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 SEPTEMBER 30, 2007
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 (I.R.S. Employer Identification
incorporation 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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer[ ] Accelerated filer[X] Non-accelerated filer[ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Exchange Act Rule 12b-2). Yes [ ] No [X]
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:
19,640,087 shares outstanding as of October 31, 2007
Mission West Properties, Inc.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2007
INDEX
Page
Part I Financial Information ----
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of September 30, 2007
and December 31, 2006 (unaudited).......................................................................2
Condensed Consolidated Statements of Operations for the three
and nine months ended September 30, 2007 and 2006 (unaudited)...........................................3
Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 2007 and 2006 (unaudited)...............................................4
Notes to Condensed Consolidated Financial Statements (unaudited)........................................5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................................................................12
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 1A. Risk Factors...........................................................................................25
Item 5. Other Information......................................................................................25
Item 6. Exhibits...............................................................................................25
Signatures........................................................................................................26
Exhibits
Exhibit 31.1 - Certification Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934
Exhibit 31.2 - Certification Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934
Exhibit 31.3 - Certification Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934
Exhibit 32 - Certification of CEO and CFO Pursuant to 18 U.S.C.
ss. 1350, as Adopted Pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002
- 1 -
PART I - Financial Information
ITEM 1. Condensed Consolidated Financial Statements
MISSION WEST PROPERTIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
(unaudited)
---------
September 30, 2007 December 31, 2006
--------------------- ----------------------
ASSETS
Real estate:
Land $ 312,152 $ 272,223
Buildings and improvements 764,408 756,596
Real estate related intangible assets 6,422 19,529
--------------------- ----------------------
Total investments in properties 1,082,982 1,048,348
Less accumulated depreciation and amortization (155,619) (149,459)
--------------------- ----------------------
Total investments in real estate, net 927,363 898,889
Cash and cash equivalents 37,800 33,785
Restricted cash 65,468 48,245
Deferred rent receivable, net 14,523 18,489
Investment in unconsolidated joint venture 2,835 3,468
Other assets, net 25,522 24,611
--------------------- ----------------------
Total assets $1,073,511 $1,027,487
===================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Mortgage notes payable $ 340,225 $ 348,101
Mortgage notes payable (related parties) 9,335 9,654
Interest payable 1,334 1,375
Security deposits 4,738 6,977
Deferred rental income 4,021 6,874
Dividends and distributions payable 16,832 16,745
Accounts payable and accrued expenses 22,906 7,601
--------------------- ----------------------
Total liabilities 399,391 397,327
--------------------- ----------------------
Commitments and contingencies (Note 10)
Minority interests 534,268 501,282
--------------------- ----------------------
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,
19,640,087 and 19,443,587 shares issued and outstanding
at September 30, 2007 and December 31, 2006 20 19
Paid-in capital 152,619 149,541
Accumulated deficit (12,787) (20,682)
--------------------- ----------------------
Total stockholders' equity 139,852 128,878
--------------------- ----------------------
Total liabilities and stockholders' equity $1,073,511 $1,027,487
===================== ======================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
- 2 -
MISSION WEST PROPERTIES, INC
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except share and per share amounts)
(unaudited)
---------
Three months ended September 30, Nine months ended September 30,
-------------------------------------- ----------------------------------------
2007 2006 2007 2006
------------------ ------------------- -------------------- ------------------
Rental revenue from real estate $19,000 $22,444 $61,350 $68,281
Above market lease intangible asset amortization - (472) (4,091) (1,416)
Tenant reimbursements 3,454 3,260 9,908 9,383
Lease termination fees 47,238 - 57,515 16,068
Other income, including interest 1,895 1,011 5,909 2,826
------------------ ------------------- -------------------- -------------------
Total revenues 71,587 26,243 130,591 95,142
------------------ ------------------- -------------------- -------------------
Expenses:
Property operating, maintenance and real estate taxes 6,229 4,955 15,307 13,558
Interest 5,061 5,172 15,175 15,580
Interest (related parties) 180 188 546 569
General and administrative 982 531 2,369 1,803
Depreciation and amortization of real estate 5,532 5,513 17,084 15,993
------------------ ------------------- -------------------- -------------------
Total expenses 17,984 16,359 50,481 47,503
------------------ ------------------- -------------------- -------------------
Income before equity in earnings of unconsolidated
joint venture and minority interests 53,603 9,884 80,110 47,639
Equity in earnings of unconsolidated joint venture 371 856 1,058 1,538
Minority interests (43,153) (8,644) (64,980) (39,997)
------------------ ------------------- -------------------- -------------------
Income from continuing operations 10,821 2,096 16,188 9,180
------------------ ------------------- -------------------- -------------------
Discontinued operations, net of minority interests:
Gain from disposal of discontinued operations 1,127 - 1,127 -
(Loss)/income attributable to discontinued operations (7) 10 5 200
------------------ ------------------- -------------------- -------------------
Income from discontinued operations 1,120 10 1,132 200
------------------ ------------------- -------------------- -------------------
Net income to common stockholders $11,941 $2,106 $17,320 $ 9,380
================== =================== ==================== ===================
Net income to minority interests $48,550 $8,700 $70,469 $41,057
================== =================== ==================== ===================
Income per common share from continuing operations:
Basic $0.55 $0.11 $0.82 $0.49
================== =================== ==================== ===================
Diluted $0.54 $0.11 $0.81 $0.48
================== =================== ==================== ===================
Income per common share from discontinued operations:
Basic $0.06 - $0.06 $0.01
================== =================== ==================== ===================
Diluted $0.06 - $0.06 $0.01
================== =================== ==================== ===================
Net income per common share to common stockholders:
Basic $0.61 $0.11 $0.88 $0.50
================== =================== ==================== ===================
Diluted $0.60 $0.11 $0.87 $0.49
================== =================== ==================== ===================
Weighted average shares of
common stock outstanding (basic) 19,640,087 19,350,672 19,621,144 18,948,214
================== =================== ==================== ===================
Weighted average shares of
common stock outstanding (diluted) 19,818,806 19,418,884 19,914,374 19,024,662
================== =================== ==================== ===================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
- 3 -
MISSION WEST PROPERTIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
---------
Nine months ended September 30,
---------------------------------------
2007 2006
------------------- -------------------
Cash flows from operating activities:
Net income $17,320 $9,380
Adjustments to reconcile net income to net cash provided by operating activities:
Minority interests income 70,469 41,057
Minority interest distributions (41,424) (41,057)
Depreciation and amortization of real estate and in-place leases 17,232 16,632
Amortization of above market lease 4,091 1,416
Gain from disposal of properties classified as discontinued operations (6,529) -
Equity in earnings of unconsolidated joint venture (1,058) (1,538)
Distributions from unconsolidated joint venture 1,691 1,330
Interest earned on restricted cash (722) (314)
Lease termination fee related to restricted cash (38,004) (6,748)
Stock-based compensation expense 472 176
Other 147 35
Changes in operating assets and liabilities:
Deferred rent receivable 3,966 1,048
Other assets (911) (175)
Interest payable (41) -
Security deposits (2,246) (1,300)
Deferred rental income (2,853) 3,185
Accounts payable and accrued expenses 8,294 5,048
------------------- -------------------
Net cash provided by operating activities 29,894 28,175
------------------- -------------------
Cash flows from investing activities:
Improvements to real estate assets (4,621) (1,349)
Proceeds from sale of real estate 15,431 -
Restricted cash held in escrow (15,431) -
Purchase of real estate (47,491) (15,959)
Restricted cash released for purchase of real estate 43,191 13,447
Excess restricted cash 630 1,835
------------------- -------------------
Net cash used in investing activities (8,291) (2,026)
------------------- -------------------
Cash flows from financing activities:
Principal payments on mortgage notes payable (7,876) (7,481)
Principal payments on mortgage notes payable (related parties) (319) (295)
Refund of appeal bond - 1,551
Net proceeds from exercise of stock options - 802
Minority interest distributions in excess of earnings - (717)
Dividends paid to common stockholders (9,393) (9,007)
------------------- -------------------
Net cash used in financing activities (17,588) (15,147)
------------------- -------------------
Net increase in cash and cash equivalents 4,015 11,002
Cash and cash equivalents, beginning of period 33,785 31,441
------------------- -------------------
Cash and cash equivalents, end of period $37,800 $42,443
=================== ===================
Supplemental information:
Cash paid for interest $14,704 $15,944
=================== ===================
Supplemental schedule of non-cash investing and financing activities:
Issuance of common stock upon conversion of O.P. units $ 2,606 $ 9,977
=================== ===================
Issuance of operating partnership units in connection with real estate acquisition $ 6,603 -
=================== ===================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
- 4 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except per share and per square footage)
(unaudited)
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. 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 September 30, 2007, the Company owns a controlling general
partnership interest of 20.08%, 21.78%, 16.26% and 12.48% 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 an 18.75% 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 109 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 nine months
ended September 30, 2007 and 2006.
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 Statement of
Financial Accounting Standards ("SFAS") No. 131, "Disclosures about
Segments of an Enterprise and Related Information," purposes.
2. BASIS OF PRESENTATION
PRINCIPLES OF CONSOLIDATION AND FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited interim condensed consolidated financial
statements of the Company have been prepared in accordance with Rule 10-01
of Regulation S-X promulgated by the Securities and Exchange Commission
("SEC") and, therefore, do not include all information and footnotes
necessary for a fair presentation of financial position, results of
operations and cash flows in conformity with accounting principles
generally accepted in the United States of America. In the opinion of the
Company, however, the accompanying unaudited interim condensed consolidated
financial statements contain all adjustments, consisting only of normal
recurring adjustments, necessary to present fairly the Company's
consolidated financial position as of September 30, 2007, their
consolidated results of operations for the three and nine months ended
September 30, 2007 and 2006, and their cash flows for the nine months ended
September 30, 2007 and 2006. All significant inter-company balances have
been eliminated in consolidation. The condensed consolidated financial
statements as of September 30, 2007 and for the three and nine months ended
September 30, 2007 and 2006 and related footnote disclosures are unaudited.
The results of operations for the three and nine months ended September 30,
2007 are not necessarily indicative of the results to be expected for the
entire year.
The December 31, 2006 condensed consolidated balance sheet data was derived
from audited financial statements, but does not include all disclosures
required by accounting principles generally accepted in the United States
of America.
The Company consolidates all variable interest entities ("VIE") in which it
is deemed to be the primary beneficiary in accordance with FASB
Interpretation No. 46R, "Consolidation of Variable Interest Entities" ("FIN
46R"). As of September 30, 2007, the Company consolidated one VIE in the
accompanying condensed consolidated balance sheets in connection with an
assignment of a lease agreement with an unrelated party, M&M Real Estate
Control & Restructuring, LLC. See Note 5 for further discussion of this
transaction.
- 5 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
STOCK-BASED OPTION COMPENSATION ACCOUNTING
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment"
("SFAS 123R"), which addresses the accounting for stock options. SFAS 123R
requires that the cost of all employee, director and consultant 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 123R is an amendment to SFAS 123, "Accounting for
Stock-Based Compensation," and supersedes Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). SFAS
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. At September 30, 2007, the
Company had one stock-based compensation plan. The Company adopted the
requirements of SFAS 123R effective January 1, 2006 using the modified
prospective method of transition. The adoption of this standard did not
have a material effect on the Company's condensed consolidated statements
of operations, cash flows or financial position.
In the first quarter of 2007, stock options to purchase 710,000 shares of
common stock were granted to four employees, three non-employee directors
and four consultants, which options vest monthly for 48 months from date of
grant, 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 $12.09 per share. The
estimated fair value of the options granted in 2007 was $1.45 per share on
the date of grant using the Black-Scholes option pricing model with the
following assumptions: dividend yield of 5.3%, volatility of 18.94%, risk
free rates of 4.5% and an expected life of six years. All options were
granted at the fair market value at the date of grant.
The following table shows the activity and detail for the 2004 Equity
Incentive Plan.
Weighted Average
2004 Equity Option Price
Incentive Plan Per Share
--------------- ------------------
Balance, December 31, 2006 1,037,100 $10.48
Options granted 710,000 $12.09
Options exercised -
Options cancelled -
---------------
Balance, September 30, 2007 1,747,100 $11.13
===============
The Company measures compensation cost for its stock options at fair value
on the date of grant and recognizes compensation expense relating to the
remaining unvested portion of outstanding stock options at the time of
adoption ratably over the vesting period, generally four years. The fair
value of the Company's stock options is determined using the Black-Scholes
option pricing model. Compensation expense related to the Company's
share-based awards is included in general and administrative expenses in
the Company's accompanying condensed consolidated statements of operations.
Under SFAS 123R, the Company recorded approximately $157 and $59 of expense
for the three months ended September 30, 2007 and 2006, respectively, and
$472 and $176 of expense for share-based compensation relating to grants of
stock options for the nine months ended September 30, 2007 and 2006,
respectively.
As of September 30, 2007, there was approximately $651 of total
unrecognized compensation cost related to unvested share-based compensation
arrangements granted under the compensation plan. That cost is expected to
be recognized over a weighted-average period of 3.0 years.
MINORITY INTERESTS
Minority interests represent 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. As of
September 30, 2007, these interests accounted for approximately 81.25% of
the ownership interests in the real estate operations of the Company on a
consolidated weighted average basis. Minority interests in net income is
calculated by taking the net income of the operating partnerships (on a
stand-alone basis) multiplied by the respective weighted average minority
interests ownership percentage.
Allocation of corporate general and administrative expenses to the
operating partnerships is performed based upon shares and operating
partnership units outstanding for each operating partnership in relation to
the total for all four operating partnerships.
RECLASSIFICATIONS
Certain reclassifications have been made to the previously reported 2006
condensed consolidated financial statements in order to conform to the 2007
presentation.
The following notes, which present interim disclosures as required by the
SEC, highlight significant changes to the notes to the Company's December
31, 2006 audited consolidated financial statements and should be read
together with the consolidated financial statements and notes thereto
included in the Company's 2006 Annual Report on Form 10-K filed on March
15, 2007.
- 6 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
3. REAL ESTATE
PROPERTY DISPOSITION
On August 16, 2007, the Company disposed of one R&D property located at
45700 Northport Loop in Fremont, California consisting of approximately
39,000 rentable square feet. A total net gain of approximately $1,699 was
recognized and classified as discontinued operations, net of minority
interests, on the total sales price of $7,742.
On September 5, 2007, the Company disposed of one R&D property located at
1170 Morse Avenue in Sunnyvale, California consisting of approximately
48,000 rentable square feet. A total net gain of approximately $4,830 was
recognized and classified as discontinued operations, net of minority
interests, on the total sales price of $8,301.
PROPERTY ACQUISITION
On September 30, 2007, the Company acquired an approximately 99,000
rentable square foot newly constructed R&D building located at 5845 Hellyer
Avenue in San Jose, California from the Berg Group under the Berg Land
Holdings Option Agreement. The total acquisition price for this property
was approximately $10,903. The Company acquired this property by issuing
548,236 O.P. units to the Berg Group and $4,300 in cash, which was paid in
the fourth quarter of 2007. The Company has allocated the purchase price to
land and building based upon the estimated relative fair values of such
assets. Since the property was acquired vacant, there was no purchase price
allocation to lease intangible assets.
4. RESTRICTED CASH
Restricted cash totaled approximately $65,468 as of September 30, 2007. Of
this amount, approximately $15,493 represents proceeds received from
property sales and interest income held in a separate cash account at a
trust company for future use in tax-deferred exchanges. The remaining
$49,975 represents cash held by the Company's consolidated VIE. The Company
does not have possession or control over these funds or any right to
receive them except in accordance with the payment terms of the lease
agreement that has been assigned to the VIE.
5. VARIABLE INTEREST ENTITY
In December 2003, the FASB issued FIN 46R, a revision to FIN 46, which was
issued in January 2003. Under FIN 46R, a variable interest entity must be
consolidated by a company if that company is subject to a majority of the
entity's expected losses or entitled to receive a majority of the entity's
expected residual returns or both. FIN 46R requires disclosures about
variable interest entities that a company is not required to consolidate,
but in which it has a significant variable interest.
Under FIN 46R, for an entity to qualify as a VIE one or more of the
following three characteristics must exist:
1. The equity investment at risk is not sufficient to permit the entity
to finance its activities without additional subordinated financial
support by any parties, including the equity holders.
2. The equity investors lack one or more of the following essential
characteristics of a controlling financial interest:
a. The direct or indirect ability to make decisions about the
entity's activities through voting or similar rights.
b. The obligation to absorb the expected loss of the entity.
c. The right to receive the expected residual returns of the entity.
3. The equity investors have voting rights that are not proportionate to
their economic interests, and the activities of the entity involve or
are conducted on behalf of an investor with a disproportionately small
voting interest.
In March 2006, one of the Company's tenants, JDS Uniphase ("JDS"), entered
into an assignment of lease agreement with an unrelated party, M&M Real
Estate Control & Restructuring, LLC ("M&M"), in connection with leases for
approximately 252,000 rentable square feet located in San Jose, California.
M&M assumed all of JDS's remaining obligations under these leases, acquired
certain personal property of JDS located on the premises and received a
payment of approximately $11,147. At the same time, the Company entered
into a consent for assignment of lease with both parties and a mutual
release agreement with JDS, pursuant to which all of the JDS's obligations
under these leases have been effectively transferred to M&M. M&M was
obligated to continue to perform all of the obligations under the assumed
JDS leases and had the right to sublease any or all of the 252,000 rentable
square feet vacated by JDS for the remainder of the terms of the assigned
leases. Under the terms of the assignment of lease agreement, the Company
received monthly rent payments of approximately $733 from April 2006
through December 2006, $545 from January 2007 through August 2007 and is
receiving $330 per month from September 2007 through November 2007. Based
upon the provisions of FIN 46R, the Company determined that M&M is a
variable interest entity. The Company further determined that it is
- 7 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
the primary beneficiary of this variable interest entity and therefore has
consolidated this entity for financial reporting purposes. Upon
consolidation, the Company recognized a gross lease termination fee of
approximately $11,147 in March 2006.
In August 2007, one of the Company's tenants, Ciena, entered into an
assignment of lease agreement with M&M, in connection with leases for
approximately 445,000 rentable square feet located in San Jose, California.
M&M assumed all of Ciena's remaining obligations under these leases and
received a payment from Ciena of $53,000, of which $7,000 was reserved for
tenant improvements. At the same time, the Company entered into a consent
for assignment of lease with both parties and a mutual release agreement
with Ciena, pursuant to which all of Ciena's obligations under these leases
have been effectively transferred to M&M. M&M is obligated to continue to
perform all of the obligations under the assumed Ciena leases and has the
right to sublease any or all of the 445,000 rentable square feet vacated by
Ciena for the remainder of the current lease term, which expire in 2011.
Under the terms of the assignment of lease agreement, the Company will
receive monthly rent payments of approximately $789 from July 2007 through
June 2008, $818 from July 2008 through June 2009, $849 from July 2009
through June 2010, $881 from July 2010 through June 2011 and $915 from July
2011 through December 2011. Based upon the provisions of FIN 46R, the
Company determined that M&M is a variable interest entity. The Company
further determined that it is the primary beneficiary of this variable
interest entity and therefore has consolidated this entity for financial
reporting purposes. Upon consolidation, the Company recognized a gross
lease termination fee of $46,000 in August 2007.
Factors considered by the Company in determining whether M&M should be
considered a VIE for financial reporting purposes included the following:
- No equity was contributed by the partners in the formation of M&M.
- At present, the assigned leases are the only properties under
management by M&M.
- Because M&M does not have an operating history that demonstrates its
ability to finance its activities without additional subordinated
financial support.
- All revenues, other than interest income, are generated by M&M from
the Company in the form of fees or commissions.
The Company remains at risk with respect to the assigned leases because if
M&M's operating expenses exceed its interest income, fees and commissions
there would be insufficient funds to meet the assigned lease obligation
without additional financial support from equity holders or other parties.
The Company, which had released the original tenants from its obligations
under the leases, would have to absorb the majority of any loss, making it
the primary beneficiary of M&M's activities.
6. STOCK TRANSACTIONS
During the nine months ended September 30, 2007, two limited partners
exchanged a total of 196,500 O.P. units for 196,500 shares of the Company's
common stock under the terms of the Exchange Rights Agreement among the
Company and all limited partners of the operating partnerships resulting in
a reclassification of approximately $2,606 from minority interests to
paid-in capital. Neither the Company nor the operating partnerships
received any proceeds from the issuance of the common stock in exchange for
O.P. units.
7. DISCONTINUED OPERATIONS
Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets" ("SFAS 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 is classified as discontinued operations in the condensed
consolidated statements of operations. Prior period condensed consolidated
statements of operations presented in this report have been reclassified to
reflect the income or loss related to properties that were sold and
presented as discontinued operations in 2006. All periods presented in this
report will likely require further reclassification in future periods if
there are properties held for sale or property sales occur.
During the third quarter of 2007, the Company sold two R&D properties. See
Note 3 above for additional details. In the third quarter of 2006, the
Company classified three R&D properties as assets held for sale and sold
them in the fourth quarter of 2006, which qualified as discontinued
operations. Condensed results of operations for these properties for the
three and nine months ended September 30, 2007 and 2006 are as follows:
- 8 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2007 2006 2007 2006
------------- ------------- ------------ ------------
(dollars in thousands)
(unaudited)
Revenues
Rental revenue from real estate $ 118 $ 390 $ 389 $2,140
Tenant reimbursements 56 51 83 303
Other income 1 57 1 64
------------- ------------- ------------ ------------
Total revenues 175 498 473 2,507
------------- ------------- ------------ ------------
Expenses
Property operating, maintenance and real estate taxes 150 219 233 608
Interest 1 - 1 -
Depreciation of real estate 35 214 148 639
------------- ------------- ------------ ------------
Total expenses 186 433 382 1,247
------------- ------------- ------------ ------------
(Loss)/income from discontinued operations (11) 65 91 1,260
Gain on disposal of discontinued operations 6,529 - 6,529 -
Minority interest in earnings attributable to
discontinued operations (5,398) (55) (5,488) (1,060)
------------- ------------- ------------ ------------
Income from discontinued operations $1,120 $ 10 $1,132 $ 200
============= ============= ============ ============
8. 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.
The computation for weighted average shares is detailed below:
Three Months Ended September 30, Nine Months Ended September 30,
--------------------------------- ---------------------------------
2007 2006 2007 2006
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 19,640,087 19,350,672 19,621,144 18,948,214
Incremental shares from assumed option exercise 178,719 68,212 293,230 76,448
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 19,818,806 19,418,884 19,914,374 19,024,662
=============== ============== ============== ===============
Outstanding options to purchase 647,000 shares in 2006 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 period. 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 September 30, 2007 and 2006 was 85,557,935 and
85,231,199, respectively.
9. RELATED PARTY TRANSACTIONS
As of September 30, 2007, the Berg Group owned 77,926,384 O.P. units. The
Berg Group's combined ownership of O.P. units and shares of common stock as
of September 30, 2007 represented approximately 74% of the total equity
interests, assuming conversion of all O.P. units outstanding into the
Company's common stock.
As of September 30, 2007, debt in the amount of approximately $9,335 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 mortgage
note was approximately $180 and $188 for the three months ended September
30, 2007 and 2006, respectively, and $546 and $569 for the nine months
ended September 30, 2007 and 2006, respectively.
On September 30, 2007, the Company acquired an approximately 99,000
rentable square foot newly constructed R&D building located at 5845 Hellyer
Avenue in San Jose, California from the Berg Group under the Berg Land
Holdings Option Agreement. The total acquisition price for this property
was approximately $10,903. The Company acquired this property by issuing
548,236 O.P. units to the Berg Group and $4,300 in cash, which was paid in
the fourth quarter of 2007. The transaction was approved by the Independent
Directors Committee of the Company's Board of Directors.
- 9 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
During the first nine months of 2007 and 2006, Carl E. Berg or entities
controlled by Mr. Berg held financial interests in several companies that
lease space from the operating partnerships, which include companies where
Mr. Berg has a greater than 10% ownership interest. These related tenants
contributed approximately $361 and $162 in rental revenue for the three
months ended September 30, 2007 and 2006, respectively, and $1,082 and $486
in rental revenue for the nine months ended September 30, 2007 and 2006,
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.
In March 2006, the Company and Fujitsu Limited, or Fujitsu, agreed to the
termination of a lease for one building consisting of approximately 125,000
rentable square feet. Fujitsu is responsible for repairing damage to the
building and with the Company's Independent Directors Committee approval
has hired Berg & Berg Enterprises, LLC to perform the restoration work for
a total of approximately $4,500, which is substantially complete.
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 has recorded this portion of
the purchase price paid to the Berg Group in "Other assets" on its
condensed consolidated balance sheets. The Berg Group is in the process of
satisfying this commitment to complete certain tenant improvements.
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 has recorded
this portion of the purchase price paid to the Berg Group in "Other assets"
on its condensed 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, for the Company's
headquarters. Rental amounts and overhead reimbursements paid to Berg &
Berg Enterprises, Inc. were approximately $24 and $23 for the three months
ended September 30, 2007 and 2006, respectively, and $71 and $68 for the
nine months ended September 30, 2007 and 2006, respectively.
10. 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 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 the following legal
proceedings, and does not believe the ultimate outcome of any of these
proceedings will have a material adverse effect on its financial condition
or operating results.
Mission West Properties, L.P. v. Republic Properties Corporation, et al.
Santa Clara County Superior Court, Case No. CV 796249. Republic Properties
Corporation ("RPC") is a former 50% partner with Mission West Properties,
L.P. in the Hellyer Avenue Limited Partnership ("Hellyer LP"), which was
formed in July 2000. Under the terms of the Hellyer LP partnership
agreement and other related contracts, Mission West Properties, L.P.
("MWP") had the right to obtain RPC's entire interest in Hellyer LP in the
event of certain payment defaults which occurred in August 2000. Therefore,
on September 1, 2000, MWP, as the general partner of Hellyer LP, ceased all
allocations of income and cash flow to RPC and exercised the right under
the partnership agreement to cancel RPC's entire interest in the
partnership. Following discussions with and approval by the Independent
Directors Committee, the Company authorized the transfer of RPC's interest
in Hellyer LP to Berg & Berg Enterprises, Inc. Under the Berg Land Holdings
Option Agreement and the Acquisition Agreement dated as of May 14, 1998,
the Independent Directors Committee had the right, but not the obligation,
to reacquire the property interest and the related distributions related to
the property interest at any time. The transfer was effective as of
September 1, 2000. On November 20, 2000, RPC commenced a lawsuit against
MWP in the Circuit Court of Maryland for Baltimore City. After lengthy
litigation, which included a trial on the merits and subsequent appeals, in
April 2006 Maryland's highest Court upheld an earlier Maryland Appeals
Court ruling in favor of MWP, finding that the Circuit Court of Maryland
could not assert personal jurisdiction over MWP in the RPC suit. The Court
vacated the judgment and decision in the trial court and dismissed the
entire Maryland suit. In February 2001, while the Maryland case was
pending, the Company filed a suit against RPC in the Superior Court of the
State of California for the County of Santa Clara. The case was stayed
pending resolution of the Maryland case, and the Company dismissed its suit
on March 4, 2005. In April 2005, RPC submitted a motion asking the Superior
Court to reinstate the case, which the Court granted on May 25, 2005. On
July 5, 2006, RPC filed a cross-complaint in the case seeking partnership
distributions to which the Company demurred. The Court sustained the
Company's demurrer with leave to amend. Subsequently, RPC filed an amended
complaint and the Company submitted another demurrer seeking dismissal of
the
- 10 -
claims on statute of limitations grounds. On February 20, 2007, the Court
overruled the Company's demurrer. The Company sought a writ from the
California State Court of Appeal for the Sixth District to direct the lower
court to reverse its decision, but the petition for the writ was denied. A
trial in the California Superior Court will commence in early 2008.
The Company has a receivable from a Berg Group affiliate for the amount of
distributions it has received as the successor to RPC's interest in Hellyer
LP. Furthermore, the Company has never accounted for the 50% interest of
RPC as its asset, and if it is ultimately determined that RPC should have
retained that interest or it reacquires that interest, the Company's
balance sheet and financial condition would not be impacted adversely,
although to date, the Company has consolidated the assets, liabilities and
operating results of Hellyer LP and allocated 50% of the operating income
to the minority interest holder.
GUARANTEES AND INDEMNITIES
Under its articles 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 recorded no liabilities for these agreements
as of September 30, 2007.
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 typically agrees to indemnify and hold
harmless the indemnified party for losses suffered or incurred by the
indemnified party as a result of certain kinds of activities or inactions
of the Company. 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 recorded no liabilities for these agreements as of September
30, 2007.
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.
ASSET DISPOSITIONS SUBJECT TO CERTAIN CONDITIONS
The Company has entered into sales agreements with unrelated parties
subject to numerous material conditions, including but not limited to
re-zoning of the property and negotiating certain agreements with the local
municipality acceptable to the buyer. As a result of the conditions agreed
to by the Company and the respective buyers, these assets do not meet the
criteria set forth in SFAS 144 to be classified as assets held for sale.
The following summarizes the assets for which the Company has executed
sales contracts as of September 30, 2007 that are subject to material
conditions as previously described:
Property Number of Buildings Rentable Square Feet Acres Sales Prices
-------- ------------------- -------------------- ----- ------------
McCandless Drive
Milpitas, California 8 427,000 23.03 $76,500
11. SUBSEQUENT EVENTS
On October 4, 2007, the Company paid dividends of $0.16 per share of common
stock to all common stockholders of record as of September 28, 2007. On the
same date, the operating partnerships paid a distribution of $0.16 per O.P.
unit to all holders of O.P. units. Aggregate dividends and distributions
amounted to approximately $16,832.
- 11 -
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 condensed
consolidated financial statements and notes thereto under Part I, Item 1 of this
Report and our audited consolidated financial statements and notes thereto
contained in our Annual Report on Form 10-K as of and for the year ended
December 31, 2006. The results for the three and nine months ended September 30,
2007 are not necessarily indicative of the results to be expected for the entire
fiscal year ending December 31, 2007.
FORWARD-LOOKING INFORMATION
This quarterly report on Form 10-Q 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 are
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 or would cause actual results in the future to differ materially from
any of our forward-looking statements include, but are not limited to, the
following:
- economic conditions generally and the real estate market specifically,
- the occupancy rates of the properties,
- rental rates on new and renewed leases,
- 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.
These risks and uncertainties, together with the other risks described under
Part I, Item 1A - "Risk Factors" of our 2006 Annual Report on Form 10-K and from
time to time in our other reports and documents filed with the Securities and
Exchange Commission ("SEC"), 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 September 30,
2007, we owned and managed 109 properties totaling approximately 7.9 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 September 30, 2007, the three tenants who each leased in
excess of 300,000 rentable square feet from us were Microsoft Corporation, NEC
Electronics America, Inc. (a subsidiary of NEC Electronics Corporation) and
Apple, Inc.
For federal income tax purposes, we have operated as a self-managed,
self-administered and fully integrated real estate investment trust ("REIT")
since the beginning of 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
- 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.
- 12 -
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. Historically, the Silicon Valley R&D property market has fluctuated
with the local economy. The Silicon Valley economy and business activity have
slowed markedly from 2001 through the middle of 2006 after fast-paced growth in
1999 and 2000, and has been growing steadily since then. According to a recent
report by NAI BT Commercial Real Estate (the "BT Report"), the vacancy rate for
Silicon Valley R&D property was approximately 18.3% in late 2006 and 16.2% at
the end of the third quarter of 2007. Total vacant R&D square footage in Silicon
Valley at the end of the third quarter of 2007 amounted to 24.7 million square
feet, of which 16.2%, or 4.0 million square feet, was being offered under
subleases. According to the BT Report, total positive net absorption (which is
the computation of gross square footage leased less gross new square footage
vacated for the period presented) in 2006 amounted to approximately 1.9 million
square feet, but in the first nine months of 2007, there was total positive net
absorption of approximately 3.6 million square feet. According to the BT Report,
the average asking market rent per square foot at the end of the third quarter
of 2007 was $1.21 compared to $0.99 in late 2006. The Silicon Valley R&D
property market is characterized by a substantial number of submarkets, with
rent and vacancy rates varying by submarket and location within each submarket,
however, and individual properties within any particular submarket presently may
be leased above or below the current average asking market rental rates within
that submarket and the region as a whole.
Our occupancy rate at September 30, 2007 was 62.3% compared to 64.2% at
September 30, 2006. 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 227,000 rentable square feet are expiring prior to the end of
2007. The properties subject to these leases may take anywhere from 24 to 36
months or longer to re-lease. We believe that the average 2007 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.
Despite our strategic focus on single tenant properties and leases, in order to
meet market conditions, we have been, and expect to continue leasing less than
the entire premises of some of our R&D properties to a single tenant from time
to time. Leasing our R&D properties, which generally have been built for single
tenant occupancy, to multiple tenants can increase our leasing costs and
operating expenses and reduce the profitability of our leasing activities.
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; if we restructure existing leases and lower existing
rents in order to retain tenants for an extended term; or if we increase our
lease costs and operating expenses substantially to accommodate multiple tenants
in our R&D properties, 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 condensed 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 condensed 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
condensed 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 ("SFAS") No.
141, "Business Combinations" ("SFAS 141"), 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
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 and below market in place leases, and the
determination of their useful lives are guided by a combination of SFAS 141 and
management's estimates. Amortization expense of above and below market lease
intangible asset is offset against rental revenue in the revenue section while
amortization of in-place lease value intangible asset is included in
depreciation and amortization of real estate in the expense section of our
condensed consolidated statements of
- 13 -
operations. 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 SFAS No. 144, "Accounting for
the Impairment and Disposal of Long-Lived Assets" ("SFAS 144"). If the carrying
amount of the asset exceeds its 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, the remaining lease term, whether or
not the tenant is currently occupying our building, 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 condensed consolidated
financial statements, with appropriate allocation to minority interests, 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.
STOCK-BASED COMPENSATION. In December 2004, the FASB issued SFAS 123R, which
addresses the accounting for stock options. SFAS 123R requires that the cost of
all employee, director and consultant 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 123R is an amendment to
SFAS 123 and supersedes APB 25. SFAS 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. We have
adopted the requirements of SFAS 123R effective January 1, 2006 using the
modified prospective method of transition. Accordingly, prior periods have not
been restated. The adoption of this standard did not have a material effect on
our condensed consolidated statements of operations or financial position.
Compensation cost under SFAS 123R may differ due to different assumptions and
treatment of forfeitures.
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 condensed 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, cease
operations or are likely to seek a negotiated settlement of their obligation. 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
- 14 -
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.
SFAS No. 66, "Accounting for Sales of Real Estate" ("SFAS 66"), 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 when the tenant no longer has the right to occupy 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. We cannot predict or forecast the
timing or amounts of future lease termination fees.
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 regard 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.
- 15 -
RESULTS OF OPERATIONS
COMPARISON OF THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 TO THE THREE
AND NINE MONTHS ENDED SEPTEMBER 30, 2006
As of September 30, 2007, through our controlling interests in the operating
partnerships, we owned 109 properties totaling approximately 7.9 million
rentable square feet compared to 110 properties totaling approximately 7.9
million rentable square feet owned by us as of September 30, 2006. This
represents a net decrease of approximately 1.0% in total rentable square
footage, as we acquired four R&D properties consisting of approximately 247,100
rentable square feet and sold five R&D properties consisting of approximately
321,900 rentable square feet since the third quarter of 2006. Included in the
7.9 million rentable square feet are approximately 854,000 rentable square feet
(or 16 buildings), which are in the process of being rezoned for residential
development.
Rental revenue from real estate for the three and nine months ended September
30, 2007 compared to the same three- and nine-month periods in 2006 are as
follows:
Three Months Ended September 30,
--------------------------------
% Change by
2007 2006 $ Change Property Group
------------- -------------- --------------- ---------------
(dollars in thousands)
Same Property (1) $18,429 $21,890 ($3,461) (15.8%)
2006 Acquisitions 554 554 - -
2007 Acquisitions 17 - 17 100%
------------- -------------- ---------------
Total $19,000 $22,444 ($3,444) (15.3%)
============= ============== ===============
Nine Months Ended September 30,
--------------------------------
% Change by
2007 2006 $ Change Property Group
------------- -------------- --------------- ---------------
(dollars in thousands)
Same Property (1) $59,651 $67,063 ($7,412) (11.1%)
2006 Acquisitions 1,661 1,218 443 36.4%
2007 Acquisitions 38 - 38 100%
------------- -------------- ---------------
Total $61,350 $68,281 ($6,931) (10.2%)
============= ============== ===============
(1) "Same Property" is defined as properties owned by us prior to 2007 that we
still owned as of September 30, 2007.
RENTAL REVENUE FROM REAL ESTATE FROM CONTINUING OPERATIONS
For the quarter ended September 30, 2007, rental revenue from real estate
decreased by approximately ($3.4) million, or (15.3%), from $22.4 million for
the three months ended September 30, 2006 to $19.0 million for the three months
ended September 30, 2007. For the nine months ended September 30, 2007, rental
revenue from real estate decreased by approximately ($6.9) million, or (10.2%),
from $68.3 million for the nine months ended September 30, 2006 to $61.4 million
for the nine months ended September 30, 2007. The decline in rental revenue
resulted primarily from renewing existing leases at lower rental rates and the
loss of several tenants due to lease terminations, relocation or cessation of
their operations since September 30, 2006, all of which resulted from current
adverse market conditions. Rental revenue was offset by amortization expense of
approximately ($0.5) million for the three months ended September 30, 2006, and
($4.1) million and ($1.4) million for the nine months ended September 30, 2007
and 2006, respectively, for an above-market lease intangible asset. The increase
year-over-year was attributable to a lease termination in the first quarter of
2007, which resulted in the write-off of all remaining above-market lease
intangible asset. Our occupancy rate at September 30, 2007 was approximately
62.6%, compared to approximately 64.2% at September 30, 2006.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of September 30, 2007, we had investments in three R&D buildings, totaling
466,600 rentable square feet, through an unconsolidated joint venture, TBI-MWP,
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 September 30, 2007, we
recorded equity in earnings from the unconsolidated joint venture of
approximately $0.37 million compared to equity in earnings of $0.86 million for
the same period in 2006. The decline was due to a $0.44 million gain from sale
of real estate in 2006 that did not recur in 2007. For the nine-month periods
ended September 30, 2007 and 2006, equity in earnings from the unconsolidated
joint venture was approximately $1.06 million and $1.54 million, respectively.
The occupancy rate for the properties owned by this joint venture at September
30, 2007 and 2006 was 100%.
LEASE TERMINATION INCOME
Lease termination fees for the three months ended September 30, 2007 were
approximately $47.2 million. Lease termination fees for the nine months ended
September 30, 2007 and 2006 were approximately $57.5 million and $16.1 million,
respectively. These fees were paid by tenants who terminated their lease
obligations before the end of the contractual term of the lease by agreement
with us. We do not consider those transactions to be recurring items.
- 16 -
OTHER INCOME FROM CONTINUING OPERATIONS
Other income of approximately $1.9 million for the three months ended September
30, 2007 included approximately $0.8 million from interest, $0.2 million from
management fees and $0.9 million from miscellaneous income. Other income of
approximately $1.0 million for the three months ended September 30, 2006
included approximately $0.6 million from interest, $0.3 million from management
fees and $0.2 million from security deposit forfeitures and miscellaneous
income. For the nine months ended September 30, 2007, other income of
approximately $5.9 million included approximately $1.6 million from a forfeited
deposit under a contract for the sale of property, $2.1 million from interest,
$0.8 million from management fees, $0.3 million from a bankruptcy settlement
claim and $1.1 million from security deposit forfeitures and miscellaneous
income. For the nine months ended September 30, 2006, other income of
approximately $2.8 million included approximately $1.5 million from interest,
$0.8 million from management fees and $0.5 million from bankruptcy settlement
claims, security deposit forfeitures and miscellaneous income.
EXPENSES FROM CONTINUING OPERATIONS
Property operating expenses and real estate taxes during the third quarter of
2007 increased by approximately $1.3 million, or 25.7%, from $4.9 million to
$6.2 million for the three months ended September 30, 2006 and 2007,
respectively. The increase in 2007 is primarily attributable to a write-off of
approximately $1.0 million of lease commissions related to a lease termination.
Tenant reimbursements increased by approximately $0.2 million, or 6.0%, from
$3.3 million for the three months ended September 30, 2006 to $3.5 million for
the three months ended September 30, 2007 due to reimbursements of non-recurring
operating expenses. Certain expenses such as property insurance, real estate
taxes, and other fixed operating expenses are not recoverable from vacant
properties, however. For the nine months ended September 30, 2007, property
operating expenses and real estate taxes increased by approximately $1.7
million, or 12.9%, from $13.6 million for the nine months ended September 30,
2006 to $15.3 million for the nine months ended September 30, 2007. The increase
in property operating expenses and real estate taxes was mainly due to higher
lease commission expense and property taxes. General and administrative expenses
increased by approximately $0.5 million, or 84.9%, from $0.5 million to $1.0
million for the three months ended September 30, 2006 and 2007, respectively.
The increase in general and administrative expenses was primarily due to higher
legal fees associated with a potential acquisition of the Company, salaries and
wages and share-based compensation expense. For the nine months ended September
30, 2006 and 2007, general and administrative expenses increased by
approximately $0.6 million, or 31.4%, from $1.8 million to $2.4 million,
respectively, for similar reasons.
Real estate depreciation and amortization expense remained relatively constant
at approximately $5.5 million for the three months ended September 30, 2007 and
2006. Real estate depreciation and amortization expense increased by
approximately $1.1 million, or 6.8%, from $16.0 million to $17.1 million for the
nine months ended September 30, 2006 and 2007, respectively. The increase was
attributable primarily to the write-offs of additional amortization expense
relating to in-place lease value intangible assets pursuant to SFAS 141 in
connection with two lease terminations and additional tenant improvements.
Interest expense decreased by approximately ($0.1) million, or (2.1%), from $5.2
million for the three months ended September 30, 2006 to $5.1 million for the
three months ended September 30, 2007 due to lower total debt in 2007. Interest
expense (related parties) was approximately $0.2 million in both three-month
periods ended September 30, 2007 and 2006. Total debt outstanding, including
amounts due related parties, decreased by approximately ($8.2) million, or
(2.3%), from $357.8 million as of September 30, 2006 to $349.6 million as of
September 30, 2007. Overall interest expense, including amounts paid to related
parties, for the quarter ended September 30, 2007 decreased by approximately
($0.1) million compared to the same quarter a year ago.
Interest expense decreased by approximately ($0.4) million, or (2.6%), from
$15.6 million for the nine months ended September 30, 2006 to $15.2 million for
the nine months ended September 30, 2007. Interest expense (related parties) was
approximately $0.6 million for the nine months ended September 30, 2007 and
2006.
INCOME FROM DISCONTINUED OPERATIONS
The following table depicts the amounts of income from discontinued operations
for the three and nine months ended September 30, 2007 and 2006.
Three Months Ended September 30, Nine Months Ended September 30,
------------------------------ -------------------------------
2007 2006 2007 2006
----------- ------------ ------------ ------------
(dollars in thousands)
(unaudited)
(Loss)/income attributable to discontinued operations ($ 11) $65 $ 91 $ 1,260
Gain on disposal of discontinued operations 6,529 - 6,529 -
Minority interests in earnings attributable to
discontinued operations (5,398) (55) (5,488) (1,060)
----------- ------------ ------------ ------------
Income from discontinued operations $1,120 $10 $ 1,132 $ 200
=========== ============ ============ ============
In accordance with our adoption of SFAS 144, in the third quarter of 2007 we
sold two R&D properties and classified them as discontinued operations, and in
the third quarter of 2006 we classified three R&D properties as assets held for
sale and sold them in the fourth quarter of 2006 and classified them as
discontinued operations. The income to common stockholders attributable to
discontinued operations from these properties for the three months ended
September 30, 2007 and 2006 was approximately $1.1 million and $10,000,
respectively. The income to common stockholders attributable to discontinued
operations from these properties for the nine months ended September 30, 2007
and 2006 was approximately $1.1 million and $0.2 million, respectively.
- 17 -
NET INCOME TO COMMON STOCKHOLDERS AND NET INCOME TO MINORITY INTERESTS
Net income to common stockholders increased by approximately $9.8 million, or
467.0%, from $2.1 million for the three months ended September 30, 2006 to $11.9
million for the same period in 2007. The minority interest portion of income
increased by approximately $39.9 million, or 458.0%, from $8.7 million for the
three months ended September 30, 2006 to $48.6 million for the three months
ended September 30, 2007. The increase in the quarter's net income for both
common stockholders and minority interests was primarily due to higher lease
termination fees in the third quarter of 2007. For the nine months ended
September 30, 2007 and 2006, the minority interest portion of income was
approximately $65.0 million and $40.0 million, respectively, and net income to
common stockholders was approximately $16.2 million and $9.2 million,
respectively. The increase in net income for both common stockholders and
minority interests in the first nine months of 2007 was primarily from higher
lease termination fee income, offset by lower rental income and higher
amortization expenses.
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 interests represent the
ownership interest of all limited partners in the operating partnerships taken
as a whole, which was approximately 81% as of September 30, 2007 and 2006.
CHANGES IN FINANCIAL CONDITION
The most significant changes in our financial condition during the three months
ended September 30, 2007 resulted from the disposition of two R&D properties and
the acquisition of one R&D property.
At September 30, 2007, total investments in properties increased on a net basis
by approximately $34.6 million from December 31, 2006 primarily due to four R&D
property acquisitions consisting of approximately 247,000 rentable square feet
located in the Silicon Valley, the acquisition of 55 acres of vacant land
located in Morgan Hill, California and the construction of additional tenant
improvements.
Total stockholders' equity, net, increased by approximately $11.0 million from
December 31, 2006 as we obtained additional capital from the issuance of 196,500
shares of our common stock for the exchange of O.P. units and a decrease in
accumulated deficit of approximately $7.9 million. The newly issued shares of
common stock increased additional paid-in capital by approximately $2.6 million.
Share-based compensation relating to grants of stock options increased
additional paid-in capital by approximately $0.5 million.
LIQUIDITY AND CAPITAL RESOURCES
We expect a slight increase in operating cash flows from our operating property
portfolio in 2007 as compared to 2006. The increase in cash flows is resulting
from early lease terminations. If we are unable to lease a significant portion
of the approximately 227,000 rentable square feet scheduled to expire during the
remainder of 2007 or an equivalent amount of our currently available space of
approximately 2.9 million rentable square feet, however, our operating cash
flows after 2007 may be affected adversely. With the expectation of lower rental
revenues for the remainder of 2007, we expect our properties' net operating
income to show a year over year decline when compared to 2006 driven by excess
capacity of commercial office and R&D space in the Silicon Valley. 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. Cash flows from lease terminations
are non-recurring and to maintain or increase cash flows in the future we must
re-lease our vacant properties.
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 or future borrowings. We
expect these sources of liquidity to be adequate to meet projected distributions
to stockholders and other presently anticipated liquidity requirements in 2007.
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 cash and investments, 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 cash reserves or other short-term borrowings. We expect our total
interest expense to increase through new financing activities. In the remainder
of 2007, we will be obligated to make payments totaling approximately $2.8
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.
Cash and cash equivalents increased by approximately $4.0 million from $33.8
million as of December 31, 2006 to $37.8 million as of September 30, 2007
primarily from lease termination fees.
Restricted cash totaled approximately $65.5 million as of September 30, 2007. Of
this amount, approximately $15.5 million represents proceeds received from
property sales and interest income held in a separate cash account at a trust
company for future use in tax-deferred exchanges. The remaining $50.0 million
represents cash held by our consolidated VIE from a lease termination in the
third quarter of 2007. We include this in our restricted cash under the
principles of FIN 46R. We do not possess or control these funds or have any
rights to receive them except as provided in the applicable agreements, however.
The restricted cash is not available for distribution to stockholders.
- 18 -
DISTRIBUTIONS
On October 4, 2007, we paid dividends of $0.16 per share of common stock to all
common stockholders of record as of September 28, 2007. On the same date, the
operating partnerships paid a distribution of $0.16 per O.P. unit to all holders
of O.P. units. Aggregate dividends and distributions amounted to approximately
$16.8 million. For the remainder of 2007, we expect to maintain our current
quarterly dividend payment rate to common stockholders 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 September 30, 2007, we had total indebtedness of approximately $349.5
million, including $340.2 million of fixed rate mortgage debt and $9.3 million
debt under the Berg Group mortgage note (related parties), as detailed in the
table below. The Allianz and SCVNB loans contain certain financial loan and
reporting covenants as defined in the loan agreements. As of September 30, 2007,
we were in compliance with these loan covenants.
CONTRACTUAL OBLIGATIONS
The following table identifies the contractual obligations as of September 30,
2007 that will impact our liquidity and cash flow in future periods:
------------ ------------ ------------- ------------ ------------- ------------ ------------
2007 2008 2009 2010 2011 Thereafter Total
------------ ------------ ------------- ------------ ------------- ------------ ------------
(dollars in thousands)
Long-Term Debt Obligations(1) $2,816 $121,589 $9,561 $10,105 $10,681 $194,808 $349,560
Operating Lease Obligations (2) 24 24 - - - - 48
------------ ------------ ------------- ------------ ------------- ------------ ------------
Total $2,840 $121,613 $9,561 $10,105 $10,681 $194,808 $349,608
============ ============ ============= ============ ============= ============ ============
(1) Our long-term debt obligations are set forth in detail in the schedule
below.
(2) Our operating lease obligations relate to a lease of our corporate office
facility from a related party.
- 19 -
The following table sets forth information regarding debt outstanding as of
September 30, 2007:
Maturity Interest
Debt Description Collateral Properties Balance Date Rate
-------------------------------------------- -------------------------------------- -------------------- ------------- ------------
(dollars in thousands)
Line of Credit:
Santa Clara Valley National Bank Not Applicable - 12/07 (3)
--------------------
Mortgage Notes Payable (related parties): 5300 & 5350 Hellyer Avenue, San Jose, CA $ 9,335 6/10 7.65%
--------------------
Mortgage Notes Payable(1):
Prudential Insurance Co. of America(2) 10300 Bubb Road, Cupertino, CA 113,171 10/08 6.56%
10500 N. De Anza Boulevard, Cupertino, CA
4050 Starboard Drive, Fremont, CA
45738 Northport Loop, Fremont, CA
450 National Avenue, Mountain View, CA
6311 San Ignacio Avenue, San Jose, CA
6321 San Ignacio Avenue, San Jose, CA
6325 San Ignacio Avenue, San Jose, CA
6331 San Ignacio Avenue, San Jose, CA
6341 San Ignacio Avenue, San Jose, CA
6351 San Ignacio Avenue, 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
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 Co.(4) 1750 Automation Parkway, San Jose, CA 85,844 1/13 5.64%
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 Avenue, San Jose, CA
2251 Lawson Lane, Santa Clara, CA
1325 McCandless Drive, Milpitas, CA
1650-1690 McCandless Drive, Milpitas, CA
20605-20705 Valley Green Drive, Cupertino, CA
Allianz Life Ins. Co.(Allianz Loan I)(5) 5900 Optical Court, San Jose, CA 24,022 8/25 5.56%
Allianz Life Ins. Co.(Allianz Loan II)(5) 5325-5345 Hellyer Avenue, San Jose, CA 117,188 8/25 5.22%
1768 Automation Parkway, San Jose, CA
2880 Scott Boulevard, Santa Clara, CA
2890 Scott Boulevard, Santa Clara, CA
2800 Scott Boulevard, Santa Clara, CA
20400 Mariani Avenue, Cupertino, CA
10450-10460 Bubb Road, Cupertino, CA
--------------------
340,224
--------------------
--------------------
TOTAL $349,560
====================
(1) Mortgage notes payable generally require monthly installments of principal
and interest ranging from approximately $177,000 to $840,000 over various
terms extending through the year 2025. The weighted average interest rate
of mortgage notes payable was 5.85% at September 30, 2007.
(2) The Prudential Insurance loan is payable in monthly installments of
approximately $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. In the
third quarter of 2007, the Company sold 45700 Northport Loop in Fremont,
California and 1170 Morse Avenue in Sunnyvale, California, which were
collateral properties under the Prudential Insurance loan. Prudential has
agreed to release these properties without delivery of substitute
properties provided that the Company pay a fee of $40,000 and deposit
$1,500,000 in escrow with Prudential for a full year. The Company made the
payments in the fourth quarter of 2007.
(3) Interest rate equal to LIBOR plus 1.75%. The Santa Clara Valley National
Bank ("SCVNB") line of credit contains certain financial loan and reporting
covenants as defined in the loan agreements, including minimum tangible net
worth and debt service coverage ratio. As of September 30, 2007, the
Company was in compliance with these loan covenants. SCVNB was acquired by
Wells Fargo Bank and the Company is in the process of transferring its
day-to-day primary banking relationship to Heritage Bank of Commerce. The
SCVNB line of credit will expire in December 2007, and at this time, the
Company does not perceive a need to establish a new line of credit.
(4) The Northwestern loan is payable in monthly installments of approximately
$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.
(5) The Allianz loans are payable in monthly aggregate installments of
approximately $1,017,000, which includes principal (based upon a 20-year
amortization) and interest. Costs and fees incurred with obtaining these
loans aggregated approximately $1,089,000, which were deferred and
amortized over the loan periods. The Allianz loans contain certain
customary covenants as defined in the loan agreements. As of September 30,
2007, the Company was in compliance with these loan covenants.
- 20 -
At September 30, 2007, 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 $12.15 per share on September 28, 2007) on a fully diluted basis, including
the conversion of all O.P. units into common stock, was approximately 21.4%. On
September 28, 2007, the last trading day in the quarter, total market
capitalization was approximately $1.63 billion.
At September 30, 2007, the outstanding balance remaining under certain notes
that we owed to the operating partnerships was approximately $1.9 million. The
due date of these notes has been extended to September 30, 2008. 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 condensed 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 interests as reported on the condensed
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 nine months ended September 30, 2007 to the nine months ended
September 30, 2006
Net cash provided by operating activities for the nine months ended September
30, 2007 was approximately $29.9 million compared to $28.2 million for the same
period in 2006. Cash flow increases came primarily from lease termination fees,
a forfeited deposit under a contract for the sale of property, and rent payments
from M&M, LLC in 2007 (see Note 5 of Notes to Condensed Consolidated Financial
Statements in Part I, Item 1, above). Higher leasing commission payments
(included in other assets) in 2007 compared to 2006 reduced the amount of the
overall increase in cash flows.
Net cash used in investing activities was approximately ($8.3) million and
($2.0) million for the nine months ended September 30, 2007 and 2006,
respectively. Cash used in investing activities during the nine months ended
September 30, 2007 related principally to the acquisition of 50 acres of vacant
land at the Morgan Hill Ranch in Morgan Hill, California for approximately $25.5
million, the acquisition of five acres of vacant land at the Morgan Hill Ranch
in Morgan Hill, California for approximately $2.3 million, and the acquisition
of three R&D properties at Montague Expressway in Milpitas, California and one
R&D property at 5845 Hellyer Avenue in San Jose, California for approximately
$19.7 million. The acquisition at Montague Expressway was completed as a
tax-deferred exchange transaction involving our former R&D properties at
2033-2243 Samaritan Drive in San Jose, California. The remaining excess
restricted cash of approximately $0.6 million was transferred to our general
cash account. Capital expenditures for real estate improvements were
approximately $4.6 million for the nine months ended September 30, 2007.
Net cash used in investing activities during the nine months ended September 30,
2006 related principally to the acquisition of the property at 233 South
Hillview Drive in Milpitas, California for approximately $13.5 million, pursuant
to a tax-deferred exchange transaction involving our former R&D property at 800
Embedded Way in San Jose, California. Excess restricted cash of approximately
$1.8 million from the sale of 800 Embedded Way was transferred to our general
cash account. Capital expenditures for real estate improvements were
approximately $1.3 million for the nine months ended September 30, 2006.
Net cash used in financing activities was approximately ($17.6) million for the
nine months ended September 30, 2007 compared to approximately ($15.1) million
for the nine months ended September 30, 2006. During the first nine months of
2007, we used approximately $8.2 million to pay outstanding debt and paid
approximately $9.4 million of dividends to common stockholders. During the same
period in 2006, we received approximately $0.8 million from stock option
exercises, received approximately $1.6 million from the refund of an appeal
bond, used approximately $7.8 million to pay outstanding debt, paid
approximately $9.0 million of dividends to common stockholders and paid
approximately $0.7 million to minority interests for distributions in excess of
earnings.
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 to be an appropriate supplemental measure
of our operating and financial performance because when compared year over year,
it reflects the impact to operations from trends in occupancy rates, rental
rates, operating costs, general and administrative expenses and interest costs,
providing a perspective not immediately apparent from net income. In addition,
management believes that FFO provides useful information about our financial
performance when compared to other REITs because FFO is generally recognized as
the industry standard for reporting the operations of REITs. In addition to 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.
- 21 -
Our definition of FFO also assumes conversion at the beginning of the period of
all convertible securities, including minority interests represented by O.P.
Units 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.
FFO for the three and nine months ended September 30, 2007 and 2006, as
reconciled to net income to common stockholders, are summarized in the following
table:
Three Months Ended September 30, Nine Months Ended September 30,
----------------------------------------- -----------------------------------------
2007 2006 2007 2006
------------------ ------------------ ------------------ ------------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders $11,941 $ 2,106 $ 17,320 $ 9,380
Add:
Minority interests (1) 48,420 8,566 70,098 40,676
Depreciation & amortization of real estate(2) 7,184 6,333 19,986 18,429
Less:
Gain on sale of real estate (6,529) (438) (6,529) (438)
------------------ ------------------ ------------------ ------------------
FFO $61,016 $16,567 $100,875 $68,047
================== ================== ================== ==================
(1) Minority interests in net income is calculated by taking the net income of
the operating partnerships (on a stand-alone basis) multiplied by the
respective weighted average minority interests ownership percentage.
Minority interests for third parties totaling approximately $130 and $134
for the three months ended September 30, 2007 and 2006, respectively, and
$371 and $382 for the nine months ended September 30, 2007 and 2006,
respectively, were deducted from total minority interests in calculating
FFO.
(2) Includes our portion of depreciation and amortization of real estate and
leasing commissions from our unconsolidated joint venture totaling
approximately $189 and $238 for the three months ended September 30, 2007
and 2006, respectively, and $568 and $660 for the nine months ended
September 30, 2007 and 2006, respectively. Also includes our amortization
of leasing commissions of approximately $1,426 and $368 for the three
months ended September 30, 2007 and 2006, respectively, and $2,187 and
$1,138 for the nine months ended September 30, 2007 and 2006, respectively.
Amortization of leasing commissions is included in the property operating,
maintenance and real estate taxes line item in the Company's condensed
consolidated statements of operations.
The increase in FFO year-over-year was primarily due to higher lease termination
fee income, offset by lower rental income and higher amortization expenses in
2007 compared to 2006.
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;
- the amount of our annual debt service requirements;
- prospects of tenant renewals and re-leases of properties subject to
expiring leases;
- cash required for re-leasing activities;
- 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 June 2006, the FASB issued Interpretation 48, "Accounting for Uncertainty in
Income Taxes" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in
income taxes recognized in our financial statements in accordance with SFAS No.
109, "Accounting for Income Taxes." The provisions of FIN 48 are effective for
our fiscal year beginning January 1, 2007. The adoption of FIN 48 on January 1,
2007 is not expected to have a significant impact on our consolidated results of
operations or financial position.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
("SFAS 157"). SFAS 157 defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles, and expands disclosures
about fair value measurements. The provisions of SFAS 157 are effective for our
fiscal year beginning January 1, 2008. We are currently evaluating the
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impact of the provisions of SFAS 157 and currently cannot estimate the impact to
our consolidated results of operations or financial position.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities" ("SFAS 159"). SFAS 159 provides
companies with an option to report selected financial assets and liabilities at
fair value. SFAS 159's objective is to reduce both complexity in accounting for
financial instruments and the volatility in earnings caused by measuring related
assets and liabilities differently. SFAS 159 is effective for financial
statements issued for fiscal years beginning after November 15, 2007. We are
evaluating whether to adopt the provisions of SFAS 159 and cannot estimate the
impact to our consolidated results of operations, financial position or cash
flows.
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
variable rate debt 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 September 30, 2007. 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
fixed rate debt, we estimate fair value by using discounted cash flow analyses
based on borrowing rates for similar kinds of borrowing arrangements.
For fixed rate debt, the table presents the assumption that the outstanding
principal balance at September 30, 2007 will be paid according to scheduled
principal payments and that we will not prepay any of the outstanding principal
balance.
Three
Months Year Ending December 31,
Remaining -----------------------------------------------
2007 2008 2009 2010 2011 Thereafter Total Fair Value
----------- ----------- ----------- ----------- ----------- ----------- ----------- ------------
(dollars in thousands)
Fixed Rate Debt:
Secured notes payable $2,816 $121,589 $9,561 $10,105 $10,681 $194,808 $349,560 $451,126
Weighted average interest rate 5.85% 5.85% 5.85% 5.85% 5.85% 5.85%
The primary market risks we face are interest rate fluctuations. 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 September 30, 2007.
As of September 30, 2007, we had no interest rate risk since there was no
variable rate debt outstanding.
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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 designed 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 and procedures.
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 (as defined in
Rule 13a-15(e) or Rule 15d-15(e)) were effective as of September 30, 2007.
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, our internal control over financial reporting.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Legal proceedings are incorporated herein by reference from Part I "Item 1. -
Notes to Condensed Consolidated Financial Statements - Note 10 - Commitments and
Contingencies."
ITEM 1A. RISK FACTORS
While we attempt to identify, manage and mitigate risks and uncertainties
associated with our business to the extent practical under the circumstances,
some level of risk and uncertainty will always be present. In addition to the
other information contained in this report, you should carefully review the
factors discussed under Item 1A of our 2006 Form 10-K which describes some of
the risks and uncertainties associated with our business. These risks and
uncertainties have the potential to materially affect our business, financial
condition, results of operations, cash flows, and future prospects. Additional
risks and uncertainties not presently known to us or that we currently deem
immaterial also may impair our business operations.
ITEM 5. OTHER INFORMATION
As of October 31, 2007, we are continuing discussions with two interested
parties in regarding the possible acquisition of the Company, but otherwise have
ceased active efforts to effect an acquisition of the Company with any other
parties.
ITEM 6. EXHIBITS
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: November 8, 2007 By: /s/ Carl E. Berg
------------------------------------
Carl E. Berg
Chief Executive Officer
Date: November 8, 2007 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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