UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Amendment No. 1
Form 10-Q/A
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
COMMISSION FILE NUMBER 1-8383
Mission West Properties, Inc.
(Exact name of registrant as specified in its charter)
Maryland 95-2635431
-------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
10050 Bandley Drive
Cupertino, California 95014-2188
(Address of principal executive offices)
Registrant's telephone number, including area code is (408) 725-0700
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
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:
18,421,291 shares outstanding as of November 4, 2005
Mission West Properties, Inc.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2005
INDEX
PAGE
PART I FINANCIAL INFORMATION ----
Item 1. Financial Statements:
Consolidated Balance Sheets as of September 30, 2005 (unaudited)
and December 31, 2004 ..................................................................................2
Consolidated Statements of Operations for the
three and nine months ended September 30, 2005 and 2004 (unaudited).....................................3
Consolidated Statements of Cash Flows for the
nine months ended September 30, 2005 and 2004 (unaudited)...............................................4
Notes to Consolidated Financial Statements (unaudited)..................................................5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................................................................11
Item 3. Quantitative and Qualitative Disclosures about Market Risk.............................................24
Item 4. Controls and Procedures................................................................................25
PART II OTHER INFORMATION
Item 1. Legal Proceedings......................................................................................26
Item 6. Exhibits...............................................................................................26
EXHIBITS
Exhibit 31.1 - Certification Pursuant to Rule 13a-14 of the
Securities Exchange Act of 1934
Exhibit 31.2 - Certification Pursuant to Rule 13a-14 of the
Securities Exchange Act of 1934
Exhibit 31.3 - Certification Pursuant to Rule 13a-14 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
SIGNATURES...........................................................................................................27
- 1 -
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
MISSION WEST PROPERTIES, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
(unaudited)
---------
September 30, 2005 December 31, 2004
--------------------- ----------------------
ASSETS (A)
Real estate assets, at cost:
Land $ 273,933 $ 273,663
Buildings and improvements 766,209 770,757
Real estate related intangible assets 17,410 18,284
--------------------- ----------------------
Total investments in properties 1,057,552 1,062,704
Less accumulated depreciation and amortization (124,670) (110,062)
Assets held for sale, net of accumulated depreciation of $1,770 and $1,578
at 9/30/05 and 12/31/04, respectively 14,245 8,221
--------------------- ----------------------
Net investments in properties 947,127 960,863
Cash and cash equivalents 40,443 1,519
Restricted cash 1,551 1,551
Deferred rent receivable, net of $2,000 allowance at 9/30/05 and 12/31/04 19,302 18,511
Investment in unconsolidated joint venture 3,472 3,559
Other assets, net of accumulated amortization of $7,317 and $5,667
at 9/30/05 and 12/31/04, respectively 24,812 19,653
--------------------- ----------------------
Total assets $1,036,707 $1,005,656
===================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Mortgage notes payable $ 359,891 $ 292,822
Mortgage notes payable (related parties) 10,146 10,420
Line of credit (related parties) - 9,560
Revolving line of credit - 24,208
Interest payable 327 327
Security deposits 8,434 8,544
Deferred rental income 11,691 11,038
Liabilities related to assets held for sale 80 14
Dividend/distribution payable 16,727 16,718
Accounts payable and accrued expenses 10,971 6,704
--------------------- ----------------------
Total liabilities 418,267 380,355
--------------------- ----------------------
Commitments and contingencies
Minority interests 503,769 512,089
--------------------- ----------------------
Stockholders' equity:
Preferred stock, $.001 par value, 20,000,000 shares authorized,
none issued and outstanding - -
Common stock, $.001 par value, 200,000,000 shares authorized,
18,367,691 and 18,097,191 shares issued and outstanding
at 9/30/05 and 12/31/04, respectively 18 18
Paid-in-capital 137,217 134,539
Accumulated deficit (22,564) (21,345)
--------------------- ----------------------
Total stockholders' equity 114,671 113,212
--------------------- ----------------------
Total liabilities and stockholders' equity $1,036,707 $1,005,656
===================== ======================
The accompanying notes are an integral part of these consolidated
financial statements.
(A) Derived from the Company's 2004 audited consolidated financial statements.
- 2 -
MISSION WEST PROPERTIES, INC
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except share and per share amounts)
(unaudited)
---------
Three months ended September 30, Nine months ended September 30,
2005 2004 2005 2004
-------------------- ------------------- -------------------- -------------------
Revenues:
Rental revenue from real estate $24,692 $29,494 $76,043 $90,526
Tenant reimbursements 4,031 3,740 11,254 11,623
Other income, including lease terminations,
settlements and interest 426 396 3,018 5,401
-------------------- ------------------- -------------------- -------------------
Total revenues 29,149 33,630 90,315 107,550
-------------------- ------------------- -------------------- -------------------
Expenses:
Property operating, maintenance and real estate taxes 5,301 4,805 14,101 15,241
Interest 5,494 4,468 16,046 13,051
Interest (related parties) 229 256 779 760
General and administrative 424 395 1,542 1,628
Depreciation and amortization of real estate 5,268 5,269 16,005 16,168
-------------------- ------------------- -------------------- -------------------
Total expenses 16,716 15,193 48,473 46,848
-------------------- ------------------- -------------------- -------------------
Income before equity in earnings of unconsolidated
joint venture and minority interests 12,433 18,437 41,842 60,702
Equity in earnings of unconsolidated joint venture 291 345 677 1,564
Minority interests (10,551) (15,590) (35,172) (51,757)
-------------------- ------------------- -------------------- -------------------
Income from continuing operations 2,173 3,192 7,347 10,509
-------------------- ------------------- -------------------- -------------------
Discontinued operations, net minority interests:
Gain from disposal of discontinued operations 291 - 305 -
(Loss) attributable to discontinued operations (13) (19) (98) (18)
-------------------- ------------------- -------------------- -------------------
Income/(loss) from discontinued operations 278 (19) 207 (18)
-------------------- ------------------- -------------------- -------------------
Net income to common stockholders $ 2,451 $ 3,173 $ 7,554 $10,491
==================== =================== ==================== ===================
Net income to minority interests $11,541 $15,488 $35,823 $51,596
==================== =================== ==================== ===================
Income per share from continuing operations:
Basic $0.12 $0.18 $0.40 $0.58
==================== =================== ==================== ===================
Diluted $0.12 $0.18 $0.40 $0.58
==================== =================== ==================== ===================
Income per share from discontinued operations:
Basic $0.01 - $0.01 -
==================== =================== ==================== ===================
Diluted $0.01 - $0.01 -
==================== =================== ==================== ===================
Net income per share to common stockholders:
Basic $0.13 $0.18 $0.41 $0.58
==================== =================== ==================== ===================
Diluted $0.13 $0.18 $0.41 $0.58
==================== =================== ==================== ===================
Weighted average shares of
common stock outstanding (basic) 18,356,278 18,071,484 18,242,495 18,019,277
==================== =================== ==================== ===================
Weighted average shares of
common stock outstanding (diluted) 18,407,891 18,098,174 18,289,699 18,077,854
==================== =================== ==================== ===================
The accompanying notes are an integral part of these
consolidated financial statements.
- 3 -
MISSION WEST PROPERTIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
---------
Nine months ended September 30,
2005 2004
------------------- -------------------
Cash flows from operating activities:
Net income $ 7,554 $ 10,491
Adjustments to reconcile net income to net cash provided by operating activities:
Income allocated to minority interests, including discontinued operations 35,823 51,596
Depreciation and amortization of real estate and in place leases 16,005 16,167
Depreciation and amortization from discontinued operations 316 477
Amortization of above market rent intangible asset 1,416 1,416
Gain on sale of real estate (1,408) -
Equity in earnings of unconsolidated joint venture (677) (1,564)
Distributions from unconsolidated joint venture 765 1,418
Changes in operating assets and liabilities, net of liabilities assumed:
Deferred rent receivable (791) (141)
Other assets (5,159) 1,608
Interest payable - (2)
Security deposits (110) (1,477)
Deferred rental income 653 (1,101)
Accounts payable and accrued expenses 4,346 3,479
------------------- -------------------
Net cash provided by operating activities 58,733 82,367
------------------- -------------------
Cash flows from investing activities:
Improvements to real estate assets (871) (371)
Net proceeds from sales of real estate 12,447 -
Purchase of real estate (14,184) -
------------------- -------------------
Net cash used in investing activities (2,608) (371)
------------------- -------------------
Cash flows from financing activities:
Proceeds from mortgage loan 150,800 -
Principal payments on mortgage notes payable (5,021) (4,574)
Principal payments on mortgage notes payable (related parties) (274) (254)
Net payments under line of credit (related parties) (9,560) (5,118)
Payment on mortgage loan payable (78,710) -
Net payments under revolving line of credit (24,208) -
Proceeds from revolving line of credit - 2,527
Restricted cash - (1,551)
Proceeds from stock options exercised 480 165
Minority interest distributions (41,979) (62,769)
Dividends (8,729) (12,954)
------------------- -------------------
Net cash used in financing activities (17,201) (84,528)
------------------- -------------------
Net increase/(decrease) in cash and cash equivalents 38,924 (2,532)
Cash and cash equivalents, beginning of period 1,519 4,129
------------------- -------------------
Cash and cash equivalents, end of period $ 40,443 $ 1,597
=================== ===================
Supplemental information:
Cash paid for interest $ 16,471 $ 13,602
=================== ===================
Supplemental schedule of non-cash investing and financing activities:
Issuance of common stock upon conversion of O.P. units $ 2,197 $ 2,047
=================== ===================
The accompanying notes are an integral part of these
consolidated financial statements.
- 4 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
1. ORGANIZATION AND FORMATION OF THE COMPANY
Mission West Properties, Inc. ("the Company") is a fully integrated,
self-administered and self-managed real estate company that acquires and
manages R&D/office properties in the portion of the San Francisco Bay Area
commonly referred to as Silicon Valley. In July 1998, the Company purchased
an approximate 12.11% of four existing limited partnerships (referred to
collectively as the "operating partnerships") and obtained control of these
partnerships by becoming the sole general partner in each one effective
July 1, 1998 for financial accounting and reporting purposes. The Company
purchased an approximate 12.11% interest in each of the operating
partnerships. All limited partnership interests in the operating
partnerships were converted into 59,479,633 operating partnership ("O.P.")
units, which represented a limited partnership ownership interest of
approximately 87.89% of the operating partnerships. The operating
partnerships are the vehicles through which the Company holds its real
estate investments, makes real estate acquisitions, and generally conducts
its business.
On December 30, 1998, the Company was reincorporated under the laws of the
State of Maryland through a merger with and into Mission West Properties,
Inc. Accordingly, shares of the former company, Mission West Properties, a
California corporation (no par), which were outstanding at December 30,
1998, were converted into shares of common stock ($.001 par value per
share) on a one-for-one basis.
As of September 30, 2005, the Company owns a controlling general
partnership interest of 17.44%, 21.65%, 16.15% and 12.39% in Mission West
Properties, L.P., Mission West Properties, L.P. I, Mission West Properties,
L.P. II and Mission West Properties, L.P. III, respectively, which
represents a 17.46% general partnership interest in the operating
partnerships, taken as a whole, on a consolidated weighted average basis.
Through the operating partnerships, the Company owns interests in 108 R&D
properties, all of which are located in Silicon Valley.
The Company has elected to be taxed as a real estate investment trust
("REIT") under the Internal Revenue Code of 1986, as amended. Accordingly,
no provision has been made for income taxes for the three and nine months
ended September 30, 2005.
BUSINESS SEGMENT INFORMATION
The Company's primary business is the ownership and management of
R&D/office real estate with a geographic concentration in the Silicon
Valley of the San Francisco Bay Area. Accordingly, the Company has
concluded it currently has a single reportable segment for Statement of
Financial Accounting Standards ("SFAS") No. 131, "Disclosures about
Segments of an Enterprise and Related Information," purposes.
2. BASIS OF PRESENTATION
PRINCIPLES OF CONSOLIDATION AND FINANCIAL STATEMENT PRESENTATION
The accompanying unaudited interim 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 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 consolidated financial statements contain all adjustments,
consisting only of normal recurring adjustments, necessary to present
fairly the Company's consolidated financial position as of September 30,
2005, and its consolidated results of operations for the three and nine
months ended September 30, 2005 and 2004, and its cash flows for the nine
months ended September 30, 2005 and 2004, respectively. All significant
intercompany balances have been eliminated in consolidation. The
consolidated financial statements as of September 30, 2005 and for the
three and nine months ended September 30, 2005 and 2004 and related
footnote disclosures are unaudited. The results of operations for the three
and nine months ended September 30, 2005 are not necessarily indicative of
the results to be expected for the entire year.
The following notes, which present interim disclosures as required by the
SEC, highlight significant changes to the notes to the Company's December
31, 2004 audited consolidated financial statements and should be read
together with the consolidated financial statements and notes thereto
included in the Company's 2004 Form 10-K filed on March 16, 2005.
MINORITY INTERESTS
Minority interest represents the separate private ownership of the
operating partnerships by the Berg Group (defined as Carl E. Berg, his
brother Clyde J. Berg, members of their respective immediate families, and
certain entities they control) and other non-affiliate interests. In total,
these interests account for approximately 82.54% of the ownership interests
in the real estate operations of the Company as of September 30, 2005.
Minority interest in net income is calculated by taking the net income of
the operating partnerships (on a stand-alone basis) multiplied by the
respective minority interest ownership percentage.
- 5 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
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 2004
consolidated financial statements in order to conform to the 2005
presentation.
ACCOUNTING FOR STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but
does not require companies to record compensation cost for stock-based
employee compensation plans at fair value. The Company has chosen to
continue to account for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion ("APB") No. 25,
"Accounting for Stock Issued to Employees" and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess,
if any, of the quoted market price of the Company's stock at the date of
the grant over the amount an employee must pay to acquire the stock.
The following table illustrates the unaudited pro forma effect on
consolidated net income available to common stockholders and consolidated
earnings per share if the fair value method had been applied to all
outstanding and unvested stock options for the three and nine months ended
September 30, 2005 and 2004.
Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
--------------- --------------- --------------- ---------------
(dollars in thousands, except per share data)
Historical net income to common stockholders $2,451 $3,173 $7,554 $10,491
Deduct compensation expense for stock options
determined under fair value based method (51) (44) (110) (132)
Allocation of expense to minority interest 42 36 91 109
--------------- --------------- --------------- ---------------
Pro forma net income to common stockholders $2,442 $3,165 $7,535 $10,468
=============== =============== =============== ===============
Earnings per share - basic:
Historical net income to common stockholders $0.13 $0.18 $0.41 $0.58
Pro forma net income to common stockholders $0.13 $0.18 $0.41 $0.58
Earnings per share - diluted:
Historical net income to common stockholders $0.13 $0.18 $0.41 $0.58
Pro forma net income to common stockholders $0.13 $0.17 $0.41 $0.58
Options were granted to four employees and three directors totaling 710,000
in 2005, which vest monthly for 33 months from date of grant, subject to
continued employment or other service to the Company. Each option grant has
a term of six years from the date of grant subject to earlier termination
in certain events related to termination of employment. The options were
granted at an exercise price of $10.00 per share. The estimated fair value
of the options granted in 2005 was $1.12 per share on the date of grant
using the Black-Scholes option pricing model with the following
assumptions: dividend yield of 6.4%, volatility of 21.97%, risk free rates
of 4.2% and an expected life of six years.
The following table shows the activity and detail for the 2004 Equity
Incentive Plan.
2004 Equity Weighted Average
Incentive Option Price
Plan Per Share
-------------- ----------------
Balance, December 31, 2004 767,000 $11.44
Options granted 710,000 $10.00
Options exercised (55,000) $8.73
Options cancelled -
--------------
Balance, September 30, 2005 1,422,000 $10.83
==============
- 6 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
3. STOCK TRANSACTIONS
During the nine months ended September 30, 2005, stock options to purchase
40,000 shares of common stock were exercised at $8.25 per share and stock
options to purchase 15,000 shares of common stock were exercised at $10.00
per share. Total proceeds to the Company were $480. During the same period,
four limited partners exchanged 215,500 O.P. units for 215,500 shares of
the Company's common stock under the terms of the December 1998 Exchange
Rights Agreement among the Company and all limited partners of the
operating partnerships resulting in a reclassification of $2,197 from
minority interest to paid-in-capital.
4. DISCONTINUED OPERATIONS
Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets," 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 consolidated statements of
operations. Prior period consolidated statements of operations presented in
this report have been reclassified to reflect the income or loss related to
properties that were held for sale or sold and presented as discontinued
operations during the three and nine months ended September 30, 2005.
Additionally, all periods presented in this report will likely require
further reclassification in future periods if additional properties are
held for sale or property sales occur.
As of September 30, 2005, there was one property under contract to be sold
or otherwise disposed of which would qualify as an asset held for sale or
discontinued operation. That property was sold for $15,105 in October 2005.
During the first quarter of 2005, the Company sold two properties for a
combined sales price of $12,750. Condensed results of operations for these
properties for the three and nine months ended September 30, 2005 and 2004
are as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
--------------------------------------------------------------
(dollars in thousands)
(unaudited)
Revenues
Rental revenue from real estate $ - $ 86 $ 14 $ 531
Tenant reimbursements - 26 1 98
Other income - 1 - 3
----------- ------------ ------------ ------------
Total revenues - 113 15 632
----------- ------------ ------------ ------------
Expenses
Property operating, maintenance and real estate taxes - 76 250 335
Depreciation 77 159 316 476
----------- ------------ ------------ ------------
Total expenses 77 235 566 811
----------- ------------ ------------ ------------
(Loss) from discontinued operations (77) (122) (551) (179)
Gain on disposition of property 1,345 - 1,408 -
Minority interest in earnings/(loss) attributable
to discontinued operations (990) 103 (650) 161
----------- ------------ ------------ ------------
Income/(loss) from discontinued operations $ 278 ($ 19) $ 207 ($ 18)
=========== ============ ============ ============
For the three and nine months ended September 30, 2005 and 2004, income
from discontinued operations included results of operations from one asset
held for sale at September 30, 2005 and the two properties that were sold
in the first quarter of 2005.
A deferred gain of approximately $1,408 was recorded on one of the disposed
properties. The gain was recognized as revenue based on the installment
method of profit recognition because the purchaser of the property did not
make a sufficiently large down payment under SFAS No. 66, "Accounting for
Sales of Real Estate" ("SFAS No. 66"). SFAS No. 66 establishes accounting
standards for recognizing profit or loss on sales of real estate. Gain on
the sale is recognized proportionately as the seller receives payments from
the purchaser. Interest income is recognized on an accrual basis, when
appropriate. The Company received the remaining balance of the sales price
from the purchaser in September 2005 and all of the remaining deferred gain
was recognized in the third quarter of 2005. The Company recorded a $63
gain in the first quarter of 2005 and $1,345 gain in the third quarter of
2005.
5. NET INCOME PER SHARE
Basic operating net income per share is computed by dividing net income by
the weighted average number of common shares outstanding for the period.
Diluted operating net income per share is computed by dividing net income
by the sum of the weighted-average number of common shares outstanding for
the period plus the assumed exercise of all dilutive securities using the
treasury stock method.
- 7 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
The computation for weighted average shares is detailed below:
Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (basic) 18,356,278 18,071,484 18,242,495 18,019,277
Incremental shares from assumed option exercise 51,613 26,690 47,204 58,577
--------------- -------------- -------------- ---------------
Weighted average shares outstanding (diluted) 18,407,891 18,098,174 18,289,699 18,077,854
=============== ============== ============== ===============
Outstanding options to purchase 647,000 and 272,000 shares in 2005 and 2004
were excluded from the computation of diluted net income per share under
the treasury stock method because the option exercise price was greater
than the weighted average exercise price of the Company's common stock
during the respective periods. The outstanding O.P. units, which are
exchangeable at the unit holder's option, subject to certain conditions,
for shares of common stock on a one-for-one basis have been excluded from
the diluted net income per share calculation, as there would be no effect
on the calculation after adding the minority interests' share of income
back to net income. The total number of O.P. units outstanding at September
30, 2005 and 2004 was 86,169,195 and 86,404,695, respectively.
6. RELATED PARTY TRANSACTIONS
As of September 30, 2005, the Berg Group owned 77,572,028 O.P. units. The
Berg Group's combined ownership of O.P. units and shares of common stock as
of September 30, 2005 represented approximately 74% of the total equity
interests, assuming conversion of the 86,169,195 O.P. units outstanding
into the Company's common stock.
The Berg Group has extended to the Company a $20,000 line of credit that
bears interest at LIBOR plus 1.30%, or 4.99% as of September 30, 2005, and
matures in March 2006. The Company believes that the terms of the Berg
Group line of credit are more favorable than those available from
commercial lenders. As of September 30, 2005, $0 was due the Berg Group
under the line of credit, and debt in the amount of $10,146 was due the
Berg Group under a mortgage note established on May 15, 2000 in connection
with the acquisition of a 50% interest in Hellyer Avenue Limited
Partnership, the obligor under the mortgage note. The mortgage note bears
interest at 7.65% and is due in June 2010 with principal payments amortized
over 20 years. Interest expense incurred in connection with the Berg Group
line of credit and mortgage note was $229 and $256 for the three months
ended September 30, 2005 and 2004, respectively, and $779 and $760 for the
nine months ended September 30, 2005 and 2004, respectively.
During the first nine months of 2005 and 2004, Carl E. Berg or entities
controlled by Mr. Berg held financial interests in several companies that
lease space from the operating partnerships, which include three companies
in which Mr. Berg has a greater than 10% ownership interest. These related
tenants occupy approximately 48,000 square feet and contributed $160 and
$217 in rental revenue during the three months ended September 30, 2005 and
2004, respectively, and $570 and $650 in rental revenue during the nine
months ended September 30, 2005 and 2004, respectively. Under the Company's
charter, bylaws and agreements with the Berg Group, the individual members
of the Berg Group are prohibited from acquiring or holding shares of the
Company's common stock if such acquisition would result in their beneficial
ownership percentage of the Company's common stock causing the Company to
violate any REIT qualification requirement.
The Berg Group has an approximately $2,500 commitment to complete certain
tenant improvements in connection with the Company's 2002 acquisition of
5345 Hellyer Avenue in San Jose. The Company recorded this portion of the
purchase price paid to the Berg Group as an Other Asset on its Consolidated
Balance Sheets. The Berg Group plans to satisfy this commitment to complete
certain tenant improvements when requested by the Company following the
approval of the Independent Directors Committee of the Company's board of
directors (the "Independent Directors Committee").
The Berg Group has an approximately $7,500 commitment to complete an
approximately 75,000 to 90,000 square foot building in connection with the
Company's 2001 acquisition of 245 Caspian in Sunnyvale which is comprised
of approximately three acres of unimproved land. The Company recorded this
portion of the purchase price paid to the Berg Group as an Other Asset on
its Consolidated Balance Sheets. The Berg Group plans to satisfy this
commitment to construct a building when requested by the Company following
the approval of the Independent Directors Committee.
The Company currently leases office space owned by Berg & Berg Enterprises,
Inc., an affiliate of Carl E. Berg and Clyde J. Berg. Rental amounts and
overhead reimbursements paid to Berg & Berg Enterprises, Inc. were $23 for
each of the three-month periods ended September 30, 2005 and 2004 and $68
for each of the nine-month periods ended September 30, 2005 and 2004.
7. COMMITMENTS AND CONTINGENCIES
Neither the operating partnerships, the Company's properties nor the
Company are subject to any material litigation nor, to the Company's
knowledge, is any material litigation threatened against the operating
partnerships, the properties or the Company. From
- 8 -
MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
time to time, the Company is engaged in legal proceedings arising in the
ordinary course of business. The Company does not expect any of such
proceedings to have a material adverse effect on its cash flows, financial
condition or results of operations. The Company is currently involved in
the following legal proceedings, and does not believe the ultimate outcome
of any of these proceedings will have a material adverse effect on its
financial condition or operating results.
Republic Properties Corporation ("RPC") v. Mission West Properties, L.P.
("MWP"), in the Circuit Court of Maryland for Baltimore City Case No.
24-C-00-005675. RPC is a former partner with Mission West Properties, L.P.
in the Hellyer Avenue Limited Partnership ("Hellyer LP"). In April 2004,
the Circuit Court for Baltimore City, Maryland issued a Memorandum Opinion
in the case and awarded damages of approximately $934 to the RPC
plaintiffs, which represented a liability of the Company or MWP. The
Company has a receivable from a Berg Group affiliate for the amount of
distributions it received as the successor to RPC's interest in the Hellyer
LP, which exceeds the amount of the damages awarded to the RPC parties and
would be used to pay those damages in the event the decision of the Circuit
Court is upheld ultimately. The Company has never accounted for the 50%
interest in Hellyer LP that is claimed by RPC as an asset of the Company.
In February 2001, the Company filed a suit against RPC in Superior Court of
the State of California for the County of Santa Clara Case No. CV 796249
which was stayed pending resolution of the Maryland case. In March 2005,
the Company voluntarily dismissed its California suit. On March 1, 2005,
the Maryland Appeals Court ruled in favor of Mission West Properties, L.P.,
finding that the Circuit Court of Maryland lacked personal jurisdiction
over MWP. In April 2005, the decision of the Maryland Appeals Court became
final, and the Company obtained a court order for the release of a $1,551
bond, which it posted to remove an attachment order issued to RPC. In April
2005, RPC submitted a motion to the Superior Court of the State of
California effectively asking the court to prevent MWP from dismissing the
previously dismissed California suit. In July 2005, the Maryland Supreme
Court agreed to hear an appeal filed by RPC, which is scheduled to occur in
December 2005.
In January 2004, the Global Crossing Estate Representative, for itself and
the Liquidating Trustee of the Global Crossing Liquidating Trust v. Mission
West Properties filed an action in United States Bankruptcy Court Southern
District of New York Case No. 02-40188 (REG) asserting that payments of
approximately $815 made in the ordinary course of business within 90 days
of the Global Crossing bankruptcy filing were preference payments. The
Company has engaged legal counsel to defend itself in this claim and intend
to vigorously contest the matter. On February 9, 2005, the Court held a
hearing to consider the objection filed with respect to Mission West
Properties' claim. In April 2005, the Company filed a motion for summary
judgment in the United States Bankruptcy Court Southern District of New
York requesting the Court to dismiss the preference claim. The motion for
summary judgment was denied. Discovery continues by both parties and no
trial date has been set.
GUARANTEES AND INDEMNITIES
Under its articles of incorporation and bylaws, the Company has agreed to
indemnify its officers and directors for certain events or occurrences
arising as a result of the officer or director's serving in such capacity.
The maximum potential amount of future payments the Company could be
required to make under these indemnification agreements is unlimited. The
Company believes the estimated fair value of these indemnification
agreements is minimal and has recorded no liabilities for these agreements
as of September 30, 2005.
The Company also enters into indemnification provisions under its
agreements with other companies in the ordinary course of business,
typically with lenders, joint venture partners, contractors, and tenants.
Under these provisions the Company typically agrees to indemnify and hold
harmless the indemnified party for losses suffered or incurred by the
indemnified party as a result of certain kinds of activities or inactions
of the Company. These indemnification provisions generally survive
termination of the underlying agreement. The maximum potential amount of
future payments the Company could be required to make under these
indemnification provisions is unlimited. To date, the Company has not
incurred material costs to defend lawsuits or settle claims related to
these indemnification agreements. As a result, the Company believes the
estimated fair value of these agreements is minimal. Accordingly, the
Company has recorded no liabilities for these agreements as of September
30, 2005.
SEISMIC ACTIVITY
The Company's properties are located in an active seismic area of Silicon
Valley. Insurance policies currently maintained by the Company do not cover
seismic activity, although they do cover losses from fires after an
earthquake.
ENVIRONMENTAL ISSUES
The environmental investigations that have been conducted on the Company's
properties have not revealed any environmental liability that the Company
believes would have a material adverse effect on its financial condition,
results of operations and assets, and the Company is not aware of any such
liability. Nonetheless, it is possible that there are material
environmental liabilities of which the Company is unaware. In addition, the
Company cannot assure that future laws, ordinances, or regulations will not
impose any material environmental liability, or that the current
environmental condition of the properties has not been, or will not be,
affected by tenants and occupants of the properties, by the condition of
properties in the vicinity of the properties, or by third parties unrelated
to the Company.
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MISSION WEST PROPERTIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(dollars in thousands, except share, per share, O.P. units and
per square footage amounts)
(unaudited)
BERG LAND HOLDINGS OPTION AGREEMENT
On April 27, 2005, the Berg Group disclosed the receipt of an offer from an
unrelated party to purchase a portion of the Piercy & Hellyer land
comprised of approximately 10 acres in San Jose, California that is subject
to the Berg Land Holdings Option Agreement with the Company. The
prospective purchaser has disclosed its intention to develop "for sale"
industrial type buildings. In light of the overcapacity in the market and
the Company's current inventory of available buildings for lease in this
submarket, the Independent Directors Committee, which is responsible for
reviewing, evaluating and authorizing action with respect to any
transaction between us and any member of the Berg Group, has authorized
removal of this approximately 10 acre parcel of land from the scope of the
Berg Land Holdings Option Agreement, subject to the completion of the sale
to the unrelated party. In making this determination, the Independent
Directors Committee considered a number of factors, including risks and
other potentially adverse consequences that could be associated with
acquiring undeveloped land for future development. In the event this parcel
of land is not sold to this prospective purchaser, the parcel would not be
deemed to be removed from the scope of the Berg Land Holdings Option
Agreement and would remain eligible for potential future acquisition by the
Company, under the Berg Land Holdings Option Agreement.
8. MORTGAGE NOTES PAYABLE AND OTHER DEBT
The following information is an update of mortgage notes payable obtained
during the second quarter of 2005 and other debt transactions that occurred
during the third quarter of 2005. For additional details regarding the
Company's mortgage notes payable and other debt outstanding as of September
30, 2005, see Item 2, "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Debt."
ALLIANZ LOAN I
On April 6, 2005, the Company obtained a $25,800 secured mortgage loan from
Allianz Life Insurance Company of North America ("Allianz Loan I"). The
Allianz Loan I originally matures on April 10, 2020 and must be paid in
full at that time unless payment is accelerated by reason of a default or
sale of the property that secures the loan. The Company paid approximately
$251 in loan fees and financing costs, which are being amortized over the
20 year amended loan period, and used the proceeds primarily to pay down
short-term debt and the Berg Group line of credit. On July 26, 2005, in
connection with the Allianz Loan II, the Company entered into a "Loan
Modification Agreement" with Allianz, which extended the amortization
period and maturity date of the Allianz Loan I from April 10, 2020 to
August 10, 2025. This loan bears a fixed interest rate of 5.56% and
principal payments are amortized over 20 years. The mortgage loan is
secured by one property.
ALLIANZ LOAN II
On July 27, 2005, the Company obtained a $125,000 secured mortgage loan
from Allianz Life Insurance Company of North America ("Allianz Loan II").
The Allianz Loan II matures on August 10, 2025, and must be paid in full at
that time, unless payment is accelerated by reason of a default or sale of
any property that secures the loan. This loan bears a fixed interest rate
of 5.22% and principal payments are amortized over 20 years. The mortgage
loan is secured by eight properties. The Company paid approximately $838 in
loan fees and financing costs, which are being amortized over the 20 year
loan period, and used the proceeds primarily to pay down short-term debt
and the Berg Group line of credit.
CUPERTINO NATIONAL BANK LINE OF CREDIT
The Company entered into a "Change in Terms Agreement" with Cupertino
National Bank ("CNB") on July 22, 2005, which reduced the maximum borrowing
amount on the Company's revolving line of credit facility with that bank
from $40,000 to $9,000.
9. SUBSEQUENT EVENTS
On October 6, 2005, the Company paid dividends of $0.16 per share of common
stock to all common stockholders of record as of September 30, 2005. On the
same date, the operating partnerships paid a distribution of $0.16 per O.P.
unit to all holders of O.P. units.
On October 12, 2005, the Company completed the sale of a 239,000 rentable
square foot R&D property at 800 Embedded Way, San Jose, California. A gain
of approximately $800 will be recognized in the fourth quarter of 2005 on
the total sales price of $15,105.
On October 26, 2005, the Independent Directors Committee of the Board of
Directors of the Company approved the termination of the $20,000 line of
credit agreement between the Company and the Berg Group (as defined in the
Company's previously filed periodic reports), effective October 31, 2005.
The Berg Group line of credit was originally scheduled to mature in March
2006. Based on existing cash reserves and credit facilities, the Company
has determined that it no longer foresees a need for the Berg Group line of
credit. There are no borrowings currently outstanding under the Berg Group
line of credit. The Company will not incur any fees or charges for
terminating the Berg Group line of credit.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the accompanying consolidated
financial statements and notes thereto contained herein and our consolidated
financial statements and notes thereto contained in our Annual Report on Form
10-K as of and for the year ended December 31, 2004. The results for the three
and nine months ended September 30, 2005 are not necessarily indicative of the
results to be expected for the entire fiscal year ending December 31, 2005. The
following discussion includes forward-looking statements, including but not
limited to, statements with respect to our future financial performance,
operating results, plans and objectives. Actual results may differ materially
from those currently anticipated depending upon a variety of factors, including
those described under the sub-heading, "Forward-Looking Information."
FORWARD-LOOKING INFORMATION
This quarterly report contains forward-looking statements within the meaning of
the federal securities laws. We intend such forward-looking statements to be
covered by the safe harbor provisions for forward-looking statements contained
in the Private Securities Reform Act of 1995, and 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 include, but are not limited to, the following:
- economic conditions generally and the real estate market specifically,
- legislative or regulatory provisions (including changes to laws
governing the taxation of REITs),
- availability of capital,
- interest rates,
- competition,
- supply of and demand for R&D, office and industrial properties in our
current and proposed market areas,
- tenant defaults and bankruptcies,
- lease term expirations and renewals, and
- changes in general accounting principles, policies and guidelines
applicable to REITs.
In addition, the actual timing of development, construction, and leasing on any
projects that we believe we may acquire in the future under the Berg Land
Holdings Option Agreement is presently unknown, and reliance should not be
placed on estimates concerning these projects. These risks and uncertainties,
together with the other risks described from time to time in our reports and
other documents filed with the Securities and Exchange Commission, should be
considered in evaluating forward-looking statements and undue reliance should
not be placed on such statements.
OVERVIEW
We acquire, market, lease, and manage R&D/office properties, primarily located
in the Silicon Valley portion of the San Francisco Bay Area. As of September 30,
2005, we owned and managed 108 properties totaling approximately 8.0 million
rentable square feet through four limited partnerships, or operating
partnerships, for which we are the sole general partner. This class of property
is designed for research and development and office uses and, in some cases,
includes space for light manufacturing operations with loading docks. We believe
that we have one of the largest portfolios of R&D/office properties in the
Silicon Valley. As of September 30, 2005, the six tenants who each leased in
excess of 300,000 rentable square feet from us were Microsoft Corporation,
Fujitsu America (a subsidiary of Fujitsu Limited), JDS Uniphase Corporation, NEC
Electronics America, Inc. (a subsidiary of NEC Electronics Corporation), Ciena
Corporation and Apple Computer, Inc. For federal income tax purposes, we have
operated as a self-managed, self-administered and fully integrated real estate
investment trust ("REIT") since fiscal 1999.
Our acquisition, growth and operating strategy incorporates the following
elements:
- working with the Berg Group to take advantage of their abilities and
resources to pursue development opportunities which we have an option
to acquire, on pre-negotiated terms, upon completion and leasing;
- capitalizing on opportunistic acquisitions from third parties of
high-quality R&D/office properties that provide attractive initial
yields and significant potential for growth in cash-flow;
- focusing on general purpose, single-tenant Silicon Valley R&D/office
properties for information technology companies in order to maintain
low operating costs, reduce tenant turnover and capitalize on our
relationships with these companies and our extensive knowledge of
their real estate needs; and
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- maintaining prudent financial management principles that emphasize
current cash flow while building long-term value, the acquisition of
pre-leased properties to reduce development and leasing risks and the
maintenance of sufficient liquidity to acquire and finance properties
on desirable terms.
CURRENT ECONOMIC ENVIRONMENT
All of our properties are located in the Northern California area known as
Silicon Valley, which generally consists of portions of Santa Clara County,
Southwestern Alameda County, Southeastern San Mateo County and Eastern Santa
Cruz County. The Silicon Valley R&D property market has historically fluctuated
with the local economy. The Silicon Valley economy and business activity have
slowed markedly since 2001 after fast-paced growth in 1999 and 2000. According
to a recent report by NAI BT Commercial Real Estate, the vacancy rate for
Silicon Valley R&D property was approximately 22.4% in late 2004 and 20.6% at
the end of the third quarter of 2005. Total vacant R&D square footage in Silicon
Valley at the end of the third quarter of 2005 amounted to 31.8 million square
feet, of which 23.0%, or 7.3 million square feet, was being offered under
subleases. Total negative net absorption (which is the computation of gross
square footage leased less gross new square footage vacated for the period
presented) in 2004 amounted to approximately (0.3) million square feet. During
the first nine months of 2005, there was total positive net absorption of
approximately 2.1 million square feet. Average asking market rent per square
foot at the end of the third quarter of 2005 remained the same at $0.88 compared
to late 2004, although individual properties within any particular submarket
presently may be leased above or below the current average asking market rental
rates within that submarket. The Silicon Valley R&D property market has been
characterized by a substantial number of submarkets, with rent and vacancy rates
varying by submarket and location within each submarket.
Our occupancy rate at September 30, 2005 was 67.5% compared to 69.0% at
September 30, 2004. We believe that our occupancy rate could decline further
going forward if key tenants seek the protection of bankruptcy laws, consolidate
operations or discontinue operations. In addition, leases with respect to
approximately 558,000 rentable square feet are expiring prior to the end of
2006. The properties subject to these leases may take anywhere from 24 to 36
months or longer to re-lease. We believe that the average 2006 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.
In order to meet market conditions, we have been, and expect to continue leasing
less than the entire premises of some of our R&D properties to a single tenant
from time to time. Leasing our R&D properties, which generally have been built
for single tenant occupancy, to multiple tenants can increase our leasing costs
and operating expenses and reduce the profitability of our leasing activities.
If we are unable to lease a significant portion of any vacant space or space
subject to expiring leases; if we experience significant tenant defaults as a
result of the current economic downturn; if we are not able to lease space at or
above current market rates; if we restructure existing leases and lower existing
rents in order to retain tenants for an extended term; or if we increase our
lease costs and operating expenses substantially to accommodate multiple tenants
in our R&D properties, our results of operations and cash flows will be
adversely affected. Furthermore, in this event it is probable that our board of
directors will reduce the quarterly dividend on the common stock and the
outstanding O.P. units. Our operating results and ability to pay dividends at
current levels remain subject to a number of material risks, as indicated under
the caption "Forward-Looking Information" above and in the section entitled
"Risk Factors" in our most recent annual report on Form 10-K.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We prepare the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP"), which
requires us to make certain estimates, judgments and assumptions that affect the
reported amounts in the accompanying consolidated financial statements,
disclosure of contingent assets and liabilities and related footnotes.
Accounting and disclosure decisions with respect to material transactions that
are subject to significant management judgments or estimates include impairment
of long lived assets, deferred rent reserves, and allocation of purchase price
relating to property acquisitions and the related depreciable lives assigned.
Actual results may differ from these estimates under different assumptions or
conditions.
Critical accounting policies are defined as those that require management to
make estimates, judgments and assumptions, giving due consideration to
materiality, in certain circumstances that affect amounts reported in the
consolidated financial statements, and potentially result in materially
different results under different conditions and assumptions. We believe that
the following best describe our critical accounting policies:
BUSINESS COMBINATIONS. Statement of Financial Accounting Standards No. 141,
"Business Combinations" ("SFAS No. 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
No. 141 are based on an allocation of the acquisition cost to land, building,
tenant improvements, and intangibles for at market, including lease origination
and lease up period costs, and above market in place leases, and the
determination of their useful lives are guided by a combination of SFAS No. 141
and management's estimates. If we do not appropriately allocate these
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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 No. 144"). If the
carrying amount of the asset exceeds its estimated undiscounted net cash flow,
before interest, we will recognize an impairment loss equal to the difference
between its carrying amount and its estimated fair value. If impairment is
recognized, the reduced carrying amount of the asset will be accounted for as
its new cost. For a depreciable asset, the new cost will be depreciated over the
asset's remaining useful life. Generally, fair values are estimated using
discounted cash flow, replacement cost or market comparison analyses. The
process of evaluating for impairment requires estimates as to future events and
conditions, which are subject to varying market factors, such as the vacancy
rates, future rental rates, lease periods, deferred maintenance and operating
costs for R&D facilities in the Silicon Valley area and related submarkets.
Therefore, it is reasonably possible that a change in estimate resulting from
judgments as to future events could occur which would affect the recorded
amounts of the property.
ALLOWANCE FOR DOUBTFUL ACCOUNTS AND DEFERRED RENT. We must estimate the
uncollectibility of our accounts receivable based on the evaluation of our
tenants' financial position, analyses of accounts receivable and current
economic trends. We also make estimates for reserves against our deferred rent
receivable for existing tenants with the potential of early termination,
bankruptcy or ceasing operations. We charge or credit rental income for
increases or decreases to our deferred rent reserves. Our estimates are based on
our review of tenants' payment histories, the remaining lease term, whether or
not the tenant is currently occupying our building, publicly available financial
information and such additional information about their financial condition as
tenants provide to us. The information available to us might lead us to
overstate or understate these reserve amounts. The use of different estimates or
assumptions could produce different results. Moreover, actual future collections
of accounts receivable or reductions in future reported rental income due to
tenant bankruptcies or other business failures could differ materially from our
estimates.
CONSOLIDATED JOINT VENTURES. We, through an operating partnership, own three
properties that are in joint ventures of which we have controlling interests. We
manage and operate all three properties. The recognition of these properties and
their operating results are 100% reflected on our consolidated financial
statements, with appropriate allocation to minority interest, because we have
operational and financial control of the investments. We make judgments and
assumptions about the estimated monthly payments made to our minority interest
joint venture partners, which are reported with our periodic results of
operations. Actual results may differ from these estimates under different
assumptions or conditions.
INVESTMENT IN UNCONSOLIDATED JOINT VENTURE. We, through an operating
partnership, have a 50% non-controlling limited partnership interest in one
unconsolidated joint venture. This investment is not consolidated because we do
not exercise significant control over major operating and financial decisions.
We account for this joint venture interest using the equity method of
accounting.
FAIR VALUE OF FINANCIAL INSTRUMENTS. Our financial instruments include cash and
cash equivalents, accounts receivable, accounts payable, and debt. Considerable
judgment is required in interpreting market data to develop estimates of fair
value. Our estimates of fair value are not necessarily indicative of the amounts
that we could realize in a current market exchange. The use of different market
assumptions and/or estimation methodologies may have a material effect on the
estimated fair value amounts. Cash and cash equivalents, accounts receivable,
and accounts payable are carried at amounts that approximate their fair values
due to their short-term maturities. The carrying amounts of our variable rate
debt approximate fair value since the interest rates on these instruments are
equivalent to rates currently offered to us. For fixed rate debt, we estimate
fair value by using discounted cash flow analyses based on borrowing rates for
similar kinds of borrowing arrangements.
REVENUE RECOGNITION. Rental revenue is recognized on the straight-line method of
accounting required by GAAP under which contractual rent payment increases are
recognized evenly over the lease term, regardless of when the rent payments are
received by us. The difference between recognized rental income and rental cash
receipts is recorded as Deferred Rent Receivable on the consolidated balance
sheets.
Rental revenue is affected if existing tenants terminate or amend their leases.
We try to identify tenants who may be likely to declare bankruptcy, 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 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 No. 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
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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 regards to critical accounting policies, where applicable, we have
explained and discussed the criteria for identification and selection,
methodology in application and impact on the financial statements with the Audit
Committee of our Board of Directors. The Audit Committee has reviewed the
critical accounting policies we identified.
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RESULTS OF OPERATIONS
COMPARISON OF THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 TO THE THREE
AND NINE MONTHS ENDED SEPTEMBER 30, 2004
As of September 30, 2005, through our controlling interests in the operating
partnerships, we owned 108 properties totaling approximately 8.0 million
rentable square feet compared to 109 properties totaling approximately 7.9
million rentable square feet owned by us as of September 30, 2004. This
represents a net increase of approximately 1% in total rentable square footage,
as we acquired one property consisting of approximately 203,800 rentable square
feet and disposed of two properties consisting of approximately 103,350 rentable
square feet during the first quarter of 2005.
RENTAL REVENUE FROM REAL ESTATE FROM CONTINUING OPERATIONS
For the quarter ended September 30, 2005, rental revenue from real estate
decreased by approximately ($4.8) million, or 16.3%, from $29.5 million for the
three months ended September 30, 2004 to $24.7 million for the same period of
2005. For the nine months ended September 30, 2005, rental revenue from real
estate decreased by approximately ($14.5) million, or 16.0%, from $90.5 million
for the nine months ended September 30, 2004 to $76.0 million for the nine
months ended September 30, 2005. Rental revenue includes approximately $0.5
million in amortization for the three months ended September 30, 2005 and 2004
and approximately $1.4 million in amortization for the nine months ended
September 30, 2005 and 2004 for the amortization of the above-market lease
intangible asset pursuant to SFAS No. 141. The decline in rental revenue was
primarily a result of the lower rental rate under the new Microsoft blend and
extend lease, which was signed in the first quarter of 2005 and accounted for
over half the decline. Other factors contributing to the decline in rental
revenue were lower rental rates on new leases and renewals and the loss of
several tenants due to their bankruptcy, relocation or cessation of operations
since September 30, 2004, all of which resulted from current adverse market
conditions. Our occupancy rate at September 30, 2005 was approximately 67.5%,
compared to approximately 69.0% at September 30, 2004. Due to an over supply of
R&D properties and competition from other landlords in the Silicon Valley, our
occupancy rate may drop further if the 72,000 rentable square feet scheduled to
expire during the remainder of 2005 is not renewed or re-leased.
EQUITY IN EARNINGS FROM UNCONSOLIDATED JOINT VENTURE
As of September 30, 2005, we had investments in four R&D buildings, totaling
593,000 rentable square feet, through an unconsolidated joint venture, TBI-MSW,
in which we acquired a 50% interest in January 2003 from the Berg Group under
the Berg Land Holdings Option Agreement. We have a non-controlling limited
partnership interest in this joint venture, which we account for using the
equity method of accounting. For the three months ended September 30, 2005, we
recorded equity in earnings from the unconsolidated joint venture of
approximately $0.29 million compared to equity in earnings of $0.34 million for
the same period in 2004. Our equity in earnings from this unconsolidated joint
venture declined in the third quarter of 2005 due to lower rents received as a
result of lower occupancy rate. For the nine-month periods ended September 30,
2005 and 2004, equity in earnings from the unconsolidated joint venture was
approximately $0.68 million and $1.56 million, respectively. The decline in
equity in earnings from unconsolidated joint venture for the nine-month period
ended September 30, 2005 resulted from the write-offs of leasing commission and
tenant improvements for a tenant that terminated its lease agreement in December
2004 as well as lower rents received from the properties of this joint venture.
The occupancy rate for the properties owned by this joint venture year to date
through September 30, 2005 was approximately 78.7% compared to 100% at September
30, 2004.
OTHER INCOME FROM CONTINUING OPERATIONS
Other income remained relatively the same at approximately $0.4 million for the
three months ended September 30, 2005 compared to the third quarter of 2004. For
the nine months ended September 30, 2005 and 2004, other income was $3.0 million
and $5.4 million, respectively. Other income was higher for the period ended
September 30, 2004 because we realized higher lease termination fee and tenant
bankruptcy settlement income in 2004. We do not consider those transactions to
be recurring items.
EXPENSES FROM CONTINUING OPERATIONS
Property operating expenses and real estate taxes during the third quarter of
2005 increased by approximately $0.5 million, or 10.4%, from $4.8 million to
$5.3 million for the three months ended September 30, 2004 and 2005,
respectively, due primarily to higher assessments of our property value and
increase in utility usage. Tenant reimbursements increased by approximately $0.3
million, or 8.1%, from $3.7 million for the three months ended September 30,
2004 to $4.0 million for the three months ended September 30, 2005 due to tenant
direct billing of operating expenses during the third quarter of 2005. Property
operating expenses and real estate taxes decreased by approximately ($1.1)
million, or 7.2%, from $15.2 million to $14.1 million for the nine months ended
September 30, 2004 and 2005, respectively, due to lower operating expenses from
lower occupancy of our properties, the disposition of two properties during the
first quarter of 2005 and property tax refunds totaling approximately $0.7
million in 2005 and $0.09 million in 2004. Tenant reimbursements decreased by
approximately ($0.4) million, or 3.4%, from $11.6 million for the nine months
ended September 30, 2004 to $11.2 million for the nine months ended September
30, 2005. The decrease in tenant reimbursements for the nine months ended
September 30, 2005 as compared to the same period in 2004 was due to lower
occupancy. Certain expenses such as property insurance, real estate taxes, and
other fixed expenses are not recoverable from vacant properties. General and
administrative expenses remained relatively the same at approximately $0.4
million for the three months ended September 30, 2004 and 2005. For the nine
months ended September 30, 2004 and 2005, general and administrative expenses
decreased by approximately ($0.1) million, or 6.3%, from $1.6 million to $1.5
million, respectively. General and administrative expenses for the nine months
ended September 30, 2004 included additional legal and accounting expenses in
connection with the resignation of PricewaterhouseCoopers LLP, our former
independent
- 15 -
accountants, and the need to re-audit consolidated financial statements for
years 2001 and 2002 and audit 2003 results during the second quarter of 2004,
which did not recur in 2005.
Real estate depreciation and amortization expense remained the same at $5.3
million for the three months ended September 30, 2004 and 2005. Depreciation and
amortization expense of real estate decreased by approximately ($0.2) million,
or 1.2%, from $16.2 million to $16.0 million for the nine months ended September
30, 2004 and 2005, respectively. The decrease for the nine months ended
September 30, 2005 compared to the same period in 2004 was attributable,
primarily, to the disposition of two properties during the first quarter of 2005
and a fully amortized in-place lease intangible asset in the second quarter of
2005.
Interest expense increased by approximately $1.0 million, or 22.2%, from $4.5
million for the three months ended September 30, 2004 to $5.5 million for the
three months ended September 30, 2005. Interest expense (related parties)
decreased by approximately ($27,000), or 10.5%, from $256,000 for the three
months ended September 30, 2004 to $229,000 for the three months ended September
30, 2005 due to a lower balance on the Berg Group line of credit in 2005. Total
debt outstanding, including amounts due related parties, increased by
approximately $36.6 million, or 11.0%, from $333.4 million as of September 30,
2004 to $370.0 million as of September 30, 2005. Overall interest expense,
including amounts paid to related parties, for the quarter ended September 30,
2005 increased by approximately $1.0 million compared to the same quarter a year
ago principally due to new debt and the substitution of new debt at slightly
higher rates for borrowings under the Berg Group line of credit.
Interest expense increased by approximately $3.0 million, or 23.1%, from $13.0
million for the nine months ended September 30, 2004 to $16.0 million for the
nine months ended September 30, 2005. The increase in interest expense resulted
principally from losses of approximately $0.8 million taken from a cash flow
interest rate derivative, higher interest rates on variable rate debt, and two
new fixed rate secured mortgage loans of $25.8 million and $125 million from
Allianz Life Insurance Company ("Allianz Loan I" & "Allianz Loan II") obtained
in early April 2005 and July 2005, respectively, which primarily paid off lower
interest rate debt. Interest expense (related parties) increased by
approximately $19,000, or 2.5%, from $760,000 for the nine months ended
September 30, 2004 to $779,000 for the nine months ended September 30, 2005 due
to higher interest rates.
INCOME FROM DISCONTINUED OPERATIONS
The following table depicts the amounts of income from discontinued operations
for the three and nine months ended September 30, 2005 and 2004.
Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
--------------------------------------------------------------
(dollars in thousands)
(unaudited)
Gain on disposition of property $1,345 $ - $1,408 $ -
(Loss) attributable to discontinued operations (77) (122) (551) (179)
Minority interest in (loss)/earnings attributable
to discontinued operations (990) 103 (650) 161
----------- ------------ ------------ ------------
Income/(loss) from discontinued operations $ 278 ($ 19) $ 207 ($ 18)
=========== ============ ============ ============
In accordance with our adoption of SFAS No. 144, in the first quarter of 2005 we
sold and classified as discontinued operations two properties consisting of
103,350 rentable square feet and recorded a gain of $63,000, of which $14,000
and $49,000 were attributable to common stockholders and minority interests,
respectively. In the third quarter of 2005, we classified one property as an
asset held for sale and discontinued operations because we have committed to an
action to sell the property, the property has a buyer and is available for
immediate sale in its present condition (subject to terms that are usual and
customary for sales of such property), the sale is probable and actions required
to complete the plan indicate that it is unlikely that significant changes to
the plan will be made or that the plan will be withdrawn.
In accordance with SFAS No. 66, in the third quarter of 2005 we received the
remaining balance owed on one of the properties disposed of in the first quarter
of 2005 and recorded the remaining gain of approximately $1.3 million, of which
$0.3 million and $1.0 million were attributable to common stockholders and
minority interests, respectively.
The income/(loss) to common stockholders and minority interests attributable to
discontinued operations from these three properties for the three months ended
September 30, 2005 and 2004 was approximately $278,000 and $990,000,
respectively, and ($19,000) and ($103,000), respectively. The income/(loss) to
common stockholders and minority interests attributable to discontinued
operations from these three properties for the nine months ended September 30,
2005 and 2004 was approximately $207,000 and $650,000, respectively, and
($18,000) and ($161,000), respectively.
- 16 -
NET INCOME TO COMMON STOCKHOLDERS AND NET INCOME TO MINORITY INTEREST
Minority interest in net income has been calculated by taking the net income of
the operating partnerships (on a stand-alone basis) multiplied by the respective
minority interest ownership percentage. Minority interest represents the
ownership interest of all limited partners in the operating partnerships taken
as a whole, which was approximately 82% and 83% as of September 30, 2005 and
2004, respectively.
Net income to common stockholders decreased by approximately ($0.7) million, or
21.9%, from $3.2 million for the three months ended September 30, 2004 to $2.5
million for the same period in 2005. The minority interest portion of income
decreased by approximately ($4.0) million, or 25.8%, from $15.5 million for the
three months ended September 30, 2004 to $11.5 million for the three months
ended September 30, 2005. For the nine months ended September 30, 2005 and 2004,
the minority interest portion of income was approximately $35.8 million and
$51.6 million, respectively, resulting in net income to common stockholders of
approximately $7.6 million and $10.5 million, respectively. The decline in net
income for both common stockholders and minority interests was primarily due to
lower rental revenue, the realization of higher termination fee and settlement
income in 2004, increases in interest expense and higher non-reimbursable
operating expenses from vacant properties.
- 17 -
CHANGES IN FINANCIAL CONDITION
The most significant changes in our financial condition during the nine months
ended September 30, 2005 resulted from the disposition of two R&D properties and
acquisition of one R&D property. In addition, total stockholders' equity
increased from the exchange of O.P. units for common stock and stock option
exercises.
At September 30, 2005, total investments in properties had a net decrease of
approximately ($5.2) million from December 31, 2004 due to two property
dispositions and one asset held for sale reclassification, which was partially
offset by one property acquisition. During the first nine months of 2005, we
acquired one vacant R&D property representing approximately 203,800 rentable
square feet located in the Silicon Valley. The purchase price for this property
was approximately $14.0 million. We also disposed of two R&D properties
consisting of approximately 103,350 rentable square feet for a total sales price
of approximately $12.8 million. One of the disposed properties was classified as
an asset held for sale at December 31, 2004 for $8.2 million. In the third
quarter of 2005, we classified one R&D property consisting of 239,000 rentable
square feet as asset held for sale. That property was sold in October 2005 for
approximately $15.1 million. A gain of approximately $0.8 million will be
recognized on this property in the fourth quarter of 2005.
Total stockholders' equity, net, increased by approximately $1.5 million from
December 31, 2004 as we obtained additional capital from the exchange of O.P.
units for shares of our common stock and stock option exercises, while incurring
a deficit of approximately ($1.2) million due to dividends declared in excess of
net income for the period. During the first nine months of 2005, four limited
partners exchanged 215,500 O.P. units for 215,500 shares of our common stock
under the Exchange Rights Agreement among us and the limited partners in the
operating partnerships. In addition, stock options to purchase 55,000 shares of
common stock were exercised. The newly issued shares increased additional paid
in capital by approximately $2.7 million.
LIQUIDITY AND CAPITAL RESOURCES
We expect a continued decline in operating cash flows from our operating
property portfolio in 2005 as compared to 2004. The reduction in cash flows
reflects the overall reduced demand for R&D space, lower rental rates for new
and renewed leases, and an increase in vacant properties in 2005. In addition,
if we are unable to lease a significant portion of the approximately 72,000
rentable square feet scheduled to expire during the remainder of 2005 or an
equivalent amount of our currently available space of approximately 2.5 million
rentable square feet, our operating cash flows may be affected adversely. With
the expectation of lower revenues for the remainder of 2005, we expect the
properties' net operating income to continue to show year over year declines
when compared to 2004. As noted above, we expect cash flows from operating
activities to continue to show declines primarily driven by the general downturn
in the Silicon Valley's economy in recent years, the softening of the Company's
market specifically, and the expected weaker performance of our properties. We
are also subject to risks of decreased occupancy through tenant defaults and
bankruptcies and potential reduction in rental rates upon renewal of properties,
which would result in reduced cash flow from operations. It is reasonably likely
that vacancy rates may continue to increase and effective rental rates on new
and renewed leases may continue to decrease.
We expect our principal source of liquidity for distributions to stockholders
and O.P. unit holders, debt service, leasing commissions and recurring capital
expenditures to come from cash provided by operations and/or the borrowings
under the line of credit with Cupertino National Bank ("CNB"). We expect these
sources of liquidity to be adequate to meet projected distributions to
stockholders and other presently anticipated liquidity requirements in 2005. We
expect to meet our long-term liquidity requirements for the funding of property
development, property acquisitions and other material non-recurring capital
improvements through cash and investments, long-term secured and unsecured
indebtedness and the issuance of additional equity securities by us. We have the
ability to meet short-term obligations or other liquidity needs based on a line
of credit with CNB. We expect our total interest expense to increase as interest
rates rise and through new financing activities. In the remainder of 2005, we
will be obligated to make payments totaling approximately $2.5 million of debt
principal under mortgage notes without regard to any debt refinancing or new
debt obligations that we might incur, or optional payments of debt principal.
DISTRIBUTIONS
On October 6, 2005, we paid dividends of $0.16 per share of common stock to all
common stockholders of record as of September 30, 2005. On the same date, the
operating partnerships paid a distribution of $0.16 per O.P. unit to all holders
of O.P. units. For the remainder of 2005, we expect to maintain our current
quarterly dividend payment rate to common shareholders and O.P. unit holders of
$0.16 per share. However, distributions are declared at the discretion of our
Board of Directors and are subject to actual cash available for distribution,
our financial condition, capital requirements and such other factors, as our
Board of Directors deems relevant.
DEBT
At September 30, 2005, we had total indebtedness of $370.0 million, including
$359.9 million of fixed rate mortgage debt and $10.1 million under the Berg
Group mortgage note (related parties), as detailed in the table below. In July
2005, the Citicorp USA and Washington Mutual loans were paid off in their
entirety from proceeds received from the Allianz Loan II. Proceeds from the
Allianz Loan II were also used to pay down balances on the CNB and Berg Group
lines of credit. The CNB loan contains certain financial loan and reporting
covenants as defined in the loan agreements. As of September 30, 2005, we were
in compliance with these loan covenants.
- 18 -
On April 6, 2005, we obtained a $25.8 million secured mortgage loan from Allianz
Life Insurance Company of North America ("Allianz Loan I") that bears a fixed
interest rate at 5.56% and originally matures in 15 years with principal
payments amortized over 20 years. The mortgage loan is secured by one property.
We paid approximately $251,000 in loan fees and financing costs, which are being
amortized over the 20 year amended loan period, and used the proceeds primarily
to pay down short-term debt and the Berg Group line of credit. On July 26, 2005,
in connection with the Allianz Loan II, we entered into a "Loan Modification
Agreement" with Allianz, which extended the amortization period and maturity
date of the Allianz Loan I from April 10, 2020 to August 10, 2025.
On July 26, 2005, we obtained a $125 million secured mortgage loan from Allianz
Life Insurance Company of North America ("Allianz Loan II"). The Allianz Loan II
matures on August 10, 2025, and must be paid in full at that time, unless
payment is accelerated by reason of a default or sale of one or more of the
properties that secure the loan. This loan bears a fixed interest rate of 5.22%
and principal payments are amortized over 20 years. The loan can be prepaid
subject to certain yield maintenance provisions and is assumable with the
payment of an assumption fee. The mortgage loan is secured by eight properties.
We paid approximately $0.8 million in loan fees and financing costs, which will
be amortized over the 20 year loan period. The proceeds were used primarily to
repay the Citicorp loan, retire the Washington Mutual loan, reduce the balance
of the CNB and Berg Group lines of credit, and for other working capital needs.
The Allianz Loans I and II now contain cross-default provisions.
On July 22, 2005, we entered into a "Change in Terms Agreement" with Cupertino
National Bank, which reduced the maximum borrowing amount on the Company's
revolving line of credit facility with that bank from $40 million to $9 million.
On October 26, 2005, the Independent Directors Committee of the Board of
Directors of the Company approved the termination of the $20 million line of
credit agreement between the Company and the Berg Group (as defined in the
Company's previously filed periodic reports), effective October 31, 2005. The
Berg Group line of credit was originally scheduled to mature in March 2006.
Based on existing cash reserves and credit facilities, we have determined that
we no longer foresee a need for the Berg Group line of credit. There are no
borrowings currently outstanding under the Berg Group line of credit. We will
not incur any fees or charges for terminating the Berg Group line of credit.
- 19 -
The following table sets forth information regarding debt outstanding as of
September 30, 2005:
Maturity Interest
Debt Description Collateral Properties Balance Date Rate
-------------------------------------------------- -------------------------------------- ---------------- ----------- -----------
(dollars in thousands)
Line of Credit:
Berg Group (related parties) 2033-2043 Samaritan Drive, San Jose, CA $ - 3/06 (1)
2133 Samaritan Drive, San Jose, CA ----------------
2233-2243 Samaritan Drive, San Jose, CA
1310-1450 McCandless Drive, Milpitas, CA
1795-1845 McCandless Drive, Milpitas, CA
Cupertino National Bank Not Applicable - 11/06 (4)
----------------
Mortgage Notes Payable (related parties): 5300 & 5350 Hellyer Avenue, San Jose, CA 10,146 6/10 7.65%
----------------
Mortgage Notes Payable (2):
Prudential Insurance Company of America (3) 10300 Bubb Road, Cupertino, CA 117,841 10/08 6.56%
10500 N. De Anza Blvd, Cupertino, CA
4050 Starboard Drive, Fremont, CA
45700 Northport Loop, Fremont, CA
45738 Northport Loop, Fremont, CA
450 National Avenue, Mountain View, CA
6311 San Ignacio Avenue, San Jose, CA
6321 San Ignacio Avenue, San Jose, CA
6325 San Ignacio Avenue, San Jose, CA
6331 San Ignacio Avenue, San Jose, CA
6341 San Ignacio Avenue, San Jose, CA
6351 San Ignacio Avenue, San Jose, CA
3236 Scott Boulevard, Santa Clara, CA
3560 Bassett Street, Santa Clara, CA
3570 Bassett Street, Santa Clara, CA
3580 Bassett Street, Santa Clara, CA
1135 Kern Avenue, Sunnyvale, CA
1212 Bordeaux Lane, Sunnyvale, CA
1230 E. Arques, Sunnyvale, CA
1250 E. Arques, Sunnyvale, CA
1170 Morse Avenue, Sunnyvale, CA
1600 Memorex Drive, Santa Clara, CA
1688 Richard Avenue, Santa Clara, CA
1700 Richard Avenue, Santa Clara, CA
3540 Bassett Street, Santa Clara, CA
3542 Bassett Street, Santa Clara, CA
3544 Bassett Street, Santa Clara, CA
3550 Bassett Street, Santa Clara, CA
Northwestern Mutual Life Insurance Company (5) 1750 Automation Parkway, San Jose, CA 92,198 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 Insurance Co. (Allianz Loan I)(6) 5900 Optical Court, San Jose, CA 25,446 8/25 5.56%
Allianz Life Insurance Co. (Allianz Loan II)(6) 5325-5345 Hellyer Avenue, San Jose, CA 124,406 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
----------------
Mortgage Notes Payable Subtotal 359,891
----------------
TOTAL $370,037
================
(1) The Berg Group line of credit was terminated by agreement effective October
31, 2005.
(2) Mortgage notes payable generally require monthly installments of interest
and principal ranging from $177,000 to $840,000 over various terms
extending through the year 2025. The weighted average interest rate of
mortgage notes payable was 5.84% at September 30, 2005.
(3) The Prudential Insurance loan is payable in monthly installments of
$827,000, which includes principal (based upon a 30-year amortization) and
interest. A limited partner who is not a member of the Berg Group has
guaranteed approximately $12.0 million of this debt. Costs and fees
incurred with obtaining this loan aggregated approximately $900,000, which
were deferred and amortized over the loan period.
(4) Interest rate equal to LIBOR plus 2%. The Cupertino National Bank line of
credit contains certain financial loan and reporting covenants as defined
in the loan agreements, including minimum tangible net worth, debt service
coverage ratio and combined average daily cash balances with the bank, and
a maximum loan to value ratio. As of September 30, 2005, the Company was in
compliance with these loan covenants.
(5) The Northwestern loan is payable in monthly installments of $696,000, which
includes principal (based upon a 20-year amortization) and interest. Costs
and fees incurred with obtaining this loan aggregated approximately
$675,000, which were deferred and amortized over the loan period.
(6) The Allianz loans are payable in monthly installments of $1,017,000, which
includes principal (based upon a 20-year amortization) and interest. Costs
and fees incurred with obtaining these loans aggregated approximately
$1,089,000, which were deferred and amortized over the loan periods. The
Allianz loans contain certain customary covenants as defined in the loan
agreements. As of September 30, 2005, the Company was in compliance with
these loan covenants.
- 20 -
At September 30, 2005, our debt to total market capitalization ratio, which is
computed as our total debt outstanding divided by the sum of total debt
outstanding plus the market value of common stock (based upon the closing price
of $10.04 per share on September 30, 2005) on a fully diluted basis, including
the conversion of all O.P. units into common stock, was approximately 26.1%. On
September 30, 2005, the last trading day for the quarter, total market
capitalization was approximately $1.4 billion.
At September 30, 2005, the outstanding balance remaining under certain notes
that we owed to the operating partnerships was $1.7 million. The due date of
these notes has been extended to September 30, 2006. The principal amount of
these notes, along with the interest expense, which is interest income to the
operating partnerships, is eliminated in consolidation and is not included in
the corresponding line items within the consolidated financial statements.
However, the interest income earned by the operating partnerships, which is
interest expense to us, in connection with this debt, is included in the
calculation of minority interest as reported on the consolidated statement of
operations, thereby reducing our net income by this same amount. At present, our
only means for repayment of this debt is through distributions that we receive
from the operating partnerships that are in excess of the amount of dividends to
be paid to our stockholders or by raising additional equity capital.
HISTORICAL CASH FLOWS
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2005 TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2004
Net cash provided by operating activities for the nine months ended September
30, 2005 was $58.7 million compared to $82.4 million for the same period in
2004. The decline resulted primarily from the decrease in rental revenue from
our current portfolio of property and reduction in tenant expense reimbursements
due to tenant lease obligation defaults, tenant re-locations, decrease in
occupancy and lower rent renewal rates during the last three months of 2004 and
the first nine months of 2005. The decline in cash flow from operating
activities was also caused by payments of leasing commissions (included in other
assets) which amounted to approximately $4.0 million, including approximately
$2.9 million with respect to the modification and extension of our lease with
Microsoft.
Net cash used in investing activities was approximately ($2.6) million and
($0.4) million for the nine months ended September 30, 2005 and 2004,
respectively. Cash used in investing activities during the nine months ended
September 30, 2005 related principally to the acquisition of the property at
5521 Hellyer Avenue for $14.2 million and the disposition of two existing
properties for a total of $12.4 million. We partially financed one of the sales
with a note receivable for approximately $4.1 million, which was fully paid in
the third quarter of 2005. Capital expenditures relating to real estate
improvements were approximately $0.9 million and $0.4 million for the nine
months ended September 30, 2005 and 2004, respectively.
Net cash used in financing activities was ($17.2) million for the nine months
ended September 30, 2005 compared to ($84.5) million for the nine months ended
September 30, 2004. During the first nine months of 2005, we received $150.8
million from two new mortgage loans, received $0.5 million from stock option
exercises, used $117.8 million to pay outstanding debt, and paid $42.0 million
for minority interest distributions and $8.7 million for dividends to common
stockholders. During the same period in 2004, we used $9.9 million to repay
outstanding debt, drew an additional $2.5 million from the Cupertino National
Bank line of credit, deposited $1.5 million for an appeals bond, received $0.2
million from stock option exercises and paid $62.8 million to minority interests
for distributions and $13.0 million to common stockholders for dividends.
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 the Company's 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 the
Company's financial performance when compared to other REITs since FFO is
generally recognized as the industry standard for reporting the operations of
REITs. In addition to the disclosure of operating earnings per share, we will
continue to use FFO as a measure of our performance. FFO should not be
considered as an alternative for net income as a measure of profitability nor is
it comparable to cash flows provided by operating activities determined in
accordance with GAAP, nor is FFO necessarily indicative of funds available to
meet our cash needs, including the need to make cash distributions to satisfy
REIT requirements. For example, FFO is not adjusted for payments of debt
principal required under our debt service obligations.
Our definition of FFO also assumes conversion at the beginning of the period of
all convertible securities, including minority interests that might be exchanged
for common stock. FFO does not represent the amount available for management's
discretionary use; as such funds may be needed for capital replacement or
expansion, debt service obligations or other commitments and uncertainties.
- 21 -
Furthermore, FFO is not comparable to similarly entitled items reported by other
REITs that do not define FFO exactly as we do.
FFO for the three and nine months ended September 30, 2005 and 2004, as
reconciled to net income to common stockholders, are summarized in the following
tables:
Three Months Ended September 30, Nine Months Ended September 30,
2005 2004 2005 2004
------------------ ------------------ ------------------ ------------------
(dollars in thousands) (dollars in thousands)
Net income to common stockholders $ 2,451 $ 3,173 $ 7,554 $10,491
Add:
Minority interests (1) 11,414 15,377 35,441 51,228
Depreciation & amortization of real estate (2) 6,008 5,969 18,390 18,619
Less:
Gain on sale of asset (1,345) - (1,408) -
------------------ ------------------ ------------------ ------------------
FFO $18,528 $24,519 $59,977 $80,338
================== ================== ================== ==================
(1) The minority interest for third parties totaling $127 and $111 for the
three months ended September 30, 2005 and 2004, respectively, and $382 and
$368 for the nine months ended September 30, 2005 and 2004, respectively,
was deducted from total minority interest in calculating FFO.
(2) Includes our portion of depreciation and amortization of real estate and
leasing commissions from our unconsolidated joint venture totaling $210 and
$218 for the three months ended September 30, 2005 and 2004, respectively,
and $774 and 655 for the nine months ended September 30, 2005 and 2004,
respectively. Also includes amortization of leasing commissions of $453 and
$322 for the three months ended September 30, 2005 and 2004, respectively,
and $1,295 and $1,320 for the nine months ended September 30, 2005 and
2004, respectively. Amortization of leasing commissions is included in the
property operating, maintenance and real estate taxes line item in the
Company's consolidated statements of operations.
DISTRIBUTION POLICY
Our board of directors determines the amount and timing of distributions to our
stockholders. The board of directors will consider many factors prior to making
any distributions, including the following:
- the amount of cash available for distribution;
- our financial condition;
- whether to reinvest funds rather than to distribute such funds;
- our committed and projected capital expenditures;
- the amount of cash required for new property acquisitions, including
acquisitions under existing agreements with the Berg Group;
- prospects of tenant renewals and re-leases of properties subject to
expiring leases;
- cash required for re-leasing activities;
- the annual distribution requirements under the REIT provisions of the
federal income tax laws; and
- such other factors as the board of directors deems relevant.
We cannot assure you that we will be able to meet or maintain our cash
distribution objectives.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
We do not believe recently issued accounting standards will materially impact
our financial position, results of operations, or cash flows.
In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment" ("SFAS
No. 123R"), which addresses the accounting for employee and director stock
options. Statement 123R requires that the cost of all employee and director
stock options, as well as other equity-based compensation arrangements, be
reflected in the financial statements based on the estimated fair value of the
awards. SFAS No. 123R is an amendment to SFAS No. 123 and supersedes APB Opinion
No. 25 ("APB No. 25"). SFAS No. 123R is applicable to any award that is settled
or measured in stock, including stock options, restricted stock, stock
appreciation rights, stock units, and employee stock purchase plans. SFAS No.
123R will be effective for public companies starting with the first interim
period commencing after June 15, 2005. On April 14, 2005, the SEC announced a
new rule that delays the implementation of SFAS No. 123R until the beginning of
the next fiscal year that begins after December 15, 2005. We will adopt the
requirements of SFAS No. 123R beginning 2006. We expect that the adoption of
this standard will reduce our net income and earnings per share; however, it
will have no impact on cash flow. Although we have not yet determined whether
the adoption of SFAS No. 123R will result in amounts that are similar to the
current pro forma disclosures under SFAS No. 123, we are evaluating the
requirements under SFAS No. 123R including the valuation methods and support for
the assumptions that underlie the valuation of the awards and the transition
methods (modified prospective transition method or the modified retrospective
transition method).
In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary
Assets" ("SFAS No. 153"). SFAS No. 153 amends the guidance in APB Opinion No.
29, "Accounting for Non-monetary Transactions" to eliminate certain exceptions
to the principle that exchanges of non-monetary assets be measured based on the
fair value of the assets exchanged. SFAS No. 153 eliminates the exception
- 22 -
for non-monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non-monetary assets that do not have
commercial substance. This statement is effective for non-monetary asset
exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS
No. 153 is not expected to have an impact on our consolidated results of
operations, financial position or cash flows.
- 23 -
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not generally hold market risk sensitive instruments for trading purposes.
We use fixed and variable rate debt to finance our operations. Our exposure to
market risk for changes in interest rates relates primarily to our current
variable rate debt and future debt obligations. We are vulnerable to significant
fluctuations of interest rates on our floating rate debt and pricing on our
future debt. We manage our market risk by monitoring interest rates where we try
to recognize the unpredictability of the financial markets and seek to reduce
potentially adverse effect on the results of our operations. This takes frequent
evaluation of available lending rates and examination of opportunities to reduce
interest expense through new sources of debt financing. Several factors
affecting the interest rate risk include governmental monetary and tax policies,
domestic and international economics and other factors that are beyond our
control. The following table provides information about the principal cash
flows, weighted average interest rates, and expected maturity dates for debt
outstanding as of September 30, 2005. The current terms of this debt are
described in Item 2, "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources."
For variable rate debt, the table presents the assumption that the outstanding
principal balance at September 30, 2005 will be paid upon maturity. There was no
variable rate debt at September 30, 2005.
For fixed rate debt, the table presents the assumption that the outstanding
principal balance at September 30, 2005 will be paid according to scheduled
principal payments and that we will not prepay any of the outstanding principal
balance.
Three
Months Year Ending December 31,
Remaining ----------------------------------------------
2005 2006 2007 2008 2009 Thereafter Total Fair Value
-----------------------------------------------------------------------------------------------
(dollars in thousands)
Variable Rate Debt:
Secured and unsecured debt - - - - - - - -
Weighted average interest rate - - - - - - - -
Fixed Rate Debt:
Secured notes payable $2,504 $10,427 $11,046 $121,623 $9,598 $214,839 $370,037 $467,602
Weighted average interest rate 5.84% 5.84% 5.84% 5.84% 5.84% 5.84%
The primary market risks we face are interest rate fluctuations. Principal
amounts outstanding under the Berg Group line of credit and the CNB line of
credit, which are tied to a LIBOR based interest rate, were $0.00, of the total
$370.0 million of outstanding debt as of September 30, 2005. As a result, we pay
lower rates of interest in periods of decreasing interest rates and higher rates
of interest in periods of increasing interest rates. All of our debt is
denominated in United States dollars. We had no interest rate caps or interest
rate swap contracts at September 30, 2005.
As of September 30, 2005, we had no interest rate risk since there was no
variable rate debt outstanding.
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ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
We strive to maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms, and that such information is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer, as appropriate, to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving the desired control objectives and management necessarily is required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls.
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 were effective
in timely alerting them to material information relating to us (including our
subsidiaries) required to be included in our periodic SEC filings as of
September 30. 2005.
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 1 "Item 1. -
Financial Statements - Note 7 - Commitments and Contingencies."
ITEM 6. EXHIBITS
31.1 Section 1350 Certificate of CEO
31.2 Section 1350 Certificate of President & COO
31.3 Section 1350 Certificate of Principal Financial Officer
32 Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
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================================================================================
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto duly authorized.
Mission West Properties, Inc.
(Registrant)
Date: November 9, 2005 By: /s/ Carl E. Berg
----------------------------------------
Carl E. Berg
Chief Executive Officer
Date: November 9, 2005 By: /s/ Wayne N. Pham
----------------------------------------
Wayne N. Pham
Vice President of Finance and Controller
(Principal Accounting Officer and Duly
Authorized Officer)
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