Item 1. Business
General
As used herein, the terms “we,” “us,” “our” or the “Company” refer to Brandywine Realty Trust, a Maryland real estate investment trust, individually or together with its subsidiaries, including Brandywine Operating Partnership, L.P. (the “Operating Partnership”), a Delaware limited partnership. We are a self-administered and self-managed real estate investment trust (“REIT”) active in acquiring, developing, redeveloping, leasing and managing office and industrial properties. As of December 31, 2003, we owned 208 office properties, 25 industrial facilities and one mixed-use property (the “Properties”) containing an aggregate of approximately 15.7 million net rentable square feet. We were also performing management and leasing services for 41 properties containing an aggregate of 3.6 million net rentable square feet. In addition, as of December 31, 2003, we held economic interests in ten unconsolidated real estate ventures (the “Real Estate Ventures”) that we formed with third parties to develop or own commercial properties. The Real Estate Ventures own ten office buildings that contain approximately 1.8 million net rentable square feet. As of December 31, 2003, we had an aggregate investment in the Real Estate Ventures of approximately $15.9 million (net of returns of invested amounts). We also own approximately 445 acres of undeveloped land and hold options to purchase approximately 61 additional acres. The Properties are located in the office and industrial markets in and surrounding Philadelphia, Pennsylvania, New Jersey and Richmond, Virginia.
Recent Developments
On January 12, 2004, we sold 2,645,000 Common Shares for net proceeds of approximately $69.3 million. We used the net proceeds to reduce the outstanding balance under our revolving credit facility.
On February 3, 2004, we entered into an agreement with Commonwealth Atlantic Operating Properties, Inc., the holder of 1,950,000 then outstanding Series B Preferred Units (the “Series B Preferred Units”) in the Operating Partnership. The Series B Preferred Units had an aggregate stated value of $97.5 million and accrued distributions at 7.25% per annum. During February 2004, we redeemed all of the Series B Preferred Units for an aggregate price of $93.0 million, together with accrued but unpaid distributions from January 1, 2004.
On February 27, 2004, we sold 2,300,000 7.375% Series D Cumulative Redeemable Preferred Shares for net proceeds of approximately $55.5 million. We used the net proceeds to reduce the outstanding balance under our revolving credit facility, including amounts advanced under our revolving credit facility to fund the redemption of Series B Preferred Units.
On March 3, 2004, we sold 1,840,000 Common Shares for net proceeds of approximately $50.7 million. We used the net proceeds to reduce the outstanding balance under our revolving credit facility.
Business Objective
Our business objective is to maximize return on investment and to accomplish our objective we seek to:
• maximize cash flow through leasing strategies designed to capture potential rental growth as rental rates increase and as below-market leases are renewed;
• attain a high tenant retention rate through aggressive tenant service programs responsive to the varying needs of our diverse tenant base;
• increase economic diversification while maximizing economies of scale;
• develop high-quality office and industrial properties on our existing inventory of land, as warranted by market conditions;
• capitalize on our redevelopment expertise to selectively acquire, redevelop and reposition underperforming properties in desirable locations;
• acquire high-quality office and industrial properties and portfolios of such properties at attractive yields in selected submarkets within the Mid-Atlantic region that we expect will experience economic growth and provide barriers to entry; and
• pursue joint venture opportunities with high-quality partners having attractive real estate holdings or significant financial resources.
We expect to continue to concentrate our real estate activities in submarkets within the Mid-Atlantic region where we believe that: (i) barriers to entry (such as zoning restrictions, utility availability, infrastructure limitations, development moratoriums and limited developable land) will create supply constraints on office and industrial space; (ii) current market rents and absorption statistics justify limited new construction activity; (iii) we can maximize market penetration by accumulating a critical mass of properties and thereby enhance operating efficiencies; and (iv) there is potential for economic growth.
Organization
Brandywine Realty Trust was organized and commenced its operations in 1986 as a Maryland REIT. We own our assets and conduct our operations through the Operating Partnership and subsidiaries of the Operating Partnership. As of December 31, 2003, our ownership interest in the Operating Partnership entitled us to approximately 95.8% of the Operating Partnership’s distributions after distributions by the Operating Partnership to holders of its then outstanding Series B Preferred Units. Our structure as an “UPREIT” is designed, in part, to permit persons contributing properties to us to defer some or all of the tax liability they might otherwise incur in a sale of properties. We conduct our real estate management services through Brandywine Realty Services Corporation (the “Management Company”), a subsidiary of which 95% is owned by the Operating Partnership. The remaining five percent is owed by a partnership comprised of two executives of the Company. See “Management Activities.”
Our executive offices are located at 401 Plymouth Road, Suite 500, Plymouth Meeting, Pennsylvania 19462 and our telephone number is (610) 325-5600. We have an internet website at www.brandywinerealty.com. We also have regional offices in Mount Laurel, New Jersey and Richmond, Virginia.
Credit Facility
We maintain an unsecured credit facility (the “Credit Facility”) with a bank group (comprising 21 banks) led by Bank of America, N.A. A majority of our direct and indirect subsidiaries are parties to the Credit Facility, as guarantors. The Credit Facility provides up to $500 million in credit availability for working capital advances and letters of credit. As of December 31, 2003, there was unused availability of $184.3 million under the Credit Facility. The Credit Facility is scheduled to mature in June 2004, but may be extended at our election for a period of one year upon payment of a fee equal to .25% of the amount of the Credit Facility at the time of extension.
Advances under the Credit Facility currently bear interest at the London Inter-Bank Offered Rate (“LIBOR”) (1.12% at December 31, 2003) plus 1.50%. The spread over LIBOR varies, based on our leverage, from a low of 1.25% to a high of 1.75%. We have the option to elect an interest rate equal to the higher of the Federal Funds rate plus .75% or Bank of America’s prime rate plus .25%. We generally elect the interest rate based on LIBOR for all or most of our borrowings under the Credit Facility. An alternative rate and pricing structure are set forth in the Credit Facility if we obtain an investment grade debt rating, from at least two of the three major rating agencies.
We have entered into interest rate swap and rate cap agreements designed to reduce the impact of interest rate changes on certain variable rate debt. At December 31, 2003, we had interest rate swap agreements for notional principal amounts aggregating $175 million. The swap agreements effectively fix the LIBOR portion of our interest rate on $100 million of Credit Facility borrowings at 4.230% and $75 million of Credit Facility borrowings at 4.215%, in each case until June 2004. The interest rate cap agreement effectively limits the interest rate on a mortgage with a notional value of $28 million at 8.7% until July 2004.
The Credit Facility contains provisions limiting: the incurrence of additional debt; the granting of liens; the consummation of mergers and consolidations; the disposition of assets and interests in subsidiaries; the making of loans and investments; and the payment of dividends. The restriction on dividends permits us to pay dividends in the amount required for us to retain our qualification as a REIT under the Internal Revenue Code of 1986, and otherwise limits dividends to 90% of our funds from operations, as defined in the Credit Facility.
The Credit Facility also contains financial covenants that require us to maintain a debt service coverage ratio, an interest coverage ratio, a fixed charge coverage ratio, an unsecured debt ratio and an unencumbered cash flow ratio above certain specified minimum levels; to maintain net worth above an amount determined on a specified formula; and to maintain a leverage ratio and a secured debt ratio below certain maximum levels. Another financial covenant limits the percentage of our total assets (on a consolidated basis) that can be held by subsidiaries not party to the Credit Facility.
Term Loan
We entered into a $100 million unsecured term loan (the “Term Loan”) in July 2002. We used the proceeds of the Term Loan to repay existing indebtedness, consisting primarily of indebtedness that had been outstanding under the Credit Facility. The Term Loan, like the Credit Facility, is recourse to us, including those of our subsidiaries that are parties, as guarantors, to the Term Loan agreement (which are the same subsidiaries that are guarantors of the Credit Facility). Bank of America, N.A. serves as administrative agent for a group of lenders under the Term Loan, as it does for the lenders under the Credit Facility, although the groups of lenders are not identical under the Term Loan and Credit Facility.
There is no required principal amortization of the Term Loan prior to maturity. The Term Loan matures on July 15, 2005, subject to two extensions of one year each upon payment by us of an extension fee and the absence of any defaults at the time of each extension.
The Term Loan bears interest at a per annum floating rate equal to the one, two, three or six month LIBOR, plus between 1.05% and 1.90% (1.12% at December 31, 2003), depending on our the leverage and debt rating. At our option, the Term Loan may bear interest at the prime rate plus .25%. Interest is due at the end of the LIBOR term, unless a six month LIBOR term is selected, in which case interest is also paid at the end of the third month of the LIBOR term. If we elect interest based on the prime rate, then interest payments will be due monthly.
The Term Loan agreement contains financial and operating covenants identical to those in the Credit Facility agreement. In addition, the Term Loan agreement, like the Credit Facility agreement, requires payment of prepayment premiums in certain instances.
Additional Debt
Mortgage Indebtedness. The following table sets forth information regarding our mortgage indebtedness outstanding at December 31, 2003:
Annual
Debt
Principal
Interest
Service
Balance
Rate
(in 000’s)
Maturity
Property/Location
(in 000’s)
(a)
(a) (b)
Date
630 Allendale Road (c)
$ 19,797
2.62 % $
Mar-04
400 Berwyn Park (c)
15,726
2.72 %
Jul-04
1000 Howard Boulevard
3,647
9.25 %
Nov-04
Croton Road
6,209
7.81 %
Jan-06
111 Arrandale Blvd.
1,152
8.65 %
Aug-06
429 Creamery Way
3,235
8.30 %
Sep-06
Interstate Center (a)
1,131
3.00 %
Mar-07
440 & 442 Creamery
5,862
8.55 %
Jul-07
Norriton Office Center
5,342
8.50 %
Oct-07
481 John Young Way
2,475
8.40 %
Nov-07
400 Commerce Drive
12,346
7.12 %
1,059
Jun-08
200 Commerce Drive
6,165
7.12 %
Jan-10
Plymouth Meeting Executive Campus
48,299
7.00 %
4,142
Dec-10
Arboretum I, II, III & V
24,109
7.59 %
2,235
Jul-11
993, 997 and 2000 Lenox Drive, 2000, 4000, 9000 Midlantic Drive and 1 Righter Parkway
65,993
8.05 %
6,325
Oct-11
Newtown Square, Berwyn, Libertyview
66,000
7.25 %
5,333
May-13
Southpoint III
6,257
7.75 %
Apr-14
Grande B (30 properties)
81,704
7.48 %
7,444
Jul-27
Grande A (23 properties)
Tranche 1
63,526
7.48 %
6,086
Jul-27
Tranche 2 (a)
20,000
1.88 %
Jul-27
Tranche 3 (a)
3,684
2.05 %
Jul-27
Total mortgage indebtedness
$ 462,659
$ 39,061
(a) For loans that bear interest at a variable rate, the rates in effect at December 31, 2003 have been assumed to remain constant.
(b) “Annual Debt Service” is calculated by annualizing the regularly scheduled principal and interest amortization.
(c) “Annual Debt Service” for construction loans that require payment of interest only is calculated by annualizing the interest payment based on the outstanding debt balances and rates in effect at December 31, 2003.
Guaranties. As of December 31, 2003, we had guaranteed repayment of approximately $17.4 million of loans on behalf of the Real Estate Ventures, including a $16.2 million guaranty that terminated in January 2004. See Item 2.
Item 2. Properties
Operating Property Acquisitions
We acquired the following operating properties during the year ended December 31, 2003:
During 2003, we acquired one parcel of land, containing 10.0 acres, for $3.0 million.
Development Properties Placed in Service
We placed in service the following properties during the year ended December 31, 2003:
We place a property under development in service once a property reaches 95% occupancy or one year after the completion of shell construction, whichever is earlier.
Property Sales and Dispositions
We sold or disposed of the following properties during the year ended December 31, 2003:
(a) These two properties were contributed to a joint venture in which we retained a 20% interest.
During 2003, we sold four parcels of land, containing 24.1 acres, for $4.2 million.
Properties
As of December 31, 2003, we owned 208 office properties, 25 industrial facilities and one mixed-use property that contained an aggregate of approximately 15.7 million net rentable square feet. The properties are located in the markets in and surrounding Philadelphia, Pennsylvania; New Jersey; and Richmond, Virginia. As of December 31, 2003, the Properties were approximately 90.7% leased to 1,025 tenants and had an average age of approximately 16.7 years. The office properties are primarily one to three story suburban office buildings containing an average of approximately 60,580 net rentable square feet. The industrial properties accommodate a variety of tenant uses, including light manufacturing, assembly, distribution and warehousing. We carry comprehensive liability, fire, extended coverage and rental loss insurance covering all of the Properties, with policy specifications and insured limits which we believe are adequate.
We had the following projects in development or redevelopment as of December 31, 2003:
(a) Stabilization date represents date at which the property is projected to be 95% leased.
(b) Total development cost includes land acquisition costs, land carry costs, hard and soft construction costs, tenant improvements and broker commissions.
The following table sets forth information with respect to the Properties at December 31, 2003:
(a) Calculated by dividing net rentable square feet included in leases signed on or before December 31, 2003 at the property by the aggregate net rentable square feet of the Property.
(b) “Total Base Rent” for the twelve months ended December 31, 2003 represents base rents received during such period, excluding tenant reimbursements, calculated in accordance with generally accepted accounting principles (GAAP) determined on a straight-line basis. Tenant reimbursements generally include payment of real estate taxes, operating expenses and common area maintenance and utility charges.
(c) “Average Annualized Rental Rate” is calculated as follows: (i) for office leases written on a triple net basis, the sum of the annualized contracted base rental rates payable for all space leased as of December 31, 2003 (without giving effect to free rent or scheduled rent increases that would be taken into account under GAAP) plus the 2003 budgeted operating expenses excluding tenant electricity; and (ii) for office leases written on a full service basis, the annualized contracted base rent payable for all space leased as of December 31, 2003. In both cases, the annualized rental rate is divided by the total square footage leased as of December 31, 2003 without giving effect to free rent or scheduled rent increases that would be taken into account under GAAP.
(d) This Property is subject to a ground lease.
(e) These properties are under redevelopment and are excluded from the percentages for Weighted Average Percentage Leased and Average Annualized Rental Rate information.
The following table shows certain information regarding rental rates and lease expirations for the Properties at December 31, 2003, assuming none of the tenants exercises renewal options or termination rights, if any, at or prior to scheduled expirations:
(a) “Final Annualized Base Rent” for each lease scheduled to expire represents the cash rental rate of base rents, excluding tenant reimbursements, in the final month prior to expiration multiplied by 12. Tenant reimbursements generally include payment of real estate taxes, operating expenses and common area maintenance and utility charges.
At December 31, 2003, the Properties were leased to 1,025 tenants that are engaged in a variety of businesses. The following table sets forth information regarding leases at the Properties with the 20 tenants with the largest amounts leased based upon Annualized Escalated Rent from the Properties as of December 31, 2003:
(a) The identified tenant includes affiliates in certain circumstances.
(b) Annualized Escalated Rent represents the monthly Escalated Rent for each lease in effect at December 31, 2003 multiplied by 12. Escalated Rent represents fixed base rental amounts plus tenant reimbursements which include payment of real estate taxes, operating expenses and common area maintenance and utility charges. The Company estimates operating expense reimbursements based on historical amounts and comparable market data.
The following table sets forth the year-end occupancy percentages of the Company’s Properties for the last five years:
Real Estate Ventures
As of December 31, 2003, we had invested approximately $15.9 million in ten unconsolidated Real Estate Ventures (net of returns of investment received). We formed these ventures with unaffiliated third parties to develop office properties or to acquire land in anticipation of possible development of office properties. Nine of the Real Estate Ventures own ten office buildings that contain an aggregate of approximately 1.8 million net rentable square feet and one Real Estate Venture developed a hotel property that contains 137 rooms. At December 31, 2003, the operating properties owned by the Real Estate Ventures were approximately 81% leased to 80 tenants.
Our investment in Real Estate Ventures is as follows (in thousands):
(1) Ownership percentage represents our entitlement to residual distributions after payments of priority returns.
(2) During 2003, the Company recorded an impairment charge of $861,000 associated with this non-operating real estate venture. This amount consisted primarily of legal and acquisition costs related to a parcel of land that ultimately was not acquired.
(3) Our interest consists solely of a residual profits interest.
Item 3.
Item 3. Legal Proceedings
We are involved from time to time in litigation on various matters, which include disputes with tenants and disputes arising out of agreements to purchase or sell properties. Given the nature of our business activities, these lawsuits are considered routine to the conduct of its business. The result of any particular lawsuit cannot be predicted, because of the very nature of litigation, the litigation process and its adversarial nature, and the jury system.
As we have reported in our prior Annual Report on Form 10-K, we are a defendant in a case in which the plaintiffs allege that we breached our obligation to purchase a portfolio of properties for approximately $83.0 million. On July 9, 1999, the Superior Court of New Jersey, Camden County, dismissed the complaint against us with prejudice. Plaintiffs subsequently filed a motion for reconsideration, which motion the Superior Court denied. Plaintiffs then appealed to the Appellate Division, which is the intermediate appellate level court in New Jersey. In December 2000, the Appellate Division affirmed in part and reversed in part the Chancery Division’s earlier dismissal of the entire action. The Appellate Division affirmed the dismissal of the non-contractual counts in the Complaint, but reversed the contract and reformation counts and remanded these to the lower court for further proceedings. We sought review of this decision by the Supreme Court of New Jersey, but that Court declined to consider the appeal. The case thereafter returned to the Chancery Division, where written and oral discovery was conducted in 2002 and in the first quarter of 2003. Discovery terminated on February 14, 2003. We filed a motion for summary judgment seeking dismissal of all counts against us, and judgment for us on our counterclaim. The Chancery Division granted our summary judgment motion on March 25, 2003 and dismissed the case with prejudice. Plaintiffs appealed the judgment in our favor, and we do not know whether plaintiffs will be successful in their appeal.
There have been recent reports of lawsuits against owners and managers of multifamily and office properties asserting claims of personal injury and property damage caused by the presence of mold in residential units or office space. We have been named as a defendant in two lawsuits that allege personal injury as a result of the presence of mold. Unspecified damages are sought. We have referred these lawsuits to our environmental insurance carrier and, as of the date of this Form 10-K, the insurance carrier is tendering a defense to these claims.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
We did not submit any matters to a vote of security holders in the fourth quarter of the fiscal year ended December 31, 2003.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Shareholder Matters and Issuer Purchases of Equity Securities
Our Common Shares are traded on the New York Stock Exchange (“NYSE”) under the symbol “BDN.” On March 10, 2004, there were 373 holders of record of our Common Shares. On March 10, 2004, the last reported sales price of the Common Shares on the NYSE was $28.88. The following table sets forth the quarterly high and low closing sales price per share reported on the NYSE for the indicated periods and the distributions paid by us with respect to each such period.
Future distributions by us will be declared at the discretion of the Board of Trustees and will depend on our actual cash flow, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986 and such other factors as our Board of Trustees deems relevant.
During 2003 and through the date of this Annual Report on Form 10-K, we did not issue any securities that were not registered under the Securities Act of 1993.
The following table provides information as of December 31, 2003 with respect to compensation plans under which our equity securities are authorized for issuance:
Equity Compensation Plan Information as of December 31, 2003
(a)
(b)
(c)
Plan category
Number of securities to be issued upon exercise of outstanding options, warrants and rights
Weighted-average exercise price of outstanding options, warrants and rights
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by security holders (1)
2,773,444
$26.70 (2)
1,265,045
Equity compensation plans not approved by security holders
-
-
-
Total
2,773,444
$26.70 (2)
1,265,045
(1) Relates to our 1997 Long-Term Incentive Plan.
(2) Weighted-average exercise price of outstanding options; excludes restricted Common Shares.
During the quarter ended December 31, 2003, we did not purchase any of our outstanding equity securities.
Item 6.
Item 6. Selected Financial Data
(in thousands, except per Common Share data and number of properties)
The following discussion should be read in conjunction with the financial statements appearing elsewhere herein. The results of operations and cash flows of the Company include the historical results of operations of the Properties held by the Company during the years ended December 31, 2003, 2002 and 2001. This Annual Report on Form 10-K contains forward-looking statements for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934 and as such may involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, there can be no assurance that these expectations will be realized. See Item 1. Business - Risk Factors.
OVERVIEW
The Company currently manages its portfolio within three geographic segments: (1) Pennsylvania, (2) New Jersey and (3) Virginia. The Company believes it has established an effective platform in these office and industrial markets that provides a foundation for achieving its goals of maximizing market penetration and optimizing operating economies of scale.
During 2003, the Company sold eight office properties containing an aggregate of approximately 343,000 net rentable square feet, two industrial properties containing an aggregate of approximately 131,000 net rentable square feet and four parcels of land containing an aggregate of approximately 24.1 acres for an
aggregate of $45.6 million. In December 2003, the Company sold two office properties containing an aggregate of approximately 633,000 net rentable square feet for an aggregate of $112.8 million, of which $52.9 million of proceeds were used to pay off existing mortgage notes payable secured by the two properties. The Company retained a 20% interest in a venture that purchased the properties. The Company recognized a gain on the partial sale of approximately $18.5 million for the piece sold and deferred the gain on the piece retained. The Company also purchased five office properties containing approximately 360,000 net rentable square feet and one parcel of land containing approximately 10.0 acres for an aggregate of $67.8 million.
The Company receives income primarily from rental revenue (including tenant reimbursements) from the Properties and, to a lesser extent, from the management of properties owned by third parties and from investments in the Real Estate Ventures.
The Company’s financial performance is dependent upon the demand for office and other commercial space in its markets. Current economic conditions, including recessionary pressures and capital market volatility, have enhanced the challenges facing the Company.
In the current economic climate, the Company continues to seek revenue growth through an increase in occupancy of its portfolio (90.7% at December 31, 2003). However, with a downturn in general leasing activity, owners of commercial real estate, including the Company, are experiencing longer periods in which to lease unoccupied space, and may face higher capital costs and leasing commissions to achieve targeted tenancies.
As the Company seeks to increase revenue, management also focuses on strategies to minimize operating risks, including (i) tenant rollover risk, (ii) tenant credit risk and (iii) development risk.
Tenant Rollover Risk:
The Company is subject to the risk that, upon expiration, leases may not be renewed, the space may not be relet, or the terms of renewal or reletting (including the cost of renovations) may be less favorable than the current lease terms. Leases accounting for approximately 10.8% of the aggregate annualized base rents from the Properties as of December 31, 2003 (representing approximately 11.6% of the net rentable square feet of the Properties) expire without penalty in 2004. The Company maintains an active dialogue with its tenants in an effort to achieve a high level of lease renewals. The Company’s retention rate for leases that were scheduled to expire in the year ended December 31, 2003 was 80.2%. If the Company is unable to renew leases for a substantial portion of the space under expiring leases, or to promptly relet this space, at anticipated rental rates, the Company’s cash flow could be adversely impacted.
Tenant Credit Risk:
In the event of a tenant default, the Company may experience delays in enforcing its rights as a landlord and may incur substantial costs in protecting its investment. Management regularly evaluates its accounts receivable reserve policy in light of its tenant base and general and local economic conditions. The accounts receivable allowance was $4.0 million or 11.2% of total receivables (including accrued rent receivable) as of December 31, 2003 compared to $4.6 million or 12.5% of total receivables (including accrued rent receivable) as of December 31, 2002.
Development Risk:
The Company currently has in development or redevelopment seven sites aggregating approximately 1.1 million square feet. The total cost of these projects is estimated to be $225.5 million, of which $17.9 million was incurred as of December 31, 2003. While the Company is actively marketing space at these projects to prospective tenants, management cannot provide assurance as to the timing or terms of any leases of such space. As of December 31, 2003, the Company owned approximately 445 acres of undeveloped land and held options to purchase approximately 61 additional acres. Risks associated with development of this land include construction cost overruns and construction delays, insufficient occupancy rates and inability to obtain necessary zoning, land-use, building, occupancy and other required governmental approvals.
CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
The Company’s significant accounting policies are described in Note 2 to the consolidated financial statements included this Annual Report on Form 10-K. While the estimates and judgments associated with the application of these accounting policies may be affected by different assumptions or conditions, the Company believes the estimates and judgments associated with the reported amounts are appropriate in the circumstances. The following identifies critical accounting policies that are used in preparing the Company’s consolidated financial statements, including those policies which require significant judgment and estimates:
Revenue Recognition
Rental revenue is recognized on a straight-line basis over the lease term regardless of when payments are due. Certain lease agreements contain provisions that require tenants to reimburse a pro rata share of real estate taxes and common area maintenance costs.
Real Estate Investments
Real estate investments are carried at cost. The Company records acquisition of real estate investments under the purchase method of accounting and allocates the purchase price to land, buildings and intangible assets on a relative fair value basis. Depreciation is computed using the straight-line method over the useful lives of buildings and capital improvements (25 to 40 years) and over the shorter of the lease term or the life of the asset for tenant improvements. Direct construction costs related to the development of Properties and land holdings are capitalized as incurred. The Company expenses routine repair and maintenance expenditures.
Impairment of Long-Lived Assets
Management reviews investments in real estate and real estate ventures for impairment if facts and circumstances indicate that the carrying value of such assets may not be recoverable. Measurement of any impairment loss will be based on the fair value of the asset, determined using customary valuation techniques, such as the present value of expected future cash flows.
In accordance with SFAS No. 144 (“SFAS 144”), Accounting for the Impairment or Disposal of Long-Lived Assets, long-lived assets, such as real estate investments and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities relating to assets classified as held-for-sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
Income Taxes
The Company may elect to treat one or more of its corporate subsidiaries as a taxable REIT subsidiary (“TRS”). In general, a TRS of the Company may perform additional services for tenants of the Company and generally may engage in any real estate or non-real estate related business (except for the operation or management of health care facilities or lodging facilities or the providing to any person, under a franchise, license or otherwise, rights to any brand name under which any lodging facility or health care facility is operated). A TRS is subject to corporate federal income tax. The Company has elected to treat certain of its corporate subsidiaries as a TRS. If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate tax rates.
Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts that represents an estimate of losses that may be incurred from the inability of tenants to make required payments. The allowance is an estimate based on two calculations that are combined to determine the total amount reserved. First, the Company evaluates specific accounts where it has been determined that a tenant may have an inability to meet its financial obligations. In these situations, the Company uses its judgment, based on the facts and circumstances, and records a specific reserve for that tenant against amounts due to reduce the receivable to the amount that the Company expects to collect. These reserves are reevaluated and adjusted as additional information becomes available. Second, a reserve is established for all tenants based on a range of percentages applied to aging categories. These percentages are based on historical collection and write-off experience. If the financial condition of the Company’s tenants were to deteriorate, additional allowances may be required.
Deferred Costs
The Company incurs direct costs related to the financing, development and leasing of the Properties. Management exercises judgment in determining whether such costs meet the criteria for capitalization or must be expensed. Capitalized financing fees are amortized over the related loan term and capitalized leasing costs are amortized over the related lease term. Management re-evaluates the remaining useful lives of leasing costs as the creditworthiness of the Company’s tenants and economic and market conditions change.
Purchase Price Allocation
The Company allocates the purchase price of properties to net tangible and identified intangible assets acquired based on fair values. Above-market and below-market in-place lease values for acquired properties are recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) the Company’s estimate of the fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancellable term of the lease. Capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancellable terms of the respective leases. Capitalized below-market lease values amortized as an increase of rental income over the remaining non-cancellable terms of the respective leases, including any fixed-rate renewal periods.
The aggregate value of other intangibles acquired is measured based on the difference between (i) the property valued with in-place leases adjusted to market rental rates and (ii) the property valued as if it was vacant. The Company allocates a portion of the purchase price to lease origination costs. The Company estimates the cost to execute leases with terms similar to the remaining lease terms of the in-place leases, include leasing commissions, legal and other related expenses. This intangible asset is amortized to expense over the remaining term of the respective leases. Company estimates of value are made using methods similar to those used by independent appraisers. Factors considered by the Company in their analysis include an estimate of the carrying costs during the expected lease-up periods considering current market conditions and costs to execute similar leases. The Company also considers information obtained about each property as a result of its pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from three to twelve months.
The total amount of these other intangible assets is further allocated to tenant relationships and in-place leases based on the Company’s evaluation of the specific characteristics of each tenant’s lease and the Company’s overall relationship with the respective tenant. Characteristics considered by the Company in allocating value to its tenant relationships include the nature and extent of the Company’s business relationship with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals, among other factors. The value of tenant relationship intangibles is amortized over the remaining initial lease term and renewals, but in no event longer than the remaining depreciable life of the building. The value of in-place leases is amortized over the remaining non-cancellable term of the respective leases and any fixed-rate renewal periods.
In the event that a tenant terminates its lease, the unamortized portion of each intangible, including market rate adjustments, lease origination costs, in-place lease values and tenant relationship values, would be charged to expense.
RESULTS OF OPERATIONS
Comparison of the Year Ended December 31, 2003 to the Year Ended December 31,
The results of operations for the years ended December 31, 2003 and 2002 include the respective operations of the Properties. Of the 234 Properties owned by the Company as of December 31, 2003, a total of 211 Properties containing an aggregate of approximately 13.6 million net rentable square feet (“Same Store Properties”) were owned for the entire twelve-month periods ended December 31, 2003 and 2002. The following table set forth revenue and expense information as to these Same Store Properties for the twelve-month periods ended December 31, 2003 and 2002:
The following table is a reconciliation of income from continuing operations to Same Store net operating income:
Management generally considers Same Store net operating income a useful financial measure because the results of the Same Store Properties are directly comparable period to period. Same Store net operating income is a non-GAAP financial measure and does not represent income from continuing operations because it does not reflect the consolidated operations of the Company.
Revenue increased to $305.7 million for 2003 as compared to $291.0 million for 2002, primarily due to increased rental rates and additional properties in 2003, offset by decreased occupancy. The straight-line rent adjustment increased revenues by $5.9 million in 2003 and $5.8 million in 2002. Revenue for Same Store Properties increased to $247.0 million in 2003 from $242.3 million in 2002. This increase was the result of increased occupancy as well as increased tenant reimbursements from higher operating expenses in 2003 as compared to 2002. Average occupancy for the Same Store Properties increased to 91.0% in 2003 from 90.9% in 2002. Other revenue represents lease termination fees, bankruptcy settlement proceeds, leasing commissions, third-party management fees and interest income. Other revenue increased to $11.0 million in 2003 from $9.7 million in 2002 primarily due to bankruptcy settlement proceeds received in 2003.
Property operating expenses increased to $80.8 million in 2003 as compared to $75.0 million in 2002, primarily due to increased snow removal costs and additional properties in 2003. Property operating expenses included a provision for doubtful accounts of $.2 million in 2003 and $.9 million in 2002 to provide for increased tenant credit risk. Property operating expenses for the Same Store Properties increased to $75.3 million in 2003 as compared to $69.7 million in 2002 as a result of increased snow removal costs in 2003 as compared to 2002.
Real estate taxes increased to $27.9 million in 2003 as compared to $25.2 million in 2002, primarily due to increased real estate tax assessments in 2003 and additional properties in 2003. Real estate taxes for the Same Store Properties increased to $22.9 million in 2003 as compared to $21.6 million in 2002 as a result of higher tax rates and property assessments.
Interest expense decreased to $57.8 million in 2003 as compared to $63.5 million in 2002, primarily due to decreased interest rates and decreased average borrowings during 2003. Average outstanding debt balances for 2003 were $948.7 million as compared to $1.0 billion for 2002. The Company’s weighted-average interest rate from its unsecured credit facilities after giving effect to hedging activities on the unsecured credit facilities decreased to 4.60% in 2003 from 5.41% in 2002 and on mortgage notes payable decreased to 7.09% in 2003 from 7.27% in 2002.
Depreciation increased to $53.5 million in 2003 as compared to $50.8 million in 2002 primarily due to additional properties in 2003 and additional depreciation from increased tenant improvements during 2003. Amortization, related to deferred leasing costs, increased to $7.1 million in 2003 as compared to $5.6 million in 2002, primarily due to increased leasing activity and additional properties in 2003.
Administrative expenses decreased to $14.5 million in 2003 as compared to $14.8 million in 2002, primarily due to decreased amortization of restricted stock.
Equity in income of Real Estate Ventures decreased to $52,000 in 2003 as compared to $1.0 million in 2002. During 2003, the Company recorded an impairment charge of $861,000 associated with the write-down its investment in a non-operating joint venture.
During 2003, the Company sold four parcels of land containing an aggregate of 24.1 acres for an aggregate of $4.2 million, realizing an aggregate gain of $2.0 million. In addition, the Company sold two office properties containing an aggregate of approximately 633,000 net rentable square feet for an aggregate of $112.8 million, of which $52.9 million of proceeds were used to pay off existing mortgage notes payable secured by the two properties. The Company recognized a gain on the sale of approximately $18.5 million, which is recorded in net gain on sale of real estate interests due to a continuing 20% interest that the Company has maintained in the properties. During 2002, the Company sold two land parcels containing an aggregate of 12.8 acres for $.7 million with no net gain realized.
Minority interest from continuing operations represents the equity in income attributable to the portion of the Operating Partnership not owned by the Company. Minority interest from continuing operations increased to $10.1 million in 2003 as compared to $9.3 million in 2002, primarily due to increased results of continuing operations in 2003 as compared to 2002.
Discontinued operations decreased to $11.3 million in 2003 as compared to $15.1 million in 2002 primarily due to net gain on sales of real estate investments of $8.6 million in 2002. During 2003, the Company sold eight office properties containing an aggregate of 343,000 net rentable square feet and two industrial properties containing an aggregate of 131,000 net rentable square feet for an aggregate of $41.4 million, realizing an aggregate gain of $9.7 million. During 2002, the Company sold 23 office properties containing an aggregate of 1.4 million net rentable square feet and 20 industrial properties containing an aggregate of .9 million net rentable square feet for an aggregate of $190.1 million, realizing a net gain of $8.6 million. The Company also recorded an impairment loss in 2002 of $665,000 related to one property held-for-sale for which the anticipated net sales price is less than the book value of the asset.
Comparison of the Year Ended December 31, 2002 to the Year Ended December 31, 2001
The results of operations for the years ended December 31, 2002 and 2001 include the respective operations of the Properties. Of the 238 Properties owned by the Company as of December 31, 2002, a total of 194 Properties containing an aggregate of 13.2 million net rentable square feet (“Same Store Properties”) were owned for the entire twelve-month periods ended December 31, 2002 and 2001. The following table set forth revenue and expense information as to these Same Store Properties for the twelve-month periods ended December 31, 2002 and 2001:
The following table is a reconciliation of income from continuing operations to Same Store net operating income:
Revenue increased to $291.0 million for 2002 as compared to $270.5 million for 2001, primarily due to increased rental rates and additional properties in 2002, offset by decreased occupancy. The straight-line rent adjustment increased revenues by $5.8 million in 2002 and $5.4 million in 2001. Revenue for Same Store Properties decreased to $233.3 million in 2002 from $236.6 million in 2001. This decrease was the result of decreased occupancy in 2002 as compared to 2001. Average occupancy for the Same Store Properties decreased to 90.4% in 2002 from 94.5% in 2001. Other revenue represents lease termination fees, leasing commissions, third-party management fees and interest income. Other revenue decreased to $9.7 million in 2002 from $10.3 million in 2001 primarily due to reduced interest income earned in 2002 as compared to 2001.
Property operating expenses increased to $75.0 million in 2002 as compared to $70.6 million in 2001, primarily due to increased insurance and security costs and additional properties in 2002. Property operating expenses included a provision for doubtful accounts of $.9 million in 2002 and $2.9 million in 2001 to provide for increased tenant credit risk. Property operating expenses for the Same Store Properties increased to $71.2 million in 2002 as compared to $69.9 million in 2002 as a result of higher insurance and security costs.
Real estate taxes increased to $25.2 million in 2002 as compared to $22.4 million in 2001, primarily due to increased real estate tax assessments in 2002 and additional properties in 2002. Real estate taxes for the Same Store Properties increased to $21.9 million in 2002 as compared to $20.8 million in 2001 as a result of higher tax rates and property assessments.
Interest expense decreased to $63.5 million in 2002 as compared to $67.5 million in 2001, primarily due to decreased interest rates, partially offset by increased average borrowings during 2002. Average outstanding debt balances for 2002 were $1.0 billion as compared to $949.5 million for 2001. The Company’s weighted-average interest rate on its unsecured credit facilities after giving effect to hedging activities on the unsecured credit facilities decreased to 5.41% in 2002 from 6.48% in 2001 and on its mortgage notes payable decreased to 7.27% in 2002 from 7.39% in 2001.
Depreciation decreased to $50.8 million in 2002 as compared to $62.9 million in 2001 primarily due to a change made by the Company in the estimated useful lives of buildings from 25 to 40 years. The impact of this change in useful lives was $19.0 million or $.53 per share for the year ended December 31, 2002. Management determined that the longer period better reflected the useful lives of the buildings. Amortization, related to deferred leasing costs, increased to $5.6 million in 2002 as compared to $4.3 million in 2001, primarily due to increased leasing activity and additional properties in 2002.
Administrative expenses decreased to $14.8 million in 2002 as compared to $15.2 million in 2001, primarily due to decreased amortization of restricted stock.
Equity in income of Real Estate Ventures decreased to $1.0 million in 2002 as compared to $2.8 million in 2001. The 2001 results include a $785,000 gain on the sale of the Company’s interests in a Real Estate Venture. In addition, the Company acquired the remaining partnership interests in three Real Estate Ventures, and, accordingly, the results attributable to these properties are now consolidated from the date of acquisition.
During 2002, the Company sold two land parcels containing an aggregate of 12.8 acres for $.7 million with no net gain realized. During 2001, the Company sold three office properties, eight industrial properties and four land parcels for $31.3 million, realizing a net gain of $4.5 million.
Minority interest from continuing operations represents the equity in income attributable to the portion of the Operating Partnership not owned by the Company. Minority interest from continuing operations increased to $9.3 million in 2002 as compared to $7.9 million in 2001, primarily due to increased results of continuing operations in 2002 as compared to 2001.
Discontinued operations increased to $15.1 million in 2002 from $13.3 million in 2001 primarily due to net gain on sales of real estate investments of $8.6 million in 2002. During 2002, the Company sold 23 office properties containing an aggregate of 1.4 million net rentable square feet and 20 industrial properties containing an aggregate of .9 million net rentable square feet for an aggregate of $190.1 million, realizing a net gain of $8.6 million. The Company also recorded an impairment loss in 2002 of $665,000 related to one property held-for-sale for which the anticipated net sales price was less than the book value of the asset.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows
During 2003, the Company generated $118.8 million in cash flow from operating activities. Other sources of cash in-flows consisted of: (i) $220.0 million of proceeds from the Term Loan and draws on the Credit Facility, (ii) $159.1 million in net proceeds from share issuances, (iii) $87.5 million of net proceeds from property sales, (iv) $3.3 million of cash distributions from Real Estate Ventures, (v) $2.5 million from payments on employee loans and (vi) $1.9 million of escrowed cash. During 2003, cash out-flows consisted of: (i) $222.0 million of Credit Facility repayments, (ii) $91.4 million of Preferred Share redemptions, including $1.2 million of related warrant repurchases, (iii) $82.1 million of mortgage note repayments, (iv) $78.8 million of distributions to shareholders, (v) $67.5 million for property acquisitions, (vi) $50.9 million to fund capital expenditures, (vii) $10.2 million of distributions to minority interest holders, (viii) $7.8 million of leasing costs, (ix) $.5 million of additional investment in Real Estate Ventures and (x) $.1 million of debt costs.
During 2002, the Company generated $128.8 million in cash flow from operating activities. Other sources of cash in-flows consisted of: (i) $115.0 million of proceeds from the Term Loan and draws on the Credit Facility, (ii) $78.0 million of net proceeds from property sales, (iii) proceeds from $20.2 million of additional mortgage notes payable, (iv) $2.6 million of escrowed cash, (v) $2.0 million of cash distributions from Real Estate Ventures and (vi) $1.7 million from payments on employee loans. During 2002, cash out-flows consisted of: (i) $102.3 million of Credit Facility repayments, (ii) $75.0 million of distributions to shareholders, (iii) $48.6 million of mortgage note repayments, (iv) $38.8 million to fund capital expenditures, (v) $25.1 million for property acquisitions, (vi) $20.2 million to repurchase Common Shares and minority interest units in the Operating Partnership, (vii) $13.1 million of leasing costs, (viii) $10.6 million of distributions to minority interest holders, (ix) $.7 million of debt costs and (x) $.4 million of additional investment in Real Estate Ventures.
During 2001, the Company generated $152.0 million in cash flow from operating activities. Other sources of cash in-flows consisted of: (i) proceeds from $135.2 million of additional mortgage notes payable, (ii) $91.0 million of proceeds from draws on the Credit Facility, (iii) $31.3 million of net proceeds from property sales, (iv) $5.5 million of cash distributions from Real Estate Ventures and (v) $1.0 million from payments on employee loans. During 2001, cash out-flows consisted of: (i) $127.9 million of mortgage note repayments, (ii) $107.4 million to fund capital expenditures, (iii) $72.5 million of distributions to shareholders, (iv) $40.4 million for property acquisitions, (v) $35.0 million to repay borrowings under the Credit Facility, (vi) $10.7 million of distributions to minority interest holders, (vii) $9.2 million of leasing costs, (viii) $6.5 million to repurchase Common Shares and minority interest units in the Operating Partnership, (ix) $5.6 million of debt costs, (x) $2.5 million of additional investment in Real Estate Ventures and (xi) $1.0 million of escrowed cash.
Capitalization
At December 31, 2003, the Company maintained a $500 million Credit Facility. (See Item 1. Business-Credit Facility)
As of December 31, 2003, the Company had approximately $867.7 million of debt outstanding, consisting of $305.0 million of borrowings under the Credit Facility, $100 million of borrowings under the Term Loan and $462.7 million of mortgage notes payable. The mortgage notes payable consists of $402.3 million of fixed rate loans and $60.4 million of variable rate loans. Additionally, the Company has entered into interest rate swap agreements to fix the interest rate on $175 million of the Credit Facility. The mortgage loans mature between March 2004 and July 2027. As of December 31, 2003, the Company also had $10.7 million of letters of credit outstanding under the Credit Facility and $184.3 million of unused availability under the Credit Facility. For the year ended December 31, 2003, the weighted-average interest rate under the Credit Facility and the related swap agreements was 4.60%, the weighted-average interest rate for the Term Loan was 2.95% and the weighted-average interest rate for borrowings under mortgage notes payable and the related cap agreements was 7.09%.
The following table outlines the timing of payment requirements related to the Company’s commitments as of December 31, 2003:
The Company intends to refinance its mortgage notes payable as they become due or repay those that are secured by properties being sold. The Company expects to renegotiate its Credit Facility and Term Loan prior to maturity or extend their terms.
On January 12, 2004, we sold 2,645,000 Common Shares for net proceeds of approximately $69.3 million. We used the net proceeds to reduce the outstanding balance under our revolving credit facility.
On February 3, 2004, we entered into an agreement with Commonwealth Atlantic Operating Properties, Inc., the holder of 1,950,000 then outstanding Series B Preferred Units (the “Series B Preferred Units”) in the Operating Partnership. The Series B Preferred Units had an aggregate stated value of $97.5 million and accrued distributions at 7.25% per annum. During February 2004, we redeemed all of the Series B Preferred Units for an aggregate price of $93.0 million, together with accrued but unpaid distributions from January 1, 2004.
On February 27, 2004, we sold 2,300,000 7.375% Series D Cumulative Redeemable Preferred Shares for net proceeds of approximately $55.5 million. We used the net proceeds to reduce the outstanding balance under our revolving credit facility, including amounts advanced under our revolving credit facility to fund the redemption of Series B Preferred Units.
On March 3, 2004, we sold 1,840,000 Common Shares for net proceeds of approximately $50.7 million. We used the net proceeds to reduce the outstanding balance under our revolving credit facility.
As of December 31, 2003, the Company’s debt-to-market capitalization ratio was 40.5%. As a general policy, the Company intends, but is not obligated, to adhere to a policy of maintaining a long-term average debt-to-market capitalization ratio of no more than 50%.
The Company’s Board of Trustees approved a share repurchase program authorizing the Company to repurchase up to 4,000,000 of its outstanding Common Shares. Through December 31, 2003, the Company had repurchased 3.2 million of its Common Shares at an average price of $17.75 per share. Under the share repurchase program, the Company has the authority to repurchase an additional 762,000 shares. No time limit has been placed on the duration of the share repurchase program. The following table summarizes the share repurchases during the three years ended December 31, 2003:
The following table summarized the Class A Units tendered for redemption during the three years ended December 31, 2003:
Short- and Long-Term Liquidity
The Company believes that cash flow from operations and current financing alternatives are adequate to fund its short-term liquidity requirements for 2004. Cash flow from operations is generated primarily from rental revenues, operating expense reimbursements from tenants, and by providing management services to third parties. The Company intends to use these funds to meet its principal short-term liquidity needs, which are to fund operating expenses, debt service requirements, recurring capital expenditures, tenant allowances, leasing commissions and the minimum distributions required to maintain the Company’s REIT qualifications under the Internal Revenue Code.
On December 18, 2003, the Board of Trustees declared a quarterly dividend distribution of $0.44 per share, paid on January 15, 2004 to common shareholders of record as of December 31, 2003. Distributions of $1.76 per share were declared in 2003 and 2002.
Future distributions by us will be declared at the discretion of the Board of Trustees and will depend on our actual cash flow, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986 and such other factors as our Board of Trustees deems relevant.
The Company expects to meet its long-term liquidity requirements, such as for property acquisitions, development, investments in real estate ventures, scheduled debt maturities, major renovations, expansions and other significant capital improvements, through borrowings under its Credit Facility, long-term secured and unsecured indebtedness, the issuance of equity securities and the disposition of certain properties.
Off-Balance Sheet Arrangements
The Company is not dependent on the use of any off-balance sheet financing arrangements for liquidity. The Company’s off-balance sheet arrangements are discussed in Note 6 to the financial statements: “Investment in Unconsolidated Real Estate Ventures”. Additional information about the debt of the Company’s unconsolidated Real Estate Ventures is included in “Item 2 - Properties”.
Inflation
A majority of the Company’s leases provide for escalations of real estate taxes and operating expenses either on a triple net basis or over a base amount. In addition, many of the office leases provide for fixed base rent increases. The Company believes that inflationary increases in expenses will be significantly offset by expense reimbursement and contractual rent increases.
Interest Rate Risk and Sensitivity Analysis
The analysis below presents the sensitivity of the market value of the Company’s financial instruments to selected changes in market rates. The range of changes chosen reflects the Company’s view of changes which are reasonably possible over a one-year period. Market values are the present value of projected future cash flows based on the market rates chosen.
The Company’s financial instruments consist of both fixed and variable rate debt. As of December 31, 2003, the Company’s consolidated debt consisted of $402.3 million in fixed rate mortgages and $60.4 million in variable rate mortgage notes, $305.0 million borrowings under its Credit Facility and $100.0 million under its Term Loan. All financial instruments were entered into for other than trading purposes and the net market value of these financial instruments is referred to as the net financial position. Changes in interest rates have different impacts on the fixed and variable rate portions of the Company’s debt portfolio. A change in interest rates on the fixed portion of the debt portfolio impacts the net financial instrument position, but has no impact on interest incurred or cash flows. A change in interest rates on the variable portion of the debt portfolio impacts the interest incurred and cash flows, but does not impact the net financial instrument position.
The Company has entered into interest rate swap and rate cap agreements designed to reduce the impact of interest rate changes on its variable rate debt. At December 31, 2003, the Company had interest rate swap agreements for notional principal amounts aggregating $175 million. The swap agreements effectively fix the LIBOR interest rate on $100 million of Credit Facility borrowings at 4.230% and on $75 million of Credit Facility borrowings at 4.215%, in each case until June 2004. The interest rate cap agreement effectively limits the interest rate on a mortgage with a notional value of $28 million at 8.7% until July 2004. The impact of the cap agreement is recorded as a component of interest expense.
If market rates of interest on our variable rate debt increase by 1%, the increase in annual interest expense on our variable rate debt would decrease future earnings and cash flows by approximately $3.8 million. If market rates of interest on our variable rate debt decrease by 1%, the decrease in interest expense on our variable rate debt would increase future earnings and cash flows by approximately $3.8 million. If market rates of interest increase by 1%, the fair value of our total outstanding debt would decrease by approximately $24.5 million. If market rates of interest decrease by 1%, the fair value of our total outstanding debt would increase by approximately $27.1 million.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk
See discussion in Management’s Discussion and Analysis included in Item 7
Item 8. Financial Statements and Supplementary Data
The financial statements and supplementary financial data are listed under Item 15(a) and filed as part of this Annual Report on Form 10-K. See Item 15.
PricewaterhouseCoopers LLP (“PWC”) is the Company’s independent public auditors. KPMG LLP (“KPMG”) provides the Company with tax compliance and advisory services. The Audit Committee of the Board of Trustees of the Company has approved the provision of services by PWC and KPMG to the Company. See Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On May 23, 2002, the Company dismissed Arthur Andersen LLP (“Arthur Andersen”) as its independent public accountants and appointed KPMG LLP (“KPMG”) as its independent public accountants. The decision to dismiss Arthur Andersen and to retain KPMG was approved by the Audit Committee. Arthur Andersen’s reports on the Company’s consolidated financial statements as of and for the fiscal years ended December 31, 2001 and 2000 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles.
During the Company’s fiscal years ended December 31, 2001 and 2000, and the subsequent interim period through May 30, 2002, there were no disagreements between the Company and Arthur Andersen on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to Arthur Andersen’s satisfaction, would have caused them to make reference to the subject matter of the disagreement in connection with their reports.
None of the reportable events described under Item 304(a)(1)(v) of Regulation S-K occurred within the Company’s fiscal years ended December 31, 2001 and 2000 and the subsequent interim period through May 30, 2002.
A copy of Arthur Andersen’s letter dated May 30, 2002 with respect to certain of the above statements is attached as Exhibit 16 to the Company’s Form 8-K filed with the Securities and Exchange Commission on May 30, 2002.
During the Company’s fiscal years ended December 31, 2001 and 2000, and the subsequent interim period through May 30, 2002, neither the Company nor anyone acting on behalf of the Company consulted with KPMG regarding any of the matters or events set forth in Item 304(a)(2) of Regulation S-K.
On June 19, 2003, the Company informed KPMG that they would be dismissed effective as of June 19, 2003.
The audit report of KPMG on the Company’s consolidated financial statements for the years ended December 31, 2002 and 2001 did not contain an adverse opinion or a disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles, except that effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. During its audit for the fiscal years ended December 31, 2002 and 2001, and for the subsequent interim period through June 25, 2003, (i) there were no disagreements with KPMG on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to KPMG’s satisfaction, would have caused KPMG to make reference to the subject matter of such disagreements in their reports, and (ii) there have been no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K.
The Audit Committee authorized the dismissal of KPMG and appointment of PWC. The Company retained PWC as its independent accountants effective June 19, 2003.
During the Company’s fiscal years ended December 31, 2002 and 2001, and for the subsequent interim period through June 25, 2003, neither the Company nor anyone acting on behalf of the Company engaged PWC regarding any of the items described in Item 304(a)(2) of Regulation S-K.
A copy of KPMG’s letter dated June 25, 2003 with respect to certain of the above statements is attached as Exhibit 16.1 to the Company’s Form 8-K filed with the Securities and Exchange Commission on June 25, 2003.
Item 9A.
Item 9A. Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this annual report, have concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in rules and forms of the Securities and Exchange Commission.
PART III
Item 10.
Item 10. Trustees and Executive Officers of the Registrant
Incorporated herein by reference to the Company’s definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders expected to be held on May 3, 2004.
The Company has adopted a code of ethics that applies to its employees, including its principal executive officer, principal financial officer and principal accounting officer. The Company has posted its code of ethics on its internet website at www.brandywinerealty.com.
Item 11.
Item 11. Executive Compensation
Incorporated herein by reference to the Company’s definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders expected to be held on May 3, 2004.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
Incorporated herein by reference to the Company’s definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders expected to be held on May 3, 2004.
Item 13.
Item 13. Certain Relationships and Related Transactions
Incorporated herein by reference to the Company’s definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders expected to be held on May 3, 2004.
Item 14.
Item 14. Principal Accountant Fees and Services
Audit Fees. Fees to PWC for audit services totaled approximately $413,000 in 2003, including fees associated with the annual audit, review of the Company’s quarterly reports on Form 10-Q and procedures relating to Company securities offerings. The Company did not pay PWC fees for audit services in 2002. Fees to KPMG for audit services totaled approximately $320,000 in 2003 and approximately $692,000 in 2002, including fees associated with the annual audit for 2002, review of the Company’s quarterly reports on Form 10-Q and procedures relating to Company securities offerings.
Audit-Related Fees. The Company did not pay either PWC or KPMG fees for audit-related services in 2003 or 2002.
Tax Fees. The Company did not pay PWC fees for tax services in 2003 or 2002. Fees to KPMG for tax services, including tax advice and tax planning, totaled approximately $267,000 in 2003 and $106,000 in 2002. Fees to KPMG for tax compliance services totaled approximately $162,000 in 2003 and $201,000 in 2002.
All Other Fees. The Company did not pay other fees to PWC or KPMG for services provided to the Company in 2003 or 2002.
We have been advised by each of PWC and KPMG that neither the firm, nor any member of the firm, has any financial interest, direct or indirect, in any capacity in the Company or its subsidiaries.
All audit related services, tax services and other services were pre-approved by the Audit Committee, which concluded that the provision of such services by PWC or KPMG, respectively, was compatible with the maintenance of that firm’s independence in the conduct of its auditing functions. The charter of the Audit Committee provides for pre-approval of audit, audit-related, tax services and other services on an annual basis, including a review of the independent auditor’s audit procedures and risk assessment process in establishing the scope of the services, proposed fees and reports to be rendered.
PART IV
Item 15.
Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K
(a)
1. and 2. Financial Statements and Schedules
The financial statements and schedules listed below are filed as part of this annual report on the pages indicated.
Index to Financial Statements and Schedules
Page
Report of Independent Public Auditors
Consolidated Balance Sheets as of December 31, 2003 and December 31, 2002
Consolidated Statements of Operations for the Years Ended December 31, 2003, 2002 and 2001
Consolidated Statements of Beneficiaries’ Equity and 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
Schedule II - Valuation and Qualifying Accounts
Schedule III - Real Estate and Accumulated Depreciation
3.
Exhibits
1. Previously filed as an exhibit to the Company’s Form 8-K dated June 9, 1997 and incorporated herein by reference.
2. Previously filed as an exhibit to the Company’s Form 8-K dated September 10, 1997 and incorporated herein by reference.
3. Previously filed as an exhibit to the Company’s Form 8-K dated June 3, 1998 and incorporated herein by reference.
4. Previously filed as an exhibit to the Company’s Form 8-K dated October 13, 1998 and incorporated herein by reference.
5. Previously filed as an exhibit to the Company’s Form 10-K for the fiscal year ended December 31, 1999 and incorporated herein by reference.
6. Previously filed as an exhibit to the Company’s Form 8-K dated April 26, 1999 and incorporated herein by reference.
7. Previously filed as an exhibit to the Company’s Form 8-A dated December 29, 2003 and incorporated herein by reference.
8. Previously filed as an exhibit to the Company’s Form 8-A dated February 5, 2004 and incorporated herein by reference.
9. Previously filed as an exhibit to the Company’s Form 8-K dated October 14, 2003 and incorporated herein by reference.
10. Previously filed as an exhibit to the Company’s Registration statement of Form S-11 (File No. 33-4175) and incorporated herein by reference.
11. Previously filed as an exhibit to the Company’s Form 10-K for the fiscal year ended December 31, 2002 and incorporated herein by reference.
12. Previously filed as an exhibit to the Company’s Form 8-K dated December 17, 1997 and incorporated herein by reference.
13. Previously filed as an exhibit to the Company’s Form 8-K dated August 13, 1998 and incorporated herein by reference.
14. Previously filed as an exhibit to the Company’s Form 8-K dated May 14, 1998 and incorporated herein by reference.
15. Previously filed as an exhibit to the Company’s Form 8-K dated July 30, 1998 and incorporated herein by reference.
16. Previously filed as an exhibit to the Company’s Form 8-K dated August 13, 1998 and incorporated herein by reference.
17. Previously filed as an exhibit to the Company’s Form 10-K for the fiscal year ended December 31, 1997 and incorporated herein by reference.
18. Previously filed as an exhibit to the Company’s Form 10-K for the fiscal year ended December 31, 2000 and incorporated herein by reference.
19. Previously filed as an exhibit to the Company’s Form 10-Q for the quarter ended June 30, 2002 and incorporated herein by reference.
20. Previously filed as an exhibit to the Company’s Form 8-K dated July 12, 2001 and incorporated herein by reference.
21. Previously filed as an exhibit to the Company’s Form 8-K dated July 16, 2002 and incorporated herein by reference.
22. Previously filed as an exhibit to the Company’s Form 8-K dated August 27, 2002 and incorporated herein by reference.
23. Previously filed as an exhibit to the Company’s Form 10-Q for the quarter ended September 30, 2002 and incorporated herein by reference.
24. Previously filed as an exhibit to the Company’s Form 10-Q for the quarter ended June 30, 2003 and incorporated herein by reference.
25. Previously filed as an exhibit to the Company’s Form 8-K dated February 3, 2004 and incorporated herein by reference.
** Management contract or compensatory plan or arrangement.
(b)
Reports on Form 8-K
During the three months ended December 31, 2003 and through March 12, 2004, the Company filed or furnished the following:
(i) Current Report on Form 8-K filed October 14, 2003 (reporting under Items 5 and 7).
(ii) Current Report on Form 8-K filed October 15, 2003 (reporting under Items 5 and 7).
(iii) Current Report on Form 8-K furnished October 24, 2003 (reporting under Items 7, 9 and 12).
(iv) Current Report on Form 8-K filed December 9, 2003 (reporting under Items 5 and 7).
(v) Current Report on Form 8-K filed December 24, 2003 (reporting under Item 5).
(vi) Current Report on Form 8-K filed December 29, 2003 (reporting under Items 5 and 7).
(vii) Current Report on Form 8-K filed January 7, 2004 (reporting under Items 5 and 7).
(viii) Current Report on Form 8-K filed February 3, 2004 (reporting under Items 5 and 7).
(ix) Current Report on Form 8-K filed February 5, 2004 (reporting under Items 5 and 7).
(x) Current Report on Form 8-K furnished February 12, 2004 (reporting under Items 7 and 12).
(xi) Current Report on Form 8-K filed February 27, 2004 (reporting under Items 5 and 7).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
BRANDYWINE REALTY TRUST
By: / s/ Gerard H. Sweeney
Gerard H. Sweeney
President and Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Anthony A. Nichols, Sr.
Anthony A. Nichols, Sr.
Chairman of the Board and Trustee
March 12, 2004
/s/ Gerard H. Sweeney
Gerard H. Sweeney
President, Chief Executive Officer and Trustee (Principal Executive Officer)
March 12, 2004
/s/ Christopher P. Marr
Christopher P. Marr
Senior Vice President and Chief Financial Officer (Principal Financial Officer)
March 12, 2004
/s/ Bradley W. Harris
Bradley W. Harris
Vice President and Chief Accounting Officer (Principal Accounting Officer)
March 12, 2004
/s/ Walter D’Alessio
Walter D’Alessio
Trustee
March 12, 2004
/s/ Charles P. Pizzi
Charles P. Pizzi
Trustee
March 12, 2004
/s/ Donald E. Axinn
Donald E. Axinn
Trustee
March 12, 2004
/s/ Robert C. Larson
Robert C. Larson
Trustee
March 12, 2004
/s/ D. Pike Aloian
D. Pike Aloian
Trustee
March 12, 2004
REPORT OF INDEPENDENT AUDITORS
To the Board of Trustees and Shareholders:
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) and (2) present fairly, in all material respects, the consolidated financial position of Brandywine Realty Trust and its subsidiaries (the “Company”) at December 31, 2003, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the consolidated financial statement schedules listed in the index appearing under Item 15(a)(1) and (2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These consolidated financial statements and consolidated financial statement schedules are the responsibility of the Company’s management; our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
February 20, 2004
INDEPENDENT AUDITORS’ REPORT
To the Shareholders and Board of Trustees
of Brandywine Realty Trust:
We have audited the consolidated balance sheet of Brandywine Realty Trust and subsidiaries as of December 31, 2002 and the related consolidated statements of operations, beneficiaries’ equity and comprehensive income and cash flows for each of the years in the two-year period ended December 31, 2002. These consolidated financial statements and are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brandywine Realty Trust and subsidiaries as of December 31, 2002 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.
As discussed in note 2 to the consolidated financial statements, effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Also, as discussed in note 2 to the consolidated financial statements, on January 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.
/s/ KPMG LLP
Philadelphia, Pennsylvania
February 26, 2003, except as to Notes 9, 12, and 13 which are dated as of December 31, 2003
BRANDYWINE REALTY TRUST
CONSOLIDATED BALANCE SHEETS
(in thousands, except number of shares)
The accompanying notes are an integral part of these consolidated financial statements.
BRANDYWINE REALTY TRUST
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share information)
The accompanying notes are an integral part of these consolidated financial statements.
BRANDYWINE REALTY TRUST
CONSOLIDATED STATEMENTS OF BENEFICIARIES’ EQUITY AND COMPREHENSIVE INCOME
For the years ended December 31, 2003, 2002 and 2001
(in thousands, except number of shares)
The accompanying notes are an integral part of these consolidated financial statements.
BRANDYWINE REALTY TRUST
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
BRANDYWINE REALTY TRUST
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003, 2002 AND 2001
1.
ORGANIZATION AND NATURE OF OPERATIONS
Brandywine Realty Trust, a Maryland Real Estate Investment Trust (collectively with its subsidiaries, the “Company”), is a self-administered and self-managed real estate investment trust (a “REIT”) active in acquiring, developing, redeveloping, leasing and managing office and industrial properties. As of December 31, 2003, the Company’s portfolio included 208 office properties, 25 industrial facilities and one mixed-use property (collectively, the “Properties”) that contained an aggregate of approximately 15.7 million net rentable square feet. The Properties are located in the office and industrial markets in and surrounding Philadelphia, Pennsylvania, New Jersey and Richmond, Virginia. As of December 31, 2003, the Company also held economic interests in ten unconsolidated real estate ventures (the “Real Estate Ventures”) formed with third parties to develop or own commercial properties.
The Company’s interest in its assets is held through Brandywine Operating Partnership, L.P., a Delaware limited partnership (the “Operating Partnership”). The Company is the sole general partner of the Operating Partnership and, as of December 31, 2003, was entitled to approximately 95.8% of the Operating Partnership’s distributions after distributions to holders of then outstanding Series B Preferred Units (as defined in Note 3 below). The Operating Partnership owns a 95% interest in a taxable REIT subsidiary, Brandywine Realty Services Corporation, a Pennsylvania corporation (the “Management Company”), that, as of December 31, 2003, was performing management and leasing services for properties containing an aggregate of approximately 19.3 million net rentable square feet, of which approximately 15.7 million net rentable square feet related to properties owned by the Company and approximately 3.6 million net rentable square feet related to properties owned by third parties. The remaining 5% of the Management Company is owned by a partnership comprised of two executives of the Company.
2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include all accounts of the Company, its majority-owned and/or controlled subsidiaries, which consist principally of the Operating Partnership as well as the Management Company (consolidated subsequent to January 1, 2001, see below). The portion of these entities not owned by the Company is presented as minority interest as of and during the periods consolidated. All intercompany accounts and transactions have been eliminated in consolidation.
See Investments in Unconsolidated Real Estate Ventures in Note 6 for the Company’s treatment of unconsolidated real estate venture interests. All significant intercompany accounts and transactions have been eliminated.
Management Company
The Management Company, a taxable REIT subsidiary, provides management, leasing, construction, development, redevelopment and other real estate related services for the Company’s properties and for third parties. Prior to December 31, 2000, the Company owned 100% of the Management Company’s non-voting preferred stock and 5% of its voting common stock and accounted for its investment using the equity method. Effective January 1, 2001, the Company converted its non-voting interest in the Management Company to a voting interest. As a result, the Company owns 95% of the Management Company’s equity, has voting control and, therefore, has consolidated the Management Company since January 1, 2001.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Management makes significant estimates regarding revenue, impairment of long-lived assets, allowance for doubtful accounts and deferred costs.
Operating Properties
Operating properties are carried at historical cost less accumulated depreciation and impairment losses. The cost of operating properties reflects their purchase price or development cost. Costs incurred for the acquisition and renovation of an operating property are capitalized to the Company’s investment in that property. Ordinary repairs and maintenance are expensed as incurred; major replacements and betterments, which improve or extend the life of the asset, are capitalized and depreciated over their estimated useful lives. Fully- depreciated assets are removed from the accounts.
Purchase Price Allocation
The Company allocates the purchase price of properties to net tangible and identified intangible assets acquired based on fair values. Above-market and below-market in-place lease values for acquired properties are recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) the Company’s estimate of the fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancellable term of the lease. Capitalized above-market lease values are amortized as a reduction of rental income over the remaining non-cancellable terms of the respective leases. Capitalized below-market lease values amortized as an increase of rental income over the remaining non-cancellable terms of the respective leases, including any fixed-rate renewal periods.
The aggregate value of other intangibles acquired is measured based on the difference between (i) the property valued with in-place leases adjusted to market rental rates and (ii) the property valued as if it was vacant. The Company allocates a portion of the purchase price to lease origination costs. The Company estimates the cost to execute leases with terms similar to the remaining lease terms of the in-place leases, include leasing commissions, legal and other related expenses. This intangible asset is amortized to expense over the remaining term of the respective leases. Company estimates of value are made using methods similar to those used by independent appraisers. Factors considered by the Company in their analysis include an estimate of the carrying costs during the expected lease-up periods considering current market conditions and costs to execute similar leases. The Company also considers information obtained about each property as a result of its pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. In estimating carrying costs, the Company includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from three to twelve months.
The total amount of these other intangible assets is further allocated to tenant relationships and in-place leases based on the Company’s evaluation of the specific characteristics of each tenant’s lease and the Company’s overall relationship with the respective tenant. Characteristics considered by the Company in allocating value to its tenant relationships include the nature and extent of the Company’s business relationship with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals, among other factors. The value of tenant relationship intangibles is amortized over the remaining initial lease term and renewals, but in no event longer than the remaining depreciable life of the building. The value of in-place leases is amortized over the remaining non-cancellable term of the respective leases and any fixed-rate renewal periods.
In the event that a tenant terminates its lease, the unamortized portion of each intangible, including market rate adjustments, lease origination costs, in-place lease values and tenant relationship values, would be charged to expense.
As of December 31, 2003 and 2002, intangible assets and acquired lease liabilities consist of the following:
Depreciation and Amortization
The costs of buildings and improvements are depreciated using the straight-line method based on the following useful lives: buildings and improvements (five to 40 years) and tenant improvements (the shorter of the lease term or the life of the asset).
Effective January 1, 2002, the Company changed the estimated useful lives of various buildings from 25 to 40 years. This change resulted in an increase of net income of $19.0 million or $.53 per share for the year ended December 31, 2002. Management determined the longer period to be a better estimate of the useful lives of the buildings.
Construction in Progress
Project costs directly associated with the development and construction of a real estate project are capitalized as construction in progress. In addition, interest, real estate taxes and general and administrative expenses that are directly associated with the Company’s development activities are capitalized until completion of the building shell. Once the building shell of a real estate project is completed, the costs capitalized to construction in progress are transferred to land and buildings. Direct construction costs totaling $1.7 million in 2003, $2.2 million in 2002 and $2.7 million in 2001 and interest totaling $1.5 million in 2003, $2.9 million in 2002 and $5.2 million in 2001 were capitalized related to development of certain Properties and land holdings.
Impairment of Long-Lived Assets
Statement of Financial Accounting Standard No. 144 (“SFAS 144”), Accounting for the Impairment or Disposal of Long-Lived Assets, provides a single accounting model for long-lived assets as held-for-sale, broadens the scope of businesses to be disposed of that qualify for reporting as discontinued operations and changes the timing of recognizing losses on such operations. The company adopted SFAS 144 on January 1, 2002.
In accordance with SFAS 144, long-lived assets, such as real estate investments and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The other assets and liabilities related to assets classified as held-for-sale are presented separately in the consolidated balance sheet. For the year ended December 31, 2002, the Company recorded an impairment charge associated with an asset held-for-sale (See Note 9). The Company recorded no impairment losses for the years ended December 31, 2003 and 2001.
Cash and Cash Equivalents
Cash and cash equivalents are highly-liquid investments with original maturities of three months or less. The Company maintains cash equivalents in financial institutions in excess of insured limits, but believes this risk is mitigated by only investing in or through major financial institutions.
Escrowed Cash
Restricted cash consists of cash held as collateral to provide credit enhancement for the Company’s mortgage debt, cash for property taxes, capital expenditures and tenant improvements.
Accounts Receivable
Leases with tenants are accounted for as operating leases. Minimum annual rentals under tenant leases are recognized on a straight-line basis over the term of the related lease. Accrued rent receivable represents the amount that straight-line rental income exceeds rents currently due under the lease agreements. Included in current tenant receivables are tenant reimbursements which are comprised of amounts recoverable from tenants for common area maintenance expenses and certain other recoverable expenses that are recognized as revenue in the period in which the related expenses are incurred. As of December 31, 2003 and 2002, no tenant represents more than 10% of accounts receivable.
Tenant receivables and accrued rent receivables are carried net of the allowances for doubtful accounts of $1.5 million and $2.5 million in 2003 and $2.3 million and $2.3 million in 2002. Management’s determination of the adequacy of these allowances is based primarily upon evaluations of historical loss experience, individual receivables and current economic conditions.
Marketable Securities
The Company accounts for its investments in equity securities according to the provisions of SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, which requires securities classified as “available-for-sale” to be stated at fair value. Adjustments to fair value of available-for-sale securities are recorded as a component of other comprehensive income (loss). A decline in the market value of equity securities below cost that is deemed to be other than temporary results in a reduction in the carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established.
As of December 31, 2003, the Company had no material exposure to market risk (including foreign currency exchange risk, commodity price risk or equity price risk).
Investments in Unconsolidated Real Estate Ventures
The Company accounts for its investments in unconsolidated Real Estate Ventures under the equity method of accounting as the Company exercises significant influence, but does not control these entities under the provisions of the entities’ governing agreements. These investments are recorded initially at cost, as Investments in Real Estate Ventures, and subsequently adjusted for equity in earnings and cash contributions and distributions.
On a periodic basis, management assesses whether there are any indicators that the value of the Company’s investments in unconsolidated Real Estate Ventures may be impaired. An investment is impaired only if management’s estimate of the value of the investment is less than the carrying value of the investment. To the extent impairment has occurred, the loss shall be measured as the excess of the carrying amount of the investment over the value of the investment. During the year ended December 31, 2003, the Company recorded an impairment charge associated with an investment in a non-operating Real Estate Venture (see Note 9).
Deferred Costs
Costs incurred in connection with property leasing are capitalized as deferred leasing costs. Deferred leasing costs consist primarily of leasing commissions that are amortized on the straight-line method over the life of the respective lease which generally ranges from one to 15 years. Management re-evaluates the remaining useful lives of leasing costs as economic and market conditions change. Internal direct leasing costs deferred totaled $3.9 million in 2003, $3.6 million in 2002 and $3.1 million in 2001.
Costs incurred in connection with debt financing are capitalized as deferred financing costs and charged to interest expense over the terms of the related debt agreements. Deferred financing costs consist
primarily of loan fees which are amortized over the related loan term. Total accumulated amortization related to these costs was $5.0 million in 2003 and $3.5 million in 2002.
Other Assets
As of December 31, 2003, other assets included a direct financing lease of $16.1 million, intangible assets related to property acquisitions of $6.2 million, prepaid real estate taxes of $5.4 million, deposits on properties to be purchased in 2004 totaling $5.1 million, cash surrender value of life insurance of $3.7 million, furniture, fixtures and equipment of $2.1 million and $6.5 million of other assets. As of December 31, 2002, other assets included a direct financing lease of $16.0 million, prepaid real estate taxes of $5.6 million, promissory notes of $4.0 million, furniture, fixtures and equipment of $2.1 million and $6.8 million of other assets.
Fair Value of Financial Instruments
Carrying amounts reported in the balance sheet for cash, accounts receivable, other assets, accounts payable and accrued expenses, and borrowings under the Credit Facility approximate fair value. Accordingly, these items have been excluded from the fair value disclosures.
Revenue Recognition
Rental revenue is recognized on the straight-line basis from the later of the date of the origination of the lease or the date of acquisition of the facility subject to existing leases, which averages minimum rents over the terms of the leases. The cumulative difference between lease revenue recognized under this method and contractual lease payment terms is recorded as “accrued rent receivable” on the accompanying balance sheets. The straight-line rent adjustment increased revenue by approximately $5.9 million in 2003, $5.9 million in 2002 and $6.2 million in 2001. The leases also typically provide for tenant reimbursement of common area maintenance and other operating expenses. Deferred rental revenue represents rental revenue received from tenants prior to their due dates.
No tenant represented greater than 10% of the Company’s rental revenue in 2003, 2002 or 2001.
Income Taxes
The Company elects to be taxed as a real estate investment trust under Sections 856-860 of the Internal Revenue Code. In management’s opinion, the requirements to maintain this election are being met. Accordingly, no provision for Federal income taxes has been reflected in the financial statements.
Earnings and profits, which determine the taxability of distributions to shareholders, differ from net income reported for financial reporting purposes due to differences in cost basis, the estimated useful lives used to compute depreciation, and the allocation of net income and loss for financial versus tax reporting purposes. The tax basis in the Company’s assets was $1.4 billion as of December 31, 2003 and $1.3 billion as of December 31, 2002.
The Company is subject to a 4% Federal excise tax, if sufficient taxable income is not distributed within prescribed time limits. The excise tax equals 4% of the annual amount, if any, by which the sum of (a) 85% of the Company’s ordinary income and (b) 95% of the Company’s net capital gain exceeds cash distributions and certain taxes paid by the Company. No excise tax was incurred in 2003, 2002, or 2001.
The Management Company is subject to Federal and state income taxes. There was no provision required for income taxes in 2003, 2002 and 2001.
Earnings Per Share
Basic earnings per share is calculated by dividing income applicable to Common Shares by the weighted-average number of shares outstanding during the period. Diluted earnings per share includes the effect of common share equivalents outstanding during the period.
Stock-Based Compensation Plans
In December 2002, the Financial Accounting Standards Board issued SFAS 148 (“SFAS 148”), Accounting for Stock-Based Compensation - Transition and Disclosure. SFAS 148 amends SFAS 123 (“SFAS 123”), Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily adopts the fair value recognition method of recording stock option expense. SFAS 148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock options on reported net income and earnings per share in annual and interim financial statements. The Company adopted SFAS 148 on a prospective basis for all grants subsequent to January 1, 2002.
Prior to 2002, the Company accounted for stock options issued under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees and Related Interpretations. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share amounts):
Comprehensive Income
Comprehensive income or loss is recorded in accordance with the provisions of SFAS 130 (“SFAS 130”), Reporting Comprehensive Income. SFAS 130 establishes standards for reporting comprehensive income and its components in financial statements. Comprehensive income includes unrealized gains and losses on available-for-sale securities and the effective portions of changes in the fair value of derivatives.
Accounting for Derivative Instruments and Hedging Activities
The Company accounts for its derivative instruments and hedging activities under SFAS No. 133 (“SFAS 133”), Accounting for Derivative Instruments and Hedging Activities, and its corresponding amendments under SFAS No. 138, Accounting for Certain Derivative Instruments and Hedging Activities - An Amendment of SFAS 133. SFAS 133 requires the Company to measure every derivative instrument (including certain derivative instruments embedded in other contracts) at fair value and record them in the balance sheet as either an asset or liability. For derivatives designated as fair value hedges, the changes in fair value of both the derivative instrument and the hedged item are recorded in earnings. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in other comprehensive income. Changes in fair value of derivative instruments and ineffective portions of hedges are recognized in earnings in the current period. For the year ended December 31, 2003, the Company was not party to any derivative contract designated as a fair value hedge.
The Company actively manages its ratio of fixed-to-floating rate debt. To manage its fixed and floating rate debt in a cost-effective manner, the Company, from time to time, enters into interest rate swap agreements as cash flow hedges, under which it agrees to exchange various combinations of fixed and/or variable interest rates based on agreed upon notional amounts. See Note 8.
New Pronouncements
As of January 1, 2003, the Company adopted SFAS No 145 (“SFAS 145”), Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. In adopting SFAS 145, the Company has reclassified an extraordinary item recorded during 2001 relating to the write-off of $1.1 million of unamortized deferred financing costs as interest expense.
In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” an interpretation of ARB 51. FIN 46 provides guidance on identifying entities for which control is achieved through means other than through voting rights (a “variable interest entity” or “VIE”), and how to determine when and which business enterprise should consolidate a VIE. This new models for consolidation applies to an entity which either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial interest from other parties. The provisions of this interpretation apply to the first fiscal year or interim period ending after December 15, 2003.
The Company was originally required to implement the consolidation guidance established in Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities, immediately for new or modified transactions and by July 1, 2003 for the Variable Interest Entities (“VIEs”) with which the Company became involved prior to February 1, 2003. However, in October 2003 and December 2003, the FASB deferred application of FIN 46 twice from July 1, 2003 to December 31, 2003, and then to March 31, 2004 for VIEs entered into prior to February 1, 2003. The Company is in process of determining whether it will need to consolidate previously unconsolidated VIEs or to deconsolidate previously consolidated VIEs. Based upon its relationships with such entities, the Company believes that the implementation of the consolidation guidance will not have a material effect on the Company’s consolidated financial position.
In May 2003, the FASB issued SFAS No. 150 (“SFAS 150”), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 generally applies to instruments that are mandatorily redeemable, that represent obligations that will be settled with a variable number of the Company’s shares, or that represent an obligation to purchase a fixed number of the Company’s shares. For instruments within its scope, the statement requires classification as a liability with initial measurement at fair value. Subsequent measurement depends upon the certainty of the terms of the settlement (amount, timing) and whether the obligation will be settled by a transfer of assets or by issuance of a variable number of equity shares. SFAS 150 is applicable now for instruments issued since SFAS 150 was issued, and as of July 1, 2003, for instruments that predate SFAS 150’s issuance. On November 7, 2003, the FASB issued Financial Statement Position 150-3 which among other things deferred indefinitely certain portions of SFAS 150 affecting the accounting for minority interests representing non-controlling interests in finite life entities. The adoption of SFAS 150, as modified, did not have a significant effect at adoption nor is it expected to have a significant prospective impact on the Company’s financial position, results of operations or comprehensive income.
Emerging Issue Task Force 00-21 (“EITF 00-21”), Accounting for Revenue Arrangements with Multiple Deliverables, issued during the fourth quarter of 2003, provides guidance on revenue recognition for revenues derived from a single contract that contains multiple products or services. EITF 00-21 also provides additional requirements to determine when these revenues may be recorded separately for accounting purposes. EITF 00-21 did not impact our consolidated financial statements.
In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB 104”), Revenue Recognition, which supercedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind the accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of EITF 00-21. SAB 104 did not impact our consolidated financial statements.
3.
MINORITY INTEREST
Minority interest is comprised of Class A Units of limited partnership interest (“Class A Units”) and Series B Preferred Units of limited partnership interest (“Series B Preferred Units”). The Operating Partnership issued these interests to persons that contributed assets to the Operating Partnership. The Operating Partnership is obligated to redeem, at the request of a holder, each Class A Unit for cash or one Common Share, at the option of the Company. Each Series B Preferred Unit has a stated value of $50.00
and is convertible, at the option of the holder, into Class A Units at a conversion price of $28.00. The Series B Preferred Units bear a preferred distribution of 7.25% per annum, subject to an increase in the event quarterly distributions paid to holders of Common Shares exceed $0.51 per share. Income allocated to minority interest includes the amount of the Series B Preferred Unit distribution and the prorata share of net income of the Operating Partnership allocated to the Class A Units. The Company declared distributions of $7.1 million in 2003, 2002 and 2001 to the holders of Series B Preferred Units and $3.1 million in 2003, $3.3 million in 2002 and $3.7 million in 2001 to holders of Class A Units. As of December 31, 2003 and 2002, the Company had the following Class A Units and Series B Preferred Units held by third party investors:
Subsequent to December 31, 2003, the Company redeemed all of the Series B Preferred Units (see Note 20).
4.
REAL ESTATE INVESTMENTS
As of December 31, 2003 and 2002, the carrying value of the Company’s Properties is as follows:
5.
ACQUISITIONS AND DISPOSITIONS OF REAL ESTATE INVESTMENTS
The Company’s acquisitions were accounted for by the purchase method. The results of each acquired property are included in the Company’s results of operations from their respective purchase dates.
During 2003, the Company sold eight office properties containing an aggregate of approximately 343,000 net rentable square feet, two industrial properties containing an aggregate of approximately 131,000 net rentable square feet and four parcels of land containing an aggregate of approximately 24.1 acres for an aggregate of $45.6 million. In December 2003, the Company sold two office properties containing an aggregate of approximately 633,000 net rentable square feet for an aggregate of $112.8 million, of which $52.9 million of proceeds were used to pay off existing mortgage notes payable secured by the two properties. The Company retained a 20% interest in the venture that purchased the properties. The Company recognized a gain on the partial sale of approximately $18.5 million, which is recorded in net gain on sale of real estate interests due to a continuing 20% interest that the Company has maintained in the properties for the portion sold and deferred the gain on the piece retained.. The gain on sale and historical results for these properties have not been reflected as discontinued operations because of the Company’s continuing involvement. The Company also purchased five office properties containing approximately 360,000 net rentable square feet and one parcel of land containing approximately 10.0 acres for an aggregate of $67.8 million.
During 2002, the Company sold 23 office properties containing an aggregate of 1.4 million net rentable square feet, 20 industrial properties containing an aggregate of .9 million net rentable square feet and two parcels of land containing an aggregate of 12.8 acres for an aggregate of $190.8 million, realizing a net gain of $8.6 million before minority interest. The Company also purchased seven office properties containing 617,000 net rentable square feet and one parcel of land containing 9.0 acres for an aggregate of $99.1 million.
During 2001, the Company sold three office and eight industrial properties, containing 440,000 net rentable square feet, and four parcels of land, containing 15.8 acres, for $31.3 million, realizing a net gain of $4.5 million. Seven of the properties were sold for $21.6 million realizing an aggregate gain of $4.3 million, four of the properties were sold for $7.1 million, realizing an aggregate loss of $.7 million and four land parcels were sold for $2.6 million realizing an aggregate gain of $.9 million. The Company also acquired two office properties, containing 146,000 net rentable square feet, and three parcels of land, containing 36.0 acres, for $31.5 million, of which $4.2 million was satisfied with an exchange of property.
In addition to the sales and acquisitions above, the Company consummated an exchange of properties with Prentiss Properties Acquisition Partners, L.P. (“Prentiss”) during 2001. The Company acquired from Prentiss 30 properties (29 office and 1 industrial) containing 1.6 million net rentable square feet and 6.9 acres of developable land for total consideration of $215.2 million. The Company conveyed to Prentiss four office properties located in Northern Virginia that contain an aggregate of 657,000 net rentable square feet, assumed $79.7 million of mortgage debt secured by certain of the Prentiss properties, issued a $7.8 million promissory note, paid $15.9 million at closing and agreed to make additional payments totaling $7.0 million (including $5.4 million of payments discounted at 7.5%) over a three-year period subsequent to closing. The Company also contributed to Prentiss its interest in a real estate venture that owns two additional office properties that contain an aggregate of 452,000 net rentable square feet and received a combination of preferred and common units of limited partnership interest in Prentiss having a value of $10.7 million, as of the closing. In addition as part of the Prentiss transaction in June 2001, the Company purchased a 103,000 square foot building then under construction for $4.2 million and six acres of related developable land for $5.7 million.
6.
INVESTMENT IN UNCONSOLIDATED REAL ESTATE VENTURES
As of December 31, 2003, the Company had an aggregate investment of approximately $15.9 million in ten Real Estate Ventures (net of returns of investment received by the Company). The Company formed these ventures with unaffiliated third parties to develop office properties or to acquire land in anticipation of possible development of office properties. Nine of the Real Estate Ventures own ten office buildings that contain an aggregate of approximately 1.8 million net rentable square feet and one Real Estate Venture developed a hotel property that contains 137 rooms.
The Company accounts for its non-controlling interests in the Real Estate Ventures using the equity method. Non-controlling ownership interests generally range from 6% to 65%. Ownership percentages represent the Company’s entitlement to residual distributions after payments of priority returns. The Company’s investments, initially recorded at cost, are subsequently adjusted for the Company’s net equity in the ventures’ income or loss and cash contributions and distributions.
The Company’s investment in Real Estate Ventures as of December 31, 2003 is as follows (in thousands):
(1) Ownership percentage represents the Company’s entitlement to residual distributions after payments of priority returns.
(2) During 2003, the Company recorded an impairment charge of $861,000 associated with this non-operating real estate venture. This amount consisted primarily of legal and acquisition costs related to a parcel of land that ultimately was not acquired.
(3) Company’s interest consists solely of a residual profits interest.
The following is a summary of the financial position of the unconsolidated Real Estate Ventures in which the Company had investment interests as of December 31, 2003 and 2002 (in thousands):
The following is a summary of results of operations of the unconsolidated Real Estate Ventures in which the Company had interests as of December 31, 2003, 2002 and 2001 (in thousands):
The following is a summary of the financial position as of December 31, 2003 and the results of operations for the year ended December 31, 2003 for each of the unconsolidated Real Estate Ventures in which the Company had interests as of December 31, 2003 (in thousands):
As of December 31, 2003, the aggregate principal payments of non-recourse debt payable to third-parties is as follows (in thousands):
As of December 31, 2003, the Company had guaranteed repayment of approximately $17.4 million of loans on behalf of the Real Estate Ventures, including a $16.2 million guaranty that terminated in January 2004. See Item 2. Properties - Real Estate Ventures. The Company also provides customary environmental indemnities in connection with construction and permanent financing both for its own account and on behalf of its Real Estate Ventures.
7.
INDEBTEDNESS
Credit Facility
The Company utilizes credit facility borrowings for general business purposes, including the acquisition of properties and the repayment of other debt. The Company maintains a $500 million unsecured credit facility (the “Credit Facility”) that matures in June 2004. Borrowings under the Credit Facility bear interest at 30-day LIBOR (LIBOR was 1.12% at December 31, 2003) plus 1.5% per annum, with the spread over LIBOR subject to reductions from .10% to .25% or increases of .25% based on the Company’s leverage. As of December 31, 2003, the Company had $305.0 million of borrowings and $10.7 million of letters of credit outstanding under the Credit Facility, leaving $184.3 million of unused availability. The weighted-average interest rate on the Company’s unsecured credit facilities was 4.60% in 2003, 5.41% in 2002, and 6.48% in 2001.
Unsecured Term Loan
The Company also maintains a $100 million term loan. The term loan is unsecured and matures on July 15, 2005, subject to two extensions of one year each upon payment of an extension fee and the absence of any defaults at the time of each extension. There are no scheduled principal payments prior to maturity. The term loan bears interest at a spread over the one, two, three or six month LIBOR that varies between 1.05% and 1.90% per annum (1.12% as of December 31, 2003), based on the Company’s leverage ratio. The weighted-average interest rate on the Company’s term loan was 3.0% in 2003 and 3.0% in 2002.
Mortgage Notes Payable
As of December 31, 2003, the Company had $462.7 million of mortgage notes payable, secured by 93 of the Properties and certain land holdings. Fixed rate mortgages, totaling $402.3 million, require payments of principal and/or interest (or imputed interest) at rates ranging from 7.00% to 9.25% per annum and mature on dates from November 2004 through July 2027. Variable rate mortgages, totaling $60.4 million, require payments of principal and/or interest at rates ranging from 30-day LIBOR plus .76% to 1.60% per annum or 75% of prime (prime rate was 4.00% at December 31, 2003) and mature on dates from March 2004 through July 2027. The weighted-average interest rate on the Company’s mortgages was 7.09% in 2003, 7.27% in 2002, and 7.39% in 2001.
Debt Covenants
The Credit Facility and Term Loan require the maintenance of certain ratios related to minimum net worth, debt-to-total capitalization and fixed charge coverage and various non-financial covenants. As of December 31, 2003, the Company was in compliance with all debt covenants. As of December 31, 2003, the carrying value of the Company’s debt was below fair market value by approximately $85.7 million, as determined by using year-end interest rates and market conditions.
Principal Payments
The following table outlines the timing of payment requirements related to the Company’s indebtedness as of December 31, 2003:
8.
RISK MANAGEMENT AND USE OF FINANCIAL INSTRUMENTS
Risk Management
In the normal course of its on-going business operations, the Company encounters economic risk. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk on its interest-bearing liabilities. Credit risk is the risk of inability or unwillingness of tenants to make contractually required payments. Market risk is the risk of declines in the value of properties due to changes in rental rates, interest rates or other market factors affecting the valuation of properties held by the Company.
Use of Derivative Financial Instruments
The Company’s use of derivative instruments is limited to the utilization of interest rate agreements or other instruments to manage interest rate risk exposures and not for speculative purposes. The principal objective of such arrangements is to minimize the risks and/or costs associated with the Company’s operating and financial structure, as well as to hedge specific transactions. The counterparties to these arrangements are major financial institutions with which the Company and its affiliates may also have other financial relationships. The Company is potentially exposed to credit loss in the event of non-performance by these counterparties. However, because of the high credit ratings of the counterparties, the Company does not anticipate that any of the counterparties will fail to meet these obligations as they come due. The Company does not hedge credit or property value market risks.
The Company formally assesses, both at inception of the hedge and on an on-going basis, whether each derivative is highly-effective in offsetting changes in cash flows of the hedged item. If management determines that a derivative is not highly-effective as a hedge or if a derivative ceases to be a highly-effective hedge, the Company will discontinue hedge accounting prospectively.
The following table summarizes the terms and fair values of the Company’s derivative financial instruments at December 31, 2003 (in thousands).
The Company has entered into interest rate swap and rate cap agreements designated as cash flow hedges that are designed to reduce the impact of interest rate changes on its variable rate debt. At December 31, 2003, the Company had interest rate swap agreements for notional principal amounts aggregating $175 million. The swap agreements effectively fix the 30-day LIBOR interest rate on $100 million of Credit Facility borrowings at 4.230% per annum and on $75 million of Credit Facility borrowings at 4.215% per annum, in each case until June 2004. The weighted-average interest rate on borrowings under the Credit
Facility, including the effect of cash flow hedges, was 4.60% in 2003, 5.41% in 2002 and 6.48% in 2001. The interest rate cap agreement effectively limits the interest rate on a mortgage with a notional value of $28 million at 8.7% per annum until July 2004. The notional amount at December 31, 2003 provides an indication of the extent of the Company’s involvement in these instruments at that time, but does not represent exposure to credit, interest rate or market risks.
As of December 31, 2003, the maximum length of time until which the Company was hedging its exposure to the variability in future cash flows was through June 2004. There was no gain or loss reclassified from accumulated other comprehensive loss into earnings during 2003, 2002 and 2001 as a result of the discontinuance of a cash flow hedge due to the probability of the original forecasted transaction not occurring.
Over time, the unrealized gains and losses held in Other Comprehensive Income (“OCI”) will be reclassified to earnings in the same period(s) in which the hedged items are recognized in earnings. The current balance held in OCI is expected to be reclassified to earnings over the lives of the current hedging instruments, or for realized losses on forecasted debt transactions, over the related term of the debt obligation, as applicable. The Company expects that $3.0 million of net hedging losses will be reclassified into earnings over the next twelve months.
Concentration of Credit Risk
Concentrations of credit risk arise when a number of tenants related to the Company’s investments or rental operations are engaged in similar business activities, or are located in the same geographic region, or have similar economic features that would cause their inability to meet contractual obligations, including those to the Company, to be similarly affected. The Company regularly monitors its tenant base to assess potential concentrations of credit risk. Management believes the current credit risk portfolio is reasonably well diversified and does not contain any unusual concentration of credit risk. No tenant accounted for 10% or more of the Company’s rents during 2003, 2002 and 2001. See Note 12 for geographic segment information.
9.
DISCONTINUED OPERATIONS
For the years ended December 31, 2003, 2002 and 2001, income from discontinued operations relates to 53 properties containing approximately 2.7 million net rentable square feet that the Company sold between January 1, 2002 and December 31, 2003 and two properties containing approximately 82,000 net rentable square feet that the Company has designated as “held-for-sale” as of December 31, 2003. The following table summarizes information for two properties designated as held-for-sale as of December 31, 2003 and December 31, 2002:
The following table summarizes revenue and expense information for the 53 properties sold since January 1, 2002 and the two properties designated as held-for-sale as of December 31, 2003 (in thousands):
In 2002, the Company recorded an impairment charge of $665,000 in its consolidated statements of operations related to one of the assets held-for-sale.
Discontinued operations have not been segregated in the consolidated statements of cash flows. Therefore, amounts for certain captions will not agree with respective data in the Consolidated Statements of Operations.
10.
PREFERRED SHARES AND BENEFICIARIES’ EQUITY
In 1998, the Company issued $37.5 million of convertible preferred shares with a 7.25% coupon rate (the Series A Preferred Shares). Each Series A Preferred Share has a stated value of $50.00 and is convertible into Common Shares, at the option of the holder, at a conversion price of $28.00. The Series A Preferred Shares distribution is subject to an increase, if quarterly distributions paid to Common Share holders exceeds $0.51 per share. The Series A Preferred Shares are perpetual and may be redeemed, at the Company’s option, at par beginning in January 2004.
In 1999, the Company issued $105.0 million of convertible preferred shares with an 8.75% coupon rate (the Series B Preferred Shares) for net proceeds of $94.8 million. Each Series B Preferred Share was convertible into one Common Shares and was entitled to quarterly dividends equal to the greater of $0.525 per share or the quarterly dividend on a Common Share. As part of the transaction in which the Company issued Series B Preferred Shares, the Company issued the holder of the Series B Preferred Shares seven-year warrants exercisable for 500,000 Common Shares at an exercise price of $24.00 per share.
On December 30, 2003, the holder converted 1,093,750 shares of the Series B Preferred Shares into 1,093,750 Common Shares, and the Company redeemed the remaining 3,281,250 Series B Preferred Shares at $27.50 per share for approximately $90.2 million (plus accrued distributions thereon for the period from October 1, 2003 through the redemption date) and purchased 250,000 warrants with an exercise price of $24.00 per share for approximately $1.2 million. The Company incurred a charge of $20.6 million associated with the redemption/conversion of the Series B Preferred Shares.
On December 30, 2003, the Company also issued 2,000,000 shares of 7.50% Series C Cumulative Redeemable Preferred Shares for net proceeds of $48.1 million. The Series C Preferred Shares are perpetual. The Company may not redeem Series C Preferred Shares before December 30, 2008 except to preserve its REIT status. On or after December 30, 2008, the Company, at its option, may redeem Series C Preferred Shares, in whole or in part, by paying $25.00 per share plus accrued but unpaid dividends.
The Company’s Board of Trustees has approved a share repurchase program authorizing the Company to repurchase up to 4,000,000 of its outstanding Common Shares. Through December 31, 2003, the
Company had repurchased 3.2 million of its Common Shares at an average price of $17.75 per share. Under the share repurchase program, the Company has the authority to repurchase an additional 762,000 shares. No time limit has been placed on the duration of the share repurchase program. The following table summarizes the share repurchases during the three years ended December 31, 2003:
The following table summarizes the Class A Units tendered for redemption in cash during the three years ended December 31, 2003:
At December 31, 2003, 362,321 unvested restricted Common Shares were held by employees of the Company. The restricted shares, valued at $18.4 million at issuance, are amortized over their respective vesting periods of three to eight years from dates of the original award. The Company recorded compensation expense of $2.6 million in 2003, $2.5 million in 2002 and $2.8 million in 2001 related to these shares.
As of December 31, 2003, there were warrants outstanding exercisable for 250,000 Common Shares at an exercise price of $24.00.
11.
STOCK BASED COMPENSATION AND EMPLOYEE BENEFITS
The Company maintains a plan that authorizes the issuance of various equity-based awards including incentive stock options. The terms and conditions of option awards are determined by the Board of Trustees. Incentive stock options may not be granted at exercise prices less than fair value of the stock at the time of grant. Options granted by the Company generally vest over two to five years. All options awarded by the Company to date are non-qualified stock options. As of December 31, 2003, the Company is authorized to issue five million equity-based awards of which 1.3 million shares remain available for future issuance under the plan.
The following table summarizes option activity for the three years ended December 31, 2003:
The following table summarizes stock options outstanding as of December 31, 2003:
The following table summarizes stock options outstanding as of December 31, 2003:
Based on the Black-Scholes option pricing model, the estimated weighted-average fair value of stock options granted was $2.51 in 2002. Assumptions made in determining estimates of fair value include: risk-free interest rate of 2.7% in 2002, a volatility factor of .280 in 2002, a dividend yield of 8.4% in 2002, and a weighted-average life expectancy of 3 years in 2002.
Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, prospectively for all employee awards granted, modified, or settled after January 1, 2002 (see Note 2). Accordingly, the Company recorded compensation expense of $104,000 in 2003 and $43,000 in 2002. This compensation expense relates to the Company’s grant of 100,000 stock options during 2002.
The Company sponsors a 401(k) defined contribution plan for its employees. Each employee may contribute up to 100% of annual compensation, subject to specific limitations under the Internal Revenue Code. At its discretion, the Company can make matching contributions equal to a percentage of the employee’s elective contribution and profit sharing contributions. Employees vest in employer contributions over a three-year service period. The Company contributions were $821,000 in 2003, $816,000 in 2002 and $669,000 in 2001.
12.
SEGMENT INFORMATION
The Company currently manages its portfolio within three segments: (1) Pennsylvania, (2) New Jersey and (3) Virginia. Corporate is responsible for cash and investment management and certain other general support functions.
Segment information for the three years ended December 31, 2003, 2002 and 2001 is as follows (in thousands):
Net operating income is defined as total revenue less property operating expenses and real estate taxes. Below is reconciliation of consolidated net operating income to consolidated income from continuing operations:
13.
NET INCOME PER COMMON SHARE
The following table details the number of shares and net income used to calculate basic and diluted earnings per share for the three years ended December 31, 2003 (in thousands, except per share amounts):
Securities totaling 6,558,632 in 2003, 11,256,776 in 2002 and 11,622,922 in 2001 were excluded from the earnings per share computations above as their effect would have been antidilutive. Certain preferred equity and preferred operating partnership units would participate in earnings at certain levels whether or not distributed. These thresholds have not been met in years presented and therefore, no additional participation has occurred.
14.
DISTRIBUTIONS (UNAUDITED):
15.
RELATED-PARTY TRANSACTIONS
In 1998, the Board authorized the Company to make loans totaling up to $5.0 million to enable employees of the Company to purchase Common Shares at fair market value. The loans have five-year terms, are full recourse, and are secured by the Common Shares purchased. Interest, payable quarterly, accrues on the loans at the lower of the interest rate borne on borrowings under the Company’s Credit Facility or a rate based on the dividend payments on the Common Shares. As of December 31, 2003, the interest rate was 2.62% per annum. The loans are payable at the earlier of the stated maturity date or 90 days following the employee’s termination. As of December 31, 2003, the outstanding balance of these loans totaled $1.5 million and were secured by an aggregate of 85,163 Common Shares.
The Company owns 384,615 shares of US Realtel, Inc. (“USR”) Common Stock and holds warrants exercisable for 600,000 additional shares. The warrants have an exercise price of $8.00 per share and expire on December 31, 2004. In addition, the Company held warrants exercisable for 123,077 shares at an exercise price of $3.25, and these warrants expire on August 15, 2005. As of December 31, 2003, the Company’s recorded value for its investment in USR was $1.1 million. An officer of the Company holds a position on USR’s Board of Directors.
In February 2000, the Company loaned an aggregate of $2.5 million to two executive officers to enable them to purchase Common Shares of the Company. One loan had a four-year term and bears interest at the lower of the Company’s cost of funds or a rate based on the dividend payable on the Common Shares, but not to exceed 10% annum. This loan was subject to forgiveness over a three-year period, with the amount of forgiveness tied to the Company’s total shareholder return compared to the total shareholder return of peer group companies. This loan was also subject to forgiveness in the event of a change of control of the Company. This loan was reflected as a reduction in beneficiaries equity. In 2001, the Company recorded a $4.1 million charge to restructure the other loan in connection with the executive’s transition to a non-executive, non-managerial status. Principal and interest totaling $1.0 million was forgiven related to these loans in 2003 and $.9 million in 2002 and 2001.
In connection with the sale by the Company of a land parcel in 2003, the Company paid a $42,000 commission to Kevin Nichols, son of Anthony A. Nichols, Sr., Chairman of the Board of the Company, for brokerage services relating to the sale.
Robert Larson, a Trustee of the Company, is a managing director of Lazard Freres & Co. LLC (“Lazard”). The Company paid Lazard a fee of approximately $909,000 for investment banking services related to the Company’s sale of two office properties to a Real Estate Venture in the fourth quarter of 2003.
16.
OPERATING LEASES
The Company leases properties to tenants under operating leases with various expiration dates extending to 2020. As of December 31, 2003, leases covering approximately 1.8 million square feet or 12.8% of the net rentable square footage are scheduled to expire during 2004. Minimum future rentals on non-cancelable leases at December 31, 2003 are as follows (in thousands):
Total minimum future rentals presented above do not include amounts to be received as tenant reimbursements for increases in certain operating costs.
17.
SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
The following is a summary of quarterly financial information as of and for the years ended December 31, 2003 and 2002 (in thousands, except per share data):
The summation of quarterly earnings per share amounts do not necessarily equal year to date amounts.
18.
COMMITMENTS AND CONTINGENCIES
Legal Proceedings
The Company is involved from time to time in litigation on various matters, including disputes with tenants and disputes arising out of agreements to purchase or sell properties. Given the nature of the Company’s business activities, these lawsuits are considered routine to the conduct of its business. The result of any particular lawsuit cannot be predicted, because of the very nature of litigation, the litigation process and its adversarial nature, and the jury system.
The Company is a defendant in a case in which the plaintiffs allege that the Company breached its obligation to purchase a portfolio of properties of approximately $83.0 million. On July 9, 1999, the Superior Court of New Jersey, Camden County, dismissed the complaint against the Company with prejudice. Plaintiffs subsequently filed a motion for reconsideration, which motion the Superior Court denied. Plaintiffs then appealed to the Appellate Division, which is the intermediate appellate level court in New Jersey. In December 2000, the Appellate Division affirmed in part and reversed in part the Chancery Division’s earlier dismissal of the entire action. The Appellate Division affirmed the dismissal of the non-contractual counts in the Complaint, but reversed the contract and reformation counts and remanded these to the lower court for further proceedings. The Company sought review of this decision by the Supreme Court of New Jersey, but that Court declined to consider the appeal. The case thereafter returned to the Chancery Division, where written and oral discovery were conducted in 2002 and in the first quarter of 2003. Discovery terminated on February 14, 2003. The Company filed a motion for summary judgment seeking dismissal of all counts against it, and judgment for the Company on our counterclaim. The Chancery Division granted the Company’s summary judgment motion on March 25, 2003 and dismissed the case with prejudice. Plaintiffs appealed the judgment in our favor, and the Company does not know whether plaintiffs will be successful in their appeal.
There have been recent reports of lawsuits against owners and managers of multifamily and office properties asserting claims of personal injury and property damage caused by the presence of mold in residential units or office space. The Company has been named as a defendant in two lawsuits that allege personal injury as a result of the presence of mold. Unspecified damages are sought. The Company has referred these lawsuits to its environmental insurance carrier and, as of the date of this Form 10-K, the insurance carrier is tendering a defense to these claims.
Letters-of-Credit
In connection with certain mortgages, the Company is required to maintain leasing and capital reserve accounts with the mortgage lenders through letters-of-credit which totaled $11.5 million at December 31, 2003. The Company is also required to maintain escrow accounts for taxes, insurance and tenant security
deposits that amounted to $14.4 million at December 31, 2003. The related tenant rents are deposited into the loan servicer’s depository accounts, which are used to fund debt service, operating expenses, capital expenditures and the escrow and reserve accounts, as necessary. Any excess cash is included in cash and cash equivalents.
Other Commitments
As of December 31, 2003, the Company owned 446 acres of land for future development and held options to purchase 61 additional acres.
19.
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The following table details the components of accumulated other comprehensive income (loss) as of and for the three years ended December 31, 2003 (in thousands):
20.
SUBSEQUENT EVENTS
On January 12, 2004, the Company sold 2,645,000 Common Shares in an underwritten public offering for net proceeds (net of transaction costs) of $69.3 million.
On February 3, 2004, the Company entered into an agreement to redeem 1,950,000 Series B Preferred Units, with a stated aggregate value of $97.5 million, on or before March 15, 2003 for an aggregate price of $93.0 million plus accrued but unpaid dividends from January 1, 2004. The Company subsequently redeemed all of such Units.
On February 27, 2004, the Company sold 2,300,000 7.375% Series D Cumulative Redeemable Preferred Shares, each with a liquidation preference of $25.00 per share in an underwritten public offering for net proceeds (net of transaction costs) of $55.5 million.
On March 3, 2004, the Company sold 1,840,000 Common Shares in an underwritten public offering for net proceeds (net of transaction costs) of $50.7 million.
Brandywine Realty Trust
Schedule II
Valuation and Qualifying Accounts
(in thousands)
Brandywine Realty Trust
Schedule III
Real Estate and Accumulated Depreciation
(in thousands)
Brandywine Realty Trust
Schedule III
Real Estate and Accumulated Depreciation
(in thousands)
Brandywine Realty Trust
Schedule III
Real Estate and Accumulated Depreciation
(in thousands)
Brandywine Realty Trust
Schedule III
Real Estate and Accumulated Depreciation
(in thousands)
Brandywine Realty Trust
Schedule III
Real Estate and Accumulated Depreciation
(in thousands)
(a) Reconciliation of Real Estate:
The following table reconciles the real estate investments from January 1, 2002 to December 31, 2003 (in thousands):
(b) Reconciliation of Accumulated Depreciation:
The following table reconciles the accumulated depreciation on real estate investments from January 1, 2003 to December 31, 2003 (in thousands):