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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x | Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2007 |
OR
¨ | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to |
Commission file number 333-136273
INSTITUTIONAL REIT, INC.
(Exact name of registrant as specified in its charter)
| Maryland | 20-4992451 | |
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number) |
6200 The Corners Parkway
Norcross, Georgia 30092
(Address of principal executive offices)
(Zip Code)
(770) 449-7800
(Registrant’s telephone number, including area code)
N/A
(Former name, former address, and former fiscal year, if changed since last report)
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 ¨ No x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one).
Large Accelerated filer ¨ Accelerated filer ¨ Non-Accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Number of shares outstanding of the registrant’s only
class of common stock, as of October 31, 2007: 100 shares
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INSTITUTIONAL REIT, INC.
TABLE OF CONTENTS
| Page No. | ||||||
PART I. | ||||||
Item 1. | 4 | |||||
Consolidated Balance Sheets as of September 30, 2007 (unaudited) and December 31, 2006 | 5 | |||||
| 6 | ||||||
| 7 | ||||||
| 8 | ||||||
Condensed Notes to Consolidated Financial Statements (unaudited) | 9 | |||||
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 16 | ||||
Item 3. | 21 | |||||
Item 4. | 21 | |||||
PART II. | ||||||
Item 1. | 22 | |||||
Item 1A. | 22 | |||||
Item 2. | 22 | |||||
Item 3. | 22 | |||||
Item 4. | 22 | |||||
Item 5. | 22 | |||||
Item 6. | 23 | |||||
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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this Quarterly Report on Form 10-Q of Institutional REIT, Inc. (“Institutional REIT,” the “Registrant,” “we,” “our” or “us”) other than historical facts may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We intend for all such forward-looking statements to be covered by the applicable safe harbor provisions for forward-looking statements contained in those acts. Such statements include, in particular, statements about our plans, strategies, and prospects and are subject to certain risks and uncertainties, including known and unknown risks, which could cause actual results to differ materially from those projected or anticipated. Therefore, such statements are not intended to be a guarantee of our performance in future periods. Such forward-looking statements can generally be identified by our use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “anticipate,” “estimate,” “believe,” “continue,” or other similar words. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date that this report is filed with the Securities and Exchange Commission (the “SEC”). We make no representations or warranties (express or implied) about the accuracy of any such forward-looking statements contained in this report, and we do not intend to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Any such forward-looking statements are subject to risks, uncertainties, and other factors and are based on a number of assumptions involving judgments with respect to, among other things, future economic, competitive, and market conditions, all of which are difficult or impossible to predict accurately. To the extent that our assumptions differ from actual results, our ability to meet such forward-looking statements, including our ability to generate positive cash flow from operations, make distributions to stockholders, and maintain the value of our real estate properties, may be significantly hindered. See Item 1A herein, as well as Item 1A in our quarterly report on Form 10-Q for the quarterly period ended March 31, 2007, for a discussion of some, although not all of the risks and uncertainties that could cause actual results to differ materially from those presented in our forward-looking statements.
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ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
The information furnished in the accompanying consolidated balance sheets and related consolidated statements of operations, stockholder’s equity (deficit), and cash flows reflects all adjustments that are, in management’s opinion, necessary for a fair and consistent presentation of the aforementioned financial statements.
The accompanying financial statements should be read in conjunction with the notes to Institutional REIT’s financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this quarterly report on Form 10-Q. Institutional REIT’s results of operations for the three months and nine months ended September 30, 2007 are not necessarily indicative of the operating results expected for the full year.
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CONSOLIDATED BALANCE SHEETS
(Unaudited) September 30, 2007 | December 31, 2006 | |||||||
Assets: | ||||||||
Cash and cash equivalents | $ | 899,804 | $ | 100,000 | ||||
Prepaid expenses | 123,180 | 244,154 | ||||||
Total assets | $ | 1,022,984 | $ | 344,154 | ||||
Liabilities: | ||||||||
Due to affiliate | $ | 628,501 | $ | 290,056 | ||||
Note payable to affiliate | 800,000 | — | ||||||
Total liabilities | 1,428,501 | 290,056 | ||||||
Commitments and Contingencies | — | — | ||||||
Minority Interest in Operating Partnership | — | 53,557 | ||||||
Stockholder’s Equity (Deficit): | ||||||||
Common stock, $0.01 par value; 1 billion shares authorized, 100 shares issued and outstanding | 1 | 1 | ||||||
Additional paid-in capital | 999 | 999 | ||||||
Accumulated deficit | (406,517 | ) | (459 | ) | ||||
Total stockholder’s equity (deficit) | (405,517 | ) | 541 | |||||
Total liabilities, minority interest, and stockholder’s equity (deficit) | $ | 1,022,984 | $ | 344,154 | ||||
See accompanying notes.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited) Three Months September 30, | (Unaudited) Period from July 21, 2006 (Inception) through September 30, 2006 | (Unaudited) Nine Months Ended September 30, | (Unaudited) Period from July 21, 2006 (Inception) through September 30, 2006 | |||||||||||||
Revenues | $ | — | $ | — | $ | — | $ | — | ||||||||
Expenses: | ||||||||||||||||
General and administrative | (146,002 | ) | (5,939 | ) | (433,589 | ) | (5,939 | ) | ||||||||
Interest expense | (12,804 | ) | — | (26,026 | ) | — | ||||||||||
Loss before minority interest | (158,806 | ) | (5,939 | ) | (459,615 | ) | (5,939 | ) | ||||||||
Minority interest in loss of Operating Partnership | — | 5,880 | 53,557 | 5,880 | ||||||||||||
Net loss | $ | (158,806 | ) | $ | (59 | ) | $ | (406,058 | ) | $ | (59 | ) | ||||
Per-share information – basic and diluted: | ||||||||||||||||
Net loss allocated to common stockholder | $ | (1,588.06 | ) | $ | (0.59 | ) | $ | (4,060.58 | ) | $ | (0.59 | ) | ||||
Weighted-average common shares outstanding – basic and diluted | 100 | 100 | 100 | 100 | ||||||||||||
See accompanying notes.
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CONSOLIDATED STATEMENTS OF STOCKHOLDER’S EQUITY (DEFICIT)
FOR THE PERIOD FROM JULY 21, 2006 (INCEPTION) THROUGH DECEMBER 31, 2006
AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 (UNAUDITED)
| Common Stock | Additional Capital | Accumulated Deficit | Total Equity | |||||||||||||
| Shares | Amount | |||||||||||||||
Balance, July 21, 2006 (inception) | — | $ | — | $ | — | $ | — | $ | — | |||||||
Issuance of common stock | 100 | 1 | 999 | — | 1,000 | |||||||||||
Net loss | — | — | — | (459 | ) | (459 | ) | |||||||||
Balance, December 31, 2006 | 100 | 1 | 999 | (459 | ) | 541 | ||||||||||
Net loss | — | — | — | (406,058 | ) | (406,058 | ) | |||||||||
Balance, September 30, 2007 | 100 | $ | 1 | $ | 999 | $ | (406,517 | ) | $ | (405,517 | ) | |||||
See accompanying notes.
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CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited) Nine Months September 30, | (Unaudited) Period from July 21, 2006 (Inception) through September 31, 2006 | |||||||
Cash Flows from Operating Activities: | ||||||||
Net loss | $ | (406,058 | ) | $ | (59 | ) | ||
Adjustment to reconcile net loss to net cash used in operating activities: | ||||||||
Decrease in prepaid expenses | 120,974 | — | ||||||
Minority interest in loss of Operating Partnership | (53,557 | ) | (5,880 | ) | ||||
Net cash used in operating activities | (338,641 | ) | (5,939 | ) | ||||
Cash Flows from Financing Activities: | ||||||||
Due to affiliate | 338,445 | 5,939 | ||||||
Note payable to affiliate | 800,000 | — | ||||||
Issuance of common stock | — | 1,000 | ||||||
Contribution from minority interest partner in operating partnership | — | 99,000 | ||||||
Net cash provided by financing activities | 1,138,445 | 105,939 | ||||||
Net increase in cash and cash equivalents | 799,804 | 100,000 | ||||||
Cash and cash equivalents, beginning of period | 100,000 | — | ||||||
Cash and cash equivalents, end of period | $ | 899,804 | $ | 100,000 | ||||
See accompanying notes.
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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007 (UNAUDITED)
1. ORGANIZATION
Institutional REIT, Inc. (“Institutional REIT”) was formed in December 2005 as a Maryland corporation that intends to qualify as a real estate investment trust (“REIT”) beginning with the tax year in which it commences active operations. Substantially all of Institutional REIT’s business is expected to be conducted through Institutional Operating Partnership, L.P. (“Institutional OP”), a Delaware limited partnership formed in June 2006. Institutional REIT is the sole general partner of Institutional OP and owns 1% of the limited partner units of Institutional OP. Wells Capital, Inc., Institutional REIT’s external advisor, (the “Advisor”) is the only other limited partner of Institutional OP and has contributed $99,000 to Institutional OP in exchange for 9,900 limited partnership units. As of September 30, 2007, neither Institutional REIT nor Institutional OP has engaged in any active operations. Unless otherwise noted, references to Institutional REIT herein shall include Institutional REIT and Institutional OP.
Institutional REIT executed an agreement with the Advisor on December 27, 2006 (the “Advisory Agreement”), under which the Advisor will perform certain key functions on behalf of Institutional REIT, including, among others, the investment of capital proceeds and management of day-to-day operations.
Institutional REIT expects to engage in the acquisition and ownership of commercial real properties throughout the United States, including properties that are under construction, are newly constructed or have operating histories. Institutional REIT may invest in office buildings, shopping centers, other commercial and industrial properties or other real estate properties. All such properties may be acquired directly or through joint ventures with real estate investment entities sponsored by the Advisor, affiliates of the Advisor, or other third parties.
As of September 30, 2007, Institutional REIT has neither purchased nor contracted to purchase any assets, nor has the Advisor identified any assets in which there is a reasonable probability that Institutional REIT will invest.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Principles of Consolidation
The consolidated financial statements of Institutional REIT have been prepared in accordance with the rules and regulations of the SEC, including the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, the financial statements for the unaudited interim period presented include all adjustments, which are of a normal and recurring nature, necessary for a fair and consistent presentation of the results for such period. Results for the interim period are not necessarily indicative of results for a full year. Institutional REIT’s consolidated financial statements shall include the accounts of any variable interest entity (“VIE”) in which Institutional REIT or its subsidiaries are deemed the primary beneficiary. With respect to entities that are not VIEs, Institutional REIT’s consolidated financial statements shall also include the accounts of any entity in which Institutional REIT or its subsidiaries own a controlling financial interest and any limited partnership in which Institutional REIT or its subsidiaries own a controlling general partnership interest. In determining whether a controlling interest exists, Institutional REIT considers, among other factors, the ownership of voting interests, protective rights and participatory rights of the investors.
Institutional REIT owns a controlling general partnership interest in Institutional OP, as the limited partners of Institutional OP may not remove the general partner with or without cause. Accordingly, Institutional REIT’s consolidated financial statements include the accounts of Institutional OP. The financial statements of Institutional OP are prepared using accounting policies consistent with those used by Institutional REIT. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of the accompanying consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
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Cash and Cash Equivalents
Institutional REIT considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents may include cash and short-term investments. Short-term investments are stated at cost, which approximates fair value and may consist of investments in money market accounts. There are no restrictions on the use of Institutional REIT’s cash balances as of September 30, 2007.
Prepaid Expenses
Prepaid expenses represent costs incurred in connection with securing financing from third-party lenders and prepayments of directors’ fees and directors and officers’ insurance premiums. Once financing is secured, associated costs will be capitalized and amortized on a straight-line basis over the term of the related financing arrangement. Prepayments of directors’ fees and insurance premiums will be expensed in the periods to which the services relate. Balances without a future economic benefit are written off as they are identified.
Financial Instruments
Institutional REIT considers its cash and cash equivalents and note payable to affiliate to meet the definition of financial instruments. As of September 30, 2007, the carrying values of cash and cash equivalents and note payable to affiliate approximated their respective fair values.
Independent Director Compensation
Institutional REIT pays each of its independent directors an annual retainer of $18,000. In addition, the independent directors are paid for attending meetings as follows: (i) $2,500 for each board meeting attended, (ii) $2,500 for each audit committee meeting attended (except that the committee chairman is paid $3,000 for each meeting attended in person), (iii) $250 for each special board meeting attended (whether held in person or by telephone conference), and (iv) $1,500 for all other committee meetings attended (except that the committee chairman is paid $2,000 for each committee meeting attended in person). When a committee meeting immediately follows a board meeting, an additional fee will not always be paid for attending the committee meeting. All directors also receive reimbursement of reasonable out-of-pocket expenses incurred in connection with attendance at meetings of the board of directors. For the nine months ended September 30, 2007, Institutional REIT had incurred independent director fees of approximately $83,500.
Income Taxes
Institutional REIT intends to elect to be taxed as a REIT under the Internal Revenue Code of 1986 (the “Code”), as amended, and intends to operate as such beginning with the year in which it commences active operations. To qualify as a REIT, Institutional REIT must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of its REIT taxable income, as defined in the Code, to stockholders. As a REIT, Institutional REIT generally will not be subject to federal income tax on income that it distributes to stockholders. If Institutional REIT fails to qualify as a REIT in any taxable year, it will then be subject to federal income taxes on its taxable income at regular corporate income tax rates and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service grants Institutional REIT relief under certain statutory provisions.
Institutional REIT was organized as a C Corporation for the period ended December 31, 2006 and, accordingly, was subject to federal income taxes. Institutional REIT accounts for income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109,Accounting for Income Taxes, whereby deferred taxes are provided for based upon the differences between the financial statement and income tax basis of assets and liabilities using currently enacted tax laws and the tax rates expected to be in effect when such taxes are incurred or recovered. Deferred tax expenses or benefits are recognized in the financial statements according to the changes in deferred assets or liabilities between years. Valuation allowances are established to reduce deferred tax assets when it becomes more likely than not that such assets, or portions thereof, will not be realized.
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Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the relevant criteria and approach for the recognition, derecognition, and measurement of uncertain tax positions. Institutional REIT adopted FIN 48 on January 1, 2007 and concluded that its adoption did not have a material effect on Institutional REIT’s consolidated financial statements. Institutional REIT expects to record interest and penalties related to uncertain tax positions, if any, as general and administrative expense.
In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures required for fair value measurements under GAAP. SFAS 157 emphasizes that fair value is a market-based measurement, as opposed to a transaction-specific measurement. SFAS 157 will be effective for Institutional REIT beginning January 1, 2008. Institutional REIT is currently assessing the provisions and evaluating the financial impact of SFAS 157 on its consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 will be effective for Institutional REIT beginning January 1, 2008. Institutional REIT is currently assessing the provisions and evaluating the financial statement impact of SFAS 159 on its consolidated financial statements.
In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 07-1,Clarification of the Scope of the Audit and Accounting Guide "Investment Companies" and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies, which provides guidance for determining which entities fall within the scope of the AICPA Audit and Accounting Guide for Investment Companies and requires additional disclosures for certain of those entities. SOP 07-1 was to be effective for Institutional REIT beginning January 1, 2008; however, in October 2007, the FASB elected to indefinitely defer the effective date of SOP 07-1. As such, Institutional REIT has postponed its evaluation of the provisions of SOP 07-1 and related impact on its consolidated financial statements and accompanying notes.
3. RELATED PARTY TRANSACTIONS
Advisory Agreement
Institutional REIT has executed an Advisory Agreement that entitles the Advisor to specified fees for certain services, including, among other services, the investment of capital proceeds and management of day-to-day operations.
Under the terms of the Advisory Agreement, organization and offering costs are incurred by the Advisor on behalf of Institutional REIT. Such costs include legal and accounting fees, printing costs, and other offering expenses, and specifically exclude sales or underwriting commissions. Upon raising at least $10.0 million from the sale of common stock to the public in its initial public offering, Institutional REIT will become obligated to reimburse the Advisor for organization and offering costs equal to the lesser of actual costs incurred or 1.0% of total gross offering proceeds raised. To the extent that organization and offering costs exceed 1.0% of gross offering proceeds or if Institutional REIT does not raise at least $10.0 million in its initial public offering on or before January 10, 2008, offering costs will be incurred by the Advisor and not by Institutional REIT. As of September 30, 2007, the Advisor has incurred aggregate organization and offering expenses on behalf of Institutional REIT of approximately $1.3 million.
Institutional REIT will pay an asset management fee to the Advisor for services related to formulating and implementing strategies to administer, promote, manage, operate, maintain, improve, finance and refinance, market, lease, and dispose of properties. Under the terms of the Advisory Agreement, Institutional REIT will pay a monthly asset management fee equal to one-twelfth of 0.50% of the sum of the costs of all investments made on behalf of Institutional REIT. Additionally, Institutional REIT will reimburse the Advisor for all costs and expenses the Advisor incurs in fulfilling its duties as the asset portfolio manager. These costs and expenses may include wages and salaries and other employee-related expenses of the Advisor’s employees engaged in the management, administration, operations, and marketing functions. Employee-related expenses include taxes, insurance and benefits relating to such employees, and legal, travel and other out-of-pocket expenses that are directly related to the services they provide. The Advisor will allocate its reimbursable costs of providing these services among Institutional REIT and the various affiliated entities of Wells Real Estate Funds, Inc. (“Wells Real Estate Funds”) based on time spent on each entity by individual personnel or other reasonable allocation methodology.
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Institutional REIT will pay a fee to the Advisor for services related to the acquisition and disposition of investment properties. Institutional REIT will pay the Advisor acquisition fees equal to 1.5% of the costs of investments acquired by Institutional REIT, including acquisition expenses and any debt attributable to such investments. These acquisition fees serve as compensation for services the Advisor will render in connection with the investigation, selection and acquisition of properties. Institutional REIT will pay the acquisition fees at the time a property is acquired. In addition to this acquisition fee, Institutional REIT may also incur customary third-party acquisition expenses in connection with the acquisition (or attempted acquisition) of a property. Additionally, when Institutional REIT sells a property, it will pay the Advisor a fee equal to 1.0% of the contract price for the property sold. As of September 30, 2007, the Advisor has not earned any asset management, acquisition or disposition fees with regard to Institutional REIT.
The Advisor may also earn success-based fees in connection with the listing of Institutional REIT’s shares of common stock or the sale of Institutional REIT’s assets. If Institutional REIT sells properties and receives proceeds enabling it to distribute to stockholders all of the capital stockholders invested plus an amount sufficient to provide stockholders with a cumulative, non-compounded annual return of 9.0%, the Advisor will be entitled to an incentive fee. This incentive fee will equal 8.0% of the net sales proceeds remaining only after Institutional REIT has made the distributions providing shareholders a complete return of capital and the 9.0% annual return. The Advisor may be entitled to a similar fee if the Advisory Agreement is terminated and the Advisor would have been entitled to participation in net sale proceeds had the portfolio been liquidated on the date of termination. Furthermore, if Institutional REIT lists its shares on a national securities exchange, the Advisor will be entitled to a fee. This fee will only be payable if the market value of Institutional REIT’s outstanding stock plus distributions paid prior to listing exceeds the sum of the amount of capital stockholders invested plus the amount that would be required to be paid to stockholders to provide a cumulative, non-compounded annual return of 9%. The fee would equal 8.0% of that excess and would be offset by any incentive fees previously paid. Further, if Institutional REIT pays this fee following a listing of shares, it will not be obligated to pay any further incentive fees to the Advisor. As of September 30, 2007, the Advisor has not earned any such fees with regard to Institutional REIT.
The Advisory Agreement has a two-year term that began on December 27, 2006 and may be renewed for an unlimited number of successive two-year periods upon mutual consent of the Advisor and Institutional REIT. Institutional REIT will be able to terminate the Advisory Agreement without penalty upon 60 days’ written notice. If Institutional REIT terminates the Advisory Agreement, Institutional REIT will pay the Advisor all unpaid reimbursements of expenses and all earned but unpaid fees.
Dealer-Manager Agreement
Institutional REIT has executed a dealer-manager agreement whereby Wells Investment Securities, Inc. (“WIS”), an affiliate of the Advisor, will perform the dealer-manager function for Institutional REIT. For these services, WIS shall earn a fee of 1.0% of the gross offering proceeds from the sale of the shares of Institutional REIT.
WIS plans to use Integrity Investments, Inc. (“Integrity”), a member firm of the National Association of Securities Dealers, Inc., as the primary participating broker dealer for Institutional REIT’s best efforts offering. In return for Integrity’s professional sales services, WIS will reallow up to 25% of its dealer-manager fee to Integrity. If another participating broker dealer is involved with a sale, WIS will reallow up to an additional 25% of its dealer-manager fee to that participating broker dealer.
In addition to the dealer-manager fee discussed above, commencing twelve months from the date of sale of a share, deferred sales commissions will become payable to WIS at an annual rate of 0.50% of the price paid to acquire the share over a period of up to 12 years, of which, up to 50% of the deferred sales commission will be reallowed to Integrity over the same twelve-year period. If another participating broker dealer is involved in a particular sale, WIS will reallow up to an additional 50% of the deferred sales commissions attributable to that participating broker dealer over the same period of up to 12 years. The payment of deferred sales commissions will cease upon the listing of Institutional REIT’s common stock on a national securities exchange or upon the commencement of a liquidation plan approved by Institutional REIT’s board of directors.
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Dealer-manager fees apply only to the sale of shares in the primary offering and do not apply to the sale of shares under the dividend reinvestment plan. Dealer-manager fees are recorded when incurred, based on the sale of Institutional REIT’s shares of common stock, as a reduction to additional paid-in capital. As of September 30, 2007, WIS has not earned any such fees with regard to Institutional REIT.
Due to Affiliate
As of September 30, 2007, due to affiliate represents amounts due to the Advisor for general and administrative expenditures funded on behalf of Institutional REIT pursuant to the Advisory Agreement. The amounts funded by the Advisor on behalf of the Institutional REIT for general and administrative expenditures are non-interest bearing and have no specific maturity date; however, Institutional REIT intends to repay this amount upon commencing active operations.
Note Payable to Affiliate
As of September 30, 2007, note payable to affiliate represents a promissory note payable to the Advisor that bears interest at an annual rate of 6.35% and matures on March 28, 2008. Institutional REIT may prepay the unpaid principal balance under the promissory note, in whole or in part, together with all interest then accrued under the note, at any time, without premium or penalty. The promissory note is unsecured.
Conflicts of Interest
The Advisor also is a general partner or advisor in various other entities sponsored by Wells Real Estate Funds. As such, in connection with serving as a general partner or advisor for these other entities, the Advisor may encounter conflicts of interest with regard to allocating resources and making decisions related to investments, operations and dispositions for Institutional REIT and these other Wells-sponsored entities.
Additionally, certain members of the board of Institutional REIT also serve on the boards of one or more other REITs sponsored by the Advisor and, accordingly, may encounter certain conflicts of interest regarding investment and operations decisions.
4. MINORITY INTEREST
On July 21, 2006, Institutional OP issued 9,900 limited partnership units to the Advisor for $99,000, which represents a 99% limited partnership interest therein. The Advisor’s interest in Institutional OP is reflected as minority interest in operating partnership in the accompanying consolidated balance sheets. Minority interest in loss of operating partnership in the consolidated statement of operations represents the net loss allocated to the Advisor based on its economic ownership percentage of Institutional OP, subject to the limitations described below.
Per the terms of Institutional OP’s limited partnership agreement, losses shall not be allocated to a limited partner to the extent that such allocation would cause a deficit in a limited partner’s capital account. Any losses in excess of this limitation shall be allocated to the general partner. For the nine months ended September 30, 2007, approximately $54,000 of minority interest in loss of operating partnership was allocated to the Advisor, which reduced its minority interest in Institutional OP to $0. As such, Institutional REIT, as the general partner, absorbed the remaining net loss of approximately $406,000.
5. STOCKHOLDER’S EQUITY
General
As of September 30, 2007, Institutional REIT had issued 100 shares of common stock to the Advisor.
Institutional REIT’s charter authorizes it to issue 1,010,000,000 shares of capital stock, consisting of 1,000,000,000 common shares and 10,000,000 preferred shares, each as defined by the charter. The common shares have a par value of $0.01 per share and entitle the holders to one vote per share on all matters upon which stockholders are entitled to vote, to receive dividends and other distributions (subject to any preferential rights of any shares of preferred stock that may be issued in the future) as authorized by the board of directors in accordance with the Maryland General Corporation Law and to all rights of a stockholder pursuant to the Maryland General Corporation Law. The common stock has no preferences or preemptive, conversion or exchange rights.
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Institutional REIT is authorized to issue one or more series of preferred stock. Prior to the issuance of such shares, the board of directors shall have the power from time to time to classify or reclassify, in one or more series, any unissued shares constituting such series and the designation, preferences, conversion, and other rights, voting powers, restrictions, limitations as to dividends and other distributions, qualifications and terms and conditions of redemption of such shares. As of September 30, 2007, Institutional REIT had issued no shares of preferred stock.
Independent Director Stock Option Plan
Institutional REIT has adopted an independent director stock option plan, which will be used to attract and retain qualified independent directors, subject to certain limitations. A total of 100,000 shares of common stock are authorized and reserved for issuance under the independent director stock option plan.
In addition to cash compensation, as long as certain requirements are met and upon the appointment of an independent director to Institutional REIT’s board, each independent director will receive a grant of options to purchase 2,500 shares of Institutional REIT’s common stock. Institutional REIT expects the initial grant of options to be anti-dilutive with an exercise price of $12.00 per share. Upon each subsequent re-election of the independent director to the board, he or she will receive a subsequent grant of options to purchase 1,000 shares of Institutional REIT’s common stock. The exercise price for the subsequent options will be the greater of (1) $12.00 per share or (2) the fair market value of the shares on the date of grant. Fair market value is generally defined to mean (1) the closing sales price on the immediately preceding date on which sales were reported if the shares are listed on a securities exchange or are traded over the Nasdaq Global Market or (2) the mean between the bid and offered prices as quoted by Nasdaq for such immediately preceding trading date if the shares are not listed on a securities exchange or traded over the Nasdaq Global Market. However, if the conflicts committee of the board of directors determines that the fair market value of Institutional REIT’s shares is not properly reflected by such Nasdaq quotations, or if its shares are not quoted by Nasdaq, then the conflicts committee will determine fair market value in good faith.
No option issued may be exercised if such exercise would jeopardize Institutional REIT’s status as a REIT under the Internal Revenue Code. Institutional REIT may not grant options at any time when the issuance of the shares underlying the grant, when combined with those issuable upon exercise of outstanding options or warrants granted to its advisor, directors, officers or any of their affiliates, would exceed 10% of Institutional REIT’s outstanding shares. The independent directors may not sell, pledge, assign or transfer their options other than by will or the laws of descent and distribution. As of September 30, 2007, Institutional REIT had not issued any options to purchase shares of common stock under this plan.
Long-Term Incentive Plan
Institutional REIT has adopted a long-term incentive plan, which will be used to attract and retain qualified employees, advisors and consultants, as applicable, subject to certain limitations. A total of 750,000 shares of common stock are authorized and reserved for issuance under the long-term incentive plan. Awards may consist of nonqualified stock options, incentive stock options, restricted and unrestricted shares of stock, stock appreciation rights, phantom stock awards and other stock-based awards.
The exercise price for options granted under the plan will be the greater of (1) $11.00 per share or (2) the fair market value of the shares on the date the option is granted. Fair market value for this plan will be determined in the same manner as under the Independent Director Stock Option Plan. The conflicts committee of the board of directors will conduct the general administration of the plan. The conflicts committee is authorized to grant “non-qualified” stock options to selected employees of the Advisor and Wells Management Company, Inc. based upon the recommendation of the Advisor and subject to the absolute discretion of the conflicts committee and applicable limitations of the plan.
The maximum number of shares of common stock with respect to awards made under the long-term incentive plan when added to the number of shares of common stock subject to other awards outstanding and the number of shares of common stock previously issued with respect to awards granted under the long-term incentive plan shall not exceed 10% of Institutional REIT’s outstanding common stock on a fully diluted basis as of such date; provided, however, that such number of shares may not exceed 750,000 shares subject to certain provisions allowing for adjustment for changes in Institutional REIT’s capital structure. As of September 30, 2007, Institutional REIT had not granted any awards under the plan, and Institutional REIT had no timetable for the grant of any awards under the long-term incentive plan.
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Dividend Reinvestment Plan
Institutional REIT has adopted a dividend reinvestment plan (the “DRP”) through which stockholders may elect to reinvest an amount equal to the dividends declared on their shares of common stock into additional shares of Institutional REIT’s common stock in lieu of receiving cash distributions. The purchase price per share will be the higher of $10.00 or 100% of the estimated value of a share of Institutional REIT’s common stock, as estimated by the Advisor or another firm chosen for the purpose of estimating the value of Institutional REIT’s common stock. Participants in the DRP may purchase fractional shares so that 100% of the distributions may be used to acquire additional shares of Institutional REIT’s common stock.
Share Redemption Program
The board of directors of Institutional REIT anticipates adopting a share redemption program that may enable stockholders that meet the requirements below to sell their shares back to Institutional REIT, subject to certain limitations. Under the terms of the proposed share redemption program, a stockholder could present all or any portion of such stockholder’s common stock for repurchase under the program only if such request relates to the shares beneficially owned by a trust and the trust has dissolved other than (i) at the discretion of the trustee or grantor of the trust or (ii) on the account of the passage of time if the trust agreement called for the dissolution of the trust prior to 2018. Institutional REIT would repurchase shares under the share redemption program at the then-current price per share at which Institutional REIT is selling shares or, if Institutional REIT is not then conducting a public offering, at the fair market value of a share of common stock. Institutional REIT would not be obligated to redeem in any calendar year more than 10% of the weighted-average number of shares outstanding in the prior calendar year. Even if adopted, Institutional REIT could later amend, suspend or terminate the proposed share redemption program upon 30 days’ notice.
6. ECONOMIC DEPENDENCY
Institutional REIT has engaged the Advisor and WIS to provide certain services essential to Institutional REIT, including asset management services, supervision of the management and leasing of some properties Institutional REIT may acquire, asset acquisition and disposition services, the sale of shares of Institutional REIT’s common stock, as well as other administrative responsibilities for Institutional REIT, including accounting services, stockholder communications, and investor relations. As a result of these relationships, Institutional REIT is dependent upon the Advisor and WIS.
The Advisor and WIS are owned and controlled by Wells Real Estate Funds. The operations of the Advisor, WIS and Wells Management Company, Inc., a property manager that Institutional REIT may engage to manage some or all of its properties, represent substantially all of the business of Wells Real Estate Funds. Accordingly, Institutional REIT focuses on the financial condition of Wells Real Estate Funds when assessing the financial condition of the Advisor and WIS. In the event that Wells Real Estate Funds were to become unable to meet its obligations as they become due, Institutional REIT might be required to find alternative service providers.
Future net income generated by Wells Real Estate Funds will be largely dependent upon the amount of fees earned by the Advisor and its affiliates based on, among other things, the level of investor proceeds raised from the sale of common stock of Wells Real Estate Funds-sponsored investment products and the volume of future acquisitions and dispositions of real estate assets by Wells Real Estate Funds-sponsored programs as well as dividend income earned from equity interests in another REIT. In addition, Wells Real Estate Funds guarantees unsecured debt of $160 million held by another Wells Real Estate Funds-sponsored product that is in the start-up phase of its operations. As of September 30, 2007, Institutional REIT believes that Wells Real Estate Funds is generating adequate cash flow from operations and has adequate liquidity available in the form of cash on hand and current receivables necessary to meet its current and future obligations as they become due.
7. COMMITMENTS AND CONTINGENCIES
Litigation
Institutional REIT is not subject to any material litigation nor, to management’s knowledge, is any material litigation currently threatened against Institutional REIT.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
The following discussion and analysis should be read in conjunction with our accompanying consolidated financial statements and notes thereto. See also “Cautionary Note Regarding Forward Looking Statements” preceding Part I.
We are a newly organized Maryland corporation that intends to qualify as a REIT beginning with the year in which we commence active operations. During the period ended September 30, 2007, our attention focused primarily on our formation, the registration of our initial offering of shares to the public and preparing for active operations. The SEC declared the registration statement for our initial public offering effective on January 10, 2007 and our offering commenced January 16, 2007. As of September 30, 2007, we had not sold any shares of our common stock under our initial public offering. After the minimum subscription of 1,000,000 shares at $10.00 per share is achieved in our offering, subscription proceeds will be released to us and applied to investments in properties and other assets and the payment of other organization and offering expenses. As of September 30, 2007, we had neither purchased nor contracted to purchase any properties nor had we identified any assets in which there is a reasonable probability that we will invest.
We have no paid employees and are managed by our external advisor, Wells Capital, Inc. (the “Advisor”). The Advisor will conduct our operations and manage our portfolio of real estate investments pursuant to an agreement between the Advisor and us executed on December 27, 2006 (the “Advisory Agreement”).
We intend to generate the substantial majority of our revenue and income by buying, owning and operating commercial real estate consisting primarily of high-quality, income-generating office and industrial properties leased to creditworthy companies and governmental entities. We anticipate funding the acquisition of such properties with equity or debt, or a combination thereof, the allocation of which will primarily depend upon the availability of these resources relative to the timing and availability of suitable investment opportunities.
Our most significant risks and challenges include our ability to raise a sufficient amount of equity to invest in a diversified portfolio. To the extent that we do not raise significant funds in our offering, we may not be able to achieve sufficient diversification to guard against the general economic, industry-specific, financing, and operational risks generally associated with individual investments.
Liquidity and Capital Resources
Overview
In the future, we anticipate raising capital from the sale of our common stock under our initial public offering and investing such proceeds in acquisitions of commercial real properties. We expect our primary source of future operating cash flows to be generated from the operations of properties we acquire. The amount and timing of future dividends to our stockholders will be largely dependent upon, among other things, the amount of cash generated from our operating activities, how quickly we are able to invest proceeds from our offering in quality income-producing assets, our expectations of future cash flows, and our determination of near-term cash needs for capital expenditures and debt repayments.
Short-Term Liquidity and Capital Resources
During the nine months ended September 30, 2007, net cash used in operating activities was approximately $0.3 million and represents payments for administrative costs. Our net cash used in operating activities was financed entirely by the Advisor. Net cash provided by financing activities was approximately $1.1 million for the nine months ended September 30, 2007 and represents borrowings from our Advisor. As of September 30, 2007, we held cash balances of approximately $0.9 million, and we owed the Advisor $0.8 million pursuant to a promissory note (described below) we executed in favor of the Advisor and $0.6 million for current and prior period operating expenditures funded on our behalf. The $0.6 million of general and administrative expenses funded by the Advisor is reimbursable by us to the Advisor under the Advisory Agreement. Amounts funded by the Advisor on our behalf for general and administrative expenses are non-interest bearing and have no maturity date; however, we intend to repay this amount upon commencing active operations.
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We executed a promissory note in the principal amount of $0.8 million in favor of the Advisor on March 28, 2007. We agreed to repay the outstanding principal and interest under the note by March 28, 2008. The unpaid principal under the promissory note bears simple interest from the date advanced at the rate of 6.35% per annum. We may prepay the unpaid principal balance under the promissory note, in whole or in part, together with all interest then accrued under the note, at any time, without premium or penalty. The promissory note is unsecured.
In the future, we intend to raise capital proceeds from the sale of common stock under our initial offering and from third-party borrowings, and to use such capital primarily to fund future acquisitions of commercial real properties. Further, we intend to repay amounts due to the Advisor upon breaking escrow in our offering and commencing active operations.
As of September 30, 2007, the Advisor has incurred aggregate organization and offering expenses on our behalf of approximately $1.3 million. Under the terms of the Advisory Agreement, organization and offering costs are initially incurred by the Advisor. These organization and offering expenses include all expenses (other than the dealer manager fee and the deferred selling commissions) to be paid by us in connection with the offering, including our legal, accounting, printing, mailing and filing fees and amounts to reimburse the Advisor for the salaries of its employees and other costs in connection with preparing supplemental sales materials. Upon raising at least $10.0 million from the sale of common stock in our initial public offering, we will become obligated to reimburse the Advisor for organization and offering costs equal to the lesser of actual costs incurred or 1.0% of total gross offering proceeds raised. To the extent that organization and offering costs exceed 1.0% of gross offering proceeds or if we do not raise at least $10.0 million in our initial public offering on or before January 10, 2008, offering costs will be incurred by the Advisor and not by us.
Long-Term Liquidity and Capital Resources
Potential future sources of capital include proceeds from the sale of our common stock, proceeds from secured or unsecured financings from banks and other lenders, and net cash flows from operations. We anticipate funding dividends to our stockholders from net cash flows from operations; however, we may periodically borrow funds on a short-term basis to fund dividends as well.
We expect our principal demands for capital to include funding acquisitions of commercial real properties, either directly or through investments in joint ventures, capital improvements for such commercial real properties, offering-related costs, operating expenses, including interest expense on any outstanding indebtedness, and dividends. We will make payments to the Advisor in connection with the selection and purchase of our real estate investments, the management of our assets and costs incurred by the Advisor in providing services to us.
We have also deferred the payment of selling commissions in our initial public offering. By deferring the selling commissions in the offering over a 12-year period rather than paying large up-front commissions, we will increase the amount of offering proceeds that we may invest directly in real estate during our offering stage. The maximum amount of deferred selling commissions we could pay is $0.05 per share per year for up to 12 years for each share we sell in the offering, or an aggregate of up to $150.0 million over 12 years. The deferral of selling commissions will result in higher net proceeds in offering, which should cause our initial portfolio to be worth more than it otherwise would be and which should also result in greater revenues. However, our revenues will be offset by the payment of these deferred selling commissions, which will reduce the funds that would otherwise be available for distribution to our stockholders in the form of a higher per share dividend.
In determining how and when to allocate cash resources in the future, we will initially consider the source of the cash. Substantially all cash raised from operations, after payments of operating expenses, certain capital expenditures required for our commercial real properties and deferred selling commissions, is anticipated to be used to pay dividends to stockholders. Therefore, to the extent that cash flows from operations are lower, dividends are anticipated to be lower as well. Substantially all net proceeds generated from the sale of our shares under our initial offering or from debt financing will be available to fund acquisitions of commercial real properties, capital expenditures identified at the time of acquisition, and to pay down outstanding borrowings. If sufficient equity or debt capital is not available, our future investments in commercial real properties will be lower.
Over the long term, we intend to target a debt level of approximately 25% of the cost of our assets. However, in order to facilitate property acquisitions during the early stages of our offering, we may temporarily borrow at higher levels. Our board has adopted a leverage policy which limits our ability to incur debt that would cause our borrowings to exceed 50% of our assets (valued at cost before depreciation and other non-cash reserves) unless a majority of the members of the conflicts committee of our board of directors approves borrowings in excess of this limitation. Our independent directors have approved our ability to borrow in excess of this threshold up to $1.5 million of aggregate borrowings or until raising the minimum offering of $10.0 million from the sale of our common stock, whichever occurs sooner.
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Results of Operations
We have not received and accepted the minimum subscription of $10.0 million in our initial public offering and, accordingly, did not engage in any significant operations during the nine months ended September 30, 2007. Our net loss for the nine months ended September 30, 2007 is primarily comprised of administrative costs related to directors and officers insurance premiums, directors fees, and other professional fees.
Our results of operations are not indicative of those expected in future periods. After raising equity proceeds under our initial offering, we expect to acquire interests in commercial real properties and to subsequently generate revenues, net of operating expenses, general and administrative expenses, and interest expense.
Election as a REIT
We intend to elect to be taxed as a REIT under the Internal Revenue Code of 1986 (the “Code”), as amended, and intend to operate as such beginning with the year in which we commence active operations. To qualify as a REIT, we must meet certain organizational and operational requirements, including a requirement to distribute at least 90% of our ordinary taxable income, as defined in the Code, to stockholders. As a REIT, we generally will not be subject to federal income tax on income that we distribute to stockholders. If we fail to qualify as a REIT in any taxable year, we will then be subject to federal income taxes on our taxable income at regular corporate income tax rates and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service grants us relief under certain statutory provisions. Such an event could materially adversely affect our net income and net cash available for distribution to stockholders. However, we believe that we are organized and operate in such a manner as to qualify for treatment as a REIT for federal income tax purposes.
Critical Accounting Policies
Our accounting policies have been established to conform with GAAP. The preparation of financial statements in conformity with GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied, thus resulting in a different presentation of the financial statements. Additionally, other companies may utilize different estimates that may impact the comparability of our results of operations to those of companies in similar businesses.
A discussion of the accounting policies that we intend to adopt upon commencing active operations, and which management deems critical because they may require complex judgment in their application or otherwise require estimates about matters that are inherently uncertain, is provided below.
Investment in Real Estate Assets
We will be required to make subjective assessments as to the useful lives of our depreciable assets. We consider the period of future benefit of the asset to determine the appropriate useful lives. These assessments have a direct impact on net income. We anticipate the estimated useful lives of our assets by class to be as follows:
Building | 40 years | |
Building improvements | 5-25 years | |
Tenant improvements | Shorter of economic life or lease term | |
Intangible lease assets | Lease term |
If we use inappropriate useful lives or methods for depreciation, our net income will be misstated.
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Allocation of Purchase Price of Acquired Assets
When we acquire real properties, we will allocate the purchase price of properties to acquired tangible assets and identified intangible assets and liabilities based on their fair values. Tangible assets generally consist of land and building. Identified intangible assets and liabilities generally consist of the value of above-market and below-market leases and the value of in-place leases.
We will determine the fair values of land and building by valuing the property as if it were vacant. We will then allocate the “as-if vacant” value to land and building based on our determination of the relative fair value of these assets. We will determine the as-if vacant fair value of a property using methods similar to those used by independent appraisers. Factors we consider in performing these analyses will include an estimate of carrying costs during the expected lease-up periods considering current market conditions and costs to execute similar leases. In estimating carrying costs, we will include real estate taxes, insurance, and other operating expenses during the expected lease-up periods based on current market demand. We will estimate costs to execute similar leases, including leasing commissions and other related costs.
We will record the fair values of above-market and below-market in-place leases based on the present value (using an interest rate that reflects the risks associated with the leases acquired) of the difference between (1) the contractual amounts to be paid pursuant to the in-place leases and (2) our estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining terms of the leases. We will amortize the capitalized above-market and below-market lease values as an adjustment to rental income over the remaining terms of the respective leases. The fair values of in-place leases will include direct costs associated with obtaining a new tenant, opportunity costs associated with lost rentals, which are avoided by acquiring an in-place lease, and tenant relationships. Direct costs associated with obtaining a new tenant will include commissions, tenant improvements and other direct costs and will be estimated based on our consideration of current market costs to execute a similar lease. We will include these direct costs in deferred leasing costs in our consolidated balance sheet and will amortize such costs to expense over the remaining terms of the respective leases. We will calculate the value of opportunity costs using the contractual amounts to be paid pursuant to the in-place leases over market absorption periods for similar leases. We will value customer relationships based on expected renewal of a lease or the likelihood of obtaining a particular tenant for other locations. We will include these lease intangibles in intangible lease assets in our consolidated balance sheet and amortize these assets to rental income over the remaining terms of the respective leases.
Estimating the fair values of the tangible and intangible assets will 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 is held for investment. Using inappropriate estimates would result in an incorrect assessment of our purchase price allocations, which could impact the amount of our reported net income.
Valuation of Real Estate Assets
We will continually monitor events and changes in circumstances that could indicate that the carrying amounts of the real estate and related intangible assets of both operating properties and properties under construction, in which we have an ownership interest, either directly or through investments in joint ventures, may not be recoverable. When indicators of potential impairment are present that suggest that the carrying amounts of real estate and related intangible assets may not be recoverable, we will assess the recoverability of these assets by determining whether the carrying value will be recovered through the undiscounted future operating cash flows expected from the use of the asset and its eventual disposition. In the event that such expected undiscounted future cash flows do not exceed the carrying value, we will decrease the carrying value of the real estate and related intangible assets to the estimated fair values, as defined by SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets, and recognize an impairment loss. Estimated fair values are calculated based on the following information, in order of preference, dependent upon availability: (i) recently quoted market prices, (ii) market prices for comparable properties, or (iii) the present value of undiscounted cash flows, including estimated salvage value.
Projections of expected future operating cash flows require that we estimate future market rental income amounts subsequent to the expiration of current lease agreements, property operating expenses, the number of months it takes to re-lease the property, and the number of years the property is held for investment, among other factors. The subjectivity of assumptions used in the future cash flow analysis, including discount rates, could result in an incorrect assessment of the property’s fair value and could result in the misstatement of the carrying value of our real estate and related intangible assets and net income.
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Related Parties
Transactions and Agreements
We have engaged the Advisor and its affiliates to perform certain services under agreements which require us to pay fees and reimbursements to the Advisor or its affiliates, including acquisition and disposition fees, deferred selling commissions, dealer-manager fees, asset management fees, as well as, subject to certain limitations, reimbursements of organization and offering costs, and certain operating costs. See Note 3 to our accompanying consolidated financial statements included herein for a discussion of our related-party agreements and the related transactions, fees and reimbursements.
Assertion of Litigation Against Related Parties
On March 12, 2007, a stockholder of Piedmont Office Realty Trust, Inc., formerly known as Wells Real Estate Investment Trust, Inc. (referenced herein as “Piedmont REIT”) filed a putative class action and derivative complaint, styledWashtenaw County Employees’ Retirement System v. Wells Real Estate Investment Trust, Inc., et al., in the United States District Court for the District of Maryland against, among others, Piedmont REIT, the Advisor, Leo F. Wells, III, and certain affiliates of Wells Real Estate Funds and certain officers and directors of Institutional REIT who formerly served as officers or directors of Piedmont REIT prior to the closing of the Piedmont REIT internalization transaction on April 16, 2007. The complaint alleges, among other things, violations of the federal proxy rules and breaches of fiduciary duty arising from the Piedmont REIT internalization transaction and the related proxy statement filed with the SEC on February 26, 2007, as amended. The complaint seeks, among other things, unspecified monetary damages and nullification of the Piedmont REIT internalization transaction. On April 9, 2007, the District Court denied the plaintiff’s motion for an order enjoining the internalization transaction. On April 17, 2007, the Court granted the defendants’ motion to transfer venue to the United States District Court for the Northern District of Georgia, and the case was docketed in the Northern District of Georgia on April 24, 2007. On June 7, 2007, the court granted a motion to designate the class lead plaintiff and class co-lead counsel. On June 27, 2007, the plaintiff filed an amended complaint, which attempts to assert class action claims on behalf of those persons who received and were entitled to vote on the Piedmont REIT proxy statement filed with the SEC on February 26, 2007 and derivative claims on behalf of Piedmont REIT. On July 9, 2007, the court denied the plaintiff’s motion for expedited discovery related to an anticipated motion for a preliminary injunction. On August 13, 2007, the defendants filed a motion to dismiss the amended complaint. The motion to dismiss has been fully briefed and is currently pending before the court. The Advisor and officers and directors who are named in the complaint intend to vigorously defend this action. Any financial loss incurred by the Advisor or its affiliates could hinder their ability to successfully manage Institutional REIT’s operations and portfolio of investments.
On August 24, 2007, two stockholders of Piedmont REIT filed a putative derivative complaint, styled Donald and Donna Goldstein, Derivatively on behalf of Defendant Wells Real Estate Investment Trust, Inc. v. Leo F. Wells, III, et. al.,in the Superior Court of Fulton County, Georgia on behalf of Piedmont REIT against the Advisor, Leo F. Wells, III, Douglas R. Williams, Randall D. Fretz, Donald A. Miller, Michael R. Buchanan, Richard W. Carpenter, Bud Carter, William H. Keogler, Jr., Donald S. Moss, Neil H. Strickland, W. Wayne Woody, and Robert E. Bowers. The complaint alleges, among other things, that the consideration paid by Piedmont REIT as part of the internalization transaction was excessive; that the defendants breached their fiduciary duties to Piedmont REIT; and that the internalization transaction unjustly enriched the defendants. The complaint seeks, among other things, a judgment declaring that the defendants committed breaches of their fiduciary duties and were unjustly enriched at the expense of Piedmont REIT; monetary damages equal to the amount by which Piedmont REIT was damaged by the defendants; an order awarding Piedmont REIT restitution from the defendants and ordering disgorgement of all profits and benefits obtained by the defendants from their wrongful conduct and fiduciary breaches; an order rescinding the internalization transaction; and the establishment of a constructive trust upon any benefits improperly received by the defendants as a result of their wrongful conduct. On October 19, 2007, the court granted the defendants’ motion for a protective order staying discovery until the court rules on an anticipated motion to dismiss the complaint. On October 31, 2007, the defendants filed their motion to dismiss the plaintiffs’ derivative complaint, which is currently pending before the Court. The Advisor and officers and directors who are named in the complaint intend to vigorously defend this action. Any financial loss incurred by the Advisor or its affiliates could hinder their ability to successfully manage Institutional REIT’s operations and our portfolio of investments.
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Commitments and Contingencies
As of September 30, 2007, the Advisor had incurred organization and offering expenses on our behalf of approximately $1.3 million, of which we will reimburse the Advisor up to 1.0% of total gross capital raised from the sale of our common stock to the public. To the extent that organization and offering costs exceed 1.0% of gross offering proceeds, or if we are unable to raise a minimum of $10.0 million under our initial offering on or before January 10, 2008, we will not be obligated to reimburse the Advisor for such costs.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
To the extent we have some form of debt outstanding, we will have exposure to interest rate risk. We expect that we will incur indebtedness in the future at both variable rates and fixed rates to finance our real estate investments and maintain liquidity. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flow by maintaining low to moderate levels of overall borrowings and securing variable rate facilities with the lowest margins available. We may also enter into interest rate swaps, caps, or other arrangements in order to mitigate interest rate risk on a related financial instrument. We will not enter into derivative or interest rate transactions for speculative purposes.
Our board has adopted a leverage policy which limits our ability to incur debt that would cause our borrowings to exceed 50% of our assets (valued at cost before depreciation and other non-cash reserves) unless a majority of the members of the conflicts committee of our board of directors approves borrowings in excess of this limitation. Our independent directors have approved our ability to borrow in excess of this threshold up to $1.5 million of aggregate borrowings or until raising the minimum offering of $10.0 million from the sale of our common stock, whichever occurs sooner.
As of September 30, 2007, we had $0.8 million of fixed-rate debt outstanding. Our fixed-rate debt is in the form of a note payable to the Advisor. On March 28, 2007, we borrowed $0.8 million from the Advisor. We agreed to repay the outstanding principal and interest by March 28, 2008. The unpaid principal under the promissory note bears simple interest from the date advanced at the rate of 6.35% per annum. We may prepay the unpaid principal balance under the promissory note, in whole or in part, together with all interest then accrued under the note, at any time, without premium or penalty. The promissory note is unsecured. A change in the market interest rate impacts the net financial instrument position of our fixed-rate debt but has no impact on interest incurred or cash flows.
ITEM 4. CONTROLS AND PROCEDURES
Management’s Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures
We carried out an evaluation, under the supervision and with the participation of management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report in providing a reasonable level of assurance that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods in SEC rules and forms, including providing a reasonable level of assurance that information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Principal Executive Officer and our Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2007, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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From time to time, we are party to legal proceedings that arise in the ordinary course of our business. We are not currently involved in any legal proceedings of which the outcome is reasonably likely to have a material adverse effect on our results of operations or financial condition, nor are we aware of any such legal proceedings contemplated by governmental authorities.
There have been no material changes from the risk factors disclosed in the “Risk Factors” section of our periodic report on Form 10-Q for the quarterly period ended March 31, 2007.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
On January 10, 2007, our Registration Statement on Form S-11 (File No. 333-136273), covering a public offering of up to 340,000,000 shares of common stock, was declared effective under the Securities Act of 1933. Of the 340,000,000 shares registered in the offering, we are offering 250,000,000 shares in our primary offering at $10.00 per share and 90,000,000 shares pursuant to our dividend reinvestment plan at a purchase price equal to the higher of $10.00 per share or 100% of the estimated value of a share of our common stock. The offering commenced on January 16, 2007. Wells Investment Securities, Inc., an affiliate of our advisor, is the dealer-manager of the offering. We will not sell any shares unless we receive subscriptions for 1,000,000 shares from persons who are not affiliated with us or our advisor. Pending satisfaction of this condition, all subscription payments will be placed in an account held by the escrow agent in trust for subscribers’ benefit. Regardless of whether we sell the minimum number of 1,000,000 shares, all participating investors will receive interest on all escrowed funds until the offering is terminated or the funds are released to us. After the minimum offering amount of 1,000,000 shares of common stock is sold, we plan to hold closings on an ongoing basis monthly on the first business day of each month.
As of September 30, 2007, the Advisor had incurred organization and offering expenses on our behalf of approximately $1.3 million, of which we will reimburse the Advisor up to 1.0% of total gross capital raised from the sale of our common stock to the public. To the extent that organization and offering costs exceed 1.0% of gross offering proceeds, or if we are unable to raise a minimum offering amount on or before January 10, 2008, we will not be obligated to reimburse the Advisor for such costs.
If we have not sold all of the primary offering shares we have registered by January 10, 2009, we may extend the offering under rules promulgated by the SEC.
During the period covered by this Form 10-Q, we did not sell any equity securities that were not registered under the Securities Act of 1933, and we did not repurchase any of our securities.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
(a) Not applicable.
(b) Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our stockholders during the third quarter of 2007.
(a) Not applicable.
(b) Not applicable.
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The exhibits required to be filed with this report are set forth on the Exhibit Index hereto and incorporated by reference herein.
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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 thereunto duly authorized.
INSTITUTIONAL REIT, INC. (Registrant) | ||||
Dated: November 7, 2007 | By: | /s/ DOUGLAS P. WILLIAMS | ||
Douglas P. Williams Executive Vice President, Treasurer and Principal Financial Officer | ||||
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EXHIBIT INDEX TO
THIRD QUARTER 2007 FORM 10-Q OF
INSTITUTIONAL REIT, INC.
Exhibit Number | Description | |
3.1 | Form of Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to Pre-Effective Amendment No. 2 to the Registration Statement on Form S-11 (No. 333-136273) filed with the SEC on November 9, 2006 (“Pre-Effective Amendment No. 2”) | |
3.2 | Bylaws (incorporated by reference to Exhibit 3.2 to Pre-Effective Amendment No. 2) | |
4.1 | Form of Subscription Agreement (Sample) with Consent to Electronic Delivery Form (incorporated by reference to Appendix A to the prospectus included in Pre-Effective Amendment No. 3 to the Registration Statement on Form S-11 (No. 333-136273) filed with the SEC on December 28, 2006 (“Pre-Effective Amendment No. 3”) | |
4.2 | Statement regarding restrictions on transferability of shares of common stock (to appear on stock certificate or to be sent upon request and without charge to stockholders issued shares without certificates) (incorporated by reference to Exhibit 4.2 to Pre-Effective Amendment No. 2) | |
4.3 | Dividend Reinvestment Plan (included as Appendix B to the prospectus included in Pre-Effective Amendment No. 3) | |
4.4 | Description of Proposed Share Redemption Program (included in the prospectus included in Pre-Effective Amendment No. 3 under the caption “Description of Shares — Share Redemption Program”) | |
4.5 | Escrow Agreement between the registrant and The Bank of New York (incorporated by reference to Exhibit 4.5 to Pre-Effective Amendment No. 1 to the Registration Statement on Form S-11 (No. 333-136273) filed with the SEC on September 28, 2006) | |
31.1 | Certification of the Principal Executive Officer of the Company, pursuant to Securities Exchange Act Rule 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2 | Certification of the Principal Financial Officer of the Company, pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32.1 | Statement of the Principal Executive Officer and Principal Financial Officer of the Company, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |