Item 1. Business.
EQUITY OFFICE
As used herein, “Equity Office”, “we”, “us” and “our” refer to Equity Office Properties Trust, a Maryland real estate investment trust, together with its consolidated subsidiaries, including EOP Operating Limited Partnership, a Delaware limited partnership (“EOP Partnership”), and the predecessors thereof, except where the context otherwise requires. Equity Office was organized in 1996 and began operations in 1997. We own substantially all of our assets and conduct all of our operations through EOP Partnership, which, though its various subsidiaries, is principally engaged in owning, managing, leasing, acquiring and developing office properties. We are the sole general partner of, and owned, at December 31, 2002, an approximate 89.1% interest in, EOP Partnership. Equity Office has elected to be taxed as a real estate investment trust (“REIT”) for federal income tax purposes, and generally will not be subject to federal income tax if 100% of its taxable income is distributed and it complies with a number of organizational and operational requirements.
At December 31, 2002, we had a portfolio of 734 office properties comprising approximately 125.7 million square feet of commercial office space in 20 states and the District of Columbia (the “Office Properties”), 77 industrial properties comprising approximately 6.0 million square feet (the “Industrial Properties” and, together with the Office Properties, the “Properties”) and approximately 1.5 million square feet of office properties under development.
Our executive offices are located at Two North Riverside Plaza, Suite 2100, Chicago, Illinois 60606, and our telephone number is (312) 466-3300.
Equity Office’s internet site is at http://www.equityoffice.com. Equity Office will provide to the public on its website, free of charge, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.
DEVELOPMENT OF OUR BUSINESS IN 2002
During the year ended December 31, 2002, we completed the following key transactions:
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disposed of 45 office properties, four parking facilities, two industrial properties and three land parcels in various transactions to unaffiliated parties for approximately $508.3 million. The sold office properties consisted of approximately 3,113,189 square feet, the industrial properties consisted of approximately 77,072 square feet, and the parking facilities consisted of approximately 7,464 parking spaces;
•
acquired two office buildings for approximately $92.3 million. The properties are located in Washington, D.C., and consist of approximately 327,550 square feet, of which approximately 260,372 square feet is office space;
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placed two developments into service consisting of three buildings and approximately 330,646 square feet;
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commenced two developments consisting of approximately 292,000 square feet;
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exchanged our equity interest in a land parcel under option and operating business in exchange for Wilson/Equity Office’s equity interest in several developments and land parcels;
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issued $500 million of unsecured notes due February 2012 at an all-in cost of 7.0% and exchanged approximately $260.0 million of these notes for the previously outstanding $250.0 million MandatOry Par Put Remarketed SecuritiesSM which were subject to mandatory redemption; repaid $310 million of unsecured notes upon maturity and repaid approximately $156.1 million of mortgage debt;
•
redeemed the 7,994,000 outstanding 8.98% Series A Cumulative Redeemable Preferred Shares at an aggregate redemption price of approximately $201.9 million, including accrued distributions;
•
issued 8,500,000 7.75% Series G Cumulative Redeemable Preferred Shares for approximately $206.1 million;
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repurchased 7,901,900 Common Shares at an average price of $24.92 per share for a total of $196.9 million in the aggregate as part of a Common Share repurchase program for up to $400 million of our Common Shares;
•
redeemed 3,727,925 units of limited partnership interest of EOP Partnership (“Units”) for cash at an average price of $28.62 per Unit for a total of approximately $106.7 million;
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recognized approximately $105.5 million from lease termination fees, including approximately $46.1 million and 5,000,000 common shares (which were initially valued at zero and subsequently sold and recognized in March 2003 for a gain on sale of securities of approximately $8.1 million) from one tenant. In addition, we recognized approximately $46.4 million from lease terminations at our unconsolidated joint ventures, including approximately $40 million from one tenant; and
•
received approximately $20.1 million from CT Convertible Trust I in connection with the redemption of its non-convertible preferred securities.
BUSINESS AND GROWTH STRATEGIES
Our primary business objective is to achieve sustainable long-term growth in cash flow and portfolio value in order to maximize shareholder value. We intend to achieve this objective by owning and operating high-quality office buildings and providing a superior level of service to customers across the United States.
Internal Growth
We believe that our future internal growth will come from:
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increasing occupancy by leasing up vacant space, retaining tenants, reducing the lease cycle time and improving customer service;
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recycling of capital through selective disposition of certain assets and reinvestment in properties or other assets more consistent with our desire to focus on core assets in core markets;
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our ability to achieve economies of scale over time, including anticipated cost savings from the implementation of our EOPlus initiatives; and
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completion and lease-up of development properties.
At December 31, 2002, approximately 12.7 million rentable square feet, or 10.1%, of our office space, was vacant. During the period from December 31, 2002 through December 31, 2007, there is approximately 71.6 million square feet, or 64.2%, of currently occupied office space scheduled to become vacant. As of December 31, 2002, the average annual total rent, including base rent and estimated expense reimbursements from tenants per occupied square foot for this space was $28.95 per square foot (see Item 2.
Item 2. Properties). The actual rental rates at which available space will be relet will depend on prevailing market factors at the time.
At December 31, 2002, approximately 1.5 million square feet of projects were under development. Our policy is to prudently pursue projects where customer need is evident and market conditions warrant.
In addition to our current development pipeline, we own various undeveloped land parcels on which approximately 12 million square feet of office space could be developed, assuming our receipt of necessary permits, licenses and approvals. Our policy is to develop land only when market conditions warrant. Although we may develop some properties ourselves, a portion of this activity may also be conducted with joint venture partners. If we develop a property with a joint venture partner, we may not have the same degree of control over the property as if we owned it ourselves. In addition, if we develop a property with a joint venture partner, we will be required to share a portion of the economic benefits from such property with our joint venture partner.
EOPlus
In 2001, we initiated a comprehensive analysis of our operating structure with the help of a management consulting firm and our employees. The goal of the analysis was to significantly reduce operating expenses, improve customer service, reduce lease cycle time, increase occupancy and retain tenants. The analysis resulted in a significant reengineering effort called EOPlus. As part of this effort, most of the activities that occurred at the property level will eventually be centralized into core regional offices with a view towards allowing property managers to spend more time building customer relationships. The centralization of each region’s operations is designed to permit us to manage our Properties with fewer people. By the end of 2003, we expect to have 16% fewer employees than at the end of 2001 as a result of staff reductions and attrition. We expect the related severance expenses to be immaterial. By consolidating our property management offices, we expect to make available between 130,000 square feet and 160,000 square feet of office space for leasing. We anticipate this new model will be fully implemented in all of our markets by the end of 2003. We have also created a central purchasing function to review and analyze our goods and services expenditures. The goal of the central purchasing function is to obtain preferred pricing, reduce the number of our vendors and reduce the number of invoices we process. Beginning in 2004, after the new model is fully implemented, we expect annual cost savings of $75 million to $100 million. Since a significant portion of these savings will be passed on to our tenants, we expect to benefit from an ability to offer our tenants a lower cost of occupancy than our competition.
External Growth
As part of our long-term growth strategy, assuming that capital is available to us on reasonable terms, we intend to continue to acquire additional office properties. Properties may be acquired separately or as part of a portfolio and may be acquired for cash and/or in exchange for our debt or equity securities. These acquisitions may be individual asset transactions, joint ventures, mergers or other business combinations.
ACQUISITION ACTIVITY
Over the past five years, we have invested approximately $15.3 billion, calculated on a cost basis, in acquisitions of institutional quality office properties, industrial properties and parking facilities throughout the United States.
Management considers various factors when evaluating potential property acquisitions. These factors include:
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the attractiveness of the property to existing and potential tenants;
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the likelihood and relative attractiveness of competitive supply;
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the anticipated demand for space in the local market;
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the creditworthiness and diversity of risk in the current tenants occupying the property;
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the ability to acquire the asset at an attractive going-in yield, as well as the potential to increase operating income over time by renewing leases for increasing rents;
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the physical condition of the property, including the extent of funds required for its maintenance and for physical upgrades needed in order to establish or sustain its market competitiveness;
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the ability to operate the property with a competitive cost structure; and
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the property’s location in one of our target markets.
In determining whether to enter into a new development, the foregoing factors are considered as well as the additional risks of development, including the following:
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the extent of lease-up risk in the context of the demand/supply characteristics of the local market;
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the ability to minimize construction risks; and
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the quality of local development partners, if relevant.
DISPOSITION ACTIVITY
Over the past five years, we have disposed of approximately $2.4 billion, calculated based on the sales price, of office properties, industrial properties and parking facilities throughout the United States. Management considers various factors when evaluating potential property dispositions. These factors include but are not limited to:
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our ability to recycle capital into markets consistent with our long-term strategy;
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exiting markets that are not core markets;
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whether the property is strategically located;
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tenant composition and lease rollover for the asset;
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general economic conditions, including job growth in the local market;
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the general quality of the asset; and
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the long-term outlook for the market for which the asset is located.
FINANCING POLICIES
We conduct substantially all of our investment and debt-financing activities through EOP Partnership. To date, we have financed our investments through a combination of equity, which may be issued by either EOP Partnership or us, as well as secured and unsecured debt (which would be issued by EOP Partnership but in many cases guaranteed by us). The terms of EOP Partnership’s line of credit and unsecured notes contain various financial covenants which require satisfaction of certain total debt-to-asset ratios, secured debt-to-total-asset ratios, debt service coverage ratios, and unsecured debt-to-unencumbered-asset ratios, as well as other limitations. In addition, EOP Partnership has obtained investment grade credit ratings on its unsecured debt from each of Standard & Poors, Fitch and Moodys rating agencies. A primary objective of our financing policy is to manage our financial position to allow us to raise capital at competitive rates. As of December 31, 2002, approximately 97.9% of our outstanding debt had a fixed interest rate which limits the risk of fluctuating interest rates. In addition, we utilize certain derivative financial instruments at times to limit interest rate risk. Derivatives are used for hedging purposes rather than speculation.
To the extent that our Board of Trustees decides to obtain additional capital, we may elect to issue equity securities, cause EOP Partnership to issue additional Units or debt securities, retain our earnings (subject to the provisions of the Internal Revenue Code requiring distributions of taxable income to maintain REIT status), or dispose of some of our properties or utilize a combination of these methods. Under the terms of EOP Partnership’s partnership agreement, the proceeds of all equity capital raised by Equity Office are contributed to EOP Partnership in exchange for additional interests in EOP Partnership.
INDUSTRY SEGMENTS
Our primary business is the ownership and operation of office properties. Our long-term tenants are in a variety of businesses, and no single tenant is significant to our business. Information related to this segment for the years ended December 31, 2002, 2001 and 2000 is set forth in Item 8. Financial Statements and Supplementary Data - Note 20 - Segment Information.
COMPETITION
The leasing of real estate is highly competitive. We compete for tenants in our markets primarily on the basis of property location, rent charged, services provided and the design and condition of improvements. We also experience competition when attempting to acquire or divest ownership of desirable real estate, building sites or redevelopment opportunities, including competition from domestic and foreign financial institutions, other REITs, life insurance companies, pension trusts, trust funds, partnerships and individual investors.
ENVIRONMENTAL EXPOSURE
As an owner of real estate, we are subject to various environmental laws of federal, state and local governments. Compliance with existing laws has not had a material adverse effect on our financial condition and results of operations, and management does not believe it will have such an impact in the future. However, we cannot predict the impact of unforeseen environmental contingencies or new or changed laws or regulations on our Properties, properties that we have sold or on properties that may be acquired in the future.
EMPLOYEES
As of December 31, 2002, we had approximately 2,500 employees providing in-house expertise in leasing, property management, investments and dispositions, finance, tax, property development, marketing, accounting, information systems and law.
Our nine executive officers have an average tenure of nine years with us or our affiliates or predecessors and an average of 19 years experience in the real estate industry.
EXECUTIVE AND SENIOR OFFICERS OF EQUITY OFFICE
As of March 14, 2003, the following executive and senior officers of Equity Office held the offices indicated:
Set forth below is biographical information for each of the executive officers:
Samuel Zell has been a trustee and Chairman of the Board of Equity Office since October 1996 and has been interim Chief Executive Officer of Equity Office since April 2002. He also has been chairman of Equity Group Investments, L.L.C., an owner and financier of real estate and corporate investments, since January 1999 and chief executive officer of Danielson Holding Corporation, an insurance holding company, since July 2002. Additionally, Mr. Zell currently serves as a director and chairman of the board of a number of public companies and also has held the following executive positions:
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Interim President of Equity Office from April 2002 until November 2002; and
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Chairman of Equity Group Investments, Inc., a related entity of Equity Group Investments, L.L.C., for more than five years until December 1998.
Richard D. Kincaid has been a trustee and President of Equity Office since November 2002 and will become Chief Executive Officer of Equity Office effective April 1, 2003. Mr. Kincaid also has held the following positions:
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Executive Vice President of Equity Office from March 1997 until November 2002;
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Chief Operating Officer of Equity Office from September 2001 until November 2002;
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Chief Financial Officer of Equity Office from March 1997 until August 2002;
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Senior Vice President of Equity Office from October 1996 until March 1997;
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Senior Vice President and Chief Financial Officer of Equity Office Holdings, L.L.C., a predecessor of Equity Office, from July 1995 until October 1997;
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Senior Vice President of Equity Group Investments, Inc. from February 1995 until July 1995;
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Senior Vice President of the Yarmouth Group, a real estate investment company in New York, New York, from August 1994 until February 1995;
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Senior Vice President - Finance of Equity Group Investments, Inc. from December 1993 until July 1994; and
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Vice President - Finance of Equity Group Investments, Inc. from August 1990 until December 1993.
Peter H. Adams has been Executive Vice President - Strategic Planning and Operations of Equity Office since September 2001. Mr. Adams also has held the following positions:
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Senior Vice President - Strategic Planning and Operations of Equity Office from May 2000 until September 2001;
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Senior Vice President - Pacific Region of Equity Office from March 1998 until May 2000;
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Regional Vice President - Pacific of Equity Office from July 1997 until March 1998;
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Vice President/ Regional Manager of Equity Office Holdings, L.L.C. from March 1997 until October 1997;
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Vice President/ Regional Manager of Equity Office Properties, L.L.C., a predecessor of Equity Office, from July 1995 until October 1997; and
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Vice President/ Group Manager of Equity Office Properties, Inc., a provider of real estate property management services and a former subsidiary of Equity Group Investments, Inc., from July 1994 until January 1998.
David A. Helfand has been Executive Vice President and Chief Investment Officer of Equity Office since September 2001. Mr. Helfand also has held the following positions:
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Executive Vice President - Business Development of Equity Office from February 2000 until September 2001;
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Senior Vice President - New Business Development of Equity Office from July 1998 until February 2000; and
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Managing Director of Equity International Properties, Ltd., a real estate investment company, from December 1997 until July 1998.
Lawrence J. Krema has been Executive Vice President - Human Resources and Communications of Equity Office since November 2002. Mr. Krema also has held the following positions:
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Senior Vice President - Human Resources of Equity Office from March 2001 until November 2002 and
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Vice President of NEC Technologies, Inc., a leading supplier of presentation systems, computing and other empowering technologies for the North American market, from April 1995 until October 2000 (in this capacity, Mr. Krema managed the human resources division of the company in North America and was responsible for corporate services, which included real estate, travel and office services).
Christopher P. Mundy has been Executive Vice President - Strategic Planning and Operations of Equity Office since September 2001. Mr. Mundy also has held the following positions:
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Senior Vice President - Strategic Planning and Operations of Equity Office from May 2000 until September 2001;
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Senior Vice President - Northeast Region of Equity Office from March 1998 until May 2000;
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Regional Vice President - Northeast of Equity Office from July 1997 until March 1998;
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Vice President/ Regional Manager of Equity Office Holdings, L.L.C. from March 1997 until October 1997;
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Vice President/ Regional Leasing Director of Equity Office Properties, L.L.C. from July 1995 until October 1997; and
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Vice President/ Regional Leasing Director of Equity Office Properties, Inc. from September 1993 until January 1998.
Stanley M. Stevens has been Executive Vice President of Equity Office since September 1996 and Chief Legal Counsel and Secretary of Equity Office since October 1996. Mr. Stevens also has held the following position:
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Executive Vice President and General Counsel of Equity Office Holdings, L.L.C. from September 1996 until October 1997.
Marsha C. Williams has been Executive Vice President and Chief Financial Officer of Equity Office since August 2002. Ms. Williams also has held the following positions:
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Chief Administrative Officer of Crate and Barrel, a national Chicago-based leading retailer of contemporary home furnishings and accessories (Crate and Barrel is the trade name of Euromarket Designs Inc., which is an indirect majority owned subsidiary of Otto Versand Gmbh & Co., a German mail-order company), from May 1998 until August 2002 (in this capacity, Ms. Williams participated in the planning and execution of Crate and Barrel’s growth strategy and managed its finance, accounting, information technology, warehousing, distribution and logistics, loss prevention, strategic planning, direct marketing operations and purchasing departments); and
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Vice President of Amoco Corporation, a worldwide energy and chemical company, from December 1997 until April 1998 and Treasurer of Amoco Corporation from October 1993 until April 1998, as well as other capacities and positions from May 1989 until October 1993.
Robert J. Winter, Jr. has been Executive Vice President - Development and Portfolio Management of Equity Office since November 2002. Mr. Winter also has held the following positions:
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Senior Vice President - Development of Equity Office from June 2002 until November 2002;
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Senior Vice President - Development Investments of Equity Office from July 2001 until June 2002;
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President and Chief Executive Officer of Amli Commercial Properties Trust, a private real estate investment trust with office and industrial properties in the suburban Chicago market, from August 1998 until July 2001 (in this capacity, Mr. Winter was responsible for all aspects of the company’s business, including the development, management and ownership of its properties); and
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President and Chief Executive Officer of Amli Commercial Properties, LLC, a limited liability company and predecessor of Amli Commercial Properties Trust, from November 1996 until July 1998 (in this capacity, along with developing the business, Mr. Winter was responsible for forming Amli Commercial Properties Trust, the future growth vehicle for the business).
Item 2. Properties.
All capitalized terms used herein and not otherwise defined shall have the meaning given in the financial statements and notes thereto set forth in Item 8. For information regarding encumbrances on our properties, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Debt Financing - Mortgage Debt” and “Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K - Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2002”. All of our consolidated properties are held in fee simple interest, except for approximately 80 properties in which we have leasehold interests and do not own the land or a portion thereof and one property in which we are the mortgage holder.
General
We are the largest publicly-held owner and operator of office properties in the United States based upon equity market capitalization and square footage. At December 31, 2002, we had a portfolio of 734 Office Properties comprising approximately 125.7 million square feet of commercial office space in 20 states and the District of Columbia, 77 Industrial Properties comprising approximately 6.0 million square feet and approximately 1.5 million square feet of office properties under development. Approximately 41.1% of the total square feet of our office properties is located in central business districts (“CBDs”) and approximately 58.9%
is located in suburban markets. At December 31, 2002, our Office Properties were approximately 88.6% occupied on a weighted average basis. No single tenant accounts for more than 1.6% of the aggregate annualized rent or 1.9% of the aggregate occupied square feet.
For segment reporting purposes, the Office Properties are included in the “Office Properties” segment and the Industrial Properties are included in the “Corporate and Other” segment.
All property data presented below are as of December 31, 2002.
Property Statistics
Office Properties
The following table sets forth certain data relating to our Office Properties, including those we own in joint ventures with other partners.
Industrial Properties
The following table sets forth certain data relating to our Industrial Properties.
Lease Distribution
The following table sets forth information relating to the distribution of the Office Property leases, based on occupied square feet.
(a)
Annualized rent is the monthly contractual rent under existing leases as of December 31, 2002, multiplied by 12 months. Annualized rent per occupied square foot is annualized rent divided by occupied square feet at December 31, 2002. This amount reflects total base rent and estimated expense reimbursements from tenants, as of December 31, 2002 without regard to any rent abatements and contractual increases or decreases in rent subsequent to December 31, 2002.
(b)
Reconciliation for total net rentable square feet for Office Properties is as follows:
Lease Expiration
The following table sets forth information relating to expiration patterns of our Office Property leases. (Dollars in thousands, except per square foot amounts)
(1)
Total net rentable square feet represented by expiring leases.
(2)
Percentage of total net rentable feet represented by expiring leases.
(3)
Annualized rent is the monthly contractual rent under existing leases as of December 31, 2002, multiplied by 12 months. Annualized rent per occupied square foot is annualized rent divided by occupied square feet at December 31, 2002. This amount reflects total base rent and estimated expense reimbursements from tenants as of December 31, 2002 without regard to any rent abatements and contractual increases or decreases in rent subsequent to December 31, 2002.
(4)
Total square feet on month to month leases is 1,389,831.
(5)
Management offices and building use square footage is included with no rent per square foot.
Item 3.
Item 3. Legal Proceedings.
Equity Office is not presently subject to material litigation nor, to Equity Office’s knowledge, is any litigation threatened against Equity Office, other than routine actions for negligence and other claims and administrative proceedings arising in the ordinary course of business, some of which are expected to be covered by liability insurance and all of which collectively are not expected to have a material adverse effect on the liquidity, results of operations, business or financial condition of Equity Office.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
Our Common Shares are traded on the New York Stock Exchange (“NYSE”) under the symbol “EOP.” On March 13, 2003, the reported closing sale price per Common Share on the NYSE was $24.08 and there were approximately 3,241 holders of record. The high and low sales prices and closing sales prices on the NYSE and distributions for the Common Shares during 2002 and 2001 are set forth in the table below:
Item 6.
Item 6. Selected Financial Data.
The following sets forth selected consolidated financial and operating information on a historical basis for Equity Office. The selected financial data has been derived from the historical consolidated financial statements of Equity Office audited by Ernst & Young LLP, independent auditors. The following information should be read together with the consolidated financial statements and notes thereto of Equity Office included in “Item 8. Financial Statements and Supplementary Data.”
(1)
In 2002, we recognized approximately $105.5 million in lease termination fees from consolidated properties and an additional $46.4 million in lease termination fees from unconsolidated joint ventures.
See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of Year Ended December 31, 2002 to December 31, 2001.
(2)
On July 2, 2001, Equity Office completed its acquisition by merger (the “Spieker Merger”) of Spieker Properties, Inc. (“Spieker”) at a cost of approximately $7.2 billion. As a result of the Spieker Merger, Equity Office acquired an interest in 391 office properties containing approximately 28.3 million square feet and 98 industrial properties containing approximately 10.1 million square feet.
(3)
On June 19, 2000, Equity Office completed its acquisition by merger (the “Cornerstone Merger”) of Cornerstone Properties, Inc. (“Cornerstone”) at a cost of approximately $4.5 billion. As a result of the Cornerstone Merger, Equity Office acquired an interest in 82 office properties containing approximately 18.9 million square feet.
(4)
Refer to Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
The following discussion and analysis is based primarily on the consolidated financial statements of Equity Office for the years presented and should be read together with the notes thereto contained in this Form 10-K. Terms employed herein as defined terms, but without definition, shall have the meaning set forth in the notes to the financial statements.
Key Transactions of 2002
During the year ended December 31, 2002, we completed the following key transactions:
•
disposed of 45 office properties, four parking facilities, two industrial properties and three land parcels in various transactions to unaffiliated parties for approximately $508.3 million. The sold office properties consisted of approximately 3,113,189 square feet, the industrial properties consisted of approximately 77,072 square feet, and the parking facilities consisted of approximately 7,464 parking spaces;
•
acquired two office buildings for approximately $92.3 million. The properties are located in Washington, D.C., and consist of approximately 327,550 square feet, of which approximately 260,372 square feet is office space;
•
placed two developments into service consisting of three buildings and approximately 330,646 square feet;
•
commenced two developments consisting of approximately 292,000 square feet;
•
exchanged our equity interest in a land parcel under option and operating business in exchange for Wilson/Equity Office’s equity interest in several developments and land parcels;
•
issued $500 million of unsecured notes due February 2012 at an all-in cost of 7.0% and exchanged approximately $260.0 million of these notes for the previously outstanding $250.0 million MandatOry Par Put Remarketed SecuritiesSM which were subject to mandatory redemption; repaid $310 million of unsecured notes upon maturity and repaid approximately $156.1 million of mortgage debt;
•
redeemed the 7,994,000 outstanding 8.98% Series A Cumulative Redeemable Preferred Shares at an aggregate redemption price of approximately $201.9 million, including accrued distributions;
•
issued 8,500,000 7.75% Series G Cumulative Redeemable Preferred Shares for approximately $206.1 million;
•
repurchased 7,901,900 Common Shares at an average price of $24.92 per share for a total of $196.9 million in the aggregate as part of a Common Share repurchase program for up to $400 million of our Common Shares;
•
redeemed 3,727,925 Units for cash at an average price of $28.62 per Unit for a total of approximately $106.7 million;
•
recognized approximately $105.5 million from lease termination fees, including approximately $46.1 million and 5,000,000 common shares (which were initially valued at zero and subsequently sold and recognized in March 2003 for a gain on sale of securities of approximately $8.1 million) from one tenant. In addition, we recognized approximately $46.4 million from lease terminations at our unconsolidated joint ventures, including approximately $40 million from one tenant; and
•
received approximately $20.1 million from CT Convertible Trust I in connection with the redemption of its non-convertible preferred securities.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of this Form 10-K. We believe our most critical accounting policies include revenue recognition, allowance for doubtful accounts, impairment of long-lived assets, depreciation and the fair value of financial instruments including derivative instruments, each of which we discuss below.
Revenue Recognition and Allowance for Doubtful Accounts
Rental revenue from our tenants is our principal source of revenue and is recognized in accordance with GAAP based on the contractual terms of the leases. We monitor the liquidity and creditworthiness of our tenants on an on-going basis. Based on this analysis, historical experiences and the current economic environment, we establish provisions, and maintain an allowance for doubtful accounts for estimated losses resulting from the possible inability of our tenants to make required rent payments to us. An allowance for doubtful accounts is recorded during each period and the bad debt expense is netted against rental revenue in our consolidated statements of operations. The allowance for doubtful accounts, which represents the cumulative allowances less write-offs of uncollectible rent, is netted against tenant and other receivables and deferred rent receivable on our consolidated balance sheets.
As a result of the slow down in economic activity, we have experienced over the past two years an increase in the amount of uncollectible receivables relating to tenants in bankruptcy and tenants in financial distress and have increased our bad debt expense and allowance for doubtful accounts accordingly. Although our historical bad debt expense has been based on the factors described above, if we incorrectly estimate the required allowance for doubtful accounts, our financial condition and results of operations could be adversely affected. Below is our historical bad debt expense for each of the three years in the period ended December 31, 2002.
Impairment of Long-Lived Assets
Under GAAP, we are required to record at fair value any of our long-lived assets that we have determined to be permanently impaired. Our long-lived assets consist primarily of our investments in real estate and unconsolidated joint ventures, but we also have investments in preferred securities and notes receivable. The fair value of our investments in real estate and unconsolidated joint ventures depends on the future cash flows from operations of the properties or joint ventures over our anticipated holding period. The fair value of our investments in preferred securities and notes receivable depends on the underlying fair value of the issuer. In assessing potential impairment for our investments, we consider these factors. If these factors result in a fair value that is less than our carrying value, an impairment may be recognized if we determine the loss to be permanent. There were no impairments in 2002. During 2001, we recognized an impairment of approximately $2.5 million on an investment in an unconsolidated joint venture that was subsequently sold. Also during 2001, we recognized an impairment of approximately $132.7 million on several investments in securities and other investments. Of this amount, securities and other investments with carrying values of $125.7 million were entirely written-off. If we do not recognize impairments at appropriate times and in appropriate amounts, our consolidated balance sheet may overstate the value of our long-lived assets.
Depreciation
We compute depreciation on our Properties using the straight-line method based on an estimated useful life of 40 years. A significant portion of the acquisition cost of each property is allocated to building (usually 85% to 90% unless the property is subject to a ground lease in which case 100% of the acquisition cost is allocated to building). The allocation of the acquisition cost to building and the determination of the useful life are based on management’s estimates. If we do not allocate appropriately to building or we incorrectly estimate the useful life of our Properties, our computation of depreciation will not appropriately reflect the allocation of our capital expenditures over future periods.
Fair Value of Financial Instruments
We are required to determine periodically the fair value of our mortgage debt and unsecured notes for disclosure purposes. In determining the fair value of these financial instruments, we use internally developed models that are based on current market conditions. For example, in determining the fair value of our mortgage debt and unsecured notes, we discount the spread between the future contractual interest payments and future interest payments based on a current market rate. In determining the current market rate, we add a credit spread to the quoted yields on federal government debt securities with similar maturity dates to our own debt. The credit spread estimate is based on our historical experience in obtaining either secured or unsecured financing and also is affected by current market conditions.
We are also required periodically to adjust the carrying values of interest rate swaps and caps, as well as the underlying hedged liability, if applicable, to its fair value. In determining the fair value of interest rate swaps and caps, we rely on third party quotations to adjust these instruments, as well as the hedged liability, if applicable, to its fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives either will be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings.
Because our valuations of our financial instruments are based on these types of estimates, the fair value of our financial instruments may change if our estimates are inaccurate. For the effect of hypothetical changes in market rates of interest on interest expense for variable rate debt, the fair value of total outstanding debt and our forward-starting interest rate swaps, see the Market Risk section.
New Accounting Policies Adopted in
Effective January 1, 2002, we adopted the provisions of Statement of Financial Accounting Standards No. 144 (“SFAS No. 144”) Accounting for the Impairment or Disposal of Long-Lived Assets, which is effective for financial statements issued for fiscal years beginning after December 15, 2001. SFAS No. 144 addresses the financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 extends the reporting requirements of discontinued operations to include components of an entity that have either been disposed of or are classified as held for sale. During 2002, we disposed of 47 properties in various geographical regions consisting of approximately 3,190,261 square feet. The operating results of these properties have been reclassified as discontinued operations in the consolidated statements of operations for each of the three years in the period ended December 31, 2002 included herein.
In accordance with Statement of Financial Accounting Standards No. 145 (“SFAS No. 145”), Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, effective for financial statements issued for fiscal years beginning after May 15, 2002, any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods shall be reclassified. As a result of the adoption, extraordinary losses of $9,374 and $1,802, for each of the two years in the period ended December 31, 2001, were reclassified to “amortization of deferred financing costs and prepayment expenses”.
Accounting Policy Adopted in 2003
Effective January 1, 2003, we adopted Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”) Accounting for Stock Based Compensation, which requires a fair value based accounting method for determining compensation expense associated with the issuance of stock options and other equity awards. We decided to adopt the accounting provisions of SFAS No. 123 to reflect the cost to the company of issuing stock options and other equity awards to certain individuals in the consolidated financial statements. We will employ the prospective method for adopting SFAS No. 123 which requires the recognition of compensation expense for stock options and other equity compensation granted on or after January 1, 2003 and to record compensation expense for modifications of stock options and other equity awards that were outstanding as of December 31, 2002. We anticipate recognizing compensation expense of approximately $6.0 million, $12.0 million and $18.0 million for the years ending December 31, 2003, 2004 and 2005, respectively, for both Option and Share Award grants accounted for under SFAS No. 123. These anticipated compensation expense amounts are based on the existing compensation structure for 2003 and assumes a similar level of Option and Share Award compensation in future years. Future Option and Share Award compensation is subject to change based on actual Option and Share Award grants in future years and their respective fair values.
Compensation expense related to Share Award grants was previously recognized in accordance with APB No. 25. The adoption of SFAS No. 123 does not significantly change the amount of compensation expense recognized for Share Awards.
Mergers
Spieker Merger
On July 2, 2001, Spieker merged into Equity Office and Spieker Partnership merged into EOP Partnership. The transaction, which was accounted for by the purchase method, valued Spieker (including the outside interests in Spieker Partnership) at approximately $7.2 billion, which included transaction costs, the assumption of approximately $2.1 billion in debt and the issuance of 14.25 million of Equity Office preferred shares valued at approximately $356.3 million. We paid approximately $1.1 billion in cash and issued approximately 101.5 million Common Shares and EOP Partnership issued approximately 16.7 million Units to third parties, each valued at $29.29 per Common Share/Unit. Equity Office financed the $1.1 billion cash portion of the purchase price using a combination of available cash and a new $1.0 billion bridge loan facility that was entered into before the closing of the Spieker Merger. The $1.0 billion bridge loan facility had a term of 364 days and an interest rate based on LIBOR plus 80 basis points. The $1.0 billion bridge loan facility was repaid in full with the net proceeds from the issuance of $1.4 billion of unsecured notes in July 2001 and terminated upon repayment. Through the Spieker Merger, we acquired 391 office properties comprising approximately 28.3 million square feet, 98 industrial properties comprising approximately 10.1 million square feet and several development properties which added to our ownership in key markets across the western United States.
Cornerstone Merger
On June 19, 2000, Cornerstone merged into Equity Office and Cornerstone Partnership merged into EOP Partnership. The transaction, which was accounted for by the purchase method, valued Cornerstone (including the outside interests in Cornerstone Partnership) at approximately $4.5 billion, which included transaction costs, the assumption of approximately $1.7 billion in debt, the redemption of 3.0 million shares of Cornerstone preferred stock valued at $18.00 per share, including accrued but unpaid dividends for a total of approximately $57.6 million, the redemption of approximately 58.5 million shares of Cornerstone common stock valued at $18.00 per share for a total of approximately $1.1 billion, the issuance of approximately 51.2 million Common Shares and the issuance by EOP Partnership of approximately 12.4 million Units each valued at $24.68 per Common Share/ Unit. We financed the $1.2 billion in cash from credit facilities available to us when the Cornerstone Merger closed.
Results of Operations
Trends in Property Operating Revenues
Income is received primarily from rental revenue from the Office Properties, including reimbursements from tenants for certain operating costs and from parking revenue from Office Properties. As a result of the current slowdown in economic activity, there has been a decrease in our occupancy rates and a general decline in overall market rental rates for our Office Properties. Below is a summary of our leasing activity for leases commencing in 2002 in our top 5 markets, top 10 markets and our total portfolio for our Office Properties. Our top 10 markets in terms of square footage in order from greatest to least are Boston, Chicago, San Francisco, Seattle, San Jose, Atlanta, Los Angeles, Orange County, Washington, D.C. and New York.
(a)
Average annual rent per square foot for new office leases for which the tenants have occupied the space during the relevant period may lag behind market because leasing decisions typically are made anywhere from one month to 12 or more months prior to taking occupancy.
One of the main factors contributing to the decline in occupancy for our Office Properties was the increased level of early lease terminations. For the year ended December 31, 2002, we had approximately 6.1 million square feet of early lease terminations and received lease termination fees on a portion of the terminations of approximately $151.9 million. Future rental income may be affected by future lease terminations as we may be unable to collect the full amount that was due under the lease and would incur additional cost in re-leasing the space. Although there is no way of predicting future lease terminations, we currently anticipate they will be significantly lower in 2003.
As mentioned above, there has been a general decline in the overall market rates for our Office Properties. As of December 31, 2002, the average annual total rent, including base rent and estimated expense reimbursements from tenants, per occupied square foot under existing leases for our Office Properties was approximately $30.55 (See Item 2. Properties - Property Statistics). The weighted average annual base rent per square foot calculated in accordance with GAAP but without regard to estimated expense reimbursements from tenants on leases executed during 2002 was approximately $28.48. If this declining trend in market rates continues, we would experience a decrease in rental revenues if the average annual contractual rent per square foot on leases expiring is greater than the average annual market rent per square foot on new leases executed.
As of December 31, 2002, approximately 71,577,209 occupied square feet (approximately 64.2% of the occupied office square feet) is expiring through 2007. The average annual rent per square foot for these leases is presented in the table below.
(a) See Item 2. Properties for an explanation of how these amounts are calculated.
We believe that it is not currently possible to draw any conclusions about where occupancy levels or market rents ultimately will stabilize. Further decreases in occupancy rates and/or declines in rents could adversely affect our revenues and results of operations in subsequent periods. We estimate that each one percent change in weighted average occupancy for our Office Properties can equate to a $30 million to $35 million change in rental revenue.
In addition to the downward trends in occupancy and market rents, we have experienced an increase in the amount of uncollectible receivables relating to tenants in bankruptcy and tenants that are having financial difficulties. For the years ended December 31, 2002, 2001 and 2000, bad debt expense was approximately $28.0 million, $26.1 million and $6.3 million, respectively. Although we have collateral from many of our tenants, we anticipate additional write-offs to occur in subsequent periods.
Trends in Property Operating Expenses
Increased Costs Due to Terrorism Threat
As a result of the terrorist acts on September 11, 2001, we have realized increased costs for property insurance and safety and security. We believe that these increased costs will remain higher than similar costs incurred in previous periods for the foreseeable future.
Substantially all of the office leases require the tenant to pay, as additional rent, a portion of any increases in these operating expenses over a base amount. We believe a significant portion of any increase in these operating expenses will be offset by expense reimbursements from tenants.
In addition to the increased cost for property insurance described above, the insurance coverage provided through third-party insurance carriers is subject to coverage limitations. Should an uninsured or underinsured loss occur, we could lose all or a portion of our investment in, and anticipated cash flows from, one or more of the Properties. In addition, there can be no assurance that third-party insurance carriers will be able to maintain reinsurance sufficient to cover any losses that may be incurred. A description of our insurance coverage is described in “Item 8. Financial Statements and Supplementary Data - Note 25 - Commitments and Contingencies” and “Note 26 - Subsequent Events.”
EOPlus
In 2001, we initiated a comprehensive analysis of our operating structure with the help of a management consulting firm and our employees. The goal of the analysis was to significantly reduce operating expenses, improve customer service, reduce lease cycle time, increase occupancy and retain tenants. The analysis
resulted in a significant reengineering effort called EOPlus. As part of this effort, most of the activities that occurred at the property will eventually be centralized into core regional offices with a view towards allowing property managers to spend more time building customer relationships. The centralization of each region’s operations is designed to permit us to manage our buildings with fewer people. By the end of 2003, we expect to have 16% fewer employees than at the end of 2001 as a result of staff reductions and attrition. We expect the related severance expenses to be immaterial. By consolidating our property management offices, we expect to make available between 130,000 square feet and 160,000 square feet of office space for leasing. We anticipate this new model will be fully implemented in all of our markets by the end of 2003. We have also created a central purchasing function to review and analyze our goods and services expenditures. The goal of the central purchasing function is to obtain preferred pricing, reduce the number of our vendors and reduce the number of invoices we process. Beginning in 2004, after the new model is fully implemented, we expect annual cost savings of $75 million to $100 million. Since a significant portion of these savings will be passed on to our tenants, we expect to benefit from an ability to offer our tenants a lower cost of occupancy than our competition.
Acquisition and Disposition Activity
Below is a summary of our acquisition and disposition activity since January 1, 2001. The buildings and total square feet shown include properties we own in joint ventures with other partners and reflect the total square feet of the properties. Excluding the joint venture partners’ share of the square feet of these properties, we effectively owned 119,563,201 square feet of office space as of December 31, 2002.
(a)
Building remeasurements during 2001 relate to the office properties and industrial properties acquired in the Spieker Merger. The initial property count was based on a count prepared prior to the Spieker Merger by the former management of Spieker. We count our properties based on the actual number of buildings at the property, which is different than the method used by the former management of Spieker.
Primarily as a result of the Spieker Merger in July 2001, the Cornerstone Merger in June 2000, and the acquisition and disposition of certain properties, the financial data presented show significant changes in revenues and expenses from period-to-period. Therefore, we do not believe our period-to-period financial data are necessarily comparable. The following analysis shows changes attributable to the Properties that were held during the entire period for the periods being compared (the “Core Portfolio”) and the changes in our aggregate total portfolio of Properties (the “Total Portfolio”).
As reflected in the tables below, property revenues include rental revenues, reimbursements from tenants for certain expenses, parking revenue and other property operating revenues, which includes lease termination
income. Property operating expenses include real estate taxes, insurance, repairs and maintenance and other property operating expenses.
Comparison of year ended December 31, 2002 to December 31, 2001
The table below represents selected operating information for the Total Portfolio and for the Core Portfolio consisting of 378 Office Properties acquired or placed in service on or prior to January 1, 2001.
(a)
Interest expense on unsecured notes and the line of credit are not allocated to the Core Portfolio.
(b)
For the Total Portfolio, these amounts include amounts from discontinued operations and exclude amounts from unconsolidated joint ventures.
Property Revenues
The increase in property revenues in the Total Portfolio is primarily due to the Spieker Merger in July 2001, which was partially offset by a decrease in occupancy in the Core Portfolio as described below. In addition, lease termination fees were $105.5 million in 2002 as compared to $40.2 million in 2001. Included in the lease termination fees of $105.5 million in 2002 is approximately $46.1 million from one tenant. The primary reason for the increase in the lease termination fees and the decrease in occupancy is a result of the continued slowdown in economic activity. Lease termination fees relate to specific tenants, each of whom has paid a fee to terminate its lease obligations before the end of the contractual term of the lease. Although there is no way of predicting the precise timing or amounts of future lease termination fees, we currently anticipate that lease termination fees will be significantly lower in 2003.
The decrease in property revenues in the Core Portfolio is primarily due to a decrease in occupancy from 94.5% at January 1, 2001 to 89.2% at December 31, 2002. Occupancy decreased primarily due to tenant rollover and early lease terminations where the space was not re-leased. The decrease in property revenues was partially offset by lease termination fees of $46.5 million in 2002 as compared to $34.7 million in 2001.
Interest/ Dividend Income
Interest/dividend income decreased for the Total Portfolio as a result of a $8.5 million decrease in dividends and discount amortization from our $90.6 million investment in HQ Global Workplaces, Inc. (“HQ Global”) Series A Convertible Cumulative Preferred Stock (“HQ Preferred Stock”) which was written-off in 2001 and a reduction in interest income on notes receivable of approximately $6.6 million. In addition, CT Convertible Trust I redeemed its non-convertible preferred securities that earned a 13% annual dividend for approximately $20.1 million, including accrued dividends, in September 2002.
Interest Expense
Total Portfolio interest expense increased from the prior year as a result of having more debt outstanding during 2002, mainly as a result of the Spieker Merger. This increase was partially offset by interest rate swap agreements in effect during 2002 and 2001 which effectively reduced interest expense by approximately $21.3 million by converting the fixed interest rates to variable rates for a portion of the unsecured notes. The swap agreements were all terminated in 2001 and 2002. Total proceeds resulting from the termination of approximately $90.2 million are being amortized ratably over the remaining terms of the respective unsecured notes as a reduction to interest expense. Core Portfolio interest expense decreased from the prior year as a result of the repayment and refinancing of certain mortgage notes.
Depreciation and Amortization
Total Portfolio depreciation and amortization expense increased primarily due to the Spieker Merger and capital and tenant improvements made during each year. Core Portfolio depreciation and amortization expense increased as a result of capital and tenant improvements made during each year.
Property Operating Expenses
Total Portfolio property operating expenses increased primarily due to the Spieker Merger. Core Portfolio property operating expenses increased primarily due to an increase of approximately $4.5 million for safety and security expense and approximately $8.4 million in insurance expense due to higher premiums both primarily due to the terrorist attacks on September 11, 2001, an increase of approximately $10.6 million for repairs and maintenance and an increase in real estate taxes of approximately $5.2 million. The increase in property operating expenses was partially offset by a decrease of approximately $8.2 million in utilities expense.
Ground Rent
Ground rent for the Total Portfolio increased from the prior period primarily due to the Spieker Merger as several Properties acquired in the Spieker Merger are subject to ground leases.
General and Administrative Expenses
General and administrative expenses increased primarily due to professional and consulting fees related to the EOPlus initiative of $15.7 million in 2002 and severance expense of approximately $7.3 million in 2002. The total severance consists of severance payments and the accelerated vesting of share options and restricted shares.
Beginning in fiscal 2003, we will be reclassifying regional operating expenses and other costs directly associated with property operations from general and administrative expenses to property operating expenses. The regional offices exist to provide oversight for the management and leasing of the Properties. Accordingly, these expenses will be classified as property operating expenses and all prior periods will be reclassified to provide for comparability. This reclassification will not change the prior period results or shareholders’ equity.
Impairment on Securities and Other Investments and Assets Held for Sale
For information on this item refer to “Item 8. Financial Statements and Supplementary Data - Note 7 - Impairment on Securities, Other Investments and Assets Held for Sale”.
Income from Investment in Unconsolidated Joint Ventures
Income from investment in unconsolidated joint ventures increased for the Total Portfolio primarily due to lease termination fees of $46.4 million in 2002 as compared to $1.0 million in 2001. Included in the lease termination fees of $46.4 million in 2002 is approximately $40 million from one tenant.
Income from investment in unconsolidated joint ventures increased for the Core Portfolio primarily due to lease termination fees of $6.4 million in 2002 as compared to $1.0 million in 2001 and also increased due to a $7.6 million decrease in interest expense as a result of lower interest rates on variable rate mortgage notes and the repayment of a mortgage note. The increase in income from unconsolidated joint ventures was partially offset by a decrease in property revenues as a result of a decrease in occupancy.
Net Gain on Sales of Real Estate and Discontinued Operations
Net gain on sales of real estate for the Total Portfolio decreased from the prior period as a result of a presentation change for sold properties in accordance with SFAS No. 144. Gains and losses from properties sold prior to 2002 are reflected as “net gain on sales of real estate” and gains and losses from properties sold in 2002 are reflected in “discontinued operations”. The increase in discontinued operations is primarily due to the gain on the sale of the properties sold in 2002. The gain on sale of real estate in 2001 from the Core Portfolio represents income received from an unaffiliated party for an easement allowing highway access under an Office Property.
Extraordinary Items
The extraordinary item relates to repair costs to certain Office Properties located in Seattle, Washington that were incurred as a result of damage from an earthquake in February 2001.
Comparison of year ended December 31, 2001 to December 31, 2000
The table below represents selected operating information for the Total Portfolio and for the Core Portfolio consisting of 287 Office Properties and five parking facilities acquired or placed in service on or prior to January 1, 2000.
(a)
Interest expense on unsecured notes and the line of credit are not allocated to the Core Portfolio.
(b)
These amounts include amounts from discontinued operations and exclude amounts from unconsolidated joint ventures.
Property Revenues
The increase in property revenues in the Total Portfolio is primarily due to the properties acquired in the Spieker Merger in 2001 and the Cornerstone Merger in 2000. The increase in property revenues in the Core Portfolio resulted primarily from an increase in rental rates and an increase in lease termination fees partially offset by the write-off of uncollectible receivables and a decrease in occupancy. The weighted average
occupancy of the Core Portfolio decreased from 93.7% at January 1, 2000 to 91.3% at December 31, 2001, mainly due to tenant rollover at various properties where the space was not re-leased due to the slowdown in economic activity. As a result of the slowdown in economic activity, we also experienced an increase in the amount of uncollectible receivables relating to tenants in bankruptcy and tenants that are having financial difficulties. The amount of bad debts written off for the year ended December 31, 2001 was approximately $26.1 million as compared to $6.3 million for the prior period.
Interest Expense
Total Portfolio interest expense increased from the prior period as a result of having a higher average outstanding debt balance as compared to the prior period, mainly as a result of the Spieker Merger and the Cornerstone Merger, partially offset by a reduction to interest expense of approximately $10.6 million from interest rate swap agreements which converted the fixed interest rate to a variable interest rate for a portion of our unsecured notes.
Depreciation and Amortization
Total Portfolio depreciation and amortization expense increased from the prior period primarily as a result of the Spieker Merger in July 2001, the Cornerstone Merger in June 2000 and capital and tenant improvements made during the periods. In addition, there was approximately $9.4 million of prepayment expenses in 2001 which consisted of a $5.0 million prepayment penalty and the write-off of approximately $4.4 million of unamortized mark-to-market adjustments relating to the prepayment of $185 million of mortgage debt (See “Item 8. - Financial Statements and Supplementary Data - Note 23 - Related Party Transactions, subfootnote (1)”) and the repayment of approximately $32.6 million of mortgage debt on parking facilities sold. In 2000, there were prepayment expenses of approximately $1.8 million related to the write-off of unamortized deferred loan costs and unamortized discounts and premiums and pre-payment penalties.
Core Portfolio depreciation and amortization expense increased as a result of capital and tenant improvements made during the periods.
Property Operating Expenses
Total Portfolio property operating expenses increased mainly as a result of the Spieker Merger in 2001 and the Cornerstone Merger in 2000. Core Portfolio property operating expenses increased mainly as a result of increases in utilities of $8.3 million consisting primarily of electricity expense, increases in repairs and maintenance of approximately $6.4 million primarily due to higher wages and increases in contract services, increases in insurance expenses of approximately $1.1 million due to higher premiums and an increase in real estate taxes of approximately $4.6 million.
General and Administrative Expenses
General and administrative expenses increased due to an increase in the number of employees at the corporate and regional offices as a result of the Spieker Merger and the Cornerstone Merger.
Impairment on Securities and Other Investments and Assets Held for Sale
For information on this item refer to “Item 8. Financial Statements and Supplementary Data - Note 7 - Impairment on Securities, Other Investments and Assets Held for Sale”.
Income from Investment in Unconsolidated Joint Ventures
Income from investment in unconsolidated joint ventures increased for the Total Portfolio due to an increase in property revenues at several Office Properties and the acquisition of an interest in 1301 Avenue of the Americas office property in August 2000.
Net Gain on Sales of Real Estate and Discontinued Operations
Net gain on sales of real estate increased due to the combined gross sales price in excess of book value at the time of disposition for the real estate assets sold in 2001 being more than the combined gross sales price in excess of book value at the time of disposition for the real estate assets sold in 2000.
The gain on sale of real estate in 2001 from the Core Portfolio represents income received from an unaffiliated party for an easement allowing highway access under an Office Property.
Please see “New Accounting Policies Adopted in 2002” related to SFAS No. 144 for an explanation of discontinued operations.
Extraordinary Items
The extraordinary item relates to repair costs to certain Office Properties located in Seattle, Washington that were incurred as a result of damage from an earthquake in February 2001.
Property Dispositions
During 2002, we disposed of 45 office properties, four parking facilities, two industrial properties and three land parcels in separate transactions to various unaffiliated parties for approximately $508.3 million. The total gain on the sale of these properties was approximately $17.9 million. The sold office properties consisted of approximately 3,113,189 square feet, the industrial properties consisted of approximately 77,072 square feet, and the parking facilities consisted of approximately 7,464 parking spaces. The net income, including the gain on sale, of the properties is reflected in “discontinued operations” for each year presented in the consolidated statements of operations.
During 2001, we disposed of eight office properties, four parking facilities, a land parcel and an apartment property in separate transactions to various unaffiliated parties for approximately $327.8 million. The total gain on the sale of these properties was approximately $81.7 million. The sold office properties consisted of approximately 879,388 square feet, the parking facilities contained approximately 3,721 parking spaces and the apartment property contained approximately 161 units.
We disposed of 19 industrial properties that were acquired in the Spieker Merger for approximately $213.4 million. There was no gain or loss on the sale of these properties. The sold industrial properties are located in California and Oregon and consist of approximately 4.1 million square feet.
During 2000, we disposed of seven office properties totaling approximately 964,136 square feet, 11 parking facilities and a partial interest in two Office Properties for approximately $536.0 million and recognized a total net gain on sale of real estate of approximately $36.0 million.
Segment Reporting
For segment reporting purposes, the office properties, the apartment property and the land parcels that were sold are included in the “Office Properties” segment and the industrial properties and parking facilities that were sold are included in the “Corporate and Other” segment.
Below is a summary of the results of operations of these properties through their respective disposition dates:
Liquidity and Capital Resources
Liquidity
Net cash flow from operations represents the primary source of liquidity to fund distributions, debt service, capital improvements and tenant improvements. We expect that our $1.0 billion line of credit will provide for funding of working capital and unanticipated cash needs as well as acquisitions and development costs.
Our net cash flow from operations is dependent upon the occupancy level of our properties, the rental rates on our leases, the collectibility of rent from our tenants, the level of operating and other expenses, and other factors. Material changes in these factors may adversely affect our net cash flow from operations. Such changes, in turn, would adversely affect our ability to fund distributions, debt service, capital improvements and tenant improvements. In addition, a material adverse change in our net cash flow from operations may affect the financial performance covenants under our line of credit and unsecured notes. If we fail to meet any of our financial performance covenants our line of credit may become unavailable to us, or the interest charged on the line of credit may increase. Either of these circumstances could adversely affect our ability to fund working capital and unanticipated cash needs, acquisitions and development costs.
In order to qualify as a REIT for federal income tax purposes, Equity Office must distribute at least 90% of its REIT taxable income (excluding capital gains). Accordingly, we currently intend to continue to make regular quarterly distributions to holders of Common Shares and preferred shares.
Subject to the foregoing, we have established quarterly distribution rates which, if annualized, would be as follows:
(a)
In July 2002, Equity Office redeemed its 7,994,000 outstanding 8.98% Series A Cumulative Redeemable Preferred Shares at an aggregate redemption price of approximately $201.9 million, including accrued distributions. In addition, Equity Office issued 8,500,000 7.75% Series G Cumulative Redeemable Preferred Shares on July 29, 2002. Substantially all of the net proceeds from the issuance and sale of the Series G Preferred Shares totaling approximately $206.1 million were used to redeem the Series A Preferred Shares.
Since our anticipated distributions will not allow us to retain sufficient cash to repay all of our debt as it comes due using only cash from operations, we will be required to repay maturing debt with proceeds from debt and/or equity offerings. There can be no assurance that such financing will be available on acceptable terms or at all.
Contractual Obligations
As of December 31, 2002, we were subject to certain contractual payment obligations as described in the table below. We are not subject to capital lease obligations or unconditional purchase obligations as of December 31, 2002.
(1)
Balance excludes net discount of $(12.6) million, net of accumulated amortization of approximately $(6.4) million.
(2)
Balance excludes net premium of $41.2 million, net of accumulated amortization of approximately ($15.4) million.
Forward-Starting Interest Rate Swaps
In October 2002, we entered into $1.1 billion of forward-starting interest rate swaps to effectively fix the 10-year Treasury rate at approximately 3.7% for future note offerings that occurred in 2003 and are anticipated to occur in 2004. The forward-starting interest rate swaps were entered into at current market rates and, therefore, had no initial cost. The terms of the forward-starting interest rate swaps require us to pay a fixed-interest rate to the counterparties and to receive a variable rate from the counterparties. The swaps settle at six-month intervals beginning in 2003 and 2004 and are scheduled to terminate in 2004. The market value of the forward-starting swaps at December 31, 2002 was a liability of approximately $18.6 million which is included in other liabilities and in other comprehensive income. In January 2003, we settled one of the forward-starting swaps that had a notional amount of $300 million and received approximately $0.8 million. The forward-starting swap was settled in connection with $500 million of unsecured notes that were issued in February 2003. We are obligated to settle the remaining swap agreements no later than the commencement of their term in early 2004. Upon settlement of the swaps, we may be obligated to pay the counterparties a settlement payment, or alternatively to receive settlement proceeds from the counterparties. Any monies paid or received will be amortized to interest expense over the term of the respective note offering.
Off-Balance Sheet Arrangements
Commitments
In accordance with the agreement governing the investment in Wright Runstad Associates Limited Partnership (“WRALP”) made in 1997, we agreed, for a period generally continuing until December 31, 2007, to make available to WRALP up to $20.0 million in additional financing or credit support for future development. As of December 31, 2002, no amounts have been funded pursuant to this agreement. However, we have unconditionally guaranteed payment of WRALP’s $19.5 million revolving line of credit, which has an outstanding balance of approximately $12.9 million as of December 31, 2002, in the event of WRALP’s non-payment. WRALP’s current line of credit matures in July 2003. We do not have a liability accrued related to this guarantee. In the event we make payment on WRALP’s line of credit and WRALP does not repay us, we are entitled to (i) terminate the credit facility provided to WRALP from us and (ii) declare all amounts borrowed by WRALP due and payable. We believe the risk of an unrecovered loss is minimal at this time.
Letters of Credit
As of December 31, 2002, we had provided approximately $3.3 million in letters of credit. The letters of credit were required to be issued under the provisions of our worker’s compensation insurance policies and certain utility contracts.
Debt Financing
The table below summarizes our consolidated mortgage debt, unsecured notes and line of credit indebtedness at December 31, 2002 and 2001, including a net unamortized discount on mortgage debt of $(12.6) million and $(11.8) million, respectively, and a net unamortized premium on unsecured notes of $41.2 million and $17.5 million, respectively, recorded in connection with property acquisitions, mergers, issuance of unsecured notes and interest rate swap terminations.
(1)
The variable rate debt as of December 31, 2001 included $817 million of fixed rate unsecured notes that were converted to a variable rate based on various spreads over LIBOR through several interest rate swap agreements. During 2002, the interest rate swap agreements were terminated.
(2)
The variable rate debt bears interest at a rate based on various spreads over LIBOR.
Mortgage Debt
As of December 31, 2002, total mortgage debt (excluding our share of unconsolidated debt of approximately $819.0 million) consisted of approximately $2.5 billion of fixed rate debt with a weighted average interest rate of approximately 7.70% and $36.0 million of variable rate debt based on LIBOR plus 55
basis points (as of December 31, 2002, the variable rate was approximately 1.98%). See “Liquidity and Capital Resources - Contractual Obligations” for annual payment of obligations under our mortgage debt.
The instruments encumbering the properties restrict transfer of the respective properties subject to the terms of the mortgage, prohibit additional liens, require payment of real estate taxes on the properties, maintenance of the properties in good condition, maintenance of insurance on the properties and a requirement to obtain lender consent to enter into material tenant leases.
Line of Credit
EOP Partnership has a $1.0 billion revolving credit facility that was obtained in May 2000. As of December 31, 2002, $205.7 million was outstanding under this facility. The line of credit bears interest at LIBOR plus 60 basis points and matures on May 12, 2003 (as of December 31, 2002, the variable rate was approximately 2.44%). There is also an annual facility fee of $2.0 million payable quarterly. In addition, a competitive bid option, whereby the lenders participating in the credit facility bid on the interest to be charged, is available for up to $350 million of the borrowings under the credit facility. We have guaranteed outstanding obligations under the line of credit.
Unsecured Notes
Unsecured notes decreased to approximately $9,057.7 million at December 31, 2002 compared to approximately $9,094.0 million at December 31, 2001, as a result of the following transactions:
The table below summarizes the unsecured notes outstanding as of December 31, 2002:
(a)
Includes the effect of terminated interest rate protection and swap agreements, offering and transaction costs and premiums and discounts on certain unsecured notes.
(b)
The notes are exchangeable into Common Shares at an exchange rate of $34.00 per share. If the closing price at the time a holder exercises its exchange right is less than the exchange price of $34.00, the holder will receive, in lieu of Common Shares, cash in an amount equal to 97% of the product of the number of Common Shares into which the principal amount of notes subject to such exercise would otherwise be exchangeable and the current market price per Common Share.
As of March 13, 2003, $1.6 billion of capacity was available for issuance, under a shelf registration statement.
Restrictions and Covenants under Unsecured Indebtedness
Agreements or instruments relating to our unsecured notes and the line of credit contain certain financial restrictions and requirements described below. As of December 31, 2002, we were in compliance with each of these financial restrictions and requirements.
Set forth below are the financial restrictions and requirements to which we are subject under our line of credit agreement:
•
total liabilities to total asset value may not exceed 0.55:1 at any time;
•
earnings before interest, taxes, depreciation and amortization to interest expense may not be less than 2.00:1;
•
cash flow to fixed charges may not be less than 1.5:1;
•
secured debt to total asset value may not exceed 0.40:1;
•
unsecured debt to unencumbered asset value may not exceed 0.55:1;
•
unencumbered net operating income to unsecured debt service may not be less than 2.0:1;
•
consolidated tangible net worth may not be less than the sum of $7.8 billion and 70% of all net offering proceeds received by Equity Office or EOP Partnership after February 29, 2000;
•
we may not pay any distributions on Common Shares and Units in excess of 90% of annual funds from operations (“FFO”); and
•
our investments in unimproved assets, interest in taxable REIT subsidiaries, developments, unconsolidated joint ventures, mortgages and securities, in the aggregate, may not exceed 25% of our total asset value.
Set forth below are the financial restrictions and requirements to which we are subject under our unsecured note indentures and our performance under each covenant as of December 31, 2002:
Equity Securities
A summary of the activity of our Common Shares and EOP Partnership’s Units (exclusive of Units owned by us) during the year ended 2002 is as follows:
(a)
In July 2002, Equity Office announced a Common Share repurchase program allowing for the repurchase of up to $200 million of Common Shares, which was later increased to $400 million in November 2002, over the next 12 months at the discretion of management. The Common Shares may be repurchased in the open market or privately negotiated transactions. During 2002, 7,901,900 Common Shares were repurchased at an average price of $24.92 for approximately $196.9 million in the aggregate. From January 1, 2003 through March 13, 2003, 2,518,100 Common Shares were repurchased at an average price of $23.82 for approximately $60.0 million in the aggregate.
(b)
During 2002, EOP Partnership redeemed 3,727,925 Units for cash at an average price of $28.62 for a total of approximately $106.7 million.
Cash Flows
The following summary discussion of our cash flows is based on the consolidated statements of cash flows in “Item 8. - Financial Statements and Supplementary Data” and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below.
Years Ended December 31, 2002 and
Cash and cash equivalents decreased by approximately $2.7 million to approximately $58.5 million at December 31, 2002, compared to $61.1 million at December 31, 2001. This decrease was the net result of approximately $1,390.9 million provided by operating activities, approximately $85.2 million provided by investing activities (consisting primarily of approximately $377.2 million provided by property dispositions and approximately $167.0 million released from escrows partially offset by approximately $433.6 million used for capital and tenant improvements and lease acquisition costs) and approximately $1,478.8 million used for financing activities.
Years Ended December 31, 2001 and
Cash and cash equivalents increased by approximately $7.9 million to approximately $61.1 million at December 31, 2001, compared to $53.3 million at December 31, 2000. This increase was the net result of approximately $1,241.6 million provided by operating activities, approximately $1,348.2 million used for investing activities (consisting primarily of approximately $1,077.0 million used for the acquisition of Spieker and approximately $437.7 million used for capital and tenant improvements and lease acquisition costs) and approximately $114.5 million provided by financing activities.
Additional Items
Tenant and Other Receivables
Tenant and other receivables decreased from approximately $120.4 million at December 31, 2001 to approximately $77.6 million at December 31, 2002 primarily due to the collection of receivables from tenants during 2002 relating to reimbursable expenses. In the fourth quarter 2001, receivables from tenants for reimbursable expenses were increased based on an analysis of actual reimbursable expenses compared to the amount billed to the tenants during 2001.
Deferred Rent Receivables
Certain leases provide for tenant occupancy during periods for which no rent is due or where minimum rent payments increase during the term of the lease. We record rental income for the full term of each lease on a straight-line basis. Accordingly, a receivable is recorded from tenants for the current difference between the straight-line rent and the rent that is actually due from the tenant. This receivable amount is included in the consolidated balance sheets as “deferred rent receivable”. The deferred rent receivable increased approximately $62.1 million to $331.9 million at December 31, 2002, from $269.8 million at December 31, 2001. The increase was due to a net increase in the difference between the straight-line rent and the rent that is actually due from tenants primarily from the acquisition of the Properties acquired in the Spieker Merger on July 2, 2001 and certain development properties that were placed in service.
Escrow Deposits and Restricted Cash
Escrow deposits primarily consist of amounts held by lenders to provide for future real estate tax expenditures and tenant improvements, earnest money deposits on acquisitions and net proceeds from tax-deferred dispositions. Restricted cash represents amounts committed for various utility deposits and security deposits. Certain of these amounts may be reduced upon the fulfillment of certain obligations. The escrow deposits and restricted cash decreased approximately $167.1 million to $29.2 million at December 31, 2002, from $196.3 million at December 31, 2001. The decrease was primarily due to the disbursement of approximately $162.0 million of proceeds from the sale of certain parking facilities in 2001 that were deposited into a tax-deferred escrow account.
Investments in Unconsolidated Joint Ventures
Investments in unconsolidated joint ventures decreased to approximately $1,087.8 million at December 31, 2002 from $1,321.1 million at December 31, 2001 primarily due to the consolidation of several properties that were previously accounted for under the equity method. See Developments - subfootnote (b) for additional information.
Other Liabilities
Other liabilities increased from approximately $330.3 million at December 31, 2001 to approximately $392.0 million at December 31, 2002 primarily due to an increase in prepaid rents and other accruals.
Market Risk
Qualitative Information About Market Risk
Our future earnings, cash flows and fair values relevant to financial instruments are dependent upon prevalent market rates for those financial instruments. Market risk is the risk of loss from adverse changes in market prices and interest rates. We manage our market risk by matching projected cash inflows from operating, investing and financing activities with projected cash outflows to fund debt service, acquisitions, capital expenditures, distributions to shareholders and other cash requirements. The majority of our outstanding debt obligations (maturing at various times through 2031) have fixed interest rates which limit the risk of fluctuating interest rates. We utilize certain derivative financial instruments at times to further reduce interest rate risk. Interest rate protection and swap agreements are used to convert some variable rate
debt to a fixed rate basis, fixed rate debt to a variable rate basis, or to hedge anticipated financing transactions. Derivatives are used for hedging purposes rather than speculation. We do not enter into financial instruments for trading purposes.
Quantitative Information About Market Risk
Interest Rate Risk - Debt
The tables below disclose the effect of hypothetical changes in market rates of interest on interest expense for variable rate debt and the fair value of total outstanding debt. Interest risk amounts were determined by considering the impact of hypothetical interest rates on our debt. This analysis does not reflect the impact that a changing interest rate environment could have on the overall level of economic activity. Further, in the event of a changing interest rate environment, management would likely take actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no change in our financial structure.
(a)
The variable rate debt as of December 31, 2001 includes $817 million of fixed rate unsecured notes that were converted to a variable rate based on various spreads over LIBOR through several interest rate swap agreements.
(b)
As of December 31, 2002, the fair value of our fixed-rate debt was approximately $1.0 billion higher than the book value of approximately $11.5 billion primarily due to the general decrease in market interest rates on secured and unsecured debt. As of December 31, 2001, the fair value of our fixed-rate debt approximated book value.
Interest Rate Risk - Derivatives
Interest Rate Swaps
During 2002 and 2001, we entered into and terminated several interest rate swap agreements that hedged certain unsecured notes. In each case, we were the variable interest rate payer and the counterparty was the fixed rate payer. The variable interest rates were based on various spreads over LIBOR. The settlement dates correspond to the interest payment dates of the respective unsecured notes being hedged. Each of the interest rate swap agreements were to terminate on the maturity date of the respective unsecured notes being hedged. The interest rate swap agreements were designated as fair value hedges. As of December 31, 2001, approximately $1.4 million was included in other assets and approximately $9.5 million was included in other liabilities which represented the fair value of the interest rate swaps. A corresponding amount is included in discounts/ premium on unsecured notes. As of December 31, 2002, all of the interest rate swaps in the table
below had been terminated. The table below summarizes the interest rate swap agreements that were effective during 2002 and 2001.
(a)
The proceeds from the swap terminations were recorded as additional premium on the respective unsecured note that was hedged by the terminated swap. The amount recorded as additional premium is being amortized over the remaining term of the unsecured notes.
Forward-Starting Interest Rate Swaps
In October 2002, we entered into $1.1 billion of forward-starting interest rate swaps to effectively fix the 10-year Treasury rate at approximately 3.7% for note offerings that occurred in 2003 and are anticipated to occur in 2004. The forward-starting interest rate swaps were entered into at current market rates and, therefore, had no initial cost. The terms of the forward-starting interest rate swaps require us to pay a fixed-interest rate to the counterparties and to receive a variable rate from the counterparties. The swaps settle at six-month intervals beginning in 2003 and 2004 and are scheduled to terminate in 2004. The market value of the forward-starting swaps at December 31, 2002 was a liability of approximately $18.6 million which is included in other liabilities and in other comprehensive income. If the market interest rates were 10 basis points higher, our liability under the swaps would have been approximately $3.0 million at December 31, 2002. If the market interest rates were 10 basis points lower, our liability under these swaps would have been approximately $21.8 million at December 31, 2002. In January 2003, we settled one of the forward-starting swaps that had a notional amount of $300 million and received approximately $0.8 million. The forward-starting swap was settled in connection with $500 million of unsecured notes that were issued in February 2003. We are obligated to settle the remaining swap agreements no later than the commencement of their term in early 2004. Upon settlement of the swaps, we may be obligated to pay the counterparties a settlement payment, or alternatively to receive settlement proceeds from the counterparties. Any monies paid or received will be amortized to interest expense over the term of the respective note offering.
Market Rate Risk
During 2002, we sold our investments in marketable securities that were owned as of December 31, 2001, and realized a gain of approximately $0.1 million. In addition, we received marketable securities from a tenant in connection with a lease termination and from the buyout of another company in which we owned common stock. Our cost basis in these investments is zero and the market value of approximately $0.4 million is included in other assets and other comprehensive income as of December 31, 2002.
In August 2001, we had put option agreements outstanding in connection with the acquisition of certain properties in 1997. We paid approximately $1.4 million in settlement of these put options. We previously recognized approximately $4.1 million as a total potential payment for the put option exercise between the period from August 1999 to August 2000. The difference of approximately $2.7 million between the $4.1 million previously recognized and the $1.4 million actually paid was recognized as a put option settlement during the third quarter 2001.
During 2001, we recorded a permanent impairment on our investment in marketable securities and reduced the carrying value to a nominal amount, which approximates the current market value. A 10% increase or decrease in the market price of these securities would increase or decrease our investment in these securities by approximately $0.01 million. Changes in the market prices of these securities are required to be reflected as a corresponding adjustment to accumulated other comprehensive income. At December 31, 2001, we had an unrealized holding loss on these investments totaling approximately $0.1 million, which is reflected as accumulated other comprehensive (loss). There will be no impact on earnings or cash flows from market price fluctuations unless we dispose of these investments or write-down the investments upon the determination that these investments have suffered a permanent impairment.
Capital Improvements, Tenant Improvements and Leasing Commissions
Capital Improvements
Significant renovations and improvements which improve or extend the useful life of our Properties are capitalized. We categorize these capital expenditures as follows:
• Capital Improvements - improvements that enhance the value of the property such as lobby renovations, roof replacement, significant renovations for Americans with Disabilities Act compliance, chiller replacement and elevator upgrades.
• Development and Redevelopment Costs - include costs associated with the development or redevelopment of a property including tenant improvements, leasing commissions, capitalized interest and operating costs incurred during completion of the property and incurred while the property is made ready for its intended use.
The table below details the costs incurred for each type of improvement.
(a)
Properties included in redevelopment for 2002 are Tabor Center, Polk and Taylor Buildings, Worldwide Plaza and 500-600 City Parkway. Redevelopments in 2001 are US Bancorp, 100 Summer and Tabor Center.
Tenant Improvements and Leasing Commissions
Costs related to the renovation, alteration or build-out of existing second-generation space, as well as related leasing commissions, are capitalized. These tenant improvements may include, but are not limited to, floor coverings, ceilings, walls, HVAC, mechanical, electrical, plumbing and fire protection systems. We categorize tenant improvements and leasing commissions as follows:
•
Revenue enhancing - costs incurred on space which is vacant at the time of acquisition or has been vacant for nine months or more.
•
Non-revenue enhancing - costs incurred in connection with the renewal or retenanting of currently leased space to maintain the revenue being generated by such space.
The amounts shown below represent the total tenant improvement and leasing commissions for leases which commenced during the period, regardless of when such costs were actually paid, which is a more useful measure of the total tenant improvement and leasing commission costs for the periods presented.
(a)
Represents Equity Office’s share of unconsolidated joint venture tenant improvement and leasing costs. All joint ventures are office properties.
The above information includes actual capital improvements incurred and tenant improvements and leasing commissions for leases which commenced during the years shown. The amounts included in the consolidated statements of cash flows represent the cash expenditures made during each of these years. The differences between these amounts represent timing differences between the lease commencement dates and the actual cash expenditures as well as expenditures for corporate furniture, fixtures and equipment, software,
leasehold improvements and other. The reconciliation between the amounts above for the consolidated properties and the amounts disclosed in the consolidated statements of cash flows are as follows:
Developments
Consolidated Developments:
We currently own directly and through joint ventures several properties in various stages of development or pre-development. These developments are funded by working capital and the line of credit. Specifically identifiable direct acquisition, development and construction costs are capitalized, including, where applicable, salaries and related costs, real estate taxes and interest essential to the development of a property. The properties under development and all figures stated below are as of December 31, 2002.
Unconsolidated Developments:
(a)
The Estimated Placed in Service Date represents the date the certificate of occupancy was or is currently anticipated to be obtained. Subsequent to obtaining the certificate of occupancy, the property is expected to undergo a lease-up period.
For consolidated developments, Equity Office’s Costs Incurred and the Total Estimated Costs are based on Equity Office’s Effective Ownership Percentage, and include, for Foundry Square II, Equity Office’s portion of the first mortgage financing described in footnote (b). The Total Project Estimated Costs represent 100% of the development’s estimated costs including Equity Office’s and any unaffiliated parties’ portions.
For unconsolidated developments, the Effective Ownership Percentage represents Equity Office’s direct interest in the development and its indirect interest through its 49.9% interest in Wilson/ Equity Office (“W/EO”). Equity Office’s Costs Incurred and Total Estimated Costs are based on Equity Office’s Effective Ownership Percentage and include Equity Office’s portion of the first mortgage financing described in footnote (b). The Total Project Estimated Costs represent 100% of the development’s estimated costs including Equity Office’s, Wilson Investors’ (“WI”) and any third parties’ portions.
The Total Estimated Costs and the Total Project Estimated Costs are subject to change upon, or prior to, the completion of the development and include amounts required to lease the property.
(b)
Equity Office and WI previously entered into a joint venture agreement to form W/EO for the purpose of developing, constructing, leasing and managing developments in northern California. W/EO is owned 49.9% by Equity Office and 50.1% by WI. William Wilson III, a trustee of Equity Office, through his ownership of WI, owns approximately 22% of W/EO and approximately 30% of any promote to which WI is entitled under the joint venture agreement. Equity Office had agreed to loan up to $25 million to WI for its required contribution to W/EO at a 15% interest rate per annum. All amounts outstanding have been repaid and as a result of the recent transactions with WI described below, the loan commitment has been terminated.
Equity Office created joint ventures with W/EO and, in certain cases, unaffiliated parties for the development of various office properties. Equity Office has agreed to provide first mortgage financing to the ownership entities of each of these developments at the greater of 6.5% or LIBOR plus 3.25%, generally maturing 36 months after initial funding or earlier at the option of Equity Office in the event alternative financing sources are available on terms reasonably acceptable to WI and any unaffiliated party. The aggregate amount of any such financing would generally be capped at 70% of budgeted construction costs (76% in the case of Concar which, at December 31, 2002 had been completed and leased and as such is no longer included in the Developments summary above). At December 31, 2002, Equity Office had committed to make mortgage loans for Foundry Square IV and Concar totaling approximately $96 million, of which approximately $74 million in principal and approximately $.4 million in accrued interest was outstanding. In addition, the mortgage loan commitment on Foundry Square II is approximately $117 million of which approximately $77 million of principal and $.4 million in accrued interest was outstanding as of December 31, 2002.
In December 2002, Equity Office, W/EO and WI completed a transaction pursuant to which Equity Office acquired W/EO’s interests in various projects known as Foundry Square II, Foundry Square III (a land parcel under option), the Ferry Building, San Rafael Corporate Center I and San Rafael Corporate Center II (a land parcel). WI acquired W/EO’s interest in a project known as Larkspur (a land parcel under option) and WI acquired the operating business and all assets of W/EO other than its ownership interests in the development projects known as Foundry Square IV and Concar. In accordance with the W/EO operating agreement, Equity Office may, but is not required to, purchase the W/EO interest in Foundry Square IV and Concar, subsequent to project stabilization. A WI subsidiary will continue providing the development management services to Foundry Square II, the Ferry Building and Concar. Equity Office also engaged a subsidiary of WI to provide leasing brokerage services for Foundry Square II and the Ferry Building. Equity Office’s and W/EO’s interests in Foundry Square IV and Concar remain unchanged as a result of this transaction. Joint ventures with other unaffiliated parties on the projects in which Equity Office acquired W/EO’s interest also remain unchanged as a result of this transaction.
(c)
A joint venture between Equity Office and other unaffiliated parties leased the Ferry Building from the City and County of San Francisco, through its Port Commission (the “Port”). Under this lease, the Port is paid a stated base rent. In addition, once the lessee has received from the project a cumulative
preferred return of 8% (prior to stabilization) and 11% (after stabilization), then 50% of the proceeds from the operation and ownership of the project are paid to the Port as percentage rent.
The joint venture is redeveloping the Ferry Building in a manner to permit the use of federal rehabilitation tax credits (“Historic Tax Credits”). Since the original members of the joint venture could not take full advantage of the Historic Tax Credits, the joint venture admitted a new member who could do so. This investor member will contribute approximately $23.5 million in equity to fund a portion of the Total Project Estimated Costs for the project, and will be entitled to a preferred return with an effective annual rate of approximately 3% on its capital investment. The investor member’s interest in the joint venture is subject to put/call rights during the sixth and seventh years after the Ferry Building is placed in service. Upon the purchase of the investor member’s interest pursuant to the put/call, it is estimated that the joint venture will retain approximately $11 million of the capital contributed by the investor member, based on a formula to determine the purchase price for the investor member’s interest and after taking into account the preferred return that will have been paid to the investor member by such time. Through the creation of a master lease, Equity Office’s Effective Ownership Percentage in the net cash flow of the Ferry Building project is effectively 100%, after the payment to the Port of the percentage rent described above and the distribution of preferred returns to the investor member.
In addition to the developments described above, we own or have under option various land parcels available for development. These sites represent possible future development of up to approximately 12 million square feet of office space. The development of these sites will be impacted by the timing and likelihood of success of the entitlement process, both of which are uncertain. These various sites include, among others: Russia Wharf, Boston, MA; Reston Town Center, Reston, VA; Prominence in Buckhead, Atlanta, GA; Perimeter Center, Atlanta, GA; Tabor Center, Denver, CO; Bridge Pointe, San Diego, CA; La Jolla Centre, San Diego, CA; Orange Center, Orange, CA; Water’s Edge, Los Angeles, CA; Skyport Plaza, San Jose, CA; Foundry Square, San Francisco, CA; San Rafael Corporate Center, San Rafael, CA; Station Oaks, Walnut Creek, CA; Parkshore Plaza, Folsom, CA; City Center Bellevue; Bellevue, WA; and 8th Street, Bellevue, WA.
Consolidated developments in process increased to approximately $284.7 million at December 31, 2002 compared to $165.0 million at December 31, 2001, primarily due to the consolidation of the Ferry Building and Foundry Square II in 2002 (see Item 8. Financial Statements and Supplementary Data - Note 8 - Investment in Unconsolidated Joint Venture-subfootnote (6)), the commencement of two developments and additional expenditures made during 2002, partially offset by two developments that were placed in service.
Subsequent Events
The following transactions occurred subsequent to December 31, 2002 through March 13, 2003:
In January 2003, EOP Partnership issued $500 million of 5.875% unsecured notes due January 15, 2013. Including all offering expenses, the all-in effective rate of the unsecured notes is 5.98%. The notes are guaranteed by Equity Office. Total cash proceeds net of selling commissions and other expenses were approximately $494.9 million. The net proceeds were used to repay $300 million of unsecured notes that matured in February 2003. The remaining net proceeds were used to repay outstanding balances on the line of credit and for general business purposes, including working capital.
In January 2003, we sold the ABAM Building, Washington Park and the Federal Way office buildings to an unaffiliated party for approximately $13.5 million. The properties comprised three office properties, approximately 114,527 square feet and are located in Seattle, Washington.
In February 2003, we sold the U.S. West Dex Center office building to an unaffiliated party for approximately $11.6 million. The property comprised one office building, approximately 136,176 square feet and is located in Salt Lake City, Utah.
In February 2003, we sold the Commerce Park office building to an unaffiliated party for approximately $16.1 million. The property comprised one office building, approximately 94,367 square feet and is located in Santa Monica, CA.
Effective in February 2003, we amended our third-party insurance coverage for acts of terrorism as a result of the Terrorism Risk Insurance Act of 2002 (“TRIA”) enacted by Congress and signed into law by President Bush on November 26, 2002. We canceled the terrorism insurance program that provided a limit of $270 million in the aggregate per year and replaced it with a limit of $825 million in the current property
insurance program which provides coverage for chemical and biological exposure, whereas the previous insurance coverage excluded this exposure. Under TRIA, we have a per occurrence deductible of $750,000 and retain 10% of each and every loss up to a maximum of $33.25 million per occurrence, inclusive of the deductible. The federal government is obligated to cover the remaining 90% of the loss above the deductible up to $100 billion in the aggregate annually.
In March 2003, we sold the Janss Court office building to an unaffiliated party for approximately $35.5 million. The property comprised one office building, approximately 92,403 square feet, 32 residential units and is located in Santa Monica, CA.
Inflation
Substantially all of our office leases require the tenant to pay, as additional rent, a portion of any increases in real estate taxes (except in the case of certain California leases, which limit the ability of the landlord to pass through to the tenants the effect of increased real estate taxes attributable to a sale of real property interests) and operating expenses over a base amount. In addition, many of our office leases provide for fixed increases in base rent or indexed escalations (based on the Consumer Price Index or other measures). We believe that the majority of inflationary increases in expenses will be offset, in part, by the expense reimbursements and contractual rent increases described above.
Funds From Operations
Funds from Operation (“FFO”) is a non-GAAP financial measure. We believe FFO, as defined by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”), to be an appropriate measure of performance for an equity REIT. While FFO is a relevant and widely used measure of operating performance of equity REITs, it does not represent cash flow from operations or net income as defined by GAAP, and it should not be considered as an alternative to these indicators in evaluating liquidity or operating performance.
The following table reflects the reconciliation of FFO to net income available for Common Shares, the most directly comparable GAAP measure, for the five years ended December 31, 2002:
FFO is defined as net income, computed in accordance with GAAP, excluding gains (or losses) from sales of properties (which we believe includes impairments on properties held for sale), plus real estate related depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures. We believe that FFO is helpful to investors as a measure of the performance of an equity REIT because, along with cash flow from operating activities, investing activities and financing activities, it provides investors with an indication of the ability of a company to incur and service debt, to make capital expenditures and to fund other cash needs. Equity Office computes FFO in accordance with standards established by NAREIT, which may not be comparable to FFO reported by other REITs that do not define the term in accordance with the current NAREIT definition or that interpret the current NAREIT definition differently than Equity Office. FFO does not represent cash generated from operating activities in accordance with GAAP, nor does it represent cash available to pay distributions and should not be considered as an alternative to net income, determined in accordance with GAAP, as an indication of Equity Office’s financial performance or to cash flow from operating activities, determined in accordance with GAAP, as a measure of Equity Office’s liquidity, nor is it indicative of funds available to fund Equity Office’s cash needs, including its ability to make cash distributions.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Quantitative and qualitative disclosures about market risk are incorporated herein by reference from “Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Market Risk.”
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT AUDITORS
The Board of Trustees and Shareholders of Equity Office Properties Trust
We have audited the accompanying consolidated balance sheets of Equity Office Properties Trust (“Equity Office”) as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders’ equity, net comprehensive income and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and the schedule are the responsibility of Equity Office’s management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Equity Office at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
ERNST & YOUNG LLP
Chicago, Illinois
February 5, 2003, except for Note 26
as to which the date is March 13, 2003
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
See accompanying notes.
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED STATEMENTS OF NET COMPREHENSIVE INCOME
See accompanying notes.
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED STATEMENTS OF CASH FLOWS
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
EQUITY OFFICE PROPERTIES TRUST
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
See accompanying notes.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - BUSINESS AND FORMATION OF EQUITY OFFICE
As used herein, “Equity Office” means Equity Office Properties Trust, a Maryland real estate investment trust, together with its subsidiaries, including EOP Operating Limited Partnership, a Delaware limited partnership (“EOP Partnership”), and the predecessors thereof (“Equity Office Predecessors”), except where the context otherwise requires. Equity Office was organized in 1996 to continue and expand the national office property business organized by Mr. Samuel Zell, Chairman of the Board of Trustees of Equity Office, and to complete the consolidation of the Equity Office Predecessors (the “Consolidation”). Equity Office completed its initial public offering (the “IPO”) on July 11, 1997, having sold its common shares of beneficial interest, $0.01 par value per share (“Common Shares”). The net proceeds from the IPO were contributed to EOP Partnership in exchange for units of partnership interest (“Units”). Equity Office is a fully integrated, self-administered and self-managed real estate company principally engaged, through its subsidiaries, in owning, managing, leasing, acquiring and developing office properties. At December 31, 2002, Equity Office owned or had an interest in 734 office properties (the “Office Properties”) comprising approximately 125.7 million rentable square feet of office space and 77 industrial properties (the “Industrial Properties”) comprising approximately 6.0 million rentable square feet of industrial space (together with the Office Properties, the “Properties”). The Office Properties were, on a weighted average basis, 88.6% occupied at December 31, 2002, and are located in 138 submarkets in 32 markets in 20 states and the District of Columbia. The Office Properties, by rentable square feet, are located approximately 41.1% in central business districts (“CBDs”) and approximately 58.9% in suburban markets.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Equity Office owns substantially all of its assets and conducts all of its operations through EOP Partnership and its subsidiary entities. Equity Office is the sole general partner of, and owned at December 31, 2002 an approximate 89.1% interest in, EOP Partnership. Due to Equity Office’s ability as general partner to control EOP Partnership and various other property holding entities and other subsidiaries, each such entity has been consolidated for financial reporting purposes.
The Consolidation and Equity Office’s mergers with Spieker Properties, Inc., Cornerstone Properties Inc. and Beacon Properties Corporation were accounted for using the purchase method in accordance with Accounting Principles Board Opinion No. 16 and Statement of Financial Accounting Standards No. 141, Business Combinations. The fair value of the consideration given in these transactions was used as the valuation basis for the transactions. The assets acquired and liabilities assumed in these transactions were recorded at their fair values as of the closing dates of the transactions. The results of operations of the companies acquired in the mergers for the period from their respective closing dates were included in the consolidated statements of operations.
Investment in Real Estate
Rental property and improvements, including interest and other costs capitalized during construction, are included in investment in real estate and are stated at cost. Expenditures for ordinary maintenance and repairs are expensed to operations as they are incurred. Significant renovations and improvements, which improve or extend the useful life of the assets, are capitalized. Rental property and improvements, excluding land, are
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
depreciated over their estimated useful lives using the straight-line method. The estimated useful lives by asset category are:
Rental properties are individually evaluated for impairment when conditions exist which may indicate that it is probable that the sum of expected future cash flows (on an undiscounted basis) from a rental property over the anticipated holding period is less than its historical net cost basis. Upon determination that a permanent impairment has occurred, rental properties are reduced to their fair value. For properties to be disposed of, an impairment loss is recognized when the fair value of the property, less the estimated cost to sell, is less than the carrying amount of the property measured at the time Equity Office has a commitment to sell the property and/or is actively marketing the property for sale. A property to be disposed of is reported at the lower of its carrying amount or its estimated fair value, less its cost to sell. Subsequent to the date that a property is held for disposition, depreciation expense is not recorded.
The FASB issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long Lived Assets. Statement 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. The provisions of Statement 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. We adopted the standard in 2002 and it did not have a material effect on our financial condition or results of operations.
Developments in process are carried at cost, which includes land acquisition cost, architectural fees, general contractor fees, capitalized interest, internal costs related directly to the development and other costs related directly to the construction of the property. Depreciation is not recorded until the property is placed in service, which occurs shortly after receipt of a certificate of occupancy.
Land available for development is carried at cost and is not depreciated. Land available for development includes various vacant land parcels that may have some improvements such as utility service.
Investments in Unconsolidated Joint Ventures
Investments in unconsolidated joint ventures are accounted for using the equity method of accounting because Equity Office does not have control over the activities of the investees. The net equity investment of Equity Office is reflected on the consolidated balance sheets, and the consolidated statements of operations include Equity Office’s share of net income or loss from the unconsolidated joint ventures. Any difference between the carrying amount of these investments on the consolidated balance sheet of Equity Office and the value of the underlying equity is depreciated as an adjustment to income from unconsolidated joint ventures over 40 years. In 2001, Equity Office adopted SFAS 142 “Goodwill and Other Intangible Assets” upon its effective date and it did not have an effect on the consolidated financial statements.
Deferred Leasing and Financing Costs
Deferred leasing and financing costs, which consist of, but are not limited to, commissions paid to third parties for new or renewal leases, and fees paid to third parties for unsecured note offerings, are recorded at cost. The deferred leasing costs are amortized over the terms of the respective leases and the deferred financing costs are amortized over the terms of the respective financings on a straight-line basis, which approximates the effective yield method.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
Revenue Recognition
Certain leases provide for tenant occupancy during periods for which no rent is due or where minimum rent payments increase during the term of the lease. Equity Office records rental income for the full term of each lease on a straight-line basis. Accordingly, a receivable is recorded from tenants for the current difference between the straight-line rent and the rent that is contractually due from the tenant (“Deferred Rent Receivable”). When a property is acquired, the term of existing leases is considered to commence as of the acquisition date for purposes of this calculation. The amounts included in rental income for the years ended December 31, 2002, 2001 and 2000, which had not yet been billed as of such dates, were approximately $72.9 million, $69.1 million and $69.8 million, respectively. Deferred rental revenue is not recognized for income tax purposes.
Cash Equivalents
Cash equivalents are considered to be all highly liquid investments purchased with a maturity of three months or less at the date of purchase.
Allowance for Doubtful Accounts
Allowance for doubtful accounts is maintained for estimated losses resulting from the inability of certain tenants to meet the contractual obligations under their lease agreements.
Escrow Deposits and Restricted Cash
Escrow deposits primarily consist of amounts held by lenders to provide for future real estate tax expenditures and tenant improvements, earnest money deposits on acquisitions and net proceeds from tax-deferred dispositions. Restricted cash represents amounts committed for various utility deposits and security deposits. Certain of these amounts may be reduced upon the fulfillment of certain obligations.
Fair Value of Financial Instruments and Other Assets
Investments in notes receivable approximate their fair value and are included in other assets.
The fair value of the fixed-rate mortgage debt and unsecured notes as of December 31, 2002 was approximately $1.0 billion higher than the book value of approximately $11.5 billion primarily due to the general decrease in market interest rates on secured and unsecured debt. As of December 31, 2001, the fair value of our fixed-rate debt approximated book value. The fair value of the mortgage debt and the unsecured notes was determined by discounting the spread between the future contractual interest payments and the future interest payments based on a market rate. The fair value of the interest rate swap agreements was determined by third party quotations. In addition, management believes that the carrying values of cash equivalents, restricted cash, escrow deposits, tenant and other rents receivable, prepaid expenses and other assets, accounts payable and accrued expenses and other liabilities are reasonable estimates of their fair value.
Derivatives and Hedging Activities
Equity Office periodically enters into certain interest rate protection and swap agreements to effectively convert or cap floating rate debt to a fixed rate basis, fixed rate debt to a floating rate basis, as well as to hedge anticipated future financing transactions. Net amounts paid or received under these agreements are recognized as an adjustment to interest expense when such amounts are incurred or earned. Settlement amounts paid or received in connection with terminated interest rate protection agreements and interest rate swap agreements are deferred and amortized as an adjustment to interest expense over the remaining term of the related financing transaction on a straight-line basis, which approximates the effective yield method.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
In June 1998, the FASB issued Statement No. 133 “Accounting for Derivative Instruments and Hedging Activities” as amended by FASB Statement Nos. 137 and 138, which is effective for financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000. The statement requires recording all derivative instruments as assets or liabilities, measured at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives either will be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. Equity Office adopted the standard on January 1, 2001 and recorded a cumulative effect of a change in accounting principle resulting in a loss of approximately $1.1 million in the year ended December 31, 2001.
Deferred Revenue
During 2000 and 1999, Equity Office received common stock and/or warrants to purchase common stock for allowing companies that provide telecommunication and other services access to the Properties. The securities received from these companies were recorded as deferred revenue at fair value at the time such securities were earned and were included in other liabilities on the balance sheet. The deferred revenue was being amortized into other income over the terms of the respective license agreements. During 2001, it was determined that there was no remaining future benefit period for the unamortized deferred revenue. The unamortized deferred revenue balance as of December 31, 2001 and 2000 was $0 and $37.2 million, respectively. The amount of deferred revenue recognized in other income, net of the write-off of the related securities, for the years ended December 31, 2001 and 2000 was approximately $3.1 million and $5.7 million, respectively.
Income Taxes
The Office Properties and Industrial Properties primarily are owned by limited partnerships or limited liability companies, which are substantially pass-through entities. However, various consolidated entities owned by Equity Office are individually subject to certain taxes. Some of the pass-through entities have corporate general partners or members, which are subject to federal and state income and franchise taxes. In addition, the property management business is owned by a corporation and is subject to federal and state income and franchise taxes.
Equity Office has elected to be taxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, Equity Office generally will not be subject to federal income tax if it distributes 100% of its taxable income for each tax year to its shareholders. REITs are subject to a number of organizational and operational requirements. If Equity Office fails to qualify as a REIT in any taxable year, it will be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate tax rates. Even if Equity Office qualifies for taxation as a REIT, Equity Office may be subject to state and local income taxes and to federal income tax and excise tax on its undistributed income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes. The aggregate cost of land and depreciable property for federal income tax purposes as of December 31, 2002 and 2001 was approximately $14.8 billion and $15.0 billion, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
Reconciliation Between Net Income and Estimated Taxable Income (Unaudited):
Reconciliation Between Cash Distributions Paid and Distributions Paid Deduction (Unaudited):
Characterization of Distributions (Unaudited):
Minority Interests
EOP Partnership
Net income is allocated to minority interests based on their respective ownership percentage of EOP Partnership. The ownership percentage is calculated by dividing the number of Units held by the minority interests by the total Units held by both the minority interests and Equity Office. Issuance of additional Common Shares and Units changes the ownership interests of both the minority interests and Equity Office.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
Such transactions and the proceeds therefrom are treated as capital transactions. As of December 31, 2002 and 2001, Equity Office had an 89.1% and 88.0% interest in EOP Partnership, respectively.
Partially Owned Properties
Minority interests in consolidated Properties are reflected in the consolidated balance sheets as “Minority interests - partially owned properties” and represents the minority interests’ share in the assets and liabilities of the Properties. The earnings or losses from these properties attributable to the minority interests are reflected as “Minority interests - Partially owned properties” in the consolidated statements of operations.
Use of Estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to the previously reported 2001 and 2000 statements in order to provide comparability with the 2002 statements reported herein. These reclassifications have not changed the 2001 or 2000 results of operations or shareholders’ equity.
NOTE 3 - MERGERS
Spieker Merger
On July 2, 2001, Spieker Properties, Inc. (“Spieker”) merged into Equity Office and Spieker Properties, L.P. (“Spieker Partnership”), Spieker’s operating partnership subsidiary, merged into EOP Partnership (collectively, the “Spieker Merger”) which was accounted for using the purchase method. The transaction valued Spieker (including the outside interests in Spieker Partnership) at approximately $7.2 billion, which included transaction costs, the assumption of approximately $2.1 billion in debt and the issuance of 14.25 million of Equity Office preferred shares valued at approximately $356.3 million. Equity Office paid approximately $1.1 billion in cash and issued approximately 101.5 million Common Shares and EOP Partnership issued approximately 16.7 million Units to third parties, each valued at $29.29 per Common Share/ Unit. Equity Office financed the $1.1 billion cash portion of the purchase price using a combination of available cash and a new $1.0 billion bridge loan facility that was entered into before the closing of the Spieker Merger. The $1.0 billion bridge loan facility had a term of 364 days and an interest rate based on LIBOR plus 80 basis points. The $1.0 billion bridge loan facility was repaid in full with the net proceeds from the issuance of $1.4 billion of unsecured notes in July 2001 and terminated upon the repayment. Through the Spieker Merger, Equity Office acquired 391 Office Properties comprising approximately 28.3 million square feet, 98 Industrial Properties comprising approximately 10.1 million square feet and several development properties which added to Equity Office’s ownership in key markets across the western United States.
Shortly after completion of the Spieker Merger, Equity Office expanded its Board of Trustees from 13 to 16 members. The new members are Warren E. Spieker, Jr., previous chairman of Spieker, and Craig G. Vought and John A. Foster, previous Co-Chief Executive Officers of Spieker.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 3 -
MERGERS - (continued)
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition:
Cornerstone Merger
On June 19, 2000, Cornerstone Properties Inc. (“Cornerstone”) merged into Equity Office and Cornerstone Properties Limited Partnership (“Cornerstone Partnership”), Cornerstone’s operating partnership subsidiary, merged into EOP Partnership (collectively, the “Cornerstone Merger”). The transaction, which was accounted for by the purchase method, valued Cornerstone, including the outside interests in Cornerstone Partnership at approximately $4.5 billion, which included transaction costs, the assumption of approximately $1.7 billion in debt, the redemption of 3.0 million shares of Cornerstone preferred stock valued at $18.00 per share, including accrued but unpaid dividends for a total of approximately $57.6 million, the redemption of approximately 58.5 million of Cornerstone common stock valued at $18.00 per share for a total of approximately $1.1 billion, the issuance of approximately 51.2 million Common Shares and the issuance by EOP Partnership of approximately 12.4 million Units valued at $24.68 per Common Share/ Unit. We financed the $1.2 billion in cash from our credit facilities. As a result of the Cornerstone Merger, Equity Office acquired an interest in 82 Office Properties containing approximately 18.9 million square feet of office space.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 4 - INVESTMENT IN REAL ESTATE
Investment in real estate, including Office Properties, Industrial Properties, properties under development and vacant land, was as follows:
During 2002, the Army and Navy Club Building and Liberty Plaza were acquired for a total of approximately $92.3 million from an unaffiliated party. These properties are located in Washington, D.C. and comprise approximately 260,372 square feet of office space.
During 2001, in addition to the properties acquired in the Spieker Merger, the Three Lafayette Centre office building was acquired for a total cost of approximately $68.7 million from an unaffiliated party. The property is located in Washington, D.C. and comprises approximately 259,441 square feet.
During 2000, in addition to the Properties acquired in the Cornerstone Merger, several Properties, or the remaining interests therein, were acquired for a total cost of approximately $130.2 million. These Properties comprised approximately 317,616 square feet.
NOTE 5 - DISPOSITIONS
During 2002, Equity Office disposed of 45 office properties, four parking facilities (see Note 8 sub footnote (4)), two industrial properties and three land parcels in separate transactions to various unaffiliated parties for approximately $508.3 million. The total gain on the sale of these properties was approximately $17.9 million. The sold office properties consisted of approximately 3,113,189 square feet, the industrial properties consisted of approximately 77,072 square feet, and the parking facilities consisted of approximately 7,464 parking spaces.
During 2001, Equity Office disposed of eight office properties, four parking facilities, a land parcel and an apartment property in separate transactions to various unaffiliated parties for approximately $327.8 million. The total gain on the sale of these properties was approximately $81.7 million. The sold office properties consisted of approximately 879,388 square feet, the parking facilities contained approximately 3,721 parking spaces and the apartment property contained approximately 161 units.
Equity Office sold 19 industrial properties that were acquired in the Spieker Merger for approximately $213.4 million. There was no gain or loss on the sale of these properties. The sold industrial properties are located in California and Oregon and consist of approximately 4.1 million square feet.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 5 - DISPOSITIONS - (continued)
During 2000, Equity Office disposed of seven office properties totaling approximately 964,136 square feet, 11 parking facilities and a partial interest in two Office Properties for approximately $536.0 million and recognized a total net gain on sale of real estate of approximately $36.0 million.
Segment Reporting
For segment reporting purposes, the office properties, the apartment property and the land parcels that were sold are included in the “Office Properties” segment and the industrial properties and parking facilities that were sold are included in the “Corporate and Other” segment.
Below is a summary of the results of operations of these properties through their respective disposition dates:
NOTE 6 - INVESTMENT IN NOTES RECEIVABLE AND PREFERRED STOCK
The following investments are included in Prepaid Expenses and Other Assets:
During 1999, a 67% share of a $202.2 million mezzanine-level debt position was acquired for approximately $73.9 million as part of a debt restructuring related to the SunAmerica Center office property. The unamortized discount to the face amount of the note of approximately $62.9 million may be amortized to interest income based on the estimated yield of the investment. The note accrues interest at 7.25% per annum and matures in August 2014 and is payable based on cash flow, as defined in the respective loan agreement. Equity Office recognizes interest income on this investment based on actual cash receipts. In addition, Equity Office has the option to acquire 67% of the aggregate face amount of two other subordinate notes from the current holder, an affiliate of the property owner. The aggregate face amount of these notes is $15.0 million.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 6 - INVESTMENT IN NOTES RECEIVABLE AND PREFERRED STOCK - (continued)
In July 1998, 50,000 preferred shares of CT Convertible Trust I, an investment management and real estate finance company, were acquired for approximately $48.5 million. The preferred shares have a liquidation preference of $1,000 each. The discount of $1.5 million is being amortized as additional dividend income over the term of 20 years. The terms of the preferred shares are as follows:
(a) For 60% of the investment, or approximately $30 million of the preferred shares:
•
the coupon rate of 8.25% per annum remains fixed through March 31, 2002. Thereafter, the rate will increase to the greater of:
•
10% per annum, increasing by 75 basis points per annum commencing October 1, 2004 and on each October 1 thereafter, or
•
a rate equal to Capital Trust, Inc.’s then annual dividend per common share divided by $7.00;
•
the conversion price is $7.00 per share;
•
the common share equivalent is fixed at 4,285,714 shares; and
•
the preferred shares are callable through September 30, 2004.
(b) For 40% of the investment, or approximately $20 million of the preferred shares:
•
the coupon rate is 13.0% per annum and is fixed until October 1, 2004 when it will increase by 75 basis points per annum; and
•
the preferred shares are callable at any time.
On September 30, 2002, CT Convertible Trust I redeemed the non-convertible amount of its preferred securities at par, including accrued dividends. Equity Office received approximately $20.1 million upon the redemption. Equity Office still has an approximate $29.2 million investment in the convertible portion of the preferred securities of CT Convertible Trust I.
NOTE 7 -
IMPAIRMENT ON SECURITIES, OTHER INVESTMENTS AND ASSETS HELD FOR SALE
During 2001, an impairment on securities and other investments of approximately $132.7 million was recognized in connection with various investments and other assets. The impairment is included in the statement of operations as “Impairment on securities and other investments.” The total impairment consisted of the investment in HQ Global Workplaces, Inc. preferred stock, including accrued but unpaid dividends, of approximately $90.6 million, the investments in several telecom, technology and advertising related companies, investments in two full-service business center joint ventures, and a portion of an investment in an internally developed software system.
During the latter part of 2001, HQ Global was in default with respect to certain covenant and payment obligations under its senior and mezzanine indebtedness, but received forbearance periods from both its senior and mezzanine lenders. HQ Global was unable to restructure its indebtedness during these forbearance periods. Based on these circumstances and other factors, Equity Office determined that its investment in HQ Global was not recoverable and, therefore, recorded a permanent impairment on 100% of its investment. Subsequently, in March 2002 HQ Global filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code.
Equity Office’s telecom, technology and advertising related investments and full-service business center joint venture investments have been experiencing operating losses due, in part, to the current economic environment. These investments were considered to be impaired based on their current fair value as compared to the carrying value. The fair value of the investments was based on internally prepared valuations considering current economic conditions. The impairments represent Equity Office’s entire investment in the respective assets, except for the internally developed software system, for which the impairment represented
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 7 -
IMPAIRMENT ON SECURITIES, OTHER INVESTMENTS AND ASSETS HELD FOR SALE - (continued)
approximately one-half of the investment. These investments and the related impairment are reported under the “Corporate and Other” segment for segment reporting purposes.
During 2001, an impairment on assets held for sale of approximately $2.5 million was recognized in connection with the sale of the St. Louis Parking Garage located in St. Louis, Missouri. The impairment is included in the statement of operations as “Impairment on assets held for sale.” The property was sold in January 2002. The sales price less costs to sell was less than the carrying amount of the property as of December 31, 2001. Equity Office had a 50% interest in the property and accounted for its investment using the equity method of accounting. Equity Office’s share of the net income from the property is included in “Income from Unconsolidated Joint Ventures” and was approximately $1.7 million and $2.0 million for the years ended December 31, 2001 and 2000, respectively. The asset and the related impairment are reported under the “Corporate and Other” segment for reporting purposes.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 8 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES
The following is a summary of Equity Office’s economic ownership in unconsolidated joint ventures. All of the properties are Office Properties except for the St. Louis parking garages and the entities included in the other category.
(1)
The amounts shown above approximate Equity Office’s economic ownership interest for the periods presented. Cash flow from operations, capital transactions and net income are allocated to the joint venture partners in accordance with their respective partnership agreements. Equity Office’s share of these items is subject to change based on, among other things, the operations of the Property and the timing and amount of capital transactions. Equity Office’s legal ownership may differ.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 8 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES - (continued)
(2)
In 2002, in connection with the restructuring of the partnership Equity Office contributed approximately $30.9 million to the joint venture which increased Equity Office’s economic ownership of Rowes Wharf to 44%.
(3)
In 2002, Equity Office acquired the remaining interest in the joint venture in exchange for the assumption by Equity Office of the joint venture partner’s share of the joint venture debt of approximately $50.8 million. Equity Office had previously accounted for the investment in Griffin Towers under the equity method and is now consolidating the investment.
(4)
In January 2002, Equity Office disposed of its 50% interest in four parking facilities in St. Louis, Missouri to an unaffiliated party for approximately $47.5 million and repaid Equity Office’s share of the mortgage debt of approximately $28.7 million. During 2001, an impairment on assets held for sale of approximately $2.5 million was recognized in connection with the sale (see Note 7). The parking facilities contained approximately 7,464 parking spaces.
(5)
In 2000, Equity Office formed a joint venture with Wilson Investors (“WI”, of which William Wilson III, a trustee of Equity Office, is principal), through its interest in Wilson/Equity Office (“W/EO” of which 49.9% is owned by Equity Office and 50.1%, is owned by WI), and an unaffiliated party to develop, construct, lease and manage Foundry Square I, a 327,000 square foot office building project located in San Francisco, California which was scheduled to be completed in the third quarter of 2003 and was leased to a single tenant. In March 2002, the tenant terminated its lease for $85 million. WI’s share of the lease termination income and consideration for its joint venture interest was approximately $26 million from which WI repaid the $12 million outstanding balance under a $25 million loan commitment from Equity Office previously made to WI and the accrued interest of approximately $2 million. Equity Office’s share of the lease termination income was approximately $40 million and was recorded as income from investment in unconsolidated joint ventures in the first quarter 2002.
(6)
In December 2002, Equity Office and WI, entered into a nonmonetary exchange in which Equity Office acquired Wilson Investors’ ownership of the Ferry Building, San Rafael Corporate Center I and II (a land parcel) and Foundry Square II and III (a land parcel under option), in exchange for its ownership in Larkspur (a land parcel under option) and its ownership in the W/EO operating business. The transaction was accounted for as a nonmonetary exchange since the assets included in the exchange were similar and since the cash consideration exchanged was minimal. Equity Office’s investment in Larkspur and the W/EO operating business was recorded as additional basis in the assets received since it represented the fair value of WI’s equity in the assets received. As a result of the exchange, the Ferry Building, San Rafael Corporate Center I and II, and Foundry Square II and III are now consolidated.
(7)
A joint venture between Equity Office and other unaffiliated parties leased the Ferry Building from the City and County of San Francisco, through its Port Commission (the “Port”). Under this lease, the Port is paid a stated base rent. In addition, once the lessee has received from the project a cumulative preferred return of 8% (prior to stabilization) and 11% (after stabilization), then 50% of the proceeds from the operation and ownership of the project are paid to the Port as percentage rent.
The joint venture is redeveloping the Ferry Building in a manner to permit the use of federal rehabilitation tax credits (“Historic Tax Credits”). Since the original members of the joint venture could not take full advantage of the Historic Tax Credits, the joint venture admitted a new member who could do so. This investor member will contribute approximately $23.5 million in equity to fund a portion of the Total Project Estimated Costs for the project, and will be entitled to a preferred return with an effective annual rate of approximately 3% on its capital investment. The investor member’s interest in the joint venture is subject to put/call rights during the sixth and seventh years after the Ferry Building is placed in service. Upon the purchase of the investor member’s interest pursuant to the put/call, it is estimated that the joint venture will retain approximately $11 million of the capital contributed by the investor member, based on a formula to determine the purchase price for the investor member’s interest and after taking into account the preferred return that will have been paid to the investor member by such time. Through
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 8 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES - (continued)
the creation of a master lease, Equity Office’s effective ownership percentage in the net cash flow of the Ferry Building project is approximately 100% after the payment to the Port of the percentage rent described above and the distribution of the preferred returns.
Combined summarized financial information of the unconsolidated joint ventures is as follows:
(a)
Equity Office’s share of the scheduled payments of principal on mortgage debt for each of the next five years and thereafter through maturity as of December 31, 2002 are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 8 - INVESTMENT IN UNCONSOLIDATED JOINT VENTURES - (continued)
NOTE 9 - MORTGAGE DEBT
Equity Office had outstanding mortgage debt of approximately $2.5 billion and $2.7 billion as of December 31, 2002 and 2001, respectively. The historical cost, net of accumulated depreciation, of encumbered properties at December 31, 2002 and 2001 was approximately $5.2 billion and $5.6 billion, respectively. During the years ended December 31, 2002 and 2001, the following transactions occurred:
(1)
Excludes net discount on mortgage debt of approximately $(12,584) and $(11,761) as of December 31, 2002 and 2001, respectively.
Fixed Interest Rate Mortgage Debt
As of December 31, 2002 and 2001, approximately $2.5 billion and $2.6 billion, respectively, of mortgage debt was at a fixed interest rate. Payments on fixed interest rate mortgage debt are generally due in monthly installments of principal and interest or interest only. As of December 31, 2002 and 2001, the effective interest rates ranged from 5.81% to 8.63% and 6.80% to 8.63%, respectively, and the weighted average effective interest rate was approximately 7.70% and 7.74%, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 9 - MORTGAGE DEBT - (continued)
Variable Interest Rate Mortgage Debt
As of December 31, 2002 and 2001, approximately $36.0 million of mortgage debt was at variable interest rates based on spreads over LIBOR. Payments on variable interest rate mortgage debt are due in monthly installments of interest only. As of December 31, 2002 and 2001, the weighted average variable effective interest rate was approximately 1.98% and 2.59%, respectively.
Repayment Schedule
Scheduled payments of principal for the next five years and thereafter through maturity as of December 31, 2002 are as follows:
NOTE 10 - LINE OF CREDIT AND TERM LOAN
EOP Partnership has a $1.0 billion revolving credit facility that was obtained in May 2000. The line of credit bears interest at LIBOR plus 60 basis points and matures on May 12, 2003. There is also an annual facility fee of $2.0 million payable quarterly. In addition, a competitive bid option, whereby the lenders participating in the credit facility bid on the interest to be charged, is available for up to $350 million of the borrowings under the credit facility. Agreements or instruments relating to the line of credit contain certain financial restrictions and requirements described below. As of December 31, 2002, Equity Office was in compliance with each of these financial restrictions and requirements.
Set forth below are the financial restrictions and requirements to which we are subject under our line of credit agreement:
•
total liabilities to total asset value may not exceed 0.55:1 at any time;
•
earnings before interest, taxes, depreciation and amortization to interest expense may not be less than 2.00:1;
•
cash flow to fixed charges may not be less than 1.5:1;
•
secured debt to total asset value may not exceed 0.40:1;
•
unsecured debt to unencumbered asset value may not exceed 0.55:1;
•
unencumbered net operating income to unsecured debt service may not be less than 2.0:1;
•
consolidated tangible net worth may not be less than the sum of $7.8 billion and 70% of all net offering proceeds received by Equity Office or EOP Partnership after February 29, 2000;
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 10 - LINES OF CREDIT AND TERM LOANS - (continued)
•
we may not pay any distributions on Common Shares and Units in excess of 90% of annual Funds From Operations; and
•
our investments in unimproved assets, interest in taxable REIT subsidiaries, developments, unconsolidated joint ventures, mortgages and securities, in the aggregate, may not exceed 25% of our total asset value.
Prior to the closing of the Spieker Merger on July 2, 2001, Equity Office obtained a $1.0 billion bridge term facility to finance a portion of the cash portion of the Spieker Merger. This $1.0 billion bridge term facility had a term of 364 days and an interest rate based on LIBOR plus 80 basis points. The $1.0 billion bridge loan facility was repaid and terminated on July 18, 2001 with proceeds from $1.4 billion unsecured note offering.
NOTE 11 - UNSECURED NOTES
During 2002, the following transactions occurred:
The following notes were outstanding as of December 31, 2002:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 11 - UNSECURED NOTES - (continued)
(a)
Includes the effect of terminated interest rate protection and swap agreements, offering and transaction costs and premiums and discounts on certain unsecured notes.
(b)
The notes are exchangeable into Common Shares at an exchange rate of $34.00 per share. If the closing price at the time a holder exercises its exchange right is less than the exchange price of $34.00, the holder will receive, in lieu of Common Shares, cash in an amount equal to 97% of the product of the number of Common Shares into which the principal amount of notes subject to such exercise would otherwise be exchangeable and the current market price per Common Share.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 11 - UNSECURED NOTES - (continued)
As of December 31, 2002, $2.1 billion of unsecured debt securities and related guarantees were available for issuance under a shelf registration statement.
Restrictions and Covenants under Unsecured Indebtedness
Agreements or instruments relating to our unsecured notes and the line of credit contain certain financial restrictions and requirements described below. As of December 31, 2002, Equity Office was in compliance with each of these financial restrictions and requirements.
Restrictions and Covenants
Set forth below are the financial restrictions and requirements to which we are subject under our unsecured note indentures and Equity Office’s performance under each covenant as of December 31, 2002:
NOTE 12 - DERIVATIVE FINANCIAL INSTRUMENTS
Interest Rate Swaps
During 2002 and 2001, Equity Office entered into and terminated several interest rate swap agreements that hedged certain unsecured notes. In each case, Equity Office was the variable interest rate payer and the counterparty was the fixed rate payer. The variable interest rates were based on various spreads over LIBOR. The settlement dates corresponded to the interest payment dates of the respective unsecured notes being hedged. Each of the interest rate swap agreements were to terminate on the maturity date of the respective unsecured notes being hedged. The interest rate swap agreements were designated as fair value hedges. As of December 31, 2001, approximately $1.4 million was included in other assets and approximately $9.5 million was included in other liabilities which represented the fair value of the interest rate swaps. A corresponding amount is included in discounts/premiums on unsecured notes at December 31, 2001. As of December 31,
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 12 -
DERIVATIVE FINANCIAL INSTRUMENTS - (continued)
2002, all of the interest rate swaps in the table below had been terminated. The table below summarizes the interest rate swap agreements that were effective during 2002 and 2001.
(a)
The proceeds from the swap terminations were recorded as additional premium on the respective unsecured note that was hedged by the terminated swap. The amount recorded as additional premium is being amortized over the remaining term of the unsecured notes.
Forward-Starting Interest Rate Swaps
In October 2002, Equity Office entered into $1.1 billion of forward-starting interest rate swaps to effectively fix the 10-year Treasury rate at approximately 3.7% for note offerings that occurred in 2003 and are anticipated to occur in 2004. The forward-starting interest rate swaps were entered into at current market rates and, therefore, had no initial cost. The terms of the forward-starting interest rate swaps require Equity Office to pay a fixed-interest rate to the counterparties and to receive a variable rate from the counterparties. The swaps settle at six-month intervals beginning in 2003 and 2004 and are scheduled to terminate in 2004. The market value of the forward-starting swaps at December 31, 2002 was a liability of approximately $18.6 million which is included in other liabilities and in other comprehensive income. In January 2003, Equity Office settled one of the forward-starting swaps that had a notional amount of $300 million and received approximately $.8 million. The forward-starting swap was settled in connection with $500 million of unsecured notes that were issued in February 2003. Equity Office is obligated to settle the remaining swap agreements no later than the commencement of their term in early 2004. Upon settlement of the swaps, Equity Office may be obligated to pay the counterparties a settlement payment, or alternatively to receive settlement proceeds from the counterparties. Any monies paid or received will be amortized to interest expense over the term of the respective note offering.
NOTE 13 - MINORITY INTERESTS IN PARTIALLY OWNED PROPERTIES
Although the financial condition and results of operations of the following Properties are consolidated, there are unaffiliated parties that own an interest in these Properties. These Properties are consolidated since Equity Office owns at least 50% of the respective ownership entities and controls the major decisions regarding the respective Properties. All of the Properties are Office Properties except for Fremont Bayside, an Industrial Property. Equity Office’s legal ownership of each Property and its economic interest in each Property is substantially the same.
The amounts shown below approximate Equity Office’s economic ownership interest for the period presented. Cash flow from operations, capital transactions and net income are allocated to the minority interests in accordance with their respective partnership agreements. Equity Office’s share of these items is
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 13 - MINORITY INTERESTS IN PARTIALLY OWNED PROPERTIES - (continued)
subject to change based on, among other things, the operations of the Property and the timing and amount of capital transactions.
(1)
Equity Office acquired the remaining 33% interest in April 2001.
(2)
This property is currently under development.
(3)
Acquired in the Spieker Merger.
Equity Office has additional Properties that are partially owned by unaffiliated parties where Equity Office’s approximate economic ownership is 100%.
NOTE 14 - REDEEMABLE COMMON SHARES
As of December 31, 2000, 1,717,844 redeemable Common Shares were outstanding which related to Common Shares subject to a put option agreement entered into with an affiliate of the Wright Runstad & Company in connection with the acquisition of certain Properties in December 1997. In September 2001, Equity Office paid approximately $1.4 million in settlement of this put option. Equity Office previously recognized approximately $4.1 million as a total potential payment for the put option exercise between the period from August 1999 to August 2000. The difference of approximately $2.7 million between the $4.1 million previously recognized and the $1.4 million actually paid was recognized as a put option settlement.
NOTE 15 - SHAREHOLDERS’ EQUITY
Common Shares
The following table presents the changes in the issued and outstanding Common Shares since January 1, 2001 (excluding 50,206,731 Units and 56,490,302 Units outstanding at December 31, 2002 and 2001,
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 15 - SHAREHOLDERS’ EQUITY - (continued)
respectively, which are convertible into Common Shares on a one-for-one basis, or the cash equivalent thereof, subject to certain restrictions):
(1)
In July 2002, Equity Office announced a Common Share repurchase program allowing for the repurchase of up to $200 million of Common Shares, which was later increased to $400 million in November 2002, over the next 12 months at the discretion of management. The Common Shares may be repurchased in the open market or privately negotiated transactions. During 2002, 7,901,900 Common Shares were repurchased at an average price of $24.92 for approximately $196.9 million in the aggregate.
Distributions
Distributions are declared and paid quarterly to holders of Common Shares as of the record dates of each declaration. The current quarterly distribution is $0.50 per Common Share. For the years ended December 31, 2002, 2001 and 2000, the per share distributions were $2.00, $1.90 and $1.74, respectively.
Preferred Shares
Listed below is a summary of Equity Office’s preferred shares. The preferred shareholders are entitled to receive, when and as authorized by the Board of Trustees of Equity Office, cumulative preferential cash distributions. Equity Office may redeem the preferred shares at certain dates in whole or in part at a cash redemption price equal to the redemption preference plus all accrued unpaid dividends to the date fixed for redemption.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 15 - SHAREHOLDERS’ EQUITY - (continued)
The annual per share distributions are as follows:
(1)
In July 2002, Equity Office redeemed its 7,994,000 outstanding 8.98% Series A Cumulative Redeemable Preferred Shares at an aggregate redemption price of approximately $201.9 million, including accrued distributions. In addition, Equity Office issued 8,500,000 7.75% Series G Cumulative Redeemable Preferred Shares in an offering that closed July 29, 2002. Substantially all of the net proceeds from the issuance and sale of the Series G Preferred Shares totaling approximately $206.1 million were used to redeem the Series A Preferred Shares.
(2)
The Series B Preferred Shares are convertible at any time by the holder into Common Shares at a conversion price of $35.70 per share. These shares are non-callable for five years with a mandatory call on February 15, 2008.
(3)
The Series D, E and F preferred shares were issued in connection with the Spieker Merger. In November 2001, Equity Office redeemed all of its 4,250,000 outstanding 9.45% Cumulative Redeemable Series D Preferred Shares at a redemption price of $25.00 per share, plus accrued and unpaid distributions for the period from October 1, 2001 to the redemption date of $0.2821875 per share, or an aggregate redemption price of approximately $107.4 million.
In March 2001, a holder of 10,000 Series B Preferred Shares exercised its right to convert its Series B Preferred Shares into 14,005 Common Shares.
In January 2000, Equity Office repurchased 6,000 Series A Cumulative Redeemable Preferred Shares and 37,100 Series C Cumulative Redeemable Preferred Shares at an average share price of $20.66 for approximately $0.9 million in the aggregate and the shares were retired. The difference between the share repurchase amount and the carrying amount of the preferred shares was classified as a preferred distribution in the consolidated statement of operations for the year ended December 31, 2000.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 16 - FUTURE MINIMUM RENTS
Future minimum rental receipts due on noncancelable operating leases at the Office Properties and Industrial Properties as of December 31, 2002 were as follows:
Equity Office is subject to the usual business risks associated with the collection of the above scheduled rents. The future minimum rental receipts due on noncancelable operating leases from Equity Office’s investment in unconsolidated joint ventures are not included in the above schedule.
NOTE 17 - FUTURE MINIMUM LEASE PAYMENTS
Certain Office Properties are subject to ground leases. Certain of these leases are subject to rental increases based upon the appraised value of the Property at specified dates or certain financial calculations based on the operations of the respective Property. Future minimum lease obligations under these noncancelable leases as of December 31, 2002 were as follows:
Rental expense for the years ended December 31, 2002, 2001 and 2000 was approximately $24.4 million, $19.9 million and $12.8 million, respectively, including rental expenses included in discontinued operations of $0, $.1 million and $.1 million, respectively. These rental expense amounts include ground rent and rent for the corporate offices.
NOTE 18 - EXTRAORDINARY ITEM
The $1.0 million extraordinary loss in 2001 related to costs on certain Office Properties located in Seattle, Washington as a result of damage from an earthquake in February 2001.
In accordance with SFAS 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections”, effective for fiscal years beginning after May 15, 2002, any gain or loss on extinguishment of debt that was classified as an extraordinary loss in prior periods shall be reclassified. During the years ended December 31, 2001 and 2000, Equity Office recognized approximately $9.4 million and approximately $1.8 million relating to early extinguishments of debt as extraordinary items. These amounts have been reclassified to “amortization of deferred financing costs and prepayment expenses”.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 19 - EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per Common Share and common share equivalent:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 19 - EARNINGS PER SHARE - (continued)
The following securities were not included in the computation of diluted earnings per Common Share and common share equivalent since they would have an antidilutive effect:
For additional disclosures regarding employee share options and restricted shares, see Note 23 - Share Option Plan and Share Award Plan.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION
As discussed in Note 1, Equity Office’s primary business is the ownership and operation of Office Properties. Management operates each Office Property as an individual operating segment and has aggregated these operating segments into a single operating segment for financial reporting purposes due to the fact that the individual operating segments have similar economic characteristics. Equity Office’s long-term tenants are in a variety of businesses, and no single tenant is significant to Equity Office’s business. The property operating revenues generated at the “Corporate and Other” segment consists primarily of revenues earned by the Industrial Properties and the stand-alone parking facilities. The “Other revenues” generated at the “Corporate and Other” segment consist primarily of fee income from the management of office properties owned by third parties and interest and dividend income from various investments.
(1)
Interest expense for the Office Properties does not include allocation of interest expense on the unsecured notes or the line of credit.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION - (continued)
(1)
Interest expense for the Office Properties does not include allocation of interest expense on the unsecured notes or the line of credit.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION - (continued)
(1)
Interest expense for the Office Properties does not include allocation of interest expense on the unsecured notes or the line of credit.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 21 - QUARTERLY DATA (UNAUDITED)
Quarterly data for the last two years are presented in the tables below:
(a)
The amounts presented for the three months ended September 30, 2002, June 30, 2002, and March 31, 2002 are not equal to the same amounts previously reported in the Form 10-Q filed with the SEC for each period as a result of discontinued operations consisting of properties sold in 2002. Below is a reconciliation to the amounts previously reported in the Form 10-Q:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 21 - QUARTERLY DATA (UNAUDITED) - (continued)
(a)
The amounts presented for the three months ended September 30, 2001, June 30, 2001 and March 31, 2001 are not equal to the same amounts previously reported in the Form 10-Q filed with the SEC for each period as a result of discontinued operations consisting of properties sold in 2002. Below is a reconciliation to the amounts previously reported in the Form 10-Q:
(b)
The extraordinary item of $1.0 million related to costs on certain Office Properties located in Seattle,WA as a result of damage from an earthquake in February 2001.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 22 - RELATED PARTY TRANSACTIONS
Related parties provide various services to Equity Office. Fees and reimbursements paid to related parties for the years ended December 31, 2002, 2001 and 2000 were as follows (there was approximately $1.7 million and $0.3 million payable to related parties as of December 31, 2002 and 2001, respectively:
(1)
Equity Office and WI entered into a joint venture agreement to form W/EO for the purpose of developing, constructing, leasing and managing developments in northern California. W/EO is owned 49.9% by Equity Office and 50.1% by WI. William Wilson III, a trustee of Equity Office, through his ownership of WI, owns approximately 22% of W/EO and approximately 30% of any promote to which WI is entitled under the joint venture agreement. Equity Office has agreed to loan up to $25 million to WI for its required contribution to W/EO at a 15% interest rate per annum. In 2002, WI repaid the outstanding loan balance of approximately $12.0 million of principal and $2.0 million of accrued interest. As a result of the recent transactions with WI (refer to Note 8 - Investment in Unconsolidated Joint Venture - subfootnote (5)) the loan commitment has been terminated. Equity Office’s investment in W/EO as of December 31, 2002 and 2001 was approximately $3.6 million and $32.3 million, respectively.
Equity Office created joint ventures with W/EO and, in certain cases, unaffiliated parties for the development of various office properties. Equity Office has agreed to provide first mortgage financing to the ownership entities of each of these developments at the greater of 6.5% or LIBOR plus 3.25%, generally maturing 36 months after initial funding or earlier at the option of Equity Office in the event alternative financing sources are available on terms reasonably acceptable to WI and any unaffiliated party. The aggregate amount of any such financing would generally be capped at 70% of budgeted construction costs (76% in the case of Concar which, at 12/31/02 had been completed and leased and as such is now reflected as investment in real estate). At December 31, 2002, Equity Office had committed to make mortgage loans for Foundry Square IV and Concar totaling approximately $96 million, of which approximately $74 million in principal and approximately $.4 million in accrued interest was outstanding.
In December 2002, Equity Office, W/EO and WI completed a transaction pursuant to which Equity Office acquired W/EO’s interests in various projects known as Foundry Square II, Foundry Square III (a land parcel under option), the Ferry Building, San Rafael Corporate Center I and San Rafael Corporate Center II (a land parcel). WI acquired W/EO’s interest in a project known as Larkspur (a land parcel under option) and WI acquired the operating business and all assets of W/EO other than its ownership interests in the development projects known as Foundry Square IV and Concar. In accordance with the W/EO operating agreement, Equity Office may, but is not required to, purchase the W/EO interest in Foundry Square IV and Concar, subsequent to project stabilization. A WI subsidiary will continue providing the development management services to Foundry Square II, the Ferry Building and Concar. Equity Office also engaged a subsidiary of WI to provide leasing brokerage services for Foundry Square II and the Ferry Building. Equity Office’s and W/EO’s interests in Foundry Square IV and Concar remain unchanged as a result of this transaction. Joint ventures with other unaffiliated parties on the projects in which Equity Office acquired W/EO’s interest also remain unchanged as a result of this transaction.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 22 - RELATED PARTY TRANSACTIONS - (continued)
(2)
In connection with the Cornerstone Merger, $250 million of mortgage debt was assumed on certain properties payable to Stichting Pensioenfonds Voor de Gezondheid, Geestelijke en Maatcschappellijke Belangen (“PGGM”), of which Jan H.W.R. van der Vlist, a trustee of Equity Office, is a director of real estate. In October 2000, Equity Office repaid $65 million of mortgage debt encumbering, TransPotomac Plaza 5, upon its maturity. In December 2001, the remaining $185 million of mortgage debt encumbering several properties was prepaid. As a result of the prepayment, Equity Office paid a $5.0 million prepayment penalty to PGGM.
(3)
Equity Office leases office space at Two North Riverside Plaza, Chicago, Illinois from Two North Riverside Plaza Joint Venture, a partnership composed of trusts established for the benefit of the families of Samuel Zell and Robert Lurie, a deceased former business partner of Mr. Zell.
(4)
H. Jon Runstad, a former trustee who resigned in July 2000, is a principal of Wright Runstad & Company, the general partner of Wright Runstad Associates Limited Partnership (“WRALP”), which provides property management, leasing and development services. Equity Office owns a 30% limited partnership interest in WRALP. During 2000, Equity Office received distributions of approximately $9.7 million from WRALP. Since December 1997, affiliates of WRALP served as the co-property manager with Equity Office and leasing agent for certain Office Properties acquired in December 1997 from WRALP and for several other Office Properties. In addition to the amounts paid above to WRALP for development and management fees, leasing commissions and related expense reimbursements with respect to some of our Properties, an additional $5.0 million was paid during 2000 to WRALP for the reimbursement of salaries of personnel in connection with such management services.
WRALP owned a 20% interest and Equity Office owned an 80% interest in Sunset North Corporate Campus, a three-building office complex located in Bellevue, Washington. WRALP served as developer of the project. In June 2000, Equity Office acquired the interest held by WRALP at a price based on a formula set forth in the joint venture agreement.
WRALP owns a 20% interest and Equity Office owns an 80% interest in Key Center, an Office Property located in Bellevue, Washington. WRALP served as developer of the project and currently serves as co-property manager with Equity Office and the leasing agent.
In September 2000, Equity Office purchased the World Trade Center East located in Seattle, Washington, from WRALP. WRALP served as the developer of the project.
See Note 25 - Commitments and Contingencies for information regarding Equity Office’s guarantee of WRALP’s line of credit.
Transaction with Trustee
In connection with the Cornerstone Merger in 2000, Equity Office paid $5.0 million to John S. Moody to enter into a non-compete agreement. Mr. Moody became a trustee of Equity Office at the time of the Cornerstone Merger and is the former president and chief executive officer of Cornerstone.
Access Holdings
In October 2000, five current and previous executive officers of Equity Office organized Access Holdings Company, L.L.C. and on August 2000 organized its sister company, AHC II, L.L.C., which Equity Office refers to collectively as “Access Holdings,” to provide or arrange for services for tenants that Equity Office could not provide under the REIT tax rules then in effect and to make certain investments that Equity Office was precluded from making under the REIT rules then in effect. Equity Office made loans totaling approximately $2.3 million in the aggregate at an annual interest rate of 7.0% to certain current and previous executive officers to finance their investment in Access Holdings. Of this amount, approximately $0.3 million
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 22 - RELATED PARTY TRANSACTIONS - (continued)
was used by Access Holdings to purchase the voting interests in various tenant service and management companies owned by affiliates of Mr. Zell and the balance was used to operate Access Holdings. In consideration of the assumption of an outstanding capitalization note in the principal amount of $1.0 million payable by certain affiliates of Mr. Zell to EOP Office Company, Access Holdings also acquired the voting interest in EOP Office Company. EOP Office Company holds various assets, including 109,987 Units, a 10.2% interest in the Sunset North Property and a 30% interest in WRALP.
In connection with the formation of Access Holdings, Equity Office entered into an option agreement with Access Holdings under which Access Holdings granted Equity Office the right on or after January 1, 2001 to acquire its assets, subject to its liabilities. Equity Office also granted to Access Holdings the right to sell its assets to Equity Office for a period of five years from the date of the tax law change. Neither Equity Office nor Access Holdings was obligated to exercise its respective contractual rights, and there was no assurance prior to January 1, 2001 that either would do so. The parties also entered into marketing and cost-sharing agreements pursuant to which Access Holdings paid an affiliate a total of $1.8 million during 2000. In 2001, Equity Office determined that it was in Equity Office’s best interests to exercise its option to acquire the assets of Access Holdings and, accordingly, submitted the matter to the Conflicts Committee of Equity Office’s Board of Trustees. The Conflicts Committee engaged the services of a third party to perform a valuation analysis of the assets and liabilities of Access Holdings for purposes of calculating the applicable purchase price under the option agreements. That firm delivered its valuation report and, in reliance on such report and on other factors it considered to be relevant, the Conflicts Committee approved the exercise of the option effective as of January 1, 2001 at a purchase price equal to the fair market value of the assets plus the assumption of liabilities and determined the applicable purchase prices under the option agreements to be as follows: (a) $2.3 million for the assets of Access Holdings Company, L.L.C., plus assumption of liabilities of $1.4 million; and (b) $0.2 million for the assets of AHC II Company, L.L.C., plus the assumption of liabilities of $0.1 million. The executive officers of Equity Office repaid their loans from Equity Office, collectively totaling approximately $2.3 million, using a portion of the purchase price paid by Equity Office for the assets of Access Holdings. These executive officers each earned a profit of approximately $52,000 on their investment in Access Holdings.
As a result of these transactions, Equity Office now owns interests through its subsidiaries in several tenant service entities, interests in certain Office Properties and minority voting securities of certain former non-controlled subsidiaries engaged in real estate, insurance and management businesses.
Amounts Received from Related Parties
As described in Note 6, Equity Office owns preferred shares of CT Convertible Trust I, of which Mr. Zell is Chairman of the Board.
Equity Office has entered into third-party management contracts and a licensing agreement to manage and lease space at certain Properties owned or controlled by affiliates of Mr. Zell. Income recognized by Equity Office for providing these management services during 2002 and 2001 was approximately $1.0 million and $1.5 million.
In addition, Equity Office provided real estate tax consulting and risk management services to related parties for which it received approximately $1.6 million, $1.7 million and $1.4 million during 2002, 2001 and 2000, respectively.
NOTE 23 - SHARE OPTION PLAN AND SHARE AWARD PLAN
Equity Office has established the 1997 Share Option and Share Award Plan, as amended (the “Employee Plan”). The purpose of the Employee Plan is to attract and retain highly qualified executive officers, trustees and employees. Through the Employee Plan, certain officers, trustees, employees and consultants of Equity
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 23 - SHARE OPTION PLAN AND SHARE AWARD PLAN - (continued)
Office are offered the opportunity to acquire Common Shares pursuant to grants of (i) options to purchase Common Shares (“Options”) and (ii) Share Awards (defined below). The Employee Plan is administered by the Compensation and Option Committee (the “Compensation Committee”), which is appointed by the Board of Trustees. The Compensation Committee determines those officers, trustees, key employees and consultants to whom, and the time or times at which, grants of Options and Share Awards will be made. The Compensation Committee interprets the Employee Plan, adopts rules relating thereto and determines the terms and provisions of Options and Share Awards. In 2002, 2001, and 2000 the Common Shares subject to Options and Share Awards under the Employee Plan were limited to 32,030,650, 23,733,869 and 19,433,472, respectively. The maximum aggregate number of Options and Share Awards that may be granted under the Plan may not exceed 6.8% of the outstanding Common Shares calculated on a fully diluted basis and determined annually on the first day of each calendar year. No more than one-half of the maximum aggregate number of Options and Share Awards shall be granted as Share Awards. To the extent that Options expire unexercised or are terminated, surrendered or canceled, the Options and Share Awards become available for future grants under the Plan, unless the Plan has terminated. The Employee Plan will terminate at such time as all of the unissued Common Shares reserved for the Plan have been issued. The Board of Trustees may at any time amend or terminate the Employee Plan, but termination will not affect Options and Share Awards previously granted. Any Options or Share Awards which vest prior to any such termination will continue to be exercisable by the holder thereof.
The Compensation Committee determines the vesting schedule of each Option and the term, which shall not exceed 10 years from the grant date. As to the Options that have been granted through December 31, 2002, the vesting schedules range from one-third of the Options being exercisable as of the first anniversary of the grant date, an additional one-third being exercisable as of the second anniversary of the grant date and the remaining one-third being exercisable as of the third anniversary of the grant date. The exercise price for all Options under the Employee Plan shall not be less than the fair market value of the underlying Common Shares at the time the Option is granted.
Each non-employee member of the Board of Trustees receives an annual grant of an Option to purchase 10,000 Common Shares (other than Mr. van der Vlist, who receives a grant of an equivalent share appreciation right exercisable for cash). If an individual becomes a trustee other than at an annual meeting, he or she is entitled to a prorated Option grant based upon the number of days until the next annual meeting of shareholders.
The Employee Plan permits the issuance of Share Awards to executive officers, trustees and key employees upon such terms and conditions as are determined by the Compensation Committee in its sole discretion. A Share Award is an award of a Common Share which (i) may be fully vested upon issuance (“Share Award”) or (ii) may vest over time (“Restricted Share Award”). Generally, members of the Board of Trustees have been granted Share Awards pursuant to the Employee Plan as payment of their board fees. In each case, the number of Share Awards granted to trustees was equal to the dollar value of the fee divided by the fair market value of a Common Share on the date the fee would have been paid. Restricted Share Awards were granted to certain officers and employees in 2002, 2001 and 2000. Restricted Share Awards granted in 2002 vest evenly over a five-year period, 20% per year on each of the first five anniversaries of the grant date. The Restricted Share Awards granted before 2002 vest over a five-year period as follows: 50% on the third anniversary of the grant date, 25% on the fourth anniversary of the grant date and the remaining 25% on the fifth anniversary of the grant date.
Equity Office has elected to apply the accounting provisions of Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees (“APB No. 25”) in the computation of compensation expense. Under APB No. 25, an intrinsic value method is used to determine compensation expense by computing the excess of the market price of the Common Shares subject to the Option or Share Award over the exercise price on the grant date or the measurement date. For Options, there is no intrinsic value on the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 23 - SHARE OPTION PLAN AND SHARE AWARD PLAN - (continued)
grant date or measurement date because the option exercise price equalled the Common Share market price. For Share Awards, the intrinsic value equals the Common Share market price on the grant date or measurement date because there is no exercise price.
Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”) requires the disclosure of pro forma net income and earnings per share as if a fair value based accounting method had been used in the computation of compensation expense. The fair value of the Options computed under SFAS No. 123 would be recognized over the vesting period of the Options. The fair value for Options granted in 2002, 2001, and 2000 was estimated at the time the Options were granted using the Black-Scholes option-pricing model with the following weighted average assumptions:
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the expected stock price volatility. Under the fair value method approximately $11.1 million, $11.9 million and $15.1 million would have been recognized as additional compensation expense for 2002, 2001 and 2000, respectively. For purposes of pro forma disclosures, the estimated fair value of the Options is amortized to expense evenly over the Options’ vesting period. The following is the unaudited pro forma information for the years ended December 31, 2002, 2001 and 2000:
Effective January 1, 2003, Equity Office adopted Statement of Financial Accounting Standards No. 123, (“SFAS No. 123”) Accounting for Stock Based Compensation, which requires a fair value based accounting method for determining compensation expense associated with the issuance of stock options and other equity awards. Equity Office decided to adopt the accounting provisions of SFAS No. 123 to reflect the cost to the company of issuing stock options and other equity awards to certain individuals in the consolidated financial statements. Equity Office will employ the prospective method for adopting SFAS No. 123 which requires the recognition of compensation expense for stock options and other equity compensation granted on or after January 1, 2003 and to record compensation expense for modifications of stock options and other equity awards that were outstanding as of December 31, 2002. Equity Office anticipates recognizing compensation expense of approximately $6.0 million, $12.0 million and $18.0 million for the years ending December 31, 2003, 2004 and 2005, respectively, for both Option and Share Award grants accounted for under SFAS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 23 - SHARE OPTION PLAN AND SHARE AWARD PLAN - (continued)
No. 123. These anticipated compensation expense amounts are based on the existing compensation structure for 2003 and assumes a similar level of Option and Share Award compensation in future years. Future Option and Share Award compensation is subject to change based on actual Options and Share Award grants in future years and their respective fair values.
Compensation expense related to Share Award grants was previously recognized in accordance with APB No. 25. The adoption of SFAS No. 123 does not significantly change the amount of compensation expense recognized for Share Awards.
The table below summarizes the Option activity of the Employee Plan for the years ended December 31, 2002, 2001 and 2000:
The following table summarizes information regarding Options outstanding at December 31, 2002:
(a)
Includes 3,681,212 Options granted in connection with the Cornerstone Merger.
(b)
Includes 1,890,648 Options granted in connection with the Spieker Merger.
(c)
Expiration dates ranged from May 2004 to September 2012.
During 2002, 2001 and 2000, there were 541,055, 602,666 and 555,100 Restricted Share Awards granted, respectively. The Restricted Shares Awards issued in 2002, 2001 and 2000 were, on average, valued at an average of $28.01, $20.61 and $23.91 each, respectively. The value of the Restricted Share Awards is recognized as compensation expense evenly over the vesting period.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 24 - 401(K) PLAN
The Equity Office Properties Trust Section 401(k) Savings/ Retirement Plan (the “401(k) Plan”) was established to cover eligible employees of Equity Office and employees of any designated affiliate. The 401(k) Plan permits eligible persons to defer up to 16% of their annual compensation into the 401(k) Plan, subject to certain limitations imposed by the Internal Revenue Code. Employees’ elective deferrals are immediately vested and nonforfeitable upon contribution to the 401(k) Plan. Equity Office matches dollar for dollar employee contributions to the 401(k) Plan up to 4% of the employee’s annual salary. In addition, Equity Office may elect to make an annual discretionary profit-sharing contribution. Equity Office expensed approximately $4.2 million, $3.8 million and $3.6 million in each of the years ended December 31, 2002, 2001 and 2000, respectively, related to the 401(k) Plan.
NOTE 25 - COMMITMENTS AND CONTINGENCIES
Concentration of Credit Risk
Equity Office maintains its cash and cash equivalents at financial institutions. The combined account balances at each institution typically exceed FDIC insurance coverage and, as a result, there is a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. Management of Equity Office believes that the risk is not significant.
Environmental
Equity Office, as an owner of real estate, is subject to various environmental laws of federal and local governments. Compliance by Equity Office with existing laws has not had a material adverse effect on Equity Office’s financial condition and results of operations, and management does not believe it will have such an impact in the future. However, Equity Office cannot predict the impact of unforeseen environmental contingencies or new or changed laws or regulations on its current Properties or on properties that it may acquire in the future.
Litigation
Equity Office is not presently subject to material litigation nor, to Equity Office’s knowledge, is any material litigation threatened against Equity Office, other than routine actions for negligence and other claims and administrative proceedings arising in the ordinary course of business, some of which are expected to be covered by liability insurance and all of which collectively are not expected to have a material adverse effect on the liquidity, results of operations, or financial condition of Equity Office.
Contingencies
Certain Properties owned in joint ventures with unaffiliated parties have buy/sell options that may be exercised to acquire the other partner’s interest by Equity Office or its joint venture partner may acquire Equity Office’s interest if certain conditions are met as set forth in the respective joint venture agreement. In addition, Equity Office has granted options to a tenant to purchase two of its Office Properties.
In connection with the acquisition of certain Properties, Equity Office has agreed not to sell such Properties in a taxable transaction for a period of time as defined in their respective agreements or Equity Office may be obligated to make additional payments to the respective sellers.
Insurance
Property Damage, Business Interruption, Earthquake and Terrorism: The insurance coverage provided through third-party insurance carriers is subject to coverage limitations. For each type of insurance coverage described below, should an uninsured or underinsured loss occur, Equity Office could lose all or a portion of its
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 25 - COMMITMENTS AND CONTINGENCIES - (continued)
investment in, and anticipated cash flows from, one or more of the Properties. In addition, there can be no assurance that third-party insurance carriers will be able to maintain reinsurance sufficient to cover any losses that may be incurred.
(a)
In September 2002, Equity Office began retaining up to $75 million of such loss calculated throughout the Equity Office portfolio. In the event of a loss in excess of these retention limits, the third-party insurance carriers would be obligated to cover the losses up to the stated coverage amounts in the above table.
(b)
The amount of the third-party insurance relating to earthquakes is based on maximum probable loss studies performed by independent third parties. The maximum annual aggregate payment amount for earthquake loss is $325 million, inclusive of Equity Office’s loss exposure of $75 million plus $1 million per occurrence deductible. There can be no assurance that these actuarial studies have correctly estimated any losses that may occur.
(c)
These amounts include Equity Office’s loss exposure/deductible amount.
(d)
The third-party insurance coverage excludes nuclear, chemical or biological acts of terrorism. There can be no assurance that insurance coverage for acts of terrorism will be available in the future. It is also possible that the lenders under our unsecured credit facility and our secured mortgage indebtedness could seek to declare a default based on the absence of insurance coverage for terrorist acts for the type and amount in place. If one or more lenders were to declare such a default, Equity Office would challenge such conclusion as not being commercially reasonable in the context of the current marketplace. See Note 26. Subsequent Events for changes to the terrorism insurance.
(e)
This amount is in excess of Equity Office’s deductible amounts.
Workers Compensation, Automobile Liability and General Liability: Equity Office has per occurrence deductible amounts on workers compensation of $500,000, auto liability of $250,000 and general liability of $1,000,000.
Off-Balance Sheet Arrangements
Commitments
In accordance with the agreement governing the investment in Wright Runstad Associates Limited Partnership (“WRALP”) made in 1997, Equity Office agreed, for a period generally continuing until December 31, 2007, to make available to WRALP up to $20.0 million in additional financing or credit support for future development. As of December 31, 2002, no amounts have been funded pursuant to this agreement. However, Equity Office has unconditionally guaranteed payment of WRALP’s $19.5 million revolving line of
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 25 - COMMITMENTS AND CONTINGENCIES - (continued)
credit which has an outstanding balance of approximately $12.9 million as of December 31, 2002 in the event of WRALP’s non-payment. WRALP’s current line of credit matures in July 2003. Equity Office does not have a liability accrued related to this guarantee. In the event Equity Office makes payment on WRALP’s line of credit and WRALP does not repay Equity Office, Equity Office is entitled to (i) terminate the credit facility provided to WRALP from Equity Office and (ii) declare all amounts borrowed by WRALP due and payable. Equity Office believes the risk of an unrecovered loss is minimal at this time.
Letters of Credit
As of December 31, 2002, Equity Office had provided approximately $3.3 million in letters of credit. The letters of credit were required to be issued under the provisions of our worker’s compensation insurance policies and certain utility contracts.
NOTE 26 - SUBSEQUENT EVENTS
The following transactions occurred subsequent to December 31, 2002, through March 13, 2003:
In January 2003, EOP Partnership issued $500 million of 5.875% unsecured notes due January 15, 2013. Including all offering expenses, the all-in effective rate of the unsecured notes is 5.98%. The notes are guaranteed by Equity Office. Total cash proceeds net of selling commissions and other expenses were approximately $494.9 million. The net proceeds were used to repay $300 million of unsecured notes that matured in February 2003. The remaining net proceeds were used to repay outstanding balances on the line of credit and for general business purposes, including working capital.
In January 2003, Equity Office sold the ABAM Building, Washington Park and the Federal Way office buildings to an unaffiliated party for approximately $13.5 million. The properties comprised three office properties, approximately 114,527 square feet and are located in Seattle, Washington.
In February 2003, Equity Office sold the U.S. West Dex Center office building to an unaffiliated party for approximately $11.6 million. The property comprised one office building, approximately 136,176 square feet and is located in Salt Lake City, Utah.
In February 2003, Equity Office sold the Commerce Park office building to an unaffiliated party for approximately $16.1 million. The property comprised one office building, approximately 94,367 square feet and is located in Santa Monica, CA.
Effective in February 2003, Equity Office amended its third-party insurance coverage for acts of terrorism as a result of the Terrorism Risk Insurance Act of 2002 (“TRIA”) enacted by Congress and signed into law by President Bush on November 26, 2002. Equity Office cancelled the terrorism insurance program that provided a limit of $270 million in the aggregate per year and replaced it with a limit of $825 million in the current property insurance program which provides coverage for chemical and biological exposure, whereas the previous insurance coverage excluded this exposure. Under TRIA, Equity Office has a per occurrence deductible of $750,000 and retains 10% of each and every loss up to a maximum of $33.25 million per occurrence, inclusive of the deductible. The federal government is obligated to cover the remaining 90% of the loss above the deductible up to $100 billion in the aggregate annually.
In March 2003, Equity Office sold the Janss Court office building to an unaffiliated party for approximately $35.5 million. The property comprised one office building, approximately 92,403 square feet, 32 residential units and is located in Santa Monica, CA.
From January 1, 2003 through March 13, 2003, Equity Office had repurchased 2,518,100 Common Shares under a share repurchase program at an average price of $23.82 for approximately $60.0 million in the aggregate.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Information about Trustees of Equity Office is incorporated by reference from the discussion under Proposal 1 in our Proxy Statement for the 2003 Annual Meeting of Shareholders. The balance of the response to this item is contained in the discussion entitled “Executive and Senior Officers of Equity Office” under Item 1 of Part I of this report.
Item 11.
Item 11. Executive Compensation.
Information about executive compensation is incorporated by reference from the discussion under the heading “Executive Compensation” in our Proxy Statement for the 2003 Annual Meeting of Shareholders.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information about security ownership of certain beneficial owners and management, and information about our equity compensation plans, are incorporated by reference from the discussion under the headings “Common Share and Unit Ownership by Trustees and Executive Officers” and “Equity Compensation Plan Information” in our Proxy Statement for the 2003 Annual Meeting of Shareholders.
Item 13.
Item 13. Certain Relationships and Related Transactions.
Information about certain relationships and transactions with related parties is incorporated herein by reference from the discussion under the heading “Certain Relationships and Related Transactions” in our Proxy Statement for the 2003 Annual Meeting of Shareholders.
Item 14.
Item 14. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Our principal executive officer, Samuel Zell, and our principal financial officer, Marsha C. Williams, evaluated within 90 days prior to the filing of this Form 10-K the effectiveness of the design and operation of our disclosure controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As a result of this evaluation, these executive officers have concluded that, as of such date, the design and operation of our disclosure controls and procedures were effective.
Changes in Internal Controls
Since the date of the evaluation of our disclosure controls and procedures by Mr. Zell and Ms. Williams described above, there have been no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a)(1) Financial Statements
Report of Independent Auditors
Consolidated Balance Sheets as of December 31, 2002 and 2001
Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2002, 2001 and 2000
Consolidated Statement of Net Comprehensive Income for the years ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules
Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2002
All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and therefore have been omitted.
(a)(3) Exhibits:
The exhibits required by this item are set forth on the Exhibit Index attached hereto.
(b) Reports on Form 8-K:
The following report(s) on Form 8-K were filed during the quarter ended December 31, 2002:
(c) Exhibits:
See Item 15(a)(3) above.
(d) Financial Statement Schedules:
None.
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.
EQUITY OFFICE PROPERTIES TRUST
By:
/s/ SAMUEL ZELL
Samuel Zell
Chairman of the Board of Trustees
and Chief Executive Officer
Date: March 28, 2003
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 in the capacities and on the dates indicated.
CERTIFICATIONS
I, Samuel Zell, certify that:
1. I have reviewed this annual report on Form 10-K of Equity Office Properties Trust;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing similar functions):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
/s/ SAMUEL ZELL
Samuel Zell
Chief Executive Officer and
Chairman of the Board of Trustees
Date: March 28, 2003
I, Marsha C. Williams, certify that:
1. I have reviewed this annual report on Form 10-K of Equity Office Properties Trust;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing similar functions):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
/s/ MARSHA C. WILLIAMS
Marsha C. Williams
Executive Vice President and
Chief Financial Officer
Date: March 28, 2003
EXHIBIT INDEX
*
Incorporated herein by reference to the same-numbered exhibit to Equity Office’s Annual Report on Form 10-K for the year ended December 31, 1997, as amended.

Represents a management contract or compensatory plan, contract or agreement.
Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2002
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(1)
The aggregate cost for federal income tax purposes as of December 31, 2002 was approximately $14.8 billion net of accumulated depreciation.
(2)
The life to compute depreciation on building is 40 years, except for Palo Alto Square (#254) which is subject to a ground lease that terminates in 2023. Therefore, the building is depreciated over the remaining term of the ground lease. The life to compute depreciation on building improvements is 4-40 years.
(3)
The date acquired represents the date these Properties were acquired by Equity Office Predecessors. The acquisition of the Properties, or interest therein, by the Company from Equity Office Predecessors in connection with the Consolidation on July 11, 1997, was accounted for using the purchase method of accounting in accordance with Accounting Principles Board Opinion No. 16. Accordingly, the assets were recorded by the Company at their fair values.
(4)
These loans are subject to cross default and collateralization provisions.
(5)
These loans are subject to cross default and collateralization provisions.
(6)
These properties were previously under development and have been placed into service during 2002.
(7)
These loans are subject to cross default and collateralization provisions.
(8)
These loans are subject to cross default and collateralization provisions.
(9)
These properties are in various development stages. During the development period certain operating costs, including real estate taxes together with interest incurred during the development stages will be capitalized.
(10)
The encumbrances at December 31, 2002 include a net discount (net of accumulated amortization of approximately $6.4 million) of approximately $12.6 million.
A summary of activity of investment in real estate and accumulated depreciation is as follows:
The changes in investment in real estate for each of the years presented below are as follows:
The changes in accumulated depreciation for each of the years presented below are as follows:
(1)
Approximately $3.7 million relates to the value of building equipment received in exchange for Equity Office’s equity position in a telecom company and the remainder relates to the write-off of internally developed software.
(2)
The 2000 Properties disposed of amounts include approximately $.4 billion of disposed assets related to the partial sale of interests in various Properties. The related accumulated depreciation on the partially sold Properties was approximately $18.7 million.