Item 1.
Business.
EOP PARTNERSHIP
As used herein, “we”, “us” and “our” refer to EOP Operating Limited Partnership, a Delaware limited partnership, together with its consolidated subsidiaries, and the predecessors thereof, except where the context otherwise requires. We are a subsidiary of Equity Office Properties Trust (“Equity Office”), a Maryland real estate investment trust (“REIT”). We were organized in 1996 and began operations in 1997. We are principally engaged, through various subsidiaries, in owning, managing, leasing, acquiring and developing office properties. Equity Office’s assets are owned and substantially all of its operations are conducted through us and our subsidiaries. Equity Office is our sole general partner and owned at December 31, 2003, an approximate 89.1% interest in us. Equity Office has elected to be taxed as a REIT for federal income tax purposes, and generally will not be subject to federal income tax if 100% of its taxable income is distributed and it complies with a number of organizational and operational requirements.
At December 31, 2003, we had a portfolio of 684 office properties comprising approximately 122.3 million square feet of commercial office space in 18 states and the District of Columbia (the “Office Properties”), 75 industrial properties comprising approximately 5.8 million square feet (the “Industrial Properties” and, together with the Office Properties, the “Properties”) and approximately 0.4 million square feet of office properties under development.
Our internet site is http://www.equityoffice.com. Beginning on or about March 22, 2004, we will provide to the public on our website, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other reports and amendments to those reports filed or furnished pursuant to Section 13 or 15(d) of the Exchange Act as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.
KEY TRANSACTIONS IN 2003
During 2003, we completed the following key transactions:
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we disposed of 53 office properties, two industrial properties and four vacant land parcels in various transactions to unaffiliated parties for approximately $933.1 million. The sold office properties consisted of approximately 5,182,707 square feet and 32 residential units, and the industrial properties consisted of approximately 216,900 square feet. With these transactions, we exited the following markets: Salt Lake City, UT; Riverside, CA; Fort Worth, TX; Charlotte, NC; and San Antonio, TX;
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we sold partial interests in 13 Office Properties consisting of approximately 3,284,431 square feet for approximately $596.5 million;
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we acquired two Office Properties for approximately $183.2 million consisting of approximately 829,293 square feet;
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we placed into service four developments consisting of five buildings and approximately 1,218,215 square feet;
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we entered into $500 million of forward-starting interest rate swaps;
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we repaid $400 million of unsecured notes that matured in November 2003;
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we issued $500 million of unsecured notes due January 2013 at an effective annual interest rate of 5.98% and used a portion of the net proceeds to repay $300 million of unsecured notes that matured in February 2003;
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we obtained a new three-year $1.0 billion revolving credit facility in May 2003;
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we obtained a $1.0 billion 364-day credit facility in December 2003;
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Equity Office announced the redemption of, and subsequently redeemed in 2004, 4,562,900 outstanding 8 5/8% Series C Cumulative Redeemable Preferred Shares of Beneficial Interest for approximately $114.6 million, which included approximately $0.6 million of accrued distributions. In connection with such redemption, we redeemed all of the Series C Preferred Units from Equity Office;
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Equity Office redeemed the 7.875% Series E Cumulative Redeemable Preferred Shares for approximately $151.9 million, which included approximately $1.9 million of accrued distributions. In connection with such redemption, we redeemed all of the Series E Preferred Units from Equity Office;
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Equity Office redeemed the 8.00% Series F Cumulative Redeemable Preferred Shares for approximately $100.0 million. In connection with such redemption, we redeemed all of the Series F Preferred Units from Equity Office; and
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Equity Office repurchased 14,236,400 Common Shares at an average price of $25.53 per share for a total of $363.5 million. In connection with the repurchases, we purchased from Equity Office and retired a corresponding number of Units for an aggregate purchase price equal to the aggregate purchase price for all Common Share repurchases.
BUSINESS STRATEGY
Our primary business objective is to achieve sustainable long-term growth in cash flow and portfolio value in order to maximize unitholder value. We intend to achieve this objective by owning and operating high-quality office buildings and providing a superior level of service to customers across the United States.
Our business strategy involves:
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increasing occupancy by leasing up vacant space on economically attractive terms, retaining tenants, reducing lease cycle time and improving customer service;
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concentrating our capital in 15 to 20 core markets with the best prospects for employment growth and where we believe we can best position ourselves to outperform our competition;
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taking advantage of favorable market opportunities to exit non-core markets and selectively disposing of properties in certain of our core markets that do not fit within our long-term strategy; and
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achieving economies of scale over time, including anticipated cost savings from the implementation of our new operating model.
New Operating Model
In 2001, we initiated a comprehensive analysis of our operating structure with the help of a management consulting firm and our employees. The goal of the analysis was to streamline operations, improve customer service, reduce lease cycle time, increase occupancy, retain tenants and reduce operating expenses. The analysis resulted in a significant reengineering effort called EOPlus. As part of this effort, many of the activities that occurred at the property level have been centralized into regional offices with a view towards allowing property managers to spend more time building customer relationships. The centralization of each region’s operations is designed to provide higher service to our customers at a lower cost. By consolidating our property management offices, we made available for leasing almost 400,000 square feet of office space in 2003. As of December 31, 2003, we have approximately 15% fewer employees at the property level than at the end of 2001. We have also created a central purchasing function to review and analyze our goods and services expenditures. The goal of the central purchasing function is to obtain preferred pricing, reduce the number of our vendors and reduce the number of invoices we process.
ACQUISITION AND DISPOSITION ACTIVITY
Over the past five years, we have invested approximately $12.9 billion, calculated on a cost basis, and have disposed of approximately $3.7 billion, calculated based on the sales price, of institutional quality office
properties, industrial properties, parking facilities and vacant land parcels throughout the United States. In the past two years we have taken advantage of the favorable market conditions for property sales and we have been a net seller of real estate.
Management considers various factors when evaluating potential property acquisitions. These factors include but are not limited to:
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the attractiveness of the property to existing and potential tenants;
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the likelihood and relative attractiveness of competitive supply;
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the anticipated demand for space in the local market;
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the creditworthiness and diversity of risk in the tenants occupying the property;
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the ability to acquire the asset at an attractive going-in yield, as well as the potential to increase operating income over time by renewing leases for higher rents;
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the physical condition of the property, including the extent of funds required for its maintenance and for physical upgrades needed in order to establish or sustain its market competitiveness;
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the ability to operate the property with a competitive cost structure; and
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the property’s location in one of our core markets.
As part of our business strategy, assuming that capital and acquisition opportunities are available to us on reasonable terms, we intend to continue to acquire additional office properties in our core markets. Properties may be acquired separately or as part of a portfolio and may be acquired for cash and/or in exchange for our debt or equity securities. These acquisitions may be individual asset transactions, joint ventures, mergers or other business combinations.
Management considers various factors when evaluating potential property dispositions. These factors include but are not limited to:
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the ability to sell the property at a price we believe would provide an attractive return to our unitholders;
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our ability to recycle capital into core markets consistent with our business strategy;
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our desire to exit markets that are not core markets;
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whether the property is strategically located;
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tenant composition and lease rollover for the property;
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general economic conditions and outlook, including job growth in the local market; and
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the general quality of the asset.
DEVELOPMENT ACTIVITY
At December 31, 2003, approximately 0.4 million square feet of projects were under development. Our policy is to prudently pursue projects where customer need is evident and market conditions warrant. In addition to our current development pipeline, we own various undeveloped land parcels on which
approximately 12 million square feet of office space could be developed, assuming our receipt of necessary permits, licenses and approvals. Our policy is to develop land only when market conditions warrant. Although we may develop some properties ourselves, a portion of this activity may also be conducted with joint venture partners. If we develop a property with a joint venture partner, we may not have the same degree of control over the property as if we owned it ourselves. In addition, if we develop a property with a joint venture partner, we will be required to share a portion of the economic benefits from such property with our joint venture partner.
In determining whether to enter into a new development, the foregoing acquisition factors are considered as well as the additional risks of development, including the following:
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our assessment of the returns from such development;
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the extent of lease-up risk in the context of the demand/supply characteristics of the local market;
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the ability to minimize construction risks; and
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the quality of local development partners, if applicable.
FINANCING POLICIES
Equity Office conducts substantially all of its investment and debt-financing activities through us. To date, we have financed our investments through a combination of equity, which may be issued by either Equity Office or us, as well as secured and unsecured debt (which would be issued by us). The terms of our lines of credit and unsecured notes contain various financial covenants which require satisfaction of certain total debt-to-asset ratios, secured debt-to-total-asset ratios, debt service coverage ratios, and unsecured debt-to-unencumbered asset ratios, as well as other limitations. In addition, we have obtained investment grade credit ratings on our unsecured debt from each of Standard & Poors, Fitch and Moodys rating agencies. A primary objective of our financing policy is to manage our financial position to allow us to raise capital at competitive rates. As of December 31, 2003, approximately 96.8% of our outstanding debt had a fixed interest rate, which limits the risk of fluctuating interest rates.
In addition, we utilize certain derivative financial instruments at times to limit interest rate risk. The derivatives we enter into, and the only derivative transactions approved by Equity Office’s Board of Trustees, are those which are used only for hedging purposes rather than speculation. If an anticipated hedged transaction does not occur, any positive or negative value of the derivative will be recognized immediately in net income.
To the extent that Equity Office’s Board of Trustees decides to obtain additional capital, Equity Office may elect to issue equity securities, cause us to issue additional Units or debt securities, retain our earnings (subject to the provisions of the Internal Revenue Code requiring distributions of taxable income to maintain REIT status), or dispose of some of our properties or utilize a combination of these methods. Under the terms of our partnership agreement, the proceeds of all equity capital raised by Equity Office must be contributed to us in exchange for additional interests in us.
DIVIDEND POLICY
In order to qualify as a REIT for federal income tax purposes, Equity Office must distribute at least 90% of its taxable income (excluding capital gains) to its shareholders. Equity Office currently distributes capital gains to its shareholders, however, these gains may be retained by Equity Office and taxed at the corporate tax rate. Our partnership agreement generally requires us to distribute substantially all of the net cash from operations each quarter and to make reasonable efforts to distribute to Equity Office enough cash for it to meet the 90% distribution requirement. Accordingly, we currently intend, although we are not legally obligated, to continue to make regular quarterly distributions to holders of Units and preferred units. The declaration of dividends on common and preferred shares is at the discretion of Equity Office’s Board of Trustees, which decision is made from time to time by Equity Office’s Board of Trustees based on then prevailing circumstances.
INDUSTRY SEGMENTS
Our primary business is the ownership and operation of office properties. Our long-term tenants are in a variety of businesses, and no single tenant is significant to our business. Information related to this segment for the years ended December 31, 2003, 2002 and 2001 is set forth in Item 8. Financial Statements and Supplementary Data - Note 20 - Segment Information.
COMPETITION
The leasing of real estate is highly competitive. We compete for tenants in our markets primarily on the basis of property location, rent charged, services provided and the design and condition of improvements. We also experience competition when attempting to acquire or divest ownership of real estate, building sites or redevelopment opportunities, including competition from domestic and foreign financial institutions, other real estate companies, life insurance companies, pension trusts, trust funds, partnerships and individual investors.
ENVIRONMENTAL EXPOSURE
As an owner of real estate, we are subject to various environmental laws of federal, state and local governments. Compliance with existing laws has not had a material adverse effect on our financial condition and results of operations, and management does not believe it will have such an impact in the future. However, we cannot predict the impact of unforeseen environmental contingencies or new or changed laws or regulations on our Properties, properties that we have sold or on properties that may be acquired in the future.
EMPLOYEES
As of December 31, 2003, Equity Office had approximately 2,400 employees that provide real estate operations, leasing, legal, financial and accounting, acquisition, disposition and marketing expertise throughout the country.
The seven executive officers of Equity Office have an average tenure of six years with Equity Office or its affiliates or predecessors and an average of 18 years experience in the real estate industry.
EXECUTIVE AND SENIOR OFFICERS OF EQUITY OFFICE
As of March 15, 2004, the following executive and senior officers of Equity Office held the offices indicated:
Set forth below is biographical information for each of the executive officers:
Richard D. Kincaid has been a trustee and President since November 2002 and Chief Executive Officer since April 2003. Mr. Kincaid also has held the following positions:
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Executive Vice President from March 1997 until November 2002;
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Chief Operating Officer from September 2001 until November 2002;
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Chief Financial Officer from March 1997 until August 2002;
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Senior Vice President from October 1996 until March 1997;
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Senior Vice President and Chief Financial Officer of Equity Office Holdings, L.L.C., a predecessor of ours, from July 1995 until October 1997;
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Senior Vice President of Equity Group Investments, Inc., an owner and financier of real estate and corporate investments, from February 1995 until July 1995;
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Senior Vice President of the Yarmouth Group, a real estate investment company in New York, New York, from August 1994 until February 1995;
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Senior Vice President - Finance of Equity Group Investments, Inc. from December 1993 until July 1994; and
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Vice President - Finance of Equity Group Investments, Inc. from August 1990 until December 1993.
Jeffrey L. Johnson has been Executive Vice President and Chief Investment Officer since May 2003. Mr. Johnson also has held the following positions:
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Managing Partner and owner of Lakeshore Holdings, LLC, a private equity firm focusing on real estate investment founded by Mr. Johnson in conjunction with Lehman Brothers Holdings Inc., a global financial services firm, from December 2002 until May 2003 (in this capacity, Mr. Johnson was responsible for all aspects of the business);
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Managing Director of Lehman Brothers Holdings Inc. from March 2000 until November 2002 (in this capacity, Mr. Johnson was a founding partner and co-head of domestic investments for Lehman Brothers’ first real estate private equity group and was instrumental in helping raise the company’s $1.6 billion fund and developing the investment strategy for the fund, built the investment team and implemented its investment process);
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Chief Investment Officer of Equity Office from March 1998 until June 1999; and
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Senior Vice President of Equity Office from March 1997 until June 1999.
Lawrence J. Krema has been Executive Vice President - Human Resources and Communications since November 2002. Mr. Krema also has held the following positions:
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Senior Vice President - Human Resources from March 2001 until November 2002; and
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Vice President of NEC Technologies, Inc., a supplier of presentation systems, computing and related technologies for the North American market, from April 1995 until October 2000 (in this capacity, Mr. Krema managed the human resources division of the company in North America and was responsible for corporate services, which included real estate, travel and office services).
Peyton H. Owen, Jr. has been Executive Vice President and Chief Operating Officer since October 2003. Mr. Owen also has held the following positions:
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Chief Operating Officer - Americas Region of Jones Lang LaSalle, a global provider of integrated real estate and investment management services, from April 1999 until October 2003 (in this capacity, Mr. Owen oversaw 5,500 people in 100 markets in the United States, Canada and Mexico; Investor Services, which included leasing and property management; Corporate Solutions, which included tenant representation, facility management and project management; and Capital Markets; and
implemented standardized processes, new technologies and compliance measurements, and consolidated the organizational structure); and
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Executive Vice President and Chief Operating Officer - Leasing and Management of LaSalle Partners, predecessor of Jones Lang LaSalle, from January 1996 until April 1999 (in this capacity, Mr. Owen oversaw the leasing and management activities for a 200-million-square-foot investment property portfolio, restructured leasing and management across 20 markets and led due diligence and integration in various corporate acquisitions.
Stanley M. Stevens has been Executive Vice President since September 1996 and Chief Legal Counsel and Secretary since October 1996. Mr. Stevens also was Executive Vice President and General Counsel of Equity Office Holdings, L.L.C. from September 1996 until October 1997.
Marsha C. Williams has been Executive Vice President and Chief Financial Officer since August 2002. Ms. Williams also has held the following positions:
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Chief Administrative Officer of Crate and Barrel, a national Chicago-based retailer of home furnishings and accessories (Crate and Barrel is the trade name of Euromarket Designs Inc., which is an indirect majority-owned subsidiary of Otto Versand Gmbh & Co., a German mail-order company), from May 1998 until August 2002 (in this capacity, Ms. Williams participated in the planning and execution of Crate and Barrel’s growth strategy and managed its finance, accounting, information technology, warehousing, distribution and logistics, loss prevention, strategic planning, direct marketing operations and purchasing departments); and
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Vice President of Amoco Corporation, a worldwide energy and chemical company, from December 1997 until April 1998 and Treasurer of Amoco Corporation from October 1993 until April 1998, as well as other capacities and positions from May 1989 until October 1993.
Robert J. Winter, Jr. has been Executive Vice President - Development and Portfolio Management since November 2002. Mr. Winter also has held the following positions:
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Senior Vice President - Development from June 2002 until November 2002;
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Senior Vice President - Development Investments from July 2001 until June 2002;
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President and Chief Executive Officer of Amli Commercial Properties Trust, a private real estate investment trust with office and industrial properties in the suburban Chicago market, from August 1998 until July 2001 (in this capacity, Mr. Winter was responsible for all aspects of the company’s business, including the development, management and ownership of its properties); and
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President and Chief Executive Officer of Amli Commercial Properties, LLC, a limited liability company and predecessor of Amli Commercial Properties Trust, from November 1996 until July 1998 (in this capacity, along with developing the business, Mr. Winter was responsible for forming Amli Commercial Properties Trust).
Item 2.
Item 2.
Properties.
All capitalized terms used herein and not otherwise defined shall have the meanings given in the financial statements and notes thereto set forth in Item 8. Financial Statements and Supplementary Data. For information regarding encumbrances on our properties, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Debt Financing - Mortgage Debt and Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K - Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2003. All of our consolidated properties are held in fee simple interest, except for approximately 79 properties in which we have leasehold interests and do not own the land or a portion thereof and one property in which we are the mortgage holder.
General
We are the largest publicly-held owner and operator of office properties in the United States based upon equity market capitalization and square footage. At December 31, 2003, we had a portfolio of 684 Office Properties comprising approximately 122.3 million square feet of commercial office space in 18 states and the District of Columbia, 75 Industrial Properties comprising approximately 5.8 million square feet and approximately 0.4 million square feet of office properties under development. Approximately 42.3% of the total square feet of our office properties is located in central business districts (“CBDs”) and approximately 57.7% is located in suburban markets. At December 31, 2003, our Office Properties were approximately 86.3% occupied and our Industrial Properties were approximately 86.6% occupied on a weighted average basis. No single tenant accounts for more than 2.0% of the aggregate annualized rent or 1.9% of the aggregate occupied square feet.
For segment reporting purposes, the Office Properties are included in the “Office Properties” segment and the Industrial Properties are included in the “Corporate and Other” segment.
All property data presented below are as of December 31, 2003.
Property Statistics
Office Properties
The following table sets forth certain data relating to our Office Properties, including those we own in joint ventures with other partners. Our ten largest markets are presented from greatest to least based on property net operating income from continuing operations.
Industrial Properties
The following table sets forth certain data relating to our Industrial Properties.
Lease Distribution
The following table sets forth information relating to the distribution of the Office Property leases, based on occupied square feet.
(a)
Annualized rent is the monthly contractual rent as of the reporting date, or if the current rent payable is $0 then the first monthly rent payment due, under existing leases as of December 31, 2003 multiplied by 12 months (“Annualized Rent”). This amount reflects total base rent and estimated expense reimbursements from tenants as of December 31, 2003 without regard to any rent abatements and contractual increases or decreases in rent subsequent to December 31, 2003. Total rent abatements for leases in place as of December 31, 2003, for the period from January 1, 2004 to December 31, 2004, are approximately $38.2 million for Office Properties and approximately $0.1 million for Industrial Properties. We believe Annualized Rent is a useful measure because this information can be used for comparison to current market rents as published by various third party sources.
(b)
Reconciliation for total net rentable square feet for Office Properties is as follows:
Office Lease Expiration Schedule (a)
December 31, 2003
The following schedule is based upon the contractual termination date of the leases, without regard to any lease termination and/or renewal options. Some of our leases are subject to various forms of lease termination options exercisable by tenants. Depending on the form of the option, some of these options may or may not require the payment of a fee and a notice period as a condition to exercise. Although it is not possible to predict which tenants are likely to exercise these options, it has been our experience that markets in which the contractual rents are significantly higher than current market rents incur the greatest incidence of lease termination option exercises. As a result of these lease termination options and other factors, such as tenant insolvencies, the actual termination dates of some portion of the leases may vary from the contractual expiration date set forth in the schedule.
[Additional columns below]
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[Additional columns below]
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(a)
Based on the contractual termination date of the lease without regard to any early lease termination and/or renewal options.
(b)
Total square feet subject to month to month leases is approximately 955,976.
(c)
Total net rentable square feet represented by expiring leases.
(d)
Percentage of total net rentable square feet represented by expiring leases.
(e)
Based on annualized rent. Annualized rent is the monthly contractual rent as of the reporting date, or if the current rent payable is $0 then the first monthly rent payment due, under existing leases as of December 31, 2003 multiplied by 12 months (“Annualized Rent”). This amount reflects total base rent and estimated expense reimbursements from tenants as of December 31, 2003 without regard to any rent abatements and contractual increases or decreases in rent subsequent to December 31, 2003. Total rent abatements for leases in place as of December 31, 2003, for the period from January 1, 2004 to December 31, 2004, are approximately $38.2 million. We believe Annualized Rent is a useful measure because this information can be used for comparison to current market rents as published by various third party sources.
(f)
Management offices and building use square footage are included with $0 rent per square foot.
Item 3.
Item 3.
Legal Proceedings.
Except as described below, we are not presently subject to material litigation nor, to our knowledge, is any material litigation threatened against us, other than routine actions for negligence and other claims and administrative proceedings arising in the ordinary course of business, some of which are expected to be covered by liability insurance and all of which collectively are not expected to have a material adverse effect on our financial condition, results of operations, or liquidity.
On May 8, 2003, Broadband Office, Inc. and the official committee of unsecured creditors of Broadband Office Inc. (collectively, the “Plaintiffs”), filed a complaint (the “Complaint”) in the United States Bankruptcy Court for the District of Delaware against one private and seven public real estate companies, various affiliated entities (collectively the “Corporate Defendants”) and certain individuals, including Equity Office, EOP Partnership, David Helfand (a former executive vice president of Equity Office), Spieker Properties, Inc. and Spieker Properties, L.P. (which we acquired in 2001) and Craig Vought (formerly co-chief executive officer of Spieker Properties, Inc. and a former Equity Office trustee). Under the terms of our indemnification agreements with Messrs. Helfand and Vought, we may be responsible to reimburse them for the effect of any judgment rendered against them personally as well as the costs of their defense. We were an equity investor in, landlord to and customer of Broadband Office, and Messrs. Helfand and Vought were members of the board of directors of Broadband Office until their resignations on May 1, 2001 and May 2, 2001, respectively. Mr. Vought also served as a member of Broadband Office’s executive committee. Broadband Office filed for bankruptcy protection on May 9, 2001. The First Amended Complaint alleges, among other things, breaches of fiduciary duty and seeks recovery of what it characterizes as preferential payments and fraudulent transfers. It further seeks to hold us liable for the outstanding debts of the corporation, jointly and severally with all of the Corporate Defendants, as an alleged “general partner” of Broadband Office. The Plaintiffs allege that the amount of these claims exceeds $300 million in the aggregate. Due to the inherent uncertainties of the judicial process and the early stage of this action, we are unable to predict the outcome of this matter with certainty. We intend to vigorously defend this matter and believe we have meritorious defenses. As a result, we have not accrued for any potential liability in connection with this litigation. As in any litigation, there can be no assurance that we will prevail. Should the court not resolve this matter in our favor it could have a material adverse effect on our financial condition, results of operations and liquidity.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity and Related Stockholder Matters.
There is no established public trading market for the Units. Equity Office’s Common Shares are traded on the New York Stock Exchange (“NYSE”) under the symbol “EOP.” On February 27, 2004, there were approximately 528 holders of record and 450,162,700 Units outstanding, 401,322,247 of which were held by Equity Office. The high and low sales prices and closing sales prices on the NYSE and distributions for the Common Shares during 2003 and 2002 are set forth in the table below. We paid an equivalent distribution on our Units to the distributions paid by Equity Office on its Common Shares during each of the periods presented.
Item 6.
Item 6.
Selected Financial Data.
The following sets forth our selected consolidated financial and operating information on a historical basis. The selected financial data has been derived from our historical consolidated financial statements. The following information should be read together with our consolidated financial statements and notes thereto included in Item 8. Financial Statements and Supplementary Data.
(1)
On July 2, 2001, we completed our acquisition by merger of Spieker Properties, L.P. (“Spieker Partnership”) at a cost of approximately $7.2 billion. As a result of the Spieker Partnership merger, we
acquired an interest in 391 office properties containing approximately 28.3 million square feet and 98 industrial properties containing approximately 10.1 million square feet.
(2)
On June 19, 2000, we completed our acquisition by merger of Cornerstone Properties Limited Partnership (“Cornerstone Partnership”) at a cost of approximately $4.5 billion. As a result of the Cornerstone Partnership merger, we acquired an interest in 82 properties containing approximately 18.9 million square feet.
(3)
These amounts are from continuing and discontinued operations and our share of unconsolidated joint ventures.
(4)
Refer to Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
The following discussion and analysis is based primarily on the consolidated financial statements of EOP Operating Limited Partnership for the years presented and should be read together with the notes thereto contained in this Form 10-K. Terms employed herein as defined terms, but without definition, have the meanings set forth in the notes to the financial statements (See Item 8. Financial Statements and Supplementary Data).
Executive Summary
Equity Office is the largest office REIT and publicly held owner of Office Properties in the nation based on market capitalization and square footage. We receive our revenue primarily from rental revenues generated by leases for our office space. The key factors that affect our business and financial results are the following:
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the current economic environment, including its effect on white-collar job growth in markets in which we have a presence;
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the occupancy rates of our Office Properties;
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rental rates on new Office Property leases;
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tenant improvement and leasing costs incurred to retain and obtain tenants;
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the extent of early lease terminations and any lease termination fees;
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operating expenses; and
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the extent of any dispositions and acquisitions of Office Properties.
2003 was the third consecutive year of economic slowdown marked by slow employment growth and the highest office vacancy in the United States in over 10 years. The poor economic environment and weak office markets adversely impacted our financial results. Our overall office occupancy has declined from 88.6% at December 31, 2002 to 86.3% at December 31, 2003. This was due to early lease terminations, which totaled approximately 5.4 million square feet and equated to approximately 4.4% of occupancy lost in our office portfolio. Market rental rates have continued to decline during the last two years and have significantly declined from their peak levels. Tenant improvement and leasing costs have increased dramatically due to the competitive market conditions for new leases. During 2003, we took advantage of favorable market conditions for property sales by disposing of approximately $933.1 million in non-core assets. In addition, we entered into joint ventures and sold a 75% to 80% interest in 13 Office Properties for approximately $596.5 million. We
used the proceeds from these asset sales to pay down debt, redeem preferred units, acquire strategic assets in core markets, partially fund distributions to unitholders and repurchase Units.
On a macroeconomic level, we see office markets beginning to recover and a minimal new supply of space in most of our core markets. We expect net absorption of 25 to 30 million square feet in our top 20 markets in 2004. We anticipate annual growth in the gross domestic product in the range of 4% to 4.5% and office job growth of approximately 2.5% which we believe will lead to an increase in our occupancy level. Any changes in these assumptions could impact our financial results.
As a result of the successful implementation of our new operating model, we enter 2004 with a more efficient operating platform. We intend to continue to refine our operating model in an effort to obtain additional efficiencies while improving customer service. Over the last two quarters, our occupancy has been stable at approximately 86% and we expect our average occupancy to increase approximately 1% to 2% during 2004. Although market rental rates have begun to stabilize in many of our markets, the roll down of rents on our expiring leases (assuming market rental rates do not recover from their existing levels) will continue to adversely impact our rental revenues, net income and funds from operations for the foreseeable future. We expect the cost to obtain and keep tenants, such as tenant improvements, leasing commissions, free rent and other concessions to approximate 2003 levels during 2004. As part of our capital allocation strategy of taking advantage of favorable market conditions to exit non-core markets, we expect to be net sellers of real estate again in 2004, which will further reduce our income from continuing operations and funds from operations, and may also result in gains or losses on sales of properties and potential impairment charges.
The remaining portion of our Management’s Discussion and Analysis of Financial Condition and Results of Operations will help you understand:
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the key transactions that we completed during the year;
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our critical accounting policies and estimates;
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our results of operations for the last three years;
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our liquidity and capital resources; and
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our funds from operations.
Key Transactions in 2003
During 2003, we completed the following key transactions:
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we disposed of 53 office properties, two industrial properties and four vacant land parcels in various transactions to unaffiliated parties for approximately $933.1 million. The sold office properties consisted of approximately 5,182,707 square feet and 32 residential units, and the industrial properties consisted of approximately 216,900 square feet. With these transactions, we exited the following markets: Salt Lake City, UT; Riverside, CA; Fort Worth, TX; Charlotte, NC; and San Antonio, TX;
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we sold partial interests in 13 Office Properties consisting of approximately 3,284,431 square feet for approximately $596.5 million;
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we acquired two Office Properties for approximately $183.2 million consisting of approximately 829,293 square feet;
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we placed into service four developments consisting of five buildings and approximately 1,218,215 square feet;
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we entered into $500 million of forward-starting interest rate swaps;
•
we repaid $400 million of unsecured notes that matured in November 2003;
•
we issued $500 million of unsecured notes due January 2013 at an effective annual interest rate of 5.98% and used a portion of the net proceeds to repay $300 million of unsecured notes that matured in February 2003;
•
we obtained a new three-year $1.0 billion revolving credit facility in May 2003;
•
we obtained a $1.0 billion 364-day credit facility in December 2003;
•
Equity Office announced the redemption of, and subsequently redeemed in 2004, 4,562,900 outstanding 8 5/8% Series C Cumulative Redeemable Preferred Shares of Beneficial Interest for approximately $114.6 million, which included approximately $0.6 million of accrued distributions. In connection with such redemption, we redeemed all of the Series C Preferred Units from Equity Office;
•
Equity Office redeemed the 7.875% Series E Cumulative Redeemable Preferred Shares for approximately $151.9 million, which included approximately $1.9 million of accrued distributions. In connection with such redemption, we redeemed all of the Series E Preferred Units from Equity Office;
•
Equity Office redeemed the 8.00% Series F Cumulative Redeemable Preferred Shares for approximately $100.0 million. In connection with such redemption, we redeemed all of the Series F Preferred Units from Equity Office; and
•
Equity Office repurchased 14,236,400 Common Shares at an average price of $25.53 per share for a total of $363.5 million. In connection with the repurchases, we purchased from Equity Office and retired a corresponding number of Units for an aggregate purchase price equal to the aggregate purchase price for all Common Share repurchases. We also redeemed 240,240 Units directly from the holders for approximately $6.4 million.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of this Form 10-K. We believe our most critical accounting policies include allowance for doubtful accounts, impairment of long-lived assets, depreciation and the fair value of financial instruments including derivative instruments, each of which we discuss below.
Allowance for Doubtful Accounts
Rental revenue from our tenants is our principal source of revenue and is recognized in accordance with GAAP based on the contractual terms of the leases. We monitor the collectibility of accounts receivable from our tenants on an on-going basis. Based on this analysis, historical experiences and the current economic environment, we establish provisions, and maintain an allowance for doubtful accounts for estimated losses resulting from the possible inability of our tenants to make required rent payments to us. An allowance for doubtful accounts is recorded during each period and the bad debt expense is netted against rental revenue in our consolidated statements of operations. The allowance for doubtful accounts, which represents the cumulative allowances less write-offs of uncollectible rent, is netted against tenant and other receivables and deferred rent receivable on our consolidated balance sheets.
As a result of the slow down in economic activity, we have continued to experience uncollectible receivables, although at lower levels than prior periods, relating to tenants in bankruptcy or tenants experiencing financial difficulty. Although our historical bad debt expense has been based on the factors described above, if we incorrectly estimate the required allowance for doubtful accounts, our financial condition and results of operations could be adversely affected. Below is our bad debt expense from continuing operations for each of the three years in the period ended December 31, 2003.
Impairment of Long-Lived Assets
We review our long-lived assets for potential impairment in accordance with FAS 144, Accounting for the Impairment and Disposal of Long-Lived Assets. Under FAS 144, an impairment loss must be recognized when the carrying value of a long lived asset is not recoverable. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. If it is determined that a permanent impairment of a long-lived asset has occurred, the carrying value of the asset is reduced to its fair value and an impairment loss is recognized for the difference between the carrying value and the fair value.
Our estimate of the expected future cash flows used in testing for impairment is highly subjective and based on among other things, our estimates regarding current and future market conditions, rental rates, occupancy levels, costs of tenant improvements, leasing commissions and other tenant concessions, and assumptions regarding the residual value of our Properties at the end our anticipated holding period. These assumptions could differ materially from actual results in future periods. Since FAS 144 provides that the future cash flows used in this analysis be considered on an undiscounted basis, our historically established intent to hold properties over the long term directly decreases the likelihood of recording an impairment loss. If our strategy changes or if market conditions otherwise dictate an earlier sale date, an impairment loss could be recognized and such loss could be material.
During 2003, we recognized an impairment of approximately $7.5 million on an Office Property (See Item 8. Financial Statements and Supplementary Data Note 8 - Impairment). There were no impairments in 2002. During 2001, we recognized an impairment of approximately $2.5 million on an investment in an unconsolidated joint venture that was held for sale.
Depreciation
Statement of Financial Accounting Standards No. 141 (“SFAS No. 141”) Business Combinations was effective July 1, 2001. Depreciation expense on Properties acquired prior to July 1, 2001 was computed using the straight-line method based on an estimated useful life of 40 years. A significant portion of the acquisition cost of each property was allocated to building (usually 85% to 90% unless the property was subject to a ground lease in which case 100% of the acquisition cost was allocated to building). Depreciation expense on properties acquired subsequent to the effective date of SFAS No. 141 is based on the allocation of the acquisition cost to land, building, tenant improvements and intangibles and the determination of their useful lives are based on management’s estimates. If we do not appropriately allocate to these components or we incorrectly estimate the useful lives of these components, our computation of depreciation and amortization expense may not appropriately reflect the actual impact of these costs over future periods, which will affect net income.
Fair Value of Financial Instruments
We are required to determine periodically the fair value of our mortgage debt and unsecured notes for disclosure purposes. In determining the fair value of these financial instruments, we use internally developed models that are based on current market conditions. For example, in determining the fair value of our mortgage debt and unsecured notes, we discount the spread between the future contractual interest payments and future interest payments based on a current market rate. In determining the current market rate, we add a credit spread to the quoted yields on federal government debt securities with similar maturity dates to our own debt. The credit spread estimate is based on our historical experience in obtaining either secured or unsecured financing and also is affected by current market conditions.
We are also required periodically to adjust the carrying values of interest rate swaps, as well as the underlying hedged liability, if applicable, to its fair value. In determining the fair value of interest rate swaps, we rely on third party quotations to adjust these instruments, as well as the hedged liability, if applicable, to its fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives either will be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or
recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings.
Because our valuations of our financial instruments are based on these types of estimates, the fair value of our financial instruments may change if our estimates are inaccurate. For the effect of hypothetical changes in market rates of interest on interest expense for variable rate debt, the fair value of total outstanding debt and our forward-starting interest rate swaps, see the Market Risk section.
Accounting Policy Adopted in 2003
Effective January 1, 2003, we adopted Statement of Financial Accounting Standards No. 123 (“Statement 123”) Accounting for Stock Based Compensation, which requires a fair value based accounting method for determining compensation expense associated with the issuance of share options and other equity awards. See Item 8. Financial Statements and Supplementary Data Note 2 - Summary of Significant Accounting Policies for more information.
Accounting Policies Adopted in 2002
Effective January 1, 2002, we adopted the provisions of Statement of Financial Accounting Standards No. 144 (“SFAS No. 144”) Accounting for the Impairment or Disposal of Long-Lived Assets, which is effective for financial statements issued for fiscal years beginning after December 15, 2001. SFAS No. 144 addresses the financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 extends the reporting requirements of discontinued operations to include components of an entity that have either been disposed of or are classified as held for sale. The operating results of the properties sold in 2003 and 2002 have been classified as discontinued operations in the consolidated statements of operations for each of the three years in the period ended December 31, 2003 included herein.
In accordance with Statement of Financial Accounting Standards No. 145 (“SFAS No. 145”), Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, effective for financial statements issued for fiscal years beginning after May 15, 2002, any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods shall be reclassified. As a result of the adoption, an extraordinary loss of approximately $9.4 million in the year ended December 31, 2001 was reclassified to “amortization of deferred financing costs and prepayment expenses”.
Impact of New Accounting Standards
See Item 8. Financial Statements and Supplementary Data Note 3 - Impact of New Accounting Standards for the impact of new accounting standards on our financial condition and results of operations.
Results of Operations
Trends in Occupancy, Rental Rates, Lease Terminations, Tenant Improvements and Leasing Costs and Uncollectible Receivables
We receive our revenue primarily from rental revenue generated by leases for office and industrial space for which we are the lessor. Our revenues also include reimbursements from our tenants for certain operating costs and revenues from parking facilities. As a result of the slowdown in economic activity and decline in white-collar employment, we have experienced a decrease both in our occupancy rates and overall market rental rates and an increase in costs to re-lease space. Below is a summary of our leasing activity for tenants taking occupancy for the periods presented for our Office Properties. Our 10 largest markets in terms of property net operating income from continuing operations in order from greatest to least are San Francisco, Boston, San Jose, Seattle, New York, Chicago, Washington D.C., Los Angeles, Atlanta and Orange County.
These markets accounted for approximately 78.4% of our property net operating income from continuing operations in the fourth quarter of 2003.
(a)
These weighted average rental rates are based on the average annual base rent per square foot over the term of each of the leases and the current estimated tenant reimbursements, if any.
(b)
Weighted average annual rent per square foot for new office leases for which the tenants have occupied the space during the relevant period may lag behind market because leasing decisions typically are made anywhere from one month to 12 or more months prior to taking occupancy.
A significant contributor to the decline in occupancy for our Office Properties since the beginning of 2002 has been early lease terminations. From January 1, 2002 through December 31, 2003, early lease terminations affected approximately 11.2 million square feet and we received lease termination fees of approximately $219.8 million. Although lease termination fees increase current period income, future rental income will most likely be reduced because, given the decline in market rents, it is unlikely we will collect the full contracted amount which had been payable under the terminated leases from new tenants who may occupy the vacated space. We will also often incur downtime and additional costs to relet the space. Although there is no way of predicting future lease terminations, we currently anticipate that lease termination fees will be relatively stable in 2004 as compared to 2003 and the affected square feet should be less in 2004 than 2003. The amount of lease termination fees are not necessarily proportionate to the square footage of leases being terminated. Although occupancy has declined since the beginning of 2002, it has stabilized over the last two quarters at approximately 86% and given the current rate of new leasing activity, we expect our average occupancy to increase approximately 1% to 2% in 2004. We estimate that for each 1% change in the average occupancy of our Office Properties there is a corresponding $30 million to $35 million change in our net operating income.
As indicated in the table above, due to the weak economy, there has been a general decline in market rental rates for Office Properties in 2002 and 2003 as reflected by the difference between the weighted average annual rent per square foot for expiring and terminated leases compared to the weighted average annual rent per square foot for tenants whose lease term commenced during the same period. This roll down in rents adversely affected our rental revenues in 2002 and 2003 and unless the economy recovers and market rental rates increase substantially from their current levels, is expected to adversely affect our rental revenues in subsequent periods as we enter into new leases. The actual rental rates at which available space will be relet will depend on prevailing market factors at the time. We currently estimate that the average annual total rent of approximately $30.43 per square foot as of December 31, 2003 for all our Office Properties (See Item 2. Properties) is approximately $3.50 to $4.00 per square foot above market rent and expect this trend to continue in 2004. As of December 31, 2003, approximately 65.8 million square feet of occupied space (approximately 62.4% of the total occupied square feet) is scheduled to expire through 2008. The square footage of leases scheduled to expire in each of the next five years and the average annual rent per square foot for these leases is presented below.
(a)
Based on the contractual termination date of the lease without regard to any early lease termination and/or renewal options.
(b)
Based on annualized rent. Annualized rent is the monthly contractual rent as of the reporting date, or if the current rent payable is $0 then the first monthly rent payment due, under existing leases as of December 31, 2003 multiplied by 12 months (“Annualized Rent”). This amount reflects total base rent and estimated expense reimbursements from tenants as of December 31, 2003 without regard to any rent abatements and contractual increases or decreases in rent subsequent to December 31, 2003. Total rent abatements for leases in place as of December 31, 2003, for the period from January 1, 2004 to December 31, 2004 are approximately $38.2 million. We believe Annualized Rent is a useful measure because this information can be used for comparison to current market rents as published by various third party sources.
During 2003, we experienced material increases in tenant improvement and leasing costs as a result of competitive market conditions for new and renewal leases. The weighted average tenant improvement and leasing cost per square foot incurred for office leases which commenced during 2003 was approximately $19.05, a substantial increase compared to the cost of $13.59 per square foot incurred in 2002. These increases in tenant improvement and leasing costs resulted in a decrease in net effective rents (contract rents reduced by tenant improvement costs, leasing commissions and any free rent periods) for lease renewals and retenanted properties. We expect tenant improvement and leasing costs to be approximately $18 to $20 per square foot in 2004.
We have also continued to experience uncollectible receivables, although at lower levels than prior periods, relating to tenants in bankruptcy or tenants experiencing financial difficulty. Bad debt expense relating to uncollectible receivables (from continuing operations) was approximately $12.6 million, $27.8 million and $24.7 million in 2003, 2002 and 2001, respectively. We anticipate that the level of uncollectible receivables in 2004 will be similar to 2003. Although we have collateral from many of our tenants, mostly in the form of security deposits and letters of credit, such collateral is generally not sufficient to cover the full cost of releasing the space and additional write-offs of tenant receivables may occur.
Trends in Property Operating Expenses
In 2001, we initiated a comprehensive analysis of our operating structure with the help of a management consulting firm and our employees. The goal of the analysis was to streamline operations, improve customer service, reduce lease cycle time, increase occupancy, retain tenants and reduce operating expenses. The analysis resulted in a significant reengineering effort called EOPlus. As part of this effort, many of the activities that occurred at the property level have been centralized into regional offices with a view towards allowing property managers to spend more time building customer relationships. The centralization of each region’s operations is designed to provide higher service to our customers at a lower cost. By consolidating our property management offices, we made available for leasing almost 400,000 square feet of office space in 2003. As of December 31, 2003, we have approximately 15% fewer employees at the property level than at the end of 2001. We have also created a central purchasing function to review and analyze our goods and services expenditures. The goal of the central purchasing function is to obtain preferred pricing, reduce the number of our vendors and reduce the number of invoices we process.
Period-to-Period Comparisons
Acquisition and Disposition Activity
Below is a summary of our acquisition and disposition activity since January 1, 2002. The buildings and total square feet shown include properties we own in joint ventures with other partners that we either consolidate or account for under the equity method. The total square feet of these unconsolidated properties is included in the table. Excluding the joint venture partners’ share of the square feet of the office properties, we effectively owned 113,580,631 square feet of office space as of December 31, 2003.
(a)
Excludes partial sales of real estate because the properties are still included in our portfolio.
(b)
Cambridge Science Center (f/k/a Riverview I) is now considered a development and 175 Wyman has been taken out of service and is being held for potential redevelopment.
The financial data presented in the consolidated statements of operations show changes in revenues and expenses from period-to-period. We do not believe our period-to-period financial data are necessarily comparable because we acquire and dispose of properties on an ongoing basis. The following tables show results attributable to the Properties that were held during both periods being compared (the “Core Portfolio”) and the changes in our aggregate total portfolio of Properties (the “Total Portfolio”).
Included in property operating revenues are rental revenue, tenant reimbursements, parking and other. Included in property operating expenses are insurance, repairs and maintenance and property operating expenses.
Comparison of the year ended December 31, 2003 to the year ended December 31, 2002
The table below represents selected operating information for the Total Portfolio and for the core portfolio consisting of 647 consolidated Office Properties, 75 Industrial Properties and 22 unconsolidated joint venture Properties acquired or placed in service on or prior to January 1, 2002. The core portfolio results below include the results of the 13 Office Properties in which we sold partial interests and entered into joint venture agreements during the fourth quarter 2003 because these properties were sold on December 30, 2003.
(a)
Corporate general and administrative expense is not allocated to the Core Portfolio because these expenses are not directly incurred in connection with any specific Property.
(b)
Interest expense (including amortization of deferred financing costs and prepayment expenses) for the core portfolio represents interest expense on property secured mortgage debt and does not include interest expense on the unsecured notes or the line of credit.
(c)
Represents segment data. See Item 8. Financial Statements and Supplementary Data Note 20 - Segment Information.
Property Operating Revenues
The decrease in property operating revenues in the Total Portfolio was primarily attributable to reduced occupancy in the core portfolio from 91.8% at January 1, 2002 to 86.5% at December 31, 2003 and a decrease in lease termination fees. A large portion of the decrease in occupancy was due to early lease terminations. In addition to the decline in occupancy, rental revenues declined as a result of decreased average rental rates on new leases as compared to average rental rates on expiring leases.
Depreciation and Amortization
Total Portfolio and core portfolio depreciation and amortization expense increased from the prior period primarily as a result of capital and tenant improvements made since the beginning of the prior period and from an increase in deferred leasing costs.
Real Estate Taxes
Real estate taxes decreased for the Total Portfolio and core portfolio primarily due to a decrease in real estate taxes in the California regions of approximately $11.5 million and the Seattle region of approximately $2.8 million, partially offset by an increase in real estate taxes in the New York region of approximately $6.3 million.
Property Operating Expenses
For the core portfolio, property operating expenses decreased primarily as a result of lower utility expense of approximately $13.8 million and lower insurance expense of approximately $11.0 million. Insurance expense decreased primarily as a result of changes in our insurance program and favorable loss experience. In addition, repairs and maintenance expense decreased by approximately $8.8 million primarily due to lower occupancy and the renegotiation of service contracts. Payroll expense decreased by approximately $4.3 million due to staff reductions. These decreases in property operating expenses were partially offset by increases in property operating general and administrative expenses which include legal, advertising, leasing and payroll costs and by severance expense of approximately $5.4 million in 2003.
General and Administrative Expenses
We incurred approximately $4.2 million of corporate level severance expense in 2003 compared to $7.2 million in 2002. The severance expense consisted of the accelerated vesting of share options and restricted shares as well as cash payments.
Beginning in fiscal 2003, we reclassified regional operating expenses and other costs directly associated with property operations from general and administrative expenses to property operating expenses. The regional offices exist to provide oversight for the management and leasing of the Properties. Accordingly, these expenses were classified as property operating expenses and all prior periods have been reclassified to provide for comparability. This reclassification did not change the prior period results or partners’ capital.
Impairment
During 2003, an Office Property was deemed to be impaired due to an analysis of its future undiscounted cash flows. As a result, we recognized a permanent impairment charge of $7.5 million, which reduced the book value of the property to its estimated fair value of $3.8 million.
Interest/ Dividend Income
Interest and dividend income decreased for the Total Portfolio by approximately $9.6 million primarily as a result of lower interest and dividends from various notes receivable and investments, which either matured or were redeemed during the period.
Realized Gain on Sale of Marketable Securities
During 2002, we entered into an early lease termination agreement with a tenant that was scheduled to occupy an entire building. As part of the consideration for the lease termination, we received five million shares of common stock. These securities were sold during the first quarter of 2003 at a gain of approximately $8.1 million. The remaining realized gain of approximately $1.2 million was due to the sale of other securities.
Interest Expense
Interest expense for the Total Portfolio increased primarily as a result of a $10.4 million decrease of capitalized interest related to several developments that were completed and placed into service. Interest expense for the core portfolio decreased primarily as a result of mortgage debt repayments.
Income Taxes
Income taxes for the Total Portfolio decreased because in 2002 we incurred approximately $5.0 million of income taxes as a result of a $40.0 million lease termination. (See “Income from Investment in Unconsolidated Joint Ventures” below).
Income from Investments in Unconsolidated Joint Ventures
Income from investments in unconsolidated joint ventures decreased for the Total Portfolio primarily due to a decrease in lease termination fees from $46.4 million to $3.7 million and a decrease in property operating revenues at the core portfolio, partially offset by a $2.3 million decrease in interest expense on variable rate mortgage debt at the core portfolio and by a development property placed in service in 2003. The decrease in property operating revenues at the core portfolio was primarily attributable to reduced occupancy and decreased average rental rates on new leases as compared to average rental rates on expiring leases.
Net Gain on Partial Sales of Real Estate
The net gain in 2003 related to the partial sale of our interests in 13 Office Properties. In accordance with SFAS No. 144, the net income from these Properties, which includes the net gain on sale, is not classified as discontinued operations because we still maintain an on-going involvement with the operation of these Properties.
Discontinued Operations
The increase in discontinued operations is a result of a higher net gain on the sale of properties in 2003 as compared to 2002, offset by the loss of net income due to the sales. Discontinued operations in 2002 includes the net income of properties sold in 2002 and in 2003 whereas the discontinued operations in 2003 only includes the net income of properties sold in 2003.
Comparison of the year ended December 31, 2002 to the year ended December 31, 2001
The table below represents selected operating information for the Total Portfolio and for the core portfolio consisting of 355 consolidated Office Properties and 23 unconsolidated joint venture Office Properties acquired or placed in service on or prior to January 1, 2001.
(a)
Corporate general and administrative expense is not allocated to the core portfolio because these expenses are not directly incurred in connection with any specific Property.
(b)
Interest expense (including amortization of deferred financing costs and prepayment expenses) for the core portfolio represents interest expense on property secured mortgage debt and does not include interest expense on the unsecured notes or the line of credit.
(c)
Represents segment data. See Item 8. Financial Statements and Supplementary Data Note 20-Segment Information.
Property Operating Revenues
The increase in property operating revenues in the Total Portfolio was primarily due to the Spieker Partnership merger in July 2001, which was partially offset by a decrease in occupancy in the core portfolio as described below. In addition, lease termination fees were $104.2 million in 2002 as compared to $39.4 million in 2001. Included in the lease termination fees of $104.2 million in 2002 was approximately $46.1 million from one tenant. The primary reason for the increase in the lease termination fees and the decrease in occupancy was the slowdown in economic activity. Lease termination fees relate to specific tenants, each of which has paid a fee to terminate its lease obligations before the end of the contractual term of the lease.
The decrease in property operating revenues in the core portfolio was primarily due to a decrease in occupancy from 94.5% at January 1, 2001 to 89.2% at December 31, 2002. Occupancy decreased primarily due to tenant rollover and early lease terminations where the space was not re-leased. The decrease in property operating revenues was partially offset by lease termination fees of $46.5 million in 2002 as compared to $34.7 million in 2001.
Depreciation and Amortization
Total Portfolio depreciation and amortization expense increased primarily due to the Spieker Partnership merger and capital and tenant improvements made during each year. Core portfolio depreciation and amortization expense increased as a result of capital and tenant improvements made during each year.
Property Operating Expenses and Real Estate Taxes
Total Portfolio property operating expenses and real estate taxes increased primarily due to the Spieker Partnership merger. Core portfolio property operating expenses and real estate taxes increased primarily due to an increase of approximately $4.5 million for safety and security expense and higher insurance premiums of approximately $8.4 million primarily due to the terrorist attacks on September 11, 2001, an increase of approximately $10.6 million for repairs and maintenance and an increase in real estate taxes of approximately $5.2 million. The increase in property operating expenses and real estate taxes was partially offset by a decrease of approximately $8.2 million in utilities expense.
Ground Rent
Ground rent for the Total Portfolio increased from the prior period primarily due to the Spieker Partnership merger as several Properties acquired in the Spieker Partnership merger are subject to ground leases.
General and Administrative Expenses
General and administrative expenses increased primarily due to professional and consulting fees related to the EOPlus initiative of $15.7 million and severance expense of approximately $7.3 million in 2002. The total severance consisted of severance payments and the accelerated vesting of share options and restricted shares.
Beginning in fiscal 2003, we reclassified regional operating expenses and other costs directly associated with property operations from general and administrative expenses to property operating expenses. The regional offices exist to provide oversight for the management and leasing of the Properties. Accordingly, these expenses were classified as property operating expenses and all prior periods have been reclassified to provide for comparability. This reclassification did not change the prior period results or partners’ capital.
Impairments
For information on this item refer to “Item 8. Financial Statements and Supplementary Data - Note 8 - Impairment”.
Interest/Dividend Income
Interest/dividend income decreased for the Total Portfolio as a result of an $8.5 million decrease in dividends and discount amortization from our $90.6 million investment in HQ Global Workplaces, Inc. (“HQ Global”) Series A Convertible Cumulative Preferred Stock (“HQ Preferred Stock”) which was written-off in 2001 and a reduction in interest income on notes receivable of approximately $6.6 million. In addition, CT Convertible Trust I redeemed its non-convertible preferred securities that earned a 13% annual dividend for approximately $20.1 million, including accrued dividends, in September 2002.
Interest Expense
Total Portfolio interest expense increased from the prior year as a result of having more debt outstanding during 2002, mainly as a result of the Spieker Partnership merger. This increase was partially offset by interest rate swap agreements in effect during 2002 and 2001 which effectively reduced interest expense by approximately $21.3 million by converting the fixed interest rates to variable rates for a portion of the unsecured notes. The swap agreements were all terminated in 2001 and 2002. Total proceeds of approximately $90.2 million resulting from the settlement of the swaps are being amortized ratably over the remaining terms of the respective unsecured notes as a reduction to interest expense. Core portfolio interest expense decreased from the prior year as a result of the repayment and refinancing of certain mortgage notes.
Income from Investment in Unconsolidated Joint Ventures
Income from investment in unconsolidated joint ventures increased for the Total Portfolio primarily due to lease termination fees of $46.4 million in 2002 as compared to $1.0 million in 2001. Included in the lease termination fees of $46.4 million in 2002 was approximately $40 million from one tenant.
Income from investment in unconsolidated joint ventures increased for the core portfolio primarily due to lease termination fees of $6.4 million in 2002 as compared to $1.0 million in 2001 and also increased due to a $7.6 million decrease in interest expense as a result of lower interest rates on variable rate mortgage notes and the repayment of a mortgage note. The increase in income from unconsolidated joint ventures was partially offset by a decrease in property revenues as a result of a decrease in occupancy.
Net Gain on Sales of Real Estate and Discontinued Operations
Net gain on sales of real estate for the Total Portfolio decreased from the prior period as a result of a presentation change for sold properties in accordance with SFAS No. 144. Gains and losses from properties sold prior to 2002 are reflected as “net gain on sales of real estate” and gains and losses from properties sold in 2002 are reflected in “discontinued operations”. The increase in discontinued operations was primarily due to the gain on the sale of the properties sold in 2002 and properties sold in 2003 that were acquired through the Spieker Partnership merger in July 2001. The gain on sale of real estate in 2001 from the Core Portfolio represents income received from an unaffiliated party for an easement allowing highway access under an Office Property.
Extraordinary Item
The extraordinary item relates to repair costs to certain Office Properties located in Seattle, Washington that were incurred as a result of damage from an earthquake in February 2001.
Discontinued Operations
The net income for properties sold subsequent to December 31, 2001 is reflected in the consolidated statements of operations as Discontinued Operations for the periods presented. Below is a summary of the results of operations of these properties through their respective disposition dates:
Segment Reporting
For segment reporting purposes, the office properties, apartment properties and the land parcels that were sold are included in the “Office Properties” segment and the industrial properties and parking facilities that were sold are included in the “Corporate and Other” segment.
Liquidity and Capital Resources
Liquidity
Our net cash provided by operating activities is primarily dependent upon the occupancy level of our properties, the rental rates on our leases, the collectibility of rent from our tenants, the level of operating and other expenses, and other factors. Our net cash provided by operating activities, including our share of net cash provided by operating activities from unconsolidated joint ventures, has been our primary source of liquidity to fund debt service, capital improvements, tenant improvements and leasing costs for operating properties as well as distributions to our unitholders. We expect that our lines of credit will adequately provide for any additional amounts which may be needed to fund working capital and unanticipated cash needs as well as acquisitions and development costs.
In order to qualify as a REIT for federal income tax purposes, Equity Office must distribute at least 90% of its taxable income (excluding capital gains) to its shareholders. Equity Office currently distributes capital gains to its shareholders; however, these gains can be retained by Equity Office and taxed at the corporate tax rate. Our partnership agreement generally requires us to distribute substantially all of the net cash from
operations each quarter and to make reasonable efforts to distribute to Equity Office enough cash for it to meet the 90% distribution requirement. Accordingly, we currently intend, although we are not legally obligated, to continue to make regular quarterly distributions to holders of Units and preferred units. The declaration of dividends on common and preferred shares is at the discretion of Equity Office’s Board of Trustees, which decision is made from time to time by Equity Office’s Board of Trustees based on then prevailing circumstances.
A material adverse change in our net cash provided by operating activities may affect our ability to fund these items and may affect the financial performance covenants under our lines of credit and unsecured notes. If we fail to meet our financial performance covenants and to reach a satisfactory resolution with our lenders, the maturity dates for our unsecured notes could be accelerated, and our lines of credit could become unavailable to us or the interest charged on the line of credit could increase. Our interest charged on the line of credit could also increase if our debt ratings adversely change. Any of these circumstances could adversely affect our ability to fund working capital and unanticipated cash needs, acquisitions and development costs.
Lower occupancy levels, reduced rental rates, and reduced revenues as a result of asset sales have had the effect of reducing our net cash provided by operating activities. In addition, our tenant improvement and leasing costs have increased significantly due to competitive market conditions for new and renewal leases. During the year ended December 31, 2003, our net free cash flow was insufficient to pay capital improvements, tenant improvements and leasing costs and distributions to our unitholders by approximately $179 million. We funded this net free cash flow deficit primarily with a combination of borrowings under our line of credit and proceeds from property dispositions. We define net free cash flow as (a) net cash provided by operating activities determined in accordance with GAAP plus funds from operations from our joint venture activities and minority interest (which we view as an integral part of our business) plus changes in non-cash items, such as rents receivable and accounts payable, which are expected to be settled in cash but are not reflected in net cash provided by operating activities determined in accordance with GAAP due to timing differences between the accrual of the receivable or payable and the cash settlement of such items, less (b) expenditures for capital improvements, tenant improvements and leasing costs and distributions to our unitholders. Net free cash flow is a non-GAAP financial measure and is reconciled to net cash provided by operating activities, the most directly comparable GAAP measure, for the period presented below. Our calculation of net free cash flow is not necessarily comparable to similar measures that may be presented by other companies.
If our net cash from operating activities and tenant improvements and leasing costs continue at these levels, and if Equity Office’s Board of Trustees continues to declare distributions on its common shares at current levels, our net free cash flow deficit would continue in subsequent periods and we would fund this deficit in a similar manner. We currently anticipate that the deficit for 2004 will be similar to 2003. Beyond this, we have $1.4 billion of debt maturing through December 31, 2004. Because our anticipated distributions will not allow us to retain sufficient cash to repay all of our debt as it comes due using only cash from operating
activities, we will be required to repay most of our maturing debt with proceeds from asset sales and debt offerings. Although there can be no assurance that such funding at acceptable terms will be available to us, we believe that net cash provided by operating activities, draws under our lines of credit, proceeds from other financing sources that we expect to be available to us and proceeds from anticipated asset sales will together provide sufficient liquidity to meet our cash needs during this period.
Distributions
In 2003, Equity Office’s Board of Trustees declared dividends on preferred units as reflected below:
(a)
Equity Office redeemed the Series C Preferred Shares in January 2004 and redeemed the Series E and Series F Preferred Shares in June 2003. In connection with such redemptions, we redeemed all of the Series C, E and F Preferred Units from Equity Office.
Equity Office’s Board of Trustees also declared dividends on the Units for the four quarters of 2003, at the rate of $.50 per Unit per quarter.
Contractual Obligations
As of December 31, 2003, we were subject to certain material contractual payment obligations as described in the table below. We were not subject to any material capital lease obligations or unconditional purchase obligations as of December 31, 2003.
(1)
Balance excludes a net unamortized discount of $13.7 million.
(2)
Balance excludes a net unamortized premium of $12.4 million.
Forward-Starting Interest Rate Swaps
See “Market Risk” for information on our forward-starting interest rate swaps.
Energy Contracts
In an ongoing effort to control energy costs, from time to time we enter into contracts for the purchase of gas or electricity for properties in states which have deregulated their energy markets. Typically, these contracts provide for a term of one to three years. Although all or a portion of the commodity price under these contracts is generally fixed, the amounts actually expended under these contracts will vary in accordance with actual energy usage or the timing of energy usage during the period. As a result, the amounts to be expended under these contracts are difficult to predict. During 2003 more than half of our energy expenditures were made under various contracts of this nature and most of these expenditures were reimbursable by our tenants as ordinary operating expenses.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements with any unconsolidated investments or joint ventures that we believe have or are reasonably likely to have a material effect on our financial condition, results of operations, liquidity or capital resources.
Debt Financing
The table below summarizes our consolidated mortgage debt, unsecured notes and line of credit indebtedness at December 31, 2003 and 2002. The amounts shown include unamortized discounts on mortgage debt of approximately $13.7 million and $12.6 million, respectively, and unamortized premiums on unsecured notes of $12.4 million and $41.2 million, respectively. The discounts and premiums were originally recorded in connection with certain property acquisitions, mergers, issuances of unsecured notes and interest rate swap settlements.
(a)
The interest rate for these notes is based on various spreads over LIBOR.
Mortgage Debt
As of December 31, 2003, total mortgage debt (excluding our share of the mortgage debt encumbering unconsolidated properties of approximately $797.3 million) consisted of approximately $2,279.9 million of fixed rate debt with a weighted average interest rate of approximately 7.72% and $36.0 million of variable rate debt based on LIBOR plus 55 basis points (1.72% as of December 31, 2003). See “Liquidity and Capital Resources - Contractual Obligations” for annual payment obligations under our mortgage debt.
The instruments encumbering the properties restrict title transfer of the respective properties subject to the terms of the mortgage, prohibit additional liens, require payment of real estate taxes on the properties, maintenance of the properties in good condition, maintenance of insurance on the properties and include a requirement to obtain lender consent to enter into material tenant leases.
Line of Credit
We have a $1.0 billion revolving credit facility that was obtained in May 2003. As of March 12, 2004 and December 31, 2003, $921.7 million and $334.0 million was outstanding under this facility, respectively. The line of credit bears interest at LIBOR plus 60 basis points, has an annual facility fee of 20 basis points payable quarterly and matures in May 2006. The effective rate on the line of credit at December 31, 2003 was approximately 1.95%. In addition, a competitive bid option, whereby the lenders participating in the credit facility may bid on the interest to be charged resulting in an interest rate lower than LIBOR plus 60 basis points, is available for up to $350 million of the borrowings under the credit facility.
364-Day Line of Credit
In December 2003, we obtained a $1.0 billion 364-day credit facility. The facility has a $200 million revolving component and a $800 million term component. As of December 31, 2003, no amounts were outstanding under this facility. The line of credit bears interest at LIBOR plus 65 basis points, has an annual facility fee of 15 basis points payable quarterly and matures in December 2004. In addition, a competitive bid option, whereby the lenders participating in the credit facility may bid on the interest to be charged resulting in an interest rate lower than LIBOR plus 65 basis points, is available for up to $350 million of the borrowings under the credit facility.
Unsecured Notes
Unsecured notes decreased to approximately $8,828.9 million at December 31, 2003 compared to approximately $9,057.7 million at December 31, 2002, as a result of the repayment of $300 million 6.38% unsecured notes in February 2003, the repayment of $400 million 7.38% unsecured notes in November 2003 and amortization of discounts and premiums, partially offset by the issuance in January 2003 of $500 million 5.88% unsecured notes due January 15, 2013.
The table below summarizes the unsecured notes outstanding as of December 31, 2003:
(a)
Includes the effect of settled interest rate protection and interest rate swap agreements, offering and transaction costs and premiums and discounts on certain unsecured notes.
(b)
Through 2004, $880 million of unsecured notes will mature and become payable, including the $400 million of unsecured notes that matured in January 2004 and were repaid with our line of credit. Our options for repaying the remaining notes include proceeds from our lines of credit, proceeds from additional debt and/or equity offerings or proceeds from property dispositions.
(c)
The notes are exchangeable into Equity Office Common Shares at an exchange rate of $34.00 per share. If the closing price of a Common Share at the time a holder exercises its exchange right is less than the exchange price of $34.00, the holder will receive, in lieu of Common Shares, cash in an amount equal to 97% of the product of the number of Common Shares into which the principal amount of notes subject to such exercise would otherwise be exchangeable and the current market price per Common Share. Upon exchange of a $1,000 note for Common Shares of Equity Office, we would issue a corresponding number of Units to Equity Office on a one-for-one basis.
As of March 12, 2004, $1.6 billion was available for issuance under a previously filed $4.0 billion shelf registration statement.
Restrictions and Covenants under Unsecured Indebtedness
Agreements or instruments relating to our lines of credit and unsecured notes contain certain financial restrictions and requirements regarding total debt-to-assets ratios, debt service coverage ratios, minimum ratio of unencumbered assets to unsecured debt and other limitations. As of December 31, 2003, we were in compliance with each of these financial restrictions and requirements. If we fail to comply with any of these restrictions and requirements, then the indebtedness could become due and payable before its stated due date.
Set forth below are the financial restrictions and requirements to which we are subject under our unsecured note indentures and our performance under each covenant as of December 31, 2003:
(a)
The calculations of our actual performance under each covenant are included as Appendix A to this Form 10-K.
(b)
The unsecured notes assumed in the merger with Spieker Partnership are subject to a minimum ratio of 165%.
Equity Securities
The following table presents the changes in Equity Office’s issued and outstanding Common Shares and EOP Partnership’s Units (exclusive of Units owned by Equity Office) since December 31, 2002:
(a)
In July 2002, Equity Office announced a Common Share repurchase program allowing for the repurchase of up to $200 million of Common Shares, which was later increased to $400 million in November 2002 and to $600 million in March 2003, over the next 12 months at the discretion of management. The Common Shares may be repurchased in the open market or privately negotiated transactions. During 2003, 14,236,400 Common Shares were repurchased at an average price of $25.53 for approximately $363.5 million in the aggregate. In connection with the repurchases, we purchased from Equity Office and retired a corresponding number of Units for an aggregate purchase price equal to the aggregate purchase price for all Common Share repurchases.
(b)
During 2003, we redeemed 240,240 Units at an average price of $26.76 for a total of approximately $6.4 million.
Cash Flows
The following summary discussion of our cash flows is based on the consolidated statements of cash flows in Item 8. - Financial Statements and Supplementary Data and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below.
Years Ended December 31, 2003 and
Cash and cash equivalents increased by approximately $10.9 million to $69.4 million at December 31, 2003, compared to $58.5 million at December 31, 2002. This increase was the net result of approximately $1,132.3 million provided by operating activities, approximately $744.8 million provided by investing activities (consisting primarily of approximately $1,345.6 million provided by property dispositions partially offset by approximately $577.6 million used for capital and tenant improvements and lease acquisition costs) and approximately $1,866.2 million used for financing activities (consisting primarily of $619.9 million used for Common Share, Unit and preferred unit repurchases and approximately $901.3 million used for distributions to unitholders).
Years Ended December 31, 2002 and
Cash and cash equivalents decreased by approximately $2.7 million to $58.5 million at December 31, 2002, compared to $61.1 million at December 31, 2001. This decrease was the net result of approximately $1,390.9 million provided by operating activities, approximately $85.2 million provided by investing activities (consisting primarily of $377.2 million provided by property dispositions and approximately $167.0 million
released from escrows partially offset by approximately $433.6 million used for capital and tenant improvements and lease acquisition costs) and approximately $1,478.8 million used for financing activities.
Additional Items for 2003
Developments in Process
Developments in process decreased from approximately $284.7 million at December 31, 2002 to approximately $75.2 million at December 31, 2003 due to three developments that were placed in service (Ferry Building, Foundry Square II and Water’s Edge of which total costs incurred at December 31, 2002 were approximately $269.0 million) partially offset by the effect of a previously operational property being re-characterized as held for development during 2003 (Cambridge Science Center of which total costs incurred at December 31, 2003 were approximately $31.6 million) and approximately $27.9 million of expenditures during 2003 on current developments.
Deferred Rent Receivable
Deferred rent receivable increased by approximately $47.4 million to $379.3 million at December 31, 2003, compared to $331.9 million at December 31, 2002. This increase was a result of a $72.2 million increase in receivables recorded from tenants for the current difference between the straight-line rent and the rent that is contractually due from tenants partially offset by an approximate $17.8 million decrease due to the partial sales of office properties in 2003.
Escrow Deposits and Restricted Cash
Escrow deposits primarily consist of amounts held by lenders to provide for future real estate tax expenditures and tenant improvements, earnest money deposits on acquisitions and net proceeds from tax-deferred dispositions. Restricted cash represents amounts committed for various utility deposits and security deposits. Certain of these amounts may be reduced upon the fulfillment of certain obligations. The escrow deposits and restricted cash increased approximately $46.0 million to $75.2 million at December 31, 2003 from $29.2 million at December 31, 2002. The increase was primarily due to proceeds of $50.0 million from the sale of certain properties in 2003 that were deposited into an escrow account pending a tax deferred like kind exchange pursuant to section 1031 of the Internal Revenue Code.
Deferred Leasing Costs and Other Related Intangibles
Deferred leasing costs and other related intangibles increased by approximately $79.6 million to $314.6 million at December 31, 2003, compared to $235.0 million at December 31, 2002. This increase was a result of approximately $142.3 million in new leasing costs and approximately $21.9 million of intangibles recorded in accordance with SFAS No. 141 related to the acquisition of two properties in 2003, partially offset by amortization expense of approximately $66.4 million, and $20.2 million from the partial sales of office properties sold in 2003.
Prepaid Expenses and Other Assets
Prepaid expenses and other assets increased by approximately $71.2 million to $344.9 million at December 31, 2003, compared to $273.7 million at December 31, 2002. This increase was primarily a result of an $18.2 million increase in prepaid real estate taxes, an $11.1 million increase in the market value of our forward-starting interest rate swaps, a $25.0 million equity investment in the joint venture that owns The John Hancock Complex in Boston, Massachusetts, and a $16.8 million increase in our Supplemental Employee Retirement Plan.
Deferred Compensation
Deferred compensation decreased by approximately $9.6 million to approximately $5.9 million at December 31, 2003 compared to $15.5 million at December 31, 2002. This decrease was a result of the
continued amortization of restricted units issued prior to 2003, which were accounted for under APB 25 prior to our adoption of SFAS No. 123.
Market Risk
Qualitative Information About Market Risk
Our future earnings, cash flows and fair values relevant to financial instruments depend upon prevalent market rates for those financial instruments. Market risk is the risk of loss from adverse changes in market prices and interest rates. We manage our market risk by matching projected cash inflows from operating, investing and financing activities with projected cash outflows to fund debt service, acquisitions, capital expenditures, distributions to unitholders and other cash requirements. The majority of our outstanding debt obligations (maturing at various times through 2031) have fixed interest rates which limit the risk of fluctuating interest rates. We utilize certain derivative financial instruments at times to further reduce interest rate risk. Interest rate protection and swap agreements are used to convert some variable rate debt to a fixed rate basis, fixed rate debt to a variable rate basis, or to hedge anticipated financing transactions. Derivatives are used for hedging purposes rather than speculation. We do not enter into financial instruments for trading purposes.
Quantitative Information About Market Risk
Interest Rate Risk - Debt
The tables below disclose the effect of hypothetical changes in market rates of interest on interest expense for variable rate debt and the fair value of total outstanding debt. Interest risk amounts were determined by considering the impact of hypothetical interest rates on our debt. This analysis does not reflect the impact that a changing interest rate environment could have on the overall level of economic activity. Further, in the event of a changing interest rate environment, management would likely take actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no change in our financial structure.
(a)
As of December 31, 2003 and 2002, the fair value of our fixed-rate debt was approximately $1.3 billion and $1.0 billion higher than the book value of approximately $11.1 billion and $11.5 billion, respectively, primarily due to the general decrease in market interest rates on secured and unsecured debt.
Interest Rate Risk - Derivatives
Interest Rate Swaps
During 2002 and 2001, we entered into and terminated several interest rate swap agreements that hedged certain unsecured notes. In each case, we were the variable interest rate payer and the counterparty was the fixed rate payer. The variable interest rates were based on various spreads over LIBOR. The settlement dates corresponded to the interest payment dates of the respective unsecured notes hedged. Each of the interest rate swap agreements were to terminate on the maturity date of the respective unsecured notes hedged. The interest rate swap agreements were designated as fair value hedges. As of December 31, 2002, these interest rate swaps had been terminated.
Forward-Starting Interest Rate Swaps
As of December 31, 2003 and 2002, we had $1.3 billion and $1.1 billion of forward-starting interest rate swaps outstanding, respectively. The outstanding swaps will hedge the future interest payments of debt anticipated to be issued in 2004. The market value of the forward-starting interest rate swaps at December 31, 2003 represented a net liability to us of approximately $10.4 million (approximately $11.1 million is recorded in other assets and $21.5 million is recorded in other liabilities) and, as of December 31, 2002, was approximately $18.6 million which is included in other liabilities. The entire net market value is also included in accumulated other comprehensive income. No hedge ineffectiveness has been recorded in earnings as these swaps were perfectly effective. As of March 5, 2004, the net market value of these forward-starting interest rate swaps represented a net liability to us of approximately $64.9 million. The market value of the forward-starting interest rate swaps is dependent upon existing market interest rates and swap spreads, which change over time. If the market interest rates were 50 basis points higher, the value of the swaps would have been approximately $41.4 million and $33.3 million at December 31, 2003 and 2002, respectively. If the market interest rates were 50 basis points lower, our liability under these swaps would have been approximately $65.0 million and $60.5 million at December 31, 2003 and 2002, respectively.
Upon settlement of the swaps, we may be obligated to pay the counterparties a settlement payment, or alternatively to receive settlement proceeds from the counterparties. In accordance with FASB Statement No. 133 Accounting for Derivative Instruments and Hedging Activities, if the swaps are deemed to be effective hedges upon settlement, any monies paid or received will be amortized to interest expense over the term of the respective hedged interest payments. If the swaps are deemed to be only partially effective hedges upon settlement, a portion of the monies paid or received will be immediately recognized in earnings and the remainder will be amortized to interest expense over the term of the respective hedged interest payments. If the swaps are deemed to be completely ineffective hedges upon settlement, any monies paid or received will be immediately recognized in earnings.
Capital Improvements, Tenant Improvements and Leasing Costs
Capital Improvements
Significant renovations and improvements, which improve or extend the useful life of our Properties are capitalized. We categorize these capital expenditures as follows:
•
Capital Improvements - improvements that enhance the value of the property such as lobby renovations, roof replacement, significant renovations for Americans with Disabilities Act compliance, chiller replacement and elevator upgrades.
•
Development and Redevelopment Costs - include costs associated with the development or redevelopment of a property including tenant improvements, leasing commissions, capitalized interest and operating costs incurred during completion of the property and incurred while the property is made ready for its intended use.
The table below details the costs incurred for each type of improvement.
(a)
Properties included in redevelopment costs for 2003 are the Tabor Center, the Polk and Taylor Buildings and Worldwide Plaza (amenities area). Redevelopments for 2002 included the 500-600 City Parkway, the Tabor Center, the Polk and Taylor Buildings and Worldwide Plaza (amenities area). Redevelopments for 2001 included US Bancorp, 100 Summer and the Tabor Center.
Tenant Improvements and Leasing Costs
Costs related to the renovation, alteration or build-out of existing office space, as well as related leasing costs, are capitalized and depreciated or amortized over the lease term. These tenant improvements may include, but are not limited to, floor coverings, ceilings, walls, HVAC, mechanical, electrical, plumbing and fire protection systems.
The amounts shown below represent the total tenant improvement and leasing costs for leases which commenced during the period, regardless of when such costs were actually paid.
(a)
Represents our share of unconsolidated joint venture tenant improvement and leasing costs. All joint venture information included above is from office properties.
During 2003, we saw evidence suggesting that contract rents may have begun to stabilize. Tenant improvements and leasing costs, however, have increased significantly due to competitive market conditions for new leases. This has had the effect of reducing net effective rents (contract rents reduced by the impact of tenant improvement costs, leasing commissions and any free rent periods) on lease renewals and retenanted space. This adverse trend may continue until market conditions improve.
The above information includes capital improvements, tenant improvements and leasing costs incurred for leases which commenced during the period shown. The amounts included in the consolidated statement of cash flows represent the cash expenditures made during the period. The differences between these amounts represent timing differences between the lease commencement dates and the dates of the cash expenditures. In addition, the figures below include expenditures for corporate furniture, fixtures and equipment, software, leasehold improvements and other. The reconciliation between the amounts above for the consolidated properties and the amounts disclosed in the consolidated statements of cash flows is as follows:
Developments
We own directly several properties in various stages of development or pre-development. These developments are funded by working capital and our line of credit. Specifically identifiable direct acquisition, development and construction costs are capitalized, including, where applicable, salaries and related costs, real estate taxes and interest incurred in developing the property. The properties under development and all figures stated below are as of December 31, 2003.
(a)
The Estimated Placed in Service Date represents the date the certificate of occupancy was or is currently anticipated to be obtained. Subsequent to obtaining the certificate of occupancy, the property is expected to undergo a lease-up period.
(b)
The Total Estimated Costs represent 100% of the development’s estimated costs, including the acquisition cost of the land and building, if any. The Total Estimated Costs are subject to change upon, or prior to, the completion of the development and include amounts required to lease the property.
In addition to the developments described above, we own or have under option various land parcels available for development. These sites represent possible future development of up to approximately 12 million square feet of office space. These developments will be impacted by the timing and likelihood of success of the entitlement process, both of which are uncertain. These various sites include, among others: Russia Wharf, Boston, MA; Reston Town Center, Reston, VA; Prominence in Buckhead, Atlanta, GA; Perimeter Center, Atlanta, GA; Tabor Center, Denver, CO; Bridge Pointe Corporate Centre, San Diego, CA; La Jolla Centre, San Diego, CA; Orange Center, Orange, CA; Water’s Edge, Los Angeles, CA; Skyport Plaza, San Jose, CA; Foundry Square I, San Francisco, CA; San Rafael Corporate Center, San Rafael, CA; Station Landing, Walnut Creek, CA; Parkshore Plaza, Folsom, CA; City Center Bellevue; Bellevue, WA; and 8th Street, Bellevue, WA.
Subsequent Events
See Note 26 - Subsequent Events for transactions that occurred subsequent to December 31, 2003 through March 5, 2004.
Inflation
Substantially all of our office leases require the tenant to pay, as additional rent, a portion of real estate taxes and operating expenses. In addition, many of our office leases provide for fixed increases in base rent or indexed escalations (based on the Consumer Price Index or other measures). We believe that the majority of inflationary increases in expenses will be offset, in part, by the expense reimbursements and contractual rent increases described above.
Funds From Operations (“FFO”)
FFO is a non-GAAP financial measure. We believe FFO, as defined by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”), to be an appropriate measure of performance for a real estate company, for the reasons, and subject to the qualifications, specified in footnote (a) below. The following table reflects the reconciliation of FFO to net income, the most directly comparable GAAP measure, for the periods presented:
(a)
FFO is a non-GAAP financial measure. The most directly comparable GAAP measure is net income, to which it is reconciled.
(b)
FFO per unit may not total the sum of the per unit components in the reconciliation due to rounding.
FFO Definition
FFO is defined as net income, computed in accordance with accounting principles generally accepted in the United States (“GAAP”), excluding gains or losses from sales of properties, plus real estate related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. We believe that FFO is helpful to investors as one of several measures of the performance of a real estate company. We further believe that by excluding the effect of depreciation, amortization and gains or losses from sales of real estate, all of which are based on historical costs and which may be of limited relevance in evaluating current performance, FFO can facilitate comparisons of operating performance between periods and between other real estate companies. Investors should review FFO, along with GAAP net income and cash flow from operating activities, investing activities and financing activities, when trying to understand a real estate company’s operating performance. We compute FFO in accordance with standards established by NAREIT, which may not be comparable to FFO reported by other real estate companies that do not define the term in accordance with the current NAREIT definition or that interpret the current NAREIT definition differently than we do. FFO does not represent cash generated from operating activities in accordance with GAAP, nor does it represent cash available to pay distributions and should not be considered as an alternative to net income, determined in accordance with GAAP, as an indication of our financial performance, or to cash flow from operating activities, determined in accordance with GAAP, as a measure of our liquidity, nor is it indicative of funds available to fund our cash needs, including our ability to make cash distributions.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Quantitative and qualitative disclosures about market risk are incorporated herein by reference from Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Market Risk.
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT AUDITORS
The Partners of EOP Operating Limited Partnership
We have audited the accompanying consolidated balance sheets of EOP Operating Limited Partnership (“EOP Partnership”) as of December 31, 2003 and 2002, and the related consolidated statements of operations, partners’ capital, net comprehensive income 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 Index at Item 15(a). These financial statements and the schedule are the responsibility of EOP Partnership’s management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of EOP 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, in 2003 EOP Partnership changed its method of accounting for stock-based employee compensation. In addition, in 2002 EOP Partnership changed its method of accounting for discontinued operations.
ERNST & YOUNG LLP
Chicago, Illinois
February 5, 2004, except for Note 26
as to which the date is March 5, 2004
EOP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
EOP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
EOP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERS’ CAPITAL
See accompanying notes.
EOP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CASH FLOWS
EOP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
EOP OPERATING LIMITED PARTNERSHIP
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
See accompanying notes.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -
BUSINESS AND FORMATION OF EOP PARTNERSHIP
EOP Operating Limited Partnership (“EOP Partnership”) is a Delaware limited partnership. Our general partner is Equity Office Properties Trust (“Equity Office”), a Maryland real estate investment trust (“REIT”). The use of the word “we”, “us”, or “our” refers to EOP Partnership and its subsidiaries, except where the context otherwise requires. We were organized in 1996 to continue and expand the national office property business organized by Mr. Samuel Zell, the Chairman of the Board of Trustees of Equity Office, and to complete the consolidation of our predecessors. Equity Office completed its initial public offering (the “IPO”) on July 11, 1997, having sold its common shares of beneficial interest, $0.01 par value per share (“Common Shares”). The net proceeds from the IPO were contributed to us in exchange for units of partnership interest (“Units”). Equity Office has elected to be taxed as a REIT for federal income tax purposes and generally will not be subject to federal income tax if it distributes 100% of its taxable income and complies with a number of organizational and operational requirements.
We are a fully integrated, self-administered and self-managed real estate company principally engaged, through our subsidiaries, in owning, managing, leasing, acquiring and developing office properties. At December 31, 2003, we owned or had an interest in 684 office properties comprising approximately 122.3 million rentable square feet of office space in 18 states and the District of Columbia and were located in 27 markets and 124 submarkets (the “Office Properties”). On a weighted average basis, the Office Properties were 86.3% occupied at December 31, 2003. Approximately 42.3% of the rentable square feet is located in central business districts and approximately 57.7% of the rentable square feet is located in suburban markets. At December 31, 2003, we also owned 75 industrial properties comprising approximately 5.8 million square feet of industrial space (the “Industrial Properties” and together with the Office Properties, the “Properties”) and approximately 0.4 million square feet of office properties under development. On a weighted average basis, the Industrial Properties were 86.6% occupied at December 31, 2003.
NOTE 2 -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements represent our financial condition and results of operations and those of our subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. Property holding entities and other subsidiaries of which we own 100% of the equity are consolidated. For those joint ventures of which we own less than 100% of the equity interest, we consolidate the property if we have the direct or indirect ability to make decisions about the entities’ activities based on the terms of the respective joint venture agreements which specify the sharing of participating and protective rights such as decisions regarding major leases, encumbering the entities with debt and whether to dispose of entities. We would also consolidate certain property holding entities and other subsidiaries if we own less than a 100% equity interest if we are deemed to be the primary beneficiary in a variable interest entity (as defined in FASB Interpretation 46 Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, as revised (“FIN 46”)).
Investments in Real Estate
Rental property and improvements, including interest and other costs capitalized during construction, are included in investments in real estate and are stated at cost. Expenditures for ordinary maintenance and repairs are expensed to operations as they are incurred. Significant renovations and improvements, which improve or extend the useful life of the assets, are capitalized. Rental property and improvements, excluding
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
land, are depreciated over their estimated useful lives using the straight-line method. The estimated useful lives by asset category are:
In accordance with Statement of Financial Accounting Standards No. 141 Business Combinations (“Statement 141”), we allocate the purchase price of real estate to land, building, tenant improvements and, if determined to be material, intangibles, such as the value of above, below and at-market leases, origination costs associated with the in-place leases, and the value of tenant relationships, if any. We depreciate the amount allocated to building and other intangible assets over their estimated useful lives, which generally range from three to 40 years. The values of the above and below market leases are amortized and recorded as either an increase (in the case of below market leases) or a decrease (in the case of above market leases) to rental income over the remaining term of the associated lease. The value associated with in-place leases and tenant relationships is amortized over the expected term, which includes an estimated probability of the lease renewal, and its estimated term. If a tenant vacates its space prior to the contractual termination of the lease and no rental payments are being made on the lease, any unamortized balance of the related intangible will be written off. The tenant improvements and origination costs are amortized as an expense over the remaining life of the lease (or charged against earnings if the lease is terminated prior to its contractual expiration date).
In accordance with Statement 141 and its applicability to acquired in-place leases, we perform (or engage a third party to perform) the following procedures for properties we acquire:
1)
estimate the value of the real estate “as if vacant” as of the acquisition date;
2)
allocate that value among land, building improvements, building, and equipment and determine the associated asset life for each;
3)
compute the value of the difference between the “as if vacant” value and the purchase price, which will represent the total intangible assets;
4)
allocate the value of the above and below market leases to the intangible assets and determine the associated life of the above/below market leases;
5)
calculate the value and associated life of the tenant relationships, if any, by taking the direct identifiable benefits of the customer relationship and discounting them to present value;
6)
estimate the fair value of the in-place tenant improvements and leasing commissions and calculate the associated asset life; and
7)
allocate the remaining intangible value to the in-place leases and their associated lives.
Rental properties are individually evaluated for impairment when conditions exist which may indicate that it is probable that the sum of expected future cash flows (on an undiscounted basis) from a rental property over the anticipated holding period is less than its historical net cost basis. Upon determination that a permanent impairment has occurred, rental properties are reduced to their fair value. For properties to be disposed of, an impairment loss is recognized when the fair value of the property, less the estimated cost to sell, is less than the carrying amount of the property measured at the time we have a commitment to sell the property which is not subject to any significant contingencies. A property to be disposed of is reported at the lower of its carrying amount or its estimated fair value, less its cost to sell. Subsequent to the date that a property is held for disposition, depreciation expense is not recorded.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
The FASB issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long Lived Assets. Statement 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. The provisions of Statement 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. We adopted the standard in 2002 and it did not have a material effect on our financial condition or results of operations.
Developments in process are carried at cost, which includes land acquisition cost, architectural fees, general contractor fees, capitalized interest, internal costs related directly to the development and other costs related directly to the construction of the property. Depreciation is not recorded until the property is placed in service, which occurs shortly after receipt of a certificate of occupancy.
Land available for development is carried at cost and is not depreciated. Land available for development includes various vacant land parcels that may have some improvements such as utility service.
Investments in Unconsolidated Joint Ventures
Investments in unconsolidated joint ventures are accounted for using the equity method of accounting because we do not have control over the activities of the investees. Our net equity investment is reflected on the consolidated balance sheets, and the consolidated statements of operations include our share of net income or loss from the unconsolidated joint ventures. Any difference between the carrying amount of these investments on our consolidated balance sheet and the historical cost of the underlying equity is depreciated as an adjustment to income from unconsolidated joint ventures generally over 40 years.
Deferred Leasing and Financing Costs
Deferred leasing and financing costs, which consist of, but are not limited to, commissions paid to third parties for new or renewal leases, and fees paid to third parties for unsecured note offerings and mortgage debt, are recorded at cost. The deferred leasing costs are amortized over the terms of the respective leases and the deferred financing costs are amortized over the terms of the respective financings on a straight-line basis, which approximates the effective yield method. We also record deferred leasing costs in accordance with Statement 141 when allocating the purchase price to acquired in-place leases (see Investment in Real Estate above).
Revenue Recognition
We record rental income for the full term of each lease on a straight-line basis. Certain leases provide for tenant occupancy during periods for which no rent is due or where minimum rent payments increase during the term of the lease. Accordingly, a receivable is recorded from tenants for the current difference between the straight-line rent and the rent that is contractually due from the tenant (“Deferred Rent Receivable”). When a property is acquired, the term of existing leases is considered to commence as of the acquisition date for purposes of this calculation. The amounts included in rental income for the years ended December 31, 2003, 2002 and 2001 were approximately $73.1 million, $67.4 million and $66.5 million from continuing operations, respectively. Deferred rental revenue is not recognized for income tax purposes.
Tenant reimbursements consisting of amounts due from tenants for common area maintenance, real estate taxes and other recoverable costs are recognized as revenue in the period in which the expenses are incurred.
Lease termination income (included in other revenue) represents amounts received from tenants in connection with the early termination of their remaining lease obligation. We will also record deferred revenue in connection with a lease termination fee received if it is probable that a tenant will file for bankruptcy within
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
90 days, if significant contingencies in the lease termination agreement exist or if the tenant has not yet vacated the building.
We recognize income from rent, tenant reimbursements and lease termination fees and other income once all of the following criteria are met in accordance with SEC Staff Accounting Bulletin 104:
•
the agreement has been fully executed and delivered;
•
services have been rendered;
•
the amount is fixed or determinable; and
•
the collectibility is reasonably assured.
Cash Equivalents
Cash equivalents are considered to be all highly liquid investments purchased with a maturity of three months or less at the date of purchase.
Allowance for Doubtful Accounts
Allowance for doubtful accounts is maintained for estimated losses resulting from the inability of certain tenants to meet the contractual obligations under their lease agreements. Management actively reviews tenant receivables and determines the probability of collection for receivables identified as potentially uncollectible. The amount of the allowance takes into account any security deposits or outstanding letters of credit.
Escrow Deposits and Restricted Cash
Escrow deposits primarily consist of amounts held by lenders to provide for future real estate tax expenditures and tenant improvements, earnest money deposits on acquisitions and net proceeds from property sales that were executed as a tax-deferred disposition. Restricted cash represents amounts committed for various utility deposits and security deposits.
Fair Value of Financial Instruments and Other Assets
Investments in notes receivable approximate their fair value and are included in other assets.
We have debt at fixed and variable rates. The fair market value of variable rate debt approximates book value because the interest rate is based on LIBOR plus a credit premium, which represents a market rate. The fair value of the fixed-rate mortgage debt and unsecured notes as of December 31, 2003 was approximately $1.3 billion higher than the book value of approximately $11.1 billion primarily due to the general decrease in market interest rates on secured and unsecured debt. As of December 31, 2002, the fair value of our fixed-rate debt was approximately $1.0 billion higher than the book value. The fair value of the mortgage debt and the unsecured notes was determined by discounting the spread between the future contractual interest payments and the future interest payments based on a market rate. The fair value of interest rate swap agreements is determined using third party valuations. In addition, the carrying values of cash equivalents, restricted cash, escrow deposits, tenant and other rents receivable, prepaid expenses and other assets, accounts payable and accrued expenses and other liabilities approximate their fair value.
Derivatives and Hedging Activities
We may periodically enter into certain interest rate protection and swap agreements to effectively convert floating rate debt to a fixed rate basis, fixed rate debt to a floating rate basis, as well as to hedge anticipated future financing transactions. Net amounts paid or received under these agreements upon their periodic reset dates are recognized as an adjustment to interest expense when such amounts are incurred or earned.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
Settlement amounts paid or received in connection with settled interest rate protection agreements and interest rate swap agreements are deferred and amortized as an adjustment to interest expense over the remaining term of the related financing transaction on a straight-line basis, which approximates the effective yield method.
All derivative instruments are recorded at fair value. Derivatives that are not hedges must be adjusted to fair value through net income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will be offset against the corresponding change in fair value of the hedged asset, liability, or firm commitments through net income or recognized in other comprehensive income until the hedged item is recognized in net income. The ineffective portion of a derivative’s change in fair value will be recognized in net income. We recorded a cumulative effect of a change in accounting principle resulting in a loss of approximately $1.1 million in the year ended December 31, 2001 as a result of adopting FASB Statement No. 133 Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).
Income Taxes
We are generally not liable for federal taxes because our partners recognize their proportionate share of our income or loss on their tax returns. The Office Properties and Industrial Properties are primarily owned by limited partnerships or limited liability companies, which are substantially pass-through entities. Some of the pass-through entities have corporate general partners or members, which are subject to federal and state income and franchise taxes. In addition, our property management business which provides management services to Properties owned by third parties and provides certain other services to many of our Properties is owned by a corporation and is subject to federal and state income and franchise taxes.
Equity Office has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, Equity Office generally will not be subject to federal income tax if it distributes 100% of its annual taxable income to its shareholders. REITs are subject to a number of organizational and operational requirements. If Equity Office fails to qualify as a REIT in any taxable year, it will be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate tax rates. Even if Equity Office qualifies for taxation as a REIT, Equity Office may be subject to state and local income taxes and to federal income tax and excise tax on its undistributed income. In addition, taxable income from Equity Office’s taxable REIT subsidiaries is subject to federal, state and local income taxes. The aggregate cost of land and depreciable property for federal income tax purposes as of December 31, 2003 and 2002 was approximately $14.4 billion and $14.8 billion, respectively.
Minority Interests - Partially Owned Properties
We consolidate certain Properties that we control, but do not wholly own. The minority interests share of the equity of these consolidated Properties is reflected in the consolidated balance sheets as “Minority interests - partially owned properties” and represents the minority interests’ share in the total equity of these Properties. The net income from these properties attributable to the minority interests is reflected as “Minority interests - Partially owned properties” in the consolidated statements of operations.
In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“Statement 150”). Statement 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. Statement 150 is effective for all financial instruments created or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 (July 1, 2003 for calendar quarter companies). We adopted Statement 150 on July 1, 2003, which had no effect on our financial statements. Several of the Properties that we consolidate but do not wholly own are subject to finite life joint
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
venture agreements. Statement 150 requires the disclosure of the estimated settlement value of these noncontrolling interests. As of December 31, 2003 the estimated settlement value of these noncontrolling interests approximated the book value of approximately $169.7 million.
Use of Estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to the previously reported 2002 and 2001 statements in order to provide comparability with the 2003 statements reported herein. These reclassifications have not changed the 2002 or 2001 results of operations or combined partners’ capital and mandatorily redeemable preferred units.
Share Based Employee Compensation Plans
Prior to January 1, 2003, we used the accounting provisions provided by Accounting Principles Board Opinion No. 25 (“APB 25”) to account for the issuance of share options and other equity awards. Effective January 1, 2003, we adopted Statement of Financial Accounting Standards No. 123 (“Statement 123”) Accounting for Stock Based Compensation, which requires a fair value based accounting method for determining compensation expense associated with the issuance of share options and other equity awards. We adopted the accounting provisions of Statement 123 to reflect the cost of issuing share options and other equity awards. Statement of Financial Accounting Standards No. 148 (“Statement 148”) Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment of FASB Statement No. 123, issued December 2002 and effective for interim periods beginning after December 15, 2002, provided various methods of applying Statement 123. In accordance with Statement 148, we employed the prospective method for adopting Statement 123, which requires the recognition of compensation expense based on the fair value method for share options and other equity awards granted on or after January 1, 2003 and for certain modifications made subsequent to December 31, 2002 to share options and other equity awards that were outstanding as of December 31, 2002. Compensation expense is recognized ratably over the respective vesting period of the award.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 2 -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
The following table illustrates the unaudited effect on net income available to unitholders and earnings per unit if the fair value based method had been applied to all outstanding and unvested share options for the last three years. Compensation expense related to restricted share awards is not presented in the table below because the expense amount is the same under APB No. 25 and Statement 123 and therefore, is already reflected in net income.
NOTE 3 - IMPACT OF NEW ACCOUNTING STANDARDS
In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. The objective of this Interpretation is to provide guidance on how to identify a variable interest entity (“VIE”) and determine when the assets, liabilities, non-controlling interests, and results of operations of a VIE need to be included in consolidated financial statements. A company that holds variable interests in an entity will need to consolidate such entity if the company absorbs a majority of the VIE’s expected losses or receive a majority of the entity’s expected residual returns if they occur, or both.
The provisions of FIN 46 apply upon initial involvement with the respective entity for transactions created after January 31, 2003. The adoption in 2003 had no effect on us. The provisions of FIN 46 and related revised interpretations apply no later than the end of the first interim reporting period ending March 15, 2004 (March 31, 2004) for entities created before February 1, 2003.
In 1999, we invested in a 67% share of a $202.2 million mezzanine-level debt position for approximately $73.9 million as part of a debt restructuring related to the SunAmerica Center office property located in Century City, California which consists of approximately 780,000 square feet. The note accrues interest at 7.25% per annum and matures in August 2014 and is payable based on cash flow. We recognize interest income from this investment on a cash basis. We also have an option to acquire 67% of the $15.0 million face amount of two other subordinate notes from an affiliate of the property owner. We have accounted for our investment as a note receivable included in other assets.
Under the provisions of FIN 46, we are required to consolidate the financial condition and results of operations of SunAmerica Center effective January 1, 2004. Our maximum exposure to loss as a result of the investment is equivalent to the $73.9 million we invested in 1999. However, we may be required to contribute additional funds to support the operations of the property. Any additional funding will be in the form of a shortfall note, which is repayable from available cash flow. The shortfall notes may not exceed $2.5 million in the aggregate. As of December 31, 2003, SunAmerica Center’s total assets were approximately $300 million
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 3 - IMPACT OF NEW ACCOUNTING STANDARDS - (continued)
and total liabilities were approximately $235 million. Our only recourse is against the mezzanine lender entity’s sole interest in the property-owning entity. The property is encumbered by a $203 million first mortgage owed to a third party.
NOTE 4 - SPIEKER MERGER
On July 2, 2001, Spieker Properties, Inc. (“Spieker”) merged into Equity Office and Spieker Properties, L.P. (“Spieker Partnership”), Spieker’s operating partnership subsidiary, merged into EOP Partnership (collectively, the “Spieker Partnership merger”) which was accounted for using the purchase method. The transaction valued Spieker (including the outside interests in Spieker Partnership) at approximately $7.2 billion, which included transaction costs, the assumption of approximately $2.1 billion in debt and the issuance of 14.25 million of our preferred units valued at approximately $356.3 million. We paid approximately $1.1 billion in cash and Equity Office issued approximately 101.5 million Common Shares and we issued approximately 16.7 million Units to third parties, each valued at $29.29 per Common Share/Unit. We financed the $1.1 billion cash portion of the purchase price using a combination of available cash and a new $1.0 billion bridge loan facility that was entered into before the closing of the Spieker Merger. The $1.0 billion bridge loan facility had a term of 364 days and an interest rate based on LIBOR plus 80 basis points. The $1.0 billion bridge loan facility was repaid in full with the net proceeds from the issuance of $1.4 billion of unsecured notes in July 2001 and terminated upon the repayment. Through the Spieker Partnership merger, we acquired 391 Office Properties comprising approximately 28.3 million square feet, 98 Industrial Properties comprising approximately 10.1 million square feet and several development properties which added to our ownership in key markets across the western United States.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 5 - INVESTMENTS IN REAL ESTATE
Investments in real estate, including Office Properties, Industrial Properties, properties under development and vacant land, was as follows:
During 2003, we acquired the U.S. Bank Tower and 225 West Santa Clara (a/k/a the Opus Center) office buildings for approximately $183.2 million. The office properties are located in Denver, Colorado and San Jose, California, respectively, and consist of approximately 829,293 square feet.
In May 2003, we acquired approximately 8.1% of the equity in the joint venture that owns The John Hancock Complex in Boston, Massachusetts for approximately $25.0 million. The investment in the joint venture is accounted for under the cost method of accounting because we own a noncontrolling interest in the property and is included in prepaid expenses and other assets on the consolidated balance sheet.
In September 2003, we acquired the remaining 20% equity interest in Key Center (see Note 9 - Investments in Unconsolidated Joint Ventures for more information).
In September 2003, we acquired a vacant land parcel in Folsom, California, for approximately $3.4 million.
During 2002, we acquired the Army and Navy Club Building and Liberty Plaza for a total of approximately $92.3 million from an unaffiliated party. These properties are located in Washington, D.C. and consists of approximately 260,372 square feet of office space.
During 2001, in addition to the properties acquired in the Spieker Merger, we acquired the Three Lafayette Centre office building for a total cost of approximately $68.7 million from an unaffiliated party. The property is located in Washington, D.C. and consists of approximately 259,441 square feet.
NOTE 6 - SALES OF REAL ESTATE
During 2003, we disposed of 53 office properties, two industrial properties and four vacant land parcels in separate transactions to various unaffiliated parties for approximately $933.1 million. The total gain on the sale of these properties was approximately $62.0 million which is included in discontinued operations. The sold office properties consisted of approximately 5,182,707 square feet and 32 residential units, and the industrial properties consisted of approximately 216,900 square feet. We also sold partial interests and entered into joint venture agreements on 13 office properties consisting of approximately 3,284,431 square feet. The total sales price to us from these partial sale transactions was approximately $596.5 million. The net gain on the interests sold totaled $99.1 million. The net income of the properties that were partially sold is included in net income from continuing operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 6 - SALES OF REAL ESTATE - (continued)
During 2002, we disposed of 45 office properties, four parking facilities, two industrial properties and three land parcels in separate transactions to various unaffiliated parties for approximately $508.3 million. The total gain on the sale of these properties was approximately $17.9 million. The sold office properties consisted of approximately 3,113,189 square feet, the industrial properties consisted of approximately 77,072 square feet, and the parking facilities consisted of approximately 7,464 parking spaces.
During 2001, we disposed of eight office properties, four parking facilities, a land parcel and an apartment property in separate transactions to various unaffiliated parties for approximately $327.8 million. The total gain on the sale of these properties was approximately $81.7 million. The sold office properties consisted of approximately 879,388 square feet, the parking facilities contained approximately 3,721 parking spaces and the apartment property contained approximately 161 units.
During 2001, we also disposed of 19 industrial properties that were acquired in the Spieker Partnership merger for approximately $213.4 million. There was no gain or loss on the sale of these properties. The sold industrial properties consisted of approximately 4,052,476 square feet.
The net income for properties sold in 2002 and 2003 is reflected in the consolidated statements of operations as Discontinued Operations for the periods presented. The properties that were partially sold during 2003 are not required to be reflected as discontinued operations in accordance with Statement 144. Below is a summary of the results of operations for the properties sold in 2002 and 2003, except for the properties that were partially sold, through their respective sale dates which are classified as discontinued operations:
Segment Reporting
For segment reporting purposes, the office properties, apartment properties and the land parcels that were sold are included in the “Office Properties” segment and the industrial properties and parking facilities that were sold are included in the “Corporate and Other” segment.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 7 - INVESTMENT IN PREFERRED STOCK
The following investment is included in Prepaid Expenses and Other Assets:
In July 1998, 50,000 preferred shares of CT Convertible Trust I, an investment management and real estate finance company, were acquired for approximately $48.5 million. The preferred shares have a liquidation preference of $1,000 each. The discount of $1.5 million is being amortized as additional dividend income over the term of 20 years. The terms of the preferred shares are as follows:
(a) For 60% of the investment, or approximately $30 million of the preferred shares:
•
the coupon rate of 8.25% per annum was fixed through March 31, 2002. Thereafter, the rate increased to the greater of:
•
10% per annum, increasing by 75 basis points per annum commencing October 1, 2004 and on each October 1 thereafter, or
•
a rate equal to Capital Trust, Inc.’s then annual dividend per common share divided by $7.00;
•
the conversion price is $7.00 per share;
•
the common share equivalent is fixed at 4,285,714 shares; and
•
the preferred shares are callable through September 30, 2004.
(b) For 40% of the investment, or approximately $20 million of the preferred shares:
•
the coupon rate is 13.0% per annum and is fixed until October 1, 2004 when it will increase by 75 basis points per annum; and
•
the preferred shares are callable at any time.
On September 30, 2002, CT Convertible Trust I redeemed the non-convertible amount of its preferred securities at par, including accrued dividends. We received approximately $20.1 million upon the redemption. We still have an approximate $29.3 million investment in the convertible portion of the preferred securities of CT Convertible Trust I.
NOTE 8 - IMPAIRMENT
During 2003, an Office Property was deemed to be impaired due to an analysis of the undiscounted cash flows. As a result, we recognized a permanent impairment charge of $7.5 million, which reduced the book value of the property to its fair value of $3.8 million. Fair value was determined as the present value of the future cash flows. This asset and the related impairment charge are reported under the “Office Properties” segment for segment reporting purposes.
During 2001, an impairment on securities and other investments of approximately $132.7 million was recognized in connection with various investments and other assets. The total impairment consisted of the investment in HQ Global Workplaces, Inc. preferred stock, including accrued but unpaid dividends, of approximately $90.6 million, investments in several telecom, technology and advertising related companies, investments in two full-service business center joint ventures, and a portion of an investment in an internally developed software system.
During 2001, HQ Global was in default with respect to certain covenant and payment obligations under its senior and mezzanine indebtedness, but received forbearance periods from both its senior and mezzanine lenders. HQ Global was unable to restructure its indebtedness during these forbearance periods. Based on these circumstances and other factors, we determined that our investment in HQ Global was not recoverable and, therefore, recorded a permanent impairment on 100% of our investment. Subsequently, in March 2002 HQ Global filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code.
During 2001, our telecom, technology and advertising related investments and full-service business center joint venture investments experienced operating losses due, in part, to the negative economic environment. These investments were considered to be impaired based on their fair value as compared to the carrying value.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 8 - IMPAIRMENT - (continued)
The fair value of the investments was based on internally prepared valuations considering the then present economic conditions. The impairment represented our entire investment in the respective assets, except for the internally developed software system, for which the impairment represented approximately one-half of the investment. These investments and the related impairment are reported under the “Corporate and Other” segment for segment reporting purposes.
During 2001, we recognized a $2.5 million impairment on a parking facility that was held for sale because the sales price less costs to sell was less than the carrying amount of the property as of December 31, 2001. The asset and the related impairment are reported under the “Corporate and Other” segment for reporting purposes.
NOTE 9 - INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES
The entities listed below are owned in joint ventures by us with unaffiliated parties and are accounted for under the equity method.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 9 - INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES - (continued)
(a)
Represents our approximate economic ownership interest for the periods presented. Net income, cash flow from operations and capital transactions are allocated to us and our joint venture partners in accordance with the respective partnership agreements. Our share of these items is subject to change based upon, among other things, the operations of the Property and the timing and amount of capital transactions. Our legal ownership may differ.
(b)
In 2002, in connection with the restructuring of the partnership, we contributed approximately $30.9 million to the joint venture, which increased our economic ownership of Rowes Wharf to 44% from 39%.
(c)
In 2003, we acquired the remaining 20% equity interest in the Key Center office building from Wright Runstad Associates Limited Partnership (“WRALP”) and affiliates in exchange for our 30% equity interest in WRALP and a cash payment by us of approximately $7.9 million. In connection with the acquisition of Key Center, we assumed and subsequently repaid the mortgage debt secured by the Property. As a result of the acquisition, the property is now consolidated.
(d)
In 2000, we formed a joint venture with Wilson Investors-California (“WI,” of which William Wilson III, one of our trustees, is a principal), through its interest in Wilson/ Equity Office (“W/ EO”, of which 49.9% is owned by us and 50.1% is owned by WI), and an unaffiliated party to develop, construct, lease and manage Foundry Square IV, a 225,490 square foot office building located in San Francisco, California. Through the sale of the office building in July 2003, we disposed of our 40% indirect interest, which includes a 10% indirect interest through W/ EO and WI disposed of its 10% indirect interest through W/ EO to an unaffiliated party. Our share of the gain on the sale of the property was approximately $7.1 million and is included in income from investments in unconsolidated joint ventures. Our share of the gross proceeds from the sale was approximately $56.6 million, which includes the repayment of a $44.5 million construction loan. WI’s share of the proceeds was approximately $17.1 million.
(e)
In December 2003, we sold partial interests in these office properties and no longer consolidate their operations. See Note 6 - Sales of Real Estate for more information.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 9 - INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES - (continued)
Combined summarized financial information for these unconsolidated joint ventures is as follows:
(a)
Our share of the scheduled payments of principal on mortgage debt for each of the next five years and thereafter through maturity as of December 31, 2003 is as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 9 - INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES - (continued)
NOTE 10 - MORTGAGE DEBT
We had outstanding fixed interest rate mortgage debt of approximately $2.3 billion and $2.5 billion as of December 31, 2003 and 2002, respectively and outstanding variable interest rate mortgage debt of approximately $36.0 million as of December 31, 2003 and 2002. Payments are generally due in monthly installments of principal and interest or interest only. As of December 31, 2003 and 2002, the effective interest rates on the fixed interest rate mortgage debt ranged from 5.81% to 8.63%, and the weighted average effective interest rate was approximately 7.72% and 7.70%, respectively. As of December 31, 2003 and 2002, the weighted average variable effective interest rate was approximately 1.72% and 1.98%, respectively. The historical cost, net of accumulated depreciation, of encumbered properties at December 31, 2003 and 2002 was approximately
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 10 - MORTGAGE DEBT - (continued)
$4.9 billion and $5.2 billion, respectively. During the years ended December 31, 2003 and 2002, the following transactions occurred:
(a)
Excludes net discount on mortgage debt of approximately $13,663 and $12,584 as of December 31, 2003 and 2002, respectively.
Repayment Schedule
Scheduled payments of principal for the next five years and thereafter through maturity as of December 31, 2003 are as follows:
NOTE 11 - LINES OF CREDIT
Our previous $1.0 billion line of credit matured in May 2003 at which time we obtained a new $1.0 billion line of credit. Our $1.0 billion line of credit bears interest at LIBOR plus 60 basis points and matures in May 2006. We also pay an annual facility fee of $2.0 million payable quarterly. In addition, a competitive bid option, whereby the lenders participating in the credit facility may bid on the interest to be charged which may result in an interest rate lower than LIBOR plus 60 basis points, is available for up to $350 million of the borrowings under the credit facility. As of December 31, 2003, $334 million was outstanding.
In December 2003 we obtained a $1.0 billion 364-day credit facility. This credit facility bears interest at LIBOR plus 65 basis points and matures in December 2004. We also pay an annual facility fee of $1.5 million payable quarterly. In addition, a competitive bid option, whereby the lenders participating in the credit facility bid on the interest to be charged which may result in an interest rate lower than LIBOR plus 65 basis points, is available for up to $350 million of the borrowings under the credit facility.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 11 - LINES OF CREDIT - (continued)
Agreements or instruments relating to the lines of credit contain certain financial restrictions and requirements described below. As of December 31, 2003, we were in compliance with each of these financial restrictions and requirements.
•
total liabilities to total asset value may not exceed 0.55:1 at any time;
•
earnings before interest, taxes, depreciation and amortization to interest expense may not be less than 2.00:1;
•
cash flow to fixed charges may not be less than 1.5:1;
•
secured debt to total asset value may not exceed 0.40:1;
•
unsecured debt to unencumbered asset value may not exceed 0.55:1;
•
unencumbered net operating income to unsecured debt service may not be less than 2.0:1;
•
consolidated tangible net worth may not be less than the sum of $10.7 billion and 70% of all net offering proceeds received by us or Equity Office after December 31, 2002;
•
we may not pay any distributions on Common Shares and Units in excess of 90% of annual Funds From Operations; and
•
our investments in unimproved assets, interest in taxable REIT subsidiaries, developments, unconsolidated joint ventures, mortgages and securities, in the aggregate, may not exceed 25% of our total asset value.
NOTE 12 - UNSECURED NOTES
During 2003, we repaid $700 million of unsecured notes upon their maturity and issued $500 million 5.88% unsecured notes due January 15, 2013. The table below summarizes the unsecured notes outstanding as of December 31, 2003:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 12 - UNSECURED NOTES - (continued)
(a)
Includes the effect of settled interest rate protection and interest rate swap agreements, offering and transaction costs and premiums and discounts on certain unsecured notes.
(b)
Through 2004, $880 million of unsecured notes will mature and become payable. The $400 million of unsecured notes that matured in January 2004 were repaid with our line of credit. We anticipate repaying the remaining notes with our lines of credit, proceeds from additional debt and/or equity offerings or proceeds from property dispositions.
(c)
The notes are exchangeable into Equity Office Common Shares at an exchange rate of $34.00 per share. If the closing price of a Common Share at the time a holder exercises their exchange right is less than the exchange price of $34.00, the holder will receive, in lieu of Common Shares, cash in an amount equal to 97% of the product of the number of Common Shares into which the principal amount of notes subject to such exercise would otherwise be exchangeable and the current market price per Common Share. Upon exchange of a $1,000 note for Common Shares of Equity Office, we would issue a corresponding number of Units to Equity Office on a one-for-one basis.
Restrictions and Covenants under Unsecured Indebtedness
Agreements or instruments relating to our unsecured notes contain certain financial restrictions and requirements described below. As of December 31, 2003, we were in compliance with each of these financial restrictions and requirements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 12 - UNSECURED NOTES - (continued)
Restrictions and Covenants
Set forth below are the financial restrictions and requirements to which we are subject under our unsecured note indentures and our performance under each covenant as of December 31, 2003:
(a)
The calculations of our actual performance under each covenant are included as Appendix A to this Form 10-K.
(b)
The outstanding unsecured notes assumed in the merger with Spieker Partnership are subject to a minimum ratio of 165%.
NOTE 13 - DERIVATIVE FINANCIAL INSTRUMENTS
Forward-Starting Interest Rate Swaps
As of December 31, 2003 and 2002, we had $1.3 billion and $1.1 billion of forward-starting interest rate swaps outstanding, respectively. The outstanding swaps will hedge the future interest payments of debt anticipated to be issued in 2004. The market value of the swaps at December 31, 2003 represented a net liability to us of approximately $10.4 million (approximately $11.1 million is recorded in other assets and $21.5 million is recorded in other liabilities). The market value at December 31, 2002 was $18.6 million (all of which is included in other liabilities). The net market value is also included in accumulated other comprehensive income. No hedge ineffectiveness has been recorded in earnings as these swaps were perfectly effective. As of March 5, 2004, the market value of these forward-starting interest rate swaps represented a net liability to us of approximately $64.9 million. The market value of the forward-starting interest rate swaps is dependent upon existing market interest rates and swap spreads, which change over time.
Upon settlement of the swaps, we may be obligated to pay the counterparties a settlement payment, or alternatively to receive settlement proceeds from the counterparties. In accordance with SFAS No. 133, if the swaps are deemed to be effective hedges upon settlement, any monies paid or received will be amortized to interest expense over the term of the respective hedged interest payments. If the swaps are deemed to be only partially effective hedges upon settlement, a portion of the monies paid or received will be immediately recognized in earnings and the remainder will be amortized to interest expense over the term of the respective hedged interest payments. If the swaps are deemed to be completely ineffective hedges upon settlement, any monies paid or received will be immediately recognized in earnings.
Interest Rate Swaps
During 2002 and 2001, we entered into and settled several interest rate swap agreements that hedged certain unsecured notes. In each case, we were the variable interest rate payer and the counterparty was the fixed rate payer. The variable interest rates were based on various spreads over LIBOR. The settlement dates corresponded to the interest payment dates of the respective unsecured notes being hedged. Each of the interest rate swap agreements were to terminate on the maturity date of the respective unsecured notes being hedged. The interest rate swap agreements were designated as fair value hedges. As of December 31, 2002, all of the interest rate swaps had been terminated.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 14 -
MINORITY INTERESTS IN PARTIALLY OWNED PROPERTIES
Although the financial condition and results of operations of the following Properties are consolidated, there are unaffiliated parties that own an interest in these Properties. We consolidate these properties because we own at least 50% of the respective ownership entities and control major decisions. All of the Properties are Office Properties except for Fremont Bayside, which is an Industrial Property. Our legal ownership and economic interest in each Property is substantially the same. We have additional Properties that are partially owned by unaffiliated parties where our approximate economic ownership is 100%.
The amounts shown below approximate our economic ownership interest for the periods presented. Net income, cash flow from operations and capital transactions are allocated to us and our minority interest partners in accordance with the respective partnership agreements. Our share of these items is subject to change based upon, among other things, the operations of the Property and the timing and amount of capital transactions.
(a)
A joint venture between us and other unaffiliated parties leased the Ferry Building from the City and County of San Francisco, through its Port Commission (the “Port”). Under this lease, the Port is paid a stated base rent. In addition, once the lessee has received from the project a cumulative preferred return of 8% (prior to stabilization) and 11% (after stabilization), then 50% of the proceeds from the operation and ownership of the project are paid to the Port as percentage rent.
The joint venture redeveloped the Ferry Building in a manner to permit the use of federal rehabilitation tax credits (“Historic Tax Credits”). Since the original members of the joint venture could not take full advantage of the Historic Tax Credits, the joint venture admitted a new member who could do so. This investor member has contributed approximately $21.3 million in equity and has committed to contribute an additional $3.5 to fund a portion of the Total Project Estimated Costs for the project, and will be entitled to a
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 14 - MINORITY INTERESTS IN PARTIALLY OWNED PROPERTIES - (continued)
preferred return with an effective annual rate of approximately 3% on its capital investment. The investor member’s interest in the joint venture is subject to put/call rights during the sixth and seventh years after the Ferry Building is placed in service. Upon the purchase of the investor member’s interest pursuant to the put/call, it is estimated that the joint venture will retain approximately $11 million of the capital contributed by the investor member, based on a formula to determine the purchase price for the investor member’s interest and after taking into account the preferred return that will have been paid to the investor member by such time. Through the creation of a master lease, our effective ownership percentage in the net cash flow of the Ferry Building project is approximately 100% after the payment to the Port of the percentage rent described above and the distribution of the preferred returns.
NOTE 15 - PARTNERS’ CAPITAL AND MANDATORILY REDEEMABLE PREFERRED UNITS
Units
The following table presents the changes in the issued and outstanding Units since January 1, 2002:
(a)
In July 2002, Equity Office announced a Common Share repurchase program allowing for the repurchase of up to $200 million of Common Shares, which was later increased to $400 million in November 2002 and to $600 million in March 2003, over the next 12 months at the discretion of management. The Common Shares may be repurchased in the open market or privately negotiated transactions. During 2003 and 2002, 14,236,400 and 7,901,900 Common Shares were repurchased at an average price of $25.53 and $24.92 for approximately $363.5 million and $196.9 million in the aggregate, respectively. In connection with the repurchases, we purchased from Equity Office and retired a corresponding number of Units for an aggregate purchase price equal to the aggregate purchase price for all Common Share repurchases.
Ownership of EOP Partnership
As of December 31, 2003 and 2002, Equity Office had a 1% general partnership interest and an approximate 88.1% limited partnership interest in us, respectively. The remaining limited partners had an approximate 10.9% interest in us, respectively and consist of various individuals and entities that contributed their properties in exchange for partnership interests. Each of our limited partners, excluding Equity Office, may, subject to certain limitations, require that we redeem its Units. Under our partnership agreement, Equity Office has the right to assume directly and satisfy the redemption right of a limited partner by issuing its Common Shares or cash in exchange for any Units tendered for redemption. If Equity Office does not assume our obligation to redeem the Units, upon redemption, the limited partner will receive cash in an amount equal
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 15 - PARTNERS’ CAPITAL AND MANDATORILY REDEEMABLE PREFERRED UNITS - (continued)
to the market value of the Common Shares for which the Units would have been redeemed if Equity Office had elected to assume and satisfy our obligation by paying Common Shares. Under an assignment and assumption agreement entered into on June 29, 2001, if Equity Office elects to assume directly and satisfy the redemption right of a limited partner, we are entitled to make the election as to whether Equity Office issues Common Shares or cash in exchange for Units tendered for redemption.
Distributions
Distributions are declared and paid quarterly to holders of Units as of the record dates of each declaration. The current quarterly distribution is $0.50 per Unit. For the years ended December 31, 2003, 2002 and 2001, the per unit distributions were $2.00, $2.00 and $1.90, respectively.
Mandatorily Redeemable Preferred Units
Under the terms of the Series B Convertible, Cumulative Redeemable Preferred Units (“Series B Preferred Units”), in connection with any redemption by Equity Office of its outstanding 5.25% Series B Convertible, Cumulative Redeemable Preferred Shares, we are obligated to provide to Equity Office cash equal to the redemption price and one Series B Preferred Unit is required to be canceled with respect to each Series B Preferred Share redeemed by Equity Office. The Series B Preferred Units are mandatorily redeemable by Equity Office on February 15, 2008 at a price of $50.00 per share, plus accumulated and unpaid distributions to the redemption date.
Preferred Units
Listed below is a summary of our outstanding preferred units. We are the original issuer of our remaining outstanding series of preferred units (Series C and G) and have recorded the deferred issuance costs associated with these preferred units to partners’ capital. Upon any redemption of these preferred units, we will recognize the deferred issuance costs as an additional preferred distribution in the determination of net income available for unitholders in accordance with EITF Topic D-42. The preferred unitholders are entitled to receive, when and as authorized by the Board of Trustees of Equity Office, cumulative preferential cash distributions. We are obligated to redeem the preferred units at their liquidation preference plus all accrued distributions in connection with any redemption by Equity Office of the corresponding series of Equity Office preferred shares.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 15 -
PARTNERS’ CAPITAL AND MANDATORILY REDEEMABLE PREFERRED UNITS - (continued)
The annual per unit distributions were as follows:
(a)
Equity Office may redeem the corresponding series of its preferred shares during these periods solely out of the sale proceeds of other equity shares of Equity Office, except for the portion of the redemption price equal to any accrued but unpaid dividends. Under our partnership agreement, sale proceeds from the sale of shares by Equity Office must be contributed to us in exchange for additional units. The number of shares redeemed is limited to the aggregate sales proceeds received from such other equity shares of Equity Office. Equity Office may acquire any outstanding preferred shares that have been transferred to a charitable beneficiary under Article VII of the declaration of trust of Equity Office because they were owned or acquired by a shareholder of Equity Office in violation of the ownership limits. If Equity Office redeems or acquires any or all of its outstanding preferred shares, we will redeem and cancel an equal number of preferred units and provide cash to Equity Office with respect thereto in an amount equal to the amount paid with respect to the Equity Office preferred shares redeemed or acquired by Equity Office. We are not subject to sinking fund requirements pertaining to the preferred units.
(b)
In January 2004, Equity Office redeemed the Series C Preferred Shares. See Note 26 - Subsequent Events.
(c)
In July 2002, we issued 8,500,000 7.75% Series G Cumulative Redeemable Preferred Units to Equity Office in exchange for Equity Office’s contribution of the proceeds of its issuance and sale of 8,500,000 7.75% Series G Cumulative Redeemable Preferred Shares in an offering that closed July 29, 2002. On that same date, substantially all of the net proceeds from the issuance of the Series G Preferred Units, totaling approximately $206.1 million were used to redeem the Series A Preferred Units from Equity Office and in turn, Equity Office used the proceeds to redeem its 7,994,000 outstanding 8.98% Series A Cumulative Redeemable Preferred Shares. In December 2003, the terms of the Series G Preferred Units were amended to require our consent to any redemption by Equity Office of these units.
(d)
In November 2001, Equity Office redeemed its 4,250,000 outstanding 9.45% Cumulative Redeemable Series D Preferred Shares, which were issued in connection with the Spieker Merger, at a redemption price of $25.00 per share, plus accrued and unpaid distributions for the period from October 1, 2001 to the redemption date of $0.2821875 per share, or an aggregate redemption price of approximately $107.4 million. In connection with such redemption, we redeemed all of the Series D Preferred Units from Equity Office.
(e)
On June 27, 2003, Equity Office redeemed its 6,000,000 outstanding 7.875% Series E Cumulative Redeemable Preferred Shares, which were issued in connection with the Spieker Merger, at a redemption price of $25.00 per share for an aggregate redemption price of approximately $151.9 million, which includes approximately $1.9 million of accrued and unpaid distributions. In connection with such redemption, we redeemed all of the Series E Preferred Units from Equity Office.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 15 -
PARTNERS’ CAPITAL AND MANDATORILY REDEEMABLE PREFERRED UNITS - (continued)
(f)
On June 30, 2003, Equity Office redeemed its 4,000,000 outstanding 8.0% Series F Cumulative Redeemable Preferred Shares, which were issued in connection with the Spieker Merger, at a redemption price of $25.00 per share for an aggregate redemption price of $100.0 million. In connection with such redemption, we redeemed all of the Series F Preferred Units from Equity Office.
Put Option Settlement
As of December 31, 2000, 1,717,844 redeemable units were outstanding which related to Common Shares subject to a put option agreement entered into with an affiliate of the Wright Runstad & Company in connection with the acquisition of certain Properties in December 1997. In September 2001, we paid approximately $1.4 million in settlement of this put option. We previously recognized approximately $4.1 million as a total potential payment for the put option exercise between the period from August 1999 to August 2000. The difference of approximately $2.7 million between the $4.1 million previously recognized and the $1.4 million actually paid was recognized as a put option settlement.
NOTE 16 - FUTURE MINIMUM RENTS
Future minimum rental receipts due on noncancelable operating leases at the Office Properties and Industrial Properties as of December 31, 2003 were as follows:
We are subject to the usual business risks associated with the collection of the above scheduled rents. The future minimum rental receipts due on noncancelable operating leases from our investments in unconsolidated joint ventures are not included in the above schedule.
NOTE 17 - FUTURE MINIMUM LEASE PAYMENTS
Certain Office Properties are subject to ground leases. Certain of these leases are subject to rental increases based upon the appraised value of the Property at specified dates or certain financial calculations based on the operations of the respective Property. Any incremental changes in the rental payments as a result of these adjustments are not included in the table below because the amount of the change is not
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 17 - FUTURE MINIMUM LEASE PAYMENTS - (continued)
determinable. Future minimum lease obligations under these noncancelable leases as of December 31, 2003 were as follows:
Rental expense from continuing operations for the years ended December 31, 2003, 2002 and 2001 was approximately $24.2 million, $24.2 million and $19.7 million, respectively. These rental expense amounts include ground rent and rent for our corporate offices.
NOTE 18 - EXTRAORDINARY ITEM
The $1.0 million extraordinary loss in 2001 related to costs on certain Office Properties located in Seattle, Washington as a result of damage from an earthquake in February 2001.
NOTE 19 - EARNINGS PER UNIT
The following table sets forth the computation of basic and diluted earnings per unit:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 19 - EARNINGS PER UNIT - (continued)
(a)
Net income available to unitholders per unit may not total the sum of the per unit components due to rounding.
The following securities were not included in the diluted earnings per unit computation because they would have had an antidilutive effect:
For additional disclosures regarding employee share options and restricted shares, see Note 2 - Summary of Significant Accounting Policies - Share Based Employee Compensation Plans and Note 23 - Share-Based Employee Compensation Plans.
NOTE 20 - SEGMENT INFORMATION
As discussed in Note 1, our primary business is the ownership and operation of Office Properties. We account for each Office Property as an individual operating segment and have aggregated the related operating accounts into a single operating segment for financial reporting purposes due to the fact that the individual operating segments have similar economic characteristics. The net property operating income from continuing operations generated at the “Corporate and Other” segment consist primarily of the Industrial Properties and stand-alone parking facilities that were sold in 2002 and 2001. The “Other revenues” generated at the “Corporate and Other” segment consist primarily of fee income from the management of office properties owned by third parties, interest and dividend income from various investments and realized gains on sale of certain marketable securities.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION - (continued)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION - (continued)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION - (continued)
(a)
Included in property operating revenues are rental revenues, tenant reimbursements, parking income and other income.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 20 - SEGMENT INFORMATION - (continued)
(b)
Included in property operating expenses are real estate taxes, insurance, repairs and maintenance and property operating expenses.
(c)
Interest expense for the Office Properties represents interest expense on property secured mortgage debt and does not include interest expense on the unsecured notes or the line of credit.
(d)
Property operating margin is calculated by dividing property net operating income by property operating revenues.
NOTE 21 - QUARTERLY DATA (UNAUDITED)
(a)
The amounts presented for the three months ended September 30, 2003, June 30, 2003, and March 31, 2003 are not equal to the same amounts previously reported in the Form 10-Q filed with the SEC for each period as a result of discontinued operations consisting of properties sold in 2003. Total revenues presented for the three months ended June 30, 2003 and March 31, 2003 also differ from the same amounts previously reported in the Form 10-Q filed with the SEC for each period due to the reclassification of interest/dividend income and realized gain on sale of marketable securities previously reported as revenues to other income. Below is a reconciliation to the amounts previously reported in the Form 10-Q:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 21 - QUARTERLY DATA (UNAUDITED) - (continued)
(b)
The amounts presented for the three months ended December 31, 2002, September 30, 2002, June 30, 2002, and March 31, 2002 are not equal to the same amounts previously reported in the Form 10-Q or Form 10-K filed with the SEC for each period as a result of discontinued operations consisting of properties sold in 2003. Total revenues presented for the three months ended December 31, 2002, June 30, 2002 and March 31, 2002 also differ from the same amounts previously reported in the Form 10-Q or Form 10-K filed with the SEC for each period due to the reclassification of interest/dividend income and realized gain on sale of marketable securities previously reported as revenues to other income. Below is a reconciliation to the amounts previously reported in the Form 10-Q or Form 10-K:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 21 - QUARTERLY DATA (UNAUDITED) - (continued)
NOTE 22 - RELATED PARTY TRANSACTIONS
Fees and reimbursements paid to related parties for the years ended December 31, 2003, 2002 and 2001 were as follows:
(a)
Amounts paid in 2003 were paid to an affiliate of William Wilson III, one of Equity Office’s trustees. Amounts paid in 2002 and 2001 were paid to W/EO. In 2000, we entered into a joint venture agreement with Wilson Investors - California, LLC (“WIC”) to form W/ EO for the purpose of developing, constructing, leasing and managing developments in northern California. We own 49.9% of W/ EO and WIC owns 50.1% of W/ EO. William Wilson III, through his ownership of WIC, indirectly owns approximately 22% of W/EO and approximately 30% of any promote to which WIC is entitled under the joint venture agreement. We agreed to loan up to $25 million to WIC for its required contribution to W/ EO at a 15% interest rate per annum. In 2002, WIC repaid the outstanding loan balance of approximately $12.0 million of principal and $2.0 million of accrued interest. Upon this repayment and as a result of certain transactions with WIC the loan commitment has been terminated. Our investment in W/ EO as of December 31, 2003 and 2002 was approximately $1.3 million and $3.6 million, respectively, which represents our indirect interest in Concar at December 31, 2003 and Concar and Foundry IV (which was sold in 2003) at December 31, 2002.
We created joint ventures with W/ EO and, in certain cases, unaffiliated parties for the development of various office properties. We agreed to provide first mortgage financing to the ownership entities of each of these developments at the greater of 6.5% or LIBOR plus 3.25%, generally maturing 36 months after initial funding or earlier at our option, in the event alternative financing sources are available on terms
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 22 - RELATED PARTY TRANSACTIONS - (continued)
reasonably acceptable to WIC and any unaffiliated party. The aggregate amount of any such financing would generally be capped at 70% of budgeted construction costs (76% in the case of Concar which, at December 31, 2002 had been completed and leased and as such is now reflected as investment in real estate). At December 31, 2002, we had committed to make mortgage loans for Foundry Square IV and Concar totaling approximately $96 million, of which approximately $74 million in principal and approximately $0.4 million in accrued interest was outstanding. The total principal and interest outstanding on these mortgage loans at December 31, 2003 was approximately $40 million. The mortgage loan for Foundry Square IV was repaid in 2003.
In December 2002, we completed a transaction with W/ EO and WIC pursuant to which we acquired W/ EO’s interests in various projects known as Foundry Square II, Foundry Square III (a land parcel that was under option), the Ferry Building, San Rafael Corporate Center I and San Rafael Corporate Center II (a land parcel). WIC acquired W/ EO’s interest in a project known as Larkspur (a land parcel under option) and WIC acquired the operating business and all assets of W/ EO other than its ownership interests in the development projects known as Foundry Square IV and Concar. W/ EO’s and our interests in Foundry Square IV and Concar remained unchanged as a result of this transaction. Joint ventures with other unaffiliated parties on the projects in which we acquired W/ EO’s interest also remain unchanged as a result of this transaction. This transaction was accounted for as a nonmonetary exchange because the assets included in the exchange were similar and because the cash consideration exchanged was minimal. No gain or loss was recognized in connection with the transaction. A WIC subsidiary will continue providing the development management services to Foundry Square II, the Ferry Building and Concar until the earlier of project stabilization or June 2004. We also engaged a subsidiary of WIC to provide leasing brokerage services for Foundry Square II and the Ferry Building. These services for Foundry Square II were terminated by us and these services for the Ferry Building were terminated in part by us in January 2004. In July, 2003, Foundry Square IV was sold. Following this sale, W/ EO’s sole asset is its ownership interest in Concar. In accordance with the W/ EO operating agreement, we may, but are not required to, purchase the W/ EO interest in Concar subsequent to project stabilization.
(b)
In connection with the Cornerstone Merger, $250 million of mortgage debt was assumed on certain properties payable to Stichting Pensioenfonds Voor de Gezondheid, Geestelijke en Maatschappelijke Belangen (“PGGM”), of which Jan H.W.R. van der Vlist, one of Equity Office’s trustees, is a director of real estate. In October 2000, we repaid $65 million of mortgage debt encumbering TransPotomac Plaza 5 upon its maturity. In December 2001, the remaining $185 million of mortgage debt encumbering several properties was prepaid. As a result of the prepayment, we paid a $5.0 million prepayment penalty to PGGM.
(c)
We lease office space from Two North Riverside Plaza Joint Venture, a partnership composed of trusts established for the benefit of the families of Samuel Zell and Robert Lurie, a deceased former business partner of Mr. Zell.
Amounts Received from Related Parties
As described in Note 7, we own, and receive distributions from, preferred shares of CT Convertible Trust I, of which Mr. Zell is Chairman of the Board.
We have entered into third-party management contracts and a licensing agreement to manage and lease space at certain Properties owned or controlled by affiliates of Mr. Zell. Income recognized by us for providing these management services during 2003, 2002, and 2001 was approximately $.8 million, $1.0 million, and $1.5 million, respectively.
In addition, we provided real estate tax consulting and risk management services to related parties for which we received approximately $.3 million, $1.6 million, and $1.7 million during 2003, 2002 and 2001, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 22 - RELATED PARTY TRANSACTIONS - (continued)
We received approximately $0.8 million from W/ EO during 2003 for lease commissions.
NOTE 23 - SHARE-BASED EMPLOYEE COMPENSATION PLANS
Equity Office has three share-based employee compensation plans: the 1997 Share Option and Share Award Plan, as amended (the “1997 Plan”), the 2003 Share Option and Share Incentive Plan, as amended (the “2003 Plan”) and the 1997 Non-Qualified Share Purchase Plan, as amended (the “Non-Qualified Share Purchase Plan”). We also have assumed individual options in connection with prior merger transactions.
The following is a description of the 1997 Plan, as amended, which is included in the financial statements because any Common Shares issued pursuant to the 1997 Plan will result in us issuing Units to Equity Office, on a one-for-one basis. The purpose of the 1997 Plan is to attract and retain highly qualified executive officers, trustees and employees. Through the 1997 Plan, eligible officers, trustees, employees and consultants are offered the opportunity to acquire Common Shares pursuant to grants of (a) options to purchase Common Shares (“Options”) and (b) Share Awards (defined below). The 1997 Plan is administered by the Compensation and Option Committee (the “Compensation Committee”), which is appointed by the Board of Trustees. The Compensation Committee determines those officers, trustees, key employees and consultants to whom, and the time or times at which, grants of Options and Share Awards will be made. The Compensation Committee interprets the 1997 Plan, adopts rules relating thereto and determines the terms and provisions of Options and Share Awards. In 2003, 2002, and 2001 the Common Shares subject to Options and Share Awards under the 1997 Plan were limited to 31,375,726, 32,030,650, and 23,733,869, respectively. The maximum aggregate number of Options and Share Awards that may be granted under the 1997 Plan may not exceed 6.8% of the outstanding Common Shares calculated on a fully diluted basis and determined annually on the first day of each calendar year. The issuance of awards or shares under the 2003 Plan does not increase the number of shares that may be issued under the 1997 Plan. No more than one-half of the maximum aggregate number of Options and Share Awards may be granted as Share Awards. To the extent that Options expire unexercised or are terminated, surrendered or canceled, the Options and Share Awards become available for future grants under the 1997 Plan, unless the 1997 Plan has terminated. The 1997 Plan has a 10-year term. The Board of Trustees may at any time prior thereto amend or terminate the 1997 Plan, but termination will not affect Options and Share Awards previously granted. Any Options or Share Awards which vest prior to any such termination will continue to be exercisable by the holder thereof.
The Compensation Committee determines the vesting schedule of each Option and the term, which shall not exceed 10 years from the grant date. As to the Options that have been granted, each vests evenly over a three year period, one-third per year on each of the first three anniversaries of the grant date. The exercise price for Options is equivalent to the fair market value of the underlying Common Shares at the grant date.
The 1997 Plan permits the issuance of Share Awards to executive officers, trustees and key employees upon such terms and conditions as are determined by the Compensation Committee in its sole discretion. A Share Award is an award of a Common Share which (a) may be fully vested upon issuance (“Share Award”) or (b) may vest over time (“Restricted Share Award”). Generally, members of the Board of Trustees have been granted Share Awards pursuant to the 1997 Plan as payment of their board fees. In each case, the number of Share Awards granted to trustees was equal to the dollar value of the fee divided by the fair market value of a Common Share on the date the fee would have been paid. Restricted Share Awards granted in 2003 and 2002 vest evenly over a five-year period, 20% per year on each of the first five anniversaries of the grant date. The Restricted Share Awards granted before 2002 vest over a five-year period as follows: 50% on the third anniversary of the grant date, 25% on the fourth anniversary of the grant date and the remaining 25% on the fifth anniversary of the grant date.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 23 - SHARE-BASED EMPLOYEE COMPENSATION PLANS - (continued)
The fair value for Options granted in 2003, 2002, and 2001 was estimated at the time the Options were granted using the Black-Scholes option-pricing model with the following weighted average assumptions:
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the expected stock price volatility.
In 2003, 2002, and 2001, we recognized compensation expense related to Restricted Shares and Options issued to employees of $17.1 million, $15.0 million, and $9.2 million, respectively.
The table below summarizes the Option activity of the 1997 Plan for the last three years:
The following table summarizes information regarding Options outstanding at December 31, 2003:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 23 - SHARE-BASED EMPLOYEE COMPENSATION PLANS - (continued)
(1)
Includes 1,890,648 non-plan options assumed in connection with the Spieker Partnership merger.
(2)
Expiration dates ranged from January 2004 to December 2013.
During 2003, 2002 and 2001, there were 926,511, 541,055 and 602,666 Restricted Share Awards granted, respectively. The Restricted Shares Awards issued in 2003, 2002 and 2001 were, on average, valued at an average of $24.56, $28.01 and $20.61 each, respectively. The value of the Restricted Share Awards is recognized as compensation expense evenly over the vesting period.
Equity Office’s shareholders approved the 2003 Plan at the 2003 annual meeting of shareholders. A total of 20,000,000 Common Shares are reserved for issuance under the 2003 Plan to trustees, officers, employees and consultants of Equity Office and its subsidiaries. The 2003 Plan provides for awards of share options, restricted shares, unrestricted shares, share units, dividend equivalent rights, share appreciation rights and performance awards. No more than 10,000,000 of the Common Shares reserved under the 2003 Plan may be issued in connection with awards other than options. The maximum number of shares subject to options and share appreciation rights that can be awarded to any person is 750,000 per year, and the maximum number of shares that can be awarded to any person, other than pursuant to an option or share appreciation right, is 300,000 per year. The 2003 Plan is administered by the Compensation Committee. Subject to the terms of the 2003 Plan, the Compensation Committee may select participants to receive awards, determine the types of awards and the terms and conditions of awards, and interpret the provisions of the 2003 Plan. The exercise price of each share option awarded under the 2003 Plan may not be less than 100% of the fair market value of a Common Share on the date of grant. The term of the 2003 Plan is 10 years. Prior thereto, the Compensation Committee may terminate or amend the 2003 Plan at any time and for any reason, but termination will not affect awards previously made. There were no awards made under the 2003 Plan during 2003.
The Non-Qualified Purchase Plan was adopted to encourage eligible employees and trustees to purchase Common Shares. Under the Non-Qualified Purchase Plan, a total of 2,000,000 Common Shares are reserved for issuance. The minimum amount an eligible employee can contribute is $10 per pay period. The maximum amount an eligible employee can contribute is 20% of gross pay per pay period, up to $100,000 per calendar year. Trustees may contribute up to $100,000 per year. Contributions are held as part of the general assets of Equity Office. All contributions are fully vested. At the end of each purchase period, participant contributions are used to purchase Common Shares. The price for the Common Shares is 85% of the lesser of: (a) the closing price of the Common Shares on the last business day of the applicable purchase period and (b) the average closing price of the Common Shares for the purchase period. The number of Common Shares purchased is calculated on a per participant basis by dividing the contributions made by each participant during the Purchase Period by the purchase price. Only whole Common Shares are purchased, with any partial share of remaining cash being rolled over to the next purchase period. Shares purchased under the Non-Qualified Purchase Plan generally may not be sold, transferred or disposed of until the first anniversary of the purchase. If a participant violates this restriction, he or she is required to pay Equity Office an amount equal to the discount on the shares when purchased less, the excess, if any, of the amount the participant paid for the shares over the then current market price of the shares. At December 31, 2003, a total of 1,509,443 Common Shares remained available for issuance under the Non-Qualified Purchase Plan. Common Share purchases under this plan totaled 93,815, 90,484 and 76,645 in 2003, 2002 and 2001, respectively.
NOTE 24 - 401(K) PLAN
Our 401(k) Plan was established to cover eligible employees and employees of any designated affiliate. The 401(k) Plan permits eligible persons to defer up to 16% of their annual compensation into the 401(k) Plan, subject to certain limitations imposed by the Internal Revenue Code. Employees’ elective deferrals are immediately vested upon contribution to the 401(k) Plan. We match employee contributions to the 401(k) Plan dollar for dollar up to 4% of the employee’s annual salary. In addition, we may elect to make an annual
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 24 - 401(K) PLAN - (continued)
discretionary profit-sharing contribution. Approximately $6.7 million, $4.2 million and $3.8 million was recognized as expense in each of the years ended December 31, 2003, 2002 and 2001, respectively.
NOTE 25 - COMMITMENTS AND CONTINGENCIES
Concentration of Credit Risk
We maintain cash and cash equivalents at financial institutions. The combined account balances at each institution typically exceed FDIC insurance coverage and, as a result, there is a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. We believe the risk is not significant.
Environmental
As an owner of real estate, we are subject to various environmental laws of federal and local governments. Our compliance with existing laws has not had a material adverse effect on our financial condition and results of operations, and we do not believe it will have a material adverse effect in the future. However, we cannot predict the impact of unforeseen environmental contingencies or new or changed laws or regulations on our current Properties or on properties that we may acquire.
Litigation
Except as described below, we are not presently subject to material litigation nor, to our knowledge, is any material litigation threatened against us, other than routine actions for negligence and other claims and administrative proceedings arising in the ordinary course of business, some of which are expected to be covered by liability insurance and all of which collectively are not expected to have a material adverse effect on our financial condition, results of operations, or liquidity.
On May 8, 2003, Broadband Office, Inc. and the official committee of unsecured creditors of Broadband Office Inc. (collectively, the “Plaintiffs”), filed a complaint (the “Complaint”) in the United States Bankruptcy Court for the District of Delaware against one private and seven public real estate companies, various affiliated entities (collectively the “Corporate Defendants”) and certain individuals, including Equity Office, EOP Partnership, David Helfand (a former executive vice president of Equity Office), Spieker Properties, Inc. and Spieker Properties, L.P. (which we acquired in 2001) and Craig Vought (formerly co-chief executive officer of Spieker Properties, Inc. and a former Equity Office trustee). Under the terms of our indemnification agreements with Messrs. Helfand and Vought, we may be responsible to reimburse them for the effect of any judgment rendered against them personally as well as the costs of their defense. We were an equity investor in, landlord to and customer of Broadband Office, and Messrs. Helfand and Vought were members of the board of directors of Broadband Office until their resignations on May 1, 2001 and May 2, 2001, respectively. Mr. Vought also served as a member of Broadband Office’s executive committee. Broadband Office filed for bankruptcy protection on May 9, 2001. The First Amended Complaint alleges, among other things, breaches of fiduciary duty and seeks recovery of what it characterizes as preferential payments and fraudulent transfers. It further seeks to hold us liable for the outstanding debts of the corporation, jointly and severally with all of the Corporate Defendants, as an alleged “general partner” of Broadband Office. The Plaintiffs allege that the amount of these claims exceeds $300 million in the aggregate. Due to the inherent uncertainties of the judicial process and the early stage of this action, we are unable to predict the outcome of this matter with certainty. We intend to vigorously defend this matter and believe we have meritorious defenses. As a result, we have not accrued for any potential liability in connection with this litigation. As in any litigation, there can be no assurance that we will prevail. Should the court not resolve this matter in our favor it could have a material adverse effect on our financial condition, results of operations and liquidity.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 25 - COMMITMENTS AND CONTINGENCIES - (continued)
Forward-Starting Interest Rate Swaps
See Note 13 - Derivative Financial Instruments for information on our forward-starting interest rate swaps.
Contingencies
Certain joint venture agreements contain buy/ sell options in which each party has the option to acquire the interest of the other party. Except for certain agreements in which our partners in three of our Office Properties can require us to buy their interests, such agreements do not generally require that we buy our partners’ interest. The exceptions allow our unaffiliated partners, at their election, to require that we buy their interests during specified future time periods, commencing in 2004 and at amounts that represent the fair market value of their interest at that time or at amounts based on formulas contained in the respective agreements. In addition, we have granted options to each of two tenants to purchase the Office Property it occupies.
In accordance with Statement of Accounting Standards No. 5 Accounting for Contingencies, we have not recorded a liability or the related asset that would result from the acquisition in connection with the above potential obligations because the probability of our unaffiliated partners requiring us to buy their interest is not currently determinable and we are unable to estimate the amount of the payment required for that purpose.
Approximately 260 of our properties, consisting of 33.1 million square feet, are subject to restrictions on taxable dispositions under tax protection agreements entered into with some of the contributors of the properties. The carrying value of these properties was approximately $6.7 billion at December 31, 2003. The restrictions on taxable dispositions are effective for periods expiring at different times through 2021. The terms of these tax protection agreements generally prevent us from selling specific properties in taxable transactions unless we indemnify the contributing partners for their income tax liability on the portion of the gain on sale allocated to them as a result of the property’s value at the time of its contribution to us or, in some cases, to our predecessor. We do not believe that the tax protection agreements materially affect the conduct of our business or our decisions whether to dispose of restricted properties during the restriction period because we generally hold these and our other properties for investment purposes, rather than for sale. Historically, however, where we have deemed it to be in our shareholders’ best interests to dispose of restricted properties, we have done so through transactions structured as tax-deferred transactions under section 1031 of the Internal Revenue Code. We anticipate structuring any future dispositions of restricted properties as transactions intended to qualify for tax-deferred treatment. We therefore view the likelihood of incurring any such material indemnification obligations to be remote. Were we to dispose of a restricted property in a taxable transaction, we generally would be required to pay to a partner that is a beneficiary of one of the tax protection agreements an amount based on the amount of income tax the partner would be required to pay on the incremental gain allocated to such partner as a result of the built-in gain that existed with respect to such property at the time of its contribution to us, or in some cases, to our predecessor. In some cases there is a further requirement to reimburse any additional tax liability arising from the indemnification payment itself. The exact amount that would be payable with respect to any particular taxable sale of a restricted property would depend on a number of factors, many of which can only be calculated at the time of any future sale, including the sale price of the property at the time of the sale, the partnership’s basis in the property at the time of the sale, the partner’s basis in the assets at the time of the contribution, the partner’s applicable rate of federal, state and local taxation at the time of the sale, and the timing of the sale itself.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 25 - COMMITMENTS AND CONTINGENCIES - (continued)
Insurance
Property Damage, Business Interruption, Earthquake and Terrorism: The insurance coverage provided through third-party insurance carriers is subject to coverage limitations. For each type of insurance coverage described below, should an uninsured or underinsured loss occur, we could lose all or a portion of our investment in, and anticipated cash flows from, one or more of the Properties. In addition, there can be no assurance that third-party insurance carriers will be able to maintain reinsurance sufficient to cover any losses that may be incurred.
Type of Insurance
Equity Office
Third-Party
Coverage
Loss Exposure/Deductible
Coverage Limitation
Property damage and business interruption(a)
$75 million annual aggregate exposure (which includes amounts paid for earthquake loss), plus $1 million per occurrence deductible
$1.0 billion per occurrence(c)
Earthquake(a)(b)
$75 million annual aggregate exposure (which includes amounts paid for property damage and business interruption loss), plus $1 million per occurrence deductible
$325 million in the aggregate per year(c)
Acts of terrorism(d)
$2.8 million per occurrence deductible (plus 10% of each and every loss with a maximum per occurrence exposure of $35.3 million which includes the $2.8 million deductible)
$825 million per occurrence(e)
(a)
We retain up to $75 million of such loss calculated throughout the portfolio. In the event of a loss in excess of this retention limit, the third-party insurance carriers would be obligated to cover the losses up to the stated coverage amounts in the above table.
(b)
The amount of the third-party insurance relating to earthquakes is based on maximum probable loss studies performed by independent third parties. The maximum annual aggregate payment amount for earthquake loss is $325 million, inclusive of our loss exposure of $75 million plus $1 million per occurrence deductible. There can be no assurance that the maximum probable loss studies have accurately estimated losses that may occur.
(c)
These amounts include our loss exposure/deductible amount.
(d)
The coverage includes nuclear, chemical and biological events. The coverage does not apply to non-TRIA (Terrorism Insurance Act of 2002) events (which are terrorism events that are not committed by a foreigner or a foreign country). We maintain separate insurance with a $325 million annual aggregate limit subject to a deductible of $1 million for non-TRIA events. This separate coverage for non-TRIA events excludes nuclear, biological and chemical events.
(e)
This amount is in excess of our deductible amounts.
Pollution: We have pollution and remediation insurance coverage for both sudden and gradual events. Limits for this exposure are $2 million per loss and $10 million aggregate per year subject to a deductible of $100,000.
Workers Compensation, Automobile Liability and General Liability: We have per occurrence deductible amounts for workers compensation of $500,000, auto liability of $250,000 and general liability of $1,000,000.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued)
NOTE 26 - SUBSEQUENT EVENTS
The following transactions occurred subsequent to December 31, 2003, through March 5, 2004:
1.
In January 2004, Equity Office redeemed all of its 4,562,900 outstanding 8 5/8% Series C Cumulative Redeemable Preferred Shares of Beneficial Interest. The Series C Preferred Shares were redeemed at a redemption price of $25.00 per share for an aggregate redemption price of approximately $114.6 million, including accrued distributions. The deferred issuance costs of approximately $4.1 million will be reflected as a preferred distribution and a reduction of net income available to unitholders. In connection with such redemption, we redeemed all of the Series C Preferred Units from Equity Office.
2.
We repaid $300 million of 6.50% unsecured notes and $100 million of 6.90% unsecured notes that matured in January 2004.
3.
We extended the cash settlement dates of two $400 million forward-starting interest rate swaps from January 2004 to April 2004.
4.
We sold Cal Center located in Sacramento, California to an unaffiliated party for approximately $18.5 million. Cal Center consisted of approximately 118,172 square feet.
5.
We acquired the remaining interest in the 1301 Avenue of the Americas office building for approximately $60.7 million. Our economic interest in the joint venture after the acquisition is 100% and as a result of the acquisition the property is now consolidated.
6.
In February 2004, we prepaid the mortgage notes that were secured by 580 California for approximately $56.5 million.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
Equity Office’s principal executive officer, Richard D. Kincaid, and principal financial officer, Marsha C. Williams, evaluated as of December 31, 2003 the effectiveness of the design and operation of our disclosure controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As a result of this evaluation, these executive officers have concluded that, as of such date, the design and operation of our disclosure controls and procedures were effective.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting identified in connection with the evaluation referred to above that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
Information about Trustees of Equity Office is incorporated by reference from the discussion under Proposal 1 in Equity Office’s Proxy Statement for the 2004 Annual Meeting of Shareholders. We believe that, during 2003, all Section 16(a) filing requirements with respect to our equity securities were made by executive officers and trustees of Equity Office on a timely basis. The balance of the response to this item is contained in the discussion entitled “Executive and Senior Officers of Equity Office” under Item 1 of Part I of this report.
Information about our audit committee financial expert is incorporated by reference to Equity Office’s Proxy Statement for the 2004 Annual Meeting of Shareholders.
Equity Office has adopted a code of ethics that applies to its principal officer, principal financial officer and principal accounting officer, which is available on our website at: http://www.equityoffice.com. Any amendment to, or waiver from, a provision of such code of ethics will be posted on our website.
Item 11.
Item 11. Executive Compensation.
Information about executive compensation is incorporated by reference from the discussion under the heading “Executive Compensation” in Equity Office’s Proxy Statement for the 2004 Annual Meeting of Shareholders.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information about security ownership of certain beneficial owners and management, and information about Equity Office’s equity compensation plans are incorporated by reference from the discussion under the headings “Common Share and Unit Ownership by Trustees and Executive Officers” and “Equity Compensation Plan Information” in Equity Office’s Proxy Statement for the 2004 Annual Meeting of Shareholders.
Item 13.
Item 13. Certain Relationships and Related Transactions.
Information about certain relationships and transactions with related parties is incorporated herein by reference from the discussion under the heading “Certain Relationships and Related Transactions” in Equity Office’s Proxy Statement for the 2004 Annual Meeting of Shareholders.
Item 14.
Item 14. Principal Accountant Fees and Services.
Information about principal accountant fees and services is incorporated by reference from the discussion under the heading “Independent Auditors” in Equity Office’s Proxy Statement for the 2004 Annual Meeting of Shareholders.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a)(1) Financial Statements:
Report of Independent Auditors
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Changes in Partners’ Capital and Net Comprehensive Income for the years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules:
Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2003
All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and therefore have been omitted.
(a)(3) Exhibits:
The exhibits required by this item are set forth on the Exhibit Index attached hereto.
(b) Reports on Form 8-K:
The following report on Form 8-K was filed during the quarter ended December 31, 2003:
(c) Exhibits:
See Item 15(a)(3) above.
(d) Financial Statement Schedules:
Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2003.
Appendix A
FINANCIAL COVENANT CALCULATIONS AS OF DECEMBER 31, 2003
UNDER CERTAIN INDENTURE AGREEMENTS
EOP OPERATING LIMITED PARTNERSHIP
UNSECURED NOTES FINANCIAL COVENANT COMPLIANCE AS OF DECEMBER 31, 2003
(Dollars in thousands)
Compliance with these financial covenants requires EOP Partnership to apply specialized terms, the definitions of which are set forth in the related unsecured note indentures, and to calculate ratios in the manner prescribed in the indentures.
This section presents such ratios as of December 31, 2003 to show that EOP Partnership was in compliance with the applicable financial covenants contained in the unsecured note indentures, copies of which have been filed as exhibits to the EOP Partnership’s periodic reports filed with the SEC. Management is not presenting these ratios and the related calculations for any other purpose or for any other period, and is not intending for these measures to otherwise provide information about EOP Partnership’s financial condition or results of operations. Investors should not rely on these measures other than for the purpose of testing EOP Partnership’s compliance with the financial covenants contained in the unsecured note indentures as of December 31, 2003.
Debt to Adjusted Total Assets
EOP Partnership may not, and may not permit a subsidiary to, incur any Debt, other than intercompany Debt, if, immediately after giving effect to the incurrence of such additional Debt, the aggregate principal amount of all outstanding Debt of EOP Partnership and its Subsidiaries on a consolidated basis determined in accordance with GAAP is greater than 60% of the sum of:
(i) Total Assets as of the end of the fiscal quarter covered in EOP Partnership’s Annual Report on Form 10-K or Quarterly Report on Form 10-Q, as the case may be, most recently filed with the SEC prior to the incurrence of such additional Debt and
(ii) the increase or decrease in Total Assets from the end of such quarter including, without limitation, any increase in Total Assets resulting from the incurrence of such additional Debt (such increase or decrease together with EOP Partnership’s Total Assets is referred to as the “Adjusted Total Assets”).
A-1
Secured Debt to Adjusted Total Assets
EOP Partnership may not, and may not permit any Subsidiary to, incur any Secured Debt of EOP Partnership or any Subsidiary if, immediately after giving effect to the incurrence of such additional Secured Debt, the aggregate principal amount of all outstanding Secured Debt of EOP Partnership and its Subsidiaries on a consolidated basis is greater than 40% of Adjusted Total Assets.
Consolidated Income Available for Debt Service to Annual Debt Service Charge
EOP Partnership may not, and may not permit any Subsidiary to, incur any Debt, other than intercompany Debt (provided that, in the case of Debt owed to Subsidiaries, such Debt is subordinate in right of payment to the debt securities), if the ratio of Consolidated Income Available for Debt Service to Annual Debt Service Charge (in each case as defined below) for the period consisting of the four consecutive fiscal quarters most recently ended prior to the date on which the additional Debt is to be incurred shall have been less than 1.5 to 1 on a pro forma basis after giving effect to the incurrence of such Debt and to the application of the proceeds therefrom, and calculated on the assumption that:
•
such Debt and any other Debt incurred by EOP Partnership or a Subsidiary since the first day of such four-quarter period, which was outstanding at the end of such period, had been incurred at the beginning of such period and continued to be outstanding throughout such period, and the application of the proceeds of such Debt, including to refinance other Debt, had occurred at the beginning of such period;
•
the repayment or retirement of any other Debt by EOP Partnership or a Subsidiary since the first day of such four-quarter period had been repaid or retired at the beginning of such period, except that, in determining the amount of Debt so repaid or retired, the amount of Debt under any revolving credit facility is computed based upon the average daily balance of such Debt during such period;
•
in the case of Acquired Indebtedness or Debt incurred in connection with any acquisition since the first day of the four-quarter period, the related acquisition had occurred as of the first day of the period with the appropriate adjustments with respect to the acquisition being included in the pro forma calculation; and
•
in the case of any increase or decrease in Total Assets, or any other acquisition or disposition by EOP Partnership or any Subsidiary of any asset or group of assets, since the first day of such four-quarter period, including by merger, stock purchase or sale, or asset purchase or sale, such increase, decrease or other acquisition or disposition or any related repayment of Debt had occurred as of the first day of
A-2
such period with the appropriate adjustments to revenues, expenses and Debt levels with respect to such increase, decrease or other acquisition or disposition being included in such pro forma calculation.
Total Unencumbered Assets to Unsecured Debt
EOP Partnership is required at all times to maintain Total Unencumbered Assets of not less than 150% of the aggregate outstanding principal amount of all outstanding Unsecured Debt of EOP Partnership and its Subsidiaries on a consolidated basis.
(a)
The unsecured notes assumed in the merger with Spieker Partnership are subject to a minimum ratio of 165%.
A-3
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EOP OPERATING LIMITED PARTNERSHIP
By:
EQUITY OFFICE PROPERTIES TRUST
its general partner
By:
/s/ RICHARD D. KINCAID
Richard D. Kincaid
President and Chief Executive Officer
Date: March 15, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated as of March 15, 2004.
EXHIBIT INDEX

Represents a management contract or compensatory plan, contract or arrangement.
Schedule III - Real Estate and Accumulated Depreciation as of December 31, 2003
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(1)
The aggregate cost for Federal Income Tax purposes as of December 31, 2003 was approximately $14.4 billion.
(2)
The life to compute depreciation on building is 35-40 years, except for Palo Alto which is subject to a ground lease that terminates in 2023. Therefore, the building is depreciated over the remaining term of the ground lease. The life to compute depreciation on building improvements is 3-40 years.
(3)
The date acquired represents the date these Properties were acquired by Equity Office Predecessors. The acquisition of the Properties, or interest therein, by the Company from Equity Office Predecessors in connection with the Consolidation on July 11, 1997, was accounted for using the purchase method of accounting in accordance with Accounting Principles Board Opinion No. 16. Accordingly, the assets were recorded by the Company at their fair values.
(4)
This Property contains 106 residential units in addition to 226,197 square feet of office space.
(5)
These loans are subject to cross default and collateralization provisions.
(6)
These properties were previously under development and have been placed into service during 2003.
(7)
These loans are subject to cross default and collateralization provisions.
(8)
These loans are subject to cross default and collateralization provisions.
(9)
These properties are in various development stages. During the development period certain operating costs, including real estate taxes together with interest incurred during the development stages will be capitalized.
(10)
The encumbrances at December 31, 2003 include a net premium of approximately $13.7 million.
A summary of activity of investment in real estate and accumulated depreciation is as follows:
The changes in investment in 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, 2001 and 2000, are as follows:
(1)
Approximately $3.7 million relates to the value of building equipment received in exchange for Equity Office’s equity position in a telecom company and the remainder relates to the write-off of internally developed software.