UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005
COMMISSION FILE NUMBER 1-8383
MISSION WEST PROPERTIES, INC.
(Exact name of registrant as specified in its charter)
Maryland 95-2635431
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(State or other jurisdiction of incorporation (I.R.S. Employer Identification
or organization) Number)
10050 Bandley Drive
Cupertino, California 95014-2188
(Address of principal executive offices)
Registrant's telephone number, including area code is (408) 725-0700
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date:
18,352,691 shares outstanding as of July 31, 2005
MISSION WEST PROPERTIES, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2005
INDEX
PAGE
PART I FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets as of June 30, 2005 (unaudited)
and December 31, 2004 ..................................................................................2
Consolidated Statements of Operations for the
three and six months ended June 30, 2005 and 2004 (unaudited)...........................................3
Consolidated Statements of Cash Flows for the
six months ended June 30, 2005 and 2004 (unaudited).....................................................4
Notes to Consolidated Financial Statements (unaudited)..................................................5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................................................................11
Item 3. Quantitative and Qualitative Disclosures about Market Risk.............................................23
Item 4. Controls and Procedures................................................................................24
PART II OTHER INFORMATION
Item 1. Legal Proceedings......................................................................................25
Item 4. Submission of Matters to a Vote of Security Voters.....................................................25
Item 6. Exhibits ..............................................................................................25
SIGNATURES...........................................................................................................26
Exhibit Index
Certifications:
Section 1350 Certificates
Certificate pursuant to Section 906 of the Sarbanes Oxley Act of 2002
- 1 -
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
MISSION WEST PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
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June 30, 2005 December 31, 2004
--------------------- ----------------------
ASSETS (unaudited)
Real estate assets, at cost:
Land $ 277,647 $ 273,663
Buildings and improvements 778,277 770,757
Real estate related intangible assets 17,410 18,284
--------------------- ----------------------
Total investments in properties 1,073,334 1,062,704
Less accumulated depreciation and amortization (120,623) (110,062)
Assets held for sale, net of accumulated depreciation of $1,578 at 12/31/04 - 8,221
--------------------- ----------------------
Net investments in properties 952,711 960,863
Cash and cash equivalents 1,565 1,519
Restricted cash 1,551 1,551
Note receivable, net of deferred gain on sale of real estate of $1,345 at 6/30/05 2,715 -
Deferred rent receivable, net of $2,000 allowance at 6/30/05 and 12/31/04 19,401 18,511
Investment in unconsolidated joint venture 3,436 3,559
Other assets, net of accumulated amortization of $6,737 and $5,667
at 6/30/05 and 12/31/04, respectively 26,258 19,653
--------------------- ----------------------
Total assets $ 1,007,637 $ 1,005,656
===================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Line of credit (related parties) $ 444 $ 9,560
Revolving line of credit 19,172 24,208
Mortgage notes payable 314,506 292,822
Mortgage notes payable (related parties) 10,239 10,420
Interest payable 327 327
Security deposits 8,509 8,544
Deferred rental income 9,290 11,038
Liabilities related to assets held for sale - 14
Dividend/distribution payable 16,718 16,718
Accounts payable and accrued expenses 7,215 6,704
--------------------- ----------------------
Total liabilities 386,420 380,355
Commitments and contingencies
Minority interests 506,208 512,089
Stockholders' equity:
Preferred stock, $.001 par value, 20,000,000 shares authorized,
none issued and outstanding - -
Common stock, $.001 par value, 200,000,000 shares authorized,
18,352,691 and 18,097,191 shares issued and outstanding
at 6/30/05 and 12/31/04, respectively 18 18
Paid-in-capital 137,067 134,539
Accumulated deficit (22,076) (21,345)
--------------------- ----------------------
Total stockholders' equity 115,009 113,212
--------------------- ----------------------
Total liabilities and stockholders' equity $ 1,007,637 $ 1,005,656
===================== ======================
The accompanying notes are an integral part of these
consolidated financial statements.
- 2 -
MISSION WEST PROPERTIES, INC
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except share and per share amounts)
(unaudited)
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Three months ended June 30, Six months ended June 30,
2005 2004 2005 2004
------------------ ------------------- ------------------ -----------------
Revenues:
Rental revenue from real estate $25,104 $29,821 $51,351 $61,032
Tenant reimbursements 3,594 3,716 7,222 7,883
Other income, including lease terminations,
settlements and interest 2,289 4,612 2,592 5,005
------------------ ------------------- ------------------ -----------------
Total revenues 30,987 38,149 61,165 73,920
------------------ ------------------- ------------------ -----------------
Expenses:
Property operating, maintenance and real estate taxes 4,129 5,133 9,019 10,586
Interest 5,905 4,220 10,552 8,583
Interest (related parties) 243 252 549 504
General and administrative 443 885 1,118 1,233
Depreciation and amortization of real estate 5,369 5,611 10,942 11,052
------------------ ------------------- ------------------ -----------------
Total expenses 16,089 16,101 32,180 31,958
------------------ ------------------- ------------------ -----------------
Income before equity in earnings of unconsolidated
joint venture and minority interests 14,898 22,048 28,985 41,962
Equity in earnings of unconsolidated joint venture 393 627 387 1,218
Minority interests (12,594) (18,871) (24,272) (35,915)
------------------ ------------------- ------------------ -----------------
Income from continuing operations 2,697 3,804 5,100 7,265
------------------ ------------------- ------------------ -----------------
Discontinued operations, net minority interests:
Gain from disposal of discontinued operations - - 14 -
(Loss)/income attributable to discontinued operations (2) (9) (12) 53
------------------ ------------------- ------------------ -----------------
(Loss)/income from discontinued operations (2) (9) 2 53
------------------ ------------------- ------------------ -----------------
Net income to common stockholders $ 2,695 $ 3,795 $ 5,102 $ 7,318
================== =================== ================== =================
Net income to minority interests $12,587 $18,838 $24,282 $36,108
================== =================== ================== =================
Income per share from continuing operations:
Basic $0.15 $0.21 $0.28 $0.40
================== =================== ================== =================
Diluted $0.15 $0.21 $0.28 $0.40
================== =================== ================== =================
Income per share from discontinued operations:
Basic - - - $0.01
================== =================== ================== =================
Diluted - - - -
================== =================== ================== =================
Net income per share to common stockholders:
Basic $0.15 $0.21 $0.28 $0.41
================== =================== ================== =================
Diluted $0.15 $0.21 $0.28 $0.40
================== =================== ================== =================
Weighted average shares of
common stock outstanding (basic) 18,257,982 18,016,356 18,184,661 17,992,886
================== =================== ================== =================
Weighted average shares of
common stock outstanding (diluted) 18,283,058 18,079,139 18,229,245 18,075,734
================== =================== ================== =================
The accompanying notes are an integral part of these
consolidated financial statements.
- 3 -
MISSION WEST PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
---------
Six months ended June 30,
2005 2004
------------------- -------------------
Cash flows from operating activities:
Income from continuing operations $ 5,100 $ 7,265
Adjustments to reconcile net income to net cash provided by operating activities:
Gain from disposal of discontinued operations 14 -
(Loss)/income attributable to discontinued operations (12) 53
Minority interests 24,282 36,108
Depreciation and amortization of real estate and in place leases 10,976 11,216
Amortization of above market rent intangible asset 944 944
Gain on sale of real estate (63) -
Equity in earnings of unconsolidated joint venture (387) (1,218)
Distributions from unconsolidated joint venture 510 1,000
Changes in operating assets and liabilities, net of liabilities assumed:
Deferred rent receivable (890) 148
Other assets (6,605) (21)
Interest payable - (2)
Security deposits (35) (348)
Deferred rental income (1,748) 1,458
Accounts payable and accrued expenses 510 644
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Net cash provided by operating activities 32,596 57,247
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Cash flows from investing activities:
Improvements to real estate assets (637) (370)
Proceeds from sales of real estate 8,387 -
Purchase of real estate (14,183) -
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Net cash used in investing activities (6,433) (370)
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Cash flows from financing activities:
Proceeds from mortgage loan 25,800 -
Principal payments on mortgage notes payable (4,116) (2,608)
Principal payments on mortgage notes payable (related parties) (181) (168)
Net payments under line of credit (related parties) (9,116) (4,619)
Net payments under revolving line of credit (5,036) (1,452)
Proceeds from stock options exercised 330 165
Minority interest distributions (27,999) (41,849)
Dividends (5,799) (8,618)
------------------- -------------------
Net cash used in financing activities (26,117) (59,149)
------------------- -------------------
Net increase/(decrease) in cash and cash equivalents 46 (2,272)
Cash and cash equivalents, beginning of period 1,519 4,129
------------------- -------------------
Cash and cash equivalents, end of period $ 1,565 $ 1,857
=================== ===================
Supplemental information:
Cash paid for interest $ 10,038 $ 8,934
=================== ===================
Supplemental schedule of non-cash investing and financing activities:
Issuance of common stock upon conversion of O.P. units $ 2,197 $ 1,895
Issuance of note receiveable from sale of real estate $ 4,060 $ -
=================== ===================
The accompanying notes are an integral part of these
consolidated financial statements.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
The Company's consolidated financial statements have been prepared pursuant
to the Securities and Exchange Commission's ("SEC") rules and regulations.
The following notes, which present interim disclosures as required by the
SEC, highlight significant changes to the notes to the Company's December
31, 2004 audited consolidated financial statements and should be read
together with the financial statements and notes thereto included in the
Company's Form 10-K. The results of operations for the three and six months
ended June 30, 2005 are not necessarily indicative of the results to be
expected for the entire year.
1. Organization and Formation of the Company
Mission West Properties, Inc. ("the Company") is a fully integrated,
self-administered and self-managed real estate company that acquires and
manages R&D/office properties in the portion of the San Francisco Bay Area
commonly referred to as Silicon Valley. In July 1998, the Company purchased
an approximate 12.11% of four existing limited partnerships (referred to
collectively as the "operating partnerships") and obtained control of these
partnerships by becoming the sole general partner in each one effective
July 1, 1998 for financial accounting and reporting purposes. The Company
purchased an approximate 12.11% interest in each of the operating
partnerships. All limited partnership interests in the operating
partnerships were converted into 59,479,633 operating partnership ("O.P.")
units, which represented a limited partnership ownership interest of
approximately 87.89% of the operating partnerships. The operating
partnerships are the vehicles through which the Company holds its real
estate investments, makes real estate acquisitions, and generally conducts
its business.
On December 30, 1998, the Company was reincorporated under the laws of the
State of Maryland through a merger with and into Mission West Properties,
Inc. Accordingly, shares of the former company, Mission West Properties, a
California corporation (no par), which were outstanding at December 30,
1998, were converted into shares of common stock ($.001 par value per
share) on a one-for-one basis.
As of June 30, 2005, the Company owns a controlling general partnership
interest of 17.34%, 21.63%, 16.14% and 12.38% in Mission West Properties,
L.P., Mission West Properties, L.P. I, Mission West Properties, L.P. II and
Mission West Properties, L.P. III, respectively, which represents a 17.40%
general partnership interest in the operating partnerships, taken as a
whole, on a consolidated weighted average basis.
Through the operating partnerships, the Company owns interests in 108 R&D
properties, all of which are located in Silicon Valley.
The Company has elected to be taxed as a real estate investment trust
("REIT") under the Internal Revenue Code of 1986, as amended. Accordingly,
no provision has been made for income taxes for the three and six months
ended June 30, 2005.
BUSINESS SEGMENT INFORMATION
The Company's primary business is the ownership and management of
R&D/office real estate with a geographic concentration in the Silicon
Valley of the San Francisco Bay Area. Accordingly, the Company has
concluded it currently has a single reportable segment for SFAS No. 131
purposes.
2. Basis of Presentation
PRINCIPLES OF CONSOLIDATION AND FINANCIAL STATEMENT PRESENTATION
The accompanying consolidated financial statements include the accounts of
Mission West Properties, Inc. and its controlled subsidiaries, including
the operating partnerships. All significant intercompany balances have been
eliminated in consolidation. The consolidated financial statements as of
and for the three and six months ended June 30, 2005 and 2004 and related
footnote disclosures are unaudited. In the opinion of management, such
financial statements reflect all adjustments necessary for a fair
presentation of the results of the interim periods. All such adjustments
are of a normal recurring nature.
MINORITY INTERESTS
Minority interest represents the separate private ownership of the
operating partnerships by the Berg Group (defined as Carl E. Berg, his
brother Clyde J. Berg, members of their respective immediate families, and
certain entities they control) and other non-affiliate interests. In total,
these interests account for approximately 83% of the ownership interests in
the real estate operations of the Company as of June 30, 2005. Minority
interest in net income is calculated by taking the net income of the
operating partnerships (on a stand-alone basis) multiplied by the
respective minority interest ownership percentage.
RECLASSIFICATIONS
Certain reclassifications have been made to the previously reported 2004
statements in order to conform to the 2005 presentation.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
ACCOUNTING FOR STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but
does not require companies to record compensation cost for stock-based
employee compensation plans at fair value. The Company has chosen to
continue to account for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion ("APB") No. 25,
"Accounting for Stock Issued to Employees" and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess,
if any, of the quoted market price of the Company's stock at the date of
the grant over the amount an employee must pay to acquire the stock.
The following table illustrates the unaudited pro forma effect on
consolidated net income available to common stockholders and consolidated
earnings per share if the fair value method had been applied to all
outstanding and unvested stock options for the three and six months ended
June 30, 2005 and 2004.
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
--------------- --------------- --------------- ---------------
(dollars in thousands, except per share data)
Historical net income to common stockholders $2,695 $3,795 $5,102 $7,318
Deduct compensation expense for stock options determined
under fair value based method (40) (44) (59) (88)
Allocation of expense to minority interest 33 36 48 73
--------------- --------------- --------------- ---------------
Pro forma net income to common stockholders $2,688 $3,787 $5,091 $7,303
=============== =============== =============== ===============
Earnings per share - basic:
Historical net income to common stockholders $0.15 $0.21 $0.28 $0.41
Pro forma net income to common stockholders $0.15 $0.21 $0.28 $0.41
Earnings per share - diluted:
Historical net income to common stockholders $0.15 $0.21 $0.28 $0.40
Pro forma net income to common stockholders $0.15 $0.21 $0.28 $0.40
Options were granted to four employees and three directors totaling 710,000
during the second quarter 2005, which vests monthly for 33 months, subject
to continued employment or other service to the Company. Each option grant
has a term of six years from the date of grant subject to earlier
termination in certain events related to termination of employment. The
options were granted at an exercise price of $10.00 per share.
On April 27, 2005, the Company's Compensation Committee of the Board of
Directors, in accordance with the provisions of the 2004 Equity Incentive
Plan, unanimously approved the following awards of dividend equivalent
rights ("DER's"), each such DER representing the current right to receive
the dividend paid on one share of the Company's common stock, when paid by
the Company:
- The non-employee outside directors will each receive 45,000 DER's
effective as of the second quarter of 2005, which will remain in
effect as long as the individual continues to serve on the Board of
Directors; and
- Key employees of the Company will receive a total of 155,000 DER's
effective as of the second quarter of 2005, which will remain in
effect as long as they continue to be employed by the Company.
A total of 290,000 DER's were awarded by the Company's Board of Directors
on April 27, 2005. In the second quarter 2005, the Company accrued
approximately $46 for DER compensention expense. The Company expects these
awards to result in additional annual compensation expense of $186, based
on the most recent quarterly dividend of $0.16 per share of common stock.
3. STOCK TRANSACTIONS
During the six months ended June 30, 2005, stock options to purchase 40,000
shares of common stock were exercised at $8.25 per share. Total proceeds to
the Company were $330. During the same period, four limited partners
exchanged 215,500 O.P. units for 215,500 shares of the Company's common
stock under the terms of the December 1998 Exchange Rights Agreement among
the Company and all limited partners of the operating partnerships.
- 6 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
4. Discontinued Operations
Effective January 1, 2002, the Company adopted SFAS No. 144, which
addresses financial accounting and reporting for the impairment and
disposal of long lived assets. In general, income or loss attributable to
the operations and sale of property and the operations related to property
held for sale are classified as discontinued operations in the consolidated
statements of operations. Prior period consolidated statements of
operations presented in this report have been reclassified to reflect the
income or loss related to properties that were held for sale or sold and
presented as discontinued operations during the three and six months ended
June 30, 2005. Additionally, all periods presented in this report will
likely require further reclassification in future periods if additional
properties are held for sale or property sales occur.
As of June 30, 2005, there were no properties under contract to be sold or
otherwise disposed of which would qualify as an asset held for sale or
discontinued operation.
During the first quarter of 2005, the Company sold two properties for a
combined sales price of $12,750. Condensed results of operations for these
properties for the three and six months ended June 30, 2005 and 2004 are as
follows:
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
--------------------------------------------------------------
(dollars in thousands)
(unaudited)
Revenues
Rental revenue from real estate - $ 79 $ 14 $ 445
Tenant reimbursements - 23 1 73
Other income - 1 - 1
----------- ------------ ------------ ------------
Total revenues - 103 15 519
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Expenses
Property operating, maintenance and real estate taxes $ 10 63 33 109
Depreciation - 82 33 164
----------- ------------ ------------ ------------
Total expenses 10 145 66 273
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(Loss)/income from discontinued operations (10) (42) (51) 246
Gain on disposition of property - - 63 -
Minority interest in (loss)/earnings attributable to
discontinued operations 8 33 (10) (193)
----------- ------------ ------------ ------------
(Loss)/income from discontinued operations ($ 2) ($ 9) $ 2 $ 53
=========== ============ ============ ============
For the three and six months ended June 30, 2005 and 2004, income from
discontinued operations included results of operations from the two
properties that were sold in the first quarter of 2005.
A deferred gain of approximately $1,400 was recorded on one of the disposed
properties. The gain will be recognized as revenue based on the installment
method of profit recognition because the purchaser of the property did not
make a sufficiently large down payment under Statement of Financial
Accounting Standards No. 66 ("SFAS No. 66"), Accounting for Sales of Real
Estate. SFAS No. 66 establishes accounting standards for recognizing profit
or loss on sales of real estate. Gain on the sale is recognized
proportionately as the seller receives payments from the purchaser.
Interest income is recognized on an accrual basis, when appropriate. The
Company recorded a $63 gain in the first quarter 2005, and the balance of
the expected gain has been deferred.
As of June 30, 2005, the note receivable from one of the property sales was
approximately $2,715, net of the expected deferred gain on sale of real
estate of $1,345.
5. NET INCOME PER SHARE
Basic operating net income per share is computed by dividing net income by
the weighted average number of common shares outstanding for the period.
Diluted operating net income per share is computed by dividing net income
by the sum of the weighted-average number of common shares outstanding for
the period plus the assumed exercise of all dilutive securities using the
treasury stock method.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
The computation for weighted average shares is detailed below:
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 18,257,982 18,016,356 18,184,661 17,992,886
Incremental shares from assumed option exercise 25,076 62,783 44,584 82,848
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 18,283,058 18,079,139 18,229,245 18,075,734
=============== ============== ============== ===============
Outstanding options to purchase 647,000 and 272,000 shares in 2005 and 2004
were excluded from the computation of diluted net income per share under
the treasury stock method because the option exercise price was greater
than the weighted average exercise price of the Company's common stock
during the respective periods. The outstanding O.P. units, which are
exchangeable at the unit holder's option, subject to certain conditions,
for shares of common stock on a one-for-one basis have been excluded from
the diluted net income per share calculation, as there would be no effect
on the calculation after adding the minority interests' share of income
back to net income. The total number of O.P. units outstanding at June 30,
2005 and 2004 was 86,169,195 and 86,418,195, respectively.
6. RELATED PARTY TRANSACTIONS
As of June 30, 2005, the Berg Group owned 77,572,028 O.P. units. The Berg
Group's combined ownership of O.P. units and shares of common stock as of
June 30, 2005 represented approximately 74% of the total equity interests,
assuming conversion of the 86,169,195 O.P. units outstanding into the
Company's common stock.
The Berg Group has extended to the Company a $20,000 line of credit that
bears interest at LIBOR plus 1.30%, or 4.99% as of June 30, 2005, and
matures in March 2006. The Company believes that the terms of the Berg
Group line of credit are more favorable than those available from
commercial lenders. As of June 30, 2005, debt in the amount of $444 was due
the Berg Group under the line of credit, and debt in the amount of $10,239
was due the Berg Group under a mortgage note established on May 15, 2000 in
connection with the acquisition of a 50% interest in Hellyer Avenue Limited
Partnership, the obligor under the mortgage note. The mortgage note bears
interest at 7.65% and is due in June 2010 with principal payments amortized
over 20 years. Interest expense incurred in connection with the Berg Group
line of credit and mortgage note was $243 and $252 for the three months
ended June 30, 2005 and 2004, respectively, and $549 and $504 for the six
months ended June 30, 2005 and 2004, respectively.
During the first six months of 2005 and 2004, Carl E. Berg or entities
controlled by Mr. Berg held financial interests in several companies that
lease space from the operating partnerships, which include three companies
in which Mr. Berg has a greater than 10% ownership interest. These related
tenants occupy approximately 48,000 square feet and contributed $193 and
$217 in rental revenue during the three months ended June 30, 2005 and
2004, respectively, and $409 and $433 in rental revenue during the six
months ended June 30, 2005 and 2004, respectively. Under the Company's
charter, bylaws and agreements with the Berg Group, the individual members
of the Berg Group are prohibited from acquiring or holding shares of the
Company's common stock if such acquisition would result in their beneficial
ownership percentage of the Company's common stock causing the Company to
violate any REIT qualification requirement.
The Berg Group has an approximately $2,500 commitment to complete certain
tenant improvements in connection with the Company's 2002 acquisition of
5345 Hellyer Avenue in San Jose. The Company recorded this portion of the
purchase price paid to the Berg Group as an Other Asset on its Consolidated
Balance Sheets. The Berg Group plans to satisfy this commitment to complete
certain tenant improvements when requested by the Company following the
approval of the Independent Directors Committee of the Company's board of
directors (the "Independent Directors Committee").
The Berg Group has an approximately $7,500 commitment to complete an
approximately 75,000 to 90,000 square foot building in connection with the
Company's 2001 acquisition of 245 Caspian in Sunnyvale which is comprised
of approximately three acres of unimproved land. The Company recorded this
portion of the purchase price paid to the Berg Group as an Other Asset on
its Consolidated Balance Sheets. The Berg Group plans to satisfy this
commitment to construct a building when requested by the Company following
the approval of the Independent Directors Committee.
The Company currently leases office space owned by Berg & Berg Enterprises,
Inc., an affiliate of Carl E. Berg and Clyde J. Berg. Rental amounts and
overhead reimbursements paid to Berg & Berg Enterprises, Inc. were $23 for
each of the three-month periods ended June 30, 2005 and 2004 and $45 for
each of the six-month periods ended June 30, 2005 and 2004.
7. COMMITMENTS AND CONTINGENCIES
Neither the operating partnerships, the Company's properties nor the
Company are subject to any material litigation nor, to the Company's
knowledge, is any material litigation threatened against the operating
partnerships, the properties or the Company. From
- 8 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
time to time, the Company is engaged in legal proceedings arising in the
ordinary course of business. The Company does not expect any of such
proceedings to have a material adverse effect on its cash flows, financial
condition or results of operations. The Company is currently involved in or
has recently concluded the following legal proceedings, which it believes
the ultimate outcome will have no material adverse effect on its
consolidated financial statements.
Republic Properties Corporation ("RPC") v. Mission West Properties, L.P.
("MWP"), in the Circuit Court of Maryland for Baltimore City Case No.
24-C-00-005675. RPC is a former partner with Mission West Properties, L.P.
in the Hellyer Avenue Limited Partnership ("Hellyer LP"). In April 2004,
the Circuit Court for Baltimore City, Maryland issued a Memorandum Opinion
in the case and awarded damages of approximately $934 to the RPC
plaintiffs, which represented a liability of the Company or MWP. The
Company has a receivable from a Berg Group affiliate for the amount of
distributions it received as the successor to RPC's interest in the Hellyer
LP, which exceeds the amount of the damages awarded to the RPC parties and
would be used to pay those damages in the event the decision of the Circuit
Court is upheld ultimately. The Company has never accounted for the 50%
interest in Hellyer LP that is claimed by RPC as an asset of the Company.
In February 2001, the Company filed a suit against RPC in Superior Court of
the State of California for the County of Santa Clara Case No. CV 796249
which was stayed pending resolution of the Maryland case. In March 2005,
the Company voluntarily dismissed its California suit. On March 1, 2005,
the Maryland Appeals Court ruled in favor of Mission West Properties, L.P.,
finding that the Circuit Court of Maryland lacked personal jurisdiction
over MWP. In April 2005, the decision of the Maryland Appeals Court became
final, and the Company obtained a court order for the release of a $1,551
bond, which it posted to remove an attachment order issued to RPC. In April
2005, RPC submitted a motion to the Superior Court of the State of
California effectively asking the court to prevent MWP from dismissing the
previously dismissed California suit. In July 2005, the Maryland Supreme
Court agreed to hear an appeal filed by RPC, which is scheduled to occur in
December 2005.
In January 2004, the Global Crossing Estate Representative, for itself and
the Liquidating Trustee of the Global Crossing Liquidating Trust v. Mission
West Properties filed an action in United States Bankruptcy Court Southern
District of New York Case No. 02-40188 (REG) asserting that payments of
approximately $815 made in the ordinary course of business within 90 days
of the Global Crossing bankruptcy filing were preference payments. The
Company has engaged legal counsel to defend itself in this claim and intend
to vigorously contest the matter. On February 9, 2005, the Court held a
hearing to consider the objection filed with respect to Mission West
Properties' claim. In April 2005, the Company filed a motion for summary
judgment in the United States Bankruptcy Court Southern District of New
York requesting the Court to dismiss the preference claim. A hearing date
for the motion for summary judgment has not been scheduled.
GUARANTEES AND INDEMNITIES
Under its certificate of incorporation and bylaws, the Company has agreed
to indemnify its officers and directors for certain events or occurrences
arising as a result of the officer or director's serving in such capacity.
The maximum potential amount of future payments the Company could be
required to make under these indemnification agreements is unlimited. The
Company believes the estimated fair value of these indemnification
agreements is minimal and has no liabilities recorded for these agreements
as of June 30, 2005.
The Company also enters into indemnification provisions under its
agreements with other companies in the ordinary course of business,
typically with lenders, joint venture partners, contractors, and tenants.
Under these provisions the Company generally indemnifies and holds harmless
the indemnified party for losses suffered or incurred by the indemnified
party as a result of the Company's activities. These indemnification
provisions generally survive termination of the underlying agreement. The
maximum potential amount of future payments the Company could be required
to make under these indemnification provisions is unlimited. To date, the
Company has not incurred material costs to defend lawsuits or settle claims
related to these indemnification agreements. As a result, the Company
believes the estimated fair value of these agreements is minimal.
Accordingly, the Company has no liabilities recorded for these agreements
as of June 30, 2005.
SEISMIC ACTIVITY
The Company's properties are located in an active seismic area of Silicon
Valley. Insurance policies currently maintained by the Company do not cover
seismic activity, although they do cover losses from fires after an
earthquake.
ENVIRONMENTAL ISSUES
The environmental investigations that have been conducted on the Company's
properties have not revealed any environmental liability that the Company
believes would have a material adverse effect on its financial condition,
results of operations and assets, and the Company is not aware of any such
liability. Nonetheless, it is possible that there are material
environmental liabilities of which the Company is unaware. In addition, the
Company cannot assure that future laws, ordinances, or regulations will not
impose any material environmental liability, or that the current
environmental condition of the properties has not been, or will not be,
affected by tenants and occupants of the properties, by the condition of
properties in the vicinity of the properties, or by third parties unrelated
to the Company.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
BERG LAND HOLDINGS OPTION AGREEMENT
On April 27, 2005, the Berg Group disclosed that they received an offer
from an unrelated party to purchase a portion of the Piercy & Hellyer land
comprised of approximately 10 acres in San Jose, California, that is
subject to the Berg Land Holdings Option Agreement with the Company. The
prospective purchaser has disclosed that they intend to develop "for sale"
industrial type buildings. In light of the overcapacity in the market and
the Company's current inventory of available buildings for lease in this
submarket, the Independent Directors Committee, which is responsible for
reviewing, evaluating and authorizing action with respect to any
transaction between us and any member of the Berg Group, has authorized
removal of this approximately 10 acre parcel of land from the scope of the
Berg Land Holdings Option Agreement, subject to the completion of the sale
to the unrelated party. In making this determination, the Independent
Directors Committee considered a number of factors, including risks and
other potentially adverse consequences that could be associated with
acquiring undeveloped land for future development. In the event the
approximately 10 acre parcel of land is not sold to this unrelated party,
the parcel would not be deemed to be removed from the scope of the Berg
Land Holdings Option Agreement and it would remain eligible for potential
future acquisition under the Berg Land Holdings Option Agreement.
8. MORTGAGE NOTES PAYABLE
ALLIANZ LOAN I
On April 6, 2005, the Company obtained a $25,800 secured mortgage loan from
Allianz Life Insurance Company of North America ("Allianz Loan I"). The
Allianz Loan I matures on April 10, 2020, and must be paid in full at that
time, unless payment is accelerated by reason of a default or sale of the
property that secures the loan. This loan bears a fixed interest rate at
5.56% and principal payments are amortized over 20 years. The mortgage loan
is secured by one property. The Company paid approximately $251 in loan
fees and financing costs, which are being amortized over the 15 year loan
period, and used the proceeds primarily to pay down short-term debt and the
Berg Group line of credit.
INTEREST RATE DERIVATIVE
During the second quarter of 2005, we entered into cash flow interest rate
derivative as a means to hedge exposure to an increase in interest rates
prior to securing a loan commitment in connection with a refinancing of
certain variable rate debt to fixed rate long term mortgage debt. In June
2005, the Company secured a 20 year fixed rate mortgage loan commitment for
$125,000 at 5.22% annual interest rate and closed the derivative contracts
shortly thereafter. Since the interest rate derivative contracts did not
qualify as a designated cash flow interest rate hedge in accordance with
Statement of Financial Accounting Standards No. 133 ("SFAS No. 133"),
Accounting for Derivative Instruments and Hedging Activities, the Company
recorded an approximately $834 charge to interest expense in the second
quarter of 2005.
9. SUBSEQUENT EVENTS
On July 7, 2005, the Company paid dividends of $0.16 per share of common
stock to all common stockholders of record as of June 30, 2005. On the same
date, the operating partnerships paid a distribution of $0.16 per O.P. unit
to all holders of O.P. units.
On July 26, 2005, the Company obtained a $125,000 secured mortgage loan
from Allianz Life Insurance Company of North America ("Allianz") ("Allianz
Loan II"). The Allianz Loan II matures on July 10, 2025, and must be paid
in full at that time, unless payment is accelerated by reason of a default
or sale of one or more of the properties that secure the loan. This loan
bears a fixed interest rate of 5.22% and principal payments are amortized
over 20 years. The loan can be prepaid subject to certain yield maintenance
provisions and is assumable with the payment of an assumption fee. The
mortgage loan is secured by eight properties. The Company paid
approximately $800 in loan fees and financing costs, which will be
amortized over the 20 year loan period. The proceeds will be used primarily
to repay short-term debt, retire one long-term mortgage debt, reduce the
balance of the Cupertino National Bank and Berg Group lines of credit, and
for other working capital needs. In connection with the Allianz Loan II,
the Company entered into a "Loan Modification Agreement" with Allianz on
July 26, 2005, which extends the amortization period and maturity date of
the $25,800 secured mortgage Allianz Loan I from April 10, 2020 to July 10,
2025. The Allianz Loans I and II now contain cross-default provisions.
The Company entered into a "Change in Terms Agreement" with Cupertino
National Bank on July 22, 2005, which reduced the maximum borrowing amount
on the Company's revolving line of credit facility with that bank from
$40,000 to $9,000.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the accompanying consolidated
financial statements and notes thereto contained herein and our consolidated
financial statements and notes thereto contained in our Annual Report on Form
10-K as of and for the year ended December 31, 2004. The results for the three
and six months ended June 30, 2005 are not necessarily indicative of the results
to be expected for the entire fiscal year ending December 31, 2005. The
following discussion includes forward-looking statements, including but not
limited to, statements with respect to our future financial performance,
operating results, plans and objectives. Actual results may differ materially
from those currently anticipated depending upon a variety of factors, including
those described under the sub-heading, "Forward-Looking Information."
FORWARD-LOOKING INFORMATION
This quarterly report contains forward-looking statements within the meaning of
the federal securities laws. We intend such forward-looking statements to be
covered by the safe harbor provisions for forward-looking statements contained
in the Private Securities Reform Act of 1995, and is including this statement
for purposes of complying with these safe harbor provisions. Forward-looking
statements, which are based on certain assumptions and describe future plans,
strategies and expectations of the Company, are generally identifiable by use of
the words "believe," "expect," "intend," "anticipate," "estimate," "project" or
similar expressions. Additionally, all disclosures under Part I, Item 3
constitute forward-looking statements. Our ability to predict results or the
actual effect of future plans or strategies is inherently uncertain.
Factors that could have a material adverse effect on our operations and future
prospects include, but are not limited to, the following:
- economic conditions generally and the real estate market specifically,
- legislative or regulatory provisions (including changes to laws governing
the taxation of REITs),
- availability of capital,
- interest rates,
- competition,
- supply of and demand for R&D, office and industrial properties in our
current and proposed market areas,
- tenant defaults and bankruptcies,
- lease term expirations and renewals, and
- changes in general accounting principles, policies and guidelines
applicable to REITs.
In addition, the actual timing of development, construction, and leasing on any
projects that we believe we may acquire in the future under the Berg Land
Holdings Option Agreement is presently unknown, and reliance should not be
placed on the estimates concerning these projects. These risks and
uncertainties, together with the other risks described from time to time in our
reports and other documents filed with the Securities and Exchange Commission,
should be considered in evaluating forward-looking statements and undue reliance
should not be placed on such statements.
OVERVIEW
We acquire, market, lease, and manage R&D/office properties, primarily located
in the Silicon Valley portion of the San Francisco Bay Area. As of June 30,
2005, we owned and managed 108 properties totaling approximately 8.0 million
rentable square feet through four limited partnerships, or operating
partnerships, for which we are the sole general partner. This class of property
is designed for research and development and office uses and, in some cases,
includes space for light manufacturing operations with loading docks. We believe
that we have one of the largest portfolios of R&D/office properties in the
Silicon Valley. As of June 30, 2005, the six tenants who each leased in excess
of 300,000 rentable square feet from us were Microsoft Corporation, Fujitsu
America (a subsidiary of Fujitsu Limited), JDS Uniphase Corporation, NEC
Electronics America, Inc. (a subsidiary of NEC Electronics Corporation), Ciena
Corporation and Apple Computer, Inc. For federal income tax purposes, we have
operated as a self-managed, self-administered and fully integrated real estate
investment trust ("REIT") since fiscal 1999.
Our acquisition, growth and operating strategy incorporates the following
elements:
- working with the Berg Group to take advantage of their abilities and
resources to pursue development opportunities which we have an option to
acquire, on pre-negotiated terms, upon completion and leasing;
- capitalizing on opportunistic acquisitions from third parties of
high-quality R&D/office properties that provide attractive initial yields
and significant potential for growth in cash-flow;
- focusing on general purpose, single-tenant Silicon Valley R&D/office
properties for information technology companies in order to maintain low
operating costs, reduce tenant turnover and capitalize on our relationships
with these companies and our extensive knowledge of their real estate
needs; and
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- maintaining prudent financial management principles that emphasize current
cash flow while building long-term value, the acquisition of pre-leased
properties to reduce development and leasing risks and the maintenance of
sufficient liquidity to acquire and finance properties on desirable terms.
CURRENT ECONOMIC ENVIRONMENT
All of our properties are located in the Northern California area known as
Silicon Valley, which generally consists of portions of Santa Clara County,
Southwestern Alameda County, Southeastern San Mateo County and Eastern Santa
Cruz County. The Silicon Valley economy and business activity have slowed
markedly since 2001 after fast-paced growth in 1999 and 2000. The Silicon Valley
R&D property market has historically fluctuated with the local economy.
According to a recent report by BT Commercial Real Estate, vacancy rates for
Silicon Valley R&D property were approximately 22.4% in late 2004 and 21.0% at
the end of the second quarter 2005. Total vacant R&D square footage in Silicon
Valley at the end of the second quarter of 2005 amounted to 32.3 million square
feet, of which 24.5%, or 7.9 million square feet, was being offered under
subleases. Total negative net absorption (which is the computation of gross
square footage leased less gross new square footage vacated for the period
presented) in 2004 amounted to approximately (0.3) million square feet. During
the first six months of 2005, there was total positive net absorption of
approximately 1.5 million square feet. Average asking market rent per square
foot has decreased from $0.88 in late 2004 to $0.87 at the end of the second
quarter of 2005, although individual properties within any particular submarket
presently may be leased above or below the current average asking market rental
rates within that submarket. The impact of the rental market decline has not
been uniform throughout the area, however. The Silicon Valley R&D property
market has been characterized by a substantial number of submarkets, with rent
and vacancy rates varying by submarket and location within each submarket.
Our occupancy rate at June 30, 2005 was 65.7% compared to 71.6% at June 30,
2004. We believe that our occupancy rate could decline further going forward if
key tenants seek the protection of bankruptcy laws, consolidate operations or
discontinue operations. In addition, leases with respect to approximately
190,000 rentable square feet are expiring prior to the end of 2005. The
properties subject to these leases may take anywhere from 24 to 36 months or
longer to re-lease. We believe that the average 2005 renewal rental rates for
our properties will be approximately equal to, or perhaps, below current market
rents, but we cannot give any assurance that leases will be renewed or that
available space will be re-leased at rental rates equal to or above the current
quoted market rates. If we are unable to lease a significant portion of any
vacant space or space subject to expiring leases; if we experience significant
tenant defaults as a result of the current economic downturn; if we are not able
to lease space at or above current market rates; or if we restructure existing
leases and lower existing rents in order to retain tenants for an extended term,
our results of operations and cash flows will be adversely affected.
Furthermore, in this event it is probable that our board of directors will
reduce the quarterly dividend on the common stock and the outstanding O.P.
units. Our operating results and ability to pay dividends at current levels
remain subject to a number of material risks, as indicated under the caption
"Forward-Looking Information" above and in the section entitled "Risk Factors"
in our most recent annual report on Form 10-K.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We prepare the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP"), which
requires us to make certain estimates, judgments and assumptions that affect the
reported amounts in the accompanying consolidated financial statements,
disclosure of contingent assets and liabilities and related footnotes.
Accounting and disclosure decisions with respect to material transactions that
are subject to significant management judgments or estimates include impairment
of long lived assets, deferred rent reserves, and allocation of purchase price
relating to property acquisitions and the related depreciable lives assigned.
Actual results may differ from these estimates under different assumptions or
conditions.
Critical accounting policies are defined as those that require management to
make estimates, judgments and assumptions, giving due consideration to
materiality, in certain circumstances that affect amounts reported in the
consolidated financial statements, and potentially result in materially
different results under different conditions and assumptions. We believe that
the following best describe our critical accounting policies:
BUSINESS COMBINATIONS. Statement of Financial Accounting Standards No. 141
("SFAS No. 141"), Business Combinations, was effective July 1, 2001. The
acquisition costs of each property acquired prior to July 1, 2001 were allocated
only to building, land and leasing commissions with building depreciation being
computed based on an estimated weighted average composite useful life of 40
years and leasing commission amortization being computed over the term of the
lease. Acquisitions of properties made subsequent to the effective date of SFAS
No. 141 are based on an allocation of the acquisition cost to land, building,
tenant improvements, and intangibles for at market, including lease origination
and lease up period costs, and above market in place leases, and the
determination of their useful lives are guided by a combination of SFAS No. 141
and management's estimates. If we do not appropriately allocate these components
or we incorrectly estimate the useful lives of these components, our computation
of depreciation and amortization expense may not appropriately reflect the
actual impact of these costs over future periods, which will affect net income.
IMPAIRMENT OF LONG-LIVED ASSETS. We review real estate assets for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable in accordance with Statement of Financial
Accounting Standards No. 144 ("SFAS No. 144"), Accounting for the Impairment and
Disposal of Long-Lived Assets. If the carrying amount of the asset exceeds its
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estimated undiscounted net cash flow, before interest, we will recognize an
impairment loss equal to the difference between its carrying amount and its
estimated fair value. If impairment is recognized, the reduced carrying amount
of the asset will be accounted for as its new cost. For a depreciable asset, the
new cost will be depreciated over the asset's remaining useful life. Generally,
fair values are estimated using discounted cash flow, replacement cost or market
comparison analyses. The process of evaluating for impairment requires estimates
as to future events and conditions, which are subject to varying market factors,
such as the vacancy rates, future rental rates, lease periods, deferred
maintenance and operating costs for R&D facilities in the Silicon Valley area
and related submarkets. Therefore, it is reasonably possible that a change in
estimate resulting from judgments as to future events could occur which would
affect the recorded amounts of the property.
ALLOWANCE FOR DOUBTFUL ACCOUNTS AND DEFERRED RENT. We must estimate the
uncollectibility of our accounts receivable based on the evaluation of our
tenants' financial position, analyses of accounts receivable and current
economic trends. We also make estimates for reserves against our deferred rent
receivable for existing tenants with the potential of early termination,
bankruptcy or ceasing operations. We charge or credit rental income for
increases or decreases to our deferred rent reserves. Our estimates are based on
our review of tenants' payment histories, publicly available financial
information and such additional information about their financial condition as
tenants provide to us. The information available to us might lead us to
overstate or understate these reserve amounts. The use of different estimates or
assumptions could produce different results. Moreover, actual future collections
of accounts receivable or reductions in future reported rental income due to
tenant bankruptcies or other business failures could differ materially from our
estimates.
CONSOLIDATED JOINT VENTURES. We, through an operating partnership, own three
properties that are in joint ventures of which we have controlling interests. We
manage and operate all three properties. The recognition of these properties and
their operating results are 100% reflected on our consolidated financial
statements, with appropriate allocation to minority interest, because we have
operational and financial control of the investments. We make judgments and
assumptions about the estimated monthly payments made to our minority interest
joint venture partners, which are reported with our periodic results of
operations. Actual results may differ from these estimates under different
assumptions or conditions.
INVESTMENT IN UNCONSOLIDATED JOINT VENTURE. We, through an operating
partnership, have a 50% non-controlling limited partnership interest in one
unconsolidated joint venture. This investment is not consolidated because we do
not exercise significant control over major operating and financial decisions.
We account for this joint venture interest using the equity method of
accounting.
FAIR VALUE OF FINANCIAL INSTRUMENTS. Our financial instruments include cash and
cash equivalents, accounts receivable, accounts payable, and debt. Considerable
judgment is required in interpreting market data to develop estimates of fair
value. Our estimates of fair value are not necessarily indicative of the amounts
that we could realize in a current market exchange. The use of different market
assumptions and/or estimation methodologies may have a material effect on the
estimated fair value amounts. Cash and cash equivalents, accounts receivable,
and accounts payable are carried at amounts that approximate their fair values
due to their short-term maturities. The carrying amounts of our variable rate
debt approximate fair value since the interest rates on these instruments are
equivalent to rates currently offered to us. For fixed rate debt, we estimate
fair value by using discounted cash flow analyses based on borrowing rates for
similar kinds of borrowing arrangements.
REVENUE RECOGNITION. Rental revenue is recognized on the straight-line method of
accounting required by GAAP under which contractual rent payment increases are
recognized evenly over the lease term, regardless of when the rent payments are
received by us. The difference between recognized rental income and rental cash
receipts is recorded as Deferred Rent Receivable on the consolidated balance
sheets.
Rental revenue is affected if existing tenants terminate or amend their leases.
We try to identify tenants who may be likely to declare bankruptcy or cease
operations. By anticipating these events in advance, we expect to take steps to
minimize their impact on our reported results of operations through lease
renegotiations, reserves against deferred rent, and other appropriate measures.
Our judgments and estimations about tenants' capacity to continue to meet their
lease obligations will affect the rental revenue recognized. Material
differences may result in the amount and timing of our rental revenue for any
period if we made different judgments or estimations.
Statement of Financial Accounting Standards No. 66 ("SFAS No. 66"), Accounting
for Sales of Real Estate, establishes accounting standards for recognizing
profit or loss on sales of real estate. The gain on the sale is only recognized
proportionately as the seller receives payments from the purchaser. Interest
income is recognized on an accrual basis, when appropriate.
Lease termination fees are recognized as other income when there is a signed
termination letter agreement, all of the conditions of the agreement have been
met, and the tenant is no longer occupying the property. These fees are paid by
tenants who want to terminate their lease obligations before the end of the
contractual term of the lease. There is no way of predicting or forecasting the
timing or amounts of future lease termination fees.
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We recognize income from rent, tenant reimbursements and lease termination fees
and other income once all of the following criteria are met in accordance with
SEC Staff Accounting Bulletin 104:
- the agreement has been fully executed and delivered;
- services have been rendered;
- the amount is fixed and determinable; and
- collectibility is reasonably assured.
With regards to critical accounting policies, where applicable, we have
explained and discussed the criteria for identification and selection,
methodology in application and impact on the financial statements with the Audit
Committee of our Board of Directors. The Audit Committee has reviewed the
critical accounting policies we identified.
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RESULTS OF OPERATIONS
COMPARISON OF THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 TO THE THREE AND SIX
MONTHS ENDED JUNE 30, 2004
As of June 30, 2005, through our controlling interests in the operating
partnerships, we owned 108 properties totaling approximately 8.0 million
rentable square feet compared to 109 properties totaling approximately 7.9
million rentable square feet owned by us as of June 30, 2004. This represents a
net increase of approximately 1% in total rentable square footage, as we
acquired one property consisting of approximately 203,800 rentable square feet
and disposed of two properties consisting of approximately 103,350 rentable
square feet during the first quarter of 2005.
RENTAL REVENUE FROM REAL ESTATE FROM CONTINUING OPERATIONS
For the quarter ended June 30, 2005, rental revenue from real estate decreased
by approximately ($4.7) million, or 15.8%, from $29.8 million for the three
months ended June 30, 2004 to $25.1 million for the same period of 2005. For the
six months ended June 30, 2005, rental revenue from real estate decreased by
approximately ($9.7) million, or 15.9%, from $61.0 million for the six months
ended June 30, 2004 to $51.3 million for the six months ended June 30, 2005.The
decline in rental revenue was primarily a result of the lower rental rate under
the new Microsoft blend and extend lease, which was signed in the first quarter
of 2005 and accounted for over half the decline. Other factors attributing to
the decline in rental revenue were lower rental rates on new leases and renewals
and the loss of several tenants due to their bankruptcy, relocation or cessation
of operations since June 30, 2004, all of which resulted from adverse market
conditions. Our occupancy rate at June 30, 2005 was approximately 66%, compared
to approximately 72% at June 30, 2004. Due to an over supply of R&D properties
and competition from other landlords in the Silicon Valley, our occupancy rate
may drop further if the 190,000 rentable square feet scheduled to expire during
the remainder of 2005 is not renewed or re-leased.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of June 30, 2005, we had investments in four R&D buildings, totaling 593,000
rentable square feet, through an unconsolidated joint venture, TBI-MSW, in which
we acquired a 50% interest in January 2003 from the Berg Group under the Berg
Land Holdings Option Agreement. We have a non-controlling limited partnership
interest in this joint venture, which we account for using the equity method of
accounting. For the three months ended June 30, 2005, we recorded equity in
earnings from the unconsolidated joint venture of approximately $0.4 million
compared to equity in earnings of $0.6 million for the same period in 2004. Our
equity in earnings from this unconsolidated joint venture declined in the second
quarter of 2005 due to lower rents received as a result of lower occupancy rate.
For the six-month periods ended June 30, 2005 and 2004, equity in earnings from
the unconsolidated joint venture was approximately $0.4 million and $1.2
million, respectively. The decline in equity in earnings from unconsolidated
joint venture for the six-month period ended June 30, 2005 resulted from the
write-offs of leasing commission and tenant improvements for a tenant that
terminated its lease agreement as well as lower rents received from the
properties of this joint venture. The occupancy rate for these properties at
June 30, 2005 was approximately 78.7% compared to 100% at June 30, 2004.
OTHER INCOME FROM CONTINUING OPERATIONS
Other income decreased to approximately $2.3 million for the three months ended
June 30, 2005 from $4.6 million for the second quarter of 2004. Approximately
$2.0 million and $3.7 million of termination fee and tenant bankruptcy
settlement income accounted for other income in the second quarter of 2005 and
2004, respectively. For the six months ended June 30, 2005 and 2004, other
income was $2.6 million and $5.0 million, respectively. We realized higher lease
termination fee and tenant bankruptcy settlement income in 2004. We do not
consider these transactions to be recurring items.
EXPENSES FROM CONTINUING OPERATIONS
Property operating expenses and real estate taxes during the second quarter of
2005 decreased by approximately ($1.0) million, or 19.6%, from $5.1 million to
$4.1 million for the three months ended June 30, 2004 and 2005, respectively,
due primarily to the lower occupancy rate on our properties, the disposition of
two properties during the first quarter of 2005 and property tax refunds. Tenant
reimbursements decreased by approximately ($0.1) million, or 2.7%, from $3.7
million for the three months ended June 30, 2004 to $3.6 million for the three
months ended June 30, 2005. Property operating expenses and real estate taxes
decreased by approximately ($1.6) million, or 15.1%, from $10.6 million to $9.0
million for the six months ended June 30, 2004 and 2005, respectively, due to
lower repair and maintenance expenses and real estate taxes to our existing
properties. Tenant reimbursements decreased by approximately ($0.7) million, or
8.9%, from $7.9 million for the six months ended June 30, 2004 to $7.2 million
for the six months ended June 30, 2005. The decrease in tenant reimbursements
for both periods ended June 30, 2005 as compared to the same periods in 2004 was
due to lower occupancy. Certain expenses such as property insurance, real estate
taxes, and other fixed expenses are not recoverable from vacant properties.
General and administrative expenses decreased by approximately ($0.4) million,
or 44.4%, from $0.9 million to $0.5 million for the three months ended June 30,
2004 and 2005, respectively. For the six months ended June 30, 2004 and 2005,
general and administrative expenses decreased by approximately ($0.1) million,
or 8.3%, from $1.2 million to $1.1 million, respectively. The decrease in
general and administrative expenses for the quarter and the six months ended
June 30, 2005 was primarily a result of incurring additional legal and
accounting expenses in connection with the resignation of PricewaterhouseCoopers
LLP, our former independent accountants, and the need to re-audit consolidated
financial statements for years 2001 and 2002 and audit 2003 results during the
second quarter of 2004, which did not recur in 2005.
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Real estate depreciation and amortization expense decreased by approximately
($0.2) million, or 3.6%, from $5.6 million to $5.4 million for the three months
ended June 30, 2004 and 2005, respectively. Depreciation and amortization
expense of real estate decreased by approximately ($0.1) million, or 1.0%, from
$11.0 million to $10.9 million for the six months ended June 30, 2004 and 2005,
respectively. The decrease for both periods ended June 30, 2005 compared to the
same periods in 2004 reflected the write-off of a remaining in-place lease
intangible asset due to lease termination in the second quarter 2004 and the
disposition of two properties during the first quarter 2005.
Interest expense increased by approximately $1.7 million, or 40.5%, from $4.2
million for the three months ended June 30, 2004 to $5.9 million for the three
months ended June 30, 2005. Interest expense (related parties) remained stable
at approximately $0.25 million for the current three-month period compared to
the same period one year ago. Total debt outstanding, including amounts due
related parties, increased by approximately $12.4 million, or 3.7%, from $332.0
million as of June 30, 2004 to $344.4 million as of June 30, 2005. Overall
interest expense, including amounts paid to related parties, for the quarter
ended June 30, 2005 increased by approximately $1.7 million compared to the same
quarter a year ago principally due to a cash flow interest rate derivative loss
of approximately $0.8 million, higher interest rates on the variable rate debt
and the substitution of new debt at slightly higher rates for borrowings under
the Berg Group line of credit.
Interest expense increased by approximately $2.0 million, or 23.3%, from $8.6
million for the six months ended June 30, 2004 to $10.6 million for the six
months ended June 30, 2005. The increase in interest expense resulted
principally from losses taken from a cash flow interest rate derivative, higher
interest rates on variable rate debt, and a new $25.8 million secured mortgage
loan from Allianz Life Insurance Company ("Allianz Loan I") obtained in early
April 2005, which substituted for lower interest rate debt under the Berg Group
line of credit. Interest expense (related parties) increased by approximately
$45,000, or 8.9%, from $504,000 for the six months ended June 30, 2004 to
$549,000 for the six months ended June 30, 2005 due to higher interest rates.
INCOME FROM DISCONTINUED OPERATIONS
The following table depicts the amounts of income from discontinued operations
for the three and six months ended June 30, 2005 and 2004.
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
--------------------------------------------------------------
(dollars in thousands)
(unaudited)
Gain from disposal of property - - $ 63 -
(Loss)/income attributable to discontinued operations ($ 10) ($ 42) (51) $ 246
Minority interest in (loss)/earnings attributable
to discontinued operations 8 33 (10) (193)
----------- ------------ ------------ ------------
(Loss)/income from discontinued operations ($ 2) ($ 9) $ 2 $ 53
=========== ============ ============ ============
In accordance with our adoption of SFAS No. 144, in the first quarter 2005 we
sold and classified as discontinued operations two properties consisting of
103,350 rentable square feet and recorded a gain of $63,000, of which $14,000
and $49,000 were attributable to common stockholders and minority interests,
respectively. The (loss) to common stockholders and minority interests
attributable to discontinued operations from these two properties for the three
months ended June 30, 2005 and 2004 was approximately ($2,000) and ($8,000),
respectively, and ($9,000) and ($33,000), respectively. The income to common
stockholders and minority interests attributable to discontinued operations from
these two properties for the six months ended June 30, 2005 and 2004 was
approximately $2,000 and $10,000, respectively, and $53,000 and $193,000,
respectively.
NET INCOME TO COMMON STOCKHOLDERS AND NET INCOME TO MINORITY INTEREST
Minority interest in net income has been calculated by taking the net income of
the operating partnerships (on a stand-alone basis) multiplied by the respective
minority interest ownership percentage. Minority interest represents the
ownership interest of all limited partners in the operating partnerships taken
as a whole, which was approximately 82% and 83% as of June 30, 2005 and 2004,
respectively.
Net income to common stockholders decreased by approximately ($1.1) million, or
28.9%, from $3.8 million for the three months ended June 30, 2004 to $2.7
million for the same period in 2005. The minority interest portion of income
decreased by approximately ($6.2) million, or 33.0%, from $18.8 million for the
three months ended June 30, 2004 to $12.6 million for the three months ended
June 30, 2005. For the six months ended June 30, 2005 and 2004, the minority
interest portion of income was approximately $24.3 million and $36.1 million,
respectively, resulting in net income to common stockholders of approximately
$5.1 million and $7.3 million, respectively. The decline in net income and
minority interest portion of income was primarily due to lower rental revenue,
the existence of higher termination fee and settlement income in 2004 that did
not recur in 2005, increases in interest expense and higher non-reimbursable
operating expenses from vacant properties.
- 16 -
CHANGES IN FINANCIAL CONDITION
The most significant changes in our financial condition during the six months
ended June 30, 2005 resulted from the disposition of two R&D properties and
acquisition of one R&D property. In addition, total stockholders' equity
increased from the exchange of O.P. units for common stock and stock option
exercises.
At June 30, 2005, total investments in properties had a net increase of
approximately $10.6 million from December 31, 2004 from one property acquisition
and two property dispositions. During the first six months of 2005, we acquired
one vacant R&D property representing approximately 203,800 rentable square feet
located in the Silicon Valley. The purchase price for this property was
approximately $14.0 million. We also disposed of two R&D properties consisting
of approximately 103,350 rentable square feet for a total sales price of
approximately $12.8 million. One of the disposed properties was classified as an
asset held for sale at December 31, 2004 for $8.2 million.
Total stockholders' equity, net, increased by approximately $1.8 million from
December 31, 2004 as we obtained additional capital from the exchange of O.P.
units for shares of our common stock and stock option exercises, while incurring
a deficit of approximately ($0.7) million due to dividends declared in excess of
net income for the period. During the first six months of 2005, four limited
partners exchanged 215,500 O.P. units for 215,500 shares of our common stock
under the Exchange Rights Agreement among us and the limited partners in the
operating partnerships. The newly issued shares increased additional paid in
capital by approximately $2.5 million.
LIQUIDITY AND CAPITAL RESOURCES
We expect a continued decline in operating cash flows from our operating
property portfolio in 2005 as compared to 2004. The reduction in cash flows
reflects the overall reduced demand for R&D space, lower rental rates for new
and renewed leases, and an increase in vacant properties in 2005. In addition,
if we are unable to lease a significant portion of the approximately 190,000
rentable square feet scheduled to expire during the remainder of 2005 or an
equivalent amount of our currently available space of approximately 2.8 million
rentable square feet, our operating cash flows may be affected adversely. With
the expectation of lower revenues for the remainder of 2005, we expect the
properties' net operating income to continue to show year over year declines
when compared to 2004. As noted above, we expect cash flows from operating
activities to continue to show declines primarily driven by the general downturn
in the Silicon Valley's economy in recent years, the softening of the Company's
market specifically, and the expected weaker performance of our properties. We
are also subject to risks of decreased occupancy through tenant defaults and
bankruptcies and potential reduction in rental rates upon renewal of properties,
which would result in reduced cash flow from operations. It is reasonably likely
that vacancy rates may continue to increase and effective rental rates on new
and renewed leases may continue to decrease.
We expect our principal source of liquidity for distributions to stockholders
and O.P. unit holders, debt service, leasing commissions and recurring capital
expenditures to come from cash provided by operations and/or the borrowings
under the lines of credit with the Berg Group and Cupertino National Bank. We
expect these sources of liquidity to be adequate to meet projected distributions
to stockholders and other presently anticipated liquidity requirements in 2005.
We expect to meet our long-term liquidity requirements for the funding of
property development, property acquisitions and other material non-recurring
capital improvements through long-term secured and unsecured indebtedness and
the issuance of additional equity securities by us. We have the ability to meet
short-term obligations or other liquidity needs based on lines of credit with
the Berg Group and Cupertino National Bank. We expect our total interest expense
to increase as interest rates rise and through new financing activities. In the
remainder of 2005, we will be obligated to make payments totaling approximately
$4.5 million of debt principal under mortgage notes without regard to any debt
refinancing or new debt obligations that we might incur, or optional payments of
debt principal.
DISTRIBUTIONS
On July 7, 2005, we paid dividends of $0.16 per share of common stock to all
common stockholders of record as of June 30, 2005. On the same date, the
operating partnerships paid a distribution of $0.16 per O.P. unit to all holders
of O.P. units. For the remainder of 2005, we expect to maintain our current
quarterly dividend payment rate to common shareholders and O.P. unit holders of
$0.16 per share. However, distributions are declared at the discretion of our
Board of Directors and are subject to actual cash available for distribution,
our financial condition, capital requirements and such other factors, as our
Board of Directors deems relevant.
DEBT
At June 30, 2005, we had total indebtedness of $344.4 million, including $237.1
million of fixed rate mortgage debt, $10.2 million under the Berg Group mortgage
note (related parties), $77.4 million under the Citicorp USA ("Citicorp")
mortgage loan, $19.2 million under the Cupertino National Bank ("CNB") line of
credit, and $0.5 million under the Berg Group line of credit (related parties),
as detailed in the table below. The CNB and Citicorp loans contain certain
financial loan and reporting covenants as defined in the loan agreements. As of
June 30, 2005, we were in compliance with these loan covenants.
On April 6, 2005, we obtained a $25.8 million secured mortgage loan from Allianz
Life Insurance Company of North America ("Allianz Loan I") that bears a fixed
interest rate at 5.56% and matures in 15 years with principal payments amortized
over 20 years. The mortgage loan is secured by one property. We paid
approximately $251,000 in loan fees and financing costs, which are being
amortized over the 15 year loan period, and used the proceeds primarily to pay
down short-term debt and the Berg Group line of credit.
- 17 -
On July 26, 2005, we obtained a $125 million secured mortgage loan from Allianz
Life Insurance Company of North America ("Allianz Loan II"). The Allianz Loan II
matures on July 10, 2025, and must be paid in full at that time, unless payment
is accelerated by reason of a default or sale of one or more of the properties
that secure the loan. This loan bears a fixed interest rate of 5.22% and
principal payments are amortized over 20 years. The loan can be prepaid subject
to certain yield maintenance provisions and is assumable with the payment of an
assumption fee. The mortgage loan is secured by eight properties. We paid
approximately $0.8 million in loan fees and financing costs, which will be
amortized over the 20 year loan period. The proceeds will be used primarily to
repay the Citicorp loan, retire the Washington Mutual loan, reduce the balance
of the CNB and Berg Group lines of credit, and for other working capital needs.
In connection with the Allianz Loan II, we entered into a "Loan Modification
Agreement" with Allianz Life Insurance Company of North America on July 26,
2005, which extends the amortization period and maturity date of the $25.8
million secured mortgage loan entered into with Allianz Life Insurance Company
of North America on April 6, 2005 ("Allianz Loan I") from April 10, 2020 to July
10, 2025. The Allianz Loans I and II now contain cross-default provisions.
On July 22, 2005, we entered into a "Change in Terms Agreement" with Cupertino
National Bank, which reduced the maximum borrowing amount on the Company's
revolving line of credit facility with that bank from $40 million to $9 million.
- 18 -
The following table sets forth information regarding debt outstanding as of June
30, 2005:
Maturity Interest
Debt Description Collateral Properties Balance Date Rate
---------------------------------------------- -------------------------------------- ------------------ ------------- ------------
(dollars in thousands)
Line of Credit:
Berg Group (related parties) 2033-2043 Samaritan Dr., San Jose, CA $ 444 3/06 (1)
2133 Samaritan Dr., San Jose, CA ------------------
2233-2243 Samaritan Dr., San Jose, CA
1310-1450 McCandless Dr., Milpitas, CA
1795-1845 McCandless Dr., Milpitas, CA
Cupertino National Bank Not Applicable 19,172 11/06 (4)
------------------
Mortgage Notes Payable (related parties): 5300 & 5350 Hellyer Avenue, San Jose, CA 10,239 6/10 7.650%
------------------
Mortgage Notes Payable (2):
Washington Mutual 10460 Bubb Road, Cupertino, CA 113 12/06 9.500%
Prudential Insurance Company of America (3) 10300 Bubb Road, Cupertino, CA 118,383 10/08 6.560%
10500 N. De Anza Blvd., Cupertino, CA
4050 Starboard Drive, Fremont, CA
45700 Northport Loop, Fremont, CA
45738 Northport Loop, Fremont, CA
450 National Avenue, Mountain View, CA
6311 San Ignacio Ave., San Jose, CA
6321 San Ignacio Ave., San Jose, CA
6325 San Ignacio Ave., San Jose, CA
6331 San Ignacio Ave., San Jose, CA
6341 San Ignacio Ave., San Jose, CA
6351 San Ignacio Ave., San Jose, CA
3236 Scott Boulevard, Santa Clara, CA
3560 Bassett Street, Santa Clara, CA
3570 Bassett Street, Santa Clara, CA
3580 Bassett Street, Santa Clara, CA
1135 Kern Avenue, Sunnyvale, CA
1212 Bordeaux Lane, Sunnyvale, CA
1230 E. Arques, Sunnyvale, CA
1250 E. Arques, Sunnyvale, CA
1170 Morse Avenue, Sunnyvale, CA
1600 Memorex Drive, Santa Clara, CA
1688 Richard Avenue, Santa Clara, CA
1700 Richard Avenue, Santa Clara, CA
3540 Bassett Street, Santa Clara, CA
3542 Bassett Street, Santa Clara, CA
3544 Bassett Street, Santa Clara, CA
3550 Bassett Street, Santa Clara, CA
Northwestern Mutual Life Insurance Company (5) 1750 Automation Parkway, San Jose, CA 92,967 1/13 5.640%
1756 Automation Parkway, San Jose, CA
1762 Automation Parkway, San Jose, CA
6320 San Ignacio Avenue, San Jose, CA
6540-6541 Via Del Oro, San Jose, CA
6385-6387 San Ignacio Ave., San Jose, CA
2251 Lawson Lane, Santa Clara, CA
1325 McCandless Dr., Milpitas, CA
1650-1690 McCandless Dr., Milpitas, CA
20605-20705 Valley Green Dr., Cupertino, CA
Citicorp USA, Inc. 2001 Walsh Avenue, Santa Clara, CA 77,420 9/06 (4)
2880 Scott Boulevard, Santa Clara, CA
2890 Scott Boulevard, Santa Clara, CA
2770-2800 Scott Blvd., Santa Clara, CA
2300 Central Expy., Santa Clara, CA
2220 Central Expy., Santa Clara, CA
2330 Central Expy,, Santa Clara, CA
20400 Mariani Avenue, Cupertino, CA
Allianz Life Insurance Company 5900 Optical Court, San Jose, CA 25,623 4/20 5.560%
--------------------
Mortgage Notes Payable Subtotal 314,506
--------------------
TOTAL $344,361
(1) The debt owed to the Berg Group under the line of credit carries a variable
interest rate equal to LIBOR plus 1.30% and is payable in full in March
2006. The interest rate at June 30, 2005 was 4.99%.
(2) Mortgage notes payable generally require monthly installments of interest
and principal ranging from $8,000 to $827,000 over various terms extending
through the year 2020. The weighted average interest rate of mortgage notes
payable was 5.91% at June 30, 2005.
(3) The Prudential Insurance loan is payable in monthly installments of
$827,000, which includes principal (based upon a 30-year amortization) and
interest. A limited partner who is not a member of the Berg Group has
guaranteed approximately $12.0 million of this debt. Costs and fees
incurred with obtaining this loan aggregated approximately $900,000, which
were deferred and amortized over the loan period.
(4) Interest rate equal to LIBOR plus 2%. The interest rates for the Cupertino
National Bank line of credit and the Citicorp USA, Inc. mortgage loan at
June 30, 2005 were 5.13% and 5.14%, respectively. The Cupertino National
Bank line of credit and Citicorp USA, Inc. loan contain certain financial
loan and reporting covenants as defined in the loan agreements. As of June
30, 2005, the Company was in compliance with these loan covenants.
(5) The Northwestern loan is payable in monthly installments of $696,000, which
includes principal (based upon a 20-year amortization) and interest. Costs
and fees incurred with obtaining this loan aggregated approximately
$675,000, which were deferred and amortized over the loan period.
- 19 -
At June 30, 2005, our debt to total market capitalization ratio, which is
computed as our total debt outstanding divided by the sum of total debt
outstanding plus the market value of common stock (based upon the closing price
of $10.27 per share on June 30, 2005) on a fully diluted basis, including the
conversion of all O.P. units into common stock, was approximately 24.3%. On June
30, 2005, the last trading day for the quarter, total market capitalization was
approximately $1.4 billion.
At June 30, 2005, the outstanding balance remaining under certain notes that we
owed to the operating partnerships was $1.6 million. The due date of these notes
has been extended to September 30, 2006. The principal amount of these notes,
along with the interest expense, which is interest income to the operating
partnerships, is eliminated in consolidation and is not included in the
corresponding line items within the consolidated financial statements. However,
the interest income earned by the operating partnerships, which is interest
expense to us, in connection with this debt, is included in the calculation of
minority interest as reported on the consolidated statement of operations,
thereby reducing our net income by this same amount. At present, our only means
for repayment of this debt is through distributions that we receive from the
operating partnerships that are in excess of the amount of dividends to be paid
to our stockholders or by raising additional equity capital.
HISTORICAL CASH FLOWS
COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2005 TO THE SIX MONTHS ENDED JUNE
30, 2004
Net cash provided by operating activities for the six months ended June 30, 2005
was $32.6 million compared to $57.2 million for the same period in 2004. The
decline resulted primarily from the reduction in tenant expense reimbursements
and decrease in rental revenue from our current portfolio of property due to
tenant lease obligation defaults, tenant re-locations, decrease in occupancy and
lower rent renewal rates during the last six months of 2004 and the first six
months of 2005. The decline in cash flow from operating activities was also
caused by payments of leasing commissions which amounted to approximately $4.0
million, including approximately $2.9 million with respect to the modification
and extension of our lease with Microsoft.
Net cash used in investing activities was approximately ($6.4) million and
($0.4) million for the six months ended June 30, 2005 and 2004, respectively.
Cash used in investing activities during the six months ended June 30, 2005
related principally to the acquisition of the property at 5521 Hellyer Avenue
for $14.2 million and the disposition of two existing properties for a total of
$8.4 million. We partially financed one of the sales with a note receivable for
approximately $4.1 million, which has been reflected as a non-cash transaction.
Capital expenditures relating to real estate improvements were approximately
$0.6 million and $0.4 million for the six months ended June 30, 2005 and 2004,
respectively.
Net cash used in financing activities was ($26.1) million for the six months
ended June 30, 2005 compared to ($59.1) million for the six months ended June
30, 2004. During the first six months of 2005, we received $25.8 million from a
new mortgage loan, used $18.5 million to pay outstanding debt, and paid $28.0
million for minority interest distributions and $5.8 million for dividends to
common stockholders. During the same period in 2004, we used $8.8 million to
repay outstanding debt, $41.8 million for minority interest distributions and
$8.6 million for dividends to common stockholders.
FUNDS FROM OPERATIONS ("FFO")
FFO is a non-GAAP financial measurement used by real estate investment trusts to
measure and compare operating performance. As defined by NAREIT, FFO represents
net income (loss) before minority interest of O.P. unit holders, computed in
accordance with GAAP, plus non-recurring events other than "extraordinary items"
under GAAP, excluding gains and losses from sales of depreciable operating
properties, plus real estate related depreciation and amortization, excluding
amortization of deferred financing costs and depreciation of non-real estate
assets, and after adjustments for unconsolidated partnerships and joint
ventures. FFO does include impairment losses for properties held for sale and
held for use. Management considers FFO an appropriate measure of performance of
an equity REIT because, along with cash flows from operating activities,
financing activities and investing activities, it provides investors with an
understanding of our ability to incur and service debt and make capital
expenditures. With the emphasis on the disclosure of operating earnings per
share, we will continue to use FFO as a measure of our performance. FFO should
not be considered as an alternative for net income as a measure of profitability
nor is it comparable to cash flows provided by operating activities determined
in accordance with GAAP, nor is FFO necessarily indicative of funds available to
meet our cash needs, including the need to make cash distributions to satisfy
REIT requirements. For example, FFO is not adjusted for payments of debt
principal required under our debt service obligations.
Our definition of FFO also assumes conversion at the beginning of the period of
all convertible securities, including minority interests that might be exchanged
for common stock. FFO does not represent the amount available for management's
discretionary use; as such funds may be needed for capital replacement or
expansion, debt service obligations or other commitments and uncertainties.
Furthermore, FFO is not comparable to similarly entitled items reported by other
REITs that do not define FFO exactly as we do.
- 20 -
FFO for the three and six months ended June 30, 2005 and 2004, as reconciled to
net income to common stockholders, are summarized in the following tables:
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
------------------ ------------------ ------------------ ------------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders $ 2,695 $ 3,795 $ 5,102 $ 7,318
Add:
Minority interests (1) 12,453 18,706 24,028 35,850
Depreciation & amortization of real estate (2) 5,993 6,240 12,382 12,650
Less:
Gain on sale of asset - - (63) -
------------------ ------------------ ------------------ ------------------
FFO $21,141 $28,741 $41,449 $55,818
================== ================== ================== ==================
(1) The minority interest for third parties totaling $133,000 and $132,000 for
the three months ended June 30, 2005 and 2004, respectively, and $254,000
and $258,000 for the six months ended June 30, 2005 and 2004, respectively,
was deducted from total minority interest in calculating FFO.
(2) Includes our portion of depreciation and amortization of real estate and
leasing commissions from our unconsolidated joint venture totaling $210,000
and $218,000 for the three months ended June 30, 2005 and 2004,
respectively, and $564,000 and 437,000 for the six months ended June 30,
2005 and 2004, respectively. Also includes amortization of leasing
commissions of $414,000 and $328,000 for the three months ended June 30,
2005 and 2004, respectively, and $842,000 and 997,000 for the six months
ended June 30, 2005 and 2004, respectively. Amortization of leasing
commissions is included in the property operating, maintenance and real
estate taxes line item in the Company's consolidated statements of
operations.
DISTRIBUTION POLICY
Our board of directors determines the amount and timing of distributions to our
stockholders. The board of directors will consider many factors prior to making
any distributions, including the following:
- the amount of cash available for distribution;
- our financial condition;
- whether to reinvest funds rather than to distribute such funds;
- our committed and projected capital expenditures;
- the amount of cash required for new property acquisitions, including
acquisitions under existing agreements with the Berg Group;
- prospects of tenant renewals and re-leases of properties subject to
expiring leases;
- cash required for re-leasing activities; o the annual distribution
requirements under the REIT provisions of the federal income tax laws; and
- such other factors as the board of directors deems relevant.
We cannot assure you that we will be able to meet or maintain our cash
distribution objectives.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
We do not believe recently issued accounting standards will materially impact
our financial position, results of operations, or cash flows.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," ("SFAS
No. 123R") which addresses the accounting for employee and director stock
options. Statement 123R requires that the cost of all employee and director
stock options, as well as other equity-based compensation arrangements, be
reflected in the financial statements based on the estimated fair value of the
awards. SFAS No. 123R is an amendment to SFAS No. 123 and supersedes APB Opinion
No. 25 ("APB No. 25"). SFAS No. 123R is applicable to any award that is settled
or measured in stock, including stock options, restricted stock, stock
appreciation rights, stock units, and employee stock purchase plans. SFAS No.
123R will be effective for public companies starting with the first interim
period commencing after June 15, 2005. On April 14, 2005, the SEC announced a
new rule that delays the implementation of SFAS No. 123R until the beginning of
the next fiscal year that begins after December 15, 2005. We will adopt the
requirements of SFAS No. 123R beginning 2006. We expect that the adoption of
this standard will reduce our net income and earnings per share; however, it
will have no impact on cash flow. Although we have not yet determined whether
the adoption of SFAS No. 123R will result in amounts that are similar to the
current pro forma disclosures under SFAS No. 123, we are evaluating the
requirements under SFAS No. 123R including the valuation methods and support for
the assumptions that underlie the valuation of the awards and the transition
methods (modified prospective transition method or the modified retrospective
transition method).
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets" ("SFAS No. 153"). SFAS No. 153 amends the guidance in APB Opinion No.
29, "Accounting for Non-monetary Transactions" to eliminate certain exceptions
to the principle that exchanges of non-monetary assets be measured based on the
fair value of the assets exchanged. SFAS No. 153 eliminates the exception for
non-monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non-monetary assets that do not have
commercial substance. This statement is effective for non-monetary asset
exchanges in fiscal years beginning after June
- 21 -
15, 2005. The adoption of SFAS No. 153 is not expected to have an impact on our
consolidated results of operations, financial position or cash flows.
- 22 -
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not generally hold market risk sensitive instruments for trading purposes.
We use fixed and variable rate debt to finance our operations. Our exposure to
market risk for changes in interest rates relates primarily to our current and
future debt obligations. We are vulnerable to significant fluctuations of
interest rates on our floating rate debt and pricing on our future debt. We
manage our market risk by monitoring interest rates where we try to recognize
the unpredictability of the financial markets and seek to reduce potentially
adverse effect on the results of our operations. This takes frequent evaluation
of available lending rates and examination of opportunities to reduce interest
expense through new sources of debt financing. Several factors affecting the
interest rate risk include governmental monetary and tax policies, domestic and
international economics and other factors that are beyond our control. The
following table provides information about the principal cash flows, weighted
average interest rates, and expected maturity dates for debt outstanding as of
June 30, 2005. The current terms of this debt are described in Item 2,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources."
For variable rate debt, the table presents the assumption that the outstanding
principal balance at June 30, 2005 will be paid upon maturity.
For fixed rate debt, the table presents the assumption that the outstanding
principal balance at June 30, 2005 will be paid according to scheduled principal
payments and that we will not prepay any of the outstanding principal balance.
Six Months Year Ending December 31,
Remaining ----------------------------------------------
2005 2006 2007 2008 2009 Thereafter Total Fair Value
-----------------------------------------------------------------------------------------------
(dollars in thousands)
Variable Rate Debt:
Secured and unsecured debt $1,290 $95,746 - - - - $97,036 $97,036
Weighted average interest rate 5.14% 5.14%
Fixed Rate Debt:
Secured notes payable $3,236 $6,796 $7,148 $117,518 $5,273 $107,354 $247,325 $276,104
Weighted average interest rate 6.16% 6.16% 6.16% 6.16% 6.16% 6.16%
The primary market risks we face are interest rate fluctuations. Principal
amounts outstanding under the Berg Group line of credit, the CNB line of credit
and the Citicorp mortgage loan, which are tied to a LIBOR based interest rate,
were approximately $0.4 million, $19.2 million and $77.4 million, or 0.1%, 5.6%
and 22.5%, respectively, of the total $344.4 million of outstanding debt as of
June 30, 2005. As a result, we pay lower rates of interest in periods of
decreasing interest rates and higher rates of interest in periods of increasing
interest rates. All of our debt is denominated in United States dollars. We had
no interest rate caps or interest rate swap contracts at June 30, 2005.
During the second quarter of 2005 we entered into cash flow interest rate
derivative as a means to hedge exposure to an increase in interest rates prior
to securing a loan commitment in connection with a refinancing of certain
variable rate debt to fixed rate long term mortgage debt. In June 2005, the
Company secured a 20 year fixed rate mortgage loan commitment for $125 million
at 5.22% annual interest rate and closed the derivative contracts shortly
thereafter. Since the interest rate derivative contracts did not qualify as a
designated cash flow interest rate hedge in accordance with SFAS No. 133, we
recorded an approximately $0.8 million charge to interest expense in the second
quarter of 2005.
The following discussion of market risk is based solely on a possible
hypothetical change in future market conditions related to our variable-rate
debt. It includes "forward-looking statements," as previously defined, regarding
market risk, but we are not forecasting the occurrence of these market changes.
Based on the amount of variable debt outstanding as of June 30, 2005, a 1%
increase or decrease in interest rates on our $97.0 million of floating rate
debt would decrease or increase, respectively, six months earnings and cash
flows by approximately $0.5 million, as a result of the increased or decreased
interest expense associated with the change in rate, and would not have an
impact on the fair value of the floating rate debt. This amount is determined by
considering the impact of hypothetical interest rates on our borrowing cost. Due
to the uncertainty of fluctuations in interest rates and the specific actions
that might be taken by us to mitigate such fluctuations and their possible
effects, the foregoing sensitivity analysis assumes no changes to our financial
structure.
- 23 -
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
We strive to maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our Exchange Act reports 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 management, including our chief executive officer and chief
financial officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designated and operated, can provide only reasonable assurance of
achieving the desired control objectives and management necessarily is required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls.
As required by SEC Rule 13a-15(b) we conducted an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer, President and Vice President of Finance, of the effectiveness
of the design and operation of our disclosure controls and procedures. Based
upon that evaluation, the Chief Executive Officer, President and Vice President
of Finance concluded that our disclosure controls and procedures are effective
in timely alerting them to material information relating to us (including our
subsidiaries) required to be included in our periodic SEC filings.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There was no material change in our internal control over financial reporting
during the last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, internal control over financial reporting. We have
determined that our internal control over financial reporting was effective as
of June 30, 2005.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Legal proceedings are incorporated herein by reference from Part 1 "Item 1. -
Financial Statements - Note 7 - Commitments and Contingencies."
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a) The annual meeting of stockholders of the Company was held on June 1,
2005 in which proxies representing 10,111,522 shares of common stocks,
or 55.2% of the total outstanding shares, voted.
b) At the annual meeting of stockholders, Carl E. Berg, John C. Bolger,
William A. Hasler, Lawrence B. Helzel, and Raymond V. Marino were
elected as directors for the ensuing year, all of whom were serving on
the board of directors at the time of the meeting.
c) The following proposals were voted upon at the meeting:
Proposal No. 1: Election of Directors
Total Vote for Each Total Vote Withheld
Directors Director from Each Director Total Abstentions
---------------------------- ---------------------- ---------------------- ----------------------
Carl E. Berg 7,828,984 2,158,570 123,968
John C. Bolger 9,820,463 167,091 123,968
William A. Hasler 7,355,599 2,631,955 123,968
Lawrence B. Helzel 9,829,463 158,091 123,968
Raymond V. Marino 7,682,163 2,305,391 123,968
Proposal No. 2: Ratification of the selection of the accounting firm
of BDO Seidman, LLP as the Company's independent registered public
accounting firm for the year ended December 31, 2005. There were
10,000,258 votes in favor of the proposal, 110,221 votes against the
proposal and 1,043 abstentions.
ITEM 6. EXHIBITS
a. Exhibits
10.51 Allianz Loan II Secured Installment Note dated July 26, 2005
10.52 Allianz Loan II Deed of Trust, Security Agreement, Fixture
Filing with Absolute Assignment of Rents dated July 26, 2005
10.53 Allianz Loan II Limited Guaranty dated July 26, 2005
10.54 Allianz Loan II Loan Modification Agreement dated July 26, 2005
31.1 Section 1350 Certificate of CEO
31.2 Section 1350 Certificate of President & COO
31.3 Section 1350 Certificate of Principal Financial Officer
32 Certification pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
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================================================================================
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto duly authorized.
Mission West Properties, Inc.
(Registrant)
Date: August 9, 2005 By: /s/ Carl E. Berg
--------------------------------------------
Carl E. Berg
Chief Executive Officer
Date: August 9, 2005 By: /s/ Wayne N. Pham
--------------------------------------------
Wayne N. Pham
Vice President of Finance and Controller
(Principal Accounting Officer and Duly
Authorized Officer)
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