ITEM 1. BUSINESS
Our Company
Sentio Healthcare Properties, Inc., (formerly Cornerstone Healthcare Plus REIT, Inc.) a Maryland corporation (the “Company”), was formed on October 16, 2006 under the General Corporation Law of Maryland for the purpose of engaging in the business of investing in and owning commercial real estate. As used in this report, the “Company”, “we”, “us” and “our” refer to Sentio Healthcare Properties, Inc. and its consolidated subsidiaries, except where context otherwise requires. We have qualified, and intend to continue to qualify, as a real estate investment trust (“REIT”) for federal tax purposes.
We are structured as an umbrella partnership REIT, referred to as an “UPREIT,” under which substantially all of our current and future business is, and will be, conducted through a majority owned subsidiary, Sentio Healthcare Properties OP, L.P (formerly known as Cornerstone Healthcare Plus Operating Partnership, L.P.), a Delaware limited partnership, formed on October 17, 2006. We are the sole general partner of the operating partnership and have control over its affairs.
Our external advisor, Sentio Investments, LLC, (formerly SpringLake Healthcare Capital, LLC) a Florida limited liability company (our “Advisor”), was formed on December 20, 2011 for the purpose of acting as our Advisor. The Advisor is responsible for managing our affairs on a day-to-day basis and for identifying and making acquisitions and investments on our behalf under the terms of an advisory agreement. Our Advisor has contractual and fiduciary responsibilities to us and our stockholders. Under the terms of the advisory agreement, our Advisor will use commercially reasonable efforts to present to us investment opportunities and to provide a continuing and suitable investment program consistent with the investment policies and objectives adopted by our board of directors. Currently, we have no direct employees and all management and administrative personnel responsible for conducting our business are employed by our Advisor and its affiliates.
On June 20, 2008, we commenced an initial public offering of up to 50,000,000 shares of our common stock, consisting of 40,000,000 shares for sale pursuant to a primary offering and 10,000,000 shares for sale pursuant to our distribution reinvestment plan. We stopped making offers under our initial public offering on February 3, 2011 after raising gross offering proceeds of $123.9 million from the sale of 12.4 million shares, including shares sold under the distribution reinvestment plan.
On February 4, 2011, the U.S. Securities and Exchange Commission (“SEC”) declared the registration statement for our follow-on offering effective and we commenced a follow-on offering of up to 55,000,000 shares of our common stock, consisting of 44,000,000 shares for sale pursuant to a primary offering and 11,000,000 shares for sale pursuant to our dividend reinvestment plan. As of December 31, 2011, we had sold a total of 12.7 million shares of our common stock pursuant to our initial and follow-on public offerings for aggregate gross proceeds of $127.0 million.
On April 29, 2011 we informed our stockholders that the Independent Directors Committee of our board of directors had directed us to suspend our follow-on offering, our dividend reinvestment program and our stock repurchase program (except repurchases due to death) because of the uncertainty associated with our Independent Directors Committee consideration of various strategic alternatives to enhance our stockholders’ value. On October 18, 2011, we announced that the Independent Directors Committee had suspended its analysis of strategic alternatives for the Company and concluded that the Company is well positioned as an investment program with a continued focus on healthcare real estate. The Independent Directors Committee identified strategies in its evaluation process that it
believes will enhance this position and is implementing operating changes designed to increase portfolio cash flow and increase shareholder value. In particular, the Company will focus on portfolio performance, identifying investment and financing opportunities, implementing operational efficiencies and the potential for growth in the future. As of December 31, 2011, sales pursuant to our follow-on offering remained suspended.
Investment Objectives
Our investment objectives are to:
•
preserve stockholder capital by acquiring and operating real estate;
•
realize growth in the value of your investment by:
•
purchasing stabilized, income-producing properties with the potential for capital appreciation and
•
profiting from the purchase, development or repositioning of other properties;
•
provide stockholders with current income from the operations of the properties we acquire, including the income from properties we develop or reposition (redevelop or employ other asset-management strategies to enhance existing cash flow) once they are stabilized (no longer in the lease-up stage following development or redevelopment and substantially leased); and
•
provide long-term liquidity to our stockholders within seven years of the termination of our primary public offering after accomplishing the above objectives by:
•
liquidating our assets,
•
listing our shares on a national securities exchange,
•
another liquidity event such as a merger with another company or
•
expanding our proposed stock repurchase program to redeem upon stockholder request up to 10% of our prior-year outstanding shares utilizing proceeds from the sale of our properties or other sources of funds irrespective of the amount of proceeds raised under our distribution reinvestment plan.
We intend to use the net proceeds of our offering to primarily invest in existing leased properties as well as other properties where we believe there are opportunities to enhance cash flow and value. We cannot assure you that we will attain these objectives or that our capital will not decrease. We may not change our investment policies or the investment restrictions described below except upon approval of the independent directors committee. Decisions relating to the purchase or sale of properties will be made by our Advisor, subject to approval by our board of directors.
We currently own three completed properties and one development property through joint ventures and we may acquire additional properties through joint venture investments in the future. This is one of the ways we anticipate diversifying the portfolio of properties we own in terms of geographic region, property type and tenant industry group. Joint ventures will also allow us to acquire an interest in a property without requiring that we fund the entire purchase price. In determining whether to recommend a particular joint venture investment, our Advisor will evaluate the structure of the joint venture, the real property that the joint venture owns or will acquire using the same criteria for the selection of our other real estate investments.
Investment Strategy
Our independent directors committee will review our investment policies at least annually to determine whether these policies continue to be in the best interest of our stockholders. We may change our investment policies without stockholder approval. Our Advisor will recommend property acquisitions to our investment committee, which will approve or reject proposed acquisitions.
Our objective is to acquire a long-term stabilized portfolio of real estate properties from the proceeds of our offering that consists of at least 50% core plus properties. The attributes associated with Core Plus Properties are outlined in Acquisition Policies. We may
acquire value-added and opportunistic properties. We may utilize our offering proceeds to acquire more value-added and opportunistic properties than core plus properties, with a view to achieving a more balanced portfolio of properties through a combination of development efforts, refinancings and subsequent acquisitions.
We intend for our investments in real estate assets to be concentrated in the healthcare sector. To date, our investments have been exclusively in the healthcare sector.
Healthcare real estate includes a variety of property types, including senior housing facilities, medical office buildings, hospital facilities, skilled nursing facilities and outpatient centers. According to The National Coalition on Healthcare, by 2016 nearly $1 in every $5 in the U.S. will be spent on healthcare, and the aging US population is expected to continue to fuel the need for healthcare services. The over age 65 population of the United States is projected to grow 36% between 2010 and 2020, compared with 9% for the general population, according to the US Census Bureau. Presently, the healthcare real estate market is fragmented, with a local or regional focus, offering opportunities for consolidation and market dominance. A diversified portfolio of healthcare property types minimizes risks associated with third-party payors, such as Medicare and Medicaid.
Our Advisor believes that investment opportunities in healthcare properties are ordinarily not readily available to investors other than large institutional investors and experienced real estate operators with specialized knowledge, experience in specific geographic areas, industry expertise and established relationships with operators of these property types.
Although we intend to focus on acquiring and developing a portfolio of healthcare properties, we may also invest in other real estate-related assets that we believe may assist us in meeting our investment objectives. Our charter limits our investments in unimproved real property or mortgage loans on unimproved real property to 10% of our total assets, but we are not otherwise restricted in the proportion of net proceeds from this offering that we must allocate to investment in any specific type of property. We do not expect to engage in the underwriting of securities of other issuers.
Acquisition Policies
Core Plus Properties
We expect to use a significant portion of the net proceeds from our offering to invest in “core plus” investment grade properties that are:
•
owned and operated with a low to moderate level of permanent mortgage financing;
•
of a high-quality and currently producing income;
•
leased to a diversified tenant base, though we are not restricted from investing in properties occupied by a single tenant if the property meets other key investment criteria or to a single tenant/operator for certain healthcare properties;
•
leased on terms that generally allow for annual rental increases, and
•
operated by companies that specialize in the specific healthcare service being delivered at a specific community,
Value-Added and Opportunistic Properties
Value-Added Properties
We may acquire “value-added” properties, which include properties that are currently under construction and/or have existing building structures in need of redevelopment, re-leasing or repositioning. We may acquire properties with low occupancy rates or vacant properties when we believe our leasing or development efforts could add significant value. We may seek to acquire a portion of our value-added properties through joint ventures with large institutional partners, but we are not obligated to do so. Our value-added properties will employ moderate to high levels of indebtedness, which will be determined on a property-by-property basis. Our long-term investment objective for investment in value-added properties is to develop and transform these properties into the same type of core plus property investments with lower levels of permanent mortgage indebtedness as described above.
Opportunistic Properties
We also may acquire opportunistic properties. We define “opportunistic” properties primarily as unimproved land that we will develop. We will construct or develop the property through the use of third-parties or through developers affiliated with our Advisor. If an affiliated developer is used, we may coinvest with institutional investors. However, we have no agreements with institutional investors to acquire any opportunistic properties at this time. We will invest in opportunistic properties with a view of developing a core plus property. Similar to our value-added properties, we expect to incur a moderate to high level of indebtedness when acquiring opportunistic properties, but with the long-term goal of developing the property into a core plus property with a lower level of permanent mortgage indebtedness. The development of properties is subject to risks relating to a builder’s ability to control construction costs or to build in conformity with plans, specifications and timetables. We may help ensure performance by the builders of properties that are under construction at the price contracted by obtaining either a performance bond or completion bond. As an alternative to a performance bond or completion bond, we may rely upon the substantial net worth of the contractor or developer or a personal guarantee provided by a high net worth affiliate of the person entering into the construction or development contract. Our opportunistic property acquisitions will generally be located in growth areas within our target markets.
Target Market Criteria
We intend to acquire properties located in markets with strong fundamentals and strong supply and demand dynamics throughout the United States. Among the most important criteria we expect to use in evaluating the markets in which we purchase properties are:
•
historic and projected population growth;
•
historically high levels of tenant demand and lower historic investment volatility for the type of property being acquired;
•
markets with historic and growing numbers of qualified and affordable workforce;
•
historic market liquidity for buying and selling of commercial real estate;
•
stable household income and economic conditions; and
•
sound real estate fundamentals, such as high occupancy rates and potential for increasing rental rates.
Leases and Tenant Improvements
For our investments in multi-tenant medical office buildings we expect that a portion of any tenant improvements to be funded by us for newly acquired properties will be funded from the net proceeds of the offering or through borrowings. Additionally, when a tenant or resident at one of our properties vacates its space, it is likely that we will be required to expend funds for tenant improvements and refurbishments to the vacated space in order to attract new tenants. If we do not have adequate cash on hand to fund tenant improvements and refurbishments, we may use debt financing in order to fulfill our obligations under lease agreements with new tenants.
Mortgages, Debt Securities and Other Real Estate-Related Investments
Although we expect that substantially all of our acquisitions will be of the types of properties described above, we may acquire other investments, including mortgages and other illiquid real estate-related securities. To the extent that our Advisor determines that it is advantageous for us to make or acquire mortgage loans or other real estate-related investments, we will seek to obtain fixed income through the receipt of payments from these investments. If we invest in mortgages and other real estate-related investments, we do not expect that we would invest more than 20% of our long-term stabilized asset portfolio in such investments.
Our charter does not limit the amount of gross offering proceeds that we may apply to mortgage loans or other real estate-related investments and during the early stages of this offering, the percentage of our assets invested in these investments may exceed 20% of our total assets. While we have no intention of becoming a mortgage REIT, we may acquire or make the following:
•
first and second mortgages;
•
convertible mortgages;
•
construction loans on real estate;
•
mortgage loan participation investments;
•
common, preferred and convertible preferred equity securities issued by real estate companies;
•
mezzanine and bridge loans; and
•
other illiquid real estate-related securities.
Joint Ventures and Other Arrangements
We currently own three completed properties and one development property through joint ventures and we may acquire additional properties through joint venture investments in the future, including ventures with affiliates of our Advisor. See “Conflicts of Interest.” Among other reasons, we anticipate acquiring properties through joint ventures in order to diversify our portfolio of properties in terms of geographic region, property type and tenant industry group. Joint ventures may also allow us to acquire an interest in a property without requiring that we fund the entire purchase price. In addition, certain properties may be available to us only through joint ventures. In determining whether to recommend a particular joint venture, the advisor will evaluate the structure of the joint venture, the real property that such joint venture owns or is being formed to own under the same criteria described elsewhere in this prospectus. These entities may employ debt financing consistent with our borrowing policies. See “Borrowing Policies” below. Our joint ventures may take the form of equity joint ventures with one or more large institutional partners. They may also include ventures with developers who contribute land, development services and expertise rather than equity. Currently, we have no commitments or agreements to acquire any additional properties or enter into any additional joint ventures and we have not established the specific terms we will require in the joint venture agreements we may enter. We will establish the terms with respect to any particular joint venture agreement on a case-by-case basis.
We may enter into joint ventures with affiliates of our Advisor for the acquisition of properties, but only if the independent directors committee (by majority vote) approves the transaction as being fair and reasonable to us and on substantially the same terms and conditions as those received by the affiliated equity joint venturers. If such a joint venture also involves a third party that negotiated the terms of its participation on an arms-length basis, then our investment must be either on terms and conditions no worse than those received by the affiliate or on terms and conditions no worse than those received by a third-party equity joint venturer that negotiated the terms of its participation on an arms-length basis.
Borrowing Policies
Debt Financing
When we refer to debt financing, we are referring to all types of debt financing at fixed or variable interest rates or some combination of both. For our stabilized core plus properties, our long-term goal will be to use low to moderate levels of debt financing with leverage ranging from 50% to 65% of the value of the asset. For the value-added and opportunistic properties, our goal will be to acquire and develop or redevelop these properties using moderate to high levels of debt financing with leverage ranging from 65% to 75% of the cost of the asset. We may exceed these debt levels on an individual property basis. Once these value-added and opportunistic properties are developed, redeveloped and stabilized with tenants, we plan to reduce the levels of debt to fall within target debt ranges appropriate for core plus properties. While we seek to fall within the outlined targets on a portfolio basis, for any specific property we may exceed these estimates. While we do not expect to utilize debt financing in excess of 300% of our net assets (equivalent to 75% of the cost of our tangible assets), upon the vote of a majority of our independent directors, we will be able to temporarily exceed this debt limitation. It is likely that our debt financing will be secured by the underlying property, but it will not necessarily be the case each time. We may enter into interest rate protection agreements to mitigate interest rate fluctuation exposure if we believe the benefit of such contracts outweigh the costs of purchasing these instruments.
Other Indebtedness
We may also incur indebtedness for working capital requirements, tenant improvements, capital improvements, leasing commissions and, if necessary, to make distributions, including those necessary to maintain our qualification as a REIT for federal income tax purposes. We will endeavor to borrow such funds on an unsecured basis but we may secure indebtedness with properties if our independent directors committee determines that it is in our best interests.
Our Advisor may also create an affiliated entity that will purchase properties using debt financing and hold them for us pending our ability to acquire the properties at a low to moderate level of indebtedness. Any properties that we purchase from the affiliated acquisition holding company will meet our core plus investment criteria and be approved by our independent directors committee. Our purchase price for the property would reflect the costs associated with holding the property. In no event will we acquire the property at an amount in excess of its current appraised value as determined by an independent expert selected by our independent directors not otherwise interested in the transaction.
Competition
We compete with a considerable number of other real estate companies seeking to acquire, develop and reposition commercial real estate many of which may have greater marketing and financial resources than we do. Principal factors of competition in our business are the quality of properties (including the design and condition of improvements), leasing terms (including rent and other charges and allowances for tenant improvements), attractiveness and convenience of location, the quality and breadth of tenant services provided and reputation as an owner and operator of quality properties in the relevant sector and market. Our ability to compete also depends on, among other factors, trends in the national and local economies, financial condition and operating results of current and prospective tenants, availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation and population trends.
We may hold interests in properties located in the same geographic locations as other entities managed by our Advisor or our Advisor’s affiliates. Our properties may face competition in these geographic regions from such other properties owned, operated or managed by other entities managed by our Advisor or our Advisor’s affiliates. Our Advisor or its affiliates have interests that may vary from those we may have in such geographic markets.
Government Regulations
We, the properties that we own, and the properties we expect to own are subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Federal laws such as the National Environmental Policy Act, the Comprehensive Environmental Response, Compensation, and Liability Act, the Resource Conservation and Recovery Act, the Federal Water Pollution Control Act, the Federal Clean Air Act, the Toxic Substances Control Act, the Emergency Planning and Community Right to Know Act and the Hazard Communication Act govern such matters as wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials and the remediation of contamination associated with disposals. Some of these laws and regulations impose joint and several liabilities on tenants, owners or operators for the costs to investigate or remediate contaminated properties, regardless of fault or whether the acts causing the contamination were legal. Compliance with these laws and any new or more stringent laws or regulations may require us to incur material expenditures. Future laws, ordinances or regulations may impose material environmental liability. In addition, there are various federal, state and local fire, health, life-safety and similar regulations with which we may be required to comply, and which may subject us to liability in the form of fines or damages for noncompliance.
Our properties may be affected by our tenants’ operations, the existing condition of land when we buy it, operations in the vicinity of our properties, such as the presence of underground storage tanks, or activities of unrelated third parties. The presence of hazardous substances, or the failure to properly remediate these substances, may make it difficult or impossible to sell or rent such property.
The healthcare industry is highly regulated by federal, state and local licensing requirements, facility inspections, reimbursement policies, regulations concerning capital and other expenditures, certification requirements and other laws, regulations and rules. In addition, regulators require compliance with a variety of safety, health, staffing and other requirements relating to the design and conditions of the licensed facility and quality of care provided. Additional laws and regulations may be enacted or adopted that could require changes in the design of properties and certain operations of our tenants and third-party operators. The failure of any tenant or operator to comply with such laws, requirements and regulations could affect a tenant’s or operator’s ability to operate the facilities that we own.
One of our properties is a skilled nursing facility where the property operator receives most of its revenues from Medicare and Medicaid, with the balance representing private pay, including private insurance. Consequently, changes in federal, state or local
reimbursement policies may also adversely affect an operator’s ability to cover its expenses, including our rent or debt service. Skilled nursing facilities and hospitals are subject to periodic pre- and post-payment reviews and other audits by federal and state authorities. A review or audit of claims of a property operator could result in recoupments, denials or delays of payments in the future, which could have a material adverse effect on the operator’s ability to meet its obligations to us.
Acquisition Activity
At December 31, 2011, we owned 15 properties. All of these properties are consolidated into our accompanying consolidated financial statements and included in the properties summary as provided under “Item 2 Properties” referenced below.
We have acquired our properties to date with a combination of the proceeds from our public offerings and debt incurred upon the acquisition of such properties.
As of December 31, 2011, we operated in three reportable business segments: senior living operations, triple-net leased properties, and medical office building. Financial Information by segment is presented in Note 12 to our accompanying consolidated financial statements, which begin on page of this Form 10-K.
Employees
We have no employees and our executive officers are all employees of our Advisor’s affiliates. Substantially all of our work is performed by employees of our Advisor. We are dependent on our Advisor for certain services that are essential to us, including the identification, evaluation, negotiation, purchase and disposition of properties; the oversight and management of the daily operations of our real estate portfolio; and other general and administrative responsibilities. In the event that our Advisor was unable to provide these services, we will be required to obtain such services from other sources.
Available Information
Information about us is available on our website (http://www.sentiohealthcareproperties.com). We make available, free of charge, on our Internet website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with the SEC. These materials are also available at no cost in print to any person who requests it by contacting our Investor Services Department at 189 South Orange Avenue, Suite 1700, Orlando, Florida 32801; telephone (407) 999-7679. Our filings with the SEC are available to the public over the Internet at the SEC’s website at http://www.sec.gov. You may read and copy any filed document at the SEC’s public reference room in Washington, D.C. at 100 F Street, N.E., Room 1580, Washington D.C. Please call the SEC at (800) SEC-0330 for further information about the public reference rooms.
ITEM 1A.
ITEM 1A. RISK FACTORS
The risks and uncertainties described below can adversely affect our business, operating results, prospects and financial condition. These risks and uncertainties could cause our actual results to differ materially from those presented in our forward looking statement.
General
Continued disruptions in the financial markets and uncertain economic conditions could adversely affect our ability to secure debt financing on attractive terms and the values of the investments we make.
Despite improved access to capital for some companies, the capital and credit markets continue to be affected significant volatility and disruption during the past several years. The health of the global capital markets remains a concern. The banking industry has been experiencing improved earnings, but the relatively low growth economic environment has caused the markets to question whether financial institutions are truly appropriately capitalized. The downgrade of the U.S. government debt has increased these concerns, especially for the larger, money center banks. Smaller financial institutions have continued to work with borrowers to amend and extend existing loans; however, as these loans reach maturity, there is the potential for future credit losses. The FDIC’s list of troubled financial institutions is still quite large and the threat of more bank closings will weigh heavily on the financial markets.
New lending is expected to remain subdued in the near term. We intend to rely on debt financing to finance our properties. As a result of the credit market turmoil, we may not be able to obtain debt financing at attractive terms. As such, we may be forced to use a
greater proportion of equity to finance our acquisitions, reducing the number of acquisitions we would otherwise make. If the current debt market environment persists we may modify our investment strategy in order to optimize our portfolio performance. Our options would include limiting or eliminating the use of debt and focusing on those higher yielding investments that do not require the use of leverage to meet our portfolio goals
Further disruptions in the financial markets and uncertain economic conditions could adversely affect the values of our investments. Turmoil in the capital markets has constrained equity and debt capital available for investment in real estate, resulting in fewer buyers seeking to acquire properties and possible increases in capitalization rates and lower property values. Furthermore, declining economic conditions could negatively impact real estate fundamentals and result in lower occupancy, lower rental rates and declining values in real estate that we own or may acquire. These could have the following negative effects on us:
•
the values of our investments in commercial properties could decrease below the amounts we paid for the investments;
•
revenues from our properties could decrease due to lower occupancy rates, reduced rental rates and potential increases in uncollectible receivables;
•
we may not be able to refinance our indebtedness or to obtain additional debt financing on attractive terms.
These factors could impair our ability to make distributions to and decrease the value of our stockholders’ investment in us.
Our limited operating history makes it difficult for you to evaluate us. In addition, as a company in its early stages of operations we have incurred losses in the past and may continue to incur losses.
We have a limited operating history. We cannot assure our stockholders that we will be able to operate our business successfully or implement our operating policies and strategies described in our prospectus. Our stockholders should not assume that our performance will be similar to the past performance of other real estate investment programs sponsored by affiliates of our sponsors. As a consequence, our past performance and the past performance of other real estate investment programs sponsored by affiliates of our advisor may not be indicative of the performance we will achieve. We were formed on October 16, 2006 in order to invest primarily in healthcare, industrial and net-leased retail real estate. We have acquired thirteen properties as of the date of this report and generated limited income, cash flow, funds from operations or funds from which to make distributions to our shareholders. In addition, as a company in its early stages of operations, we have incurred losses since our inception and we may continue to incur losses.
Because there is no public trading market for our stock, it will be difficult for our stockholders to sell their stock. If our stockholders are able to sell their stock, it may be at a substantial discount.
There is no current public market for our stock and there is no assurance that a public market will ever exist for our stock. Our charter contains restrictions on the ownership and transfer of our stock, and these restrictions may inhibit the ability of our stockholders to sell their stock. Our charter prevents any one person from owning more than 9.8% in number of shares or value, whichever is more restrictive, of the outstanding shares of any class or series of our stock unless exempted by our board of directors. Our charter also limits the ability or our stockholders to transfer the stock to prospective stockholders unless (i) they meet suitability standards regarding income or net worth, and (ii) the transfer complies with minimum purchase requirements. We have adopted a stock repurchase program, but it is limited in terms of the number of shares of stock which may be redeemed annually. Our board of directors may also limit, suspend or terminate our stock repurchase program at any time. We have no obligations to repurchase our stockholders’ stock if redemption would violate restrictions on cash distribution under Maryland law.
It may be difficult for our stockholders to sell their stock promptly or at all. If our stockholders are able to sell shares of stock, they may only be able to sell them at a substantial discount from the price they paid. This may be the result, in part, of the fact that the amount of funds available for investment is expected to be reduced by sales commissions, dealer manager fees, organization and offering expenses, and acquisition fees and expenses. If our offering expenses are higher than we anticipate, we will have a smaller amount available for investment. Unless our aggregate investments increase in value to compensate for these up-front fees and expenses, it is unlikely that our stockholders will be able to sell their stock, whether pursuant to our stock repurchase program or otherwise, without incurring a substantial loss.
Stockholders may not be able to sell their stock under our stock repurchase program.
Our stock repurchase program, which is currently suspended other than for redemption requests made in connection with the death of a stockholder, includes numerous restrictions that limit our stockholders’ ability to sell their shares. Furthermore, our board of directors could choose to amend the terms of our stock repurchase program without stockholder approval. Our board is also free to terminate the program at any time upon 30 days written notice to our stockholders. In addition, the stock repurchase program includes numerous restrictions that would limit our stockholders ability to sell stock. .
We are dependent upon our Advisor, Sentio Investments, LLC, and its affiliates to conduct our operations. Any adverse changes in the financial health of our Advisor or its affiliates, or our relationship with any of them could hinder our operating performance and the return on your investment. Furthermore, if our Advisor became unable to continue in that role, we may have difficulty finding a qualified successor, and any successor advisor may not be as well suited to manage us and our portfolio.
We are dependent on our Advisor, Sentio Investments, LLC, and its affiliates, to manage our operations and our portfolio of real estate assets. Our Advisor has limited operating history and it will depend upon the fees and other compensation that it will receive from us in connection with the purchase, management and sale of our properties to conduct its operations. Any adverse changes in the financial condition of our Advisor or our relationship with our Advisor could hinder its ability to successfully manage our operations and our portfolio of investments. If our Advisor cannot meet its obligations as they arise, or if it is are unable to provide adequate service to us as required under the terms of its agreement with us, we may have to find another Advisor. If we are required to find a new Advisor we may have difficulty doing so, and any successor advisor may not be as well suited to manage us and our portfolio. As we have no employees and are entirely dependent on our Advisor to manage our operations, these potential changes could result in a significant disruption of our business
The inability of our Advisor to retain or obtain key personnel, property managers and leasing agents could delay or hinder implementation of our investment strategies, which could impair our ability to make distributions and could reduce the value of our stockholders’ investment.
Our success depends to a significant degree upon the contributions of John Mark Ramsey, the President and Chief Executive Officer of our Advisor. Neither we nor our Advisor have an employment agreement with Mr. Ramsey or with any of the other executive officers. If Mr. Ramsey was to cease his affiliation with our Advisor, our Advisor may be unable to find a suitable replacement, and our operating results could suffer. We believe that our future success depends, in large part, upon our Advisor’s, property managers’ and leasing agents’ ability to hire and retain highly skilled managerial, operational and marketing personnel. Competition for highly skilled personnel is intense, and our Advisor and any property managers we retain may be unsuccessful in attracting and retaining such skilled personnel. If we lose or are unable to obtain the services of highly skilled personnel, property managers or leasing agents, our ability to implement our investment strategies could be delayed or hindered, and the value of our stockholders’ investments may decline.
If we are unable to find or experience delays in finding suitable investments, we may experience a disruption of distributions and a lower rate of return to investors.
Our ability to achieve our investment objectives and to make distributions depends upon the performance of our Advisor in the acquisition and operation of our investments, and upon the performance of property managers and leasing agents in the management of our properties and the identification of prospective tenants. Additionally, disruptions and dislocations in the credit markets in recent years have materially impacted the cost and availability of debt to finance real estate acquisitions, which is a key component of our acquisition strategy. This lack of available debt could result in a further reduction of suitable investment opportunities and create a competitive advantage to other entities that have greater financial resources than we do. We may be delayed in making investments in properties due to delays in the sale of our stock, delays in negotiating or obtaining the necessary purchase documentation for properties, delays in locating suitable investments or other factors. We cannot be sure that our Advisor will be successful in obtaining suitable investments on financially attractive terms or that our investment objectives will be achieved. We may also make other real estate investments, such as investments in public and private real estate companies which own real estate properties and make real estate investments. Until we make real estate investments, we will hold the proceeds from our offering in an interest-bearing account or invest the proceeds in short-term, investment-grade securities. We expect the rates of return on these short-term investments to be substantially less than the returns we make on real estate investments. If we are unable to invest the proceeds from this offering in properties or other real estate investments for an extended period of time, distributions to our stockholders may be delayed and may be lower and the value of our stockholders’ investment could be reduced.
Sales of common stock pursuant to our follow-on public offering are currently suspended and we can provide no assurance of when or if sales under our follow-on offering will resume. If we do not raise substantial funds in our public offerings or through alternative capital raising efforts, we will be limited in the number and type of investments we may make, and the value of our stockholders’ investment in us will fluctuate with the performance of the specific properties we acquire.
Sales of common stock pursuant to our follow-on public offering are currently suspended and may not resume. Prior to the current suspension, sales of our common stock were made on a “best efforts” basis and no individual, firm or corporation had agreed to purchase any of our stock. It is likely that the amount of proceeds we raise in the follow-on offering will be substantially less than the amount we would need to achieve a broadly diversified property portfolio. If we raise substantially less than the maximum offering amount, and we are unable to raise significant new capital through alternative means, we will make fewer investments resulting in less diversification in terms of the number of investments owned and the geographic regions in which our investments are located. In that case, the likelihood that any single property’s performance would materially reduce our overall profitability will increase. We are not limited in the number or size of our investments or the percentage of net proceeds we may dedicate to a single investment. In addition, any inability to raise substantial funds would increase our fixed operating expenses as a percentage of gross income, and our net income and the distributions we make to stockholders would be reduced.
The cash distributions our stockholders receive may be less frequent or lower in amount than expected.
We currently expect to make distributions to our stockholders quarterly, if not more frequently. All expenses we incur in our operations are deducted from cash funds generated by operations prior to computing the amount of cash available to be paid as distributions to our stockholders. Our directors will determine the amount and timing of distributions. Our directors will consider all relevant factors, including the amount of cash available for distribution, capital expenditure and reserve requirements and general operational requirements. We cannot determine with certainty how long it may take to generate sufficient available cash flow to make distributions or that sufficient cash will be available to make distributions to our stockholders. We may borrow funds, return capital or sell assets to make distributions. With limited prior operations, we cannot predict the amount of distributions our stockholders may receive. We may be unable to pay or maintain cash distributions or increase distributions over time, and we may need to cease distributions to stockholders.
We have paid, and may in the future pay, distributions from sources other than cash provided from operations.
Until proceeds from our offerings are invested and generating operating cash flow sufficient to support distributions to stockholders, we intend to pay a portion of our distributions from the proceeds of our offerings or from borrowings in anticipation of future cash flow. Our organizational documents do not limit the amount of distributions we can fund from sources other than from operating cash flow. To the extent that we use offering proceeds to fund distributions to stockholders, the amount of cash available for investment in properties will be reduced. In addition, to the extent distributions exceed cash flow from operations, a stockholder’s basis in our stock will be reduced and, to the extent distributions exceed a stockholder's basis, the stockholder may recognize capital gain. For the four quarters ended December 31, 2011, our cash inflow from operations was approximately $5.2 million. During that period we paid distributions to investors of approximately $4.4 million, of which approximately $1.1 million was reinvested pursuant to our distribution reinvestment plan and approximately $5.5 million was paid to investors in cash from our offering proceeds.
Because our distribution reinvestment plan is currently suspended, we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions.
Historically, we have used a portion of the proceeds from our distribution reinvestment plan to offset the cash required to fund distributions to our stockholders, which has left more cash flow from operations available for general corporate purposes, including capital expenditures on our real estate investments, tenant improvement costs and leasing costs related to our investments in real estate properties; reserves required by financings of our investments in real estate properties; and the repayment of debt. Because our distribution reinvestment plan was suspended on May 10, 2011, and currently remains suspended, we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions. As a consequence, we may not have sufficient cash available to maintain our current level of distributions.
To the extent proceeds from our offerings have been used to pay fees to our current or prior advisors, or to fund distributions, our investors have realized dilution and future investors, if any, may also realize a lower rate of return than investors who invested earlier in one of our offerings.
Our advisor and its affiliates provide services for us in connection with, among other things, the selection and acquisition of our investments, the management and leasing of our properties, and the disposition of our assets. We pay them substantial upfront fees for some of these services, which reduces the amount of cash available for investment in real estate or distribution to you. In addition, we have used offering proceeds to fund distributions, and investors who did not receive those distributions will therefore experience additional immediate dilution of their investment. Also, to the extent we incurred debt to fund distributions earlier in our public offerings, the amount of cash available for distributions in future periods will be decreased by the repayment of such debt.
The use of offering proceeds to pay fees to our advisor and its affiliates or to fund distributions increases the risk that the amount available for distribution to stockholders upon a liquidation of our portfolio would be less than the purchase price of the shares in our offering. As of December 31, 2011, our net tangible book value per share was $8.95. Ignoring discounts for certain categories of purchase, shares in our primary offering were most recently sold at $10.00 per share.
A limit on the percentage of our securities a person may own may discourage a takeover or business combination, which could prevent our stockholders from realizing a premium price for their stock.
In order for us to qualify as a REIT, no more than 50% of our outstanding stock may be beneficially owned, directly or indirectly, by five or fewer individuals (including certain types of entities) at any time during the last half of each taxable year beginning after our first taxable year. To assure that we do not fail to qualify as a REIT under this test, our charter restricts direct or indirect ownership by one person or entity to no more than 9.8% in number of shares or value, whichever is more restrictive, of the outstanding shares of any class or series of our stock unless exempted by our board of directors. This restriction may have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price to our stockholders.
Our charter permits our board of directors to issue stock with terms that may subordinate the rights of our common stockholders or discourage a third party from acquiring us in a manner that could result in a premium price to our stockholders.
Our board of directors may increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class or series that we have authority to issue and classify or reclassify any unissued common stock or preferred stock and establish the preferences, conversion or other rights, voting powers, restrictions, limitations as to distributions, qualifications and terms or conditions of redemption of any such stock. Our board of directors could authorize the issuance of preferred stock with terms and conditions that could have priority as to distributions and amounts payable upon liquidation over the rights of the holders of our common stock. Such preferred stock could also have the effect of delaying, deferring or preventing a change in control of us, including an extraordinary transaction (such as a merger, tender offer or sale of all or substantially all of our assets) that might provide a premium price to holders of our common stock.
Our stockholders will have limited control over changes in our policies and operations, which increases the uncertainty and risks of an investment in us.
Our board of directors determines our major policies, including our policies regarding financing, growth, debt capitalization, REIT qualification and distributions. Our board of directors may amend or revise these and other policies without a vote of the stockholders. Under Maryland General Corporation Law and our charter, our stockholders have a right to vote only on limited matters. Our board’s broad discretion in setting policies and our stockholders’ inability to exert control over those policies increases the uncertainty and risks of an investment on us.
We may change our targeted investments without stockholder consent.
We may make adjustments to our target portfolio based on real estate market conditions and investment opportunities, and we may change our targeted investments and investment guidelines at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, the investments described in our prospectus. A change in our targeted investments or investment guidelines may increase our exposure to interest rate risk, default risk and real estate market fluctuations, all of which could adversely affect the value of our common stock and our ability to make distributions to our stockholders.
A stockholder’s interest in us may be diluted if we issue additional stock.
Our stockholders do not have preemptive rights to any stock we issue in the future. Therefore, in the event that we (1) sell stock in the future, including stock issued pursuant to our distribution reinvestment plan, (2) sell securities that are convertible into stock, (3) issue stock in a private offering, (4) issue stock upon the exercise of the options granted to our independent directors, employees of our Advisor or others, or (5) issue stock to sellers of properties acquired by us in connection with an exchange of limited partnership interests in our operating partnership, investors purchasing stock in this offering will experience dilution of their percentage ownership in us. Depending on the terms of such transactions, most notably the price per share, which may be less than the price paid per share in the offerings, and the value of our properties, investors in our follow-on offering might also experience a dilution in the book value per share of their stock.
A stockholder’s interest in us may be diluted if we acquire properties for units in our operating partnership.
Holders of units of our operating partnership will receive distributions per unit in the same amount as the distributions we pay per share to our stockholders and will generally have the right to exchange their units of our operating partnership for cash or shares of our stock (at our option). In the event we issue units in our operating partnership in exchange for properties, investors purchasing stock in the offerings will experience potential dilution in their percentage ownership interest in us. Depending on the terms of such transactions, most notably the price per unit, which may be less than the price paid per share in the offerings, the value of our properties and the value of the properties we acquire through the issuance of units of limited partnership interests in our operating partnership, investors in this offering might also experience a dilution in the book value per share of their stock.
Although we are not currently afforded the protection of the Maryland General Corporation Law relating to business combinations our board of directors could opt into these provisions of Maryland law in the future, which may discourage others from trying to acquire control of us and may prevent our stockholders from receiving a premium price for their stock in connection with a business combination.
Under Maryland law, “business combinations” between a Maryland corporation and certain interested stockholders or affiliates of interested stockholders are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder. These business combinations include a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. Also under Maryland law, control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter. Shares owned by the acquirer, by officers or by directors who are employees of the corporation are not entitled to vote on the matter. Should our board opt into these provisions of Maryland law, it may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer. Similarly, provisions of Title 3, Subtitle 8 of the Maryland General Corporation Law could provide similar anti-takeover protection.
Our stockholder’s and our rights to recover claims against our independent directors are limited, which could reduce our stockholders’ and our recovery against our independent directors if they negligently cause us to incur losses.
Our charter provides that no independent director shall be liable to us or our stockholders for monetary damages and that we will generally indemnify them for losses unless they are grossly negligent or engage in willful misconduct. As a result, our stockholders and we may have more limited rights against our independent directors than might otherwise exist under common law, which could reduce our stockholders’ and our recovery from these persons if they act in a negligent manner. In addition, we may be obligated to fund the defense costs incurred by our independent directors (as well as by our other directors, officers, employees and agents) in some cases, which would decrease the cash otherwise available for distributions to our stockholders.
If we are unable to obtain funding for future capital needs, cash distributions to our stockholders could be reduced and the value of our investments could decline.
If we need additional capital in the future to improve or maintain our properties or for any other reason, we will have to obtain financing from other sources, such as cash flow from operations, borrowings, property sales or future equity offerings. These sources of funding may not be available on attractive terms or at all. If we cannot procure additional funding for capital improvements, our investments may generate lower cash flows or decline in value, or both.
Our Advisor does not have as strong an economic incentive to avoid losses as do sponsors who have made significant equity investments in the companies they sponsor.
Our Advisor has not made an equity investment in us. Therefore, our Advisor has little exposure to losses in the value of our stock. Without this exposure, our investors may be at a greater risk of loss because our Advisor and its affiliates do not have as much to lose from a decrease in the value of our stock as do those sponsors who make more significant equity investments in the companies they sponsor.
If we do not successfully implement our long-term liquidity strategy, our stockholders may have to hold their investment for an indefinite period.
Although we presently intend to complete a transaction providing liquidity to stockholders by February 3, 2018, our charter does not require our board of directors to pursue such a liquidity event. Market conditions and other factors could cause us to delay the listing of our shares on a national securities exchange or delay the commencement of our liquidation beyond 2018 from the termination of our offering stage. If our board of directors does determine to pursue our liquidation policy, we would be under no obligation to conclude the process within a set time. The timing of the sale of assets will depend on real estate and financial markets, economic conditions in the areas in which properties are located, and federal income tax effects on stockholders, that may prevail in the future. We cannot guarantee that we will be able to liquidate all assets. After we adopt a plan of liquidation, we would remain in existence until all properties and assets are liquidated. If we do not pursue a liquidity event, or delay such an event due to market conditions, our stockholders’ shares may continue to be illiquid and they may, for an indefinite period of time, be unable to convert their investment to cash easily and could suffer losses on their investment.
If we internalize our management functions, your interest in us could be diluted, and we could incur other significant costs associated with being self-managed.
We may decide to internalize our management functions and, should we do so, we may elect to negotiate to acquire our advisor’s assets and personnel. At this time, we cannot be sure of the form or amount of consideration or other terms relating to any such acquisition. Such consideration could take many forms, including cash payments, promissory notes and shares of our stock. The payment of such consideration could result in dilution of your interests as a stockholder and could reduce the net income per share and funds from operations per share attributable to your investment. In addition, we may incur costs defending against stockholder lawsuits initiated against us in response to our decision to internalize our management functions. Such lawsuits could result in awards of damages, payment of attorneys’ fees and substantial litigation costs, which would reduce the amount of cash available for investments and stockholder distributions.
In addition, while we would no longer bear the costs of the various fees and expenses we expect to pay to our advisor under the advisory agreement if we internalize, our direct expenses would include general and administrative costs, including legal, accounting and other expenses related to corporate governance and SEC reporting and compliance. We would also incur the compensation and benefits costs of our officers and other employees and consultants that we now expect will be paid by our advisor or its affiliates. In addition, we may issue equity awards to officers, employees and consultants, which awards would decrease net income and funds from operations and may further dilute your investment. We cannot reasonably estimate the amount of fees to our advisor we would save and the costs we would incur if we became self-managed. If the expenses we assume as a result of an internalization are higher than the expenses we avoid paying to our advisor, our net income per share and funds from operations per share would be lower as a result of the internalization than it otherwise would have been, potentially decreasing the amount of funds available to distribute to our stockholders and the value of our shares.
As currently organized, we will not directly employ any employees. If we elect to internalize our operations, we would employ personnel and would be subject to potential liabilities commonly faced by employers, such as workers disability and compensation claims, potential labor disputes and other employee-related liabilities and grievances. Nothing in our charter prohibits us from entering into the transaction described above.
If we internalize our management functions, we could have difficulty integrating these functions as a stand-alone entity. As of the date of this prospectus, certain personnel of our advisor and its affiliates perform asset management and general and administrative functions, including accounting and financial reporting, for multiple entities. We could fail to properly identify the appropriate mix of personnel and capital needs to operate as a stand-alone entity. An inability to manage an internalization transaction effectively could thus result in our incurring excess costs and/or suffering deficiencies in our disclosure controls and procedures or our internal control over financial reporting. Such deficiencies could cause us to incur additional costs, and our management’s attention could be diverted from effectively managing our portfolio of investments.
Risks Related to Conflicts of Interest
Our Advisor and its affiliates, including our officers, one of whom is also a director, may face conflicts of interest caused by compensation arrangements with us and other sponsored programs, which could result in actions that are not in the long-term best interests of our stockholders.
Our Advisor and its affiliates will receive substantial fees from us that are partially tied to the performance of our stockholders’ investment. These fees could influence our Advisor’s advice to us, as well as the judgment of the affiliates of our Advisor who serve as our officers, one of whom is also a director. Among other matters, the compensation arrangements could affect their judgment with respect to:
•
the continuation, renewal or enforcement of our agreements with the Advisor and its affiliates, including the advisory agreement;
•
public offerings of equity by us, which would likely entitle the Advisor to increased acquisition and asset-management fees;
•
sales of properties and other investments (including, subject to the approval of our conflicts committee, sales to affiliates), which entitle the Advisor to disposition fees;
•
acquisitions of properties and other investments, which entitle the Advisor to acquisition and asset-management fees, and, in the case of acquisitions of investments from other Advisor-sponsored programs, might entitle affiliates of the Advisor to disposition fees and possible subordinated incentive fees in connection with its services for the seller;
•
borrowings to acquire properties and other investments, which borrowings will increase the acquisition and asset-management fees payable to the Advisor;
•
whether we seek stockholder approval to internalize our management, which may entail acquiring assets (such as office space, furnishings and technology costs) and negotiating compensation for real estate professionals at our advisor and its affiliates that may result in such individuals receiving more compensation from us than they currently receive from our advisor;
•
whether and when we seek to list our common stock on a national securities exchange, which listing could entitle our Advisor to a success-based listing fee but could also adversely affect its sales efforts for other programs if the price at which our stock trades is lower than the price at which we offered stock to the public; and
•
whether and when we seek to sell the company or its assets, which sale could entitle our Advisor to success-based fees but could also adversely affect its sales efforts for other programs if the sales price for the company or its assets resulted in proceeds less than the amount needed to preserve our stockholders’ capital.
Considerations relating to their compensation from other programs could result in decisions that are not in the best interests of our stockholders, which could hurt our ability to make distributions to our stockholders or result in a decline in the value of their investments in us.
Our Advisor will face conflicts of interest relating to the purchase and leasing of properties, and such conflicts may not be resolved in our favor, which could limit our investment opportunities, impair our ability to make distributions and reduce the value of our stockholders’ investments in us.
We rely on our Advisor to identify suitable investment opportunities. Our agreement with our Advisor does not restrict our Advisor from sponsoring or providing advisory services to other programs. Therefore, we may be buying properties at the same time as other entities that are affiliated with or sponsored by our Advisor. Other programs sponsored by our Advisor or its affiliates may also rely on our Advisor for investment opportunities. Many investment opportunities would be suitable for us as well as other programs. Our Advisor could direct attractive investment opportunities or tenants to other entities. Such events could result in our investing in properties that provide less attractive returns, thus reducing the level of distributions which we may be able to pay to stockholders and the value of their investments in us.
If we acquire properties from affiliates of our Advisor, the price may be higher than we would pay if the transaction was the result of arm’s-length negotiations.
The prices we pay to affiliates of our Advisor for our properties will be equal to the prices paid by them, plus the costs incurred by them relating to the acquisition and financing of the properties or if the price to us is in excess of such cost, substantial justification for such excess will exist and such excess will be reasonable and consistent with current market conditions as determined by a majority of our independent directors. Substantial justification for a higher price could result from improvements to a property by the affiliate of our Advisor or increases in market value of the property during the period of time the property is owned by the affiliates of our Advisor as evidenced by an appraisal of the property. These prices will not be the subject of arm’s-length negotiations, which could mean that the acquisitions may be on terms less favorable to us than those negotiated in an arm’s-length transaction. Even though we will use an independent third-party appraiser to determine fair market value when acquiring properties from our Advisor and its affiliates, we may pay more for particular properties than we would have in an arm’s-length transaction, which would reduce our cash available for investment in other properties or distribution to our stockholders.
We may purchase properties from persons with whom our Advisor or its affiliates have prior business relationships and our Advisor’s interest in preserving its relationship with these persons could result in us paying a higher price for the properties than we would otherwise pay.
We may have the opportunity to purchase properties from third parties, including affiliates of our directors who have prior business relationships with our Advisor or its affiliates. If we purchase properties from such third parties, our Advisor may experience a conflict between our interests and its interest in preserving any ongoing business relationship with these sellers.
Our Advisor will face conflicts of interest relating to joint ventures that we may form with affiliates of our Advisor, which conflicts could result in a disproportionate benefit to the other venture partners at our expense.
We may enter into joint venture agreements with third parties (including entities that are affiliated with our Advisor or our independent directors) for the acquisition or improvement of properties. Our Advisor may have conflicts of interest in determining which program should enter into any particular joint venture agreement. The co-venturer may have economic or business interests or goals that are or may become inconsistent with our business interests or goals. In addition, our Advisor may face a conflict in structuring the terms of the relationship between our interests and the interest of the affiliated co-venturer and in managing the joint venture. Since our Advisor and its affiliates will control both the affiliated co-venturer and, to a certain extent, us, agreements and transactions between the co-venturers with respect to any such joint venture will not have the benefit of arm’s-length negotiation of the type normally conducted between unrelated co-venturers. Co-venturers may thus benefit to our and our stockholders’ detriment.
Our Advisor and its affiliates receive commissions, fees and other compensation based upon our property acquisitions, the property we own and the sale of our properties and therefore our Advisor and its affiliates may make recommendations to us that we buy, hold or sell property in order to increase their compensation. Our Advisor will have considerable discretion with respect to the terms and timing of our acquisition, disposition and leasing transactions.
Our Advisor and its affiliates receive commissions, fees and other compensation based upon our investments. Therefore, our Advisor may recommend that we purchase properties that generate fees for our Advisor, but are not necessarily the most suitable investment for our portfolio. In some instances our Advisor and its affiliates may benefit by us retaining ownership of our assets, while our stockholders may be better served by sale or disposition. In other instances they may benefit by us selling the properties which may entitle our Advisor to disposition fees and possible success-based sales fees. In addition, our Advisor’s ability to receive asset management fees and reimbursements depends on our continued investment in properties and in other assets which generate fees to them. Therefore, the interest of our Advisor and its affiliates in receiving fees may conflict with our interests.
If the competing demands for the time of our Advisor, its affiliates and our officers result in them spending insufficient time on our business, we may miss investment opportunities or have less efficient operations, which could reduce our profitability and result in lower distributions to our stockholders.
We do not have any employees. We rely on the employees of our Advisor and its affiliates for the day-to-day operation of our business. The amount of time that our Advisor and its affiliates spend on our business will vary from time to time and is expected to be more while we are raising money and acquiring properties. Our Advisor and its affiliates, including our officers, may have interests in other programs and may engage in other business activities. As a result, they may face conflicts of interest in allocating their time between us and other programs and activities in which they are involved. During times of intense activity in other programs and ventures, they may devote less time and fewer resources to our business than are necessary or appropriate to manage our business. We expect that as our real estate activities expand, our Advisor will attempt to hire additional employees who would devote substantially
all of their time to our business. There is no assurance that our Advisor will devote adequate time to our business. If our Advisor suffers or is distracted by adverse financial or operational problems in connection with its operations unrelated to us, it may allocate less time and resources to our operations. If any of these things occur, the returns on our investments, our ability to make distributions to stockholders and the value of their investments in us may suffer.
Our officers, one of whom is also a director, face conflicts of interest related to the positions they hold with our Advisor and its affiliates, which could hinder our ability to successfully implement our business strategy and to generate returns to our stockholders.
Our officers, one of whom is also a director, are also officers of our Advisor. As a result, they owe fiduciary duties to these various entities and their stockholders and members, which fiduciary duties may from time to time conflict with the fiduciary duties that they owe to us and our stockholders. Their loyalties to these other entities could result in actions or inactions that are detrimental to our business, which could harm the implementation of our business strategy and our investment, property management and leasing opportunities. If we do not successfully implement our business strategy, we may be unable to generate cash needed to make distributions our stockholders and to maintain or increase the value of our assets.
General Risks Related to Investments in Real Estate and Real-Estate Related Investments
Economic and regulatory changes that impact the real estate market may reduce our net income and the value of our properties.
By owning our stock, stockholders will be subjected to the risks associated with owning real estate. The performance of an investment in us is subject to, among other things, risks related to the ownership and operation of real estate, including but not limited to:
•
worsening general or local economic conditions and financial markets could cause lower demand, tenant defaults, and reduced occupancy and rental rates, some or all of which would cause an overall decrease in revenue from rents;
•
increases in competing properties in an area which could require increased concessions to tenants and reduced rental rates;
•
increases in interest rates or unavailability of permanent mortgage funds which may render the sale of a property difficult or unattractive; and
•
changes in laws and government regulations, including those governing real estate usage, zoning and taxes.
Some or all of the foregoing factors may affect our properties, which would reduce our net income, and our ability to make distributions to our stockholders.
A concentration of our investments in the healthcare sector may leave our profitability vulnerable to a downturn or slowdown in the sector.
We expect to concentrate our investments in the healthcare sector. As a result, we will be subject to risks inherent in investments in a single type of property. If our investments are substantially in the healthcare sector, then the potential effects on our revenues, and as a result, on cash available for distribution to our stockholders, resulting from a downturn or slowdown in the healthcare sector could be more pronounced than if we had more fully diversified our investments.
Competition with third parties for properties and other investments may result in our paying higher prices for properties which could reduce our profitability and the return on investment.
We compete with many other entities engaged in real estate investment activities, including individuals, corporations, banks, insurance companies, other REITs, and real estate limited partnerships, many of which have greater resources than we do. Some of these investors may enjoy significant competitive advantages that result from, among other things, a lower cost of capital and enhanced operating efficiencies. In addition, the number of entities and the amount of funds competing for suitable investments may increase. Any such increase would result in increased demand for these assets and increased prices. If competitive pressures cause us to pay higher prices for properties, our ultimate profitability may be reduced and the value of our properties may not appreciate or may decrease significantly below the amount paid for such properties. At the time we elect to dispose of one or more of our properties, we will be in competition with sellers of similar properties to locate suitable purchasers, which may result in us receiving lower proceeds from the disposal or result in us not being able to dispose of the property due to the lack of an acceptable return. This may cause our stockholders to experience a lower return on their investments in us.
The healthcare properties we own may derive a substantial portion of their income from third-party payors.
Most of our healthcare facilities will be directly affected by risks associated with the healthcare industry. Many of our lessees [?] will derive a substantial portion of their net operating revenues from third-party payors, including the Medicare and Medicaid programs. These programs are highly regulated by federal, state and local laws, rules and regulations and are subject to frequent and substantial change. There are no assurances that payments from governmental payors will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for reimbursement under these programs.
Failure to comply with government regulations could adversely affect our healthcare tenants and operators.
The healthcare industry is highly regulated by federal, state and local licensing requirements, facility inspections, reimbursement policies, regulations concerning capital and other expenditures, certification requirements and other laws, regulations and rules. In addition, regulators require compliance with a variety of safety, health, staffing and other requirements relating to the design and conditions of the licensed facility and quality of care provided. Additional laws and regulations may be enacted or adopted that could require changes in the design of properties and certain operations of our tenants and third-party operators. The failure of any tenant or operator to comply with such laws, requirements and regulations could affect a tenant’s or operator’s ability to operate the facilities that we own.
In some states, advocacy groups have been created to monitor the quality of care at health care facilities, and these groups have brought litigation against operators. Additionally, in some instances, private litigation by patients has succeeded in winning large demand awards for alleged abuses. The effect of this litigation and potential litigation has increased the costs of monitoring and reporting quality of care compliance incurred by our tenants. In addition, the cost of liability and medical malpractice insurance has increased and may continue to increase as long as the present litigation environment affecting the operations of health care facilities continues. Continued cost increases could cause our tenants to be unable to pay their lease payments, decreasing our cash flow available for distribution.
Our tenants may be affected by the financial deterioration, insolvency and/or bankruptcy of other significant operators in the healthcare industry.
Certain companies in the healthcare industry, including some key senior housing operators, none of which are currently our tenants, are experiencing considerable financial, legal and/or regulatory difficulties which have resulted or may result in financial deterioration and, in some cases, insolvency and/or bankruptcy. The adverse effects on these companies could have a significant impact on the industry as a whole, including but not limited to negative public perception by investors, lenders and consumers. As a result, our tenants could experience the damaging financial effects of a weakened industry driven by negative industry headlines, ultimately making them unable to meet their obligations to us, and our business could be adversely affected.
We may be unable to complete development and re-development projects on advantageous terms.
As part of our investment plan, we intend to develop new and re-develop existing properties. Such activities involve significant risks that could adversely affect our financial condition, results of operations, cash flow and ability to make distributions on our common stock, which include:
•
we may not be able to obtain, or may experience delays in obtaining, all necessary zoning, land-use, building, occupancy and other governmental permits and authorizations;
•
we may not be able to obtain financing for development projects on favorable terms and complete construction on schedule or within budget, resulting in increased debt service expense and construction costs and delays in leasing the properties and generating cash flow; and
•
the properties may perform below anticipated levels, producing cash flow below budgeted amounts and limiting our ability to sell such properties to third parties or affiliates.
Newly developed and acquired properties may not produce the cash flow that we expect, which could adversely affect our overall financial performance.
We intend to acquire and develop real estate properties. In deciding whether to acquire or develop a particular property, we make assumptions regarding the expected future performance of that property. If our estimated return on investment proves to be inaccurate, it may fail to perform as we expected. With certain properties we plan to acquire, our business plan contemplates repositioning or redeveloping that property with the goal of increasing its cash flow, value or both. Our estimate of the costs of repositioning or redeveloping an acquired property may prove to be inaccurate, which may result in our failure to meet our profitability goals. Additionally, we may acquire new properties not fully leased, and the cash flow from existing operations may be insufficient to pay the operating expenses and debt service associated with that property until the property is more fully leased. If one or more of these new properties do not perform as expected or we are unable to successfully integrate new properties into our existing operations, our financial performance and our ability to make distributions may be adversely affected.
Reduced occupancy levels could reduce our revenues from rents and our distributions to our stockholders and cause the value of our stockholders’ investment in us to decline
The success of our investments depends upon the occupancy levels, rental income and operating expenses of our properties and our company. In the event of tenant default or bankruptcy, we may experience delays in enforcing our rights as landlord and may incur costs in protecting our investment and re-leasing our property. In the event of tenant default or bankruptcy, or lease termination or expiration, we may be unable to re-lease the property for the rent previously received. We may be unable to sell a property with low occupancy without incurring a loss. These events and others could cause us to reduce the amount of distributions we make to stockholders and the value of our stockholders’ investment in us to decline.
Rising expenses at both the property and the company level could reduce our net income and our cash available for distribution to stockholders.
Our properties are subject to operating risks common to real estate in general, any or all of which may reduce our net income. If any property is not substantially occupied or if rents are being paid in an amount that is insufficient to cover operating expenses, we could be required to expend funds with respect to that property for operating expenses. The properties are subject to increases in tax rates, utility costs, operating expenses, insurance costs, repairs and maintenance and administrative expenses. If we are unable to lease properties on a basis requiring the tenants to pay such expenses, we would be required to pay some or all of those costs which would reduce our income and cash available for distribution to stockholders.
Costs incurred in complying with governmental laws and regulations may reduce our net income and the cash available for distributions.
Our company and the properties we own are subject to federal, state and local laws and regulations relating to environmental protection and human health and safety. Federal laws such as the National Environmental Policy Act, the Comprehensive Environmental Response, Compensation, and Liability Act, the Resource Conservation and Recovery Act, the Federal Water Pollution Control Act, the Federal Clean Air Act, the Toxic Substances Control Act, the Emergency Planning and Community Right to Know Act and the Hazard Communication Act govern such matters as wastewater discharges, air emissions, the operation and removal of underground and above-ground storage tanks, the use, storage, treatment, transportation and disposal of solid and hazardous materials and the remediation of contamination associated with disposals. The properties we own and those we expect to acquire are subject to the Americans with Disabilities Act of 1990 which generally requires that certain types of buildings and services be made accessible and available to people with disabilities. These laws may require us to make modifications to our properties. Some of these laws and regulations impose joint and several liability on tenants, owners or operators for the costs to investigate or remediate contaminated properties, regardless of fault or whether the acts causing the contamination were legal. Compliance with these laws and any new or more stringent laws or regulations may require us to incur material expenditures. Future laws, ordinances or regulations may impose material environmental liability. In addition, there are various federal, state and local fire, health, life-safety and similar regulations with which we may be required to comply, and which may subject us to liability in the form of fines or damages for noncompliance.
Our properties may be affected by our tenants’ operations, the existing condition of land when we buy it, operations in the vicinity of our properties, such as the presence of underground storage tanks, or activities of unrelated third parties. The presence of hazardous substances, or the failure to properly remediate these substances, may make it difficult or impossible to sell or rent such property. Any material expenditures, fines, or damages we must pay will reduce our ability to make distributions and may reduce the value of our stockholders’ investments in us.
Discovery of environmentally hazardous conditions may reduce our cash available for distribution to our stockholders.
Under various federal, state and local environmental laws, ordinances and regulations, a current or previous real property owner or operator may be liable for the cost to remove or remediate hazardous or toxic substances on, under or in such property. These costs could be substantial. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. Environmental laws also may impose restrictions on the manner in which property may be used or businesses may be operated, and these restrictions may require substantial expenditures or prevent us from entering into leases with prospective tenants that may be impacted by such laws. Environmental laws provide for sanctions for noncompliance and may be enforced by governmental agencies or, in certain circumstances, by private parties. Certain environmental laws and common law principles could be used to impose liability for release of and exposure to hazardous substances, including asbestos-containing materials into the air. Third parties may seek recovery from real property owners or operators for personal injury or property damage associated with exposure to released hazardous substances. The cost of defending against claims of liability, of complying with environmental regulatory requirements, of remediating any contaminated property, or of paying personal injury claims could be substantial and reduce our ability to make distributions and the value of our stockholders’ investments in us.
Any uninsured losses or high insurance premiums will reduce our net income and the amount of our cash distributions to stockholders.
Our Advisor will attempt to obtain adequate insurance to cover significant areas of risk to us as a company and to our properties. However, there are types of losses at the property level, generally catastrophic in nature, such as losses due to wars, acts of terrorism, earthquakes, floods, hurricanes, pollution or environmental matters, which are uninsurable or not economically insurable, or may be insured subject to limitations, such as large deductibles or co-payments. We may not have adequate coverage for such losses. If any of our properties incurs a casualty loss that is not fully insured, the value of our assets will be reduced by any such uninsured loss. In addition, other than any working capital reserve or other reserves we may establish, we have no source of funding to repair or reconstruct any uninsured damaged property. Also, to the extent we must pay unexpectedly large amounts for insurance, we could suffer reduced earnings that would result in lower distributions to stockholders.
We may have difficulty selling real estate investments, and our ability to distribute all or a portion of the net proceeds from such sale to our stockholders may be limited.
Equity real estate investments are relatively illiquid. Therefore, we will have a limited ability to vary our portfolio in response to changes in economic or other conditions. In addition, the liquidity of real estate investments has been further reduced by the recent turmoil in the capital markets, which has constrained equity and debt capital available for investment in commercial real estate, resulting in fewer buyers seeking to acquire commercial properties and consequent reductions in property values. As a result of these factors we will also have a limited ability to sell assets in order to fund working capital and similar capital needs. When we sell any of our properties, we may not realize a gain on such sale. We may not elect to distribute any proceeds from the sale of properties to our stockholders; for example, we may use such proceeds to:
•
purchase additional properties;
•
repay debt, if any;
•
buy out interests of any co-venturers or other partners in any joint venture in which we are a party;
•
create working capital reserves; or
•
make repairs, maintenance, tenant improvements or other capital improvements or expenditures to our remaining properties.
Our ability to sell our properties may also be limited by our need to avoid a 100% penalty tax that is imposed on gain recognized by a REIT from the sale of property characterized as dealer property. In order to ensure that we avoid such characterization, we may be required to hold our properties for a minimum period of time, generally two years, and comply with certain other requirements in the Internal Revenue Code.
Real estate market conditions at the time we decide to dispose of a property may be unfavorable which could reduce the price we receive for a property and lower the return on our stockholders’ investments in us.
We intend to hold the properties in which we invest until we determine that selling or otherwise disposing of properties would help us to achieve our investment objectives. General economic conditions, availability of financing, interest rates and other factors, including supply and demand, all of which are beyond our control, affect the real estate market. We may be unable to sell a property for the price, on the terms, or within the time frame we want. Accordingly, the gain or loss on our stockholders’ investments in us could be affected by fluctuating market conditions.
As part of otherwise attractive portfolios of properties, we may acquire some properties with existing lock-out provisions, which may inhibit us from selling a property, or may require us to maintain specified debt levels for a period of years on some properties.
Loan provisions could materially restrict us from selling or otherwise disposing of or refinancing properties. These provisions would affect our ability to turn our investments into cash and thus affect cash available for distributions to our stockholders. Loan provisions may prohibit us from reducing the outstanding indebtedness with respect to properties, refinancing such indebtedness on a non-recourse basis at maturity, or increasing the amount of indebtedness with respect to such properties.
Loan provisions could impair our ability to take actions that would otherwise be in the best interests of our stockholders and, therefore, may have an adverse impact on the value of our stock, relative to the value that would result if the loan provisions did not exist. In particular, loan provisions could preclude us from participating in major transactions that could result in a disposition of our assets or a change in control even though that disposition or change in control might be in the best interests of our stockholders.
If we sell properties by providing financing to purchasers of our properties, distribution of net sales proceeds to our stockholders would be delayed and defaults by the purchasers could reduce our cash available for distribution to stockholders.
If we provide financing to purchasers, we will bear the risk that the purchaser may default. Purchaser defaults could reduce our cash distributions to our stockholders. Even in the absence of a purchaser default, the distribution of the proceeds of sales to our stockholders, or their reinvestment in other assets, will be delayed until the promissory notes or other property we may accept upon a sale are actually paid, sold, refinanced or otherwise disposed of or completion of foreclosure proceedings.
Actions of our joint venture partners could subject us to liabilities in excess of those contemplated or prevent us from taking actions which are in the best interests of our stockholders which could result in lower investment returns to our stockholders.
We are likely to enter into joint ventures with affiliates and other third parties to acquire or improve properties. We may also purchase properties in partnerships, co-tenancies or other co-ownership arrangements. Such investments may involve risks not otherwise present when acquiring real estate directly, including, for example:
•
joint venturers may share certain approval rights over major decisions;
•
that such co-venturer, co-owner or partner may at any time have economic or business interests or goals which are or which become inconsistent with our business interests or goals, including inconsistent goals relating to the sale of properties held in the joint venture or the timing of termination or liquidation of the joint venture;
•
the possibility that our co-venturer, co-owner or partner in an investment might become insolvent or bankrupt;
•
the possibility that we may incur liabilities as a result of an action taken by our co-venturer, co-owner or partner;
•
that such co-venturer, co-owner or partner may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives, including our policy with respect to qualifying and maintaining our qualification as a REIT;
•
disputes between us and our joint venturers may result in litigation or arbitration that would increase our expenses and prevent its officers and directors from focusing their time and effort on our business and result in subjecting the properties owned by the applicable joint venture to additional risk; or
•
that under certain joint venture arrangements, neither venture partner may have the power to control the venture, and an impasse could be reached which might have a negative influence on the joint venture.
These events might subject us to liabilities in excess of those contemplated and thus reduce our stockholders’ investment returns. If we have a right of first refusal or buy/sell right to buy out a co-venturer, co-owner or partner, we may be unable to finance such a buy-out if it becomes exercisable or we may be required to purchase such interest at a time when it would not otherwise be in our best interest to do so. If our interest is subject to a buy/sell right, we may not have sufficient cash, available borrowing capacity or other capital resources to allow us to elect to purchase an interest of a co-venturer subject to the buy/sell right, in which case we may be forced to sell our interest as the result of the exercise of such right when we would otherwise prefer to keep our interest. Finally, we may not be able to sell our interest in a joint venture if we desire to exit the venture.
If we make or invest in mortgage loans as part of our plan to acquire the underlying property, our mortgage loans may be affected by unfavorable real estate market conditions, including interest rate fluctuations, which could decrease the value of those loans and the return on our stockholders’ investments in us.
If we make or invest in mortgage loans, we will be at risk of defaults by the borrowers on those mortgage loans as well as interest rate risks. To the extent we incur delays in liquidating such defaulted mortgage loans; we may not be able to obtain sufficient proceeds to repay all amounts due to us under the mortgage loan. Further, we will not know whether the values of the properties securing the mortgage loans will remain at the levels existing on the dates of origination of those mortgage loans. If the values of the underlying properties fall, our risk will increase because of the lower value of the security associated with such loans. In addition, interest rate fluctuations could reduce our returns as compared to market interest rates and reduce the value of the mortgage loans in the event we sell them.
Second mortgage loan investments involve a greater risk of loss in the event of default than traditional mortgage loans.
If we decide to invest in second mortgages, our subordinated priority to the senior lender or lenders will place our investment at a greater risk of loss than a traditional mortgage. In the event of default, any recovery of our second mortgage investment will be subordinate to the senior lender. Further, it is likely that any investments we make in second mortgages will be placed with private entities and not insured by a government sponsored entity, placing additional credit risk on the borrower which may result in a loss to our portfolio.
Construction loan investments involve a greater risk of loss of investment and reduction of return than traditional mortgage loans.
If we decide to invest in construction loans, the nature of these loans pose a greater risk of loss than traditional mortgages. Since construction loans are made generally for the express purpose of either the original development or redevelopment of a property, the risk of loss is greater than a traditional mortgage because the underlying properties subject to construction loans are generally unable to generate income during the period of the loan. Construction loans may also be subordinate to the first lien mortgages. Any delays in completing the development or redevelopment project may increase the risk of default or credit risk of the borrower which may increase the risk of loss or risk of a lower than expected return to our portfolio.
Bridge loan investments involve a greater risk of loss of investment and reduction of return than traditional mortgage loans.
If we decide to acquire or make bridge loans secured by first lien mortgages on properties to borrowers who are typically seeking short-term capital to be used in an acquisition or renovation of real estate, these loans pose a greater risk than traditional mortgages. Borrowers usually identify undervalued assets that have been under-managed or are located in recovering markets. If the market in which the asset is located fails to recover according to the borrower’s projections, or if the borrower fails to improve the quality of the asset’s management or the value of the asset, the borrower may not receive a sufficient return on the asset to satisfy the bridge loan, and we may not recover some or all of our investment.
In addition, owners usually borrow funds under a conventional mortgage loan to repay a bridge loan. We may therefore be dependent on a borrower’s ability to obtain permanent financing to repay our bridge loan, which could depend on market conditions and other factors. Bridge loans are also subject to risks of borrower defaults, bankruptcies, fraud, losses and special hazard losses that are not covered by standard hazard insurance. In the event of any default under bridge loans held by us, we bear the risk of loss of principal and non-payment of interest and fees to the extent of any deficiency between the value of the mortgage collateral and the principal amount of the bridge loan. To the extent we suffer such losses with respect to our investments in bridge loans; the value of our company may be adversely affected.
Mezzanine loan investments involve a greater risk of loss of investment and reductions of return than senior loans secured by income producing properties.
If we invest in mezzanine loans, they may take the form of subordinated loans secured by second mortgages on the underlying real property or loans secured by a pledge of the ownership interests of either the entity owning the real property or the entity that owns the interest in the entity owning the real property. These types of investments involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property because the investment may become unsecured as a result of foreclosure by the senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to our loan, or in the event of a borrower bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or all of our investment. In addition, mezzanine loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the real property and increasing the risk of loss of principal.
Investments in real estate-related securities may be illiquid, and we may not be able to adjust our portfolio in response to changes in economic and other conditions.
If we invest in certain real estate-related securities that we may purchase in connection with privately negotiated transactions, they will not be registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. As a result, our ability to vary our long-term stabilized portfolio in response to changes in economic and other conditions may be relatively limited. The mezzanine and bridge loans we may purchase will be particularly illiquid investments due to their short life. Moreover, in the event of a borrower’s default on an illiquid real estate security, the unsuitability for securitization and potential lack of recovery of our investment could pose serious risks of loss to our investment portfolio.
Delays in restructuring or liquidating non-performing real estate-related securities could reduce the return on our stockholders’ investment.
If we invest in real estate-related securities, they may become non-performing after acquisition for a wide variety of reasons. Such non-performing real estate investments may require a substantial amount of workout negotiations and/or restructuring, which may entail, among other things, a substantial reduction in the interest rate and a substantial write-down of such loan or asset. However, even if a restructuring is successfully accomplished, upon maturity of such real estate security, replacement “takeout” financing may not be available. We may find it necessary or desirable to foreclose on some of the collateral securing one or more of our investments. Intercreditor provisions may substantially interfere with our ability to do so. Even if foreclosure is an option, the foreclosure process can be lengthy and expensive. Borrowers often resist foreclosure actions by asserting numerous claims, counterclaims and defenses, including, without limitation, lender liability claims and defenses, in an effort to prolong the foreclosure action. In some states, foreclosure actions can take up to several years or more to litigate. At any time during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure action and further delaying the foreclosure process. Foreclosure litigation tends to create a negative public image of the collateral property and may result in disrupting ongoing leasing and management of the property. Foreclosure actions by senior lenders may substantially affect the amount that we may receive from an investment.
Our stockholders’ investment return may be reduced if we are required to register as an investment company under the Investment Company Act; if we or our subsidiaries become an unregistered investment company, we could not continue our business. [this disclosure seems disproportionately and unnecessarily long. Damon, can you trim it?]
Neither we nor any of our subsidiaries intend to register as investment companies under the Investment Company Act. If we or our subsidiaries were obligated to register as investment companies, we would have to comply with a variety of substantive requirements under the Investment Company Act that impose, among other things:
•
limitations on capital structure;
•
restrictions on specified investments;
•
prohibitions on transactions with affiliates; and
•
compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations that would significantly increase our operating expenses.
Under the relevant provisions of Section 3(a)(1) of the Investment Company Act, an investment company is any issuer that:
•
is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities (the “primarily engaged test”); or
•
is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of such issuer's total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis (the “40% test”). “Investment securities” excludes U.S. government securities and securities of majority-owned subsidiaries that are not themselves investment companies and are not relying on the exception from the definition of investment company under Section 3(c)(1) or Section 3(c)(7) (relating to private investment companies).
Depending on the nature of our portfolio, we believe that we and our Operating Partnership may be able to satisfy both tests above. With respect to the 40% test, we expect that most of the entities through which we and our Operating Partnership own our assets will be majority-owned subsidiaries that are not themselves investment companies and are not relying on the exceptions from the definition of investment company under Section 3(c)(1) or Section 3(c)(7).
With respect to the primarily engaged test, we and our Operating Partnership are holding companies and do not intend to invest or trade in securities ourselves. Rather, through the majority-owned subsidiaries of our Operating Partnership, we and our Operating Partnership will be primarily engaged in the non-investment company businesses of these subsidiaries.
We expect that most of the subsidiaries of our Operating Partnership will be able to rely on Section 3(c)(5)(C) of the Investment Company Act for an exception from the definition of an investment company. (Any other subsidiaries of our Operating Partnership should be able to rely on the exceptions for private investment companies pursuant to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.) As reflected in no-action letters, the SEC staff's position on Section 3(c)(5)(C) generally requires that an issuer maintain at least 55% of its assets in “mortgages and other liens on and interests in real estate,” or qualifying assets; at least 80% of its assets in qualifying assets plus real estate-related assets; and no more than 20% of the value of its assets in other than qualifying assets and real estate-related assets, which we refer to as miscellaneous assets. To constitute a qualifying asset under this 55% requirement, a real estate interest must meet various criteria based on no-action letters.
If, however, the value of the subsidiaries of our Operating Partnership that must rely on Section 3(c)(1) or Section 3(c)(7) is greater than 40% of the value of the assets of our Operating Partnership, then we and our Operating Partnership may seek to rely on the exception from registration under Section 3(c)(6) if we and our Operating Partnership are “primarily engaged,” through majority-owned subsidiaries, in the business of purchasing or otherwise acquiring mortgages and other interests in real estate. The SEC staff has issued little interpretive guidance with respect to Section 3(c)(6); however, it is our view that we and our Operating Partnership may rely on Section 3(c)(6) if 55% of the assets of our Operating Partnership consist of, and at least 55% of the income of our Operating Partnership is derived from, majority-owned subsidiaries that rely on Section 3(c)(5)(C).
To maintain compliance with the Investment Company Act, our subsidiaries may be unable to sell assets we would otherwise want them to sell and may need to sell assets we would otherwise wish them to retain. In addition, our subsidiaries may have to acquire additional assets that they might not otherwise have acquired or may have to forego opportunities to make investments that we would otherwise want them to make and would be important to our investment strategy. Moreover, the SEC may issue interpretations with respect to various types of assets that are contrary to our views and current SEC staff interpretations are subject to change, which increases the risk of non-compliance and the risk that we may be forced to make adverse changes to our portfolio. If we were required to register as an investment company but failed to do so, we would be prohibited from engaging in our business and criminal and civil actions could be brought against us. In addition, our contracts would be unenforceable unless a court required enforcement and a court could appoint a receiver to take control of us and liquidate our business.
Rapid changes in the values of our assets may make it more difficult for us to maintain our qualification as a REIT or our exception from the definition of an investment company under the Investment Company Act.
If the market value or income potential of our qualifying real estate assets changes as compared to the market value or income potential of our non-qualifying assets, or if the market value or income potential of our assets that are considered “real estate-related assets” under the Investment Company Act or REIT qualification tests changes as compared to the market value or income potential of our assets that are not considered “real estate-related assets” under the Investment Company Act or REIT qualification tests, whether
as a result of increased interest rates, prepayment rates or other factors, we may need to modify our investment portfolio in order to maintain our REIT qualification or exception from the definition of an investment company. If the decline in asset values or income occurs quickly, this may be especially difficult, if not impossible, to accomplish. This difficulty may be exacerbated by the illiquid nature of many of the assets that we may own. We may have to make investment decisions that we otherwise would not make absent REIT and Investment Company Act considerations.
Risks Associated with Debt Financing
We will use debt financing to acquire properties and otherwise incur other indebtedness, which will increase our expenses and could subject us to the risk of losing properties in foreclosure if our cash flow is insufficient to make loan payments.
We have and expect to continue to acquire properties using debt financing. We intend to incur indebtedness up to 300% of our net assets (equivalent to 75% of the cost of our tangible assets), but upon a vote of the majority of our independent directors we may exceed this level of indebtedness. We may borrow funds for working capital requirements, tenant improvements, capital improvements, and leasing commissions. We may also borrow funds to make distributions including but not limited to funds to satisfy the REIT tax qualification requirement that we distribute at least 90% of our annual REIT taxable income (excluding net capital gains) to our stockholders. We may also borrow if we otherwise deem it necessary or advisable to ensure that we maintain our qualification as a REIT for federal income tax purposes or to avoid taxation on undistributed income or gain. To the extent we borrow funds; we may raise additional equity capital or sell properties to pay such debt.
If there is a shortfall between the cash flow from a property and the cash flow needed to service acquisition financing on that property, then the amount available for distributions to stockholders may be reduced. In addition, incurring mortgage debt increases the risk of loss since defaults on indebtedness secured by a property may result in lenders initiating foreclosure actions. In that case, we could lose the property securing the loan that is in default, thus reducing the value of our stockholders’ investment. For tax purposes, a foreclosure of any of our properties would be treated as a sale of the property for a purchase price equal to the outstanding balance of the debt secured by the mortgage. If the outstanding balance of the debt secured by the mortgage exceeds our tax basis in the property, we would recognize taxable income on foreclosure, but we would not receive any cash proceeds. We may give full or partial guarantees to lenders of mortgage debt to the entities that own our properties. When we give a guaranty on behalf of an entity that owns one of our properties, we will be responsible to the lender for satisfaction of the debt if it is not paid by such entity. If any mortgages contain cross-collateralization or cross-default provisions, a default on a single property could affect multiple properties. If any of our properties are foreclosed upon due to a default, the value of our stockholders’ investments in us will be reduced. Liquidity in the global credit markets has been significantly contracted by market disruptions during the past two years, making it costly to obtain new debt financing, when debt financing is available at all. To the extent that market conditions prevent us from obtaining temporary acquisition financing on financially attractive terms, our ability to make suitable investments in commercial real estate could be delayed or limited. If we are unable to invest the proceeds from this offering in suitable real estate investments for an extended period of time, distributions to our stockholders may be suspended and may be lower and the value of investments in our shares could be reduced.
Lenders may require us to enter into restrictive covenants relating to our operations, which could limit our ability to make distributions to our stockholders.
When providing financing, a lender may impose restrictions on us that affect our distribution and operating policies and our ability to incur additional debt. Loan documents we enter into may contain covenants that limit our ability to further mortgage the property, discontinue insurance coverage, or replace our Advisor. These or other limitations may limit our flexibility and prevent us from achieving our operating plans.
High levels of debt or increases in interest rates could increase the amount of our loan payments, reduce the cash available for distribution to stockholders and subject us to the risk of losing properties in foreclosure if our cash flow is insufficient to make loan payments.
Our policies do not limit us from incurring debt. High debt levels would cause us to incur higher interest charges, would result in higher debt service payments, and could be accompanied by restrictive covenants. Interest we pay could reduce cash available for distribution to stockholders. Additionally, if we incur variable rate debt, increases in interest rates would increase our interest costs, which would reduce our cash flows and our ability to make distributions to our stockholders. In addition, if we need to repay existing debt during periods of rising interest rates, we could be required to liquidate one or more of our investments in properties at times which may not permit realization of the maximum return on such investments and could result in a loss.
High mortgage rates may make it difficult for us to finance or refinance properties, which could reduce the number of properties we can acquire, our cash flows from operations and the amount of cash distributions we can make
If mortgage debt is unavailable at reasonable rates, we may not be able to finance the purchase of properties. If we place mortgage debt on properties, we run the risk of being unable to refinance the properties when the debt becomes due or of being unable to refinance on favorable terms. If interest rates are higher when we refinance the properties, our income could be reduced. We may be unable to refinance properties. If any of these events occurs, our cash flow would be reduced. This, in turn, would reduce cash available for distribution to you and may hinder our ability to raise capital by issuing more stock or borrowing more money.
Federal Income Tax Risks
Failure to qualify as a REIT would subject us to federal income tax, which would reduce the cash available for distribution to you.
We expect to operate in a manner that will allow us to continue to qualify as a REIT for federal income tax purposes. However, the federal income tax laws governing REITs are extremely complex, and interpretations of the federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis. While we intend to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, including the tax treatment of certain investments we may make, and the possibility of future changes in our circumstances, no assurance can be given that we will so qualify for any particular year. If we fail to qualify as a REIT in any calendar year and we do not qualify for certain statutory relief provisions, we would be required to pay federal income tax on our taxable income. We might need to borrow money or sell assets to pay that tax. Our payment of income tax would decrease the amount of our income available for distribution to you. Furthermore, if we fail to maintain our qualification as a REIT and we do not qualify for certain statutory relief provisions, we no longer would be required to distribute substantially all of our REIT taxable income to our stockholders. Unless our failure to qualify as a REIT were excused under federal tax laws, we would be disqualified from taxation as a REIT for the four taxable years following the year during which qualification was lost.
Even if we qualify as a REIT for federal income tax purposes, we may be subject to other tax liabilities that reduce our cash flow and our ability to make distributions to our stockholders.
Even if we qualify as a REIT for federal income tax purposes, we may be subject to some federal, state and local taxes on our income or property. For example:
•
In order to qualify as a REIT, we must distribute annually at least 90% of our REIT taxable income to our stockholders (which is determined without regard to the dividends-paid deduction or net capital gain). To the extent that we satisfy the distribution requirement but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on the undistributed income.
•
We will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions we pay in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from prior years.
•
If we elect to treat property that we acquire in connection with a foreclosure of a mortgage loan or certain leasehold terminations as “foreclosure property,” we may avoid the 100% tax on gain from a resale of that property, but the income from the sale or operation of that property may be subject to corporate income tax at the highest applicable rate.
•
If we sell an asset, other than foreclosure property, that we hold primarily for sale to customers in the ordinary course of business, our gain would be subject to the 100% “prohibited transaction” tax unless such sale were made by one of our taxable REIT subsidiaries.
We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal Revenue Code.
To maintain our REIT status, we may be forced to forego otherwise attractive opportunities, which may delay or hinder our ability to meet our investment objectives and reduce the overall return to our stockholders.
To qualify as a REIT, we must satisfy certain tests on an ongoing basis concerning, among other things, the sources of our income, nature of our assets and the amounts we distribute to our stockholders. We may be required to make distributions to stockholders at times when it would be more advantageous to reinvest cash in our business or when we do not have funds readily available for distribution. Compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits and the value of our stockholders’ investments in us.
If we borrow money to meet the REIT minimum distribution requirement or for other working capital needs, our expenses will increase, our net income will be reduced by the amount of interest we pay on the money we borrow and we will be obligated to repay the money we borrow from future earnings or by selling assets, which will decrease future distributions to stockholders.
To qualify as a REIT, we generally must distribute annually to our stockholders a minimum of 90% of our taxable income, excluding capital gains. We will be subject to regular corporate income taxes to the extent that we distribute less than 100% of our REIT taxable income each year. Additionally, we will be subject to a 4% nondeductible excise tax on any amount by which distributions paid (or deemed paid) by us in any calendar year are less than the sum of 85% of our ordinary income, 95% of our capital gain net income and 100% of our undistributed income from previous years. Payments we make to redeem our shares generally are not taken into account for purposes of these distribution requirements. If we do not have sufficient cash to make distributions necessary to preserve our REIT status for any year or to avoid taxation, we may be forced to borrow funds or sell assets even if the market conditions at that time are not favorable for these borrowings or sales. We may decide to borrow funds in order to meet the REIT minimum distribution requirements even if our management believes that the then prevailing market conditions generally are not favorable for such borrowings or that such borrowings would not be advisable in the absence of such tax considerations. Distributions made in excess of our net income will generally constitute a return of capital to stockholders.
If we were considered to actually or constructively pay a “preferential dividend” to certain of our stockholders, our status as a REIT could be adversely affected.
In order to qualify as a REIT, we must distribute to our stockholders at least 90% of our annual REIT taxable income (excluding net capital gain), determined without regard to the deduction for dividends paid. In order for distributions to be counted as satisfying the annual distribution requirements for REITs, and to provide us with a REIT-level tax deduction, the distribution must not be “preferential dividends.” A dividend is not a preferential dividend if the distribution is pro rata among all outstanding shares of stock within a particular class, and in accordance with the preferences among different classes of stock as set forth in our organizational documents. There is no de minimus exception with respect to preferential dividends; therefore, if the IRS were to take the position that we paid a preferential dividend, we may be deemed to have failed the 90% distribution test, and our status as a REIT could be terminated for the year in which such determination is made if we were unable to cure such failure.
If our operating partnership is classified as a “publicly-traded partnership” under the Internal Revenue Code, it could be subjected to tax on its income and the amount of distributions we make to our stockholders will be less.
We structured the operating partnership so that it would be classified as a partnership for federal income tax purposes. In this regard, the Internal Revenue Code generally classifies “publicly traded partnerships” (as defined in Section 7704 of the Internal Revenue Code) as associations taxable as corporations (rather than as partnerships), unless substantially all of their taxable income consists of specified types of passive income. In order to minimize the risk that the Internal Revenue Code would classify the operating partnership as a “publicly traded partnership” for tax purposes, we placed certain restrictions on the transfer and/or redemption of partnership units in our operating partnership. If the Internal Revenue Service were to assert successfully that our operating partnership is a “publicly traded partnership,” and substantially all of the operating partnership’s gross income did not consist of the specified types of passive income, the Internal Revenue Code would treat our operating partnership as an association taxable as a corporation. In such event, the character of our assets and items of gross income would change and would likely prevent us from qualifying and maintaining our status as a REIT. In addition, the imposition of a corporate tax on our operating partnership would reduce the amount of cash distributable to us from our operating partnership and therefore would reduce our amount of cash available to make distributions to our stockholders.
The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans that would be treated as sales for federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of assets, other than foreclosure property, deemed held primarily for sale to customers in the ordinary course of business.
We might be subject to this tax if we were to dispose of or securitize loans in a manner that was treated as a sale of the loans for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans at the REIT level, and may limit the structures we utilize for our securitization transactions, even though the sales or structures might otherwise be beneficial to us.
It may be possible to reduce the impact of the prohibited transaction tax by conducting certain activities through taxable REIT subsidiaries. However, to the extent that we engage in such activities through taxable REIT subsidiaries, the income associated with such activities may be subject to full corporate income tax.
Dividends payable by REITs do not qualify for the reduced tax rates.
Legislation enacted in 2003 and modified in 2005 and 2010 generally reduces the maximum tax rate for dividends payable to domestic stockholders that are individuals, trusts and estates to 15% (through 2012). Dividends payable by REITs, however, are generally not eligible for the reduced rates. Although this legislation does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in stock of non-REIT corporations that pay dividends, which could adversely affect the value of the stock of REITs, including our common stock.
We may be subject to adverse legislative or regulatory tax changes.
At any time, the federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be amended. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation or interpretation may take effect retroactively. We and our stockholders could be adversely affected by any such change in, or any new, federal income tax law, regulation or administrative interpretation.
Distributions to tax-exempt investors may be classified as unrelated business taxable income and tax-exempt investors would be required to pay tax on the unrelated business taxable income and to file income tax returns.
Neither ordinary nor capital gain distributions with respect to our common stock nor gain from the sale of stock should generally constitute unrelated business taxable income to a tax-exempt investor. However, there are certain exceptions to this rule. In particular:
•
under certain circumstances, part of the income and gain recognized by certain qualified employee pension trusts with respect to our stock may be treated as unrelated business taxable income if our stock is predominately held by qualified employee pension trusts, such that we are a “pension-held” REIT (which we do not expect to be the case);
•
part of the income and gain recognized by a tax exempt investor with respect to our stock would constitute unrelated business taxable income if such investor incurs debt in order to acquire the common stock; and
•
part or all of the income or gain recognized with respect to our stock held by social clubs, voluntary employee benefit associations, supplemental unemployment benefit trusts and qualified group legal services plans which are exempt from federal income taxation under Sections 501(c)(7), (9), (17), or (20) of the Code may be treated as unrelated business taxable income.
Foreign investors may be subject to FIRPTA tax on the sale of our stock if we are unable to qualify as a “domestically controlled” REIT.
A foreign person disposing of a U.S. real property interest, including stock of a U.S. corporation whose assets consist principally of U.S. real property interests is generally subject to a tax, known as the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) tax, on the gain recognized on the disposition. Distributions that are attributable to gains from the disposition of US real property interests by a REIT are subject to FIRPTA tax for foreign investors as though they were engaged in a trade or business and the distribution constitutes income which is effectively connected with such a business. Such FIRPTA tax does not apply, if the REIT is “domestically controlled.” A REIT is “domestically controlled” if less than 50% of the REIT’s capital stock, by value, has been owned directly or indirectly by persons who are not qualifying U.S. persons during a continuous five-year period ending on the date of disposition or, if shorter, during the entire period of the REIT’s existence.
We cannot be sure that we will qualify as a “domestically controlled” REIT. If we were to fail to so qualify, gain realized by foreign investors on a sale of our stock would be subject to FIRPTA tax, unless our stock were traded on an established securities market and the foreign investor did not at any time during a specified testing period directly or indirectly own more than 5% of the value of our outstanding common stock.
Retirement Plan Risks
If the fiduciary of an employee benefit plan subject to ERISA (such as a profit sharing, Section 401(k) or pension plan) or an owner of a retirement arrangement subject to Section 4975 of the Internal Revenue Code (such as an individual retirement account (“IRA”)) fails to meet the fiduciary and other standards under ERISA or the Internal Revenue Code as a result of an investment in our stock, the fiduciary could be subject to penalties and other sanctions.
There are special considerations that apply to employee benefit plans subject to the Employee Retirement Income Security Act (“ERISA”) (such as profit sharing, Section 401(k) or pension plans) and other retirement plans or accounts subject to Section 4975 of the Internal Revenue Code (such as an IRA) that are investing in our shares. Fiduciaries and IRA owners investing the assets of such a plan or account in our common stock should satisfy themselves that:
•
the investment is consistent with their fiduciary and other obligations under ERISA and the Internal Revenue Code;
•
the investment is made in accordance with the documents and instruments governing the plan or IRA, including the plan’s or account’s investment policy;
•
the investment satisfies the prudence and diversification requirements of Sections 404(a)(1)(B) and 404(a)(1)(C) of ERISA and other applicable provisions of ERISA and the Internal Revenue Code;
•
the investment in our shares, for which no public market currently exists, is consistent with the liquidity needs of the plan or IRA;
•
the investment will not produce an unacceptable amount of “unrelated business taxable income” for the plan or IRA;
•
our stockholders will be able to comply with the requirements under ERISA and the Internal Revenue Code to value the assets of the plan or IRA annually; and
•
the investment will not constitute a prohibited transaction under Section 406 of ERISA or Section 4975 of the Internal Revenue Code.
With respect to the annual valuation requirements described above, we will provide an estimated value for our shares annually. We can make no claim whether such estimated value will or will not satisfy the applicable annual valuation requirements under ERISA and the Internal Revenue Code. The Department of Labor or the Internal Revenue Service may determine that a plan fiduciary or an IRA custodian is required to take further steps to determine the value of our common stock. In the absence of an appropriate determination of value, a plan fiduciary or an IRA custodian may be subject to damages, penalties or other sanctions.
Failure to satisfy the fiduciary standards of conduct and other applicable requirements of ERISA and the Internal Revenue Code may result in the imposition of civil and criminal penalties and could subject the fiduciary to claims for damages or for equitable remedies, including liability for investment losses. In addition, if an investment in our shares constitutes a prohibited transaction under ERISA or the Internal Revenue Code, the fiduciary or IRA owner who authorized or directed the investment may be subject to the imposition of excise taxes with respect to the amount invested. In addition, the investment transaction must be undone. In the case of a prohibited transaction involving an IRA owner, the IRA may be disqualified as a tax-exempt account and all of the assets of the IRA may be deemed distributed and subjected to tax. ERISA plan fiduciaries and IRA owners should consult with counsel before making an investment in our common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 2011, our portfolio consists of 15 healthcare facilities. The following table provides summary information regarding our facilities.
(1) Development joint venture. The projected development cost was $16.3 million and we received the Certificate of Occupancy in January 2011.
(2) Represents estimated gross square footage upon completion of development.
(3) Development joint venture. The projected development cost is $7.3 million and is expected to be completed in the second quarter of 2012.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time in the ordinary course of business, we may become subject to legal proceeding, claims, or disputes. As of the date hereof, we are not a party to any pending legal proceedings.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not Applicable
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
During the period covered by this report, there was no established public trading market for our shares of common stock.
On December 22, 2011, we announced an estimated per-share value of our common stock equal to $9.02 per share, calculated as of September 30, 2011. This estimate is being provided to assist broker-dealers in connection with their obligations under applicable Financial Industry Regulatory Authority (“FINRA”) Rules with respect to customer account statements and to assist fiduciaries in discharging their obligations under Employee Retirement Income Security Act (“ERISA”) reporting requirements.
Our overall objective was to determine an estimated per-share value that is supported by a methodology and assumptions that are appropriate given our current circumstances and that employ procedures and calculations that can be reliably repeated in future periods. In furtherance of this objective, we engaged Integra Realty Resources, Inc., a third-party commercial real estate valuation firm (“Integra”), to appraise all of our real estate assets. The engagement of Integra was approved by our Board of Directors at a time when our Board of Directors was comprised entirely of independent directors not affiliated with our Advisor, our former advisor or our former sub-advisor. Integra’s analyses, opinions, and conclusions were developed in conformity with the Code of Professional Ethics and the Standards of Professional Appraisal Practice of the Appraisal Institute and in conformity with the Uniform Standards of Professional Appraisal Practice. Integra appraised each of our real estate assets individually. Additionally, Integra valued each of our real estate assets as part of a portfolio and ascribed a portfolio premium of 5% to each asset reflecting premiums observed in the marketplace at or around the date of the appraisal. The Board of Directors, our former advisor, and our former sub-advisor reviewed the appraisals and concluded that the net asset value should be reported using the appraised value of each asset excluding the portfolio premium.
The Board of Directors also engaged Robert A. Stanger & Co., Inc., a real estate investment banking firm (“Stanger”), who worked with Integra, our former advisor, our former sub-advisor and our Board of Directors to gather information regarding all of our assets and liabilities. On December 16, 2011, Stanger delivered a final report to our Board of Directors, our advisor and our sub-advisor. Our advisor and sub-advisor each reviewed the report and recommended an estimated per-share value, excluding any portfolio premium included in the Integra appraisal reports. Our Board of Directors considered all information provided in light of its own knowledge regarding our assets and unanimously agreed upon an estimated value of $9.02 per share, which is consistent with the recommendations of our former advisor and former sub-advisor and the estimate included in Stanger’s report.
Our estimated per-share value was calculated by aggregating the appraised value of our real estate and the estimated fair value of our other assets, subtracting the estimated fair value of our liabilities, adjusting the valuations for interests in joint ventures on selected assets, and dividing the total by the number of our common shares outstanding as of September 30, 2011. Our estimated aggregate share value is the same as our net asset value. As described above, it does not reflect any portfolio premium.
Calculation:
As of September 30, 2011, our estimated per-share value was calculated as follows:
(1) Our real estate assets were appraised using valuation methods that we believe are typically used by investors for properties
similar to ours, including capitalization of the net property operating income, comparison with sales of similar properties and a cost approach. Primary emphasis was placed on the direct capitalization analysis, with the other approaches used to confirm the reasonableness of the value conclusion. Using this methodology, the appraised value of our real estate assets reflects an overall increase from original purchase price, exclusive of acquisition costs, plus post-acquisition capital investments, of 19.1%. We believe that the assumptions employed in the property appraisals are reasonable and within the ranges used for properties similar to ours and held by investors with similar expectations to our investors. However, a change in the assumptions would impact the calculation of the value of our real estate assets. For example, assuming all other factors remain unchanged, a change in the assumed weighted-average capitalization rate by 0.25% would yield a change in our net asset value by approximately $0.38 per share.
Based upon the net property operating income for our properties as estimated by Integra, the aggregate appraised value of the portfolio, excluding any portfolio premium is $197,000,000. We note that the appraisal also considered the remaining cost to complete the one of our assets, Littleton Specialty Rehabilitation Facility.
(2) The fair value of our debt instruments was estimated using discounted cash flow models, which incorporate assumptions that we believe reflect the terms currently available on similar borrowing arrangements to borrowers with credit profiles similar to ours.
(3) The fair value of our non-real estate assets and liabilities is estimated to materially reflect book value given their typically short-term (less than 1 year) settlement periods. Such adjustment also includes the effect of ownership of certain of our properties by joint venture partners.
We look to bolster this performance with our recently-adopted a business strategy that involves (i) refinancing certain outstanding debt at more favorable interest rates and (ii) deploying capital into additional acquisitions.
We plan to update our estimated per-share value on an annual basis.
As with any valuation methodology, our methodology is based upon a number of estimates and assumptions that may not be accurate or complete (see the footnotes to the table above). Different parties with different assumptions and estimates could derive a different estimated per-share value. Accordingly, with respect to our estimated per-share value, we can provide no assurance that:
•
a stockholder would be able to realize this estimated value per share upon attempting to resell his or her shares;
•
we would be able to achieve, for our stockholders, the estimated value per share, upon a listing of our shares of common stock on a national securities exchange, selling our real estate portfolio, or merging with another company; or
•
the estimated share value, or the methodologies relied upon to estimate the share value, will be found by any regulatory authority to comply with FINRA, ERISA, or any other regulatory requirements.
Furthermore, the estimated value of our shares was calculated as of a particular point in time. The value of our shares will fluctuate over time in response to, among other things, changes in real estate market fundamentals, capital markets activities, and attributes specific to the properties within our portfolio.
Stock Repurchase Program
In 2007, our board of directors adopted a stock repurchase program that enabled our stockholders to sell their stock to us in limited circumstances, as described below. Effective May 29, 2011, our board of directors suspended this program for all repurchases except repurchases due to death of stock holders. Our directors may elect not to reinstate the repurchase program or to reinstate it under different repurchase terms than those previously in effect.
During the twelve months ended December 31, 2011, we redeemed shares pursuant to our stock repurchase program as follows:
(1) Prior to the suspension of our stock repurchase program on May 29, 2011, our stockholders who had held their stock for at least one year were able, under certain circumstances, to have all or any portion of their shares redeemed in accordance with the procedures outlined in the prospectus relating to the shares they purchased.
During the year ended December 31, 2011, we redeemed an aggregate of 251,482 shares of common stock for approximately $2,444,000 ($9.72 per share). During the year ended December 31, 2011, we received requests to repurchase a total of 369,250 shares pursuant to the program. Stock redemption requests related to 86,182 shares were not fulfilled because such shares were not eligible for redemption under the terms of the program. We have funded share redemptions with proceeds from our public offerings.
One of the limitations of our stock repurchase program is that during any calendar year we may redeem only the number of shares that we can purchase with the amount of the net proceeds from the issuance of shares under the distribution reinvestment plan during the prior calendar year. During the year ended December 31, 2010, we issued shares under our distribution reinvestment plan for gross offering proceeds of approximately $2.2 million, and, therefore, our redemptions in 2011 were limited to the shares that we could purchase with this amount, prior to suspension of the repurchase program on May 29, 2011.
Our board of directors reserves the right in its sole discretion at any time and from time to time, upon 30 days prior notice to our stockholders, to amend, reinstate or terminate our stock repurchase program.
Stockholders
As of March 12, 2012, we had approximately 12.9 million shares of common stock outstanding held by 3,681 stockholders of record.
Distributions
In order to meet the requirements for being treated as a REIT under the Internal Revenue Code, we must pay distributions to our shareholders each taxable year equal to at least 90% of our net ordinary taxable income. Until proceeds from our public offerings are invested and generating operating cash flow sufficient to make distributions to stockholders, we may pay all or a substantial portion of our distributions from the proceeds of our offerings and or from borrowings in anticipation of future cash flow. Our board generally declares distributions on a quarterly basis, which are paid on a monthly basis. Monthly distributions are paid based on daily record dates so our investor will be entitled to be paid distributions beginning on the day that they purchase shares.
In 2007, we adopted a distribution reinvestment plan that allows our stockholders to have dividends and other distributions otherwise distributable to them, invested in additional shares of our common stock at their election. We registered 10,000,000 shares of our common stock for sale pursuant to the distribution reinvestment plan. The purchase price per share is 95% of the price paid by the purchaser for our common stock, but not less than $9.50 per share. As of December 31, 2011 and December 31, 2010, 551,000 and 394,000 shares, respectively, had been issued under the distribution reinvestment plan.
On April 29, 2011, we informed our stockholders that our Independent Directors Committee had directed us to suspend our offering, our dividend reinvestment plan and our stock repurchase program (except repurchases due to death) because of the uncertainty associated with our Independent Directors Committee consideration of various strategic alternatives to enhance our stockholders’ value. As a result, we suspended our distribution reinvestment plan effective as of May 10, 2011.
During the years ended December 31, 2011 and 2010, we paid distributions, including any distributions reinvested, aggregating approximately $5.3 million and $5.7 million, respectively to our stockholders. From October 16, 2006 (date of inception) to December 31, 2011, distribution declared was approximately $6.3 million. Since inception, we had experienced a cumulative negative cash flow from operations of approximately $2.2 million.
The following table shows the distributions declared on daily record dates for each day during the period from January 1, 2010 through December 31, 2011, aggregated by quarter as follows:
Since our inception in 2006, we have paid aggregate distributions of $9.0 million. Of this amount, $5.2 million has been reinvested through our dividend reinvestment plan and $9.0 million has been paid in cash to stockholders. For the corresponding period our aggregate cash flow used in operating activities was $2.2 million. Accordingly, from our inception to date, our total distributions have exceeded our cash flows from operations. Currently, we make cash distributions to our stockholders from capital at an annualized rate of 2.5%, based on a $10.00 per share purchase price. A portion of these distributions are being paid in anticipation of future cash flow from our investments. Until proceeds from our offering are invested and generating operating cash flow sufficient to make distributions to stockholders, we intend to pay all or a substantial portion of our distributions from the proceeds of our offering or from borrowings in anticipation of future cash flow, reducing the amount of funds that would otherwise be available for investment.
The declaration of distributions is at the discretion of our board of directors and our board will determine the amount of distributions on a regular basis. The amount of distributions will depend on our funds from operations, financial condition, capital requirements, annual distribution requirements under the REIT provisions of the Internal Revenue Code and other factors our board of directors deems relevant. We may amend or terminate the distribution reinvestment plan for any reason at any time upon 10 days prior written notice to participants.
Recent Sales of Unregistered Securities
We did not sell any equity securities that were not registered under the Securities Act of 1933 during the period covered by this Form 10-K.
Equity Compensation Plans
Information about securities authorized for issuance under our equity compensation plans required for this item is incorporated by reference from our definitive Proxy Statement to be filed in connection with our 2011 annual meeting of stockholders.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following should be read with the sections titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the notes thereto.
(1) Net loss and dividends per share are based upon the weighted average number of shares of common stock outstanding.
(2) Dividend per common share for 2008 is calculated based on days outstanding during the year.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements and notes appearing elsewhere in this Form 10-K. See also “Special Note about Forward Looking Statements” preceding Item 1 of this report.
Overview
We were incorporated on October 16, 2006 for the purpose of engaging in the business of investing in and owning commercial real estate. We intend to invest the net proceeds from our offerings primarily in investment real estate including health care, multi-tenant industrial, net-leased retail properties and other real estate related assets located in major metropolitan markets in the United States. As of December 31, 2011, we had raised $127 million of gross proceeds from the sale of approximately 12.7 million shares of our common stock in our public offerings, and we had acquired fifteen real estate properties.
Our revenues, which are comprised largely of rental income, include rents reported on a straight-line basis over the initial term of the lease. Our growth depends, in part, on our ability to (i) increase rental income and other earned income from leases by increasing rental rates and occupancy levels; (ii) maximize tenant recoveries given the underlying lease structures; and (iii) control operating and other expenses. Our operations are impacted by property specific, market specific, general economic and other conditions.
Highlights for the Twelve Months Ended December 31, 2011
•
Following an intensive analysis of strategic alternatives for the Company, conducted by the Independent Directors Committee of our Board of Directors in consultation with its independent financial advisor, our Independent Directors Committee and our Board of Directors determined that it was in the best interests of our Company and its stockholders to transition advisory services previously rendered to us by Cornerstone Leveraged Realty Advisors, LLC, an affiliate of Cornerstone Ventures, Inc., our original sponsor, and to engage, commencing on January 1, 2012, as our replacement advisor Sentio Investments, LLC (f/k/a Springlake Healthcare Capital, LLC), a newly formed company controlled by John Mark Ramsey, the Chief Executive Officer and an owner of our prior sub-advisor, Servant Healthcare Investments, LLC.
•
We acquired interests in two properties during 2011 as follows:
•
On January 14, 2011, through a wholly-owned subsidiary, we purchased the assets of an assisted-living property, Forestview Manor, from 153 Parade Road, LLC, for $10.8 million. The acquisition was funded by our revolving credit facility from Key Bank National Association and with proceeds from our initial public offering.
•
On April 14, 2011, through a wholly-owned subsidiary, we purchased an assisted-living property, Sunrise of Allentown, from an affiliate of Sunrise Senior Living, Inc., for $9.0 million. The property has been rebranded as Woodland Terrace at the Oaks Senior Living. The acquisition of Woodland Terrace was funded with proceeds from our public offerings and a mortgage loan from an unaffiliated lender, post-closing.
•
We obtained acquisition financing of $11.7 million at an average variable interest rate of approximately 5.75% as of December 31, 2011.
Results of Operations
As of December 31, 2011, we operated in three reportable business segments: senior living operations, triple-net leased properties, and medical office building (“MOB”) properties. Our senior living operations segment invests in and operates assisted living, memory care and other senior housing communities located in the United States. We engage independent third party managers to operate these properties. Our triple-net leased properties segment invests in healthcare properties in the United States leased under long term “triple-
net” or “absolute-net” leases, which require the tenants to pay all property-related expenses. Our MOB segment invests in medical office buildings and leases those properties to healthcare providers under long term “full service” leases which require tenants to reimburse expenses related to us.
We began accepting subscriptions for shares under our initial public offering on June 20, 2008. We purchased our first senior housing property in January 2009, and at December 31, 2011, we owned fifteen properties. These properties included ten_ assisted living facilities, which comprise our senior housing segment, one medical office building, which comprises our MOB segment, and one skilled nursing facility, two inpatient rehabilitation facilities and one development project, which comprise our triple-net leased segment.
As of December 31, 2011, we owned 10 assisted living facilities which comprise our senior housing segment, one medical office building, which comprises our MOB segment, one skilled nursing and two inpatient rehabilitation facilities and one development project which comprise our triple-net leased segment. As of December 30, 2010, we owned eight assisted living facilities which comprise our senior housing segment, one medical office building, which comprised our MOB segment, one skilled nursing facility, and one inpatient rehabilitation facility and two development projects, which comprised our triple-net leased segment.
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
(1) Net operating income is defined as total revenue less property operating and maintenance expenses. We use net operating income to evaluate the operating performance of our real estate investments and to make decisions concerning the operation of the property. We believe that net operating income is useful to investors in understanding the value of income-producing real estate. Net income is the GAAP measure that is most directly comparable to net operating income; however, net operating income should not be considered as an alternative to net income as the primary indicator of operating performance as it excludes certain items such as depreciation and amortization, interest expense and corporate general and administrative expenses. Additionally, net operating income as we define it may not be comparable to net operating income as defined by other REITs or companies.
Senior Living Operations
Total revenue for senior living operations includes rental revenue and resident fees and service income. Property operating and maintenance expenses include labor, food, utilities, marketing, management and other property operating costs. Net operating income for the year ended December 31, 2011 increased to $10.5 million from $4.4 million for the year ended December 31, 2010. The increase is primarily due to acquisitions completed during 2011 and 2010 and higher occupancy for properties owned in 2010.
Triple-Net Leased Properties
Total revenue for triple-net leased properties includes rental revenue and expense reimbursements from tenants. Property operating and maintenance expenses include insurance and property taxes and other operating expenses reimbursed by our tenants. Net operating income increased to $5.1 million for the year ended December 31, 2011 compared to $2.3 million for the year ended December 31, 2010 primarily due to the acquisitions completed in 2010 and the completion of one development property in the first quarter of 2011.
Medical Office Buildings
Total revenue for medical office buildings includes rental revenue and expense reimbursements from tenants. Property operating and maintenance expenses include utilities, repairs and maintenance, insurance and property taxes. Net operating income increased to $0.8 million for the year ended December 31, 2011 compared to $26,000 for the year ended December 31, 2010, due to a full year of operations in 2011. The office building was acquired in December 2010.
(a) Due to this property being acquired in December 2010, the presentation of percentage changes from 2010 to 2011 are not considered meaningful for 2011.
Unallocated (expenses) income
General and administrative expenses increased to $3.7 million for the year ended December 31, 2011 from $2.4 million for the year ended December 31, 2010. The increase is primarily due to nonrecurring expenses incurred as a part of the Company’s evaluation of strategic alternatives. These expenses include consulting, legal, accounting and income tax expenses as well as board of directors and committee meeting fees and director and officer insurance costs.
As a result of real estate investments in 2011 asset management fees and expenses for the years ended December 31, 2011 and 2010 increased to $1.6 million from $1.0 million and depreciation and amortization for the same periods increased to $7.7 million from $4.1 million. Average real estate investments increased to $160.0 million in 2011 from $85.5 million in 2010.
For the years ended December 31, 2011 and 2010 real estate acquisition costs, consisting of fees paid to our prior advisor and third-party expenses, were $2.5 million and $3.3 million, respectively. The 2011 decrease in acquisition fees is due to lower offering proceeds and few acquisitions closed in 2011, since the Company’s offering activities were suspended in April 2011, partially offset by higher earn out and joint venture promote costs. A portion of acquisition fees due to our Advisor are paid upon receipt of offering proceeds and the balance is paid at the time of investment acquisition.
Interest expense for the year ended December 31, 2010 increased to $2.4 million from $1.1 million for the year ended December 31, 2009 due to increased real estate acquisition financing in 2010.
Interest and other income were comparable for years ended December 31, 2011 and 2010.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
(1) Net operating income is defined as total revenue less property operating and maintenance expenses.
Senior Living Operations
Total revenue for senior living operations includes rental revenue and resident fees and service income. Property operating and maintenance expenses include labor, food, utilities, marketing, management and other property operating costs. Net operating income for the year ended December 31, 2010 increased to $4.4 million from $1.5 million for the year ended December 31, 2009. The increase is primarily due to acquisitions completed during 2010.
Triple-Net Leased Properties
Total revenue for triple-net leased properties includes rental revenue and expense reimbursements from tenants. Property operating and maintenance expenses include insurance and property taxes and other operating expenses reimbursed by our tenants. Net operating income increased to $2.3 million for the year ended December 31, 2010 compared to $0 for the year ended December 31, 2009 due to the acquisitions completed in 2010 and one acquisition completed on December 31, 2009.
Medical Office Buildings
Total revenue for medical office buildings includes rental revenue and expense reimbursements from tenants. Property operating and maintenance expenses include utilities, repairs and maintenance, insurance and property taxes. Net operating income increased to $26,000 for the year ended December 31, 2010 from $0 compared to the year ended December 31, 2009, due to acquisitions completed in December 2010.
Unallocated (expenses) income
General and administrative expenses increased to $2.4 million for the year ended December 31, 2010 from $1.1 million for the year ended December 31, 2009. The increase is primarily due to an increase in reimbursements to the Advisor for the direct and indirect costs of providing administrative and management services and higher professional fees, including audit, tax and legal fees, all of which resulted from the higher level of investment and asset management activities in 2010.
As a result of the acquisitions in 2010, asset management fees and expenses for the years ended December 31, 2010 and 2009 increased to $1.0 million from $0.3 million and depreciation and amortization for the same periods increased to $4.1 million from $1.4 million.
For the years ended December 31, 2010 and 2009 real estate acquisition costs, consisting of fees paid to the Advisor and third-party expenses, were $3.3 million and $1.8 million, respectively. The 2010 increase in acquisition fees is due to higher offering proceeds and increased acquisition activity in 2010 compared to 2009. A portion of acquisition fees due to our Advisor are paid upon receipt of offering proceeds and the balance is paid at the time of investment acquisition.
Interest expense for the year ended December 31, 2010 increased to $2.4 million from $1.1 million for the year ended December 31, 2009 due to increased real estate acquisition financing in 2010.
Interest and other income are comparable for years ended December 31, 2010 and 2009.
Liquidity and Capital Resources
On April 29, 2011, we informed our stockholders that our Independent Directors Committee had directed us to suspend our offering, our dividend reinvestment program and our stock repurchase program (except repurchases due to death of a stockholder) because of the uncertainty associated with their consideration of various strategic alternatives to enhance our stockholders’ value. The Independent Directors Committee subsequently evaluated possible changes to our advisory relationships. An agreement (the Omnibus Agreement) dated July 29, 2011, implemented a number of advisory relationship changes. Furthermore, on December 22, 2011, following an intensive analysis conducted by the Independent Directors Committee of our Board of Directors in consultation with its independent financial advisor, our Independent Directors Committee and our Board of Directors determined that it was in the best interests of the company and our stockholders to transition advisory services from our then-advisor, Cornerstone Leveraged Realty Advisors, LLC, an affiliate of Cornerstone Ventures, Inc., our original sponsor, and to engage, commencing on January 1, 2012, as our replacement advisor Sentio Investments, LLC (f/k/a Springlake Healthcare Capital, LLC), a newly formed company controlled by John Mark Ramsey, the Chief Executive Officer and an owner of our prior sub-advisor, Servant Healthcare Investments, LLC. The success of these changes in accomplishing the Independent Directors’ objectives is uncertain. In addition to uncertainties associated with our advisor relationships, financial markets have recently experienced unusual volatility and uncertainty. Liquidity has tightened in all financial markets, including the debt and equity markets. We expect that our primary uses of capital over the next twelve months will be for the payment of tenant improvements, earn out and promote liabilities, operating expenses, including interest expense on any outstanding indebtedness, reducing outstanding indebtedness and for the payment of distributions. We expect to have sufficient cash available from cash on hand and operations to fund capital improvements and principal payments due on our borrowings in the next twelve months. Two loans, the KeyBank credit facility and the construction loan on the Rome LTACH project, mature in the second half of 2012. The Rome LTACH loan provides for two one-year maturity extensions. We are pursuing opportunities to refinance these loans and other variable rate borrowing at lower borrowing rates to take advantage of historically favorable interest rates and to meet the payment obligations due in the second half of 2012. Although the response to our initial refinancing efforts has been positive, there can be no assurance that the Company will be able to refinance its obligations at favorable rates or at all. We expect to fund stockholder distributions from the excess of cash on hand and from the excess of cash provided by operations over required capital improvements and debt payments. This excess may be insufficient to make distributions at the current level or at all. On December 31, 2011 , our directors declared distributions for the first quarter of 2012 at an annualized rate of 2.5%. As of December 31, 2011, we had approximately $28.3 million in cash and cash equivalents on hand. Available cash may be temporarily invested in short-term, liquid investments that yield lower returns than investments in real estate.
On November 19, 2010, we entered into an agreement with KeyBank National Association, an unaffiliated financial institution, to obtain a $25.0 million revolving credit facility (the “Facility”). The Facility included a financial covenant requiring us to raise at least $20.0 million in our public offering in the six-month period ending June 30, 2011, and to raise an additional $20.0 million in net offering proceeds during each six-month calendar period thereafter. Because we suspended our public offering on April 29, 2011, we were not able to satisfy this covenant; however, effective August 1, 2011, the Company successfully negotiated the terms of a modification to the credit facility. The terms of the agreement were amended to convert the Facility from a revolving loan commitment to a term loan and reduced the maximum amount of the commitment from $25.0 million to the current outstanding amount of $16.3 million. The amendment also changed the maturity date of the Facility from November 18, 2012 to July 31, 2012 (subject to one ninety-day extension option). The amendment increased the minimum amount of cash and cash equivalents that the Company must maintain from $5.0 million to $8.0 million, but eliminated a covenant that required the Company to raise equity capital of at least $20.0 million during each calendar six-month period. The interest rate for this Facility is one-month LIBOR plus a margin of 400 basis points, with a floor of 200 basis points for one-month LIBOR. We are entitled to prepay the obligations at any time without penalty.
Distributions
Some or all of our distributions have been paid from sources other than operating cash flow, such as offering proceeds and proceeds from loans, including those secured by our assets. Through June 30, 2011, we made cash distributions to our stockholders at an annualized rate of 7.5%, based on a $10.00 per-share purchase price. On June 30, 2011, our board of directors resolved to lower our
distributions to a current annualized rate of $0.25 per share (2.5% based on a share price of $10.00). The distribution rate was effective July 1, 2011. This distribution rate is expected to more closely align distributions to funds available from operations. Historically, we have used a portion of the proceeds from our distribution reinvestment plan for general corporate purposes, including capital expenditures on our real estate investments, tenant improvement costs and leasing costs related to our investments in real estate properties; reserves required by financings of our investments in real estate properties; and the repayment of debt. Because our distribution reinvestment plan was suspended on May 10, 2011, we will no longer have distribution reinvestment plan proceeds available for such general corporate purposes. Because such funds will not be available from the distribution reinvestment plan offering, we may have to use a greater proportion of our cash flow from operations to meet our general cash requirements, which would reduce cash available for distributions. As noted above, the distribution rate was decreased to an annualized rate of 2.5% on June 30, 2011 in response to the current situation.
Distributions paid to stockholders for the twelve months ended December 31, 2011 were $6.4 million. Of this amount, $1.6 million was reinvested through our distribution reinvestment plan and $4.8 million was paid in cash to stockholders. For the twelve months ended December 31, 2011, a substantial portion of distributions to stockholders were paid from proceeds of our offering in anticipation of future cash flow. Potential future sources of capital include proceeds from future equity offerings, proceeds from secured or unsecured financings from banks or other lenders, proceeds from the sale of properties and undistributed funds from operations.
Financial markets have recently experienced unusual volatility and uncertainty. Liquidity has tightened in all financial markets, including the debt and equity markets. Our ability to fund property acquisitions or development projects, as well as our ability to repay or refinance debt maturities could be adversely affected by an inability to secure financing at reasonable terms, if at all.
Election as a REIT
For federal income tax purposes, we have elected to be taxed as a REIT, under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code) beginning with our taxable year ending December 31, 2008. Under the Internal Revenue Code of 1986, we are not subject to federal income tax on income that we distribute to our stockholders. REITs are subject to numerous organizational and operational requirements in order to avoid taxation as a regular corporation, including a requirement that they generally distribute at least 90% of their annual ordinary taxable income to their stockholders. If we fail to qualify for taxation as a REIT in any year, our income will be taxed at regular corporate rates, and we may be precluded from qualifying for treatment as a REIT for the four-year period following our failure to qualify. Our failure to qualify as a REIT could result in us having a significant liability for taxes.
REIT status imposes limitations related to operating assisted-living properties. Generally, to qualify as a REIT, we cannot directly operate assisted-living facilities. However, such facilities may generally be operated by a taxable REIT subsidiary (“TRS”) pursuant to a lease with the REIT. Therefore, we have formed a TRS to lease any assisted-living properties we acquire and to operate the assisted-living properties pursuant to contracts with qualified unaffiliated management companies. The TRS and the REIT have made the applicable election for the TRS to qualify as a TRS. Under the management contracts, the unaffiliated management companies will have direct control of the daily operations of these assisted-living properties.
Other Liquidity Needs
Property Acquisitions
We expect to purchase properties and have expenditures for capital improvements and tenant improvements in the next twelve months; however, those amounts cannot be estimated at this time. We cannot be certain however, that we will have sufficient funds to make any acquisitions or related capital expenditures.
Debt Service Requirements
A number of the properties in which we have made equity investments are currently subject to senior mortgage loans and other indebtedness as described in the following table:
(1) As of December 31, 2011 all notes payable are secured by the underlying real estate.
(2) The aggregate loan amount is composed of a restatement date balance of $12.9 million outstanding with respect to a prior loan (the “Initial Loan”), and an additional amount of $5.1 million disbursed on the closing date (the “Restatement Date Loan”). From June 1, 2010 through the maturity date, payments on the Restatement Date Loan are due monthly and based upon a 30-year amortization schedule. From June 1, 2010 through January 10, 2011, payments on the Initial Loan were due monthly based upon a 25-year amortization schedule, thereafter through maturity, payments on the Initial Loan are due monthly based upon a 30-year amortization schedule. The Restatement Date Loan bears interest at a variable rate equal to 5.45% per annum plus the greater of 1.0% or the 3-month LIBOR rate (the “Contract Rate”). The outstanding balance of the Initial Loan bore interest at a rate of 6.62% per annum until January 10, 2011 and thereafter bears interest at the Contract Rate.
(3) Of the total loan amount, $2.4 million bears a fixed interest rate of 6.25% per annum. The remaining $0.4 million bears a variable interest rate equivalent to the prevailing market certificate of deposit rate plus a 1.5% margin. Monthly payments for the first twelve months were interest-only. Thereafter, monthly payments included interest and principal based on a 25-year amortization period.
(4) In November 2010, we entered into an agreement with KeyBank National Association, an unaffiliated financial institution (“KeyBank”), to obtain a $25,000,000 revolving credit facility. The initial term of the credit facility was 24 months, maturing on November 18, 2012, and could be extended by six months subject to satisfaction of certain conditions, including payment of an extension fee. The actual amount of credit available under the credit facility was a function of certain loan to cost, loan to value and debt service coverage ratios contained in the credit facility. The amount outstanding under the credit facility was $16.3 million and $7.6 million at December 31, 2011 and December 31, 2010, respectively.
Contractual Obligations
The following table reflects our contractual obligations as of December 31, 2011:
(1) Represents principal amount owed on all outstanding debt as of December 31, 2011.
(2) Represents interest expense related to various loan agreements in connection with all acquisitions as of December 31, 2011. The information in the table above reflects our projected interest rate obligations for these loan agreements based on the contract interest rates, interest payment dates, and scheduled maturity dates.
Off-Balance Sheet Arrangements
There are no off-balance sheet transactions, arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in the financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Inflation
Although the real estate market has not been affected significantly by inflation in the recent past due to the relatively low inflation rate, we expect that the majority of our tenant leases will include provisions that would protect us to some extent from the impact of inflation. Where possible, our leases will include provisions for rent escalations and partial reimbursement to us of expenses. Our ability to include provisions in the leases that protect us against inflation is subject to competitive conditions that vary from market to market.
Critical Accounting Policies
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, or GAAP, requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We believe that our critical accounting policies are those that require significant judgments and estimates such as those related to fair value, real estate purchase price allocation, evaluation of possible impairment of real property assets, revenue recognition and valuation of receivables, income taxes, and uncertain tax positions. These estimates are made and evaluated on an on-going basis using information that is currently available as well as various other assumptions believed to be reasonable under the circumstances. Actual results could vary from those estimates, perhaps in material adverse ways, and those estimates could be different under different assumptions or conditions.
Investments in Real Estate
Upon acquisition of a property, we allocate the purchase price of the property based upon the fair value of the assets acquired, which generally consist of land, buildings, site improvements, tenant improvements, intangible lease assets or liabilities including in-place leases, above market and below market leases, tenant relationships and goodwill. We allocated the purchase price to the fair value of the tangible assets of an acquired property by valuing the property as if it were vacant. The value of the building and improvements are depreciated over an estimated useful life of 15 to 39 years.
In-place lease values are calculated based on management’s evaluation of the specific characteristics of each tenant’s lease and our overall relationship with the respective tenant.
Acquired above and below market leases are valued based on the present value of the difference between prevailing market rates and the in-place rates over the remaining lease term. The value of acquired above and below market leases is amortized over the remaining non-cancelable terms of the respective leases as an adjustment to rental revenue on our consolidated statements of operations.
We consider any bargain periods in our calculation of fair value of below-market leases and to amortize our below-market leases over the remaining non-cancelable lease term plus any bargain renewal periods in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 840-20-20, as determined by our management at the time we acquire real property with an in-place lease. The renewal option rates for our acquired leases do not include any fixed rate options and, instead, contain renewal options that are based on fair value terms at the time of renewal. Accordingly, no fixed rate renewal options were included in the fair value of below-market leases acquired and the amortization period is based on the acquired non-cancelable lease term.
Should a significant tenant terminate their lease, the unamortized portion of intangible assets or liabilities is charged to revenue.
Fair Value of Financial Instruments
FASB ASC 825-10, “Financial Instruments”, requires the disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practical to estimate that value.
Fair value represents the estimate of the proceeds to be received, or paid in the case of a liability, in a current transaction between willing parties. ASC 820, Fair Value Measurement (“ASC 820”) establishes a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Inputs are either observable or unobservable in the marketplace. Observable inputs are based on market data from independent sources and unobservable inputs reflect the reporting entity’s assumptions about market participant assumptions used to value an asset or liability.
Financial assets and liabilities recorded at fair value on the condensed consolidated balance sheets are categorized based on the inputs to the valuation techniques as follows:
Level 1. Quoted prices in active markets for identical instruments.
Level 2. Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3. Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
Assets and liabilities measured at fair value are classified according to the lowest level input that is significant to their valuation. A financial instrument that has a significant unobservable input along with significant observable inputs may still be classified as a Level 3 instrument.
We generally determine or calculate the fair value of financial instruments using present value or other valuation techniques, such as discounted cash flow analyses, incorporating available market discount rate information for similar types of instruments and our estimates for non-performance and liquidity risk. These techniques are significantly affected by the assumptions used, including the discount rate, credit spreads, and estimates of future cash flow.
Our balance sheets include the following financial instruments: cash and cash equivalents, tenant and other receivables, restricted cash, security deposits, accounts payable and accrued liabilities, distributions payable, and notes payable. With the exception of accrued earn out and promote liabilities and notes payable discussed below, we consider the carrying values of our financial instruments to approximate fair value because of the short period of time between origination of the financial assets and liabilities and their expected settlement.
The fair value of accrued earn out payments and promote liabilities is estimated using projected operating results and capitalization rates and discount rates that are derived from market data that other inputs from comparable properties and transactions. The fair market value of notes payable is estimated using lending rates available to us for financial instruments with similar terms and maturities. As of December 31, 2011 and December 31, 2010, the fair value of notes payable was $101.1 million and $81.7 million, compared to the carrying values of $100.0 million and $80.8 million, respectively.
Impairment of Real Estate Assets and Goodwill
Real Estate Assets
Rental properties, properties undergoing development and redevelopment, land held for development and intangibles are individually evaluated for impairment in accordance with ASC 360-10, “Property, Plant & Equipment” when conditions exist which may indicate that it is probable that the sum of expected future undiscounted cash flows is less than the carrying amount. We assess the expected undiscounted cash flows based upon numerous factors, including, but not limited to, appropriate capitalization rates, construction costs, available market information, historical operating results, known trends and market/economic conditions that may affect the property and our assumptions about the use of the asset, including, if necessary, a probability-weighted approach if multiple outcomes are under consideration. Upon determination that impairment has occurred, a write-down will be recorded to reduce the carrying amount to its estimated fair value.
In accordance with ASC 360 “Accounting for the Impairment or Disposal of Long-lived Assets”, we assess whether there has been impairment in the value of its investments in real estate whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Our portfolio is evaluated for impairment on a property-by-property basis. Indicators of potential impairment include the following:
•
Change in strategy resulting in a decreased holding period;
•
Decreased occupancy levels;
•
Deterioration of the rental market as evidenced by rent decreases over numerous quarters;
•
Properties adjacent to or located in the same submarket as those with recent impairment issues;
•
Significant decrease in market price; and/or
•
Tenant financial problems.
During 2011 and 2010, we did not record any impairment charges related to our investments in real estate.
Goodwill
We review goodwill for impairment annually and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. The guidance on goodwill impairment requires us to annually test goodwill for impairment under a two-step impairment test, or, as discussed below, under a qualitative assessment which became optional in 2011. In the first step of the two-step test, we compare the fair value of each reporting unit to its carrying value. We determine the fair value of our reporting unit based on the income approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the second step of the impairment test is performed in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then the company records an impairment loss equal to the difference.
In September 2011, ASU 2011-08 was issued and provides companies the option to perform a qualitative assessment of a reporting unit before being required to perform Step 1 of the two-step goodwill test as prescribed by FASB Topic 350 “Intangibles-Goodwill and Other” (“Topic 350”). ASU 2011-08 has amended Topic 350 to state “An entity may first assess qualitative factors to determine whether it is necessary to perform the two-step goodwill impairment test .” The qualitative assessment requires management to perform the assessment using a “more likely than not” concept. According to ASC 350-20-35-3C, in evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, relevant events and circumstances shall be assessed
We performed a qualitative assessment as of December 31, 2011. In this assessment we considered certain macroeconomic factors including changes in the general economic conditions, interest rates, capital markets, market-dependent multiples or metrics and regulatory developments. Additionally, reporting unit specific factors evaluated included negative or declining cash flows, decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods, declines in occupancy rates, changes in management, key personnel, strategy, or customers, contemplation of bankruptcy, litigation, changes in the carrying amount of net assets, more-likely-than-not expectation of selling or disposing all, or a portion of a reporting unit and testing for recoverability of a significant asset group within a reporting unit.
When required, determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, discount rates and future economic and market conditions. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management’s assumptions, which would not reflect unanticipated events and circumstances that may occur.
The annual goodwill impairment analysis, which we performed as of the fourth quarter of 2011, did not result in an impairment charge.
Revenue Recognition
Revenue is recorded in accordance with ASC 840-10, “Leases”, and SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements, as amended” (“SAB 104”). Revenue is recognized when four basic criteria are met: persuasive evidence of an arrangement exists, services have been delivered, the amount of revenue is fixed or determinable, and collection is reasonably assured. Leases with fixed annual rental escalators are generally recognized on a straight-line basis over the initial lease period, subject to a collectability assessment. Rental income related to leases with contingent rental escalators is generally recorded based on the contractual cash rental payments due for the period. Because our leases may provide for free rent, lease incentives, or other rental increases at specified intervals, we straight-line the recognition of revenue, which results in the recording of a receivable for rent not yet due under the lease terms. Our revenues are comprised largely of rental income and other income collected from tenants.
Consolidation Considerations for Our Investments in Joint Ventures
ASC 810-10, “Consolidation”, addresses how a business enterprise should evaluate whether it has a controlling interest in an entity through means other than voting rights and, accordingly, should consolidate the entity. We analyze our joint ventures in accordance with this accounting standard to determine whether they are variable interest entities and, if so, whether we are the primary beneficiary. Our judgment with respect to our level of influence or control over an entity and whether we are the primary beneficiary of a variable interest entity involves consideration of various factors including the form of our ownership interest, our voting interest, the size of our investment (including loans) and our ability to participate in major policy-making decisions. Our ability to correctly assess our influence or control over an entity affects the presentation of these investments in our condensed consolidated financial statements. Please refer to Note 10. Investments in Joint Venture of the accompanying consolidated financial statements.
Income Taxes
As part of the process of preparing our condensed consolidated financial statements, significant management judgment is required to evaluate our compliance with REIT requirements. Our determinations are based on interpretation of tax laws, and our conclusions may have an impact on the income tax expense recognized. Adjustments to income tax expense may be required as a result of: (i) audits conducted by federal and state tax authorities, (ii) our ability to qualify as a REIT and (iii) changes in tax laws.
For federal income tax purposes, we have elected to be taxed as a REIT, under Sections 856 through 860 of the Code beginning with our taxable year ended December 31, 2008, which imposes limitations related to operating assisted-living properties. As of December 31, 2011, we had acquired ten assisted-living facilities and formed ten wholly owned taxable REIT subsidiaries, or TRSs, which includes a Master TRS that consolidates our wholly owned TRSs. The properties are operated pursuant to leases with our TRSs. Our TRSs have engaged qualified unaffiliated management companies to operate the assisted-living facilities. Under the management contracts, the managers have direct control of the daily operations of the properties.
We are subject to state and local income taxes in some jurisdictions, and in certain circumstances we may also be subject to federal excise taxes on undistributed income. In addition, certain of our activities must be conducted by subsidiaries which elect to be treated as TRSs. TRSs are subject to both federal and state income taxes. We recognize tax penalties relating to unrecognized tax benefits as additional tax expense. Interest relating to unrecognized tax benefits is recognized as interest expense. Under section 857(b), an excise tax of 100% is imposed on any excessive amount of rental income received by the REIT in connection with services performed by its TRS to a tenant of the REIT and the deductions of the TRS for payments made to the REIT if rental income and deductions are not at arms’ length. Several safe harbors are provided for rental income received by the REIT, any of which, if met, prohibit the imposition of the 100% excise tax.
Recently Issued Accounting Pronouncements
Reference is made to Notes to our Consolidated Financial Statements, which begin on page of this Form 10-K.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. We invest our cash and cash equivalents in government backed securities and FDIC insured savings account which, by its nature, are subject to interest rate fluctuations. However, we believe that the primary market risk to which we will be exposed to is interest rate risk relating the variable portion of our debt financing. As of December 31, 2011, we had approximately $67.4 million of variable rate debt, the majority of which is at a rate tied to short term LIBOR rates. A 1.0% change in 3-Month LIBOR would result in a change in annual interest expense of approximately $0.7 million per year. Our interest rate risk management objectives will be to monitor and manage the impact of interest rate changes on earnings and cash flows by using certain derivative financial instruments such as interest rate swaps and caps in order to mitigate our interest rate risk on variable rate debt. We will not enter into derivative or interest rate transactions for speculative purposes.
In addition to changes in interest rates, the fair value of our real estate is subject to fluctuations based on changes in the real estate capital markets, market rental rates for office space, local, regional and national economic conditions and changes in the credit worthiness of tenants. All of these factors may also affect our ability to refinance our debt if necessary.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the index included at Item 15. Exhibits, Financial Statement Schedules.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our senior management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Our Chief Executive Officer and our Chief Financial Officer have reviewed the effectiveness of our disclosure controls and procedures and have concluded that the disclosure controls and procedures were effective as of the end of the period covered by this report.
In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Our Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on their evaluation as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that we maintained effective internal control over financial reporting as of December 31, 2011.
There have been no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
This annual report does not include an attestation report of our independent registered public accounting firm regarding control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to the Dodd-Frank Wall Street and Consumer Protection Act, which exempts non-accelerated filers from the auditor attestation requirement of Section 404 (b) of the Sarbanes-Oxley Act.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item is incorporated by reference from our definitive proxy statement to be filed with the SEC no later than April 29, 2012.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from our definitive proxy statement to be filed with the SEC no later than April 29, 2012.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference from our definitive proxy statement to be filed with the SEC no later than April 29, 2012.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is incorporated by reference from our definitive proxy statement to be filed with the SEC no later than April 29, 2012.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this item is incorporated by reference from our definitive proxy statement to be filed with the SEC no later than April 29, 2012.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The exhibits listed on the Exhibit Index (following the signatures section of this report) are included, or incorporated by reference, in this annual report
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Sentio Healthcare Properties, Inc.
We have audited the accompanying consolidated balance sheets of Sentio Healthcare Properties, Inc. and subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, equity and cash flows for each of the three years in the period ended December 31, 2011. Our audit also included the financial statement schedules listed in the index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Sentio Healthcare Properties, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects, the information set forth therein.
/s/ DELOITTE & TOUCHE LLP
Costa Mesa, California
March 22, 2012
SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2011 and 2010
The accompanying notes are an integral part of these consolidated financial statements.
SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2011, 2010 and 2009
The accompanying notes are an integral part of these consolidated financial statements.
SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EQUITY
For the Years Ended December 31, 2010, 2009 and 2008
The accompanying notes are an integral part of these consolidated financial statements.
SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2011, 2010 and 2009
The accompanying notes are an integral part of these consolidated figures
SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2011, 2010 and 2009
1. Organization
Sentio Healthcare Properties, Inc. (formerly known as Cornerstone Healthcare Plus REIT, Inc.), a Maryland corporation, was formed on October 16, 2006 under the Maryland General Corporation Law for the purpose of engaging in the business of investing in and owning commercial real estate. As used in this report, the “Company”, “we”, “us” and “our” refer to Sentio Healthcare Properties, Inc. and its consolidated subsidiaries, except where context otherwise requires. We are recently formed and are subject to the general risks associated with a start-up enterprise, including the risk of business failure. Effective January 1, 2012, subject to certain restrictions and limitations, our business is managed by Sentio Investments, LLP, a Florida limited liability company that was formed on December 20, 2011 (the “Successor Advisor”). Prior to January 1, 2012, Cornerstone Leveraged Realty Advisors, LLC, a Delaware limited liability company that was formed on October 16, 2006 (the “Advisor”), was our advisor
Effective July 29, 2011, the Company and the Advisor, together with Cornerstone Ventures, Inc., an affiliate of the Company’s advisor (“CVI”), CIP Leveraged Fund Advisors, LLC, the sole member of the Company’s advisor (“CLFA”), Servant Healthcare Investments, LLC, the Company’s sub-advisor (the “Sub-Advisor”), and Terry Roussel (together with CVI, CLFA and the Advisor, the “Cornerstone Parties”), entered into an Omnibus Agreement (the “Omnibus Agreement”) which, among other actions: (1) amended the advisory agreement, initially executed on September 12, 2007, by and between the Advisor and the Company (as amended, “the Advisory Agreement”); (2) provided for the transfer of certain interests in the Company from the Cornerstone Parties to the Company; (3) terminated the alliance agreement, dated as of May 19, 2008, by and between CVI and the Sub-Advisor; (4) modified and assigned to the Company the Sub-Advisory Agreement, dated as of May 19, 2008, by and between the Advisor, CLFA and the Sub-Advisor; and (5) canceled and forgave certain amounts due from the Advisor to the Company, all as further described herein.
Furthermore, on December 22, 2011, following an intensive analysis conducted by the Independent Directors Committee of our Board of Directors in consultation with its independent financial advisor, our Independent Directors Committee and our Board of Directors determined that it was in the best interests of the company and our stockholders to transition advisory services from our then-advisor, Cornerstone Leveraged Realty Advisors, LLC, an affiliate of Cornerstone Ventures, Inc., our original sponsor, and to engage, commencing on January 1, 2012, as our replacement advisor Sentio Investments, LLC (f/k/a Springlake Healthcare Capital, LLC), a newly formed company controlled by John Mark Ramsey, the Chief Executive Officer and an owner of our prior sub-advisor, Servant Healthcare Investments, LLC.
Sentio Healthcare Properties OP, LP (formerly Cornerstone Healthcare Plus Operating Partnership, L.P)., a Delaware limited partnership (the “Operating Partnership”), was formed on October 17, 2006. At December 31, 2011, we owned 100% of the interest in the Operating Partnership and the HC Operating Partnership, LP (formerly CGI Healthcare Operating Partnership, L.P.), a subsidiary of the Operating Partnership. We anticipate that we will conduct all or a portion of our operations through the Operating Partnership. Our financial statements and the financial statements of the Operating Partnership are consolidated in the accompanying condensed consolidated financial statements. All intercompany accounts and transactions have been eliminated in consolidation.
For federal income tax purposes, we have elected to be taxed as a real estate investment trust under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), beginning with our taxable year ended December 31, 2008. REIT status imposes limitations related to operating assisted-living properties. Generally, to qualify as a REIT, we cannot directly operate assisted-living facilities. However, such facilities may generally be operated by a taxable REIT subsidiary (“TRS”) pursuant to a lease with the Company. Therefore, we have formed Master HC TRS, LLC (“Master TRS”), a wholly owned subsidiary of CGI Healthcare Operating Partnership, LP, to lease any assisted-living properties we acquire and to operate the assisted-living properties pursuant to contracts with unaffiliated management companies. Master TRS and the Company made the applicable election for Master TRS to qualify as a TRS. Under the management contracts, the management companies direct control of the daily operations of these assisted-living properties.
2. Public Offering and Strategic Alternatives
Our charter authorizes the issuance of up to 580,000,000 shares of common stock with a par value of $0.01 per share and 20,000,000 shares of preferred stock with a par value of $0.01 per share.
On June 20, 2008, we commenced an initial public offering of up to 50,000,000 shares of our common stock, consisting of 40,000,000 shares for sale pursuant to a primary offering and 10,000,000 shares for sale pursuant to our distribution reinvestment plan. We stopped making offers under our initial public offering on February 3, 2011 after raising gross offering proceeds of $123.9 million from the sale of 12.4 million shares, including shares sold under the distribution reinvestment plan..
On February 4, 2011, the U.S. Securities and Exchange Commission (“SEC”) declared the registration statement for our follow-on offering effective and we commenced a follow-on offering of up to 55,000,000 shares of our common stock, consisting of 44,000,000 shares for sale pursuant to a primary offering and 11,000,000 shares for sale pursuant to our dividend reinvestment plan. As of December 31, 2011, we had sold a total of 12.7 million shares of our common stock pursuant to our initial and follow-on public offerings for aggregate gross proceeds of $127.0 million.
On April 29, 2011 we informed our stockholders that the Independent Directors Committee of our board of directors had directed us to suspend our follow-on offering, our dividend reinvestment program and our stock repurchase program (except repurchases due to death) because of the uncertainty associated with our Independent Directors Committee consideration of various strategic alternatives to enhance our stockholders’ value. On October 18, 2011, we announced that the Independent Directors Committee had suspended its analysis of strategic alternatives for the Company and concluded that the Company is well positioned as an investment program with a continued focus on healthcare real estate. The Independent Directors Committee identified strategies in its evaluation process that it believes will enhance this position and is implementing operating changes designed to increase portfolio cash flow and increase shareholder value. In particular, the Company will focus on portfolio performance, identifying investment and financing opportunities, implementing operational efficiencies and the potential for growth in the future. As of December 31, 2011, sales pursuant to our follow-on offering remained suspended.
3. Summary of Significant Accounting Policies
The summary of significant accounting policies presented below is designed to assist in understanding our consolidated financial statements. Such financial statements and accompanying notes are the representations of our management, who is responsible for their integrity and objectivity. These accounting policies conform to accounting principles generally accepted in the United States of America, or GAAP, in all material respects, and have been consistently applied in preparing the accompanying consolidated financial statements.
Cash and Cash Equivalents
We consider all short-term, highly liquid investments that are readily convertible to cash with a maturity of three months or less at the time of purchase to be cash equivalents.
Restricted Cash
Restricted cash represents cash held in interest bearing accounts and amounts related to impound reserve accounts for property taxes and insurance as required under the terms of mortgage loan agreements. Based on the intended use of the restricted cash, we have classified changes in restricted cash within the statements of cash flows as operating or investing activities.
Real Estate Purchase Price Allocation
We allocate the purchase price of our properties in accordance with ASC 805-10, “Business Combinations”. Upon acquisition of a property, we allocate the purchase price of the property based upon the fair value of the assets acquired, which generally consist of land, buildings, site improvements, tenant improvements, intangible lease assets or liabilities including in-place leases, above market and below market leases, tenant relationships and goodwill. We allocated the purchase price to the fair value of the tangible assets of an acquired property by valuing the property as if it were vacant. We are required to make subjective assessments as to the useful lives of our depreciable assets. We consider the period of future benefit of the asset to determine the appropriate useful lives. Depreciation of our assets is being charged to expense on a straight-line basis over the assigned useful lives. The value of the building and improvements are depreciated over an estimated useful life of 15 to 39 years.
In-place lease values are calculated based on management’s evaluation of the specific characteristics of each tenant’s lease and our overall relationship with the respective tenant.
Acquired above and below market leases are valued based on the present value of the difference between prevailing market rates and the in-place rates over the remaining lease term. The value of acquired above and below market leases is amortized over the remaining non-cancelable terms of the respective leases as an adjustment to rental revenue on our consolidated statements of operations.
We amortize the value of in-place leases and above and below market leases over the initial term of the respective leases. Should a tenant terminate its lease, the unamortized portion of the tenant improvements, intangible lease assets or liabilities and the in-place lease value will be immediately charged to expense.
Goodwill represents the excess of acquisition cost over the fair value of identifiable net assets of the business acquired.
Impairment of Real Estate Assets and Goodwill
Real Estate Assets
We assess whether there has been impairment in the value of its investments in real estate whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Our portfolio is evaluated for impairment on a property-by-property basis. Indicators of potential impairment include the following:
•
Change in strategy resulting in a decreased holding period;
•
Decreased occupancy levels;
•
Deterioration of the rental market as evidenced by rent decreases over numerous quarters;
•
Properties adjacent to or located in the same submarket as those with recent impairment issues;
•
Significant decrease in market price; and/or
•
Tenant financial problems.
During 2011, 2010 and 2009, we did not record any impairment charges related to our investments in real estate. The assessment as to whether our investments in real estate are impaired is highly subjective. The calculations, which are primarily based on discounted cash flow analyses, involve management’s best estimate of the holding period, market comparables, future occupancy levels, rental rates, capitalization rates, lease-up periods and capital requirements for each property. A change in any one or more of these factors could materially impact whether a property is impaired as of any given valuation date.
Goodwill
We review goodwill for impairment annually and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. The guidance on goodwill impairment requires us to annually test goodwill for impairment under a two-step impairment test, or, as discussed below, under a qualitative assessment which became optional in 2011. In the first step of the two-step test, we compare the fair value of each reporting unit to its carrying value. We determine the fair value of our reporting unit based on the income approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the second step of the impairment test is performed in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then the company records an impairment loss equal to the difference.
In September 2011, ASU 2011-08 was issued and provides companies the option to perform a qualitative assessment of a reporting unit before being required to perform Step 1 of the two-step goodwill test as prescribed by FASB Topic 350 “Intangibles-Goodwill and Other” (“Topic 350”). ASU 2011-08 has amended Topic 350 to state “An entity may first assess qualitative factors to determine whether it is necessary to perform the two-step goodwill impairment test .” The qualitative assessment requires management to perform the assessment using a “more likely than not” concept. According to ASC 350-20-35-3C, in evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, relevant events and circumstances shall be assessed.
We performed a qualitative assessment as of December 31, 2011. In this assessment we considered certain macroeconomic factors including changes in the general economic conditions, interest rates, capital markets, market-dependent multiples or metrics and regulatory developments. Additionally, reporting unit specific factors evaluated included negative or declining cash flows, decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods, declines in occupancy rates, changes in management, key personnel, strategy, or customers, contemplation of bankruptcy, litigation, changes in the carrying amount of net assets, more-likely-than-not expectation of selling or disposing all, or a portion of a reporting unit and testing for recoverability of a significant asset group within a reporting unit.
Goodwill and intangibles with infinite lives must be tested for impairment annually or more frequently if events or changes in circumstances indicate that the related asset might be impaired. Management uses all available information to make these fair value determinations, including the present values of expected future cash flows using discount rates commensurate with the risks involved in the assets. Impairment testing entails estimating future net cash flows relating to the asset, based on management’s estimate of market conditions including market capitalization rate, future rental revenue, future operating expenses and future occupancy percentages. Determining the fair value of goodwill involves management judgment and is ultimately based on management’s assessment of the value of the assets and, to the extent available, third party assessments. We perform our annual impairment test as of December 31 of each year. We completed the required annual impairment test through the qualitative assessment described above and determined that and none of our reporting units are at risk and no impairment was recognized based on the results of the annual goodwill impairment test.
Income Taxes
For federal income tax purposes, we have elected to be taxed as a REIT, under Sections 856 through 860 of the Code beginning with our taxable year ended December 31, 2008, which imposes limitations related to operating assisted-living properties.
Each TRS is a tax paying component for purposes of classifying deferred tax assets and liabilities. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. In the event we were to determine that we would not be able to realize our deferred income tax assets in the future in excess of their net recorded amount, we would make an adjustment to the valuation allowance which would reduce the provision for income taxes.
Uncertain Tax Positions
In accordance with the requirements of ASC 740-10, “Income Taxes”, favorable tax positions are included in the calculation of tax liabilities if it is more likely than not that the Company’s adopted tax position will prevail if challenged by tax authorities. As a result of our REIT status, we are able to claim a dividends-paid deduction on our tax return to deduct the full amount of common dividends paid to stockholders when computing our annual taxable income. A REIT is subject to a 100% tax on the net income from prohibited transactions. A “prohibited transaction” is the sale or other disposition of property held primarily for sale to customers in the ordinary course of a trade or business. There is a safe harbor which, if met, expressly prevents the IRS from asserting the prohibited transaction test. As we have not had any sales of properties to date, the prohibited transaction tax is not applicable. We have no income tax expense, deferred tax assets or deferred tax liabilities associated with any such uncertain tax positions for the operations of any entity included in the consolidated results of operations.
Tenant and Other Receivables
Tenant and other receivables are comprised of rental and reimbursement billings due from tenants. Tenant receivables are recorded at the original amount earned, less an allowance for any doubtful accounts. Management assesses the realizability of tenant receivables on an ongoing tenant by tenant basis and provides for allowances as such balances, or portions thereof, become uncollectible. For the years ended December 31, 2011 and December 31, 2010 provisions for bad debts amounted to approximately $1,706,000 and $35,000 respectively, of which $1,630,000 relates to the allowance on a related party receivable, and $76,000 relates to tenant receivables. The allowance for tenant receivables are included in property operating and maintenance expenses in the accompanying consolidated statements of operations.
Deferred Costs and Other Assets
Deferred costs and other assets consist primarily of deferred tax assets and prepaid insurance.
Deferred Financing Costs
Costs incurred in connection with debt financing are recorded as deferred financing costs. Deferred financing costs are amortized using the straight-line basis, which approximates the effective interest rate method, over the contractual terms of the respective financings.
Consolidation Considerations for Our Investments in Joint Ventures
ASC 810-10, “Consolidation”, which addresses how a business enterprise should evaluate whether it has a controlling interest in an entity through means other than voting rights and accordingly should consolidate the entity. We analyze our joint ventures in accordance with this accounting standard to determine whether they are variable interest entities and, if so, whether we are the primary beneficiary. Our judgment with respect to our level of influence or control over an entity and whether we are the primary beneficiary of a variable interest entity involves consideration of various factors including the form of our ownership interest, our voting interest, the size of our investment (including loans) and our ability to participate in major policy-making decisions. Our ability to correctly assess our influence or control over an entity affects the presentation of these investments in our condensed consolidated financial statements.
Revenue Recognition
Revenue is recorded in accordance with ASC 840-10, “Leases”, and SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements, as amended” (“SAB 104”). Revenue is recognized when four basic criteria are met: persuasive evidence of an arrangement, the rendering of service, fixed and determinable income and reasonably assured collectability. Leases with fixed annual rental escalators are generally recognized on a straight-line basis over the initial lease period, subject to a collectability assessment. Rental income related to leases with contingent rental escalators is generally recorded based on the contractual cash rental payments due for the period. Because our leases may provide for free rent, lease incentives, or other rental increases at specified intervals, we straight-line the recognition of revenue, which results in the recording of a receivable for rent not yet due under the lease terms. Our revenues are comprised largely of rental income and other income collected from tenants.
Future Minimum Lease Payments
All resident leases in our senior operations living segment are on a month to month basis and are excluded from the following schedule. Future minimum lease payments to be received from leases under the triple-net leased segment and medical office building segments as of December 31, 2011 are as follows:
Organizational and Offering Costs. Organizational and offering costs paid by the Advisor on our behalf are being reimbursed to the Advisor from the proceeds of our offerings. Organizational and offering costs consist of all expenses (other than sales commissions and the dealer manager fee) to be paid by us in connection with our offerings, including our legal, accounting, printing, mailing and filing fees, charges of our escrow holder and other accountable offering expenses, including, but not limited to, (i) amounts to reimburse the Advisor for all marketing related costs and expenses such as salaries and direct expenses of employees of the Advisor and its affiliates in connection with registering and marketing our shares; (ii) technology costs associated with the offering of our shares; (iii) our costs of conducting our training and education meetings; (iv) our costs of attending retail seminars conducted by participating broker-dealers; and (v) payment or reimbursement of bona fide due diligence expenses. At times during our offering stage, the amount of organization and offering expenses that we incur, or that the Advisor and its affiliates incur on our behalf, may exceed 3.5% of the gross offering proceeds then raised, but our Advisor is required to reimburse us to the extent that our organization
and offering expenses exceed 3.5% of aggregate gross offering proceeds at the conclusion of our offering. In addition, the Advisor will also pay any organization and offering expenses to the extent that such expenses, plus sales commissions and the dealer manager fee (but not the acquisition fees or expenses) are in excess of 13.5% of gross offering proceeds. In no event will we have any obligation to reimburse the Advisor for organizational and offering costs totaling in excess of 3.5% of the gross proceeds from our primary offerings.
Noncontrolling Interest in Consolidated Subsidiaries
Noncontrolling interests relate to the interests in the consolidated entities that are not wholly-owned by us.
ASC 810-10-65, Consolidation, clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. ASC 810-10-65 also requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest and requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest.
We periodically evaluate individual noncontrolling interests for the ability to continue to recognize the noncontrolling interest as permanent equity in the consolidated balance sheets. Any noncontrolling interest that fails to qualify as permanent equity will be reclassified as temporary equity and adjusted to the greater of (a) the carrying amount, or (b) its redemption value as of the end of the period in which the determination is made.
Fair Value of Financial Instruments
FASB ASC 825-10, “Financial Instruments”, requires the disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practical to estimate that value.
Fair value represents the estimate of the proceeds to be received, or paid in the case of a liability, in a current transaction between willing parties. ASC 820, Fair Value Measurement (“ASC 820”) establishes a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. Inputs are either observable or unobservable in the marketplace. Observable inputs are based on market data from independent sources and unobservable inputs reflect the reporting entity’s assumptions about market participant assumptions used to value an asset or liability.
Financial assets and liabilities recorded at fair value on the condensed consolidated balance sheets are categorized based on the inputs to the valuation techniques as follows:
Level 1. Quoted prices in active markets for identical instruments.
Level 2. Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3. Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
Assets and liabilities measured at fair value are classified according to the lowest level input that is significant to their valuation. A financial instrument that has a significant unobservable input along with significant observable inputs may still be classified as a Level 3 instrument.
We generally determine or calculate the fair value of financial instruments using present value or other valuation techniques, such as discounted cash flow analyses, incorporating available market discount rate information for similar types of instruments and our estimates for non-performance and liquidity risk. These techniques are significantly affected by the assumptions used, including the discount rate, credit spreads, and estimates of future cash flow.
Our balance sheets include the following financial instruments: cash and cash equivalents, tenant and other receivables, restricted cash, security deposits, accounts payable and accrued liabilities, distributions payable, and notes payable. With the exception of accrued promote liabilities and notes payable discussed below, we consider the carrying values of our financial instruments to approximate fair value because of the short period of time between origination of the financial assets and liabilities and their expected settlement.
The fair value of accrued promote liabilities is estimated using projected operating results and capitalization rates and discount rates that are derived from market data and other inputs from comparable properties and transactions. Accordingly, we consider promote liabilities to be level 3. The following is a reconciliation of activity for level 3 liabilities:
The fair market value of notes payable is estimated using lending rates available to us for financial instruments with similar terms and maturities. As of December 31, 2011 and December 31, 2010, the fair value of notes payable was $101.1 million and $81.7 million, compared to the carrying values of $100.0 million and $80.8 million, respectively.
Basic and Diluted Net Loss per Common Share Attributable to Common Stockholders
Basic and diluted net loss per common share attributable to common stockholders per share is computed by dividing net loss attributable to common stockholders by the weighted-average number of common shares outstanding for the period. For the years ended December 31, 2011, 2010 and 2009, there were no potential dilutive common shares.
Basic and diluted net loss per share is calculated as follows:
Use of Estimates
The preparation of our consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of the assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could materially differ from those estimates.
Recently Issued Accounting Pronouncements
In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs” (“ASU 2011-04”). The amendment provides a uniform framework for fair value measurements and related disclosures between GAAP and International Financial Reporting Standards (“IFRS”). Additional disclosure requirements in the update include: (1) for Level 3 fair value measurements, quantitative information about unobservable inputs used, a description of the valuation processes used by the entity, and a qualitative discussion about the sensitivity of the measurements to changes in the unobservable inputs; (2) for an entity’s use of a nonfinancial asset that is different from the asset’s highest and best use, the reason for the difference; (3) for financial instruments not measured at fair value but for which disclosure of fair value is required, the fair value hierarchy level in which the fair value measurements were determined; and (4) the disclosure of all transfers between Level 1 and Level 2 of the fair value hierarchy. ASU 2011-04 will be effective for interim and annual periods beginning on or after December 15, 2011, which for us will be our 2012 first quarter. We are currently evaluating the impact ASU 2011-04 will have on our financial statements.
In April 2011, the FASB issued Accounting Standards Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“ASU 2011-02”). The amendments in this update clarify, among other things, the guidance on a
creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties. The Company’s adoption of ASU 2011-02 on July 1, 2011 did not have a significant impact on its consolidated financial position or results of operations.
In September 2011, the FASB issued ASU No. 2011-08, Testing Goodwill for Impairment (the revised standard). The amendment gives companies the option to perform a qualitative assessment that may allow them to skip the annual two-step goodwill impairment test. The current two-step test requires companies to assess goodwill for impairment by quantitatively comparing the fair value of a reporting unit with its carrying amount (step 1). If the reporting unit’s fair value is less than its carrying amount, step 2 of the goodwill impairment test must be performed to measure the amount of the goodwill impairment, if any. ASU 2011-08 gives companies the option to first perform a qualitative assessment to determine whether it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount. If a company concludes that this is the case, it must perform the two-step test. Otherwise, a company can skip the two-step test. The revised standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. Our adoption of ASU 2011-08 on December 31, 2011 did not have a significant impact on its consolidated financial position or results of operations.
4. Investments in Real Estate
The following table provides summary information regarding our property portfolio as of December 31, 2011:
(1) Under the purchase and sale agreement executed in connection with the acquisition, a portion of the purchase price for the property was to be calculated and paid to the seller as earn-out payments based upon the net operating income of the property, as defined, during each of the three years following our acquisition of the property. The earn-out liability associated with this acquisition was estimated to have a fair value of approximately $1.0 million and $0.4 million as of December 31, 2011 and December 31, 2010, respectively. The earn-out payment of approximately $1.0 million was made in January of 2012.
(2) Rome LTACH, a development project, was completed in February 2011 and its first tenant moved in on February 1, 2011. As of December 31, 2011 the real estate assets costs for the property were $15.6 million. We may be obligated to monetize a portion of our partner’s interest in the appreciation of value in this joint venture. Refer to Note 10 for more information on the project’s promote monetization feature.
(3) Under the purchase and sale agreement executed in connection with the acquisition, a portion of the purchase price for the property was to be calculated and paid to the seller as earn-out payments based upon the net operating income, as defined, of the property during each of the three years following our acquisition of the property. The earn-out value of $1.0 million was paid during the second quarter of 2011.
(4) Represents estimated gross square footage upon completion of development.
(5) Littleton Specialty Rehabilitation Facility is currently under development. As of December 31, 2011, a total of $1.6 million had been invested in this project by the Company. We may be obligated to monetize a portion of our partner’s interest in the appreciation of value in this joint venture. Refer to Note 5 for more information on the project’s promote monetization feature.
As of December 31, 2011, cost and accumulated depreciation and amortization related to real estate assets and related lease intangibles were as follows:
As of December 31, 2010, accumulated depreciation and amortization related to investments in real estate and related lease intangibles were as follows:
Depreciation expense associated with buildings and improvements, site improvements and furniture, fixtures and equipment for the years ended December 31, 2011, 2010, and 2009 was approximately $4.0 million, $1.7, and $0.5 million, respectively. Amortization associated with the intangible assets for the years ended December 31, 2011, 2010 and 2009 was $3.7 million, $2.4 million, and $0.9 million, respectively.
As of December 31, 2011, the Company has not recorded any long-lived asset impairment charges as a result of its impairment analyses.
The estimated useful lives for intangible assets range from one to twenty years. As of December 31, 2011, the weighted-average amortization period for intangible assets was approximately 12 years.
Estimated amortization for each of the five following years ended December 31 is as follows:
5. Allowance for Doubtful Accounts
As of December 31, 2011, 2010 and 2009, we had recorded $76,000, $35,000 and $0 allowance for doubtful accounts, respectively.
6. Concentration of Credit Risks
Financial instruments that potentially subject the Company to a concentration of credit risk are primarily cash investments; cash is generally invested in investment-grade short-term instruments. On July 21, 2010, President Obama signed into law the “Dodd-Frank Wall Street Reform and Consumer Protection Act” that includes provisions that made permanent the $250,000 limit for federal deposit insurance and increased the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000. It also provides for unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts at all insured depository institutions. As of December 31, 2011, we had no cash accounts in excess of Federal Deposit Insurance Corporation insured limits.
Concentrations of credit risks arise when a number of operators, tenants or obligors related to our investments are engaged in similar business activities, located in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations, including those to the Company, to be similarly affected by changes in economic conditions. We regularly monitor various segments of our portfolio to assess potential concentration of risks. Management believes the current portfolio is reasonably diversified across healthcare related real estate and does not contain any other significant concentration of credit risks, except as presented below.
Our senior living operation segment accounted for approximately 83.1%, 85.3% and 100% of total revenues for the years ended December 31, 2011, 2010 and 2009, respectively. The following table provides information about our senior living operation segment for the year ended December 31, 2011:
Our triple-net leased segment accounted for approximately 14.2%, 14.6% and 0% of total revenues for the years ended December 31, 2011, 2010 and 2009, respectively. The following table provides information about our triple-net leased segment for the year ended December 31, 2011:
Our medical office building segment accounted for approximately 3%, 0.1% and 0% of total revenues for the years ended December 31, 2011, 2010 and 2009, respectively.
As of December 31, 2011, we owned 15 properties geographically located in ten states. The following table provides information about our geographic risks by operating segment for the year ended December 31, 2011:
(1) Under construction as of December 31, 2011
7. Income Taxes
For federal income tax purposes, we have elected to be taxed as a REIT, under Sections 856 through 860 of the Code beginning with our taxable year ended December 31, 2008, which imposes limitations related to operating assisted-living properties. As of December 31, 2011, we had acquired ten assisted-living facilities and formed ten wholly owned taxable REIT subsidiaries, or TRSs, which includes a Master TRS that consolidates our wholly owned TRSs.
Each TRS is a tax paying component for purposes of classifying deferred tax assets and liabilities. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. In the event we were to determine that we would not be able to realize our deferred income tax assets in the future in excess of their net recorded amount, we would establish a valuation allowance which would offset the previously recognized income tax benefit.
For the years ended December 31, 2011 and 2010, our TRS reported net taxable income of approximately $1.0 million and $0.5 million, respectively. The TRS recognized a $0.6 million benefit and expensed $0.3 million of Federal and State income taxes in 2011 and 2010, respectively which have been recorded in general and administrative expenses. Net deferred tax assets related to the TRS entities totaled $1.1 million and $0.0 million at December 31, 2011 and 2010, respectively, related primarily to book and tax basis differences for straight-line rent and accrued liabilities. Realization of these deferred tax assets is dependent in part upon generating sufficient taxable income in future periods. These deferred tax assets are included in deferred costs and other assets in our condensed consolidated balance sheets. We have not recorded a valuation allowance against our deferred tax assets as of December 31, 2011 as we have determined the future taxable income from the operations of the TRS entities are sufficient to cover the additional future expenses resulting from these book tax differences.
8. Payable to Related Parties
We had no payable or receivables with related parties as of December 31, 2011. The payable to related parties at December 31, 2010 of $0.1 million related to offering costs, acquisition fees, expense reimbursement payable, sales commissions and dealer manager fees paid by Cornerstone Leveraged Realty Advisors, LLC (“CLRA”) and Pacific Cornerstone Capital, Inc. (“PCC”).
9. Equity
Common Stock
Our charter authorizes the issuance of 580,000,000 shares of common stock with a par value of $0.01 per share and 20,000,000 shares of preferred stock with a par value of $0.01 per share. As of December 31, 2011, 2010, and 2009, including distributions reinvested, we had issued 13.3 million, 11.3 million, and 4.9 million shares of common stock for a total of $132.3 million, $112.9 million, and $49.1 million of gross proceeds, respectively, in our initial and follow-on public offerings.
Distributions
In 2007, we adopted a distribution reinvestment plan that allows our stockholders to have dividends and other distributions otherwise distributable to them, invested in additional shares of our common stock at their election. We registered 10,000,000 shares of our common stock for sale pursuant to the distribution reinvestment plan. The purchase price per share is 95% of the price paid by the purchaser for our common stock, but not less than $9.50 per share. As of December 31, 2011 and December 31, 2010, 551,000 and 394,000 shares, respectively, had been issued under the distribution reinvestment plan.
On April 29, 2011, we informed our stockholders that our Independent Directors Committee had directed us to suspend our offering, our dividend reinvestment plan and our stock repurchase program (except repurchases due to death) because of the uncertainty associated with our Independent Directors Committee consideration of various strategic alternatives to enhance our stockholders’ value. As a result, we suspended our distribution reinvestment plan effective as of May 10, 2011.
The following are the distributions declared during the years ended December 31, 2011 and 2010:
(1) Distributions declared for 2011 represented a return of capital and taxable ordinary income and 2010 represented a return of capital for tax purposes. In order to meet the requirements for being treated as a REIT under the Internal Revenue Code, we must pay distributions to our stockholders each taxable year equal to at least 90% of our net ordinary taxable income. Some of our distributions have been paid from sources other than operating cash flow, such as offering proceeds. Until proceeds from our offerings are fully invested and generating operating cash flow sufficient to fully cover distributions to stockholders, we intend to pay all or a portion of our distributions from the proceeds of our offerings or from borrowings in anticipation of future cash flow.
The declaration of distributions is at the discretion of our board of directors. Our board will determine the amount of distributions on a regular basis. The amount of distributions will depend on our funds from operations, financial condition, capital requirements, annual distribution requirements under the REIT provisions of the Internal Revenue Code and other factors our board of directors deems relevant. On June 30, 2011, our board of directors resolved to lower our distributions to a current annualized rate of $0.25 per share (2.5% based on a share price of $10.00) from the prior annualized rate of $0.75 per share (7.5% based on a share price of $10.00), effective July 1, 2011 and continuing until and including December 31, 2011. Distributions are paid quarterly commencing with the third quarter distribution paid in October 2011. The rate and frequency of distributions is subject to the discretion of our board of directors and may change from time to time based on our operating results and cash flow.
From our inception in October 2006 through December 31, 2011, we declared aggregate distributions of $14.6 million, our cumulative net loss attributable to common stockholders during the same period was $17.1 million and our cumulative cash flow used in operations during the same period was $2.2 million.
Stock Repurchase Program
In 2007, we adopted a stock repurchase program for investors who have held their shares for at least one year, unless the shares are being repurchased in connection with a stockholder’s death. Under our stock repurchase program, the repurchase price varies depending on the purchase price paid by the stockholder and the number of years the shares are held. Our board of directors may amend, suspend or terminate the program at any time with 30 days prior notice to stockholders. We have no obligation to repurchase our stockholders’ shares. In 2009, our board of directors waived the one-year holding period in the event of the death of a stockholder and adjusted the repurchase price to 100% of such stockholders purchase price if the stockholder held the shares for less than three years.
During the years ended December 31, 2011 and 2010, we redeemed shares pursuant to our stock repurchase program as follows:
During the years ended December 31, 2011 and 2010, we repurchased 251,482 and 95,087 shares pursuant to our stock repurchase program.
During the year ended December 31, 2011, we received requests to have an aggregate of 369,250 shares repurchased pursuant to our stock repurchase program. Of these requests, 86,182 shares were not able to be repurchased due to the limitations contained in the terms of our stock repurchase program and the suspension of our stock repurchase program as of May 29, 2011, as described below. During the year ended December 31, 2010, all but 3,692 shares were repurchased. Such shares were not repurchased due to limitations contained in the terms of our stock repurchase program.
On April 29, 2011, we informed our stockholders that our Independent Directors Committee had directed us to suspend our offering, our dividend reinvestment program and our stock repurchase program (except repurchases due to death) because of the uncertainty associated with our Independent Directors Committee consideration of various strategic alternatives to enhance our stockholder value. As a result, we suspended our stock repurchase program effective as of May 29, 2011.
Employee and Director Incentive Stock Plan
We have adopted an Employee and Director Incentive Stock Plan (“the Plan”) which provides for the grant of awards to our directors and full-time employees, as well as other eligible participants that provide services to us. We have no employees, and we do not intend to grant awards under the Plan to persons who are not directors. Awards granted under the Plan may consist of nonqualified stock options, incentive stock options, restricted stock, share appreciation rights, and dividend equivalent rights. The term of the Plan is 10 years. The total number of shares of common stock reserved for issuance under the Plan is equal to 10% of our outstanding shares of stock at any time. As of December 31, 2011 and 2010, we have not granted any awards under the Plan.
Tax Treatment of Distributions
For tax purposes, our distributions are comprised of taxable ordinary dividend and return of capital. The return of capital for the distributions per share to common stockholders reportable for the years ended December 31, 2011, 2010, and 2009 were as follows:
10. Investments in Joint Ventures
Oakleaf Joint Venture
On April 30, 2010, we invested $21.6 million to acquire 80% equity interests in Royal Cornerstone South Carolina Portfolio, LLC (“Portfolio LLC”) and Royal Cornerstone South Carolina Tenant Portfolio, LLC (“Tenant LLC”) (collectively, we refer to the Portfolio LLC and the Tenant LLC as the “Oakleaf Joint Venture”). The Oakleaf Joint Venture, which is consolidated in the Company’s condensed consolidated financial statements, owns and operates two assisted-living properties located in Lexington and Greenville, South Carolina. As of December 31, 2011, total net assets related to Oakleaf Joint Venture were $17.7 million, which includes $23.1 million of net real estate assets and total liabilities of $18.1 million. Liabilities include $17.7 million of secured mortgage debt. We may be required to fund additional capital contributions, including funding of any capital expenditures deemed necessary to continue to operate the entity, and any operating cash shortfalls that the entity may experience.
Rome LTACH Project
On January 12, 2010, we funded an investment in a joint venture with affiliates of The Cirrus Group, an unaffiliated entity, to develop a $16.3 million free-standing medical facility on the campus of the Floyd Medical Center in Rome, Georgia. We contributed $2.7 million of capital to acquire a 75.0% limited partnership interest in Rome LTH Partners, LP. Cornerstone Private Equity Fund Operating Partnership, LP, an affiliate of CLRA contributed $0.5 million of capital to acquire a 15.0% limited partnership interest in Rome LTH Partners, LP. Three affiliates of The Cirrus Group contributed an aggregate of $0.3 million to acquire an aggregate 9.5% limited partnership interest in the Rome LTH Partners, LP. A fourth affiliate of the Cirrus Group acts as the general partner and holds the remaining 0.5% interest in the Rome LTH Partners LP. As of both December 31, 2011 and December 31, 2010, we owned a 75.0% limited partnership interest in Rome LTH Partners, LP. This joint venture is consolidated in the Company’s condensed consolidated financial statements.
Under the terms of this joint venture, we may be obligated to monetize a portion of our partners’ interest in the appreciation of value in the joint venture property. These obligations may be exercised by our partners at their sole discretion between years two and four of the joint venture. At December 31, 2011, the construction of the medical facility had been completed. During the first quarter of 2011, we determined that payments under these obligations were probable; accordingly, we recorded $2.2 million with respect to the monetization feature which is included in accounts payable and accrued liabilities on our condensed consolidated balance sheet. Of the $2.2 million, we capitalized certain construction period costs of $1.8 million and $0.2 million, which are included in intangible lease assets and building and improvements, respectively, on our condensed consolidated balance sheet. We expensed post construction period costs of $0.2 million, which are included in real estate acquisition costs and earn-out costs in our condensed consolidated statement of operations. As of December 31, 2011, total assets related to this project were $16.5 million, which includes $15.6 million of net real estate assets. Total liabilities were $14.1 million at December 31, 2011, which includes $10.9 million of secured mortgage debt.
The liability associated with the redemption feature of this joint venture is adjusted to estimated fair value as of each reporting period. As of December 31, 2011, we estimated the fair value of the redemption feature at $2.2 million. The fair value of the liability was derived using an income approach primarily utilizing Level 3 inputs. This approach estimates fair value based on estimates of fair value of the property as if the partners’ promote interest was redeemed at each reporting period end and calculated based on the expected promote interest pay-out, which includes estimates for preferred returns, debt repayment and a return of partners’ capital. The fair value of the property includes estimates for expected future cash flows and requires us to estimate, among other things, risk-adjusted rate of return and capitalization rates and the number of years the property would be held for investment from a market participant perspective. Level 3 inputs utilized in the valuation as of December 31, 2011 included a capitalization rate of 8.7% and a risk-adjusted rate of return of 10%. A change in any one or more of these factors could materially impact the fair value of the liability. When available, current market information, such as bids on the property, is used to corroborate the fair value of the property.
Littleton Specialty Rehabilitation Facility
On December 16, 2010, we funded an investment in a joint venture with affiliates of The Cirrus Group, an unaffiliated entity, to develop a $7.3 million specialty rehabilitation facility in Littleton, CO. We agreed to contribute $1.6 million of capital to acquire a 90% limited partnership interest in Littleton Med Partners, LP. Three affiliates of The Cirrus Group contributed an aggregate of $0.2 million to acquire an aggregate 9.5% limited partnership interest in the Littleton Med Partners, LP. A fourth affiliate of the Cirrus Group acts as the general partner and holds the remaining 0.5% interest in the Littleton Med Partners, LP. As of December 31, 2011 and December 31, 2010, we owned a 90.0% limited partnership interest in Littleton Med Partners, LP. This joint venture is consolidated in the Company’s financial statements.
Under the terms of this joint venture, we may be obligated to monetize a portion of our partners’ interest in the appreciation of value in the joint venture property. These obligations may be exercised by our partners at their sole discretion between years two and four of the joint venture. The amount that would be paid upon monetization is subject to change based on a number of factors, including the value of the property, net income earned by the property and payment of preferred returns on equities. As of December 31, 2011, the specialty rehabilitation facility in Littleton, CO is still under construction, and we believe that the probability of payments under these obligations is reasonably possible, accordingly, we have not recognized these obligations in our December 31, 2011 consolidated financial statements. As of the date of this report, the amount of contingent liability with respect to the monetization feature is estimated to range from $27,000 and $900,000.
11. Related Party Transactions
The Company has no employees. During 2011, CLRA was primarily responsible for managing our business affairs and carrying out the policies established by our board of directors. As discussed in Note 1, on July 29, 2011, the Company executed the Omnibus Agreement, which provided for a number of significant changes to the Company’s Advisory Agreement with CLRA (the “2011 Advisory Agreement”). Effective January 1, 2012, Sentio Investments, LLC became the successor advisor under a new advisory agreements (the “2012 Advisory Agreement”).
Advisory Agreement
Advisory Agreement Overview. Under the terms of the 2011 Advisory Agreement, CLRA was required to use commercially reasonable efforts to present to us investment opportunities to provide a continuing and suitable investment program consistent with the investment policies and objectives adopted by our board of directors. The Advisory Agreement called for CLRA to provide for our day-to-day management and to retain property managers and leasing agents, subject to the authority of our board of directors, and to perform other duties. The fees and expense reimbursements payable to CLRA under the 2011 Advisory Agreement are described below.
Organizational and Offering Costs. Organizational and offering costs paid by CLRA on our behalf were reimbursed to CLRA from the proceeds of our offerings. Organizational and offering costs consist of all expenses (other than sales commissions and the dealer manager fee) to be paid by us in connection with our offerings, including our legal, accounting, printing, mailing and filing fees, charges of our escrow holder and other accountable offering expenses, including, but not limited to, (i) amounts to reimburse CLRA for all marketing related costs and expenses such as salaries and direct expenses of employees of CLRA and its affiliates in connection
with registering and marketing our shares; (ii) technology costs associated with the offering of our shares; (iii) our costs of conducting our training and education meetings; (iv) our costs of attending retail seminars conducted by participating broker-dealers; and (v) payment or reimbursement of bona fide due diligence expenses. At times during our offering stage, the amount of organization and offering expenses that we incur, or that CLRA and its affiliates incur on our behalf, may exceed 3.5% of the gross offering proceeds then raised, but CLRA was required to reimburse us to the extent that our organization and offering expenses exceed 3.5% of aggregate gross offering proceeds at the conclusion of our offering. In addition, CLRA was obligated to pay any organization and offering expenses to the extent that such expenses, plus sales commissions and the dealer manager fee (but not the acquisition fees or expenses) were in excess of 13.5% of gross offering proceeds.
As of December 31, 2011, CLRA and its affiliates had incurred organizational and offering costs totaling $5.1 million, including $0.1 million of organizational costs that have been expensed and $5.0 million of offering costs that reduce net proceeds of our offerings. Of this amount $4.0 million reduced the net proceeds of our initial public offering and $1.0 million reduced the net proceeds of our follow-on offering. As of December 31, 2010, CLRA and its affiliates had incurred organizational and offering costs totaling $4.6 million, including $0.1 million of organizational costs that have been expensed and $4.5 million of offering costs which reduce net proceeds of our offerings. Upon the execution of the Omnibus Agreement, we forgave $0.8 million of organization and offering costs in excess of the 3.5% of gross offering proceeds advanced to CLRA pursuant to the 2011 Advisory Agreement. This amount reduced our offering proceeds and has therefore been treated as a reduction in additional paid-in capital in our condensed consolidated balance sheet.
Acquisition Fees and Expenses. The 2011 Advisory Agreement required us to pay CLRA acquisition fees in an amount equal to 2.0% of the investments acquired, including any debt attributable to such investments. A portion of the acquisition fees will be paid upon receipt of offering proceeds, and the balance will be paid at the time we acquire a property. However, if the 2011 Advisory Agreement was terminated or not renewed, CLRA was required to return acquisition fees not yet allocated to one of our investments. In addition, we were required to reimburse CLRA for direct costs CLRA incurred and amounts CLRA paid to third parties in connection with the selection and acquisition of a property, whether or not ultimately acquired. For the years ended December 31, 2011, 2010 and 2009, CLRA earned $0.0 million, $2.3 million and $1.1 million in acquisition fees, respectively.
As of December 31, 2011, the amount of acquisition fees advanced to CLRA but not yet allocated to an investment was $0.9 million. This amount has been expensed and included in real estate acquisition costs and earn-out costs in our condensed consolidated statements of operations. Upon the execution of the Omnibus Agreement, we forgave the advance not earned through services rendered in connection with future acquisitions.
Management Fees. Prior to the execution of the Omnibus Agreement, the 2011 Advisory Agreement required us to pay CLRA a monthly asset management fee of one-twelfth of 1.0% of the sum of the aggregate basis in book carrying values of our assets invested, directly or indirectly, in equity interests in and loans secured by real estate before reserves for depreciation or bad debts or other similar non-cash reserves, calculated in accordance with GAAP (Average Invested Assets). These fees were in addition to management fees that we paid to third-party property managers. Upon the execution of the Omnibus Agreement, the asset management fee payable to CLRA was reduced to a maximum annual rate of 0.5% of Average Invested Assets and a separate asset management fee payable to the our then Sub-Advisor at a maximum annual rate of 0.25% of Average Invested Assets was added. CLRA earned $0.9 million, $0.7 million, and $0.2 million of management fees for the years ended December 31, 2011, 2010 and 2009, respectively. In addition, we reimbursed CLRA for approximately $0.3 million, $0.4 million and $0.1 million of direct and indirect costs incurred by our Advisor in providing asset management services for the years ended December 31, 2011, 2010, and 2009.
Pursuant to the Omnibus Agreement, our then Sub-Advisor earned $0.5 million of management fees for the year ended December 31, 2011. Management fees are expensed as incurred.
Operating Expenses. The 2011 Advisory Agreement provided for reimbursement of CLRA’s direct and indirect costs of providing administrative and management services to us. For the years ended December 31, 2011, 2010, and 2009 $1.4 million, $1.2 million, and $0.5 million of such costs, respectively, were reimbursed and included in general and administrative expenses on our condensed consolidated statements of operations. Under the 2011 Advisory Agreement, CLRA was obligated to restrict its total operating expenses for the preceding four consecutive fiscal quarters, as determined at the end of each fiscal quarter, to the greater of 2% of the Company’s Average Invested Assets or 25% of the Company’s net income for such period (the “2%/25% Guidelines”), unless the Independent Directors Committee of the Board of Directors of the Company (the “Committee”) determined that a higher level of expenses (an “Excess Amount”) was justified, based on unusual and non-recurring factors. In the event that operating expenses exceeded the 2%/25% Guidelines, the asset management fees were subject to reductions on a pro-rata basis with a minimum 0.35% annual asset management fee rate. The total operating expenses include operating expenses incurred by both CLRA and our then
Sub-Advisor. CLRA was required to estimate and submit all of its reasonable direct internal expenses on a semi-monthly basis for the prior approval of the Committee and/or its financial advisor. The Committee would not approve any operating expenses (other than those determined to be justified based on unusual and non-recurring factors) if, in its reasonable discretion, the Committee determined that such operating expenses, considered together with operating expenses previously approved for the relevant period, as well as estimated operating expenses for the remainder of the relevant period, would exceed the 2%/25% Guidelines. CLRA was required to submit any operating expenses which it deemed unusual and non-recurring to the Committee, after review by the Committee’s financial advisor, for the Committee’s determination of whether such expenses were justified prior to any payment thereof.
For the four quarters ended December 31, 2011, our management fees and expenses and operating expenses totaled $5.9 million. This amount exceeded the greater of 2% of our average invested assets and 25% of our net loss by $2.8 million. Our Independent Directors Committee determined that $1.7 million of the Excess Amount was justified as unusual and non-recurring due to CLRA’s recent exploration of strategic alternatives for the Company. The remaining Excess Amount was forgiven by us through the Omnibus agreement executed on July 29, 2011.
Disposition Fee. Prior to the execution of the Omnibus Agreement, the 2011 Advisory Agreement provided that if CLRA or its affiliate provided a substantial amount of the services (as determined by a majority of our directors, including a majority of our independent directors) in connection with the sale of one or more properties, we would pay CLRA or such affiliate at closing a disposition fee up to 3% of the sales price of such property or properties. Upon the execution of the Omnibus Agreement, the disposition fee payable to CLRA was reduced to 0.25% of the sales price of properties sold and a separate disposition fee to the then Sub Advisor of 1% of the sales price of properties sold was added. The then Sub Advisor would receive monthly advances of its disposition fee at a rate of 1/12th of 0.25% of the Company’s Average Invested Assets, for up to, but not exceeding, six monthly installments. Such advances would be credited against the final disposition fee payable to the Sub-Advisor upon the sale of the Company’s properties. The disposition fee may be paid in addition to real estate commissions paid to non-affiliates, provided that the total real estate commissions (including such disposition fee) paid to all persons by us for each property shall not exceed an amount equal to the lesser of (i) 6% of the aggregate contract sales price of each property or (ii) the competitive real estate commission for each property. We ordinarily pay the disposition fees for a property at the time the property is sold. No properties were sold in 2011, 2010, or 2009.
Subordinated Participation Provisions. Prior to the execution of the Omnibus Agreement, CLRA was entitled to receive a subordinated participation upon the sale of our properties, listing of our common stock or termination of the Advisor. However, Pursuant to the Omnibus Agreement, no fees, other than the disposition fee described above, including any incentive fees or subordinated participations in cash flows, will be due to CLRA upon the sale of the Company’s properties or the termination of the 2011 Advisory Agreement.
Dealer Manager Agreements
PCC was the dealer manager for our initial and follow-on public offerings. Prior to the suspension of our follow-on offering on April 29, 2011, PCC was entitled to receive a sales commission of up to 7% of gross proceeds from sales in our primary offerings. PCC was also entitled to receive a dealer manager fee of up to 3% of gross proceeds from sales in our primary offerings. PCC was also entitled to receive a reimbursement of bona fide due diligence expenses up to 0.5% of the gross proceeds from sales in our primary offerings. . For the years ended December 31, 2011, 2010 and 2009, our dealer manager earned sales commissions and dealer manager fees of $1.1 million, $6.2 million, and $3.8 million, respectively. Dealer manager fees and sales commissions paid to PCC are a cost of capital raised and, as such, are included as a reduction of additional paid in capital in the accompanying condensed consolidated balance sheets.
12. Segment Reporting
As of December 31, 2011, we operated in three reportable business segments for management and internal financial reporting purposes: senior living operations, triple-net leased properties, and medical office building (“MOB”) properties. These operating segments are the segments of the Company for which separate financial information is available and for which segment results are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Our senior living operations segment primarily consists of investments in senior housing communities located in the United States for which we engage independent third-party managers. Our triple-net leased properties segment consists of investments in skilled nursing and hospital facilities in the United States. These facilities are leased to healthcare operating companies under long-term “triple-net” or “absolute-net” leases, which require the tenants to pay all property-related expenses. Our MOB operations segment primarily consists of investing in medical office buildings and leasing those properties to healthcare providers under long-term leases, which may require tenants to pay property-related expenses.
We evaluate performance of the combined properties in each segment based on net operating income. Net operating income is defined as total revenue less property operating and maintenance expenses. There are no intersegment sales or transfers. We use net operating income to evaluate the operating performance of our real estate investments and to make decisions concerning the operation of the property. We believe that net operating income is useful to investors in understanding the value of income-producing real estate. Net income is the GAAP measure that is most directly comparable to net operating income; however, net operating income should not be considered as an alternative to net income as the primary indicator of operating performance as it excludes certain items such as depreciation and amortization, asset management fees and expenses, real estate acquisition costs, interest expense and corporate general and administrative expenses. Additionally, net operating income as we define it may not be comparable to net operating income as defined by other REITs or companies.
The following tables reconcile the segment activity to consolidated net income for the years ended December 31, 2011, 2010 and 2009:
The following table reconciles the segment activity to Consolidated Total Assets as of December 31, 2011 and December 31, 2010:
For the years ended December 31, 2011 and 2010, due to acquisitions in our senior living operations segment, we recorded approximately $0.6 million and $4.2 million, respectively, of goodwill. As of December 31, 2011 and 2010, goodwill had a balance of approximately $6.0 million and $5.3 million, respectively, all related to senior living operations segment.
13. Notes Payable
Notes payable were $100.0 million and $80.8 million as of December 31, 2011 and 2010, respectively. As of December 31, 2011, we had fixed and variable rate secured mortgage loans with effective interest rates ranging from 3.45% to 6.50% per annum and a weighted-average effective interest rate of 5.91% per annum. As of December 31, 2011, we had $32.7 million of fixed rate debt, or 33% of notes payable, at a weighted average interest rate of 6.01% per annum and $67.4 million of variable rate debt, or 67% of notes payable, at a weighted average interest rate of 5.86% per annum. As of December 31, 2010, we had fixed and variable rate mortgage loans with effective interest rates ranging from 2.50% to 6.50% per annum and a weighted average effective interest rate of 6.36% per annum.
We are required by the terms of the applicable loan documents to meet certain financial covenants, such as debt service coverage ratios, rent coverage ratios and reporting requirements. We were in compliance with all such covenants and requirements as of December 31, 2011.
(1) As of December 31, 2011 and December 31, 2010, all notes payable are secured by the underlying real estate.
(2) The aggregate loan amount is composed of a restatement date balance of $12.9 million outstanding with respect to a prior loan (the “Initial Loan”), and an additional amount of $5.1 million disbursed on the closing date (the “Restatement Date Loan”). From June 1, 2010 through the maturity date, payments on the Restatement Date Loan are due monthly and based upon a 30-year amortization schedule. From June 1, 2010 through January 10, 2011, payments on the Initial Loan were due monthly based upon a 25-year amortization schedule, thereafter through maturity, payments on the Initial Loan are due monthly based upon a 30-year amortization schedule. The Restatement Date Loan bears interest at a variable rate equal to 5.45% per annum plus the greater of 1.0% or the 3-month LIBOR rate (the “Contract Rate”). The outstanding balance of the Initial Loan bore interest at a rate of 6.62% per annum until January 10, 2011 and thereafter bears interest at the Contract Rate.
(3) Of the total loan amount, $2.4 million bears a fixed interest rate of 6.25% per annum. The remaining $0.4 million bears a variable interest rate equivalent to the prevailing market certificate of deposit rate plus a 1.5% margin. Monthly payments for the first twelve months were interest-only. Thereafter, monthly payments included interest and principal based on a 25-year amortization period.
(4) In November 2010, we entered into an agreement with KeyBank National Association, an unaffiliated financial institution (“KeyBank”), to obtain a $25,000,000 revolving credit facility. The initial term of the credit facility was 24 months, maturing on November 18, 2012, and could be extended by six months subject to satisfaction of certain conditions, including payment of an extension fee. The actual amount of credit available under the credit facility was a function of certain loan to cost, loan to value and debt service coverage ratios contained in the credit facility. The amount outstanding under the credit facility was $16.3 million and $7.6 million at December 31, 2011 and December 31, 2010, respectively. The facility included a financial covenant requiring us to raise at least $20.0 million in our public offering in the six-month period ending June 30, 2011, and to raise an additional $20.0 million in net offering proceeds during each six-month calendar period thereafter. Because we suspended our public offering on April 29, 2011, we were not able to satisfy this covenant; however, effective August 1, 2011, the Company successfully negotiated the terms of a modification to the credit facility. KeyBank agreed to remove the covenant and revise the maturity date to July 31, 2012, which can be extended to October 30, 2012 subject to satisfaction of certain conditions, including payment of an extension fee. The credit facility was further modified to limit the outstanding balance to the current balance outstanding, impose additional monthly reporting covenants and require the establishment of tax and insurance impound accounts. The credit facility is secured by first priority liens on our eligible real property assets that make up the borrowing base (as such term is defined) for the credit facility. The interest rate for this credit facility is one-month LIBOR plus a margin of 400 basis points, with a floor of LIBOR plus 200 basis points. The original credit facility required payment of a fee of up to 25 basis points related to unused credit available to us under the credit facility. As a result of the modification, this fee is no longer applicable. We are entitled to prepay the obligations at any time without penalty. Financing fees associated with this modification were insignificant and were incurred primarily during the third quarter of 2011.
The principal payments due on our notes payable as of December 31, 2011 for each of the next five years are as follows:
Interest Expense and Deferred Financing Cost
The following table sets forth our gross interest expense and deferred financing cost amortization for the years ended December 31, 2011, 2010 and 2009. The capitalized amount is a cost of development and increases the carrying value of construction in progress.
As of December 31, 2011 and December 31, 2010, our net deferred financing costs were $1.1 million and $1.4 million, respectively. All deferred financing costs are capitalized and amortized over the life of the loan agreements.
14. Commitments and Contingencies
We monitor our properties for the presence of hazardous or toxic substances. While there can be no assurance that a material environmental liability does not exist, we are not currently aware of any environmental liability with respect to the properties that we believe would have a material effect on our financial condition, results of operations and cash flows. Further, we are not aware of any environmental liability or any unasserted claim or assessment with respect to an environmental liability that we believe would require additional disclosure or the recording of a loss contingency.
Our commitments and contingencies include the usual obligations of real estate owners and operators in the normal course of business. In the opinion of management, these matters are not expected to have a material impact on our condensed consolidated financial position, cash flows and results of operations. We are not presently subject to any material litigation nor, to our knowledge, is any material litigation threatened against the Company which if determined unfavorably to us would have a material adverse effect on our cash flows, financial condition or results of operations.
15. Selected Quarterly Data (unaudited)
Set forth below is certain unaudited quarterly financial information. We believe that all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly, and in accordance with generally accepted accounting principles, the selected quarterly information when read in conjunction with the consolidated financial statements.
16. Business Combinations
We completed two property acquisitions during 2011. On January 14, 2011, through a wholly-owned subsidiary, we purchased the assets of an assisted-living property, Forestview Manor, from 153 Parade Road, LLC, for $10.8 million. The acquisition was funded by our revolving credit facility from Key Bank National Association and with proceeds from our initial public offering. On April 14, 2011, through a wholly-owned subsidiary, we purchased an assisted-living property, Sunrise of Allentown, from an affiliate of Sunrise Senior Living, Inc., for $9.0 million. The property has been rebranded as Woodland Terrace at the Oaks Senior Living. The acquisition of Woodland Terrace was funded with proceeds from our public offerings and a mortgage loan from an unaffiliated lender, post-closing.
The following summary provides the allocation of the acquired assets and liabilities of Forestview Manor and Sunrise of Allentown (the “2011 Acquisitions”) as of the respective dates of acquisitions. We have accounted for the acquisitions as business combinations under U.S. GAAP. Under business combination accounting, the assets and liabilities of acquired properties were recorded as of the acquisition date, at their respective fair values, and consolidated in our financial statements.
The Company recorded revenues and net losses for the year ended December 31, 2011 of approximately $5.7 million and $1.2million, respectively, related to the 2011 Acquisitions. The following unaudited pro forma information for the years ended December 31, 2011 and 2010 has been prepared to reflect the incremental effect of the 2011 Acquisitions as if such acquisitions had occurred on January 1, 2010.
For the year ended December 31, 2011, acquisition-related costs of $0.3 million were excluded from pro forma net loss.
We completed six property acquisitions during 2010. The following summary provides the allocation of the acquired assets and liabilities of Forestview and Oakleaf at Greenville and Oakleaf at Lexington, together as Oakleaf Village, Global Rehab Inpatient Facility, Terrace at Mountain Creek, Hedgcoxe Health Plaza, Carriage Court of Hilliard, and River’s Edge of Yardley (the “2010 Acquisitions”) as of the respective acquisition dates. We have accounted for the acquisitions as business combinations under U.S. GAAP. Under business combination accounting, the assets and liabilities of acquired properties were recorded as of the acquisition date, at their respective fair values, and consolidated in our financial statements. The detail of the purchase price of the six acquired properties:
(1) The facility was purchased, from an affiliate of Wilkinson Real Estate, a non-related party, for a purchase price of approximately $8.5 million. The acquisition includes a $1.0 million earn-out provision. Wilkinson Real Estate may exercise the earn-out provision at any point during the first three years after closing. The earn out amount value will be calculated based on the excess of trailing six month net operating income, capped at 10%, over the purchase price.
The Company recorded revenues and net losses for the year ended December 31, 2010 of approximately $5.8 million and $0.9 million, respectively, related to the 2010 Acquisitions. The following unaudited pro forma information for the years ended December 31, 2010 and 2009 has been prepared to reflect the incremental effect of the 2010 Acquisitions as if such acquisitions had occurred on January 1, 2009.
Pro forma net loss for the year ended December 31, 2010 was adjusted to include $302 million of acquisition-related costs incurred for the 2011 acquisitions.
17. Subsequent Events
Other than the advisory agreement with Sentio Investments, LLC, discussed in footnote 1, that became effective January 1, 2012, and the payment of the Greentree earnout indicated in note 1 to the table in footnote 4, there were no reportable subsequent events.
SCHEDULE VALUATION AND QUALIFYING ACCOUNTS SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
December 31, 2011
REAL ESTATE AND ACCUMULATED DEPRECIATION SENTIO HEALTHCARE PROPERTIES, INC. AND SUBSIDIARIES
Schedule III
REAL ESTATE AND ACCUMULATED DEPRECIATION
December 31, 2011
(a) The changes in total real estate for the three years ended December 31, 2011 are as follows.
(b) For federal income tax purposes, the aggregate cost of our fifteen properties is approximately $121.7 million.
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SENTIO HEALTHCARE PROPERTIES, INC.
By:
/s/ SHARON C. KAISER
SHARON C. KAISER
Chief Financial Officer, Treasurer and Secretary
Date: March 22, 2012
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 22, 2012.
Name
Title
/s/ John Mark Ramsey
President, Chief Executive Officer and Director
John Mark Ramsey
(Principal Executive Officer)
/s/ Sharon C. Kaiser
Chief Financial Officer Treasurer and Secretary
Sharon C. Kaiser
(Principal Financial and Accounting Officer)
/s/ Steven M. Pearson
Director
Steven M. Pearson
/s/ James M. Skorheim
Director
James M. Skorheim
/s/ Barry A. Chase
Director
Barry A. Chase
/s/ William Bloomer
Director
William Bloomer
/s/ Romeo Cefalo
Director
Romeo Cefalo
/s/ Ronald Shuck
Director
Ronald Shuck
* XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections