Item 1. Business
General
ERP Operating Limited Partnership (“ERPOP”), an Illinois limited partnership, was formed in May 1993 to conduct the multifamily residential property business of Equity Residential (“EQR”). EQR is a Maryland real estate investment trust (“REIT”) formed in March 1993 and is a fully integrated real estate company engaged in the acquisition, development, ownership, management and operation of multifamily properties.
EQR is one of the largest publicly traded REIT’s and is the largest publicly traded REIT owner of multifamily properties (based on the aggregate market value of EQR’s outstanding Common Shares, the number of apartment units wholly owned and total revenues earned). The Operating Partnership’s corporate headquarters are located in Chicago, Illinois and the Operating Partnership also leases (under operating leases) approximately thirty-five divisional, regional and area property management offices throughout the United States.
EQR is the general partner of, and as of December 31, 2003, owned an approximate 92.7% ownership interest in ERPOP. ERPOP is, directly or indirectly, a partner, member or shareholder of numerous partnerships, limited liability companies and corporations which have been established primarily to own fee simple title to multifamily properties or to conduct property management activities and other businesses related to the ownership and operation of multifamily residential real estate. As used herein, the term “Operating Partnership” includes ERPOP and those entities owned or controlled by it. As used herein, the term “Company” means EQR and the Operating Partnership.
As of December 31, 2003, the Operating Partnership owned or had investments in 968 properties in 34 states consisting of 207,506 units. The ownership breakdown includes:
The Operating Partnership has approximately 6,000 employees as of March 1, 2004. An on-site manager, who supervises the on-site employees and is responsible for the day-to-day operations of the property, directs each of the Operating Partnership’s properties. An assistant manager and/or leasing staff generally assist the manager. In addition, a maintenance director at each property supervises a maintenance staff and/or contractors whose responsibilities include a variety of tasks, including responding to service requests, preparing vacant apartments for the next resident and performing preventive maintenance procedures year-round.
Certain capitalized terms as used herein are defined in the Notes to Consolidated Financial Statements.
Business Objectives and Operating Strategies
The Operating Partnership seeks to maximize both current income and long-term growth in income, thereby increasing:
• the value of the properties;
• distributions on a per limited partnership interest (“OP Unit”) basis; and
• partners’ value.
The Operating Partnership’s strategies for accomplishing these objectives are:
• maintaining and increasing property occupancy while increasing rental rates;
• controlling expenses, providing regular preventive maintenance, making periodic renovations and enhancing amenities;
• maintaining a ratio of consolidated debt-to-total market capitalization of less than 50%;
• strategically acquiring and disposing of properties, with an emphasis on acquiring attractive properties in high barrier to entry markets and on selling properties in low barrier to entry markets;
• purchasing newly developed, as well as co-investing in the development of, multifamily communities;
• entering into joint ventures related to the ownership of established properties; and
• strategically investing in various businesses that will enhance services for the properties.
The Operating Partnership is committed to resident satisfaction by striving to anticipate industry trends and implementing strategies and policies consistent with providing quality resident services. In addition, the Operating Partnership continuously surveys rental rates of competing properties and conducts resident satisfaction surveys to determine the factors they consider most important in choosing a particular apartment unit and/or property.
Acquisition and Development Strategies
The Operating Partnership anticipates that future property acquisitions and developments will occur within the United States. Management will continue to use market information to evaluate opportunities. The Operating Partnership’s market database allows it to review the primary economic indicators of the markets where the Operating Partnership currently owns properties and where it expects to expand its operations. Acquisitions and developments may be financed from various sources of capital, which may include retained cash flow, issuance of additional equity and debt securities, sales of properties, joint venture agreements and collateralized and uncollateralized borrowings. In addition, the Operating Partnership may acquire additional properties in transactions that include the issuance of OP Units as consideration for the acquired properties. Such transactions may, in certain circumstances, enable the sellers to defer, in part, the recognition of taxable income or gain, which might otherwise result from the sales.
When evaluating potential acquisitions and developments, the Operating Partnership will consider:
• the geographic area and type of community;
• the location, construction quality, condition and design of the property;
• the current and projected cash flow of the property and the ability to increase cash flow;
• the potential for capital appreciation of the property;
• the terms of resident leases, including the potential for rent increases;
• income levels and employment growth trends in the relevant market;
• employment and household growth and net migration of the relevant market’s population;
• the potential for economic growth and the tax and regulatory environment of the community in which the property is located;
• the occupancy and demand by residents for properties of a similar type in the vicinity (the overall market and submarket);
• the prospects for liquidity through sale, financing or refinancing of the property;
• the benefits of integration into existing operations;
• barriers to entry that would limit competition (zoning laws, building permit availability, supply of undeveloped or developable real estate, local building costs and construction labor costs among other factors);
• purchase prices and yields of available existing stabilized communities, if any; and
• competition from existing multifamily properties, residential properties under development and the potential for the construction of new multifamily properties in the area.
Disposition Strategies
Management uses market information to evaluate dispositions. Factors the Operating Partnership considers in deciding whether to dispose of its properties include the following:
• potential increases in new construction;
• submarkets that will underperform the average performance of the portfolio in the mid and long-term;
• markets where the Operating Partnership does not intend to establish long-term concentrations; and
• age or location of a particular property.
The Operating Partnership will reinvest the proceeds received from property dispositions primarily to fund property acquisitions as well as fund development activities. In addition, when feasible, the Operating Partnership may structure these transactions as tax deferred exchanges.
Financing Strategies
The Operating Partnership’s “Consolidated Debt-to-Total Market Capitalization Ratio” as of December 31, 2003 is presented in the following table. The Operating Partnership calculates the equity component of its market capitalization as the sum of (i) the total outstanding OP Units at the equivalent market value of the closing price of EQR’s Common Shares on the New York Stock Exchange; (ii) the “OP Unit Equivalent” of all convertible preference interests/units; and (iii) the liquidation value of all perpetual preference interests/units outstanding.
Capitalization as of December 31, 2003
Convertible Preference Units, Preference Interests
and Junior Preference Units
as of December 31, 2003
The Operating Partnership’s policies are to maintain a ratio of consolidated debt-to-total market capitalization of less than 50% and that EQR shall not incur indebtedness other than short-term trade, employee compensation or similar indebtedness that will be paid in the ordinary course of business.
Equity Offerings For the Years Ended December 31, 2003, 2002 and 2001
During 2003, EQR contributed all of the net proceeds, as discussed below, to the Operating Partnership in exchange for OP Units or preference units:
• EQR issued 600,000 Series N Cumulative Redeemable Preferred Shares with a liquidation value of $150.0 million and received net proceeds of approximately $145.3 million.
• EQR issued 3,249,555 Common Shares pursuant to its Share Incentive Plans and received net proceeds of approximately $68.4 million.
• EQR issued 289,274 Common Shares pursuant to its Employee Share Purchase Plan and received net proceeds of approximately $6.3 million.
During 2002, EQR contributed all of the net proceeds, as discussed below, to the Operating Partnership in exchange for OP Units:
• EQR issued 1,435,115 Common Shares pursuant to its Share Incentive Plans and received net proceeds of approximately $29.6 million.
• EQR issued 324,238 Common Shares pursuant to its Employee Share Purchase Plan and received net proceeds of approximately $7.4 million.
• EQR issued 31,354 Common Shares pursuant to its Share Purchase - DRIP Plan and received net proceeds of approximately $0.9 million.
• EQR issued 41,407 Common Shares pursuant to its Dividend Reinvestment - DRIP Plan and received net proceeds of approximately $1.2 million.
• EQR repurchased 5,092,300 of its Common Shares on the open market at an average price of $22.58 per share. The purchases were made between October 1 and October 22, 2002. EQR paid approximately $115.0 million in connection therewith. These shares were subsequently retired. Concurrent with this transaction, the Operating Partnership repurchased and retired 5,092,300 OP Units previously issued to EQR.
During 2001, EQR contributed all of the net proceeds, as discussed below, to the Operating Partnership in exchange for OP Units:
• EQR issued 3,187,217 Common Shares pursuant to its Share Incentive Plans and received net proceeds of approximately $65.4 million.
• EQR issued 310,261 Common Shares pursuant to its Employee Share Purchase Plan and received net proceeds of approximately $6.9 million.
• EQR issued 33,106 Common Shares pursuant to its Share Purchase - DRIP Plan and received net proceeds of approximately $0.9 million.
• EQR issued 42,649 Common Shares pursuant to its Dividend Reinvestment - DRIP Plan and received net proceeds of approximately $1.2 million.
In February 1998, EQR filed and the SEC declared effective a Form S-3 Registration Statement to register $1.0 billion of equity securities. In addition, EQR carried over $272.4 million related to a prior registration statement. As of February 4, 2004, $956.5 million in equity securities remained available for issuance under this registration statement. Per the terms of ERPOP’s partnership agreement, EQR contributes the net proceeds of all equity offerings to the capital of the Operating Partnership in exchange for additional OP Units (on a one-for-one Common Share per OP Unit basis) or preference units (on a one-for-one preferred share per preference unit basis).
Cumulative through December 31, 2003, a subsidiary of ERPOP issued various series of Preference Interests (the “Preference Interests”) with an equity value of $246.0 million receiving net proceeds of $239.9 million.
Debt Offerings For the Years Ended December 31, 2003, 2002 and 2001
During 2003:
• The Operating Partnership issued $400.0 million of redeemable unsecured fixed rate notes (the “April 2013 Notes”) in a public debt offering in March 2003. The April 2013 Notes were issued at a discount, which is being amortized over the life of the notes on a straight-line basis. The April 2013 Notes are due April 1, 2013. The annual interest rate on the April 2013 Notes is 5.20%, which is payable semiannually in arrears on April 1 and October 1, commencing October 1, 2003. The Operating Partnership received net proceeds of approximately $397.5 million in connection with this issuance.
During 2002:
• The Operating Partnership issued $400.0 million of redeemable unsecured fixed rate notes (the “March 2012 Notes”) in a public debt offering in March 2002. The March 2012 Notes were issued at a discount, which is being amortized over the life of the notes on a straight-line basis. The March 2012 Notes are due March 15, 2012. The annual interest rate on the March 2012 Notes is 6.625%, which is payable semiannually in arrears on September 15 and March 15, commencing September 15, 2002. The Operating Partnership received net proceeds of approximately $394.5 million in connection with this issuance.
• The Operating Partnership issued $50.0 million of redeemable unsecured fixed rate notes (the “November 2007 Notes”) in a public debt offering in November 2002. The November 2007 Notes are due November 30, 2007. The annual interest rate on the November 2007 Notes is 4.861%, which is payable semiannually in arrears on May 30 and November 30, commencing May 30, 2003. The Operating Partnership received net proceeds of approximately $49.9 million in connection with this issuance.
During 2001:
• The Operating Partnership issued $300.0 million of redeemable unsecured fixed rate notes (the “March 2011 Notes”) in a public debt offering in March 2001. The March 2011 Notes were issued at a discount, which is being amortized over the life of the notes on a straight-line basis. The March 2011 Notes are due March 2, 2011. The annual interest rate on the March 2011 Notes is 6.95%, which is payable semiannually in arrears on September 2 and March 2, commencing September 2, 2001. The Operating Partnership received net proceeds of approximately $297.4 million in connection with this issuance.
In June 2003, the Operating Partnership filed and the SEC declared effective a Form S-3 registration statement to register $2.0 billion of debt securities. In addition, the Operating Partnership carried over $280.0 million related to a prior registration statement. As of February 4, 2004, $2.28 billion in debt securities remained available for issuance under this registration statement.
Credit Facilities
In May 2002, the Operating Partnership obtained a new three-year $700.0 million unsecured revolving credit facility maturing May 29, 2005. The new line of credit replaced the $700.0 million unsecured revolving credit facility that was scheduled to expire in August 2002. The prior existing revolving credit facility was terminated upon the closing of the new facility. Advances under the new credit facility bear interest at variable rates based upon LIBOR at various interest periods, plus a spread dependent upon the Operating Partnership’s credit rating, or based upon bids received from the lending group. As of December 31, 2003, $10.0 million was outstanding and $56.7 million was restricted (dedicated to support letters of credit and not available for borrowing) on the line of credit. During the year ended December 31, 2003, the weighted average interest rate on borrowings under the line of credit was 1.85%.
Business Combinations
In January 2002, the Company sold the former Globe Business Resources, Inc. (“Globe”) furniture rental business it acquired in July 2000 for approximately $30.0 million in cash, which approximated the net book value at the sale date. The Company has retained ownership of the former Globe short-term furnished housing business, which is now known as Equity Corporate Housing (“ECH”).
For the year ended December 31, 2002, the Company recorded approximately $17.1 million of asset impairment charges related to ECH. Following the guidance in SFAS No. 142, these charges were the result of the Company’s decision to reduce the carrying value of ECH to $30.0 million, given the continued weakness in the economy and management’s expectations for near-term performance and were determined based upon a discounted cash flow analysis of the business. This impairment loss is reflected on the consolidated statements of operations as impairment on corporate housing business and on the consolidated balance sheets as a reduction in goodwill, net.
Competition
All of the properties are located in developed areas that include other multifamily properties. The number of competitive multifamily properties in a particular area could have a material effect on the Operating Partnership’s ability to lease units at the properties or at any newly acquired properties and on the rents charged. The Operating Partnership may be competing with other entities that have greater resources than the Operating Partnership and whose managers have more experience than the Operating Partnership’s managers. In addition, other forms of rental properties and single-family housing provide housing alternatives to potential residents of multifamily properties. Throughout 2002 and 2003,
historically low mortgage interest rates coupled with increased residential construction and single-family home sales have had an adverse competitive effect on the Operating Partnership.
Risk Factors
The following Risk Factors may contain defined terms that are different from those used in the other sections of this report. Unless otherwise indicated, when used in this section, the terms “we” and “us” refer to ERP Operating Limited Partnership, an Illinois limited partnership, and its subsidiaries. ERP Operating Limited Partnership is controlled by its general partner, Equity Residential, a Maryland real estate investment trust.
Set forth below are the risks that we believe are important to investors who purchase or own our preference interests (“Interests”) of a subsidiary of ERP Operating Limited Partnership; preference units (“Units”); or units of limited partnership interest (“OP Units”) of ERP Operating Limited Partnership, which are redeemable on a one-for-one basis for common shares or their cash equivalent. In this section, we refer to the Interests, Units and the OP Units together as our “securities,” and the investors who own Interests, Units and/or OP Units as our “security holders.”
Our Performance and OP Unit Value are Subject to Risks Associated with the Real Estate Industry
General
Real property investments are subject to varying degrees of risk and are relatively illiquid. Several factors may adversely affect the economic performance and value of our properties. These factors include changes in the national, regional and local economic climate, local conditions such as an oversupply of multifamily properties or a reduction in demand for our multifamily properties, the attractiveness of our properties to residents, competition from other available multifamily property owners and changes in market rental rates. Our performance also depends on our ability to collect rent from residents and to pay for adequate maintenance, insurance and other operating costs, including real estate taxes, which could increase over time. Also, the expenses of owning and operating a property are not necessarily reduced when circumstances such as market factors and competition cause a reduction in income from the property.
We May be Unable to Renew Leases or Relet Units as Leases Expire
When our residents decide not to renew their leases upon expiration, we may not be able to relet their units. Even if the residents do renew or we can relet the units, the terms of renewal or reletting may be less favorable than current lease terms. Because virtually all of our leases are for apartments, they are generally for terms of no more than one year. If we are unable to promptly renew the leases or relet the units, or if the rental rates upon renewal or reletting are significantly lower than expected rates, then our results of operations and financial condition will be adversely affected. Consequently, our cash flow and ability to service debt and make distributions to security holders would be reduced. As a result of general economic conditions and competitive factors discussed above, we have experienced a trend of declining rents and increased concessions when entering into new leases across our portfolio during the last two years.
New Acquisitions or Developments May Fail to Perform as Expected and Competition for Acquisitions May Result in Increased Prices for Properties
We intend to continue to actively acquire and develop multifamily properties. Newly acquired or developed properties may fail to perform as expected. We may underestimate the costs necessary to bring an acquired property up to standards established for its intended market position or to develop a property. Additionally, we expect that other major real estate investors with significant capital will compete with us for attractive investment opportunities or may also develop properties in markets
where we focus our development efforts. This competition may increase prices for multifamily properties. We may not be in a position or have the opportunity in the future to make suitable property acquisitions on favorable terms. The total number of development units, cost of development and estimated completion dates are subject to uncertainties arising from changing economic conditions (such as the cost of labor and construction materials), competition and local government regulation.
Because Real Estate Investments Are Illiquid, We May Not Be Able To Sell Properties When Appropriate
Real estate investments generally cannot be sold quickly. We may not be able to change our portfolio promptly in response to economic or other conditions. This inability to respond promptly to changes in the performance of our investments could adversely affect our financial condition and ability to make distributions to our security holders.
Changes in Laws Could Affect Our Business
We are generally not able to pass through to our residents under existing leases real estate taxes, income taxes or other taxes. Consequently, any such tax increases may adversely affect our financial condition and limit our ability to make distributions to our security holders. Similarly, changes that increase our potential liability under environmental laws or our expenditures on environmental compliance would adversely affect our cash flow and ability to make distributions on our securities.
Environmental Problems are Possible and can be Costly
Federal, state and local laws and regulations relating to the protection of the environment may require a current or previous owner or operator of real estate to investigate and clean up hazardous or toxic substances or petroleum product releases at such property. The owner or operator may have to pay a governmental entity or third parties for property damage and for investigation and clean-up costs incurred by such parties in connection with the contamination. These laws typically impose clean-up responsibility and liability without regard to whether the owner or operator knew of or caused the presence of the contaminants. Even if more than one person may have been responsible for the contamination each person covered by the environmental laws may be held responsible for all of the clean-up costs incurred. In addition, third parties may sue the owner or operator of a site for damages and costs resulting from environmental contamination emanating from that site.
Substantially all of our properties have been the subject of environmental assessments completed by qualified independent environmental consultant companies. These environmental assessments have not revealed, nor are we aware of, any environmental liability that our management believes would have a material adverse effect on our business, results of operations, financial condition or liquidity.
Over the past three years, there have been an increasing number of lawsuits against owners and managers of multifamily properties other than EQR alleging personal injury and property damage caused by the presence of mold in residential real estate. Some of these lawsuits have resulted in substantial monetary judgments or settlements. Insurance carriers have reacted to these liability awards by excluding mold related claims from standard policies and pricing mold endorsements at prohibitively high rates. We have adopted programs designed to minimize the existence of mold in any of our properties as well as guidelines for promptly addressing and resolving reports of mold to minimize any impact mold might have on residents or the property.
We cannot be assured that existing environmental assessments of our properties reveal all environmental liabilities, that any prior owner of any of our properties did not create a material environmental condition not known to us, or that a material environmental condition does not
otherwise exist as to any one or more of our properties.
Insurance Policy Deductibles and Exclusions
In order to partially mitigate the substantial increase in insurance costs in recent years, management has determined to gradually increase deductible and self-insured retention amounts. As of December 31, 2003, the Operating Partnership’s property insurance policy (for Wholly Owned Properties) provides for a per occurrence deductible of $250,000 and self insured retention of $5.0 million per occurrence, subject to a maximum annual aggregate self insured retention of $7.5 million. The Operating Partnership’s liability and worker’s compensation policies at December 31, 2003, provide for a $1.0 million per occurrence deductible. While higher deductible and self-insured retention amounts expose the Operating Partnership to greater potential uninsured losses, management believes that the savings in insurance premium expense justifies this increased exposure.
As a result of the terrorist attacks of September 11, 2001, insurance carriers have created exclusions for losses from terrorism from our “all risk” insurance policies. While separate terrorism insurance coverage is available in certain instances, premiums for such coverage are generally very expensive, with very high deductibles. Moreover, the terrorism insurance coverage that are available typically excludes coverage for losses from acts of foreign governments as well as nuclear, biological and chemical attacks. At the present time, the Operating Partnership has determined that it is not economically prudent to obtain terrorism insurance for its portfolio to the extent otherwise available, especially given the significant risks that are not covered by such insurance. In the event of a terrorist attack impacting one or more of the properties, we could lose the revenues from the property, our capital investment in the property and possibly face liability claims from residents or others suffering injuries or losses. The Operating Partnership believes, however, that the number and geographic diversity of its portfolio helps to mitigate its exposure to the risks associated with potential terrorist attacks.
Debt Financing, Preferred Shares and Preference Interests and Units Could Adversely Affect Our Performance
General
The Operating Partnership’s total debt summary, as of December 31, 2003, included:
Debt Summary
* Net of the effect of any derivative instruments.
In addition to debt, the Operating Partnership has issued $919.1 million of combined liquidation value of outstanding preference interests and units, with a weighted average dividend preference of 8.17% per annum, as of December 31, 2003. Our use of debt and preferred equity financing creates certain risks, including the following:
Scheduled Debt Payments Could Adversely Affect Our Financial Condition
In the future, our cash flow could be insufficient to meet required payments of principal and interest or to pay distributions on our securities at expected levels.
We may not be able to refinance existing debt (which in virtually all cases requires substantial principal payments at maturity) and, if we can, the terms of such refinancing might not be as favorable as the terms of existing indebtedness. If principal payments due at maturity cannot be refinanced, extended or paid with proceeds of other capital transactions, such as new equity capital, our cash flow will not be sufficient in all years to repay all maturing debt. As a result, we may be forced to postpone capital expenditures necessary for the maintenance of our properties and may have to dispose of one or more properties on terms that would otherwise be unacceptable to us. The Operating Partnership’s debt maturity schedule as of December 31, 2003 is as follows:
Debt Maturity Schedule
(1) Includes $300 million of unsecured debt with a final maturity of 2015 that is putable/callable in 2005.
(2) Includes $150 million of unsecured debt with a final maturity of 2026 that is putable in 2006.
Financial Covenants Could Adversely Affect the Operating Partnership’s Financial Condition
If a property we own is mortgaged to secure payment of indebtedness and we are unable to meet the mortgage payments, the holder of the mortgage could foreclose on the property, resulting in loss of income and asset value. Foreclosure on mortgaged properties or an inability to refinance existing indebtedness would likely have a negative impact on our financial condition and results of operations. A foreclosure could also result in our recognition of taxable income without our actually receiving cash proceeds from the disposition of the property with which to pay the tax. This could adversely affect our cash flow and could make it more difficult for EQR to meet its REIT distribution requirements.
The mortgages on our properties may contain customary negative covenants that, among other things, limit our ability, without the prior consent of the lender, to further mortgage the property and to reduce or change insurance coverage. In addition, our unsecured credit facilities contain certain customary restrictions, requirements and other limitations on our ability to incur indebtedness. The indentures under which a substantial portion of our debt was issued also contain certain financial and operating covenants including, among other things, maintenance of certain financial ratios, as well as limitations on our ability to incur secured and unsecured indebtedness (including acquisition financing), and to sell all or substantially all of our assets. Our credit facility and indentures are cross-defaulted and also contain cross default provisions with other material indebtedness. Our unsecured public debt covenants as of December 31, 2003 and 2002, respectively, are (terms are defined in the indentures):
Unsecured Public Debt Covenants
Some of the properties were financed with tax-exempt bonds that contain certain restrictive covenants or deed restrictions. We have retained an independent outside consultant to monitor compliance with the restrictive covenants and deed restrictions that affect these properties. If these bond compliance requirements restrict our ability to increase our rental rates to attract low or moderate-income residents, or eligible/qualified residents, then our income from these properties may be limited.
Our Degree of Leverage Could Limit Our Ability to Obtain Additional Financing
Our Consolidated Debt-to-Total Market Capitalization Ratio was 35% as of December 31, 2003. We have a policy of incurring indebtedness for borrowed money only through ERPOP and its subsidiaries and only if upon such incurrence our debt to market capitalization ratio would be approximately 50% or less. Our degree of leverage could have important consequences to security holders. For example, the degree of leverage could affect our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, development or other general corporate purposes, making us more vulnerable to a downturn in business or the economy in general.
Rising Interest Rates Could Adversely Affect Cash Flow
Advances under our credit facility bear interest at variable rates based upon LIBOR at various interest periods, plus a spread dependent upon our credit rating, or based upon bids received from the lending group. Certain public issuances of our senior unsecured debt instruments may also, from time to time, bear interest at floating rates. We may also borrow additional money with variable interest rates in the future. Increases in interest rates would increase our interest expenses under these debt instruments and would increase the costs of refinancing existing indebtedness and of issuing new debt. Accordingly, higher interest rates could adversely affect cash flow and our ability to service our debt and to make distributions to security holders.
We Depend on Our Key Personnel
We depend on the efforts of the Chairman of EQR’s Board of Trustees, Samuel Zell, and EQR’s executive officers, particularly Bruce W. Duncan, EQR’s President and Chief Executive Officer and Gerald A. Spector, EQR’s Chief Operating Officer. If they resign, our operations could be temporarily adversely effected. Mr. Zell has entered into executive compensation and retirement benefit agreements with the Company. Mr. Duncan and Mr. Spector have entered into Deferred Compensation Agreements with the Company that under certain conditions could provide both with a salary benefit after their respective termination of employment with the Company. In addition, Mr. Zell and Mr. Spector have entered into Noncompetition Agreements with the Company and Mr. Duncan’s Employment Agreement contains covenants not to compete in favor of the Company.
Control and Influence by Significant OP Unit holders Could be Exercised in a Manner Adverse to Other OP Unit holders
The consent of certain affiliates of Mr. Zell is required for certain amendments to ERPOP’s Fifth Amended and Restated Agreement of Limited Partnership (the “Partnership Agreement”). As a result of their security ownership and rights concerning amendments to the Partnership Agreement, Mr. Zell may have substantial influence over ERPOP. Although these OP Unit holders have not agreed to act together on any matter, they would be in a position to exercise even more influence over ERPOP’s affairs if they were to act together in the future. This influence might be exercised in a manner that is inconsistent with the interests of other OP Unit holders.
Our Success is Dependent on our General Partner’s Compliance With Federal Income Tax Requirements
We rely to a significant extent upon our general partner, EQR, as our source of equity capital. EQR is required to satisfy numerous technical requirements to remain qualified as a REIT for federal income tax purposes. EQR’s failure to qualify as a REIT could have a material adverse impact upon its, and consequently our, ability to raise equity capital. Please see the “Risk Factors-Our Success as a REIT is Dependent on Compliance with Federal Income Tax Requirements” and “Federal Income Tax Consideration” sections in EQR’s Annual Report on Form 10-K for a discussion of these federal income tax considerations
Our General Partner’s Compliance with REIT Distribution Requirements May Affect Our Financial Condition
Distribution Requirements May Increase the Indebtedness of the Operating Partnership
We may be required from time to time, under certain circumstances, to accrue as income for tax purposes interest and rent earned but not yet received. In such event, or upon our repayment of principal on debt, we could have taxable income without sufficient cash to enable our general partner to meet the distribution requirements of a REIT. Accordingly, we could be required to borrow funds or liquidate investments on adverse terms in order to meet these distribution requirements.
Available Information
You may access our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and any amendments to any of those reports we file with the SEC free of charge at our website, www.equityapartments.com. These reports are made available at our website as soon as reasonably practicable after we file them with the SEC.
Item 2.
Item 2. The Properties
As of December 31, 2003, the Operating Partnership owned or had investments in 968 properties in 34 states consisting of 207,506 units. The Operating Partnership’s properties are more fully described as follows:
Resident leases are generally for twelve months in length and typically require security deposits. The garden-style properties are generally defined as properties with two and/or three story buildings while the mid-rise/high-rise are defined as properties with greater than three story buildings. These two property types typically provide residents with amenities, which may include a clubhouse, swimming pool, laundry facilities and cable television access. Certain of these properties offer additional amenities such as saunas, whirlpools, spas, sports courts and exercise rooms or other amenities. The ranch-style properties are defined as single story properties, which do not provide additional amenities for residents other than laundry facilities and cable television access. The military housing properties are defined as those properties located on military bases.
It is management’s role to monitor compliance with property policies and to provide preventive maintenance of the properties including common areas, facilities and amenities. The Operating Partnership has a dedicated training and education department that creates and coordinates training and strategic implementation for the Operating Partnership’s property management personnel. The Operating Partnership believes that, due in part to its emphasis on training and employee quality, the properties historically have had high occupancy rates.
The distribution of the properties throughout the United States reflects the Operating Partnership’s belief that geographic diversification helps insulate the portfolio from regional and economic influences. At the same time, the Operating Partnership has sought to create clusters of properties within each of its primary markets in order to achieve economies of scale in management and operation. The Operating Partnership may nevertheless acquire additional multifamily properties located anywhere in the continental United States.
The following tables set forth certain information by type and state relating to the Operating Partnership’s properties at December 31, 2003:
GARDEN-STYLE PROPERTIES
MID-RISE/HIGH-RISE PROPERTIES
RANCH-STYLE PROPERTIES
MILITARY HOUSING PROPERTIES
The properties currently in various stages of development at December 31, 2003 are included in the following table.
DEVELOPMENT PROJECTS as of December 31, 2003
(Amounts in millions except for project and unit amounts)
(1) The Operating Partnership generally funds between 25% and 35% of the estimated development cost for the unconsolidated projects (constituting 100% of the equity), with the remaining cost financed through third-party construction mortgages.
(2) Properties were substantially complete as of December 31, 2003. As such, these properties are also included in the outstanding property and unit counts.
Item 3.
Item 3. Legal Proceedings
The Operating Partnership is a party to a class action lawsuit in Florida state court alleging that several of the types of fees that the Operating Partnership charged when residents breached their leases were illegal, as were all efforts to collect them. The Operating Partnership is vigorously contesting the plaintiffs’ claims and has sought immediate appellate review of the 2003 class action certification decision. Due to the uncertainty of many critical factual and legal issues, including the viability of the case as a class action, it is not possible to determine or predict the outcome. While no assurances can be given, the Operating Partnership does not believe that this lawsuit, if adversely determined, will have a material adverse effect on the Operating Partnership.
The Operating Partnership does not believe there is any other litigation pending or threatened against the Operating Partnership which, individually or in the aggregate, reasonably may be expected to have a material adverse effect on the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Shareholder Matters
There is no established public trading market for the OP Units.
The following table sets forth, for the years indicated, the distributions paid on the Operating Partnership’s OP Units:
The number of holders of record of OP Units and Junior Convertible Preference Units in the Operating Partnership at January 31, 2004, were 434 and 26, respectively. The number of outstanding OP Units and Junior Convertible Preference Units as of January 31, 2004 were 300,201,002 and 27,700 respectively.
OP Units Issued in 2003
During 2003, the Operating Partnership directly issued 165,628 OP Units having a value of $4.6 million in exchange for direct or indirect interests in multifamily properties in private placement transactions under section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”). OP Units are generally exchangeable into Common Shares of EQR on a one-for-one basis or, at the option of EQR, the cash equivalent thereof at any time one year after the date of issuance.
On October 31, 2003, the Operating Partnership issued 6,201 OP Units to former partners of Glen Meadow Associates, L.P. This issuance was made in connection with certain contingent “earnout” rights granted to such former partners upon Grove Property Trust’s (“Grove”) acquisition of the Glen Meadow property in 1998. The Operating Partnership succeeded to Grove’s earnout obligations as a result of the Grove merger in 2000. No separate consideration was payable upon issuance of these OP Units. The Operating Partnership relied upon certifications from each such former partner as to his or her status as an “accredited investor” within the meaning of SEC rule 501 to claim an exemption from registration under Securities Act section 4(2).
On December 22, 2003, the Operating Partnership issued 148,092 OP Units as a result of the automatic conversion of 36,283 Series A Junior Convertible Preference Units.
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected financial and operating information on a historical basis for the Operating Partnership. The following information should be read in conjunction with all of the financial statements and notes thereto included elsewhere in this Form 10-K. The historical operating and balance sheet data have been derived from the historical Financial Statements of the Operating Partnership. All amounts have also been restated in accordance with the discontinued operations provisions of SFAS No. 144. Certain capitalized terms as used herein are defined in the Notes to Consolidated Financial Statements.
CONSOLIDATED HISTORICAL FINANCIAL INFORMATION
(Financial information in thousands except for per share and property data)
(1) The National Association of Real Estate Investment Trusts (“NAREIT”) defines funds from operations (“FFO”) (April 2002 White Paper) as net income (computed in accordance with accounting principles generally accepted in the United States), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis. FFO has also been adjusted by preferred distributions and premium on redemption of preference units to arrive at FFO available to OP Units. The April 2002 White Paper states that gain or loss on sales of property is excluded from FFO for previously depreciated operating properties only. Once the Operating Partnership commences the conversion of units to condominiums, it simultaneously discontinues depreciation of such property. Accordingly, the Operating Partnership included in FFO its incremental gains or losses from the sale of condominium units to third parties, which represented net gains of $10,280, $1,682 and $0 for the years ended December 31, 2003, 2002 and 2001, respectively. Effective January 1, 2003, the Operating Partnerhsip no longer adds back
impairment losses when computing FFO in accordance with NAREIT’s definition. As a result, FFO for the years ended December 31, 2002, 2001 and 2000 have been reduced by $18,284, $71,766 and $1,000, respectively, to conform to the current year presentation. For the year ended December 31, 2001, FFO has been reduced by $5,324 to reflect the SEC’s clarification of EITF Topic D-42 regarding premiums on redemption of preference units. See Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion and analysis of the results of operations and financial condition of the Operating Partnership should be read in connection with the Consolidated Financial Statements and Notes thereto. Due to the Operating Partnership’s ability to control its subsidiaries (other than entities owning interests in the Unconsolidated Properties and certain other entities in which it has investments), each such subsidiary entity has been consolidated for financial reporting purposes. Capitalized terms used herein and not defined are as defined elsewhere in this Annual Report on Form 10-K for the year ended December 31, 2003.
Forward-looking statements in this Item 7 as well as Item 1 of this Annual Report on Form 10-K are intended to be made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believes”, “estimates”, “expects” and “anticipates” and other similar expressions that are predictions of or indicate future events and trends and which do not relate solely to historical matters identify forward-looking statements. Such forward-looking statements are subject to risks and uncertainties, which could cause actual results, performance, or achievements of the Operating Partnership to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Factors that might cause such differences include, but are not limited to, the following:
• The total number of development units, cost of development and completion dates as well as anticipated capital expenditures for replacements and building improvements all reflect the Operating Partnership’s best estimates and are subject to uncertainties arising from changing economic conditions (such as the cost of labor and construction materials), competition and local government regulation;
• Sources of capital to the Operating Partnership or labor and materials required for maintenance, repair, capital expenditure or development are more expensive than anticipated;
• Occupancy levels and market rents may be adversely affected by national and local economic and market conditions including, without limitation, new construction of multifamily housing, slow employment growth, availability of low interest mortgages for single-family home buyers and the potential for geopolitical instability, all of which are beyond the Operating Partnership’s control; and
• Additional factors as discussed in Part I of this Annual Report on Form 10-K, particularly those under “Risk Factors”.
Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Operating Partnership undertakes no obligation to publicly release any revisions to these forward-looking statements, which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Forward-looking statements and related uncertainties are also included in Note 7 and 14 to the Notes to Consolidated Financial Statements in this report.
Results of Operations
The following table summarizes the number of properties and related units for the periods presented:
Properties that the Operating Partnership owned for all of both 2003 and 2002 (the “2003 Same Store Properties”), which represented 171,841 units, impacted the Operating Partnership’s results of operations. Properties that the Operating Partnership owned for all of both 2002 and 2001 (the “2002 Same Store Properties”), which represented 188,027 units, also impacted the Operating Partnership’s results of operations. Both the 2003 Same Store Properties and 2002 Same Store Properties are discussed in the following paragraphs.
The Operating Partnership’s acquisition, disposition and completed development activities also impacted overall results of operations for the years ended December 31, 2003 and 2002. The impacts of these activities are also discussed in greater detail in the following paragraphs.
Comparison of the year ended December 31, 2003 to the year ended December 31, 2002
For the year ended December 31, 2003, income before allocation to Minority Interests, income (loss) from investments in unconsolidated entities, net gain on sales of unconsolidated entities, discontinued operations and cumulative effect of change in accounting principle decreased by approximately $23.1 million when compared to the year ended December 31, 2002.
Revenues from the 2003 Same Store Properties decreased primarily as a result of lower overall physical occupancy, increased concessions and lower rental rates charged to both new and renewal residents. Property operating expenses from the 2003 Same Store Properties increased primarily due to higher payroll, maintenance, utility, real estate taxes, insurance, leasing and advertising and building costs. The following tables provide comparative revenue, expense, net operating income (“NOI”) and
weighted average occupancy for the 2003 Same Store Properties (NOI represents rental income less: property and maintenance expense; real estate taxes and insurance expense; and property management expense):
2003 vs. 2002
Year over Year Same-Store Results
$in Millions - 171,841 Same-Store Units
Same-Store Occupancy Statistics
The Operating Partnership’s primary financial measure for evaluating each of its apartment communities is NOI. The Operating Partnership believes that NOI is helpful to investors as a supplemental measure of the operating performance of a real estate company because it is a direct measure of the actual operating results of the Operating Partnership’s apartment communities.
For properties that the Operating Partnership acquired prior to January 1, 2003 and expects to continue to own through December 31, 2004, the Operating Partnership anticipates the following same store results for the full year ending December 31, 2004:
Same-Store Assumptions
These 2004 assumptions are based on current expectations and are forward-looking.
Rental income from properties other than 2003 Same Store Properties increased by approximately $47.5 million primarily as a result of revenue from newly acquired properties not yet included as 2003 Same Store Properties and additional Partially Owned Properties consolidated in the fourth quarter of 2002 and during the year ended December 31, 2003.
Fee and asset management revenues, net of fee and asset management expenses, increased by $4.9 million primarily as a result of additional income allocated from Ft. Lewis. As of December 31, 2003 and 2002, the Operating Partnership managed 18,475 units and 18,965 units, respectively, for third parties and unconsolidated entities.
Property management expenses include off-site expenses associated with the self-management of the Operating Partnership’s properties as well as management fees paid to any third party management companies. These expenses decreased by approximately $4.4 million or 6.0%. This decrease is primarily
attributable to a reversal of a profit sharing accrual in the first quarter of 2003 related to the 2002 calendar year as the Operating Partnership didn’t achieve its stated goals and management elected not to make a discretionary contribution to the plan. In addition, the Operating Partnership recorded lower expense in connection with granting less EQR restricted shares and reducing the expense associated with the Operating Partnership’s matched funding of its 401(k) plan during 2003 and not incurring an expense for 2003 discretionary profit sharing contributions.
Depreciation expense, which includes depreciation on non-real estate assets, increased $25.3 million primarily as a result of properties acquired after December 31, 2002, many of which had significantly higher per unit acquisition costs than properties previously acquired, and additional depreciation on capital expenditures for all properties owned.
General and administrative expenses, which include corporate operating expenses, decreased approximately $7.7 million between the periods under comparison. This decrease was primarily due to lower expenses recorded in connection with granting less EQR restricted shares to employees during 2003, partially offset by approximately a $2.6 million increase related to EQR’s decision to begin to expense its stock based compensation in accordance with SFAS No. 123 and its amendment (SFAS No. 148). In addition, lower state income and franchise taxes also contributed to this decrease.
The Operating Partnership recorded impairment charges on its technology investments and its corporate housing business of approximately $1.2 million and $18.3 million for the years ended December 31, 2003 and 2002, respectively. See Note 22 in the Notes to Consolidated Financial Statements for further discussion.
Interest and other income increased by approximately $1.4 million, primarily as a result of higher cash balances available for short-term investments throughout 2003.
Interest expense, including amortization of deferred financing costs, decreased approximately $6.1 million primarily due to lower variable interest rates and lower overall levels of debt. During the year ended December 31, 2003, the Operating Partnership capitalized interest costs of approximately $20.6 million as compared to $27.2 million for the year ended December 31, 2002. This capitalization of interest primarily related to equity investments in unconsolidated entities engaged in development activities. The effective interest cost on all indebtedness for the year ended December 31, 2003 was 6.36% as compared to 6.54% for the year ended December 31, 2002.
Loss from investments in unconsolidated entities increased approximately $6.4 million between the periods under comparison. This increase is primarily the result of increased operating losses from equity investments partially offset by unrealized gains on derivative instruments.
Net gain on sales of discontinued operations increased approximately $206.4 million between the periods under comparison. This increase is primarily the result of a greater number of properties sold during the year ended December 31, 2003, as well as the fact that several properties had lower net carrying values at sale.
Discontinued operations, net, decreased approximately $48.6 million between the periods under comparison. See Note 16 in the Notes to Consolidated Financial Statements for further discussion.
Comparison of the year ended December 31, 2002 to the year ended December 31, 2001
For the year ended December 31, 2002, income before allocation to Minority Interests, income (loss) from investments in unconsolidated entities, net gain on sales of unconsolidated entities, discontinued operations and cumulative effect of change in accounting principle decreased by approximately $61.0 million when compared to the year ended December 31, 2001.
Revenues from the 2002 Same Store Properties decreased primarily as a result of lower overall physical occupancy, increased concessions and lower rental rates charged to both new and renewal residents. Property operating expenses from the 2002 Same Store Properties, which include property and maintenance, real estate taxes and insurance and an allocation of property management expenses, remained relatively stable with increases in real estate taxes and insurance costs offset by a decrease in utility costs. The following tables provide comparative revenue, expense, NOI and weighted average occupancy for the 2002 Same Store Properties:
2002 vs. 2001
Year over Year Same-Store Results
$in Millions - 188,027 Same Store Units
Same-Store Occupancy Statistics
Rental income from properties other than 2002 Same Store Properties increased by approximately $19.8 million primarily as a result of revenue from newly acquired properties not yet included as 2002 Same Store Properties.
Fee and asset management revenues, net of fee and asset management expenses, increased by $1.5 million as a result of managing additional units at Fort Lewis, Washington starting in April 2002. As of December 31, 2002 and 2001, the Operating Partnership managed 18,965 units and 16,539 units, respectively, for third parties and unconsolidated entities.
Property management expenses include off-site expenses associated with the self-management of the Operating Partnership’s properties. These expenses decreased by approximately $4.6 million or 5.9%. This decrease is primarily attributable to lower amounts accrued for employee bonuses and profit sharing for 2002 and lower headcount in 2002.
Depreciation expense, which includes depreciation on non-real estate assets, increased $22.3 million primarily as a result of properties acquired after December 31, 2001, many of which had significantly higher per unit acquisition costs than properties previously acquired, and additional depreciation on capital expenditures for all properties owned.
General and administrative expenses, which include corporate operating expenses, increased approximately $11.1 million between the years under comparison. This increase was primarily due to retirement plan expenses for certain key executives, EQR restricted shares/awards granted to key employees, additional compensation charges and costs associated with EQR’s new President, higher state income taxes in Michigan and New Jersey and income taxes incurred by one of the Company’s taxable REIT subsidiaries which has an ownership interest in properties that in prior periods were classified as Unconsolidated Properties.
The Operating Partnership recorded impairment charges on its technology investments and its corporate housing business of approximately $18.3 million and $11.8 million for the years ended December 31, 2002 and 2001, respectively. See Note 22 in the Notes to Consolidated Financial Statements for further discussion.
Interest and other income decreased by approximately $6.7 million, primarily as a result of lower balances available for investment and related interest rates being earned on short-term investment accounts along with lower balances on deposit in tax-deferred exchange accounts.
Interest income - investment in mortgage notes decreased by $8.8 million as a result of the consolidation of previously Unconsolidated Properties in July 2001. No additional interest income will be recognized on such mortgage notes in future years as the Operating Partnership now consolidates the results related to these previously Unconsolidated Properties.
Interest expense, including amortization of deferred financing costs, decreased approximately $11.0 million primarily due to lower variable interest rates and lower overall levels of debt. During the year ended December 31, 2002, the Operating Partnership capitalized interest costs of approximately $27.2 million as compared to $28.2 million for the year ended December 31, 2001. This capitalization of interest primarily related to equity investments in unconsolidated entities engaged in development activities. The effective interest cost on all indebtedness for the year ended December 31, 2002 was 6.54% as compared to 6.89% for the year ended December 31, 2001.
Income (loss) from investments in unconsolidated entities decreased approximately $7.5 million between the periods under comparison. This decrease is primarily the result of increased equity losses and unrealized losses on derivative instruments.
Net gain on sales of discontinued operations decreased approximately $44.6 million between the periods under comparison. This decrease is primarily the result of the properties sold in 2001 having a lower net carrying value at sale, which resulted in higher gain recognition for financial reporting purposes.
Discontinued operations, net, increased approximately $48.5 million between the periods under comparison. This increase is primarily attributable to a one-time $60.0 million impairment on the furniture rental business in 2001, which was subsequently sold in January 2002. See Note 16 in the Notes to Consolidated Financial Statements for further discussion.
Liquidity and Capital Resources
For the Year Ended December 31, 2003
As of January 1, 2003, the Operating Partnership had approximately $29.9 million of cash and cash equivalents and $499.2 million available under its line of credit (net of $60.8 million which was restricted/dedicated to support letters of credit and not available for borrowing). After taking into effect the various transactions discussed in the following paragraphs and the net cash provided by operating activities, the Operating Partnership’s cash and cash equivalents balance at December 31, 2003 was approximately $49.6 million and the amount available on the Operating Partnership’s line of credit was $633.3 million (net of $56.7 million which was restricted/dedicated to support letters of credit and not available for borrowing).
During the year ended December 31, 2003, the Operating Partnership generated proceeds from various transactions, which included the following:
• Disposed of ninety-six properties (including two Unconsolidated Properties) and received net proceeds of approximately $1.1 billion;
• Issued $400.0 million of 5.20% fixed rate unsecured debt receiving net proceeds of $397.5 million;
• Issued $150.0 million of 6.48% Series N Cumulative Redeemable Preference Units and received net proceeds of $145.3 million;
• Obtained $111.2 million in new mortgage financing; and
• Issued approximately 3.5 million OP Units and received net proceeds of $74.7 million.
During the year ended December 31, 2003, the above proceeds were primarily utilized to:
• Acquire seventeen properties, and two additional units at an existing property, utilizing cash of $595.1 million;
• Pay OP Unit dividends of $510.7 million ($1.73 per share);
• Pay preference interest/unit dividends of $99.9 million;
• Repay $432.9 million of mortgage loans;
• Repay $130.0 million on its line of credit;
• Repay $100.0 million of floating rate public notes at maturity;
• Repay $50.0 million and $40.0 million of 6.65% and 6.875%, respectively, fixed rate public notes at maturity;
• Repay $4.5 million of other unsecured notes;
• Redeem $295.3 million of 7.25% Series G Convertible Cumulative Preference Units which included a cash redemption premium of $8.3 million; and
• Redeem $100.0 million of 7.625% Series L Cumulative Redeemable Preference Units at liquidation value.
Depending on its analysis of market prices, economic conditions, and other opportunities for the investment of available capital, the Company may repurchase up to an additional $85.0 million of its Common Shares pursuant to its existing share buyback program authorized by the Board of Trustees. The Operating Partnership in turn would repurchase $85.0 million of its OP Units held by EQR. The Operating Partnership did not repurchase any of EQR’s Common Shares during the year ended December 31, 2003.
The Operating Partnership’s total debt summary and debt maturity schedule as of December 31, 2003, are as follows:
Debt Summary
* Net of the effect of any interest rate protection agreements.
Debt Maturity Schedule
(1) Includes $300 million of unsecured debt with a final maturity of 2015 that is putable/callable in 2005.
(2) Includes $150 million of unsecured debt with a final maturity of 2026 that is putable in 2006.
In June 2003, the Operating Partnership filed and the SEC declared effective a Form S-3 registration statement to register $2.0 billion of debt securities. In addition, the Operating Partnership carried over $280.0 million related to a prior registration statement. As of February 4, 2004, $2.28 billion in debt securities remained available for issuance under this registration statement.
The Operating Partnership’s “Consolidated Debt-to-Total Market Capitalization Ratio” as of December 31, 2003 is presented in the following table. The Operating Partnership calculates the equity component of its market capitalization as the sum of (i) the total outstanding OP Units at the equivalent market value of the closing price of EQR’s Common Shares on the New York Stock Exchange; (ii) the “OP Unit Equivalent” of all convertible preference interests/units; and (iii) the liquidation value of all perpetual preference interests/units outstanding.
Capitalization as of December 31, 2003
Convertible Preference Units, Preference Interests
and Junior Preference Units
as of December 31, 2003
The Operating Partnership’s policy is to maintain a ratio of consolidated debt-to-total market capitalization of less than 50%.
From January 1, 2004 through February 4, 2004, the Operating Partnership:
• Acquired four properties (including two additional units at an existing property) consisting of 1,130 units for approximately $151.3 million;
• Assumed $36.9 million of mortgage debt on one property in connection with its acquisition;
• Disposed of twelve properties (including one Unconsolidated Property) and various individual condominium units consisting of 2,972 units for approximately $140.9 million;
• Obtained $16.5 million in new mortgage financing; and
• Repaid $50.0 million of mortgage loans.
Capitalization of Fixed Assets and Improvements to Real Estate
Our policy with respect to capital expenditures is generally to capitalize expenditures that improve the value of the property or extend the useful life of the component asset of the property. We track improvements to real estate in two major categories and several subcategories:
• Replacements (inside the unit). These include:
• carpets and hardwood floors;
• appliances;
• mechanical equipment such as individual furnace/air units, hot water heaters, etc;
• furniture and fixtures such as kitchen/bath cabinets, light fixtures, ceiling fans, sinks, tubs, toilets, mirrors, countertops, etc;
• flooring such as vinyl, linoleum or tile; and
• blinds/shades.
All replacements are depreciated over a five-year estimated useful life. We expense as incurred all maintenance and turnover costs such as cleaning, interior painting of individual units and the repair of any replacement item noted above.
• Building improvements (outside the unit). These include:
• roof replacement and major repairs;
• paving or major resurfacing of parking lots, curbs and sidewalks;
• amenities and common areas such as pools, exterior sports and playground equipment, lobbies, clubhouses, laundry rooms, alarm and security systems and offices;
• major building mechanical equipment systems;
• interior and exterior structural repair and exterior painting and siding;
• major landscaping and grounds improvement; and
• vehicles and office and maintenance equipment.
All building improvements are depreciated over a five to ten-year estimated useful life. We expense as incurred all recurring expenditures that do not improve the value of the asset or extend its useful life.
For the year ended December 31, 2003, our actual improvements to real estate totaled approximately $181.9 million. This includes the following detail (amounts in thousands except for unit and per unit amounts):
Capitalized Improvements to Real Estate
For the Year Ended December 31, 2003
(1) Total units exclude 22,578 unconsolidated units.
(2) Wholly Owned Properties acquired prior to January 1, 2001.
(3) Wholly Owned Properties acquired during 2001, 2002 and 2003. Per unit amounts are based on a weighted average of 10,533 units.
(4) Includes properties either Partially Owned or sold during the period, commercial space, condominium conversions and $6.5 million included in building improvements spent on seven specific assets related to major renovations and repositioning of these assets.
For the year ended December 31, 2002, our actual improvements to real estate totaled approximately $156.8 million. This includes the following detail (amounts in thousands except for unit and per unit amounts):
Capitalized Improvements to Real Estate
For the Year Ended December 31, 2002
(1) Total units exclude 21,774 unconsolidated units.
(2) Wholly Owned Properties acquired prior to January 1, 2000.
(3) Wholly Owned Properties acquired during 2000, 2001 and 2002. Per unit amounts are based on a weighted average of 19,478 units.
(4) Includes properties either Partially Owned or sold during the period, commercial space, condominium conversions and $9.1 million included in building improvements spent on six specific assets related to major renovations and repositioning of these assets.
The Operating Partnership expects to fund approximately $160.0 million for capital expenditures for replacements and building improvements for all consolidated properties in 2004.
During the year ended December 31, 2003, the Operating Partnership’s total non-real estate capital additions, such as computer software, computer equipment, and furniture and fixtures and leasehold improvements to the Operating Partnership’s property management offices and its corporate offices, was approximately $2.9 million. The Operating Partnership expects to fund approximately $6.5 million in total additions to non-real estate property in 2004.
Improvements to real estate and additions to non-real estate property were funded from net cash provided by operating activities.
Derivative Instruments
In the normal course of business, the Operating Partnership is exposed to the effect of interest rate changes. The Operating Partnership limits these risks by following established risk management policies and procedures including the use of derivatives to hedge interest rate risk on debt instruments.
The Operating Partnership has a policy of only entering into contracts with major financial institutions based upon their credit ratings and other factors. When viewed in conjunction with the underlying and offsetting exposure that the derivatives are designed to hedge, the Operating Partnership has not sustained a material loss from those instruments nor does it anticipate any material adverse effect on its net income or financial position in the future from the use of derivatives.
See Note 14 in the Notes to Consolidated Financial Statements for additional discussion of derivative instruments at December 31, 2003.
Other
Total distributions paid in January 2004 amounted to $141.9 million (excluding distributions on Partially Owned Properties), which included certain distributions declared during the fourth quarter ended December 31, 2003.
The Operating Partnership expects to meet its short-term liquidity requirements, including capital expenditures related to maintaining its existing properties and certain scheduled unsecured note and mortgage note repayments, generally through its working capital, net cash provided by operating activities and borrowings under its line of credit. The Operating Partnership considers its cash provided by operating activities to be adequate to meet operating requirements and payments of distributions. The Operating Partnership also expects to meet its long-term liquidity requirements, such as scheduled unsecured note and mortgage debt maturities, property acquisitions, financing of construction and development activities and capital improvements through the issuance of unsecured notes and equity securities, including additional OP Units, and proceeds received from the disposition of certain properties. In addition, the Operating Partnership has significant unencumbered properties available to secure additional mortgage borrowings in the event that the public capital markets are unavailable or the cost of alternative sources of capital is too high. The fair value of and cash flow from these unencumbered
properties are in excess of the requirements the Operating Partnership must maintain in order to comply with covenants under its unsecured notes and line of credit.
The Operating Partnership has a revolving credit facility with potential borrowings of up to $700.0 million. This facility matures in May 2005 and may, among other potential uses, be used to fund property acquisitions, costs for certain properties under development and short term liquidity requirements. As of March 1, 2004, $255.0 million was outstanding under this facility (and $56.7 was restricted and dedicated to support letters of credit).
Off-Balance Sheet Arrangements and Contractual Obligations
The Operating Partnership has co-invested in various properties with unrelated third parties that are unconsolidated and accounted for under the equity method of accounting. Management does not believe these investments have a materially different impact upon the Operating Partnership’s liquidity, capital resources, credit or market risk than its property management and ownership activities generally, except to the extent the development ventures mitigate risk by deploying the skill and expertise of locally based real estate developers. The nature and business purpose of these ventures are as follows:
• Institutional Ventures - During 2000 and 2001, the Operating Partnership entered into ventures with an unaffiliated partner. At the respective closing dates, the Operating Partnership sold and/or contributed 45 properties containing 10,846 units to these ventures and retained a 25% ownership interest in the ventures. The Operating Partnership’s joint venture partner contributed cash equal to 75% of the agreed-upon equity value of the properties comprising the ventures, which was then distributed to the Operating Partnership. The Operating Partnership’s strategy with respect to these ventures was to reduce its concentration of properties in a variety of markets.
• Development Ventures - Since 1998, the Operating Partnership has generally engaged in development activities through various joint ventures with third party developers. The Operating Partnership uses the local expertise of these developers and lowers the overall risks associated with development by grouping various development properties into aggregated pools. The Operating Partnership generally contributes between 25% and 35% of these projects with the remaining cost financed through third-party construction mortgages. Voting rights are shared equally between the Operating Partnership and its respective development partners.
As of December 31, 2003, the Operating Partnership has 13 projects in various stages of development with estimated completion dates ranging through June 30, 2005. The three development agreements currently in place have the following key terms:
• The first development partner has the right, at any time following completion of a project, to stipulate a value for such project and offer to sell its interest in the project to the Operating Partnership based on such value. If the Operating Partnership chooses not to purchase the interest, it must agree to a sale of the project to an unrelated third party at such value. The Operating Partnership’s partner must exercise this right as to all projects within five years after the receipt of the final certificate of occupancy on the last developed property. In connection with this development agreement, the Operating Partnership has an obligation to provide up to $40.0 million in credit enhancements to guarantee a portion of the third party construction financing. As of February 4, 2004, the Operating Partnership had set-aside $20.0 million towards this credit enhancement. The Operating Partnership would be required to perform under this agreement only if there was a material default under a third party construction mortgage agreement. This agreement expires no later than December 31, 2018. Notwithstanding the termination of the agreement, the Operating Partnership shall have recourse against its development partner for any losses incurred.
• The second development partner has the right, at any time following completion of a project, to require the Operating Partnership to purchase the partners’ interest in that project at a mutually agreeable price. If the Operating Partnership and the partner are unable to agree on a price, both parties will obtain appraisals. If the appraised values vary by more than 10%, both the Operating Partnership and its partner will agree on a third appraiser to determine which original appraisal is closest to its determination of value. The Operating Partnership may elect at that time not to purchase the property and instead, authorize its partner to sell the project at or above the agreed-upon value to an unrelated third party. Five years following the receipt of the final certificate of occupancy on the last developed property, the Operating Partnership must purchase, at the agreed-upon price, any projects remaining unsold.
• The third development partner has the exclusive right for six months following stabilization (generally defined as having achieved 90% occupancy for three consecutive months following the substantial completion of a project) to market a project for sale. Thereafter, either the Operating Partnership or its development partner may market a project for sale. If the Operating Partnership’s development partner proposes the sale, the Operating Partnership may elect to purchase the project at the price proposed by its partner or defer the sale until two independent appraisers appraise the project. If the two appraised values vary by more than 5%, a third appraiser will be chosen to determine the fair market value of the property. Once a value has been determined, the Operating Partnership may elect to purchase the property or authorize its development partner to sell the project at the agreed-upon value.
See Note 9 in the Notes to Consolidated Financial Statements for additional discussion regarding the Operating Partnership’s investments in unconsolidated entities.
In connection with one of its mergers, the Operating Partnership provided a guaranty of a credit enhancement agreement with respect to certain tax-exempt bonds issued to finance certain public improvements at a multifamily development project. The Operating Partnership has the obligation to provide this guaranty for a period of eight years from the consummation of the merger or through May 2005. The Operating Partnership would be required to perform under this guaranty only if there was a draw on the letter of credit issued by the credit enhancement party. The counterparty has also indemnified the Operating Partnership for any losses suffered. As of February 4, 2004, this guaranty was still in effect at a commitment amount of $12.7 million and no current outstanding liability.
The following table summarizes the Operating Partnership’s contractual obligations for the next five years and thereafter as of December 31, 2003:
Payments Due by Year (in thousands)
(a) Amounts include aggregate principal payments only. The Operating Partnership paid $352,391, $365,782 and $380,745 for interest on debt, inclusive of derivate instruments, for the years ended December 31, 2003, 2002 and 2001, respectively.
(b) Minimum basic rent due for various office space the Operating Partnership leases and fixed base rent due on a ground lease for one property.
(c) Estimated payments to EQR’s Chairman, former CEO and two other executive officers based on planned retirement dates.
(d) Promissory note due on one property.
Critical Accounting Policies and Estimates
The Operating Partnership’s significant accounting policies are described in Note 2 in the Notes to Consolidated Financial Statements. These policies were followed in preparing the consolidated financial statements at and for the year ended December 31, 2003.
The Operating Partnership has identified six significant accounting policies as critical accounting policies. These critical accounting policies are those that have the most impact on the reporting of our financial condition and those requiring significant judgments and estimates. With respect to these critical accounting policies, management believes that the application of judgments and assessments is consistently applied and produces financial information that fairly presents the results of operations for all periods presented. The six critical accounting policies are:
Impairment of Long-Lived Assets, Including Goodwill
The Operating Partnership periodically evaluates its long-lived assets, including its investments in real estate and goodwill, for indicators of permanent impairment. The judgments regarding the existence of impairment indicators are based on factors such as operational performance, market conditions, expected holding period of each asset and legal and environmental concerns. Future events could occur which would cause the Operating Partnership to conclude that impairment indicators exist and an impairment loss is warranted.
Depreciation of Investment in Real Estate
The Operating Partnership depreciates the building component of its investment in real estate over a 30-year estimated useful life, building improvements over a 5-year to 10-year estimated useful life and both the furniture, fixtures and equipment and replacements components over a 5-year estimated useful life, all of which are judgmental determinations.
Cost Capitalization
See the Capitalization of Fixed Assets and Improvements to Real Estate section for discussion of the policy with respect to capitalization vs. expensing of fixed asset/repair and maintenance costs. In addition, the Operating Partnership capitalizes the payroll and associated costs of employees directly responsible for and who spend all of their time on the supervision of major capital projects. These costs are reflected on the balance sheet as an increase to depreciable property.
The Operating Partnership follows the guidance in SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, for all development projects and uses its professional judgment in determining whether such costs meet the criteria for capitalization or must be expensed as incurred. The Operating Partnership capitalizes interest, real estate taxes and insurance and payroll and associated costs for those individuals directly responsible for and who spend all of their time on development activities. The Operating Partnership expenses as incurred all payroll costs of employees working directly at our properties, except for costs that are incurred during the initial lease-up phase on
a development project. An allocated portion of payroll costs is capitalized based upon the occupancy of the project until stabilized occupancy is achieved. The incremental payroll and associated costs are capitalized to the projects under development based upon the effort directly identifiable with such projects. These costs are reflected on the balance sheet as either construction in progress or a separate component of investments in unconsolidated entities. The Operating Partnership ceases the capitalization of such costs as the property becomes substantially complete and ready for its intended use.
Fair Value of Financial Instruments, Including Derivative Instruments
The valuation of financial instruments under SFAS No. 107 and SFAS No. 133 and its amendments (SFAS Nos. 137/138/149) requires the Operating Partnership to make estimates and judgments that affect the fair value of the instruments. The Operating Partnership, where possible, bases the fair values of its financial instruments, including its derivative instruments, on listed market prices and third party quotes. Where these are not available, the Operating Partnership bases its estimates on other factors relevant to the financial instruments.
Revenue Recognition
Rental income attributable to leases is recorded when due from residents and is recognized monthly as it is earned, which is not materially different than on a straight-line basis. Leases entered into between a resident and a property for the rental of an apartment unit are generally year-to-year, renewable upon consent of both parties on an annual or monthly basis. Interest income is recorded on an accrual basis.
Stock-Based Compensation
Prior to 2003, the Company had chosen to account for its stock-based compensation in accordance with APB No. 25, Accounting for Stock Issued to Employees, which resulted in no compensation expense for options issued with an exercise price equal to or exceeding the market value of EQR’s Common Shares on the date of grant (intrinsic method). The Company has elected to account for its stock-based compensation in accordance with SFAS No. 123 and its amendment (SFAS No. 148), Accounting for Stock Based Compensation, effective in the first quarter of 2003, which resulted in compensation expense being recorded based on the fair value of the stock compensation granted. Any Common Shares issued pursuant to EQR’s incentive equity compensation and employee share purchase plans will result in the Operating Partnership issuing OP Units to EQR on a one-for-one basis, with the Operating Partnership receiving the net cash proceeds of such issuances.
SFAS No. 148 provides three transition methods for entities that adopt the fair value recognition provisions of SFAS No. 123. The Company has chosen to use the “Prospective Method”. This method requires that companies apply the recognition provisions of SFAS No. 123 to only employee awards granted or modified after the beginning of the fiscal year in which the recognition provisions are first applied, or January 1, 2003. Compensation expense under all of the Company’s plans is generally recognized over periods ranging from three months to five years. Therefore, the cost related to stock-based employee compensation included in the determination of net income for the year ended December 31, 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123. See Note 2 in the Notes to Consolidated Financial Statements for further discussion and comparative information regarding application of the fair value method to all outstanding employee awards.
Funds From Operations
For the year ended December 31, 2003, Funds From Operations (“FFO”) available to OP Units decreased $78.9 million, or 11.0%, as compared to the year ended December 31, 2002. For the year
ended December 31, 2002, FFO available to OP Units increased $13.0 million, or 1.8%, as compared to the year ended December 31, 2001.
The following is a reconciliation of net income to FFO available to OP Units for the years ended December 31, 2003, 2002 and 2001:
Funds From Operations
(Amounts in thousands)
(1) The National Association of Real Estate Investment Trusts (“NAREIT”) defines funds from operations (“FFO”) (April 2002 White Paper) as net income (computed in accordance with accounting principles generally accepted in the United States), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis. The April 2002 White Paper states that gain or loss on sales of property is excluded from FFO for previously depreciated operating properties only. Once the Operating Partnership commences the conversion of units to condominiums, it simultaneously discontinues depreciation of such property. Accordingly, the Operating Partnership included in FFO its incremental gains or losses from the sale of condominium units to third parties, which represented net gains of $10,280, $1,682 and $0 for the years ended December 31, 2003, 2002 and 2001, respectively. Effective January 1, 2003, the Operating Partnership no longer adds back impairment losses when computing FFO in accordance with NAREIT’s definition. As a result, FFO for the years ended December 31, 2002, 2001 and 2000 have been reduced by $18,284, $71,766 and $1,000, respectively, to conform to the current year presentation. For the year ended December 31, 2001, FFO has been reduced by $5,324 to reflect the SEC’s clarification of EITF Topic D-42 regarding premiums on redemption of preference units.
(2) The Operating Partnership believes that FFO is helpful to investors as a supplemental measure of the operating performance of a real estate company because it provides investors an understanding of the ability of the Operating Partnership to incur and service debt and to make capital expenditures. FFO in and of itself does not represent net income or net cash flows from operating activities in accordance with GAAP. Therefore, FFO should not be exclusively considered as an alternative to net income or to net cash flows from operating activities as determined by GAAP or as a measure of liquidity. The Operating Partnership’s calculation of FFO may differ from other real estate companies due to, among other items, variations in cost capitalization policies for capital expenditures and, accordingly, may not be comparable to such other real estate companies.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure about Market Risk
Market risks relating to the Operating Partnership’s operations result primarily from changes in short-term LIBOR interest rates. The Operating Partnership does not have any direct foreign exchange or other significant market risk.
The Operating Partnership’s exposure to market risk for changes in interest rates relates primarily to the unsecured line of credit. The Operating Partnership typically incurs fixed rate debt obligations to finance acquisitions and capital expenditures, while it typically incurs floating rate debt obligations to finance working capital needs and as a temporary measure in advance of securing long-term fixed rate financing. The Operating Partnership continuously evaluates its level of floating rate debt with respect to total debt and other factors, including its assessment of the current and future economic environment.
The Operating Partnership also utilizes certain derivative financial instruments to limit market risk. Interest rate protection agreements are used to convert floating rate debt to a fixed rate basis or vice versa. Derivatives are used for hedging purposes rather than speculation. The Operating Partnership does not enter into financial instruments for trading purposes. See also Note 14 to the Notes to Consolidated Financial Statements for additional discussion of derivative instruments.
The fair values of the Operating Partnership’s financial instruments (including such items in the financial statement captions as cash and cash equivalents, other assets, lines of credit, accounts payable and accrued expenses, rents received in advance and other liabilities) approximate their carrying or contract values based on their nature, terms and interest rates that approximate current market rates. The fair value of the Operating Partnership’s mortgage notes payable and unsecured notes approximates their carrying value at December 31, 2003.
The Operating Partnership had total outstanding floating rate debt of approximately $750.0 million, or 14.0% of total debt at December 31, 2003, net of the effects of any derivative instruments. If market rates of interest on all of the floating rate debt permanently increased by 22 basis points (a 10% increase from the Operating Partnership’s existing weighted average interest rates), the increase in interest expense on the floating rate debt would decrease future earnings and cash flows by approximately $1.7 million. If market rates of interest on all of the floating rate debt permanently decreased by 22 basis points (a 10% decrease from the Operating Partnership’s existing weighted average interest rates), the decrease in interest expense on the floating rate debt would increase future earnings and cash flows by approximately $1.7 million.
At December 31, 2003, the Operating Partnership had total outstanding fixed rate debt of approximately $4.6 billion, net of the effects of any derivative instruments. If market rates of interest permanently increased by 67 basis points (a 10% increase from the Operating Partnership’s existing weighted average interest rates), the estimated fair value of the Operating Partnership’s fixed rate debt would be approximately $4.2 billion. If market rates of interest permanently decreased by 67 basis points (a 10% decrease from the Operating Partnership’s existing weighted average interest rates), the estimated fair value of the Operating Partnership’s fixed rate debt would be approximately $5.1 billion.
At December 31, 2003, the Operating Partnership’s consolidated derivative instruments had a net asset fair value of approximately $3.9 million. If market rates of interest permanently increased by 25 basis points (a 10% increase from the Operating Partnership’s existing weighted average interest rates), the net asset fair value of the Operating Partnership’s consolidated derivative instruments would be approximately $8.0 million. If market rates of interest permanently decreased by 25 basis points (a 10% decrease from the Operating Partnership’s existing weighted average interest rates), the net liability fair value of the Operating Partnership’s consolidated derivative instruments would be approximately $0.1 million.
At December 31, 2003, the Operating Partnership’s unconsolidated derivative instruments had a net liability fair value of approximately $5.2 million. If market rates of interest permanently increased by 11 basis points (a 10% increase from the Operating Partnership’s existing weighted average interest rates), the net liability fair value of the Operating Partnership’s unconsolidated derivative instruments would be approximately $5.1 million. If market rates of interest permanently decreased by 11 basis points (a 10% decrease from the Operating Partnership’s existing weighted average interest rates), the net liability fair value of the Operating Partnership’s unconsolidated derivative instruments would be approximately $5.3 million.
These amounts were determined by considering the impact of hypothetical interest rates on the Operating Partnership’s financial instruments. The foregoing assumptions apply to the entire amount of the Operating Partnership’s debt and derivative instruments and do not differentiate among maturities. These analyses do not consider the effects of the changes in overall economic activity that could exist in such an environment. Further, in the event of changes of such magnitude, management would likely take actions to further mitigate its exposure to the changes. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no changes in the Operating Partnership’s financial structure or results.
The Operating Partnership cannot predict the effect of adverse changes in interest rates on its debt and derivative instruments and, therefore, its exposure to market risk, nor can there be any assurance that long term debt will be available at advantageous pricing. Consequently, future results may differ materially from the estimated adverse changes discussed above.
Item 8.
Item 8. Financial Statements and Supplementary Data
See Index to Consolidated Financial Statements on page of this Form 10-K.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Disclosure Controls and Procedures
Effective as of December 31, 2003, the Operating Partnership carried out an evaluation, under the supervision and with the participation of the Operating Partnership’s management, including the Chief Executive Officer and Chief Financial Officer of EQR, of the effectiveness of the design and operation of the Operating Partnership’s disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures are effective in timely alerting them to material information. During the fiscal year ended December 31, 2003, there were no changes to the internal controls over financial reporting of the Operating Partnership identified in connection with the Operating Partnership’s evaluation or otherwise that has materially affected, or is reasonably likely to materially affect, the Operating Partnership’s internal controls over financial reporting.
PART III
Items 10,11,12, 13 and 14 of this Form 10-K may omit the use of certain defined terms used elsewhere herein and may contain certain defined terms that are different from those used in the other sections of this report.
Item 10.
Item 10. TRUSTEES AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Operating Partnership does not have any trustees or executive officers. The following is a biographical summary, as of March 1, 2004, of the age, experience and position and offices of the trustees and executive officers of EQR, ERPOP’s General Partner. Officers serve at the pleasure of the Board of Trustees (the “Board”).
Trustees
All trustees are elected at each annual meeting of EQR’s shareholders. EQR’s Board of Trustees may appoint trustees to fill vacancies (including vacancies resulting from an increase in the number of trustees) arising between shareholders meetings.
John W. Alexander, 56, has been a Trustee of EQR since May 1993 and is the President of Mallard Creek Capital Partners, Inc., an investment company with interests in real estate, development entities and operating companies. He is also a partner of Meringoff Equities, a real estate investment and development company, and is a member of the International Council of Shopping Centers and the Urban Land Institute.
Charles L. Atwood, 55, has been a Trustee of EQR since July 2003. Mr. Atwood is Senior Vice President and Chief Financial Officer of Harrah’s Entertainment, Inc. (“Harrah’s”), a public owner and operator of gaming facilities. Mr. Atwood has been with Harrah’s and its predecessor companies since 1979. He received an M.B.A. in finance from Tulane University and is a member of the American Institute of Certified Public Accountants.
Bruce W. Duncan, 52, has been President and a Trustee of EQR since March 2002 and was appointed Chief Executive Officer of EQR in January 2003. He was a private investor from April 2000 until joining EQR. Mr. Duncan served as Chairman, President and Chief Executive Officer of The Cadillac Fairview Corporation Limited, a real estate operating company, from December 1995 until its sale in March 2000. Mr. Duncan is a director of The Rouse Company, a public real estate management and development company, a director of Starwood Hotels & Resorts Worldwide, Inc. (“Starwood”) and a trustee of Starwood Hotels & Resorts, a real estate investment trust and a subsidiary of Starwood. In addition, Mr. Duncan is on the Executive Committee of the National Multi-Housing Council and the Executive Committee of NAREIT Board of Governors, a member of the Urban Land Institute, and a past trustee of the International Council of Shopping Centers.
Stephen O. Evans, 59, has been a Trustee of EQR since December 23, 1997, the date of the merger of Evans Withycombe Residential, Inc. (“Evans”), a public multifamily property company founded by Mr. Evans, into EQR (the “Evans Merger”). Mr. Evans is President of Evans Realty Associates, a real estate investment company and serves as a director of Biltmore Bank of Arizona. Mr. Evans also served as an Executive Vice President of Equity Residential from December 1997 to December 1999 and as the Chairman of the Board and Chief Executive Officer of Evans from its formation in May 1994 until the Evans Merger. Mr. Evans is a member of Lambda Alpha, a national land economics fraternity, and the Urban Land Institute.
James D. Harper, Jr., 70, has been a Trustee of EQR since May 1993. Mr. Harper is the President of JDH Realty Co., a real estate development and investment company, and is the principal partner in AH Development, S.E., a special limited partnership formed to develop over 400 acres of land in Puerto Rico. He is a trustee of Equity Office Properties Trust (“EOP”), a public office building company.
Boone A. Knox, 67, has been a Trustee of EQR since October 19, 1998, the date of the merger of Merry Land & Investment Company, Inc. (“Merry Land”), a public multifamily property company, into EQR (the “Merry Land Merger”). Mr. Knox had been a director of Merry Land Properties, Inc. (“MRYP”), a publicly traded diversified real estate company, from its formation as part of the Merry Land Merger through February 2001. Mr. Knox had been Chairman of the Board of Directors of Merry Land from December 1996 until the Merry Land Merger. Mr. Knox has served as Chairman of the Board of Directors of Regions Bank, Central Georgia since January 1997, and is a director of Cousins Properties, Incorporated, a public retail and office building company.
Desiree G. Rogers, 44, has been a Trustee of the Company since October 2003. Ms. Rogers joined Peoples Energy Corporation in 1977 and currently serves as Senior Vice President of Peoples Energy Corporation, a publicly diversified energy company. She received an M.B.A from Harvard Business School.
Sheli Z. Rosenberg, 62, has been a Trustee of EQR since March 1993, and Lead Trustee since 2002. Ms. Rosenberg was Vice Chairman of Equity Group Investments, LLC (“EGI LLC”), an investment company, from January 1, 2000 to March 2003, at which time she retired, and Chief Executive Officer and President of EGI LLC from January 1, 1999 to January 1, 2000. Ms. Rosenberg is a trustee of EOP and is a director of Capital Trust, Inc. (“Capital Trust”), a specialized finance company, Manufactured Home Communities, Inc. (“MHC”), a public manufactured home community company, Ventas, Inc., a public real estate company focusing on the ownership and acquisition of health care properties, CVS Corporation, a drugstore chain and Cendant Corporation, a provider of business and consumer services primarily within the real estate and travel sectors.
Gerald A. Spector, 57, has been a Trustee and Executive Vice President of EQR since March 1993 and Chief Operating Officer of EQR since February 1995.
Michael N. Thompson, 55, has been a Trustee of EQR since October 19, 1998, the date of the Merry Land Merger. Mr. Thompson has been a principal of Merry Land Properties, L.L.C., a private entity performing development activities in the Southeast, since May 2003. Mr. Thompson had been President, Chief Operating Officer and a director of MRYP since its formation as part of the Merry Land Merger until May 2003. Mr. Thompson served as Executive Vice President and Chief Operating Officer of Merry Land from December 1996 until the Merry Land Merger.
B. Joseph White, 56, has been a Trustee of EQR since May 1993. Mr. White is the Wilbur K. Pierpont Collegiate Professor at the University of Michigan Business School. In 2003, he served as Managing Director of Fred Alger Management Company, an Asset Management firm. In 2002, he served as Interim President of the University of Michigan. From 1991 to 2001 he was dean of the University of Michigan Business School. Mr. White is a director of Kelly Services, Inc., a temporary services firm, and Kaydon Corporation, a manufacturer of precision engineered metal products.
Samuel Zell, 62, has been Chairman of the Board of EQR since March 1993. Since January 1999, Mr. Zell has been Chairman of EGI LLC. He is also Chairman of the Board of EOP, MHC, Capital Trust, Anixter International Inc., a provider of integrated network and cabling systems, Angelo & Maxie’s, Inc., an owner and operator of restaurants, Danielson Holding Corporation, a holding company with separate subsidiaries in the insurance and marine transportation industries, and Rewards Network Inc., an administrator of loyalty based consumer rewards programs.
Executive Officers
Bruce W. Duncan, Chief Executive Officer, President and a Trustee of EQR. See biographical information above.
Gerald A. Spector, Chief Operating Officer, Executive Vice President and a Trustee of EQR. See biographical information above.
David J. Neithercut, 48, has been Executive Vice President - Corporate Strategy since January 1, 2004, and Executive Vice President and Chief Financial Officer of EQR since February 1995.
J. Donald Couvillion, 49, has been Executive Vice President - Development since December 2001. From December 1997 to November 2001, he was Senior Vice President - Development of EQR. Mr. Couvillion will leave the employ of EQR on or about May 1, 2004, depending upon EQR’s transitional needs.
Alan W. George, 46, has been Executive Vice President - Chief Investment Officer of EQR since January 2002. Mr. George was Executive Vice President - Acquisitions/Dispositions of EQR from February 1997 to January 2002.
Edward J. Geraghty, 54, has been Executive Vice President of EQR since March 1998 and President - Eastern Division since April 1999.
Michael J. McHugh, 48, has been Executive Vice President of EQR since January 1998 and Chief Accounting Officer and Treasurer of EQR since February 1995.
Gregory H. Smith, 52, has been Executive Vice President - Portfolio Investment of EQR since January 1, 2004, and Executive Vice President since December 1994. Mr. Smith was also President - Central Division from April 1999 to December 2003.
Bruce C. Strohm, 49, has been Executive Vice President and General Counsel of EQR since March 1995 and Secretary of EQR since November 1995.
Mark N. Tennison, 43, has been Executive Vice President - Development of EQR since March 2004. Mr. Tennison served as Senior Vice President and Chief Operating Officer of Pritzker Residential from 1997 through 2003.
Frederick C. Tuomi, 49, has been Executive Vice President of EQR since January 1994 and President - Western Division since April 1999.
Audit Committee
The current members of the Audit Committee of EQR’s Board of Trustees are B. Joseph White (Chair), John W. Alexander, Boone A. Knox, James D. Harper, Jr., and Charles L. Atwood. The Audit Committee is comprised entirely of trustees who meet the independence and financial literacy requirements of NYSE listing standards. In addition, the Board has determined that Mr. Atwood qualifies as an “audit committee financial expert” as defined in SEC rules.
Code of Ethics and Business Conduct
EQR’s Board has adopted a Code of Ethics and Business Conduct that applies to all trustees, officers and employees, including EQR’s principal executive officer, principal financial officers and principal accounting officers. The purpose of the Code of Ethics and Business Conduct is to promote honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest
between personal and professional relationships to promote full, fair, accurate, timely and understandable disclosure in periodic reports required to be filed by EQR; and to promote compliance with all applicable rules and regulations that apply to EQR and its officers and Trustees. If the Board amends any provisions of the Code of Ethics and Business Conduct that apply to EQR’s chief executive officer or senior financial officers or grants a waiver in favor of any such persons, it will promptly publish the text of the amendment or the specifics of the waiver on its website. EQR’s Code of Ethics and Business Conduct may be viewed on EQR’s website at www.equityapartments.com under the Investor Relations section.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires the Operating Partnership to report whether or not, based on its review of reports to the SEC filed by its more than 10% beneficial owners, about transactions in its OP Units furnished to the Operating Partnership, and the written representation of its more than 10% beneficial owners that any such required reports were not filed or were filed untimely. There were no such failures to report or late reports during 2003.
Item 11.
Item 11. EXECUTIVE COMPENSATION
Compensation Of Trustees
The following information is provided for the Board of Trustees of EQR.
To link trustee compensation to performance and to more effectively align the Board’s interests with the interests of the shareholders, the Board believes that over 50% of the trustees’ base annual fee (excluding committee or other Board service fees) should be payable in some form of Company equity. Each of EQR’s trustees, excluding EQR’s Chairman, Mr. Zell, and the employee trustees, Mr. Duncan and Mr. Spector, is entitled to receive an annual cash fee of $45,000 for serving on the Board. In addition, trustees who serve on the Audit, Compensation, Nominating, Corporate Governance or Executive Committee receive an additional $4,000 per year for each committee on which they serve. The chair of the Audit Committee receives an additional $11,000 per year and the chairs of the Compensation, Nominating and Corporate Governance Committees each receive an additional $6,000 per year. Mr. Zell does not receive a fee for acting as Chair of the Executive Committee. The Lead Trustee receives an additional annual fee of $10,000 for such service. EQR also reimburses the trustees for travel expenses incurred in connection with their activities on behalf of EQR. As of January 1, 2003, EQR’s Chairman, Mr. Zell, and the employee trustees no longer receive any such annual trustee’s fee and/or long-term incentive grant for their service on the Board.
Each trustee of EQR, excluding EQR’s Chairman, Mr. Zell, and the employee trustees, Mr. Duncan and Mr. Spector, is entitled to receive an annual long-term incentive grant of $50,000 of options and restricted shares. This grant will be allocated between options and restricted shares in the same ratio and utilizing the same valuation criteria as approved by the Board for the annual long-term incentive grants to EQR’s executive officers. The 2003 and 2004 grants were allocated 25% to options and 75% to restricted shares. The options granted vest in approximately equal installments of six months, one year and two years from the date of grant. The restricted shares vest in full on the third anniversary of the grant date. Distributions are paid on these restricted shares at the same rate as on unrestricted common shares.
Trustees who are first appointed or elected to the Board after the beginning of a fiscal year receive prorated cash fees and long-term incentive grants for their first year of service.
Because EQR’s financial results were impacted during 2002, the trustees voluntarily agreed to reduce their base annual trustee compensation by approximately ten percent during 2003. Accordingly, each non-employee trustee’s annual fee for 2003 was reduced from $45,000 to $40,000, and the annual
long-term incentive grant of $50,000 was reduced to $45,000.
For trustees retiring from the Board or completing a scheduled term on the Board without re-nomination, vesting of all outstanding options and restricted shares granted as compensation for serving as a trustee is accelerated, and options may be exercised through the expiration of the exercise period (i.e., ten years from the grant date). Options and restricted share awards issued to Mr. Zell as Chairman are subject to the same vesting restriction upon retirement as other employees of EQR.
Mr. Zell receives restricted shares and options for his services as Chairman as described in “Employment Contracts and Change in Control Arrangements” below.
EQR has an optional deferred compensation plan in which trustees may participate. The trustees may defer receipt of any percentage of their annual cash compensation, which amount is then deposited in a supplemental executive retirement savings plan (the “SERP”) on a tax-deferred basis. These deferred funds (as well as any cash trustee fees which are not deferred) may be used to purchase EQR Common Shares under the EQR Employee Share Purchase Plan (the “ESPP”) at the discounted purchase price under the plan. Each trustee is immediately 100% vested in his or her purchased ESPP shares held in the SERP and is allowed to begin withdrawals over a one to ten year period following termination of his or her trusteeship. The majority of the trustees have elected to join the deferred compensation plan and defer the taxation of all cash trustee fees. The trustees may also elect to defer receipt of their restricted shares to the SERP prior to the vesting of the shares. Non-employee trustees do not participate in EQR’s profit sharing plan or receive any matching contributions on any fees or restricted shares so deferred.
Executive Compensation
The following tables show the compensation for Bruce W. Duncan, the Chief Executive Officer and President, and the other four most highly compensated executive officers of Equity Residential, the general partner of the Operating Partnership.
(1) Includes any compensation deferred under EQR’s deferred compensation plan. Cash bonuses are reported in the year earned, even if paid in a subsequent year.
(2) Mr. Duncan’s 2002 salary of $388,309 represents time worked from April 8, 2002, his first day of employment, through December 31, 2002. His annualized base salary for 2002 was $550,000. Mr. Duncan voluntarily reduced his 2002 bonus from $750,000 to $550,000, with $100,000 of the reduction used to fund employee recognition cash grants. Mr. Duncan also voluntary reduced his 2003 bonus by $100,000, to be used to fund employee recognition cash grants.
(3) The dollar amount shown equals the number of restricted shares granted in each year on account of the prior year’s service, multiplied by the fair market value of the common shares on the grant date. These shares vest upon completion of three years of continuous employment following the grant date, with the exception of restricted shares issued in connection with the termination of the 2000 performance share grants, which vest in equal installments over three years. The valuations do not take into account the diminution in value attributable to the restrictions applicable to the common shares. Distributions are paid on restricted shares at the same rate as on unrestricted common shares. The total number of restricted common shares awarded to each named executive officer for 2003, 2002 and 2001, respectively, were: Mr. Duncan 35,644, 9,072 and 0; Mr. Spector 85,462, 71,663 and 60,262; Mr. Neithercut 32,980, 31,743 and 25,626; Mr. George 25,807, 26,736 and 24,350; and Mr. Tuomi 22,355, 24,438 and 25,252.
The number and value ($29.51 per share) of the restricted share holdings of each executive officer listed above at December 31, 2003 were as follows:
(4) Shares underlying options are reported in the year granted.
(5) The dollar amount shown reflects the fair market value of vested shares issued in each year, multiplied by the fair market value of the common shares on the grant date. These vested shares represent shares issued under EQR’s performance share grants, as further described in “Long-Term Incentive Plan Awards” below, based on EQR’s financial performance during the three calendar years following the date of grant. Fifty percent of the shares were vested upon issuance with the balance issued as restricted shares vesting equally over two years from the grant date. These restricted shares are reflected in the Restricted Share Awards column. The total number of vested shares awarded to each named executive for 2003, 2002 and 2001, respectively, were Mr. Duncan 0, 0 and 0; Mr. Spector 30,048, 37,575 and 27,922; Mr. Neithercut 8,537, 15,750 and 16,754; Mr. George 8,451, 13,500 and 18,724; and Mr. Tuomi 5,635, 13,500 and 18,724.
(6) Principally includes employer matching and profit-sharing contributions to EQR’s 401(k) Plan. This column also reflects the dollar value of premiums paid for the purchase of split-dollar life insurance policies for the following executives: Mr. Neithercut: 2003 - $-0-, 2002 - $10,000 and 2001 - $54,000; Mr. George: 2003 - $-0-, 2002 - $10,000 and 2001 - $54,000; and Mr. Tuomi: 2003 - $-0-, 2002 - $10,000 and 2001 - $54,000. While the executive is the owner of such policy, upon the executive’s death, EQR will receive from the death benefits all premiums paid by it on the executive’s behalf, plus 10% interest per annum on such premium payments for up to the first 10
years of such payments (collectively, “Company Premiums”), and the executive’s beneficiary will receive the balance of the death benefits. In addition, the executive is entitled to 50% of the cash surrender value of the policy at age 62, and 50% at age 65. Upon termination of employment prior to age 62, the executive must borrow against the policy or partially surrender the policy in an amount sufficient to repay the Company Premiums to EQR. EQR ceased making payment of premiums on these policies in 2003.
OPTION GRANTS IN 2003
(1) All options are granted at the fair market value of the common shares at the grant date. Options granted have a term of not more than ten years from the grant date and vest in equal installments over three years.
(2) The estimated present value at grant date of option grants in 2003 has been calculated using the Black-Scholes option pricing model based on the following assumptions: an estimated time until exercise of 5 years, a volatility of 20.8%, a risk-free interest rate of 3.02% and a dividend yield of 6.46%. The real value of these options depends on the actual performance of EQR’s common shares during the applicable period and on the date or dates when options are exercised. No gain to the optionee is possible without an increase in common share price, which would benefit all shareholders as well.
OPTION EXERCISES IN 2003
AND YEAR-END OPTION VALUES
(1) Represents the market value of a common share on the exercise date less the exercise price of the option.
(2) Represents the market value of a common share at December 31, 2003 ($29.51) less the exercise price of in-the-money options.
LONG-TERM INCENTIVE PLAN AWARDS
The table set forth below identifies the target number of performance units awarded in early 2004 for services rendered during 2003. The executive officers have the opportunity to earn in common shares an amount as little as 0% to as much as 225% of the target number of performance units. The owners of performance units have no right to vote, receive dividends or transfer the units until common shares are issued in exchange for the units. The number of common shares the executive actually receives on the third anniversary of the grant date will depend on the excess, if any, by which EQR’s Average Annual Return (i.e., the average of the common share dividends declared during each year as a percentage of the common share price as of the first business day of January 2004 ($29.53), and the average percentage increase in funds from operations (“FFO”) for each calendar year on a per share basis over the prior year) for the three performance years exceeds the average of the 10-year Treasury Note interest rate as of the first business day in January of each performance year (the “T-Note Rate”).
Fifty percent of the common shares to which an executive may be entitled under the performance share grants will vest, subject to the executive’s continued employment with EQR, on the third anniversary of the award (which will be the date the common shares are issued); twenty-five percent will vest on the fourth anniversary and the remaining twenty-five percent will vest on the fifth anniversary. The common shares will also fully vest upon the executive’s death, retirement at or after age 62, disability or upon a change in control of EQR.
LONG-TERM INCENTIVE PLAN AWARDS FOR 2003
Employment Contracts And Change In Control Arrangements
Employment Contracts. EQR entered into an Employment Agreement with Mr. Duncan in January 2003 reflecting Mr. Duncan’s appointment as President and Chief Executive Officer as of January 1, 2003. The term of the agreement is four years from January 1, 2003 until December 31, 2006, with annual one-year extensions thereafter unless terminated by either party upon 90 days notice. Mr. Duncan’s base annual salary is $750,000, subject to periodic increases in the Board’s discretion. His target cash bonus is 144% of base salary, or $1,080,000. His target long-term incentive annual grant of options, restricted shares and performance shares is 246% of annual cash compensation, or $4,500,000. The “target” criteria for achievement of Mr. Duncan’s bonus and long-term incentive awards will be determined using the same criteria utilized by the Compensation Committee of EQR’s Board for achievement of target bonuses and long-term incentive awards for EQR’s other senior executives.
Mr. Duncan’s employment agreement provides that upon his termination of employment for any reason (other than having left EQR voluntarily without good reason or as a result of termination for cause or a Change in Control (as defined below)), he would receive the following benefits:
• All his options, restricted shares and performance share units would vest in full, with the performance share units vesting at the greater of the 100% level or the performance level achieved through the date of termination. He would have the balance of the 10-year option period to exercise any vested options.
• He would receive a severance payment equal to two and one-half times his current base annual salary and two and one-half times the average of the prior two years’ cash bonuses (or two and one-half times the 2004 target bonus if termination occurs prior to the payment of the 2004 calendar year bonus), unless his employment is terminated due to his death or disability, in which case he would receive only the proceeds payable under EQR’s standard employee life insurance and disability programs.
• He would receive a prorated cash bonus (based on the number of days in the calendar year worked) equal to the prior year’s bonus, as well as any accrued unpaid base salary, accrued unreimbursed expenses and benefits, and his accrued unpaid bonus, if any, for the prior year.
Upon Mr. Duncan’s continuous employment with EQR through December 31, 2006, he will be deemed to have sufficient years of service for retiree eligibility under all EQR incentive and benefit plans (specifically excluding Mr. Duncan’s Deferred Compensation Agreement and his Retirement Benefits Agreement, which will remain in effect thereafter in accordance with their terms), including continued exercisability of share options at the most senior tier upon a termination of employment, but not less than the lesser of five years or the remaining term of the grant. Mr. Duncan also receives five weeks of vacation and an EQR paid non-golf club membership and may maintain two additional for-profit directorships. EQR also has agreed to renominate Mr. Duncan for reelection to its Board as long as he is the Chief Executive Officer of EQR. In accordance with EQR’s policy, Mr. Duncan has agreed to submit his resignation as trustee upon the termination of his employment with EQR for any reason.
EQR entered into a Compensation Agreement with Mr. Zell in October 2001 (as amended in March 2003) for services provided by Mr. Zell as Chairman of the Board for the calendar years 2001, 2002 and 2003, which entitles Mr. Zell to an annual long-term incentive grant of $3,250,000 of options and restricted shares. Mr. Zell is also responsible for his own business related expenses. Subject to Mr. Zell’s continuing service as EQR’s Chairman, his annual long-term incentive grant of $3,250,000 shall be allocated between options and restricted shares in the same ratio as approved by the Board for the annual long-term incentive grants to EQR’s executive officers, utilizing the same valuation criteria described below. For the 2003 and 2004 grants, the $3,250,000 was allocated 25% to options and 75% to restricted shares. In January 2004, Mr. Zell was granted 359,518 options at an exercise price of $29.25 per share and 83,333 restricted shares for his contribution during 2003 in his capacity as Chairman of the Board.
The number of options granted is determined by dividing the dollar amount allocated to options by the fair market value of each option using the same valuation criteria utilized by EQR’s Compensation Committee in its annual employee option grants made as of the same date. The options are granted at the fair market value of EQR’s common shares at the date of grant, are granted for a period of ten years and vest over a period of three years at a rate of one third of such grant each year. The number of restricted shares granted is determined by dividing the dollar amount allocated to restricted shares by the closing price of common shares of EQR on the grant date. The restricted shares vest in full on the third anniversary of the grant date. Distributions are paid on these restricted shares at the same rate as on unrestricted common shares.
EQR also entered into a Retirement Benefits Agreement with Mr. Zell in October 2001. The Retirement Benefits Agreement provides Mr. Zell with a cash retirements benefit after the termination of his service as Chairman of the Board. If Mr. Zell’s employment as Chairman is terminated for any reason, other than by EQR for cause, he (or his estate in the event of his death) will be entitled to an annual retirement benefit of $500,000 (as increased by a CPI index from January 2002 through the termination date) over a ten year period commencing on the termination date. Should Mr. Zell be terminated for cause, he would not be entitled to any such retirement benefit.
Deferred Compensation Agreements. EQR has entered into Deferred Compensation Agreements with Messrs. Duncan and Spector.
Mr. Duncan’s Deferred Compensation Agreement, entered into in January 2003, provides Mr. Duncan with a salary benefit after the termination of his employment with EQR. If Mr. Duncan’s employment is terminated by EQR without cause, Mr. Duncan resigns for good reason, or Mr. Duncan resigns for any reason on or after December 31, 2006, he would be entitled to annual deferred compensation for a ten-year period commencing on the termination date (or age 62 if Mr. Duncan resigns without good reason between December 31, 2006 and December 31, 2011) in an amount equal to $750,000 (increased by a CPI Index from January 2003 through the termination date), multiplied by a percentage equal to 10% for each year Mr. Duncan was employed by EQR since March 15, 2002, but not to exceed 100%. In the event Mr. Duncan’s employment is terminated as a result of his death, permanent disability or incapacity, he would be entitled to a similar amount except that the annual percentage would be 15%, not 10%. Should Mr. Duncan be terminated for cause or should he choose to leave voluntarily, without good reason, prior to December 31, 2006, he would not be entitled to any deferred compensation.
Mr. Spector’s Deferred Compensation Agreement, entered into in 1996, as most recently amended in January 2002, provides Mr. Spector with a salary benefit after the termination of his employment with EQR. If Mr. Spector’s employment is terminated by EQR without cause, Mr. Spector resigns for good reason, or Mr. Spector resigns for any reason on or after January 1, 2009, he would be entitled to annual deferred compensation for a ten-year period commencing on the termination date in an amount equal to $550,000 (increased by a CPI Index from January 2002 through the termination date), multiplied by a percentage equal to 6.67% for each year Mr. Spector was employed by EQR since December 31, 1993, but not to exceed 100%. In the event Mr. Spector’s employment is terminated as a result of his death, permanent disability or incapacity, he would be entitled to a similar amount except that the annual percentage would be 10%, not 6.67%. Should Mr. Spector be terminated for cause or should he choose to leave voluntarily, without good reason, prior to January 1, 2009, he would not be entitled to any deferred compensation.
Change in Control Agreements. EQR has Change in Control/Severance Agreements (the “Agreements”) with the persons named in the Summary Compensation Table and other key employees of EQR that become effective upon either a “Change in Control” or termination of employment within three years following the hiring of a new Chief Executive Officer. A Change in Control will generally be deemed to have occurred upon a third party’s acquisition of 30% or more of EQR’s common shares, whether through purchase, merger or consolidation or a sale of all or substantially all of the assets of EQR. In the event that an employee is dismissed without Cause or resigns for Good Reason (as such terms are defined in the Agreements) during the three-year period following either the effective date of the Change in Control or, for all executives other than the Chief Executive Officer, the hiring of a new Chief Executive Officer, he or she will be entitled to all accrued but unpaid compensation and benefits in a lump sum cash payment consisting of the employee’s base salary through the date of termination, and a severance payment equal to a multiple (ranging from 3.0 for the CEO to 2.0 for other executive officers) of the employee’s annual base salary plus the average of the employee’s annual bonus for the last three fiscal years. The employee is also entitled to continued employee welfare benefits for the remainder of the applicable time period. Several of EQR’s employment benefit plans also provide for enhanced employee benefits upon a “Change in Control” of EQR. In general, upon a Change in
Control, all options, restricted shares and performance shares immediately vest.
Retirement Benefits Agreements. EQR has entered into Executive Retirement Benefits Agreements with the persons named in the Summary Compensation Table and other Executive Vice Presidents of EQR. These agreements provide that, if after reaching age 62 or older, either the executive retires from EQR or is terminated as a result of a Change in Control, the executive will be eligible to receive health and life benefits for the remainder of his or her life as any regular active employee. These benefits will be offered at the same rates as would be paid by an active employee for like coverage and subject to increase as any other active employee.
Compensation Committee Interlocks And Insider Participation
The members of the Compensation Committee of EQR’s Board are John W. Alexander (Chair), James D. Harper, Jr. and Sheli Z. Rosenberg. No member of the Compensation Committee is a past or present officer or employee of EQR.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information, as of January 31, 2004, regarding the beneficial ownership of the OP Units by each person known by the Operating Partnership to be the beneficial owner of more than five percent of the Operating Partnership’s outstanding OP Units, and in addition, each trustee of EQR, EQR’s five most highly compensated executive officers at year end, and by all trustees and executive officers of EQR as a group. Each person named in the table has sole voting and investment power with respect to all OP Units shown as beneficially owned by such person, except as otherwise set forth in the notes to the table. In addition, the table also sets forth information, as of January 31, 2004, regarding each such person’s (other than EQR) beneficial ownership of EQR Common Shares and Common Shares that may be acquired within 60 days through the exercise of options.
* Less than 1%.
(1) The number of common shares beneficially owned is based on SEC regulations regarding the beneficial ownership of securities. On January 31, 2004, a total of 278,543,863 common shares and 21,657,139 OP units were outstanding, including both vested and unvested restricted share awards. OP Units are exchangeable on a one-for-one basis into common shares. Percentage ownership amounts are calculated by treating the holders’ options and, in the case of EQR, OP Units, as outstanding EQR Common Shares. Except as otherwise noted, the persons named in the table have sole voting and investment power over the shares listed.
(2) Reflects EQR Common Shares which may be acquired within 60 days after January 31, 2004.
(3) Includes 4,863,502 OP Units. Mr. Zell does not have a pecuniary interest in 600 common shares reported above held by the Helen Zell Revocable Trust (“HZRT”), the trustee of which is Helen Zell, Mr. Zell’s spouse. Mr. Zell also does not have a pecuniary interest in 60,000 common shares held by the Zell Family Foundation, of which Mr. Zell is a director. The number in the table includes 1,206,968 common shares and 4,462,828 OP Units in which Mr. Zell has a pecuniary interest but does not have voting or dispositive power. 1,206,968 common shares and 3,388,316 OP Units are indirectly held by trusts established for the benefit of Mr. Zell and his family, the trustee of which is Chai Trust Company, L.L.C. (“Chai Trust”). Mr. Zell is not an officer or director of Chai Trust and does not have voting or dispositive power over such common shares or OP Units. Additionally, 1,074,512 OP Units are held by EGIL Investments, Inc. Under a shareholders’ agreement dated December 31, 1999, trusts established for the benefit of the family of Ann and Robert Lurie have the power to vote and to dispose of the common shares and OP Units beneficially owned by EGIL Investments, Inc. Mr. Zell disclaims beneficial ownership of such 1,206,968 common shares and 4,462,828 OP Units except to the extent of his pecuniary interest therein.
(4) Includes 44,794 OP Units.
(5) Includes 100,000 common shares and 35,550 OP Units beneficially owned by The Evans Family Limited Liability Company, of which Mr. Evans serves as the manager. Also includes four OP Units beneficially owned by The Evans Family Revocable Trust, of which Mr. Evans serves as the trustee. As such, Mr. Evans may be deemed the beneficial owner of all the foregoing common shares and OP Units. Also includes 1,133,224 OP Units beneficially owned by limited partnerships (collectively, the “EW LPs”), of which Mr. Evans serves as a general partner and has a 50% ownership interest. As such, Mr. Evans may be deemed the beneficial owner of approximately 50% of the common shares and OP Units beneficially owned by the EW LPs. Mr. Evans disclaims beneficial ownership of the other 50% interest in such common shares and OP Units, which are beneficially owned by other persons.
(6) Includes 2,347,898 common shares beneficially owned by Knox, Ltd., of which Mr. Knox is the general partner, and includes 6,774 common shares beneficially owned by BT Investments, of which Mr. Knox is the managing partner. Mr. Knox disclaims beneficial ownership of the common shares owned by Knox, Ltd. and BT Investments, except to the extent of his pecuniary interest in 230,232 common shares. Also includes 6,228 common shares beneficially owned by Mr. Knox’s spouse and 848 common shares beneficially owned by Mr. Knox, not individually, but as custodian for his niece and nephew, as to all of which Mr. Knox disclaims beneficial ownership. Also includes 359,678 common shares beneficially owned by the Knox Foundation, of which Mr. Knox is the trustee. Mr. Knox disclaims beneficial ownership of the common shares owned by the Knox Foundation. Also includes 335,892 common shares beneficially owned by Folkstone Limited Partnership (“FLP”), of which Mr. Knox is a general partner. Mr. Knox disclaims beneficial ownership of the common shares owned by FLP, except to the extent of his pecuniary interest therein. Also includes 144,298 common shares, over which Mr. Knox has investment authority, beneficially owned by his sister-in-law. Mr. Knox disclaims beneficial ownership of these common shares.
(7) Includes 59,342 common shares beneficially owned by Ms. Rosenberg’s spouse, as to which Ms. Rosenberg disclaims beneficial ownership. Also includes 3,056 OP Units.
(8) Includes 239,919 common shares beneficially owned by Mr. Spector’s spouse, and 6,328 common shares beneficially owned by Mr. Spector as custodian for his minor children, as to all of which Mr. Spector disclaims beneficial ownership. Also includes 218 OP Units.
(9) Includes 173,290 common shares beneficially owned by Deep South Investments, Ltd., of which Mr. Thompson is general partner. Mr. Thompson disclaims beneficial ownership of the shares, except to the extent of his pecuniary interest therein.
(10) Includes 9,974 common shares beneficially owned by Benemi Partners, L.P., of which Mr. Neithercut is general partner.
Equity Compensation Plan Information
The following table provides information as of December 31, 2003 with respect to EQR’s Common Shares that may be issued under existing equity compensation plans. Any Common Shares issued pursuant to EQR’s equity compensation plans will result in the Operating Partnership issuing OP Units to EQR on a one-for-one basis.
(1) Amount shown includes 21,970 shares reserved for issuance upon exercise of outstanding options assumed by EQR as a result of mergers.
(2) The amounts shown in columns (a) and (b) of the above table do not include 1,362,733 outstanding common shares (all of which are restricted and subject to vesting requirements) that were granted under EQR’s Fifth Amended and Restated 1993 Share Option and Share Award Plan (the “1993 Plan”) and EQR’s 2002 Share Incentive Plan (the “2002 Plan”) and outstanding common shares that have been purchased by employees and trustees under EQR’s ESPP.
(3) Includes 20,488,513 common shares that may be granted under the 2002 Plan, of which only 25% may be in the form of restricted shares, and 5,046,553 common shares that may be sold to employees and trustees under the ESPP.
The aggregate number of securities available for issuance (inclusive of restricted shares previously granted and outstanding and shares underlying outstanding options) under the 2002 Plan equals 7.5% of EQR’s outstanding common shares, calculated on a fully diluted basis, determined annually on the first day of each calendar year. On January 1, 2004, this amount equaled 22,736,239.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
(a) Transactions with Management and Others
Pursuant to the terms of the partnership agreement for the Operating Partnership, the Operating Partnership is required to reimburse EQR for all expenses incurred by EQR in excess of income earned by EQR through its indirect 1% ownership of various entities. Amounts paid on behalf of EQR are reflected in the Consolidated Statements of Operations as general and administrative expenses.
(b) Certain Business Relationships
• EQR’s management company managed a multifamily residential community owned by an affiliate of Mr. Zell on terms equivalent to a third-party transaction. The property management fees received from such affiliate were $250,854 for 2003.
• During 2003, the Operating Partnership reimbursed Mr. Spector in the amount of $224,943 for the actual operating costs (excluding acquisition costs) of operating his personal aircraft for himself and other employees on business.
• The Operating Partnership leases its corporate headquarters from an entity controlled by Mr. Zell. Amounts incurred for such office space and related office facility services in 2003 were $1,733,486.
• Since the Merry Land Merger, the Operating Partnership has leased space in an office building in Augusta, Georgia indirectly owned by Mr. Thompson since May 2003 and directly owned by MRYP from 1998 to 2003. The Operating Partnership paid $168,822 in annual rent in 2003 for this space.
(c) Indebtedness of Management - None
(d) Transactions with Promoters - None
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Fees billed to EQR and the Operating Partnership by Ernst & Young for the years ended December 31, 2003 and 2002 were as follows:
(1) Audit fees are incurred for the review and audit of EQR’s and the Operating Partnership’s annual financial statements included in their respective Annual Reports on Form 10-K, the review of EQR’s and the Operating Partnership’s interim financial statements included in their Quarterly Reports on Form 10-Q, and for comfort and consent letters related to SEC registration statements and public offerings of registered securities.
(2) Fees for audit-related services include consultations regarding EQR’s and the Operating Partnership’s internal control documentation, lender required partnership audits and legally required employee benefit plan audits.
(3) Tax compliance/preparation fees are incurred for the preparation of original and amended tax returns for EQR, the Operating Partnership and numerous subsidiaries, claims for refunds and tax payment compliance.
(4) Tax consulting fees relate primarily to tax planning advice incident to acquisitions, dispositions, financings and taxable REIT subsidiaries.
(5) All other fees relate to real estate tax appeal consulting services.
Pre-Approval Policies
EQR’s Audit Committee, pursuant to its exclusive authority, has reviewed and approved EQR’s engagement of Ernst & Young as the Operating Partnership’s independent auditors, and the incurrence of all of the fees described above, for 2003 and 2002 and has selected Ernst & Young as independent auditor for 2004, subject to review and approval of the final terms of its engagement as such and its audit fees. The Audit Committee has also adopted Pre-Approval Policies for all other services Ernst & Young may perform for EQR and the Operating Partnership in 2004. The Pre-Approval Policies detail with specificity the services that are authorized within each of the above-described categories of services and provide for aggregate maximum dollar amounts for such pre-approved services. Any additional services not described or otherwise exceeding the maximum dollar amounts prescribed by the Pre-Approval Policies for 2004 will require the further advance review and approval of the Audit Committee. The Audit Committee has delegated the authority to grant any such additional required approval to its Chairman between meetings of the Committee, provided that the Chairman report the details of the exercise of any such delegated authority at the next meeting of the Audit Committee.
PART IV
Item 15.
Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K
(a)
(1 & 2) See Index to Financial Statements and Schedules on page of this Form 10-K.
(3) Exhibits:
2.1^
Agreement and Plan of Merger among Grove Property Trust, Grove Operating, L.P. and ERP Operating Limited Partnership dated as of July 17, 2000.
3.1*
Fifth Amended and Restated Agreement of Limited Partnership of ERP Operating Limited Partnership.
4.1**
Indenture, dated October 1, 1994, between the Operating Partnership, as obligor and The First National Bank of Chicago, as trustee.
10.1+
Amended and Restated Master Reimbursement Agreement dated as of November 1, 1996 by and between Federal National Mortgage Association and EQR-Bond Partnership.
10.2
Master Amendment to Other Securities Term Sheets and Joinders to Operating Partnership Agreement of ERP Operating Limited Partnership dated December 19, 2003.
10.3
Assignment and Assumption Agreement between Equity Residential and ERP Operating Limited Partnership dated December 19, 2003.
10.4++
Amended and Restated Limited Partnership Agreement of Lexford Properties, L.P.
10.5+++
Revolving Credit Agreement dated as of May 29, 2002 among the Operating Partnership, Bank of America, National Association, as administrative agent, JP Morgan Chase Bank, as syndication agent, and the banks named therein.
10.6+++
Guaranty of Payment dated as of May 29, 2002 between Equity Residential and Bank of America, N.A., as administrative agent.
Computation of Ratio of Earnings to Combined Fixed Charges.
List of Subsidiaries of ERP Operating Limited Partnership.
23.1
Consent of Ernst & Young LLP.
24.1
Power of Attorney for John W. Alexander dated March 3, 2004.
24.2
Power of Attorney for Stephen O. Evans dated March 5, 2004.
24.3
Power of Attorney for Charles L. Atwood dated March 8, 2004.
24.4
Power of Attorney for Desiree G. Rogers dated March 9, 2004.
24.5
Power of Attorney for B. Joseph White dated March 3, 2004.
24.6
Power of Attorney for Sheli Z. Rosenberg dated March 5, 2004.
24.7
Power of Attorney for James D. Harper, Jr. dated March 4, 2004.
24.8
Power of Attorney for Boone A. Knox dated March 3, 2004.
24.9
Power of Attorney for Michael N. Thompson dated March 5, 2004.
24.10
Power of Attorney for Samuel Zell dated March 2, 2004.
24.11
Power of Attorney for Gerald A. Spector dated March 2, 2004.
31.1
Certification of Bruce W. Duncan, Chief Executive Officer of Registrant’s General Partner.
31.2
Certification of David J. Neithercut, Chief Financial Officer of Registrant’s General Partner.
32.1
Certification Pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of Bruce W. Duncan, Chief Executive Officer of Registrant’s General Partner.
32.2
Certification Pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of David J. Neithercut, Chief Financial Officer of Registrant’s General Partner.
^ Included as Appendix A to Equity Residential’s Form S-4 filed on July 23, 2000.
* Included as an exhibit to the Operating Partnership’s Form 8-K/A dated July 23, 1998, filed on August 18, 1998.
** Included as an exhibit to the Operating Partnership’s Form 10/A dated December 12, 1994, File No. 0-24920, and incorporated herein by reference.
+ Included as an exhibit to the Operating Partnership’s Form 10-K for the year ended December 31, 1996.
++ Included as an exhibit to Equity Residential’s Form 10-K for the year ended December 31, 1999 and incorporated herein by reference.
+++ Included as an exhibit to the Operating Partnership’s Form 10-Q for the quarterly period ended June 30, 2002 and incorporated herein by reference.
(b) Reports on Form 8-K: None.
(c) Exhibits: See Item 15(a)(3) above.
(d) Financial Statement Schedules: See Index to Financial Statements attached hereto on page of this Form 10-K.
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 behalf by the undersigned thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the registrant and in the capacities and on the dates indicated have signed this report below.
INDEX TO FINANCIAL STATEMENTS AND SCHEDULE
ERP OPERATING LIMITED PARTNERSHIP
PAGE
FINANCIAL STATEMENTS FILED AS PART OF THIS REPORT
Report of Independent Auditors
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001
to
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001
to
Consolidated Statements of Changes in Partners’ Capital for the years ended December 31, 2003, 2002 and 2001
to
Notes to Consolidated Financial Statements
to
SCHEDULE FILED AS PART OF THIS REPORT
Schedule III - Real Estate and Accumulated Depreciation
S-1 to S-17
All other schedules have been omitted because they are inapplicable, not required or the information is included elsewhere in the consolidated financial statements or notes thereto.
REPORT TO INDEPENDENT AUDITORS
To the Partners
ERP Operating Limited Partnership
We have audited the accompanying consolidated balance sheets of ERP Operating Limited Partnership (the “Operating Partnership”) as of December 31, 2003 and 2002 and the related consolidated statements of operations, partners’ capital and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the accompanying index to financial statements and schedule. These financial statements and schedule are the responsibility of the Operating Partnership’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of ERP Operating Limited Partnership at December 31, 2003 and 2002, and the consolidated results of its operations and its 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. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, the Operating Partnership changed its method of accounting for stock-based compensation in 2003, changed its method of accounting for goodwill and discontinued operations in 2002 and changed its method of accounting for derivative instruments in 2001.
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands except per OP Unit data)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF OPERATIONS (Continued)
(Amounts in thousands except per OP Unit data)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Amounts in thousands)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Amounts in thousands)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF PARTNERS’ CAPITAL
(Amounts in thousands)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF PARTNERS’ CAPITAL (Continued)
(Amounts in thousands)
See accompanying notes
ERP OPERATING LIMITED PARTNERSHIP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Business
ERP Operating Limited Partnership (“ERPOP”), an Illinois limited partnership, was formed in May 1993 to conduct the multifamily residential property business of Equity Residential (“EQR”). EQR is a Maryland real estate investment trust (“REIT”) formed in March 1993 and is a fully integrated real estate company engaged in the acquisition, development, ownership, management and operation of multifamily properties.
EQR is the general partner of, and as of December 31, 2003 owned an approximate 92.7% ownership interest in ERPOP. ERPOP is, directly or indirectly, a partner, member or shareholder of numerous partnerships, limited liability companies and corporations which have been established primarily to own fee simple title to multifamily properties or to conduct property management activities and other businesses related to the ownership and operation of multifamily residential real estate. As used herein, the term “Operating Partnership” includes ERPOP and those entities owned or controlled by it. As used herein, the term “Company” means EQR and the Operating Partnership.
As of December 31, 2003, the Operating Partnership owned or had investments in 968 properties in 34 states consisting of 207,506 units. The ownership breakdown includes:
The “Wholly Owned Properties” are accounted for under the consolidation method of accounting. The Operating Partnership beneficially owns 100% fee simple title to 842 of the 849 Wholly Owned Properties. The Operating Partnership owns the building and improvements and leases the land underlying the improvements under a long-term ground lease that expires in 2026 for one property. This one property is consolidated and reflected as a real estate asset while the ground lease is accounted for as an operating lease in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 13, Accounting for Leases. The Operating Partnership owns the debt collateralized by two properties and owns an interest in the debt collateralized by the remaining four properties. The Operating Partnership consolidates its interest in these six properties in accordance with the accounting standards outlined in the AcSEC guidance for real estate acquisition, development and construction arrangements issued in the CPA letter dated February 10, 1986, and as such, reflects these assets as real estate in the consolidated financial statements.
The “Partially Owned Properties” are controlled by the Operating Partnership but have partners with minority interests and are accounted for under the consolidation method of accounting. The “Unconsolidated Properties” are partially owned but not controlled by the Operating Partnership. With the exception of one property, the Unconsolidated Properties consist of investments in partnership interests and/or subordinated mortgages that are accounted for under the equity method of accounting. The remaining one property consists of an investment in a limited liability company that, as a result of the terms of the operating agreement, is accounted for as a management contract right with all fees recognized as fee and asset management revenue. The above table does not include various uncompleted development properties summarized in Note 9.
2. Summary of Significant Accounting Policies
Basis of Presentation
Due to the Operating Partnership’s ability as general partner to control either through ownership or by contract its subsidiaries, other than entities that own controlling interests in the Unconsolidated Properties and certain other entities in which the Operating Partnership has investments, each such subsidiary has been consolidated with the Operating Partnership for financial reporting purposes. In July 2001, the Operating Partnership acquired 100% of a management company entity, which had a controlling ownership interest in a portfolio of 21 previously Unconsolidated Properties. Subsequent to this transaction, the Operating Partnership consolidated these 21 properties. In September 2001, the Operating Partnership acquired the remaining 5% of the preferred stock it did not own and 100% of the voting common stock in two other management company entities. As a result, the Operating Partnership now wholly-owns these two entities. The Operating Partnership consolidated the results of these two entities prior to this transaction despite not having legal control, the effects of which were immaterial.
Minority interests represented by EQR’s indirect 1% interest in various entities are immaterial and have not been accounted for in the Consolidated Financial Statements. In addition, certain amounts due from EQR for its 1% interest in various entities have not been reflected in the Consolidated Balance Sheets since such amounts are immaterial.
The Company’s mergers and acquisitions were accounted for as purchases in accordance with either Accounting Principles Board (“APB”) Opinion No. 16, Business Combinations, or SFAS No. 141, Business Combinations. SFAS No. 141 requires all business combinations initiated after June 30, 2001 be accounted for under the purchase method of accounting. The fair value of the consideration given by the Company in the mergers was used as the valuation basis for each of the combinations. The accompanying consolidated statements of operations and cash flows include the results of the properties purchased through the mergers and through acquisitions from their respective closing dates.
Real Estate Assets and Depreciation of Investment in Real Estate
The Operating Partnership allocates the purchase price of properties to net tangible and identified intangible assets acquired based on their fair values in accordance with the provisions of SFAS No. 141. In making estimates of fair values for purposes of allocating purchase price, the Operating Partnership utilizes a number of sources, including independent appraisals that may be obtained in connection with the acquisition or financing of the respective property, our own analysis of recently acquired and existing comparable properties in our portfolio, and other market data. The Operating Partnership also considers information obtained about each property as a result of its pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. The Operating Partnership allocates the purchase price of acquired real estate to various components as follows:
• Land - Based on actual purchase price if acquired separately or market research/comparables if acquired with an operating property.
• Furniture, Fixtures and Equipment - Ranges between $1,500 and $3,000 per apartment unit acquired as an estimate of the fair value of the appliances & fixtures inside a unit. The per-unit amount applied depends on the type of apartment building acquired. Depreciation is calculated on the straight-line method over an estimated useful life of five years.
• In-Place Leases - The Operating Partnership considers the value of acquired in-place leases that meet the definition outlined in SFAS No. 141, paragraph 37. The amortization period is the remaining term of each respective in-place acquired lease. Should a resident terminate its lease, the unamortized portion of the deferred in-place lease would be fully expensed.
• Other Intangible Assets - The Operating Partnership considers whether it has acquired other intangible assets that meet the definition outlined in SFAS No. 141, paragraph 39, including
any customer relationship intangibles. The amortization period is the estimated useful life of the acquired intangible asset.
• Building - Based on the fair value determined on an “as-if vacant” basis. Depreciation is calculated on the straight-line method over an estimated useful life of thirty years.
Replacements inside a unit such as appliances and carpeting, are depreciated over a five-year estimated useful life. Expenditures for ordinary maintenance and repairs are expensed to operations as incurred and significant renovations and improvements that improve and/or extend the useful life of the asset are capitalized over their estimated useful life, generally five to ten years. Initial direct leasing costs are expensed as incurred as such expense approximates the deferral and amortization of initial direct leasing costs over the lease terms. Property sales or dispositions are recorded when title transfers and sufficient consideration has been received by the Operating Partnership. Upon disposition, the related costs and accumulated depreciation are removed from the respective accounts. Any gain or loss on sale is recognized in accordance with accounting principles generally accepted in the United States.
The Operating Partnership classifies real estate assets as real estate held for disposition when it is certain a property will be disposed of in accordance with SFAS No. 144 (see further discussion below).
The Operating Partnership classifies properties under development and/or expansion and properties in the lease up phase as construction in progress until construction has been completed and all certificates of occupancy permits have been obtained. The Operating Partnership also classifies land relating to construction in progress as land on its balance sheets.
Impairment of Long-Lived Assets, Including Goodwill
In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 prohibits the amortization of goodwill and requires that goodwill be reviewed for impairment at least annually. In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS Nos. 142 and 144 were effective for fiscal years beginning after December 15, 2001. The Operating Partnership adopted these standards effective January 1, 2002. See Notes 16 and 22 for further discussion.
The Operating Partnership periodically evaluates its long-lived assets, including its investments in real estate and goodwill, for indicators of permanent impairment. The judgments regarding the existence of impairment indicators are based on factors such as operational performance, market conditions, expected holding period of each asset and legal and environmental concerns. Future events could occur which would cause the Operating Partnership to conclude that impairment indicators exist and an impairment loss is warranted.
For long-lived assets to be held and used, the Operating Partnership compares the expected future undiscounted cash flows for the long-lived asset against the carrying amount of that asset. If the sum of the estimated undiscounted cash flows is less than the carrying amount of the asset, an impairment loss would be recorded for the difference between the estimated fair value and the carrying amount of the asset.
For long-lived assets to be disposed of, an impairment loss is recognized when the estimated fair value of the asset, less the estimated cost to sell, is less than the carrying amount of the asset measured at the time that the Operating Partnership has determined it will sell the asset. Long-lived assets held for disposition and the related liabilities are separately reported at the lower of their carrying amounts or their estimated fair values, less their costs to sell, and are not depreciated after reclassification to real estate held for disposition.
Prior to January 1, 2002, the Operating Partnership followed the guidance in SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of.
Prior to 2002, the Operating Partnership amortized goodwill on a straight-line basis over a period of 20 years. The accumulated amortization of goodwill was $5.5 million at December 31, 2001. Subsequent to January 1, 2002, goodwill is not amortized but is subject to annual impairment tests.
Cost Capitalization
See the Real Estate Assets and Depreciation of Investment in Real Estate section for discussion of the policy with respect to capitalization vs. expensing of fixed asset/repair and maintenance costs. In addition, the Operating Partnership capitalizes the payroll and associated costs of employees directly responsible for and who spend all of their time on the supervision of major capital projects. These costs are reflected on the balance sheet as an increase to depreciable property.
The Operating Partnership follows the guidance in SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, for all development projects and uses its professional judgment in determining whether such costs meet the criteria for capitalization or must be expensed as incurred. The Operating Partnership capitalizes interest, real estate taxes and insurance and payroll and associated costs for those individuals directly responsible for and who spend all of their time on development activities. The Operating Partnership expenses as incurred all payroll costs of employees working directly at our properties, except for costs that are incurred during the initial lease-up phase on a development project. An allocated portion of payroll costs is capitalized based upon the occupancy of the project until stabilized occupancy is achieved. The incremental payroll and associated costs are capitalized to the projects under development based upon the effort directly identifiable with such projects. These costs are reflected on the balance sheet as either construction in progress or a separate component of investments in unconsolidated entities. The Operating Partnership ceases the capitalization of such costs as the property becomes substantially complete and ready for its intended use.
Cash and Cash Equivalents
The Operating Partnership considers all demand deposits, money market accounts and investments in certificates of deposit and repurchase agreements purchased with a maturity of three months or less, at the date of purchase, to be cash equivalents. The Operating Partnership maintains its cash and cash equivalents at financial institutions. The combined account balances at one or more institutions periodically exceed the Federal Depository Insurance Corporation (“FDIC”) insurance coverage, and, as a result, there is a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. The Operating Partnership believes that the risk is not significant, as the Operating Partnership does not anticipate the financial institutions’ non-performance.
Deferred Financing Costs
Deferred financing costs include fees and costs incurred to obtain the Operating Partnership’s line of credit, long-term financings and costs for certain interest rate protection agreements. These costs are amortized over the terms of the related debt. Unamortized financing costs are written-off when debt is retired before the maturity date. The accumulated amortization of such deferred financing costs was $16.0 million and $15.2 million at December 31, 2003 and 2002, respectively.
Fair Value of Financial Instruments, Including Derivative Instruments
The valuation of financial instruments under SFAS No. 107, Disclosures about Fair Value of Financial Instruments, and SFAS No. 133 and its amendments (SFAS Nos. 137/138/149), Accounting for Derivative Instruments and Hedging Activities, requires the Operating Partnership to make estimates and judgments that affect the fair value of the instruments. The Operating Partnership, where possible, bases the fair values of its financial instruments, including its derivative instruments, on listed market prices
and third party quotes. Where these are not available, the Operating Partnership bases its estimates on other factors relevant to the financial instruments.
In the normal course of business, the Operating Partnership is exposed to the effect of interest rate changes. The Operating Partnership limits these risks by following established risk management policies and procedures including the use of derivatives to hedge interest rate risk on debt instruments.
The Operating Partnership has a policy of only entering into contracts with major financial institutions based upon their credit ratings and other factors. When viewed in conjunction with the underlying and offsetting exposure that the derivatives are designed to hedge, the Operating Partnership has not sustained a material loss from those instruments nor does it anticipate any material adverse effect on its net income or financial position in the future from the use of derivatives.
On January 1, 2001, the Operating Partnership adopted SFAS No. 133 and its amendments (SFAS Nos. 137/138/149), which requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and to measure those instruments at fair value. Additionally, the fair value adjustments will affect either partners’ capital or net income depending on whether the derivative instruments qualify as a hedge for accounting purposes and, if so, the nature of the hedging activity. When the terms of an underlying transaction are modified, or when the underlying transaction is terminated or completed, all changes in the fair value of the instrument are marked-to-market with changes in value included in net income each period until the instrument matures. Any derivative instrument used for risk management that does not meet the hedging criteria of SFAS No. 133 is marked-to-market each period. The Operating Partnership does not use derivatives for trading or speculative purposes.
As of January 1, 2001, the adoption of the new standard resulted in derivative instruments reported on the balance sheet as liabilities of approximately $6.6 million; an adjustment of approximately $5.3 million to accumulated other comprehensive loss, which are gains and losses not affecting retained earnings in the consolidated statements of partners’ capital; and a charge of approximately $1.3 million as a cumulative effect of change in accounting principle in the consolidated statements of operations.
The fair values of the Operating Partnership’s financial instruments, other than derivative instruments, including cash and cash equivalents, mortgage notes payable, other notes payable, line of credit and other financial instruments, approximate their carrying or contract values.
Revenue Recognition
Rental income attributable to leases is recorded when due from residents and is recognized monthly as it is earned, which is not materially different than on a straight-line basis. Interest income is recorded on an accrual basis. Leases entered into between a resident and a property, for the rental of an apartment unit, are generally year-to-year, renewable upon consent of both parties on an annual or monthly basis.
Stock-Based Compensation
Prior to 2003, the Company had chosen to account for its stock-based compensation in accordance with APB No. 25, Accounting for Stock Issued to Employees, which resulted in no compensation expense for options issued with an exercise price equal to or exceeding the market value of EQR’s Common Shares on the date of grant (intrinsic method). The Company has elected to account for its stock-based compensation in accordance with SFAS No. 123 and its amendment (SFAS No. 148), Accounting for Stock Based Compensation, effective in the first quarter of 2003, which resulted in compensation expense being recorded based on the fair value of the stock compensation granted. Any Common Shares issued pursuant to EQR’s incentive equity compensation and employee share purchase plans will result in the Operating Partnership issuing OP Units to EQR on a one-for-one basis, with the Operating Partnership receiving the net cash proceeds of such issuances.
SFAS No. 148 provides three transition methods for entities that adopt the fair value recognition provisions of SFAS No. 123. The Company has chosen to use the “Prospective Method”. This method requires that companies apply the recognition provisions of SFAS No. 123 to only employee awards granted or modified after the beginning of the fiscal year in which the recognition provisions are first applied, or January 1, 2003. Compensation expense under all of the Company’s plans is generally recognized over periods ranging from three months to five years. Therefore, the cost related to stock-based employee compensation included in the determination of net income for the year ended December 31, 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123.
The following table illustrates the effect on net income and earnings per OP Unit if the fair value based method had been applied to all outstanding and unvested awards in each period presented:
(1) Share options for the year ended December 31, 2003 included $1.4 million of expense recognition related to options granted in the first quarter of 2003 to EQR’s former chief executive officer. These options vested immediately upon grant.
The fair value of the option grants as computed under SFAS No. 123 would be recognized over the vesting period of the options. The fair value for the Company’s share options was estimated at the time the share options were granted using the Black Scholes option pricing model with the following weighted-average assumptions:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s share options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its share options.
Income Taxes
The Operating Partnership generally is not liable for Federal income taxes as the partners recognize their proportionate share of the Operating Partnership’s income or loss in their tax returns; therefore generally no provision for Federal income taxes is made in the financial statements of the Operating Partnership. However, the Operating Partnership is subject to certain state and local income, excise and franchise taxes. The aggregate cost of land and depreciable property for federal income tax purposes as of December 31, 2003 and 2002 was approximately $8.5 billion and $8.7 billion, respectively.
Effective in 2001, the Operating Partnership has elected Taxable REIT Subsidiary (“TRS”) status for certain of its corporate subsidiaries. The provisions for federal income taxes for these TRS entities were not material during 2003, 2002 or 2001 and were recognized as general and administrative expenses in the consolidated statements of operations.
During the years ended December 31, 2003, 2002 and 2001, the Operating Partnership’s tax treatment of distributions were as follows:
Partners’ Capital
The “Limited Partners” of ERPOP include various individuals and entities that contributed their properties to ERPOP in exchange for units of limited partnership interest in ERPOP (“OP Units”). The “General Partner” of ERPOP is EQR. Net income is allocated to the Limited Partners based on their
respective ownership percentage of the Operating Partnership. The ownership percentage is calculated by dividing the number of OP Units held by the Limited Partners by the total OP Units held by the Limited Partners and the General Partner. Issuance of additional EQR common shares of beneficial interest, $0.01 par value per share (the “Common Shares”), and OP Units changes the ownership interests of both the Limited Partners and EQR. Such transactions and the proceeds therefrom are treated as capital transactions.
Minority Interests
The Operating Partnership reflects minority interests in partially owned properties on the balance sheet for the portion of properties consolidated by the Operating Partnership that are not wholly owned by the Operating Partnership. The earnings or losses from those properties attributable to the minority interests are reflected as minority interests in partially owned properties in the consolidated statements of operations.
Use of Estimates
In preparation of the Operating Partnership’s financial statements in conformity with accounting principles generally accepted in the United States, management makes 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 as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
Reclassifications
Certain reclassifications considered necessary for a fair presentation have been made to the prior period financial statements in order to conform to the current year presentation. These reclassifications have not changed the results of operations or partners’ capital.
Other
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145, among other items, rescinds the automatic classification of costs incurred on debt extinguishment as extraordinary charges. Instead, gains and losses from debt extinguishment should only be classified as extraordinary if they meet the “unusual and infrequently occurring” criteria outlined in APB No. 30. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. The Operating Partnership adopted the standard effective January 1, 2003. Prior period gains/losses have been reclassified to a component of interest expense.
In January 2003, the FASB issued Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities. FIN No. 46 requires a variable interest entity to be consolidated if a company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The Operating Partnership will adopt FIN No. 46 as required effective March 31, 2004. FASB Staff Position (“FSP”) No. FIN 46-6 deferred the effective date for applying the provisions of FIN No. 46 (for entities created before February 1, 2003) from July 1, 2003 to December 31, 2003. FIN No. 46-R released in December 2003 further deferred the effective date for the Operating Partnership’s variable interest entities to March 31, 2004. The Operating Partnership has preliminarily determined that its unconsolidated stabilized development projects and projects under development (see Note 9) are variable interest entities in which the Operating Partnership is the primary beneficiary as of the date of the original formation of the respective joint ventures. On such respective formation dates, the fair value of the assets, liabilities and non-controlling interests of these development projects approximates carryover basis. If these development projects had been consolidated as of December 31, 2003, the Operating Partnership’s investment in real estate and mortgage notes payable would have increased by $1.3 billion and $877.7 million, respectively, and investments in unconsolidated entities would have decreased by $465.4 million. The Operating Partnership does not anticipate that the
adoption of FIN No. 46 will have any material effect on net income.
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 classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. On November 7, 2003, the FASB issued FSP No. FAS 150-3, which deferred for an indefinite period the classification and measurement provisions, but not the disclosure provisions (see discussion below), of SFAS No. 150 as it relates to noncontrolling interests that are classified as equity in the financial statements of a subsidiary but would be classified as a liability in the parent’s financial statements under SFAS No. 150 (e.g., minority interests in consolidated limited-life subsidiaries). The Operating Partnership has determined that it does not have any mandatorily redeemable preferred shares/units that fall within the scope of SFAS No. 150.
With regards to the aforementioned disclosure provisions, the Operating Partnership is presently the controlling partner in various consolidated partnerships consisting of 35 properties and 6,778 units having a minority interest book value of $9.9 million at December 31, 2003. These partnerships contain provisions that require the partnerships to be liquidated through the sale of its assets upon reaching a date specified in each respective partnership agreement. The Operating Partnership, as controlling partner, has an obligation to cause the property owning partnerships to distribute proceeds of liquidation to the Minority Interests in these Partially Owned Properties only to the extent that the net proceeds received by the partnerships from the sale of its assets warrant a distribution based on the partnership agreements. As of December 31, 2003, the Operating Partnership estimates the value of Minority Interest distributions would have been approximately $104 million (“Settlement Value”) had the partnerships been liquidated. This Settlement Value is based on estimated third party consideration realized by the partnerships upon disposition of the Partially Owned Properties and is net of all other assets and liabilities including yield maintenance on the mortgages encumbering the properties that would have been due on December 31, 2003 had those mortgages been prepaid. Due to, among other things, the inherent uncertainty in the sale of real estate assets, the amount of any potential distribution to the Minority Interests in the Operating Partnership’s Partially Owned Properties is subject to change. To the extent that the partnerships’ underlying assets are worth less than the underlying liabilities, the Operating Partnership has no obligation to remit any consideration to the Minority Interests in Partially Owned Properties.
On July 31, 2003, the SEC clarified its position with respect to Emerging Issues Task Force (“EITF”) Topic D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock. Under the SEC’s revised interpretation, in connection with the redemption of preferred shares/units, the original issuance costs of these shares/units must be treated in a manner similar to preferred distributions and deducted from net income in arriving at net income available to OP Units. The clarification of EITF Topic D-42 was required to be adopted effective July 1, 2003 on a retroactive basis by restating prior periods included in the current financial statements. The adoption of the clarification of EITF Topic D-42 resulted in the retroactive write-off of $5.3 million of original issuance costs related to the Operating Partnership’s redemption of its Series A Preference Units in June 2001. In addition, the Operating Partnership recorded an $8.3 million cash premium and $11.9 million in original issuance costs related to the redemption of its Series G Preference Units in December 2003. The Operating Partnership had no recorded original issuance costs associated with, nor did it incur any cash redemption premium upon redemption of, its Series F Preference Units redeemed in 2001 or its Series L Preference Units redeemed in 2003.
3. Business Combinations
During 2001 and prior to the one-year anniversary of the Globe Business Resources, Inc. (“Globe”) acquisition, the Operating Partnership recorded net increases to goodwill of $9.5 million to reallocate the original purchase price recorded at the acquisition date. Also during 2001, the Operating Partnership recorded a $60.0 million asset impairment charge related to its furniture rental business. During 2002, the Operating Partnership recorded a $17.1 million asset impairment charge related to
Equity Corporate Housing (“ECH”). See Notes 16 and 22.
On January 11, 2002, the Operating Partnership sold the former Globe furniture rental business for approximately $30.0 million in cash, which approximated the net book value at the sale date. The Operating Partnership has retained ownership of the former Globe short-term furnished housing business, which is now known as ECH.
4. Partners’ Capital
The following table presents the changes in the Operating Partnership’s issued and outstanding OP Units for the years ended December 31, 2003, 2002 and 2001:
In February 1998, EQR filed and the SEC declared effective a Form S-3 Registration Statement to register $1.0 billion of equity securities. In addition, EQR carried over $272.4 million related to a prior registration statement. As of December 31, 2003, $956.5 million in equity securities remained available for issuance under this registration statement. Per the terms of ERPOP’s partnership agreement, EQR contributes the net proceeds of all equity offerings to the capital of the Operating Partnership in exchange for additional OP Units (on a one-for-one Common Share per OP Unit basis) or preference units (on a one-for-one preferred share per preference unit basis).
During October 2002, EQR repurchased 5,092,300 of its Common Shares on the open market at an average price of $22.58 per share. EQR paid approximately $115.0 million for these shares, which were retired subsequent to the repurchase. Concurrent with this transaction, the Operating Partnership repurchased and retired 5,092,300 OP Units previously issued to EQR.
The limited partners of the Operating Partnership as of December 31, 2003 include various individuals and entities that contributed their properties to the Operating Partnership in exchange for OP Units (“the Limited Partners”) and own an approximate 7.3% ownership interest in ERPOP. Subject to applicable securities law restrictions, the Limited Partners may exchange their OP Units for EQR Common Shares on a one-for-one basis.
EQR contributes all net proceeds from its various equity offerings (including proceeds from exercise of options for EQR Common Shares) to the Operating Partnership. In return for those contributions, EQR receives a number of OP Units in ERPOP equal to the number of Common Shares it has issued in the equity offering (or in the case of a preferred equity offering, a number of preference units in ERPOP equal in number and having the same terms as the preferred shares issued in the equity offering).
During 2003, the Operating Partnership issued 313,720 OP Units to various limited partners at an average price of $26.11 per unit. These OP Units are classified as Limited Partners capital in the accompanying consolidated balance sheets.
The following table presents the Operating Partnership’s issued and outstanding “Preference Units” as of December 31, 2003 and 2002:
(1) On or after the redemption date, redeemable preference units (Series B, C, D, K, and N) may be redeemed for cash at the option of the Operating Partnership, in whole or in part, at a redemption price equal to the liquidation price per unit, plus accrued and unpaid distributions, if any, in conjunction with the concurrent redemption of the corresponding EQR Preferred Shares.
(2) On or after the redemption date, convertible preference units (Series E & H) may be redeemed under certain circumstances at the option of the Operating Partnership for cash or OP Units, in whole or in part, at various redemption prices per unit based upon the contractual conversion rate, plus accrued and unpaid distributions, if any, in conjunction with the concurrent redemption/conversion of the corresponding EQR Preferred Shares.
(3) Dividends on all series of Preference Units are payable quarterly at various pay dates. Dividend rates listed for Series B, C, D and N are Preference Unit rates and the equivalent depositary unit annual dividend rates are $2.281252, $2.281252, $2.15 and $1.62, respectively.
(4) On June 19, 2003, the Operating Partnership redeemed all of its outstanding Series L Cumulative Redeemable Preference Units at liquidation value for total cash consideration of $100.0 million in conjunction with the concurrent redemption of the corresponding EQR Preferred Share. The Operating Partnership did not incur any original issuance costs as these units were issued by Merry Land and Investment Company, Inc. prior to its merger with the Company.
(5) On June 19, 2003, EQR issued 600,000 Series N Cumulative Redeemable Preferred Shares in a public offering. The Company received $145.3 million in net proceeds from this offering after payment of the underwriters’ fee. These net proceeds were contributed by EQR to the Operating Partnership in exchange for 600,000 of the Operating Partnership’s 6.48% Series N Cumulative Redeemable Preference Units.
(6) On December 26, 2003, the Operating Partnership redeemed the remaining outstanding Series G Convertible Cumulative Preference Units for cash consideration of $295.3 million, which included the liquidation value of $287.0 million and a cash redemption premium of $8.3 million. This redemption was completed in conjunction with the concurrent redemption of the corresponding EQR Preferred Share. The Operating Partnership recorded the $8.3 million cash redemption premium along with the write-off of $11.9 million in original issuance costs as a premium on redemption of preference units in the accompanying consolidated statements of operations.
Cumulative through December 31, 2003, a subsidiary of ERPOP issued various series of Preference Interests with an equity value of $246.0 million receiving net proceeds of $239.9 million. The following table presents the issued and outstanding Preference Interests as of December 31, 2003 and December 31, 2002:
(1) On or after the fifth anniversary of the respective issuance (the “Redemption Date”), all of the Preference Interests may be redeemed for cash at the option of the Company, in whole or in part, at any time or from time to time, at a redemption price equal to the liquidation preference of $50.00 per unit plus the cumulative amount of accrued and unpaid distributions, if any.
(2) On or after the tenth anniversary of the respective issuance (the “Conversion Date”), all of the Preference Interests are exchangeable at the option of the holder (in whole but not in part) on a one-for-one basis for a respective reserved series of EQR Preferred Shares. In addition, on or after the Conversion Date, the convertible Preference Interests (Series H, I & J) may be converted under certain circumstances at the option of the holder (in whole but not in part) to Common Shares based upon the contractual conversion rate, plus accrued and unpaid distributions, if any.
(3) Dividends on all series of Preference Interests are payable quarterly on March 25th, June 25th, September 25th, and December 25th of each year.
The following table presents the Operating Partnership’s issued and outstanding Junior Convertible Preference Units (the “Junior Preference Units”) as of December 31, 2003 and December 31, 2002:
(1) On the fifth anniversary of the respective issuance (the “Redemption Date”), the Series A Junior Preference Units shall be automatically converted into OP Units based upon the conversion rate. Prior to the Redemption Date, the Operating Partnership or the holders may elect to convert the Series A Junior Preference Units to OP Units under certain circumstances based upon the conversion rate.
(2) On or after the tenth anniversary of the issuance (the “Redemption Date”), the Series B Junior Preference Units may be converted into OP Units at the option of the Operating Partnership based on the contractual conversion rate. Prior to the Redemption Date, the holders may elect to convert the Series B Junior Preference Units to OP Units under certain circumstances based on the contractual conversion rate. The contractual conversion rate is based upon a ratio dependent upon the closing price of EQR’s Common Shares.
(3) Dividends on both series of Junior Preference Units are payable quarterly at various pay dates.
(4) On December 22, 2003, 36,283 Series A Junior Preference Units issued on December 22, 1998 automatically converted to 148,092 OP Units. The remaining 20,333 Series A Junior Preference Units will automatically convert to OP Units on June 29, 2004, if not converted sooner.
5. Real Estate Acquisitions
The following table summarizes the carrying amounts for investment in real estate (at cost) as of December 31, 2003 and 2002 (Amounts are in thousands):
During the year ended December 31, 2003, the Operating Partnership acquired the entire equity interest in seventeen properties containing 5,200 units from unaffiliated parties, inclusive of two additional units at an existing property, for a total purchase price of $684.1 million.
During the year ended December 31, 2003, the Operating Partnership acquired the majority of the remaining third party equity interests it did not previously own in eleven properties containing 1,090 units. These properties were accounted for under the equity method of accounting and subsequent to each purchase were consolidated. The Operating Partnership recorded $111.1 million in investment in real estate and the following:
• Assumed $51.6 million in mortgage debt;
• Issued 153,851 OP Units having a value of $4.2 million;
• Recorded $42,000 of minority interest in partially owned properties;
• Reduced investments in unconsolidated entities by $34.9 million;
• Consolidated and/or received net cash of $6.9 million; and
• Assumed $27.2 million of other liabilities net of other assets acquired.
During the year ended December 31, 2002, the Operating Partnership acquired the entire equity interest in twelve properties containing 3,634 units for a total purchase price of $289.9 million.
During the fourth quarter of 2002, the Operating Partnership paid $40.1 million in cash and used tax-deferred (1031) exchange proceeds of $42.3 million to acquire the remaining third-party equity interests it did not previously own in two properties containing 826 units. These properties were accounted for under the equity method of accounting and subsequent to these purchases were consolidated. Accordingly, the Company recorded an additional $102.1 million in investment in real estate.
On December 31, 2002, the Operating Partnership contributed one of its development properties to one of its development partners, retaining a 50% common equity ownership interest. As a result of this contribution, the Company no longer can exercise sole control over the major decisions (such as sale and/or financing/refinancing) regarding this property. Effective with the contribution, the Operating Partnership accounted for this project under the equity method of accounting. No gain or loss on sale was recognized as the contribution was effectuated at carryover basis. As a result of this transaction, the Operating Partnership reduced investment in real estate by $203.7 million (of which land and construction in progress were reduced by $60.6 million and $143.1 million, respectively), reduced mortgage debt by $118.4 million and increased investments in unconsolidated entities by $80.7 million.
6. Real Estate Dispositions
During the year ended December 31, 2003, the Operating Partnership disposed of ninety-six properties containing 23,486 units to unaffiliated parties, inclusive of various individual condominium units, for a total sales price of $1.22 billion allocated as follows:
• Wholly Owned Properties - 91 properties containing 22,698 units for a total sales price of $1.19 billion;
• Partially Owned Properties - 3 properties containing 465 units for a total sales price of $13.6 million; and
• Unconsolidated Properties - 2 properties containing 323 units for a total sales price of $13.9 million (represents the Operating Partnership’s allocated share of the net disposition proceeds).
The Operating Partnership recognized a net gain on sales of discontinued operations of approximately $310.7 million and a net gain on sales of unconsolidated entities of approximately $4.9 million on the above sales.
During the year ended December 31, 2002, the Operating Partnership sold fifty-eight properties containing 10,713 units to unaffiliated parties for a total sales price of $546.2 million. The Operating Partnership recognized a net gain on sales of discontinued operations of approximately $104.3 million and a net gain on sales of unconsolidated entities of approximately $5.1 million.
7. Commitments to Acquire/Dispose of Real Estate
As of February 4, 2004, in addition to the properties that were subsequently acquired as discussed in Note 24, the Operating Partnership had entered into a separate agreement to acquire one multifamily property containing 540 units from an unaffiliated party. The Operating Partnership expects a purchase price of approximately $73.0 million.
As of February 4, 2004, in addition to the properties that were subsequently disposed of as discussed in Note 24, the Operating Partnership had entered into separate agreements to dispose of eleven multifamily properties containing 3,626 units to unaffiliated parties. The Operating Partnership expects a combined disposition price of approximately $208.5 million.
The closings of these pending transactions are subject to certain contingencies and conditions, therefore, there can be no assurance that these transactions will be consummated or that the final terms thereof will not differ in material respects from those summarized in the preceding paragraphs.
8. Investment in Mortgage Notes, Net
In 1995, the Operating Partnership invested $89 million in various partnership interests and subordinated mortgages collateralized by 21 properties consisting of 3,896 units. Prior to the consolidation of these properties, the Operating Partnership received $61.4 million in cash during 2001 as partial repayment of its investment in these mortgage notes.
On July 2, 2001, the Operating Partnership acquired an additional ownership interest in the 21 entities that own the Unconsolidated Properties. As a result of this additional ownership interest, the Operating Partnership now has a controlling interest, and as such, consolidates these properties for financial reporting purposes.
During 2001, the Operating Partnership amortized $2.3 million, which represented a portion of the original discount when the notes were purchased. This discount was being amortized utilizing the effective yield method based on the expected life of the investment.
9. Investments in Unconsolidated Entities
The Operating Partnership has co-invested in various properties with unrelated third parties. The following table summarizes the Operating Partnership’s investments in unconsolidated entities as of December 31, 2003 (amounts in thousands except for project and unit amounts):
(1) Includes seven projects under development containing 2,038 units, which are not included in the Operating Partnership’s property/unit counts at December 31, 2003. Totals also exclude Fort Lewis Military Housing consisting of one property and 3,757 units, which is not accounted for under the equity method of accounting. The Fort Lewis Military Housing is included in the Operating Partnership’s property/unit counts as of December 31, 2003.
(2) A total of $666.6 million is available for funding under this construction debt, of which $502.5 million was funded and outstanding at December 31, 2003.
(3) As of February 4, 2004, the Operating Partnership has funded $44.0 million as additional collateral on selected debt (see Note 10). All remaining debt is non-recourse to the Operating Partnership.
Investments in unconsolidated entities include the Unconsolidated Properties as well as various development properties under construction or pending construction. These investments are accounted for utilizing the equity method of accounting. Under the equity method of accounting, the net equity investment of the Operating Partnership is reflected on the consolidated balance sheets and after the project is completed, the consolidated statements of operations include the Operating Partnership’s share of net income or loss from the unconsolidated entity. Prior to the project being completed, the Operating Partnership capitalizes interest on its equity contribution in accordance with the provisions of SFAS No. 58, Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method. During the years ended December 31, 2003, 2002 and 2001, the Operating Partnership capitalized $20.6 million, $17.2 million and $19.9 million, respectively, in interest cost related to its unconsolidated development projects (which reduced interest expense incurred in the consolidated statements of operations).
The Operating Partnership generally contributes between 25% and 35% of the project cost of the unconsolidated projects under development (constituting 100% of the equity), with the remaining cost financed through third-party construction mortgages. Voting rights are shared equally between the Operating Partnership and its respective development partners.
See Note 2 for further discussion regarding FIN No. 46 and its anticipated effect on the Operating Partnership’s unconsolidated development projects.
10. Deposits - Restricted
As of December 31, 2003, deposits-restricted totaled $133.8 million and primarily included the following:
• Deposits in the amount of $44.0 million held in third party escrow accounts to provide collateral for third party construction financing in connection with unconsolidated development projects;
• Approximately $27.7 million in tax-deferred (1031) exchange proceeds; and
• Approximately $62.1 million for resident security, utility, and other deposits.
As of December 31, 2002, deposits-restricted totaled $141.3 million and primarily included the following:
• Deposits in the amount of $51.0 million held in third party escrow accounts to provide collateral for third party construction financing in connection with unconsolidated development projects;
• Approximately $25.4 million in tax-deferred (1031) exchange proceeds; and
• Approximately $64.9 million for resident security, utility, and other deposits.
11. Mortgage Notes Payable
As of December 31, 2003, the Operating Partnership had outstanding mortgage indebtedness of approximately $2.7 billion.
During the year ended December 31, 2003, the Operating Partnership:
• Repaid $432.9 million of mortgage loans;
• Assumed $141.1 million of mortgage debt on certain properties in connection with their acquisitions and/or consolidations;
• Obtained $111.2 million of mortgage loans on certain properties; and
• Relinquished $53.3 million of mortgage debt assumed by the purchaser on disposed properties.
As of December 31, 2003, scheduled maturities for the Operating Partnership’s outstanding mortgage indebtedness were at various dates through November 1, 2033. At December 31, 2003, the interest rate range on the Operating Partnership’s mortgage debt was 1.06% to 12.465%. During the year ended December 31, 2003, the weighted average interest rate on the Operating Partnership’s mortgage debt was 5.80%.
The historical cost, net of accumulated depreciation, of encumbered properties was $3.8 billion and $4.1 billion at December 31, 2003 and 2002, respectively.
Aggregate payments of principal on mortgage notes payable for each of the next five years and thereafter are as follows (amounts in thousands):
As of December 31, 2002, the Operating Partnership had outstanding mortgage indebtedness of approximately $2.9 billion.
During the year ended December 31, 2002, the Operating Partnership:
• Repaid $407.7 million of mortgage loans;
• Assumed $50.5 million of mortgage debt on certain properties in connection with their acquisitions and/or consolidations;
• Relinquished $128.3 million of mortgage debt assumed by the purchaser on disposed properties and the furniture rental business;
• Obtained $30.0 million of mortgage loans on certain properties; and
• Obtained $96.1 million in construction loans on certain properties.
As of December 31, 2002, scheduled maturities for the Operating Partnership’s outstanding mortgage indebtedness were at various dates through October 1, 2033. At December 31, 2002, the interest rate range on the Operating Partnership’s mortgage debt was 1.29% to 12.465%. During the year ended December 31, 2002, the weighted average interest rate on the Operating Partnership’s mortgage debt was 6.35%.
12. Notes
The following tables summarize the Operating Partnership’s unsecured note balances and certain interest rate and maturity date information as of and for the years ended December 31, 2003 and 2002,
respectively:
(1) The interest rate on this note was LIBOR (reset quarterly) plus a spread equal to 0.63% throughout all of 2002 and through August 21, 2003. On August 21, 2003, these notes matured and were repaid in full.
The Operating Partnership’s unsecured public debt contains certain financial and operating covenants including, among other things, maintenance of certain financial ratios. The Operating Partnership was in compliance with its unsecured public debt covenants for the years ended December 31, 2003 and 2002.
In June 2003, the Operating Partnership filed and the SEC declared effective a Form S-3 registration statement to register $2.0 billion of debt securities. In addition, the Operating Partnership carried over $280.0 million related to a prior registration statement. As of December 31, 2003, $2.28 billion in debt securities remained available for issuance under this registration statement.
During the year ended December 31, 2003, the Operating Partnership:
• Issued $400.0 million of ten-year 5.20% fixed-rate public notes, receiving net proceeds of $397.5 million;
• Repaid $100.0 million of floating rate public notes at maturity;
• Repaid $50.0 million and $40.0 million of 6.65% and 6.875%, respectively, fixed rate public notes at maturity; and
• Repaid $4.5 million of other unsecured notes.
During the year ended December 31, 2002, the Operating Partnership:
• Issued $400.0 million of ten-year 6.625% fixed-rate public notes and $50.0 million of five-year 4.861% fixed rate public notes, receiving net proceeds of $444.4 million;
• Repaid $100.0 million of 9.375% fixed rate public notes at maturity;
• Repaid $125.0 million of 7.95% fixed rate public notes at maturity; and
• Repaid $40.0 million of 7.25% fixed rate public notes at maturity.
Aggregate payments of principal on unsecured notes payable for each of the next five years and thereafter are as follows (amounts in thousands):
(1) Includes $300 million with a final maturity of 2015 that is putable/callable in 2005.
(2) Includes $150 million with a final maturity of 2026 that is putable in 2006.
13. Line of Credit
On May 30, 2002, the Operating Partnership obtained a new three-year $700.0 million unsecured revolving credit facility maturing May 29, 2005. The new line of credit replaced the $700.0 million unsecured revolving credit facility that was scheduled to expire in August 2002. The prior existing revolving credit facility was terminated upon the closing of the new facility. Advances under the new credit facility bear interest at variable rates based upon LIBOR at various interest periods, plus a spread dependent upon the Operating Partnership’s credit rating, or based upon bids received from the lending group. EQR has guaranteed the Operating Partnership’s line of credit up to the maximum amount and for the full term of the facility.
As of December 31, 2003 and 2002, $10.0 million and $140.0 million, respectively, was outstanding and $56.7 million and $60.8 million, respectively, was restricted (dedicated to support letters of credit and not available for borrowing) on the line of credit. During the years ended December 31, 2003 and 2002, the weighted average interest rate was 1.85% and 2.30%, respectively.
14. Derivative Instruments
The following table summarizes the consolidated derivative instruments at December 31, 2003 (dollar amounts are in thousands):
During the year ended December 31, 2003, the Operating Partnership paid approximately $13.0 million to terminate eight forward starting interest rate swaps in conjunction with the issuance of $400.0 million of ten-year unsecured notes. The $13.0 million payment has been deferred as a component of accumulated other comprehensive loss and will be recognized as additional interest expense over the ten-
year life of the unsecured notes.
At December 31, 2003, certain unconsolidated development partnerships in which the Operating Partnership invested had entered into swaps to hedge the interest rate risk exposure on unconsolidated floating rate construction mortgage loans. The Operating Partnership has recorded these hedges on its consolidated balance sheets. These swaps have been designated as cash flow hedges with a current aggregate notional amount of $277.9 million (notional amounts range from $26.5 million to $285.9 million over the terms of the swaps) at interest rates ranging from 1.78% to 6.94% maturing at various dates ranging from 2004 to 2005 with a net liability fair value of $5.2 million. During the years ended December 31 2003 and 2002, the Operating Partnership recognized an unrealized gain of $1.5 million and an unrealized loss of $1.1 million, respectively, due to ineffectiveness of certain of these unconsolidated development derivatives (included in loss from investments in unconsolidated entities).
On December 31, 2003, the derivative instruments were reported at their fair value as other assets of approximately $10.4 million, as other liabilities of approximately $6.5 million and as a reduction to investments in unconsolidated entities of approximately $5.2 million. As of December 31, 2003, there were approximately $23.3 million in deferred losses, net, included in accumulated other comprehensive loss. Based on the estimated fair values of the net derivative instruments at December 31, 2003, the Operating Partnership may recognize an estimated $9.4 million of accumulated other comprehensive loss as additional interest expense ($5.7 million related to its consolidated derivatives) or as additional loss on investments in unconsolidated entities ($3.7 million related to its unconsolidated development partnerships) during the twelve months ending December 31, 2004.
15. Earnings Per OP Unit
The following tables set forth the computation of net income per OP Unit - basic and net income per OP Unit - diluted:
Convertible preference units/interests that could be converted into 14,745,904, 15,335,977 and 15,461,626 weighted average Common Shares (which would be contributed to the Operating Partnership in exchange for OP Units) for the years ended December 31, 2003, 2002 and 2001, respectively, were outstanding but were not included in the computation of diluted earnings per OP Unit because the effects would be anti-dilutive.
For additional disclosures regarding the employee share options and restricted shares, see Notes 2 and 17.
16. Discontinued Operations
The Operating Partnership has presented separately as discontinued operations in all periods the results of operations for all wholly owned assets disposed of on or after January 1, 2002 (the date of adoption of SFAS No. 144).
The components of discontinued operations are outlined below and include the results of operations for the respective periods that the Operating Partnership owned such assets during each of the years ended December 31, 2003, 2002 and 2001, including the following:
• The ninety-one Wholly Owned Properties and various individual condominium units containing 22,698 units sold during 2003; and
• The fifty-two Wholly Owned Properties and various individual condominium units containing 9,586 units and the furniture rental business sold during 2002.
(1) Includes expenses paid in the current period for Wholly Owned Properties sold in prior periods related to the Operating Partnership’s period of ownership.
(2) Interest includes only specific amounts from each property sold.
For the properties sold during 2003, the investment in real estate, net of accumulated depreciation, and the mortgage notes payable balances at December 31, 2002 were $883.6 million and $89.1, million respectively.
During the year ended December 31, 2002, the Operating Partnership disposed of its furniture rental business for $30.0 million and received net proceeds of $28.7 million. After giving effect to a previously recorded impairment loss, no gain/loss on sale was recognized as the net book value at the sale date approximated the sales price.
During the year ended December 31, 2001, the Operating Partnership recorded $60.0 million of asset impairment charges related to its furniture rental business. These charges were the result of a review of the existing intangible and tangible assets reflected on the consolidated balance sheet as of September 30, 2001. The Operating Partnership reviewed the current net book value taking into consideration existing business and economic conditions as well as projected cash flows. The impairment loss includes the write-down of the following assets: a) goodwill of approximately $26.0 million; b) rental furniture, net of approximately $28.6 million; c) property and equipment, net of approximately $4.5 million; and d) other assets of approximately $0.9 million.
17. Share Incentive Plans
Any Common Shares issued pursuant to EQR’s incentive equity compensation and employee
share purchase plans will result in the Operating Partnership issuing OP Units to EQR on a one-for-one basis, with the Operating Partnership receiving the net cash proceeds of such issuances.
On May 15, 2002, the shareholders of EQR approved the Company’s 2002 Share Incentive Plan. The maximum aggregate number of awards that may be granted under this plan may not exceed 7.5% of the Company’s outstanding Common Shares calculated on a “fully diluted” basis and determined annually on the first day of each calendar year. In January 2003, the Company filed a Form S-8 registration statement to register 23,125,828 Common Shares for issuance under this plan. As of January 1, 2004, 22,736,239 shares were available for issuance under this plan. No awards may be granted under the 2002 Share Incentive Plan after February 20, 2012.
Pursuant to the 2002 Share Incentive Plan and the Fifth Amended and Restated 1993 Share Option and Share Award Plan (collectively the “Share Incentive Plans”), officers, trustees, key employees and consultants of the Company may be offered the opportunity to acquire Common Shares through the grant of share options (“Options”) including non-qualified share options (“NQSOs”), incentive share options (“ISOs”) and share appreciation rights (“SARs”) or may be granted restricted or non-restricted shares. Additionally, officers and key employees of the Company may be awarded Common Shares, subject to conditions and restrictions as described in the Share Incentive Plans. Finally, certain executive officers of the Company are subject to the Company’s performance based restricted share plan. Options, SARs, restricted shares and performance shares are sometimes collectively referred to herein as “Awards”.
The Options generally are granted at the fair market value of the Company’s Common Shares at the date of grant, vest over a three year period, are exercisable upon vesting and expire ten years from the date of grant. The exercise price for all Options under the Share Incentive Plans shall not be less than the fair market value of the underlying Common Shares at the time the Option is granted. The Fifth Amended and Restated 1993 Share Option and Share Award Plan will terminate at such time as all outstanding Awards have expired or have been exercised/vested. The Board of Trustees may at any time amend or terminate the Share Incentive Plans, but termination will not affect Awards previously granted. Any Options, which had vested prior to such a termination, would remain exercisable by the holder thereof.
As to the Options that have been granted through December 31, 2003, generally, one-third are exercisable one year after the initial grant, one-third are exercisable two years following the date such Options were granted and the remaining one-third are exercisable three years following the date such Options were granted.
As to the restricted shares that have been awarded through December 31, 2003, these shares generally vest three years from the award date. During the three-year period of restriction, the employee receives quarterly dividend payments on their shares. The Company’s unvested restricted shareholders receive dividends at the same rate and on the same date as any other Common Share holder. In addition, the Company’s unvested restricted shareholders have the same voting rights as any other Common Share holder. As a result, dividends paid on unvested restricted shares are included as a distribution in excess of accumulated earnings and have not been considered in reducing net income available to OP Units in a manner similar to the Operating Partnership’s preference unit dividends for the earnings per OP Unit calculation. If employment is terminated prior to the lapsing of the restriction, the shares are canceled.
In addition, each year the Company’s executive officers receive performance-based awards. Three years after grant, restricted shares may be issued based upon the total return (Common Share dividends and funds from operations (“FFO”) growth per share) of the Company. One-half of any such restricted shares are then subject to vesting over an additional two-year period. The performance-based awards generally are expensed over a five-year period based upon the Company’s estimates of the number of shares expected to be awarded.
The following table summarizes information regarding both the restricted and performance-based share plans for the three years ended December 31, 2003, 2002 and 2001:
Prior to 2003, the Company had chosen to account for its stock-based compensation in accordance with APB No. 25, Accounting for Stock Issued to Employees, which resulted in no compensation expense for options issued with an exercise price equal to or exceeding the market value of the Company’s Common Shares on the date of grant (intrinsic method). The Company has elected to account for its stock-based compensation in accordance with SFAS No. 123 and its amendment (SFAS No. 148), Accounting for Stock Based Compensation, effective in the first quarter of 2003, which resulted in compensation expense being recorded based on the fair value of the stock compensation granted.
Compensation expense related to restricted and performance-based share grants was previously recognized in accordance with APB No. 25. The adoption of SFAS No. 123 does not significantly change the amount of compensation expense recognized for these grants.
See Note 2 for additional information regarding the Company’s stock-based compensation.
The table below summarizes the Option activity of the Share Incentive Plans and options assumed in connection with mergers (the “Merger Options”) for the three years ended December 31, 2003, 2002 and 2001:
The following table summarizes information regarding options outstanding at December 31, 2003:
As of December 31, 2002 and 2001, 8,252,203 Options (with a weighted average exercise price of $22.25) and 7,291,897 Options (with a weighted average exercise price of $21.62) were exercisable, respectively.
18. Employee Plans
The Company established an Employee Share Purchase Plan (the “ESPP”) to provide employees and EQR trustees the ability to annually acquire up to $100,000 of Common Shares of EQR. In 2003, EQR’s shareholders approved an increase in the aggregate number of EQR Common Shares available under the ESPP to 7,000,000 (from 2,000,000). The Common Shares may be purchased quarterly at a price equal to 85% of the lesser of: (a) the closing price for a share on the last day of such quarter; and (b) the greater of: (i) the closing price for a share on the first day of such quarter, and (ii) the average closing price for a share for all the business days in the quarter. During 2003, EQR issued 289,274 Common Shares at net prices that ranged from $20.64 per share to $24.74 per share and received proceeds of approximately $6.3 million. During 2002, EQR issued 324,238 Common Shares at net prices that ranged from $21.65 per share to $24.43 per share and received proceeds of approximately $7.4 million. During 2001, EQR issued 310,261 Common Shares at net prices that ranged from $21.76 per share to $23.69 per share and received proceeds of approximately $6.9 million. The net proceeds were contributed to the Operating Partnership in exchange for OP Units.
The Company established a defined contribution plan (the “401(k) Plan”) to provide retirement benefits for employees that meet minimum employment criteria. The Operating Partnership, on behalf of the Company, matches dollar for dollar up to the first 2% of eligible compensation that a participant contributes to the 401(k) Plan (4% for 2002 and prior years). Participants are vested in the Company’s contributions over five years. The Operating Partnership, on behalf of the Company, made contributions in the amount of $3.5 million and $3.1 million for the years ended December 31, 2002 and 2001, respectively, and expects to make contributions in the amount of approximately $2.7 million for the year ended December 31, 2003.
The Operating Partnership, on behalf of the Company, may also elect to make an annual discretionary profit-sharing contribution as a percentage of each individual employee’s eligible compensation under the 401(k) Plan. The Operating Partnership, on behalf of the Company, made a contribution in the amount of $2.6 million for the year ended December 31, 2001. The Operating Partnership, on behalf of the Company, did not make a contribution for both the years ended December 31, 2003 and 2002.
The Company established a supplemental executive retirement savings plan (the “SERP”) to provide certain officers and EQR trustees an opportunity to defer a portion of their eligible compensation in order to save for retirement and for the education of their children. The SERP is restricted to investments in EQR Common Shares, certain marketable securities that have been specifically approved, and cash equivalents. The deferred compensation liability represented in the SERP and the securities issued to fund such deferred compensation liability are consolidated by the Operating Partnership and carried on the Operating Partnership’s balance sheet, and the Company’s Common Shares held in the SERP are accounted for as a reduction to General Partner’s capital.
19. Distribution Reinvestment and Share Purchase Plan
On November 3, 1997, the Company filed with the SEC a Form S-3 Registration Statement to register 14,000,000 Common Shares pursuant to a Distribution Reinvestment and Share Purchase Plan (the “DRIP Plan”). The registration statement was declared effective on November 25, 1997.
The DRIP Plan provides holders of record and beneficial owners of Common Shares and Preferred Shares with a simple and convenient method of investing cash distributions in additional Common Shares
(which is referred to herein as the “Dividend Reinvestment - DRIP Plan”). Common Shares may also be purchased on a monthly basis with optional cash payments made by participants in the DRIP Plan and interested new investors, not currently shareholders of EQR, at the market price of the Common Shares less a discount ranging between 0% and 5%, as determined in accordance with the DRIP Plan (which is referred to herein as the “Share Purchase - DRIP Plan”). Common Shares purchased under the DRIP Plan may, at the option of EQR, be directly issued by EQR or purchased by EQR’s transfer agent in the open market using participants’ funds. The net proceeds from any Common Share issuances are contributed to the Operating Partnership in exchange for OP Units.
20. Transactions with Related Parties
Pursuant to the terms of the partnership agreement for the Operating Partnership, the Operating Partnership is required to reimburse EQR for all expenses incurred by EQR in excess of income earned by EQR through its indirect 1% ownership of various entities. Amounts paid on behalf of EQR are reflected in the consolidated statements of operations as general and administrative expenses.
The Operating Partnership provided asset and property management services to certain related entities for properties not owned by the Operating Partnership. Fees received for providing such services were approximately $0.3 million, $0.7 million and $0.8 million for the years ended December 31, 2003, 2002 and 2001, respectively.
The Operating Partnership reimbursed EQR’s Chief Operating Officer for the actual operating costs (excluding acquisition costs) of operating his personal aircraft for himself and other employees on Operating Partnership business. Amounts incurred were approximately $0.2 million, $0.5 million and $0.2 million for the years ended December 31, 2003, 2002 and 2001, respectively.
The Operating Partnership leases its corporate headquarters from an entity controlled by EQR’s Chairman of the Board of Trustees. Amounts incurred for such office space for the years ended December 31, 2003, 2002 and 2001, respectively, were approximately $1.7 million, $1.6 million and $1.8 million. The Operating Partnership believes these amounts equal market rates for such space.
The Operating Partnership leases space in an office building in Augusta, Georgia indirectly owned by one of EQR’s trustees since May 2003 and directly owned by an entity affiliated with the same EQR trustee from 1998 to 2003. Amounts incurred for such office space were approximately $0.2 million, $0.1 million and $0.1 million for the years ended December 31, 2003, 2002 and 2001, respectively. The Operating Partnership believes these amounts equal market rates for such space.
In prior years, the Company had the following additional related party transactions:
• Certain executive officers of EQR purchased Common Shares which were financed with loans made by the Company, all of which were repaid in full in 2002;
• The Operating Partnership made consulting payments to two former EQR trustees (individuals were trustees through May 2003) in the approximate amounts of $0.2 million and $0.4 million for the years ended December 31, 2002 and 2001, respectively; and
• The Operating Partnership paid legal fees to a law firm of which one of EQR’s former trustees (individual was a trustee through May 2002) is a partner in the approximate amounts of $0.3 million and $1.7 million for the years ended December 31, 2002 and 2001, respectively.
21. Commitments and Contingencies
The Operating Partnership, as an owner of real estate, is subject to various Federal, state and local environmental laws. Compliance by the Operating Partnership with existing laws has not had a material adverse effect on the Operating Partnership. However, the Operating Partnership cannot predict the impact of new or changed laws or regulations on its current properties or on properties that it may acquire in the future.
The Operating Partnership is a party to a class action lawsuit in Florida state court alleging that several of the types of fees that the Operating Partnership charged when residents breached their leases were illegal, as were all efforts to collect them. The Operating Partnership is vigorously contesting the plaintiffs’ claims and has sought immediate appellate review of the 2003 class action certification decision. Due to the uncertainty of many critical factual and legal issues, including the viability of the case as a class action, it is not possible to determine or predict the outcome. While no assurances can be given, the Operating Partnership does not believe that this lawsuit, if adversely determined, will have a material adverse effect on the Operating Partnership.
The Operating Partnership does not believe there is any other litigation pending or threatened against the Operating Partnership which, individually or in the aggregate, reasonably may be expected to have a material adverse effect on the Operating Partnership.
As of December 31, 2003, the Operating Partnership has 13 projects in various stages of development with estimated completion dates ranging through June 30, 2005. The three development agreements currently in place have the following key terms:
• The first development partner has the right, at any time following completion of a project, to stipulate a value for such project and offer to sell its interest in the project to the Operating Partnership based on such value. If the Operating Partnership chooses not to purchase the interest, it must agree to a sale of the project to an unrelated third party at such value. The Operating Partnership’s partner must exercise this right as to all projects within five years after the receipt of the final certificate of occupancy on the last developed property. In connection with this development agreement, the Operating Partnership has an obligation to provide up to $40.0 million in credit enhancements to guarantee a portion of the third party construction financing. As of February 4, 2004, the Operating Partnership had set-aside $20.0 million towards this credit enhancement. The Operating Partnership would be required to perform under this agreement only if there was a material default under a third party construction mortgage agreement. This agreement expires no later than December 31, 2018. Notwithstanding the termination of the agreement, the Operating Partnership shall have recourse against its development partner for any losses incurred.
• The second development partner has the right, at any time following completion of a project, to require the Operating Partnership to purchase the partners’ interest in that project at a mutually agreeable price. If the Operating Partnership and the partner are unable to agree on a price, both parties will obtain appraisals. If the appraised values vary by more than 10%, both the Operating Partnership and its partner will agree on a third appraiser to determine which original appraisal is closest to its determination of value. The Operating Partnership may elect at that time not to purchase the property and instead, authorize its partner to sell the project at or above the agreed-upon value to an unrelated third party. Five years following the receipt of the final certificate of occupancy on the last developed property, the Operating Partnership must purchase, at the agreed-upon price, any projects remaining unsold.
• The third development partner has the exclusive right for six months following stabilization (generally defined as having achieved 90% occupancy for three consecutive months following the substantial completion of a project) to market a project for sale. Thereafter, either the
Operating Partnership or its development partner may market a project for sale. If the Operating Partnership’s development partner proposes the sale, the Operating Partnership may elect to purchase the project at the price proposed by its partner or defer the sale until two independent appraisers appraise the project. If the two appraised values vary by more than 5%, a third appraiser will be chosen to determine the fair market value of the property. Once a value has been determined, the Operating Partnership may elect to purchase the property or authorize its development partner to sell the project at the agreed-upon value.
In connection with one of its mergers, the Operating Partnership provided a guaranty of a credit enhancement agreement with respect to certain tax-exempt bonds issued to finance certain public improvements at a multifamily development project. The Operating Partnership has the obligation to provide this guaranty for a period of eight years from the consummation of the merger or through May 2005. The Operating Partnership would be required to perform under this guaranty only if there was a draw on the letter of credit issued by the credit enhancement party. The counterparty has also indemnified the Operating Partnership for any losses suffered. As of December 31, 2003, this guaranty was still in effect at a commitment amount of $12.7 million and no current outstanding liability.
During the years ended December 31, 2003, 2002 and 2001, total operating lease payments incurred for office space, including a portion of real estate taxes, insurance, repairs and utilities, aggregated $4,985,899, $4,709,363 and $4,929,018, respectively.
The minimum basic aggregate rental commitment under the Operating Partnership’s operating leases, including fixed base rent due on a ground lease for one property, in years following December 31, 2003 is as follows:
The Company has entered into a retirement benefits agreement with its Chairman of the Board of Trustees and deferred compensation agreements with two of its executive officers and its former chief executive officer. During the years ended December 31, 2003, 2002 and 2001, the Operating Partnership recognized compensation expense of $3.0 million, $5.1 million and $3.7 million, respectively, related to these agreements. The projected commitments under these agreements based on estimated retirement dates are:
22. Asset Impairment
For the years ended December 31, 2003, 2002 and 2001, the Operating Partnership recorded approximately $1.2 million, $1.2 million and $11.8 million, respectively, of asset impairment charges related to its technology investments. These charges were the result of a review of the existing investments reflected on the consolidated balance sheet. These impairment losses are reflected on the consolidated statements of operations in total expenses and include the write-down of assets classified as other assets and investments in unconsolidated entities.
For the year ended December 31, 2002, the Company recorded approximately $17.1 million of asset impairment charges related to its corporate housing business. Following the guidance in SFAS No. 142, these charges were the result of the Company’s decision to reduce the carrying value of its corporate housing business to $30.0 million, given the continued weakness in the economy and management’s expectations for near-term performance. This impairment loss is reflected on the consolidated statements of operations as impairment on corporate housing business and on the consolidated balance sheets as a reduction in goodwill, net.
23. Reportable Segments
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by senior management. Senior management decides how resources are allocated and assesses performance on a monthly basis.
The Operating Partnership’s primary business is owning, managing, and operating multifamily residential properties, which includes the generation of rental and other related income through the leasing of apartment units to residents and includes ECH. Senior management evaluates the performance of each of our apartment communities on an individual basis; however, each of our apartment communities has similar economic characteristics, residents, and products and services so they have been aggregated into one reportable segment. The Operating Partnership’s rental real estate segment comprises approximately 99.2%, 99.5% and 99.1% of total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. The Operating Partnership’s rental real estate segment comprises approximately 99.7% and 99.7% of total assets at December 31, 2003 and 2002, respectively.
The primary financial measure for the Operating Partnership’s rental real estate segment is net operating income (“NOI”), which represents rental income less: 1) property and maintenance expense; 2) real estate taxes and insurance expense; and 3) property management expense (all as reflected in the accompanying statements of operations). The Company believes that NOI is helpful to investors as a supplemental measure of the operating performance of a real estate company because it is a direct measure of the actual operating results of the Operating Partnership’s apartment communities. Current year NOI is compared to prior year NOI and current year budgeted NOI as a measure of financial performance. NOI from our rental real estate totaled approximately $1.0 billion, $1.1 billion, and $1.1 billion for the years ended December 31, 2003, 2002 and 2001, respectively.
During the acquisition, development and/or disposition of real estate, the Operating Partnership considers its NOI return on total investment as the primary measure of financial performance.
The Operating Partnership’s fee and asset management activity is immaterial and does not meet the threshold requirements of a reportable segment as provided for in SFAS No. 131.
All revenues are from external customers and there is no customer who contributed 10% or more of the Operating Partnership’s total revenues during the three years ended December 31, 2003, 2002 or 2001.
24. Subsequent Events/Other
Subsequent to December 31, 2003 and through February 4, 2004, the Operating Partnership:
• Acquired four properties (including two additional units at an existing property) consisting of 1,130 units for approximately $151.3 million;
• Assumed $36.9 million of mortgage debt on one property in connection with its acquisition;
• Disposed of twelve properties (including one Unconsolidated Property) and various individual condominium units consisting of 2,972 units for approximately $140.9 million;
• Obtained $16.5 million in new mortgage financing; and
• Repaid $50.0 million of mortgage loans.
25. Quarterly Financial Data (Unaudited)
The following unaudited quarterly data has been prepared on the basis of a December 31 year-end. All amounts have also been restated in accordance with the discontinued operations provisions of SFAS No 144. Amounts are in thousands, except for per OP Unit amounts.
(1) The amounts presented for the first three quarters of 2003 are not equal to the same amounts previously reported in the respective Form 10-Q’s filed with the SEC for each period as a result of changes in discontinued operations due to additional property sales which occurred throughout 2003. Below is a reconciliation to the amounts previously reported in the respective Form 10-Q’s:
(2) The amounts presented for the first three quarters of 2002 are not equal to the same amounts previously reported in the respective Form 10-Q’s filed with the SEC for each period as a result of changes in discontinued operations due to additional property sales which occurred throughout 2003 and 2002 and the Operating Partnership’s adoption of SFAS No. 145 related to extraordinary items. Below is a reconciliation to the amounts previously
reported in the respective Form 10-Q’s:
* The Operating Partnership did not have any extraordinary items or cumulative effect of change in accounting principle during the years ended December 31, 2003 and 2002. Therefore, income before extraordinary items and cumulative effect of change in accounting principle is not shown as it was equal to the net income amounts disclosed above.
ERP OPERATING LIMITED PARTNERSHIP
Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
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ERP Operating Limited Partnership
Schedule III - Real Estate and Accumulated Depreciation
December 31, 2003
NOTES:
(A) The balance of furniture & fixtures included in the total investment in real estate amount was $602,647,035.02 as of December 31, 2003.
(B) The aggregate cost for Federal Income Tax purposes as of December 31, 2003 was approximately $8.45 billion.
(C) The life to compute depreciation for furniture & fixtures is 5 years.
(D) This asset consists of various acquisition dates and largely represents furniture, fixtures and equipment owned by the Management Business.
(E) Improvements are net of write-off of fully depreciated assets which are no longer in service.
(F) Represents land and/or miscellaneous improvements held for future development.
(G) A portion or all of these properties includes commercial space (retail, parking and/or office space).
(H) The mortgage debt is the balance for a property that was sold, which balance was not collateralized by the property. The amount was transferred to ERPOP.
(I) These three properties are pledged as additional collateral in connection with a tax-exempt bond financing.
(J) These three properties are pledged as additional collateral in connection with a tax-exempt bond financing.
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ERP Operating Limited Partnership
Schedule III - Real Estate and Accumulated Depreciation
Encumbrances Reconciliation
December 31, 2003
* Collateral also includes $3.1 million invested in U.S. Treasury Securities which is included in Deposits - Restricted in the accompanying consolidated balance sheets at December 21, 2003.
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ERP Operating Limited Partnership
Schedule III - Real Estate and Accumulated Depreciation
(Amounts in thousands)
The changes in total real estate for the years ended December 31, 2003, 2002 and 2001 are as follows:
The changes in accumulated depreciation for the years ended December 31, 2003, 2002, and 2001 are as follows:
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EXHIBIT INDEX
Exhibit
Document
10.2
Master Amendment to Other Securities Term Sheets and Joinders to Operating Partnership Agreement of ERP Operating Limited Partnership dated December 19, 2003.
10.3
Assignment and Assumption Agreement between the Company and ERP Operating Limited Partnership dated December 19, 2003.
Computation of Ratio of Earnings to Combined Fixed Charges.
List of Subsidiaries of ERP Operating Limited Partnership.
23.1
Consent of Ernst & Young LLP.
24.1
Power of Attorney for John W. Alexander dated March 3, 2004.
24.2
Power of Attorney for Stephen O. Evans dated March 5, 2004.
24.3
Power of Attorney for Charles L. Atwood dated March 8, 2004.
24.4
Power of Attorney for Desiree G. Rogers dated March 9, 2004.
24.5
Power of Attorney for B. Joseph White dated March 3, 2004.
24.6
Power of Attorney for Sheli Z. Rosenberg dated March 5, 2004.
24.7
Power of Attorney for James D. Harper, Jr. dated March 4, 2004.
24.8
Power of Attorney for Boone A. Knox dated March 3, 2004.
24.9
Power of Attorney for Michael N. Thompson dated March 5, 2004.
24.10
Power of Attorney for Samuel Zell dated March 2, 2004.
24.11
Power of Attorney for Gerald A. Spector dated March 2, 2004.
31.1
Certification of Bruce W. Duncan, Chief Executive Officer of Registrant’s General Partner.
31.2
Certification of David J. Neithercut, Chief Financial Officer of Registrant’s General Partner.
32.1
Certification Pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of Bruce W. Duncan, Chief Executive Officer of Registrant’s General Partner.
32.2
Certification Pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of David J. Neithercut, Chief Financial Officer of Registrant’s General Partner.