnership paid the Company $17,000 and $96,000 in asset management fees during the six months ended June 30, 2004 and 2003, respectively. The Partnership paid the Company asset management fees of $47,000 during the quarter ended June 30, 2003. The Company did not recognize earnings or receive asset management fees from the Partnership subsequent to increasing its ownership in the Partnership to 100 percent in February 2004.
Shelf Registration Statement. On June 5, 2003, the Securities and Exchange Commission declared effective the Company’s shelf registration statement relating to the future offering of up to an aggregate of $600,000,000 of common stock, preferred stock, depositary shares, debt securities and warrants exercisable for common stock. The Company believes the shelf registration statement provides the
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Company with more efficient and immediate access to capital markets when considered appropriate. As of June 30, 2004, $409,167,000 remained available for issuance under the shelf registration statement.
Property Analysis – Real Estate Held for Investment
General. Real estate held for investment is operated through NNN. As of June 30, 2004, NNN owned 346 Investment Properties that are leased to established tenants, including Academy, Barnes & Noble, Bed Bath & Beyond, Best Buy, Borders, Eckerd, Jared Jewelers, OfficeMax, The Sports Authority and the United States of America. Approximately 97 percent of the gross leasable area of NNN’s portfolio of Investment Properties was leased at June 30, 2004. The following table summarizes NNN’s portfolio of Investment Properties:
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:
In August 2003, the Company acquired two office buildings and a related parking garage located in Arlington, Virginia (the Washington, D.C. metropolitan area). Pursuant to the lease agreement, the Company has agreed to fund $27,244,000 for building, tenant improvements and other costs related to the lease, of which $19,893,000 had been funded as of June 30, 2004. These costs will be capitalized to building and improvements upon completion which is anticipated to be substantially complete by December 31, 2004. The Company anticipates funding the additional costs from borrowings under the Company’s credit facility. The properties include two office buildings containing an aggregate of 555,000 rentable square feet (505,000 usable square feet for purposes of calculating rent) and a two-level garage with 1,079 parking spaces.
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Property Dispositions. The Company evaluates anticipated property dispositions to determine whether to use anticipated sales proceeds to either (i) pay down the outstanding indebtedness of the Company’s credit facility or (ii) acquire additional properties and structure the transactions to qualify as tax-free like-kind exchange transactions for federal income tax purposes. The following table summarizes the properties held for investment disposed of by the Company:
The Company used the proceeds from the dispositions to pay down the outstanding indebtedness of the Company’s revolving credit facility during the quarters and six months ended June 30, 2004 and 2003. 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 nine properties sold during each of the six months ended June 30, 2004 and 2003, as discontinued operations. In addition, the Company has classified one leasehold interest that expired during the six months ended June 30, 2004 as discontinued operations. All 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 in the 1031 exchange or other markets. As of June 30, 2004 and 2003, Services owned 23 and 26 properties, respectively, that were held for sale (“Inventory Properties”). The Inventory Properties consisted of nine completed inventory properties, nine properties under construction and five land parcels as of June 30, 2004, and 18 completed inventory properties, seven properties under construction and one land parcel as of June 30, 2003.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:
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Property Dispositions. The following table summarizes the number of properties sold and the corresponding gain recognized on the disposition of real estate held for sale included in earnings from continuing and discontinued operations of (dollars in thousands):
During the quarters and six months ended June 30, 2004 and 2003, the Company used the proceeds from the sale of the Inventory Properties to pay down the outstanding indebtedness of the Company’s credit facility.
Revenue From Operations Analysis
General. During the quarters and six months ended June 30, 2004, the Company’s rental income increased primarily due to the acquisition of two office buildings in August 2003 (See “Results of Operations – Property Acquisitions”) and maintaining an occupancy rate 97% at June 30, 2004 and 2003. The Company anticipates any significant increase in rental income will continue to come primarily from additional property acquisitions over the next several years.
The following summarizes the Company’s revenues (dollars in thousands):
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Revenue From Operations Analysis by Source of Income. Breaking down revenues into the Company’s two primary operating segments of revenue reveals similar trends. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company has identified two primary sources of revenue: (i) NNN, which primarily derives earnings from real estate held for investment and (ii) Services, which primarily derives earnings from real estate held for sale. The following table summarizes the operating 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 Quarter and Six Months Ended June 30, 2004 to Quarter and Six Months Ended June 30, 2003. Rental Income increased 29.3 percent for the six months ended June 30, 2004, as compared to the six months ended June 30, 2003, due to the addition of an aggregate gross leasable area of 1,520,000 square feet to the Company’s portfolio resulting from the acquisition of 23 Investment Properties and the completed construction of one Investment Property since June 30, 2003.
Rental Income increased 33.9 percent for the quarter ended June 30, 2004 as compared to the quarter ended June 30, 2003, due to the addition of an aggregate gross leasable area of 1520,000 square feet to the Company’s portfolio resulting from the acquisition of 23 Investment Properties and the completed construction of one Investment Property since June 30, 2003.
Real estate expenses reimbursed by tenants increased for the six months and quarter ended June 30, 2004, primarily due to the addition of real estate expenses reimbursed by tenants from the two office buildings and a related parking garage located in Arlington, Virginia acquired by the Company in August 2003 (See “Property Analysis – Real Estate Held for Investment”).
The gain on disposition of real estate held for sale which included in continuing operations, increased primarily due to the timing of sales of Inventory Properties. The Company disposed of three land parcels and two properties with a gross leasable area of 13,650 square feet during the six months ended June 30, 2004 and 2003, respectively. The Company disposed of two land parcels and two properties with a gross leasable area of 13,650 square feet during the quarter ended June 30, 2004 and 2003, respectively.
Interest from real estate transactions increased for the six months and quarter ended June 30, 2004, primarily due to the interest earned on the $45,200,000 mezzanine loan agreement entered into in October 2003.
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Results of Operations – continued:
Expense Analysis
General. During the quarters and six months ended June 30, 2004 and 2003, operating expenses increased with 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):
Comparison of Quarter and Six Months Ended June 30, 2004 to Quarter and Six Months Ended June 30, 2003. In general, operating expenses increased 48.2 percent for the six months ended June 30, 2004, over the six months ended June 30, 2003, and increased as a percentage of total revenues by 3.9 percent to 45.8 percent. During the quarters ended June 30, 2004 and 2003, operating expenses increased 80.0 percent, and increased as a percentage of total revenues by 11.9 percent to 48.5 percent.
General and administrative expenses increased 15.0 percent for the six months ended June 30, 2004, but decreased as a percentage of total revenues by 3.2 percent to 17.7 percent. General and administrative expenses increased 1.3 percent for the quarters ended June 30, 2004, but decreased as a percentage of total revenues by 5.6 percent to 16.2 percent. General and administrative expenses increased for the quarter and six months ended June 30, 2004, primarily as a result of increases in expenses related to personnel compensation and insurance. This increase is partially offset by a decrease in professional services.
Real estate expenses increased for the quarter and six months ended June 30, 2004, primarily due to the August 2003 acquisition of two office buildings and a related parking garage in the Washington D.C. metropolitan area. Real estate expenses increased as a percentage of total revenue by 7.6 percent to 9.9 percent and by 6.5 percent to 9.8 percent, for the quarter and six months ended June 30, 2004, respectively (See “Property Analysis – Real Estate Held for Investment”).
Depreciation and amortization expense increased 42.2 percent for the six months ended June 30, 2004, and increased 0.6% to 13.2 percent of total revenues for the six months ended June 30, 2004. Depreciation and amortization expense increased 38.0 percent for the quarter ended June 30, 2004, and increased 0.1% to 12.7 percent of total revenues for the quarter ended June 30, 2004. The increase in depreciation and amortization expense for the six months and quarter ended June 30, 2004, is primarily attributable (i) the depreciation on the acquisition of 23 additional Investment Properties and the completed construction of one Investment Property, (ii) the amortization of loan costs related to the amended credit facility and (iii) the amortization of additional lease costs. The increase is partially offset by the disposition of nine Investment Properties during each of the six months ended June 30, 2004 and 2003, respectively.
During the six months ended June 30, 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 Net Lease Realty, Inc. in December 2001.
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During the quarter and six months ended June 30, 2004, the Company recorded a transition cost of $3,200,000 including severance, accelerated vesting, 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. James M. Seneff, Jr. remained as Chairman of the Board of Directors.
Analysis of Other Expenses and Revenues
General. During the quarters and six months ended June 30, 2004 and 2003, 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) (dollars in thousands):
Comparison of Quarter and Six Months Ended June 30, 2004 to Quarter and Six Months Ended June 30, 2003. In general, other expenses (revenues) increased 21.0 percent for the six months ended June 30, 2004, over the six months ended June 30, 2003, but decreased as a percentage of total revenues by 2.5 percent to 20.9 percent. During the quarters ended June 30, 2004 and 2003, other expenses increased 26.5 percent, but decreased as a percentage of total revenues by 1.6 percent to 20.9 percent.
Interest and other income decreased 15.4 percent for the six months ended June 30, 2004, and decreased as a percentage of total revenues by 1.8 percent to 2.9 percent. Interest and other income decreased 41.0 percent for the quarters ended June 30, 2004, and decreased as a percentage of total revenues by 3.1 percent to 2.4 percent. Interest and other income decreased for the six months and quarter ended June 30, 2004, primarily as a result of fee income received in the quarter ended June 30, 2003 and recognition of excess notes receivable reserves in the quarter and six months ended June 30, 2003. This decrease, however, was offset by increased borrowing levels by the Company’s unconsolidated affiliates.
Interest expense increased 15.0 percent for the six months ended June 30, 2004, but decreased as a percentage of total revenues by 4.3 percent to 23.8 percent for the six months ended June 30, 2004. Interest expense increased 13.3 percent for the quarter ended June 30, 2004, but decreased as a percentage of total revenues by 4.7 percent to 23.3 percent for the quarter ended June 30, 2004. The increase in interest expense for the six months ended June 30, 2004, was primarily attributable to the addition of the $95,000,000 fixed rate mortgage loan entered into in November 2003. The Company entered into the mortgage loan as a means of reducing floating interest rate risk. However, the increase in interest expense was partially offset by a decrease in the average interest rates and lower average debt outstanding on the Company’s variable interest rate debt.
Unconsolidated Affiliates
During the six months ended June 30, 2004 and 2003, the Company recognized equity in earnings of unconsolidated affiliates of $2,539,000 and $1,882,000, respectively, $1,286,000 and $862,000 of which was recognized during the quarters ended June 30, 2004 and 2003, respectively. The increase in equity in earnings of unconsolidated affiliates was primarily attributable to the income earned on the affiliates’ investments in mortgage loans.
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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 nine investment properties sold during each of the six months ended June 30, 2004 and 2003, as discontinued operations. In addition, the Company has classified one leasehold interest that expired during the six months ended June 30, 2004 as discontinued operations. In addition, the Company has also classified the revenues and expenses related to the three and eight held for sale properties that were sold during 2004 and 2003, respectively, and which generated rental revenues up through June 30, 2004 as discontinued operations. In addition, the Company also classified the revenues and expenses related to its nine properties held for sale that generated rental revenues as of June 30, 2004, as discontinued operations. The Company has reclassified the revenues and expenses related to all held for investment properties and Services’ properties which generated rental revenue and were sold subsequent to December 31, 2001, the effective date of SFAS No. 144, as discontinued operations. Also, the Company has classified all revenues and expenses from properties that were held for sale and have generated rental revenues as discontinued operations.
During the quarters and six months ended June 30, 2004 and 2003, the Company recognized earnings from discontinued operations of (dollars in thousands):
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 3. 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 June 30, 2004 and December 31, 2003.
The information in the table below summarizes the Company’s market risks associated with its debt obligations and interest rate derivatives outstanding as of June 30, 2004 and December 31, 2003. The table presents principal cash flows and related interest rates by year of expected maturity for debt obligations and interest rate derivatives outstanding as of June 30, 2004. The variable interest rates shown represent the weighted average rates for the credit facility at the end of the periods. As the table incorporates only those exposures that exist as of June 30, 2004 and December 31, 2003, 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.
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ITEM 4. CONTROLS AND PROCEDURES
Quarterly Evaluation. The Company carried out an evaluation as of June 30, 2004, of the effectiveness of the design and operation of its disclosure controls and procedures, which the Company refers to as disclosure controls. This evaluation was done under the supervision and the participation of management, including the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Rules adopted by the Securities and Exchange Commission (“Commission”) require that the Company present the conclusions of the CEO and CFO about the effectiveness of the Company’s disclosure controls as of the end of the period covered by this report.
CEO and CFO Certifications. Included as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10- Q are forms of “Certification” of the Company’s CEO and CFO. The forms of Certification are required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the Quarterly Report on Form 10-Q which you are currently reading is the information concerning the evaluation referred to in the Section 302 certifications. 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 our reports filed or submitted under the Securities Exchange Act of 1934, such as this Quarterly Report on Form 10-Q, 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 CEO and CFO, 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 CEO and CFO, and effected by the Company’s board of directors (the “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 and includes those policies and procedures that:
Limitations on the Effectiveness of Controls. Management, including the Company’s CEO and CFO, do not expect that our 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 person, 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; overtime, controls may become inadequate because of changes in conditions,
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ITEM 4. CONTROLS AND PROCEDURES – CONTINUED:
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.
Conclusions. Based upon the evaluation, the Company’s CEO and CFO have concluded that, as of June 30, 2004 and subject to the limitations noted above, the Company’s disclosure controls and procedures were effective at the reasonable assurance level to ensure that material information relating to the Company and its consolidated subsidiaries is made known to management.
During the six months ended June 30, 2004, there were no significant 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.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings. Not applicable.
Item 2. Changes in Securities and Use of Proceeds. Not applicable.
Item 3. Defaults Upon Senior Securities. Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders. Not applicable.
Item 5. Other Information. Not applicable.
Item 6. Exhibits and Reports on Form 8-K.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
DATED this 6th day of August, 2004.
By: /s/ Craig Macnab
By: /s/ Kevin B. Habicht
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