[PG NUMBER]
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008
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)
(408) 725-0700
(Registrant's telephone number, including area code)
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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, a non-accelerated filer, or a smaller reporting company. See
definitions of "large accelerated filer," "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ] Smaller reporting company [ ]
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:
19,743,557 shares outstanding as of July 31, 2008
MISSION WEST PROPERTIES, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2008
INDEX
PART I FINANCIAL INFORMATION PAGE
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Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets as of June 30, 2008 (unaudited)
and December 31, 2007...................................................................................2
Condensed Consolidated Statements of Operations for the three
and six months ended June 30, 2008 and 2007 (unaudited).................................................3
Condensed Consolidated Statements of Cash Flows for the
six months ended June 30, 2008 and 2007 (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 4. Submission of Matters to a Vote of Security Voters.....................................................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)
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June 30, 2008 December 31, 2007
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(unaudited)
ASSETS
Real estate:
Land $ 320,911 $ 312,152
Buildings and improvements 792,886 764,665
Real estate related intangible assets 3,240 2,119
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Total investments in real estate 1,117,037 1,078,936
Less accumulated depreciation and amortization (168,124) (156,819)
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Total investments in real estate, net 948,913 922,117
Cash and cash equivalents 769 23,691
Restricted cash 45,535 65,509
Deferred rent receivable, net 16,420 14,833
Investment in unconsolidated joint venture 2,625 2,735
Other assets, net 25,588 25,000
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Total assets $1,039,850 $1,053,885
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LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Mortgage notes payable $ 332,001 $ 337,520
Note payable (related parties) 1,923 -
Mortgage note payable (related parties) 8,997 9,224
Revolving line of credit 8,244 -
Interest payable 1,360 1,331
Security deposits 4,977 4,754
Deferred rental income 5,383 3,302
Dividends and distributions payable 21,054 16,832
Accounts payable and accrued expenses 16,174 15,618
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Total liabilities 400,113 388,581
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Commitments and contingencies (Note 9)
Minority interests 504,668 526,626
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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,
19,743,557 and 19,664,087 shares issued and outstanding
at June 30, 2008 and December 31, 2007 20 20
Additional paid-in capital 154,056 153,024
Distributions in excess of accumulated earnings (19,007) (14,366)
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Total stockholders' equity 135,069 138,678
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Total liabilities and stockholders' equity $1,039,850 $1,053,885
===================== ======================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
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MISSION WEST PROPERTIES, INC
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except share and per share amounts)
(unaudited)
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Three months ended June 30, Six months ended June 30,
-------------------------------------- ----------------------------------------
2008 2007 2008 2007
------------------ ------------------- -------------------- -------------------
Revenues:
Rental revenue from real estate $19,359 $21,148 $38,356 $42,350
Above market lease intangible asset amortization - - - (4,091)
Tenant reimbursements 3,710 3,240 7,293 6,454
Lease termination fees - 168 1,921 10,277
Other income, including interest 464 958 1,249 4,015
------------------ ------------------- -------------------- -------------------
Total revenues 23,533 25,514 48,819 59,005
------------------ ------------------- -------------------- -------------------
Expenses:
Property operating, maintenance and real estate taxes 5,511 4,558 10,398 9,078
Interest 4,956 5,045 9,884 10,114
Interest (related parties) 280 182 716 366
General and administrative 674 673 1,347 1,387
Depreciation and amortization of real estate 5,682 5,398 11,305 11,552
------------------ ------------------- -------------------- -------------------
Total expenses 17,103 15,856 33,650 32,497
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Income before equity in earnings of unconsolidated
joint venture and minority interests 6,430 9,658 15,169 26,508
Equity in earnings of unconsolidated joint venture 407 350 789 686
Minority interests (5,478) (8,007) (12,717) (21,827)
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Income from continuing operations 1,359 2,001 3,241 5,367
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Discontinued operations, net of minority interests:
Income attributable to discontinued operations - 3 - 12
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Income from discontinued operations - 3 - 12
------------------ ------------------- -------------------- -------------------
Net income to common stockholders $1,359 $2,004 $ 3,241 $ 5,379
================== =================== ==================== ===================
Net income to minority interests $5,478 $8,039 $12,717 $21,918
================== =================== ==================== ===================
Income per common share from continuing operations:
Basic $0.07 $0.10 $0.16 $0.27
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Diluted $0.07 $0.10 $0.16 $0.27
================== =================== ==================== ===================
Income per common share from discontinued operations:
Basic - - - -
================== =================== ==================== ===================
Diluted - - - -
================== =================== ==================== ===================
Net income per common share to common stockholders:
Basic $0.07 $0.10 $0.16 $0.27
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Diluted $0.07 $0.10 $0.16 $0.27
================== =================== ==================== ===================
Weighted average shares of
common stock outstanding (basic) 19,695,988 19,639,928 19,681,797 19,611,515
================== =================== ==================== ===================
Weighted average shares of
common stock outstanding (diluted) 19,902,304 20,020,596 19,766,535 19,956,752
================== =================== ==================== ===================
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)
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Six months ended June 30,
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2008 2007
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Cash flows from operating activities:
Net income $3,241 $5,379
Adjustments to reconcile net income to net cash provided by operating activities:
Minority interests income 12,717 21,918
Minority interest distributions (12,717) (21,918)
Depreciation and amortization of real estate and in-place leases 11,305 11,664
Amortization of acquired above market lease - 4,091
Equity in earnings of unconsolidated joint venture (789) (687)
Distributions from unconsolidated joint venture 900 1,100
Interest earned on restricted cash (633) (592)
Lease termination fee related to restricted cash 4,830 3,264
Stock-based compensation expense 242 316
Other 66 131
Changes in operating assets and liabilities:
Deferred rent receivable (1,587) 1,701
Other assets (588) (1,263)
Interest payable 29 (32)
Security deposits 223 (389)
Deferred rental income 2,081 17
Accounts payable and accrued expenses 556 (266)
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Net cash provided by operating activities 19,876 24,434
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Cash flows from investing activities:
Improvements to real estate assets (2,337) (2,409)
Purchase of real estate (35,764) (43,191)
Restricted cash released for purchase of real estate 8,082 43,191
Excess restricted cash 7,654 630
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Net cash used in investing activities (22,365) (1,779)
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Cash flows from financing activities:
Principal payments on mortgage notes payable (5,519) (5,222)
Principal payments on mortgage note payable (related parties) (227) (211)
Proceeds from real estate purchase financing (related parties) 19,423 -
Payments on real estate purchase financing (related parties) (17,500) -
Proceeds from note payable (related parties) 3,000 -
Payment on note payable (related parties) (3,000) -
Proceeds from line of credit 8,244 -
Payment of loan fees and costs (26) -
Proceeds from exercise of stock options 735 -
Minority interest distributions in excess of earnings (18,483) (5,703)
Dividends paid to common stockholders (7,080) (6,251)
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Net cash used in financing activities (20,433) (17,387)
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Net (decrease) increase in cash and cash equivalents (22,922) 5,268
Cash and cash equivalents, beginning of period 23,691 33,785
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Cash and cash equivalents, end of period $ 769 $39,053
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Supplemental information:
Cash paid for interest $10,572 $10,372
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Supplemental schedule of non-cash investing and financing activities:
Debt from seller in connection with real estate purchase (related parties) $19,068 -
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Issuance of common stock upon conversion of O.P. units $ 54 $ 2,606
=================== ===================
The accompanying notes are an integral part of these
condensed consolidated financial statements.
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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 research and development ("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 June 30, 2008, the Company owns a controlling general partnership
interest of 19.96%, 21.79%, 16.27% and 12.49% 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 18.71%
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 111
R&D/office properties, all of which are located in the Silicon Valley.
The Company has elected to be taxed as a real estate investment trust
("REIT") under the Internal Revenue Code of 1986, as amended. Accordingly,
no provision has been made for income taxes for the three and six months
ended June 30, 2008 and 2007.
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 BASIS OF 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 June 30, 2008, their consolidated
results of operations for the three and six months ended June 30, 2008 and
2007, and their cash flows for the six months ended June 30, 2008 and 2007.
All significant inter-company balances have been eliminated in
consolidation. The condensed consolidated financial statements as of June
30, 2008 and for the three and six months ended June 30, 2008 and 2007 and
related footnote disclosures are unaudited. The results of operations for
the three and six months ended June 30, 2008 are not necessarily indicative
of the results to be expected for the entire year.
The December 31, 2007 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 June 30, 2008, 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 3 for further discussion of this
transaction.
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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
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 June 30, 2008, 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 second quarter of 2008, options to purchase 86,250 shares held by a
former member of the Board of Directors lapsed without exercise.
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, 2007 1,747,100 $11.13
Options granted 1,025,000 $ 9.51
Options exercised (73,750) $ 9.98
Options forfeited (86,250) $10.86
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Balance, June 30, 2008 2,612,100 $10.54
==============
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 $96 and $157 of expense
for the three months ended June 30, 2008 and 2007, respectively, and
approximately $242 and $316 for share-based compensation relating to grants
of stock options for the six months ended June 30, 2008 and 2007,
respectively.
As of June 30, 2008, the total amount of unrecognized compensation cost
related to unvested share-based compensation arrangements granted under the
compensation plan was approximately $744. This cost is expected to be
recognized over a weighted-average period of 3.05 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
June 30, 2008, these interests accounted for approximately 81.3% of the
ownership interests in the real estate operations of the Company on a
consolidated weighted average basis. The amount of 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 2007
condensed consolidated financial statements in order to conform to the 2008
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, 2007 audited consolidated financial statements and should be read
together with the consolidated financial statements and notes thereto
included in the Company's 2007 Annual Report on Form 10-K filed on March
14, 2008.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS 157, "Fair Value Measurements"
("SFAS 157"). SFAS 157 defines fair value, establishes a framework for
measuring fair value and expands disclosures about fair value measurements.
SFAS 157 applies under other accounting pronouncements that require or
permit fair value measurements. Accordingly, this statement does not
require any new fair value measurements. This guidance was issued to
increase consistency and comparability in fair value measurements and to
expand disclosures about fair value measurements. SFAS establishes and
requires disclosure of fair value hierarchy that distinguishes between data
obtained from sources independent of the reporting entity and the reporting
entity's own assumptions about market participant assumptions. The three
levels of hierarchy are 1) using quoted prices in active markets for
identical assets and liabilities, 2) "significant other observable inputs"
and 3) "significant unobservable inputs". "Significant other observable
inputs" can include quoted prices for similar assets or liabilities in
active markets, as well as inputs that are observable for the asset or
liability, such as interest rates, foreign exchange rates and yield curves
that are observable at commonly quoted intervals. "Significant unobservable
inputs" are typically based on an entity's own assumptions, as there is
little, if any, related market activity. SFAS 157 is effective for
financial statements issued for fiscal years beginning after November 15,
2007. Adoption on January 1, 2008 did not have a material effect on the
Company's consolidated financial statements. The FASB has approved a
one-year deferral for the implementation of the statement for non-financial
assets and non-financial liabilities that are recognized or disclosed at
fair value in the financial statements on a nonrecurring basis. The Company
believes that the impact of these items will not be material to its
consolidated financial statements.
In February 2007, the FASB issued SFAS 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. The Company adopted SFAS 159 on a
prospective basis on January 1, 2008. The implementation of SFAS 159 did
not have a material impact on the Company's consolidated financial
statements.
In December 2007, the FASB issued SFAS 141 (Revised 2007), "Business
Combinations" ("SFAS 141R"). SFAS 141R will change the accounting for
business combinations. Under SFAS 141R, an acquiring entity will be
required to recognize all the assets acquired and liabilities assumed in a
transaction at the acquisition date fair value with limited exceptions.
SFAS 141R will change the accounting treatment and disclosure for certain
specific items in a business combination. SFAS 141R requires that
acquisition-related costs and restructuring costs be recognized separately
from the business combination and expensed as incurred. SFAS 141R applies
prospectively to business combinations for which the acquisition date is on
or after the beginning of the first annual reporting period beginning on or
after December 15, 2008. Early adoption is prohibited. The Company is
currently evaluating the impact SFAS 141R will have on its consolidated
financial statements.
In December 2007, the FASB issued SFAS 160, "Noncontrolling Interests in
Consolidated Financial Statements" ("SFAS 160"). SFAS 160 requires that
noncontrolling interests be presented as a component of consolidated
stockholders' equity, eliminates "minority interest accounting" such that
the amount of net income attributable to the noncontrolling interests will
be presented as part of consolidated net income on the consolidated
statement of operations and not as a separate component of income and
expenses. SFAS 160 is effective for fiscal years beginning on or after
December 15, 2008. Early adoption is prohibited. The Company is currently
evaluating the impact SFAS 160 will have on its consolidated financial
statements.
3. VARIABLE INTEREST ENTITY
Under FIN 46R, a variable interest entity must be consolidated by a company
if it is subject to a majority of the entity's expected losses or is
entitled to receive a majority of the entity's expected residual returns or
both. In addition, 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.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
In August 2007, one of the Company's tenants, Ciena, 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 445,000 rentable square feet located in San Jose, California.
As a result of the Assignment, 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 were 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 received monthly rent payments of
approximately $789 from July 2007 through June 2008, is receiving $818 from
July 2008 through June 2009, will receive $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.
- 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.
4. RESTRICTED CASH
Restricted cash totaled approximately $45,535 as of June 30, 2008. Of this
amount, approximately $44,035 represents cash held by M&M Real Estate
Control & Restructuring, LLC, a consolidated variable interest entity, or
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. The balance of the
restricted cash is a $1,500 certificate of deposit held by Prudential
Insurance Company of America as collateral securing the Company's mortgage
loan. The certificate of deposit was provided by the Company in the third
quarter of 2007 to replace two buildings sold by the Company that
previously served as collateral.
5. STOCK TRANSACTIONS
During the six months ended June 30, 2008, stock options to purchase 70,000
and 3,750 shares of common stock were exercised at $10.00 and $9.51 per
share, respectively. Total proceeds to the Company were approximately $735.
During the same period, two limited partners exchanged a total of 5,720
O.P. units for 5,720 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 $54 from minority interests to additional 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.
6. DISCONTINUED OPERATIONS
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 2007. 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.
In the third quarter of 2007, the Company sold two R&D properties that
qualified as discontinued operations. Condensed results of operations for
these properties for the three and six months ended June 30, 2007 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 June 30, Six Months Ended June 30,
------------------------------ -----------------------------
2008 2007 2008 2007
------------- ------------- ------------ ------------
(dollars in thousands)
(unaudited)
Revenues
Rental revenue from real estate - $135 - $271
Tenant reimbursements - 14 - 27
------------- ------------- ------------ ------------
Total revenues - 149 - 298
------------- ------------- ------------ ------------
Expenses
Property operating, maintenance and real estate taxes - 58 - 83
Depreciation of real estate - 56 - 112
------------- ------------- ------------ ------------
Total expenses - 114 - 195
------------- ------------- ------------ ------------
Income from discontinued operations - 35 - 103
Minority interest in earnings attributable to
discontinued operations - (32) - (91)
------------- ------------- ------------ ------------
Income from discontinued operations - $ 3 - $ 12
============= ============= ============ ============
7. 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 June 30, Six Months Ended June 30,
--------------------------------- ---------------------------------
2008 2007 2008 2007
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 19,695,988 19,639,928 19,681,797 19,611,515
Incremental shares from assumed option exercise 206,316 380,668 84,738 345,237
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 19,902,304 20,020,596 19,766,535 19,956,752
=============== ============== ============== ===============
At June 30, 2008, outstanding options to purchase 1,040,000 shares of
common stock 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 closing 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 June 30, 2008 and
2007 was 85,528,215 and 85,009,699, respectively.
8. RELATED PARTY TRANSACTIONS
As of June 30, 2008, the Berg Group owned 77,902,384 O.P. units. The Berg
Group's combined ownership of O.P. units and shares of common stock as of
June 30, 2008 represented approximately 74% of the total equity interests,
assuming conversion of all O.P. units outstanding into the Company's common
stock.
As of June 30, 2008, debt in the amount of approximately $8,997 was due the
Berg Group under a mortgage note established 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 $174 and $182 for the three months ended June 30,
2008 and 2007, respectively, and $349 and $366 for the six months ended
June 30, 2008 and 2007, respectively.
As of June 30, 2008, debt in the amount of approximately $1,923 was due the
Berg Group under a short-term note payable established on January 1, 2008
in connection with the acquisition of 5981 Optical Court. The note payable
bears interest at LIBOR plus 2% and is due September 30, 2008. Interest
expense incurred in connection with the loan was approximately $106 and
$355 for the three and six months ended June 30, 2008, respectively.
During the first six months of 2008 and 2007, Carl E. Berg or entities
controlled by him 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 $307 and $361 in rental revenue for the three
months ended June 30, 2008 and 2007, respectively, and $614 and $721 in
rental revenue for the six months ended June 30, 2008 and 2007,
respectively.
- 9 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
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.
Currently their share ownership is below a level at which rent from related
tenants would be excluded in determining compliance with REIT qualification
tests.
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
for the Company's headquarters. Rental amounts and overhead reimbursements
paid to Berg & Berg Enterprises were approximately $30 and $24 for the
three months ended June 30, 2008 and 2007, respectively, and $54 and $47
for the six months ended June 30, 2008 and 2007, respectively.
9. 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 it believes that the ultimate outcome of these proceedings
will not have a material adverse effect on its operating results, cash
flows or financial condition.
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. ("BBE"). 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 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. In April 2008, the Company filed a motion
for summary judgment in the California Superior Court which was denied. A
trial in the California Superior Court will commence in late 2008.
Since the inception of Hellyer LP, the Company has accounted for the
properties owned by the partnership on a consolidated basis, with
reductions for the minority interest held by the minority partner (first
RPC and then BBE). In each period, the Company has accrued amounts payable
by Hellyer LP to the minority interest partner, including BBE prior to
payment. BBE's share of earnings allocated to its 50% minority interest was
approximately $0.4 million in the first six months of 2008 and 2007. As of
June 30, 2008,
- 10 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
accumulated cash flow distributions from Hellyer LP totaling approximately
$4.9 million were accrued and distributed to BBE. If the Company's
litigation with RPC is ultimately decided in RPC's favor, the Company
anticipates that BBE may be required to return RPC's former interest in
Hellyer LP and all prior distributions to RPC. As a result of this
uncertainty, in October 2003, the Company recorded such distributions as an
account receivable from BBE, which is included in "Other assets" on the
Company's consolidated balance sheets, with an offsetting account payable
to BBE.
If the litigation is ultimately decided in favor of the Company, the
Independent Directors Committee of the Board of Directors has the right,
but not the obligation, to acquire on behalf of the Company the former RPC
interest and related distributions from BBE under the terms of the Berg
Land Holdings Option Agreement and the Acquisition Agreement between the
Company and the Berg Group.
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 June 30, 2008.
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 June 30,
2008.
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 an executed
sales contract as of June 30, 2008 that is subject to such material
conditions:
Property Number of Buildings Rentable Square Feet Acres Sales Price
-------- ------------------- -------------------- ----- -----------
McCandless Drive
Milpitas, California 8 427,000 23.03 $76,500
10. SUBSEQUENT EVENTS
On July 3, 2008, the Company paid dividends of $0.20 per share of common
stock to all common stockholders of record as of June 30, 2008. On the same
date, the operating partnerships paid a distribution of $0.20 per O.P. unit
to all holders of O.P. units. Aggregate dividends and distributions
amounted to approximately $21,054.
On July 3, 2008, a short-term note payable in the amount of approximately
$12,760 was issued to the Berg Group in connection with the quarterly
distributions. The note payable bears interest at LIBOR plus 2% and is due
September 30, 2008.
- 11 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except per share and per square footage)
(unaudited)
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, 2007. The results for the three and six months ended June 30, 2008
are not necessarily indicative of the results to be expected for the entire
fiscal year ending December 31, 2008.
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,
- changes in general accounting principles, policies and guidelines
applicable to REITs, and
- ability to timely refinance maturing debt obligations and the terms of
any such refinancing.
These risks and uncertainties, together with the other risks described under
Part I, Item 1A - "Risk Factors" of our 2007 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 June 30,
2008, we owned and managed 111 properties totaling approximately 8.0 million
rentable square feet through four limited partnerships, or operating
partnerships, for which we are the sole general partner. This class of property
is designed for research and development and office uses and, in some cases,
includes space for light manufacturing operations with loading docks. We believe
that we have one of the largest portfolios of R&D/office properties in the
Silicon Valley. As of June 30, 2008, two tenants individually lease in excess of
300,000 rentable square feet from us: Microsoft 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. After fast-paced growth in 1999 and 2000, the Silicon
Valley economy and business activity slowed markedly from 2001 through 2006 and
have been growing slowly 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 16.6% in late 2007 and 16.0% at the end of the
second quarter of 2008. Total vacant R&D square footage in Silicon Valley at the
end of the second quarter of 2008 amounted to approximately 24.7 million square
feet, of which 15.4%, or 3.8 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 2007 amounted to approximately 3.5 million
square feet, and in the first six months of 2008 there was total positive net
absorption of approximately 0.16 million square feet. Also according to the BT
Report, the average asking market rent per square foot at the end of the second
quarter of 2008 was $1.29 compared with $1.26 in late 2007. 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 June 30, 2008 was 64.9% compared with 67.8% at June 30,
2007. 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
191,000 rentable square feet are expiring prior to the end of 2008. The
properties subject to these leases may take anywhere from 24 to 36 months or
longer to re-lease. We believe that the average 2008 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 affected
adversely. 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. We recognize these properties and 100%
of their operating results in 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 SIX MONTHS ENDED JUNE 30, 2008 WITH THE THREE AND
SIX MONTHS ENDED JUNE 30, 2007
As of June 30, 2008, through our controlling interests in the operating
partnerships, we owned 111 properties totaling approximately 8.0 million
rentable square feet compared with 110 properties totaling approximately 7.8
million rentable square feet owned by us as of June 30, 2007. This represents a
net increase of approximately 2.6% in total rentable square footage, as we
acquired three R&D/office properties consisting of approximately 284,000
rentable square feet and sold two R&D/office properties consisting of
approximately 87,000 rentable square feet since the second quarter of 2007.
Included in the 8.0 million rentable square feet are approximately 854,000
rentable square feet (or 16 buildings) that we are seeking to have rezoned for
residential development.
Rental revenue from real estate for the three and six months ended June 30, 2008
compared with the same three- and six-month periods in 2007 was as follows:
Three Months Ended June 30,
--------------------------------
% Change by
2008 2007 $ Change Property Group
------------- -------------- --------------- ---------------
(dollars in thousands)
Same Property (1) $18,452 $21,126 ($2,674) (12.7%)
2007 Acquisitions 6 22 (16) (73.0%)
2008 Acquisitions 901 - 901 100.0%
------------- -------------- ---------------
Total $19,359 $21,148 ($1,789) (8.5%)
============= ============== ===============
Six Months Ended June 30,
--------------------------------
% Change by
2008 2007 $ Change Property Group
------------- -------------- --------------- ---------------
(dollars in thousands)
Same Property (1) $36,751 $42,329 ($5,578) (13.2%)
2007 Acquisitions 20 21 (1) (4.8%)
2008 Acquisitions 1,585 - 1,585 100.0%
------------- -------------- ---------------
Total $38,356 $42,350 ($3,994) (9.4%)
============= ============== ===============
(1) "Same Property" is defined as properties owned by us prior to 2007 that we
still owned as of June 30, 2008.
RENTAL REVENUE FROM REAL ESTATE FROM CONTINUING OPERATIONS
For the quarter ended June 30, 2008, rental revenue from real estate decreased
by approximately ($1.8) million, or (8.5%), from $21.1 million for the three
months ended June 30, 2007 to $19.4 million for the three months ended June 30,
2008. For the six months ended June 30, 2008, rental revenue from real estate
decreased by approximately ($4.0) million, or (9.4%), from $42.4 million for the
six months ended June 30, 2007 to $38.4 million for the six months ended June
30, 2008. 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 in 2007, all of
which resulted from current adverse market conditions. Total rental revenue was
reduced by amortization expense of approximately ($4.1) million for the six
months ended June 30, 2007 for an above-market lease intangible asset acquired
pursuant to a lease termination. That resulted in the write-off of all remaining
above-market lease intangible asset. Our occupancy rate at June 30, 2008 was
approximately 64.9%, compared with approximately 67.8% at June 30, 2007.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of June 30, 2008, we held investments in three R&D buildings totaling
approximately 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
June 30, 2008, we recorded equity in earnings from the unconsolidated joint
venture of approximately $0.41 million compared with equity in earnings of $0.35
million for the same period in 2007. For the six-month periods ended June 30,
2008 and 2007, equity in earnings from the unconsolidated joint venture was
approximately $0.79 million and $0.69 million, respectively. The occupancy rate
for the properties owned by this joint venture at June 30, 2008 and 2007 was
100%.
LEASE TERMINATION INCOME
Lease termination fee income for the three months ended June 30, 2007 was
approximately $0.2 million. Lease termination fee income for the six months
ended June 30, 2008 and 2007 were approximately $1.9 million and $10.3 million,
respectively. These lease termination 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.
OTHER INCOME FROM CONTINUING OPERATIONS
Other income of approximately $0.5 million for the three months ended June 30,
2008 included approximately $0.2 million from interest and $0.3 million from
management fees and miscellaneous income. Other income of approximately $1.0
million for the three months
- 16 -
ended June 30, 2007 included approximately $0.5 million from interest, $0.3
million from management fees and $0.2 million from security deposit forfeitures
and miscellaneous income. For the six months ended June 30, 2008, other income
of approximately $1.3 million included approximately $0.8 million from interest
and $0.5 million from management fees and miscellaneous income. For the six
months ended June 30, 2007, other income of approximately $4.0 million included
approximately $1.6 million from a forfeited deposit under a contract for the
sale of property, $1.3 million from interest, $0.6 million from management fees,
$0.3 million from a bankruptcy settlement claim and $0.2 million from security
deposit forfeitures and miscellaneous income.
EXPENSES FROM CONTINUING OPERATIONS
Property operating expenses and real estate taxes during the second quarter of
2008 increased by approximately $1.0 million, or 20.9%, from $4.5 million to
$5.5 million for the three months ended June 30, 2007 and 2008, respectively.
The increase in 2008 was primarily attributable to increases in utility usage
and repair and maintenance expenses. Tenant reimbursements increased by
approximately $0.5 million, or 14.5%, from $3.2 million for the three months
ended June 30, 2007 to $3.7 million for the three months ended June 30, 2008 due
to reimbursements of recurring operating expenses. Certain expenses such as
property insurance, real estate taxes, and other fixed operating expenses are
not recoverable from vacant properties. For the six months ended June 30, 2008,
property operating expenses and real estate taxes increased by approximately
$1.3 million, or 14.5%, from $9.1 million for the six months ended June 30, 2007
to $10.4 million for the six months ended June 30, 2008. General and
administrative expenses remained the same at approximately $0.7 million for the
three months ended June 30, 2008 and 2007, and $1.3 million and $1.4 million for
the six months ended June 30, 2008 and 2007, respectively.
Real estate depreciation and amortization expense increased by approximately
$0.3 million, or 5.3%, from $5.4 million to $5.7 million for the three months
ended June 30, 2007 and 2008, respectively. The increase resulted from the
acquisition of two R&D properties and additional tenant improvements since June
30, 2007. Real estate depreciation and amortization expense decreased by
approximately ($0.3) million, or (2.1%), from $11.6 million to $11.3 million for
the six months ended June 30, 2007 and 2008, respectively. Such expense in the
first six months of 2007 included additional amortization expense relating to
in-place lease value intangible asset pursuant to SFAS 141 in connection with
two lease terminations that did not recur in 2008.
Interest expense was approximately $5.0 million for the three months ended June
30, 2008 and 2007. Interest expense (related parties) increased by approximately
$0.1 million, or 53.8%, from $0.2 million for the three months ended June 30,
2007 to $0.3 million for the three months ended June 30, 2008 due to higher
related party debt incurred in the quarter just ended. Total debt outstanding,
including amounts due related parties, decreased by approximately ($1.1)
million, or (0.3%), from $352.3 million as of June 30, 2007 to $351.2 million as
of June 30, 2008.
INCOME FROM DISCONTINUED OPERATIONS
The following table depicts the amounts of income from discontinued operations
for the three and six months ended June 30, 2007.
Three Months Ended June 30, Six Months Ended June 30,
---------------------------- -----------------------------
2008 2007 2008 2007
----------- ------------ ------------ ------------
(dollars in thousands)
(unaudited)
Income attributable to discontinued operations - $35 - $103
Minority interests in earnings attributable to
discontinued operations - (32) - (91)
----------- ------------ ------------ ------------
Income from discontinued operations - $ 3 - $ 12
=========== ============ ============ ============
In the third quarter of 2007, we sold two R&D properties, and in accordance with
our adoption of SFAS 144, classified them as discontinued operations. The income
to common stockholders attributable to discontinued operations from these
properties for the three and six months ended June 30, 2007 was approximately
$3,000 and $12,000, respectively.
NET INCOME TO COMMON STOCKHOLDERS AND NET INCOME TO MINORITY INTERESTS
Net income to common stockholders decreased by approximately ($0.6) million, or
(32.1%), from $2.0 million for the three months ended June 30, 2007 to $1.4
million for the same period in 2008. The minority interest portion of income
decreased by approximately ($2.5) million, or (31.9%), from $8.0 million for the
three months ended June 30, 2007 to $5.5 million for the three months ended June
30, 2008. The decrease in the quarter's net income for both common stockholders
and minority interests was primarily due to lower rental revenue and higher
operating expenses in the second quarter of 2008. For the six months ended June
30, 2008 and 2007, the minority interest portion of income was approximately
$12.7 million and $21.8 million, respectively, and net income to common
stockholders was approximately $3.2 million and $5.4 million, respectively. The
combination of lower rental revenue, lower termination fee income and higher
operating expenses led to the decrease in net income for both common
stockholders and minority interests in the first half of 2008.
Minority interest in net income has been calculated by multiplying the net
income of the operating partnerships (on a stand-alone basis) 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 June 30, 2008 and 2007.
- 17 -
CHANGES IN FINANCIAL CONDITION
The most significant changes in our financial condition during the six months
ended June 30, 2008 resulted from the acquisition of two R&D properties. At June
30, 2008, total investments in real estate increased on a net basis by
approximately $38.1 million from December 31, 2007 primarily due to two R&D
property acquisitions consisting of approximately 186,000 rentable square feet
located in the Silicon Valley and the construction of additional tenant
improvements.
Total stockholders' equity, net, decreased by approximately ($3.6) million from
December 31, 2007. We obtained additional capital from the issuance of 73,750
and 5,720 shares of our common stock for stock option exercises and the exchange
of O.P. units, respectively, which increased additional paid-in capital by
approximately $0.9 million. Share-based compensation relating to grants of stock
options increased additional paid-in capital by approximately $0.1 million.
Stockholders' equity was reduced during the most recent quarter by distributions
in excess of accumulated earnings of approximately ($4.6) million.
LIQUIDITY AND CAPITAL RESOURCES
We expect a slight increase in operating cash flows from our operating property
portfolio in 2008 compared with 2007 primarily from new leases, periodic
payments from M&M Real Estate Control & Restructuring relating to the Ciena
lease termination in 2007 (see Note 3 above) and an additional early lease
termination. If we are unable to lease a significant portion of the
approximately 191,000 rentable square feet scheduled to expire during the
remainder of 2008 or an equivalent amount of our currently available space of
approximately 2.8 million rentable square feet, however, our operating cash
flows after 2008 may be affected adversely. With the expectation of lower rental
revenues for the remainder of 2008, we expect our properties' net operating
income to show a year-over-year decline compared with 2007 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, as well as borrowings
under our line of credit with Heritage Bank of Commerce ("HBC"). We expect these
sources of liquidity to be adequate to meet projected distributions to
stockholders and other presently anticipated liquidity requirements in 2008. 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 potentially, the issuance of additional equity securities by
us. We expect our total interest expense to increase through new financing
activities.
In the first half of 2008, cash and cash equivalents decreased by approximately
($22.9) million from $23.7 million as of December 31, 2007 to $0.8 million as of
June 30, 2008.
As of June 30, 2008, restricted cash totaled approximately $45.5 million. Of
this amount, approximately $44.0 million represents cash held by our
consolidated VIE from the Ciena lease termination in the third quarter of 2007.
We do not possess or control these funds or have any rights to receive them
except as provided in the applicable agreements, however. We include this in our
restricted cash under the principles of FIN 46R. The remaining $1.5 million
represents a certificate of deposit which represents a portion of our collateral
securing the Prudential Insurance mortgage loan, which we placed in escrow in
October 2007 as a substitution for two properties that we sold. We expect these
funds to be returned to us in October 2008. The restricted cash is not available
for distribution to stockholders.
DISTRIBUTIONS
On July 3, 2008, we paid dividends of $0.20 per share of common stock to all
common stockholders of record as of June 30, 2008. On the same date, the
operating partnerships paid a distribution of $0.20 per O.P. unit to all holders
of O.P. units. Aggregate dividends and distributions amounted to approximately
$21.1 million. For the remainder of 2008, we expect to maintain our current
quarterly dividend payment rate to common stockholders and O.P. unit holders of
$0.20 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
We currently have a $17.5 million unsecured revolving line of credit with HBC
established in April 2008. The revolving line of credit carries a variable
interest rate based on the one-month LIBOR plus 1.75% per annum and matures June
15, 2009. We are in the process of increasing that line of credit to $30
million.
At June 30, 2008, we had total indebtedness of approximately $351.1 million,
including $332.0 million of fixed rate mortgage debt, $8.2 million under the HBC
line of credit, $9.0 million debt under the Berg Group mortgage note (related
parties) and $1.9 million debt under the Berg Group note payable (related
parties), as detailed in the table below. The Prudential Insurance, Northwestern
Mutual, Allianz and HBC loans contain certain financial loan and reporting
covenants as defined in the loan agreements. As of June 30, 2008, we were in
compliance with these loan covenants.
- 18 -
Our mortgage loan from Prudential Insurance Company of America, which had a
principal balance of approximately $111.3 million as of June 30, 2008, matures
on October 15, 2008. We are currently evaluating and examining the refinancing
options available to us and are seeking favorable proposals for replacement. We
expect to be able to refinance this debt prior to maturity. We currently have
not secured a commitment for replacement financing, however, and replacement
financing is not assured. Failure to refinance this debt prior to maturity, with
either short-term or long-term borrowings, would have a material adverse effect
on our financial conditions and would prevent the payment or distributions to
stockholders and O.P unit holders until we have refinanced it.
CONTRACTUAL OBLIGATIONS
The following table identifies the contractual obligations as of June 30, 2008
that will impact our liquidity and cash flow in future periods:
--------------------------------------------------------------------------------------------
2008 2009 2010 2011 2012 Thereafter Total
--------------------------------------------------------------------------------------------
(dollars in thousands)
Debt Obligations (1) $117,764 $17,806 $10,105 $10,681 $11,032 $183,777 $351,165
Operating Lease Obligations (2) 60 30 - - - - 90
------------ ------------ ------------- ------------ ------------- ------------ ------------
Total $117,824 $17,836 $10,105 $10,681 $11,032 $183,777 $351,255
============ ============ ============= ============ ============= ============ ============
(1) Our 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 June
30, 2008:
Interest Maturity
Debt Description Collateral Properties Balance Date Rate
------------------------------------------ --------------------------------------- ------------------ ------------- ------------
(dollars in thousands)
Line of Credit:
Heritage Bank of Commerce Not Applicable $8,244 6/09 (3)
------------------
Note Payable (related parties): Not Applicable 1,923 9/08 (4)
------------------
Mortgage Note Payable (related parties): 5300 & 5350 Hellyer Avenue, San Jose, CA 8,997 6/10 7.65%
------------------
Mortgage Notes Payable (1):
Prudential Insurance Company of America (2) 10300 Bubb Road, Cupertino, CA 111,256 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
1600 Memorex Drive, Santa Clara, CA
1688 Richard Avenue, Santa Clara, CA
1700 Richard Avenue, Santa Clara, CA
3540 Bassett Street, Santa Clara, CA
3542 Bassett Street, Santa Clara, CA
3544 Bassett Street, Santa Clara, CA
3550 Bassett Street, Santa Clara, CA
Northwestern Mutual Life Insurance Co. (5) 1750 Automation Parkway, San Jose, CA 83,160 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 Dr., Cupertino, CA
Allianz Life Ins. Co. (Allianz Loan I)(6) 5900 Optical Court, San Jose, CA 23,423 8/25 5.56%
Allianz Life Ins. Co. (Allianz Loan II)(6) 5325-5345 Hellyer Avenue, San Jose, CA 114,162 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
------------------
332,001
------------------
TOTAL $351,165
==================
(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 June 30, 2008.
(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 $12,000,000 of this debt. Costs and
fees incurred with obtaining this loan aggregated approximately $900,000,
which were deferred and amortized over the loan period.
(3) Loan carries a variable interest rate equal to LIBOR plus 1.75%. The
interest rate at June 30, 2008 was 4.26%. The Heritage Bank of Commerce
("HBC") 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 June 30, 2008, we were in
compliance with these loan covenants.
(4) Loan carries a variable interest rate equal to LIBOR plus 2.0%. The
interest rate at June 30, 2008 was 4.47%.
(5) 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.
(6) 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 June 30, 2008,
we were in compliance with these loan covenants.
- 20 -
At June 30, 2008, our debt to total market capitalization ratio, which is
computed as our total debt outstanding divided by the sum of total debt
outstanding plus the market value of common stock (based upon the closing price
of $10.96 per share on June 30, 2008) on a fully diluted basis, including the
conversion of all O.P. units into common stock, was approximately 23.3%. On June
30, 2008, the last trading day in the quarter, total market capitalization was
approximately $1.50 billion.
At June 30, 2008, the outstanding balance remaining under certain notes that we
owed to the operating partnerships was approximately $2.0 million. The due date
of these notes has been extended to September 30, 2009. 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 SIX MONTHS ENDED JUNE 30, 2008 WITH THE SIX MONTHS ENDED JUNE
30, 2007
Net cash provided by operating activities for the six months ended June 30, 2008
was approximately $19.9 million compared with $24.4 million for the same period
in 2007. Cash flow decreases came primarily from lower rental and lease
termination fee income, a forfeited deposit under a contract for the sale of
property in 2007 that did not recur in 2008, and insurance premiums that were
paid in full for the entire year 2008 instead of through installment payments as
in 2007.
Net cash used in investing activities was approximately $22.4 million and $1.8
million for the six months ended June 30, 2008 and 2007, respectively. Cash used
in investing activities during the six months ended June 30, 2008 related
principally to the acquisition of one R&D property at 5981 Optical Court in San
Jose, California and one R&D property at 2904 Orchard Parkway in San Jose,
California for a total of approximately $35.8 million. The acquisition at 2904
Orchard Parkway was completed as a tax-deferred exchange transaction involving
our former R&D property at 1170 Morse Avenue in Sunnyvale, California. The
remaining excess restricted cash of approximately $7.7 million was transferred
to our general cash account. Capital expenditures for real estate improvements
were approximately $2.3 million for the six months ended June 30, 2008.
Net cash used in investing activities during the six months ended June 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 for approximately
$15.4 million. All three acquisitions were 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 $2.4 million for the six months
ended June 30, 2007.
Net cash used in financing activities was approximately $20.4 million for the
six months ended June 30, 2008 compared with approximately $17.4 million for the
six months ended June 30, 2007. During the first six months of 2008, we financed
approximately $22.4 million in short-term debt, received approximately $8.2
million from our line of credit, received approximately $0.7 million from stock
option exercises, paid approximately $26.2 million towards outstanding debt,
paid approximately $7.0 million of dividends to common stockholders and paid
approximately $18.5 million to minority interests for distributions in excess of
earnings. During the same period in 2007, we paid approximately $5.4 million
towards outstanding debt, paid approximately $6.3 million of dividends to common
stockholders and paid approximately $5.7 million to minority interests for
distributions in excess of earnings.
Under the condensed consolidated statement of cash flows in the quarterly report
on Form 10Q for the quarterly period ended June 30, 2007, filed on August 8,
2007, an inadvertent error was discovered under "supplemental information." The
cash paid for interest for the six months ended June 30, 2007 should have been
reported at approximately $10.4 million. The reported amount of approximately
$4.2 million represented the cash paid for interest for the three months ended
June 30, 2007.
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 with other REITs because FFO is generally recognized
as the industry standard for reporting the operations
- 21 -
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 neither be
considered as an alternative for net income as a measure of profitability nor is
it comparable to cash flows provided by operating activities determined in
accordance with GAAP, nor is FFO necessarily indicative of funds available to
meet our cash needs, including the need to make cash distributions to satisfy
REIT requirements. For example, FFO is not adjusted for payments of debt
principal required under our debt service obligations.
Our definition of FFO also assumes conversion at the beginning of the period of
all convertible securities, including minority interests 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 six months ended June 30, 2008 and 2007, as reconciled to
net income to common stockholders, are summarized in the following table:
Three Months Ended June 30, Six Months Ended June 30,
----------------------------------------- -----------------------------------------
2008 2007 2008 2007
------------------ ------------------ ------------------ ------------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders $ 1,359 $ 2,004 $ 3,241 $ 5,379
Add:
Minority interests (1) 5,415 7,922 12,543 21,677
Depreciation and amortization of real estate (2) 6,275 6,028 12,488 12,803
------------------ ------------------ ------------------ ------------------
FFO $13,049 $15,954 $28,272 $39,859
================== ================== ================== ==================
(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 $63 and $117
for the three months ended June 30, 2008 and 2007, respectively, and $174
and $241 for the six months ended June 30, 2008 and 2007, 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 for the three months ended June 30, 2008 and 2007, and
$379 for the six months ended June 30, 2008 and 2007. Also includes our
amortization of leasing commissions of approximately $404 and $384 for the
three months ended June 30, 2008 and 2007, respectively, and $805 and $760
for the six months ended June 30, 2008 and 2007, respectively. Amortization
of leasing commissions is included in the property operating, maintenance
and real estate taxes line item in the our condensed consolidated
statements of operations.
The decrease in FFO year-over-year was primarily due to lower rental and lease
termination fee income in 2008.
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 ability to refinance maturing debt obligations;
- 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; o the annual distribution requirements
under the REIT provisions of the federal income tax laws; and
- such other factors as the board of directors deems relevant.
We cannot assure you that we will be able to meet or maintain our cash
distribution objectives.
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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 June 30, 2008. 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 June 30, 2008 will be paid according to scheduled principal
payments and that we will not prepay any of the outstanding principal balance.
For variable rate debt, the table presents the assumption that the outstanding
principal balance at June 30, 2008 will be paid upon maturity.
Six Months Year Ending December 31,
Remaining ----------------------------------------------
2008 2009 2010 2011 2012 Thereafter Total Fair Value
------------------------------------------------------------------------------------------------
(dollars in thousands)
Fixed Rate Debt:
Secured notes payable $115,842 $9,561 $10,105 $10,681 $11,032 $183,777 $340,998 $444,096
Weighted average interest rate 5.85% 5.85% 5.85% 5.85% 5.85% 5.85%
Variable Rate Debt:
Unsecured debt $ 1,923 $8,244 - - - - $ 10,167 $ 10,167
Weighted average interest rate 4.47% 4.26%
The primary market risks we face are interest rate fluctuations. As a result, we
pay lower rates of interest in periods of decreasing interest rates and higher
rates of interest in periods of increasing interest rates. We had no interest
rate caps or interest rate swap contracts at June 30, 2008. The only variable
debt that we had as of June 30, 2008 was approximately $10.2 million owed to the
Heritage Bank of Commerce and Berg Group. This represented approximately 2.9% of
the total $351.2 million of outstanding debt as of June 30, 2008. All of our
debt is denominated in United States dollars.
The following discussion of market risk is based solely on a possible
hypothetical change in future market conditions related to our variable-rate
debt. It includes "forward-looking statements," as previously defined, regarding
market risk, but we are not forecasting the occurrence of these market changes.
Based on the amount of variable debt outstanding as of June 30, 2008, a 1%
increase or decrease in interest rates on our approximately $10.2 million of
floating rate debt would decrease or increase, respectively, six months earnings
and cash flows by approximately $51,000, as a result of the increased or
decreased interest expense associated with the change in rate, and would not
have an impact on the fair value of the floating rate debt. This amount is
determined by considering the impact of hypothetical interest rates on our
borrowing cost. Due to the uncertainty of fluctuations in interest rates and the
specific actions that might be taken by us to mitigate such fluctuations and
their possible effects, the foregoing sensitivity analysis assumes no changes to
our financial structure.
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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 June 30, 2008.
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 9 - 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 annual report on Form 10-K for the year
ended December 31, 2007 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a) The 2008 Annual Meeting of Stockholders of the Company was held on May
22, 2008 in which proxies representing 18,874,162 shares of common
stocks, or 96.0% of the total outstanding shares, were present and
voted.
b) At the 2008 Annual Meeting of Stockholders, Carl E. Berg, William A.
Hasler, Lawrence B. Helzel, Raymond V. Marino and Martin S. Roher were
elected as directors for the ensuing year, all of whom were serving on
the board of directors at the time of the meeting, except for Martin
S. Roher who was newly elected in 2008.
c) The following proposals were voted upon at the meeting:
Proposal No. 1: Election of Directors
Total Vote for Each Total Vote Withheld
Directors Director from Each Director Total Abstentions
---------------------------- ---------------------- ---------------------- ----------------------
Carl E. Berg 17,891,578 982,584 -
William A. Hasler 18,283,601 590,561 -
Lawrence B. Helzel 18,312,370 561,792 -
Raymond V. Marino 18,696,539 177,623 -
Martin S. Roher 18,748,625 125,537 -
Proposal No. 2: Ratification of the selection of the accounting firm of Burr,
Pilger & Mayer, LLP as the Company's independent registered public accounting
firm for the year ending December 31, 2008. There were 18,844,451 votes in favor
of the proposal, 12,369 votes against the proposal and 17,341 abstentions.
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: August 7, 2008 By: /s/ Carl E. Berg
----------------------------------------
Carl E. Berg
Chief Executive Officer
Date: August 7, 2008 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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