Item 1. Business.
Corporate Property Associates 12 ("CPA(R):12") Incorporated is a real estate investment trust ("REIT") that acquires and owns commercial properties leased to companies nationwide and internationally, primarily on a triple net basis. As of December 31, 2003, CPA(R):12's portfolio consisted of 120 properties leased to 62 tenants and totaling more than 9.4 million square feet.
CPA(R):12's core investment strategy is to own and manage its portfolio of properties leased to a variety of companies on a single tenant net lease basis, to maximize shareholder returns. Additional properties may be bought and net leased if appropriate opportunities arise. These leases generally place the economic burden of ownership on the tenant by requiring them to pay the costs of maintenance, insurance, taxes, structural repairs and other operating expenses. CPA(R):12 also generally includes in its leases:
- clauses providing for mandated rent increases or periodic rent increases tied to increases in the consumer price index or other indices for the jurisdiction in which the property is located or, when appropriate, increases tied to the volume of sales at the property;
- covenants restricting the activity of the tenant to reduce the risk of a change in credit quality;
- indemnification of CPA(R):12 for environmental and other liabilities; and
- guarantees from parent companies or other entities.
CPA(R):12 was formed as a Maryland corporation on July 30, 1993. Between February 1994 and September 1997, CPA(R):12 sold a total of 28,334,451 shares of common stock for a total of $283,344,510 in offering proceeds. CPA(R):12 also raised an additional $10,000,000 through a private placement of its common stock in January 2001. These proceeds have been combined with limited recourse mortgage debt to purchase CPA(R):12's property portfolio. As a REIT, CPA(R):12 is not subject to federal income taxation as long as it satisfies certain requirements relating to the nature of its income, the level of its distributions and other factors.
W. P. Carey & Co. LLC ("WPC"), CPA(R):12's advisor, provides both strategic and day-to-day management for CPA(R):12, including acquisition services, research, investment analysis, asset management, capital funding services, disposition of assets, investor relations and administrative services. WPC also provides office space and other facilities for CPA(R):12. WPC has dedicated senior executives in each area of its organization so that CPA(R):12 functions as a fully integrated operating company. CPA(R):12 pays asset management fees to WPC and pays certain transactional fees. CPA(R):12 also reimburses WPC for certain expenses. WPC also serves in this capacity for Carey Institutional Properties Incorporated ("CIP(R)"), Corporate Property Associates 14 Incorporated ("CPA(R):14"), Corporate Property Associates 15 Incorporated ("CPA(R):15") and Corporate Property Associates 16 - Global Incorporated ("CPA(R):16-Global"). WPC is a publicly-traded company on the New York Stock Exchange and Pacific Exchange under the symbol "WPC."
CPA(R):12's principal executive offices are located at 50 Rockefeller Plaza, New York, NY 10020 and its telephone number is (212) 492-1100. As of December 31, 2003, CPA(R):12 had no employees. WPC employs 120 individuals.
BUSINESS OBJECTIVES AND STRATEGY
CPA(R):12's objectives are to:
- pay quarterly dividends at an increasing rate that for taxable shareholders are partially free from current taxation;
- provide inflation protected income;
- purchase and own a diversified portfolio of net-leased real estate that will increase in value; and
- increase the value of its shares by increasing the equity in its real estate by making regular mortgage principal payments.
CPA(R):12 seeks to achieve these objectives by purchasing and holding industrial and commercial properties each net leased to a single corporate tenant. CPA(R):12 intends its portfolio to be diversified by geography, property type and by tenant.
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SIGNIFICANT DEVELOPMENTS DURING 2003
On January 16, 2003, Rheometric Scientific, Inc. ("Rheometric") completed the asset sale of one its lines of business, at which time the lease termination agreement between Rheometric and CPA(R):12 for the facility in Piscataway, New Jersey became effective and Rheometric changed its name to Proterion Corporation ("Proterion"). In connection with the settlement, CPA(R):12 recognized $3,042,227 of other income in 2003. The settlement included a grant of 650,000 shares of common stock. In connection with structuring the initial purchase transaction with Rheometric, CPA(R):12 was granted warrants for 466,140 shares of Rheometric common stock at an exercise price of $2.00. Under the lease termination agreement, the exercise price of the warrants was reduced to $0.01. On January 16, 2003, the warrants were converted on a cashless basis to 456,424 shares of common stock of Proterion.
On February 7, 2003, CPA(R):12 and two affiliates, CPA(R):14 and CPA(R):15, through a newly-formed limited liability company with ownership interests of 15%, 41% and 44%, respectively, purchased land and 15 health club facilities for $178,010,471 and entered into a master net lease with Starmark Camhood LLC. The lease obligations of Starmark are jointly and unconditionally guaranteed by seven of its affiliates. The Starmark lease provides for an initial lease term of 20 years with three ten-year renewal terms. Annual rent is initially $18,272,400 with CPI-based increases scheduled in November 2006, 2010, 2014, 2018 and 2021. In connection with the purchase, the limited liability company obtained first mortgage limited recourse financing of $88,300,000 and a mezzanine loan of $20,000,000. The first mortgage provides for monthly payments of interest and principal of $563,936 at an annual interest rate of 6.6% and based on a 30-year amortization schedule. The loan matures in March 2013 at which time a balloon payment is payable. The mezzanine loan provides for monthly payments of interest and principal of $277,201 at an annual interest rate of 11.15% and will fully amortize over its ten-year term. The limited liability company was granted warrants for Class C unit interests in Starmark. If exercised, the Unit interests would represent a 5% interest in Starmark as of the date of grant. The warrants may be exercised at any time through February 7, 2023 at an exercise price of $430 per unit. The warrant agreement does not provide for a cashless exercise of units.
On March 12, 2003, CPA(R):12 purchased a 35% interest in a limited liability company from CPA(R):15 which retained the remaining 65% interest. The limited liability company owns properties in France that are leased to Medica-France and Carrefour France, S.A. The purchase price for the 35% interest was $11,916,465 in cash and the assumption of a deferred fee payable to WPC of $1,031,046. The purchase price was based on the appraised value of the properties (based on the March 6, 2003 exchange rate for the Euro) adjusted for capital costs incurred since the acquisition by CPA(R):15 including fees paid to WPC, net of mortgage debt. The Medica leases have a remaining term through June 2011 and provide for aggregate annual rent of (euro)3,856,618 ($4,226,467) with annual rent increases based on a formula indexed to increases in the INSEE, a French cost index. The Carrefour leases have a remaining term through December 2011 for an aggregate annual rent of (euro)10,190,269 ($11,167,516) with annual rent increases based on the formula, indexed to the INSEE. In connection with the purchase of the properties, the limited liability company obtained limited recourse mortgage debt of (euro)34,000,000 ($37,260,600) and (euro)84,244,000 ($92,323,000) on the Medica and Carrefour properties, respectively. The Medica and Carrefour loans provide for quarterly payments of interest at an annual interest rate of 5.631% and 5.55%, respectively, and stated principal payments with scheduled increases over their terms. The Medica and Carrefour loans mature in October 2017 and December 2014, respectively, at which time balloon payments are payable.
On November 27, 2003, the limited liability company purchased an additional Carrefour property in Nimes, France for (euro)17,277,481 ($20,634,503 as of the date of acquisition) and obtained additional limited recourse mortgage financing of (euro)14,025,000 ($16,750,058) which was added to the existing mortgage balance on the Carrefour properties. The lease for the Nimes property provides for annual rent of (euro)1,608,750 ($1,921,330) and has a term through November 2012 with annual rent increases based on the INSEE.
In connection with the purchase of the Nimes property, WPC, the parent company of the Advisor, purchased a 22.5% interest in the Carrefour properties at which time the Company's interest in the Carrefour properties was reduced to 27.125%. WPC's purchase price was based on an independent appraisal of the properties.
In October 2003, CPA(R):12 funded approximately $700,000 improvements to its existing property leased to Wal-Mart Stores, Inc. in exchange for an increase in annual rent of $110,000 and Wal-Mart's commitment to a five-year extension term. In November 2003, Scott Companies, Inc. entered into liquidation proceedings and subsequently terminated its lease at a property in San Leandro, California. The Scott lease had provided lease revenues of $2,223,000. The property is being remarketed.
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ACQUISITION STRATEGIES
WPC has a well-developed process with established procedures and systems for acquiring net leased property on behalf of CPA(R):12. As a result of its reputation and experience in the industry and the contacts maintained by its professionals, WPC has a presence in the net lease market that has provided it with the opportunity to invest in a significant number of transactions on an ongoing basis. CPA(R):12 takes advantage of WPC's presence in the net lease market to build its portfolio. In evaluating opportunities for CPA(R):12, WPC carefully examines the credit, management and other attributes of the tenant and the importance of the property under consideration to the tenant's operations. Careful credit analysis is a crucial aspect of every transaction. CPA(R):12 believes that WPC has one of the most extensive underwriting processes in the industry and has an experienced staff of professionals involved with underwriting transactions. WPC seeks to identify those prospective tenants whose creditworthiness is likely to improve over time. CPA(R):12 believes that the experience of WPC's management in structuring sale-leaseback transactions to meet the needs of a prospective tenant enables WPC to obtain a higher return for a given level of risk than would typically be available by purchasing a property subject to an existing lease.
WPC's strategy in structuring its net lease investments for CPA(R):12 is to:
- combine the stability and security of long-term lease payments, including rent increases, with the appreciation potential inherent in the ownership of real estate;
- enhance current returns by utilizing varied lease structures;
- reduce credit risk by diversifying investments by tenant, type of facility, geographic location and tenant industry; and
- increase potential returns by obtaining equity enhancements from the tenant when possible, such as warrants to purchase tenant common stock. As of December 31, 2003, CPA(R):12 held warrant positions in four tenants.
FINANCING STRATEGIES
Consistent with its investment policies, CPA(R):12 uses leverage when available on favorable terms. CPA(R):12 has approximately $184,206,000 in property level debt outstanding. These mortgages mature between the current year and 2021 and have interest rates between 6.5% and 8.75%. CPA(R):12's credit facility matured in October 2003.
CPA(R):12 is a party to a mortgage financing securitization transaction with three affiliates, WPC, CIP(R) and CPA(R):14 entered into in August 2002. CPA(R):12 and the three affiliates obtained an aggregate of approximately $172,335,000 of limited recourse mortgage financing collateralized by 62 leased properties. The lender pooled the loans into a trust, Carey Commercial Mortgage Trust, a non-affiliate, whose assets consist solely of the loans, and sold the interests in the trust as collateralized mortgage obligations in a private placement to institutional investors. CPA(R):12 and the three affiliates agreed to acquire a separate class of subordinated interests in the trust (the "CPA(R) Interests"). The amount of CPA(R) Interests acquired by CPA(R):12 was proportional to the mortgage amounts obtained. The CPA(R) Interests were purchased for $24,128,739 of which CPA(R):12's share was $7,238,622, or 30%, and are comprised of two components, a component that will receive payments of principal and interest and a component that will receive payments of interest only. CPA(R):12 is accounting for its interest in the CPA(R) Interests as an available-for-sale security and will be measured at fair value with all gains and losses from changes in fair value reported as a component of other comprehensive income as part of shareholders' equity.
WPC continually seeks opportunities and considers alternative financing techniques to finance properties not currently subject to debt, refinance debt, reduce interest expense or improve its capital structure.
TRANSACTION ORIGINATION
In analyzing potential acquisitions, WPC reviews and structures many aspects of a transaction, including the tenant, the real estate and the lease, to determine whether a potential acquisition can be structured to satisfy CPA(R):12's acquisition criteria. The aspects of a transaction which are reviewed and structured by WPC include the following:
Tenant Evaluation. WPC subjects each potential tenant to an extensive evaluation of its credit, management, position within its industry, operating history and profitability. WPC seeks tenants it believes will have stable or improving credit. By leasing properties to these types of tenants, CPA(R):12 can generally charge rent that is higher than the rent charged to tenants with recognized credit and, thereby, enhance its current return from these properties as compared with properties leased to companies whose credit potential has
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already been recognized by the market. Furthermore, if a tenant's credit does improve, the value of CPA(R):12's properties leased to that tenant will likely increase (if all other factors affecting value remain unchanged). WPC may also seek to enhance the likelihood of a tenant's lease obligations being satisfied, such as through a letter of credit or a guaranty of lease obligations from the tenant's corporate parent. This credit enhancement provides CPA(R):12 with additional financial security.
Leases with Increasing Rents. WPC seeks to include clauses in CPA(R):12's leases that provide for increases in rent over the term of the leases. These increases are generally tied to increases in certain indices such as the consumer price index, in the case of retail stores, participation in gross sales above a stated level, mandated rental increases on specific dates and through other methods. CPA(R):12 seeks to avoid entering into leases that provide for contractual reductions in rents during their primary term (other than reductions related to reductions in debt service).
Properties Important to Tenant Operations. WPC, on behalf of CPA(R):12, generally seeks to acquire properties with operations that are essential or important to the ongoing operations of the tenant. CPA(R):12 believes that these properties provide better protection in the event that tenants file for bankruptcy, because leases on properties essential or important to the operations of a bankrupt tenant are less likely to be rejected and terminated by a bankrupt tenant. WPC also seeks to assess the income, cash flow and profitability of the business conducted at the property, so that, if the tenant is unable to operate its business, CPA(R):12 can either continue operating the business conducted at the property or re-lease the property to another entity in the industry which can operate the property profitably.
Lease Provisions that Enhance and Protect Value. When appropriate, WPC attempts to include provisions in CPA(R):12's leases that require CPA(R):12's consent to certain tenant activity or require the tenant to satisfy certain operating tests. These provisions include, for example, operational and financial covenants of the tenant, prohibitions on a change in control of the tenant and indemnification from the tenant against environmental and other contingent liabilities. Including these provisions in its leases enables CPA(R):12 to protect its investment from changes in the operating and financial characteristics of a tenant that may impact its ability to satisfy its obligations to CPA(R):12 or could reduce the value of CPA(R):12's properties.
Diversification. WPC tries to diversify CPA(R):12's portfolio of properties to avoid dependence on any one particular tenant, type of facility, geographic location and tenant industry. By diversifying its portfolio, CPA(R):12 reduces the adverse effect on CPA(R):12 of a single under-performing investment or a downturn in any particular industry or geographic location.
WPC employs a variety of other strategies and practices in connection with CPA(R):12's acquisitions. These strategies include attempting to obtain equity enhancements in connection with transactions. Typically, these equity enhancements involve warrants to purchase stock of the tenant to which the property is leased or the stock of the parent of the tenant. In certain instances, CPA(R):12 grants to the tenant a right to purchase the property leased by the tenant, but generally the option purchase price will not be less than the fair market value of the property. WPC's practices include performing evaluations of the physical condition of properties and performing environmental surveys in an attempt to determine potential environmental liabilities associated with a property prior to its acquisition.
As a transaction is structured, it is evaluated by the Chairman of the Investment Committee with respect to the potential tenant's credit, business prospects, position within its industry and other characteristics important to the long-term value of the property and the capability of the tenant to meet its lease obligations. Before a property is acquired, the transaction is reviewed by the Investment Committee to ensure that it satisfies CPA(R):12's investment criteria. Aspects of the transaction that are typically reviewed by the Investment Committee include the expected financial returns, the creditworthiness of the tenant, the real estate characteristics and the lease terms.
The Investment Committee is not directly involved in originating or negotiating potential acquisitions, but instead functions as a separate and final step in the acquisition process. WPC places special emphasis on having experienced individuals serve on its Investment Committee and does not invest in a transaction unless it is approved by the Investment Committee.
CPA(R):12 believes that the Investment Committee review process gives it a unique, competitive advantage over other unaffiliated net lease companies because of the substantial experience and perspective that the Investment Committee has in evaluating the blend of corporate credit, real estate and lease terms that combine to make an acceptable risk.
The following people serve on the Investment Committee:
- George E. Stoddard, Chairman, was formerly responsible for the direct corporate investments of The Equitable Life Assurance Society of the United States and has been involved with the CPA(R) Programs for over 20 years.
- Frank J. Hoenemeyer, Vice Chairman, was formerly Vice Chairman, Director and Chief Investment Officer of The Prudential Insurance Company of America. As Chief Investment Officer, Mr. Hoenemeyer was responsible for all of Prudential's investments, including stocks, bonds, private placements, real estate and mortgages.
- Nathaniel S. Coolidge previously served as Senior Vice President - Head of Bond & Corporate Finance Department of the John Hancock Mutual Life Insurance Company. His responsibilities included overseeing $21 billion of Fixed income investments for Hancock, its affiliates and outside clients.
- Lawrence R. Klein is Benjamin Franklin Professor of Economics Emeritus at the University of Pennsylvania and its Wharton School. Dr. Klein has been awarded the Alfred Nobel Memorial Prize in Economic Sciences and currently advises various governments and government agencies.
- Ralph F. Verni, is a private investor and business consultant and formerly Chief Investment Officer of The New England Mutual Life Insurance Company.
- Karsten von Koller was formerly Chairman and Member of the Board of Managing Directors of Eurohypo AG, the leading commercial real estate financing company in Europe.
ASSET MANAGEMENT
CPA(R):12 believes that effective management of its net lease assets is essential to maintain and enhance property values. Important aspects of asset management include restructuring transactions to meet the evolving needs of current tenants, re-leasing properties, refinancing debt, selling properties and knowledge of the bankruptcy process.
WPC monitors, on an ongoing basis, compliance by tenants with their lease obligations and other factors that could affect the financial performance of any of its properties. Monitoring involves receiving assurances that each tenant has paid real estate taxes, assessments and other expenses relating to the properties it occupies and confirming that appropriate insurance coverage is being maintained by the tenant. WPC reviews financial statements of its tenants and undertakes regular physical inspections of the condition and maintenance of its properties. Additionally, WPC periodically analyzes each tenant's financial condition, the industry in which each tenant operates and each tenant's relative strength in its industry.
HOLDING PERIOD
CPA(R):12 intends to hold each property it acquires for an extended period. The determination of whether a particular property should be sold or otherwise disposed of will be made after consideration of relevant factors with a view to achieving maximum capital appreciation and after-tax return for the CPA(R):12 shareholders. If CPA(R):12's common stock is not listed for trading on a national securities exchange or included for quotation on NASDAQ, CPA(R):12's policy is to generally begin selling properties within ten years after the proceeds of the public offering are substantially invested, subject to market conditions. Pursuant to this policy, CPA(R):12's board of directors will begin considering liquidity alternatives for CPA(R):12 over the course of the next year or two. The board of directors will make the decision whether to list the shares, liquidate or devise an alternative liquidity strategy which is likely to result in the greatest value for the shareholders.
COMPETITION
CPA(R):12 faces competition for the acquisition of office and industrial properties in general, and such properties net leased to major corporations in particular, from insurance companies, credit companies, pension funds, private individuals, investment companies and other REITs. CPA(R):12 also faces competition from institutions that provide or arrange for other types of commercial financing through private or public offerings of equity or debt or traditional
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bank financings. CPA(R):12 believes its management's experience in real estate, credit underwriting and transaction structuring will allow CPA(R):12 to compete effectively for office and industrial properties.
ENVIRONMENTAL MATTERS
Under various federal, state and local environmental laws, regulations and ordinances, current or former owners of real estate, as well as other parties, may be required to investigate and clean up hazardous or toxic chemicals, substances or waste or petroleum product or waste, releases on, under, in or from a property. These parties may be held liable to governmental entities or to third parties for specified damages and for investigation and cleanup costs incurred by these parties in connection with the release or threatened release of hazardous materials. These laws typically impose responsibility and liability without regard to whether the owner knew of or was responsible for the presence of hazardous materials, and the liability under these laws has been interpreted to be joint and several under some circumstances. CPA(R):12's leases often provide that the tenant is responsible for all environmental liability and for compliance with environmental regulations relating to the tenant's operations.
CPA(R):12 typically undertakes an investigation of potential environmental risks when evaluating an acquisition. Phase I environmental assessments are performed by independent environmental consulting and engineering firms for all properties acquired by CPA(R):12. Where warranted, Phase II environmental assessments are performed. Phase I assessments do not involve subsurface testing, whereas Phase II assessments involve some degree of soil and/or groundwater testing. CPA(R):12 may acquire a property which is known to have had a release of hazardous materials in the past, subject to a determination of the level of risk and potential cost of remediation. CPA(R):12 normally requires property sellers to indemnify it fully against any environmental problem existing as of the date of purchase. Additionally, CPA(R):12 often structures its leases to require the tenant to assume most or all responsibility for compliance with the environmental provisions of the lease or environmental remediation relating to the tenant's operations and to provide that non-compliance with environmental laws is a lease default. In some cases, CPA(R):12 may also require a cash reserve, a letter of credit or a guarantee from the tenant, the tenant's parent company or a third party to assure lease compliance and funding of remediation. The value of any of these protections depends on the amount of the collateral and/or financial strength of the entity providing the protection. Such a contractual arrangement does not eliminate CPA(R):12's statutory liability or preclude claims against CPA(R):12 by governmental authorities or persons who are not a party to the arrangement. Contractual arrangements in CPA(R):12's leases may provide a basis for CPA(R):12 to recover from the tenant damages or costs for which it has been found liable.
INDUSTRY SEGMENT
CPA(R):12 operates in one industry segment, investment in net leased real property. For the year ended December 31, 2003, Applied Materials, Inc. represented 10% of the total operating revenue of CPA(R):12. Applied Materials is publicly traded and files financial information with the United States Securities and Exchange Commission in accordance with the 1993 and 1994 Acts.
FACTORS AFFECTING FUTURE OPERATING RESULTS
The provisions of the Private Securities Litigation Reform Act of 1995 (the "Act") became effective in December 1995. The Act provides a "safe harbor" for companies that make forward-looking statements providing prospective information. The "safe harbor" under the Act relates to protection for companies with respect to litigation filed on the basis of such forward-looking statements.
CPA(R):12 wishes to take advantage of the "safe harbor" provisions of the Act and is therefore including this section in its Annual Report on Form 10-K. The statements contained in this Annual Report, if not historical, are forward-looking statements and involve risks and uncertainties which are described below that could cause actual results to differ materially from the results, financial or otherwise, or other expectations described in such forward-looking statements. These statements are identified with the words "anticipated," "expected," "intends," "seeks" or "plans" or words of similar meaning. Therefore, forward-looking statements should not be relied upon as a prediction of actual future results or occurrences.
CPA(R):12's future results may be affected by certain risks and uncertainties including the following:
We are subject to the risks of real estate ownership which could reduce the value of our properties. Our properties may include net leased industrial and commercial property. The performance of CPA(R):12 is subject to risks incident to the ownership and operation of these types of properties, including:
- changes in the general economic climate;
- changes in local conditions such as an oversupply of space or reduction in demand for real estate;
- changes in interest rates and the availability of financing;
- competition from other available space; and
- changes in laws and governmental regulations, including those governing real estate usage, zoning and taxes.
We may have difficulty selling or re-leasing our properties.
Real estate investments are relatively illiquid compared to most financial assets and this illiquidity will limit our ability to quickly change our portfolio in response to changes in economic or other conditions. Many of the net leases we enter into or acquire are for properties that are specially suited to the particular needs of our tenant. With these properties, if the current lease is terminated or not renewed, we may be required to renovate the property or to make rent concessions in order to lease the property to another tenant. In addition, in the event we are forced to sell the property, we may have difficulty selling it to a party other than the tenant due to the special purpose for which the property may have been designed. In addition, provisions of the Internal Revenue Code relating to REITs limit our ability to sell properties held for fewer than four years. These and other limitations may affect our ability to sell properties without adversely affecting returns to our shareholders.
The inability of a tenant in a single tenant property to pay rent will reduce our revenues.
Most of our properties are occupied by a single tenant and, therefore, the success of our investments is materially dependent on the financial stability of our tenants. Lease payment defaults by tenants could cause us to reduce the amount of distributions to shareholders. A default of a tenant on its lease payments to us would cause us to lose the revenue from the property and cause us to have to find an alternative source of revenue to meet the mortgage payment and prevent a foreclosure if the property is subject to a mortgage. In the event of a default, we may experience delays in enforcing our rights as landlord and may incur substantial costs in protecting our investment and reletting our property. If a lease is terminated, there is no assurance that we will be able to lease the property for the rent previously received or sell the property without incurring a loss.
The bankruptcy of tenants would cause a reduction in revenue.
A tenant in bankruptcy could cause:
- the loss of lease payments;
- an increase in the costs incurred to carry the property;
- a reduction in the value of shares; and
- a decrease in distributions to shareholders.
Under bankruptcy law, a tenant who is the subject of bankruptcy proceedings has the option of continuing or terminating any unexpired lease. If the tenant terminates the lease, any claim we have for breach of the lease (excluding collateral securing the claim) will be treated as a general unsecured claim. The maximum claim will be capped at the amount owed for unpaid rent prior to the bankruptcy unrelated to the termination, plus the greater of one year's lease payments or 15% of the remaining lease payments payable under the lease (but no more than three years' lease payments). In addition, due to the long-term nature of our leases and terms providing for the repurchase of a property by the tenant, a bankruptcy court could recharacterize a net lease transaction as a secured lending transaction. If that were to occur, we would not be treated as the owner of the property, but might have additional rights as a secured creditor.
Some of the programs managed by WPC or its affiliates have had tenants file for bankruptcy protection and are involved in litigation. Four CPA(R) programs had to reduce the rate of distributions to their partners as a result of adverse developments involving tenants.
If our tenants are highly leveraged, they may have a higher possibility of filing for bankruptcy. Of tenants that experience downturns in their operating results due to adverse changes to their business or economic conditions, those that are highly leveraged may have a higher possibility of filing for bankruptcy. In bankruptcy, a tenant has the option of vacating a property instead of paying rent. Until such a property is released from bankruptcy, our revenues would be reduced and could cause us to reduce distributions to shareholders. We have highly leveraged tenants at this time, and we may have additional highly leveraged tenants in the future.
Our tenants generally do not have a recognized credit rating, which may create a higher risk of lease defaults and therefore lower revenues than if our tenants had a recognized credit rating.
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Generally, no credit rating agencies evaluate or rank the debt or the credit risk of our tenants, as we seek tenants that we believe will have improving credit profiles. Our long-term leases with certain of these tenants may therefore pose a higher risk of default than would long term leases with tenants whose credit potential has already been recognized by the market.
There is not, and may never be a public market for our shares, so it will be difficult for shareholders to sell shares quickly.
There is no current public market for the shares and, therefore, it will be difficult for shareholders to sell their shares promptly. In addition, the price received for any shares sold is likely to be less than the proportionate value of the real estate we own.
Our success is dependent on the performance of WPC.
Our ability to achieve our investment objectives and to pay distributions is dependent upon the performance of WPC in the acquisition of investments, the selection of tenants, the determination of any financing arrangements, and upon the management of the assets. You will have no opportunity to evaluate the terms of transactions or other economic or financial data concerning our investments. You must rely entirely on the management ability of WPC and the oversight of the board of directors.
WPC may be subject to conflicts of interest.
WPC manages our business and selects our real estate investments. WPC has some conflicts of interest in its management of CPA(R):12, which arise primarily from the involvement of WPC and its affiliates in other activities that may conflict with CPA(R):12 and the payment of fees by us to WPC and its affiliates. The activities in which a conflict could arise between CPA(R):12 and WPC are:
- the receipt of commissions, fees and other compensation by WPC and its affiliates for property purchases, leases, sales and financing for CPA(R):12, which may cause WPC and its affiliates to engage in transactions that generate higher fees, rather than transactions that are more appropriate or beneficial for our business;
- agreements between CPA(R):12 and WPC or any of its affiliates, including agreements regarding compensation of WPC and its affiliates, will not be negotiated on an arm's length basis as would occur if the agreements were with unaffiliated third parties;
- purchases and loans from affiliates, subject to CPA(R):12's investment procedures, objectives and policies, which will increase fees and interest payable to affiliates, thereby decreasing our net income and possibly causing us to incur higher leverage levels;
- competition with certain affiliates for property acquisitions, which may cause WPC and its affiliates to direct properties suitable for us to other related entities;
- disposition, incentive and termination fees, which are based on the sale price of properties, may cause a conflict between the advisor's desire to sell a property and our plans to hold or sell the property.
Inherent in these transactions is the conflict of interest that arises due to the potential impact of the transaction on the amount of fees received by WPC and/or its affiliates and the distributions to shareholders.
Liability for uninsured losses could adversely affect our financial condition. Losses from disaster-type occurrences (such as wars or earthquakes) may be either uninsurable or not insurable on economically viable terms. Should an uninsured loss occur, we could lose our capital investment and/or anticipated profits and cash flow from one or more properties.
Potential liability for environmental matters could adversely affect our financial condition.. We own industrial and commercial properties and are subject to the risk of liabilities under federal, state and local environmental laws. Some of these laws could impose the following on CPA(R):12:
- Responsibility and liability for the cost of removal or remediation of hazardous substances released on our property, generally without regard to our knowledge or responsibility of the presence of the contaminants.
- Liability for the costs of removal or remediation of hazardous substances at disposal facilities for persons who arrange for the disposal or treatment of these substances.
- Potential liability for common law claims by third parties based on damages and costs of environmental contaminants.
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Our costs of investigation, remediation or removal of hazardous substances may be substantial. In addition, the presence of hazardous substances on one of our properties, or the failure to properly remediate a contaminated property, could adversely affect our ability to sell or lease the property or to borrow using the property as collateral.
Our use of debt to finance acquisitions could adversely affect our cash flow.
Most of our property acquisitions have been made by borrowing a portion of the purchase price of our properties and securing the loan with a mortgage on the property. If we are unable to make our debt payments as required, a lender could foreclose on the property or properties securing its debt. This could cause us to lose part or all of our investment which in turn could cause the value of the shares and distributions to shareholders to be reduced. We generally borrow on a non-recourse basis to limit our exposure on any property to the amount of equity invested in the property. We typically borrow between 55% and 65% of the purchase price of our properties. There is no limitation on the amount borrowed on a single property and the aggregate borrowings may not exceed 75% of the value of all properties. Any borrowings in excess of 75% of the value of all properties must be approved by a majority of the independent directors and disclosed to shareholders. As of December 31, 2003, we had limited recourse mortgage notes payable outstanding of $184,206,000.
Failure to qualify as a REIT could adversely affect our operations and ability to make distributions.
If we fail to qualify as a REIT for any taxable year, we would be subject to federal income tax on our taxable income at corporate rates. In addition, we would generally be disqualified from treatment as a REIT for the four taxable years following the year of losing our REIT status. Losing our REIT status would reduce our net earnings available for investment or distribution to shareholders because of the additional tax liability. In addition, distributions to shareholders would no longer qualify for the distributions paid deduction and we would no longer be required to make distributions. We might be required to borrow funds or liquidate some investments in order to pay the applicable tax.
Qualification as a REIT is subject to the satisfaction of tax requirements and various factual matters and circumstances which are not entirely within our control. New legislation, regulations, administrative interpretations or court decisions could change the tax laws with respect to qualification as a REIT or the federal income tax consequences of being a REIT.
The IRS may treat sale-leaseback transactions as loans, which could jeopardize our REIT status.
The Internal Revenue Service may take the position that specific sale-leaseback transactions we will treat as true leases are not true leases for federal income tax purposes but are, instead, financing arrangements or loans. If a sale-leaseback transaction were so recharacterized, we might fail to satisfy the Asset Tests or the Income Tests and consequently lose our REIT status effective with the year of recharacterization. Alternatively, the amount of our REIT Taxable Income could be recalculated which could cause us to fail the Distribution Test.
Balloon payment obligations may adversely affect our financial condition.
Some of our financing may require us to make a lump-sum or "balloon" payment at maturity. Our ability to make any balloon payment is uncertain and may depend upon our ability to obtain additional financing or our ability to sell the property. At the time the balloon payment is due, we may or may not be able to refinance the balloon payment on terms as favorable as the original loan or sell the property at a price sufficient to make the balloon payment. A refinancing or sale could affect the rate of return to shareholders and the projected time of disposition of our assets.
Scheduled balloon payments for the next five years are as follows:
- 2004 - None;
- 2005 - $4.1 million;
- 2006 - $5.2 million;
- 2007 - $18.5 million; and
- 2008 - $16.9 million
A limit on the number of shares a person may own may discourage a takeover.
Our articles of incorporation restrict ownership of more than 9.8% of the outstanding shares by one person. These restrictions may discourage a change of control of CPA(R):12 and may deter individuals or entities from making tender offers for shares, which offers might be financially attractive to shareholders or which may cause a change in the management of CPA(R):12.
Maryland law could restrict change in control.
Provisions of Maryland law applicable to us prohibit business combinations with:
- any person who beneficially owns 10% or more of the voting power of outstanding shares;
- an affiliate of us who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of our outstanding shares ("an interested shareholder"); or
- an affiliate of an interested shareholder.
These prohibitions last for five years after the most recent date on which the interested shareholder became an interested shareholder. Thereafter, any business combination must be recommended by our board of directors and approved by the affirmative vote of at least 80% of the votes entitled to be cast by holders of our outstanding shares and two-thirds of the votes entitled to be cast by holders of our shares other than shares held by the interested shareholder. These requirements could have the effect of inhibiting a change in control even if a change in control were in shareholders' interest. These provisions of Maryland law do not apply, however, to business combinations that are approved or exempted by our board of directors prior to the time that someone becomes an interested shareholder.
Our participation in joint ventures creates additional risk. We participate in joint ventures with other entities, some of which may be unaffiliated with us. There are additional risks involved in these types of transactions. These risks include the potential of our joint venture partner becoming bankrupt and the possibility of diverging or inconsistent economic or business interests of us and our partner. These diverging interests could result in, among other things, exposing us to liabilities of the joint venture in excess of our proportionate share of these liabilities. The partition rights of each owner in a jointly owned property could reduce the value of each portion of the divided property. In addition, the fiduciary obligation that WPC may owe to our partner in an affiliated transaction may make it more difficult for us to enforce our rights.
In some of our joint venture relationships with publicly registered investment programs or other entities sponsored by WPC or one of its affiliates, we enter into investments as tenants-in-common. This poses risks in addition to those mentioned above. The partition rights of each co-tenant in a tenancy-in-common could reduce the value of each portion of the divided property. In addition, the fiduciary obligation that WPC may owe to our partner in an affiliated transaction may make it more difficult for us to enforce our rights.
International investments involve additional risks. We own an interest in properties in France and we may purchase additional property located outside the United States. These investments may be affected by factors peculiar to the laws of the jurisdiction in which the property is located. These laws may expose us to risks that are different from and in addition to those commonly found in the United States. Foreign investments could be subject to the following risks:
- changing governmental rules and policies;
- enactment of laws relating to the foreign ownership of property and laws relating to the ability of foreign persons or corporations to remove profits earned from activities within the country to the person's or corporation's country of origin;
- variations in the currency exchange rates;
- adverse market conditions caused by changes in national or local economic conditions;
- changes in relative interest rates;
- change in the availability, cost and terms of mortgage funds resulting from varying national economic policies;
- changes in real estate and other tax rates and other operating expenses in particular countries;
- changes in land use and zoning laws; and
- more stringent environmental laws or changes in such laws.
We may incur costs to finish build-to-suit properties.
We may sometimes acquire undeveloped or partially developed land parcels for the purpose of owning to-be-built facilities for a prospective tenant. Oftentimes, completion risk, cost overruns and on-time delivery are the obligations of the prospective tenant. To the extent that the tenant or the third-party developer experiences financial difficulty or other complications during the construction process we may be required to incur project costs to complete all or part of the project within a specified time frame. The incurrence of these costs or the non-occupancy by the tenant may reduce the project's and our portfolio returns.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
Item 2.
Item 2. Properties.
Set forth below is certain information relating to the Company's properties owned as of December 31, 2003.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
1. Percentage of ownership in land and building, except as noted. If ownership is less than 100%, ownership is as a tenant-in-common unless otherwise indicated.
2. Share of Current Annual Rents is the product of the Square Footage, the Rent per Square Foot, and the Ownership Interest percentage.
3. These properties are encumbered by mortgage notes payable. 4. Includes percentage of sales rents.
5. Under the limited liability company agreement, the Company has a 100% interest in a portion of the leased properties and a 50.01% interest in the other portion of the property.
6. Mendota, Plover and Toppenish properties are owned through an interest in a limited liability company and the Yakima property is owned as a tenant-in-common.
7. Subject to short-term leases.
8. Based on exchange rates at December 31, 2003.
9. INSEE construction index, an index published quarterly by the French Government.
10. A lease with The Retail Distribution Group, Inc. is effective as of January 1, 2004.
Item 3.
Item 3. Legal Proceedings.
As of the date hereof, Registrant is not a party to any material pending legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matter was submitted during the fourth quarter of the year ended December 31, 2003 to a vote of security holders, through the solicitation of proxies or otherwise.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Information with respect to the Company's common equity is hereby incorporated by reference to page 31 of Registrant's Annual Report contained in Appendix A.
Item 6.
Item 6. Selected Financial Data.
Selected Financial Data are hereby incorporated by reference to page 1 of the Company's Annual Report contained in Appendix A.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Management's Discussion and Analysis are hereby incorporated by reference to pages 2 to 10 of the Company's Annual Report contained in Appendix A.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk:
Market risk is the exposure to loss resulting from changes in interest rates, credit spreads, foreign currency exchange rates and equity prices. In pursuing our business plan, the primary market risks to which we are exposed are interest rate risk and currency exchange rates.
The value of our real estate is subject to fluctuations based on changes in interest rates, local and regional economic conditions and changes in the creditworthiness of lessees, and which may affect our ability to refinance our debt when balloon payments are scheduled.
All of the Company's $184,206,000 long term debt bears interest at fixed rates, and the fair value of these instruments is affected by changes in market interest rates. The following table presents principal cash flows based upon expected maturity dates of the debt obligations and the related weighted-average interest rates by expected maturity dates for the fixed rate debt. The interest rate on the fixed rate debt as of December 31, 2003 ranged from 6.50% to 8.75% per annum.
The Company's credit facility matured in October 2003.
CPA(R):12 has ownership interests in properties in France. The foreign operations are not material to CPA(R):12's consolidated financial position, results of operations or cash flow during the three-year period ended December 31, 2003. CPA(R):12 was not subject to material foreign currency exchange rate risk; however, it is expected to cause some fluctuation in the results of operations or cash flow. To date, CPA(R):12 has not entered into any foreign currency exchange contracts or other derivative financial instruments to hedge the effects of adverse fluctuations in foreign currency exchange rates.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data.
The following consolidated financial statements and supplementary data of Registrant are hereby incorporated by reference to pages 11 to 30 of the Company's Annual Report contained in Appendix A:
(i) Report of Independent Auditors.
(ii) Consolidated Balance Sheets as of December 31, 2003 and 2002.
(iii) Consolidated Statements of Income for the years ended December 31, 2003, 2002 and 2001.
(iv) Consolidated Statement of Shareholders' Equity for the years ended December 31, 2001, 2002 and 2003.
(v) Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001.
(vi) Notes to Consolidated Financial Statements.
Item 9.
Item 9. Disagreements on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures
The Co-Chief Executive Officers and Chief Financial Officer of the Company have conducted a review of the Company's disclosure controls and procedures as of December 31, 2003.
The Company's disclosure controls and procedures include the Company's controls and other procedures designed to ensure that information required to be disclosed in this and other reports filed under the Securities Exchange Act of 1934, as amended (the "Exchange Act") is accumulated and communicated to the Company's management, including its chief executive officers and chief financial officer, to allow timely decisions regarding required disclosure and to ensure that such information is recorded, processed, summarized and reported, within the required time periods. Based upon this review, the Company's co-chief executive officers and chief financial officer have concluded that the Company's disclosure controls (as defined in pursuant to Rule 13a-14(c) promulgated under the Exchange Act) are sufficiently effective to ensure that the information required to be disclosed by the Company in the reports it files under the Exchange Act is recorded, processed, summarized and reported with adequate timeliness. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referred to above.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
This information will be contained in Registrant's definitive Proxy Statement with respect to the Company's Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company's fiscal year, and is hereby incorporated by reference.
Item 11.
Item 11. Executive Compensation.
This information will be contained in Registrant's definitive Proxy Statement with respect to the Company's Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company's fiscal year, and is hereby incorporated by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
This information will be contained in Registrant's definitive Proxy Statement with respect to the Company's Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company's fiscal year, and is hereby incorporated by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions.
This information will be contained in Registrant's definitive Proxy Statement with respect to the Company's Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company's fiscal year, and is hereby incorporated by reference.
Item 14.
Item 14. Principal Accountant Fees and Services.
This information will be contained in Registrant's definitive Proxy Statement with respect to the Company's Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company's fiscal year, and is hereby incorporated by reference.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) 1. Consolidated Financial Statements:
The following consolidated financial statements are filed as a part of this Report:
Report of Independent Auditors.
Consolidated Balance Sheets, December 31, 2003 and 2002.
Consolidated Statements of Income for the years ended December 31, 2003, 2002, and 2001.
Consolidated Statement of Shareholders' Equity for the years ended December 31, 2001, 2002, and 2003.
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, and 2001.
Notes to Consolidated Financial Statements.
The consolidated financial statements are hereby incorporated by reference to pages 11 to 30 of the Company's Annual Report contained in Appendix A.
(a) 2. Financial Statement Schedules:
The following schedules are filed as a part of this Report:
Report of Independent Auditors.
Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2003.
Schedule III of the Company is contained on pages 29 to 33 of this Form 10-K.
Financial Statement Schedules other than those listed above are omitted because the required information is given in the Consolidated Financial Statements, including the Notes thereto, or because the conditions requiring their filing do not exist.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
(a) 3. Exhibits:
The following exhibits are filed as part of this Report. Documents other than those designated as being filed herewith are incorporated herein by reference.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
(b) Reports on Form 8-K
During the year ended December 31, 2003 the Registrant was not required to file any reports on Form 8-K.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
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.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED a Maryland corporation
3/10/04 BY: /s/ John J. Park - -------------- --------------------------------------------- Date John J. Park Managing Director and Chief Financial Officer (Principal Financial Officer)
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.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
3/10/04 BY: /s/ William Polk Carey - -------------- ------------------------------------ Date William Polk Carey Chairman of the Board, Co-Chief Executive Officer and Director (Principal Executive Officer)
3/10/04 BY: /s/ Gordon F. DuGan - -------------- ------------------------------------ Date Gordon F. DuGan Vice Chairman of the Board, Co-Chief Executive Officer, Senior Managing Director and Chief Acquisitions Officer
3/10/04 BY: /s/ Elizabeth P. Munson - -------------- ------------------------------------ Date Elizabeth P. Munson Director
3/10/04 BY: /s/ Charles E. Parente - -------------- ------------------------------------ Date Charles E. Parente Director
3/10/04 BY: /s/ William Ruder - -------------- ------------------------------------ Date William Ruder Director
3/10/04 BY: /s/ George E. Stoddard - -------------- ------------------------------------ Date George E. Stoddard Director
3/10/04 BY: /s/ John J. Park - -------------- ------------------------------------ Date John J. Park Managing Director and Chief Financial Officer (Principal Financial Officer)
3/10/04 BY: /s/ Claude Fernandez - -------------- ------------------------------------ Date Claude Fernandez Managing Director and Chief Accounting Officer (Principal Accounting Officer)
REPORT of INDEPENDENT AUDITORS ON FINANCIAL STATEMENT SCHEDULE
To the Board of Directors and Shareholders of Corporate Property Associates 12 Incorporated:
Our audits of the consolidated financial statements referred to in our report dated March 10, 2004 appearing in the 2003 Annual Report to Shareholders of Corporate Property Associates 12 Incorporated (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
New York, New York March 10, 2004
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
SCHEDULE III - REAL ESTATE and ACCUMULATED DEPRECIATION
as of December 31, 2003
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
SCHEDULE III - REAL ESTATE and ACCUMULATED DEPRECIATION
as of December 31, 2003
See accompanying notes to Schedule.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
SCHEDULE III - REAL ESTATE and ACCUMULATED DEPRECIATION
as of December 31, 2003
See accompanying notes to Schedule
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
NOTES to SCHEDULE III - REAL ESTATE and ACCUMULATED DEPRECIATION
(a) Consists of the costs of improvements subsequent to purchase and acquisition costs including legal fees, appraisal fees, title costs and other related professional fees.
(b) Represents (i) partial refund of purchase price, (ii) impairment charges, and (iii) the sale of real estate.
(c) At December 31, 2003, the aggregate cost of real estate owned by Registrant and its subsidiaries for Federal income tax purposes is $315,867,815.
(d)
APPENDIX A TO FORM 10-K
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
2003 ANNUAL REPORT
SELECTED FINANCIAL DATA
(In thousands except share amounts)
(1) Includes gain from sale of real estate.
(2) The Company has a simple equity capital structure with only common stock outstanding. As a result, the Company has presented basic per share amounts only.
(3) Represents scheduled mortgage principal amortization paid.
(4) Represents mortgage obligations and deferred acquisition fees due after more than one year.
MANAGEMENT'S DISCUSSION AND ANALYSIS
Overview
The following discussion and analysis of financial condition and results of operations of Corporate Property Associates 12 Incorporated ("CPA(R):12") should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2003. The following discussion includes forward looking statements. Forward looking statements, which are based on certain assumptions, describe future plans, strategies and expectations of CPA(R):12. Forward-looking statements discuss matters that are not historical facts. Because they discuss future events or conditions, forward-looking statements may include words such as "anticipate", "believe", "estimate", "intend", "could", "should", "would", "may", or similar expressions. Do not unduly rely on forward looking statements. They give our expectations about the future and are not guarantees, and speak only as of the date they are made. Such statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievement of CPA(R):12 to be materially different from the results of operations or plan expressed or implied by such forward looking statements. The risk factors are fully described in Item 1 of this Annual Report on Form 10-K. Accordingly, such information should not be regarded as representations by CPA(R):12 that the results or conditions described in such statements or objectives and plans of CPA(R):12 will be achieved.
CPA(R):12 was formed in 1993 for the purpose of engaging in the business of investing in and owning commercial and industrial real estate. Substantially all of CPA(R):12's net leases have been structured to place certain economic burdens of ownership on these corporate tenants by requiring them to pay the costs of maintenance and repair, insurance and real estate taxes. The lease obligations are unconditional. If possible, CPA(R):12 also negotiates guarantees of the obligations from the parent company of the lessees. The leases have generally been structured to include periodic rent increases that are stated or based on increases in the Consumer Price Index ("CPI") or, for certain retail properties, may provide for additional rents based on sales in excess of a specified base amount. In addition to investing directly, CPA(R):12 may also acquire interests in real estate through joint ventures. These joint ventures are generally with affiliates.
As a real estate investment trust ("REIT"), CPA(R):12 is not subject to federal income taxes on amounts distributed to shareholders provided it meets certain conditions including distributing at least 90% of its REIT taxable income to its shareholders. CPA(R):12's primary objectives are to provide increasing distributions and to protect its investors from the effects of inflation through rent escalation provisions, property appreciation, tenant credit improvement and regular paydown of limited recourse mortgage debt. In addition, CPA(R):12 has successfully negotiated grants of common stock warrants from selected tenants and expects to realize the benefits of appreciation from those grants. CPA(R):12 cannot guarantee that its objectives will be ultimately realized.
CPA(R):12 is advised by W. P. Carey & Co. LLC ("WPC") pursuant to an Advisory Agreement. CPA(R):12's contract with WPC is renewable annually by Independent Directors who are elected by CPA(R):12's shareholders. In connection with each renewal, WPC is required to provide the Independent Directors with a comparison of the fee structure with several similar companies. The Advisory Agreement also provides that an independent portfolio valuation be performed annually. The portfolio valuation is used to determine the asset base for calculating asset management and performance fees.
Operating segments are components of an enterprise about which financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Management evaluates the performance of its portfolio of properties as a whole, rather than by identifying discrete operating segments. This evaluation includes assessing CPA(R):12's ability to meet distribution objectives, increase the dividend and increase value by evaluating potential investments in single tenant net lease real estate and by seeking opportunities such as refinancing mortgage debt at lower rates of interest, restructuring leases or paying off lenders at a discount to the face value of the outstanding mortgage balance.
Management evaluates the results of CPA(R):12 with a primary focus on the ability to generate cash flow necessary to meet its investment objectives of overall property appreciation and increasing its distribution rate to its shareholders. As a result, Management's assessment of operating results gives less emphasis to the effect of unrealized gains and losses which may cause fluctuations in net income for comparable periods but has no impact on cash flow and to
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
other noncash charges such as depreciation and impairment charges. While impairment charges are intended to reflect an actual or potential decrease in the value of an asset, accounting principles do not permit increasing an asset to fair value when such fair value exceeds the asset's carrying value (historical costs less accumulated depreciation). Based on annual independent valuations, Management believes that there has been an increase in the value of the portfolio and that this increase is not reflected in its financial statements. In evaluating cash flow from operations, Management includes equity distributions that are included in investing activities to the extent that the distributions in excess of equity income are the result of noncash charges such as depreciation. For the year ended December 31, 2003, cash flow generated from operations and equity investments was substantially greater than dividends paid but such cash flow was not sufficient to fully fund distributions to minority partners, that is, to affiliates who have interests in investments that are included in the Company's consolidated financial statements, and scheduled mortgage principal payments. Cash flow generated was $31,223,000 and the uses were $31,932,000, a net operating shortfall of $709,000. CPA(R):12 has cash balances of $13,305,000 which is in excess of what we believe is necessary to sustain operations. In determining the distribution rate to shareholders, Management considers its projections of future operations as well as its historical results. CPA(R):12 is addressing challenges at several underperforming properties but it also has used its resources during the past year to participate in new transactions with its affiliates including a 15% interest in fifteen health club properties and interests in properties in France. Management believes that CPA(R):12 remains a strong portfolio and continues to benefit from a strategy of diversification.
Results of Operations
Year Ended December 31, 2003 compared to Year Ended December 31, 2002
Net income for the year ended December 31, 2003 was $21,501,000 and the results of the operations reflected increases in net income and income from continuing operations of $4,850,000 and $5,871,000, respectively, as compared with the year ended December 31, 2002. Results for the year ended December 31, 2003, included gains of $2,366,000 (of which $620,000 are unrealized), a noncash impairment charge of $1,000,000 and other income from lease terminations of $3,042,000. Results for the year ended December 31, 2002 included a charge on the early extinguishment of debt of $2,245,000 and unrealized losses of $447,000. The results for the comparable periods reflected increases in income from equity investments and interest income which were offset by a decrease in lease revenues (rental income and interest income from direct financing leases) and increases in interest and property expenses. There was no significant change in general and administrative expenses for the comparable periods.
The increase in equity income was due to purchasing minority interests in net lease transactions, with the remaining interests owned by affiliates, between December 2002 and March 2003. The new investments own properties leased to TruServ Corporation, Starmark Camhood LLC, Carrefour France, S.A. and Medica-France. An existing equity investment in a distribution facility in Grand Rapids, Michigan had been leased to The Fleming Companies until the lease was terminated in March 2003 pursuant to Fleming's bankruptcy proceedings. A new lease for the Grand Rapids property was entered into in December 2003 with The Retail Distribution Group, Inc., effective January 1, 2004. The lease has an initial term through August 2009. Income from equity investments in 2002 included a charge on the early extinguishment of debt of $961,000.
In August 2002, CPA(R):12 and three affiliates purchased a subordinated interest in a mortgage securitization. Interest income from holding the investment for the full fiscal year was $1,080,000 as compared with $371,000 in 2002. Interest income from uninvested cash balances decreased by $330,000 due to lower average cash balances in 2003 as compared with 2002.
The decrease in lease revenues was due in part to the reclassification in 2002 of properties leased to ShopRite Supermarkets, Inc. to equity investments; however, the reclassification has no effect on income for the comparable years. The remaining decrease was primarily due to the termination of several short-term tenants at CPA(R):12's multi-tenant property in Newark, Delaware, the termination of the lease with The Scott Companies, Inc. and lower rents from the former Rheometric Scientific, Inc. property in Piscataway, New Jersey. Revenues from the Newark property decreased by $562,000 and the property is substantially vacant. Scott entered into liquidation in the fourth quarter; annual rentals from Scott were $2,223,000. Rents from the former Rheometric property decreased by approximately $110,000 after a lease termination agreement was completed in January 2003. CPA(R):12 received substantial consideration in connection for the termination and the successors to Rheometric leased a portion of the
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
building until January 2004. There are currently several short-term tenants at the property and CPA(R):12 has engaged a nationally recognized real estate brokerage company to remarket the property.
Interest expense increased solely as a result of the $46,335,000 of limited recourse financing obtained in August 2002 in connection with the mortgage securitization. Most of the cash that was received in connection with the financings has been redeployed in new real estate investments.
The increase in property expenses was primarily due to an increase in asset management fees from the increase in CPA(R):12's asset base because of the purchase of interests in the TruServ, Starmark, Carrefour and Medica investments and carrying costs at the Piscataway property which were $761,000.
CPA(R):12 faces several challenges including re-leasing the Newark, Piscataway and former Scott properties. Management is evaluating the potential of selling the Scott property as Management believes the property's best use may be redevelopment for single-family homes. CPA(R):12's lease with International Management Consulting, Inc. was terminated in October 2003 because the lessee was unsuccessful in its attempt to restructure. CPA(R):12 has entered into an agreement to sell the property and has reclassified the results from the property as a discontinued operation. Other than the short-term leases in Piscataway and Newark, no leases expire until 2009. CPA(R):12's lease with Wal-Mart Stores, Inc. for a distribution facility in Greenfield, Indiana which had an initial term through January 2005 has been extended for five years and annual rent increased by $110,000 in consideration for funding improvements of approximately $700,000. Garden Ridge Corporation, the lessee of a retail property in Tulsa, Oklahoma has filed a petition of bankruptcy and is in the process of reorganization. Garden Ridge may terminate its lease as part of its plan of reorganization. Annual rent from Garden Ridge is $940,000.
Because of the long-term nature of CPA(R):12's net leases, inflation and changing prices have not unfavorably affected CPA(R):12's revenues and net income. CPA(R):12's net leases generally have rent increases based on formulas indexed to increases in the CPI or other indices for the jurisdiction in which the property is located, sales overrides or other periodic increases which are designed to increase lease revenues in the future. More than 23 leases have rent increases scheduled in 2003 and 2004. The majority of these rent increases are CPI- based. The CPI has increased within a range of 1.5% and 3% over the past several years. Intervals between rent increases range between one and five years.
Year Ended December 31, 2002 compared to Year Ended December 31, 2001
Net income for the year ended December 31, 2002 decreased by $11,298,000 to $16,650,000 as compared with net income of $27,948,000 for the year ended December 31, 2001. The decrease in net income was attributable to a realized gain of $8,864,000 in 2001 on the sale of a property, charges on early extinguishment of debt in 2002 of $2,245,000 and, to a lesser extent, a $1,570,000 effect for the change in the fair value of common stock warrants, which unrealized gain or loss during the year is included in the determination of net income. In 2002, CPA(R):12 recorded an unrealized loss of $447,000 from warrants as compared with an unrealized gain of $1,124,000 in 2001. Excluding the effect of these items, income would have reflected an increase of $1,382,000. The increase in income, as adjusted, was due primarily to increases in income from equity investments, interest and other income and lease revenues, and a decrease in general and administrative expenses. These were partially offset by increases in interest expense and property expense.
Income from equity investments increased primarily as a result of the acquisition of properties in June 2001 leased to Special Devices, Inc. and the re-leasing of the property in Grand Rapids to Fleming in August 2001 that had been vacant. In addition, equity income benefited from rent increases from four leases held by equity investees. Excluding the effect of a $961,000 charge on extinguishment of debt, equity income increased $1,895,000 of which, $298,000 was due to CPA(R):12's share of earnings from the Special Devices properties, $385,000 was contributed by the new lease in Grand Rapids and approximately $447,000 was due to rent increases. A portion of the increase in income from equity investments was due to the reclassification of investments to the equity method in connection with contributing interests into limited partnerships owned with affiliates. In connection with changes in the form of ownership of jointly-held investments, interests in properties net leased to the Del Monte Corporation and ShopRite Supermarkets, Inc. (formerly Big V Holding Corp.) were reclassified to equity investments in the fourth quarter of 2001 and the third quarter of 2002, respectively. Prior to the reclassification, CPA(R):12's results of operations reflect the proportionate share of revenues and expenses. Subsequent to reclassification, CPA(R):12's share of income from Del Monte and ShopRite is recorded as equity income. The reclassification has no effect on the overall contribution to cash flows or net income. For the year ended December 31, 2002, the Del Monte and ShopRite interests contributed $898,000 of equity income.
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
Lease revenues increased by $131,000, less than 1%. However, lease revenues decreased as the result of the reclassification of the Del Monte and ShopRite investments to the equity method. Lease revenues reflected $631,000 and $2,040,000 from Del Monte and ShopRite in 2002 and 2001, respectively, for the periods prior to the reclassification. As adjusted, lease revenues for the year ended December 31, 2002 increased by $1,540,000, or 4%, primarily as result of the acquisition of properties leased to Orbseal LLC and Jen-Coat, Inc. in the third quarter of 2001 and to a lesser extent, scheduled rent increases on existing leases. These increases were partially offset by a reduction of $794,000 from the BAE Systems, Inc. property, which was sold in May 2001. Funds from the BAE property sale were used to acquire the Orbseal and Jen-Coat properties as well as the equity interest in the Special Devices properties. In 2002, CPA(R):12 negotiated lease modifications with Randall International, Inc. and International Management Consulting, Inc. Both the Randall and IMCI lease amendments provided for short-term deferral of rent and establish a schedule to systematically pay off the deferrals.
Interest expense for the year ended December 31, 2002 increased by $728,000, primarily from new mortgage loans in 2002 and 2001. Interest expense in 2001 included approximately $160,000 of interest from an advance on CPA(R):12's credit facility as well as $715,000 of interest from loans on the Del Monte and ShopRite properties which are now reflected in equity income. Interest expense on previously unencumbered properties included in a mortgage securitization was approximately $852,000 from August 2002, when the new financing was obtained. As a result of obtaining $46,335,000 of new mortgage debt in connection with the securitization, annual interest expense is projected to increase by $2,706,000 and annual debt service will increase by $3,164,000.
General and administrative expense in 2001 included a charge for writing off business development costs of $382,000 which had previously been capitalized in connection with proposed acquisitions. The capitalized costs were written off when proposed acquisitions were not completed. Excluding this writeoff, general and administrative expenses reflected a moderate increase. Property expense increased due to an increase in CPA(R):12's provision for uncollected rents. Management's evaluation of specific circumstances indicated the need to strengthen existing allowance balances.
The increase in interest and other income is the result of interest earned in CPA(R):12's subordinated interest in the mortgage pool and higher average cash balances. Management estimates that the effective rate of interest on the mortgage obtained through the securitization, net of the estimated cash flow from the interest in the mortgage trust, will be approximately 6.25%.
CPA(R):12' incurred extraordinary charges on the early extinguishment of debt of $2,245,000, including $1,473,000 in connection with paying off certain loans which were refinanced in connection with the mortgage securitization.
Financial Condition
The liquidity and financial condition of CPA(R):12 is stable and it has sufficient cash balances and cash flow from its operations (including equity investments) to maintain a prudent level of cash reserves and meet its investment objectives. Since December 31, 2002, CPA(R):12's cash balances have decreased by $26,779,000 to $13,305,000. The decrease was expected as funds were used to participate in several investments with affiliates. CPA(R):12 believes that its liquidity is strong and did not seek a renewal of a $20,000,000 credit facility which expired in 2003.
One of CPA(R):12's primary objectives is to use the cash flow from its net leases (including its equity investments) to fund an increasing rate of dividends to shareholders and meet debt service requirements. Cash flow from operations of $28,979,000, and cash flow from equity investments, which combined totaled $31,223,000, and cash reserves of $709,000, was used to pay dividends of $24,960,000, distributions of $1,443,000 to minority interest partners and mortgage principal installments of $5,529,000. The ability to generate cash flow to meet these uses will depend, in part, on whether the Newark, Piscataway and Scott property in San Leandro, California will provide cash flow in the near future, and if Garden Ridge affirms its lease. If CPA(R):12 is not successful in generating cash flow and cash balances decrease, sustaining the distribution rate to shareholders may be at risk.
CPA(R):12's investing activities included using $23,887,000 to purchase a 15% interest in the Starmark net lease and a 35% interest in the Medica and Carrefour properties. In connection with the purchase of an additional Carrefour property in November 2003, CPA(R):12 and CPA(R):15 sold a portion of their interests to W. P. Carey that reduced CPA(R):12's overall interest in the Carrefour properties from 35% to 27.125%. CPA(R):12 received $1,972,000 for the sale of a portion of the interest in the Carrefour properties as a result of an increase in the appraised value of the properties, and, to a lesser extent, appreciation of the Euro. The independent directors determined that it was prudent to CPA(R):12's diversification to not further increase CPA(R):12's overall exposure to Carrefour. CPA(R):12
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
also received $3,738,000 from a mortgage refinancing of an equity investee and used $1,275,000 to pay deferred acquisition fees. With the purchase of the Carrefour and Medica interests, CPA(R):12 is now exposed to the effects of foreign currency fluctuations. CPA(R):12 and its affiliates mitigate the risk by obtaining mortgage financing in the local currency so any changes in revenues that result from foreign currency fluctuations are substantially offset by debt service in the same currency.
In addition to the payment of dividends to shareholders, distributions to minority partners and scheduled principal payments on mortgage debt, CPA(R):12's financing activities included purchasing treasury stock for $2,282,000, issuing comon stock for $997,000 and using $5,199,000 to pay off the Telos loan. A $20,000,000 credit agreement which required CPA(R):12 to meet certain financial covenants, including restrictions on indebtedness and meeting or exceeding certain operating and coverage ratios was not renewed as CPA(R):12 had only used it for limited purposes.
In 2002, CPA(R):12 purchased a participation in a mortgage pool consisting of $172,335,000 of newly-issued mortgage debt collateralized by properties and lease assignments on properties owned by CPA(R):12 and three affiliates. CPA(R):12 and the affiliates also purchased subordinated interests of $24,129,000 of which CPA(R):12 owns a 30% interest. The subordinated interests are payable only after all other classes of ownership receive their stated interest and related principal payments. The subordinated interests, therefore, will be affected by any defaults or nonpayment by lessees. As of December 31, 2003, there have been no defaults. Three Garden Ridge properties are included in the mortgage pool and in the event the leases are terminated, cash flow from this investment might be adversely affected.
CPA(R):12 has used the capital that it has raised from its public offerings along with limited recourse mortgage financing as its primary source of liquidity. A lender of limited recourse mortgage debt has recourse only to the property and lease assignments collateralizing such debt and not to any of CPA(R):12's other assets, while unsecured financing provides a lender recourse to all of CPA(R):12's assets. The use of limited recourse mortgage debt, therefore, allows CPA(R):12 to limit the exposure of all of its assets to any one debt obligation. CPA(R):12's loans generally have terms of at least ten years, and no outstanding loans mature until 2005. In most instances, CPA(R):12 will seek to refinance maturing or recently paid-off mortgage debt with new property-level financing. Substantially all of CPA(R):12's mortgage debt provides for a fixed rate of interest and there is no assurance that existing debt will be refinanced at lower rates of interest as such debt matures. Mortgage lenders have provisions in many of the loans which restrict CPA(R):12's ability to prepay a loan or provide for payment of premiums if paid prior to its scheduled maturity.
Off-Balance Sheet and Aggregate Contractual Agreements
A summary of CPA(R):12's obligations under contractual arrangements as of December 31, 2003 is as follows:
In connection with the purchase of its properties, CPA(R):12 requires the sellers to perform environmental reviews. Management believes, based on the results of such reviews, that CPA(R):12's properties were in substantial compliance with Federal and state environmental statutes at the time the properties were acquired. However, portions of certain properties have been subject to some degree of contamination, principally in connection with either leakage from underground storage tanks, surface spills from facility activities or historical on-site activities. In most instances where contamination has been identified, tenants are actively engaged in the remediation process and addressing identified conditions. Tenants are generally subject to environmental statutes and regulations regarding the discharge of hazardous materials and any related remediation obligations. In addition, CPA(R):12's leases generally require tenants to indemnify CPA(R):12 from all liabilities and losses related to the leased properties with provisions of such indemnification specifically addressing environmental matters. The leases generally include provisions which allow for periodic environmental assessments, paid for by the tenant, and allow CPA(R):12 to extend
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
leases until such time as a tenant has satisfied its environmental obligations. Certain of the leases allow CPA(R):12 to require financial assurances from tenants such as performance bonds or letters of credit if the costs of remediating environmental conditions are, in the estimation of CPA(R):12, in excess of specified amounts. Accordingly, Management believes that the ultimate resolution of any environmental matter will not have a material adverse effect on CPA(R):12's financial condition, liquidity or results of operations.
Critical Accounting Estimates
CPA(R):12 makes certain judgments and uses certain estimates and assumptions when applying accounting principles generally accepted in the United States of America in the preparation of its consolidated financial statements that affect the reported amount of assets, liabilities, revenues and expenses. CPA(R):12 believes its most critical accounting estimates relate to its provision for uncollected amounts from lessees, potential impairment of assets, identification of discontinued operations, classification of real estate assets, determining the fair value of assets and liabilities which are "marked to market" but not actively traded in a public market and determining the interest to be capitalized in connection with real estate under construction. CPA(R):12's significant accounting policies are described in the notes to the financial statements. Certain policies, while significant, may not require the use of estimates.
CPA(R):12 must assess its ability to collect rent and other tenant-based receivables and determine an appropriate charge for uncollected amounts. Because CPA(R):12's real estate operations have a limited number of lessees, Management believes that it is necessary to evaluate the collectibility of these receivables based on the facts and circumstances of each situation rather than solely use statistical methods. CPA(R):12 generally recognizes a provision for uncollected rents which typically ranges between 0.25% and 1% of lease revenues (rental income and interest income from direct financing leases) and will measure its allowance against actual rent arrearages and adjust the percentage applied. For amounts in arrears, Management makes subjective judgments based on its knowledge of a lessee's circumstances and may reserve for the entire receivable amount from a lessee because there has been significant or continuing deterioration in the lessee's ability to meet its lease obligations. Under net leases, lessees are obligated to pay real estate taxes on behalf of CPA(R):12; however, when a lessee is in bankruptcy, CPA(R):12 may pay the tax obligation in order to preserve its interest in the property. If such a payment relates to a pre-petition period, CPA(R):12 may record such payment as an expense rather than as a receivable when it assumes the chance of reimbursement by the lessee is unlikely. Based on its actual experience in 2003, CPA(R):12 recorded a provision equal to approximately 1.5% of lease revenues.
Operating real estate is stated at cost less accumulated depreciation. Costs directly related to build-to-suit projects, primarily interest, if applicable, are capitalized. No interest was capitalized in 2003, 2002 and 2001. CPA(R):12 considers a build-to-suit project as substantially completed upon the completion of improvements, but no later than a date that is negotiated and stated in the lease. If portions of a project are substantially completed and occupied and other portions have not yet reached that stage, the substantially completed portions are accounted for separately. CPA(R):12 allocates costs incurred between the portions under construction and the portions substantially completed and only capitalizes those costs associated with the portion under construction. CPA(R):12 does not have a credit facility and determines an interest rate to be applied for capitalizing interest based on an average rate on its outstanding limited recourse mortgage debt.
CPA(R):12 classifies its directly-owned leased assets for financial reporting purposes as either real estate leased under the operating method or net investment in direct financing leases at the inception of a lease based on several criteria, including, but not limited to, estimates of the remaining economic life of the leased assets and the calculation of the present value of future minimum rents. In determining the classification of a lease, CPA(R):12 uses estimates of remaining economic life provided by independent appraisals of the leased assets. The calculation of the present value of future minimum rents includes determining a lease's implicit interest rate, which requires an estimate of the residual value of leased assets as of the end of the non-cancelable lease term. Different estimates of residual value result in different implicit interest rates and could possibly affect the financial reporting classification of leased assets. The contractual terms of CPA(R):12's leases are not necessarily different for operating and direct financing leases; however the classification is based on accounting pronouncements which are intended to indicate whether the risks and rewards of ownership are retained by the lessor or transferred to the lessee. Management believes that it retains certain risks of ownership regardless of accounting classification. Assets classified as direct financing leases are not depreciated and, therefore, the classification of assets, may have a significant impact on net income even though it has no effect on cash flows.
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
CPA(R):12 also uses estimates and judgments when evaluating whether long-lived assets are impaired. When events or changes in circumstances indicate that the carrying amount of a property accounted for under the operating method may not be recoverable, Management must first determine if the property will be held for use or held for sale. Management then performs projections of cash flows, and if such cash flows are insufficient, the assets are adjusted (i.e., written down) to their estimated fair value. An analysis of whether a real estate asset has been impaired requires Management to make its best estimate of market rents, residual values and holding periods. As CPA(R):12's investment objective is to hold properties on a long-term basis, holding periods will generally range from five to ten years. In its evaluations, CPA(R):12 obtains market information from outside sources; however, such information requires Management to determine whether the information received is appropriate to the circumstances. Depending on the assumptions made and estimates used, the estimated cash flow projected in the evaluation of long-lived assets can vary within a range of outcomes. Because CPA(R):12's properties are leased to single tenants, CPA(R):12 is more likely to incur significant writedowns when circumstances affecting a tenant deteriorate because of the possibility that a property will be vacated in its entirety. The risk of vacancy for single tenant properties is different from the risks faced by companies that own multi-tenant properties. Events or changes in circumstances can result in further writedowns and impact the gain or loss ultimately realized upon sale of the asset.
For direct financing leases, CPA(R):12 performs a review of its estimated residual value of properties at least annually to determine whether there has been an other than temporary decline in CPA(R):12's current estimate of residual value of the underlying real estate assets of direct financing leases. If the review indicates a decline in residual values that is other than temporary, a loss is recognized and the accounting for the direct financing lease will be revised using the changed estimate, that is, a portion of the future cash flow from the lessee will be recognized as a return of principal rather than as revenue. While an evaluation of potential impairment of real estate accounted for under the operating method is determined by a change in circumstances, the evaluation of a direct financing lease can be affected by changes in long-term market conditions even though the obligations of the lessee are being met. Changes in circumstances include, but are not limited to, vacancy of a property not subject to a lease and termination of a lease. CPA(R):12 may also assess properties for impairment because it expects a lease not to be renewed and the lease is within one year of its expiration, a lessee is experiencing financial difficulty and Management expects that there is a reasonable probability that the lease will be terminated in a bankruptcy organization or a property remains vacant for a period that exceeds the period anticipated in a prior impairment evaluation.
When assets are identified by management as held for sale, CPA(R):12 discontinues depreciating the assets and estimates the sales price, net of selling costs, of such assets. If in Management's opinion, the net sales price of the assets, which have been identified for sale, is less than the net book value of the assets, an impairment charge is recognized, and a valuation allowance is established. To the extent that a purchase and sale agreement has been entered into, the allowance is based on the negotiated sales price. To the extent that CPA(R):12 has adopted a plan to sell an asset but has not entered into a sales agreement, it will make judgments of the net sales price based on current market information. Accordingly, the initial assessment may be greater or less than the purchase price subsequently committed to and may result in a further adjustment to the fair value of the property. If circumstances arise that previously were considered unlikely and, as a result, the Company decides not to sell a property previously classified as held for sale, the property is reclassified as held and used. A property that is reclassified is measured and recorded individually at the lower of (a) its carrying amount before the property was classified as held for sale, adjusted for any depreciation expense that would have been recognized had the property been continuously classified as held and used, or (b) the fair value at the date of the subsequent decision not to sell.
In 2002, CPA(R):12 acquired a subordinated interest in a mortgage trust that consists of limited recourse loans on 62 properties that are owned by CPA(R):12 or three of its affiliates. The fair value of the interests in the trust is determined using a discounted cash flow model with assumptions of market rates and the credit quality of the underlying lessees. If there are adverse changes in either market rates or the credit quality of the lessees, the model and, therefore, the income recognized from the subordinated interests and the fair value will be adjusted. CPA(R):12 measures derivative instruments, including certain derivative instruments embedded in other contracts, if any, at fair value and records them as an asset or liability, depending on CPA(R):12's right or obligations under the applicable derivative contract. For derivatives designated as fair value hedges, the changes in the fair value of both the derivative instrument and the hedged item are recorded in earnings (i.e., the forecasted event occurs). For derivatives designated as cash flow hedges, the effective portions of the derivatives are reported in other comprehensive income and are subsequently reclassified into earnings when the hedged item affects earnings.
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
Changes in the fair value of derivative instruments not designated as hedging and ineffective portions of hedges are recognized in earnings in the affected period. To determine the value of warrants for common stock which are classified as derivatives, various estimates are included in the options pricing model used to determine the value of a warrant.
In connection with the acquisition of properties, purchase costs will be allocated to the tangible and intangible assets and liabilities acquired based on their estimated fair values. The value of the tangible assets, consisting of land, buildings and tenant improvements, will be determined as if vacant. Intangible assets including the above-market or below-market value of leases, the value of in-place leases and the value of tenant relationships will be recorded at their relative fair values.
The value attributed to tangible assets will be determined in part using a discount cash flow model which is intended to approximate what a third party would pay to purchase the property as vacant and rent at "market" rates. In applying the model CPA(R):12 assumes that the disinterested party would sell the property at the end of a market lease term. Assumptions used in the model are property-specific as it is available; however, when certain necessary information isn't available, CPA(R):12 will use available regional and property-type information. Assumptions and estimates include a discount rate or internal rate of return, marketing period necessary to put a lease in place, carrying costs during the marketing period, leasing commissions and tenant improvements allowances, market rents and growth factors of such rents, market lease term and a cap rate to be applied to an estimate of market rent at the end of the market lease term.
Above-market and below-market lease intangibles will be based on the difference between the market rent and the contractual rents and will be discounted to a present value using an interest rate reflecting CPA(R):12`s assessment of the risk associated with the lease acquired. CPA(R):12 acquires properties subject to net leases and considers the credit of the lessee in negotiating the initial rent.
The total amount of other intangible assets will be allocated to in-place lease values and tenant relationship intangible values based on our evaluation of the specific characteristics of each tenant's lease and our overall relationship with each tenant. Characteristics considered in allocating these values include the nature and extent of the existing relationship with the tenant, prospects for developing new business with the tenant, the tenant's credit quality and the expectation of lease renewals among other factors. The aggregate value of other intangible assets acquired will be measured based on the difference between (i) the property valued with an in-place lease adjusted to market rental rates and (ii) the property valued as if vacant. Independent appraisals or our estimates will be used to determine these values.
Factors considered include the estimated carrying costs of the property during a hypothetical expected lease-up period, current market conditions and costs to execute similar leases. Estimated carrying costs will include real estate taxes, insurance, other property operating costs and estimates of lost rentals at market rates during the hypothetical expected lease-up periods, based on assessments of specific market conditions. Estimated costs to execute leases include commissions and legal costs to the extent that such costs are not already incurred with a new lease that has been negotiated in connection with the purchase of the property.
Accounting Pronouncements
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," ("FIN 45") which changes the accounting for, and disclosure of certain guarantees. Beginning with transactions entered into after December 31, 2002, certain guarantees are required to be recorded at fair value, which is different from prior practice, under which a liability was recorded only when a loss was probable and reasonably estimable. In general, the change applies to contracts or indemnification agreements that contingently require CPA(R):12 to make payments to a guaranteed third-party based on changes in an underlying asset, liability, or an equity security of the guaranteed party. The adoption of the accounting provisions of FIN 45 on January 1, 2003 did not have a material effect on CPA(R):12's financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," which amends SFAS No. 123, Accounting for Stock Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock based compensation (i.e., recognition of a charge for issuance of stock options in the determination of income.). However,
MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED
SFAS No. 148 does not permit the use of the original SFAS No. 123 prospective method of transition for changes to the fair value based method made in fiscal years beginning after December 15, 2003. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock based employee compensation, description of transition method utilized and the effect of the method used on reported results. The transition and annual disclosure provisions for valuing stock-based compensation of SFAS No. 148 are to be applied for fiscal years ending after December 15, 2002. CPA(R):12 does not have any employees nor any stock-based compensation plans.
On January 17, 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), the primary objective of which is to provide guidance on the identification of entities for which control is achieved through means other than voting rights ("variable interest entities" or "VIEs") and to determine when and which business enterprise should consolidate the VIE (the "primary beneficiary"). In December 2003, the FASB issued a revised FIN 46 which modifies and clarifies various aspects of the original Interpretation. FIN 46 applies when either (1) the equity investors (if any) lack one or more of the essential characteristics of controlling financial interest, (2) the equity investment at risk is insufficient to finance that entity's activities without additional subordinated financial support or (3) the equity investors have voting rights that are not proportionate to their economic interest. In addition FIN 46 requires additional disclosures.
FIN 46 is effective immediately for VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. For variable interests in a VIE created or obtained prior to February 1, 2003, FIN 46 is effective for periods ending after March 15, 2004.
CPA(R):12 has evaluated the potential impact and believes this interpretation will not have a material impact on its accounting for its investments in unconsolidated joint ventures as none of these investments are VIEs. CPA(R):12's maximum loss exposure is the carrying value of its equity investments.
On April 30, 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging under SFAS No. 133. The changes in the statement improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, the statement (1) clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative instrument discussed in paragraph 6(b) of SFAS No. 133, (2) clarifies when a derivative contains a financing component, (3) amends the definition of an underlying to conform it to language used in FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others", and (4) amends certain other existing pronouncements. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 did not have a material effect on the financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). In particular, it requires that mandatorily redeemable financial instruments be classified as liabilities and reported at fair value and that changes in their fair values be reported as interest cost.
This statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for CPA(R):12 as of July 1, 2003. On November 7, 2003, the FASB indefinitely deferred the classification and measurement provisions of SFAS No. 150 as they apply to certain mandatorily redeemable non-controlling interests. This deferral is expected to remain in effect while these provisions are further evaluated by the FASB. Based on the FASB's deferral of this provision, the adoption of SFAS No. 150 did not have a material effect on CPA(R):12's financial statements.
REPORT of INDEPENDENT AUDITORS
To the Board of Directors and Shareholders of Corporate Property Associates 12 Incorporated:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, shareholders' equity and cash flows present fairly, in all material respects, the financial position of Corporate Property Associates 12 Incorporated and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of W. P. Carey & Co. LLC (the "Advisor"); our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by the Advisor, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
New York, New York March 10, 2004
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of the consolidated financial statements.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CONSOLIDATED STATEMENTS of INCOME
The accompanying notes are an integral part of the consolidated financial statements.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CONSOLIDATED STATEMENT of SHAREHOLDERS' EQUITY For the years ended December 31, 2001, 2002, and 2003
The accompanying notes are an integral part of the consolidated financial statements.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CONSOLIDATED STATEMENTS of CASH FLOWS
- continued -
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Noncash investing and financing activities:
During 2001, proceeds from the sale of a property of $30,492,012 were placed in an escrow account and were subsequently released in connection with the purchase of additional real estate.
a. Net of $1,559,055 held back from proceeds of mortgages by a mortgage lender to fund certain escrow accounts in 2002.
Included in the cost basis of real estate investments acquired in 2003, 2002, and 2001 are deferred acquisition fees payable of $1,677,019, $413,096 and $942,283, respectively.
In connection with contributing tenancy-in-common interests to jointly-owned entities in 2002 and 2001, assets and liabilities were reclassified as an equity investment as follows:
The accompanying notes are an integral part of the consolidated financial statements.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies:
Basis of Consolidation:
The consolidated financial statements include the accounts of Corporate Property Associates 12 Incorporated, its wholly-owned subsidiaries and a controlling interest in a majority-owned limited liability company (collectively, the "Company"). The Company is not a primary beneficiary of any variable interest entity ("VIE"). All material inter-entity transactions have been eliminated.
Use of Estimates:
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates relate to the assessment of the recoverability of real estate assets and investments, classification of real estate leased to others, identification of any intangible assets in connection with asset acquisitions and allowance for uncollected amounts. Actual results could differ from those estimates.
Real Estate Leased to Others:
Real estate is leased to others on a net lease basis, whereby the tenant is generally responsible for all operating expenses relating to the property, including property taxes, insurance, maintenance, repairs, renewals and improvements. For the year ended December 31 2003, lessees were responsible for the direct payment of real estate taxes of approximately $5,016,000. Expenditures for maintenance and repairs including routine betterments are charged to operations as incurred. Significant renovations which increase the useful life of the properties are capitalized.
The Company diversifies its real estate investments among various corporate tenants engaged in different industries, by property type and geographically.
The leases are accounted for under either the direct financing or operating methods. Such methods are described below.
Direct financing method - Leases accounted for under the direct financing method are recorded at their net investment (Note 4). Unearned income is deferred and amortized to income over the lease terms so as to produce a constant periodic rate of return on the Company's net investment in the lease.
Operating method - Real estate is recorded at cost less accumulated depreciation, minimum rental revenue is recognized on a straight-line basis over the term of the leases, and expenses (including depreciation) are charged to operations as incurred.
When events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable, the Company assesses the recoverability of its long-lived assets, including residual interests of real estate assets and investments, based on projections of undiscounted cash flows, without interest charges, over the life of such assets. In the event that such cash flows are insufficient, the assets are adjusted to their estimated fair value. Residual values of the net investment in direct financing leases are reviewed at least annually. If a decline in the estimated residual value is other than temporary, the accounting for the direct financing lease will be revised using the changed estimate. The resulting reduction in the net investment in the direct financing lease is recognized as a loss in the period in which the estimate is changed.
In connection with the Company's acquisition of properties, purchase costs are allocated to the tangible and intangible assets and liabilities acquired based on their estimated fair values. The value of the tangible assets, consisting of land, buildings and tenant improvements, are determined as if vacant. Intangible assets including the above-market or below-market value of leases, the value of in-place leases and the value of tenant relationships are recorded at their relative fair values.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Above-market and below-market in-place lease values for owned properties are recorded based on the present value (using an interest rate reflecting the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the leases negotiated and in-place at the time of acquisition of the properties and (ii) management's estimate of fair market lease rates for the property or equivalent property, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market lease value is amortized as a reduction of rental income over the remaining non-cancelable term of each lease. The capitalized below-market lease value is amortized as an increase to rental income over the initial term and any fixed rate renewal periods in the respective leases.
The total amount of other intangible assets are allocated to in-place lease values and tenant relationship intangible values based on management's evaluation of the specific characteristics of each tenant's lease and the Company's overall relationship with each tenant. Characteristics considered in allocating these values include the nature and extent of the existing relationship with the tenant, prospects for developing new business with the tenant, the tenant's credit quality and the expectation of lease renewals among other factors. The aggregate value of other intangible assets acquired will be measured based on the difference between (i) the property valued with an in-place lease adjusted to market rental rates and (ii) the property valued as if vacant. Independent appraisals or management's estimates are used to determine these values.
Factors considered in the analysis include the estimated carrying costs of the property during a hypothetical expected lease-up period, current market conditions and costs to execute similar leases. The Company also considers information obtained about a property in connection with its pre-acquisition due diligence. Estimated carrying costs include real estate taxes, insurance, other property operating costs and estimates of lost rentals at market rates during the hypothetical expected lease-up periods, based on management's assessment of specific market conditions. Estimated costs to execute leases including commissions and legal costs to the extent that such costs are not already incurred with a new lease that has been negotiated in connection with the purchase of the property are also considered.
The value of in-place leases will be amortized to expense over the remaining initial term of each lease. The value of tenant relationship intangibles will be amortized to expense over the initial and renewal terms of the leases but no amortization period for intangible assets will exceed the remaining depreciable life of the building.
For properties under construction, operating expenses including interest charges are capitalized and rentals received are recorded as a reduction of capitalized project (i.e., construction) costs.
Substantially all of the Company's leases provide for either scheduled rent increases, periodic rent increases based on formulas indexed to increases in the Consumer Price Index ("CPI") or sales overrides. Rents from sales overrides (percentage of sales rents) are recognized as reported by lessees, that is, after the level of sales requiring a rental payment to the Company is reached.
Depreciation:
Depreciation is computed using the straight-line method over the estimated useful lives of properties - generally 40 years.
Equity Investments:
The Company's interests in entities in which the entity is not considered to be a VIE or the Company is not deemed to be the primary beneficiary, and the Company's ownership is 50% or less and has the ability to exercise significant influence and jointly-controlled tenancy-in-common interests are accounted for under the equity method, i.e. at cost, increased or decreased by the Company's share of earnings or losses, less distributions.
Assets Held For Sale:
Assets held for sale are accounted for at the lower of carrying value or fair value less costs to dispose. Assets are classified as held for sale when the Company has committed to a plan to actively market a property for sale and expects that a sale will be completed within one year. The results of operations and the related gain or loss on
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
sale of properties classified as held for sale by the Company after December 31, 2001, are included in discontinued operations.
If circumstances arise that previously were considered unlikely and, as a result, the Company decides not to sell a property previously classified as held for sale, the property is reclassified as held and used. A property that is reclassified is measured and recorded individually at the lower of (a) its carrying amount before the property was classified as held for sale, adjusted for any depreciation expense that would have been recognized had the property been continuously classified as held and used, (b) the fair value at the date of the subsequent decision not to sell, or (c) the current carrying value.
The Company recognizes gains and losses on the sale of properties when among other criteria, the parties are bound by the terms of the contract, all consideration has been exchanged and all conditions precedent to closing have been performed. At the time the sale is consummated, a gain or loss is recognized as the difference between the sale price less any closing costs and the carrying value of the property.
Foreign Currency Translation:
The Company owns equity investments which invest in real estate in France. The functional currency for the investment is the Euro. The translation from the Euro to U.S. dollars is performed by the equity investee for assets and liabilities using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. The gains and losses resulting from such translation are reported as a component of other comprehensive income as part of shareholders' equity. The cumulative translation adjustment as of December 31, 2003 has a gain of $462,099. The Company had no foreign investments prior to 2003.
Foreign currency transactions may produce receivables or payables that are fixed in terms of the amount of foreign currency that will be received or paid. A change in the exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of that transaction. That increase or decrease in the expected functional currency cash flows is a foreign currency transaction gain or loss that generally will be included in determining net income for the period in which the exchange rate changes. Likewise, a transaction gain or loss (measured from the transaction date or the most recent intervening balance sheet date) whichever is later, realized upon settlement of a foreign currency transaction generally will be included in net income for the period in which the transaction is settled. Foreign currency transactions that are (i) designated as, and are effective as, economic hedges of a net investment and (ii) intercompany foreign currency transactions that are of a long-term nature (that is, settlement is not planned or anticipated in the foreseeable future), when the entities to the transactions are consolidated or accounted for by the equity method in the Company's financial statements will not be included in determining net income but will be accounted for in the same manner as foreign currency translation adjustments and reported as a component of other comprehensive income as part of shareholder's equity. The contributions to the equity investments were funded in part through subordinated debt.
Foreign currency intercompany transactions that are scheduled for settlement, consisting primarily of accrued interest and the translation to the reporting currency of intercompany subordinated debt with scheduled principal repayments, are included in the determination of net income, and, for the year ended December 31, 2003, the Company recognized unrealized gains of $822,108 from such transactions. In 2003, the Company recognized realized gains of $76,448 on foreign currency transactions, in connection with the transfer of cash from foreign operations of subsidiaries to the parent company.
Cash and Cash Equivalents:
The Company considers all short-term, highly liquid investments that are both readily convertible to cash and have a maturity of generally three months or less at the time of purchase to be cash equivalents. Items classified as cash equivalents include commercial paper and money market funds. At December 31, 2003 and 2002, the Company's cash and cash equivalents were held in the custody of two financial institutions, and which balances at times exceed federally insurable limits. The Company mitigates this risk by depositing funds with major financial institutions.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Marketable Securities:
Marketable securities which consist of an interest in collateralized mortgage obligations (see Note 4) and common stock in publicly-traded companies, are classified as available for sale securities and reported at fair value with the Company's interest in unrealized gains and losses on these securities reported as a component of other comprehensive income (loss) until realized. Such marketable securities had a cost basis of $7,677,799 and $7,202,031 and reflected a fair value of $8,810,482 and $7,510,030 at December 31, 2003 and 2002, respectively.
Other Assets:
Included in other assets are deferred charges and deferred rental income. Deferred charges are costs incurred in connection with mortgage financings and refinancings and are amortized over the terms of the mortgages and included in interest expense in the accompanying consolidated financial statements. Deferred rental income is the aggregate difference for operating leases between scheduled rents which vary during the lease term and rent recognized on a straight-line basis.
Derivative Instruments:
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities" became effective in 2001 and established accounting and reporting standards for derivative instruments. Certain stock warrants which were granted to the Company by lessees in connection with structuring the initial lease transactions are defined as derivative instruments because such stock warrants are readily convertible to cash or provide for net settlement upon conversion. Pursuant to SFAS No. 133, changes in the fair value of such derivative instruments as determined using an option pricing model are recognized currently in earnings as gains or losses. Changes in fair value for the years ended as of December 31, 2003, 2002 and 2001, were unrealized losses of $202,407 and $446,541, respectively and in 2001, an unrealized gain of $1,123,500. As of December 31, 2003, warrants issued to the Company by Vermont Teddy Bear Co., Inc., Sentry Technology Corporation ("Sentry") and Randall International, Inc. are classified as derivative instruments. In January 2003, the Company exercised all of its warrants in Rheometric Scientific, Inc. ("Rheometric") which subsequently became Proterion Corporation ("Proterion"). The Company also holds certain stock warrants which are not defined as derivative instruments and have been recorded at nominal values. The Company has only recognized unrealized gains or losses on stock warrants that are derivative instruments.
Costs of Raising Capital:
Costs incurred in connection with the raising of capital through the sale of common stock are charged to shareholders' equity upon the issuance of shares.
Treasury Stock:
Treasury stock is recorded at cost.
Deferred Acquisition Fees:
Fees are payable for services provided by W.P. Carey & Co. LLC (the "Advisor") to the Company relating to the identification, evaluation, negotiation, financing and purchase of properties. A portion of such fees are deferred and are payable in annual installments with each installment equal to .25% of the purchase price of the properties over no less than eight years following the first anniversary of the date a property was purchased.
Earnings Per Share:
The Company has a simple equity capital structure with only common stock outstanding. As a result, the Company has presented basic per-share amounts only for all periods presented in the accompanying consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Federal Income Taxes:
The Company is qualified as a real estate investment trust ("REIT") as of December 31, 2003 as defined under the Internal Revenue Code of 1986. The Company is not subject to Federal income taxes on amounts distributed to shareholders provided it distributes at least 90% of its REIT taxable income to its shareholders and meets certain other conditions. The Company and subsidiaries are subject to state and local and foreign taxes, which aggregate $102,033 in 2003 and $162,855 in 2002, and are included in general and administrative expenses.
Operating Segments:
Accounting standards have been established for the way public business enterprises report selected information about operating segments and guidelines for defining the operating segments of an enterprise. Based on the standards' definition, the Company has reported its real estate operations both domestically and internationally (See Note 10).
Reclassification:
Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation.
Accounting Pronouncements:
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," ("FIN 45") which changes the accounting for, and disclosure of certain guarantees. Beginning with transactions entered into after December 31, 2002, certain guarantees are required to be recorded at fair value, which is different from prior practice, under which a liability was recorded only when a loss was probable and reasonably estimable. In general, the change applies to contracts or indemnification agreements that contingently require the Company to make payments to a guaranteed third-party based on changes in an underlying asset, liability, or an equity security of the guaranteed party. The adoption of the accounting provisions of FIN 45 on January 1, 2003 did not have a material effect on the Company's financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," which amends SFAS No. 123, Accounting for Stock Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock based compensation (i.e., recognition of a charge for issuance of stock options in the determination of income.). However, SFAS No. 148 does not permit the use of the original SFAS No. 123 prospective method of transition for changes to the fair value based method made in fiscal years beginning after December 15, 2003. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock based employee compensation, description of transition method utilized and the effect of the method used on reported results. The transition and annual disclosure provisions for valuing stock-based compensation of SFAS No. 148 are to be applied for fiscal years ending after December 15, 2002. The Company does not have any employees nor any stock-based compensation plans.
On January 17, 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), the primary objective of which is to provide guidance on the identification of entities for which control is achieved through means other than voting rights ("variable interest entities" or "VIEs") and to determine when and which business enterprise should consolidate the VIE (the "primary beneficiary"). In December 2003, the FASB issued a revised FIN 46 which modifies and clarifies various aspects of the original Interpretation. FIN 46 applies when either (1) the equity investors (if any) lack one or more of the essential characteristics of controlling financial interest, (2) the equity investment at risk is insufficient to finance that entity's activities without additional subordinated financial support or (3) the equity investors have voting rights that are not proportionate to their economic interest. In addition FIN 46 requires additional disclosures.
FIN 46 is effective immediately for VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. For variable interests in a VIE created or obtained prior to February 1, 2003, FIN 46 is effective for periods ending after March 15, 2004.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The Company has evaluated the potential impact and believes this interpretation will not have a material impact on its accounting for its investments in unconsolidated joint ventures as none of these investments are VIEs. The Company's maximum loss exposure is the carrying value of its equity investments.
On April 30, 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging under SFAS No. 133. The changes in the statement improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, the statement (1) clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative instrument discussed in paragraph 6(b) of SFAS No. 133, (2) clarifies when a derivative contains a financing component, (3) amends the definition of an underlying to conform it to language used in FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others", and (4) amends certain other existing pronouncements. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 did not have a material effect on the financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). In particular, it requires that mandatorily redeemable financial instruments be classified as liabilities and reported at fair value and that changes in their fair values be reported as interest cost.
This statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for the Company as of July 1, 2003. On November 7, 2003, the FASB indefinitely deferred the classification and measurement provisions of SFAS No. 150 as they apply to certain mandatorily redeemable non-controlling interests. This deferral is expected to remain in effect while these provisions are further evaluated by the FASB. Based on the FASB's deferral of this provision, the adoption of SFAS No. 150 did not have a material effect on the Company's financial statements.
2. Transactions with Related Parties:
In connection with performing services on behalf of the Company, the Advisory Agreement between the Company and the Advisor provides that the Advisor receive asset management and performance fees, each of which are 1/2 of 1/% of Average Invested Assets as defined in the Advisory Agreement. The performance fee is subordinated to the Preferred Return, a cumulative non-compounded dividend return of 7%. The Advisor has elected at its option to receive the performance fee in restricted shares of common stock of the Company rather than cash. The Advisor is also reimbursed for the actual cost of personnel needed to provide administrative services necessary to the operation of the Company. The Company incurred asset management fees of $3,378,780, 2,847,951, and $2,782,154 in 2003, 2002, and 2001 respectively, with performance fees in like amount. The Company incurred personnel reimbursements of $1,378,810, $1,323,152, and $1,289,852, in 2003, 2002, and 2001, respectively.
Fees are payable to the Advisor for services provided to the Company relating to the identification, evaluation, negotiation, financing and purchase of properties and refinancing of mortgages. A portion of such fees are deferred and payable in equal installments over no less than eight years following the first anniversary of the date a property was purchased. Such deferred fees are only payable if the Preferred Return has been met. The unpaid portion of the deferred fees bears interest at an annual rate of 7% from the date of acquisition of a property until paid. For transaction and refinancings that were completed in 2003, 2002, and 2001, current fees were $807,467, $770,458, and $1,068,478, respectively, and deferred fees were $645,974, $413,097 and $806,283, respectively. On March 12, 2003, the Company purchased from Corporate Property Associates 15 Incorporated ("CPA(R):15"), an affiliate, a 35% interest in a company that leases thirteen properties to two lessees. In connection with the purchase, the Company assumed an obligation of the deferred acquisition fee payable to the Advisor which was $1,031,046. The Company's cash portion of the purchase price included reimbursement to CPA(R):15 for 35% of the initial current acquisition fee which was $1,288,807 (see Note 5).
The Advisor is obligated to reimburse the Company for the amount by which operating expenses of the Company exceeds the 2%/25% Guidelines (the greater of 2% of Average Invested Assets or 25% of Net Income) as defined in
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
the Advisory Agreement for any twelve-month period. If in any year the operating expenses of the Company exceed the 2%/25% Guidelines, the Advisor will have an obligation to reimburse the Company for such excess, subject to certain conditions. Only if the Independent Directors find that such excess expenses were justified based on any unusual and nonrecurring factors which they deem sufficient, the Advisor may be paid in future years for the full amount or any portion of such excess expenses, but only to the extent that such reimbursement would not cause the Company's operating expenses to exceed this limit in any such year. Charges related to asset impairment, bankruptcy of lessees, lease payment defaults, extinguishment of debt or uninsured losses are generally not considered unusual and nonrecurring. A determination that a charge is unusual and nonrecurring, such as the costs of significant litigation that are not associated with day-to day operations, or uninsured losses that are beyond the size or scope of the usual course of business based on the event history and experience of the Advisor and Independent Directors, is made at the sole discretion of the Independent Directors. The Company will record any reimbursement of operating expenses as a liability until any contingencies are resolved and will record the reimbursement as a reduction of asset management and performance fees at such time that a reimbursement is fixed, determinable and irrevocable. The operating expenses of the Company have not exceeded the amount that would require the Advisor to reimburse the Company.
The Advisor will be entitled to receive subordinated disposition fees based upon the cumulative proceeds arising from the sale of Company assets since the inception of the Company, subject to certain conditions. Pursuant to the subordination provisions of the Advisory Agreement, the disposition fees may be paid only after the shareholders receive 100% of their initial investment from the proceeds of asset sales and a cumulative annual return of 6% (based on an initial share price of $10) since the inception of the Company. The Advisor's interest in such disposition fees amounts to $1,375,681 as of December 31, 2003. Payment of such amount, however, cannot be made until the subordination provisions are met. The Company has concluded that payment of such disposition fees is probable and all fees from completed property sales have been accrued. Subordinated disposition fees are included in the determination of realized gain or loss on the sale of properties. The obligation for disposition fees is included in due to affiliates in the accompanying consolidated financial statements.
The Company owns interests in entities which range from 15% to 50% and a jointly-controlled 50% tenancy-in-common interest in a property subject to a net lease with remaining interests held by affiliates.
The Company is a participant in an agreement with certain affiliates for the purpose of leasing office space used for the administration of real estate entities and for sharing the associated costs. Pursuant to the terms of the agreement, the Company's share of rental, occupancy and leasehold improvement costs is based on gross revenues. Expenses incurred in 2003, 2002, and 2001 were $223,996, $232,498, and $232,481, respectively. The Company's current share of future minimum lease payments is $429,000 through 2006.
3. Real Estate Leased to Others Accounted for Under the Operating Method:
Scheduled future minimum rents, exclusive of renewals, under non-cancelable operating leases are approximately as follows:
Contingent rents (including percentage rents and CPI-based increases) were approximately $2,078,000, $2,396,000, and $1,938,000 in 2003, 2002, and 2001 respectively.
4. Net Investment in Direct Financing Leases:
Net investment in direct financing leases is summarized as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Scheduled future minimum rents, exclusive of renewals, under non-cancelable direct financing leases are approximately as follows:
Contingent rents (including CPI-based increases) were approximately, $322,000, $384,000, and $274,000 in 2003, 2002 and 2001, respectively.
5. Equity Investments:
The Company owns interests in properties leased to corporations through non-controlling interests. The ownership interests range from 15% to 50%. All of the underlying investments are owned with affiliates that have similar investment objectives as the Company. The lessees are Best Buy, Sicor, Inc., The Upper Deck Company, Advanced Micro Devices, Inc., Compucom Systems, Inc., Textron, Inc., McLane Company, Inc., The Retail Distribution Group, Inc., Del Monte Corporation, Special Devices, Inc., ShopRite Supermarkets, Inc., TruServ Corporation, Starmark Camhood LLC ("Starmark"), Medica-France, S.A. ("Medica") and affiliates of Carrefour France, S.A. ("Carrefour"). The equity investments in Starmark, Medica and Carrefour were acquired during the quarter ended March 31, 2003.
Distributions and allocations of income or loss from the equity investees are based on ownership percentages and no fees are paid by the Company or the partnerships to any of the general partners of the limited partnerships.
Summarized combined financial information of the Company's equity investees is as follows:
A. In February 2002, the Best Buy partnership paid off a mortgage loan of $25,743,178 and incurred a charge on the early extinguishment of debt of $2,086,384, of which the Company's share was $771,962. The retired loan provided
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
for monthly payments of interest and principal of $291,290 at an annual interest rate of 9.01%. The general partnership obtained a new limited recourse loan of $28,500,000 which provides for monthly payments of interest and principal of $210,427 at an annual interest rate of 7.49% based on a 25-year amortization schedule. The loan matures in May 2012 at which time a balloon payment is scheduled.
On March 12, 2003, the Company purchased a 35% interest in a limited liability company from CPA(R):15 which retained the remaining 65% interest. The limited liability company owns properties in France that are leased to Medica and Carrefour. The purchase price for the 35% interest was $11,916,465 in cash and the assumption of a deferred fee payable to the Advisor of $1,031,046. The purchase price was based on the appraised value of the properties (based on the March 6, 2003 exchange rate for the Euro) adjusted for capital costs incurred since the acquisition by CPA(R):15 including fees paid to the Advisor, net of mortgage debt.
The Medica leases have a remaining term through June 2011 and provide for aggregate annual rent of Euro 3,856,618 ($4,226,467) with annual rent increases based on a formula indexed to increases in the INSEE, a French construction cost index. The Carrefour leases have a remaining term through December 2011 for an aggregate annual rent of Euro 10,190,269 ($11,167,516) with annual rent increases based on a formula, indexed to the INSEE.
In connection with the purchase of the properties, the limited liability company obtained limited recourse mortgage debt of Euro 34,000,000 ($37,260,600) and Euro 84,244,000 ($92,323,000) on the Medica and Carrefour properties, respectively. The Medica and Carrefour loans provide for quarterly payments of interest at an annual interest rate of 5.631% and 5.55%, respectively, and stated principal payments with scheduled increases over their terms. The Medica and Carrefour loans mature in October 2017 and December 2014, respectively, at which time balloon payments are payable.
On November 27, 2003, the limited liability company purchased an additional Carrefour property in Nimes, France for Euro 17,277,481 ($20,634,503 as of the date of acquisition) and obtained additional recourse mortgage financing of Euro 14,025,000 ($16,750,058) which was added to the existing mortgage balance on the Carrefour properties. The lease for the Nimes property provides for annual rent of Euro 1,608,750 ($1,921,330) and has a term through November 2012 with annual rent increases based on the INSEE.
In connection with the purchase of the Nimes property, W. P. Carey & Co. LLC ("W. P. Carey"), the parent company of the Advisor, purchased a 22.5% interest in the Carrefour properties at which time the Company's interest in the Carrefour properties was reduced from 35% to 27.125%. W. P. Carey's purchase price was based on an independent appraisal of the properties. In connection with the sale of the interest, the Company recognized a gain of $1,432,858 including a $1,069,581 increase in the proportionate fair value of the real estate sold and $363,277 which resulted from an increase in value attributable to changes in foreign currency rates with the Euro and changes in the carrying cost of the property.
On February 7, 2003, the Company and two affiliates, Corporate Property Associates 14 Incorporated ("CPA(R):14") and CPA(R):15, through a newly-formed limited liability company with ownership interests of 15%, 41% and 44%, respectively, purchased land and 15 health club facilities for $178,010,471 and entered into a master net lease with Starmark. The lease obligations of Starmark are jointly unconditionally guaranteed by seven of its affiliates.
The Starmark lease provides for an initial lease term of 20 years with three ten-year renewal terms. Annual rent is initially $18,272,400 with CPI-based increases scheduled in November 2006, 2010, 2014, 2018 and 2021.
In connection with the purchase, the limited liability company obtained first mortgage limited recourse financing of $88,300,000 and a mezzanine loan of $20,000,000. The first mortgage provides for monthly payments of interest and principal of $563,936 at an annual interest rate of 6.6% and based on a 30-year amortization schedule. The loan matures in March 2013 at which time a balloon payment is payable. The mezzanine loan provides for monthly payments of interest and principal of $277,201 at an annual interest rate of 11.15% and will fully amortize over its ten-year term.
The limited liability company was granted warrants for Class C Unit interests in Starmark. If exercised, the Unit interests would represent a 5% interest in Starmark as of the date of grant. The warrants may be exercised at any time through February 7, 2023 at an exercise price of $430 per unit. The warrant agreement does not provide for a cashless exercise of units.
6. Mortgage Financing Through Loan Securitization:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
In 2002, the Company and three affiliates, W.P. Carey & Co. LLC, Carey Institutional Properties Incorporated ("CIP(R)")and Corporate Property Associates 14 Incorporated ("CPA(R):14") obtained an aggregate of approximately $172,335,000 of limited recourse mortgage financing collateralized by 62 leased properties. The lender pooled the loans into a trust, Carey Commercial Mortgage Trust, a non-affiliate, whose sole assets consist solely of the loans, and sold interests in the trust as collateralized mortgage obligations in a private placement to institutional investors (the "Offered Interests"). The Company and the three affiliates acquired a separate class of subordinated interests in the trust (the "CPA(R) Interests"). The amount of CPA(R) Interests acquired by the Company was proportional to the mortgage amounts obtained.
All of the mortgage loans provide for payments of principal and interest at an annual rate of 7.5% and are based on a 25-year amortization schedule. Each loan is collateralized by mortgages on the properties and lease assignments. Under the lease assignments, the lessees direct their rent payment to the mortgage servicing company which in turn distributes amounts in excess of debt service requirements to the applicable lessors. Under certain limited conditions, a property may be released from its mortgage by the substitution of another property. Such substitution is subject to the approval of the trustee of the trust.
The initial Offered Interests consisted of $148,206,000 of the mortgage loan balances, with different tranches of principal entitled to distributions at annual interest rates as follows: $119,772,000 - 5.97%, $9,478,000 - 6.58%, $9,478,000 - 7.18% and $9,478,000 - 8.43%. The assumed final distribution dates for the four classes of Offered Interests range from December 2011 through March 2012.
The CPA(R) Interests were purchased for $24,128,739 of which the Company's share was $7,238,622, or 30%, and are comprised of two components, a component that will receive payments of principal and interest and a component that will receive payments of interest only. The CPA(R) Interests are subordinated to the Offered Interests and will be payable only when and if all distributions to the Offered Interests are current. The assumed final distribution date for the CPA(R) Interests is June 30, 2012. The distributions to be paid to the CPA(R) Interests do not have a stated rate of interest and will be affected by any shortfall in rents received from lessees or defaults at the mortgaged properties. As of the purchase date, the Company's cost basis attributable to the principal and interest and interest only components was $4,334,840 and $2,903,782, respectively. Over the term of its ownership interest in the CPA(R) Interests, the value of the interest only component will fully amortize to $0 and the principal and interest component will amortize to its anticipated face value of its share in the underlying mortgages (which currently is $7,238,622). For financial reporting purposes, the effect of such amortization is reflected in interest income. Interest income, including all related amortization, is recognized using an effective interest method.
The Company is accounting for its interest in the CPA(R) Interests as an available-for-sale security and it is measured at fair value with all gains and losses from changes in fair value reported as a component of other comprehensive income as part of shareholders' equity. The fair value of the Company's CPA(R) Interests was $8,150,462 and $7,510,030, reflecting a cumulative unrealized gain of $1,078,004 and $307,999 and accumulated amortization of $166,164 and $36,591 at December 31, 2003 and 2002, respectively. The fair value of the interests in the trust is determined using a discounted cash flow model with assumptions of market rates and the credit quality of the underlying lessees.
The key variable in determining fair value of the CPA(R) Interests is current interest rates. As required by SFAS No. 140, "Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities," a sensitivity analysis of the current value of the CPA(R) Interests based on adverse changes in the market interest rates of 1% and 2% is as follows:
The above sensitivity is hypothetical and changes in fair value based on a 1% or 2% variation should not be extrapolated because the relationship of the change in assumption to the change in fair value may not always be linear.
In 2002, the Company obtained new mortgage financing of $46,335,000 of which $8,908,000 was used to pay off existing loans. In connection with paying off the loans, the Company incurred prepayment charges of $1,225,092. After paying off the loans, incurring costs in connection with obtaining the new mortgages and purchasing its interests in the trust for $8,582,022, the Company retained cash of approximately $26,400,000, which includes a capital distribution from an equity investee that refinanced its loan in connection with the transaction. The loans which were paid off bore interest at annual rates ranging from 8.19% to 8.92%.
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The Company owns a 45% interest in two properties leased to ShopRite Supermarkets, Inc. ("ShopRite") (formerly Big V Holding Corp.) with CIP(R) owning the remaining interest. In connection with structuring the transaction, the jointly-owned properties were contributed to limited partnerships with CIP(R) owning a 55% interest as general partner. Accordingly, the Company's interest in the limited partnership is accounted for under the equity method of accounting. The limited partnership obtained new mortgage financing of $10,890,000 in connection with the securitization with an annual interest rate of 7.5% and paid off an existing loan of $6,721,103 with an annual interest rate of 9%.
7. Mortgage Notes Payable and Line of Credit:
Mortgage notes payable, all of which are limited recourse to the Company, are collateralized by an assignment of various leases and by real property with a carrying value of approximately $300,057,000. As of December 31, 2003, mortgage notes payable had fixed interest rates ranging from 6.5% to 8.75% per annum.
Scheduled principal payments during each of the five years following December 31, 2003 are as follows:
The Company's credit facility matured in October 2003.
Interest paid, was $14,536,417, $13,661,932, and $13,085,646 in 2003, 2002, and 2001 respectively. There was no capitalized interest in 2003, 2002 and 2001.
8. Dividends:
Dividends paid to shareholders consist of ordinary income, capital gains, return of capital or a combination thereof for income tax purposes. For the three years ended December 31, 2003, dividends paid per share reported for tax purposes were as follows:
A dividend of $.2067 per share for the quarter ended December 31, 2003 ($6,271,709) was declared in December 2003 and paid in January 2004.
9. Lease Revenues:
The Company's operations consist of the investment in and the leasing of industrial and commercial real estate. The financial reporting sources of 2003, 2002, and 2001 lease revenues are as follows:
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
In 2003, 2002, and 2001 the Company earned its share of net lease revenues from its direct and indirect ownership of real estate from the following lease obligors:
(a) Net of amounts applicable to minority interests owned by Corporate Property Associates 14 Incorporated.
(b) Represents the Company's proportionate share of lease revenues from its equity investment.
(c) Includes the Company's proportionate share of lease revenues from its equity investment for the period subsequent to September 30, 2001.
(d) Includes the Company's proportionate share of lease revenues from its equity investment for the period subsequent to July 31, 2002.
10. Segment Information:
The Company has determined that it operates in one business segment, real estate operations with domestic and foreign investments. The Company had no foreign real estate investment until March 2003.
For 2003, geographic information for the real estate operations segment is as follows:
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(1) Net operating income excludes gains and losses and discontinued operations.
11. Impairment Charges:
The Company owns a property in Newark, Delaware which, for the past several years has been operated as a multi-tenant facility. During 2003, the occupancy rate of the property declined substantially. In connection with this change in circumstances, the property has been written down to its estimated fair value and an impairment charge of $1,000,000 was recognized.
12. Gain on Sale of Real Estate and Derivatives Contract:
In October 2002, the Company and Rheometric entered into an agreement that would allow Rheometric to terminate its lease for its facility in Piscataway, New Jersey upon completion of an asset sale of one of its lines of business. In January 2003, the Rheometric sale was completed, at which time the lease termination agreement became effective and Rheometric changed its name to Proterion. In connection with the settlement, the Company recognized $3,042,227 which is included in interest and other income in the accompanying consolidated financial statements for the year ended December 31, 2003. The settlement included a grant of 650,000 shares of common stock.
In connection with structuring the initial purchase transaction with Rheometric, the Company was granted warrants for 466,140 shares of Rheometric common stock at an exercise price of $2.00. Under the lease termination agreement, the exercise price of the warrants was reduced to $0.01. On January 16, 2003, the warrants were converted on a cashless basis to 456,424 shares of common stock of Proterion. Because the Company had the ability to convert the warrants to shares on a cashless basis, the warrants had been classified as a derivative instrument. Upon conversion to shares, a cumulative unrealized gain in the fair value of the warrants of $237,340 was reversed and a realized gain of $237,340, representing the gain on the settlement of a derivatives contract was recognized. The Company's 1,106,424 shares of Proterion are classified as an available-for-sale marketable security and are measured at fair value with all gains and losses in fair value reported as a component of other comprehensive income as part of shareholders' equity. As of December 31, 2003, the fair value of the Proterion shares held by the Company was $520,019 based on a quoted value per share of $0.47.
On May 1, 2001, the Company sold its property in San Diego, California leased to BAE Systems, Inc. ("BAE") for $30,497,865, and recognized a gain of $8,863,709. The BAE sale was structured as a noncash exchange for tax purposes so that the proceeds from sale were placed in an escrow account and used in connection with additional real estate acquisitions in 2001.
13. Discontinued Operations:
In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", effective for financial statements issued for fiscal years beginning after December 15, 2001, the results of operations and gain or loss on sales of real estate for properties sold or held for sale are to be reflected in the consolidated statements of operations as "Discontinued Operations" for all periods presented. The provisions of SFAS No. 144 are effective for disposal activities initiated by the Company's commitment to a plan of disposition after the date it is initially applied (January 1, 2002). Properties held for sale as of December 31, 2001 are not included in discontinued operations.
In July 2003, the Company and Sentry Technology Corporation ("Sentry") entered into a termination agreement. Sentry agreed not to contest an eviction from the Company's property in Hauppauge, New York, in consideration for forgiveness of rent arrearages of $486,000. Under the agreement, Sentry vacated the property in September 2003, and assigned the Company the right to collect rent directly from Sentry's sub-tenants. In addition, Sentry issued 1,000,000 shares of its common stock to the Company which had a quoted per share value of $0.03 as of the date of issuance and a $250,000 promissory note which Sentry is scheduled to repay over a three-year period. As of December 31, 2003, the fair value of Sentry shares held by the Company was $140,000. In connection with the settlement, the Company recognized other income of $30,000, an amount equal to the value of the shares received. Because of Sentry's inability
CORPORATE PROPERTY ASSOCIATES 12 INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
to meet lease obligations, the promissory note has been fully reserved for and settlement income from the note will be recognized as received.
In September 2003, the Company entered into an agreement to sell the Hauppauge property for $6,300,000, less selling costs, subject to the buyer's due diligence review which is currently being performed. Accordingly, the property is classified as held for sale with a carrying value of $4,361,035 as of December 31, 2003.
The Company owns a property in Ashburn , Virginia, which was leased to International Management Consulting , Inc. ("IMCI"). Following IMCI's bankruptcy, the lease was rejected in October 2003. The Company has entered into an agreement, subject to certain conditions, to sell the Ashburn property for $7,500,000. The property is classified as held for sale with a carrying value of $6,092,368 as of December 31, 2003.
The results of operations for the Hauppauge and Ashburn properties are included in discontinued operations and reflect income of $20,766, $1,041,130 and $1,075,515 for the years ended December 31, 2003, 2002 and 2001, respectively. A summary of Discontinued Operations for the years ended December 31, 2003, 2002 and 2001 is as follows.
As a result of classifying properties as held for sale, no depreciation has been incurred from the date of reclassification. The effect of suspending depreciation expenses was $20,759 in 2003. There was no effect in 2002 and 2001.
14. Disclosures About Fair Value of Financial Instruments:
The Company estimates that the fair value of mortgage notes payable was approximately $186,724,000 and $201,892,000 at December 31, 2003 and 2002, respectively. The fair value of the mortgage notes payable was evaluated using a discounted cash flow model with a rate that takes into account the credit of the tenant and interest rate risk.
15. Selected Quarterly Financial Data (unaudited):
MARKET FOR THE PARTNERSHIP'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
There is no established public trading market for the Shares of the Company.
As of December 31, 2003 there were 13,550 holders of record of the Shares of the Company.
In accordance with the Prospectus of the Company, dividends will be paid quarterly regardless of the frequency with which such dividends are declared. The Company is required to distribute annually at least 90% of its Distributable REIT Taxable Income to maintain its status as a REIT. The following shows the frequency and amount of dividends paid for the past three years.
REPORT ON FORM 10-K
The Advisor will supply to any shareholder, upon written request and without charge, a copy of the Annual Report on Form 10-K ("10-K") for the year ended December 31, 2003 as filed with the Securities and Exchange Commission ("SEC"). The 10-K may also be obtained through the SEC's EDGAR database at www.sec.gov.