Item 1. Business
Risk Factors
There are certain risk factors associated with an investment of securities issued by Duke Realty Corporation (the “General Partner”) and Duke Realty Limited Partnership (the “Partnership”). Discussion of these risk factors can be found within Item 7, Management’s Discussion and Analysis, Financial Conditions and Results of Operations, of this Annual Report Form 10-K and in the Partnership’s Current Report on Form 8-K dated September 5, 2003.
Background
The Partnership was formed on October 4, 1993, when Duke Realty Corporation (the “Predecessor” or the “General Partner”) contributed all of its properties and related assets and liabilities, along with the net proceeds of $309.2 million from the issuance of an additional 14,000,833 shares of the General Partner through an offering to the Partnership. Simultaneously, the Partnership completed the acquisition of Duke Associates, a full-service commercial real estate firm operating in the Midwest. The General Partner was formed in 1985 and qualifies as a Real Estate Investment Trust (“REIT”) under provisions of the Internal Revenue Code. The General Partner is the sole general partner of the Partnership, owning 90.6% of the common Partnership interest as of December 31, 2003 (“General Partner Units”). The remaining 9.4% of the Partnership’s common interest is owned by limited partners (“Limited Partner Units” and, together with the General Partner Units, the “Common Units”). The Limited Partner Units are exchangeable for shares of the General Partner’s common stock on a one-for-one basis subject generally to a one-year holding period. As of December 31, 2003, the Partnership owns interest in a diversified portfolio of 899 rental properties (including 15 properties totaling 2.8 million square feet under development) which encompass over 109.0 million rentable square feet and are leased by a diverse and stable base of approximately 4,100 tenants whose businesses include manufacturing, retailing, wholesale trade, distribution and professional services. The Partnership also owns or controls nearly 3,800 acres of unencumbered land ready for development.
The Partnership, through its Service Operations, also provides, on a fee basis, leasing, property and asset management, development, construction, build-to-suit, and other tenant-related services for approximately 300 tenants in over 8.4 million square feet of space at properties owned by third-party clients. With 13 primary operating platforms, the Partnership concentrates its activities in the Midwest and Southeast United States. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data” for financial information. The Partnership conducts its Service Operations through Duke Realty Services Limited Partnership (“DRSLP”) and Duke Construction Limited Partnership (“DCLP”). All references to the “Partnership” in this Form 10-K Report include the Partnership and those entities owned or controlled by the Partnership, unless the context indicates otherwise.
The Partnership’s headquarters and executive offices are located in Indianapolis, Indiana. In addition, the Partnership has twelve regional offices located in Atlanta, Georgia; Cincinnati, Ohio; Columbus, Ohio; Cleveland, Ohio; Chicago, Illinois; Dallas, Texas; Minneapolis, Minnesota; Nashville, Tennessee; Orlando, Florida; Raleigh, North Carolina; St. Louis, Missouri; and Tampa, Florida. The Partnership had 1,011 employees as of December 31, 2003.
Business Strategy
The Partnership’s business objective is to increase its Funds From Operations (“FFO”) by (i) maintaining and increasing property occupancy and rental rates through the management of its portfolio of existing properties; (ii) expanding existing properties; (iii) developing and acquiring new properties; and (iv) providing a full line of real estate services to the Partnership’s tenants and to third-parties. FFO is used by industry analysts and investors as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National
Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income (loss) determined in accordance with accounting principles generally accepted in the United States (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for unconsolidated partnerships and joint ventures.
Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminished predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors and analysts have considered presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Thus, NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from GAAP net income. Management believes that the use of FFO, combined with the required primary GAAP presentations, has improved the understanding of operating results of REITs among the investing public and made comparisons of REIT operating results more meaningful. Management generally considers FFO to be a useful measure for reviewing comparative operating and financial performance (although FFO should be reviewed in conjunction with net income which remains the primary measure of performance) because, by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies.
As a fully integrated commercial real estate firm, the Partnership believes that its in-house leasing, management, development and construction services and the Partnership’s significant base of commercially zoned and unencumbered land in existing business parks should give the Partnership a competitive advantage in its future development activities.
The Partnership believes that the analysis of real estate opportunities and risks can be done most effectively at regional or local levels. As a result, the Partnership intends to continue its emphasis on increasing its market share and effective rents in its primary markets where it owns properties. The Partnership also expects to utilize its nearly 3,800 acres of unencumbered land and its many business relationships with nearly 4,100 commercial tenants to expand its build-to-suit business (development projects substantially pre-leased to a single tenant) and to pursue other development and acquisition opportunities in its primary markets. The Partnership believes that this regional focus will allow it to assess market supply and demand for real estate more effectively as well as to capitalize on its strong relationships with its tenant base. In addition, the Partnership seeks to further capitalize on strong customer relationships to provide third party construction and build-for-sale services outside its primary markets.
The Partnership’s policy is to seek to develop and acquire Class A commercial properties located in markets with high growth potential for Fortune 500 companies and other quality regional and local firms. The Partnership’s industrial and suburban office development focuses on business parks and mixed-use developments suitable for multiple projects on a single site where the Partnership can create and control the business environment. These business parks and mixed-use developments generally include restaurants and other amenities, which the Partnership believes will create an atmosphere that is particularly efficient and desirable. The Partnership’s retail development focuses on lifestyle, community and neighborhood centers in its existing markets and is developed primarily fro held-for-sale opportunities. As a fully integrated real estate company, the Partnership is able to arrange for or provide to its industrial, office and retail tenants not only well located and well maintained facilities, but also additional services such as build-to-suit construction, tenant finish construction, expansion flexibility and advertising and marketing services.
All of the Partnership’s properties are located in areas that include competitive properties. Institutional investors, other REITs or local real estate operators generally own such properties; however, no single competitor or small group of competitors is dominant in the Partnership’s current markets. The supply and demand of similar available rental properties may affect the rental rates the Partnership will receive on its properties.
Financing Strategy
The Partnership seeks to maintain a well-balanced, conservative and flexible capital structure by: (i) extending and sequencing the maturity dates of its debt; (ii) borrowing primarily at fixed rates; (iii) generally pursuing current and future long-term debt financings and refinancing on an unsecured basis; and (iv) maintaining conservative debt service and fixed charge coverage ratios. Management believes that these strategies have enabled and should continue to enable the Partnership to access capital markets for their long-term requirements such as debt refinancing and financing development and acquisitions of additional rental properties. In addition, as discussed under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the Partnership has a $500 million unsecured line of credit available for short-term fundings of development and acquisition of additional rental properties. In addition, the Partnership pursues favorable opportunities to dispose of assets that no longer meet the Partnership’s long-term investment criteria and re-deploy the proceeds into new investments that the Partnership believes have excellent long-term growth prospects. The Partnership’s debt to total market capitalization ratio (total market capitalization is defined as the total market value of all outstanding Common Units and Preferred equity plus outstanding indebtedness) at December 31, 2003 was 30.8%. The Partnership’s ratio of earnings to debt service and ratio of earnings to fixed charges for the year ended December 31, 2003 were 2.10x and 1.81x, respectively. In computing the ratio of earnings to debt service, earnings have been calculated by adding debt service to income from continuing operations before earnings or losses from the sale of land and depreciable property dispositions, net of impairment adjustments. Debt service consists of interest expense and recurring principal amortization (excluding maturities) and excludes amortization of debt issuance costs. In computing the ratio of earnings to fixed charges, earnings have been calculated by adding fixed charges, excluding capitalized interest, to income from continuing operations before earnings or losses from the sale of land and depreciable property dispositions, net of impairment adjustments. Fixed charges consist of interest costs, whether expensed or capitalized, the interest component of rental expense, amortization of debt issuance costs and distribution requirements for preferred limited partner interest (“Preferred Units”).
Corporate Governance
As a limited partnership that has one general partner owning over 90% of the partnership interest, the governance of the Partnership is necessarily linked to the corporate governance of the General Partner. The General Partner has and continues to be a leader in issues important to investors such as disclosure and corporate governance initiatives. Summarized below are highlights of the General Partner’s Corporate Governance Initiatives.
Board Composition
General Partner’s Board is controlled by supermajority (67%+) of Independent Directors
Board Committees
General Partner’s Board Committee members are all Independent Directors
Lead Director
The Chairman of the Corporate Governance Committee serves as Lead Director of the General Partner’s Independent Directors
Board Guidelines
Code of Conduct applies to all Directors of the General Partner and Employees; waivers require the vote of the General Partner’s Independent Directors
Effective orientation program created for new Directors of the General Partner
Independence of the General Partner’s Directors is reviewed annually
Independent Directors of the General Partner meet at least quarterly in executive session
Independent Directors of the General Partner receive no compensation from the Partnership other than as Directors
Equity-based compensation plans require General Partner’s shareholder approval
Board effectiveness and performance is reviewed annually by the Corporate Governance Committee
Corporate Governance Committee conducts an annual review of the CEO succession plan
Independent Directors of the General Partner and all Board Committees may retain outside advisors, as they deem appropriate
Mandatory retirement age for Directors of the General Partner
Outstanding stock options of the General Partner may not be repriced
Directors of the General Partner are required to offer resignation upon job change
Ownership
Minimum Stock Ownership Guidelines apply to all Directors and Executive Officers of the General Partner
The General Partner’s Code of Conduct and its Corporate Governance Guidelines are available in the investor information/corporate governance section of the General Partner’s website at www.dukerealty.com. A copy of these documents may also be obtained without charge by writing to Duke Realty Corporation, 600 East 96th Street, Suite 100, Indianapolis, Indiana 46240, Attention: Investor Relations.
Other
For additional information regarding the Partnership’s investments and operations, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 8, “Financial Statements and Supplementary Data.” For additional information about the Partnership’s business segments, see Item 8, “Financial Statements and Supplementary Data.”
In addition to this Annual Report, the General Partner and the Partnership file quarterly and special reports, proxy statements and other information with the SEC. All documents that are filed with the SEC by the Partnership are available free of charge on the SEC website, which is http://www.sec.gov. You may also read and copy any document filed at the public reference facilities of the SEC at 450 Fifth Street, N.W., Washington, D.C. 25049. Please call the SEC at (800) SEC-0330 for further information about the public reference facilities. These documents also may be accessed through the SEC’s electronic data gathering, analysis and retrieval system (“EDGAR”) via electronic means, including the SEC’s home page on the Internet (http://www.sec.gov). In addition, since some of the General Partner’s securities are listed on the New York Stock Exchange, you can read its SEC filings at the offices of the New York Stock Exchange, 20 Broad Street, New York, New York 10005.
Item 2.
Item 2. Properties
Product Review
As of December 31, 2003, the Partnership owns an interest in a diversified portfolio of 899 commercial properties encompassing over 109.0 million net rentable square feet (including 15 properties comprising 2.8 million square feet under development) and nearly 3,800 acres of land for future development.
Industrial Properties: The Partnership owns interests in 642 industrial properties encompassing approximately 81.3 million square feet (74% of total square feet) more specifically described as follows:
• Bulk Warehouses - Industrial warehouse/distribution buildings with clear ceiling heights of 20 feet or more. The Partnership owns 425 buildings totaling 68.1 million square feet of such properties.
• Service Centers - Also known as flex buildings or light industrial, this product type has 12-18 foot clear ceiling heights and a combination of drive-up and dock-height loading access. The Partnership owns 217 buildings totaling 13.2 million square feet of such properties.
Office Properties: The Partnership owns interests in 250 office buildings totaling approximately 26.9 million square feet (25% of total square feet) more specifically described as follows:
• Suburban Office - The Partnership owns 246 suburban office buildings totaling 26.0 million square feet.
• CBD Office - The Partnership owns four downtown office projects totaling approximately 861,000 square feet.
Retail Properties: The Partnership owns interests in 7 retail projects totaling approximately 800,000 square feet (1% of total square feet). These properties encompass both power and neighborhood shopping centers.
Land: The Partnership owns or controls more than 3,800 acres of land located primarily in its existing business parks. The land is ready for immediate use and is unencumbered by debt. Over 60.0 million square feet of additional space can be developed on these sites substantially and all of the land is zoned for either office, industrial or retail development.
Service Operations: The Partnership provides property and asset management, development, leasing and construction services to third party owners in addition to its own properties. The Partnership’s current property management base for third parties includes over 8.4 million square feet of properties serving approximately 300 tenants.
Property Descriptions
The following schedule represents the geographic highlights of the Partnership’s properties in its primary markets.
Duke Realty Limited Partnership
Geographic Highlights
In Service Properties as of December 31, 2003
(1) Includes all wholly owned and joint venture projects shown at 100% as of report date.
(2) Represents the average annual rental property revenue due from tenants in occupancy as of the date of this report, excluding additional rent due as operating expense reimbursements, landlord allowances for operating expenses and percentage rents. Joint Venture properties are shown at the Partnership’s ownership percentage.
(3) Represents properties not located in the Partnership’s primary markets. These properties are located in similar midwest or southeast markets.
Item 3.
Item 3. Legal Proceedings
Broadband Office, Inc. and Official Committee of Unsecured Creditors of Broadband Office, Inc. recently filed a complaint against a group of real estate investment trusts and real estate operating companies and certain affiliated entities and individuals in connection with the formation and management of Broadband Office. Among the defendants are the General Partner, the Partnership and Mr. Dennis Oklak, one of the General Partner’s executive officers. The complaint alleges various breaches of purported fiduciary duties by the defendants, seeks recharacterization or equitable subordination of debt, seeks recovery of alleged avoidable transfers, appears to seek to hold them liable for, among other things, the debt of Broadband Office under alter-ego, veil-piercing and partnership theories, and seeks other relief under other theories. The complaint seeks aggregate damages in excess of $300 million from all of the defendants. The Partnership believes that it and Mr. Oklak have meritorious defenses to the plaintiff’s allegations and intends to vigorously defend this litigation. Due to the inherent uncertainties of the litigation process and the judicial system, the Partnership is not able to predict the outcome of this litigation. If this litigation is not resolved in the Partnership’s favor, it could have a material adverse effect on its business, financial condition and results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2003.
EXECUTIVE OFFICERS OF THE GENERAL PARTNER
Robert M. Chapman, age 50. Mr. Chapman has served as Senior Executive Vice President, Real Estate Operations, since November 2003. From 2000 through November 2003, Mr. Chapman served as the General Partner’s Executive Vice President, Southern Region, responsible for the General Partner’s Atlanta, Orlando, Tampa, Raleigh, Nashville and Dallas property portfolios. Mr. Chapman was Executive Vice President of the Atlanta/Texas region from 1999 to 2000, and Executive Vice President of Acquisitions and Dispositions from 1997 to 1999. Before joining the General Partner in 1997, he served as Senior Vice President and Portfolio Manager for The RREEF Funds, and held positions at Gerald Hines Interests and Lincoln Property Company.
Matthew A. Cohoat, age 44. Mr. Cohoat was named Executive Vice President and Chief Financial Officer of the General Partner on January 1, 2004. From 1990 through 2003, Mr. Cohoat held various positions in the General Partner’s accounting group, most recently that of Senior Vice President and Corporate Controller. From 1982 until 1990 he was employed by Ernst & Young, LLP.
James B. Conner, age 45. Mr. Connor has served as Regional Executive Vice President for the General Partner’s Chicago Region, which includes its Chicago, Minneapolis, St. Louis and Nashville portfolios, since December 2003. Mr. Connor served as Senior Vice President responsible for the General Partner’s Chicago Operations since joining the Company in 1998. Prior to joining the General Partner, Mr. Connor held several executive and brokerage positions with Cushman & Wakefield, most recently serving as Senior Managing Director for the Midwest area.
Howard L. Feinsand, age 56. Mr. Feinsand has served as the General Partner’s Executive Vice President and General Counsel since 1999. Mr. Feinsand served on the General Partner’s Board of Directors from 1988 to January 2003. From 1996 until 1999, Mr. Feinsand was the founder and principal of Choir Capital Ltd. From 1995 until 1996, he was Managing Director of Citicorp North America, Inc. He was the Senior Vice President and Manager-Capital Markets, Pricing and Investor Programs of GE Capital Aviation Services, Inc. from 1989 to 1995. From 1971 through 1989, Mr. Feinsand practiced law in New York City.
Robert D. Fessler, age 46. Mr. Fessler has served as Executive Vice President of the General Partner’s Atlanta Region, which includes its Atlanta, Raleigh, Florida and Dallas portfolios since July 2003. Mr. Fessler was Senior Vice President of Cincinnati Operations from 2001 to July 2003, led the Cincinnati Industrial Group from 1988 through 2001 and was a leasing representative from 1987 to 1988. Prior to
joining the General Partner, Mr. Fessler worked for the Trammell Crow Company and General Electric Company.
John W. Guinee III, age 48. Mr. Guinee has served as Executive Vice President and Chief Investment Officer of the General Partner since February 2003. From 1997 through 2001, Mr. Guinee was Executive Vice President and the Chief Investment Officer of Charles E. Smith Residential Realty. From 1985 through 1997, he was Managing Director of LaSalle Advisors (Alex. Brown Kleinwort Benson prior to a merger). From 1982 through 1985, Mr. Guinee was a development manager with Gerald D. Hines Interests in San Francisco.
Thomas L. Hefner, age 57. Mr. Hefner has served as Chief Executive Officer of the General Partner since 1993 and as its Chairman since 1998. Mr. Hefner has served as a Director of the General Partner since 1993.
Steven R. Kennedy, age 47. Mr. Kennedy was named Executive Vice President, Construction on January 1, 2004. From 1986 until 2004, he served the General Partner in various capacities in the construction group, most recently as Senior Vice President. Prior to joining the General Partner, Mr. Kennedy was employed as a project manager for Charles Pankow Builders, Inc., a West Coast-based design-build and general contractor.
Dennis D. Oklak, age 50. Mr. Oklak was named President and Chief Operating Officer of the General Partner in January 2003. He had been Co-Chief Operating Officer of the General Partner since April 2002. Mr. Oklak joined the General Partner in 1986 as Tax Manager and was later named Controller of the General Partner’s development companies before being named Vice President and Treasurer. In that position, he served as the Chief Accounting Officer with responsibility for financial reporting in public offerings of securities; assisting the vice presidents of each business unit with deal structuring; and supervising all financial aspects of the General Partner. Mr. Oklak assumed the position of Executive Vice President and Chief Administrative Officer of the General Partner in 1997 and supervised accounting, tax, information technology, human resources and tenant services.
Christopher L. Seger, age 36. Mr. Seger was appointed Executive Vice President, National Development/Construction of the General Partner in December 2003. From 2001 to 2003, Mr. Seger was Senior Vice President of the General Partner’s Florida Group, with responsibility for its office and industrial portfolio in Central and South Florida. From 1999 to 2001, Mr. Seger was Senior Vice President of the General Partner’s Indiana Office Group; and from 1993 to 1999 served in the General Partner’s Acquisitions and Leasing groups.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters
There is no established public trading market for the Common Units. The following table sets forth the cash distributions paid during each quarter. As of February 26, 2004 there were 175 record holders of Common Units.
On January 28, 2004, the Partnership declared a quarterly cash distribution of $.46 per Common Unit, payable on February 27, 2004, to Common Unitholders of record on February 12, 2004.
Item 6.
Item 6. Selected Consolidated Financial Data
The following sets forth selected consolidated financial and operating information on a historical basis for the Partnership for each of the years in the five-year period ended December 31, 2003. The following
information should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data” included in this Form 10-K (in thousands, except per units amounts):
(1) Funds From Operations (“FFO”) is used by industry analysts and investors as a supplemental operating performance measure of an equity real estate investment trust (“REIT”). FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income (loss) determined in accordance with accounting principles generally accepted in the United States (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for unconsolidated partnerships and joint ventures.
Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminished predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Thus, NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from GAAP net income. Management believes that the use of FFO, combined with the required primary GAAP presentations, has improved the understanding of operating results of REITs among the investing public and made comparisons of REIT operating results more meaningful. As a REIT subsidiary, the Partnership’s management considers FFO to be a useful measure for reviewing comparative operating and financial performance (although FFO should be reviewed in conjunction with net income which remains the primary measure of performance) because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward Looking Statements
Certain statements in this Annual Report, including those related to the Partnership’s future operations, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of the Partnership, or industry results, to differ materially from any predictions of future results, performance or achievements that we express or imply in this report. Some of the risks, uncertainties and other important factors that may affect future results include, among others:
• General economic and business conditions;
• The General Partner’s continued qualification as a real estate investment trust;
• Competition for tenants and decrease in property occupancy;
• Potential increases in real estate construction costs;
• Potential changes in interest rates;
• Continuing ability to favorably raise debt and equity in the capital markets; and
• Other risks inherent in the real estate business including tenant defaults, potential liability relating to environmental matters and liquidity of real estate investments.
This list of risks and uncertainties, however, is not intended to be exhaustive. The Partnership has on file with the Securities and Exchange Commission (“SEC”) a Current Report on Form 8-K dated September 5, 2003, with additional risk factor information.
The words “believe,” “estimate,” “expect,” “anticipate” and similar expressions or statements regarding future periods are intended to identify forward-looking statements. Although we believe that the plans, expectations and results expressed in or suggested by our forward-looking statements are reasonable, all forward-looking statements are inherently uncertain as they involve substantial risks and uncertainties beyond the Partnership’s control. New factors emerge from time to time, and it is not possible for us to predict the nature or assess the potential impact of each new factor on the Partnership’s business. Given these uncertainties, we caution you not to place undue reliance on these forward-looking statements. The Partnership undertakes no obligation to update or revise any of its forward-looking statements for events or circumstances that arise after the statement is made.
Business Overview
As of December 31, 2003, the Partnership:
• Owned or jointly controlled 899 industrial, office and retail properties (including properties under development), consisting of over 109.0 million square feet primarily located in 10 states; and
• Owned or jointly controlled approximately 3,800 acres of land with an estimated future development potential of more than 60.0 million square feet of industrial, office and retail properties.
The Partnership provides the following services for its properties and for certain properties owned by third parties:
• leasing;
• management;
• construction;
• development; and
• other tenant-related services.
The Partnership’s operating results depend primarily upon rental income from its office, industrial and retail properties (“Rental Operations”). The following highlights the areas of Rental Operations that the Partnership considers critical for future revenue growth (all square footage totals and occupancy percentages reflect both wholly-owned properties and properties in joint ventures):
Same Property Performance: The Partnership tracks same property performance, which measures the performance of properties that were in-service for all reported portions of a two-year period by comparing the results of the second year with the results of the first year. In 2003, net operating income from the same property portfolio decreased by 3.5% from 2002, compared to .3% growth in 2002 over 2001. The current year decline is a result of a decrease of $8.8 million in same property lease termination fees compared to 2002. In addition to the decrease in lease termination fees, the Partnership increased the use of free rent concessions in 2003 as an incentive to attract quality tenants.
Occupancy Analysis: The ability to maintain occupancy rates is a principal driver of the Partnership’s results of operations. The following table sets forth information regarding the Partnership’s in-service portfolio of rental properties as of December 31, 2003 and 2002 (square feet in thousands):
The overall increase in occupancy for 2003 was the result of increased activity primarily in the bulk industrial product, fewer lease terminations through lease buyouts and fewer tenant bankruptcies. An improving economy coupled with increased business spending and aggressive leasing led to the overall occupancy increase. The current year decrease in Service Centers’ occupancy was mainly the result of a tenant terminating 241,000 square feet through a lease buyout in December 2003 in exchange for a termination payment of $3.0 million.
Lease Expiration and Renewals: The Partnership’s ability to maintain and grow its occupancy rates primarily depends upon its continuing ability to re-lease expiring space. The following table reflects the Partnership’s in-service lease expiration schedule as of December 31, 2003, by product type. The table indicates square footage and annualized net effective rents (based on December 2003 rental revenue) under expiring leases (in thousands):
The Partnership renewed 72.3% of its leases up for renewal in 2003, totaling 8.1 million square feet on which it attained a 1.4% growth in net effective rents. The relatively flat growth in rental rates is indicative of excess vacancies in many of the Partnership’s markets requiring competitive pricing strategies to retain current tenants.
The average term of renewals decreased to 3.5 years in 2003, from 4.4 years in 2002. The Partnership is currently renewing tenants for shorter terms in anticipation of better market rates for future renewal periods.
The Partnership’s lease renewal percentages over the past three years have remained relatively consistent at a 70-75% success rate despite the relatively weak market conditions. The Partnership does not currently expect its renewal percentage in 2004 to significantly differ from that experienced in 2003.
Future Development: Another source of growth in earnings for the Partnership is the development of additional rental properties. The Partnership had approximately 2.8 million square feet of properties under development at December 31, 2003 with total projected costs of approximately $160.3 million. The total projected costs of properties under development at December 31, 2002 was $195.0 million. The lower volume reflects the relative slowdown in business expansion in response to the overall weakened economy, and the Partnership’s plan to limit the development of speculative properties until activity increases.
The properties under development are expected to provide future Rental Operations growth as they are placed in service or, for those properties that are being developed for sale, earnings through Service Operations upon their eventual sale. A summary of the properties under development as of December 31, 2003, follows (in thousands, except percent leased and stabilized returns):
Acquisition and Disposition Activity:The Partnership has an active capital recycling program based upon a strategy to dispose of non-strategic assets and utilize the proceeds to fund new development and acquisitions of more desirable properties. Through this program, the Partnership is continually improving the overall quality of its investment portfolio. During 2000 and 2001, the Partnership disposed of over $1 billion of properties, which generated substantially greater proceeds than were required to fund new development and acquisitions. The excess proceeds were utilized to pay down Partnership debt, which has reduced the Partnership’s debt-to-total market capitalization ratio to a conservative 30.8% at December 31, 2003.
Dispositions of held-for-rental properties slowed in 2003 and 2002, totaling $126 million and $41 million, respectively, as the slower business climate limited reinvestment opportunities. The disposition proceeds were used to partially fund 2003 and 2002 acquisitions of $232 million and $114 million, respectively. The Partnership will continue to pursue both disposition and acquisition opportunities that arise in 2004. While management expects the volume of acquisitions to exceed dispositions, management cannot predict when or if these opportunities will arise.
Funds From Operations
Funds From Operations (“FFO”) is used by industry analysts and investors as a supplemental operating performance measure of an equity real estate investment trust (“REIT”). FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income (loss) determined in accordance with accounting principles generally accepted in the United States of America (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for unconsolidated partnerships and joint ventures.
Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or
fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Thus, NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from GAAP net income. Management believes that the use of FFO, combined with the required primary GAAP presentations, has improved the understanding of operating results of REITs among the investing public and made comparisons of REIT operating results more meaningful. As a REIT subsidiary, the Partnership’s management considers FFO to be a useful measure for reviewing comparative operating and financial performance (although FFO should be reviewed in conjunction with net income which remains the primary measure of performance) because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies.
The following table summarizes the calculation of FFO for the years ended December 31 (in thousands):
Funds From Operations for 2002 and 2001 have been restated to include the effects of the Partnership’s adoption of the SEC’s July 31, 2003 Staff Policy Statement that clarifies the application of FASB-EITF Topic D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock.” See discussion of Restatement of Net Income below. Additionally, the Partnership has restated 2002 and 2001 FFO through the adoption of recent guidance from the SEC requiring the inclusion of impairment adjustments in the calculation of FFO.
Results of Operations
A summary of the Partnership’s operating results and property statistics for each of the years in the three-year period ended December 31, 2003, follows (in thousands, except number of properties and per unit amounts):
Comparison of Year Ended December 31, 2003 to Year Ended December 31, 2002
Rental Income from Continuing Operations
Rental income from continuing operations increased from $670.9 million in 2002 to $706.7 million in 2003. The following table reconciles rental income by reportable segment to the Partnership’s total reported rental income from continuing operations for the years ended December 31, 2003 and 2002 (in thousands):
Although the Partnership’s three reportable segments comprising Rental Operations (office, industrial and retail) are all within the real estate industry, they are not necessarily affected by the same economic and industry conditions. For example, the Partnership’s retail segment experienced high occupancies and strong overall performance during 2003, while the Partnership’s office and industrial segments reflected the weaker economic environment for those property types. The primary causes of the increase in rental income from continuing operations, with specific references to a particular segment when applicable, are summarized below:
• During 2003, in-service occupancy improved from 87.1% at the end of 2002 to 89.3% at the end of 2003. The second half of 2003 was highlighted by a significant increase in the industrial portfolio occupancy of 2.1% along with a slight increase in office portfolio occupancy of .9%. Increased occupancy continues to be management’s primary focus for 2004.
• Lease termination fees totaled $27.4 million in 2002 compared to $17.2 million in 2003. Most of this decrease was attributable to the office segment, which recognized $21.1 million of termination fees in 2002 as compared to $11.8 million in 2003. Lease termination fees relate to specific tenants that pay a fee to terminate their lease obligations before the end of the contractual lease term. The high volume of termination fees in 2002 was reflective of the contraction of the business of large office users during that year and their desire to downsize their use of office space. The decrease in termination fees for 2003 was indicative of an improving economy and a more stable financial position of the Partnership’s tenants. Although there is no way to predict the amount of future lease termination fees, management believes that the amount of these fees will continue to decline in 2004.
• During the year ended 2003, the Partnership acquired $232 million of properties totaling 2.1 million square feet. The acquisitions were primarily Class A office buildings in existing markets with overall occupancy near 90%. Revenues associated with these acquisitions totaled $10.2 million in 2003. In addition, revenues from 2002 acquisitions totaled $15.8 million in 2003 compared to $4.8 million in 2002. This significant increase is primarily due to a large office acquisition that closed at the end of December 2002.
• Developments placed in-service in 2003 provided revenues of $6.6 million, while revenues associated with developments placed in-service in 2002 totaled $13.7 million in 2003 compared to $4.7 million in 2002.
• Proceeds from dispositions of held for rental properties totaled $126.1 million in 2003, compared to $40.9 million in 2002. These properties generated revenue of $12.5 million in 2003 versus $19.6 million in 2002.
Equity in Earnings of Unconsolidated Companies
Equity in earnings represents the Partnership’s share of net income from investments in unconsolidated companies. These joint ventures generally own and operate rental properties and hold land for development. These earnings decreased from $27.2 million in 2002 to $23.6 million in 2003. This decrease is a result of the following significant activity:
• In 2002, a $1.8 million gain was recognized on a property that was developed and sold upon completion to a third party.
• In 2003, the Partnership’s total investment in joint ventures decreased. This decrease was the result of the Partnership acquiring its partner’s interest in three joint ventures, selling its interest in two and one venture being dissolved in the current year. While the number of joint ventures decreased, the joint ventures’ occupancy increased from 93.2% to 94.0% in 2003.
Rental Expenses and Real Estate Taxes
The following table reconciles rental expenses and real estate taxes by reportable segment to the Partnership’s total reported amounts in the statement of operations for the years ended December 31, 2003 and 2002 (in 000’s):
The increased rental and real estate tax expenses for 2003, as compared to 2002, was the result of the Partnership’s increase in average in-service square fee and occupancy. These increases resulted from the Partnership’s acquisition activities and developments placed in service in 2003.
Interest Expense
The Partnership’s interest expense increased from $114.7 million in 2002 to $129.1 million in 2003. Although the Partnership benefited from significantly lower interest rates during the year, interest expense increased because of increased borrowings during the year and a decrease in the amount of interest that was capitalized. The increased borrowings reflected the funding of the Partnership’s developments during the year and the excess of properties acquired over those disposed. Interest capitalized for 2003 was significantly lower than 2002 as development activity for 2003 was substantially slower than prior years. Development starts for 2003 totaled only $108 million compared to approximately $225 million for 2002. Other significant factors impacting interest expense for 2003 are summarized as follows (in thousands):
• The Partnership continued to replace secured debt financing with unsecured debt, and paid off over $120 million of secured loans throughout 2003. The payoffs included secured loans due in 2003 and those due in 2004 and beyond for which the Partnership was able to take advantage of expired or negotiated lower pre-payment penalties and utilize lower financing costs from unsecured debt offerings or the unsecured line of credit.
• Approximately $425 million of new unsecured debt was issued in 2003. The Partnership issued $175 million of seven-year debt in January 2003 at an effective interest rate of 5.37%, $150 million of ten-year debt in May 2003 at an effective interest rate of 4.64% and $100 million of four-year debt in November 2003 at an effective interest rate of 3.63%. The Partnership retired $175 million of debt in June 2003 that had an effective interest rate of 7.33%.
• The Partnership utilized its $500 million unsecured line of credit more heavily in 2003 than it did during 2002 in order to take advantage of the historically low borrowing costs. The balance on the line of credit was $351 million at December 31, 2003 compared to $281 million at December 31, 2002.
Depreciation and Amortization Expense
Depreciation and amortization expense for 2003 increased by over $22.5 million compared to 2002 because of an increase in tenant improvements and leasing costs. As discussed earlier, the Partnership experienced higher overall occupancy and more acquisition activity in 2003, which resulted in increased capital expenditures for tenant improvements and deferred lease commissions as well as increases in held for investment property basis. The following highlights the significant changes in depreciable and amortizable property during 2003:
• The basis of the held for investment property portfolio increased by $166 million as a result of the Partnership’s development and acquisition activity.
• The Partnership incurred tenant improvement costs of $91.3 million in 2003.
• The Partnership incurred lease commissions of $41.6 million in 2003.
Also contributing to the increased expense in 2003 was the effect of Statement of Financial Accounting Standards No. 141, Business Combinations (“SFAS 141”), on acquisitions. This accounting pronouncement requires the allocation of a portion of a property’s purchase price to intangible assets for leases acquired and in-place at the closing date of the acquisition. These intangible assets are amortized over the remaining life of the leases (generally 3-5 years) as compared to the building basis portion of the acquisition, which is depreciated over 40 years. The amortization associated with the acquired lease intangible assets recorded on 2003 acquisitions totaled $4.2 million.
Service Operations Service Operations primarily consist of leasing, management, construction and development services for joint venture properties and properties owned by third parties. These operations are heavily influenced by the current state of the economy as leasing and management fees are dependent upon occupancy while construction and development services rely on businesses expanding operations. The following highlights the significant components of revenues in Service Operations:
• The Partnership experienced more than a 2% decrease in its overall gross profit margin percentage in its general contractor business in 2003 because of more competitive pricing in many of its markets. However, despite this decrease, the Partnership was able to increase its net general contractor revenues from $21.9 million in 2002 to $26.8 million in 2003 because of a significant increase in volume. This volume increase was attributable to the low cost of financing available to businesses, thereby making it more attractive for them to own instead of lease facilities. The Partnership has a substantial backlog of $175.6 million for third party work as of December 31, 2003 that will carry into 2004.
• Property management, maintenance and leasing fee revenues have remained fairly constant between 2002 and 2003 as the number of properties managed by the Partnership has not changed significantly.
• Construction management and development activity income represents construction and development fees earned on projects where the Partnership acts as the construction manager along with profits from the Partnership’s held-for-sale program under which the Partnership develops a property with the intent to sell upon completion. The decrease in revenues from $29.4 million in 2002 to $15.5 million in 2003 is primarily due to fewer properties being sold in 2003 from the held-for-sale program. During 2002, the Partnership sold eight held-for-sale properties for a pre-tax gain of $28.2 million compared to the sale of four properties in 2003 for a pre-tax gain of $15.4 million in 2003. Profit margins on held-for-sale transactions fluctuate by sale depending on the type of property being sold, the strength of the underlying tenant and the nature of the sale, such as a pre-contracted purchase price for a primary tenant versus a sale on the open market.
Service Operations expenses decreased from $38.3 million in 2002 to $37.4 million in 2003. Included in these amounts are income taxes which decreased to $5.7 million in 2003 from $8.4 million in 2002 primarily as a result of lower income from the disposition of held-for-sale properties. Other Service Operations expenses increased by approximately $2.0 million in 2003 over 2002. This increase was driven primarily from the costs associated with increased third party construction volume.
General and Administrative Expense
General and administrative expense decreased from $24.7 million in 2002 to $21.3 million for the year ended December 31, 2003. The decrease is primarily attributable to an increase in construction volume for third party projects resulting in a greater allocation of overhead to Service Operations operating expenses.
Other Income and Expenses
Gain on sale of land and depreciable property dispositions, net of impairment adjustment, is comprised of the following amounts in 2003 and 2002:
Gain on sales of depreciable properties represent sales of previously held for investment rental properties which did not qualify to be classified as discontinued operations under SFAS 144 (see discussion under Discontinued Operations below). There were no such sales in 2003.
In 2003, the Partnership sold its interests in two joint ventures that owned and operated depreciable investment property. The Partnership owned 50% of each of these joint ventures.
Gain on land sales represents sales of undeveloped land owned by the Partnership. The Partnership pursues opportunities to dispose of land in markets with a high concentration of undeveloped land and those markets where the land no longer meets strategic development plans of the Partnership.
The Partnership recorded $560,000 of impairment charges on three land parcels that were sold in 2003. The Partnership has analyzed each of its in-service properties and has determined that there are no additional valuation adjustments that need to be made as of December 31, 2003. The $6.6 million adjustment recorded in 2002 was associated with four properties determined to be impaired.
Other revenue and expenses is comprised primarily of the write-off of contract development costs for abandoned development projects and gains on terminations of interest rate swaps. In 2003, the Partnership recorded contract development expenses of $1.0 million compared to $1.2 million in 2002. The Partnership accumulates costs of potential projects as an asset until such time as the costs are capitalized into a new project or expensed for a failed project.
In 2003, the Partnership terminated four forward starting interest rate swap agreements for a net gain of $643,000. The swap agreements were entered into as hedges for future anticipated debt issuances. These agreements were terminated as a result of the Partnership’s capital needs being met through the General Partner’s issuance of the Series J Preferred Stock in lieu of the contemplated debt issuances and the contribution of the net proceeds of such offering to the Partnership in return for the issuance of Series J Preferred Units. In 2002, a $1.4 million gain was recognized in connection with a swap that did not qualify for hedge accounting. The Partnership has no swaps or other derivative instruments outstanding at December 31, 2003. See discussion of the Partnership’s use of derivative instruments in the footnotes to the financial statements.
Discontinued Operations
The Partnership adopted Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), on January 1, 2002. SFAS 144 requires the Partnership to report in discontinued operations the results of operations of a property that has either been disposed or is classified as held-for-sale, unless certain conditions are met.
At December 31, 2003, the Partnership classified the results of operations and gains or losses of 45 buildings as discontinued operations. Of these buildings, 2 were sold in 2002 and 42 were sold in 2003. Impairment charges of $500,000 were recognized in 2003 relating to a single property that was sold in 2003. As a result of the sale, these charges were classified in discontinued operations for 2003. One property is owned at December 31, 2003, and is under contract to sell in 2004. Impairment charges totaling $2.7 million that were recognized in 2002 have been reclassed to discontinued operations as the properties to which they pertain were sold in 2003. Beginning in 2002, results of operations and any gains or losses on all sales of depreciable properties are classified in discontinued operations.
Comparison of Year Ended December 31, 2002 to Year Ended December 31, 2001
Rental Income from Continuing Operations
Rental income from continuing operations increased from $669.6 million in 2001 to $670.9 million in 2002. The following table reconciles rental income by reportable segment to the Partnership’s total reported rental income from continuing operations for the years ended December 31, 2002 and 2001 (in thousands):
The following significant fluctuations are the primary causes of the increase in rental income from continuing operations for all three segments, with specific references to a particular segment when applicable:
• Throughout 2002, in-service occupancy decreased from 88.6% at the end of 2001 to 87.1% at the end of 2002. The decline was the result of the weakened economy and its effect on business in the Partnership’s markets. These markets experienced a shortage of demand compared to the supply of office and industrial space resulting from downsizing of leased space for existing tenants, the lack of new business growth, and the tendency of existing businesses to hold off on growth plans until the economy improves.
• Lease termination fees totaled $27.4 million in 2002 compared to $17.9 million in 2001. In 2002, there were significant individual termination fees received, particularly in the office portfolio, where $21.1 million of termination fees were recognized compared to $12.1 million in 2001. This trend was consistent with the continuing decline in occupancy for office space in many of the Partnership’s markets.
• In August of 2001, the Partnership sold 21 properties or approximately 75% of its retail portfolio. As a result of this sale, the Partnership had eight months of operations associated with these properties in 2001.
Equity in Earnings of Unconsolidated Companies
Equity in earnings decreased from $31.4 million in 2001 to $27.2 million for 2002 as a result of the following:
• The Partnership’s share of lease termination fees for 2001 was approximately $2.1 million, compared to approximately $658,000 in 2002.
• During 2002, a 50% joint venture had increased interest expense of approximately $900,000 as a result of $71.0 million in debt issued during the second quarter of 2001.
Rental Expenses and Real Estate Taxes
The following table reconciles rental expenses and real estate taxes by reportable segment to the Partnership’s total reported amounts in the statement of operations for the years ended December 31, 2002 and 2001 (in 000’s):
The Partnership’s three reportable segments comprising Rental Operations (office, industrial and retail) are all within the real estate industry. The increased rental and real estate tax expense were the result of the Partnership’s increased real estate assets associated with current year developments and acquisitions.
Depreciation and Amortization
Depreciation and amortization expense for the year ended December 31, 2002, increased over the prior year through an increase in the Partnership’s building asset basis, increased investments in tenant improvements and the expensing of undepreciated tenant improvements associated with the early terminations of tenants.
Interest Expense
The $5.2 million increase in interest expense is attributable to the following:
• Interest capitalized on development projects decreased from $25.9 million in 2001 to $13.5 million in 2002 because of decreased development activity by the Partnership in response to soft demand in most of the Partnership’s markets.
• Interest expense on corporate unsecured debt increased from $98.7 million in 2001 to $100.8 million in 2002. The Partnership issued $150 million of ten-year unsecured debt in August 2002 at an effective interest rate of 5.88% and $50 million of ten-year unsecured debt in September 2002 at an effective interest rate of 5.45%. Also in 2002, the Partnership paid off $50 million of debt that matured in September, which had an effective rate of 7.31%.
• Interest expense on the Partnership’s secured debt decreased from $30.8 million in 2001 to $22.9 million in 2002 as the Partnership paid off $13.5 million of secured debt throughout 2002 and experienced lower borrowings on its secured line of credit during 2002 compared to 2001. Additionally, the Partnership paid off approximately $128.5 million of secured debt throughout 2001.
• Interest expense on the Partnership’s $500 million unsecured line of credit decreased by approximately $1.1 million in 2002 compared to 2001 as the Partnership maintained lower balances on the line throughout most of 2002.
Service Operations Service Operations primarily consist of leasing, management, construction and development services for joint venture properties and properties owned by third parties. Service Operations revenues decreased from $80.5 million for the year ended December 31, 2001, to $67.9 million for the year ended December 31, 2002. The prolonged effect of the slow economy has been the primary factor in the overall decrease in revenues. The Partnership experienced a decrease of $12.7 million in net general contractor revenues because of a decrease in the volume of construction in 2002, compared to 2001, as well as slightly lower profit margins.
Property management, maintenance and leasing fee revenues decreased from $22.8 million in 2001 to $14.3 million in 2002 primarily because of a decrease in landscaping maintenance revenue resulting from the sale of the landscaping operations in the third quarter of 2001.
Construction management and development activity income represents construction and development fees earned on projects where the Partnership acts as the construction manager along with profits from the Partnership’s held-for-sale program under which the Partnership develops a property for sale upon completion. The increase in revenues of $10.3 million was 2002 is primarily due to an increase in volume of the sale of properties from the held-for-sale program.
Service Operations expenses decreased from $45.3 million in 2001 to $38.3 million in 2002. The decrease was attributable to the decrease in construction and development activity and the reduced overhead costs as a result of the sale of the landscape business in 2001.
General and Administrative Expense
General and Administrative Expense increased from $15.5 million in 2001 to $24.7 million for the year ended December 31, 2002. The Partnership was successful in reducing total operating and administration
costs; however, reduced construction and development activities resulted in a greater amount of overhead being charged to general and administrative expense instead of being capitalized into development projects or charged to Service Operations.
Other Income and Expenses
Gain on sale of land and depreciable property dispositions, net of impairment adjustment, was comprised of the following amounts in 2002 and 2001:
Gain on sales of depreciable properties represent sales of previously held for investment rental properties. Beginning in 2000 and continuing into 2001, the Partnership pursued favorable opportunities to dispose of real estate assets that no longer met long-term investment objectives. In 2002, the Partnership significantly reduced the amount of its property sales.
Gain on land sales represents sales of undeveloped land owned by the Partnership. The Partnership pursues opportunities to dispose of land in markets with a high concentration of undeveloped land and those markets where the land no longer meets strategic development plans of the Partnership.
Other revenue for the year ended December 31, 2002, includes $1.4 million of gain related to an interest rate swap that did not qualify for hedge accounting.
Restatement of Net Income
In July of 2003, the SEC issued a Staff Policy Statement that clarified the application of FASB-EITF Topic D-42 (Topic D-42), “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Equity.” Under Topic D-42, the difference between the amounts paid to the holders of preferred equity upon redemption and the carrying amount of the preferred equity on the issuer’s balance sheet must be subtracted from net income when computing earnings per share. The Staff Policy Statement clarified that, in computing the reduction in net income, the carrying amount of the preferred equity should be reduced by the issuance costs of the preferred equity. As a result of this clarification, the Partnership’s net income per unit was restated for 2002 and 2001. The impact of this restatement is summarized as follows:
Critical Accounting Policies
The preparation of the Partnership’s consolidated financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires us 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 reported period. The Partnership’s estimates, judgments and assumptions are continually evaluated based upon available information and experience. Note 1 to the Consolidated Financial Statements includes further discussion of the Partnership’s significant accounting policies.
The Partnership’s management has assessed the accounting policies used in the preparation of its financial statements and discussed them with the General Partner’s Audit Committee and independent auditors. The following accounting policies are considered critical based upon materiality to the financial statements, degree of judgment involved in estimating reported amounts and sensitivity to changes in industry and economic conditions:
Accounting for Joint Ventures: The Partnership has equity interests ranging from 10-95% in joint ventures that own and operate rental properties and hold land for development. The Partnership consolidates those joint ventures that it controls through majority ownership interests or substantial participating rights. Control is further demonstrated by the ability of the general partner to manage day-to-day operations, refinance debt and sell the assets of the joint venture without the consent of the limited partner and inability of the limited partner to replace the general partner. The Partnership uses the equity method of accounting for those joint ventures where the Partnership does not have control over operating and financial polices. Under the equity method of accounting, the assets and liabilities of joint ventures for which the Partnership uses the equity method are not included on the Partnership’s balance sheet.
Cost Capitalization: Direct and certain indirect costs, including interest, clearly associated with the development, construction, leasing or expansion of real estate investments are capitalized as a cost of the property. The following discusses the significant categories of costs incurred by the Partnership:
Within the Rental Operations of the Partnership, direct and indirect costs are capitalized under the guidelines of SFAS 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects (“SFAS 67”), and interest costs are capitalized under the guidelines of SFAS 34, “Capitalization of Interest Cost” (“SFAS 34”). The Partnership capitalizes these project costs associated with the initial construction of a property up to the time the property is substantially complete and ready for its intended use. The Partnership believes the completion of the building shell is the proper basis for determining substantial completion and that this basis is the most widely accepted standard in the real estate industry. The interest rate used to capitalize costs is based upon the Partnership’s average borrowing rate on existing debt.
In addition, the Partnership capitalizes costs, including interest costs, on vacant space during extended lease-up periods after construction of the building shell has been completed if costs are being incurred to ready the vacant space for its intended use. If costs and activities incurred to ready the vacant space cease, then cost capitalization is also discontinued until such activities are resumed. Once necessary work has been completed on a vacant space, project costs are no longer capitalized. The Partnership ceases capitalization of all project costs on extended lease-up periods after the shorter of a one-year period after the completion of the building shell or when the property attains a 90% occupancy. The Partnership follows guidelines in SFAS 34 and SFAS
67 in determining the capitalization of project costs during the lease-up period of a property and believes that this treatment is consistent with real estate industry standards for project cost capitalization.
All direct construction and development costs associated with the development of a new property are capitalized. In addition, all leasing commissions paid to third parties for new leases or lease renewals are capitalized. A portion of the Partnership’s indirect costs associated with its construction/ development and leasing efforts are capitalized. In assessing the amount of indirect costs to be capitalized, the Partnership first allocates payroll costs, on a department-by-department basis, among activities for which capitalization is warranted (i.e., construction, development and leasing) and those for which capitalization is not warranted (e.g., property management, maintenance, acquisitions and dispositions and general corporate functions). To the extent the employees of a department split their time between capitalizable and non-capitalizable activities, the allocations are made based on estimates of the actual amount of time spent in each activity. Once the payroll costs are allocated, the non-payroll costs of each department are allocated among the capitalizable and non-capitalizable activities in the same proportion as payroll costs. The capitalized cost pool does not include any costs allocable to its executive officers.
To ensure that an appropriate amount of costs are capitalized, the amount of capitalized costs that are allocated to a specific project are limited to amounts using standards developed by the Partnership. These standards consist of a percentage of the total development costs of a project and a percentage of the total gross lease
amount payable under a specific lease. These standards are derived after considering both the amount of costs that would need to be paid by the Partnership if the services were performed by third parties, and the amounts that would be allocated if the personnel in the departments were working at full capacity. The use of these standards ensures that overhead costs attributable to downtime or to unsuccessful projects or leasing activities are not capitalized by the Partnership.
Impairment of Real Estate Investments: The Partnership evaluates its real estate investments upon occurrence of significant changes in the operations, but not less than annually, to assess whether any impairment indications are present that affect the recovery of the recorded value. If any real estate investment is considered impaired, a loss is provided to reduce the carrying value of the asset to its estimated fair value. The Partnership utilizes the guidelines established under SFAS 144 to determine if impairment conditions exist. Under SFAS 144, the Partnership reviews the expected undiscounted cash flows of each property in its held for rental portfolio to determine if there are any indications of impairment of a property. The review of anticipated cash flows involves subjective assumptions of estimated occupancy and rental rates and ultimate residual value. In addition to reviewing anticipated cash flows, the Partnership assesses other factors such as changes in business climate and legal factors that may affect the ultimate value of the property. These assumptions are subjective and the anticipated cash flows may not ultimately be achieved.
Real estate assets to be disposed of are reported at the lower of their carrying value amount or the fair value less estimated cost to sell.
Acquisition of Real Estate Property. The Partnership treats each material property acquisition as a “business” within the scope of SFAS 141. In accordance with that statement, the Partnership allocates the purchase price of acquired properties to net tangible and identified intangible assets based on their respective fair value.
The allocation to tangible assets (building and land) is based upon management’s determination of the value of the property as if it were vacant using discounted cash flow models similar to those used by independent appraisers. Factors considered by management include an estimate of carrying costs during the expected lease-up periods considering current market conditions, and costs to execute similar leases. The remaining purchase price is allocated among three categories of intangible assets consisting of the above or below market component of in-place leases, the value of in-place leases and the value of customer relationships.
• The value allocable to the above or below market component of an acquired in-place lease is determined based upon the present value (using an interest rate which reflects the risks associated with the lease) of the difference between (i) the contractual amounts to be paid pursuant to the lease over its remaining term, and (ii) management’s estimate of the amounts that would be paid using current fair market rates over the remaining term of the lease. The amounts allocated to above or below market leases are included in deferred leasing and other costs in the balance sheet and are amortized to rental income over the remaining terms of the respective leases.
• The total amount of intangible assets is further allocated to in-place lease values and to customer relationship values, based upon management’s assessment of their respective values. These intangible assets are included in deferred leasing and other costs in the balance sheet and are depreciated over the remaining term of the existing lease, or the anticipated life of the customer relationship, as applicable.
Valuation of Receivables: The Partnership is subject to tenant defaults and bankruptcies that could affect the collection of outstanding receivables. In order to mitigate these risks, the Partnership performs in-house credit review and analysis on major existing tenants and all significant leases before they are executed. The Partnership has established the following procedures and policies to evaluate the collectibility of outstanding receivables and record allowances:
• The Partnership maintains a tenant “watch list” containing a list of significant tenants for which the payment of receivables and future rent may be at risk. Various factors such as late rent payments, lease or debt instrument defaults, and indications of a deteriorating financial position are considered when determining whether to include a tenant on the watch list.
• As a matter of policy, the Partnership reserves the entire receivable balance, including straight-line rent, of any tenant with an amount outstanding over 90 days.
• Straight-line rent receivables for any tenant on the watch list or any other tenant identified as a potential long-term risk, regardless of the status of rent receivables, are reviewed and reserved as necessary. In addition, a general reserve for straight-line rent receivables is provided in an amount equal to 1% to 2% of the outstanding balance.
Revenue Recognition on Construction Contracts: The Partnership recognizes income on construction contracts where the Partnership serves as a general contractor on the percentage of completion method. Using this method, profits are recorded on the basis of the Partnership’s estimates of the overall profit and percentage of completion of individual contracts. A portion of the estimated profits is accrued based upon the Partnership’s estimates of the percentage of completion of the construction contract. Cumulative revenues recognized may be less or greater than cumulative costs and profits billed at any point in time during a contract’s term. This revenue recognition method involves inherent risks relating to profit and cost estimates with those risks reduced through approval and monitoring processes.
With regards to critical accounting policies, management has discussed the following with the Audit Committee of the General Partner’s Board of Directors:
• Criteria for identifying and selecting;
• Methodology in applying; and
• Impact on the financial statements.
The Audit Committee of the General Partner has reviewed the critical accounting policies identified by the Partnership.
Liquidity and Capital Resources
Sources of Liquidity
The Partnership expects to meet its liquidity requirements over the next twelve months, including payments of distributions to unitholders as well as recurring capital expenditures relating to maintaining the Partnership’s current real estate assets, primarily through the following:
• working capital; and
• net cash provided by operating activities
Although the Partnership historically has not used any other sources of funds to pay for recurring capital expenditures on its current real estate investments, the use of borrowings or property disposition proceeds may be needed to fund such expenditures during periods of high leasing volume. This situation could arise in 2004 if the Partnership experiences a significant increase in its occupancy.
The Partnership expects to meet its long-term liquidity requirements, such as scheduled mortgage debt maturities, preferred equity redemptions, the retirement of unsecured notes and amounts outstanding under the unsecured credit facility, property acquisitions, financing of development activities and other non-recurring capital improvements, primarily from the following sources:
• issuance of additional unsecured notes;
• issuance of additional General Partner preferred equity;
• undistributed cash provided by operating activities, if any; and
• proceeds received from real estate dispositions.
Rental Operations The Partnership believes that its principal source of liquidity, cash flows from Rental Operations, provides a stable source of cash to fund operational expenses. The Partnership believes that this cash-based revenue stream is substantially aligned with revenue recognition (except for periodic straight-line rental income
accruals) as cash receipts from the leasing of rental properties are generally received in advance of or in a short time following the actual revenue recognition. The Partnership is subject to risks of decreased occupancy through market conditions as well as tenant defaults and bankruptcies, and potential reduction in rental rates upon renewal or re-letting of properties, which would result in reduced cash flow from operations. However, management believes that these risks are mitigated by the Partnership’s strong market presence in most of its locations and the fact that the Partnership performs in-house credit review and analysis on major tenants and all significant leases before they are executed.
Credit Facilities
The Partnership had the following line of credit available (in thousands):
The line of credit is used to fund development activities to acquire additional rental properties and to provide working capital.
In January 2004, the Partnership renewed the unsecured line of credit, extending the maturity date to January 2007 and lowering the interest rate from LIBOR + .65% to LIBOR + .60%.
The line of credit contains financial covenants that require the Partnership to meet defined levels of performance. As of December 31, 2003, the Partnership is in compliance with all such covenants and expects to remain in compliance for the foreseeable future.
Debt and Equity Securities
The Partnership currently has on file with the SEC an effective shelf registration statement that permits the Partnership to sell up to an additional $670 million of unsecured debt securities as of December 31, 2003. In addition, the General Partner has on file with the SEC an effective shelf registration statement that permits the General Partner to sell up to an additional $400.7 million of common and preferred stock as of December 31, 2003. From time-to-time, the Partnership and the General Partner expect to issue additional securities under these registration statements to fund development and acquisition of additional rental properties and to fund the repayment of the credit facilities and other long-term debt upon maturity.
The indenture governing the Partnership’s unsecured notes also requires the Partnership to comply with financial ratios and other covenants regarding the operations of the Partnership. The Partnership is currently in compliance with all such covenants and expects to remain in compliance for the foreseeable future.
In January 2004, the Partnership completed a $125 million unsecured debt offering at an effective interest rate of 3.4%, due January 2008.
Sale of Real Estate Assets
The Partnership utilizes sales of real estate assets as an additional source of liquidity. During 2000 and 2001, the Partnership engaged in a capital-recycling program that resulted in sales of over $1 billion of real estate assets. In 2002 and 2003, volume was substantially reduced as capital needs were met through other sources and the slower business climate provided fewer opportunities to profitably reinvest sale proceeds. The Partnership continues to pursue opportunities to sell real estate assets when beneficial to the long-term strategy of the Partnership.
Uses of Liquidity
The Partnership’s principal uses of liquidity include the following:
• Property investments;
• Recurring leasing/capital costs;
• Distributions to unitholders;
• Long-term debt maturities; and
• Other contractual obligations.
Property Investments
The Partnership evaluates development and acquisition opportunities based upon market outlook, supply, and long-term growth potential.
Recurring expenditures
A summary of the Partnership’s recurring capital expenditures is as follows for the year ended December 31, (in thousands):
Dividends and Distributions
In order to qualify as a REIT for federal income tax purposes, the General Partner must currently distribute at least 90% of its taxable income to its shareholders. The Partnership paid distributions per Common Unit of $1.83, $1.81 and $1.76 for the years ended December 31, 2003, 2002 and 2001, respectively. The Partnership expects to continue to distribute taxable earnings at least to the extent necessary for the General Partner to maintain its REIT status. However, distributions are declared at the discretion of the General Partner’s Board of Directors and are subject to actual cash available for distribution, the Partnership’s financial condition, capital requirements and such other factors as the General Partner’s Board of Directors deems relevant.
Debt Maturities
Debt outstanding at December 31, 2003, totaled $2.3 billion with a weighted average interest rate of 5.65% maturing at various dates through 2028. The Partnership had $2.1 billion of unsecured debt and $208.6 million of secured debt outstanding at December 31, 2003. Scheduled principal amortization of such debt totaled $9.0 million for the year ended December 31, 2003.
Following is a summary of the scheduled future amortization and maturities of the Partnership’s indebtedness at December 31, 2003, including the $351 million outstanding on the unsecured line of credit in 2007 maturities to reflect the January 2004 renewal (in thousands):
Historical Cash Flows
A comparison of the Partnership’s historical cash flows for 2003, 2002 and 2001 is as follows (in millions):
Operating Activities
Cash flows from operating activities provide the cash necessary to meet normal, operational requirements. The receipt of rental income from Rental Operations continues to provide the primary source of revenues and operating cash flows for the Partnership. However, in 2002, as explained in more detail below, the Partnership had a large number of sales of buildings developed with the intent to sell, resulting in a significant source of operational cash flows and revenues in 2002 compared to 2001 and 2003. While the Partnership continues to pursue these opportunities, revenues from rental operations will continue to be the primary source of revenue of the Partnership. Management continues to focus on increasing occupancy as its primary objective for 2004.
• The Partnership sold eight build-for-sale properties in 2002 generating sales proceeds of $196.9 million. In contrast, four properties were sold in 2003 with gross proceeds of $50.1 million, and eleven properties were sold in 2001 with gross proceeds of $102.2 million.
• The Partnership has a backlog of build-for-sale buildings as of December 31, 2003, with projected project costs of $65.8 million that it anticipates selling throughout 2004.
Investing Activities
Investing activities are one of the primary uses of the Partnership’s liquidity. Development and acquisition activity is necessary to generate additional rental revenues and provide cash flows for operational requirements. Highlights of significant cash uses are as follows:
• Development costs decreased from $251.4 million in 2001 and $158.1 million in 2002 to $129.2 million in 2003. This trend is reflective of the weakened economy and excess supply over demand in many of the Partnership’s markets. New developments, particularly speculative office, have been limited by management in an effort to focus on lease-ups of existing properties in most markets.
• Acquisitions of real estate have increased significantly since 2001 as the Partnership continues to view acquisitions in current markets as sources for growth opportunities.
• Recurring costs for tenant improvements, lease commissions and building improvements have also continued to increase over the past three years in direct relation to the re-leasing of vacant space. As occupancy fell to a low in 2001, management focused its attention over the past two years on improving and re-letting its existing spaces. Towards the latter half of 2003, occupancy improved in the Partnership’s in-service portfolio. Management anticipates these costs to remain high in 2004 as occupancy trends upward, but occupancy trends are not predictable.
• Proceeds from property sales increased in 2003 over 2002 as the Partnership again looked to dispose of non-strategic assets. The Partnership experienced significant sales in 2000 and 2001 as efforts were made to de-leverage the balance sheet in anticipation of a slowed economy in 2001 and 2002. This strategy has created a low debt to market capitalization for the Partnership as of the end of 2003. Sales of property will continue to be utilized as part of the Partnership’s capital recycling program to fund acquisitions and new development.
Financing Activities
The Partnership increased its borrowings under both its unsecured line of credit and in the public debt markets as a source of capital over the past two years. In order to enhance its flexibility with respect to its properties, the Partnership has continued to replace secured debt with unsecured debt. The low leverage resulting from the large volume of property dispositions in 2000 and 2001 provided the Partnership with the opportunity to borrow funds at very attractive rates. Highlights of significant financing activities are as follows:
• The Partnership received $425.0 million in proceeds from unsecured debt offerings in 2003 and repaid $135.5 million of secured debt in accordance with the strategy outlined above. The Partnership has obtained very low coupon rates on its newly issued debt and has staggered the maturity dates over the next 10 years, with no single year having disproportionate maturities.
• Borrowings on the unsecured line of credit have increased since 2001 as the Partnership has taken advantage of lower interest rates and excess capacity to fund development, acquisition and working capital needs. The Partnership renewed its unsecured line in January 2004, extending the due date to 2007 and lowering the interest rate from LIBOR + .65% to LIBOR + .60%.
Credit Ratings
The General Partner and the Partnership are currently assigned investment grade corporate credit ratings on its senior unsecured notes from Fitch Ratings, Moody’s Investor Service and Standard and Poor’s Ratings Group. Currently, Fitch and Standard and Poor’s have assigned a rating of BBB+ and Moody’s Investors has assigned a rating of Baa1 to the senior notes. These ratings could change based upon, among other things, the Partnership’s results of operations and financial condition.
The General Partner and the Partnership also have received investment grade credit ratings from the same rating agencies on its preferred stock. Fitch and Standard and Poor’s have assigned a Preferred Stock rating of BBB and Moody’s Investors has assigned a Preferred Stock rating of Baa2. These ratings could change based upon, among other things, the Partnership’s results of operations and financial condition.
Financial Instruments
In December 2002, the Partnership simultaneously entered into two $50 million forward-starting interest rate swaps as a hedge to effectively fix the rate on unsecured debt financings expected in 2003. The fair value of the swaps was a liability of $2.1 million as of December 31, 2002, and was recorded in other liabilities in the accompanying balance sheet.
In February 2003, the Partnership simultaneously entered into two additional $25 million forward-starting interest rate swaps as a hedge to effectively fix the rate on unsecured debt financings expected in 2003. All four swaps qualified for hedge accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (“SFAS 133”); therefore, changes in fair value were recorded in other comprehensive income.
In July 2003, the Partnership terminated the swaps for a net gain of $643,000, which is included in other revenue in the Statements of Operations. The swaps were terminated because the Partnership’s capital needs were met through the issuance of the General Partner’s Series J Preferred Stock in lieu of the previously contemplated issuance of debt. The proceeds of the Series J Preferred Stock were contributed to the Partnership.
In July 2001, the Partnership terminated three interest rate swaps that were tied to an $85 million unsecured term loan. The swaps qualified for hedge accounting under SFAS 133. The cost to terminate the swaps was $548,000, which was recorded as interest expense.
In May 2003, the FASB issued Statement No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 is effective for all financial instruments created or modified after May 31, 2003, and otherwise is effective July 1, 2003. The Partnership includes the operations of five joint ventures in its consolidated financial statements. These joint ventures are partially owned by unaffiliated parties that have noncontrolling interests. SFAS 150 requires the disclosure of the estimated settlement value of these noncontrolling interests. As of December 31, 2003, the estimated settlement value of these noncontrolling interests was approximately $4.3 million as compared to the minority interest liability recorded on the Partnership’s books for these joint ventures of $1.2 million.
Off Balance Sheet Arrangements
Investments in Unconsolidated Companies The Partnership has equity interests ranging from 10 - 64% in unconsolidated joint ventures that own and operate rental properties and hold land for development. The equity method of accounting is used for these investments in which the Partnership has the ability to exercise significant influence, but not control, over operating and financial policies. As a result, the assets and liabilities of these joint ventures are not included on the Partnership’s balance sheet.
The Partnership’s investment in unconsolidated companies represents less than 6% of the Partnership’s total assets as of December 31, 2003. These investments provide several benefits to the Partnership including increased market share, tenant and property diversification and an additional source of capital to fund real estate projects.
The following tables presents summarized financial information for the unconsolidated companies for the years ended December 31, 2003 and 2002 (in thousands, except percentages):
Off Balance Sheet Arrangements
The Partnership does not have any relationships with unconsolidated entities or financial partnerships, such as “special purpose entities,” which are generally established for the purpose of facilitating off-balance sheet arrangements or other specific purposes.
Contractual Obligations
As of December 31, 2003, the Partnership is subject to certain contractual payment obligations as described in the schedule below (in thousands):
(1) This long term debt consists of both secured and unsecured debt.
(2) In January 2004, the maturity of the Partnership’s line-of-credit was extended to 2007.
(3) The Partnership has guaranteed $92.0 million of the total $278.7 million Partnership share of unconsolidated joint venture debt.
(4) Estimated remaining costs on the completion of held-for-rental, held-for-sale and third-party construction projects.
(5) These land acquisitions are subject to the completion of due diligence requirements, resolution of certain contingencies and completion of customary closing conditions. If the Partnership were to terminate these contracts, the Partnership would forfeit its total escrow amount of $100,000 and would have no further contractual obligations.
(6) This amount consists of operating leases and infrastructure development commitments.
Related Party Transactions
The Partnership provides property management, leasing, construction and other tenant related services to properties in which certain executives have ownership interests. The Partnership had an option to acquire the executive officers’ interests in these properties. Two of these properties, the Bank One Towers office buildings in Cincinnati, Ohio, were acquired in August 2003 at a price of $45.5 million. The terms of this acquisition were reviewed and approved by the independent members of the General Partner’s Board of Directors. The options on the remaining properties expired in October 2003, as the independent members of the General Partner’s Board of Directors determined that it was not in the best interests of the Partnership to exercise the options.
The Partnership received fees totaling $1.2 million, $1.4 million and $1.7 million in 2003, 2002 and 2001, respectively, for services provided to these properties. The fees charged by the Partnership for such services are equivalent to those charged to third-party owners for similar services.
The Partnership provides property management, leasing, construction and other tenant related services to unconsolidated companies in which the Partnership has equity interests. For the years ended December 31, 2003, 2002 and 2001, respectively, the Partnership received management fees of $4.9 million, $4.9 million and $4.7 million, leasing fees of $2.3 million, $2.5 million and $2.8 million and construction and development fees of $1.4 million, $4.5 million and $5.2 million from these unconsolidated companies. These fees were charged at market rates and the Partnership eliminates its ownership percentage of these fees in the consolidated financials.
In 2002, the Partnership received lease termination fees totaling $7.7 million from a tenant that is a subsidiary of Progress Energy, Inc. William Cavanaugh III is President and Chief Executive Officer of Progress Energy, Inc. and a member of the General Partner’s Board of Directors. The General Partner’s independent directors approved the transaction and management believes that the amount received approximates a value that would have been charged to tenants with similar lease terms and commitments.
The Partnership has other related party transactions that are insignificant and are at terms that management considers to be arm’s-length and equal to those negotiated with independent parties.
Commitments and Contingencies
The Partnership has the following commitments and contingencies in addition to those previously disclosed:
In 1998 and 1999, certain members of management and the General Partner’s Board of Directors purchased $69 million of common stock in connection with an Executive and Senior Officer Stock Purchase Plan. The purchases were financed by five-year personal loans from financial institutions. As of December 31, 2003, the outstanding balance on these loans was $11.7 million as some participants have exited the program and repaid their principal balance. These loans were secured by common shares with a fair market value of $18.2 million purchased through this program and owned by the remaining plan participants at December 31, 2003. As a condition of the financing agreement with the financial institution, the Partnership guaranteed the repayment of principal, interest and other obligations for each participant, but is fully indemnified by the participants. In the opinion of management, it is not probable that the Partnership will be required to satisfy these guarantees.
In October 2000, the Partnership sold or contributed industrial properties and undeveloped land with a fair value of $487 million to a joint venture (Dugan Realty LLC) in which the Partnership has a 50% interest and recognized a net gain of $35.2 million. This transaction expanded an existing joint venture with an institutional real estate investor. As a result of the total transactions, the Partnership received $363.9 million of proceeds. The joint venture partially financed this transaction with $350 million of secured mortgage debt, the repayment of which was directly or indirectly guaranteed by the Partnership. The guarantee associated with $260 million of such debt expired in December 2003 without the Partnership being required to satisfy the guarantee. The remaining $90 million of such debt is still guaranteed by the Partnership. In connection with this transaction, the joint venture partners were given an option to put up to a $50 million interest in the joint venture to the Partnership in exchange for common stock of the Partnership or cash (at
the option of the Partnership), subject to certain timing and other restrictions. As a result of this put option, the Partnership deferred $10.2 million of gain on sale of depreciated property and recorded a $50 million liability.
The Partnership has guaranteed the repayment of $3.5 million of economic development bonds issued by the City of Carmel, Indiana. The Partnership will be required to make payments under its guarantee to the extent that incremental taxes from one of its office park developments are not sufficient to pay the bond debt service. Management does not believe that it is probable that the Partnership will be required to make any significant payments in satisfaction of this guarantee.
The Partnership has also guaranteed the repayment of a $2 million mortgage loan encumbering the real estate of one its unconsolidated joint ventures. Management believes that the value of the real estate exceeds the loan balance and that the Partnership will not be required to satisfy this guarantee.
The Partnership has entered into agreements, subject to the completion of due diligence requirements, resolution of certain contingencies and completion of customary closing conditions, for the future acquisition of land totaling $13.8 million. The acquisitions are scheduled to close periodically through 2004 and will be paid for by cash.
The Partnership renewed all of its major insurance policies in 2003. These policies include coverage for acts of terrorism for its properties. The Partnership believes that this insurance provides adequate coverage against normal insurance risks and that any loss experienced would not have a significant impact on the Partnership’s liquidity, financial position, or results of operations.
Broadband Office, Inc. and Official Committee of Unsecured Creditors of Broadband Office, Inc. recently filed a complaint against a group of real estate investment trusts and real estate operating companies and certain affiliated entities and individuals in connection with the formation and management of Broadband Office. Among the defendants are the General Partner, the Partnership and Mr. Dennis Oklak, one of the General Partner’s executive officers. The complaint alleges various breaches of purported fiduciary duties by the defendants, seeks recharacterization or equitable subordination of debt, seeks recovery of alleged avoidable transfers, appears to seek to hold them liable for, among other things, the debt of Broadband Office under alter-ego, veil-piercing and partnership theories, and seeks other relief under other theories. The complaint seeks aggregate damages in excess of $300 million from all of the defendants. The Partnership believes that it has meritorious defenses to the plaintiff’s allegations and intends to vigorously defend this litigation. Due to the inherent uncertainties of the litigation process and the judicial system, the Partnership is not able to predict the outcome of this litigation. If this litigation is not resolved in the Partnership’s favor, it could have a material adverse effect on its business, financial condition and results of operations.
The Partnership is subject to various legal proceedings and claims that arise in the ordinary course of business. In the opinion of management, the amount of any ultimate liability with respect to these actions will not materially affect the Partnership’s consolidated financial statements or results of operations.
Recent Accounting Pronouncements
In January 2003, FASB issued Interpretation 46, Consolidation of Variable Interest Entities (“Interpretation 46”), which addresses the consolidation of certain entities in which a company has a controlling financial interest through means other than voting rights. This interpretation was revised in December 2003. For calendar year companies, Interpretation 46 contains an effective date of December 31, 2003 for special purpose entities and periods ending after March 15, 2004 for all other entities. The Partnership does not own interests in special purpose entities and management does not believe that the adoption of Interpretation 46 will have a material impact on the Partnership’s financial statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure About Market Risks
The Partnership is exposed to interest rate changes primarily as a result of its line of credit and long-term debt borrowings. The Partnership’s interest rate risk management objective is to limit the impact of interest rate
changes on earnings and cash flows and to lower its overall borrowing costs. To achieve its objectives the Partnership borrows primarily at fixed rates and may enter into derivative financial instruments such as interest rate swaps, caps and treasury locks in order to mitigate its interest rate risk on a related financial instrument. The Partnership does not enter into derivative or interest rate transactions for speculative purposes.
The Partnership’s interest rate risk is monitored using a variety of techniques. The table below presents the principal amounts (in thousands) of the expected annual maturities, weighted average interest rates for the average debt outstanding in the specified period, fair values and other terms required to evaluate the expected cash flows and sensitivity to interest rate changes.
As the table incorporates only those exposures that exist as of December 31, 2003, it does not consider those exposures or positions that could arise after that date. As a result, the Partnership’s ultimate realized gain or loss with respect to interest rate fluctuations will depend on the exposures that arise during the period, the Partnership’s hedging strategies at that time, and interest rates.
The Partnership’s unsecured line of credit was renewed in January 2004 with the maturity date being extended to January 2007. The table above reflects the 2007 maturity date.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements and supplementary data are included under Item 15 of this Report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Part III
Item 9A.
Item 9A. Disclosure Controls and Procedures
The Partnership maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in our annual and periodic reports filed with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. These disclosure controls and procedures are further designed to ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, to allow timely decisions regarding required disclosure.
Based on the most recent evaluation, which was completed as of December 31, 2003, the General Partner’s chief executive officer, chief operating officer and chief financial officer believe that the disclosure controls and procedures are effective. There have been no significant changes in the Partnership’s internal controls over financial reporting or in other factors that could significantly affect the internal controls over financial reporting subsequent to the date the evaluation was completed.
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The Partnership does not have any directors or officers. The information required by Item 10 for Directors and Certain Executive Officers is contained in a definitive proxy statement for the General Partner, which herein is incorporated by reference.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 is contained in a definitive proxy statement for the General Partner, which herein is incorporated by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Unitholder Matters
The information required by Item 12 is contained in a definitive proxy statement for the General Partner, which herein is incorporated by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 is contained in a definitive proxy statement for the General Partner, which herein is incorporated by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 is contained in a definitive proxy statement for the General Partner, which herein is incorporated by reference.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as part of this Form 10-K:
1. Consolidated Financial Statements
The following Consolidated Financial Statements of the Partnership, together with the Independent Auditors’ Report, are listed below:
Independent Auditors’ Report
Consolidated Balance Sheets, December 31, 2003 and 2002
Consolidated Statements of Operations, Years Ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows, Years Ended December 31, 2003, 2002 and 2001
Consolidated Statements of Partners’ Equity, Years Ended December 31, 2003, 2002 and 2001
Notes to Consolidated Financial Statements
2. Consolidated Financial Statement Schedules
Schedule III - Real Estate and Accumulated Depreciation
3. Exhibits
The following exhibits are filed with this Annual Report Form 10-K or incorporated herein by reference to the listed document previously filed with the SEC. Previously unfiled documents are noted with an asterisk (*).
Number
Description
4.1
Third Restated Articles of Incorporation of the Partnership, incorporated by reference from Exhibit 3.1 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended March 21, 2003.
4.2
Third Amended and Restated Bylaws of the Partnership, incorporated by reference from Exhibit 3.2 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2003.
4.3
Amendment to the Third Restated Articles of Incorporation, incorporated by reference from Exhibit 3 of the Partnership’s Current Report on Form 8-K dated August 25, 2003.
4.4
Amendment to the Third Restated Articles of Incorporation, incorporated by reference from Exhibit 3 of the Partnership’s Current Report on Form 8-K dated February 13, 2004.
4.5
Indenture between DRLP and The First National Bank of Chicago, Trustee, incorporated by reference to Exhibit 4.1 to the Partnership’s Current Report on Form 8-K filed September 22, 1995.
4.6
First Supplement to Indenture, incorporated by reference to Exhibit 4.2 to the Partnership’s Current Report on Form 8-K filed September 22, 1995.
4.7
Second Supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed July 12, 1996.
4.8
Third Supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed May 20, 1997.
4.9
Fourth Supplement to Indenture, incorporated by reference to Exhibit 4.8 to the Partnership’s Form S-4 Registration Statement No. 333-77645 dated May 4, 1999 (Merger Registration Statement).
4.10
Fifth Supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed June 1, 1998.
4.11
Sixth Supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed February 12, 1999.
4.12
Seventh Supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed June 29, 1999.
4.13
Eighth Supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed November 15, 1999.
4.14
Ninth supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed March 2, 2001.
4.15
Tenth supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed August 13, 2002.
4.16
Eleventh supplement to Indenture, incorporated by reference to Exhibit 4 to the Partnership’s Current Report on Form 8-K filed August 26, 2002.
4.17
Twelfth supplement to Indenture, incorporated by reference to Exhibit 4 to Partnership’s Current Report on Form 8-K filed January 16, 2002.
4.18
Thirteenth Supplement to Indenture, incorporated by Reference to Exhibit 4 to Partnership’s Current Report on Form 8-K filed May 22, 2003.
4.19
Fourteenth Supplement to Indenture, incorporated by Reference to Exhibit 4 to Partnership’s Current Report on Form 8-K filed October 24, 2003.
4.20
Fifteenth Supplement to Indenture, incorporated by Reference to Exhibit 4 to Partnership’s Current Report on Form 8-K filed January 9, 2004.
4.21
Sixteenth Supplement to Indenture, incorporated by Reference to Exhibit 4 to Partnership’s Current Report on Form 8-K filed January 23, 2004.
10.1
Second Amended and Restated Agreement of Limited Partnership of DRLP, incorporated by reference from Exhibit 4.1 to DRLP’s Current Report on Form 8-K filed July 16, 1999.
10.2
First Amendment to Second Amended and Restated Agreement of Limited Partnership of DRLP, incorporated by reference from Exhibit 10.2 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000.
10.3
Second Amendment to Second Amended and Restated Agreement of Limited Partnership of DRLP incorporated by reference from Exhibit 10.3 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
10.4
Third Amendment To Second Amended and Restated Agreement of Limited Partnership of DRLP incorporated by reference from Exhibit 10.4 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
10.5
Fourth Amendment to Second Amended and Restated Agreement of Limited Partnership of DRLP incorporated by reference from Exhibit 10.5 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
10.6
Second Amended and Restated Agreement of Limited Partnership of Duke Realty Services Limited Partnership (the “Services Partnership”), incorporated herein by reference to Exhibit 10.3 to the Partnership’s Annual Report on Form 10-K for the year ended December 31, 1995.
10.7
First Amendment to Second Amended and Restated Agreement of Limited Partnership of the Services Partnership incorporated by reference from Exhibit 10.7 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
10.8
Second Amendment to Second Amended and Restated Agreement of Limited Partnership of the Services Partnership incorporated by reference from Exhibit 10.8 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
10.9
Third Amendment to Second Amended and Restated Agreement of Limited Partnership of the Services Partnership incorporated by reference from Exhibit 10.9 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
10.10
Promissory Note of the Services Partnership, incorporated herein by reference to Exhibit 10.3 to the Partnership’s Form S-2 Registration Statement No. 33-64038 filed June 8, 1993 (the “1993 Registration Statement”).
10.11
Services Partnership 1993 Stock Option Plan, incorporated herein by reference to Exhibit 10.4 to the 1993 Registration Statement.#
10.12
Amendment One to Services Partnership 1993 Stock Option Plan incorporated by reference from Exhibit 10.12 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.13
Amendment Two to Services Partnership 1993 Stock Option Plan incorporated by reference from Exhibit 10.13 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002.#
10.14
Amendment Three to Services Partnership 1993 Stock Option Plan incorporated by reference from Exhibit 10.14 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002.#
10.15
Acquisition Option Agreement relating to certain properties not contributed to the Operating Partnership by Duke Associates (the “Excluded Properties”), incorporated herein by reference to Exhibit 10.5 to the 1993 Registration Statement.
10.16
Management Agreement relating to the Excluded Properties, incorporated herein by reference to Exhibit 10.6 to the 1993 Registration Statement.
10.17
Indemnification Agreement, incorporated herein by reference to Exhibit 10.11 to the 1993 Registration Statement.
10.18
1995 Key Employee Stock Option Plan of the Partnership, incorporated herein by reference to Exhibit 10.13 to the Partnership’s Annual Report on Form 10-K for the year ended December 31, 1995.#
10.19
Amendment One To The 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc. incorporated by reference from Exhibit 10.19 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.20
Amendment Two to the 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc. incorporated by reference from Exhibit 10.20 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.21
Amendment Three to the 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc. incorporated by reference from Exhibit 10.21 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.22
Amendment Four to the 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc. incorporated by reference from Exhibit 10.22 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.23
Amendment Five to the 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc. incorporated by reference from Exhibit 10.23 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.24
Amendment Six to the 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc. incorporated by reference from Exhibit 10.24 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.25
Amendment Seven to the 1995 Key Employees’ Stock Option Plan of Duke Realty Investments, Inc., incorporated herein by reference to Exhibit 10.1 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002.#
10.26
Amended and Restated Dividend Increase Unit Plan of the Services Partnership incorporated by reference from Exhibit 10.25 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.27
Amendment One to the Amended and Restated Dividend Increase Unit Plan of Services Partnership incorporated by reference from Exhibit 10.26 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.28
Amendment Two to the Amended and Restated Dividend Increase Unit Plan of Services Partnership incorporated by reference from Exhibit 10.27 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.29
Amendment Three to the Amended and Restated Dividend Increase Unit Plan of Duke Realty Services Limited Partnership, incorporated herein by reference to Exhibit 10.5 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2001.#
10.30
Shareholder Value Plan of the Services Partnership incorporated herein by reference to Exhibit 10.15 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 1995.#
10.31
Amendment One to the 1995 Shareholder Value Plan of Services Partnership incorporated by reference from Exhibit 10.29 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.32
Amendment Two to the 1995 Shareholder Value Plan of Services Partnership incorporated by reference from Exhibit 10.30 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.33
Amendment Three to the 1995 Shareholder Value Plan of Services Partnership incorporated by reference from Exhibit 10.31 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001.#
10.34
Amendment Four to the 1995 Shareholder Value Plan of Services Partnership, incorporated herein by reference to Exhibit 10.2 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002.#
10.35
1998 Duke Realty Severance Pay Plan, incorporated herein by reference to Exhibit 10.18 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 1998.#
10.36
Directors’ Stock Option and Dividend Increase Unit Plan, incorporated by reference to Annex F to the Prospectus in the Merger Registration Statement.#
10.37
1999 Salary Replacement Stock Option and Dividend Increase Unit Plan is incorporated by reference to Annex G to the Prospectus in the Merger Registration Statement.#
10.38
Amendment One to the 1999 Salary Replacement Stock Option and Dividend Increase Unit Plan of Duke Realty Investments, Inc. incorporated herein by reference to Exhibit 10.3 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002.#
10.39
Amendment Two to the 1999 Salary Replacement Stock Option and Dividend Increase Unit Plan of Duke Realty Investments, Inc. incorporated herein by reference to Exhibit 10.4 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002.#
10.40
Performance Share Plan of Duke-Weeks Realty Corporation incorporated herein by reference to Proposal 2 of the partnership’s 2001 Proxy filed March 13, 2001.
10.41
Amendment One to the 2000 Performance Share Plan of Duke-Weeks Realty Corporation incorporated herein by reference to Exhibit 10.6 to the Partnership’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002.
10.42
Amendment Two to the 2000 Performance Share Plan of Duke-Weeks Realty Corporation incorporated herein by reference to Exhibit 10.42 to the Partnership’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.*
10.43
Fourth Amended and Restated Revolving Credit Agreement dated January 22, 2004, among the Partnership, as borrower, Duke Realty Corporation as General Partner and Guarantor, and Bank One as Administrative Agent and Lender incorporated by reference from Exhibit 10.1 to the Partnership’s Current Report on Form 8-K filed January 22, 2004.*
11.1
Statement of Computation of Ratios of Earnings to Fixed Charges.*
11.2
Statement of Computation of Ratios of Earnings to Debt Service.*
21.
List of the Partnership’s Subsidiaries.*
23.
Consent of KPMG LLP.*
24.
Executed powers of attorney of certain directors.*
31.1
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
31.2
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
31.3
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
32.1
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
32.2
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
32.3
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
99.1
Selected Quarterly Financial Information.*
# Represents management contract or compensatory plan or arrangement.
The Partnership will furnish to any security holder, upon written request, copies of any exhibit incorporated by reference, for a fee of 15 cents per page, to cover the costs of furnishing the exhibits. Written request should include a representation that the person making the request was the beneficial owner of securities entitled to vote at the Annual Meeting of Shareholders of the General Partner.
(b) Reports on Form 8-K
A current report was filed on Form 8-K, dated January 22, 2004, reporting under items 5 and 7 the execution of a new $500 million revolving line of credit.
A current report was filed on Form 8-K, dated January 16, 2004, setting forth under item 5 the issuance of $125,000,000 aggregate principal amount of Notes due in 2008 at 3.35%.
(c) Exhibits
The exhibits required to be filed with this Form 10-K pursuant to Item 601 of Regulation S-K or listed under “Exhibits” in Part IV, Item 14(a)(3) of Form 10-K, which are incorporated herein by reference.
(d) Financial Statement Schedule
The Financial Statement Schedule required to be filed with this Form 10-K is listed under “Consolidated Financial Statement Schedules” in Part IV, Item 14(a)(2) of this Form 10-K, and is incorporated herein by reference.
Independent Auditors’ Report
The Partners
Duke Realty Limited Partnership:
We have audited the consolidated balance sheets of Duke Realty Limited Partnership and Subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, cash flows and partners’ equity for each of the years in the three-year period ended December 31, 2003. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule III. These consolidated financial statements and the financial statement schedule are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on the consolidated financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Duke Realty Limited Partnership and Subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule III, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
KPMG LLP
Indianapolis, Indiana
January 28, 2004
DUKE REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES
Consolidated Balance Sheets
As of December 31
(in thousands, except per unit amounts)
See accompanying Notes to Consolidated Financial Statements.
DUKE REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES
Consolidated Statements of Operations
For the Years Ended December 31
(in thousands, except per unit amounts)
See accompanying Notes to Consolidated Financial Statements.
DUKE REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Years Ended December 31
(in thousands)
See accompanying Notes to Consolidated Financial Statements.
DUKE REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES
Consolidated Statements of Partners’ Equity
(in thousands, except per unit data)
See accompanying Notes to Consolidated Financial Statements.
DUKE REALTY LIMITED PARTNERSHIP AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) The Partnership
Duke Realty Limited Partnership (the “Partnership”) was formed on October 4, 1993, when Duke Realty Corporation (the “General Partner”) contributed all of its properties and related assets and liabilities, along with the net proceeds of $309.2 million from the issuance of an additional 14,000,833 shares of the General Partner through an offering to the Partnership. Simultaneously, the Partnership completed the acquisition of Duke Associates, a full-service commercial real estate firm operating in the Midwest. The General Partner was formed in 1985 and qualifies as a Real Estate Investment Trust (“REIT”) under provisions of the Internal Revenue Code. The General Partner is the sole general partner of the Partnership, owning 90.6% of the common partnership interests as of December 31, 2003 (“General Partner Units”). The remaining 9.4% of the Partnership’s common interest is owned by limited partners (“Limited Partner Units” and, together with the General Partner Units, the “Common Units”). The Limited Partner Units are exchangeable for shares of the General Partner’s common stock on a one-for-one basis subject generally to a one-year holding period.
The Partnership owns and operates a portfolio of industrial, office and retail properties in the midwestern and southeastern United States and provides real estate services to third-party owners. The Partnership conducts Service Operations through Duke Realty Services Limited Partnership (“DRSLP”) and Duke Construction Limited Partnership (“DCLP”).
(2) Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Partnership and its controlled subsidiaries. The equity interests in these controlled subsidiaries not owned by the Partnership are reflected as minority interests in the consolidated financial statements. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements. Investments in entities that the Partnership does not control through majority voting interest or where the other owner has substantial participating rights are not consolidated and are reflected as investments in unconsolidated companies under the equity method of reporting.
Reclassifications
Certain 2001 and 2002 balances have been reclassified to conform to the 2003 presentation.
Real Estate Investments
Rental real property, including land, land improvements, buildings and building improvements, are included in real estate investments and are generally stated at cost. Buildings and land improvements are depreciated on the straight-line method over their estimated life not to exceed 40 and 15 years, respectively, and tenant improvement costs are depreciated using the straight-line method over the term of the related lease.
Direct and indirect costs, including interest and real estate taxes associated with the development, construction, leasing or expansion of real estate investments, are capitalized as a cost of the property. Indirect costs include an estimate of internal costs associated with the development and leasing of real estate investments. All external costs associated with the acquisition of real estate investments are capitalized as a cost of the property.
Construction in process and land held for development are included in real estate investments and are stated at cost. Real estate investments also include the Partnership’s equity interests in unconsolidated joint ventures that own and operate rental properties and hold land for development. The equity method of accounting is used for these investments in which the Partnership has the ability to exercise significant influence, but not control, over operating and financial policies. Any difference between the carrying amount
of these investments and the underlying equity in net assets is amortized to equity in earnings of unconsolidated companies over the depreciable life of the property, generally 40 years.
The Partnership adopted Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long Lived Assets (“SFAS144”), in 2002. In accordance with this statement, properties held for rental 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 its anticipated holding period is less than is historical net cost basis. Upon determination that a permanent impairment has occurred, a loss is recorded to reduce the net book value of that property to its fair market value. Real properties to be disposed of are reported at the lower of net historical cost basis or its estimated fair market value, less costs to sell. Once a property is designated as held for disposal, no further depreciation expense is recorded.
In accordance with Statement of Financial Accounting Standard No. 141, Business Combinations (“SFAS 141”), the Partnership allocates the purchase price of acquired properties to net tangible and identified intangible assets based on their respective fair values. The allocation to tangible assets (building and land) is based upon management’s determination of the value of the property as if it were vacant using discounted cash flow models similar to those used by independent appraisers. Factors considered by management include an estimate of carrying costs during the expected lease-up periods considering current market conditions, and costs to execute similar leases. The remaining purchase price is allocated among three categories of intangible assets consisting of the above or below market component of in-place leases, the value of in-place leases and the value of customer relationships.
The value allocable to the above or below market component of an acquired in-place lease is determined based upon the present value (using a discount rate which reflects the risks associated with the acquired leases) of the difference between (i) the contractual amounts to be paid pursuant to the lease over its remaining term, and (ii) management’s estimate of the amounts that would be paid using fair market rates over the remaining term of the lease. The amounts allocated to above or below market leases are included in deferred leasing and other costs in the balance sheet and are amortized to rental income over the remaining terms of the respective leases.
The total amount of intangible assets is further allocated to in-place lease values and to customer relationship values based upon management’s assessment of their respective values. These intangible assets are included in deferred leasing and other costs in the balance sheet and are depreciated over the remaining term of the existing lease, or the anticipated life of the customer relationship, as applicable.
Cash Equivalents
Highly liquid investments with a maturity of three months or less when purchased are classified as cash equivalents.
Deferred Costs
Costs incurred in connection with obtaining financing are amortized to interest expense on the straight-line method, which approximates a constant spread over the term of the related loan. All direct and indirect costs, including estimated internal costs, associated with the leasing of real estate investments owned by the Partnership are capitalized and amortized over the term of the related lease. Unamortized costs are charged to expense upon the early termination of the lease or upon early payment of the financing.
Revenues
Rental Operations
Rental income from leases with scheduled rental increases during their terms is recognized on a straight-line basis.
Service Operations
Management fees are based on a percentage of rental receipts of properties managed and are recognized as the rental receipts are collected. Maintenance fees are based upon established hourly rates and are recognized as the services are performed. Construction management and development fees represent fee based third party contracts and are recognized as earned based on the terms of the contract, which approximates the percentage of completion method.
The Partnership recognizes income on construction contracts where the Partnership serves as a general contractor on the percentage of completion method. Using this method, profits are recorded based on the Partnership’s estimates of the percentage of completion of individual contracts, commencing when the work performed under the contracts reach a point where the final costs can be estimated with reasonable accuracy. The percentage of completion estimates are based on a comparison of the contract expenditures incurred to the estimated final costs. Changes in job performance, job conditions and estimated profitability may result in revisions to costs and income and recognized in the period in which the revisions are determined.
Property Sales
Gains from sales of depreciated property are recognized in accordance with Statement of Financial Accounting Standard No. 66, Accounting for Sales of Real Estate (“SFAS 66”), and are included in earnings from sales of land and depreciable property dispositions, net of any impairment adjustments, in the Statement of Operations if identified as held-for-sale prior to adoption of SFAS 144 and in discontinued operations if identified as held-for-sale after adoption of SFAS 144.
Gains or losses from the sale of property that were developed with the intent to sell and not for long-term rental are recognized in accordance with SFAS 66 and are included in construction management and development activity income in the Statement of Operations.
Net Income Per Common Unit
Basic net income per common unit is computed by dividing net income available for common units by the weighted average number of common units outstanding for the period. Diluted net income per common unit is computed by dividing the sum of net income available for common unitholders by the sum of the weighted average number of common units and outstanding, including any dilutive potential common units for the period.
The following table reconciles the components of basic and diluted net income per common unit (in thousands):
The Partnership’s outstanding Series D Convertible Preferred Units was anti-dilutive for the years ended December 31, 2003, 2002 and 2001; therefore, no conversion to common units is included in weighted average dilutive potential common units. In September 2002, the Partnership redeemed the Series G Convertible Preferred Units at their par value of $35.0 million. These Units were anti-dilutive for the years ended December 31, 2002 and 2001; therefore, no conversion to common shares was included in weighted average dilutive potential common shares.
A joint venture partner in one of the Partnership’s unconsolidated companies has the option to convert a portion of its ownership to the General Partner’s common shares, which would require the issuance of additional Common units to the General Partner. The effect of this option on earnings per unit was anti-dilutive for the years ended December 31, 2003 and 2002 and was dilutive for the year ended December 31, 2001; therefore, conversion to common units was included in weighted dilutive potential common units for that year.
Federal Income Taxes
The Partnership recorded federal and state income taxes of $3.7 million, $11.2 million and $4.0 million for 2003, 2002 and 2001, respectively, which were primarily attributable to the earnings of the Partnership’s taxable REIT subsidiaries. The taxable REIT subsidiaries had no significant deferred income tax items.
As a partnership, the allocated share of income and loss other than the operations of the taxable REIT subsidiaries is included in the income tax returns of the partners; accordingly, no accounting for federal income taxes is required in the accompanying consolidated financial statements.
Stock Based Compensation
Under the limited partnership agreement of the partnership, the Partnership is required to issue one Common Unit to the General Partner for each share of common stock issued by the General Partner. Accordingly, the issuance of common shares by the General Partner under its stock based compensation plans requires the issuance of a corresponding number of Common Units by the Partnership to the General Partner.
The Partnership applies the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting, for all stock based awards issued by the General Partner prior to 2002. Accordingly, for stock options granted prior to 2002, no compensation expense is reflected in net income as all options granted had an exercise price equal to the market value of the General Partner’s underlying common stock on the date of the grant.
In 2002, the Partnership prospectively adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation (SFAS 123”), for all awards granted after January 1, 2002.
Awards under the General Partner’s stock based employee compensation plans generally vest over five years at 20% per year. Therefore, the expense related to these plans is less than that which would have been recognized if the fair value method had been applied to all awards since the original effective date of SFAS 123. The following table illustrates the effect on net income and earnings per share if the fair value method
had been applied to all outstanding and unvested awards in each period.
Derivative Financial Instruments
The Partnership periodically enters into certain interest rate protection agreements to effectively convert or cap floating rate debt to a fixed rate, and to hedge anticipated future financing transactions. Net amounts paid or received under these agreements are recognized as an adjustment to the interest expense of the corresponding debt. The Partnership does not utilize derivative financial instruments for trading or speculative purposes.
The Partnership adopted SFAS 133 Accounting for Derivative Instruments and Hedging Activities, as amended (“SFAS 133”), on January 1, 2001. SFAS 133 requires that all derivative instruments be recorded on the balance sheet as assets or liabilities at their fair value. The cumulative effect of adopting SFAS 133 was not material to the Partnership’s financial statements on the date of adoption. Derivatives that are not hedges must be adjusted to fair value through the recording of income or expense. If a derivative qualifies as a hedge, the changes in fair value of the effective portion of the hedge are recognized in other comprehensive income, while the ineffective portion of the derivative’s change in fair value is recognized in earnings. The Partnership estimates the fair value of derivative instruments using standard market conventions and techniques such as discounted cash flow analysis, option pricing models and termination cost at each balance sheet date.
Use Of Estimates
The preparation of the financial statements requires management to make a number of estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.
(3) Related Party Transactions
The Partnership provides property management, leasing, construction and other tenant related services to properties in which certain executives have ownership interests. The Partnership had an option to acquire the executive officers’ interests in these properties. Two of these properties, the Bank One Towers office buildings in Cincinnati, Ohio, were acquired in August 2003 at a price of $45.5 million. The terms of this acquisition were reviewed and approved by the independent members of the General Partner’s Board of Directors. The options on the remaining properties expired in October 2003, as the independent members of the General Partner’s Board of Directors determined that it was not in the best interests of the Partnership to exercise the options.
The Partnership received fees totaling $1.2 million, $1.4 million and $1.7 million in 2003, 2002 and 2001, respectively, for services provided to these properties. The fees charged by the Partnership for such services are equivalent to those charged to third-party owners for similar services.
The Partnership provides property management, leasing, construction and other tenant related services to unconsolidated companies in which the Partnership has equity interests. For the years ended December 31, 2003, 2002 and 2001, respectively, the Partnership received management fees of $4.9 million, $4.9 million and $4.7 million, leasing fees of $2.3 million, $2.5 million and $2.8 million and construction and development fees of $1.4 million, $4.5 million and $5.2 million from these unconsolidated companies. These fees were charged at market rates and the Partnership eliminates its ownership percentage of these fees in the consolidated financials.
In 2002, the Partnership received lease termination fees totaling $7.7 million from a tenant that is a subsidiary of Progress Energy, Inc. William Cavanaugh III is President and Chief Executive Officer of Progress Energy, Inc. and a member of the General Partner’s Board of Directors. The General Partner’s independent directors approved the transaction and management believes that the amount received approximates a value that would have been charged to tenants with similar lease terms and commitments.
The Partnership has other related party transactions that are insignificant and are at terms that management considers to be arm’s-length and equal to those negotiated with independent parties.
(4) Investments in Unconsolidated Companies
The Partnership has equity interests ranging from 10 - 64% in unconsolidated joint ventures that own and operate rental properties and hold land for development.
Combined summarized financial information for the unconsolidated companies as of December 31, 2003 and 2002, and for the years ended December 31, 2003, 2002, and 2001, are as follows (in thousands):
The Partnership’s share of the scheduled payments of long term debt for the unconsolidated joint ventures for each of the next five years and thereafter as of December 31, 2003, are as follows (in thousands):
The following significant transactions involving the unconsolidated companies have occurred over the past three years:
During 2003, the Partnership purchased its partner’s interest in three separate joint ventures. The Partnership had a 50% interest in each of these ventures prior to their acquisition. The Partnership also sold its 50% interest in two separate joint ventures to its partners. In addition, the Partnership contributed cash and undeveloped land to a joint venture that owns undeveloped land and an office building in return for a 50% interest.
In 2002, the Partnership recognized a gain of $1.8 million on the sale of a building that was developed for sale by a joint venture in which the Partnership owned a 50% interest. The gain was included in equity in earnings in the Statement of Operations. The Partnership also bought out its other partners’ interest in six separate joint ventures. The Partnership had a 50% interest in each of these ventures prior to their acquisition.
During 2001, the Partnership received approximately $50.0 million in cash distributions resulting from secured debt financing within two 50 % owned joint ventures. The debt is nonrecourse to the Partnership and is secured by rental properties owned by the joint ventures. In addition, the Partnership recognized a gain of $2.9 million from the sale of depreciable property by a joint venture in which the Partnership owned a 50% interest. The gain is included in equity in earnings in the Statement of Operations.
(5) Real Estate Investments
The Partnership adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets (“SFAS 144”), on January 1, 2002. SFAS 144 requires the Partnership to report in discontinued operations the results of operations of a property which has either been disposed or is classified as held-for-sale, unless certain conditions are met.
The Partnership has classified operations of 45 buildings as discontinued operations in accordance with SFAS 144. These 45 buildings consist of thirty-four industrial, seven office and four retail properties. As a result, the Partnership classified net income of $2.9 million, $5.7 million and $7.1 million as net income from discontinued operations for the years ended December 31, 2003, 2002 and 2001, respectively. Forty-two of these properties were sold during 2003, two properties were sold during 2002 and one operating property is classified as held-for-sale at December 31, 2003; therefore, the gains on disposal of these properties, net of impairment adjustment, of $13.0 million and ($17,000) for the year ended December 31, 2003 and 2002, respectively, are also reported in discontinued operations.
The following table illustrates the major classes of assets and operations affected by the 45 buildings identified as discontinued operations at December 31, 2003 (in thousands):
The Partnership allocates interest expense to discontinued operations as permitted under EITF 87-24, “Allocation of Interest to Discontinued Operations,” and has included such interest expense in computing net income from discontinued operations. Interest expense allocable to discontinued operations includes interest on the debt for the secured properties and an allocable share of the Partnership’s consolidated unsecured interest expense for unencumbered properties. The allocation of unsecured interest expense to discontinued operations was based upon the Gross Book Value of the discontinued unencumbered operations population as it related to the Partnership’s entire unencumbered population.
At December 31, 2003, the Partnership had four office, three industrial and one retail properties comprising approximately 785,000 square feet classified as held-for-sale. With the exception of one industrial property mentioned above, each of these properties was under development on that date and had no operations. Net operating income (defined as total property revenues, less property expenses, which include real estate taxes, repairs and maintenance, property management, utilities, insurance and other expenses) of the properties held-for-sale for the years ended December 31, 2003, 2002 and 2001 was approximately $206,000, $89,000 and $88,000, respectively. The net book value of the properties held-for-sale at December 31, 2003, was approximately $47.2 million.
In 2003 the Partnership recorded $1.1 million of impairment adjustments for one industrial building and three land parcels that were held-for-sale. These adjustments reflect the write-down of the carrying value of the properties to their projected sales price, less selling expenses, once it became probable that the properties would be sold. Each of these properties was later sold in 2003.
The Partnership recorded a $9.4 million impairment adjustment for six properties in 2002. This total consisted of a $7.7 million adjustment for three industrial properties and a $1.7 million adjustment for three office properties. The properties were identified as impaired upon the comparison of their projected undiscounted cash flows to their carrying value. The impairment adjustment reflects the write-down of the carrying value of the properties to their estimated fair market value. In estimating fair market value, management considers valuation factors used by independent appraisers, including the sales of comparable properties, replacement cost and the capitalization of future expected net operating income.
In 2001, the Partnership recorded a $4.8 million impairment adjustment for an industrial property that was sold in 2002. This adjustment reflected the write-down of the carrying value of that property to an amount equal to its projected sales price, less selling expenses, once it became probable the property would be sold.
(6) Indebtedness
Indebtedness at December 31 consists of the following (in thousands):
The fair value of the Partnership’s indebtedness as of December 31, 2003, was $2.5 billion.
As of December 31, 2003, the $208.6 million of secured debt was collateralized by rental properties with a carrying value of $453.7 million and by letters of credit in the amount of $15 million.
The Partnership had one unsecured line of credit available at December 31, 2003, described as follows (in thousands):
In January 2004, the line of credit was extended through January 2007 at an interest rate of LIBOR plus .60%. The line of credit is used to fund development activities and acquire additional rental properties and to provide working capital.
At December 31, 2003, the scheduled amortization and maturities of all indebtedness for the next five years and thereafter were as follows (in thousands):
The amount of interest paid in 2003, 2002, and 2001 was $130.1 million, $125.9 million and $140.5 million, respectively. The amount of interest capitalized in 2003, 2002 and 2001 was $6.7 million, $13.5 million and $25.9 million, respectively.
In January 2004, the Partnership issued $125.0 million of unsecured debt having an effective interest rate of 3.36% due 2008.
The indenture governing the Partnership’s unsecured notes also requires the Partnership to comply with financial ratios and other covenants regarding the operations of the Partnership. At December 31, 2003, the Partnership is in compliance with all such covenants and expects to remain in compliance for the foreseeable future.
(7) Segment Reporting
The Partnership is engaged in four operating segments: the ownership and rental of office, industrial and retail real estate investments (collectively, “Rental Operations”), and the providing of various real estate services such as property management, maintenance, leasing, development and construction management to third-party property owners (“Service Operations”). The Partnership’s reportable segments offer different products or services and are managed separately because each requires different operating strategies and management expertise. There are no material intersegment sales or transfers.
Non-segment revenue consists mainly of equity in earnings of unconsolidated companies. Non-segment assets consist of corporate assets including cash, deferred financing costs and investments in unconsolidated companies. Interest expense and other non-property specific revenues and expenses are not allocated to individual segments in determining the Partnership’s performance measure.
The Partnership assesses and measures segment operating results based upon an industry performance measure referred to as Funds From Operations (“FFO”), which management believes is a useful indicator of the Partnership’s operating performance. FFO is used by industry analysts and investors as a supplemental operating performance measure of an equity real estate investment trust (“REIT”). FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO, as defined by NAREIT, represents net income (loss) determined in accordance with accounting principles generally accepted in the United States of America (“GAAP”), excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for unconsolidated partnerships and joint ventures.
The revenues and FFO for each of the reportable segments for the years ended December 31, 2003, 2002, and 2001, and the assets of each reportable segment as of December 31, 2003 and 2002 are summarized as follows (in thousands):
In addition to revenues and FFO, the Partnership also reviews its recurring capital expenditures in measuring the performance of its individual segments. These recurring capital expenditures consist of tenant improvements, leasing commissions and building improvements. These expenditures are reviewed by the Partnership to determine the costs associated with re-leasing vacant space. The Partnership’s recurring capital expenditures by segment are summarized as follows for the years ended December 31, 2003, 2002 and 2001, respectively (in thousands):
(8) Leasing Activity
Future minimum rents due to the Partnership under non-cancelable operating leases at December 31, 2003, are as follows (in thousands):
In addition to minimum rents, certain leases require reimbursements of specified operating expenses that amounted to $130.3 million, $120.1 million, and $115.7 million for the years ended December 31, 2003, 2002 and 2001, respectively.
(9) Employee Benefit Plans
The Partnership maintains a 401(k) plan for its full-time employees. The Partnership makes matching contributions up to an amount equal to three percent of the employees’ salary and may also make annual discretionary contributions. The total expense recognized by the Partnership for this plan was $1.6 million, $1.7 million and $1.3 million for the years ended 2003, 2002 and 2001, respectively.
The Partnership makes contributions to a contributory health and welfare plan as necessary to fund claims not covered by employee contributions. The total expense recognized by the Partnership related to this plan was $6.4 million, $4.9 million and $5.6 million for 2003, 2002 and 2001, respectively. These expense amounts include estimates based upon the historical experience of claims incurred but not reported as of year-end.
(10) Partners’ Equity
The General Partner periodically accesses the public equity markets to fund the development and acquisition of additional rental properties or to pay down debt. The proceeds of these offerings are contributed to the Partnership in exchange for an additional interests in the Partnership.
The following series of preferred units were outstanding as of December 31, 2003 (in thousands, except percentages):
All series of preferred equity require cumulative distributions and have no stated maturity date (although the General Partner may redeem them on or following their optional redemption dates).
The Series B, Series E, Series I and Series J Preferred units may be redeemed only at the General Partner’s option, in whole or in part. The Series D Preferred units may be redeemed at the General Partner’s option in whole or in part, as well as at the option of a shareholder’s estate, upon the death of a shareholder.
The General Partner issued $100 million of Series J Preferred units in August 2003.
The Series D Preferred units are convertible at a conversion rate of .93677 General Partner common shares for each preferred unit outstanding.
The distribution rate on the Series B Preferred units increases to 9.99% after September 12, 2012. The General Partner repurchased 355,000 shares is Series B Preferred stock in September 2002, which resulted in the repurchase of 355,000 Series B Preferred units by the Partnership from the General Partner. The repurchase transaction was initiated by a group of Series B Preferred stockholders who voluntarily approached the General Partner with an opportunity for the General Partner to buyback these shares before their earliest stated redemption date.
The General Partner and the Partnership redeemed its $150.0 million Series F Preferred units in October 2002 at par value. Effective August 31, 2002, the Partnership terminated a shareholder rights plan that had included the potential issuance of Series C Junior Preferred units.
The General Partner and the Partnership redeemed the $100.0 million Series E Preferred units on January 20, 2004, at par value.
(11) Stock Based Compensation
At December 31, 2003, the General Partner had nine stock-based employee compensation plans that are described more fully below. The General Partner is authorized to issue up to 7,812,984 shares of the General Partner’s stock under these Plans.
Fixed Stock Option Plans
The General Partner had options outstanding under six fixed stock option plans as of December 31, 2003. Additional grants may be made under three of those plans.
A summary of the status of the fixed stock option plans as of December 31, 2003, 2002 and 2001 and changes during the years ended on those dates follows:
The fair values of the options were determined using the Black-Scholes option-pricing model with the following assumptions:
The options outstanding at December 31, 2003, under the fixed stock option plans have a range of exercise prices from $12.94 to $29.23 with a weighted average exercise price of $22.65 and a weighted average remaining contractual life of 6.17 years. The options exercisable at December 31, 2003 have a weighted average exercise price of $21.61.
Each option’s maximum term is ten years. With limited exceptions, options vest at 20% per year, or, if earlier, upon the death, retirement or disability of the optionee or a change in control of the General Partner.
Performance Based Stock Plans
Performance shares are granted under the 2000 Performance Share Plan, with each performance share economically equivalent to one share of the General Partner’s common stock. The performance shares vest over a 5-year period with the vesting percentage for a year dependent upon the General Partner’s attainment of certain predefined levels of earnings growth for such year. The value of vested performance shares are payable in cash upon the retirement or termination of employment of the participant. At December 31, 2003, plan participants had the right to receive up to 64,849 performance shares, of which 33,350 were vested and 31,499 were contingent upon future earnings achievement.
The amount of compensation cost was based upon the intrinsic value of the vested performance shares at the end of each applicable reporting period. The compensation cost that was charged against income for this plan was $529,000, $96,000 and $201,000 for 2003, 2002 and 2001, respectively.
In October 2002, the General Partner amended its Shareholder Value Plan (“SVP Plan”) and Dividend Increase Unit Plans (“DIU Plans”) by requiring that all payouts under these two plans to be in cash only. Payments made under the SVP Plan are based upon the General Partner’s cumulative shareholder return for a three-year period as compared to the cumulative total return of the S&P 500 and the NAREIT Equity REIT Total Return indices. Payments under the DIU Plans are based upon increases in the General Partner’s dividend per common share. The total compensation cost that was charged against income for these two plans was $1.6 million, $4.6 million and $6.0 million for 2003, 2002 and 2001, respectively.
Directors Stock Payment Plan
Under the General Partner’s 1999 Directors’ Stock Payment Plan, non-employee members of the General Partner’s Board of Directors are entitled to 1,200 shares of its common shares per year as partial compensation for services as a board member. The shares are fully vested when issued and the Partnership records the value of the shares as an expense. The amount of that expense was $415,000, $274,000 and $260,000 for 2003, 2002 and 2001, respectively.
Employee Stock Purchase Plan
Under the General Partner’s Employee Stock Purchase Plan, employees are entitled to purchase the General Partner’s common stock at a 15% discount through payroll deductions. Under SFAS 123, the Partnership is required to record the amount of the discount as compensation expense. The amount of that expense for 2003 and 2002 was $219,000 and $181,000, respectively.
(12) Financial Instruments
In December 2002, the Partnership simultaneously entered into two $50 million forward-starting interest rate swaps as a hedge to effectively fix the rate on unsecured debt financings expected in 2003. The fair value of the swaps was a liability of $2.1 million as of December 31, 2002, and was recorded in other liabilities in the accompanying balance sheet.
In February 2003, the Partnership simultaneously entered into two additional $25 million forward-starting interest rate swaps as a hedge to effectively fix the rate on unsecured debt financings expected in 2003. All four swaps qualified for hedge accounting under SFAS 133; therefore, changes in fair value were recorded in other comprehensive income.
In July 2003, the Partnership terminated the swaps for a net gain of $643,000, which is included in other revenue in the Statements of Operations. The swaps were terminated because the Partnership’s capital needs were met through the issuance of the Series J Preferred equity in lieu of the previously contemplated issuance of debt.
During the years ended December 31, 2002 and 2001, the Partnership recorded a $1.4 million gain and a $1.4 million loss, respectively, associated with an interest rate contract that did not qualify for hedge accounting. The contract expired on December 30, 2002.
In July 2001, the Partnership terminated three interest rate swaps that were tied to an $85 million unsecured term loan. The swaps qualified for hedge accounting under SFAS 133. The costs to terminate the swaps was $548,000, which was recorded as interest expense and reversed out of other comprehensive income.
In May 2003, the FASB issued SFAS No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 is effective for all financial instruments created or modified after May 31, 2003, and otherwise is effective July 1, 2003. The Partnership includes the operations of five joint ventures in its consolidated financial statements. These joint ventures are partially owned by unaffiliated parties that have noncontrolling interests. SFAS 150 requires the disclosure of the estimated settlement value of these noncontrolling interests. As of December 31, 2003, the estimated settlement value of these noncontrolling interests was approximately $4.3 million as compared to the minority interest liability recorded on the Partnership’s books for these joint ventures of $1.2 million.
(13) Recent Accounting Pronouncements
In July of 2003, the SEC issued a Staff Policy Statement that clarified the application of FASB-EITF Topic D-42 (Topic D-42), “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Equity.” Under Topic D-42, the difference between the amounts paid to the holders of preferred equity upon redemption and the carrying amount of the preferred equity on the issuer’s balance sheet must be subtracted from net income when computing earnings per share. The Staff Policy Statement clarified that, in computing the reduction in net income, the carrying amount of the preferred equity should be reduced by the issuance costs of the preferred equity. As a result of this clarification, the Partnership’s net income per unit was restated for 2002 and 2001. The impact of this restatement is summarized as follows:
In January 2003, FASB issued Interpretation 46, Consolidation of Variable Interest Entities (“Interpretation 46”), which addresses the consolidation of certain entities in which a company has a controlling financial interest through means other than voting rights. This interpretation was revised in December 2003. For calendar year companies, Interpretation 46 contains an effective date of December 31, 2003 for special purpose entities and periods ending after March 15, 2004 for all other entities. The Partnership does not own interests in special purpose entities and management does not believe that the adoption of Interpretation 46 will have a material impact on the Partnership’s financial statements.
(14) Commitments and Contingencies
In 1998 and 1999, certain members of management and the Board of Directors of the General Partner purchased $69 million of common stock in connection with an Executive and Senior Officer Stock Purchase
Plan. The purchases were financed by five-year personal loans at market interest rates from financial institutions. As of December 31, 2003, the outstanding balance on these loans was $11.7 million as some participants have exited the program and repaid their principal balance. These loans were secured by common shares with a fair market value of 18.2 million purchased through this program and owned by the remaining plan participants at December 31, 2003. As a condition of the financing agreement with the financial institution, the Partnership guaranteed repayment of principal, interest and other obligations for each participant, but is fully indemnified by the participants. In the opinion of management, it is not probable that the Partnership will be required to satisfy these guarantees.
In October 2000, the Partnership sold or contributed industrial properties and undeveloped land with a fair value of $487 million to a joint venture (Dugan Realty LLC) in which the Partnership has a 50% interest and recognized a net gain of $35.2 million. This transaction expanded an existing joint venture with an institutional real estate investor. As a result of the total transactions, the Partnership received $363.9 million of proceeds. The joint venture partially financed this transaction with $350 million of secured mortgage debt, the repayment of which was directly or indirectly guaranteed by the Partnership. The guarantee associated with $260 million of such debt expired in December 2003 without the Partnership being required to satisfy the guarantee. The remaining $90 million of such debt is still guaranteed by the Partnership. In connection with this transaction, the joint venture partners were given an option to put up to a $50 million interest in the joint venture to the Partnership in exchange for common stock of the Partnership or cash (at the option of the Partnership), subject to certain timing and other restrictions. As a result of this put option, the Partnership deferred $10.2 million of gain on sale of depreciated property and recorded a $50 million liability.
The Partnership has guaranteed the repayment of $3.5 million of economic development bonds issued by the City of Carmel, Indiana. The Partnership will be required to make payments under its guarantee to the extent that incremental taxes from one of its office park developments are not sufficient to pay the bond debt service. Management does not believe that it is probable that the Partnership will be required to make any significant payments in satisfaction of this guarantee.
The Partnership has also guaranteed the repayment of a $2 million mortgage loan encumbering the real estate of one its unconsolidated joint ventures. Management believes that the value of the real estate exceeds the loan balance and that the Partnership will not be required to satisfy this guarantee.
The Partnership has entered into agreements, subject to the completion of due diligence requirements, resolution of certain contingencies and completion of customary closing conditions, for the future acquisition of land totaling $13.8 million. The acquisitions are scheduled to close periodically through 2004 and will be paid for by cash.
The Partnership renewed all of its major insurance policies in 2003. These policies include coverage for acts of terrorism for its properties. The Partnership believes that this insurance provides adequate coverage against normal insurance risks and that any loss experienced would not have a significant impact on the Partnership’s liquidity, financial position, or results of operations.
Broadband Office, Inc. and Official Committee of Unsecured Creditors of Broadband Office, Inc. recently filed a complaint against a group of real estate investment trusts and real estate operating companies and certain affiliated entities and individuals in connection with the formation and management of Broadband Office. Among the defendants are the General Partner, the Partnership and Mr. Dennis Oklak, one of the General Partner’s executive officers. The complaint alleges various breaches of purported fiduciary duties by the defendants, seeks recharacterization or equitable subordination of debt, seeks recovery of alleged avoidable transfers, appears to seek to hold them liable for, among other things, the debt of Broadband Office under alter-ego, veil-piercing and partnership theories, and seeks other relief under other theories. The complaint seeks aggregate damages in excess of $300 million from all of the defendants. The Partnership
believes that it has meritorious defenses to the plaintiff’s allegations and intends to vigorously defend this litigation. Due to the inherent uncertainties of the litigation process and the judicial system, the Partnership is not able to predict the outcome of this litigation. If this litigation is not resolved in the Partnership’s favor, it could have a material adverse effect on its business, financial condition and results of operations.
The Partnership is subject to various legal proceedings and claims that arise in the ordinary course of business. In the opinion of management, the amount of any ultimate liability with respect to these actions will not materially affect the Partnership’s consolidated financial statements or results of operations.
DUKE REALTY LIMITED PARTNERSHIP
Schedule 3
REAL ESTATE AND ACCUMULATED DEPRECIATION
DECEMBER 31, 2003
(IN THOUSANDS)
(1) Depreciation of real estate is computed using the straight-line method over 40 years for buildings, 15 years for land improvements and shorter periods based on lease terms (generally 3 to 10 years) for tenant improvements.
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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Barrington H. Branch*
3/9/04
Director of the General Partner
Barrington H. Branch
/Gary A. Burk
3/9/04
Director of the General Partner
Gary A. Burk
/s/ Geoffrey Button *
3/9/04
Director of the General Partner
Geoffrey Button
/s/ William Cavanaugh, III*
3/9/04
Director of the General Partner
William Cavanaugh, III
/s/ Ngaire E. Cuneo *
3/9/04
Director of the General Partner
Ngaire E. Cuneo
/s/ Charles R. Eitel*
3/9/04
Director of the General Partner
Charles R. Eitel
/s/ L. Ben Lytle *
3/9/04
Director of the General Partner
L. Ben Lytle
/s/ William O. McCoy *
3/9/04
Director of the General Partner
William O. McCoy
/s/ John W. Nelley, Jr. *
3/9/04
Director of the General Partner
John W. Nelley, Jr.
/s/ James E. Rogers *
3/9/04
Director of the General Partner
James E. Rogers
/s/ Jack R. Shaw *
3/9/04
Director of the General Partner
Jack R. Shaw
/s/ Robert J. Woodward *
3/9/04
Director of the General Partner
Robert J. Woodward
/s/ Darell E. Zink, Jr. *
3/9/04
Director of the General Partner
Darell E. Zink, Jr.