| | | Six Months Ended June 30, | |
| | | 2011 | | | 2010 | |
| Capital Expenditures:(1) | | | | | | |
| Office Properties: | | | | | | |
| Acquisition of operating properties | | $ | 9,575,000 | | | $ | - | |
| Capital expenditures and tenant improvements | | | 462,442 | | | | 483,238 | |
| | | | | | | | | |
| Residential Property: | | | | | | | | |
| Acquisition of operating properties | | | 3,535,980 | | | | - | |
| | | | | | | | | |
| Retail Properties: | | | | | | | | |
| Capital expenditures and tenant improvements | | | 32,175 | | | | 89,559 | |
| | | | | | | | | |
| Self Storage Properties: | | | | | | | | |
| Acquisition of raw land | | | 415,000 | | | | 4,875,000 | |
| Capital expenditures and tenant improvements | | | 2,300 | | | | 31,582 | |
| | | | | | | | | |
| Acquisition of operating properties, net | | | 13,525,980 | | | | 4,875,000 | |
| Capital expenditures and tenant improvements | | | 496,917 | | | | 604,379 | |
| Total real estate investments | | $ | 14,022,897 | | | $ | 5,479,379 | |
____________
(1) Total consolidated capital expenditures are equal to the same amounts disclosed for total reportable segments.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to our consolidated financial statements and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report.
Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1934, as amended, or the Exchange Act. Such statements are subject to certain risks and uncertainties, which could cause actual results to materially differ from those projected. Some of the information presented is forward-looking in nature, including information concerning projected future occupancy rates, rental rate increases, project development timing and investment amounts. Although the information is based on our current expectations, actual results could vary from expectations stated in this report. Numerous factors will affect our actual results, some of which are beyond our control. These include the timing and strength of national and regional economic growth, the strength of commercial and residential markets, competitive market conditions, fluctuations in availability and cost of construction materials and labor resulting from the effects of worldwide demand, future interest rate levels and capital market conditions. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. We assume no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent we are required to do so in connection with our ongoing requirements under federal securities laws to disclose material information.
You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. We assume no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent we are required to do so in connection with our ongoing requirements under federal securities laws to disclose material information. For a discussion of important risks related to our business, and an investment in our securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information Item 1A and Item 7 included in the Form 10-K as filed with the Securities and Exchange Commission.
OVERVIEW AND BACKGROUND
We are incorporated under the General Corporation Law of the State of Maryland and we operate as a self-administered REIT headquartered in San Diego County, California, formed to own, operate and acquire income producing real estate properties.
FACTORS THAT MAY INFLUENCE FUTURE RESULTS OF OPERATIONS
Growth and Expansion. During the last three years, we have completed the acquisition of eleven income producing properties, forty model home properties and invested in five income producing real estate partnerships with investments in model home properties. We built our operational and administrative infrastructure, including hiring a staff of quality employees, to give us the capability to become a large real estate investing company as well as having the resources to deal with the additional burden of compliance with the SEC rules and regulations. On March 1, 2010, the Company acquired the assets and six employees of DMHU. Later in the year, the Company formed NetREIT Advisors and transferred the four remaining DMHU employees to this newly formed LLC. NetREIT Advisors began managing and serving as external advisor to NetREIT Dubose. NetREIT Advisors’ general and administrative expenses are currently approximately $60,000 per month. NetREIT Advisors generated fees of approximately $56,000 and $217,000 during the three months and six months ended June 30, 2011, respectively. NetREIT Dubose will continue to make additional property acquisitions and we expect revenues less rental operating costs to increase at a far greater rate than our general and administrative costs. Therefore, we anticipate that our net loss will decline and will result in net income in the future.
During the last three years we experienced rapid growth, having increased capital by approximately 93.8% to $75.2 million at June 30, 2011 from $38.8 million at June 30, 2008. Our investment portfolio, consisting of real estate assets, lease intangibles, investment in real estate ventures, land purchase option and mortgages receivable, have increased by approximately 185.5% to $127.6 million at June 30, 2011 from $44.7 million at June 30, 2008. The primary source of the growth in the portfolio during these three years was attributable to the issuance of common shares of approximately $68.7 million and from the proceeds from mortgage notes payable, net of principal repayments, of approximately $38.5 million.
Economic Outlook
The United States has shown a slow recovery from the recession that began in 2007. The current economic environment is characterized by increased residential housing foreclosures and an oversupply of homes available for purchase, depressed commercial real estate valuations, weak consumer spending, employment anxiety and concerns of inflation and higher interest rates. In general, business profits and investment seem to be improving. However, the housing sector and finance have so far not significantly improved. We believe that the pace of this recovery will likely be slow and disjointed. Full recovery will need increasing job growth, but it will not be consistent across industries, geographies or periods of the year causing an uneven tempo of growth.
There has been an improvement in the liquidity to the real estate mortgage markets, largely due to renewed life insurance company lending and, to a lesser degree, the reemergence of the collateralized mortgage backed securities (“CMBS”). However, the market is “two tiered” with favorable lending terms for the best properties in prioritized locations and a second tier for distressed properties or loans in less desirable locations. In addition, the lenders’ underwriting terms are much more stringent than prior to the financial crisis. We believe that there will be opportunities from the debt markets in the form of low interest rates for property buyers in 2011, but also for lenders willing to fill the void for smaller deals and borrowers, and for mezzanine lenders filling the equity gap on expiring loans that were made before the financial crisis.
In addition, this difficult economic environment may also make it difficult for our tenants to continue to meet their obligations to us. We have been successful maintaining relatively even levels of occupancy at our stabilized properties; however, overall progress to date in the office leasing velocity and pricing has been inconsistent both regionally and across assets of differing quality. Vacancy rates in our markets appear to have reached the top and are starting to descend at a slow pace. Several years may be required before vacancy rates decline sufficiently to support meaningful growth in rents.
Our involvement in retail properties has been limited, however, and we are seeing more rental inquiries. Retail demand for space in 2011 is expected to be positive for the first time since 2007. Although the increase is expected to be modest we, expect that well situated properties will benefit from the improving economy.
Economic growth rates have shown trends of slow growth in recent periods and inflation rates in the United States have remained low. Changes in inflation/deflation are sometimes associated with changes in long-term interest rates, which may have a negative impact on the value of the portfolio we own. To mitigate this risk, we will continue to seek to lease our properties with fixed rent increases and/or with scheduled rent increases based on formulas indexed to increases in the Consumer Price Index (“CPI”) or other indices for the jurisdiction in which the property is located. To the extent that the CPI increases, additional rental income streams may be generated from these leases and thereby mitigate the impact of inflation.
Management Evaluation of Results of Operations
Management evaluates our results of operations with a primary focus on increasing and enhancing the value, quality and quantity of properties and seeking to increase value in our real estate. Management focuses its efforts on improving underperforming assets through re-leasing efforts, including negotiation of lease renewals, or selectively selling assets in order to increase value in our real estate portfolio. The ability to increase assets under management is affected by our ability to raise capital and our ability to identify appropriate investments.
Management’s evaluation of operating results includes an assessment of our ability to generate cash flow necessary to fund distributions to our shareholders. As a result, management’s assessment of operating results gives less emphasis to the effects of unrealized gains and losses and other non-cash charges such as depreciation and amortization and impairment charges, which may cause fluctuations in net income for comparable periods but have no impact on cash flows. Management’s evaluation of our potential for generating cash flow includes assessments of our recently acquired properties, our unstabilized properties, the long-term sustainability of our real estate portfolio, our future operating cash flow from anticipated acquisitions, and the proceeds from sales of our real estate.
In light of the distressed nature of the commercial real estate economy in the past several years, including 2010 and 2011, we have exercised extreme caution with respect to potential property acquisitions, and consequently, we consummated fewer property acquisitions which resulted in the accumulation of significant cash balances that affected our current cash flow due to the very low yield on cash equivalents. Net operating income from our properties, from newly acquired properties and from the model home division growth, is increasing at a faster rate than our general and administrative expenses due to efficiencies of scale. We therefore believe that when most or all of our properties are operating at stabilized rates, and when excess available cash on hand is fully invested plus future acquisitions from continuing capital raising activities, we will be able to fund our future distributions to our shareholders from cash flow from operations.
As of June 30, 2011, we owned or had a controlling interest in nine Office Properties which total approximately 543,000 rentable square feet, four Retail Properties which total approximately 85,000 rentable square feet, five Self-Storage Properties which total approximately 487,000 rentable square feet, and one Residential Property. In 2009, we acquired ownership interests in DAP II and DAP III which own an aggregate of 14 Model Home Properties. During the last quarter of 2010, we acquired a significant interest in the three Income Funds which own in the aggregate 19 Model Home Properties. In addition, NetREIT Dubose has acquired 40 Model Home Properties.
NetREIT’s properties are located primarily in Southern California, Colorado and North Dakota with a single property located in Wyoming. Our model home properties are located in twelve states throughout the United States. We do not develop properties but acquire properties that are stabilized or that we anticipate will be stabilized within two years of acquisition. We consider a property to be stabilized once it has achieved an 80% occupancy rate for a full year as of January 1 of such year, or has been operating for three years. Our geographical clustering of assets enables us to reduce our operating costs through economies of scale by servicing a number of properties with less staff, but it also makes us more susceptible to changing market conditions in these discrete geographic areas. Most of our office and retail properties are leased to a variety of tenants ranging from small businesses to large public companies, many of which do not have publicly rated debt. We have in the past entered into, and intend in the future to enter into, purchase agreements for real estate having net leases that require the tenant to pay all of the operating expense (Net, Net, Net Leases) or pay increases in operating expenses over specific base years.
Most of our office leases are for terms of 3 to 5 years with annual rental increases built into such leases. In general, we have been experiencing decreases in rental rates in many of our submarkets due to continuing recessionary conditions and other related factors when leases expire and are extended. We cannot give any assurance that as the older leases expire or as we add new tenants that rental rates will be equal to or above the current market rates. Also decreased demand and other negative trends or unforeseeable events that impair our ability to timely renew or re-lease space could have a negative effect on our future financial condition, results of operations and cash flow.
The Residential Properties are rented on a short term basis of less than six months for our apartment property and typically 30 months for our model home leases. The Self-Storage Properties are rented pursuant to rental agreements that are for no longer than 6 months. The Self-Storage Properties are located in markets having other self-storage properties. Competition with these other properties will impact our operating results of these properties, which depends materially on our ability to timely lease vacant self-storage units, to actively manage unit rental rates, and our tenants’ ability to make required rental payments. The model home properties are leased on terms generally between 2 to 3 years. To be successful, we must be able to continue to respond quickly and effectively to changes in local and regional economic conditions by adjusting rental rates of these properties within their regional market in Southern California. We depend on advertisements, flyers, websites, etc. to secure new tenants to fill any vacancies.
CRITICAL ACCOUNTING POLICIES
The presentation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. Certain accounting policies are considered to be critical accounting policies, as they require management to make assumptions about matters that are highly uncertain at the time the estimate is made, and changes in the accounting estimate are reasonably likely to occur from period to period. As a company primarily involved in owning income generating real estate assets, management believes the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of our financial statements. For a summary of all of our significant accounting policies, see note 2 to our financial statements included elsewhere in this report.
Federal Income Taxes. We have elected to be taxed as a REIT under Sections 856 through 860 of the Code, for federal income tax purposes. To qualify as a REIT, we must distribute annually at least 90% of adjusted taxable income, as defined in the Code, to our shareholders and satisfy certain other organizational and operating requirements. As a REIT, no provision will be made for federal income taxes on income resulting from those sales of real estate investments which have or will be distributed to shareholders within the prescribed limits. However, taxes will be provided for those gains which are not anticipated to be distributed to shareholders unless such gains are deferred pursuant to Section 1031. In addition, the Company will be subject to a federal excise tax which equals 4% of the excess, if any, of 85% of the Company’s ordinary income plus 95% of the Company’s capital gain net income over cash distributions.
Earnings and profits that determine the taxability of distributions to shareholders differ from net income reported for financial reporting purposes due to differences in estimated useful lives and methods used to compute depreciation and the carrying value (basis) on the investments in properties for tax purposes, among other things. During the years ended December 31, 2010 and 2009, all distributions were considered return of capital to the shareholders and therefore non-taxable.
We believe that we have met all of the REIT distribution and technical requirements for the six months ended June 30, 2011 and for the year ended December 31, 2010.
REAL ESTATE ASSETS
Property Acquisitions. We account for our acquisitions of real estate in accordance with GAAP requiring that the purchase price of acquired properties be allocated to the acquired tangible assets and liabilities, consisting of land, building, tenant improvements, a land purchase option, long-term debt and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, the value of in-place leases, unamortized lease origination costs and tenant relationships, based in each case on their fair values.
We allocate the purchase price to tangible assets of an acquired property (which includes land, building and tenant improvements) based on the estimated fair values of those tangible assets, assuming the building was vacant. Estimates of fair value for land, building and building improvements are based on many factors including, but not limited to, comparisons to other properties sold in the same geographic area and independent third party valuations. We also consider information obtained about each property as a result of its pre-acquisition due diligence, marketing and leasing activities in estimating the fair values of the tangible and intangible assets and liabilities acquired.
The total value allocable to intangible assets acquired, which consists of unamortized lease origination costs, in-place leases and tenant relationships, are allocated based on management’s evaluation of the specific characteristics of each tenant’s lease and our overall relationship with that respective tenant. Characteristics considered by management in allocating these values include the nature and extent of the existing business relationships with the tenant, growth prospects for developing new business with the tenant, the remaining term of the lease and the tenant’s credit quality, among other factors.
The value allocable to above or below market component of an acquired in-place lease is determined based upon the present value (using a market discount rate) of the difference between (i) the contractual rents to be paid pursuant to the lease over its remaining term, and (ii) management’s estimate of rents that would be paid using fair market rates over the remaining term of the lease. The amounts allocated to above or below market leases are included in lease intangibles, net in the accompanying balance sheets and are amortized on a straight-line basis as an increase or reduction of rental income over the remaining non-cancelable term of the respective leases. Amortization of above market rents was $56,942 and $89,307 for the three and six months ended June 30, 2011, respectively. There was no amortization of above market rents in the three and six months ended June 30, 2010.
The land lease acquired with the World Plaza acquisition in 2007 has a fixed purchase price option cost of $181,710 at the termination of the lease in 2062. Management valued the land option at its residual value of $1,370,000, based upon comparable land sales adjusted to present value. The difference between the strike price of the option and the recorded cost of the land purchase option is approximately $1.2 million. Accordingly, management has determined that exercise of the option is considered probable. The land purchase option was determined to be a contract based intangible asset associated with the land. As a result, this asset has an indefinite life and is treated as a non-amortizable asset. The amount is included as land purchase option in the accompanying balance sheets.
The value of in-place leases, unamortized lease origination costs and tenant relationships are amortized to expense over the remaining term of the respective leases, which range from less than a year to ten years. The value of above market rents are amortized against rental income over the terms of the respective leases. The amount allocated to acquire in-place leases is determined based on management’s assessment of lost revenue and costs incurred for the period required to lease the “assumed vacant” property to the occupancy level when purchased. The amount allocated to unamortized lease origination costs is determined by what the Company would have paid to a third party to secure a new tenant reduced by the expired term of the respective lease. The amount allocated to tenant relationships is the benefit resulting from the likelihood of a tenant renewing its lease. Amortization expense related to these assets was $92,417 and $107,877 for the three months ended June 30, 2011 and 2010, respectively. Amortization related to these assets was $183,565 and $217,074 for the six months ended June 30, 2011 and 2010, respectively.
Estimates of the fair values of the tangible and intangible assets require us to estimate market lease rates, property-operating expenses, carrying costs during lease-up periods, discount rates, market absorption periods, and the number of years the property will be held for investment. The use of inappropriate estimates would result in an incorrect assessment of our purchase price allocation, which would impact the amount of our net income.
Sales of Undivided Interests in Properties. Gains from the sale of undivided interests in properties will not be recognized under the full accrual method until certain criteria are met. Gain or loss (the difference between the sales value and the proportionate cost of the partial interest sold) shall be recognized at the date of sale if a sale has been consummated and the following criteria are met:
| a. | The buyer is independent of the seller; |
| b. | Collection of the sales price is reasonably assured; and |
| c. | The seller will not be required to support the operations of the property or its related obligations to an extent greater than its proportionate interest. |
Gains relating to transactions which do not meet the criteria for full accrual method of accounting are deferred and recognized when the full accrual method of accounting criteria are met or by using the installment or deposit methods of profit recognition, as appropriate in the circumstances.
As of June 30, 2011, management has concluded that there are 5 model home properties aggregating approximately $2.6 million which are considered as held for sale and are included in real estate assets. These homes have mortgage notes payable of approximately $1.7 million.
Depreciation and Amortization of Buildings and Improvements Land, buildings and improvements are recorded at cost. Major replacements and betterments, which improve or extend the life of the asset, are capitalized and depreciated over their estimated useful lives, while ordinary repairs and maintenance are expensed as incurred. The cost of buildings and improvements are depreciated using the straight-line method over estimated useful lives ranging from 30 to 55 years for buildings, improvements are amortized over the shorter of the estimated life of the asset or term of the tenant lease which range from 1 to 10 years, and 4 to 5 years for furniture, fixtures and equipment. Depreciation expense for buildings and improvements for the three months ended June 30, 2011 and 2010, was $877,780 and $753,178, respectively. Depreciation expense for buildings and improvements for the six months ended June 30, 2011 and 2010, was $1,737,186 and $1,397,186, respectively.
Impairment of Real Estate Assets. The Company continually monitors events and changes in circumstances that could indicate that the carrying amounts of our real estate assets may not be recoverable as required by generally accepted accounting principles. If circumstances support the possibility of impairment, the Company prepares a projection of the undiscounted future cash flows, without interest charges, for the identified property and determines if the investment in such property is recoverable. If impairment is indicated, the carrying value of the property is written down to its estimated fair value based on the Company's best estimate of the property's discounted future cash flows. As of December 31, 2010, based on a review of each of our properties to determine if circumstances indicate impairment in the carrying value of the property exist, we determined that one of our properties was impaired. That property is the Havana Parker Office complex in Aurora, Colorado, a part of our office segment which had a carrying value of approximately $6.5 million at December 31, 2010. This property consists of 114,100 square feet of office space divided up into units ranging from 178 to 4,100 square feet and averaging 1,400 square feet. Due to many factors, including the general economy and rental competition from nearby office buildings, this property’s occupancy had decreased to 51% and rental rates had also declined. Based on these and other factors, we concluded that the property was impaired and required adjustment to fair value. Fair value of the property was based on our analysis of future discounted cash flows using new lease move-ins and rent rates starting with the new tenant results achieved in 2009 and 2010. After 2011, the rent rates were increased approximately 5% and the absorption rate remained constant until a 15% vacancy rate was achieved. We believe the assumptions are reasonable but we cannot give any assurance that they will, in fact, be realized. Based on this analysis, we determined a $1.0 million write-down of the carrying value of this property was appropriate. The mortgage note payable on the property of approximately $3.3 million is payable in monthly installments of through July 1, 2016. The mortgage note payable does not have any debt covenants that would likely to be violated as a result of this impairment and the building’s performance.
As of June 30, 2011, management does not believe that any additional indicators of impairment were evident.
Our strategy is to hold properties for long-term use. If our strategy and or market conditions change or we decide to dispose of an asset, we may be required to recognize an impairment loss to reduce the property to the lower of carrying amount or fair value and such a loss could potentially be material and could adversely affect our results of operations.
Intangible Assets. Lease intangibles represents the allocation of a portion of the purchase price of a property acquisition representing the estimated value of in-place leases, unamortized lease origination costs, tenant relationships and a land purchase option. Intangible assets are comprised of finite-lived and indefinite-lived assets. Indefinite-lived assets are not amortized. Finite-lived intangibles are amortized over their expected useful lives. We assess our intangible assets for impairment at least annually.
We are required to perform a test for impairment of other definite and indefinite lived intangible assets at least annually, and more frequently as circumstances warrant. Our testing date is the end of our calendar year. Based on our current reviews, no impairment was deemed necessary at December 31, 2010 and, as of June 30, 2011, management does not believe that any indicators of impairment were evident.
Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value. Impairment is recognized only if the carrying amount of the intangible asset is considered to be unrecoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the estimated fair value of the asset. Based on the review, no impairment was deemed necessary at December 31, 2010 and, as of June 30, 2011, management does not believe that any indicators of impairment were evident.
Investments in Real Estate Ventures. We analyze our investments in joint ventures to determine whether the joint venture should be accounted for under the equity method of accounting or consolidated into the financial statements. The Company has determined that the investors held as a tenant in common in its real estate ventures have certain protective and substantive participation rights that limit our control of the investment. Therefore, our share of investment in these real estate ventures was accounted for under the equity method of accounting in the accompanying financial statements while the properties were held as a tenant in common.
Under the equity method, our investment in real estate ventures is stated at cost and adjusted for our share of net earnings or losses and reduced by distributions. Equity in earnings of real estate ventures is generally recognized based on our ownership interest in the earnings of each of the unconsolidated real estate ventures. For the purposes of presentation in the statement of cash flows, we follow the “look through” approach for classification of distributions from joint ventures. Under this approach, distributions are reported under operating cash flow unless the facts and circumstances of a specific distribution clearly indicate that it is a return of capital (e.g., a liquidating dividend or distribution of the proceeds from the joint venture’s sale of assets) in which case it is reported as an investing activity. Management assesses whether there are any indicators that the value of our investments in unconsolidated real estate ventures may be impaired when events or circumstances indicate that there may be an impairment. An investment is impaired if management’s estimate of the fair value of the investment is less than its carrying value. To the extent impairment has occurred, and is considered to be other than temporary, the loss is measured as the excess of the carrying amount of the investment over the fair value of the investment. The Company did not have any investments in real estate ventures as of June 30, 2011 and 2010. No impairment charges related to investments in real estate ventures were recognized over the periods the Company had these assets.
Revenue Recognition. We recognize revenue from rent, tenant reimbursements, and other revenue once all of the following criteria are met:
| • | persuasive evidence of an arrangement exists; |
| • | delivery has occurred or services have been rendered; |
| • | the amount is fixed or determinable; and |
| • | the collectability of the amount is reasonably assured. |
Annual rental revenue is recognized in rental revenues on a straight-line basis over the term of the related lease.
Certain of our leases currently contain rental increases at specified intervals. We record as an asset, and include in revenues, deferred rent receivable that will be received if the tenant makes all rent payments required through the expiration of the initial term of the lease. Deferred rent receivable in the accompanying balance sheets includes the cumulative difference between rental revenue recorded on a straight-line basis and rents received from the tenants in accordance with the lease terms. Accordingly, we determine, in our judgment, to what extent the deferred rent receivable applicable to each specific tenant is collectible. We review material deferred rent receivable, as it relates to straight-line rents, on a quarterly basis and take into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. In the event that the collectability of deferred rent with respect to any given tenant is in doubt, we record an increase in the allowance for uncollectible accounts, we record a direct write-off of the specific rent receivable. No such reserves related to deferred rent receivables have been recorded as of June 30, 2011 or December 31, 2010.
Interest income on mortgages receivable is accrued as it is earned. The Company stops accruing interest income on a loan if it is past due for more than 90 days or there is doubt regarding collectability of the loan principal and/or accrued interest receivable.
RECENT EVENTS HAVING SIGNIFICANT EFFECT ON RESULTS OF OPERATIONS COMPARISONS
Property Acquisitions
In March 2010, the Company purchased certain tangible and intangible personal property from DMHU, including rights to certain names, trademarks and trade secrets, title to certain business equipment, furnishings and related personal property. DMHU had used these assets in its previous business of purchasing model homes for investment in new residential housing tracts and initially leasing the model homes back to their developer. In addition, the Company also acquired DMHU’s rights under certain contracts, including contracts to provide management services to 19 limited partnerships sponsored by DMHU and for which a DMHU affiliate serves as general partner (the “Model Home Partnerships”). These partnerships include DAP II and DAP III in each of which the Company was a 51% limited partner. In the DMHU Purchase, the Company paid the owners of DMHU $300,000 cash and agreed to issue up to 120,000 shares of the Company’s common stock, depending on the levels of production the Company achieves from its newly formed Model Homes Division over the next three years. The Company also agreed to continue to employ three former DMHU employees and to pay certain obligations of DMHU, including its office lease which expired on September 30, 2010. As Mr. Dubose is a Company director and was the founder and former president and principal owner of DMHU and certain of its affiliates, this transaction was completed in compliance with the Company’s Board’s Related Party Transaction Policy. The transaction has been accounted for as a business combination. Management performed an analysis of intangible assets acquired with the assistance of an independent valuation specialist and it was determined that $209,000 of the purchase price is attributable to customer relationships and will be amortized over 10 years. The Company also estimated a liability of $1,032,000 associated with the 120,000 shares that it believes will be issued in the future. As a result of the acquisition, the total purchase price of $1,332,000 was allocated between goodwill of $1,123,000 and intangible assets of $209,000. As a result of the transaction, the Company’s investment in DAP II and DAP III are consolidated into the financial statements of NetREIT effective March 1, 2010.
The Company has formed its Model Homes Division which will pursue investment activities based on DMHU’s business model. The Model Homes Division’s activities will initially include the purchase and leaseback of Model Homes in new residential housing tract developments and providing management services to the 19 Model Home Partnerships. To pursue this business, the Company formed a new subsidiary, NetREIT Advisors and is sponsoring the formation of NetREIT Dubose. NetREIT Dubose will invest in Model Homes it purchases from developers in transactions where the developer leases back the Model Home under a short term lease, typically one to three years in length. Upon expiration of the lease, NetREIT Dubose will seek to re-lease the Model Home until such time as it is able to sell the property. NetREIT Dubose will own substantially all of its assets and conduct its operations through the Operating Partnership. NetREIT Advisors serves as the advisor to NetREIT Dubose.
NetREIT Advisors will also provide management services to the 19 Model Home Partnerships, pursuant to the rights under the management contracts assigned to it by DMHU. For these services, NetREIT Advisors receives ongoing management fees and has the right to receive certain other fees when the respective partnership sells or otherwise disposes of its properties.
In May 2010, the Company completed the acquisition of Sparky’s Rialto located in Rialto, California. The purchase price was $4.9 million. The Company paid the purchase price through a cash payment of approximately $2.0 million and a promissory note in the amount of approximately $2.9 million. The property consists of approximately 7.5 acres of land, 101,343 rentable square feet and approximately 771 self storage units. There are three and six months results of operations included for the three months and the six months ended June 30, 2011. There are one month results of operations included in the three and six months ended June 30, 2010.
In July 2010, the Company capitalized NetREIT Dubose with a cash contribution of $1.2 million in return for a convertible promissory note, which was subsequently converted to NetREIT Dubose common stock on September 30, 2010. NetREIT Dubose has also commenced raising outside investor capital pursuant to a private offering. NetREIT Dubose seeks to sell up to 2.0 million shares of its common stock at $10.00 per share, or $20.0 million in this private placement.
In August, 2010, the Company completed the acquisition of Genesis Plaza. The purchase price was $10.0 million The Company paid the purchase price through a cash payment of $5.0 million and a new mortgage loan with an insurance company secured by the Property of $5.0 million. The loan bears interest at 4.65% with a 25 year amortization schedule and a maturity date of August, 24, 2015 that may be extended for an additional 5 years at the lender’s discretion subject to a change in the interest rates and other terms of the agreement. The Property is a four-story suburban office building built in 1988 and located in the Kearny Mesa submarket of San Diego, California, consisting of 57,685 rentable square feet. There are three and six months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In October 2010, NetREIT Dubose acquired four model home properties in Arizona and leased them back to the developer. The purchase price for the properties was $0.9 million. The Company paid the purchase price through a cash payment of $0.45 million and four promissory notes totaling $0.45 million. There are three and six months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In October 2010, NetREIT Dubose acquired ten model home properties in Oregon, Idaho and Washington and leased them back to the developer. The purchase price for the properties was $6.1 million. The Company paid the purchase price through a cash payment of $3.05 million and ten promissory notes totaling $3.05 million. There are three and six months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In December 2010, NetREIT Dubose acquired twelve model home properties in Texas and leased them back to the developer. The purchase price for the properties was $2.9 million. The Company paid the purchase price through a cash payment of $1.45 million and ten promissory notes totaling $1.45 million. There are three and six months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In November 2010, the Company completed its tender offer for the purchase of outstanding partnership units of the three Income Funds. The tender resulted in the Company acquiring 73.6%, 70.5% and 66.6% of the outstanding units of DMHI Fund #3, DMHI Fund #4 and DMHI Fund #5, respectively through the issuance of 112,890 shares of common stock and $896,893 in cash. These funds own a total of 29 model home properties. There are three and six months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In January 2011, the Company acquired two model home properties in Texas and leased them back to the home builder. The purchase price for the properties was $0.45 million. The Company paid the purchase price through a cash payment of $0.23 million and two promissory notes totaling $0.22 million. There are three and approximately five months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In February 2011, the Company acquired five model home properties in California and leased them back to the home builder. The purchase price for the properties was $1.5 million. The Company paid the purchase price through a cash payment of $0.75 million and five promissory notes totaling $0.75 million. There are three and approximately four months results of operations included for the three months and the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In March 2011, the Company acquired four model home properties in South Carolina, Florida and Texas and leased them back to the home builder. The purchase price for the properties was $1.0 million. The Company paid the purchase price through a cash payment of $0.50 million and four promissory notes totaling $0.50 million. There are no results of operations included in the three months ended June 30, 2011 and three months results of operations included for the six months ended June 30, 2011. There are no results of operations included in the three and six months ended June 30, 2010.
In May 2011, the Company acquired vacant land consisting of approximately 3 acres adjacent to its Sparky’s Rialto Self-Storage facility for approximately $0.4 million paid in cash. The Company intends to use the land for additional motor home parking or for other purposes.
In May 2011, the Company acquired the Dakota Bank Buildings for the purchase price of approximately $9.6 million. The Property is a six-story, two building office complex built in 1981 and 1986 located on 1.58 and consists of approximately120,000 rentable square feet acres in downtown Fargo, North Dakota. The Company made a down payment of approximately $3.875 million and financed the remainder of the purchase price through a monthly adjustable rate mortgage with interest at 3.0% over the one month Libor with an interest rate floor of 5.75% and ceiling of 9.75%.
In June 2011, NetREIT Dubose acquired three model home properties in Texas and leased them back to the home builder. The purchase price for the properties was approximately $0.60 million. NetREIT Dubose paid the purchase price through a cash payment of approximately $0.30 million and three promissory notes totaling approximately $0.30 million.
The Company disposed of the following properties in 2011:
During the six months ended June 30, 2011, the company disposed of fifteen model home properties. The sales price aggregated approximately $5.2 million and approximately $1.8 million in mortgage notes payable were retired in connection with the sale.
Financing
In February 2005, we commenced a private placement offering of up to $50 million of (i) Series AA Preferred Stock and (ii) units, each unit consisting of two shares of our common stock and a warrant to purchase one share of our common stock at an exercise price of $12.00 (now $9.87, as adjusted for stock dividends) exercisable as of the date of issuance and expiring if not exercised on or prior to March 31, 2010. Each Unit was priced at $20.00 and the Series AA Preferred Stock was priced at $25.00 per share. A total of 433,204 Units were sold in this offering comprising an aggregate of 433,204 warrants to purchase common stock and 866,408 shares of common stock, and a total of 50,200 shares of the Series AA Preferred Stock were sold in this offering. Each share of Series AA Preferred Stock (i) is non-voting, except under certain circumstances as provided in our Articles of Incorporation; (ii) is entitled to annual cash dividends of 7% which are cumulative and which we pay on a quarterly basis; (iii) ranks senior, as to the payment of dividends and distributions of assets upon liquidation, to common stock or any other series of preferred stock that is not senior to or on parity with the Series AA Preferred Stock; (iv) is entitled to receive $25.00 plus accrued and unpaid dividends upon liquidation; (v) may be redeemed by us prior to the mandatory conversion date at a price of $25.00 plus accrued dividends, (vi) may be converted into two shares of common stock at the option of the holder prior to the mandatory conversion date, and, (vii) if not previously redeemed or converted, shall be converted automatically into two shares of common stock on the fourth Friday of December 2015. The conversion price is subject to certain anti dilution adjustments. The Company redeemed all of the shares outstanding in May 2010 at their face or book value.
In October 2006 we terminated our offering of Series AA Preferred Stock and Units, and we commenced a new offering of up to $200 million in shares of our common stock at a price of $10.00 per share. Net proceeds received from these offerings, after commissions, due diligence fees, and syndication expenses, were approximately $13.3 million in 2010 and $5.3 million for the six months ended June 30, 2011. The net proceeds were primarily used to acquire properties and to expand our administrative staff and support capabilities to levels commensurate with our increasing assets and staff requirements.
THE FOLLOWING IS A COMPARISON OF OUR RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2011 AND 2010.
Revenues
Rental and fee income was $3,297,223 for the three months ended June 30, 2011, compared to $2,459,559 for the same period in 2010, an increase of $837,664, or 34.1%. The increase in rental income as reported in 2011 compared to 2010 is primarily attributable to:
| • | The addition of the three properties acquired in 2010 and 2011 and the addition of the model home properties which generated an additional $936,409 of rent and fee income in the three month period ended June 30, 2011 compared to the same period in 2010; and |
| • | A decrease of rental and fee income of approximately $98,746 for properties owned for the full three months ended June 30, 2011 and 2010. Rental and occupancy rates at two of our office buildings, the Rangewood Medical Building and Executive Office Park in Colorado have declined. The Company does not believe that this is a trend as both of these buildings have recently signed new tenants and the expectations are that the rent income will increase as a result. |
Overall rental and fee revenues are expected to continue to increase in future periods, as compared to historical periods, as a result of owning the assets acquired during 2010 and 2011 for an entire year and future acquisitions of real estate assets.
Interest income was $23,417 for the three month period ended June 30, 2011, compared to $27,842 for the same period in 2010, a decrease of $4,425, or 15.9%. The decrease was primarily attributable to a decrease in cash balances in 2011 that were invested in interest bearing accounts.
Rental Operating Expenses
Rental operating expenses were $1,241,519 for the three month period ended June 30, 2011 compared to $1,125,179 for the same period in 2010, an increase of $116,340, or 10.3%. The increase in operating expense year over year is primarily attributable to the same reasons that rental revenue increased. Rental operating costs as a percentage of rental income was 39.0% and 47.5% for the three months ended June 30, 2011 and 2010, respectively. The decrease in operating costs as a percentage of revenue is primarily due to the addition of the model home properties that are rented on a triple net basis.
Rental operating costs are expected to continue to increase in future periods, as compared to historical periods, as a result of owning recently acquired assets for entire periods and anticipated future acquisitions of real estate assets.
Interest Expense
Interest expense, including amortization of deferred finance charges, increased by $268,814, or 53.9% during the three month period ended June 30, 2011 compared to the same period in 2010. The primary reason for the increase is the mortgage debt additions related to the acquisition of Sparky’s Rialto Self-Storage, Genesis Plaza, the Dakota Bank Buildings and the model home properties. In addition, in late June 2011, the Company refinanced its Casa Grande and Executive Office Park properties to raise additional cash for anticipated acquisitions.
The weighted average interest rate as of June 30, 2011 was 5.71% compared to 5.84% as of June 30, 2010.
The following is a summary of our interest expense on loans by property for the three months ended June 30, 2011 and 2010:
| | Date Acquired/Financed | | 2011 | | | 2010 | |
| | | | | | | | |
| Havana/Parker Complex | June 2006 | | $ | 54,184 | | | $ | 55,369 | |
| Garden Gateway Plaza | March 2007 | | | 147,661 | | | | 151,578 | |
| World Plaza | September 2007 | | | 42,044 | | | | 44,068 | |
| Waterman Plaza | August 2008 | | | 59,652 | | | | 60,803 | |
| Sparky’s Thousand Palms Self-Storage | August 2009 | | | 61,860 | | | | 63,182 | |
| Sparky’s Hesperia East Self-Storage | December 2009 | | | 21,558 | | | | 22,137 | |
| Dubose Acquisition Partners II, LP | March 2010 | | | 33,498 | | | | 44,363 | |
| Dubose Acquisition Partners III, LP | March 2010 | | | 32,042 | | | | 29,138 | |
| Sparky’s Rialto Self-Storage | May 2010 | | | 36,173 | | | | 21,498 | |
| Genesis Plaza | August 2010 | | | 57,291 | | | | - | |
| Dubose Model Home Income Fund #3, LTD | December 2010 | | | 31,912 | | | | - | |
| Dubose Model Home Income Fund #4, LTD | December 2010 | | | 20,918 | | | | - | |
| Dubose Model Home Income Fund #5, LTD | December 2010 | | | 30,449 | | | | - | |
| NetREIT Dubose Model Home REIT, Inc. | October 2010 | | | 62,664 | | | | - | |
| Dakota Bank Buildings | May 2011 | | | 32,775 | | | | - | |
| Casa Grande Apartments | June 2011 | | | 2,836 | | | | - | |
| Executive Office Park | June 2011 | | | 10,216 | | | | - | |
| Amortization of deferred financing costs | | | | 29,990 | | | | 6,773 | |
| | | | $ | 767,723 | | | $ | 498,909 | |
General and Administrative Expenses
General and administrative expenses increased by $141,519 to $946,838 for the three months ended June 30, 2011, compared to $805,319 in the same period in 2010. As a percentage of rental and fee income, general and administrative expenses were down to 28.7% for the three months ended June 30, 2011, from 32.7% for the same three months in 2010. We anticipate that general and administrative expenses will continue to decline as a percentage of rental and fee income.
For the three months ended June 30, 2011, our salaries and employee related expenses increased $37,912 to $517,799 compared to $479,887 for the same three months in 2010, an increase of 7.8%. The increase in salary and employee expenses in 2011 was primarily attributable to additional stock based compensation expense of approximately $24,000. In addition, the Company annually grants salary increases to employees effective January 1 each year.
Legal, accounting and public company related expenses and increased by approximately $55,000 to $181,459 for the three month period ended June 30, 2011, compared to $126,459 during the same period in 2010. The increase is primarily due to the costs associated with the annual audit, the printing of annual reports and proxy statements and the annual solicitation of proxy votes for the Company’s annual meeting.
Insurance related expenses increased by $14,380 to $62,781 for the three month period ended June 30, 2011 compared to $48,401 for the same period in 2010. The increase is also attributable to the overall growth of the Company as well as general rate increases.
Other increases to general and administrative costs include increased acquisition costs related to the model home properties and increases in office and related expenses due to the overall growth of the Company.
Gain on Sale of Real Estate Assets
In the three month period ended June 30, 2011, the Company had gains on the sale of model home properties of $57,790. The gain for the quarter is considered unusual and is a result of the timing of certain sales. The Company has 73 model home properties and currently has an immaterial amount of homes up for sale.
Net Loss
Net loss for the three months ended June 30, 2011 was $730,405, or $0.06 loss per share, compared to a net loss for the three months ended June 30, 2010 of $901,890, or $0.08 loss per share. The decrease in net loss of $171,485 in the three month period ended June 30, 2011 was primarily attributable to increased net operating income of our properties, offset by an increase to the general and administrative expenses.
THE FOLLOWING IS A COMPARISON OF OUR RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2011 AND 2010.
Revenues
Rental and fee income was $6,624,453 for the six months ended June 30, 2011, compared to $4,473,235 for the same period in 2010, an increase of $2,151,218, or 48.1%. The increase in rental income as reported in 2011 compared to 2010 is primarily attributable to:
| • | The addition of the three properties acquired in 2010 and 2011 and the addition of the model home properties which generated an additional $1,926,789 of rent and fee income in the six month period ended June 30, 2011 compared to the same period in 2010; and |
| • | Rental and fee income increased by approximately $85,683 for properties owned for the full six months ended June 30, 2011 and 2010. |
| • | Rental and fee income was $138,746 less in the six month period ended June 30, 2010 for the Garden Gateway property accounted for under the equity method as discussed above. |
Overall rental and fee revenues are expected to continue to increase in future periods, as compared to historical periods, as a result of owning the assets acquired during 2010 and 2011 for an entire year and future acquisitions of real estate assets.
Interest income was $47,591 for the six month period ended June 30, 2011, compared to $54,757 for the same period in 2010, a decrease of $7,166, or 13.1%. The decrease is attributable to a decrease in cash balances in 2011 that were invested in interest bearing accounts.
Rental Operating Expenses
Rental operating expenses were $2,348,978 for the six month period ended June 30, 2011 compared to $2,059,641 for the same period in 2010, an increase of $289,337, or 14.0%. The increase in operating expense year over year is primarily attributable to the same reasons that rental revenue increased except for the model home properties which are rented on a triple net basis. Rental operating costs as a percentage of rental and fee income was 35.5% and 46.0% for the six months ended June 30, 2011 and 2010, respectively. The decrease in operating costs as a percentage of revenue is primarily due to the addition of the model home properties that are rented on a triple net basis.
Rental operating costs are expected to continue to increase in future periods, as compared to historical periods, as a result of owning recently acquired assets for entire periods and anticipated future acquisitions of real estate assets.
Interest Expense
Interest expense, including amortization of deferred finance charges, increased by $620,023, or 70.8% during the six month period ended June 30, 2011 compared to the same period in 2010. The primary reason for the increase is the mortgage debt additions related to the acquisition of Sparky’s Rialto Self-Storage, Genesis Plaza, the Dakota Bank Buildings and the model home properties. In addition, the Company refinanced its Casa Grande and Executive Office Park properties to raise additional cash for anticipated acquisitions.
The weighted average interest rate as of June 30, 2011 was 5.71% compared to 5.84% as of June 30, 2010.
The following is a summary of our interest expense on loans by property for the six months ended June 30, 2011 and 2010:
| | Date Acquired/Financed | | 2011 | | | 2010 | |
| | | | | | | | |
| Havana/Parker Complex | June 2006 | | $ | 108,081 | | | $ | 110,419 | |
| Garden Gateway Plaza | March 2007 | | | 296,323 | | | | 253,155 | |
| World Plaza | September 2007 | | | 84,603 | | | | 88,625 | |
| Waterman Plaza | August 2008 | | | 119,598 | | | | 121,882 | |
| Sparky’s Thousand Palms Self-Storage | August 2009 | | | 124,056 | | | | 126,688 | |
| Sparky’s Hesperia East Self-Storage | December 2009 | | | 42,968 | | | | 44,627 | |
| Dubose Acquisition Partners II, LP | March 2010 | | | 71,371 | | | | 58,537 | |
| Dubose Acquisition Partners III, LP | March 2010 | | | 59,165 | | | | 37,677 | |
| Sparky’s Rialto Self-Storage | May 2010 | | | 72,151 | | | | 21,498 | |
| Genesis Plaza | August 2010 | | | 114,898 | | | | - | |
| Dubose Model Home Income Fund #3, LTD | December 2010 | | | 71,363 | | | | - | |
| Dubose Model Home Income Fund #4, LTD | December 2010 | | | 46,841 | | | | - | |
| Dubose Model Home Income Fund #5, LTD | December 2010 | | | 72,524 | | | | - | |
| NetREIT Dubose Model Home REIT, Inc. | October 2010 | | | 110,528 | | | | - | |
| Dakota Bank Buildings | May 2011 | | | 32,775 | | | | - | |
| Casa Grande Apartments | June 2011 | | | 2,836 | | | | - | |
| Executive Office Park | June 2011 | | | 10,216 | | | | - | |
| Amortization of deferred financing costs | | | | 55,790 | | | | 12,956 | |
| | | | $ | 1,496,087 | | | $ | 876,064 | |
General and Administrative Expenses
General and administrative expenses increased by $296,752 to $1,864,540 for the six months ended June 30, 2011, compared to $1,567,788 in the same period in 2010. As a percentage of rental and fee income general and administrative expenses were down to 28.2% for the six months ended June 30, 2011, from 35.1% for the same three months in 2010. In comparing our general and administrative expenses with other REITs, you should take into consideration that we are a self administered REIT, which means such expenses are greater for us than an advisory administered REIT.
For the six months ended June 30, 2011, our salaries and employee related expenses increased $241,653 to $1,109,057 compared to $867,404 for the same six months in 2010, an increase of 27.9%. The increase in salary and employee expenses in 2011 was primarily attributable to the addition of the employees associated with the Dubose Partnerships and additional stock based compensation expense of approximately $50,000. In addition, the Company annually grants salary increases to employees effective January 1 each year.
Legal, accounting and public company related expenses and decreased by approximately $60,519 to $259,058 for the six month period ended June 30, 2011, compared to $319,577 during the same period in 2010. The decrease is primarily due to the costs associated with the Company’s efforts to reincorporate in Maryland in 2010.
Insurance related expenses increased by $40,284 to $129,643 for the six month period ended June 30, 2011 compared to $89,359 for the same period in 2010. The increase is also attributable to the overall growth of the Company as well as general rate increases.
Other increases to general and administrative costs include increased acquisition costs related to the model home properties and increases in office and related expenses due to the overall growth of the Company.
Loss on Sale of Real Estate Assets
In the six month period ended June 30, 2011, the Company had a loss on the sale of model home properties of $24,487. The loss year-to-date is considered unusual and is a result of the timing of certain sales. The Company has 73 model home properties and currently has an immaterial amount of homes up for sale, which if they were all sold in the same period, would result in a net gain.
Net Loss
Net loss for the six months ended June 30, 2011 was $1,269,204, or $0.10 loss per share, compared to a net loss for the six months ended June 30, 2010 of $1,769,837, or $0.17 loss per share. The decrease in net loss of $500,633 in the six month period ended June 30, 2011 was primarily attributable to increased net operating income of our properties, offset by an increase to the general and administrative expenses.
LIQUIDITY AND CAPITAL RESOURCES
As discussed above under Economic Outlook, during 2011, there have been indications of economic improvement and stabilization in the equity markets. However, we expect the market turbulence could continue in the commercial real estate arena as mortgage financing originated over the past three to seven years mature.
We believe that as a result of these negative trends, new mortgage financing will be less favorable as pre-recession days, which may negatively impact our ability to finance future acquisitions. Long-term interest rates remain relatively low by historical standards but we anticipate that interest rates will increase in the next couple of years. On the other hand, we believe the negative trends in the mortgage markets for smaller properties and in some geographic locations have reduced property prices and may, in certain cases, reduce competition for those properties.
Overview
We actively seek investments that are likely to produce income in order to pay distributions as well as long-term gains for our stockholders. Our sources of liquidity include cash and cash equivalents, cash flows from operations, mortgages on our unencumbered properties and additional equity securities from our ongoing private placement offering.
Our future capital needs include the acquisition of additional properties as we as expand our investment portfolio into other real property sectors, pay down outstanding borrowings and the payment of a competitive distribution to our shareholders. To ensure that we are able to effectively execute these objectives, we routinely review our liquidity requirements and continually evaluate all potential sources of liquidity. Our short term liquidity needs include proceeds necessary to fund our distribution to stockholders, pay the debt service on existing mortgages, and fund our current operating costs. Our long-term liquidity needs include proceeds necessary to grow and maintain our portfolio of investments.
We believe that our available liquidity is sufficient to fund our distributions to stockholders, pay the debt service costs on our existing mortgages and fund our operating costs in the near term. We further believe that our cash flow from operations along with the potential financing capital available to us in the future is sufficient to fund our long-term liquidity needs. However, we do not expect that our cash flow from operating activities will be sufficient to fund our short term liquidity needs, including the payment of cash dividends at current rates to our shareholders, and instead expect to fund such needs out of additional borrowings of secured or unsecured indebtedness, and from proceeds of the ongoing private placement of common stock. We expect to obtain additional mortgages and assumption of existing debt collateralized by some or all of our real property in the future. During June 2011, we obtained approximately $5.7 million from new mortgages collateralized by two of our unencumbered properties and we could obtain additional mortgages collateralized by some or all of the seven unencumbered existing properties. During the six months ended June 30, 2011, we received approximately $5.3 million of cash from net proceeds in connection with our private placement offering and we anticipate raising approximately $15 million additional capital during the remainder of 2011.
Cash and Cash Equivalents
At June 30, 2011, we had approximately $8.4 million in cash and cash equivalents compared to approximately $7.0 million at December 31, 2010. We intend to use this cash to make additional acquisitions, pay debt service costs on our existing mortgages and for general corporate purposes.
Our cash and cash equivalents are held in bank accounts at third party institutions and consist of invested cash and cash in our operating accounts. During 2010 or 2011, we did not experience any loss or lack of access to our cash or cash equivalents.
Debt
As of June 30, 2011, the Company had mortgage notes payables in the aggregate principal amount of $45.1 million, collateralized by a total of 11 non model home properties with terms at issuance ranging from 3 to 30 years. The weighted-average interest rate on the mortgage notes payable as of June 30, 2011 was approximately 5.69%. Our debt to book value on these properties is approximately 60% and we have 7 non model home properties with a net book value of $25.6 million that are unencumbered. We have mortgage debt balloon principal payments on one mortgage of approximately $3.1 million in 2012. Despite the disruptions in the debt market discussed in “Overview” above, we believe that we will be able to refinance these debts as they come due if we so desire.
As of June 30, 2011, NetREIT Dubose had 40 fixed-rate mortgage notes payable in the aggregate principal amount of $4.5 million, collateralized by a total of 40 model home properties. These loans generally have a term at issuance of five years. The weighted-average interest rate on these mortgage notes payable as of June 30, 2011 was 5.78%. Our debt to net book value on these properties is approximately 49.6%. The Company has guaranteed these notes. The balloon principal payments on the notes payable are in 2015 and 2016.
As of June 30, 2011, limited partnerships that the Company has a limited partnership interest in had 35 fixed-rate mortgage note payables in the aggregate principal amount of $6.7 million, collateralized by a total of 35 model home properties. The debt to book value on these properties is approximately 57.8%. All of these notes payable have mortgage debt balloon principal payments in 2011. All of the free cash flow on these limited partnerships is being held or applied to the loan balances with no distribution to the partners until all homes have been sold. All of the properties will be sold at the end of the lease agreements and we believe that all properties will be sold for more than the mortgage debt balloon amount.
During the second quarter of 2011, we have financed one acquisition with approximately 50% debt provided by regional banks and we have obtained new financing from a life insurance company on two unencumbered properties for approximately 50% their appraised values. Despite the disruptions in the debt market discussed in “Overview” above, we believe that we will be able to refinance maturing debts as on or before maturity dates.
Operating Activities
Net cash provided by operating activities for the six months ended June 30, 2011 was approximately $582,000 and compared to net cash used in operating activities of approximately $890,000 for the six months ended June 30, 2010. The increase of approximately $1,472,000 was primarily due to an increase in net operating income of our properties of $884,000 and an increase of approximately $507,000 from contributions in excess of distributions of non-controlling interests. Although the cash from operating activities did not cover the cash portion of the distribution to our stockholders of $1,697,000, we anticipate that with the maturity of the recent acquisitions and the anticipated 2011 acquisitions that the cash provided by operating activities will cover the cash distribution to shareholders in the near future.
Investing Activities
Net cash used in investing activities was approximately $9.3 million during the six months ended June 30, 2011. During this period, the Company acquired the Dakota Bank Buildings for $9.6, acquired raw land adjacent to our Sparky’s Rialto Self-Storage facility for approximately $0.4 million and spent approximately $0.5 million of capital expenditures of existing properties. In addition NetREIT Dubose acquired 14 homes for $3.5 million. The Dubose Partnerships sold 15 model homes during the period for proceeds of $5.2 million.
Net cash used in investing activities for the six months ended June 30, 2010 was approximately $5.6 million. During this period in 2010 the Company acquired the Sparky’s Rialto Self-Storage facility for $4.9 million and had capital expenditures on portfolio properties of $0.6 million.
Financing Activities
Net cash provided by financing activities for the six months ended June 30, 2011 was approximately $10.1 million, which primarily consisted of $5.4 million net proceeds from the issuance of our common stock and proceeds from mortgage notes payable of $13.1 million. The proceeds were offset by reduction in mortgage notes payable of $6.0 million ($3.5 million in connection with the sale of the 15 model homes) and cash distributions to shareholders of $1.7 million, repurchase of common stock of $0.4 million and increase in deferred stock issuance costs of $0.2 million.
Net cash provided by financing activities for the six months ended June 30, 2010 was approximately $7.1 million, which consisted of $7.5 million net proceeds from the sale and issuance of our common stock and $2.9 million in proceeds from mortgage notes payable used to finance the acquisition of Sparky’s Rialto Self-Storage facility. These proceeds were offset by redemption of preferred stock and cash portion of distributions paid to our stockholders of $1.2 and $1.4 million, respectively, payments on mortgage notes payable of $0.4 and increase in deferred stock issuance cost of the $0.3.
Contractual Obligations
The following table provides information with respect to the maturities and scheduled principal repayments of our secured debt and interest payments on our fixed-rate debt at June 30, 2011 and provides information about the minimum commitments due in connection with our ground lease obligation. Our secured debt agreements contain covenants and restrictions requiring us to meet certain financial ratios and reporting requirements. Non-compliance with one or more of the covenants or restrictions could result in the full or partial principal balance of such debt becoming immediately due and payable.
We are in compliance with all conditions and covenants of our loans.
| | | | | | | 1-3 Years (2012-2013) | | | | 3-5 Years (2014-2015) | | | | | | Total | |
| Principal payments - secured debt | | $ | 510,127 | | | $ | 4,987,445 | | | $ | 20,695,300 | | | $ | 18,911,314 | | | $ | 45,104,186 | |
| Interest payments - fixed rate debt | | | 982,170 | | | | 3,655,959 | | | | 2,397,921 | | | | 979,910 | | | | 8,015,960 | |
| Interest payments - variable rate debt | | | 286,116 | | | | 1,114,397 | | | | 1,062,297 | | | | 2,458,691 | | | | 4,921,501 | |
| Model home properties - secured debt | | | 3,367,956 | | | | 3,885,871 | | | | 2,612,810 | | | | 1,373,057 | | | | 11,239,694 | |
| Model home properties - interest payments | | | 378,891 | | | | 516,961 | | | | 391,328 | | | | 10,160 | | | | 1,297,340 | |
| Ground lease obligation (1) | | | 10,020 | | | | 41,194 | | | | 43,820 | | | | 1,095,254 | | | | 1,190,288 | |
| | | $ | 5,535,280 | | | $ | 14,201,827 | | | $ | 27,203,476 | | | $ | 24,828,386 | | | $ | 71,768,969 | |
__________
(1) Ground lease obligation represents the ground lease payments due on our World Plaza Property.
Other Liquidity Needs
We are required to distribute 90% of our REIT taxable income (excluding capital gains) on an annual basis in order to qualify and maintain our qualification as a REIT for federal income tax purposes. Accordingly, we intend to continue to make regular quarterly distributions to our common shareholders from cash flow from operating activities. We are not contractually bound to make regular quarterly dividend distributions to our common stock holders. We may be required to use borrowings or other sources of capital, if necessary, to meet REIT distribution requirements and maintain our REIT status. In the past, as noted above, we have distributed cash amounts in excess of our taxable income resulting in a return of capital to our shareholders, and we currently have the ability to refrain from increasing our distributions while still meeting our REIT requirement for 2011. If our net cash provided by operating activities and gains on sale of real estate (assuming we are successful in selling any of our properties) do not exceed our intended distributions to our common shareholders, we would have to borrow funds or use proceeds of our ongoing common stock offering to pay the distribution or reduce or eliminate the distribution. We consider market factors and our historical and anticipated performance in addition to REIT requirements in determining our distribution levels.
Until proceeds from our offering are fully invested and our acquired properties are generating operating cash flow sufficient to fully cover distributions to our shareholders, we intend to pay a portion of the distributions to our shareholders from the proceeds of our ongoing common stock private placement offering or from borrowings in anticipation of future cash flows, as deemed appropriate.
Capitalization
As of June 30, 2011, our consolidated total debt as a percentage of total capitalization was 29.9% and our total debt as a percentage of total capitalization excluding the model home properties was 23.9%, which was calculated based on the offering price per share of our common stock of $10.00 under our ongoing current private placement of our common stock.
| | | | | | Aggregate Principal Amount or $ Value Equivalent | | | % of Total Market Capitalization | |
| Debt: | | | | | | | | | |
| NetREIT, Inc. debt | | | | | $ | 45,104,186 | | | | 23.91 | % |
| Model home properties debt | | | | | | 11,239,694 | | | | 5.96 | % |
| Total debt | | | | | $ | 56,343,880 | | | | 29.86 | % |
| | | | | | | | | | | | |
| Equity: | | | | | | | | | | | |
| | | | | | | | | | | | |
| Common stock outstanding (1) | | | 13,233,522 | | | | 132,335,220 | | | | 70.14 | % |
| Total Market Capitalization | | | | | | $ | 188,679,100 | | | | | |
| | (1) | Value based on the current price of shares being sold under the current private placement offering of $10.00 per share. |
Off-Balance Sheet Arrangements
As of June 30, 2011 and 2010, we do not have any off-balance sheet arrangements or obligations, including contingent obligations.
Capital Expenditures, Tenant Improvements and Leasing Costs
We currently project that during 2011 we could spend an additional $350,000 to $1,200,000 in capital improvements, tenant improvements, and leasing costs for properties within our portfolio. Capital expenditures may fluctuate in any given period subject to the nature, extent, and timing of improvements required to the properties. We may spend more on gross capital expenditures during 2011 compared to 2010 due to rising construction costs and the anticipated increase in property acquisitions in 2011. Tenant improvements and leasing costs may also fluctuate in any given year depending upon factors such as the property, the term of the lease, the type of lease, the involvement of external leasing agents and overall market conditions.
Non-GAAP Supplemental Financial Measure: Funds From Operations (“FFO”)
Management believes that FFO is a useful supplemental measure of our operating performance. We compute FFO using the definition outlined by the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as net income (loss) in accordance with GAAP, plus depreciation and amortization of real estate assets (excluding amortization of deferred financing costs and depreciation of non-real estate assets) reduced by gains and losses from sales of depreciable operating property and extraordinary items, as defined by GAAP. Other REITs may use different methodologies for calculating FFO and, accordingly, our FFO may not be comparable to other REITs. Because FFO excludes depreciation and amortization, gains and losses from property dispositions that are available for distribution to shareholders and extraordinary items, it provides a performance measure that, when compared year over year, reflects the impact to operations from trends in occupancy rates, rental rates, operating costs, development activities, 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 to the investment community about our financial performance when compared to other REITs since FFO is generally recognized as the industry standard for reporting the operations of REITs. However, FFO should not be viewed as an alternative measure of our operating performance since it does not reflect either depreciation and amortization costs or the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties that are significant economic costs and could materially impact our results from operations.
The following table presents our FFO for the three months and six months ended June 30, 2011 and 2010. FFO should not be considered an alternative to net income (loss), as an indication of our performance, nor is FFO indicative of funds available to fund our cash needs or our ability to make distributions to our shareholders. In addition, FFO may be used to fund all or a portion of certain capitalizable items that are excluded from FFO, such as capital expenditures and payments of debt, each of which may impact the amount of cash available for distribution to our shareholders.
| | | Three months ended June 30, | | | Six months ended June 30, | |
| | | 2011 | | | 2010 | | | 2011 | | | 2010 | |
| Net loss before noncontrolling interests | | $ | (580,202 | ) | | $ | (831,687 | ) | | $ | (1,043,086 | ) | | $ | (1,640,895 | ) |
| Adjustments: | | | | | | | | | | | | | | | | |
| Preferred Stock Dividends | | | - | | | | (12,484 | ) | | | - | | | | (34,447 | ) |
| Income attributable to noncontrolling interests | | | (150,203 | ) | | | (57,719 | ) | | | (226,118 | ) | | | (94,495 | ) |
| Depreciation and amortization | | | 1,091,858 | | | | 777,482 | | | | 2,070,344 | | | | 1,767,001 | |
| Loss on sale of real estate assets | | | (57,790 | ) | | | - | | | | 24,487 | | | | - | |
| Funds from Operations | | $ | 303,663 | | | $ | (124,408 | ) | | $ | 825,627 | | | $ | (2,836 | ) |
FFO for 2011 increased in the three month period ended June 30, 2011 by $428,071, to $303,663 compared to a negative FFO of $124,408 for the same period in 2010. For the six months ended June 30, 2011, FFO increased by $828,463 to $825,627 compared to a negative FFO of $2,836 for the six months ended June 30, 2010. The increased FFO is primarily due to the increase in performance of the properties especially those acquired in 2009 and 2010 with a smaller increase in general and administrative expenses.
FFO has been affected by lower yields on our investment of excess cash balances. We anticipate FFO to improve as we continue to acquire properties and earn rental revenues on properties recently acquired without substantial increases in general and administrative expenses.
Inflation
Since the majority of our leases require tenants to pay most operating expenses, including real estate taxes, utilities, insurance and increases in common area maintenance expenses, we do not believe our exposure to increases in costs and operating expenses resulting from inflation would be material.
Segments Disclosure
Our reportable segments consist of mortgage activities and the four types of commercial real estate properties for which our decision-makers internally evaluate operating performance and financial results: Residential Properties, including Model Homes, Office Properties, Retail Properties and Self-Storage Properties. We also have certain corporate level activities including accounting, finance, legal administration and management information systems which are not considered separate operating segments.
Our chief operating decision maker evaluates the performance of our segments based upon net operating income. Net operating income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provisions for bad debts) and excludes other non-property income and expenses, interest expense, depreciation and amortization, and general and administrative expenses. There is no intersegment activity.
See the accompanying financial statements for a Schedule of the Segment Reconciliation to Net Income Available to Common Shareholders.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not required
NetREIT maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s 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 the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based closely on the definition of “disclosure controls and procedures” in Rule 13a-14(c). In designing and evaluating the disclosure controls and procedures, management recognized 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 was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the fiscal quarter ended June 30, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
None.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
During the six months ended June 30, 2011, the Company sold 651,609 shares of its common stock for an aggregate net proceeds of $5.3 million. These shares were sold at a price of $10.00 per share in a private placement offering to a total of 170 accredited investors. Each issuee purchased their shares for investment and the shares are subject to appropriate transfer restrictions. The private placement offering was made by the Company through selected FINRA member broker-dealer firms. The sales were made in reliance on the exemptions from registration under the Securities Act of 1933 and applicable state securities laws contained in Section 4(2) of the Act and Rule 506 promulgated thereunder.
During the six months ended June 30, 2011, the Company also sold 99,524 shares of its common stock to certain of its existing shareholders under its dividend reinvestment plan. The shares were sold directly by the Company without underwriters to a total of 1,479 persons participating in the plan. The Company sold these shares in reliance on the exemptions from registration under the Securities Act of 1933 and applicable state securities laws set forth in Section 4(2) of the Act and Rule 506 promulgated thereunder. Each issuee purchased the shares for investment and the shares are subject to appropriate transfer restrictions.
All shares issued in these offerings were sold for cash consideration. The Company used the net proceeds it received for the sale of these shares to acquire and/or maintain its real estate investments
